3 Things to Do Before the Stock Market Tanks . . .
By Peter C. Thoms, CFA
March 7, 2015
The U.S. stock market has roughly tripled since it bottomed in March 2009 during the global financial crisis. In this run-up, U.S. stocks have come to trade at valuations that are higher than their long-term average valuations. In terms of price-to-earnings multiples (P/E, a popular measure of stock valuation), the current market (S&P 500) trades for 18.9 times the earnings for the past 12 months versus a long-term average P/E of 15.4* (Source: Bespoke Investment Group.). By this metric today’s market can be said to be a little expensive. It is also true, however, that bonds, the other main competitor for investors’ affections, are even more expensive by historical standards.
The stock market recovery has been very steep and has come with remarkably little volatility. The last meaningful correction (decline) was in the third quarter of 2011, when U.S. stocks lost 14% amid gridlock in Washington over the U.S. debt ceiling and fraying nerves in Europe over the Greek debt situation.
Somewhere in our future is another 10 percent-plus decline in the market. Neither I nor anyone else can predict when it is going to happen or from what market level. However, I can offer a plan of action for what investors can do to prepare before it comes.
But first, the most important thing about stocks that investors should understand is this: the stock market tries as hard as it can to hurt as many investors as possible. In big declines, the bottom is only reached after an avalanche of selling by despairing investors. Only once everyone who has had enough has sold does the market begin to rebound, leaving many behind. And as it marches higher, the market lures back more and more investors who cannot bear to watch it climb without them. Finally, with the economy booming and investors confident, the market peaks and a decline begins. Humans’ innate emotions of fear and greed have driven this damaging cycle in all kinds of markets for centuries.
So, how can you avoid becoming a victim of this cycleor, even better, profit from it?
Our 3-Step Plan is to:
1) Make sure you do not hold so much of an asset class that your urge will be to sell when there is a decline. (If a 15% drop will make you want to sell, then you have too much.)
2) Hold an investment portfolio that is broadly diversified among a number of worthy asset classes. (More asset classes will usually provide lower volatility.)
3) Implement a program of systematic rebalancing based on numbersnot emotions.
Here’s how we put this plan into practice: Each of our five model portfolios has specific target weights for each asset class. (To view our models, visit www.orionportfolios.com and click on “Our Portfolios” on the top navigation bar. Then view Portfolio 3, our 60/40 portfolio.) In this portfolio, for example, U.S. large cap stocks have a 30% target weight. Our rebalancing band is set at plus or minus 20%. Thus, if, through market fluctuations, U.S. large caps should attain a 36% weighting in the portfolio, the 6% above the target weight is then sold to invest in other asset classes in the portfolio that have fallen below their target weights. If the U.S. large cap stocks weighting were to fall to 24%, then other asset classes that have appreciated would be sold and the proceeds invested in U.S. large caps to bring their weighting back up to 30%.
The mechanics of this rebalancing plan are not really that complicated. What makes rebalancing difficult for investors to execute is that it is emotionally difficult to sell something that has done well in order to buy something that has not done as well. By basing your rebalancing plan on quantitative parameters, however, you are much more likely to 1) have better and steadier investment returns over time and 2) a less stressful life.
The rebalancing part of this plan is now more important than ever. With both stocks and bonds trading at above-average valuations, it is likely that their respective returns over the medium termsay ten or twenty yearswill be below their long-term return averages. Thus it will be important for investors to take advantage of the opportunities they will have in volatile markets to buy low’ and sell high’ among the different asset classes in which they are invested.
To learn more about how we manage client portfolios and why we use Dimensional funds to construct portfolios, please visit us at www.orionportfolios.com.
Peter C. Thoms, CFA
Orion Capital Management LLC
1330 Orange Ave. Suite 302
Coronado, CA 92118
Tel: 619.435.1701
Email: [email protected]
About the Author:
Peter C. Thoms, CFA, is the founder and managing member of Orion Capital Management LLC, an independent Registered Investment Advisor based in Coronado, California. The firm manages assets for individuals, families, trusts, corporate pension plans and non-profit organizations.
Disclosure:
This document is for informational purposes only. Nothing in this report is to be construed as a specific investment recommendation. This document does not constitute the provision of investment advice, which is only provided by Orion Capital Management LLC under a written investment advisory agreement and only in states in which Orion Capital Management LLC is registered or is exempt from registration requirements. Orion is not a tax advisor and does not provide tax advice. For tax advice individuals should consult their CPA.
