In 2020, we had an extremely deep recession due to COVID 19 and the stock market dropped over 30%. However, as it has NEVER done before, the market started to rebound just weeks into the recession and did not decline a second time as we typically see in a recession. In addition, the recession ended with unprecedented economic growth in the third quarter followed by more growth in the fourth quarter.
As I have discussed before, we have been in a secular bear stock market cycle since 2000. In these cycles stocks tend to go down a lot in recessions, which is exactly what we saw in March 2020. One way to make more money in these cycles is to take a little less risk when the economic growth cycle gets a little old and to increase risk when stocks go down in a recession and are “on sale”.
Since stocks rose so fast at the beginning of the recession, there was really little to no time to buy when stocks were undervalued. However, with the recession in the rear view mirror, it may be time to consider taking more risk if we can avoid a double dip recession. At this time it does not look like the Biden administration is going to push any further restrictions on the economy. Because of this as well as the ongoing rollout of vaccines, it seems likely that we will avoid a dip into another recession and can look forward to another economic expansion for a what is usually a number of years.
With this in mind, this may be a good time to consider taking more risk in your portfolio. However, there is one thing to consider. Every year there is time when the stock market is down. On the chart below look at the red dots underneath. These are the highest inter year declines in the stock market over the last 40 years. The risk in taking more risk at this time is that the market is fairly expensive compared to current profits so there is a risk of a significant market correction. Model Capital Management, one of the Portfolio Strategists we utilize for client accounts, recently noted that the Shiller Price to Earnings Ratio, one of the many ways to measure whether the stock market is expensive, has only been higher over the last 150 years during the 1999-2001 dot.com peak. At that peak it was about 30% higher than it is today. Some other measurements don’t show that extreme valuation, but the market is still expensive.
However, the economy may very well accelerate as vaccines are deployed leading to a more broad based increase in company profits putting stock market valuations in a better place, which may or may not avoid any significant market correction. Also, even if the stock market corrects downward, with a healing and growing economy, stocks could rebound by year end and still end up positive. The gray bars in the chart above are annual returns of the S&P 500, and most non-recession years returns are positive by year end, despite inter year declines.
As one decides whether to take more risk at this time, or wait to see if there is a market correction and do so at that point, it is important to make sure you do not invest over your overall tolerance for risk. This could be detrimental to your portfolio and therefore your overall financial goals. If you have not evaluated your risk tolerance in the last year, I encourage you to do so before making any changes in your portfolio.