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Are Stocks Starting to Get Spooky?

Are you starting to get spooked by the daily swings in the stock market? 2018 has introduced us to a level of volatility in the market that hasn’t been seen since the Financial Meltdown. One day the market is down 400 points, the next day it’s up 200. This back-and-forth action has been playing out almost since the beginning of the year.

It’s not a good sign for stock market investors. The stock market thrives on stability. It likes low interest rates, slow but steady price increases, predictable earnings, and a reliable political backdrop.

2018 is showing little of that necessary stability. Does that means the nine-year bull market in stocks is about to come to an end?

Let’s dare to speculate that it is. After all, if it is, it could mark a shift in the investment world. Conventional investments, like stocks and bonds, could become losers for the first time in nine years. In order to increase returns, you’ll have to move into alternative investments. That’s not always an easy transition, but it can be easier if it’s done gradually, and before things start to get ugly.

But let’s start by focusing on stocks.

2018: A Year of Sudden Stock Market Volatility

On the surface, the stock market seems relatively stable. It closed out 2017, on December 29, at 24,849.63 on the Dow Jones Industrial Average.

By March 2, the Dow sat at 24,538.06 – down a little bit more than 300 points, or just a little bit better than a 1% decline year-to-date.

The optimist would say that the stock market is merely trading in a range, after an incredible 2017, that saw the market rise by well over 20%.

But is that really the case? Let’s drill down on some numbers here…

If we look at the trading days when the market has had major swings – defined as greater than 1% – we see an unsettling pattern:

2018 market major upswings:

  • Jan 17 +1.25%
  • Feb 6 +2.33%
  • Feb 9 + 1.38%
  • Feb 12 +1.70%
  • Feb 14 +1.03%
  • Feb 15 +1.23%
  • Feb 23 + 1.39%
  • Feb 26 +1.58%

2018 market major downswings

  • Jan 30 -1.37%
  • Feb 2 -2.54%
  • Feb 5 -4.60%
  • Feb 8 -4.15%
  • Feb 27 -1.16%
  • Feb 28 -1.50%
  • Mar 1 -1.68%

There have been 15 days in 2018 when the market has swung by 1% or more. Eight of those days have been on the upside, seven on the downside – which is roughly an even split.

But two distinct patterns emerge:

The down days are much more severe. While there was only one day when the market was up greater than 2%, there were three days when it was down greater than 2%, including two days when it was down by more than 4%.

And…

The major up days follow major down days. For example, the strongest day on the market in 2018 was a 2.33% gain on February 6. But that follows losses of 2.54% on February 2, and 4.60% on February 5. On February 9, the Dow was up 1.38%. But that followed a loss of 4.15% on February 8. The major up days seem to be a retracement of major declines. This is a phenomenon often referred to as a dead cat bounce.

Meanwhile, at the end of the period, we see three consecutive days of major downturns.

Clearly there is a lack of conviction by the bulls who have carried the market forward in the past several years.

The Interest Rate Backdrop

The Federal Reserve dropped the Fed Funds Rate to 0.25% back on December 16, 2008. The rate remained at that level for seven consecutive years, until December 17, 2015, when it was increased to 0.50%. Over the next two years, the rate stair-stepped higher in quarter-point increments, until it reached 1.50% on December 13, 2017.

During that two-year timeframe, the stock market ignored creeping interest rates. With discussions in the Fed centering around an additional four quarter-point increases in 2018, could it be that the stock market is no longer ignoring the prospect of higher rates?

This is not an arbitrary concern by stock market investors. Near zero interest rates were a major driver of the stock market from 2009 through 2017. But rates are now climbing to levels that could threaten the perception of interest rate stability.

Rising interest rates hurt stocks in two ways:

  1. They raise the cost of borrowing for publicly traded companies, and
  2. They provide an alternative to stocks, particularly among investors seeking safe yields.

The second point is particularly troubling for stocks. Investors are perfectly willing to pour money into stocks in an attempt to achieve double-digit interest rates, when it is only possible to get near zero rates on safe, fixed income investments. But as interest rate returns reach whole numbers, fixed income investments become more competitive against stocks.

