By Michael Howell
This last October, 2017 marked the 30 year anniversary of what famously became dubbed, Black Monday. For those unfamiliar with what took place on October 19, 1987, the Dow Jones Industrial Average plummeted by a then-record 508 points—a 22% decline in a single day.
Thirty years later, we look at a very different market as we begin 2018. This market has been anything but volatile and the secular bull market we're currently in now pushes into its ninth year with the last significant market pullback taking place in late 2015-early 2016.
Let's acknowledge this market for what it is. Times are good!
But what about when they're not? We all know the axiom, "What goes up, must come down." If you think rationally, you may be observing this market wondering: How long can we expect this to last?
Even though it's Winter at the time of this writing (and cold outside), from a market standpoint we're figuratively sitting in the sun lounging about on a nice boat in clear waters, and most of us are enjoying this market for what it is. For these reasons, we feel now is a great time to examine where we are in the business cycle and look back on history to draw lessons from days when waters weren't so smooth. Doing so helps us to better prepare for the next storm that inevitably passes.
We begin with today's forecast.
Even as we stand today, many market forecasters are predicting sunny weather going into 2018. American corporations reported strong profits in 2017 and the outlook may be getting better. Many onerous government regulations have been rolled back under the Trump administration, tax cuts have now been passed, economic growth has been accelerating, interest rates (though rising) still remain low, and strong corporate earnings continue to support rising stock prices.
Despite being in the ninth year of this economic recovery out of the Great Recession, if corporate earnings continue to impress, it is very possible for the market to continue rising further.
BUT – we all know the day will come when this market makes a turn. In fact, it's inevitable. Ironic as it may seem, market downturns are a healthy and necessary part of the business cycle. When markets rise, it causes demand for products and services to increase, which in time causes inflation to ensue. Practically speaking, inflation makes every dollar you own less valuable as the prices of homes, cars, and various goods you purchase increases relative to your net income.
To illustrate, can you remember what gas prices were back in the day? Some of you may remember when gas prices were less than 50 cents a gallon. If you do, that means you lived through the 1970's when gas prices were last at this level. It also means you remember when disco, station wagons and 8-tracks were a thing! Of course the days of 50 cents per gallon of gasoline are long behind us, but in the big picture, what matters is price inflation relative to growth in your wages and investments. In other words, if the costs of goods like gasoline or food begins increasing at a rate that’s faster than the growth of your wages or investments (and the same holds true for your friends and neighbors), our economy has a problem.
This is why the business cycle is important – it ultimately helps keep various market forces in check. For those reasons, it's necessary to understand how the cycle revolves.
How does the business cycle keep market forces in check?
In every business cycle, what inevitably happens is the economy over-expands and eventually reaches a peak, where consumers develop a lesser appetite (or ability) for spending and borrowing. When this occurs, demand for products and goods decreases and sets the stage for the economy and market to contract.
This period of contraction typically reduces inflation, affords consumers and businesses opportunities to repay debt, and helps stimulate greater demand for goods once again – which then begins a new business cycle for the next leg. Though the cycle expands and contracts, historically the contractions set the stage for another leg higher.
Where are we in the current cycle?
Overall, we've moved into the maturing phases of the current expansion, but we're still experiencing some areas of recovery. According to LPL Financial Research, we currently sit in a business cycle that has displayed elements of multiple stages all at the same time.
Source: LPL Financial Research Outlook 2018 Chartbook
One of the remarkable elements of the economic growth we've seen over the last eight years is that the primary driver of economic growth was largely dictated by the actions of the Federal Reserve through extraordinarily accommodative monetary policy (via quantitative easing). Through this period, our economy and markets have certainly grown, but the rate of growth has been slow in comparison to prior economic expansions. Today, these forces are no longer as influential and the forces that have historically supported economic and market growth, such as deregulation, infrastructure investment, and entrepreneurial risk taking have moved into the driver's seat.
What does the business cycle have to do with my investment portfolio?
As we've stated in multiple writings, over time, stock markets will follow where corporate earnings lead. Stocks are shares of ownership in businesses, and since businesses expand and contract through these cycles, any ownership you have in stocks will see its price action expand and contract along this cycle. More importantly, it's these contractions or downturns that ultimately create the conditions necessary for the market to move into its next leg of growth.
In a way, think of it similarly to a forest fire. Though destructive, fires are also a natural and healthy part of an ecosystem. Its fire that kills off dead trees and decaying matter in the forest, and the ashes add nutrients back into the soil to support new growth.
Those of us Californians know we can't control the dry wind and periodic drought conditions that occur in our state. Similarly, it behooves us as investors to recognize we can't control the expansion and contractions of the business cycle—we can only control our behavior along the ride as we go through them.
