Equity markets hit a bit of a rough patch last week . Following a brief rally on Wednesday, the market sold off ending the week down by over one percent. Some foreign markets were even bumpier with Japan falling nearly six percent punctuated by a one day plunge of over seven percentage points on Wednesday.
Following last week's showing many commentators have been making a case for why investors should either be reducing risk exposure or perhaps moving to the sidelines entirely. I thought it would be good to have an argument on why you might want to consider doing just the opposite. Here are five reasons why you should tune out the noise and do nothing at all.
1. Taxes and Commissions - One of the strongest arguments for why you should avoid heading to the sidelines every time the market has a sloppy week is to prevent Uncle Sam and your broker from sharing in your hard earned profits. For the purpose of illustration assume that you purchased an S&P 500 index fund (SPY) at the open on the first day of trading this year. So far, you are up 15.7%, so why not sell? After all you can't profit without booking a gain, right?
Now some readers could be in a different tax situation, but residents of Massachusetts (of which I am one) pay either 12% tax on short-term capital gains or 5.3% tax on long-term capital gains. Federal taxes vary depending on your income, however, short-term gains are taxed as ordinary income, while long-term gains are taxed at 15% for most income tax brackets. In my case a selling a stock or index fund within one-year would require me to pay a whopping 37% of my gains in taxes before adding in my broker's commission.
So now my 15.7% gain pre-tax has been reduced to 9.9% percent after taxes have been paid. That is a 5.8% fee before commissions that I have paid simply to step to the sidelines! Even if a correction of 10% starts in short order it is highly unlikely that I will be able to even recoup this 6% by identifying a new entry point below where the market was trading when I left. I am not saying that I would never sell or hedge for any reason, however, moving in and out of the market due to short-term fluctuations is an exercise in futility that only enriches Uncle Sam and your broker.
2. Volatility is Scarier the More Often Observations are Made - Maintaining a portfolio can be a rather overwhelming experience, particularly if one has to continually choose whether to buy, sell or hold positions. Personally, I prefer not to speculate in stocks because the constant decision on whether or not to do something is completely overwhelming. Take last week for example, with all the volatility the market ended down only by about 1%. A trader would have been stressed that entire time worrying whether to buy or sell. Then you have to multiply that indecision by the number of stocks in your portfolio. However, an investor would simply check how the market did for the week observe a 1% loss and move on.
Every time you view the contents of your portfolio you will either be happy because the value has gone up or sad because the value has gone down. However, it has been experimentally shown that the decrease in dopamine for an unhappy observation is twice the increase in dopamine for a happy observation. In other words, investors feel twice as sad after a loss as they feel happy after a gain. As a result, if you constantly view the market you will feel sad because you feel more pain due to losses than pleasure from gains. In the short term random price movement is as likely to be up as down and it is only after averaging many days that gains slowly materialize. The less you observe the market, the greater the chance that when you do the result will be a happy one, thus the more you tune out the short-term noise the happier you will be.
3. The 15.7% YTD Return of the S&P 500 is a Normal Bull Market - Bull markets are inherently above average, just as bear markets are inherently below average. If the S&P 500 has generated returns of nearly ten percent for many years the bull years must go up more than 10% a year. Since 1929 the average annualized return of the market during a bull run has been 21.2%.* However, I have read so many articles describing the S&P 500 as overbought implying that there is something horribly unnatural about the market being up 15.7% YTD. While this has certainly been a good year, if you had told me on the first day of 2013 that the S&P 500 would be in a bull market until the end of the year, I would have told you that most likely return by year's end is 21.2% or the S&P 500 closing at 1728. However, I also would have told you that this is if 2013 was a perfectly average bull market year, thus the return could be more or less by a fairly wide margin.
At any moment in time, it is impossible to say with certainty whether you are in a bull or a bear market. Even if the market just hit all-time highs one second ago it is not impossible that a bear market began at that very moment (the reverse is true during a bear market). If we are in a bull market for the next year you will probably see gains at a 21.2% annualized pace, conversely during a bear market, you will probably see losses as a 35.5% annualized pace. Since 1929 the S&P 500 or its equivalent has been in a bear market for 272 months (27.1% of the time) or a bull market for 731 months (72.9% of the time). However, there is nothing exceptional about a 15.7% YTD return, it is somewhat above average but a few months of above average returns are not a reason to head for the hills.
4. Cyclical Stocks Have Been Outperforming/Economic Data Has Been Solid - The bears have spent much of the past week arguing that very bad performance is in store for the stock market. To me, reading these bearish articles has confirmed over and over that I cannot articulate a good reason for bearishness.
Consider the following data:
- U.S. Consumer Sentiment just hit a new post-recession high
- U.S. Unemployment Claims remain at post-recession lows
- Home prices are rebounding, now at the highest level since the recession
- The ECRI Weekly Leading Index has risen recently
Add to this that cyclical stocks are rebounding, below is a chart of the ratio of price movement of cyclical to consumer staples stocks, which has recently confirmed a new buy signal.
Below is the price performance of the S&P 500 following buy and sell signals based on the ratio of consumer cyclical and consumer staples stocks.
This observation does not mean that the market must go higher from here, however, even if you do wish to reduce risk exposure I would watch and wait for further confirmation. Bull markets tops are not one day affairs, instead the market will churn near a new high for several months before heading lower. With a new all-time intraday high posted on Wednesday there should be no hurry to take action at the present time.
5. The Federal Reserve Will Eventually Taper and There is Nothing You Can Do About It - Much of the bearishness and volatility surrounding the market in recent weeks is the result of the Federal Reserve's intervention through quantitative easing and uncertainty regarding how the end of this intervention will play out. Regardless of your feelings on the subject, a few observations should be made:
First: there is nothing you can do about the Federal Reserve's policies. Maybe you like QE and maybe you don't, but there is nothing you can do about it one way or the other.
Second: other market participants are already heavily discounting these policies by their actions. People with greater access to information than you have are trading based on their expectations of what the Fed will do next. At times this may cause the market to go up and at other times the market may go down. However, because you have no information other than what everyone else already knows, it is highly unlikely that you will be able to profit from worrying about the Fed's next move.
Third: these policies will play out over a long period of time. Maybe QE will be tapered over years or perhaps it could end by 2014. I don't know the answer, but what I do know is that the opportunity cost of moving to the sidelines due to concerns over slowing QE is likely to be far greater than any benefit you are likely to receive. In total, so many people are fixated on QE that you can safely ignore it. The market has already priced in expectations with all the information that is available. Unless you know something that everyone else does not, stop worrying about QE.
A long-term investor should not concern himself or herself with the noise in the market over the past week. It is a certainty that the market will correct at some point, however, the recent spate of bearish articles and jittery trading causes me to believe that the likely direction of the market will be higher in the short-term. Even if this is not the case, it is unlikely that moving to the sidelines is going to enrich anyone besides Uncle Sam and your Broker.
Some stocks that are compelling long-term buys have pulled back a bit in the past several weeks, including: AutoZone (AZO), CNOOC Ltd. (CEO), Deere (DE), Main Street Capital Corp. (MAIN), Priceline.com (PCLN) and The Travelers Companies (TRV). Depending on your investment strategy, now could be a time to add to some names that have pulled-back, but for the rest of your portfolio I would encourage you to do nothing.
*Taken from Markets Never Forget (But People Do) by Ken Fisher
Additional disclosure: I am short DE puts and long MAIN stock.