The Big One

It has been, for some 26 years now, a yearly ritual on Wall Street and in various financial media to mark the anniversary of the stock market crash of October 19th, 1987, otherwise known as "Black Monday." While the anniversary last month was displaced form the scripts of the talking heads by the political shenanigans in Washington over the government shutdown, the occasion was still noted, at least as a bit of stock market history. Typically, such historical analysis is tinged with the question, Could it happen again? To consider that question, we need to be explicit about what "It" was. Many people will remember that the Dow Jones dropped by 508 points that day. More important, perhaps, is that this point drop constituted a fall of some 22.61%, which, if applied to the market today, would be a decline of some 3,500 points on the Dow. And that would be enough to send traders and investors clutching their chests and proclaiming, like Fred Sanford (Redd Foxx, pictured above, on Sanford and Son), that this time it is "The Big One."

Could it happen again? I am always of the opinion that just about anything can happen, and history has already given us, by way of the 2008 financial crisis, a repeat performance--it just didn't happen all in one day. (For the record, between October 2007 and March 2009, the market dropped more than 50%.) The choice here, as if we had one, is between a slow-acting poison like Walter White's infamous Ricin in Breaking Bad or the more common method of execution on that show, a bullet to the head. Either way, it's pretty ugly. I still have vivid memories of the ugliness of 26 years ago. I was working for an investment management firm at the time, and I remember that several of us were just gathered around the old Quotron monitor, watching with stark disbelief as the points ticked away on the averages. The "shock and awe" continued over into the next morning, when everyone in the office was summoned to be in the conference room just after dawn for what felt more like a group therapy session than a strategy meeting. What impressed me most at that time was how the reaction of the investment professionals was so different from the investors who actually had lost money, at least on paper. During the ensuing days after the crash, I spoke with a number of seasoned investors, all of whom had suffered losses. Every one of them voiced the sentiment that they wished they had more cash to put into the market. What the professionals saw as an Armageddon, they saw as opportunity. So, just what sort of temperament allows an investor to take such market drubbings in stride?

While temperament no doubt plays a role, the more helpful answer here involves positioning. We can't inoculate ourselves against market declines (at least we can't without significant opportunity costs), but we can inoculate against the damage that can be done to our standard of living by such declines. To put it another way, the steps that we can take to ensure that we will never lose money are the very same steps that will ensure that we never make money. No risk, now reward; no guts, no glory. As we have pointed out in this space before, you shouldn't buy a single share of stock until you have determined what percentage of your assets you should have, or are comfortable having, in equities. In Wall Street terminology, this is known as the "asset allocation" decision. By way of example, imagine a forty-year-old investor who earns, at his job, some $300,000 per year. This fellow lives below his means and has managed to accumulate, say, $500,000 in savings. How should he invest that money? While there is never a "one size fits all" answer with regard to financial planning, this person is a good candidate for significant equity exposure. Assuming he has at least 20 years until retirement, he doesn't need his investments to supplement his income to support his standard of living. That means that he can invest for the long term and ride out the major swings in the market. The investors who weren't rattled by the 1987 crash had other assets, probably some money in bonds or a business that was their main source of their income.

Now, as another example, consider a sixty-year-old with just a few years until retirement. The income she makes from her job will soon be gone, so riding out major market declines is not really an option. The standard move here is to shift money from stocks into bonds, or at least to invest in more conservative, dividend-paying stocks. She should probably take her gains in Netflix (NFLX, $333) and buy Johnson and Johnson (JNJ, $93), or maybe some municipal bonds. The general rule here is that you're going to sleep better at night if you aren't relying on your stock gains to pay the rent or to make an upcoming college tuition payment. If your stocks continue to go up, you've grown your nest egg for the future; if they go down, you can weather the storm without suffering much detriment to your immediate financial health.

I have found that individual investors can be very good at picking stocks but notoriously bad at market timing. During a bout of significant market volatility a couple of years ago, a friend of mine said that he had had enough and was thinking about selling all of his stocks and going to cash. I advised him not to take such a drastic step, and I pointed out that he was falling victim to a binary, "all-or-none" way of thinking. Maybe, I suggested, he could scale back enough so that the market volatility wouldn't cause him such heartburn. I believe he took my advice, because selling out would have caused him to miss the market's major move up over the past year. The problem is that investors are tempted to sell when things look really bad, and if they do, then they get frustrated watching a major move to the upside and, you guessed it, they buy back in at the top. At times it is, indeed, the "darkest before the dawn."

Of course, we have to acknowledge that right now it's not very dark out there. Quite the opposite, in fact, as the sun seems to be shining on the market with the clouds off in the distance. And while we may not be experiencing the "irrational exuberance" that Alan Greenspan warned about years ago, we would be wise to remember that the market has come a long way lately. My wife and I have some cocktail napkins that feature a photograph of three women behind bars in jail and the caption, "The trouble with trouble is that it starts out as fun." Well, it has been--and may continue to be--fun of the barrel of monkeys variety, but how will we know when that fun is morphing into trouble? (In real life, that would be when the little voice in my head tells me that it's 2:00 in the morning and time to call a cab and go home.) No one is going to ring a bell to tell us that the market rally has ended (and if someone did, everyone else would hear it and stampede for the exits all at the same time). The best course of action might be incremental, as opposed to radical, steps. If you have a stock that has doubled, you can sell half the position and then "play with the House's money." It is a good idea to review your portfolio regularly and scale back any outsized positions, always staying diversified. Dividend-paying stocks are often less volatile than aggressive growth stocks that don't pay dividends, so you should keep that aspect of diversification in mind.You can set mental stops and raise them as a stock moves higher as a way to protect your gains or limit losses. Most of all, though, if you have arrived at your asset allocation based on a serious consideration of your other resources and your future financial needs, you are less likely to be seized by panic when the market swoons.

All of the above suggestions are for steps that we should be taking as part of our regular investment discipline, whatever the market is doing. So, is there anything with predictive power as to an impending market sell-off? The technicians, who study charts and volume, purport to tell us where the market is heading. Of course, since the quantitative definition of a bear market is a market that is down 20% from its highs, that's not very helpful except for confirming a changed trend. Although I do pay attention to the technicians, the cynical side of me thinks that what the chart-followers are really saying is that the market will continue to move up until it doesn't. Not very helpful. If I were forced to make one prediction, it might be the cause of a downturn, rather than the timing of one. In order for the rally to continue, the market will need to navigate successfully the transition from being driven by Federal Reserve stimulus to being driven by earnings. The good news is that the economic strength that would cause the Fed to take its foot off the gas is the same strength that would lead to better earnings growth. But, if the Fed is no longer able to control interest rates, if the bond market is going to demand higher rates because we can't get our fiscal house in order, it is conceivable that we might see higher rates without economic strength. That would mean a lower present value of future earnings AND the prospect of higher rates choking off the recovery. That is the kind of scenario that could trigger a swift and brutal sell-off.

Investors would be wise to look for signs of such trouble in the bond market. At least we should remember the words of Walter White, as they might be applied to that market: "How are you feeling? Kind of under the weather? Like you've got the flu?"

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of NFLX and JNJ. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.