Stocks dropped by about four percent on the week and the proximate cause was the strength of the economy. In the bizarro world of investing, here’s how the reasoning goes: When the economy is expanding, the Federal Reserve has to increase short-term interest rates to ensure that inflation does not eat away at growth. That part has been built into most analyst assumptions, but only recently have we seen yields on 2, 5 and 10-year government notes start to climb. During the week, the 2-year spiked to the highest level in a decade and the 10-yr hit its top level in seven years.
Higher yields increase the cost of both consumer and corporate borrowing, which could potentially slow down the economy and hurt corporate profitability. They also can induce stock investors to move out of high-flying sectors like technology and into the safety of bonds. That’s what appeared to happen over the past week, which has resulted a very nasty start to October for U.S. stocks.
The big question, according to economist Joel Naroff is whether this is “a trend or just a temporary correction…over the past decade, each correction has been fairly quickly followed by a reversal of fortune and the markets took off. But this time it could be different.” What’s different now? A few things: we are seeing an aging expansion and bull market – and rates are rising.
The good news, says Naroff, is that “The economy is not falling apart, inflation is not surging and interest rates are getting closer to more normal levels. But, “if the taxes cuts don’t create an extended stimulus and trade issues keep pressuring the world economy, all bets on continued economic growth after next year are off.”
This period is reminiscent of a similar one earlier this year, when we had a 10 percent stock market correction. At that time, I said “Regardless of the why, it is important to cheer for this much needed market breather because it reminds us to acknowledge that investing is risky.” Here’s more of my advice from those dark, stormy February days…
I’m freaked out and can’t sleep: You probably came into this period with too much risk. If that’s the case, you may need to readjust your allocation. If you do make changes, do NOT jump back into those riskier holdings after markets stabilize. You need to make a pinky swear with yourself that you will stick to your revised plan -- FOR REAL!
I need cash from my account within the next 12 months: Whether it’s a house down payment, a car purchase or a tuition bill, that money should never have been be at risk at all, so admit that you blew it and get whatever you need out of the stock or even the bond market.
I don’t need the money for at least five years, but I’m still nervous: DO NOTHING. You should feel butterflies, because these gyrations are totally out of your control. But that does not mean that you should alter your game plan. Although you may be tempted to sell or halt your contributions into stock funds in your retirement or college funding plan, you do so at your own peril. Even if you manage to steer clear of continued drops in the market by staying in cash, you are unlikely to get back in at the bottom. This is called market timing and it is nearly impossible to do consistently over the long term. Additionally, if you are not investing on the way down, you will not be able to reinvest dividends and fixed-income payments at the bottom.
The best way to avoid falling into the trap of letting your emotions dictate investment decisions is to adhere to a diversified portfolio strategy, based on your goals, risk tolerance and time horizon. It may sound simple, but over the long term, it works. It’s tough to do, but sometimes the best action is NO ACTION.