10/16/13 – Looking Over the Cliff, Again

Posted by Brad McMillan, CFA, CAIA, MAI

This entry was posted on Oct 16, 2013 12:36:11 PM

and tagged Market Updates, Politics and the Economy

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I’ve spent quite a bit of time over the past couple of days talking with advisors about the potential consequences if the government doesn’t make a deal in time. Yesterday, I did an interview with Chuck Jaffe of MoneyLife Radio that focused on exactly that. As we move closer to the supposed drop-dead date—that would be tomorrow—I thought it would be useful to look at how I’m thinking about investing.

First of all, let’s hit a couple of points I’ve made before. In the longer term, the events of the next week or so will not be significant. The U.S. economy is diverse, solid, and set to outperform for at least the next 20 years and probably more. Markets will reflect that growth, and, longer term, you absolutely want to be invested here. At the same time, current valuations are at the very least not cheap, and it’s been some time since we’ve had a correction in the U.S. stock market. Quite apart from the current situation, we are overdue. Again, this isn’t to minimize what might happen, simply to put it in context.

The standoff in Washington, DC, doesn’t help, of course. The last time we ran this close to the deadline, in 2011, the S&P 500 dropped more than 16 percent. The fact that the market has held up thus far either suggests that it’s correctly pricing in a deal or that we’ll potentially see an even sharper drop if we don’t get one. Either way, it doesn’t seem possible to predict what the market will do without knowing whether, when, and how a deal will be cut in DC.

So what do we do? While everyone is different, for someone with a decade-plus time horizon, investing regularly and dollar-cost averaging, continuing what you’re doing may be a consideration. If the market does tank, you’ll be buying more cheaply than you would have, and you may have the time to recover from any short-term losses. A decade from now, I believe this will be a blip, although possibly quite a big one. Who, now, is still traumatized by the dot-com crash of the early 2000s?

For those with a large pot of money, it may be a good idea to start phasing it in regularly over a period of, say, six months, dollar-cost averaging as above, or, at the very least, wait until a deal is cut before making a decision. You might opt to give up a pop after the deal, but you’ll also hopefully try to avoid the risk of a drop in the absence of a deal.

For people with a large amount invested and a shorter time horizon, it may be helpful to look to your asset allocation. If you have so much in stocks that a correction would do meaningful damage—or mean that you can’t sleep at night—you may have too much in stocks. A diversified portfolio can help mitigate any damage from a market correction, as well as help preserve your chances for future gains.

Finally, for people who just refuse to take the risk, consider calculating how much you’re willing to pay to potentially avoid that risk—and pay it. It might mean selling some of your holdings and paying the taxes. The costs there, though, could go beyond the taxes into the potential foregone gains if you fail to buy back in. Many people who sold out in 2009 are still out and have missed the gains since then. If you choose that route, consider deciding how and when you will reinvest—and then do it. Make no mistake: any of these courses will cost you money with certainty—as opposed to a (at this point) theoretical loss.

Morningstar has put out a piece saying investors should sit tight. BlackRock’s Global Allocation team has a fairly typical asset allocation to stocks right now, according to a speaker I heard yesterday. With the caveats described above—and despite the very real possibility of market volatility—I hold to my prior suggestion that, for most investors, the greatest long-term risk is overreacting to current events.

Easy for me to say, possibly, but I, too, am an investor with a 401(k), a mortgage, and a five-year-old son who will be going to college if I have anything to say about it. I get the fear, but I also get the need to maintain a longer-term perspective and not be overcome by shorter-term risks. I hope I don’t get the chance, but I have a plan in case I do. I suggest you make a plan as well.

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