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The market took a hard drubbing on Friday, with the Dow Jones Industrial average, a group of some of the largest and most important industrial companies, falling about 300 points. Anytime that something like that happens, people start to get worried and look for some way they can protect their portfolios from further losses. Many people sell out of their mutual funds and individual stocks, moving into cash, bonds, or some other place that seems safe.
This may be locking the barn doors after the horses have already been stolen, however. Often when there is a big decline in the market there is a rally within a few days (often the next day) as people come in to scoop up the stocks that are now trading at a relative bargain. Even when there is a really big decline, such as in 1987 when the Dow Jones Industrial Average fell about 25% (equivalent to the Dow falling about 4000 points today), it is often the time to buy. In that case the Dow had fully recovered after a year and someone who had invested right after the fall would have made at least 25% on their money.
But still, Friday’s decline may be the start of something far nastier. You see, there are three trends in the market: the short-term trend, the medium term trend, and the long-term trend. I won’t go into these too deeply in this post (you can find more information about trends in this previous post), but basically an uptrend is where stocks keep getting higher and a downtrend is where they keep going lower. The short-term trend is based on daily closings, so in a short-term trend the market may be going up or down for a week or two. The medium term trend is based on weekly closings, so in a medium term trend you’re looking at movements that least for a month or two. It is the long-term trend, that is based on months, where the bull markets (where the long-term trend is upwards) and bear markets (where the long-term trend is downwards) that really matters for people who are investing, meaning they are buying positions in companies for long periods of time.
Note that a correction is where you have one leg down in the long-term trend. This can be a fairly severe drop, but the market then turns around the long-term trend continues to make higher highs. A bear market is where you have at least two legs downward in the long-term trend, where the market falls, recovers a bit, but then falls still further. Percentages of 10% and 20% are often assigned to corrections and bear markets, but those definitions are incorrect. Bear markets tend to be nastier than corrections because you have multiple phases where the market declines for several weeks at a time, but there is nothing stopping the market from falling 80% one month and then rallying back the next month in a correction. Likewise, if the market falls five percent in a month, rallies back 2% the next month, and then falls another 5% over the next two months it would be a bear market even though percentage-wise you’ve lost less than 10%.
So the question on everyone’s mind after a fall like we saw Friday (even if they don’t phrase it this way) is whether this is the start of a bear market, which will grind the market lower for the next several months, a correction, where the market may give up 10% or more but then come back stronger than ever, or just a brief pause in the bull market. A bigger question is whether people should move their money out of the markets, or maybe put more money in.
There are certainly reasons to suspect that this may be the end of the current bull market. Reasons include:
1. The Federal Reserve has kept interest rates insanely low for a long period of time. Eventually they will need to raise rates to prevent inflation. When that happens the economy tends to contract, and stocks tend to fall in anticipation of that contraction.
2. Things like the implementation of the healthcare law will make employing people more expensive and take money out of consumers’ pockets as health insurance rates rise. Job uncertainty will also weigh on consuners’ minds. People are sure to be laid off as small businesses try to to stay under the Affordable Care Act’s 50-person ceiling where health benefits must be offered. Layoffs will also occur at larger companies because the growing cost of healthcare will require savings be taken elsewhere. This job uncertainty will also reduce consumer spending. This in turn will result in lower profits and declines in the markets, which will feed the cycle and create more layoffs.
3. This bull market is already fairly old, having started back in 2009 after the Federal Reserve lowered rates. Stocks often get ahead of fair valuations (the amount they should be trading at, based on expected earnings) after a prolonged bull market. A correction or a bear market often follows.
Really, however, the truth is it is impossible to predict when the market will take a tumble, even if you can see that a tumble is due. Stocks can continue to rally to even higher prices even if prices are already high. Stocks can also continue to rise even as companies are laying off workers. It is for this reason that an investor should use the same tactics regardless of what the market may do. Specifically:
If you are 16-30: Get into your company’s 401k plan and contribute 10-15% of your paycheck, regardless of the company match. Also, start individual IRAs and contribute there. Open college savings accounts for your children and contribute the maximum to those each year since college will be here before you know it. Make investments in these funds in a diversified set of index funds including large cap, small cap, and international stocks. Finally, find a few hundred dollars each month and put it away in a taxable portfolio filled with index funds and/or individual stocks. This is the money that will enable you to become financially independent when you are in your 40’s or 50’s and allow you to not worry so much about your job anymore.
If you are 30-55: Continue to invest and save religiously. Try to cut your recurring expenses by paying off your mortgage and saving money for quality used cars so you won’t have a car payment. Use a little of your investment returns to supplement your income, perhaps improving your home or taking a special vacation each year, but allow most of it to compound and grow. Avoid making any large moves in your investments based on expectations for the markets but instead try to maintain your mix as closely to your investment plan as possible. If an area of your portfolio declines, focus on building it up again through new investing. If an area gets extremely oversized, cut the position a bit and reallocate to areas that have declined. During downturns realize that you have enough time to wait for the markets to recover and when they do, you’ll be better off than ever before, especially if you can invest aggressively during the downturns because you have free cashflow from your job after your required expenses are paid.
If you are 55 or older: Start to think more about portfolio protection since you’re coming up to the time where you’ll need to start living off of your investments. Start to raise cash positions (keep these relatively small until you’re within 5 years or less of retirement, then build up enough cash to allow you to stay invested without selling assets to raise cash for expenses for at least five years, should a downturn occur) and pay off any debts you have left to cut your monthly required expenses to the bone. Maybe diversify into real estate and start to increase the amount of money you have invested in fixed income assets such as bonds and high yield stocks. Consider meeting with a financial planner to discuss things like portfolio allocation, long-term care insurance, estate planning, and tax planning.
The bottom line is that you cannot predict where the market will go but the way you allocate your money has more to do with the stage of your life than the state of the markets anyway. Trying to time the market will just lead to added expenses and missing out in some of the big market moves that mean the difference between a long-term return of 5% and 15%, which changes your account balance by millions of dollars. Forget about what you hear on the news and focus on saving and investing regularly. You’ll sleep better at night and have better returns.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
