The S&P 500 fell approximately 3% over the course of nine days on election angst. The FBI’s decision to close the books on the Clinton private server investigation propelled the popular index toward reclaiming two-thirds of those losses (2%) during Monday’s session; it continued gaining ground in early Tuesday trading.
Will the relief rally be meaningful? Will it help send stocks surging upward through the inauguration of the next president by the third week of January? Probably not. For one thing, the recovery is coming on mediocre volume.
More importantly, a Wall-Street friendly president-elect will not be the determining factor for financial markets going into 2017. Stocks and bonds have been anticipating a Clinton victory as well as a Republican-controlled House of Representatives for quite some time. Highly anticipated outcomes do not tend to bolster bullish uptrends beyond what has been priced in previously.
A Clinton victory may spark modest buying demand in November. It may even send stocks to the upper end of its 2100-2200 range by year-end. But a rip-roaring bull market continuation? Broader indices like the New York Stock Exchange (NYSE) Composite demonstrate how equities have struggled ever since the Federal Reserve ended its third round of quantitative easing (“QE3”) in the 4th quarter of 2014.
In truth, riskier assets have barely prepared themselves for Fed rate hikes in 2017. Is a meager 0.25% bump to the overnight lending rate annually a cast-in-concrete policy now? Conversely, are investors prepared for alternative possibilities (e.g., multiple rate hikes on normalization efforts, rate cuts on recessionary data, etc.) that do not currently fit the present-day script?
The pawn in a Greater Fool Theory production believes that there are no downside risks. He/she believes that the central banks will always do ‘whatever it takes’ to send borrowing costs lower and/or push risk asset prices higher. It worked for the European Central Bank (ECB) in heading off the euro-zone sovereign debt crisis in 2011. It worked for the Federal Reserve with its shock-n-awe third round of quantitative easing in 2012 where QE3 arrested the development of recessionary pressures. It even worked for the Bank of England in July’s surprising Brexit vote.
Here’s the problem: Expecting that prices will always rise because of central bank support alone is as irrational as it is dangerous to your wealth.
For 30 years and counting, there have been those who foolishly bought overvalued risk assets like stocks due to a misguided belief that the “central bank put” would prop up securities indefinitely. Just lower interest rates through one tool in the Fed toolbox or another, and watch the money flow into markets.
It used to be called the “Greenspan Put.” Then it was the “Bernanke Put.” Today, one might refer to it as the “Yellen Put” or the global central bank “put.” Simply stated or put, central banks can always ride to the rescue if necessary. That’s the illogical belief system.
Yet belief systems break down. Investors forget that the Greenspan Put worked until it stopped working, when the 2000-2002 dot-com disaster ravaged the S&P 500 for 50% losses and the NASDAQ for 76% losses. The Greenspan/Bernanke Put worked until it stopped working as well, and it failed to ward off the financial crisis that terrorized investors from 10/07-3/09 (57% S&P 500 bear). For that matter, keeping interest rates too low for too long was one of the biggest reasons for the real estate collapse. Thanks Mr. Fed!
Seven-and-a-half years into the current bull market cycle has persuaded many believers that deficit spending, debt accumulation, zero percent rate policy, negative rate policy and quantitative easing will not result in bearish price depreciation. Many actually believe that central banks the world over are now capable of propping up asset prices indefinitely.
The above-described exuberance tricked investors during the “New Economy” in the late 1990s. It deceived homeowners in the mid-2000s as many assumed that “real estate never goes down.” And now? Far too many people will see their net worth damaged when the fallacy of central bank omnipotence is exposed.
Consider the reality that it may not be possible to replace what you lose on the next go around. Holding-n-hoping through the last two bear markets – even with stocks near all-time record highs – resulted in a loss in purchasing power for diversified participants.
If you keep a higher cash balance than normal when overvalued stocks are pushing into record territory during one of the longest bull market stretches in history, you may miss a portion of the upside. Yet you can make up for lost opportunity. What you probably cannot make up for? Particularly if you are in your late 40s, 50s or 60s? Huge capital losses. They could derail your standard of living.
Ask yourself whether or not you can afford to be wrong about the Federal Reserve’s magical touch. The last two bear markets witnessed stock price devaluation of 50%, turning $100,000 into $50,000. Similarly, if you have $1,000,000 in stocks, are you comfortable with the same holdings being worth $500,000?
Granted, an average bear market typically erodes one-third (33%) of a stock portfolio. An investor can “play” the averages in assuming that the next bear might only reduce $1,000,000 to $670,000. Or an investor might assume that the next bear will be shallow at the requisite 20% level; that would turn $1,000,000 into $800,000. Nevertheless, if you cannot afford the price depreciation that will occur, no matter when or how the central banks around the globe respond, then raise some cash in your portfolio at these levels.
A moderate growth-and-income investor with a current allocation of 70% diversified stock/30% diversified income might use the current relief rally to pare back exposure. For example, in the stock arena, instead of holding 70% in large-cap, small-cap and foreign stocks, one might shift to 50% in high quality domestic equities. Take a look at iShares S&P 100 (OEF) and SPDR S&P High Yield Dividend Aristocrat ETF (SDY).
In the fixed income space? Rather than place as much as 30% in an array of income producers (e.g., short, long, investment grade, higher-yielding, foreign, etc.), one might pull it back to 25% and concentrate in investment grade bonds. Take a peek at iShares Intermediate Investment Grade Credit (CIU) and SPDR Nuveen Muni (TFI).
If you cannot afford to lose the capital, you should choose to risk losing a bit of upside opportunity. This does not imply that you will definitely lose opportunity. On the contrary. By downshifting from a widely diversified 70/30 to 50% higher quality stock, 25% higher quality bond and 25% cash/cash equivalents, you are more likely to benefit from the opportunity of buying severely depressed asset prices in a future bearish turn of events. And that beats the heck out of being severely depressed that you failed to see the warning signs.
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