The Market Is At All Time Highs and What You Should Do

The current bull market is the longest running in history. Beginning in March 2009 it is now in its 128th month, well beyond the previous record of 113 months which started in October 1990. This bull has not yet beat the 417% bull run of the 1990s. But, 330% thus far isn’t anything to be disappointed about. That’s second place all-time.

It’s been an event filled 10+ plus years. We recovered from the Great Recession, a flash crash in 2010, U.S. Government debt rating was downgraded, a couple Chinese market crashes, Brexit, the election of a President with no previous political experience, Fed rate increases, Volmageddon (I’ll touch on this below), occasional fears of a global economic slowdown like December 2018 and ongoing attempts by a Democrat controlled House of Representatives to impeach a Republican president. Yet the market keeps setting new records.

The higher the market rises the greater the risk of a decline. I’m not suggesting that the market is about to turn the other way. Just suggesting that you should be prepared.

Bear markets, a fall of 20% or greater, will happen again and are a normal part of investing. We’ll see another one. Don’t worry, but be prepared. A market correction is when the market declines to where it should be or its correct level. Any decline beyond that is an oversold market. I’ve known people who try to time the market and get out just before the decline. I’ve never known anyone in my 35 years connected to the market ever do it successfully.

When will the bull stop running?

I have a friend who went to cash about three years ago claiming that the market was about to fall. He says the same in every conversation we have about the subject. I tell him that one day he will be right. So far he’s missed out on a 40% gain in S&P Index value. Now he thinks he should buy a few stocks that he knows won’t go down when everything else does. How does he know?

When might a market correction or even a bear market happen? No one really knows until it has happened. Some may say they do, but that’s not how markets work. Economic indicators, over valuations, slowdown in earnings growth, irrational exuberance can all indicate that a market slowdown is ripe to happen. But no one has a crystal ball. I’ve known people who selected their broker because he said he would get their money out of the market before a decline. If a broker or advisor has ever told you this start interviewing a replacement advisor immediately. Anyone in the profession who says it is either a novice who doesn’t understand his occupation or someone saying something that he knows he cannot deliver except by luck. I’m not referring to the professional who advises that you change your allocation or add to your cash position because of what’s going on in the market. I mean those who claims they can completely save you from a market decline

Even specialists whose only job is one type of investment cannot accurately predict the nature of their specialty. Take Volmageddon for example. Specialists in volatility and market inverse securities were caught unaware when the VIX, an index that measures market volatility sometimes called the fear index, suddenly made extreme swings in value. The majority of the surprise occurred on one day with most of it happening in the last five minutes of trading. What caused it? Psychology. And the creation of ETF’s that allow average investors to participate in this index which is best traded by seasoned experts, even the very experts who didn’t see Volmageddon coming. Pro tip: stick to investments that you understand.

We don’t know when a string of bad earnings reports may come out that. We have leading economic indicators and data upon data and metadata that we study diligently, but those have been misleading in the past year or so. We have those beating the drum of doom, some because they’ve never seen a bull market this long and others because they want to be the first to proclaim the market decline. Fears of demise or proclamations of impending demise can be self-fulfilling prophecies. We need to prepare to weather the storm but still capture the upside.

What you can do about it.

What’s your best solution? Asset allocation that fits with your risk tolerance, objectives and time horizon. Don’t confuse diversification with asset allocation. We often hear that we should diversify our investments, don’t put all of our eggs in one basket. That is diversification. It will moderately help, but you need to go beyond just that. A client once brought a referral to me, his mother. She had about 30 different holdings and thought she was well diversified. About half of the holdings in her portfolio were large growth stocks and the other half were tech startups that she bought at the IPO that her broker’s firm handled. She was 84. While diversified, almost all holdings would have moved in the same direction on a market downturn. And all were out of line with her objectives and time horizon. Before her son had become a little more educated about investing they had never questioned the broker because he was from a prominent family in the community. The stocks may have been good investments individually, but their similarities and inappropriateness for her risk tolerance should raise anyone’s eyebrows.

Asset allocation

Asset allocation takes diversification several steps further. A properly allocated portfolio holds securities across asset classes that can balance out the ups and downs and mute some of the volatility. When an event causes investors to sell and an asset class to go down in value, the proceeds from the sale are reinvested someplace which causes that asset class to go up in value. Holding assets across complimentary classes before they go up offsets your holding that go down.

