When the stock market is near record highs, it's more important than ever to think about risk.
Don’t let history repeat itself.
You’ve heard that phrase before, likely as a warning to those who might be traveling down the same dangerous path as those before them. But it’s also currently the most important piece of advice I offer to clients.
Recently, I’ve been helping clients rebalance portfolios that have become stock-heavy due to the bull market that’s taken the S&P 500 up 194% since March 2009. With the bull now more than five years long and memories of the financial crisis starting to fade, I’m finding that investors aren’t exactly excited about reducing their stock allocations.
One of my duties as a financial adviser is to encourage my clients to rebalance their portfolios to the levels that we agreed made sense for them given their risk tolerance. In August, however, the S&P 500 topped 2,000 for the first time, giving investors a new boost of confidence.
And although seeing the market at new highs is exciting, let’s not forget that markets can go the other way too. On October 19, 1987, the Dow fell 22.6% in just one day. Applied to current levels, a 22.6% drop would be 3,801 points. During the financial crisis, from October 11, 2007 through March 6, 2009, stocks fell 57%, which would be 9,586 points today. I don’t expect anything that drastic to happen anytime soon, but investors need to remember that bear markets — declines of 20% or more — historically have occurred on average every four-and-a-half to five years.
So even though I’m a big believer in holding stocks for the long run, lately I’ve been making a point to show my clients how portfolios like theirs would’ve performed during previous bear markets, including the crash of 1987 and the financial crisis. I help them understand not just stocks’ growth potential but also the risks associated with achieving that growth.
At times like this I talk about risk for two reasons. First, focusing on risk prevents clients from being caught up in the moment and making choices that they may regret. Second, risk is still very much a reality. Investors are more optimistic these days, but this optimism allows them to be tempted to abandon their rebalancing strategies in order to maintain or increase their exposure to the aggressive side of their portfolios, which reduces the downside protection that rebalancing back to bonds and cash may offer.
No matter how the market performs, I reinforce investment discipline by coaching clients to stick with their investment plans. Past performance is not a guarantee of future returns, but a good way to cut the odds of repeating the history of buying high and later selling low is to rebalance in a disciplined way. For many investors, that could mean reducing stock exposure and adding to bonds — especially at times like this, when our impulse is to do just the opposite.
David A. Schneider, CFP, is the principal of Schneider Wealth Strategies, a financial services firm based in New York City. Schneider has more than 25 years of experience in the wealth management industry and specializes in the planning needs of business owners, professionals, and affluent individuals. He is a registered representative of Cambridge Investment Research and an investment adviser representative of Cambridge Investment Research Advisors. Schneider is also a member of the Financial Planning Association.
Note: The S&P 500 and the Dow are stock market indices containing the stocks of American large-cap corporations. An index can’t be invested into directly. Asset allocation does not guarantee a profit or protection against loss.
Nothing. You should do absolutely nothing. Here's why.
[Update: The DOW went up 216 points on Oct. 23.]
The Dow Jones Industrial Average has long been held up as the stock market index to follow. Now that the Dow Jones is at such a high level, even moves that are small on a percentage basis allow for attention-grabbing headlines like “Dow Jones Today Skyrockets Over 200 points!” or “Dow Jones Plummets 150 points!”
While these headlines lure in readers, they do nothing to make us better investors. Read on to see why the best investors ignore the daily movements of the DJIA.
Dow Jones today
Do you remember when the Dow jumped 220 points after tensions with Ukraine moderated? How about the 200-point drop after Chinese industrial production slowed, or the 180-point jump following the release of minutes from the secret early-March meeting of the Federal Reserve?
I doubt it.
And don’t get me started on early October. The Dow Jones Industrial average dropped 272 points on a Tuesday — its biggest drop of the year to that point. The next day, the Dow jumped 274 points — the Dow’s biggest gain of the year. Then, on Thursday, the Dow fell 334 points.
The headlines would have you think the world is ending or that you won’t be able to retire because of these market dips. The stock market is one of the few places where, whenever things go on sale, no one wants to buy.
However, these moves only amounted to a 2% drop from the end of the previous week. To put that in an even bigger-picture perspective, the Dow is basically flat year to date.
What you should do now?
