As we write this, stocks are in the midst of the worst week since the dark days of October 2008 when the Dow Jones Industrial Average, S&P 500 and NASDAQ fell 18%, 18% and 15% respectively. While none of us know when and how this will end, here are our best thoughts on some of the more frequently asked questions.
- Isn’t this outbreak something new that has never been dealt with before? The short answer is, “No.” But each of the previous pandemics had their own unique qualities and consequences. The 1918 influenza pandemic (Spanish flu) infected approximately one quarter of the world’s population (500 million people) and the death toll has been estimated between 17 and 50 million with some projections at more than 100 million. The 2003 severe acute respiratory (SARS) outbreak had a relatively high mortality rate (9.6%) across 8,000 cases and 17 countries and the swine flu pandemic (2009-2010) saw estimates as high as 1.4 billon people infected with 500,000 fatalities. Domestic equity indices were positive in all the aforementioned years.
- Are we in recession and if not, we will have one? This event has unfolded at a very fast pace and the real and potential impact is still unknown. The incoming economic data is for previous periods and hasn’t fully captured the recent restrictions related to public events, schools and universities, sports and entertainment, and the effects on businesses and the consumer. Many people want to draw a comparison to the Global Financial Crisis in large part because of the reaction of the equity market. However, businesses, the consumer and the overall economy are in better shape today and this (the coronavirus) is something external; the 2007-2009 period exposed cracks in the economy. If we do enter a recession, it is likely to be brief and much less severe than the 2007-2009 time period. Many market-based indicators are flashing or have flashed recession warnings signs and equities have quickly priced in a much different economic environment than when they were at the record highs in February.
- How often do bear markets happen? Much more often than one might think. There have been 12 bear markets (defined as a decline greater than 20%) since WWII, with an average decline of 32.5%. In other words, stocks, on average, have experienced this type of volatility every five years.
- When and where will the stock market bottom? We have received a lot of questions about price earnings (PE) ratios at market bottoms or other methods of trying to find a bottom, specifically as it relates to PE ratios. In today’s environment, there is a question of what the E in the PE ratio is considering the decrease in business activity related to the coronavirus. Over the past 30 years (seven bear markets) the low and high PE ratios for the S&P 500 have been 12 and 29.5 respectively and the mean has been 19.1 with a standard deviation of 3.8. With bond yields at historic lows, a terminal bear market PE would potentially be higher than history suggests. Just as an example, a 15 multiple (one standard deviation below average) applied to $163 in earnings (2019 projections and assuming no earnings growth this year) equals a 2,450 value (a 28% peak to trough potential decline). That is near today’s close and levels not seen since late 2018. However, it is our experience that markets act like pendulums and often overshoot perceived fair value at inflection points. It is also our experience that valuations don’t turn markets, but news or events do. Today’s liquidity offer of $500 billion from the Fed did not stem the weakness and we have yet to see the complete capitulation typically associated with market bottoms.
- Should I change my asset allocation based on current events? In our experience, decisions made when emotions are high are often proven to be wrong in hindsight. A well-diversified portfolio with a systematic approach to rebalancing and prudently deploying excess cash across a portfolio has proven to be an effective way to weather downturns and has led to good results for long-term oriented investment plans.
In this environment, there are practical steps that can be taken to help with both emotional stability and financial success.
- Revisit Your risk tolerance, saving and spending policies. Consider the risks you are taking and why you are taking them. For nearly all investors, longer-term objectives are only possible if taking an appropriate level of risk.
- Maintain a Longer-Term Mindset. Do not let recent market volatility convince you to abandon a prudently designed, long-term investment plan. Short-term, reactive decisions can significantly impair portfolio returns.
- Deploy a Portion of Excess Cash Reserves. For investors with excess cash reserves, consider investing a portion while markets are trading at more favorable levels. Create a plan to systematically put cash to work over a series of tranches. Accept the fact that no one can regularly “time the market.”
- Thoughtfully Rebalance Over Time. After revisiting your risk tolerance, monitor your portfolio’s allocation and thoughtfully rebalance back to targets if the portfolio’s current allocation materially deviates from its target allocation.
- Harvest Losses Where Available. Taxable investors should consider using market pullbacks as an opportunity to harvest losses. Replacing sold positions with a similar – but not identical – fund can help your portfolio maintain similar exposures in line with your target allocation.
Disclosure: © 2020 Moneta Group Investment Advisors, LLC. All rights reserved. These materials were prepared for informational purposes only based on materials deemed reliable, but the accuracy of which has not been verified. You should consult with an appropriately credentialed professional before making any financial, investment, tax or legal decision. Past performance is not indicative of future returns. These materials do not take into consideration your personal circumstances, financial or otherwise.