If you’ve been thinking that stock markets have been pretty quiet this year, you are right. Through the first seven months of the year, none of three major stock market indexes has fallen by more than 5 percent. And one gauge of market movement, the CBOE Volatility Index (VIX), which measures investors’ expectation of the ups and downs of the S&P 500 Index over the next month, recently dropped to its lowest level in 24 years. Low readings have tended to be equated with low anxiety and high stock prices. Amid this environment, you might be wondering what could go wrong? There are a number of risks to the US and global markets that persist. Their existence does not mean that long-term investors should change their game plans, but they are a reminder to guard against complacency and to always approach investing with caution.
Federal Reserve Goes too Slow: In her recent testimony, Fed Chair Janet Yellen said, “We are watching inflation very carefully” because it remains so low. Although central bankers have attributed the recent slow down in prices to temporary factors, Yellen acknowledged that because inflation has been running under the Fed’s two percent target, “that there could be more going on.”
Translation: Janet & company are not so sure why inflation is so low and that lack of clarity might prompt them to keep rates too low for too long.
What’s wrong with low rates, you ask? Besides punishing savers, rock bottom rates can encourage excessive risk taking, as investors seek greater returns in stocks, higher yielding bonds or real estate. As these assets rise in value, they can often become bubbles and as we know from the past decade, bubbles have a nasty way of popping.
Central Banks Go Too Quickly: A corollary to keeping rates too low is the opposite: that the Fed, as well as the Bank of England, the European Central Bank and the Bank of China all raise rates too quickly. In doing so, officials themselves could cause a global stock and bond market sell-off or even worse, a recession.
Political Upheaval: Although politics has not impacted markets yet, a ratcheting up of anxiety and uncertainty might very well negatively impact them. That goes for the US, Britain and its Brexit negotiations with the European Union, as well as unforeseen events in the rest of the world.
You Suffer from Amnesia: When stocks rise, it tends to make you forget about the punishing losses that they can inflict. While bear markets can lure you into panic mode, where you are tempted to sell everything and hide under your bed, bull markets can also be a very dangerous time, because they can lead to complacency and even may embolden you to think that you can assume more risk than you should.
You Ignore the Basics: Rising asset values can also gloss over the basics. In 2006, I met with a then-client whose net worth had jumped because of a combination of a rising stock market and skyrocketing real estate prices. In his mind, he didn’t have to save more money, “because markets are doing the work for me!” You probably can guess what happened in the ensuing years.
Markets can go up and down, which is why the best way for you to control your financial destiny is to create a game plan, which puts you on track to save enough money to reach your goals. And yes you will need to focus on spending, which, according to Larry Stein, CFP of Disciplined Investment Management, “usually has the biggest impact on a financial plan.”