Nothing. You don’t have to do anything. If your investment strategy changes based on one day’s market movements, you’re doing it wrong. Your focus should be to stick to your plan, constantly educate yourself, and invest for the long term. And if you don’t have a clear strategy, this is your wake-up call.
Research has shown that process is one of the biggest determinants of success in the market over the long term. While your process can yield good or bad results in the short term, those with a proven process do better than the average investor over the long term.
For total beginners, I would first suggest learning about how the market works and how you can do at least as well as the market through index investing. I highly recommend The Little Book of Common Sense Investing by John Bogle as a great place to start.
If you understand the basics of the market as well as index investing, check out The Motley Fool’s 13 Steps to Investing Foolishly, which will teach you the process The Motley Fool has used to consistently beat the markets over the long term.
Everyone can learn from this
For every investor, focusing too much on daily market movements is a mistake. Things happen for no discernible reason. Rather than wasting time wondering why the market is up or down by a percent or two, we should focus on business fundamentals and continue to search for quality stocks trading at bargain prices.
We also must keep calm and not make rash decisions based on short-term market moves. Research has shown that it is far better to focus on minimizing mistakes, rather than overreaching for greatness. As economist Eric Falkenstein wrote: “In expert tennis, 80% of the points are won, while in amateur tennis, 80% are lost. The same is true for wrestling, chess, and investing: Beginners should focus on avoiding mistakes, experts on making great moves.”
And as Warren Buffett’s longtime business partner Charlie Munger said: “We try to profit more from always remembering the obvious than grasping the esoteric. It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
My Dow Jones Industrial Average prediction for today
The Dow Jones Industrial Average will continue to fluctuate. That’s a given, and we have no control over it. What you can control is your reactions to those fluctuations — and the best reaction is usually no reaction.
Dan Dzombak can be found on Twitter @DanDzombak, on his Facebook page DanDzombak, or on his blog where he writes about investing, happiness, life, and success in life. He has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Last week's tumultuous week in the stock market sets the stage for yet more nervousness and hand-wringing as a fresh set of earnings and economic data are due to be released.
When Wall Street opens for business on Monday morning, will bad news about the global economy be bad news for stocks?
That was the case for most of last week, when the equity market was hit with a frightening sell-off that reminded investors of the bad old days of the financial crisis.
Or will bad news turn out to be good news for the market, as was the case on Friday, when the Dow Jones industrial average soared more than 260 points?
Friday’s dramatic rebound in stock prices reflected two forces that are likely to move the market in the coming days.
Keep an Eye on the Fed
At the end of this month, the Federal Reserve is slated to end its stimulative bond-buying program known as quantitative easing.
Investors are naturally nervous about this development, as quantitive easing, or QE, has been credited for the strength and length of what is now a five-and-a-half-year-old bull market. As many market observers have noted, Wall Street is about to lose a major psychological crutch.
Remember that when the Fed ended its prior two rounds of quantitative easing — in 2010 and 2011 — stocks sold off fairly quickly:
But late last week, when the market was in the throes of a selloff, St. Louis Fed president James Bullard said in a Bloomberg TV interview that “we could go on pause on the taper at this juncture and wait until we see how the data shakes out into December.”
In other words, a member of the Federal Open Market Committee that sets the nation’s interest rate policy is openly mulling whether the Fed should postpone ending QE in light of recent market volatility.
Bullard’s remarks on Thursday were enough to give the markets a lift in the last two days of the week. And if there are more signs of a major global economic slowdown, including a possible recession in Europe and Japan, then the Fed may have to think twice about how — and how soon — it ends its stimulus efforts.
This week, investors will want to see if more members of the FOMC sound similar conciliatory notes of extending QE. So far, no one else has. Boston Fed president Eric Rosengren, a major defender of QE, said on Friday that he does not expect the Fed to extend the program at this juncture.
What else should investors look for?
- Wednesday’s inflation report from the Department of Labor. If the global economic slowdown is starting to impact the U.S., we will start to see it in the form of lower prices for U.S. consumers.
- Thursday’s report on the index of leading economic indicators from the Conference Board. The LEI is forward-looking barometer of economic trends, so if the global slowdown is likely to affect the U.S. in the coming months, this index should offer clues.
