What’s the downside? Stocks mounted a nice reflex rally Thursday (Dow up 188 points), giving us some breathing space to consider the larger issues. Equities’ lackluster performance so far in 2014 suggests that the U.S. stock market may be forming a “primary” top—the kind that typically occurs every three to five years. If that’s really what’s happening, how much of a setback should we prepare for?
Many investors, scarred by the experiences of 2000-02 and 2007-09, continue to fret about the risk of a third bear market of similar proportions. Obviously, I can’t rule out such a possibility.
The global economy has struggled to recover from the shocks of the 2007-09 financial crisis. Europe’s banks remain a weak link in the system, and China’s rapid buildup of domestic debt over the past five years holds the potential to cause serious disruptions—particularly in other emerging markets—if a legacy of bad investments overwhelms the ability of the Chinese authorities to carry out their recently announced economic liberalization program.
At the same time, there are countervailing positives. U.S. banks, flush with cash, have built up their capital reserves to just about the highest level in the past 25 years. (See chart.) America’s home-grown energy boom is providing jobs and chipping away at the nation’s chronic trade deficit.
Furthermore, interest rates, on the whole, are still extremely low. Qualified borrowers have no trouble finding money. Despite the Federal Reserve’s recent steps to “taper” its purchases of bonds and mortgages, any rise in short-term money market rates (above near-zero) will probably have to wait until the spring of 2015—at least.
Bottom line: The headline U.S. stock indexes could be in the early stages of a topping process that may lead to a more significant decline later this year than we’ve seen in January and February. To date, however, there’s not much evidence pointing to a bear market on the lines of 2000-02 or 2007-09.
As long as the various negatives seem fairly well contained, I think we can go forward on the assumption that any pullback will amount to less than the “Euro swoon” of 2011, when the S&P 500 fell 19.4% on a closing basis. Remember, too, that the worst of the 2011 episode was concentrated within a few weeks in August. If the next market squall blows over as quickly as that, you and I can ride through it with little difficulty.
Meanwhile, let’s keep our eyes wide open for any changes in the financial weather. As far as strategy is concerned, we’ll wait, for now, on any explicit defensive measures. Instead, we’ll build as much safety as possible into our portfolio by (1) purchasing stocks only when they’re trading at a sizable discount to their 2013 peaks, and (2) spreading out our purchases over time to take advantage of sudden dips.