Storm Is Out There; Prepare for It Now
“They don’t clang a bell at the top,” some grizzled Wall Street veteran once uttered about the stock market’s cycles.
So what is that ringing sound that so many people think they hear today?
You don’t have to be chairman of the Federal Reserve Board to know that the U.S. market is “high.” Neither do you need a college degree to arrive at the conclusion that stock prices will eventually go down again. The only questions are when, how much and for how long.
On Friday the market once more defied its naysayers, rallying despite a robust February employment report that suggested the American economy is heating up rather than cooling down.
What’s not to like about a healthy economy? It’s good for workers, good for corporate profits, good even for embattled politicians.
Yet the faster the economy grows, the greater the risk of higher inflation in wages and prices, and the greater the probability that the inflation-paranoid Fed will begin to tighten credit again via higher short-term interest rates.
There isn’t much need to rehash Fed Chairman Alan Greenspan’s recent warnings about the economy, inflation and rich stock prices. He has already said more than enough. All that’s left now is for Greenspan to act, probably with a quarter-point rate increase at the central bank’s March 25 meeting.
How would stocks react to higher interest rates? Just think back to last June and July. All it took then to trigger a nasty pullback on Wall Street was the threat of a Fed tightening move (never carried out), combined with worries about slowing corporate earnings growth.
From its spring peak of 5,778.00 on May 22, the Dow slumped 10.5% to an intraday low of 5,170 in mid-July before stabilizing.
Or consider the market’s experience in 1994, when the Fed undertook a painful round of interest rate hikes to subdue the red-hot economy. In so doing, the central bank sparked a market pullback that shaved almost 10% from blue-chip indexes, and more than that from many smaller stocks.
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It’s not that a rise in the Fed’s benchmark short-term interest rate from the current 5.25% to, say, 5.75% would necessarily be disastrous for the economy. But the effect on investor psychology is usually quite ugly. Which is why a tighter Fed historically has been the stock market’s worst enemy.
Of course, many investors will say they’re eager to see share prices pull back, because they’re dying to buy stocks cheaper. That’s what they say, anyway.
But look at the experience of many small-growth-stock mutual funds that were battered last July and still haven’t recovered. People aren’t exactly beating down the doors to get into those funds at lower prices. In fact, many of the funds have continued to see money flow out, as investors apparently fear deeper losses.
“I don’t know what the stock price outlook is,” Greenspan said last week. No kidding, Al.
Maybe he decides against raising rates, and stocks surge again. Maybe he raises rates, and the market ignores him. Maybe he raises and we get another tidy 10% pullback. Or maybe he raises, and the first genuine bear market since 1990 begins.
You can’t know, but you can protect yourself by making sure you’re prepared for any scenario. Are you prepared? You are if you can confidently make the following three statements:
1. I know exactly why I own everything I own. Look at your portfolio, however small or large. You should be able to put every security into one of two columns: investment or speculation.
Investments are securities you have purchased for the long term. That time horizon varies person to person, but certainly no one should think of “long term” as anything less than three years.
An investment is something you shouldn’t expect to sell unless its long-term fundamentals change for the worse. In other words, the short-term price action of the security--however harrowing--shouldn’t matter to you if the fundamentals remain solid.
A speculation, on the other hand, is something you have purchased for a short-term trade. You are expecting to sell it after you make a certain gain, or before it declines more than a certain amount (i.e., you aren’t willing to lose more than X amount of your money on it).
If you can tell your investments from your speculations, you’re much less likely to make the wrong move in either category, regardless of what the market dishes out in the short run.
2. I am properly diversified. Basic asset allocation--how you spread your nest egg among stocks, bonds, short-term cash securities and other assets--is the primary determinant of your long-term returns, much more so than the individual securities you choose within each class, academic studies have shown. But no academic can tell you what proper diversification means for you. It is an individual decision. Only you can know what feels “right.”
One generalization, however, is almost certainly true for most people: If you have virtually all of your nest egg in U.S. stocks, you will feel more psychological pain if the market plunges than someone who owns U.S. stocks along with a mix of other assets, including foreign stocks, bonds, bank CDs and money market accounts.
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If you’ve ever thought about diversifying more broadly among investments besides common stocks, now would be a good time to turn thought to action.
You don’t have to make an extreme move. But having even 20% of your portfolio in bonds at a time when stocks are plummeting might keep you from becoming so anguished that you panic and sell all of your stocks--probably a decision you’d come to regret.
3. I know approximately when I might need to tap my nest egg for a major expense or for retirement, and I have structured my portfolio accordingly. Do you hope to buy a house in two or three years? If you’re counting on the down payment coming from your stock investments, would your plans be ruined if the market in two years is 30% below today’s levels?
Likewise, if you’re within five years of retirement and you expect to begin drawing from your investment assets immediately upon retirement, would your retirement date be jeopardized if your assets at that point were worth considerably less than they are today?
The sooner you will actually need your money, the greater your focus should be on capital preservation rather than appreciation.
It’s true that stocks have been both great capital appreciation and preservation tools in the long run. But in the short term, stocks can fall much faster than they can rise. (This is still true, whether or not enough investors have yet experienced it in the 1990s).
Investors who need a guarantee that a particular sum will be available at a particular date need to turn to assets other than stocks for that part of their portfolio--things like money market accounts, bank CDs, or individual bonds maturing on a set date.
