On June 7, 2016, the Goldman Sachs Group Inc. (NYSE: GS) warned its clients about the risks of significant equity drawdowns and the challenges involved in making appropriate selections when attempting to seek portfolio diversification.

While many investments might seem like safe havens before a stock market slump, investors often face the unpleasant news that their attempts at portfolio diversification failed to serve the intended purpose. Worse yet, those who attempt to buy stocks on the dip, acting on an apparent signal of a stock market bottom, often learn that the stock market drawdown is only beginning. Such unfortunate individuals must either be satisfied with buying high and selling low, or wait for such an investment's returns to recover to the purchase price.

Too Much Faith in the Fed

Neuberger Berman’s investment strategy group contended that in the early 1980s, the S&P 500 had sustained long periods without drawdowns of more than 10% because of the Federal Reserve’s efforts in promoting price stability pursuant to its dual mandate. However, there have been several significant, sustained drawdowns since the early 1980s. In addition to the Great Recession, the S&P 500 experienced significant corrections during 1987, 1990 and the post-dot-com bubble bear market, which began in 2000.

During the period preceding the 1987 bear market, the last market peak occurred on Aug. 25, 1987, when the S&P 500 ended the day at 336.77. The ensuing slump brought the S&P 500 to 223.92 at the closing bell on Dec. 4, 1987, for a 33.50% drawdown. The S&P 500 did not end any session above its Aug. 25, 1987 closing level until July 26, 1989, when it finished at 338.05.

The 1990 drawdown for the S&P 500 began after the last peak for the index occurred on July 16, 1990, when it closed the session at 368.95. By Oct. 11, 1990, the S&P 500 had fallen to 295.46 for a 19.93% drawdown. It was not until Feb. 13, 1991 that the S&P 500 closed above its pre-drawdown peak by ending the session at 369.02.

Just before the depressurization of the dot-com bubble, the S&P 500 reached 1,527.46 by the closing bell on March 24, 2000. What became one of the most infamous bear markets in American history dragged the S&P 500 to 776.76 on Oct. 9, 2002, for a 49.16% drawdown. The S&P 500 did not close above its March 24, 2000 level until May 30, 2007, when it ended the session at 1,530.23.

Getting caught in any of those three drawdowns could have been extremely costly for any investor who lacked the patience or resources to wait for the storm to pass.

Warning Signals

An important admonition from the Goldman Sachs June 7, 2016 strategy paper concerned the increased risk of a stock market drawdown when the S&P 500 is close to its record high, when stock valuations are stretched and economic growth is sluggish.

During the last four trading days of the week ending June 17, 2016, the S&P 500 experienced persistent overhead resistance at its 50-day moving average. However, during that week the 50-day moving average for the S&P 500 was just 2.47% below its May 21, 2015 record-high close at 2,130.82, and the price-earnings (P/E) ratio for the S&P 500 was 23.94. The latter was 53.55% higher than its historic mean of 15.59 and 63.63% higher than its historic median of 14.63. These indicators signaled that stock valuations were stretched.

The sluggishness of the economy became apparent on June 3, 2016, when the Bureau of Labor Statistics (BLS) reported that the United States economy created the lowest number of jobs since September 2010. With Goldman’s three prerequisites satisfied, alert investors should have been ready to refocus their attention on the challenges of portfolio diversification to mitigate losses in the event of a market correction.

Slow Global Growth

Global economic growth and inflation remained persistently slow through the early months of 2016. The April 2016 World Economic Outlook (WEO) from the International Monetary Fund (IMF) bore the title, “Too Slow for Too Long”. The IMF’s baseline projection for global economic growth during 2016 was a modest 3.2 percent, consistent with 2015. The April projection brought a 0.2% downward revision from the January 2016 WEO.

In her April 5, 2016 speech at Goethe University, IMF managing director Christine Lagarde noted a slowdown in global trade and increased risks to financial stability. Meanwhile, commentators have noted that the accommodative monetary policies of the world's central banks could not adequately substitute for sound, fiscal policy. Former Dallas Federal Reserve president Richard W. Fisher frequently made this same point, stressing the need for constructive fiscal policy in the United States.

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