By Larry Swedroe
From an emotional perspective, steep market declines are difficult to deal with, as we tend to feel the pain of a loss twice as much as we feel the joy from an equal-sized gain (the ratio increases with the size of the investment).
Research also has found that losses even lead to physical responses, such as pupil dilation and increased heart rate. This has been found to be true even for people who weren’t naturally averse to losses.
The problem is that emotional responses can lead us to “catastrophize”—not only focusing solely on the negative news, but assuming the worst will occur. For investors feeling like they have been punched in the stomach, it seems like there’s plenty to worry about (which is almost always the case).
Issues include the risk of a full-scale trade war; the government shutdown; at 27.5, the Shiller CAPE 10 is still well above its historical average; the yield curve is inverted (the yields on three-year Treasury notes, at 2.47%, and five-year Treasuries, at 2.49%, are below the two-year Treasury bill’s yield of 2.50%); the Federal Reserve continues its great experiment of unwinding its balance sheet, which had peaked at $4.5 trillion and ended 2018 at $4 trillion; massive budget deficits continue; and many geopolitical risks (including Brexit, the Italian budget crisis, Russian aggression, and the death of journalist Jamal Khashoggi complicating relations with Saudi Arabia) exist. Unfortunately, catastrophizing often leads to panicked selling and the abandonment of even well-thought-out plans.
Not All Doom & Gloom
To help you keep a balanced perspective, I’ve compiled a list of some economic positives of which you should also be aware. Focusing on them might just keep you from what I refer to as committing “portfolio suicide”—that is, panicked selling, which is difficult to recover from because there is never a green light letting you know that it is safe to get back into the market.
Thus, it’s my experience that, once you sell, unless you are extremely lucky, you’re virtually doomed to fail. Here’s a dozen positives to keep in mind:
1. U.S. economic growth is strong. This year, GDP growth is expected to come in at about 3%. The consensus forecast from the Philadelphia Fed’s Survey of Professional Forecasters for next year is for growth of 2.7%.
2. Inflation remains well-contained. The Consumer Price Index is expected to show an increase of about 2.4% for the full year. Next year’s consensus is for it to be virtually unchanged, at 2.3%. Continued low inflation reduces the Fed’s need to raise interest rates.
3. Despite four rate increases in 2018, monetary policy is still quite easy. With the federal funds rate target now between 2.25% and 2.5%, the real rate of interest is effectively zero. In addition, with the 20-year Treasury yielding about 2.8%and the one-month Treasury yielding about 2.4%, the term premium (the difference between the 20-year and the one-month bonds), at 0.4%, is well below its historical average. Since 1926, the realized term premium has averaged 20 basis points a month. Thus, we have historically low real short-term rates and low real long-term rates.
4. The unwinding of the Fed’s quantitative easing (bond-buying program) has not hampered the economy. The Fed has overseen a reduction in its securities portfolio and the excess reserves that reside in the banking system for 15 months now. As I previously mentioned, its balance sheet has shrunk from its peak of about $4.5 trillion at the end of 2014 to about $4 trillion at the end of 2018. The economy appears strong, and bond yields are at about the same levels they were at the end of the first quarter of 2018. In addition, there is plenty of liquidity in the financial system. In other words, while many warned about dire consequences, the Fed has been successful so far in unwinding the great experiment that was quantitative easing.
5. Fiscal policy is very easy. In addition to a stimulative monetary policy, we have a stimulative fiscal policy, with the federal budget deficit expected to be $1 trillion for fiscal year 2019.
6. Corporate earnings are strong and generating lots of cash. The S&P 500 companies are expected to report 2018 per-share earnings of $163, up from $125 in 2017. The 30% increase was fueled by not just the strong economy, but the cut in the corporate tax rate. 2019 is expected to be another good year, with a forecast of per-share earnings of $175, an increase of about 7%.
7. Stock prices are lower and balance sheets are loaded with cash. Corporate buybacks reached $203.8 billion in the 2018’s third quarter, an all-time high. For the 12-month period ending September 2018, S&P 500 companies spent a total of $720.4 billion on buybacks, up 39.1% from $517.7 billion during the corresponding period in 2017.With continued strong earnings and strong balance sheets, and stock prices now much lower, companies are likely to continue their buying, providing support to stock prices.
8. Institutional investors will be buyers. Disciplined institutional investors who stick with their financial plans and rebalance will now be doing so (as you should be also). The sharp drop in stock prices likely will cause them to sell bonds and buy equities.
9. The “January Effect.” Year-end pressure from tax-loss harvesting is typically reversed in January. The pressure from tax-loss selling can have a large effect on the prices of less liquid, small-cap stocks, especially in bear markets when liquidity tends to dry up.
10. Progress on Trade Talks. President Trump tweeted that he had made “big progress” on trade talks with China’s President Xi. With China’s economy experiencing a dramatic slowdown (the manufacturing purchasing managers index dropped to 49.4 in December, the weakest since early 2016, and below the 50-point level that denotes contraction), the pressure on Xi to get a deal and reduce tariffs is increasing.
11. Unemployment is at its lowest levels in nearly 50 years. The continued drop in the unemployment rate to 3.7% is putting upward pressure on wages. In addition, 22 states are raising minimum wages in 2019 for 17 million workers. And there likely will be secondary effects on other workers, who will see their wages rise. This is anticipated to help fuel consumer spending.
12. Consumer confidence remains at high levels, despite the recent drop in stock prices. At 98.3, the December Michigan Survey of Consumer Confidence remained last month at the same record favorable levels as it had throughout last year. The Sentiment Index averaged 98.4 in 2018, the best year since 2000, when it was 107.6. For good reason, consumer sentiment is one of the leading economic indicators; it accounts for about 70% of the economy.
Obviously, you don’t have to look far for reasons to avoid catastrophizing. Focusing on the good things can help keep you from making poor financial decisions.
That said, as to what will actually happen, as always, my crystal ball remains cloudy. And it’s important to understand there are no clear crystal balls anywhere, only legends in their own minds who believe they have a clear view of the future.
Investing in stocks is always risky. But that’s a good thing, not a bad one. Remember, bear markets are simply a feature of the stock market, not a problem. Without them, there would be no risk and, therefore, no equity risk premium. And we would not like that world.
This commentary originally appeared January 4 on ETF.com
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