If the recent stock market swoon proved anything, it's that panic selling comes back to people easily, just like riding a bike. Staying calm when the market takes a spill? That requires practice, as was evident in late August when Wall Street suffered its biggest skid in four years.
Yet that patience is often rewarded.
The late summer downturn was the closest investors came to bear-market territory since the summer of 2011, when the S&P 500 fell nearly 20%. Prompted by a slowdown in China and other economic troubles around the world, the summer sell-off was modest by historical standards. By late September the S&P 500 had lost only about half as much as it did in the 2011 correction. And thanks to a recent rebound, the broad stock market is down only around 6% from its 2015 highs.
Is this correction over, or is one of the longest rallies in history still in jeopardy? Does a recession lurk around the corner? Answers to these and other questions should give you peace of mind — and help you make the right investment moves now.
COULD A BEAR MARKET STRIKE?
Possibly, but most market analysts think the U.S. economy still has enough momentum to get past this global economic speed bump.
For instance, U.S. gross domestic product accelerated in the spring to an above-average rate of 3.7%. And for the past year the economy has created a brisk 247,000 new jobs a month on average. "There are no signs a recession is imminent," says Edward Jones investment strategist Kate Warne.
Why is this important? For two reasons: First, it reduces the odds of a full-blown bear, as most bears foreshadow economic contraction. And in the event that selling returns to Wall Street, a growing economy lowers the likelihood of an especially grisly attack.
Major sell-offs that weren’t followed by recessions have averaged losses of around 20%. That pales in comparison to the 50% or greater losses in the last two full-blown bear markets.
YOUR BEST MOVES
• Strengthen your defense. Even though the economy is still expanding, companies are having trouble growing profits. S&P 500 earnings, in fact, are expected to shrink in the latter half of 2015. That's bad news, since corporate earnings drive the market over the long run, says Scott Clemons, chief investment strategist for Brown Brothers Harriman’s wealth management business.
Put new money to work in health care and consumer companies that don't require strong GDP growth to generate profits, says James Stack, president of InvesTech Research. Vanguard Windsor II (VWNFX), with a bigger-than-average stake in such defensive areas, has beaten 70% of its peers over the past 15 years.
• Think valuation, not volatility. In rocky times, investors tend to prefer reliable earnings over fast growth. But low-volatility Steady Eddies now trade at a 10% premium to the market. Go instead with a fund that seeks undervalued stocks. T. Rowe Price Value (TRVLX), with holdings 20% cheaper than the S&P 500, has beaten the market by nearly four percentage points a year for the past 15 years.
IS IT TOO LATE TO SELL?
You may be tempted to lighten up on equities to protect against further declines. But it's not that simple. Many stocks have already sunk into their own private corrections or bear markets. To sell those shares now would lock in sizable losses.
Meanwhile, you risk missing a rebound if you sell a broad market fund — like the near-10% rise in the market since the market lows of August 25.
Over the past quarter-century, only two out of the nine market selloffs of 10% or more morphed into real bears, formally defined as a decline of at least 20%. The seven that didn't averaged losses of 16%, nearly what you've already endured.
YOUR BEST MOVE
• Make your portfolio less taxing. One type of selling that does make sense is the kind that helps mitigate the tax bite on your bull market gains. By selling investments that are down, you'll realize losses that can be used to offset capital gains in your portfolio. But don't upend your long-term strategy in the process.
In fact, you can use such a sale to give your portfolio a makeover, says Christine Benz, Morningstar's director of personal finance. Sell a higher-fee fund that's down to get the tax loss, then buy a lower-cost fund in the same category.
For example, you could sell Longleaf Partners International, down 21% over the past year, and buy Vanguard Total International Stock Index (VGTSX), cutting your expenses from 1.25% to 0.22%. Since the funds aren't substantially the same, you won't trigger the wash-sale rule that would disqualify your tax loss.
IS IT TOO EARLY TO BUY?
For the most part, yes. The summer slide cut the S&P 500's P/E ratio from 26.9 to 24.8, based on 10 years of normalized profits. But U.S. stocks are still more expensive than the historical average P/E of 16.6. "We have a ways to go to get back to a healthy state," says New York City financial planner Lewis Altfest.
Indeed, in the 2007-2009 bear market stemming from the financial crisis and the 2000-2002 bear market stemming from the tech wreck, the S&P 500's P/E ratio sank about 50%. Even in the 1987 crash, price/earnings ratios sank 27%. This time around, valuations have sunk less than 8%.
Also, it's probably too early to replenish your equities by rebalancing, which people generally do about once a year. A portfolio that was 60% stocks and 40% bonds at the start of the year is now at 59%/41%. Adjusting isn't worth the effort.
YOUR BEST MOVES
• Cross the Atlantic. While it may be too early to value hunt in the U.S., that's not true in Europe, says Altfest. European stock valuations tend to be near ours. But European equities are now 25% cheaper. And while U.S. earnings are expected to be flat in 2015, European profits are forecast to grow 8% this year and 9% in 2016.
Oakmark International (OAKIX), in our Money 50 list of recommended mutual and exchange-traded funds, keeps more than 70% of its assets in Europe and has beaten more than 95% of foreign blue-chip funds over the past 15 years.
• Try the developing world. If you're patient and have a long time horizon, add emerging-market stocks. True, these markets are at the the epicenter of the current global slowdown.
But Chris Brightman, chief investment officer for Research Affiliates, sees a possible replay of the 1998 Asian crisis, when economic troubles devalued the region's currencies. "Everybody decided international diversification, particularly in the emerging markets, was the wrong move," he says. Yet over the next decade developing markets trounced U.S. shares.
One way to invest is via T. Rowe Price Emerging Markets Stock (PRMSX), a Money 50 fund holding less than 10% in sectors tied to commodities, which have been hardest hit by the global slowdown. In contrast, nearly a quarter of the MSCI Emerging Market index is held in energy, materials, and industrial stocks.
SHOULDN'T RETIREES AND PRE-RETIREES BE WORRIED?
"What's going on in the headlines is probably not what's going on in your portfolio," says Stuart Ritter, a financial planner with T. Rowe Price. He notes that if you're in or near retirement, you may have only 60% of your nest egg in equities — very likely down minimally, as mentioned before.
YOUR BEST MOVES
• Change your thinking, not your portfolio. Imagine that your 30-year retirement is two separate 15-year blocks, says Ritter.
What does that accomplish? Theoretically, that portion of your portfolio that’s in stocks would be in that second block, reminding you that you have time to recover market losses. Ritter also points out that equities have never lost value over any 15-year stretch in history.
• Satisfy the urge. The natural inclination in a sell-off is to, well, sell. Feed your need to do something by raising your savings rate to compensate for your losses. If you're not sure you can swing this, just do it while the selloff lasts, says Morningstar's Benz.
History shows that downturns, thankfully, don't last all that long. The average correction runs for only 138 days, while the typical bear market survives less than 18 months. Think of it as short-term pain that will help get your long-term gains back on track.