I feel a certain optimism in the air. Slowly, lockdowns are easing on a state-by-state basis. Like everyone else, I have missed seeing my friends and eating at a favorite restaurant. I even miss going to my dentist. With caution, I will adapt to the new environment. All in time, I expect to get more comfortable to meander more freely in this new normal.
There is a new normal in investing with unusual swings not typically in previous markets. As an active investor for a long time, I have seen my share and felt the pain of market volatility. When I first started working for a brokerage firm, someone told me the most successful people on Wall Street have lost their job three times and bounce back. Rites of passages like these extend to investing in the market. Through experience, I have learned the nuances of the market. However, the financial markets have been difficult to define during the coronavirus even by the most experienced investors.
Are We In A Bear Or Bull Market?
The S&P 500 index peaked on February 19, 2020. Soon after, our bull market passed away at nine years old on March 12, replaced by the bear market when the index fell 26.7% to $2,480.64. That swing took less than a month, falling to what seems to be a trough on March 23, reflecting a very quick decline of almost 34%. Volatility continued onward. Stocks surged in April, providing the best one month record since 1987. By May 20th the market reclaimed a big chunk of the fall in stocks though it is still 12% below the February peak.
The question has been raised as to whether this is a bear market, bull market, or bear market rally? A bear market occurs when a stock or market declines in value by 20% or more from previous highs over weeks or months. On the other hand, a bull market is when the securities or the market have risen over 20% over time. Traditionally, this remains a bear market unless stocks returned to their February highs. For more Wall Street Jargon, read this related post.
Bear Market Rally
A bear market rally occurs during a bear market (I know, duh) when there are increases of at least 10% in prices of stocks, bonds, or indexes. Our latest bear market began for the Dow Jones Industrial Average on March 11th, followed by S& P 500 index the next day. The market continued to drop to its lowest level on March 23, 2020. From that trough, stocks rallied nearly 30% through May 20, 2020. To me, that appears to be the epitome of a bear market rally. Don’t take my word for it.
According to the Bank of America Global Research Fund Manager Survey, 68% of these professional investors called the latest market surge a bear market rally. Just 25% of those surveyed thought it was a new bull market. Typical bear markets last 1.4 years with stocks losing 36% on average. However, we are not in normal times.
Investing should never be done in a vacuum. Traditionally, stocks go up in a good economy where low unemployment and price stability meaning low inflation. As a result of a relatively strong economy after the Great Recession, we had one of the longest bull markets. That doesn’t mean you can’t make money in a recession. You can but it is important to understand the different growth scenarios between a recession and a recovery.
Have A Working Knowledge Of The Economy
I have always recommended to new investors that they have a working knowledge of how the economy works and how it may impact the financial market. The coronavirus virus created a health crisis leading to a severe financial downturn. Stay-at-home orders affected businesses and their employees. In recent weeks, a record number of people filed for unemployment insurance and have received stimulus checks. Small businesses have been shut, many permanently. The Federal Reserve initiated aggressive actions by lowering the federal funds rate to zero and adding liquidity to the markets.
What Kind of Recovery Will We Have
The future direction of the stock market relies on the health of our economy which is dismal currently. The important question is how fast will our recovery be. The fund managers surveyed above indicated that there is a 75% chance of a U-shaped or W-shaped recovery while just 10% still see a V-shaped recovery. Let me explain these important differences of these lettered recoveries.
A V-shaped recovery is a best-case scenario where the economy rebounds as quickly as the downturn was. This financial slump is event-driven by the COVID-19. The prospects are linked to finding a vaccine quickly to curb the effects of the virus. Hopes have been raised as the FDA has approved some trials more quickly for treatments and vaccines. As a result of these headlines (eg Moderna), the markets have been exuberant, rising on those days. However, the chances appear to be small for the desirable V-shaped recovery.
The U-shaped recovery points to either sideways growth or a lack of growth with unemployment remaining high for months or years before recovery. This is a more plausible scenario. The Great Recession was such a recovery that lasted four years.
Moving on to the W-shaped recovery which looks like two conjoined V-shapes. Technically that is what kind of recovery the W shaped is. It means the economy quickly recovers but then falls into a second period of decline. This may be possible if we get a second strong wave of the virus as some health professionals have suggested. I am not speaking of the L-shaped recovery as it is simply too pessimistic.
