RETIREMENT TIPS: Regarding the Recent Market Downturn

By ALAN KONDO, CFP, CLU

The U.S. market experienced a downturn last week, with the Standard and Poors 500 index down 3.1% since the beginning of January, and the Dow Jones Industrial Average down 4.2%. The media has jumped on this negative news and is stirring up fear about whether this represents the beginning of a bear market or another recession. Their assertions about “This time it’s different” could not be farther from the truth.

To put things in perspective, the current downturn has occurred after U.S. stocks hit a record high following a 30% gain last year. The S&P 500 hit a record high of 1,848 on Jan. 15. The markets have had a pretty good run since the great recession of 2008, and we know the market never goes up in a straight line. Periodic downturns are a normal part of the market, and are a reflection of how healthy markets work. Below is a table showing the average frequency of market pullbacks.

History of Dow Jones Industrial Average Decline

Source: Capital Research & Management, Inc.

In general, Wall Street likes investors to trade as often as possible because it increases their revenue through trading charges that add up to about $100 billion each year. This is why they spend millions of dollars annually promoting strategies like stock picking and market timing that require investors to trade frequently. However, successful investors tend to be those who do not panic, trade only to rebalance their diversified portfolios, and keep their investment costs to a minimum. Those who followed this approach typically did well, even through the Great Recession.

The current correction is actually happening because the U.S. and global economies are getting stronger. In the U.S., companies are making good profits. The real estate market is doing well with the most housing starts in six years. Unemployment is down to 7%. Internationally, European countries are coming out of their recession and may experience a strong recovery similar to the U.S. rebound in 2009. The current negative blip in the market is not likely to affect these long-term prospects. The International Monetary Fund expects the U.S. economy to grow 2.8% in 2014, up from 1.9% in 2013. ¹

Ben Bernanke, the former chairman of the Federal Reserve Bank, determined that the improving health of the U.S. economy made it safe to scale back the economic stimulus. Last December, he reduced the monthly purchase of bonds from $85 billion to $75 billion. His successor, Janet Yellen, is likely to continue that process and taper back by another $10 billion this month. This will likely cause interest rates to return to normal levels, reaching perhaps 5% by 2016.

When interest rates increase, bond values tend to decline. This particularly affects bond mutual funds which have no maturity because they are a basket of various bonds. Bond fund that contain longer maturity bond funds are likely to decline the most. This will be an unwelcome surprise for those investors who panicked during the recession, sold all their stocks and put the money into long maturity bond funds. The upturn in U.S. interest rates means that long bonds have suddenly become one of the most risky investments. This is one reason why money is fleeing from long-maturity municipal bond funds and Ginnie Mae mutual funds that invest in long-maturity mortgage securities.

During the time when U.S. interest rates were declining, global assets moved to emerging market countries where they could receive a better rate of return. Now that U.S. interest rates are becoming more competitive, that money is returning to the U.S. This is one of the reasons that China’s growth is slowing. The other reason is that China is attempting to curb corruption and avoid runaway growth by purposely slowing down its economy. Both events are normal and positive.

In the meantime, the pullback in the market presents a buying opportunity. A properly diversified portfolio has assets classes that take advantage of a booming market (growth strategies), and asset classes that do well when the market is down (value strategies). In the value strategy we want to buy when stocks are a bargain and sell after they grow. Over the long term, value strategies tend to outdo growth strategies.

One of the characteristics of a globally diversified portfolio is the ability to keep pace with the growth of the market when it is doing well, but to give additional downside protection when the market pulls back. It is during these times when diversification makes more sense than ever.

¹ Associated Press 1/24/2014

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The opinions expressed above are solely those of Kondo Wealth Advisors, LLC (626-449-7783, info@kondowealthadvisors.com), a Registered Investment Advisor in the state of California. Neither Kondo Wealth Advisors, LLC nor its representatives provide legal, tax or accounting advice.