Written by: Kevin Ervin, CFP®, CPA
I hope that this holiday season has brought opportunities for you to gather with friends and family to enjoy many good times together and to forget about the stock market for a while. The markets have left a lump of coal in everyone’s stockings this December.
Time spent with loved ones can help keep everything in perspective. I also wanted to take an opportunity to discuss some perspectives of the recent market declines. I will address our view of why the market has declined, the relevance of this market decline and what we have done about it. I will also share our thoughts for the markets going forward and provide some recommendations that you might consider during these turbulent times.
Why Has The Stock Market Declined?
Perhaps the most reasonable explanation for the decline is that the market was simply over-valued earlier this year. Price/Earnings (P/E) ratios had become stretched, fueled in part by optimism for continuing economic growth spurred by the 2018 income tax cuts. Evidence is beginning to appear that the growth prompted by the tax cuts is likely not going to be sustainable beyond a few quarters, so it could be argued that the stock market, as it frequently does, over-reacted to the 2018 tax cut legislation.
Another contributing factor to the market decline is the Federal Reserve Bank’s monetary tightening policy, which has resulted in rising interest rates. The Fed has been raising short term interest rates in a bid to return monetary policy to more normal levels after the accommodative policy that was put in place during the financial crisis, and to also head off threats of inflation that could result from today’s tight labor markets and tariffs on imported goods. Higher interest rates can negatively impact corporate profits and also make bond investments relatively more attractive than stocks to some investors.
The lack of predictability and stability emanating from Washington, DC has not helped stock market performance. Stock markets perform best under stable governmental policies. The most damaging catalyst for the stock market this year has been the threat of more restrictive trade policies. This has caused market declines both domestically and internationally, particularly in emerging markets, where the reliability of foreign companies’ exports to the United States has been threatened. More recently, the federal government shutdown and turnover of cabinet and other senior executive branch personnel have generated unfavorable sentiment for the stock market.
Is This Stock Market Decline Relevant?
Unless you need to withdraw the majority of your stock market investments for some purpose in the next couple of years, the answer is no. If we were aware of some short-term need for your access to your funds, we would not have had these balances invested in stock funds. I do not see any signs in the economy that makes me think that the current market decline is anything other than another over-reaction or normal cyclical activity that will work itself out over time.
Related: Market Volatility ≠ Your Volatility
Unless there is a rally between now and the end of the year, your year-end statements will reflect a larger drop in value than we have seen for the past few years. However, there is really nothing more special about the value of your portfolio on December 31, 2018 than there was December 31 of any prior year, or any other date for that matter. Do you remember the short-term market panic that occurred in June 2016 over the unexpected outcome of the BREXIT vote? That market decline did not have any lasting impact on any of our client portfolios, nor our clients’ lives. How about March 6, 2009? On that date, the Dow Jones Industrial Average had declined over 50% from its peak value in late 2007 and was below 7,000. Did the value of your portfolio on that date have any meaningful impact on your financial life today? It only did if an investor panicked by selling out of stocks and straying from the discipline of their long-term investment strategy.
As long as we are thinking back to the past, stock market indexes are about where they were early in the second quarter of last year. At that time, I do not recall anyone panicking about their investment accounts, nor should they now.
What Have We Done About It?
The main thing that we have done with our clients’ portfolios as the result of the declining stock market is harvest losses in our clients’ taxable investment accounts. This involves the selling of positions whose market value has dropped from our original purchase date. The losses from these trades will help offset capital gains from 2018. If the losses exceed the gains in 2018, up to $3,000 of the losses can be used to offset ordinary income this year. If losses still remain, then they can be carried over to future tax years.
When we execute these loss trades, we reinvest the proceeds back into the market to participate in the eventual market recovery. However, we have to be careful to avoid the “wash loss” rules. This means that we cannot purchase the security sold at a loss within 31 days prior to, or after, the date of the trade that generated the loss. As a result, we do not purchase the exact same security, but a substitute security that should capture most of the market movement of the security that was sold for the capital loss realization.