Can You Invest And Make Money In An Economic Downturn?
Does an economic downturn mean you cannot invest stocks? Not necessarily but you need a game plan. I try to adapt to the market and what it is telling me. Financial markets go through corrections, bull and bear markets. When the market plunged in March, there was no crystal ball telling me what to do. I felt fearful and resisted selling my stocks by reminding myself that I tend to buy-hold for the long term.
While I did sell a few losers (and one or two winners which I since regret), I recognized the panic I felt. It is a very common feeling and the reason why sharp market declines occur. Naturally, I avoided looking at my retirement investment accounts on the worst days. Instead, I read and listened to some of the pundits I respect.
The problem with selling during economic downturns or market declines is that you will have actual rather than unrealized losses. Many times that is the worse time to sell your securities. Rather, it may be a good time to start buying stocks that are approaching bargain valuations. On the other hand, I have improved my discipline by trimming stocks that have risen 20%-25%. It is a good idea to at least trim some of your holdings in these kinds of markets if you are risk intolerant.
Looking back at the Great Recession in 2008-2009, and how the market reacted, you can easily see when you might have been able to make a lot of money in the stock market. It is always easier in hindsight to find that the trough or lowest point of the market was on March 9, 2009 and a good point to jump in with ready cash to buy stocks. Some smart investors did just that by looking for a bottoming of the market and for economic signs that the worst was over.
Take a look at our stock indices from peak to trough during the Great Recession:
Dates S&P 500 DJIA NASDAQ
10/09/07-Peak $1,565.15 $14,164.53 $2,803. 91
03/09/09-Trough $ 676.53 $ 6,547.05 $1,268.64
Percentage % -56.8% -53.78% -54.75%
By mid-May 2009, the S&P 500 was up 30%, rising over 60% by year-end 2009. Although you can’t pick the exact bottom of the markets, you can go bargain shopping for stocks that have undergone corrections or are in bear territory. For example, tech stocks have been strong leaders in this market. The market is not linear for long meaning it does not go straight up or straight down. There are many opportunities to invest in the market but you need to do some research on your own.
Consider These 8 Tips When Investing:
1. Emergency Funds Are Essential
Invest with what you can afford to lose. You should not have to borrow to pay for your living expenses. If this coronavirus taught us anything, it is that having a large emergency fund for liquidity purposes is important. By a simple rule of thumb, having funds to pay 6 months of living expenses may be fine for some people and hardly enough for others. How much you need to have on hand is dependent on the type of job you have and your expenses.
If you are a tenured professor or have a job that you can do remotely, you may be less likely to lose your job as many have during the pandemic. Then 6 months of savings in your E-funds may be enough. On the other hand, if you have a job with unpredictable income, your comfort level may require a year or more of savings. I recommend your emergency funds be invested in a money market deposit account (MMDA) that is FDIC-insured and liquid.
Related Post: Why You Need An Emergency Fund And How To Invest It
2. Diversified Asset Portfolio
Some of your investments should be in safer securities such as money markets and Treasuries as suggested for your emergency fund. Safe stocks may include utilities, reliable dividend stocks of companies with good balance sheets. Avoid stocks with high debt meaning a high debt-to-equity ratio. In a poor economy, companies with a lot of debt may lack liquidity and face default or credit risk. Besides dividend stocks, it is a good idea to have some growth stocks represented by companies with strong competitive advantages. Besides stocks you should have some bonds in your portfolio. Also known as fixed income, their returns tend to be lower than stocks but less risky.
While real estate may be worthwhile in your portfolio for added diversification, I am concerned about this asset, particularly commercial real estate in urban areas. As a result of remote working, many companies are discussing plans to expand flexible work options. Many businesses may close facilities, no longer needing the office space they have. Also, permanent department store closings–JC Penny, Macy’s, Nordstrom, Neiman Strauss, Victoria’s Secret, J. Crew–are increasing.
This trend has accelerated as a result of coronavirus. However, the writing has been on the wall as e-Commerce has become more desirable. These closures adding to potentially less office space needed may result in lower values of buildings and real estate.
3. Asset Allocation
Your risk tolerance often differs depending on how close you are to retirement. Young investors have longer time horizons to invest and can absorb higher risk in their portfolios with greater allocations to stocks than bonds. Investors in their 40s-50s should consider a more balanced portfolio of stocks, bonds, and money market securities. We explain this in more detail in this post on the need for diversification and asset allocation.
