The U.S. stock market might fall 5-10%, but who cares!


There’s been an opinion going around the investment world that the U.S. stock market is about to fall at least 5-10%. We agree with this assessment. There are very valid reasons why the S&P 500 might fall that much right now. However, the odds of this happening are not exceptionally high, which is why we have not sold any stocks.

Why the S&P might make a small correction

There are essentially 2 reasons: one fundamental and one technical.
Fundamental
It’s clear that Trump’s pro-growth policies are facing significant backlash in Congress. With nearly every Democrat against Trump, he needs to unite the Republican Party if he wants to pass anything. This is very difficult because on the political spectrum, the Republican party is extremely diverse. You have moderate Republicans who never believed in some of Trump’s policies in the first place, and then you have the far right Freedom Caucus who will block any policy that smells of “big government”.
The Obamacare repeal is important to the markets because it demonstrates exactly how much difficulty Trump will have in passing his policies (tax cuts and infrastructure spending). With Obamacare repeal on the verge of failing, it’s clear that Trump will have trouble passing anything (except maybe tax cuts, which has always been a central plank of the Republican Party).
Thus, some bearish investors and fund managers believe that the S&P will fall on headlines such as “Trump is having trouble passing Trumpcare” or “Trump cannot get tax cuts through Congress”!
Yes, it’s true that much of the November 2016 – March 2017 rally was due to the market’s belief in Trump’s pro-growth policies. However, that belief did not account for the entire rally. Part of the rally was due to an improving U.S. economy and global economic recovery (China and Europe coming out of a multi-year slowdown).
Technical
From a technical standpoint, some traders think that VIX (volatility index) is too low. They believe that when something like VIX is compressed for too long, it will spike upwards. This means that market volatility will skyrocket and the S&P will fall significantly. (VIX and stocks have an inverse correlation).

Why these concerns aren’t really relevant

Regarding the fundamental concern (Trump’s difficulties with Congress), we addressed this yesterday. Trump-related news is not what impacts the S&P 500 in the medium-long run. In the medium-long run, the state of the economy drives the market.
The U.S. economy is growing nicely right now. There are no signs of a slowdown. In fact, U.S. economic growth has actually picked up since October 2016! (Ignore Q1 GDP forecasts. Q1 GDP has always been exceptionally weak over the past few years, probably due to seasonal factors).
In addition, any news of Trump-related difficulties will not cause the S&P to fall 15-20%+. Trump passing no pro-growth policies will not adversely impact stocks in a significant way. Any pro-growth policies that Trump does pass will merely be extra icing on the cake.
The technical concern (VIX needs to spike) is pure BS. As of this writing, VIX is rising rapidly even though the S&P has not fallen a lot! In addition, VIX is a very poor indicator. VIX typically hits all time lows (as it’s doing right now) long before the stock market tops. This happened in 2006, an entire year before the S&P topped in October 2007!

We focus on the medium-long term

We’d say that there’s a 60% chance that the U.S. stock market will correct 5-10%. The stock market has a natural bullish bias. This means that it goes up more than it goes down during a bull market (57% of days in the past 50 years have closed higher than the day before).
Thus, it is not wise to sell stocks until you’re 95% certain that either a bear market is coming or a big correction (e.g. 20%) is coming. Small corrections of 5-10% really are anyone’s guess and cannot be predicted with consistent accuracy.
*On a sidenote, we avoid all the bear markets and big corrections that we can. We leverage our positions by 3x, which means that if we sidestep a 20% correction, we avoid a 50%+ drawdown in our portfolio! Then when we buy at the bottom and the market rallies back to a new high, we more than double our money!
On a completely unrelated sidenote, I finally recovered from an illness and got back in the water. The surf has been pretty sloppy recently, but the sunset is nice.

