Bad News In Perspective

The holiday season is supposed to be about good cheer. Given the economic news, you might think investors would have plenty to be cheerful about. For example:

Economic growth is strong. The Federal Reserve Bank of Philadelphia’s Fourth Quarter 2018 Survey of Professional Forecasters projects real GDP growth of 2.7% for 2019, down just slightly from the forecast of 2.9% for 2018.
Unemployment is at 3.7%, the lowest rate in 50 years.
Inflation is moderate. The Philadelphia Fed’s latest 2019 forecast is for an increase of 2.3% in the Consumer Price Index (CPI), down slightly from its forecast of 2.4% for 2018.
Consumer sentiment (a leading indicator) is strong. The final December University of Michigan Consumer Sentiment Surveycame in at 98.3, remaining near the highest levels we have seen over the past 18 years (despite the recent weakness in stocks). The last time the Consumer Sentiment Index was consistently above 90.0 for at least as long was 1997 through 2000, when it recorded a four-year average of 105.3.
The November ISM (Institute of Supply Management) Non-Manufacturing Purchasing Managers’ Index came in at 60.7%, 0.4 percentage point higher than the October reading of 60.3%—representing continued growth in the nonmanufacturing sector and at a slightly faster rate. The six-month moving average of the index is at about its highest level in more than 20 years. The Non-Manufacturing Business Activity Indexincreased to 65.2% in November, 2.7 percentage points higher than the October reading of 62.5%, reflecting growth for the 112^th-consecutive month, at a faster rate.

The bottom line is nothing in the economic data indicates we are headed into a recession that could lead to a bear market (with the stock market being a leading indicator). While the current economic expansion is now 10 years old, expansions don’t die of old age, as many seem to believe.

For example, the Netherlands didn't have one between 1981 and 2008, and Australia’s streak is currently at 27 years. Expansions die either because geopolitical risks show up, or because the Fed tightens monetary policy, driving real rates to high levels to fight inflation.

Today the real rate on one-month Treasury bills is about zero. Even if the Fed were to raise rates three more times over the next 12 months (the market currently expects only one more rate hike in 2019), the real rate would still only be about 1%, which is about the historical average, and certainly not indicative of a tight monetary policy that would cause a recession.

Keep Losses In Perspective

I mention the good news because it’s easy to lose sight of the facts when, for investors, there has been little cheer. The S&P 500 Index dropped 579 points from its closing high of 2,930 on Sept. 20 to finish at 2,351 on Dec. 24, a price drop (not including the return from dividends) of 19.8%. From Dec. 1 through Dec. 24, the S&P 500 fell 409 points, a drop of 14.8%. Since 1926, we have had only 10 worse months—the worst was the 29.7% loss in September 1931—and only two worse months in the last 78 years (October 1987’s loss of 21.5% and October 2008’s loss of 16.8%).

That said, large losses are not that unusual. For example, from 1948 through 2017, the Dow Jones industrial average (DJIA) fell at least 15% about once every three years—with the average duration being 275 days. It also fell by 20% or more about once every six years, with the average duration being 425 days.

What really has investors worried is whether this current drop will turn into a roaring bear market—defined as a drop of at least 20%. As you can see in the following table, over the last 100 years, the DJIA has experienced 15 such drops, with an average loss of 38.7% and an average duration of 403 days.

Investors Fear Risk

What makes such markets difficult to live through without panicking is that, on average, investors are highly risk averse. Nobel Prize winner in economics Richard Thaler, author of the book “Misbehaving,” has found that we tend to feel the pain of a loss twice as much as we feel the joy from an equal-sized gain. And that ratio increases with the size of the investment!

Research has found that losses even lead to heightened autonomic responses, compared to equivalent gains. Professors Guy Hochman and Eldad Yechiam of the Israel Institute of Technology studied the effect of losses on investors and noted that losses spurred higher physical responses, such as pupil dilation and increased heart rate. This was true even for people who weren’t naturally averse to losses.

So, if your investments are causing you to feel stressed, do not feel bad about your anxiety; your feelings are normal. However, the first step to addressing a problem is to admit its existence. Even if you have a well-thought-out plan that anticipated such declines, as the well-worn saying goes, all plans are great until the first shot is fired. Similarly, renowned philosopher Mike Tyson famously quipped that everyone’s got a plan until they get punched in the mouth.

If you’re feeling punched, it’s normal. However, it may mean that you were overconfident in estimating your ability or willingness to take risk. If that’s the case, a review of your plan is in order to determine if you could meet your financial objectives with a less risky portfolio. It’s better to admit the error now, and correct it, than to run the risk of much deeper losses that might lead to panicked selling and/or the failure of your financial plan.

Larry Swedroe is the director of research for The BAM Alliance.

This commentary originally appeared December 31, 2018 on ETF.com.

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