The last couple of weeks have been painful for investors especially those with a heavy allocation to equities. Since the S&P 500 peak on July 16, global equity markets have experienced a significant downtrend. This correction has affected various asset classes differently, but capital markets are experiencing significant stress.

Some people attribute the correction to excessive Technology stock valuations (especially for mega caps) while others point to an eminent economic recession in the US. I say, who knows? And, also, who cares? The pain is the same, but what we all need to figure out is if the pain is here to stay, or just temporary.

At this time, three weeks after the peak, my analysis and experience gained over the last 3+ decades of professional investing point to what I call a “technical” correction.

A “technical” correction is one where negative investor sentiment is the driving force at the moment. The massive jump in the volatility index (VIX) in recent weeks is a manifestation of this change in sentiment.

In contrast, a “fundamental” correction is one where asset prices are too high relative to the economic fundamentals, and a correction is needed to bring back a proper risk/return balance.

We’ll never be able to pinpoint what’s causing a correction, but on balance, I think the pain is most likely to be temporary rather than lasting. As investors, our immediate goal is to deal with the storm knowing that soon we’ll be back to calmer waters.

Impact on Different Asset Classes

Equities: Both US and international equities have been hit hard. US large-cap stocks saw a drawdown of about 7%, while US small-cap stocks experienced an even steeper decline of nearly 9%. International equities also suffered, with a drawdown of approximately 7%.

Bonds: In contrast to equities, bonds have generally provided a positive return during this period. US bonds, international government bonds, and emerging market debt all showed positive performance, albeit modest. This highlights the diversification benefits of including bonds in a portfolio.

Real Estate: REITs (Real Estate Investment Trusts) managed to stay positive, offering a small buffer against equity losses.

Commodities: This asset class experienced a significant drawdown of about 6%, indicating that even traditionally inflation-hedging assets were not immune to the correction.

Cash Equivalents: Short-term treasuries remained essentially flat, providing stability but little growth.

Economic Sector Performance

The "Sector Drawdown" chart provides insight into how different economic sectors fared during this correction:

Defensives Outperformed: Utilities and staples sectors showed positive returns, demonstrating their defensive nature during market turbulence.

Technology Hit Hard: The technology sector experienced one of the largest drawdowns, around 14%.

Cyclicals Struggled: Sectors like discretionary, energy, and financials all saw significant negative returns.

Healthcare Mixed: The healthcare sector showed a moderate decline, performing better than many cyclical sectors but worse than defensive ones.

The Importance of Long-Term Focus

Diversification Works: While equity losses outweighed bond gains, the positive performance of bonds did provide some cushion to multi-asset portfolios. This underscores the importance of diversification across asset classes.

Market Noise vs. Signal: During periods of market stress, short-term volatility can create significant "noise" that obscures long-term trends. It's crucial for investors to focus on their long-term investment goals and not be swayed by short-term market movements.

The huge jump in the equity market volatility (shown below) is mostly divorced from economic reality. Periods of market extreme market volatility are not conducive to sound decision-making. It’s best to take a step back and ignore the noise.

Historical Perspective: Market corrections are a normal part of the investment cycle. Over the long term, equities have historically provided strong returns despite periodic downturns. Stocks are likely to outperform bonds over the long term. That’s not likely to change anytime soon.

Opportunity in Volatility: For long-term investors, market corrections can present buying opportunities, allowing them to acquire assets at lower valuations. Small cap equities are one place to look through the wreckage. In terms of sectors, I would look for opportunities in technology stocks (growth focus) as well as in real estate (valuation focus).

Risk/Return Alignment: The disparate performance across sectors and asset classes highlights the importance of maintaining a well-diversified portfolio aligned with one's risk tolerance and investment horizon. Bonds, as poorly performing as they have been since the end of the pandemic, have a place in a diversified portfolio. The last few weeks have proven that.

As a reminder, here are our Q3 asset class views:

Asset Allocation Performance Review

High-Level Observations:

• All asset allocation portfolios we monitor are up year-to-date with higher-risk portfolios exhibiting commensurate higher returns.

• Conservative portfolios with a heavier allocation to bonds are still recovering from the rise in interest rates starting in 2022, but have picked up some gains over the last month as global equity markets have been in a correction.

• Over the last three years, the GF Low-Risk strategy is only up 0.7% on an annualized basis (before fees and transaction costs). Going back 5 years the annualized performance improves to 4.8.

• Equity-heavy allocations have outperformed more conservative allocations thanks largely to the performance of US large-cap equities.

• The GF High-Risk strategy is up 2.0% on an annualized pre-cost basis over the last three years. Over the last 5 years, the strategy is up a respectable 8.0%.

• Up to recently, commodities have provided a nice boost to asset allocation portfolios. Most of those gains have evaporated as inflationary expectations have been coming down.

• The baton has now been handed over to both Real Estate and Bonds. Both asset classes are beneficiaries of lower interest rates and declining inflationary expectations.

• Fixed-income strategies focused on short maturities and credit have outperformed Treasuries, but as we get closer to a likely Federal Reserve interest rate cut (September) the attractiveness of longer-dated bonds has increased. Go duration neutral.

Weekly Performance Attribution

Long-Term Asset Allocation Portfolio Characteristics

Expected Returns: Expect slightly lower than normal equity and bond market returns given valuation conditions

Risk: Diversify with alternative assets, market volatility has been significantly below historical measures

Equity Risk: Asset allocation portfolios are dominated by equity market risk, no different from the past.

A Bit of Wisdom Never Hurts

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