Keep an Eye on Earnings
Last week’s bloody selloff was peppered by major earnings disappointments on Wall Street. For instance, there was Netflix, which reported that subscriber growth wasn’t as strong as expected and saw its stock lose more than a quarter of its value on Wednesday. Google also disappointed Wall Street on earnings and revenue growth, as well as on paid clicks on ad links.
The idea is that if Wall Street is about to lose its QE crutch, it will have to fall back on the fundamentals — so corporate profit reports will have to look good.
On Friday, a slew of companies led by General Electric and Honeywell announced better-than-expected results, which helped drive stocks higher at the end of the week.
Yet the mood on Wall Street regarding earnings is somewhat pessimistic. The strengthening U.S. dollar, brought about by the global economic slowdown, is expected to crimp global profits for U.S. exporters.
This week, several high-profile earnings announcements are due to be released. Here are the major ones to look for:
- On Monday, Apple is due to report its results after the closing bell. Everything Apple reports is news these days.
- On Tuesday, Coca-Cola will reports its results before the market opens. No company is as exposed to the global economy as Coke is.
- On Wednesday, Boeing is set to reveal its earnings before the market opens. The global slowdown is expected to hurt U.S. exporters, and Boeing could be a sign of how bad things have become.
- On Thursday, Amazon.com will report after the bell. Amazon isn’t just a bellwether of the tech economy, it is now a key gauge of the health of the U.S. consumer.
Take a deep breath and consider some historical context.
The funniest thing about markets is that all past crashes are viewed as an opportunity, but all current and future crashes are viewed as a risk.
For months, investors have been saying a pullback is inevitable, healthy, and should be welcomed. Now, it’s here, with the S&P 500 down about 10% from last month’s highs.
Enter the maniacs.
Those are words I read in finance blogs this morning.
By my count, this is the 90th 10% correction the market has experienced since 1928. That’s about once every 11 months, on average. It’s been three years since the last 10% correction, but you would think something so normal wouldn’t be so shocking.
But losing money hurts more than it should, and more than you think it will. In his book Where Are the Customers’ Yachts?, Fred Schwed wrote:
There are certain things that cannot be adequately explained to a virgin either by words or pictures. Not can any description I might offer here ever approximate what it feels like to lose a chunk of money that you used to own.
That’s fair. One lesson I learned after 2008 is that it’s much easier to say you’ll be greedy when others are fearful than it is to actually do it.
Regardless, this is a critical time to pay attention as an investor. One of my favorite quotes is Napoleon’s definition of a military genius: “The man who can do the average thing when all those around him are going crazy.” It’s the same in investing. You don’t have to be a genius to do well in investing. You just have to not go crazy when everyone else is, like they are now.
Here are a few things to keep in mind to help you along.
Unless you’re impatient, innumerate, or an idiot, lower prices are your friend
You’re supposed to like market plunges because you can buy good companies at lower prices. Before long, those prices rise and you’ll be rewarded.
But you’ve heard that a thousand times.
There’s a more compelling reason to like market plunges even if stocks never recover.
The psuedoanonymous blogger Jesse Livermore asked a smart question this year: Would you rather stocks soared 200%, or fell 66% and stayed there forever? Literally, never recovering.
If you’re a long-term investor, the second option is actually more lucrative.
That’s because so much of the market’s long-term returns come from reinvesting dividends. When share prices fall, dividend yields rise, and the compounding effect of reinvesting dividends becomes more powerful. After 30 years, the plunge-and-no-recovery scenario beats out boom-and-normal-growth market by a quarter of a percentage point per year.
On that note, the S&P 500’s dividend yield rose from 1.71% in September to 1.82% this week. Whohoo!
Plunges are why stocks return more than other assets
Imagine if stocks weren’t volatile. Imagine they went up 8% a year, every year, with no volatility. Nice and stable.
What would happen in this world?
Nobody would own bonds or cash, which return about zero percent. Why would you if you could earn a steady, stable 8% return in stocks?
In this world, stock prices would surge until they offered a return closer to bonds and cash. If stocks really had no volatility, prices would rise until they yielded the same amount as FDIC-insured savings accounts.
But then — priced for perfection with no room for error — the first whiff of real-world realities like disappointing earnings, rising interest rates, recessions, terrorism, ebola, and political theater sends them plunging.
