Many people remain complete skeptics on the stock market and still believe the market is going to crash. Many of these people have been out of the market for the past several years. Investor psychology has gone from a “fear and loathing” in 2008/2009 to a “disbelief/ distrust” phase more recently. And we are probably still a long way from the “euphoric stage.” The fact that many people are still skeptical is actually bullish because of the lack of consensus. Once there is unanimity of opinion, it usually means we are at or near the end of the trend.
We know that the market inevitably goes through bull and bear phases and periodic corrections; this is normal and predictable, but these cycles do trigger emotional responses. What causes these phases or cycles? Changes in the outlook for corporate profits have a significant bearing on stock prices. When the market perceives or is comfortable that corporate earnings will rise, it will bid the prices of stocks up in anticipation of improving earnings. Conversely, when the market anticipates or becomes concerned, corporate profits may decline (such as in a recession), and it will bid the prices of stocks down.
Another key driver of stock prices is valuation. A lot of factors go into valuation, such as investor confidence, the outlook for the economy and inflation, Federal Reserve policy, health of foreign economies, geopolitical factors, energy prices, interest rates and a myriad other factors. Market cycles can be further exacerbated by “shocks,” such as financial bubbles or asset manias. These “bubbles” create imbalances that are eventually normalized through severe market corrections.
So how do we deal with market cycles from a financial planning perspective? This is best accomplished through a sound financial plan. The plan acts as a long-term roadmap for both personal finances and investments, and helps the client approach investments in a systematic and unemotional way. A good plan will help a client “stay in the game” and avoid the temptation to make emotionally based decisions at the worst possible time.
Bob Toomey is Vice President, Research, for S.R. Schill & Associates, a registered investment advisor located on Mercer Island.