Related Post: 10 Tips To Diversify Your Portfolio
Trends That Changed As A Result Of Covid-19
4. Suspended Dividends
Some companies have temporarily suspended their stock dividends during the crisis such as Disney, a reliably strong company. This is expected to be a temporary measure but there is a need to do research on stable and reliable companies that can afford their dividends. I would not be surprised to see more dividends suspended during this time of uncertainty.
5. Don’t Count On Stock BuyBacks In The Foreseeable Future
Stock buyback programs have been a positive for stock investors for a long time. For companies with a lot of cash on their balance sheet, buying back their shares in the open market has propped up some stocks by reducing their outstanding shares and buying stocks viewed as undervalued. However, these programs have likely been shelved for the foreseeable future. It had become a political hot potato in recent months as many companies (eg. airlines) had used their available cash to buy back shares. Now, as a result of coronavirus, those companies have lost significant business and have received bailouts premised on not using the funds for purchasing their stocks.
6. Survival of The Fittest
The virus outbreak has produced winners and losers that may not have been obvious pre-pandemic. Keep in mind that as lockdowns ease, the losers may become winners as businesses return. Early on, companies relying on the travel and hotel businesses were experiencing loss of demand. Energy companies were impacted by a substantial drop in oil prices due to low demand. However this may change. Companies reliant on manufactured products from China were hurt in the initial outbreak in Wuhan.
Tech companies continue to be winners in this market especially those that participate in digital transformation. As a result of this new normal, many companies need to be better prepared to adapt their systems for future disruptions. Among areas of strong growth are companies that offer cloud offerings, disaster planning, remote working, or increased virtual living. Stocks that reflect these trends for working at home, distance learning, and remote health have been winners.
With disruption in supply, many companies benefited from being able to deliver products such as groceries, cleaning supplies, and services. The streaming companies such as Netflix and gaming companies (eg. Electronic Arts) benefited from us being at home more.
7. Earnings Visibility Is Low
Most companies have dropped their earnings guidance through the end of this year. Yet, the stock market has kept rising, seemingly not to care. As a former analyst, I must share that lack of forward-looking guidance is typically a reason for declines in a stock. I recall being on a conference call with a company whose stock I had a buy rating on. Management pulled guidance completely from analysts and investors. The pit in my stomach grew big. We all knew the stock was going to drop as it did the very next morning.
While it may appear that the market is not worried about this now, at some point the market may respond to this negatively. When companies lack visibility, investors usually sell the stock. This happened about a year ago to Ulta Beauty, a favorite stock of investors when certain changes were occurring in the cosmetics market, and their shares sold off significantly. Pre-pandemic, Ulta shares still hadn’t recovered its former high price.
8. Valuation Remains Important
Whether a stock is fairly prices, undervalued, or overvalued matters to investors. A common valuation for stocks is the earnings are price-earnings (P/E) ratio. This is calculated as price per share divided by forecasted earnings per share Typically, you want to be able to compare the stock’s P/E ratio to its historical multiple, to a market multiple and to its peers multiple. It is below those multiples, the stock may be considered to be cheap or a bargain.
Another valuation metric is the PEG or price/earnings to growth. The PEG ratio compares the stock’s P/E multiple to its earnings growth rate. Generally, a company with a higher growth rate should command a higher P/E multiple. If the P/E multiple is below the growth rate, the stock may be attractive to buy. Analysts publish their EPS estimates and price targets justifying their recommendations based on the company’s fundamentals and how it is valued in the market. If they find the stock is not reflecting the company’s fundamentals fairly, they can make changes to their buy or sell recommendations.
This is too simple an explanation for an important topic such as valuation. We will explain this more deeply in a future post. I want to point out that it is difficult to truly peg a value on stocks when companies have pulled guidance. I don’t fault the management for doing so in this kind of environment. They really have no choice in the near term as the timing of the economic recovery is so uncertain. At some point, this will matter to investors in this new normal.
This is an unusual time in our lives. Major changes have occurred as a result of the coronavirus outbreak. Investing in the new normal can be rewarding even in an economic downturn which brings uncertainty. Understanding some of these trends should help you with investing. Make sure to put some of the savings into your emergency funds, be diversified and disciplined.
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With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.