Updated: September 1, 2015
You may have heard or noticed that the stock market has been going through a bit of a rough patch. As of Tuesday, January 22, US stocks, as represented by the S&P 500, were down nearly 11% year to date, and over 16% from their most recent high point on October 9, 2007. This latter drop, being larger than 10%, qualifies as a “correction.”
Non-US stock markets have suffered similarly. The table shows the returns of various indices over the same time periods. Non-US equity markets have declined slightly more than the broad US market, and US real estate significantly more.
|US Large Company||S&P 500||-16.3%||-10.8%||-7.6%|
|US Large Company||DJ Industrial Average||-15.5%||-9.8%||-3.9%|
|International||iShares MSCI EAFE (EFA)||-17.4%||-11.2%||-4.8%|
|Emerging Markets||iShares MSCI EM (EEM)||-16.4%||-12.2%||-15.6%|
|US Commercial RE||Dow Jones Wilshire REIT||-25.9%||-7.9%||-27.2%|
|Commodities||Dow Jones AIG Commodities||6.9%||0.2%||11.3%|
|US Bonds||Lehman Brothers Aggregate Bond||6.0%||2.6%||10.4%|
|Inflation Protected US Bonds||iShares Inflation Protected Bond (TIP)||8.1%||3.3%||10.6%|
On the other hand, bonds and commodities are up approximately 6% since October 9, as measured by the indices or index funds we report.
If we look back to the end of 2006, stock index returns are much less negative, bond returns are positive and Emerging Market equities are still enjoying significant net gains. So, if you’ve been investing since the end of 2006, your portfolio is probably down less since then (than since the end of 2007), and it may even be up a bit.
You might reasonably ask:
- Why has the market gone down so much?
- Is my portfolio at risk?
- What should I do?
My short answers are:
- The economy is reacting to a period of excessive economic activity brought on by loans that encouraged purchases that people and companies could not afford. The market is reacting to what it thinks will happen next in the economy.
- Your portfolio is probably at a bit more risk than in less turbulent times.
- Ideally, you have selected your target asset allocation with some care and thought. Times like these can be very useful – you get to see how you really feel about risk. If you are uncomfortable with your portfolio allocation in light of recent events, get in touch with your advisor – adjust your target allocation, revise your Investment Policy Statement to reflect the change, and modify your portfolio. Otherwise, sit tight: I don’t recommend attempting to “time the market.”
Now, for my longer answers. You certainly don’t have to read them, but they provide more detail than my somewhat cryptic short answers.
What is causing this decline?
While no one really knows (this is the kind of event that economists will be arguing about for years), there are two widely accepted (and inter-related) candidates: the “sub-prime crisis” and the anticipated arrival of a recession.
- The sub-prime crisis is the most visible manifestation of a credit shortage that has followed a long period of relaxed credit standards. Fundamentally, interest rates were (too) low, and many lenders had an extended lapse in judgment about how to lend. They lent too much money to people and organizations who were unlikely to be able to repay the loans. When many loans became delinquent (late) and even fell into default (really late, and borrowers announced they couldn’t repay), the lenders suffered large losses. Some of these lenders were among the most reputable US financial institutions (Citibank, Merrill Lynch, Bear Stearns). Lenders have now recovered their senses and raised their lending standards (perhaps over-reacting and raising standards too much), but as a group they will be unable to recover their losses. Owners of these companies will share in the losses through reduced stock prices.
In addition, many of these loans are part of very complex securities. The values of these securities are uncertain when some of their constituent loans are delinquent or in default. As a result, owners of the securities don’t know what they are worth (and investors in the companies that own the securities don’t know what the companies are worth). Some of the companies that own the securities have also been overseas, and even in emerging markets, which might account for some of the decline in these indices.
These losses, and uncertainty about the losses, are making investors nervous, and that nervousness is manifest in the stock market declines we have been experiencing.
If you’ve been following the economic news, there has been a lot of discussion about whether the economy has entered, or is about to enter, a recession. According to the National Bureau of Economic Research, a recession is simply
“a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.”
That is, less people working, less buying and selling, etc. In these circumstances, company profits decline. When investors expect company profits to go down, they aren’t willing to pay as much to own the company, and its stock price goes down. When they anticipate a recession, investors expect most companies’ profits to go down, and most stock prices go down.
- I do not mean to be flippant when I say that the stock component of your portfolio is always at risk (the bond component is, too, but mostly not subject to equity market risk). Ideally, when you established your target allocation, you did so bearing in mind the risks of investing in stocks. Those risks are always present, and they are present now.
Well, is my portfolio at more risk than usual?
- Market volatility (the day to day ups and downs in prices) has increased recently. This can be a sign of more declines to come. On the other hand, volatility was greater in April 2003, at the beginning of the recent sustained increase in stock prices, than it is today.
- I do not recommend that you attempt to “sell now, and buy back at the bottom.”
– You may recall that in earlier articles I have written about the great difficulty of market timing. That difficulty has not diminished. When the market goes down in a sustained fashion, we tend to expect it to go down further. It may, but it may not. If we do sell, and the market starts to go back up, we (including professional investors and money managers) tend to want to wait “to be sure” before re-entering the market. We thus tend to sell low, and buy high (the reverse of what we’d prefer to do).
– There is some evidence that stock prices are lower relative to bond prices than usual, suggesting that this might not be the best time to sell.
- I do recommend that you get in touch with your advisor to adjust your portfolio allocation target if you feel uncomfortable about your portfolio and your long-term strategy in light of the volatility we are experiencing. You should modify both your Investment Policy Statement and your holdings. Life is too short to spend it worrying about your money and your investments.
- I do not recommend that you monitor the market on a minute by minute basis. As usual, a lot of the “news” is noise (that is, the view of this pundit or that, and lots of anecdotes that attempt to explain what’s going on). While the news may make you feel better or worse (probably worse, as “good news is no news”), it is extremely unlikely to contain information that will help you to predict accurately what the market will do.
Please contact me if you would like to discuss these issues or any concerns you might have with me directly. I will not be able to provide any more certainty about what is happening or what is going to happen, but I can certainly help you think through what to do.