We are now nine years into one of the longest bull markets in U.S. stock market history. The Dow Jones Industrial Average has risen more than 280% from the low on March 9, 2009. The question many investors are asking themselves today is “How long can this continue?” Can the market possibly continue at this pace in 2018?
Corrections1 and bear markets2 are common and should be expected as part of a normal stock market trading pattern. Corrections are considered necessary “resets” that enable financial markets to provide sustainable long-term growth. Corrections typically occur about once every year, and bear markets about every four years. Despite these frequent pullbacks, the stock market has historically recovered quickly.
Even smart investors find it difficult to buy when the markets are at record highs. The stock market appears fully valued when looking at the current price-earnings ratio. A continued flow of increased profits could push stock prices higher, but what will drive profits going forward?
Temper your emotions.
During bear markets, I warn investors about trying to time the market and allowing pessimism to cloud their judgment. The same warning holds true when markets are at all-time highs. Don’t let market timing get in the way of a well-balanced investment strategy. Emotions generally begin affecting investment decisions when the market moves strongly in either direction.
Avoid the temptation to let your portfolio get out of balance to avoid paying tax on capital gains. When the next correction comes along, you don’t want to be over weighted in stocks. New market highs and big sell-off days should be a reminder to review your allocation and rebalance if needed. This market has not seen a correction since February 2016. This does not mean a drop in the stock market is eminent. However, it should prompt you to consider your investment strategy and what your plan will be if a correction occurs.
Review your investment strategy.
Investment planning for 2018 should begin with a review of your investment strategy. The strategy should include an allocation to growth and low risk investments. This allocation should be monitored regularly to take advantage of the strong stock markets like 2017 produced. This may be a good time to harvest some of 2017’s gains by rebalancing the allocation back to your investment strategy guidelines. Don’t let market euphoria or greed cloud your judgment into thinking you’ll wait until the market is about to correct. There will not be a red flashing light to signal the market has reached its peak and it’s time to get out. Just like there wasn’t a green flashing light on March 9, 2009 to signal the market bottom.
Stock market corrections happen regularly, and it pays to be ready for them. The best time to prepare is while the market is still going up. Part of your preparation should include having a plan in the event the stock market corrects. What is your plan if the market drops by 10% or 20%? Hopefully it does not include panic. How would you react if you lost half of 2017’s gains in the next three months? We refer to this as a fire drill with our clients. Knowing this could happen and what the plan of action will be if it does helps them to cope with the emotions they are likely to feel.
Plan for cash and/or other fixed income positions.
You will want funds on hand to allow you to add to stock positions when the market falls as part of your rebalancing strategy. You also need to plan for any short-term liquidity needs. This will help prevent the need to sell stocks to raise funds when the market is in a correction. We believe bonds are the best place to keep funds for this role. Bonds can provide liquidity when invested properly. Our bond portfolios usually have staggered maturities no longer than five years. The goal is to have an equal amount of bonds maturing every twelve months. Liquidity is provided as the bonds mature on a regular basis – usually about every three months. This reduces the need for a client to hold a sizeable amount of money in cash. Maturing bonds usually earn more than “cash” and can provide for planned and even unplanned purchases.
Bonds also provide a place to store some of the gains when equities are moving higher. Rebalancing allows us to capture some of the gains and add them to the bond ladder. The opposite occurs when equities prices are falling. Rebalancing provides the discipline to buy equities when prices are down. This discipline helps to smooth out some of the volatility.
Concern over the stock market reaching a new high is market timing in disguise. No one can consistently time the market. The good news is that market timing is not required to be successful. The financial press would like you to believe that you need to be in the market at the right times and out of it when things are bad. Just keep tuning in for more information. The truth is that the stock market is driven by many factors, of which most can never be anticipated. Successful investing has more to do with controlling your behavior. Make sure you have a long-term strategy in place and make a resolution that you will follow it, even when the financial press tells you it’s time to panic.
• Stock market corrections typically occur about once every year and bear markets about every four years.
• This market has not seen a correction since February 2016.
• Bonds can provide liquidity by staggering maturities, so they mature on a regular basis – usually about every three months.
1 A market correction is when the market falls 10% from its 52-week high.
2 A bear market is when the market falls 20% or more over at least a two-month time frame.