Are You Worried? If Not, You Should Be

Despite the unsustainability of the 2016-2018 stock market run, many bullish analysts and investors still think that there is room left for markets to rally. The unease of the past few months that has seen the Dow lose over 2,000 points from its all-time highs is, to their minds, just a temporary correction, a speed bump on the way to greater gains. While having a positive attitude is normally a good thing, when it comes to your investments you can’t look at the world with rose-colored glasses.

When you plan your investment strategy, you always need to be as conservative as possible. Don’t assume an 8% annual growth rate, assume 4%. Don’t assume that stocks will continue to make gains for decades, build in the assumption of a major correction at least once or twice over a 30-year investing horizon. If you invest conservatively and assume the worst, your investments will outperform your expectations and you’ll end up with more money than you assumed you would. But if you assume the best, you may end up with a severe lack of funds right when you planned to retire.

Right now markets are facing difficulties both from internal and external influences. Being aware of those influences is crucial to making the right investment decisions to protect your portfolio against major losses.

Internal Factors Contributing to Stock Market Instability

The primary factor that will continue to bear on stock markets is monetary policy. It took a while for the Federal Reserve’s quantitative easing to have an effect on stock markets, but those trillions of dollars of newly-created money are what drove the stock market to record highs. Inflating the money supply through the creation of new money will, all other things being equal, lead to a rise in prices. And that’s not just the price of milk and eggs, houses, and other consumer goods, but investment assets as well.

Since the Federal Reserve began its policy of quantitative easing in late 2009, the increase in the M2 money supply (the broadest money supply measure we have since the Fed stopped calculating M3 in 2006) has a 97% correlation with the performance of the Dow Jones Industrial Average. And while that doesn’t mean that there will always be a 1:1 correlation between money supply growth and stock market performance, that trend should hold together over time. If the Fed continues to draw down its balance sheet, and that has the effect of tightening the money supply, expect stock markets to drop accordingly.

But perhaps even more important than the correlation between money supply growth and stock market performance is the business cycle. The reason we have booms and busts in the economy is because the Fed’s creation of money and credit causes resources to be malinvested and misallocated within the economy. By forcing interest rates lower than market rates, the Fed encourages businesses to invest in longer-term capital-intensive projects.

But when those projects are completed, they don’t have customers. The office parks don’t have tenants, houses remain unsold, and factories produce goods that people aren’t interested in buying. Debts have to be liquidated, workers are laid off, and capital resources and equipment are put to a more productive use.

Historically in the United States business cycles are created by government intrusion into the monetary system. The pursuit of loose monetary policy results in a boom and bust, and the bust is then papered over with yet more monetary easing. We saw the dotcom bubble end badly, but it was papered over with interest rates that were held too low for too long, resulting in the housing bubble. The bursting of the housing bubble was covered up with quantitative easing, and now we’re seeing the “everything bubble” starting to show the first signs of popping, as stock markets are struggling. That’s not good news for investors, particularly for those who are hoping to retire within the next few years.

External Factors Contributing to Stock Market Instability

The major external factor that will weigh on stock markets can probably be summed up as regime uncertainty. With a President who sees trade as a zero sum game and advisers who are itching for a trade war with China, there is no telling what will happen over the next couple of years. President Trump has already shown that he isn’t concerned about the effect his trade policy will have on stock markets, and has urged investors that they need to be prepared to deal with a little pain.

That’s not much consolation for markets that are down over 10% from the Dow’s high earlier this year and that threaten to sink further as the effects of tariffs begin to take their toll. While President Trump may intend for his tariff rhetoric to be a bargaining chip in trade negotiations, now that tariffs have gone into effect no one wants to be the first to back down and lose face. With two and a half years left in Trump’s term, and the possibility of a second term, the next several years could be very bad for stock markets even without another financial crisis looming on the horizon.

It’s important for investors, particularly those saving for retirement, to take all of this into account when deciding on a portfolio allocation or investment strategy for the future. Making the wrong decision could cost you dearly, as investors found out during the financial crisis. With stock markets shedding over half of their value back then, investors who rode the dip not only saw their savings wiped out, but also saw years of subpar growth before their holdings returned to pre-crisis levels.

If you don’t want that to happen to you, then you need to think about investing in alternative assets such as gold and silver. With a gold IRA you can even roll over existing retirement assets into precious metals without any tax consequences, and continue to make tax-free gains into the future. Investors who put their money into gold when the coming financial crisis was first evident protected their portfolios from major losses, and continue to see gains today.