The Independent Market Observer

8/28/13 - Risk Off the Charts? Or Not?

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Aug 28, 2013 8:59:31 AM

and tagged Market Updates

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With the S&P 500 down almost 5 percent from its peak, and a drop yesterday, I am starting to hear from investors who are asking, “What is going on? Do I need to worry?” The short answer is, it depends on your portfolio and your time frame.

I have written extensively about how the market is either somewhat or very richly valued, based on historical standards, and how most of the appreciation this year has come from investors paying more for a given stream of earnings, rather than from an increase in the earnings themselves.

I have also written about how it has been much longer than usual since there has been a meaningful correction in stock prices. Corrections are unsettling when they happen—no one likes to lose money—but ultimately they are both necessary and healthy, as they serve to reconnect market prices with fundamental values and, quite possibly, to present buying opportunities.

The most recent decline is best compared with the drop a couple of months ago following Fed Chairman Bernanke’s comments, when the market thought tapering was imminent. It was not, then, but it may well be now. The previous decline of around 5 percent suggests that, with interest rates now having seemingly priced in much of the taper, the current decline may be played out.

On the other hand, this time around the taper looks much more possible from an economic perspective, although with political risk on the debt ceiling moving back into front-page territory, my initial reservations seem well founded. Other risks are also becoming more visible, with Syria and rising oil prices leading the list. We have seen market volatility spike once more, suggesting that investors may not be as quick to start buying again this time.

The technicals have also weakened substantially. Jim McAllister, our equity analyst and research manager here at Commonwealth, put out an internal note yesterday pointing out that we have now been below the 50-day moving average for longer than he feels comfortable with, and just yesterday we cracked the 100-day moving average. Definite signs of weakness.

We are also entering what has historically been a volatile time of the year for the stock market, although we should not make too much of this, since, in the words of Mark Twain, “October: This is one of the particularly dangerous months to invest in stocks. Other dangerous months are July, January, September, April, November, May, March, June, December, August, and February.” Nonetheless, we do tend to see more volatility in the fall.

When you add up all of the pieces—a market that is still very richly valued by historical standards, slowing growth in both revenues and earnings, rising interest rates, weakening technical factors, and political tensions both domestic and international—and combine them with the fact that we still have not had a substantial downturn in much longer than usual, it suggests that the market could be headed for a rocky time. Be aware of that, and be prepared.

That said, such a scenario is normal and usually healthy. For investors with a diversified portfolio (which should be everyone), declines in stocks can be offset by gains in other asset classes. For those still putting money in, a pullback can represent a buying opportunity. For those now drawing down their portfolios, a pullback can present an opportunity to reallocate investments to potentially create higher returns over time.

To answer the question I posed at the start of the post, if a market drop, and potentially a substantial one, over the next several months will radically impact you, then you should be worried—but if that is the case, you should also not be in the stock market. If, on the other hand, you have a diversified portfolio with a multiyear time horizon, then it certainly will not be fun if the market tanks, but you should not be worried.

Occasional pullbacks, some lasting quite a while, are the price we pay as equity investors for higher returns over time. Although this is certainly a risk, it is a much lower risk than the certainty of losing purchasing power through inflation, and with proper planning, it can be substantially mitigated.

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