Wednesday, March 11, 2015

Stocks Got Hammered Yesterday ... "MInsky Moment" or Not? ... What Now? ... Stock Market Crashes Do Happen Occasionally But Stock Prices Increase Over Time

The stock market got hammered yesterday. See U.S. Stocks Tumble; Dow Drops More Than 300 Points.
So who is it that knows what will happen to prices today, next week, next month or even next year? Nobody, that's who.

But stock prices do rise over time, and that's the reason I tend to stay invested throughout the tough times. Today, my admittedly imperfect crystal ball still says higher prices lie straight ahead and that this bull market has a long way to go before it's over. I may be wrong, of course, but that's both my view and my individual investment plan.

A strengthening economy coupled with low inflation, more jobs and higher wages, historically low interest rates and continuing low energy prices, and a strong U.S. dollar are important factors which suggest higher stock prices.

But all that said, my personal crystal ball is definitely not infallible. Nobody knows the future. That's why it's called the future.

Still, over the years, stocks go up and stocks go down, and for the most part they go up at a rate much greater than the rate of inflation. But at some point there will be a crash. Unfortunately, that's the way markets work.

And what is it that causes crashes? Counterintuitively, the thing that generally causes crashes in stock prices is stability --- that's what. Why Bear Markets Are Inevitable offers a straightforward explanation as to why crashes happen --- not when but why -- because nobody knows when:

"It has been more than seven years since the last bear market began.

When will the next rout come? I don’t know. I don’t think anyone does. But make no mistake: A new bear market—that is, a 20% or greater market drop—will occur.

Stock markets always will—indeed, must—crash from time to time. To see why, consider the work of the late economist Hyman Minsky.

In the 1970s, most theories held that modern economies were fundamentally stable. Deep recessions and financial crises were anomalies, caused by outside “shocks” such as bad policy, war or a spike in oil prices.

Mr. Minsky, an economist at Washington University in St. Louis who died in 1996, didn’t buy this.

In his view, crises “were neither accidents nor the results of policy errors” but were “the result of the normal functioning of our particular economy,” he wrote in a 1976 paper titled “A Theory of Systemic Fragility.”

In short, Mr. Minsky believed that a stable economy leads to optimism, optimism leads to excessive risk-taking, and excessive risk-taking leads to instability.

“Success breeds a disregard for the possibility of failure,” he wrote. Booming business and “the absence of serious financial difficulties over a substantial period” leads to a “euphoric economy” where consumers and businesses grow increasingly comfortable taking on debt in pursuit of profit.

The process continues until optimistic bankers lend to dubious borrowers who stand no chance of repaying their debts. That is when the next crisis begins.

The core of Mr. Minsky’s work is that a period without crises plants the seeds of the next crisis. Stability itself can be destabilizing.

His theory also can help explain why stocks boom and bust so frequently. . . .

The real world is plagued by misbehavior, bad luck, emotion, recessions, deception, inaccurate forecasts, chance, turmoil and mistakes.

When these unfortunate events occur, stocks that were erroneously priced for perfection and guaranteed returns—think dot-com stocks in 2000—get a rude awakening and abruptly decline, if not crash.

The paradox of investing is that if markets never crashed—or if investors gained the perception that they would never crash—stock prices would rise so high that a new crash would become nearly certain.

Just as Mr. Minsky described with whole economies, stability in the stock market becomes destabilizing. This is why markets will always crash from time to time.

Rather than wondering if another bear market will occur—it will—here are three things investors should do:

Realize what you are getting into. The reason stocks have historically returned more than cash or bonds is specifically because they are volatile, and crash on occasion. Significant volatility doesn’t indicate the market is broken, or that you have been cheated. It is the price of admission investors must be willing to pay to achieve returns greater than are offered in less-volatile assets.

Assess how much risk you are willing to take. Not everyone can handle the stock market’s inevitable swings, especially if they are in, or nearing, retirement. . . .

Learn from your past behavior.

“Most investors have a lower stomach for volatility than they think,” Mr. Roche says. This is especially true after a long bull market, such as the one we have enjoyed over the past six years.

Rather than trying to estimate how you will react to a big market drop in the future, assess how you reacted in the past. Past behavior can be a good indicator of future behavior.

Did you panic and sell when stocks crashed in 2008 and 2009? Then you probably have a low risk tolerance, regardless of how confident you feel today. Consider cutting your stock exposure to something less than you had before the last market crash and raising your allocation to a diverse portfolio of bonds, or even cash, taking comfort that more of your money is now cushioned against the inevitable shocks of the stock market.

Rest assured, they will come again."

Summing Up

There you have it --- Minsky Moments, aka stock market crashes, happen periodically in market investing, whether those markets are in stocks, housing, oil or something else.

So accept that the inevitable will happen, and resolve to try to remain calm when the next stock market crash occurs, which it definitely will.

And when (not if) that Minsky Moment arrives, just like all the previous ones in our long history, it too shall pass. And when it does, stocks will then resume their upward climb.

As it has always been, my bet is that it shall always be.

So like the once extremely popular Bobby McFerrin 1988 song title says, 'Don't Worry, Be Happy.' (Just click on the link and watch this oldie but goodie.).

Then smile and stay invested. Successful long term stock market investing sometimes requires a strong stomach.

That's my take.

Thanks. Bob.

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