Lately, one of the most frequently asked questions we receive at WT Wealth Management is, "why does this market keep going up, is a big correction coming?" Or, put another way, "is the stock market in a bubble?"
Market downturns are never a question of "if," but "when," the next meaningful decline will occur. Yet history reminds us that market selloffs should be viewed more as nuisances to be prepared for, rather than tragedies to be overreacted to. Every pullback, correction, and bear market in history has eventually recovered.
What's the Difference?
|Type of market downturn
||Percentage decline of recent market high
||5% - 9%
||10% - 19%
||20% or more
"We can look to Hyman Minsky, a posthumously revered American economist, for some guidance... Minsky [hypothesized] that a substantial period of investment gains creates an environment in which market participants have a diminished perception of overall market risk. This in turn can result in more speculative investing behavior. In the event of a decline, investors might be forced to sell more liquid and less speculative investments, [out of generalized fear,] amplifying the market sell-off — thus creating a 'Minsky Moment.'" (1)
Easy markets can lead investors acting on their own to make ill-advised decisions as they become fearless. It's easy to convince yourself to take more risk than you should when you feel like the market is simply going up every day. Meanwhile, experienced investors become more fearful as the length of time expands between corrections.
So, are we in a bubble? Is the market over-extended or over-valued? Probably a little bit.
The stock market is a unique, forward-looking mechanism and should trade 3, 6 or even 9 months ahead of any anticipated surges or declines in national or global GDP. Stocks typically rise in anticipation of stronger periods of economic growth. Nearly every economist today seems to be positive about the future as countries experience the effectiveness of new vaccines, begin to recover from the pandemic, reap the benefit of greater savings rates that were seen during the pandemic (2)
, and feel the economic impact of pent-up consumer demand. Add in clear signals from the US Federal Reserve that 1) inflation will be allowed to run hot and 2) there is no plan to raise interest rates to slow down the economy over the next 2 years, and you have a recipe for the general optimism characteristic of a market bubble.
Stocks, in particular, may be rising because investing is all relative and stocks are more attractive in today's low-rate environment than sovereign debt or cash. An investor in the benchmark 10-year treasury at today's 1.46% would reap only $14,600 per million invested and still have to split some portion of that with the IRS along with 2% inflation eroding their spending power. (3)
In other words, that investment in a 10-year US Treasury actually generates a net negative return. This has come to be known as "TINA" ("there is no alternative").
That being said, the 10-year treasury rate has been steadily rising over the last few weeks, recently pushing above 1.5% for several days - a level it hasn't seen in more than a year. Some investors are beginning to think MTIAA ("maybe there is an alternative"). As relatively risk-free US Treasury yields push higher, we'll also see contagion in corporate bonds, high yield and even preferred stocks or REITs. For example, corporate bonds are much more compelling as an investment alternative at 5% than 3% and high yield is far-more compelling at 7% than 5%. Investors may soon have real alternatives to equities, which may lead more risk-averse investors into more moderate "risk off" asset classes, which could further weaken equities as demand subsides.
The bottom line is that it is inevitable for all asset classes to experience cycles. Corrections are a natural part of the investing cycle. If the markets are a little bit ahead of themselves, it's understandable given the environment and we'll soon see a correction and a resetting of prices and valuations. Remember that we had a nearly 10% intra-month decline in September 2020 followed up by a 7% decline just prior to the November 4th Election. And we survived those.
In our view, corrections are not a reason for investors to abandon investing and head to the sidelines, attempt an impossible-to-execute market timing strategy, or be overly concerned at all. This is most true when investment portfolios have a long-term plan that goes beyond days, weeks, months, quarters or years and are well-diversified, across and within a variety of asset classes including equities, fixed income, real estate and alternatives. With a solid, diversified portfolio structure in place, no one needs to get too high or low emotionally.
The reality is that market rallies and corrections occur (even Minsky moments will happen), but the trend line for stocks over the long run is distinctively upward. Unfortunately, no one really knows if we are in a sustained rally or a speculative bubble until it is in the rear-view mirror — and it really doesn't matter for longer-term investors anyway. Who should worry? - Investors who have allowed greed to overtake fear, who have taken more risk than was prudent, and who do not realize or acknowledge the underlying perils to their approach.
At WT Wealth Management our investment team and your advisor are always available to discuss your accounts and how you are positioned. That way, when the next pullback, correction or bear market emerges, you clearly understand the potential impact on your portfolio. Please give us a call if you would like to discuss further.