12 comments add yours

  1. Great write up.
    You know I’ve been investing since 2015, and it wasn’t until 2016 when my portfolio went red due to large portion of my assets allocated towards the energy sector. Since the price of oil dropped significantly, it did signal several issue on a macro economic scale.
    It was a two pronged attack on the price of oil. The shale boom in the U.S. and the slowing growth of China, decreased the demand for resources.
    Instability started spreading through several countries due to the price of oil dropping. This led to many countries who relied on oil as a good portion of revenue to drop significantly. The drop led them to cut spending on social programs which was keeping unstable region somewhat subdued.
    We can see all the instability, civil conflict, and migration start to increase due to the instability.
    I’ve been hearing about a correction since 2015, and that the market was expensive etc. But we’ve had some major dips here and there due to macro economic event.
    The market is based largely on sentiment. And through my observation, the level of consumption seems to not be slowing down. People are eating out more, buying more consumer electronics, traveling and vacationing more. This could be due to the lower cost of credit which is being stimulated by the Central Bank.
    I’m not much into market timing, but for those who are betting on a market correction they haven’t been right for awhile now…

    • I agree. I the main issues that plagued the market in 2015 and 2016 are now over.
      1. oil has recovered from ridiculously low prices (who knew that oil could fall below its 2008 lows?)
      2. The political uncertainty of 2016 is over. Turns out the UK’s economy did not go to hell (as some predicted would happen post-Brexit), and Trump has not “started WWIII”
      3. China achieved a soft landing instead of a hard landing (although this was accomplished on the back of a ton of debt).

  2. I’m like you in that I think the market is going to have a huge correction. With Trump unable to push through Healthcare I think that will only embolden the Dems to dig in their heels. I hate that politics has moved in this direction that good of the party goes above good of the country but it is what it is.

    • Chuck Schumer just came out saying that he’d be willing to work with Trump if Trump doesn’t bow to the ultra-wealthy interests. So right now I’m thinking that a small tax cut and a small infrastructure plan will be possible (but nothing close to what Trump promised during the election campaign).

  3. This is some good information. People always react too quickly based on news and assumptions. The stock market naturally has its ups and downs, but as long as you have a diversified portfolio and at least some strong companies in there, you will end up fine.
    It’s too bad people don’t invest their money as easily as they gamble money away at things like casinos haha.

    • Agreed. A lot of people just base their investment decisions on what the media is telling them instead of doing their own research. I remember one time in 2006, the media said “the S&P is falling because oil prices are rising!”. Literally 1 month later, the media was saying “the S&P is rising because oil prices are rising!”
      A similar thing happened after this election. Before the election, every single media (including CNBC) said “Trump will start WWIII if elected, Sell Stocks!” The day he won, literally every single media organization flipped 180 and said “the future is beautiful! Trump will do tax cuts and infrastructure spending. Buy stocks!”

  4. It’s a sad thing to say, but I wouldn’t mind a 5-10% market decline. That would mean that I can purchase more shares for the stocks I like. Because I am a buy and hold investor for the long term, I look forward to market dips. Plainly put, I don’t realize the loss until I sell, and I won’t be selling anytime soon. That’s what I love about dividend growth investing.
    For those investors that need the income now, then obviously a market decline is not a good thing. But, that’s what investing is all about.

    • The key is definitely to just focus on the grand scheme of things. It’s not uncommon for a stock to go up 20% in 6 months. Apple went up 30% since January! In the face of a 20% rally, a 5-10% correction isn’t a big deal. In addition, the dividends will offset a lot of the losses.

  5. Well said, “Who cares?” If you are in the market for investment purposes and not trading in and out of positions then having a long term view is critical. Most of us would welcome some relief in pricing to give us better values and yields but the key is to stay the course when the world is seemingly falling apart around you. Thanks for sharing.

    • Exactly. As long as it’s not a bear market, those 15-20% declines are about as much as the S&P can fall. That’s the perfect buying opportunity

  6. Agreed. From an investing long term standpoint, a 10-20% correction or decline would actually be more beneficial to investors. It opens up more opportunities to buy since more value can be found. And from a company standpoint, they could use the opportunity as well to do share repurchases to better position their company for the future and provide more value to their shareholders. Thanks for sharing.

    • Exactly. With valuations relatively stretched right now, a medium sized decline would actually be more bullish for valuations.

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