Should you prepare for a deeper downturn?

The current bull market is 9 years old.  That’s the second longest on record and it has people wondering how much further it can go.  That question has taken on added urgency given the recent volatility, rising interest rates and political uncertainty.  Markets lost ground in February (the first losing month in over a year) and they’re on track to close lower in March as well.  Is this the beginning of something bigger?  Should you make changes to your portfolio or otherwise prepare for a deeper downturn?  I’ll share my thoughts below.

Keep Things in Perspective

First of all, I think it’s good to keep things in perspective.  Yes, there have been some scary drops recently.  In February, the Dow had its two biggest point drops ever.  The S&P 500 had four of its largest drops ever.  On a percentage basis, however, those drops didn’t even crack the top 20.  Still, when the daily loss has a comma, it’s disconcerting.  Just try to remember that pullbacks are natural and healthy, especially after the outsized gains we’ve had over the last several years.  At the beginning of this bull market (the end of the Great Recession) the Dow was below 7,000 and the S&P was below 700.  Now, even after the recent selling, they’re around 24,000 and 2,600 respectively.

Watch the Fundamentals

Warren Buffett has famously said that in the short-term the market is a voting machine, but in the long-term it’s a weighing machine.  In other words, fundamentals matter more than feelings.  How do the fundamentals look?  In a word, strong.  GDP and corporate earnings are growing at the fastest pace in years.  The tax cuts will boost profits even more.  Job creation continues to surprise on the upside.  Unemployment is low.  Consumer sentiment and consumer spending are very strong.  Interest rates are still relatively low.  Most signs point to a healthy and growing economy.

3 Key Risks

While most indicators are positive, that doesn’t mean that investors should be complacent.  The bullish case is always strongest right before it’s not.  And even if the fundamentals stay strong, you can still get some nasty price corrections.  What are the key risks?

I see three primary risks right now: 1) Valuations, 2) Interest Rates, and 3) Political/Geopolitical risks.  Because of the strong economy, stocks have been going up and valuations are at the upper end of their historical range.  Markets are priced for perfection.  What if we don’t get it?  To quote John Mauldin, an economist I follow, “the consequences of a mistake are growing.”  Or what if the Fed raises rates too aggressively?  That could tip the economy into recession.  And the uncertainty in Washington is not helping.  If we get into a trade war with China or the Mueller investigation finds serious wrongdoing, markets will not react positively.

How to Protect Yourself

I said earlier that pullbacks are healthy.  What do I mean by that?  Economist Hyman Minsky had a theory that stability leads to instability.  In other words, when the economy and markets are good, it encourages more and more risk taking.  People start to focus on reward and ignoring risk.  They invest too aggressively.  They take on too much debt.  They save less.  They get complacent.  And then a shock hits the system, losses start to build and people panic.  The bottom falls out.  That sudden instability is referred to as a Minsky Moment.  The longer the period of stability, the greater the likelihood that people are making decisions that will eventually lead to serious instability.  Periodic corrections are healthy because they keep people from straying too far from home.

Which brings me to the question at the beginning of this article.  Should you prepare for a deeper downturn?  The answer, of course, depends.  During this 9-year bull market, how far have you strayed or drifted from your appropriate investment and retirement strategy?  How can you tell?  Here are 7 areas to look at closely.

Risk Tolerance.  The longer a bull market goes, the less people worry about (or even think about) risk.  That’s a problem, because the economy and markets usually revert to the mean.  What would mean reversion look like now?  We’ve gotten a taste of it over the last several weeks.  After years of rising markets, they start to fall.  After years of almost non-existent volatility, it spikes.  After a decade of historically low interest rates, they start to climb.  If the market dropped 20-30% this year, how would that impact your portfolio?  Could you (would you) just ride it out?  If not, you should probably dial back your risk.

Asset Allocation.  The two primary ways to manage risk are through diversification and asset allocation.  Look at your portfolio.  Do you have any outsized positions?  Is your stock/bond balance appropriate given your risk tolerance?  Has your allocation drifted or changed over the years?  Review your portfolio and align your asset allocation with your risk tolerance.

Time Horizon.  All of this is a bigger deal if you’re at or near retirement.  You have less to worry about the longer you have to go.  Even after the 57% peak to trough drop in 2008-09 the markets fully recovered within about 4 years.  Those who rode it out did fine.  Could you ride out another major downturn?  If you’re already retired, maybe not.  At the very least you’re 9 years closer to retirement than you were during the last serious pullback.  And even if you have time, sharp drops can cause you to make mistakes and do the wrong thing at the wrong time, so see points 1 and 2 again.  Make sure you understand your risk tolerance and that your allocation is aligned with that.

Spending.  Most people have lifestyle bloat as they get older.  As income grows, so do expenses.  Bigger paychecks mean better houses, cars, vacations, wardrobes and gadgets.  That’s not necessarily bad, but the longer good times persist, the closer we tend to push our spending to the outer limits.  That makes a person financially fragile.  It can cause stress, limit your options and force you to make compromises in life.  You control your spending.  Beware of bloat.  The more you live below your means, the more financially resilient you will be.  And when you splurge on things or add expenses, do your best to make that spending discretionary rather than fixed.  That way you can dial back if your income drops or the economy heads into recession.  See this article on how to use dynamic spending to make your money last.

Debt.  One of the characteristics of long bull markets is that people load up on debt.  The boom years make them more comfortable borrowing for cars, houses and credit cards.  Having debt adds risk and reduces cash flow, two things that are especially troublesome for a person at or near retirement.  If you want to be better positioned to weather a financial storm, get rid of debt.

Saving.  The average savings rate in 2015 was 7.19%.  In 2016 it fell to 5.98%.  Last year it fell to 3.74%.  Care to guess which direction it will move in 2018?  This is what Minsky was talking about.  Stability leads to instability.  People become complacent.  They save less, which means they have less of a buffer, which means they’re less able to weather a storm.

Cash.  It’s always a good idea to have a portion of your portfolio in cash or short-term securities.  That way, if markets drop and a good investment opportunity presents itself, you’ll have some dry powder to invest.  Or, if you’re already retired and taking distributions from your portfolio, you can pull your distributions from your cash rather than selling your stocks into a declining market.

Will the markets drop further?  Who knows.  The risk is certainly there.  The important thing is to focus on the things you can control and make sure that if we get another downturn, it won’t derail your plans.