Congratulations! You just made it through the fastest bear market in history. Think about this—it took 22 trading days for the S&P 500 to drop 30% from all-time highs. Along the way, we saw single-day drops of 11.9%, 9.5%, and 7.6%.
With the economy still on rocky footing and unemployment soaring, you may have been surprised that stocks turned positive for the year last week. Some parts of the market even returned to all-time highs!
With all this bad news in the economy but good news in the stock market, most investors I talk to have the same four questions:
1. “How can stocks recover so quickly when the economy isn’t back to normal?”
What investors are thinking: “Are stocks in a bubble? Should I be worried?”
I wrote in a previous blog post that stocks tend to recover before the economy. Stock investors are forward-looking—looking past the bad news (which was anticipated) and predicting an economic recovery in the second half of the year.
Even in the middle of bad data, green sprouts were emerging. The pandemic was slowing, states were opening up, and the May jobs report was better than expected.
Lastly, the government fiscal response has been great in size and speed. Households and businesses were given money and credit, and unemployed workers are receiving higher weekly checks. Personal income increased 10.5% in April. With nowhere to spend, personal savings spiked to 33%. With all this money, we should continue to see a recovery in the American consumer in the coming summer months.
2. “Why is my account still negative?”
What investors are thinking: “Did I do something wrong? Tech stocks are killing it—should I invest more there?”
Chances are you have a diversified portfolio, which means your returns don’t mirror the returns of the S&P 500, Dow Jones Industrials, or the NASDAQ. Why? They only represent a segment of the stock market. All three indices are composed of larger companies. The S&P 500 even gives more pie to the largest of these companies. The NASDAQ is extremely heavy in technology companies, while the Dow Jones only has 30 companies represented.
In addition to these types of companies, you probably also own two other segments of the stock market: smaller companies (“small cap stocks”) and international stocks. How have these fared? As of June 15, small cap stocks were down over 15% year-to-date, and international stocks were down just over 12%.
It can be tempting to adjust your allocation based on these statistics. As humans, it’s natural to think that recent trends will continue. We fall for the belief that current winners will continue to win, and the latest laggards will continue to lag. The truth is, recent price performance does not indicate the future direction of prices. Moving allocation based on present-day performance is not a good strategy.
3. “Where are the opportunities?”
What investors are thinking: “Since stocks have gone up so much, is there still room to grow? Should I be looking at other asset classes?”
Instead of changing your allocation to invest more in recent winners, investors may be better off taking advantage of asset classes that haven’t done so well. Thinking opportunistically, the aforementioned area of small cap stocks may be presenting a great buying opportunity for long-term investors for the following reasons:
- While small cap stocks are more volatile than larger company stocks, they tend to outperform when the market recovers after large drawdowns.
- Furthermore, small cap stocks have historically given investors higher returns.
Because history favors small caps, especially after bear market declines, and recent performance is behind the broader market, we believe there is an opportunity in small cap stocks.
Another area to consider is your international stock exposure. Investing overseas has not been as well-rewarded as a US-based portfolio in recent years. However, this sets up international stocks to have higher expected returns over the next five to 10 years.
4. “So, are we out of the woods?”
What investors are thinking: “The virus threat isn’t over—should I pull out my money until the dust settles?”
It’s common for the market to have sharp increases during a bear market, only to lose steam and fall even lower. With the speed of a fiscal stimulus, better news about the virus, and a surprise jobs report, the market lows seem to have been made on March 23.
We don’t recommend an investor ever make bets on short-term market trends. The market always has the ability to go lower. With this in mind, we think it’s best to have a diversified portfolio that matches your tolerance for short-term volatility. This allows you to be in the market to realize the long-term trend of rising stock prices.
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