Lately, the story about market volatility is the lack of volatility. In this episode, Jonathan Clements and Peter Mallouk discuss the likelihood of a market correction in the near future and why you shouldn’t panic. They also offer tips about what to do with excess cash and fully funding your employer retirement accounts.
Hosted by Creative Planning Director of Financial Education, Jonathan Clements, and President, Peter Mallouk, this podcast takes a closer look into topics that affect investors. Included are in-depth discussions on financial planning issues, the economy and the markets. Plus, you won’t want to miss each of their monthly tips!
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Jonathan Clements: Hi, this is Jonathan Clements, Director of Financial Education at Creative Planning in Overland Park, Kansas. With me is Peter Mallouk, President of the firm, and we are Down the Middle.
If actions speak louder than words, what’s most notable about today’s market is the amount of inaction. Even as share prices have climbed nicely this year, investors collectively remained remarkably calm, or so it seems based on market volatility. If you look at the closing prices for the S&P 500, the stock market hasn’t had a 5% pullback since early 2020. That’s more than 10 months, an unusually long time. On average over the past 75 years, we’ve had a decline of at least 5%, and often much larger, every seven months. Meanwhile, the VIX, often referred to as the “fear gauge” or the “fear index,” is at just a quarter of a level it was early last year during the initial weeks of the pandemic. So that raises the obvious question, Peter: To what do we attribute this market calmness?
Peter Mallouk: Well, I think you’ve got a couple things. I think one, you just have a lot of money that’s pouring into assets. And so, when you have very low interest rates coupled with the Fed putting $5 trillion one way or another into the economy, it goes and it buys things. And that’s really lifted the markets and a lot of other asset classes like real estate and a lot of speculative assets, too.
So, while we have a reason for it to happen, it’s not normal for there to be such modest volatility. So the way the stock market works over the very, very long run is it goes up, right? So we know that over a very, very long period of time, it goes up. In the short run it goes all over the place. So if we take a given 12-month period, the odds the stock market will be positive are about three in four. Pretty reasonable expectation it will be negative. You know, one in four is quite often. If you’re starting at Creative Planning today, the odds your portfolio could be negative a year from now are about one in four. You stretch that out over three years, your odds are better than nine out of 10 that the portfolio will be positive. You stretch it out even longer, odds go more and more in your favor.
But what we know as investors is along the way, there is a price to pay for stock and real estate investing, and that price is volatility. Meaning things go up and down along the way, sometimes very violently. And we just haven’t experienced that over the last year or so.
Jonathan: Which seems unusual, Peter, given that we view volatility, earlier you said, as an indicator of uncertainty. If people are really uncertain, then you see financial market prices jumping up and down. And right now you might say there’s a lot of uncertainty out there. We don’t know what the trajectory of inflation is. We don’t know how good corporate earnings are going to be and whether we’re going to continue on this rapid recovery. There’s talk in Washington of possible tax law changes. And of course, we have the pandemic and the Delta variant, and we’re not sure how all of that is going to play out. All that would suggest that we would have a volatile market. And yet, the market seems to be telling us something entirely different. Do you think, Peter, that people are just being more certain about the future, or is there something else going on? Is it simply all this liquidity that you were talking about?
Peter: Well, I think part of it’s liquidity. And I think part of it is, as Americans, we have this incredible ability to forget. That’s probably responsible for a lot of our really poor foreign policy decisions made across both administrations over decades is we just, we forget the past and how things work. And I think we see that in bear markets when investors assume things will never get better. And we see it in bull markets when people get complacent very quickly. So if you look at what normally happens in the stock market, volatility-wise, you and I have been talking about volatility and the VIX, which measures that. In a normal year, we expect a lot of ups and downs. In an average year, the stock market will drop from its high about 14% on average every year.
So, let’s just assume this happens this year. We have an average year and at some point that happens. That would be a drop of between 4,000 and 5,000 points. Everyone is going to lose their minds, right? When that happens, because it’s been so long since it’s happened. So we just got to get in this norm and people start to de-risk and they get overconfident. And you see that because people start to move. You don’t just see lack of volatility in the market, you see people take more risk for incrementally little reward in those parts of the cycle. And that’s where we are now. We’re seeing people take excessive risks to buy bonds that pay just a little bit more than conservative bonds.
And so, I think we’re due. I mean… we could go a year and I have no idea when it’s going to happen. And I never claim to know it. I think anytime any forecaster, any advisor, gives you a forecast with certainty, you should run as far in the other direction as you can from that advisor because no one knows what’s going to happen.
But what we do know is that the market doesn’t go straight up with no volatility. We know that, right? And so we know at some point we’re going to have a return to normalcy. And so I’m not predicting when it’s going to happen. I’m just saying it very likely is going to happen sometime in the next 12 months because that’s the norm. And we should be prepared to take advantage of it instead of being scared when that happens.
