As of February of 2018, the financial markets are continuing to hit record heights. In 2016, investors were wondering when the Dow Jones Industrial Average would top 20,000. The market brushed aside that milestone on January 25, 2017 and kept on rolling, most recently clearing 26,000 on January 16, 2018. A contraction is looming, and it is in your best interest as an investor to consider adding stop-loss protection to your portfolio.
Low Anxiety About the Economy
While this ride has been exhilarating, and profitable for most investors, it’s a run we’ve seen before—markets expand and markets contract, markets rise and markets fall. So far in this bull run, however, there’s been little sign of a pullback. The pace of growth has slowed a little, but the markets keep pointing up. According to the Investopedia Anxiety Index (IAI), on February 8, 2018, 58% of Investopedia visitors felt confident about the U.S. economy and 69% thought the U.S. stock market will be higher than in six months than it is today. Also, 77% believed their income will increase within the next 12 months. All those good feelings are creating market momentum, an irresistible force that, at least for the moment, seems unstoppable.
The Power of Momentum
Optimism is good. When people feel good about the economy and feel good about their own prospects, they buy things—houses, cars, big screen TVs—and they invest more. What’s driving this bull market? One factor is regulatory reforms. Companies and investors alike are looking at a tax reform bill that frees up more cash and brings more U.S. companies stateside to run their operations, bringing with them more jobs and adding revenue domestically. The potential rollback of regulations, such as Dodd-Frank, also infuses investors with a sense of optimism as they envision a marketplace that doesn’t get slowed down by red tape. While momentum can be a good thing, there’s a downside to relying too heavily on the idea that an object in motion will remain in motion.
When momentum is the driving force of a market, investors can lose sight of underlying fundamentals and instead continue pumping money into a hot market just because it’s a hot market. We saw a similar hysteria take over in the dotcom bubble of 1999-2000 when the price-earnings (PE) ratio hit 32. The PE ratio for the current trailing 12 months stands at around 25, which puts it in the 80th percentile historically, placing it squarely into territory that at the least should give investors pause. Another reason to consider pumping the brakes on the bull market: only two market sectors—technology and financials—are primarily responsible for driving growth. Throughout 2017, technology carried the market, rising almost 40% on the year. Again, with the dotcom bubble, we saw what can happen when the market becomes too dependent on one sector. It has the power to lift up an entire market as well as the weight to drag it all down. (For related reading, see: 5 Steps of a Bubble.)
The Strength of Stop-Loss
Because today’s market is weighted so heavily on momentum and a single sector, it’s important for investors to take time now to consider implementing a defensive strategy—one that is in the market, grabbing gains, but also has a built-in mechanism offering a buffer against cataclysmic losses. When you analyze your investments, ask yourself a simple question—does your portfolio have an automatic stop-loss mechanism built in to its design?
Having the stop-loss set up automatically is important. It takes away the guessing game. You will no longer be tempted to time the market. Instead, the stop-loss is triggered when the market dips a certain amount. I typically place a stop-loss target as 10% of equity value. In short, once the equity portfolio drops 10% in value those investments are sold. What if the market drops 10% then recovers? That does happen, but that’s a chance I’m willing to take because momentum works in the other direction as well. Let’s take a look at our most recent bear market as an example.
In the 2007-2009 financial crisis, the S&P 500 would eventually lose 37% of its value. That drop was no aberration. Since 1926, the markets have dropped 10% or more 29 times. According to the U.S. Government Accountability Office, investors have lost more than $10 trillion during those bear markets. The average loss to markets was 27%. By not implementing a stop-loss strategy, you’re gambling with your investments, banking that they won’t go into free-fall.
The market is up at the beginning of 2018; at some point, the market will come down from this lofty point. When that will happen and how far it will fall is unpredictable, and trying to time that drop is a losing proposition. The best way to protect the earnings you may have already accrued during this bull run is by putting a stop-loss strategy in place. By minimizing your losses, you’ll be better positioned to grow your investments during the next bull run.
(For more from this author, see: Protect Yourself Against Powerful Financial Losses.)