Back in April and May, I had an item on my To Do list to write a post discussing the potential for a summer stock market correction and explaining what we’d do in the event that it happened. Don’t go looking for it because I didn’t get around to writing it. While I thought it was a good possibility that the stock market would finally show some volatility after nearly four years of steady gains with very few minor drops, the money managers that we talked with during that time period were generally very bullish. And during the second quarter we talked with many of the largest money managers in the world and travelled from New York to San Diego to Jackson Hole to gain their insights.
This morning the Dow Jones Industrials Average started the day down over 1,000 points. That was on top of an 800+ point combined loss on Thursday and Friday. The definition of a stock market correction is a 10% or greater drop from the recent high and the Dow managed that on Friday, while the broader S & P 500 index joined in this morning. Though it has been about four years since the last stock market correction, they are really normal. In fact, over the past 20 calendar years we’ve had a correction in 13 of them. The average intra-year drop (from high to low) has been a bit over 15% according to JP Morgan Asset Management.
The concern, of course, is that stocks will fall again as they did in 2008, when the drop from top to bottom was about 50%. But that was really rare. If we look back at the past 75 years, the stock market only dropped 50% three times, during 1973-74, 2000-02, and the 2008-09 decline. In 1973 we had the oil embargo followed by Watergate and the president’s resignation in 1974. The 2000-02 decline followed a huge surge in stock prices in the late 1990’s that drove valuations to at least 50% higher than they are today. And the 2008 crash was due to a global credit crisis as interest rates soared. Today, there is concern about China’s slowing economy, but we don’t see anything that would drive stock prices down dramatically.
The Game Plan
So if we go back to the spring, let me share what I would have written about a stock market correction game plan. The first thing is that it’s impossible to know what stock prices will do in the short term. While the financial channels on TV are enjoying surging ratings today and rolling out pundit after pundit, their track records are pretty awful and, of course, they don’t all agree. Trying to time the short term moves in the stock market is a fool’s game. Even if you are right on timing a move out of stocks, you have to be brave enough to buy back in when prices are down. And even if you get it right, the higher taxes on short term vs. long term capital gains can wipe out your advantage.
Human nature suggests that we should react to a big drop in stock prices. We naturally extrapolate the latest trend and assume that prices will continue down. Investors are very good at selling low and then chasing stocks again when prices rise and its “safe” to go back into the market. Unfortunately, the results have been well documented by Dalbar and Morningstar and this behavior costs the average investor a few percentage points a year on average.
At Vintage we regularly review the relative merits of all kinds of different investments from large cap US stocks, to emerging markets, high yield bonds, real estate, commodities and more. We try to determine what types of investments offer the best risk/reward tradeoff for the next 2-4 years. When we look at stock market valuations today, we see that the S&P 500 is trading at about 17.4 times the earnings expected for the next year. That means, at Friday’s level, your share of the earnings comes to 5.75%, with a little over 2% of that paid out in dividends. If we look to the ten year US Treasury bond, yields this morning slipped to under 2%. And, of course, cash and CDs pay well under the rate of inflation. Whether you are a younger person investing for the long term or a retiree looking for income, some of the best yields today are still from US stocks, especially on an after-tax basis.
In short, we’re still very comfortable owning stocks. This volatility is normal and will likely stick around in the coming weeks, though we’re hopeful things will settle down soon. We’re watching the markets closely and will try to take advantage of any bargains that appear in the coming weeks. Some of our clients have contacted us and want to add to their portfolios today. If you got some extra cash on the sidelines there’s a summer sale going on! While stocks are certainly cheaper, we also like the opportunity in high yield bonds as yields have climbed to over 7% in recent weeks.