Wow! What a year for stocks. On the heels of a 16%+ year in 2012, the S&P 500 nearly doubled that return in 2013. The question most investors are asking themselves today is “How high is up?” Can the market possibly continue at this pace in 2014?
Most smart investors find it difficult to buy when the markets are at all-time record highs. The S&P 500 Index and many other broad indexes soared to new records in 2013. The sentiment among mainstream investors is unmistakably bullish. Corporate profits, improving unemployment, a lower government deficit, and a more confident consumer have all been cited as reasons for the market’s strong performance. How will these factors play into the performance of the market going forward?
I warned investors about allowing pessimism to cloud their judgment during bear markets. The same warning goes for allowing euphoria to get in the way of a well-balanced investment strategy. Emotions generally begin affecting investment decisions when the market moves strongly in either direction. Some investors may feel like they’ve missed out of the rally in 2012 and 2013. They may feel compelled to invest now rather than risk missing another year of gains.
The market typically has a pullback of 10% or more roughly once each year, even during an ongoing bull market. This market has not seen a drop in the S&P 500 index of 10% since December 2011. A 10% drop in a major stock market index is called a correction. A bear market is defined as a 20% or greater decline in a major stock market index. A bear market has occurred, on average, once every five years since 1956. On March 9th of this year it will be 5 years since the major stock market indexes troughed in early March 2009. None of this means 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.
The concept of reversion to mean is talked about a lot by many investing greats, including Jeremy Grantham and Dr. Jeremy Siegel to name a few. In Dr. Siegel’s groundbreaking book, Stocks for the Long Run, he refers to stability in long-term returns “called the mean reversion of equity returns.” His book researches the return for stocks back to 1802. Dr. Siegel concludes that stocks have returned on average 6 ½ – 7% per year after inflation. He recently argued that the “mean-reverting” nature of stock returns points to several years of strong performance as markets are still 10-15% below their trend line.
Obviously the direction of the market at this junction is unclear. A case can be made for a correction as well as a continued rally. Unfortunately the future direction of the market is never clear. Millions of investors waited on the sidelines in 2009 for direction of the economy and the markets to become clear. Many more waited for the correction this year that never happened. No one can time the market. You need to accept the fact you will be invested during market corrections and rallies.
Planning for 2014 should begin with a review of your investment strategy. The strategy should include an allocation for growth and low risk investments. This allocation should be monitored regularly to take advantage of strong stock markets like 2013 produced. This is the time to harvest some of 2013’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.
Part of your review should include a fire drill 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 2013’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.
Stock market corrections happen, and it pays to be ready for them. The best time to prepare is while the market is still going up. Having a clear head and a concise plan will help you make it through the down markets.
- Strong corporate profits, lower unemployment, smaller deficits, and confident consumers contributed to the market’s strong performance in 2013.
- The market typically has a correction (10% or more drop) once each year.
- Stocks for the Long Run concluded stocks have returned on average 6 ½ – 7% per year after inflation over the past 200 years.