Let's eavesdrop on Q (the concerned investor) and A (the sage adviser) as they discuss this week's stock market:
Q: The market got creamed the past couple of days. How come?
A: Because some stockholders have decided to sell and buyers aren't willing to pay last week's prices.
Q: Yeah yeah, we've had that discussion before. Just get to why the market's selling off.
A: Oh, alright... If you believe the headlines it's because emerging market currencies have been getting whacked lately.
Q: Okay, so why is that?
A: While there are no doubt some country-specific issues involved, here's how I see things from a purely global perspective. Over the past few years emerging markets have seen monster inflows of capital, much of which came from speculators leveraging the Fed's ultra-easy monetary policy. The idea being that if the U.S. is going to print a trillion dollars a year, the dollar itself has to lose ground against certain other countries' currencies. So speculators borrow dollars at incredibly low interest rates then buy the foreign currencies they believe will appreciate against the dollar. If they're right and the dollar tanks against their currency of choice, they can make a bundle in a hurry. However, they're taking a bundle of risk in the process. If, say, the Fed looks to back off the money-creating, and the dollar looks, therefore, to increase against their currency of choice, they stand to lose a bundle as all those who were looking to exploit the same opportunity reverse their positions, thus killing the value of those other currencies. Add in a bit of utter stupidity on the part of foreign leaders who would institute capital controls (try to keep the money in the country) and you have the recipe for a nasty bit of selling. That's what's happening as we speak.
Q: But you've been so positive on emerging markets. What are you thinking now?
A: My optimism had/has nothing whatsoever to do with money flows inspired by the actions of central bankers. I remain long-term bullish based on some very basic facts. Such as: 85% of the world lives in emerging markets, younger populations live in emerging markets, infrastructure needs are extreme in many emerging markets, and lives are improving dramatically in many emerging markets. That said, the old risk/reward trade off (the higher the risk the higher the reward) exists in emerging markets like it does nowhere else. The potential reward is extreme, but, make no mistake, all manner of risk---market, political, inflation, business, currency---is extreme as well. You go there with a modest amount of your portfolio and you exercise patience.
Q: So this selloff is all about emerging markets and it's nothing to worry about?
A: No, I don't believe it's all about emerging markets, and whether or not you worry is entirely up to you.
Q: So what else is going on?
A: Well, recently reported earnings, while not horrible, have been a bit of a disappointment. I think that may have some folks rethinking 2014. Plus, a few recent economic data points have come in weaker than expected.
But here's the thing, the stock market can't simply go up forever---as much as folks would like it to. It's kinda funny how seemingly thick-skinned investors will tell you we need a good 10+% correction just to keep people honest. But when it begins to happen---and Dow 16,500 starts heading toward Dow 14,850---you'd think the whole world's coming to an end. You'd think, for example, that the default of a few fancy Chinese investment schemes will spell doom to financial life as we know it. It's amazing how quickly skin can thin...
Q: So do you think we're finally going to see that 10% correction?
A: I know we're finally going to see it.
Q: So this is it?
A: Uh, I don't know, maybe, maybe not.
Q: Is 10% as bad as it'll get?
A: No, I think it'll get a lot worse.
Q: So you're thinking this is the start of the next bear market?
A: No, that's not what I'm thinking, although it's possible. What I'm saying is, there is no doubt in my mind that one day we'll see the next bear market. I just can't tell you when.
Q: Do you think the market is expensive right now?
A: It depends on what stock, what sector, what country, and what valuation metric you're looking at. There's the q-ratio that values stocks by dividing the price of the entire market by the replacement cost of every publicly traded company. By that measure, while it remains a long way below where it was before the tech bubble burst, the U.S. market's trading on the high side. If you're looking at P/E (price to earnings) ratios, stocks are historically okay here---unless interest rates spike and earnings don't.
Q: So should I be worried?
A: Like I said, that's up to you. I'd be worried a year from now if we don't get some sort of a correction this year. I think it's way overdue, but I thought that last year as well. Thank goodness we didn't trade that thought.
Q: Should we be doing anything?
A: Yes, we should continue rebalancing your portfolio a couple times a year. If the market continues to decline we'll be buying back to your target when it's time to rebalance. If it continues higher, we'll be selling, like we've been doing for the past few years. With a little sector-tweaking in the process.
Q: So business as usual?
A: Yep, for now...