So, if stocks never crashed, prices would rise so high that a new crash was pretty much guaranteed. That’s why the whole history of the stock market is boom to bust, rinse, repeat. Volatility is the price you have to be willing to pay to earn higher returns than other assets.
They’re not indicative of the crowd
It’s easy to watch the market fall 500 points and think, “Wow, everyone is panicking. Everyone is selling. They know something I don’t.”
That’s not true at all.
Market prices reflect the last trade made. It shows the views of marginal buyers and marginal sellers — whoever was willing to buy at highest price and sell at the lowest price. The most recent price can represent one share traded, or 100,000 shares traded. Whatever it is, it doesn’t reflect the views of the vast majority of shareholders, who just sit there doing nothing.
Consider: The S&P fell almost 20% in the summer of 2011. That’s a big fall. But at Vanguard — one of the largest money managers, with more than $3 trillion — 98% of investors didn’t make a single change to their portfolios. “Ninety-eight percent took the long-term view,” wrote Vanguard’s Steve Utkus. “Those trading are a very small subset of investors.”
A lot of what moves day-to-day prices are computers playing pat-a-cake with themselves. You shouldn’t read into it for meaning.
They don’t tell you anything about the economy
It’s easy to look at plunging markets and think it’s foretelling something bad in the economy, like a recession.
But that’s not always the case.
As my friend Ben Carlson showed yesterday, there have been 13 corrections of 10% or more since World War II that were not followed by a recession. Stocks fell 35% in 1987 with no subsequent recession.
There is a huge disconnect between stocks and the economy. The correlation between GDP growth and subsequent five-year market returns is -0.06 — as in no correlation whatsoever, basically.
Vanguard once showed that rainfall — yes, rainfall — is a better predictor of future market returns than trend GDP growth, earnings growth, interest rates, or analyst forecasts. They all tell you effectively nothing about what stocks might do next.
So, breathe. Go to the beach. Hang out with your friends. Stop checking your portfolio. Life will go on.
For more on this topic:
- What I plan to do when the market crashes
- 99% of long-term investing is doing nothing
- How I think about cash
Check back every Tuesday and Friday for Morgan Housel’s columns. Contact Morgan Housel at firstname.lastname@example.org. The Motley Fool has a disclosure policy.
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Sadly, there may be no safe havens this time. Stock investors typically turn to dividend payers and "low-volatility" stocks in rocky times. But those investments have gotten pricey.
When the stock market gets choppy, as it is now—the Dow Jones industrial average plunged by triple digits again on Wednesday — equity investors tend to set sail for calmer waters.
Historically, that’s led them to a few sheltered corners of the market.
First, there are high-yielding stocks, where payouts to shareholders serve as a cushion when stock prices crater. Dividend-paying stocks don’t prevent losses altogether—this is the stock market after all—but during the 2008 financial crisis, for instance, when the S&P 500 S&P 500 INDEX SPX 0.623% lost 37% of its value, the SPDR S&P 500 Dividend ETF SPDR SERIES TRUST DIVIDEND ETF SDY 0.7516% fell just 23%.
Investors also look for safety in so-called low-volatility stocks. These are shares of “steady Eddie” companies, often found in stable but slow-growing and boring businesses, that usually gain less than the broad market during upturns but lose less in downturns. Among the biggest holdings of the PowerShares S&P 500 Low Volatility ETF POWERSHARES ETF II S&P 500 LOW VOLATILITY PORT SPLV 0.9733% , for example, are Coca-Cola THE COCA COLA CO. KO 1.0742% and Warren Buffett’s insurance and holding company Berkshire Hathaway .
Normally, tilting your portfolio toward either of these types of stocks would make sense if you’re worried that the recent jump in volatility — as seen below in the CBOE VIX “fear” index — is a sign of worse things to come.
Trouble is, nervous investors jumped the gun and bid up shares of dividend payers and “low-vol” investments before volatility actually manifested in the economy. Indeed, from 2009 to the start of this year, dividend investing proved to be one of the easiest ways to beat the market:
In other words, these two conservative and time-tested ways to stay in stocks are now expensive on a relative basis. And recent history tells us that buying an overvalued stock is fraught with risk.
