“You scream and shout. What’s it all about. I want out. I want out of you,” renowned singer/songwriter Russ Tolman sings in “I Want Out”. I felt like a lot of investors were thinking the same thing about their portfolio after watching the S&P 500 fall 3.9 percent this week, the most since early 2016.
As investors, we shouldn’t think in binary terms. There are significant opportunity costs when pessimistically viewing the stock market at it’s current level and deciding it’s time to get out. In the final twelve months of the last four bull markets, the S&P 500 had an average return of 26%. Something to think about when considering below inflation rate CD’s as the sole alternative. One could make the argument that valuations look risky across all asset classes. But with inflation and interest rates below average and economic growth looking healthy, you could justify the current equity valuations.
There are two things I don’t look forward to in February. The Los Angeles Chargers not playing in the Super Bowl and the following overused market adage, “as goes January, so goes the year.” Though we certainly hope this is the case for 2018, as January was a strong month for stock market returns. The U.S. indices were up about 5%, and international markets also had a good showing.
I can already sense the bull market haters ready to attack. But Chris, “The Dow had its worse week in 2 years.”, “The Dow fell 666 points” …OMG the number the Beast (for the Book of Revelation fans). As investors, we must avoid what is called Naïve Extrapolation. This is the tendency for people to use what recently happened and think it will go on forever. Are there clear risks in the markets now? Absolutely! The U.S. Treasury 10-year rate rose from 2.465 percent to 2.85 percent, the highest level since early 2014. Higher interest rates are normal and expected in this kind of growth environment. But it’s the Fed that yells “Last Call” at 2am and tells the investors to go home. Can the Fed unwind their massive (and experimental) balance sheet while normalizing rates at a pace that doesn’t destabilize the bull market? Let me get back to you -Miss Cleo has me on hold. Another major risk is the pending need to approve federal government spending once again. This is akin to counting on your unemployed roommate to come up with rent on the 1st.
Remember, the Trend is Your friend and the long-term trend is still intact. There hasn’t been a break of the S&P 500 50 day moving averaging since my Dodgers choked away the World Series last October.
Here are five considerations to help you navigate the choppy waters going forward:
- Those that are over the age of 70.5, or have inherited a retirement account, take your required mandatory distribution now. We are in record setting territory with the duration of low volatility.
- Those gifting stocks to charities or churches, and expecting to itemize in 2018, should get those highly appreciated stocks out.
- Meet with your financial advisor and do a stress test with your portfolio. Understand how your portfolio will respond in a bear market. Not just the drop-in percentage but the drop-in dollar amount.
- Review your bonds portfolio. In the short-term, the bond ETF’s price will be volatile because its underlying holdings will fall in value in the short-term while it waits to accrue its interest income. As yields rise, the maturing bonds will be reinvested at higher rates, so you are effectively holding the portfolio’s underlying bonds to maturity. This means there is very little long-term principal risk assuming you are actually holding the instrument across its average effective maturity. Remember the three purposes of your fixed income (bonds):
- Aligning your portfolio to your risk tolerance to prevent adverse investment behaviors during a bear market.
- Liquidity for unexpected life events and living expenses for retirees augmenting income with their portfolio.
- Optionality of rebalancing into higher valuations. This should be done systemically to remove the element of emotion. Few people wanted to put their money to work in 2009 when unemployment was ~10%, but that year the S&P 500 ended up 26.46%.
- Hedging isn’t as easy as it used to be. Until recently, an investor looking to protect against stock declines could simply purchase long-term government bonds or US dollar futures, the logic being that the assets traded inversely to one another. If stocks went up, the other assets would go down, and vice versa. But that relationship has broken down. This means considering other hedging strategies such as tactical investment managers. They tend to underperform bull markets and reward investors during major market turns. Another consideration is looking at attractively priced equity put options.