Headlines, their purpose is simple enough, to cause you to read the story. However, most of us with our busy schedules rarely take time to read the entire story. The headline and maybe the first paragraph or two generally is all the time we have for the story before we are on to the next headline. If you are an investor and managing your own funds, you cannot afford to rely solely on the headlines for your investment decisions. If you do, most often you will find yourself selling when you should be evaluating and maybe buying, and buying when you should be rebalancing or taking some of the profits off the table.
Classifying the recent market declines between "correction" and "market reversal" has yet to be determined. In the financial world, it seems it takes six months or longer to decide whether a market decline was a temporary correction, the start of a new bear market, or an actual recession. The same seems to hold true for market increases as well.
This past week's market decline may seem harsh and perhaps fearful when you see the amount of the point decline in the DOW. However, the point move should not be your guide. While the press may dramatize the moves when the point move is large, it is not always as meaningful as you might believe. At the end of 2006, a 1 percent move in the DOW was 124 points. At the end of 2000, 107 points represented a 1 percent move. However, a mere 10 years ago it required only 64 points to represent 1 percent.
This past week the DOW declined approximately four percent and is currently a little more than 5 percent off from its recent high. If you review the history of the DOW as well as other Indexes, you will see their climb in value has never been without retractions. The following example may over simplify how the markets work, but it may assist some in understanding its actions. The first thing to understand is that the markets represent the economy. Over the many decades of history, our economy has always grown larger. Until such time that our economy is expected to no longer grow and begin a long-term trend of shrinking, you should expect the markets to continue to grow as well. Naturally, there are times when the economy slows and even contracts, such as earlier this decade. But if your time horizon is long enough, the outlook will always be higher.
Our economy as well as the markets often acts like a rubber band. As they grow, they stretch. If you have ever stretched a rubber band, you know it eventually reaches a breaking point. Often, if you relax the band a little before stretching it again, it has the ability to expand beyond the previous point. The same is true with the markets. When the economy is doing well, the general public starts investing more and chasing the markets. The result can often produce an "over valued" market, meaning the average stock price is now higher than the price a prudent investor would pay. When this occurs, generally the market has to "retract" meaning decline at least a portion of the recent gains prior to the market being able move higher once more.
While this may sound like a science or straight forward rule, don't bet on it. The market has a very peculiar way of picking the times it considers itself over-valued and the trigger to cause the decline. Retirees often decline to invest in the equity markets because of this volatility and consider they can no longer risk their investments. I would concur with this strategy if you know for certain you only have a few years left and the funds you have will meet your needs. It would also hold true for those fortunate enough to have sufficient investments to continue to meet their needs through years of inflation.
However, most retirees now have 20, 30, and even more years of retirement ahead of them, and most will not have a portfolio of sufficient size to combat future cost increases without the aid of the equity markets.
As to the recent declines, the economy will dictate whether this is a market correction or the beginning of a recession. A diversified portfolio with its equity allocation in the correct segments could be one strategy. Selling and shifting to cash or bonds is certainly another. If you are not sure of the direction you need to take, the assistance from a professional may be the best solution. You can contact my firm, Quality Financial Concepts, or one of the other professionals in our area for assistance.
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Would you like a response to a financial question? Send your question to Doug Horn, 115 W. Broadway, Maryville TN 37801. Be sure to mark your envelope Money Matters.
Doug Horn, CFP, is an area financial planner with more than 21 years financial experience and founder of Quality Financial Concepts, located in downtown Maryville on Broadway.
Doug Horn, CFP, Registered Investment Advisor in Tennessee and Texas and Registered Principal, Branch Office of and Securities offered through CUE Financial, Member NASD, IPC.