Take dividend payers. They typically sport lower price/earnings (P/E) ratios than the broad market because high-yielders tend not to grow that fast. (That’s why they return dividends to shareholders in the first place.) But these days the average P/E for stocks in the SPDR S&P 500 Dividend ETF is 18.3, based on projected future corporate earnings. By comparison, the average stock in the broad market trades at a P/E of 17.
Similarly, the average holding in the PowerShares S&P 500 Low Volatility ETF trades at a higher-than-average P/E ratio of 18.
The problem with these frothy prices is that they detract from the stability that these types of stocks normally provide. Feifei Li, head of research at Research Affiliates (a major proponent of low-volatility investing), published some thoughts last year about rising prices and valuations in the low vol space. Li noted:
Empirical evidence demonstrates that low volatility strategies offer higher-than-market returns and considerably lower risks… Not surprisingly, these desirable performance characteristics have attracted many players to the market … The fast pace of growth raises the question: Does the rapid flow into this space erode the strategy’s effectiveness in delivering attractive risk-adjusted returns? This is a legitimate concern.
Does this mean you should avoid low-vol stocks and dividend payers altogether? No, but it will take more work to find the handful of examples of these types of stocks that are undervalued and attractively priced.
Hey, no one said avoiding a downturn — while remaining in the stock market — would be easy.
The stock market gets all the headlines at times like this -- but it's bond and oil prices we should really keep an eye on.
The U.S. stock market opened Wednesday morning with a big sell-off. The Dow Jones Industrial Average plummeted about 350 points before partially recovering.
The Dow and other stock indexes like the S&P 500 always get the headlines when a market frenzy kicks in. But right now a more telling number may be the yield on 10-year Treasury bonds, which fell to 1.9% this morning, the first time in 16 months that it’s dipped below 2%. (Bond’s yields fall when demand for them goes up and their prices rise.)
A few minutes later it climbed back to around 2%. But only a month ago it was 2.6%.
The fact that investors are currently so eager to own Treasuries that they will accept a yield of 2% or less should worry us. After all, it’s widely believed that inflation will run at about 2% over the next decade—that’s the Federal Reserve’s target rate. This means investors are now ready to earn basically nothing in exchange for lending their money to the U.S. government.
They are willing to do so because Treasuries offer as close to a guaranteed pay-out as a long-term investor can get: Assuming you hold one until maturity — and that armageddon doesn’t strike — you basically know you’ll get your money back plus the yield. You’ve heard of “flight to safety?” This is it.
Take this market behavior as evidence that, even after the market plunge, plenty of pessimism about the prospects for growth is still sloshing around. Yes, the U.S. has been (slowly) recovering from the 2008-2009 financial crisis, but Europe now seems dangerously close to another recession, which would put a drag on the whole global economy.
You can see the same dynamic in the oil markets. Crude oil futures are getting close to $80 a barrel, from above $90 just last week. That may come a relief for drivers, but it means that global investors are collectively anticipating the kind of drop in demand that comes with a weakening world economy.
Bottom line: If you want to understand what the markets are saying about the future, keep an eye on bond yields and oil prices, not only the stock market.
Sharp one-day drops in the market can be unnerving, but they haven't changed the basic math of investing.
You know the advice: Ignore stock market swings. They don’t mean anything. Just buy and hold.
Of course, that’s easy counsel to live by when the swinging is mostly upwards. It’s even possible to follow such advice after a long market decline, once you’ve gotten used to the bad news. And near the bottom, when even the pessimists start to express some optimism, well, then it’s fairly easy to stay the course.
Times like now, however, are a true test of a long-term investor’s resolve. After a bull-market run so smooth that pundits were complaining about “complacency,” the Dow has delivered a string of triple-digit daily drops, confusingly interrupted by a 274-point rally last Wednesday. At such times, your head is saying no one can reliably predict the market’s next flush of fear or greed. But your gut worries that maybe something’s about to break.
The reality, though, is that if you look at the factors that really drive the long-run returns you care about, the market doesn’t look much different than it did a week ago. Which is to say: It’s priced to deliver kind of meh returns. But those returns still look better than your easiest alternative, bonds.
