Lessons from a bear market: 3 actions to take now

Until a few months ago, all assets were making new highs. In the last few weeks, investors have found nowhere to hide, not even in traditional safe havens like government bonds and gold. While we may see a day or two where the market temporarily bounces back, the sell-off may continue. Markets turn volatile when it’s trying to assess a clear path for the economy. Currently, the path forward is murky, to say the least. In this blog, we will discuss the rationale for the volatility and the Fed’s role in it. But before we do that, let’s discuss the most important question: What does this mean for you as the investor?

What should investors do?

If this is the first time you have invested in the market and yet you haven’t made any drastic moves in the last few months, congratulate yourself for your poise and courage. If you have been investing for a while, you will know that these kinds of corrections are par for the course. Here are some action items for you to consider:

1. Assess your portfolio

Are you taking appropriate risks? If you started investing in the last couple of years, now is a good time to re-assess if your portfolio is correctly constructed. Is this the risk level you should be taking given how the portfolio can react? Remember that even though the S&P 500 is down about -16% since the start of the year, this is actually a small drop compared to historical recessions such as the financial crisis where the S&P dropped about -45% or during the Covid-led recession where it dropped about -33%.
Do you have the right investment objectives? Stocks are a long-term play. If you need to spend the cash in the next 5-7 years or less, stocks might not be the best place to invest as they do go through these bouts of volatility that might coincide with when you need to take the money out. So, being clear on your investment objective is extremely important.
Are you diversified enough? Year to date, the broad market as measured by the S&P 500 is down 16%. Tech-heavy NASDAQ is down 24.5% but value stocks are down much less at around 8%. Similarly, oil and commodities are up substantially. Many investors loaded up on tech stocks in the last two years and this is where they will see the portfolio come down the most. When constructing your portfolio, beware of your impulses to chase what’s already hot. Diversification always wins in the long term.

2. Recognize the opportunity

The biggest opportunities come during a bear market, when there is a lot of pessimism. Although NASDAQ is in the bear market territory, the S&P is still not there, yet as bear markets are defined as a fall of -20% or more. Stock prices are cheaper than a year ago but still expensive, compared to historical levels. Stocks are trading at 16.8 times projected earnings compared to their historical level of 15.7 times. But, should they fall more and start approaching historical levels or fall even below, there might be an opportunity to slowly deploy any cash on the sidelines.

3. Keep your focus on financial planning

Instead of focusing on the day-to-day moves of the market that is out of your control, focus on things you can control. This includes the rest of your financial picture, outside of investments. What are your cashflows like? Can you use strategies to minimize taxes? Are you appropriately planning for the big goals and stages of your life? Are you protecting your assets and do you have the right amount of insurance? Planning for these areas will have a huge positive impact on your personal net worth. Watch our video on What is Comprehensive Financial Planning.

Why the volatility?

Markets turn volatile when it’s trying to assess a clear path for the economy. On one side, there are positive spots such as the first-quarter earnings. The profits of S&P 500 companies rose 9.1% vs their forecast of 5.9%. The April unemployment rate stands at 3.6%. Consumer sentiment is also positive.

On the other hand, big questions remain about the interest rate hike and its impact on the economy.

Fed’s intervention could be risky

The Federal Reserve AKA The Fed is a government entity funded by the taxpayers. So, at least in principle, it acts on behalf of the general public and not just the market investors. However, the Fed’s actions have a big impact on market returns as the Fed sets the benchmark interest rate, against which we measure all assets, including stocks and bonds.

The Fed decreases interest rates to stimulate the economy during a slowdown and increases interest rates to tap the brakes on economy and quell inflation. It has an inflation target of 2% meaning that inflation of more than 2% can cause hardship for the general public as prices increase and it becomes harder for people to afford goods and services.

Inflation is slowing down. Annual inflation in April was 8.3%, down from 8.5% in March. The number should keep trending down. However, many analysts believe that that inflation will settle at around 4% and may require further intervention from the Fed to get down to its 2% target. This might cause further sell-off in the stock market.

Pundits are on both side

Some economists such as David J. Kostin at Goldman Sachs believe that there’s a 35% chance of a recession in the next 1-2 years. On the other hand, BlackRock analysts believe that the Fed will raise interest rates but pause to assess the impact on growth. So, interest rates will not increase as much as feared. Instead, the Fed will have to live with a higher inflation, above its 2% target in order to avoid a recession and cause economic pain.

No one has a crystal ball

What makes the scenario particularly challenging is that outside the Fed’s interest rates maneuvers, the world is still reeling from the Covid-led supply shock, war in Ukraine and the Covid shutdowns in China. While economists and analysts can plot the data and make forecasts, it is impossible to predict what will happen to the economy and the market given that there are so many forces at play.

There is still a silver lining

All is not bleak in the wake of the Fed’s interest rate hikes. As interest rates increase, this means your cash will also start yielding something. Similarly, bond yields will also go up. However, the transition period is uncertain but this too shall pass.

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Lessons from a bear market: 3 actions to take now