When the Dow Jones plunged more than 1,000 points twice during the second week of February, it took investors into correction territory and a new reality. The smooth nine-year climb of the markets is over. Maybe. Markets have already regained much of those losses. Still, this seemingly unexpected volatility has people wondering what’s next.
Allan Small weighs in on what happened, what it all means and what investors should be thinking about and doing. Spoiler: it’s not as bad as it may seem. We are not entering a bear market.
Q. What is a market correction and is this healthy?
A. By definition, a stock market correction happens when the market drops 10% from its most recent high point. So, yes, it was a brief market correction. And yes, it is a healthy thing. A correction should be expected from time to time because it’s normal for the market to behave this way. Part of the reason this has taken so many people by surprise is because it seems to have come out of nowhere. But a lot of people have forgotten the markets in Canada, the U.S. and Europe have had some negative years since 2009.
Q. What does a 1,000 point drop in the market really mean?
A. A thousand point drop equates to about 4 to 4.5% on the Dow Jones Industrial Average. You also have to understand what makes up the index. The Dow is made up of 30 stocks. How many are in people’s portfolios? Is it one? Two? I don’t think many people are going to own all 30 or even 10. You have to keep things in perspective. Significant drops may not affect you as much as you think.
Q. Is the recent market drop a signal of more volatility to come or is the bull market still intact?
A. Yes and yes. Volatility has been extremely low for a long time and that is not normal. It’s easy to forget that when things are going well. The CBOE Volatility Index or VIX, the Index that measures volatility for the U.S. markets, was below 10. We had never seen that before. To put that in perspective, after the market dropped 1,175 points on February 5, the VIX (also known as the fear gauge) spiked to 50. To that point, the markets had had abnormally low volatility for a few years now and that I think is gone.
Q. Why is this volatility happening now, especially since the economy is doing well?
A. I believe for the last several years there has been no alternative to the stock market because interest rates have been so low. If you were investing in bonds or GICs, you were earning less than the inflation rate. Now, the fear is if interest rates rise substantially to the point where you could make 3% or 4% on a bond then why would you want to assume the risk of buying a stock generating similar dividends? We are coming to a point--not yet--where there will be viable alternatives to the stock market with little to no risk or volatility. Once that happens, volatility will increase. People are looking ahead to six, 12, 18 months down the road and seeing the impact of the recent tax reforms in the U.S. that will put more money into people’s hands who will then spend it. When you have more money chasing fewer goods that leads to inflation which leads to higher interest rates. The market is beginning to price in higher inflation and interest rates. On top of that is the high level of debt people are carrying. What happens when the prime rate and mortgage rates go up? This will lead to further sell-offs in the market.
Q. What role has machine-based trading had on stock markets?
A. It adds to the volatility because these computerized programs and algorithms are designed to do trades in one direction. For example, when interest rates hit a certain level, they may be programmed to sell. This is likely what happened with the recent drop. In seconds, hundreds of thousands of shares were sold off. It wasn’t people that were selling. It’s these computer programs. It also happens on the upside, too. If something good happens, then they are programmed to buy.
Q. Should investors be worried?
A. In my opinion, over the course of time we have seen periods where the interest rates rise and the stock market rises with it. I think the fundamentals are still extremely good. Global growth is on an upswing. Corporate earnings are solid. I don’t think investors should be worried. I just think they should open their eyes to a new era of less stimulus by central banks around the world and rising interest rates.
Q. How do investors protect themselves in times of volatility?
A. Diversify your portfolios. This is a truism but when times are good diversified portfolios do not perform as well as the stock market and people opt to take on more risk to reap the rewards. For example, last year, if you were in a diversified portfolio you may have made 7% to 10% but the New York exchanges were up about 20% largely because of technology stocks. Diversification is the key to protect against downward markets. This month when the markets lost 10%, a good diversified portfolio only lost 2% to 3%. You never hit the homerun but you never strike out either. It comes down to understanding your risk profile. Another way investors can protect themselves is through good active management. Advisors should be able to make sense out of what is going on and figure out what to do. I continuously rotate assets in and amongst assets. I continuously take profits off the table. I continuously move money into stocks and sectors that have not gone up yet. You have to be smart. In my opinion, the of buy and hold approach is not viable in volatile markets.
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