What is causing the recent volatility? When we talk about market volatility we are referring to sudden wide changes in stock market prices. In the past few weeks the market has moved both up and down as much as 1% to 2.5% in a single day, depending on the particular market index.
First, let’s put this in perspective. While 100 to 300 points on the Dow is a lot of points, it only amounts to a 0.5% to 1.5% change in the index. Prior to the recent bull market that started in 2009, it was not unusual to have these kinds of moves quite frequently. In the past five and one-half years we have seen the Dow Jones Industrial Average (DJIA) go from 6,750 to 17,000, which is an overall gain of over 250%. During that time period the market had very few pullbacks, which is out of the norm. Investors have been predicting a meaningful correction since the Dow was 13,000. As of Friday, the correction has amounted to 5% for the S&P 500 and 4.7% for the DJIA. While the U.S. economic news is positive, other news, like continued economic weakness in Europe and a slowdown in China and emerging markets, has given investors a reason to do some selling. Couple this with investors on the sidelines waiting to buy on declines, and you have the kind of market we are seeing.
Is this unusual? For those of us who have been in the market for 40 years this volatility is not unusual. While the stock market has provided investors with excellent returns over the past 75 years, it has not done so without some fluctuation and it is all part of participating in the stock market. By past measures the recent volatility is quite mild. In order to own stocks one must keep in mind the fact that their portfolio is going to fluctuate both up and down. Historically, few investors have become rich investing in bonds, while many have made their wealth from stocks. Simply stated, the bottom line is that stocks provide higher returns than bonds over the long term. To make those higher returns you must accept the risk and volatility of the stock market.
What are investor’s real fears? In the past 15 years we have seen two major market declines, the tech debacle in 2000-2001 where companies with no substance were bid up to ridiculous prices, and the financial crisis in 2008-2009 which was due to the whole financial system being at risk of collapse. In both periods the market was down 45% to 55%. Market declines of this magnitude usually occur once every 30 to 40 years. While it is not unusual to experience one such decline in one’s lifetime, most investors have lived through two in the last 15 years. Investors are afraid of another major decline.
We believe the probability of a major market downturn is very low. Previous bear markets have been accompanied by an economic recession. While our economy is far from robust the probability of a recession in the near term is low. A five to fifteen percent correction is not unlikely especially after a 250% increase in the past five and one-half years.
How should an investor react to the present volatility? Are you an investor or a trader? A trader is very short-term oriented and only pays attention to short-term economic news. It could be over the horizon of a month, a week, a day, or an hour. An investor looks to build wealth as the U.S. economy and its corporations expand. There is a great deal of evidence that the investor has succeeded in their goal. There is little or no evidence that the trader has succeeded over the long term.
While it may feel that the market has just been through a major decline, the fact is that the S&P is down a mere 5% from its all-time high of 2,000. This is not evidence of the end of the bull market. If the market were to decline another 5%, or a total of 10% from its high, the move would still be considered a correction in a continuing bull market. It is a mistake for an investor to turn into a trader because the market starts to become more volatile. In accounts where money is coming out on a regular basis, it is prudent to raise cash so that you don’t have to liquidate stocks at a bad time to pay out the needed income. You should maintain a large enough cash balance to cover your withdrawals for 12 months.
We believe the recent volatility will turn out to be a good entry point for those who were waiting for a correction. The price to earnings ratio of the S&P 500 based on 2015 earnings is slightly above the long-term average of 15. With dividend yields the same as seven-year Treasuries, and money market rates for cash near zero, stocks look extremely attractive. We think recent market activity will turn out to be a correction or a pause in the bull market. While we don’t expect returns like we had over the last two years, we can expect medium to high single digit returns for the S&P 500. If you take money out of equities and sit on the sidelines in a money market account you earn nothing. Investing in five-year Treasuries earns you less than 1.5%. Investing only in money market funds and bonds will not earn enough for most people to maintain their lifestyle. You are guaranteeing the depletion of your principal.
We acknowledge that stocks have risk, but earning nothing on your portfolio and depleting it each month is the alternative. In the past 50 years the U.S. economy has been faced with many problems, both economic and geopolitical. In every situation betting against the U.S. has not worked out. We believe the economic future of the U.S. is positive and the future of the stock market will be positive. With modest economic growth accompanied by growth in corporate profits, and nowhere else to get a decent return on your investment, the bull market should continue or at least not be subject to a major decline.
We must add, we are not suggesting everyone should have all of their money in stocks and the comments above refer to the equity allocation of the portfolio. It is prudent to have an appropriate asset allocation between stocks, bonds, and cash depending on your individual situation.
The Dumont & Blake Team
October 13, 2014