Trading Lesson: Some Ideas After the Rally and Correction
02/15/2018 11:24 am EST
Lock in some gains, hedge your bets, or invest in something that has an inverse correlation to the market. Consider staying put and riding it out, writes Steve Pomeranz, CFP. Look for guides on how to get started trading every Friday on MoneyShow.com.
Chances are most of you have forgotten how spooked we were around March 2009—that’s when the Dow Jones Industrials (DJI) hit a low of about 6,600. Since then the Dow has rallied ginormously to about 23,400, up a whopping 16,350 points over the past 8½ years for an average annual increase of about 16%, well above its long-term average annual return of about 6.5–7.0% over the past 130 years. So, we’ve had quite an amazing run of late!
Dow returned 16% average annual gain
The Dow is now close to its all-time high of about 23,600, which it hit on November 7, just a few weeks ago, and well above its October 2007 pre-recession peak of about 14,100. We’re also past the dreaded month of October that’s historically been pretty traumatic for investors. And not just that, the Dow was actually up 3.6% this October, which was a welcome relief for investors.
The Nasdaq returned 21% annually
Moving on to other indexes, the S&P 500 (SPX) has essentially moved in lock-step with the Dow since 2009, but the Nasdaq (which primarily consists of tech stocks) has performed even better, with an annual average increase of about 21% over each of the past 8½ years. Pretty phenomenal!
Those who stayed invested through the downs may have had the immense satisfaction of seeing their stock portfolios soar over the past nine years or so.
Which brings me to what’s on a lot of investor’s minds nowadays. How much farther can this rally go? When might the party stop? Should you continue to stay invested? Should you cash out and wait for a dip? Should you hedge your bets? Or diversify into other asset classes?
These are really tough questions and no one, not even me, can give you definitive answers to them.
What drove the rally?
Even so, let’s try and make sense of it all. I’m going to reconstruct the factors that drove the rally, then deconstruct it to predict what might happen next.
Let’s start with why we’ve had such an amazing rally. Here are a few reasons that jump to mind.
Kudos to the Fed
The first is the Fed’s quick and decisive easing of interest rates, from 5.25% in July 2007 to virtually 0% by December 2008. When that sunk in—about three months later, by March 2009—the rally in U.S. stocks began. A potential reason for the rally is that many investors may have realized that CDs and bonds offered near-zero returns and stocks were the only place to be.
The second reason behind the rally was that the Fed saw the carnage and the massive risks to our economy and, despite a lot of opposition, stepped in and initiated its Quantitative Easing (QE) program in late November 2008. The Fed spent about $3.7 trillion to buy government bonds, bank debt, mortgage-backed securities, stocks and other financial assets in order to stimulate the economy. The idea was that buying massive amounts of financial assets would raise asset prices, keep interest rates low, reduce borrowing costs, increase the money supply and spur lending and investment that would help the economy recover.
While some may disagree, I do believe the Fed’s bold actions played a leading role in bringing our economy, our banks, our corporations, and consumer confidence back from the brink and renewed the world’s faith in our markets.
Global economies were also tanking
In addition, think back to the end of 2009: international markets were doing a lot worse than we were, with several European countries (such as Greece, Portugal, Ireland, and Spain) in the throes of near-catastrophic debt crises that went on through about the middle of 2014.
Stocks were selling at bargain basement prices
Moreover, stocks of relatively healthy U.S. companies—and especially banks and financial institutions—were selling at prices that were construed as shockingly low by many and that brought in record inflows from U.S. and foreign institutional investors.
The Trump Effect
There’s one more factor that’s been pretty key for the markets over the past year and that was Donald Trump’s election as president on November 8, 2016.
He ran on a platform of offering tax cuts and less business regulation. That stance that may be viewed as favorable to businesses, combined with generally solid earnings from U.S. corporations, led to a 31% rise in the Dow as of today from the time Trump was elected.
So now what?
Stay invested, hedge your bets, or get out completely?
Let’s deconstruct it a little.
Interest rates expected to stay low through 2020
So, this accommodative interest rate environment bodes well for housing, investments, job creation, and corporate profits.
Fed balance sheet unwinding could cause problems
On the flip side, policymakers at the Federal Reserve are confident that the U.S. economy is on a steady footing with inflation under control at about 2.2% and unemployment down to just 4.1%. So they started unwinding their purchases of government and agency bonds this past October, starting with a reduction of $10 billion each month through December and ramping up the reduction by $10 billion every quarter.
My math shows that they could take away $1.65 trillion from bond markets through the end of 2020. While this is old news and should already be factored into the market, it could just become the psychological trigger that pushes traders over the edge and causes a selloff in bonds and a spike in interest rates that could also rattle the stock market.
Let me caveat this: this unwinding could do damage, but the Fed has clearly stated that they will put “unwinding” on hold if the economy worsens. But I don’t think the Fed will stop if it’s just to prevent markets from correcting; therefore, this is still a real risk.
Lack of confidence in Trump
As I said, the Dow is up 31% since Trump was elected, but his healthcare reform efforts have failed—which is a chink in his armor.
But the clearest reason for a market correction lies in what some consider to be overheated stock valuations. For instance, just last month, Goldman Sachs reported that the S&P 500 has a forward price-to-earnings or PE ratio of 18.7 – that’s waaay above their long-term average of 12.8 and puts stock valuations in the 98th percentile, which means S&P stocks have been below current levels 98% of the time.
More tellingly, over the last four decades, stocks have been more expensive only 11% of the time.
If you buy at current valuations, there’s also a pretty good chance that your future returns on this new money will be below historic returns, so lower your return expectations going forward. These lower returns are still above what you will probably receive by investing in bonds, so it still may be preferable to you in a low return environment. Getting back to my point on how much longer will this party last, these lower returns may keep more money from coming in, which may slow things down.
Stock valuations are “trippy” right now, which makes sense when interest rates are this low and inflation is so tame. But any significant change in either of these two factors may spook investors enough for a rush to the exits for profit taking and may cause shares to give up 10 to 20%, or even more.
So…very high valuations, Fed policies, and even politics could take the punch bowl away from Wall Street and bring the party to an end. I do not foresee a major crash, but a reasonable correction is certainly not off the cards over the next few quarters and that might just be another buying opportunity.
So, speak with your financial advisor and talk about locking in some of your gains, hedging your bets, or perhaps investing in something that has an inverse correlation to the market. Having said all this, trying to play the game of cat and mouse with the markets usually ends in tears, so consider staying put and riding it out.
To find out more, go to www.stevepomeranz.com