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Well, this has been an exciting few days in the stock market hasn’t it?
On Friday, February 2nd, the Dow Jones plummeted 666 points, the single worst performing day of the stock market in Trump’s presidency.
On Monday, February 5th, the Dow did even worse, slumping another 1175 points, marking the biggest one-day drop (in # of points) in the Dow Jones’ history.
And then on Tuesday February 6th, the Dow opened down another 567 points, only to close up 567 points, for a stunning 1134-point intra-day swing.
This has caused no shortage of breathless commentary from wheezing talking-heads on TV predicting everything from the start of a bear market to a once-in-a-lifetime buying opportunity you’d be a fool to miss out on.
So what the Hell’s going on here?
Volatility Isn’t Unusual
First of all, the rather extreme reaction in the media is a reminder of just how complacent we’ve become. Despite a, shall we say, unconventional presidential election, the stock markets have gone for over a year without any multi-day triple-digit price decline on the Dow, and that’s gotten many people to forget how unusual that is.
The Chicago Board Options Exchange created an index called the VIX, which uses the spread of options prices to measure the predicted volatility on the stock market. Here’s what it looked like over the past year.
Wow, look at that big scary spike over on the right there! Looks pretty unusual, doesn’t it?
But if we just drag out the time scale over to the past 5 years we see a totally different picture.
Now we see a totally different picture. Yes, that spike on the right still looks unusual, but the real unusual bit has been the extended period of low volatility we’ve seen over the past yet. Nowhere else in the past 5 years has the stock market been that calm for so long. So in that context, a burst of volatility doesn’t seem that unreasonable, does it?
No Reason To Panic
There is a time and a place to panic. If you’re being chased by a T-rex, for example. Or a UFO has just landed in downtown NYC. Or Justin Bieber’s coming to town. Those are appropriate times to crap your pants and take stock of everything you’ve done wrong with your life.
To be fair, 1000+ drops on the Dow are fairly unusual. The last time I remember that happening was in 2008/2009, and back then banks were falling over and the global financial system was on the verge of collapse. Back then, the US housing market crash was in full swing and a certain degree of panic was warranted since nobody quite knew how the whole thing was going to play out.
But now? The prevailing narrative to explain this sudden crash has been somewhat muddy. The first day of volatility was brought about by the announcement that American had created another 200,000 jobs in January, with wages going up 3% YoY, the fastest pace of wage growth in some time. Announcements like these are usually met with cheers from stock investors as it means the US economy is growing, but this time it brought about concerns that the expansion would cause inflation to spike, which would cause the US Federal Reserve to raise interest rates too fast. This in turn caused bonds to drop anticipating a rise in yields, which caused people to sell stocks because higher bond yields made stocks less attractive.
So the prevailing narrative is that stock markets were plummeting because…the economy was…too strong?
Don’t think too hard about this stuff. It’s the media’s job to spin a neatly packaged explanation for every global event that fits inside a 1000-word article, when the reality is that sometimes the explanation is far too complex to explain in a single article, or sometimes, like in this case, no real explanation exists.
When things are going well, money floods from bonds into stocks. When things are going poorly, money floods from stocks into bonds. But when money floods out of both stocks and bonds into cash, that’s usually a sign of fear. Nobody knows where to put their money because everything looks like it’s on fire. I saw days like that where the normal anti-correlated relationship of stocks and bonds completely broke down during the 2008/2009 crisis, and back then fear was palpable in the air. But now? It doesn’t make any sense.
It’s far more likely that somewhere out there, some trading algorithm hit some limit for either stocks or bonds that it deemed “overbought” and decided to start dumping onto the market, which caused a whole bunch of other trading algorithms to pick up on the downward momentum and join in. Market moves like this are typically highly emotional in nature and the predominant emotion among experts being quoted in the media is not fear, but bewilderment.
Structure Your Life So You Don’t Care About Volatility
There are generally two phases in your investment career you can be in when dealing with a sudden spike in volatility: Accumulation and Retirement.
If you’re in the Accumulation phase, meaning you’re still working and building towards your FI target, then the answer is simple (but not easy): When you get your next paycheck, buy into the storm.
It’s a simple but ridiculously scary strategy, especially if this is your first crash. I remember distinctly the experience of putting $1000 into the market in the midst of the 2008/2009 financial crisis, and then the next day having my ETFs be worth $1000 less. I was like “Where the [email protected]%* did my money just go?!?”
But because I was picking up units at a cheaper price, when the recovery did happen, I recovered faster than the overall market and as a result I ended up getting all my money back in just a single year.
And in Retirement, volatility can be hedged using a combination of the Yield Shield and a Cash Cushion.
The Yield Shield gets created when you swing your post-retirement portfolio towards higher-yielding assets like Preferred Shares, REITs, and Corporate Bonds. It increases your overall portfolio volatility (since these are riskier assets) but the yield on your portfolio goes up. We were able to get ours up to around 3.5% when we retired.
And because your yield gets locked in at the moment that you buy, that part is no longer affected by volatility. For example, if your initial portfolio was $1M and you locked in a yield of 3.5%, you’d be yielding $35k a year. Even if your portfolio were to drop to $900k, your portfolio would STILL be yielding $35k a year, or an effective yield of 3.9%.
Combine that with a Cash Cushion that insulates you from sustained market drops that force you to sell at a capital loss, plus Geographic Arbitrage that allows you to drop your living expenses by half by moving to a low-cost locale, and you never have to worry about volatility wrecking your retirement ever again!
So in short: Don’t Panic. Nothing bad is happening in the world economy that would suggest a bear market’s coming, and even if it were, structure your life so you no longer have to care about the daily gyrations of the stock market like we did.
So what are your thoughts on this sudden drop in the markets? Let us hear in the comments below.
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