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January 21, 2016 Market Update: Surviving the Storm

Here on the east coast of the U.S., we are expecting a major winter storm. The forecast calls for up to two feet of snow. Bread and milk are disappearing from store shelves. My wife reminds me that I promised to buy a generator, and did not.

We have already been hit by ugly weather in the worldwide financial markets, starting in late December and continuing through yesterday’s intraday 3.5% decline on the S&P. (The market rallied to close down 1.2%.) So far in 2016, 8 of the 13 trading days have seen negative results for the S&P. Overall, more than $15 trillion has been erased from global market valuations. What is going on?

Let’s start by separating predictions about the real economy from commentary about the financial markets. Markets can go down, sharply and significantly, without a decline in the real economy. Markets can go up, profitably and unexpectedly, before the real economy shows clear evidence of recovery. Most recessions are preceded by market breaks, but many market breaks are not followed by recessions.

We can usually rely on economists to fail to predict even the most significant macro-economic trends. They excel at that job. As always, we will ignore most economic trends in making portfolio decisions. We do pay attention to one factor at the intersection of economics and markets: we believe that the combination of easy money and low interest rates has driven speculation, leading to over-valued assets in many market sectors.

What will happen next? We see three possible scenarios unfolding, listed in our rough estimate of likelihood:

1) We are experiencing another sudden downdraft in a volatile sideways market. Since the market bottom in 2009, we’ve seen sentiment reverse from unusually bullish (June of 2015) to extremely bearish (late August of 2015, early 2016) within weeks or months, and then reverse again. That pattern will continue, with no definitive breakout to the upside or downside, for some time.

2) The bull market that began in March of 2009, one of the longest in history, has now ended, and the current decline is the beginning of the next bear market. Since the average bear market since World War II declined 32% over 15 months, and the S&P 500 is already down more than 11%, we are already more than halfway to the bear market definition of -20%, and more than a third of the way to the typical bear market decline.

3) The bull market is not over. We will not hit the 20% decline figure that defines a bear market, the market advance will resume, and prices will ultimately make new highs.

We can’t possibly know which scenario is correct, until long after the fact. So what are we doing?

1) Anticipating a riskier market. Our portfolio positioning has been defensive since mid-2013. We have held higher-than-normal cash positions at all levels. We have also tilted our investment choices toward historically less-volatile mutual funds and ETFs.

2) Beginning to commit cash reserves. The decline in the S&P has reduced valuations enough that we are moving a portion of our cash reserves back into the markets. We will begin to do some buying, carefully and selectively.

3) Allocating capital based on price. Our relative-value measures continue to indicate that both value stocks (compared to growth) and foreign stocks (compared to U.S. equities) are unusually cheap. We’ll continue to over-weight these two sectors as we rebalance portfolios.

Difficult markets give us our best opportunities to enhance our long-term returns. In the past, we believe we’ve done a better job than many other advisors at putting dollars to work when prices trend lower. That said, we have never been able to perfectly time those buys, and thus never catch the exact market low. We probably won’t do so this time either.

What we will do is treat your money as if it were our own, and buy for you the same securities, in the same proportions, that we own for our own retirement accounts.

By James S. Hemphill, CFP®, CIMA®, CPWA®/ Managing Director & Chief Investment Strategist

Jim has been a CERTIFIED FINANCIAL PLANNER™ professional since 1982. Jim specializes in complex wealth transfer and retirement transition strategies and coordinates TGS Financial’s investment research initiatives.

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