Between February 1, 2009 and March 1, 2017, the Dow Jones Industrial Average advanced from 7,062 to 21,115, a whopping gain. The market has been hitting all-time highs since the election. The Dow surpassed 20,000 for the first time on January 25 and has been setting records not seen since the 1980s.
Although the future is unknown, ultimately the stock market will fluctuate and may reverse course at some point, erasing many of the recent gains. Towards the end of March and into April this year we've already seen some fluctuations. Here’s how advisors can prepare their clients for a downturn. (For more, see: How Advisors Can Help Clients Stomach Volatility.)
The Trump Factor
Since President Trump won the U.S. election the stock market has skyrocketed, based on his promises. Trump assures Americans that corporate and individual taxes will fall, pesky regulations will evaporate and job-creating infrastructure projects will help the consumer. Investors translate these proposed economic developments into an expectation that the market will continue to rise.
But if Trump and the government fail to deliver on these promises or other conditions ensue, there’s a possibility for a stock market downturn. Goldman Sachs Group analysts mention several potential near-term risks for the markets:
- The drop in corporate tax rates may not go into effect until well into 2018.
- The Federal Reserve Bank intends to raise interest rates multiple times during the upcoming year. This can put a damper on corporate investments and profits.
- If French presidential candidate Marine Le Pen of the nationalist party wins the April election and France exits from the Eurozone, there could be international concern putting downward pressure on stock prices. (For more, see: Stocks' Long Upward March: Is a Correction Due?)
How to Prepare Clients for a Market Downturn
An advisor wears many hats including educator and counselor. At the outset of the relationship, every financial advisory client should receive a lesson in investment history. That information would include a tutorial on the characteristics of typical asset classes. For example, stocks are more volatile than bonds. And within the equity category, foreign and small cap issues are riskier, with higher standard deviations than blue chips. In the initial meetings, an advisor should assess the client’s risk capacity and risk tolerance. This information will subsequently influence how much volatility the investor can tolerate.
If the advisor maintains regular contact with his or her clients, tallies their risk profile and counsels them on typical market activity, investors will be prepared to cope with a market decline. When that market drop does occur, the advisor must reassure nervous investors so that these folks avoid a cardinal investing mistake, selling after a market drop.
The Role of Bonds
Unlike the stock market, the bond bull market ended last July. Most likely, the bond market will continue its decline due to the increases in interest rates expected this year. Bond values trend in the opposite direction of interest rates. When interest rates increase, bond prices decline. Longer-term bonds typically fall more with an increase in interest rates than short-term bonds.
Advisors would be wise to keep bonds and bond funds in the short to intermediate-term range. Creating bond ladders is also a good approach for investors in individual bonds. Bond ladders set up investors to reinvest maturing bonds in new issues at higher future interest rates. Certificates of deposit can also be included in the fixed portion of a client portfolio.
The Bottom Line
Statistically, after a great run up in stock prices leading to frothy valuations, a market decline is more likely to occur. Financial advisors can protect themselves and their clients from making costly and hasty investment decisions by setting the stage in advance for the drop. They should keep investment portfolios diversified, balanced and in line with the client’s risk level. (For more, see: Preparing for the Next Bear Market.)