As stock allocations fall below our clients’ target levels, we have also been rebalancing portfolios by purchasing additional stock investments at lower prices. This is basically the other end of the cycle from which we sold overweight stock positions at higher prices closer to market peaks. This is precisely the buy-low and sell-high investment trading discipline that leads to long term investment success.
What Are Our Thoughts About Future Stock Market Behavior?
In the short term, “who knows?” The answer to this latter question is, “no one.” The other important response to the question is that the short-term does not matter. I would guess that any unfavorable political headlines will continue to pressure stock market prices lower. I would also guess that once we start seeing corporate earnings, starting in mid-January, that there could be a relief rally, in the absence of any other negative news.
Over the slightly longer term, I remain optimistic. At today’s stock market level, the P/E ratio based on the consensus 2019 earnings of the S&P 500 is only 13.5 times. Remember earlier when I referenced stock market prices from the second quarter of 2017 being roughly equivalent to today’s market level, at that time the P/E ratio of the S&P 500 was approximately 17.5 times. Using this important metric, the stock market is much more attractively priced as an investment today than it was in April of 2017.
I would suspect that if stock prices remain at these lower levels into next year that there will be an increase in corporate buybacks of stock, which tends to raise stock prices. Also, one should not ignore that this stock market decline has occurred in the midst of a strong economy. Growth will likely slow from the tax cut infused temporary growth spurt of 2018, but should still be positive. This should be supportive of higher stock prices as well.
What Are Our Recommendations For Clients?
The majority of our recommendations for clients deal with the emotional side of investing. The first suggestion is to simply recognize that it is necessary to have stock market investments as part of a diversified investment portfolio. Secondly, you should accept that volatility and unpredictable short-term market cycles are a fundamental part of stock market investments, and in fact, are a necessary component to allow investors to realize higher investment returns over longer periods of time.
For our moderate growth/moderate volatility investment strategies, we expect a year with an annual overall portfolio loss in the mid-single digit percentages about once every 6 years. However, it has been 10 years since this has happened, so one could argue that we are due for that lump of coal that I mentioned earlier. For these same moderate investment strategies, we generally predict long term investment returns that average 2.5% to 3.0% above inflation over the long term. This has been achieved by the majority of our longer tenured clients over most longer-term investment horizons.
I would urge investors not to compare portfolio values to peak or all-time high levels. This peak value has no relevancy to your life.
The next two recommendations concern the media. First, I would minimize your viewing of cable financial news networks. If you must watch, keep in mind that their objective is to keep you watching and to generate higher viewership ratings numbers. Quite often the way they attempt to achieve this is by over-hyping news stories and generating dramatic headlines that have nothing to do with your financial success.
The second recommendation related to media, is to the extent that you watch television news, do not limit yourself on watching just one network or channel. As you are probably aware, political agendas have become the primary mission of some “news” organizations. If you limit yourself to just one source for news, you run the risk of getting a biased perspective.
A closely related corollary of the previous recommendation is to not let your politics influence your investment portfolio strategy. This is particularly important in today’s hyper-partisan world. I have had many disagreements through the years with administrations of both parties and with varying political compositions in Congress, but I remain steadfast in not letting my personal political views infiltrate my investment decisions. Within our office, we have divergent political philosophies, but this does not impact our personal investment portfolios or advice that we provide to our clients.
The most important point that I can make to our financial planning clients is not to focus on your investment portfolio value at any given point in time, but rather to rely on the probability statistic on reaching your financial goals from your most recent financial plan. The Monte Carlo projections responsible for generating this probability take into consideration financial markets like we have experienced during the past few months, and indeed much worse, in the development of your financial plan.
I apologize for the length of this message. Despite all of the analytical reassurance and talk of long-term perspective, I know that emotionally it is difficult during market conditions such as these. On behalf of my partners and colleagues, I would like to thank you for your patience and confidence in our process and philosophy, and also to wish you the happiest of New Years, and a healthy and prosperous 2019.
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