This is particularly true among retirees, who hold a very large percentage of the investment pot. Looking for stable rates of return to create income for retirement, they prefer the safety of 3% or 4% interest rates on bonds and CDs, to the prospect of a 10% gain – or a 10% loss – on stocks.

Interest rate yields haven’t reached that level on common investments yet. But the higher interest rates creep, the more likely that outcome is. It is possible that interest rates are no longer being automatically counted in the “win” column by stock market investors.

If that’s the case, we may be experiencing a change in investor psychology.

The Stock Market and the News Backdrop

In addition to interest rate stability, investors greatly prefer Big Picture stability as well. In some ways, that still seems to be the case, at least as far as the official numbers go.

The most recent unemployment rate is an impressively low 4.1%. And on the inflation front, the Bureau of Labor Statistics reports that the Consumer Price Index is showing 2.1% price growth in the past 12 months. Both numbers are highly investor friendly.

But that’s the good news. Stock prices have charged forward, despite the fact that corporate profits are no higher than what they were in 2015.

But the non-business news is even more depressing. The administration of Donald Trump has been marked by implied scandal – and the existence of a special prosecutor – virtually since the beginning of his presidency. Internationally, Russia and China are becoming increasingly assertive, while a nuclear armed North Korea has become openly hostile to the US and its allies. Meanwhile, the situation in the Middle East – whether the subject is a Iran, Syria, Yemen or even Saudi Arabia – is at least as unstable as ever.

It seems as if the international pot could boil over at any time. And the implications in each of the current flashpoints could prove to be a game changer.

How this is Likely to Play Out for Your Investments

Stocks don’t like this kind of instability, but they’ve been ignoring the bad news up to this point. When they do finally awaken to the bad news on multiple fronts, the current volatility in the markets could well turn into a bloodbath.

It seems as if stock investors have succumbed to a strong case of normalcy bias, in which the least significant good news is held up as a promise of better things to come, while the most serious negative news is mostly ignored. So it is, nine years into a highly predictable bull market.

But as we saw in 1987, 2000, in 2007, Goldilocks bull markets tend to come to an end swiftly and severely.

One day an event will take place that will shatter the prevailing confidence. There’s no way to tell what that event will be, as the possibilities are endless. But there’s plenty of negative news in the background, that has been systematically ignored, particularly in recent years. But the volatility the market has been showing thus far in the very young year of 2018 is sending out more than a few hints that the perfect world may finally be coming to an end.

This isn’t to say that the stock market is going to crash, or that it’s going to go down and never come back. Quite the opposite is likely to happen. We’ll see some sort of significant downturn, which itself will be followed by a new bull market.

But for those who don’t like taking losses of 30%, 40%, 50% or more, in their portfolios, now is looking like a supreme opportunity to prepare your portfolio for a much different investment market.

Moving into Alternative Investments

When the current investment dam begins to crack, stocks and bonds are likely to get hit hardest. But that doesn’t mean the entire investment universe will go down at the same time. There are various investments – often referred to as countercyclical investments – that often shine when stocks and bonds are at their worst.

It’s always best to begin making a gradual shift into alternative investments before the need to do so seems obvious.

Once stocks begin to fall, and they will at some point, you’ll lose money as they do. But if you’re very heavily invested in stocks, you’ll lose a lot of money. That’s just the way things work in bear markets.

But it’s possible you’ll lose money in another direction. When alternative investments become the obvious choice, you’ll lose out by not having at least a small position in them before they take off. Unfortunately, most investors don’t even begin to notice alternative investments until they’ve already shown tremendous price appreciation.

By then, all the easy gains are gone.

Don’t let that be you! Make your move into countercyclical investments now, while the experts are still cheering on the stock market. If you do, you’ll both minimize your losses in stocks, and maximize your returns in alternatives.

You certainly don’t need to bail out of stocks completely. But now would be a good time to begin whittling down your stock positions, and moving at least a little bit of capital into alternatives. Liquidate any stock positions you’re unsure of, hold off on buying new stock positions, and begin gradually moving some money into alternatives.

Good strategy? You’ll soon find out.