There’s a very simple Finance 101 way to think about what you’ll make on equities. In essence, a stock is just a claim on the flow of cash from a company. You can think of that as the company’s earnings, or—if you want to keep things tangible—as the dividend checks it pays to investors. (No, not all companies pay dividends, but in theory that’s the eventual purpose of all profits.) Right now, investors who own an S&P 500 index fund get paid a dividend yield of about 2% per year.
The nice thing about a dividend yield is that it’s not just a measure of how much income your investment is delivering to you. It can also tell you whether stocks are generally cheap or expensive. Imagine that a stock paying out $2 in dividends per share is trading at $100—that’s a 2% yield. Now say it falls in price by $35. Terrible news for current holders, but potential buyers can now get the same $2 payout for just $65 a share—a 3% yield. In that light, the stock looks like a better bargain.
So: Low dividend yields suggest pricey stocks, and higher dividend yields cheaper. Right now, even after the recent declines, dividend yields look okay but not fat, just as they have for a while:
Note that the almost 4% dividends came in 2009, when stocks were at the bottom of the post-crisis crash. Around 2000, at the peak of the tech bubble, yields were about 1%.
Wait, does all this mean I’m only getting a 2% return on stocks? No, it doesn’t, because you also buy stocks expecting their earnings or dividends to grow over time. Using a somewhat simplified, classic rule of thumb — I’m relying on Bill Bernstein‘s book The Investor’s Manifesto plus this useful paper (PDF) from the money managers Research Affiliates — the expected return on stocks right now is the 2% dividend yield plus the historic rate of growth in dividends or earnings-per-share of about 1.5%. So think 3.5%, maybe 4%.
That’s a real return above inflation, but still a disappointment compared to the 7% historic rate for equities since 1926. Then again, it’s much better than the fixed-income alternatives: The real yield on inflation-adjusted Treasury bonds, or TIPS, is 0.35%.
A 4% return is just a baseline. If investors collectively decide they want to value stocks higher in the future, and can live with lower yield payouts, you’ll get a bump on your investment today. If they lose their taste for the risk of stocks, you’ll do worse. But that’s driven by whatever goes on deep inside the wet, gray stuff under millions of investors’ skulls, not the profitability of the companies you buy today.
The past six market days have hardly nudged this math, except to move it slightly toward stocks being a better bargain. Before the start of last week, the S&P had a one-year total return of more than 18%. Now it’s one-year return has tumbled to 12%. That’s disappointing and, yes, anxiety provoking. But if you see 4% annual return as your basic expectation, reversals from years of high gains should come as no great surprise.
Is Monday's triple-digit loss the start of something worse — like a bear market? Here are five things to watch for in the coming days and weeks.
On Monday, the Dow Jones industrial average sank more than 223 points, marking the fifth straight day of triple-digit moves in the closely watched benchmark.
Technically, this is just a “pullback,” which is loosely defined as a drop of around 5%.
The S&P 500 index has yet to reach a correction, or a 10% plunge. And the broad market is nowhere close to bear market territory, which is a sustained 20% decline in stock prices.
Still, as MONEY recently pointed out, this bull market is starting to show its age. So it’s hard not to wonder if a bear is lurking.
If you’re worried there are more troubled days ahead for equities, here are five things to watch for in the coming days and weeks:
1) Are companies reporting disappointing earnings results?
“I’d be listening to and watching third-quarter earnings reports,” says Liz Ann Sonders, chief investment strategist at the brokerage Charles Schwab.
Why? First, some companies face a new headwind in the form of the stronger dollar. While the strengthening U.S. currency is a sign of global confidence in the U.S. economy, it creates problems for American businesses. A mighty dollar makes it harder for U.S. exporters to sell their goods competitively overseas, which could crimp corporate earnings growth.
Robert Landry, a portfolio manager for USAA, put it this way:
We’re paying attention to whether companies beat, meet or fall short of revenue and earnings estimates. According to FactSet, average sales growth for the S&P 500 is expected to be 3.6% year-over-year and profit growth at 4.6%. The latter number is roughly half of where expectations stood back in late June.
What’s more, many investors think the stock market — at least prior to this sell off — was getting ahead of itself this year. Indeed, the price/earnings ratio (a common measure used to gauge market valuations) for the S&P 500 index had shot up higher than 18, based on the past 12 months of profits. That’s compared to an historic average of around 15. To justify those higher-than-average P/E ratios, investors want to see higher-than-expected earnings growth rates. The volatility of recent days suggests a worry that the bar’s been set too high.
