There are many factors to cause fear in the market today. Certain pundits and various media often hype negative stories and give the worst-case scenario for every issue. The proliferation of social media such as Facebook (FB) and Twitter (TWTR), compounds the hype very quickly and gets everyone in an emotional frenzy. The negative aspect of this is that investors may react irrationally based on temporary news. We heard of people going to all cash with the fear of going over the fiscal cliff, the fear of a European country defaulting, and recently the fear of the U.S. defaulting on its debt. There are also other issues such as tensions with Iran, North Korea, and Syria. The threat of another terrorist attack is also a factor that can make investors feel uneasy. Other concerns are: technical issues with trading systems, the fear of an overvalued market, disappointing earnings reports, and interest rate fears. I am writing this to put investors' minds at ease and to stay the course with a sound strategy.
Gridlock in Washington
The recent government shutdown demonstrates how polarized the U.S. government is. Each side, democrats and republicans, are sticking to their viewpoints and are having trouble finding common ground. This has led to a fear that the debt ceiling won't be raised and that the U.S. will default on its debt. Both parties tend to get to the point of maximum pain before they agree on a solution. This has happened before with the same issue in the beginning of the year and it just happened recently during the 16-day government shutdown. With the current polarization between parties, this is likely to come up again in the future. Stocks tend to sell-off as investors fear that the debt ceiling won't be raised. The reason for the fear is because there is the potential for a recession that would be worse than the financial crisis of 2008 in the event of a default.
The next potential date that the debt ceiling will need to be raised is February 7, 2014. So, we will be facing the debt ceiling issue again early next year. With the same politicians in office, we'll probably see a similar showdown the one we've just experienced minus the shutdown. However, this date could be extended to April 15 if the Treasury uses accounting maneuvers to provide $200 billion to fund operations until income tax revenue arrives before the April 15 deadline.
The recent war threat in Syria has caused fear among investors. Fears stemming from North Korea and Iran in their nuclear developments occasionally rise to the surface, which could be disruptive for the markets. These threats which have the potential for more military spending could create more debt for the U.S. and its allies. The potential for a disruption in the supply of oil due to international political tensions could also result in fear for investors. Since oil is the lifeblood to the economy, higher prices as a result of a supply disruption could lead to another recession. The market overcame two World Wars in the past, so it is likely that it will overcome any future wars or fears of wars.
The threat of terrorism is also a factor that creeps up from time to time. Another major terrorist attack could cause a deep sell-off for stocks. It could be difficult to thwart another major attack as terrorists can be difficult to keep track of as many of them are hiding in the shadows. If a large attack were to occur again, it could have negative economic repercussions, which would cause the market to turn bearish. If a large attack were to occur, the market would eventually recover as it did after September 11, 2001. The stock market has proven to be resilient in the past, and I think that will continue for the future. Such incidents do hurt and have negative repercussions, but eventually business as usual returns to Wall Street as well as Main Street.
Technical Trading Issues
Technical trading glitches such as the flash crash on May 6, 2010, where the Dow Jones Industrial Average (DIA) plunged 1000 points and recovered within three minutes, demonstrates how technology can create fear and a lack of confidence for investors. The flash crash was caused by a large mutual fund selling a large number of E-Mini S&P 500 contracts. This resulted in high-frequency trading firms selling the long futures positions that they primarily accumulated from that mutual fund. The high-frequency traders then began to buy and sell contracts to each other. This caused the E-Mini S&P 500 to drop 3% in minutes. As prices in the futures markets fell, the selling spilled over into the equity market. Within minutes an automatic stabilizer on the futures exchange paused trading for five seconds. When trading resumed, prices stabilized and returned to consensus values. That incident was a large scare for many market participants. Many investors lost faith in the market's integrity as a result of the flash crash.
More recently in September, the Nasdaq (QQQ) had a technical issue where a brief outage caused the inability to get quotes for certain stocks. Trading had to be halted for certain stocks for over three hours in that case. Situations like this cause investors to lose trust in the current trading systems. Some investors might be unwilling to trade at all as a result of the lack of trust in these systems. However, these incidents are temporary and normal trading prevails soon after.
Looking ahead, I think that there will probably be some new technical issues in the future. With a multitude of systems, algorithms, and high frequency trading, something is bound to cause more glitches in the future. However, I wouldn't worry about it, as these incidents are temporary and do not affect long-term investing.
Interest Rate Fears
Earlier this year, the Federal Reserve hinted that it might taper its bond-buying program. This created fear among investors that interest rates would increase. Higher interest rates would mean that mortgage rates would increase, putting the housing recovery at risk of slowing down. Thus far, the Fed has not tapered, but the threat that it will remains on the table. When the Fed does decide to taper, the decision should be based on the stability of the economy. If done correctly, any increase in interest rates should be offset by economic strength (rise in corporate earnings and personal incomes, housing market strength, etc.). Likewise, when the economy strengthens further, the Fed will eventually have a need to raise interest rates to keep a lid on inflation. However, this is done when the economy is already heating up, so higher interest rates won't necessarily be detrimental to the economy. It may slow things down a bit, but Fed tightening usually happens in a relatively orderly fashion in stages. Yes, the possibility of recession also exists as a result of Fed tightening and is a normal part of the business cycle.
Looking ahead, when the Fed decides that the economy is healthy enough, it will begin tapering the current bond-buying program. If the economy continues to strengthen and inflation increases, interest rate hikes are eventually likely to occur. The pendulum will swing from stimulating the economy to curbing inflation when the economy heats up. Eventually the series of interest rate hikes gets to the point of becoming burdensome on business and a recession takes place. Then the easing cycle begins again.
What Investors Should Do
Negative incidents will occur in the market from time to time. There will be steep corrections and bear markets. However, the market also recovers from these downturns. New highs were hit for the Dow earlier this year. New highs were just hit for the S&P 500 this week. Ultimately, investors should expect an approximate 10% annual increase in the overall market over the long term. There will be some years where the market loses 20%, and some years where it gains 20%. The point is that we have to invest based on the long term average to increase our probability of success. By properly allocating capital into stocks/bonds/cash according to your age group, investors have the ability to build significant wealth over time. Trading too frequently in the short term typically creates losses over time as it can be difficult to time the market consistently. Dollar cost averaging is the better strategy. By investing a set amount every week or every month, and not deviating from that pattern, emotion is taken out of the equation and the probability of long-term success is high. When the market falls, you're buying stocks at lower prices. When the market rises, you're benefiting from the appreciation. Investors don't need to stay glued to their computer screens all day - just dollar cost average, maintain the proper asset allocation for your age group, and watch your wealth grow over the long haul.
Some simple examples of diversified market exposure include: DIA and SPDR S&P 500 (SPY). DIA offers a 2.3% dividend yield and gives investors exposure to the 30 components of the Dow Jones Industrial Average. SPY offers a 2% dividend yield with a broader exposure to the 500 companies comprising the S&P 500.
Currently, I like the valuation of DIA over SPY. DIA has a trailing PE ratio of 15.7 as compared to SPY's PE of 17.4. With the market already on fire, DIA looks like the better deal as it is trading near the historical average PE for the market. DIA also looks attractive when looking ahead. DIA's forward PE is 14.6 as compared to SPY's 15.7.
Owning a diverse ETF such as these makes sense for some investors as the guesswork of stock picking is eliminated. Investors can eliminate the guesswork of market timing by investing a set amount every week or month, thus benefiting from long-term gains regardless of what negative events occur in the short term. Thus, getting comfortable with the new uncomfortable.