We finished a strong year, but perhaps not as strong as the numbers appear. Remember, we started from a low point after the market tanked in the 4th quarter of 2018 when the market decided the Fed was tightening too fast. The Fed reversed course, and after a few zig-zags rallied to finish strong.
I look for the stock market to return around 10% per year ON AVERAGE. Rarely does it go up 10% in any given year. It seems to be either +20% or more or -10% to flat. Furthermore, on average it goes up about 2 out of 3 years. That means it goes DOWN about 1 in every 3 years. We emphasize planning for liquidity to reduce the need to sell when the market is down. Financial planning helps define when, and how much you expect to need from your portfolio, at least for major events you can plan for.
A good year in the market does not change affect the probability that the next year will be up or down. Much like flipping a coin, the market has no memory. The market reflects what is known and expected at any given time. You can’t time the market and go to cash after years the market goes up by more than average and expect to improve the odds. That’s the gambler’s fallacy.
I view the current rally as a high risk, risk-on market. The rally is high risk because it occurred while 3 significant geopolitical events were happening: impeachment, trade war, and Brexit. A negative outcome from the market’s perspective in any one of these events could have precipitated a market correction. The trade war and Brexit appear to be moving toward a positive direction. Although pro-business Trump has been impeached by the House, the market appears to discount the possibility of conviction in the Senate.
Where do we go from here? The key variables include interest rates, valuation, and earnings. Economic indicators point to continued slow expansion rather than recession. Generous valuation is a function of low interest rates. Low interest rates coupled with continuing slow expansion can sustain current valuations. The wild card seems to be inflation. Although there is little indication that it will accelerate, it is notoriously hard to predict. The Fed wants higher inflation, and inflation could erase some Government debt (they pay it off with cheaper dollars). The Government would benefit from higher inflation. Inflation drives long-term interest rates and that would challenge valuations. Fortunately, as the last 10 years indicate, it is hard to generate inflation without stronger growth, but faster growth would help offset the effect of higher interest rates.
This starts to look like a circular argument, and that’s good news. Much like Newton’s Third Law, for every force there is an equal and opposite force, the economic forces driving markets tend to revert to long term averages. However, caveats include non-economic events such as wars, plagues, systemic failure, and meteor strikes. Sleep well!