Not a Matter of If but When…

I am talking about the next Bear Market. The stock market has been going up pretty much non-stop since March 2009 (see below). Stock market advances do not end just because of old age, but nothing grows to the sky and eventually we will get a recession and a market downturn after this impressive expansion.

The U.S. economy is in good shape today, growing 2% to 3% in real terms with moderate inflation and only slightly rising interest rates.  The recent tax loss changes will benefit both corporate profits and consumer spending. But a recession and a stock market correction will occur at some point.

How should you prepare?  First, if you have done your homework, meaning you have established a sensible asset allocation between things that are safe (bonds and cash) and things which will grow (stocks) then you really don’t have to do much. Just don’t let your emotions get the better of you.  Common stocks tend to go up 6 or 7 years out of every 10 and stock returns over long periods of time will equal the long term growth in corporate profits (4-6% today?) plus a dividend yield of 2%, or a total return of 6-8%. Keep this positive investment message clearly in mind especially when the ominous dark clouds start to appear. 

Second, review your spending and borrowing. Now is a good time to reduce your borrowings and prudently look at any spending that can be cut.  Don’t panic, just do some realistic planning and realize that finances get more difficult in tough economic times. 

And finally, avoid market timing at all costs.  The world is uncertain and the one thing we know is it is very difficult to predict the future.  You might be right to sell now and go to cash but you usually miss the subsequent low point when you need to get back in.  There are people out there who can successfully do market timing but there are many more who think they can, but who can’t. The stock market is very effective at getting investors to do exactly  the wrong thing at the wrong time. We buy at the top and sell at the bottom.  We should all learn better how to go sit quietly in our room. Best to establish an asset allocation that is just right for your needs and temperament and then….exercise extreme sloth. 

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Yes, We Are Going To Have A Correction!!... Now Get Over It...

The stock market reached bottom in mid-winter, 2009. We are now in the sixth year of this Bull market. The rise in stocks has been very broad-based with most industries benefitting. And volatility has been very low. The chart below shows this is the fourth longest Bull run in the last 85 years without a “major correction” – or a dip of 20% or more.

But we can be sure that we will get a 10% or a 20% correction at some point. It may be caused by an event out of the blue, it may be caused by financial assets getting overvalued or it may just be caused by market exhaustion. We will have to wait and see.

Robert Shiller at Yale has developed what is known as the CAPE index – the ‘cyclically adjusted price to earnings ratio’, that averages P/E’s over a ten year period. The ratio stands at 26 today, a level that has only been exceeded at the market peaks of 1929, 2000 and 2007. Ugh, this is a big red flashing light.

Other analysts however argue that the P/E ratio based on current earnings or expected earnings in 2015, is only slightly above the long term average of 15x. In addition stocks do not seem expensive relative to competing assets such as the ten-year Government bond at 2.6% today.

Our take is the market is not in Bubble territory but that we should get mentally prepared for a 20% decline. It is going to happen. Investors were shaken by the fall in stock prices between 2007 and 2009. In 2006, 63% of Americans owned stock. Today fewer than 55% own equities. A lot of people got out of stocks and have never come back. Those that held on have benefitted but the test will be the next correction and whether investors stick to their long-term goals and allocations or whether they turn tail.

Selling in anticipation of a correction never makes sense. As Peter Lynch the famous portfolio manager at Fidelity Investments has said, “far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

Even Andrew Smithers, a well-known financial consultant in London and someone who thinks the market is overvalued today, thinks that the long-term investor should maintain a minimum of 60% in stocks. Why? The reason is that over time, and this includes both Bull and Bear markets, stocks return more than the alternatives such as bonds and cash. Stocks tend to go up six or seven years out of every ten, so the patient and committed investor benefits over the long term.

Finally, what did Warren Buffett write to his trustee about investing his funds after his passing? Put 10% in short term government bonds and the other 90% in a well-diversified S&P-like fund and “never sell when the news is bad.” Face it – the market is like a pendulum, swinging between overvaluation and undervaluation. We get corrections from time to time and this is a normal part of the cycle and far from the end of the world for the serious, long term investor.