2023 forecast: 'Disorderly' market declines loom likely

We have been here before — telling ourselves and our clients that things will soon return to normal. 

Granted, this time around there's a case to be made. Due to the short-term nature of recent declines, many have come to believe that the rough roads of current markets are nearly in the rearview mirror, and that the recent past will soon become a teachable moment for clients. 

After all, the economy, employment and consumption are all strong and soon enough the S&P 500 will surely come screaming back to the annualized average growth of 13% we have enjoyed since 2009. This collective feeling that everything will soon be better is occurring despite a Federal Reserve that is willing to crimp growth in order to fight still record-high inflation.

It's time for advisors to remember that markets are counterintuitive and that complacency can be a sign not of gains, but losses, ahead. It's also important to look outside of traditional asset classes to see that parts of the market have entered a disorderly decline. Imperatively, it's crucial for advisors to consider that before markets bottom, traditional assets often enter a state of disorderly decline — and that has yet to happen.

Red flags
Think of the photos we saw of empty streets in major Chinese cities at the beginning of the pandemic in early 2020. We all thought, "Thank goodness we're not in China right now." Yet just weeks later, New York and the rest of the U.S. began to deal with a fierce iteration of the contagion. 

Recent crypto-world fractures may offer a similar preview of what will happen to traditional finance if markets enter the second phase of decline in the new year. The cryptocurrency market fiasco has been marked by its interconnectedness. Earlier this year, crypto hedge fund Three Arrows Capital went under based on crypto price declines, and then failed to repay a $350 million loan to Voyager Digital. That created a domino effect where other holders of Three Arrows Capital debt were then forced into distress. Most recently, industry-mover FTX filed for bankruptcy, leaving a trail of crippled counterparties in its wake. 

The pattern is straightforward: markets decline, weak companies fail, counterparties/lenders fail, investors panic and exit assets, markets decline further, more weak companies are exposed and fail, etc. The downward spiral becomes self-reinforcing as investors race for the exits from assets and institutions that only months earlier had seemed invincible. FTX's Sam Bankman-Fried was a real-life iteration of George Bailey in "It's a Wonderful Life," pleading with savers to leave their assets in the bank because everything is OK! 

This year, the CBOE Volatility Index, commonly known as the "fear" index, barely broke 35 — once. That's in contrast to previous periods of market peril when the VIX hit 65 or higher when markets became disorderly — a result or the cause of margin calls, defaults and panic selling when low resistance levels are penetrated and people just can't take it anymore. 

It has been a long time since we witnessed severe one-day moves like those in 2008, when the market fell about 9% three times in just over two months. It's now critical that advisors use those experiences to prepare clients for further disorderly declines and begin taking the necessary measures to protect portfolios. It's often impossible to know where vulnerability can come from: As an example of unexpected stress, look at the sterling crisis in the U.K. that saw some Treasuries lose 25% almost instantly.

Bridge over troubled assets
Now is the time for advisors to step up and begin having real conversations about how bad things can get. This is not a scare tactic, but rather an invitation for advisors to reflect on how they are taking care of their clients' financial needs. Fixed income could be crippled for years, equities may fall further, and both of these factors could propel markets into a disorderly decline. Proactively focusing on the well-being of clients, even when they're not displaying any discomfort, will help keep them from making bad decisions. 

An engaged, educated client is a better client, especially when the market is descending into disorder. Advisors must get real about the vulnerability of traditional portfolios to stagflation. Where feasible, allocate into hedged equity or buffered strategies that are or can be defensive, and unconstrained fixed-income funds that can attempt to offset bond losses. Then explain to clients in a meaningful, digestible way how their portfolios are designed to deal with inflation, rising rates and volatile equities. Talk about the history of rebounds after bear markets in equities now, while we're in a period of calm. This will add one more plank to the bridge over the bear market crevasse and help get them to the other side. 

While no advisor or investor can control the markets, they can control portfolio strategy and emphasize a pragmatic approach to investing. The time for action, however, is before markets enter a disorderly phase. Advisors should use this moment of relative calm as an opportunity to build confidence with their clients, foster those relationships and act as thought leaders for controlled, practical risk management and portfolio planning.