Jonathan: So Peter, you mentioned that the market falling 4,000 or 5,000 points, of course, what we’re talking about here is the Dow Jones Industrial Average, which is probably, justifiably or not, the most watched stock market indicator. And people think, well, 4,000 or 5,000 points, that is a massive drop. And yet on percentage terms, it wouldn’t be that huge. It would be within the realm of normal, as you say.
What would be huge is something like we saw in 1987 when… and yet, back in 1987, because the indexes were so much lower, and the Dow dropped just 500 points. But that was a 22%+ decline. So people, yeah, should definitely be prepared for a large drop in the market, particularly in point terms, if they’re looking at the Dow Jones Industrial Average.
And so, I have one final question for you, Peter, which is after the incredible run that we’ve had going all the way back to 2009 with only a few little blips along the way. We had a negative return in 2018. We had the Coronavirus crash last year, from which we recovered with amazing speed. Given that we’ve had this incredible run, given that people tend to be overconfident after you have a run like this, what could people do today to make sure that they are mentally prepared and financially prepared for a market decline?
Peter: Well, at first I would just say for those scared that the market’s too high, our philosophy is always to just, you just continue investing. So even if you look at the stock market, people go, “It’s an all-time high.” The stock market’s at an all-time high about once every 19 days. So that’s totally normal. Most years it ends that year at a new all-time high. We don’t get surprised that a Hershey’s bar or a box of Corn Flakes, hits an all-time high. We expect inflationary pressure alone to drive part of that. And the odds of the market being positive over the next year, even after an all-time high, is still three out of four.
First of all, I would not just go, “Oh my God, something bad is going to happen. I’m going to get out.” Even if there’s a correction, what will probably happen is what happened with the other 100+ corrections. Correction being a 10% drop or more. With the last 100+ corrections, the market recovered, went on to new highs. So most people should just continue to invest.
But for those of you today, if you are looking at your portfolio, you want your portfolio to hold things that participate in the market’s upward trajectory over time. And so you need to have enough in bonds to cover your short-term needs. Short-term could be as long as seven years, if you’re want[ing] to be conservatively postured, and the rest should be in things that we expect to appreciate over the long run like stocks, real estate — asset classes that are more inflation and growth-oriented.
Jonathan: So, before we get to the tip of the month, just one little fun fact, Peter. So far this year, apparently the S&P 500 has hit an all-time high more than 50 times. New all-time highs are a common occurrence and you shouldn’t be freaked out just because you see that headline about markets at record highs. That’s completely normal. So anyway, Peter, your tip of the month, what have you got for me?
Peter: So, my tip of the month is I continue to see people with too much cash on their net worth statements. And cash is really a drag. Every dollar goes to work for somebody. If you’ve got it sitting in your bank account, it’s going to work for the bank. Put that dollar to work for you. If you want to be super-conservative, put it in short-term bonds, at least earn something. But you start to look out — if you go, “Look, I don’t need part of this cash I know I don’t need.” Invest it in things that are going to serve you well over the long run. Get those dollar bills working for you in a portfolio. Only keep in cash what you need to get through in an emergency and try to get past the psychological component of having a bunch of cash that you don’t need in excess of that.
Jonathan: And when you said seven years, Peter. I mean, when you’re talking there not about somebody who’s still in the workforce. You’re talking about somebody who’s retired and is living off their portfolio.
Peter: That’s right. That’s right.
Jonathan: So anybody who’s still in the workforce can hold substantially less than seven years of spending money in cash.
Peter: Yeah, in bonds. So in cash, I would say you should have a few months to six months. But if you’re moving over into the portfolio, the most I think anyone should have in bonds is enough to get through seven years.
So, if you still have three years left of work, that covers three years. Let’s have four more years in bonds. If you have a Great Depression event or a 2008, ’09 event, even worse than 2008, ’09, we’re covered with the bond part of the portfolio without having to sell stocks into weakness. But have your long-term money in things that grow: stocks, real estate, private investments, things that have an opportunity to stay ahead of inflation for you.
Jonathan: So Peter, my tip of the month. We are now in the beginning of September here, we’ve got four months to go in the year. And one of your top financial goals, if you’re still in the workforce, is to try to fully fund your 401(k) or 403(b) plan each and every year. For 2021, you’re allowed to put $19,500 into one of these employer retirement plans. If you’re under age 50. If you’re 50 and older, you’re also allowed this catch-up contribution of $6,500, which puts you at $26,000 total. What I would suggest to people is look at whether you’re on track to hit that $19,500 or $26,000 for 2021. And if you’re not, this is a great time to up your contribution level so that you hit the max by the end of the year. It’s a lot better to do that now. And this will be a lot less of a financial burden than to wait till December and say, “Hey, I’m not going to fully fund my 401(k). I’m going to try and do it all in December.” Do it today. Call HR or whatever you need to do. Increase your contribution so you hit that max for the year.
So Peter, that’s it for this month. This is Jonathan Clements, Director of Financial Education for Creative Planning. With me is Peter Mallouk, President of the firm, and we are Down the Middle.
Disclosure: This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice. Past performance of any market result is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable, but is not guaranteed.