2) Are commodity prices sliding?
The selloff in blue chip stocks recently has “coincided with mounting evidence of a global economic slowdown,” says Edward Yardeni, president and chief investment strategist at Yardeni Research.
Indeed, the reason why the dollar has been strengthening in the first place is that while the U.S. economy has been improving, Europe and Japan are both perilously close to slipping back into recession — for the third time since the start of the global financial panic.
Yardeni adds that global slowdown fears have grown in recent days as industrial commodity prices, including crude oil, have dropped sharply. (This isn’t a big surprise: Slower-than-expected growth in Europe, China and Japan has led to weaker demand for things like steel, copper and oil.)
David Kelly, chief global strategist for J.P. Morgan Funds, notes that Europe is set to release industrial production figures for August this week, along with data on inflation trends. If there’s even a whiff of deflation in the Eurozone — led by tumbling commodity prices — expect another bout of handwringing on Wall Street.
3) Are small stocks getting mauled?
While investors typically pay more attention to large blue-chip stocks, shares of smaller companies can be a harbinger of things to come for the broad market. Why? Because of their size, tiny stocks tend to be more volatile in general and the underlying companies are more easily rattled by changes in the economy.
The bad news is, the market’s tiniest publicly traded companies are already in a correction, as measured by the Russell Micro-cap Index. And should they slide into an official bear — which could be just days away — things could get really dicey on Wall Street.
Sam Stovall, U.S. equity strategist for S&P Capital IQ, noted that there have been 10 calendar years that small stocks have declined in price since 1979. “Of those 10 times,” he said, nine of the S&P 500’s 10 annual returns were 3.5% or less, and six of the 10 years were negative.” What’s more, for all 10 observations, “the S&P 500 posted an average annual price decline of 4.6%,” he said.
4) How is the Nasdaq composite index holding up?
Another canary in the coalmine for the broad market, according to market observers, is the Nasdaq composite index. Relative to S&P 500 or the Dow, the Nasdaq tends to be made up of slightly smaller, faster-growing and economically sensitive companies. In fact, technology stocks still make up around 45% of the index.
This is why in years when stocks slip, the Nasdaq tends to skid further. This happened in 1994, 2000, 2001, 2002, and 2008.
So far this year, the Nasdaq is close to entering into a correction. Should the Nasdaq’s 8% loss expand to 10% or more, look for more volatility in the S&P and Dow.
5) Is China’s economy growing less than 7%?
Continuing worries about China have contributed to the recent sell off in stocks. China’s economy, which had been growing as fast as 9% in 2012, slowed to 7.5% in the second quarter. That figure is expected to fall even further, to 7.3% in the third quarter. Some economists, in fact, are bracing for 7% growth or below.
Why is this important?
Brian Jackson, China economist for IHS Global Insight, notes that China’s leaders “signaled somewhere between 7% and 7.2% as a ‘bottom line’ for growth to meet job creation needs; IHS estimates that 7.2% is necessary to generate the roughly 13 million jobs annually to satisfy new job market entrants.”
Should GDP growth slip below 7%, policymakers in China may have start thinking outside the box. And Wall Street hates the unexpected — especially when it comes to governments and economic policy.
Are you starting to panic? Heed the advice of the Oracle of Omaha.
Warren Buffett has never been shy about packing lessons for successful investing into his annual letter to shareholders. That letter is a treasure-trove of insight, presented in a folksy manner that is not only easy to read but incredibly entertaining.
With the market tumbling we’re all likely in need of a few doses of Warren’s unpretentious advice, so I dug through his past shareholder letters to find some gems that may help us navigate the current market drop and build a bigger nest egg for retirement.
1. “It’s better to have a partial interest in the Hope diamond than to own all of a rhinestone,” wrote Buffett in 2013.
Buffett is always hunting for great companies that he can buy for Berkshire Hathaway shareholders, but if he can’t buy the whole company, he’s OK with owning a smaller piece of it instead. Applying this advice to our own investments means spending less time considering how many shares of a company we can buy and more time figuring out where we believe the company will be in ten years. Doing that will help us avoid the pitfall of foregoing investments in great companies like Amazon AMAZON.COM INC. AMZN 1.683% ) or Priceline THE PRICELINE GROUP INC. PCLN 0.2071% when they’re on sale to buy lower quality companies with smaller share prices.
