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Are you ready for a market decline?

January 25, 2022
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The stock market has abruptly pulled back over 8% from its all-time highs. This could be the beginning of a more serious pull back. As long-term investors, we shouldn’t be trying to time the market. However, if you would be seriously alarmed or financially compromised by a serious pullback the time to act is now. If so, please contact us.

 

Why is this happening? The markets are pulling back because the Federal Reserve has announced that due to higher-than-expected inflation they will raise interest rates – and end money printing - sooner than initially planned. The last time the Federal Reserve raised rates and ended money printing, in 2018, the markets fell almost 20% in six months. In addition, certain areas of the US stock market are fully valued by many metrics, so the next fall could be further.

 

What can be done?  You might want to reduce your equities and increase your cash, bonds and alternatives. Historically investment grade bonds are not as volatile as stocks. Moreover, some academic research* has shown that investment grade bonds and treasuries can hold up better than equities in a rising interest rate environment. This is because although some bond values initially decline, their income yield will increase with rising interest rates, increasing their total return over the long term. (*John Authers Financial Times 18th February 2016 quoting work by Elroy Dimson of Cambridge University and Paul Marsh and Mike Staunton of the London Business School.)

 

Is there a perfect solution? No. We can decrease risk, but portfolios can still be volatile and decline. It is just a matter of degree. As the COVID market decline showed, even the safest areas of investment markets can decline when markets break down. Cash is the only “safe” investment. But cash has lost 7% over the last year due to inflation – so that is not necessarily the perfect answer either.

 

Of course, we don’t have a crystal ball. Markets and economies are complex and unpredictable, and the Federal Reserve may increase interest rates less than currently planned. Moreover, there is a downside to reducing risk in a well-balanced portfolio: it reduces growth over the long term historically. However, today the markets dropped more than 5% before suddenly recovering. This could be the canary in the coal mine – or an anomalous blip and a great buying opportunity. Either way, it is time to buckle up and be ready for a bumpy ride. Are you ready? If not, please give us a call.