Stocks and bonds usually move inverse to each other. It’s safe to say that they are usually negatively correlated. But there have been times that they moved in the same direction for short periods. The most notable times are the 1973-74 bear market, 1993 and 2008. Growth stocks and value stocks often move inverse to each other as well, giving you balance in your equity holding. Your mix of small, mid and large cap should be slightly tilted to where we are in the economic cycle and reallocated as the cycle matures. Spreading your bond maturities out based on where we are in the interest rate cycle should help as well. Now, mix in some non-correlated assets like real estate or commodities and you have asset allocation. At least according to Harry Marcowitz. He won the Nobel Prize in Economics for his work on Modern Portfolio Theory.

Modern Portfolio Theory

Investopedia describes MPT like this “Modern portfolio theory argues that an investment’s risk and return characteristics should not be viewed alone, but should be evaluated by how the investment affects the overall portfolio’s risk and return.” With MPT a portfolio suitable to your risk tolerance profile can be created that balances out the ups and downs (standard deviation). Standard deviation is a statistical measure of the price variations between high and low points.

Real estate and commodities have their own characteristics completely separate from stock or bonds. Commodities by themselves can be extremely volatile. They are impacted by supply and demand at the retail level and can be slammed by the unpredictability of things like weather or accidents. Nevertheless, adding them to a portfolio can balance out month to month account values because of their non-correlation characteristics.

Set it and forget it or put the stock to someone else.

If your portfolio is made up of individual equity holdings there are two other tools you can use, stop-loss orders and options. A stop-loss order acts like a set it and forget it order. Let’s say that you own Apple (AAPL), it’s trading at $265 and you don’t have time to sit in front of your computer all day ready to sell if the market begins to decline. You can enter a stop-loss order to sell the stock should the market begin to tank. For example, let’s say you enter the stop price at $230. You still hold the stock during any additional price increase but if it suddenly nose dives your order will trigger. As the stock continues upward you can change your stop loss order upward, too. Be careful, though, of the downside. Your sell price triggers the order and the next order to be filled is yours but that price may much less than $230. The other risk is a “flash crash.” A sudden temporary slip in price will trigger your order at $230 and you will be out when the stock bounces back. Don’t set your stop-loss order to close to the current market price.

Put options can be used as well. A protective put is a contract that gives you the ability to put the stock to someone else at a previously agreed upon price. The put will have a strike price. Using AAPL as the example again, let’s say you buy a put with a strike price of $250, the market falls and AAPL is trading at $225. You now have the choice to put AAPL to someone else for $250. Puts have an expiration date which enables you to execute your decision any time before the expiration. The price that you pay to buy a put contract will vary depending on strike price, expiration date and current market price of the underlying security. One contract covers 100 shares of the underlying security. The person on the other side of the contract sold you the contract because they believed the market would not fall, they could keep the option premium and never have to buy the stock.

Ride the roller coaster

But, if you don’t do anything before the market turns and you ride the roller coaster down then you have to sit tight until the market goes back up. As a broker I saw firsthand how investors wanted to sell after the market fell and didn’t get back in until they started hearing good news after the market had gone back up. Yes, it really happens, sell low buy high. I tried to educate clients in advance and still spent time talking them out of selling at the bottom. But every time that an investor sells at the bottom there has to be someone on the other side of the transaction buying at a low cost. Don’t be the person who loses out.

Sometimes investors don’t have a choice but to sell. And sometimes that happens at the bottom. Not having an emergency fund or having a mismatch in objective and time horizon will put you in this position. I am familiar with an organization that found itself in this very situation. Their need was monthly income to pay operating expenses. Their investment advisor who was a member of the group, had advised an 80/20 stock/bond allocation because the capital gains in the rising market was greater than bond interest. He was a hero until the market turned in 2008. They were unprepared and had to sell equities at a loss to satisfy their monthly income needs. When the market began to recover they no longer owned as many shares of anything and couldn’t participate fully in the recovery. They would have been better off with an allocation designed to meet their objectives in both up and down markets.

Conclusion

While the market is at all-time highs set up your asset allocation based on your objectives, time horizon and risk tolerance. When you sell equities to create your new allocation remember that as a class, mature dividend paying value stock typically do not fall as quickly or deeply as growth stocks that do not pay a dividend. Plus, you’ll earn dividends while waiting for equities to rebound. When allocating money to bonds, keep in mind that bonds have an inverse correlation to interest rates and the further out the maturity date the wider the price swing will be when interest rates move. Don’t set your stop-loss order to tight to market price and if you don’t understand options don’t get involved until you do.

As always, do your homework and pay close attention to your personal finances.

This article is written by Jeffery Thomas.

Jeffery Thomas has been in the financial industry for over 30 years as an investment advisor and financial planner. He now focuses on financial literacy and money coaching. You can learn more https://jefferythomas.org or contact him at jeff@jefferythomas.org