This is not 2008! But it could be 2011…

The stock market is back in focus after last week’s big decline. It’s caused quite a stir and has rattled investor’s confidence. Before I go on to analyze the details and suggest possible outcomes, I want to take a step back and gain some proper perspective.

We are about 7% off of all time highs, but everyone seems to want to run for their lives. We must understand that historically, the stock market has experienced a 10% decline, roughly every year. Last fall stocks dropped 9.9% due to Ebola fears and Russian/Ukraine conflicts. Most of you may have probably already forgotten that already, but stocks would then go on to gain 15% in value shortly thereafter. These short term fluctuations are part of the risk/reward trade off in investing in equities. Stocks are the best performing asset class over the long term because they come with, sometimes, stomach churning volatility.

So let’s begin….

trading_range

Since Thanksgiving the markets have been stuck, bouncing up and down inside of a trading range. The length and breadth of this trading range meant that the eventual breakout (whether up or down) would like be meaningful.

usd

Unfortunately the markets were left without a catalyst to the upside. This began last year with the steady increase in the value of the US Dollar (another failed prediction of the Doom and Gloomers). The Dollar gained some 25% last year which is a big move for a world’s reserve currency. While this is good for the consumer because it limits inflation and increases purchasing power, it can have a negative effect on corporate profits (especially big multi-national companies).

SP-Revenue

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And that is exactly what happened. Corporate revenues and profits have decelerated.

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Another factor was the decreasing level of participation of individual stocks during the rallies. This meant that fewer and fewer stocks were participating each time the market increased. I pointed that out awhile ago in a prior post for those who were following.

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Another source of unrest was the action over in China’s stock market. Even though China is still positive year to date, China’s stock market index is down over 40% from it’s recent highs.

These combination of factors left the market with little catalyst to break out to the upside. Eventually something had to give, so the market finally sold off last week.

dow

So where do we go from here? Unfortunately there is no certainties. One likely scenario now would have us fall back down to the lows of last fall’s correction, before resuming the up trend. On the Dow it is about 3% below Friday’s close at 15,855.

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If that fails to hold then the likely scenario would then be to drop to the S+P 500 equivalent at 1820. This is about 8% lower than Friday’s close.

We must understand that what happened in 2000 and 2008 were the result of economic recessions, exacerbated by the level of leverage and speculation in the system. This is a different scenario than what we are in now, as although growth has been tepid, there is no signs of recession in the near term. US Corporations (especially US banks) are in much better shape than they have been in a long time.

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The level of financial stress is still very low and the yield curve remains healthy. We remain in the middle stages of this economic expansion, that although has left a lot to be desired, is still growing. Unfortunately there is no totally reliable way to predict these 10-20% corrections, but in most cases it doesn’t warrant any portfolio changes anyway. There are transaction costs to get in and out of the market, and taxes (if in taxable account) that can make the whole process more trouble than it is worth. The odds are 50/50 at best to time the highs (in order to get out) and another 50/50 to time the lows (to get back in). This makes it a 25% chance of success and it’s why it’s usually fruitless to react to short term fluctuations. And often times these reversals can be quick and the result is you end up with a worse cost basis than you originally had.

We must remember that the financial media’s business plan is to get page views, ratings, subscription services. Their incentives are NOT aligned with you personal financial picture in mind. This is why consumption of financial media should be limited and viewed as entertainment only.

We must also remember that stocks are judged on their performance by percentages and not in overall points. In other words, as the Dow trades at an all time high, the level of daily fluctuations in points will naturally increase. This does not mean anything! A 500 point move in the Dow when it is at 17,000 is barely 3%. Meanwhile a 500 point move in the Dow back when it was trading at 6,000, would equate to almost 10% (more meaningful). In other words, focus on the percentage moves and not the total amount of points that the markets may move up or down.

In conclusion, the best rule of thumb is to NEVER own more stocks in a bull market, than you can comfortably hold during a bear market. If you found yourself shook up by last weeks events, you may have a bigger allocation to stocks than you probably should.

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