Hurricane Harvey, North Korea, and Other Puzzle Pieces

The Stock Market vs. Geopolitical Risk

When it comes to investing, many people mistakenly behave as if it’s a mystery.  They think the inputs and the outcomes are entirely unknown.  These folks will often be the ones who refer to investing in the stock market as gambling, in other words, an equal chance of gain or loss.  Investing, in fact, is not a mystery.  But what is it? Though investing is not exactly a puzzle with all of the known pieces laid out on the table waiting to be solved, I contend that it is closer to a puzzle than a mystery.

The geopolitical risk associated with North Korea and the incredible damage to the Houston area (our country’s energy hub) of Hurricane Harvey made me think about a couple of puzzle pieces.  I thought this would be a good time to share these pieces and give you some tools to gauge how events and issues affect the economy, the investment environment, and most importantly, your financial planning.

Since 2009, the U.S. economy has been in an expansion.  In turn, the U.S. stock market has, with some exception, been on a continuous rise.  This marks an almost 8½ year run.  Clients ask, “How long will this last?” It’s been said that economic expansions and bull markets don’t die of old age; they die from one or more factors that impact productivity, growth, and earnings.  Understanding what the factors are can help you align expectations.  These factors are what I’m calling puzzle pieces.

[NOTE: As I explained earlier this year, the stock market and the economy are related—but not the same.]

In every Bear Market since 1929, there have been one or more of five factors that have led to or influenced the decline in stock prices.  Let’s review all five:

• Recession – Two or more quarters in a row of negative GDP.
• Aggressive Fed – An unexpected or excessive increase in interest rates by the Federal Reserve.
• Commodity Spike – A rapid rise in the price of oil.
• Excessive Valuations – High stock prices that are not supported by market fundamentals (often measured in some way by the ratio of stock price and earnings).
• Geopolitics – An event that triggers constraints on the flow of capital and resources in one or more parts of the world.

As you walk through each of these and assess the probabilities (or ask me to), you can draw some conclusions about the direction of the economy and the market.

However, where the puzzle analogy breaks down is that there are some unknowns when it comes to investment markets.  The certainty of when, how long, and how deep a market correction will be is as uncertain as when, how long, and how high a market rise will be.  Investors wish that if they just knew “when” the market was going to drop, and “how far” it would drop. Or they wish they knew the person who could do this…though there is no such person. Since there is no chance of that happening, how do you deal with the risk associated with investing?

Now, this is the most important part of what I’m writing today.  We cannot control Fed action, commodity prices, stock valuations, recessions, or political events.  But what we can control or influence is how we react and manage our financial lives through it.  Here are the three primary concepts we employ both when the markets are rising and when they are declining, and some people are convinced “this time is different”:

1. Avoid Equity Market Risk by also having money in cash, bonds, and real property to the degree it makes sense for your financial plan.
2. Mitigate Risk by diversifying among asset classes to dilute the effect of an uncertain world.
3. Manage Risk by owning different asset styles through a full market cycle and rebalancing to a Target Investment Allocation when things get out of balance.

Market declines are as inevitable as changes in the weather.  To successfully invest and meet your financial objectives you need to make sure you do not turn unavoidable downturns into unrecoverable ones.  I am thankful people ask me to help them do this.  When the next attention getting drop occurs in the market (and it will), make sure you are employing risk management techniques to succeed.

Author: David Jeter, CFP^® | Partner and Financial Advisor | Allegheny Financial Group | September 2017

Allegheny Financial Group is a Registered Investment Advisor. Securities offered through Allegheny Investments, LTD, a registered Broker/Dealer. Member FINRA/SIPC.