Throughout the course of history you will find that prevalent disasters tend to come from a lack of preparedness or worse, overconfidence. Many of us can recall events like the Titanic, the bombing of Pearl Harbor, and the Challenger Space Shuttle. There is a tendency for human beings by nature to become complacent during times of prosperity. History has proven time and time again that unpreparedness and lack of awareness can lead to catastrophic damage. What does this have to do with your Investment Portfolio? Many of us have systems in place like doctor check -ups, Dietitian visits and news updates to routinely monitor and evaluate our status on our physical, emotional or economical health. What about financial? At HFG, we believe there are moments within a market cycle that call for “Life Boat Drills”. Why you may ask? The concept is quite simple. For one, it makes good sense to evaluate your position every now and then to make sure you are prepared. Two, when market valuations lie on the high side of the spectrum, the probability of a market correction increases and future returns tend to be tame. Obviously, the higher the valuation the higher the risk. Much like travelling across ocean in the unpredictable winter season, one might be better served to check the weather than say in the warm summer season where the probability of a storm is historically low.
Most experienced investors will be familiar with the last two significant market declines (Bear Markets) and should remember the level of optimism prior to each collapse. Our goal is to educate and make aware of the current investment climate. We hope to illustrate that attractive future returns do not occur by happenstance and that there is quantifiable order to the chaos. We have attempted to do so in our research below
Stock market declines can be measured by percentage change from top to bottom as shown in the column “% Decline”. It can also be measured by understanding what investors are willing to pay, for a dollar of earnings at the top of the market to the bottom of the market. I prefer to review the latter approach because it helps explain the change in price. Remember, all businesses that are perceived to be sustainable are worth a multiple of their future or past earnings. For example, if you owned a rental that generated $100,000 in income per year, you wouldn’t sell it for $100,000 or one times rent. No, the price that you would be willing to part would be a multiple of the annual rent. The exact multiple is a function of the market’s return expectations, future increases in the rent and the general optimism or pessimism of the economy. Historically, investors in the stock market as measured by the S&P 500 would be willing to pay as little as 5.57 for a dollar of earnings in 1932 and as much as 43.22 at the peak in 2000. This is a huge range of investor perception of value. However, if we examine the averages we can see that risk rises for a correction when investors pay over 22 and there is support for prices at 14. It is also interesting the length of time for investors to break even over the 16 bear markets. The worst of the bears take on average more than 7 years. If you are wondering where the current P/E ratio is today it is approximately 25.
We suggest that you “Stress Test” your portfolio to see how it would of held up during the four most prominent bear markets. We recommend that this life boat drill be performed so all investors are aware of the risk they are exposed to. If you are comfortable with the results, we feel you are well informed and equipped to venture forth. If you do not like what you see, we encourage you to visit with your advisor or contact a Certified Financial Planner at Haberling Financial Group and find out how you can minimize the risk within your portfolio.
“You can bail water 24/7, and no matter how good you are at not sinking, you still have a hole in your boat.” – Kelli Jae Baeli
Test Your Portfolio!
Use this stress test application to simulate how your portfolio would perform during the 4 worst bear markets in history.
Input Your Current Portfolio Values
Results: Your Portfolio Value After the Following Bear Markets
Your Portfolio Percentage Decline
* The return in bonds is assumed to be a static 5% from top to stock market bottom.
** The decline in stocks is the actual decline from top to bottom of the bear market in that time period.
*** This is what percentage loss your portfolio would experience in each of the four Bear Markets.