With Friday's close, the S&P 500 Index is 9.3% off of its closing high that was set on September 20, 2018. We are almost at a 10% correction in the S&P 500. What is interesting is that the index has fallen almost 10%, but the average S&P 500 stock has fallen over 16% and the average Top 1000 largest stock has fallen over 18%. If we do see the S&P 500 fall further, it will be the second time in 2018 that the market has fallen more than 10%. While this most recent pullback has been relatively swift, it is not an uncommon occurrence, especially in bull markets.
The following graphic is one of my favorites, as it sums up our expectations and experiences pretty well. We envision our investment plan to resemble the smooth uphill journey in the upper panel. While in reality, the lower panel resembles our actual journey. We will reach our destination, but there will certainly be "bumps" along the way. October 2018 is clearly represented below. While things seem "scary" right now, the prudent thing to do is stay the course.
As strong as the stock market was in the 1990's, there were numerous pullbacks along the way. As a matter of fact, the S&P 500 experienced a 5% pullback on 24 different occasions in the 90’s. Seven of those pullbacks resulted in a correction of 10% or more. So, for the 10-year period of the 1990's, there were seven times the S&P 500 corrected at least 10%.
2018 is displaying strong parallels to 1994. The year 1994 was labeled as a stealth bear market, because the major stock market indexes were basically flat for the year. Unlike the averages though, the average stock experienced a lot of pain (not unlike what we’re seeing this year). Looking back at 1994, the S&P 500 had two corrections (one for -8.93% and another for -6.44%). Far greater was the decline of the average economic sector; over 18% that year. In 2018, the S&P 500 has had two corrections (one of -10.2% and the current one of -9.3%), but the average sector has declined over 15%.
Another parallel to 1994 is that the Federal Reserve sharply raised interest rates, through six rate increases. The Federal Funds rate actually doubled in 12 months. The past couple of years have seen a steady rise in interest rates as well, with three increases taking place in 2018. That being said, the interest rate headwinds made it difficult for bond investors in 1994, as well as 2018. The Aggregate Bond Index ETF's (AGG) total return was down 2.92% in 1994 and currently it's down 2.07% in 2018.
As Mark Twain famously once said, "History doesn't repeat itself, but it often rhymes." So while every year is different, there are some parallels between today and previous years. Of course, things could turn out differently this time and instead of a 1995 style rally, things could look a lot like the early 2000's or 2011. For now, I will continue to pay attention to my indicators and follow the discipline that has served me well in the past.
Typically, pullbacks during bull markets tend to be viewed as buying opportunities as opposed to wholesale shifts towards defensive asset classes. Some pullbacks were steeper than others, but the bull market remained intact until the end of 1999. The structural bear or fair market of the 2000's looked much different in terms of the number of pullbacks and the magnitude of those pullbacks. For example, while the S&P 500 pulled back 5% or more 24 times in the 90's, in the decade of the 2000's, the market pulled back 5% or more 47 times and 20 of those times resulted in double-digit declines.
Prudent investment portfolios are constructed with the knowledge that there will be corrections or "scary" times in the market. Market history, as well as our own experiences tell us that. A diversified portfolio expects to experience "scary" markets. We don't know when or why these corrections will happen. Just that they will. Since weeks like these last few are to be expected, your portfolio should not be changed because of short-term market fluctuations. Investment portfolios are not designed to avoid all volatility and drawdowns. If they were, the portfolio would experience very minimal upside. Short-term volatility is the admission price for higher expected returns. As an example, your savings account at the local bank avoids all volatility. It also avoids providing you with a high return. It is important to remember that while short term volatility is uncomfortable and cannot be eliminated, the long term probabilities are skewed heavily in your favor. (see the chart above) Keep a long-term perspective, because months like October will try to knock you off of your game.
Halloween has arrived early! You would think this if the recent stock market action was any indication of such.
It is entirely normal to have a reaction to yesterday's stock market drop - probably a very, very strong reaction. It is human nature. We are wired to do so. There really is nothing you can do about preventing that reaction. I can tell you though, what you are experiencing has everything to do with feelings and nothing to do with thinking.
If you have ever taken a course in Psychology, you probably learned about the Fight-or-Flight Response. The term "fight-or-flight" represents the choices that our ancient ancestors had when faced with an imminent danger in their environment. They could either stay and fight or run away. In either case, the physiological and psychological response to this stress prepares the body to react to the danger. So why does a bad day in the stock market trigger a stone-aged response in our bodies. As I said before, it is just the way that we are wired. It is an automatic response and there is nothing that we can do to prevent it from happening.
