What happened this week? The tax cuts are still in place. The economy growth bulls were touting remains intact. The Fed hasn’t changed its stance (at least not publicly). So, why a 10% drop in the Standard and Poor’s 500 Index and the Dow Jones Industrial Average? If markets are based on fundamentals, I argue we don’t look much different than two weeks ago. There were a few changes (which I will discuss later), but was it enough to change the fundamental story?
10 Shocking Facts About the Stock Market This Week
This is the headline from an article on CNN Money on Feb 10. There are many other articles I could choose from, I simply picked the first one. Amazing how quickly the storyline changes. Consider a few of the “shocking facts.”
- The worst decline ever. Technically true, but this reminds me of the headline that reveals it was a record year for movie revenue. Did more people go to the movies or did ticket prices increase? If measuring dollars spent, either (or a combination of both would create the result). This doesn’t tell us the true story.In this case, the 1,175 drop on Monday. The article states…” It was by far the worst decline ever.” From a percentage point measurement, the loss didn’t crack the top 20 worst days. I know little comfort, but what emotions is the writer looking for by saying “by far worst decline ever?”
- The Second-Worst Decline Ever. Well…read point one.
- 2,400 Points Lost in Two Weeks. Let’s revisit how quickly this market has risen. Perhaps (for some), the “shocking point” is that what goes up eventually comes down?
- Worst Intraday Decline Ever. See point one.
- Biggest Volatility Spike. The extended low Volatility (measured via the VIX index) reading over the past years has been a discussion point during personal conversations and this blog post. The belief that volatility is gone for good because “it is different this time” is foolish at best and dangerous for those betting against it.
- First Market Correction in Two Years. What did the market do in those two years?
- Highest 10-Year Treasury Yield in Four Years. We remained at historically low rates for a historically long period of time. Higher bond yields should be welcome news for those dependent on interest rate returns. Savers have lost in real terms for a long period of time.
- Worst Week for the Dow since 2016. Two years ago, during a nine-year bull run?
- S&P Lost $2.2 Trillion since January High. How much was gained since 2009?
- Funny…the writer repeated one…I guess there were only nine “shocking facts.”
CNN Money Article link:
Before I go further, I realize declining markets make investors nervous and I am not making light of this fact. My point is markets go up and markets go down. We’ve discussed this and more importantly, we’ve expected it. The decline may be unsettling but is hardly shocking.
Emotions Trump Logic
Yes, the pun was intentional. The market has been on a bull ride since Donald Trump was elected President. This was and is an emotional reaction (at least partially). The financial news prior to the past week has been primarily good. At the same time, many academics warned about current conditions. Logic says markets will not always go up, especially in big leaps and the bigger the leap, the harder the fall. In a perfect world, the market slowly and steadily increases.
Consider the real estate market (one asset class). When pricing my father’s house, I looked at historical cycles. Buffalo, NY didn’t experience the significant downturn in real estate in the real estate bubble. It didn’t increase significantly prior the bubble either…slow and steady. The reason the two responded differently was because the underlying factors were different. States like California and Arizona experienced increasing population. Buffalo’s population stayed pretty much the same. The reason I share this is the comparison of underlying factors. Real estate was heavily influenced by population growth and an emotional belief markets only go up. The stock market had its own reason to rise…. some logical, some emotional. This week we saw what happens when logic crashes into emotion (and we’ll see the opposite again in the future).
Stop looking for the reason
This decline was particularly puzzling for market participants because there was no clear reason for the sell-off. England hadn’t surprised us with a vote to leave the European Union. The Fed Chair didn’t express his desire to begin raising rates at a faster pace. Inflation didn’t increase significantly overnight. The tax plan wasn’t repealed. Sure, we had the threat of closing the government again, but we have become used to that (sadly). No clear reason makes decisions difficult.
One of the common beliefs for those accepting risk is there will be a warning. They will “get out” before the market falls. With no clear reason, the decision is complicated. Is this drop a short-term event? Is it a buying opportunity? After all, nothing significantly changed…or has it?
Bad timing for tax breaks?
I think everyone agrees paying less in taxes is beneficial to us as individual payers. But, is it viable given the current debt level, the stage of business cycle, profitability of companies, and current employment levels?
Paying less in taxes is beneficial IF real costs don’t increase. If prices increase at a rate greater than the tax cut, we lose in real terms (which is what really matters). If people have more money to spend (assume they spend it, not always a safe assumption), there will be upward pressure on prices. The simple laws of supply and demand argues prices increase if all else is held constant (nothing truly remains constant).
It was my opinion the rise in January was emotionally based. The headlines of additional money felt good, but the unintended consequences were being ignored. The potential negative consequences include inflation which would likely lead to the Fed realizing they were behind the curve.
If this is the case, we should expect a faster pace of rate increases. Higher rates equal a greater cost of borrowing. If the benefit of a tax break is less than the increased cost of borrowing (most of Americans are borrowing), are we further ahead?
While I was thinking about it, another person was writing about it. His name is Ed Dolan. I am attaching a link to his blog post below. He points out why the timing of the tax cut might be wrong. A tax cut should arguably be done when unemployment is high. Tax cuts should boost the economy. Did we need a boost right now?
He states the optimists argue there is a room for employment given the underemployed data. He states… “let’s hope they are right.” I agree.
Ed Dolan’s Blog Post Link:
Decisions are made emotionally.
Sales trainers tell us that people make decisions emotionally and then justify them with logic (sometimes faulty logic). This is why sales pitches focus on the benefits (emotional) rather than the features (logic). This is true when buying a car, selecting a mate (maybe), and when making an investment. We are all emotional creatures (varied levels). It is my job to remove emotions (as best I can) when measuring your plan’s potential success.
