20 Oct 2017 Which is the better question?

“When will the stock market drop?” or, “How much does a market drop hurt me?”

The historic close of the Dow Jones Industrial Index above 23,000 this week, one day before the historic 30-year anniversary of the largest one-day drop of 23% of the Dow Jones Average has pundits, analysts, and everyone else wondering when the next drop will occur. We don’t have an answer for you, but can share some valuable perspectives we hope will help.

First, we understand that fear of market drops is real and not to be ignored. We can all vividly remember the damage that occurred during the financial crisis of 2007 and the Great Recession it wrought. The freshness of the memory has increased the effectiveness of the purveyors of ‘doom and gloom’ making their arguments hard to ignore. They are quite good at highlighting the facts that enhance their story, while ignoring or minimizing the facts that argue against their conclusions.

On the optimistic side of the fear and greed coin is this incessant drumbeat of new highs being reached by the Dow and other major indexes. Ben Carlson, author of the the blog A Wealth of Common Sense points out that “the S&P 500 Index has recorded more than 150 new all-time highs since eclipsing its previous peak in late March of 2013. In 2017 alone, there have been 30 new record highs through the end of last week. To put this into perspective, there were only 13 new highs for the entire decade of the 2000s.” One might easily be excused for believing this market is truly different. It’s been rising pretty steadily since March of 2008. But conversely, one might also use the rationale that this is exactly the kind of environment that precedes a market drop.

While fear and greed drive markets to excessive heights and depths, typically in the short term, much of the middle ground of market movement is driven by the numbers – corporate earnings and the prospect for the future of those earnings. Logic controls the middle ground, not emotions. That’s a relief because we trust order and reason considerably more than emotions.

Stocks are trading at higher multiples than average for some very good reasons. Interest rates remain very low so companies can borrow inexpensively, thereby generating higher earnings. Similarly, companies have garnered higher profits by producing their products and services with fewer workers. And the significant driver of higher stock prices today is the prospect of meaningfully lower taxes, and possibly, soon. Lower corporate taxes lead to higher corporate earnings. Lower individual taxes lead to higher consumption rates, taking corporate earnings higher still. As the economy grows, corporations invest their higher profits in more growth and the virtuous cycle continues, propelling stock prices to higher highs.

Focus vs. Timing

While understanding the extent to which the logic of earnings explains the long trends of stock prices and the emotions of fear and greed stir the short-run may help some feel better, the question in today’s title remains unanswered. The concern over stocks rising and falling should be more one of focus and degree, rather than of timing.

It is well proven, through our own personal experiences and through analytical studies, that no one times markets consistently enough to avoid all the downturns that will occur over a lifetime of investing. People who have been successful avoiding large downturns once or twice are not able to repeat with any consistency or confidence.

It is said over and over about stock investing that your focus should be on the long term. That’s true, but it’s not today’s main point. Your focus, both long-term and short-term should be on your whole investment portfolio, not just on your stocks or the stock market. Stocks are interesting and even exciting, but they are but one component of a well allocated portfolio. Your investment portfolio should be carefully designed to consider the appropriateness of risk, volatility, diversification, and efficiency, to get you through a lifetime of wealth accumulation and distribution.

Stocks are noisy. Portfolios by comparison can be dull and plodding. So that’s why focus is so important. The chart below illustrates the past ten years’ performance of the Dow Jones Industrials between January 2007 and December 2016. Ignoring the the circles for a moment, you might notice the general trend is rather steadily upward – in fact a double, from $100 to $200 over the 10-year period.

Now for the circles. Even though the Dow doubled in value these past ten years, the gains haven’t come without pain. The circled dips, from left to right, represent declines of 55% 14% and 15% respectively. Now take a look at what the indexes representing  our model portfolios did over the same ten-year period.

The colored lines represent eight of our model portfolios with varying allocations of stocks and the risk stocks add. Notice how the top lines (light blue, black, and green) are considerably less wavy or volatile.  The light blue line on top represents the indexes comprising our Beacon 30 model, which contains 30% stocks. The table to the right demonstrates how three of our model portfolios fared relative to the Dow Jones Industrial Index during the same three market drops.

During the peak to trough drop of the Great Recession ending 3/7/2009, the Dow lost 55%, while our most conservative Beacon 30 gave up only 3%. The other two, the B45 and B60 lost 15% and 25% respectively.

A look at the other two more normal dips reveals the same relationships. The portfolios containing less than 100% stocks, do not suffer as badly as the 100% stock Dow Jones index. Simply put, your portfolio should not suffer the same degree of volatility that the stock market does.

Now let’s shift our focus from the relatively short-lived periods represented by the circles to the longer 10-year period represented by the chart above as a whole, with visits to the troughs along the way. The dates to the left represent the bottoms of severe market corrections.

The first line of the table  represents the bottom of the trough caused by the financial crisis ending 3/7/2009. During the period from 12/31/2006 through 3/7/2009, stocks, as represented by the Dow Jones Average, declined in value by 50%. Just a little more than nine years later, by 2/11/2016, stocks had managed a 57% gain. But look at the indexes comprising the three Beacon portfolios. The B30 was up 69%, the B45 was up 71% and the B60 was up 69%. Notice that during this 10-year period (largely because of the large drop in ’07-’08), it has not paid to focus purely on stocks rather than more conservative portfolios.

When investing for a lifetime, focus is much more important than timing. Focus on controllable things like risk-appropriateness, expenses, taxes, and asset allocation is rewarded with greater wealth and confidence of achieving lifetime goals. Attempts at timing market losses or gains, in this writer’s experience, are futile and all but guarantee less than optimal outcomes.

If you are concerned about today’s markets, please give us a call. We will listen to and respect your concerns. But we will also do our best to re-focus your attention on the aspects we believe are so much more important than the relatively short-term stock market drops.