With the market falling off five percent after a thirty-seven percent surge, we ought to be wondering: "What's going on?" For the optimists, this is basically a bull market taking a breather. For pessimists, the rise of the last eight weeks was just another "dead cat bounce" of a market doomed to reflect lower corporate profits --- sooner or later.
The "Me Generation" should be asking what either of the above answers means from an individual strategy standpoint. To the well-balanced investor, the answer to the question should be "both of the above." It shouldn't matter. If you aren't well-balanced, at least from a financial standpoint, today's market level might be offering a window of opportunity to do some course correcting.
What we have just experienced is the strongest market rise since the 41 percent rise during a similar time period back in 1933. Anyone who has stayed the course and ridden the market down to its March 9th bottom has now recovered at least some of what has been lost over the past few years. It would have been foolish to sell at the bottom, and you didn't, but now you find yourself thinking that it's nice to be back --- at least part way. However, you're also probably thinking, "I'm too old for this."
A market recovery sets the stage for some investment course-correcting. The past eight weeks have lifted us out of the catatonic state brought on by the stock market's perilous journey. We can think a little more clearly now that we have seen history repeat itself. We know intellectually, that a plunging market will be followed by an equivalent upward snap, but there is always that nagging suspicion that maybe "this time, it's different."
Because this past downdraft was precipitated by a deleveraging of the financial markets, all stock of virtually all types of companies was affected. True, some industries like automobiles were hit harder than others, but this was not a typical market decline with more pronounced losses in just one or two major sectors. For a more common version of a crash, the dot-com boom comes to mind, and before that was the plunge in the '70's of the "nifty fifty" (Xerox, IBM, Litton, etc.) This time out, it was a deleveraging of the financial sector that brought everyone down with it. It wasn't funny at the time, but it amuses me now to watch an industry that limits its customers to borrowing only 50 percent of what they invest in stocks. Anything more would be too risky. Meanwhile, in 2004, the same industry succeeded with the deregulation that allowed it to borrow 97 percent of what they invested, and that ridiculous thirty-to-one leverage did them in.
Going forward, it could make sense to rearrange the deckchairs in the stock portion of a portfolio so we could relax a little more if those nattering nabobs of negatism turn out to be right. A higher proportion of money in bonds could help protect against a further downdraft, but the question becomes, "What kind of bonds and how much?"
While it may sound blasphemous, I like the possibilities presented by high-yield corporate bonds which have lost about twenty percent of their value based on current high-yield mutual fund price performance, but they still own the underlying bonds that they can hold to maturity, and the yield at the moment is about 8-13 percent depending upon the fund. Most of the more conservative of these funds, like Vanguard's for example, have low fees and very few actual defaults. The current reduced share price means that steady interest payments amount to a relatively high annual percentage return which is referred to as the yield. Bill Gross, the bond guru running PIMCO, recommends high quality (as opposed to high yield) corporate bonds, but we would expect him to say that. The important consideration is that these high yield corporate funds involve some short-term (as in seven -year) capital risk but they deliver immediate gratification in the form of reinvested dividends at a rate that is not that far below Bernie Madoff's one percent per month.
The sweet spot for bonds is to occupy one-third of a portfolio. This is the point at which they reduce the downside of a stock market crash by about one-third while only penalizing the potential upside by one percent. In other words, if an all-stock portfolio is expected to gain at a rate of 10 percent per year, having one-third in bonds will reduce that expectation to an annual 9 percent. However, if the market drops by 17 percent, that bond component will reduce the overall loss to just 12 percent. A higher percentage of bonds offers more protection, but at a much higher earnings penalty.
So, here we are with an opportunity to take breather and think rationally for a moment. Even if we decide to do nothing, that should be the consequence of an informed decision. The biggest obstacle is what behavioral economists have termed, "the status quo bias" --- otherwise known as "shoulda, coulda, woulda."