Enough about feelings. Let's do some thinking. If we zoom out a little and take a look at what is really going on we note the following two facts: U.S. corporate earnings are surging, and the U.S. economy as a whole is also surging.
There is also much noise out there to trying to throw you off of your game. For example, this Fortune Magazine cover from a couple of months ago:
The article makes for a catchy cover story, and certainly entices people to buy the magazine. But it has the potential to seriously scare and mislead investors. Why? Because, as the author himself says, nobody, including most notably economists, has been able to accurately predict economic and market downturns. So, time and time again, market “timers” have gotten burned.
My view is that the strength in U.S. stocks can continue until the Federal Reserve makes a deliberate move to slow the economy. From every indication we have from the Fed, that is still a ways off. As you know, I do not care for predictions. I am a strong believer in "What is, is." And what is right now, is the fact that despite recent volatility, U.S. stocks continue to remain the strongest asset class of the six that I follow on a daily basis. Not cash. Not bonds. Not commodities. It is U.S. stocks. I remain vigilant every day for changes that are truly long-term in nature and will adjust our portfolios accordingly.
Investment success comes from ignoring the short-term noise and following a plan. Emotions can and will wreak havoc on your portfolio. I know that it is tough to do, but try to ignore the short-term market fluctuations that will severely tempt you to abandon your plan. There will be bad days for sure. Fight the urge to react to your feelings. Think instead. The prudent and best way to maximize long-term wealth-building is to stay fully-invested in a broadly diversified portfolio.
I have often said that it is important to ignore the short-term "noise" so often heard in the markets. This noise emanates from the financial media as well as from some very highly paid professionals. (Please note: the size of one's paycheck does not signify brilliance.) While catching up on some reading over the weekend, I came across an article on MarketWatch titled, Chart of Shame: The S&P 500 vs Everyone Who Said the Market Was About to Crash. This article contained the following graphic compiled by Jon Boorman of Broadsword Capital.
Wow! This chart says it all. There are over 25 quotes from some highly paid and well respected stock market pundits from 2012-2018. All of them warning about an upcoming market crash that never materialized. Total and complete wrongness. I especially love the two "Sell everything!" directives in 2016. Since 2016, the S&P 500 has climbed an impressive 40%! If you had heeded their warnings and moved your money to cash, your investment portfolio and possibly your long-term financial goals would have taken a serious hit as you sat on the sidelines during this strong market rally.
The financial media's main mission is not to help you succeed as an investor, but instead to generate digital clicks or old-fashioned magazine sales. It's about them, not you. Sensational headlines like "The Big Crash is Coming!" sells many more magazines than a more useful headline such as "Everything is Fine. Stay the Course". Yes, I know that these headlines are usually backed up by some very credible sounding and well-researched rationale. However, the track record of these stock market pundits' predictions is horrendous.
Economist John Maynard Keynes famously said, "The only function of economic forecasting is to make astrology look respectable." Let's take a look at the accuracy of some of these so-called forecasting experts. The website Econlife.com provides a very telling report card on their past performance. When they looked at 12 month market predictions (i.e. what the "expert" thought the market would do over the next 12 months) made between 1998 and 2016, they found that 92% of the time the "market expert" predicted that the market would rise. The stock market has historically gone up more than it has gone down, so this was a pretty safe prediction from a probability standpoint. Not surprisingly, they were right 92% of the time. Most investors are more concerned about knowing ahead of time when the market is going to drop. So how did the "experts" do when it came to accurately predicting market downturns in the coming 12 months? Only 9% of the predictions accurately predicted the market downturn. Utterly worthless! Why would anyone ever listen to these people?
My portfolio methodology does not rely on forecasts. I think that we can clearly see that there is little benefit to listening to the well-paid "experts". Instead, I rely on a methodology that is based on the laws of supply and demand. We all understand why there are lemonade stands in the summer and hot chocolate stands in the winter. When there are more buyers than sellers willing to sell, prices must rise. When there are more sellers than buyers willing to buy, prices must fall. It's easy to follow the rules of a methodology when things are going well, but it's when the going gets rough that we need the rules the most. I don't listen to the "experts" who are telling us what the market should do. And either should you. I listen instead to what the market is saying. When U.S. stocks are no longer in demand, that is when I will know that it's time to alter our allocation or raise cash in our portfolios.
With Friday's close, the S&P 500 Index is 9.3% off of its closing high that was set on September 20, 2018. We are almost at a 10% correction in the S&P 500. What is interesting is that the index has fallen almost 10%, but the average S&...