TheMoneyGeek Unplugged

It’s been a long time, more than a year, since I’ve posted an article about what’s going on in the markets. Market volatility, until last week, has been mostly subdued. For what seems like years now, markets seemed immune from any meaningful drop. But this still young month of February has seen volatility return with a vengeance.

This means that the U.S. stock market will finally get something that happens, on average, about once a year: a 10+ percent drop—the definition of a market correction.  The last time this happened, better known as a bear market, was a whopper: the Great Recession drop that caused U.S. stocks to drop more than 50%–so most people today probably think that corrections are catastrophic.  They aren’t.  More typically, they last anywhere from 20 trading days (the 1997 correction, down 10.8%) to 104 days (the 2002-2003 correction, down 14.7%).  Corrections are unnerving, but they’re a healthy part of the economy and the markets—for a couple of reasons.

Reason #1: Because corrections happen so frequently, and are so unnerving to the average investor, they “force” the stock market to be more generous than alternative investments.  People buy stocks at corporate earnings multiples which are designed to generate average future returns considerably higher than, say, cash or municipal bonds—and investors require that “risk premium” (which is what economists call it) to get on that ride.  If you’re going to take on more risk, you should expect at least the opportunity to get considerably more reward.

Reason #2: The stock market roller coaster is too unsettling for some investors, who sell when they experience a market lurch.  This gives long-term investors a valuable—and frequent—opportunity to buy stocks “on sale.”  That, in turn, lowers the average cost of the stocks in your portfolio, which can be a boost to your long-term returns.

The current market downturn relates directly to the first reason, where you can see that bonds and stocks are always competing with each other.  Monday’s 4.1% decline in the S&P 500 coincided with an equally-remarkable rise in the yields on U.S. Treasury bonds last Friday.  Treasuries with a 10-year maturity are now providing yields of 2.85%–hardly generous, but well above the record lows that investors were getting just 18 months ago.  People who believe that they can get a decent, relatively risk-free return from bond investments are tempted to abandon the bumpy ride provided by stocks for a smoother course that involves clipping coupons.  Bond rates go up and the very delicate supply/demand balance shifts, at least temporarily, in their direction, and you have the recipe for a stock market correction.

This provides us all with the opportunity to do an interesting exercise.  It’s possible that the markets will drop further—perhaps even, as we saw during the Great Recession, much further.  Or, as is more often the case, they may rebound after giving us a correction that stops short of the technical definition of a bear market, which is a 20% downturn.  The rebound could happen as early as tomorrow, or some weeks or months from now as the correction plays out.

Most bear markets coincide with the onset or expectation of a recession. Some even debate whether a recession causes the bear market or vice versa. The good news is that all indications are such that a recession is not on the horizon. Jobs, housing and many other manufacturing and services data are quite strong, retail sales are healthy, and most importantly, consumer confidence is near all-time highs. While this could all change, it would take at least 9-12 month for conditions to deteriorate enough and make the probabilities of a recession more likely than not. That’s why I believe that a bear market is not imminent.

A correction or even a bear market, once they’re over (no matter how long or hard the fall) you’ll hear people say that they predicted the extent of the drop.  So now is a good time to ask yourself: do I know what’s going to happen tomorrow?  Or next week?  Or next month?  Is this a good time to buy or sell?  Does anybody seem to have a handle on what’s going to happen in the future?

Record your prediction, and any predictions you happen to run across, and pull them out a month or two from now.

Chances are, you’re like the rest of us.  Whatever happens will come as a surprise, and then look blindingly obvious in hindsight.  All we know is what has happened in the past.  Today’s market drop is nothing more than a data point on a chart that doesn’t, alas, extend into the future.

Markets have become very oversold, a market technical term that indicates that we’ve sold off too far too fast. That means a bounce is near, and it may be a big one. If you’re worried about what the markets are doing, and overexposed on your risk, you should use these bounces to hedge your portfolio or sell some portions thereof to the “sleeping point”; that is, the point where you can sleep or get through your day without worrying about your portfolio declining. Think about putting some spare cash in the markets after you see some signs of the markets stabilizing, feeling good about picking them up on sale (Disclaimer: this is not a recommendation to buy or sell any security).

For our clients, over the past several weeks, we have reduced market exposure through sales of certain positions, and have increased our hedges. But we are not preparing for an all-out bear market. In fact, we have been looking to pick up some positions that are much more attractive after this latest selloff. After all, the stock markets are still in an uptrend, the economy is hitting on all cylinders, and there are no signs of an impending recession.