Back to Black Monday
Taking us back to where we started, Black Monday was a terrifying day for many investors. You can even watch old news footage to get a feel for the sentiment on October 19, 1987. Nobody had ever seen a 22% drop in the stock market in a single day, and it caused widespread panic and selling of stock shares. On that day, more than 595 million shares were traded (the prior record was 302 million). To give you a comparison, the crash that occurred on Tuesday, October 24, 1929 (dubbed Black Tuesday) that preceded the Great Depression dropped only 13%. Needless to say, many felt like the sky was falling and pandemonium ensued. Many people wanted nothing to do with the stock market at that point and sold off the investments they held.
What caused the market to drop so significantly? Various reasons have been cited, but the consensus reporting on the 1987 crash was that it occurred as a result of a combination of forces: Exacerbated selling activity, ill-equipped computer trading systems, a weak dollar, inflation, the trade deficit, and Middle East conflict.
Putting it all in perspective.
Oppenheimer Funds did an analysis of someone receiving a $100,000 inheritance and investing it in the U.S. market on the eve of the crash. After Monday's 22% decline, the investment would have dropped in value to $77,420. However, by the following October 20th of 1988, the investment would have once again grown and surpassed $100,000 and 30 years later (today), would be worth more than $2.1 million.
Putting it in visual form and to scale, the 1987 Black Monday crash looks like a blip on the radar from where we are today.
In fact, the Dow Jones Industrial Average has increased more than 1,400% since that day 30 years ago. When looking at a mountain chart like this, it's clear a long-term perspective is essential and necessary for us to make wise investment decisions. Even so, we don't minimize the risks involved with stocks, particularly for those nearing retirement. Why? Because it takes time to recover from downturns.
For example, if someone had an investment that declined 50% in value, a 50% gain would not bring the portfolio back to break-even—rather a 100% gain would be needed to get the portfolio back to where it started. Historically, this recovery can take several years, time a pre-retiree or retiree may not have to wait.
Four Lessons to be Learned from Turbulent Markets
1. Recognize that pursuing a successful outcome in investing has more to do with our behavior than the return on our investments. We are, human, after all. When markets are rising, the human response is to have a high tolerance for taking risk. When markets turn south and stocks are tanking, the emotional response is to sell everything and go to cash. Unfortunately, these knee-jerk reactions rarely result in positive outcomes and time after time, we've historically seen markets go through the cycle and lead on to another leg of recovery.
2. View your investments in mutual funds, ETF's, stocks and bonds similarly to how you view ownership in a home—as an asset. Picture owning a home that's worth $400,000 today, but the following year changes in value to $350,000 due to a downturn in the real estate market. Though you're probably not happy about it, you likely don't look at your circumstances thinking you lost $50,000. After all, you don't lose $50,000 in this scenario unless you were to sell your home.
Yet for many, the opposite mentality is true with their investments in stocks. If the same $50,000 drop in value were to occur in a person's stock or mutual fund portfolio, many would claim they had lost $50,000. Remember, the only time you take a loss is when you sell your investment, and if you can wait on touching your investment dollars for enough time to give the market a chance to recover, the best decision is often to sit tight.
3. Be realistic about your investment risk tolerance. We recognize the advice to sit tight in circumstances similar to the above might not sit well for the retiree or soon-to-be retiree, but that's only if they're invested in a portfolio that's too volatile and aggressive for their needs. A mixed portfolio of stocks and bonds can help weather these inevitable storms and allow for enough principal growth in the portfolio to last a 20-30 year retirement.
Similarly, if you claim to have a high tolerance for risk in rising markets (because you want to maximize your returns), this means you also need to tolerate the downside during recessionary periods of the cycle. Trying to time when to be in the market and when to be out is attempted by many, but is difficult to accomplish consistently. Be realistic about how much risk you can really tolerate.
4. A financial plan will help you respond to turbulent markets rationally instead of emotionally. When you see your overall financial picture at a 30,000 foot level, your perspective changes. Depending on what you want your financial future to look like and what season of life you're in, a good financial plan will help you make wise decisions. For the retiree, it will help you draw income from the resources you have more efficiently. For the working family, it will help you see if you're on pace to maintain a similar standard of living for a future retirement.
Seeing your financial life at this level helps you balance saving for the future and spending on the present. It helps you know if you need to be saving more, but also can help you determine what rate of return you need on your investments to experience the financial future you'd like to see.
Remember, financial planning is not a science—rather it is a fluid activity. From saving money for the future, managing life after the loss of a family member, living out your retirement, and all of the life events in-between, we're here to help guide our clients through these decisions.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.