Best of Times, Worst of Times

Near its mid-point, the year 2017 has all the trappings of Dickens’ A Tale of Two Cities, in which the timeless passage reads,

“It was the best of times, it was the worst of times …”.

The broad stock and bonds market indices are up year-to-date, extending the current bull market past its eighth year, having begun in the spring of 2009 when stocks bottomed-out after the financial crisis of 2008.

On the other hand, stock valuations (as measured by the cyclically-adjusted price-to-earnings ratio, or CAPE) are high relative to their historical average. This ratio now is as high as it was before the stock market crash of 1929, higher than it was prior to the financial crisis of 2008, though not as high as it was prior to the “dot.com” crash. This valuation measure, developed by economics Nobel laureate Robert Shiller, is an average of the price-to-earnings (P/E) ratio for the S&P 500 Index over the prior ten years. This approach to calculating the P/E ratio for stocks is intended to control for swings in the business cycle (periods of economic expansion and recession). In addition, the CAPE adjusts the P/E ratio for inflation.

Bond prices are inflated as well. The Federal Reserve this week continued the process begun last December of lifting interest rates from their levels near zero. The Fed had lowered interest rates to historic lows in the years following the financial crisis in an attempt to stave off another Great Depression. As the economy continues to recover from the Great Recession, the Fed is expected to stick to its plan for raising interest rates to what it considers to be healthy long-term levels. In the meantime, bond prices reflect the fundamental math of bond valuations: prices move inversely with interest rates. In keeping with this inverse relationship, Federal Reserve interest rate decreases from September 2007 to December 2015 led to an upward trend in prices and with the exception of the year 2013 positive returns for the U.S. investment-grade bond market.

So if you have been investing in balanced, diversified portfolio of stocks and bonds, you have benefitted from these rising stock and bond valuations for the past eight years. That’s the good news. The bad news is that all good things come to an end, as another old the saying goes, and your best interests would be served by beginning to think about the next “correction,” or big drop in stock market prices. You cannot control what the markets do, but you can control how you are positioned in your investments for any big shifts that may occur in stock and bond markets.

To assess the impact of another dramatic drop in stock prices, consider the varying degree of loss you might have experienced in the past across the spectrum of portfolio allocations. Of course, history is not predictive, but it is the best you have to help you make this type of assessment.

Vanguard provides helpful data for this exercise, in the form of broad stock and bond index data and a series of portfolio allocation models. Assume you had been depressed by the escalation of America’s involvement in Vietnam and concerned about the impact on the economy by the bohemian movement symbolized by the Summer of Love, and in the year 1969 held a portfolio of 100% investment-grade U.S. bonds. Because that eventful year was the worst calendar year for an all-bond portfolio in the period from 1926 to 2015, you would have had to endure an annual return of -8.1% while the U.S. landed the first men on the moon. That is the bar on the far left in the graph below.

Assume you instead remained in this hypothetical time warp back to 1931, during the Great Depression, in the wake of the stock market crash of 1929. If in response to the suffering surrounding you, you chose to hold a portfolio of 20% U.S. stocks and 80% U.S. bonds (second bar from left above), you would have seen your portfolio balance drop 10% as the stock market crash of 1929 continued to reverberate, even for ultra-conservative investors. That same year (1931) also was the worst year in the period 1926 to 2015 for the portfolio allocation 30% to U.S. stocks and 70% to U.S. bonds, which fell 14% (third bar from left). In fact, the year 1931 was such a terrible year for stocks, it was the worst year for all portfolios with a stock allocation on the spectrum of portfolio allocations shown. The all-stock portfolio had the worst “worst year” that year, dropping 43% (bar on far right).

Even the balanced portfolio of 50% broad U.S. stocks and 50% broad U.S. bonds fell by more than one-fifth in 1931 (-22.5%) as President Hoover exacerbated the depression by attempting to balance the federal budget in the naïve hope that fiscal austerity was the best response to an economic slump (a lesson lost on many politicians during the Great Recession).

The key message from this illustration is that even a diversified balanced portfolio and a conservative allocation will not shield you from incurring losses in a bad year. No one knows whether this year will be one such bad year, but after eight good years (positive annual returns, including five double-digit calendar year returns), the increasing odds of a bad year or years (negative annual returns) are hard to ignore. In addition, since history is not predictive, one should be open to the possibility of losses more severe than those experienced by similar portfolios in the past.

One approach some investors take is holding most of their investable savings in cash, in an attempt to time the market. Doing so is problematic for numerous reasons, beginning with the fact that cash yields next to nothing in today’s environment. The all-cash portfolio would have earned next to nothing since mid-March 2009 while a portfolio consisting only of the Vanguard 500 Index fund (Admiral shares) increased 279% through May of this year (according to data from Morningstar®).

Second, holding only cash suggests you will know the right time to plunk that pile of savings into the stock and bond markets. To appreciate how risky a market-timing strategy can be, note that if you had held all your savings in cash prior to the crash of 1929 only to plunge into stocks soon afterward, you would have spent the next several years filled with regret, as large U.S. company stocks fell 25% in 1930 and 43% further in 1931 (according to data from the 2013 Ibbotson® SBBI® Classic Yearbook).

A sensible approach is to find the allocation best suited to your risk tolerance and diversify within that allocation to the “nth degree” with the use of diversified low-cost mutual funds or exchange-traded funds (ETFs). If and when the next correction arrives, that event might be an opportunity to rebalance into stocks up to the target allocation fitted to your tolerance for any future losses. You might work with a professional, or rely on your own counsel. Regardless, the plan of action should be tailored to your unique circumstances. This is one of any number of strategies and is not individualized investment advice.

Once you have tailored this general strategy to your resources, needs and timeline, your tactical approach might be to rebalance in anticipation of the next correction. In doing so, you likely will “cash in” some of the gains made during the current bull market by selling stocks and buying bonds. To minimize the tax bite, you can do most of this rebalancing in tax-deferred accounts to the extent that you have sufficient assets in those accounts (IRA, 401(k), etc.).

With this approach, and some luck, you might position yourself to turn the next “worst of times” in the stock market into your personal investing “best of times” by limiting losses to a range you can handle while affording you the opportunity to pick up new stock shares at sale prices. No investment method comes with any guarantees, but this approach offers a simple and sensible means of smoothing out the bumps while you hold on for the ride long-term.

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