The real reason the market has been falling

We have been bombarded of late with stories about the coronavirus – how terrible it is, how countries are shutting down (like Italy), and how China has had to setup emergency hospitals to deal with the overwhelming numbers of new cases (although they just reported yesterday that they are shutting down these temporary facilities, assuming China can be believed). While I do not personally trust China’s reporting of data, whether it’s data on cases or deaths due to the coronavirus, or statistics on their economy (or any other data they report), that is not the issue we face in terms of market downside.

The recent conflict between Russia and Saudi Arabia, resulting is a sharp decline in oil prices over the past few days is another reason (excuse) for the market to drop. While there are certainly sectors of the world economy (energy being the most obvious) that will suffer from lower oil prices, there are many benefits that accrue for the economy in the form of lower energy costs for consumers across a wide array of industries, as well as for individual consumers (you and me).

So what is the real reason the stock market is falling? It’s simple – the market has been selling off because it was grossly overvalued before the correction began. That’s it. Simple and straight-forward. While there is no way to test or prove it, I will state with confidence that the stock market would not have sold off by nearly as much, and might possibly have even gone up, in the wake of the coronavirus and the oil price drop, had the stock market been grossly undervalued immediately prior to these events. Yes, the virus and oil are excuses or triggers that market participants could point to as reasons to execute their trades, but they are not the real reason for such a sizable percentage drop in market value. One can look at any number of indicators including the forward price/earnings ratio, which was up around 19 times just before the market sell-off. That is one of the highest ever, and is comparable to valuations for the market that preceded other substantial drops, corrections, and crashes for stocks.

As many of my readers know, I actively manage portfolios, and often hold substantial cash positions. I was 100% in cash immediately prior to this sell-off, and have been buying, including investing about half of my cash yesterday (March 9, 2020) when the Dow closed down 2,000+ points, and additional cash this morning, when the market was down for the trading session, before it rallied to close up more than 1,100 points.

It is often difficult for me to articulate exactly how I manage portfolios, but I would say the key aspect of my management approach that sets it apart, is my active use of cash. Cash offers the most flexibility, downside protection, liquidity, and opportunities to reinvest during times of market volatility and uncertainty (just as we have experienced over the past few weeks). If you are investing with someone who follows a buy and hold strategy, after this recent drop in the market, you should realize that your strategy is flawed and you need to make a change. While a buy and hold strategy was reasonable during the rebound period after the Great Recession of 2008/9 through last year, the next 10 years will not offer the same strong positive trend, year in, year out. Those who trust the buy and hold strategy will likely find that their portfolio performance is sub par, at best, and many will experience negative returns over the longer-term.

While these statements are obviously just my personal opinion, that opinion is based on more than 30 years of direct experience. More importantly, no one can argue that we are not headed for a recession sometime in the coming few years. A strong positive trending stock market is not a realistic expectation during a period of global recession. That combination has never happened in history, ever, and it is foolish for anyone to expect it to happen now.

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