December 28th, 2014

Emergency Plan

Let’s say you have $60 invested in the stock market.  You have $30 invested in bonds and $10 sitting in your savings account, for a total of $100.  This is essentially a 60/40 stock/bond mix. You do not rely on your investments for current income.

Some crisis unfolds, sending shock waves through global markets.  Within a month, the stock market loses 30%.  Bonds have gone up 10% as investors flee to safety.  Financial soothsayers are predicting further stock losses, perhaps as much as 50%.  Others are saying that the market has bottomed.

Your stock portfolio has lost $18 (30% of the $60).  Your bond portfolio has gained 10% or $3.  Your portfolio is now valued at $42 stocks, $33 bonds, $10 savings, a 50/50 mix of stocks/bonds.

Now, let’s add some historical context. From 1968 to 1982, a period of fourteen years, there was no change in the SP500.  From 1982 to 2000, the SP500 rose 1400%.  Then from 2000 to early 2013, almost thirteen years, there was no change in the SP500.  Yes, it’s only been a year and a half since the market regained those levels of 2000.

So, what would you do?  Do you:

A)  Invest the $10 in savings to bring you back closer to your original allocation mix of 60/40 stocks/bonds.

B) Stick to allocation goals.  Keep the $10 tucked away in savings for emergencies, sell some bonds and buy stocks to get closer to your allocation goals.

C) Change your allocation mix.  Cut your losses by selling the stocks you own and buying the better performing bonds.

D) Shrug and make no changes.  Turn on the game and order a pizza. The stock market will rebound in due time and automatically rebalance your portfolio on its own.

E)  Freeze, not knowing what to do.  Yes, not knowing what you would do is a game plan, a choice.  Perhaps its not the best plan but it is often one chosen as the default.

Now, run that same scenario, changing only one thing. You rely on your investments and savings for half of your current income.  Now what do you do?

Was the past year and a half the beginning of an eighteen year run up in prices similar to the 1982 – 2000 period?  Could the SP500 index, currently trading near 2100, be valued at 21000 (1500 * 1400%) in 2032?  Maybe.  Could 2014 be the last year in the previous flat cycle so that the market drops 25% to the 1500 level of 2000 and 2007?  Maybe.

GDP

The third estimate of 3rd quarter GDP growth was a strong 5% on an annualized basis, more than offsetting the weak 1st quarter of this year. On a more sobering note, it is only in the past six months that per person GDP has firmly surpassed 2007 levels.

GDP is a measure of tradeable goods and services in an economy.  There is much important human activity that is not measured in GDP so it is far from perfect.  If you want perfect, go to the universe next door. Per person GDP growth below 1% causes concern among traders, money managers, economists and policy makers.  This year per capita growth is a healthy 2% – not robust but respectable.