Blue Haven

When stocks go down bears come out

By July 23, 2019 No Comments

The current expansion is now tied for the longest-lasting US expansion in the post-war era. The chart below, from Factset, shows that expansions have been lasting longer and longer since the 1980s. In addition, it shows that when expansions have ended, a new one has started again the very next year. In short, good times tend to last way longer than bad:

What does this mean? To us, it means what it says it means: the US economy is growing. This is consistent with low unemployment, consistent job growth, and rising stock prices. We don’t know how long the expansion will last. Moreover, we don’t know what the market will do when it ends. Though we can guess that the market will probably go lower on some level. However, what we can say with greater certainty is which way the headlines will go when the current expansion ends.

Fear sells, so don’t be scared

When the expansion ends you will see grave headlines such as, “Stocks set to crash 50%” or “Get ready for 2008 part 2.” Financial talk shows will parade out “experts,” all of whom will have dire predictions for the US economy. Friends and colleagues, who never talk to you about markets, will all of a sudden ask how your 401(k) is doing. You will likely find yourself consuming more financial news than usual, sometimes on a subconscious level. This is the most predictable behavior of all when it comes to markets and investing.

While it is possible that the market can experience a 50% drop, it isn’t likely. Even 25% drops in the market are historically rare. Since 1946, the S&P500 has dropped 25% or more just 8 times. Why are these drops so rare? The logical answer is because markets, in general, go up. And if they go up more often than they go down, you end up with stats that are skewed to the upside. The best predictor of when markets are about to go down is when they actually start going down. Anything else is just a guessing game.

A simple allocation calculation

Depending on where you are in your life, you may look at the possibility of a large market drop differently. If you’re in your 20s or 30s, a substantial market drop would actually give you an opportunity to invest at a great entry point. Had you bought the market during any of the 25% drops since 1950, you would have generated amazing returns. If you’re on the other side of 50, obviously the last thing you want to see is a giant drop in the stock market. That’s why it’s very important to have the appropriate allocations in your portfolio.

A simple equation for calculating your allocation to stocks and bonds is to take the number 120 and subtract your age. The result equals how much you should have allocated to stocks and bonds. For example, a 50-year-old would be 70% stocks and 30% bonds (120-50=70).

Bonds help stem the losses from stocks

In that case, a 25% drop in the stock market would be a 17.5% hit on the overall portfolio (70% of the portfolio falling 25% equals 17 1/2%). But keep in mind, such a drop in stocks is likely to be paired with a rise in bond prices. For example, in 2008 when the S&P500 fell 35%, an equivalent bond index was up more than 5%.

From 2000-2002, as stocks dealt with the tech bubble bursting and the tragic attacks of 9/11, bonds posted yearly gains of 11%, 8%, and 10%. If we assume a 5% return in our bond portfolio, that equates to a positive impact on our portfolio of 1.5% (30%*5%=1.5%). This would lower our losses from 17.5% to 16%. That’s still a large number, but it’s much less than 25%.

Even at age 50, you’re still likely 10-15 years away from retirement. Historically, that gives you more than enough time to recover stock market losses. It took the stock market 5 years to recover to new highs from the Great Recession in 2008. Bear in mind, 2008 was an extreme outlier. Statistically speaking, there is less than a 2% chance that a drop as large as 2008 happens again within the next 20 years.

The bottom line

At the age of 65, we’d recommend having 55% of your portfolio allocated to stocks and 45% to bonds. In that case, a 25% drop in stocks is going to result in a 13.75% drop to your stock portfolio. Assuming a 5% return from our bond portfolio, that will positively impact our returns by 2.25%. The total return for the portfolio would be (-11.5%). Still negative, but again, far less so than the 25% drop experienced in stocks alone. With proper rebalancing, your portfolio can weather stock market downturns far better than you might think.

When the US expansion inevitably ends, it wouldn’t be surprising to see stocks move lower over a 6-12 month time period. However, it’s very likely that the doom and gloom you see portrayed will be far worse than the reality of the situation. Remember that the end of an economic expansion is typically followed by a new expansion within 1-2 years. It’s statistically rare that markets experience drops of 25% or more, even during recessions. And if you are properly diversified a large drop in stocks won’t impact your total portfolio as negatively as you might think. So the next time someone tries to scare you out of the market, they’re just doing what we’d expect them to do.

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