2. “A ‘normal year,’ of course, is not something that either Charlie Munger, Vice Chairman of Berkshire and my partner, or I can define with anything like precision,” wrote Buffet in 2010.
Sure, the average annual return for the S&P 500 has been 8.14% over the past decade, but assuming that will be our return this year, next year, or any year is folly. Returns are volatile and will continue to be volatile, so we should focus less on the returns for any one period of time and instead focus on buying great companies and socking them away. Consider this point: While the S&P 500 has experienced plenty of fits-and-starts over the past 10 years, those who have owned it all along are up 103%.
3. “Long ago, Charlie laid out his strongest ambition: ‘All I want to know is where I’m going to die, so I’ll never go there,'” wrote Buffett in 2009.
Buffett avoids businesses whose future he can’t evaluate. Instead, he focuses on finding businesses that offer a predictable profit for decades to come. Taking the long-haul approach to finding great companies goes far beyond identifying the next big thing — after all, during the Internet boom there were plenty of Internet companies that soared on expectations rather than profit, and many of those companies have since gone bankrupt. Instead, we should be investing in companies we can understand that are likely to remain winners.
4. “We will never become dependent on the kindness of strangers. Too-big-to-fail is not a fallback,” wrote Buffett in 2009.
Warren’s cash stockpile is a thing of legend, and while that cash hoard holds back his returns in periods of growth, it also protects him when markets turn sour. Importantly, it also gives him the financial flexibility to take action and buy when prices are right. That plan-ahead mentality is something every investor can embrace by making sure there’s always some dry-powder around to deploy during the market’s inevitable declines.
5. “We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly — or not at all — because of a stifling bureaucracy,” wrote Buffett in 2009.
Buffett doesn’t hesitant when he’s presented with an idea that hits the mark. He recognizes that he won’t be right every time, but he also believes that taking action is critical to realizing the potential of an opportunity. As investors, we can emulate Buffett’s approach by making sure that once we’ve done our due diligence and picked our favorite investments we take action and buy, regardless of the market’s short-term machinations.
6. “Unlike many business buyers, Berkshire has no ‘exit strategy.’ We buy to keep. We do, though, have an entrance strategy, looking for businesses in this country or abroad…available at a price that will produce a reasonable return. If you have a business that fits, give me a call. Like a hopeful teenage girl, I’ll be waiting by the phone,” wrote Buffett in 2005.
Buffett keeps strictly to his investment discipline, but he also keeps an open mind to great ideas that fit into his strategy. Those ideas can come from various places. His acquisition of Clayton Homes, for example, was sparked by an autobiography of Clayton’s founder Jim Clayton which had been given to him as a gift by some University of Tennessee students. Keeping open to opportunities, regardless of their origin, may help us find worthwhile investments for the long term, too.
7. “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful,” wrote Buffett in 2004.
Buffett knows that emotion is a dangerous weapon that, if used incorrectly, can result in significant loss — and, if used correctly, can result in significant gain. Emotional reactions to surging or descending markets can make people buy when they should sell and sell when they should buy. Buffett often compares taking advantage of market slides to shopping for groceries. Last week on CNBC he summed it up by saying, “If you’re buying groceries, you like it when prices go down next week. And you like it if they go down further the next week.” Just as we like getting a good deal on the items at the grocery store we would be buying anyway, we should also be fans of getting a good deal on our favorite companies.
Following in Buffett’s footsteps
Buffett has no idea whether he’ll outperform the S&P 500 over the next year, but he does know that Berkshire Hathaway’s book value has grown a compounded annual 19.7% over the past 49 years. Similarly, we don’t know if our investments will outperform the market daily, weekly, or yearly, either. What we can feel pretty good about is the knowledge that investing in great companies like Coca Cola THE COCA COLA CO. KO 1.0742% and Wells Fargo WELLS FARGO & CO. WFC 0.5559% — two companies that are long-standing Buffett holdings — may help put us on a path to a less-worrisome retirement.