The stock market has been a bit like riding a roller coaster in total darkness ... without knowing when the next stomach-churning sharp turn is coming.

On July 7 — just over six weeks ago — the S&P 500 Index closed within a few percentage points of new multi-year highs. Today, we find ourselves well below those levels.

Investor sentiment has shifted dramatically in recent weeks, leading to a sharp spike in volatility.

It’s a familiar pattern following periods of severe financial and economic stress. 

This kind of disruptive market action will drive even the most patient investor to distraction. Others simply choose to throw in the towel and move to the sidelines. But investors who have experienced these types of patterns before understand that often when there is rampant uncertainty, you’ll find great opportunity.

By spotting investment opportunities early, ahead of the crowd, it’s possible to position yourself to take advantage of those securities poised to benefit when conditions improve.

What Follows in the Aftermath of Financial Crisis?

While the past never repeats itself exactly, history provides valuable insights that can be applied to the future. For example, in the aftermath of great financial turmoil, history tells us that the economy and financial markets rarely return to business as usual right away. Instead, the healing process takes time … years, in fact.

Consider the patterns from the past century of experience …

After the Great Depression ...

During the 1930s and early 1940s, there were several years of volatile swings in sentiment as markets and the economy struggled to recover from the Depression. As you can see in the graph above, stocks plunged from 1929 to 1932, rallied from 1933 to 1936, but rolled over again from 1937 to 1940. In other words, there were many fits and starts over a nearly two-decade period before a new bull market began!¹

1970s Recession

Next, take a look back to the 1970s and early ‘80s and you’ll see a similar pattern.

Rather than a depression, anxiety about inflation drove market volatility during this period. Again, there were plenty of sharp up and down swings in the economy and markets, but the Dow was no higher in 1982 than it was in 1966 — 15 years earlier!²

Note three separate yet significant periods of declines — some spreading over several months — occurred. After the financial stress inflicted by stagflation during the 1970s, it took time for the economy and stock market to stabilize. It was a period that severely tried the patience of investors.

But those who took advantage of this turbulence as a buying opportunity were ultimately rewarded. High-quality US stocks performed very well over the next two decades.

A Typical Pattern Emerges

If you detect similarities between these two historic periods and the pattern markets are following today, you’re not alone.

In fact, taking a closer look at 19 periods of financial turmoil stretching back nearly a century, researchers at Morgan Stanley found a typical pattern emerges, as shown in the graph below.³

Stage #1 – Major Bear Market: The median decline was minus 56 percent peak-to-trough over a period of 29 months. This is usually triggered by a severe financial crisis of some kind ...

Stage #2 – Sharp Rebound Rally: A robust 70 percent gain over 17 months, on average. The rally often begins as efforts to avert crisis take hold. Government stimulus and low interest rates finally spark an economic recovery …

Stage #3 – The Next Correction: In this stage, the initial, powerful recovery phase in the economy begins to wear off. Financial conditions often tighten as interest rates rise and the stock market corrects again …

Stage #4 –Trading Range Market: Finally a broad trading range usually sets in, typically lasting several years. It’s this last stage that can often be the most difficult period for individual investors to experience.

Is History Suggesting This Pattern May Be Repeating?

With history as our guide, can we conclude that a similar pattern is at work now?

Simply put, if the past few years are a reliable indication, then perhaps the answer is yes! Indeed, financial markets have been following this historical pattern almost to a “T”.

First, the S&P 500 suffered a bear market decline of 57 percent from the 2007 peak to the March 2009 low … right on target with stage #1 ...

Second, we witnessed an equally spectacular rebound rally with stocks nearly doubling at the market’s recent highs and completing stage #2 ...

Since then we have had a sharp correction with the S&P 500 down almost 20 percent from its high … that’s pretty close to the typical stage #3 pattern.⁴

Keep in mind, historical patterns in the markets may not repeat exactly, because every cycle is somewhat different. Still, it’s fascinating to note just how closely recent market movements track this historical pattern.

Perhaps the most difficult part is correctly spotting turning points ahead of time. It’s hard to know the market had entered a sharp correction phase until after the S&P 500 was down nearly 20 percent, especially when the bulk of this decline happened over just a few weeks.

As the pattern continues to unfold however, anticipating what’s likely to occur next can provide valuable insights for shifting our investments in an effort to take advantage.

Granted, the up and down roller-coaster ride of a volatile trading-range market can be difficult, wearing down even the most-disciplined investors.  

That’s why it’s extremely important to rely on the knowledge of an experienced advisor to help manage your wealth through turbulent environments. At Banyan Partners, our investment team averages 25-plus years of hands-on experience. We call on that experience to guide our decision-making about when and to what degree we should adjust our investment positioning for changing market conditions.

Equally important, our investment committee understands that measuring our success as your money manager means not only finding opportunities to grow your portfolio … but also making every effort to protect your wealth from volatile markets.

Perhaps the most valuable counsel we can offer at present is to be your voice of reason in challenging markets — helping you stick to your long-term investment plan. For instance, while it’s perfectly understandable why many investors move to the sidelines in volatile markets, history has proven that this is often the absolute worst time for investors to abandon stocks.

As the graph above shows, when consumer sentiment sinks to low levels, as it is right now, oftentimes this loss of confidence has already been reflected in lower stock prices. And over the ensuing 12-month period, stocks typically enjoy a strong rebound averaging +25.6 percent! Rather than being a time to sell … holding stocks (or buying) when confidence is at low levels has often been profitable.⁵

Although it may be the easy thing to do psychologically, selling in a panic when sentiment is bearish may be precisely the wrong move to make with your investments.

Finding Opportunity in the Aftermath

If this pattern continues, how can you prepare yourself and your investment portfolio to survive a longer period of volatility?

First, adjust your expectations. Prepare for a period of slower and uneven growth in the economy and financial markets over the next few years. Don’t expect unrealistically high returns from your stock portfolio, and don’t reach for unusually high yields through much riskier investments if you’re a fixed income investor.

Second, don’t expect a blind buy-and-hold approach to work — especially not when it comes to a set-it-and-forget it approach to stock index funds. This approach hasn’t worked over the last 10 years. The market index — along with mutual funds and ETFs that track them — could bounce around in a multi-year trading range without delivering much real return. This period suggests that an actively managed approach may prove more successful.

Third, recognize that volatility may be here to stay and attempt to turn this volatility to your advantage by adopting an opportunistic investment approach. For example, the dividend yields offered by many high-quality stocks can provide more income than long-term government bonds yield today, plus the potential for growing dividend income over time. Don’t neglect the opportunity that dividends can play in your portfolio compared to interest income alone. Likewise, you could find that dividends are capable of making up a much larger share of your total return in the years ahead.

Each period we experience has new lessons to teach, and at Banyan Partners, we have gleaned some valuable lessons from recent market volatility as well. We have reduced the risk profile of our equity portfolios, repositioning our asset allocation to emphasize high-quality, dividend-paying stocks in the consumer staples, health care and telecommunications sectors.

We look for opportunities in industry-leading companies with healthy balance sheets, strong global growth prospects, and led by good management teams. We look forward to adding new stocks as opportunities present themselves.

Bottom line: This kind of market environment can be challenging, and can certainly put your discipline to the test. But volatile markets can also produce some of the best long-term investment opportunities if you’re willing to be patient.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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¹ BlackRock: Weekly Commentary, 8/15/11
² Ibid.
³ Bloomberg data, 8/15/11
⁴ Standard & Poor’s, 8/16/11
⁵ Fidelity Investments: Viewpoints, 7/21/11
⁶ Ibid.
⁷ Bloomberg market data, 8/16/11