Risk questionnaires don’t work
If you’ve completed a plan with me, you know we skip over the portion that asks about your risk tolerance (or maybe you don’t notice because I pass it so quickly). After 20 years, I realize risk tolerance is heavily influenced by current and recent market conditions…emotions!
The planning program asks you to “select your risk score.” First, what does that mean? We can assume a person who claims to have a score of 30 is less risk tolerant than someone who claims a score of 70. But, what is the difference between a 65 and 70? More importantly, what risk is being measured? We could assume the program is trying to measure market risk, but what does it mean to the person answering the question?
The program addresses this question with a follow up question. The program asks… “will you stick with your investment strategy through a bad market?” The program projects a loss. This is supposed to put a real number around a percentage drop. It is supposed to make it real. But, a projected loss is not a real loss. A projected loss is a number on a screen. A real loss happens when you look at your account statement and experience the decrease. Paper losses and real losses are not the same!
Do we need a better questionnaire?
The shortcomings of this type of questionnaire are well known. Behavioral economists and psychologists have worked on better ways to measure “risk.” They ask questions not directly related to money with a goal of determining risk tolerance. The questions measuring the impact of a gain or loss are interesting. They tell us people tend to feel greater pain from losses than pleasure from gains. In other words, we don’t like to lose what we have. But, the problem persists…people answer questions logically…people act emotionally. If risk questionnaires don’t work, what should we use instead?
Measure a different goal
Our goal should not (and is not) to beat the market. Our goal is not to determine what factor will lead to the next crash. Instead, our goal is to get you to the “finish line” (is that better than the “end of the plan”) successfully. For some that means a significant safety margin. This might be due to a low risk tolerance (for unexpected expenses) or a goal to leave money for children or heirs. Others prefer to risk more today knowing they might need to adjust downward in the future. Both solutions are good…for that person and will likely not show up on a risk questionnaire.
If you agree emotions affect buying decisions, you likely recognize the limitations of basing an investment plan on a risk questionnaire. Risk questionnaires are the typical tool of those who put investments before financial planning. The completion of a questionnaire “proves” suitability for risk. This works well when markets are going up. Then tend to fail (and sometimes miserably) when markets turn south. Therefore, we focus on the decisions you have greater control over BEFORE discussing investments.
I am going to skip the “Stephanie section” this week because this post is already long and discussing the emotional decisions of an 11-year old girl could keep me writing (and you reading) for days. So, I will update you on Stephanie’s adventures next post.
Logical decisions might be uncomfortable
Most of you have a portfolio that holds less market risk than what we would likely hold in “normal times.” We’ve discussed this decision and more importantly, we’ve discussed when to adjust the overall mix of stocks and bonds. That decision is not based on an “all clear” signal from the market. It will be more comfortable to buy stocks once they have recovered. But, that defeats the oldest rule in any investment decision… buy low, sell high.
The “buy low, sell high rule” would be so much easier to implement if someone would simply tell us… “Hey, today is the high for the year (or other time frame). You might want to sell now.” Or, “this is the lowest price you will see this year (or other time frame), you might want to buy today.” Of course, retailers tell us this every week. Next week will be the “best time of the year to buy” …during the President’s Day sale. An obvious emotional pitch that will be followed up with the Easter sales pitch and then the Memorial Day…
What we know is that markets are trading at a slightly lower valuation today than they were last week. We know volatility is back (at least for now). We discuss what we will do BEFORE emotions rise. We discuss a plan logically and review adjustments beforehand.
One adjustment is buying stock as markets go down. This may be uncomfortable. “What if the markets keep going lower?” “We will buy more stock.
Most of us have discussed a plan to add 5% to your stock allocation when/if the markets (measured via Dow Jones or S&P) fell 10%. We are balancing that number right now. If we continue to fall on Monday (or this week), we will be adding equity risk to portfolios. I will discuss with you personally before placing trades. Hopefully, this post gives you time to balance emotions with logic before we have that discussion.
The previous market threats have not subsided (my opinion). We know the Fed plans to continue to raise rates. The question is whether they will do so at a faster pace than previously believed. More importantly, one of the key catalysts of this bull market has been the availability of low cost (for a long time basically free) money. Can the market continue to rise without cheap money?
Inflation appears to be an increasing threat. The bonuses and pay increases should increase inflation. By the way, many companies are saying the bonus is because of the new tax legislation. Perhaps I am a pessimist, but companies don’t often give bonuses on a future promise. The money must be available now for bonuses today. I think the companies were already doing well, which is the reason for the bonuses. We haven’t felt any real impact from the tax cuts…we only think we know what we will see…an emotional decision.
Someone asked me recently where I stood on the markets. I answered cautiously optimistic. My emphasis is on the cautious side. Where should you stand? I think you should do the same, with your focus on being optimistic about the projected results of your plan, not the weekly “market numbers.”
Most of you are more conservative than you would normally be. Those who have known upcoming cash needs are invested with that need in mind. If you are close to retiring, arguably the best scenario is a market correction while you are invested more conservatively (lower the downside). This is also true for those further away from retirement. In both cases, the more conservative portfolio helps protect and provides funds to add after the correction…when some of the uncertainty has passed.
It should be an interesting week. By the way, I can write about logic and emotion all day long, but if you are struggling with current market conditions, please let me know. I understand my job is to balance emotions and logic…no matter how uncomfortable that can be at times.Photo by Victoria Palacios on Unsplash