Good News! There’s a Clearance Sale for Stocks
Rates are climbing, gas prices are sky high, and the market is down over 13% from the start of the year. Reading the news often feels as if the sky is falling. But as crazy as it sounds, I’m excited to see a pullback. That’s right, excited! Here’s why.
Signs of a healthy market
The S&P 500 entered 2022 at all time highs amid the backdrop of waves of Covid-19 and erupting Russian warmongering against Ukraine. Historically the stock market has returned an average of around 10% annually with a wide variation of returns from year to year. So while past performance is no indication of future returns, it would be unexpected to continue to see annual market returns of 20% which we’ve averaged over the last two years. If anything, some sort of reversion to the mean might have been expected.
It’s true that the market has reached numerous all time highs over the years. The US economy has been expanding for years as we continually innovate and introduce new and better ways of doing things. So while new stock market highs are consistent with a growing economy, those increases should generally be proportional to the additional value created. One simple measure we can look at is the price of stocks relative to the company’s earnings. The Shiller PE Ratio does exactly this by comparing the price of stocks to their cyclically adjusted earnings. However, even as we control for earnings using the Shiller PE Ratio, recent stock prices are still priced at higher levels relative to their historical averages when we’re thinking about their price relative to earnings.
Pullbacks aren’t uncommon
Another way in which the recent pullback is indicative of a healthy market is the frequency with which these sorts of events occur. Over the last twenty years there has been a 50/50 chance that a pullback of 10% or more in the stock market will occur in any given year. This coin flip chance exists even as we’ve enjoyed an 11 year long bull market here in the States! I’m not claiming to have predicted this market event. In fact you’re unlikely to see many people who can accurately predict these macro level events. What I am saying is that we shouldn’t delude ourselves into thinking the market is less volatile than it is. Despite average drops of 15% during a year, most of the years with pullbacks ended with a positive return. Even in good years a healthy market can fluctuate wildly and we should expect the market to continue to be volatile. These events are common enough that they can serve as a good test of risk tolerance.
Stocks on Clearance? Yes, Please
I’ve been lucky to enjoy strong returns since starting my investing journey in 2017. Even though the US economy had recovered from the financial crisis I still had some skepticism about how long the current bull run would last. However, up until recently I hadn’t experienced a significant drop in my portfolio. The drops in 2020 and now in 2022 not only test the assumptions of my risk tolerance, but they also offer an opportunity to purchase stocks at a discount. While I don’t know what the bottom of the market will be or when we’ll hit the bottom, I do expect that the market will be higher in twenty years when I hope to retire than it is today. Therefore, I want to continue to invest on a monthly basis in the stock market. With a twenty year time horizon, the risk that I’m forced to sell my securities at a loss to provide retirement income is almost zero. So hell yeah I’ll take that 13% discount!
Buying low and selling high is Finance 101. No one needs a reminder to haggle for a lower price when buying a vehicle or trying to sell their house in a hot housing market. Yet with stocks this basic principle is often forgotten. Investors often sell after prices tumble in response to negative news and only buy back into the market after the price has recovered. The tendency of stock market investors to sell low and buy high is a losing bet that highlights the psychological effect of investing in the market. I find it useful to remind myself of this effect, even more so now that I have a taxable brokerage account. Previously I only had retirement accounts like 401k accounts or IRAs (never opened the military TSP) and would have incurred a penalty if I were to draw from these accounts early. I never considered withdrawing from those accounts and the penalty is one reason. In contrast, the only thing preventing me from cashing out money from my taxable account is my own willpower and sense. The more that I am aware of this powerful pull to sell low and buy high, the more likely I am to catch myself and reevaluate my finances with a rational lens.
Time is on my side and maybe yours too
As a 90s baby I have plenty of years before retirement. Even with my goal to achieve financial independence by 50, I still have about twenty years to contribute to and grow my retirement accounts. Over a twenty year period, today’s fluctuations upwards or downwards by 10% in market value are almost meaningless. You can see this by taking a look at a graph of the S&P 500 or another major index and zooming out to a twenty year period. As you look over a wider time span the jumps and dips fade away. Over long periods of time the market has done incredibly well. So well in fact that even if you were to invest at the peak of the dotcom bubble, the S&P 500 would have still doubled in value by 2020. In reality though, most people won’t invest a single lump sum at the peak of a market cycle. Instead, you’re more likely to invest a smaller amount of money each month from your paycheck. Investing in this way is referred to as dollar cost averaging and can reduce the risk that you invest a large sum of money at the top of a market cycle.
If you’re also in your 20s or 30s then there is a pretty good chance that you won’t need to touch your investment accounts for decades. In such a case, the losses that show in your app or online are just paper losses. The amount of shares of ETFs, mutual funds, or stocks that you own remains unchanged. The loss then is only a real loss if you sell.
A little perspective: Short bear and lengthy bull markets
At this point the decrease in the stock market is defined as a pullback (10% decrease) rather than a bear market (typically 20%). As I noted earlier, there’s a low probability that any particular pullback will turn into a bear market. However, even if this pullback were to turn into a bear market, on average the bear market would last about 15 months. In comparison, the current bull market is over 8 times as long. I don’t enjoy watching my investments decline in value and I’m sure no one else does either, but the pain is typically short lived. In comparison, the latest bull market run has lasted an astonishing 11 years!
Despite the relatively short length of bear markets, many people I’ve spoken with still remember the market downturns most vividly. Gen Z and most Millennials have never experienced a bear market, yet many of us act as if the Great Recession is just around the corner. Even after 11 years of positive market growth, all time highs in stocks and real estate, investment portfolios that have only ever known a bull market, the fear of a major recession persists. There’s value in being aware of how much the market can decrease, but the Great Recession has the word Great in it for a reason; it was an uncharacteristically deep recession.
Marching Forward
I can’t predict where the market will be in six months or a year. If I could then I’d be getting paid a lot more than I am right now. What I can say is that most pullbacks like that one we just experienced to start 2022 do not lead to a bear market. In the minority of times when there is a recession it is typically not as painful as the Great Recession. Even if there is a recession, on average it’ll last just over a year. So my plan is to do what I did during every march in the military. I’m going to keep putting one foot in front of the other by investing steadily each month and use this pullback as a test of my risk tolerance. Based on how I’m feeling I might even increase my contributions to take advantage of the clearance sale I’m seeing.
I’d love to hear how some readers are handling the market pullback. Are there any tips or suggestions that I might be missing?
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