If you are worried or would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

Sources:

https://www.fool.com/knowledge-center/6-things-you-should-know-about-a-stock-market-corr.aspx

https://www.yardeni.com/pub/sp500corrbear.pdf

https://finance.yahoo.com/news/stocks-getting-smashed-143950261.html

The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

“Good sense, innocence, cripplin’ mankind
Dead kings, many things I can’t define
Occasions, persuasions clutter your mind
Incense and peppermints, the color of time

Who cares what games we choose?
Little to win, but nothin’ to lose”

— Song Lyrics from the 1967 hit single “Incense & Peppermints” written by Tim Gilbert & John S. Carter and performed by the group known as The Strawberry Alarm Clock

Suppose somebody came up to you and shouted: “I have terrible news about the economy. I think you should sell your stocks!”
Alarmed, you say: “Oh, my God. Tell me more!”
And this mysterious stranger shouts: “Run for the hills! The American economy just added 200,000 more jobs—more than expectations—and the U.S. jobless rate now stands at 4.1%, the lowest since 2000!”
You blink your eyes. So?
“There’s more,” you’re told. “The average hourly earnings of American workers have risen a more-than-expected 2.9% over a year earlier, the most since June of 2009! You should sell your stocks while you can!”

Chances are, you don’t find this alarmist stranger’s argument very persuasive, but then again, you don’t work on Wall Street. After hearing these benign government statistics, traders rushed for the exits from the opening bell to the closing on Friday, and at the end of the day the S&P 500 stocks are, in aggregate, worth 2.13% less than they were last Thursday. The NASDAQ Composite index fell 1.96% and the Dow Jones Industrial Average, a somewhat meaningless but well-known index, was down 2.54%.

To understand why, you need to follow some tortuous logic. According to the alarmist view, those extra 200,000 jobs might have pushed America one step closer to “maximum employment”—the very hard-to-define point where companies have trouble filling job openings, and therefore have to start offering higher wages. No, that’s not a terrible thing for most of us, but the idea is that if companies have to start paying more, then they’ll be able to put less in their pockets—and the rise in the hourly earnings of American workers totally confirmed the theory.

If you’re an alarmist, it gets worse. If American workers are getting paid more, then companies will start charging more for whatever they produce or do, which might raise the inflation rate. “Might” is the operative word here. There hasn’t been any sustained sign of higher inflation, which is still not as high as the Federal Reserve Board wants it to be. But if you’re a Wall Street trader who thinks the market is in a bubble phase, you aren’t necessarily looking at facts to confirm your beliefs.

Suppose you’re not an alarmist. Then you might notice that 18 states began the new year with higher minimum wages, which might have nudged up that hourly earnings figure that looked so alarming a second ago. And some companies have recently announced bonuses following the huge reduction in U.S. corporate tax rates, whose amortized amounts are also finding their way into wage statistics.

Meanwhile, those same government statistics are showing a resurgence in factory activity and a rebound in housing, which together, account for more than 50,000 of those new jobs.

So the question we all have to ask ourselves is: are we alarmists? Selling everything in anticipation of a bear market has never been a great strategy, even though stocks are admittedly still priced higher than they have been historically. Trimming some positions and perhaps putting on some hedges into one of the greatest bull runs of our time makes a lot of sense. But panicking never paid worthwhile benefits to anyone.

If you are not an alarmist, then you have something to celebrate. The S&P 500 has now officially ended its longest streak without a 3% drop in its history—as you can see from the below chart. It’s an historic run not likely to be seen by any of us again. The truth about the markets is that short, sharp pullbacks are inevitable and routine—unless you were living in the past year and a half, when we seemed to be immune from normal market behavior.

Although the drop on Friday was a bit “jarring”, and technical indicators point to some internal deterioration, I don’t believe that this is the start of a bear market. Employment, housing and the overall economic environment are way too strong to give way to a recession, at least not in the next six to nine months.

I’ve been saying for months now that the market is way past due for a normal correction, as evidenced by the above chart. A pullback of 10-15% in the markets would be normal and healthy, to allow this market to “rest up” for the next move higher. If you think you’re nimble enough to get out of the markets now, and know when to get back in to catch the next wave higher, then I and 90% of the masses out there can probably learn from you. But as the great fund legend Peter Lynch once said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” 

If you’re concerned about the markets and you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

Sources:
https://www.bloomberg.com/news/articles/2018-02-02/u-s-added-200-000-jobs-in-january-wages-rise-most-since-2009

https://www.bloomberg.com/news/articles/2018-02-01/asia-stocks-to-slide-as-tech-stumbles-bonds-drop-markets-wrap?

https://www.theatlantic.com/business/archive/2018/02/market-dow-drop/552254/?utm_source=atltw

TheMoneyGeek thanks guest writer Bob Veres for his contribution to this post