What to Do When Stocks Appear to Defy Gravity? Use Risk Management Tools!

 In Strategy Updates

There is a growing crowd of both professional and individual investors that are in awe of the stock market’s recent ascent from the March lows. Though rebounds from market “crashes” are often significant this one is particularly unusual in its swiftness and extent – all without even a pause or normal correction of 8-10%. Of particular interest is the market’s resilience in the face of the recent civil unrest across the country – our team is saddened and dismayed by the death of George Floyd and the message that it sends to all of us as citizens. We also find the resulting violence very disturbing and hope that the protests and rallies bring about meaningful change so that no American continues to experience social injustice. As a commentator recently expressed, “we are experiencing a crisis within a crisis.”

From an investment standpoint will this “Superman” stock market continue to soar higher in the face of ongoing headwinds or will it meet its own version of kryptonite? If it turns downward again, are most investors prepared?

Stocks have rallied nearly 38% percent off the lows of just eight weeks ago and are just a bit more than 10% off their highest levels – a reminder that when stocks fall 35% it takes a gain of more than a 50% to recover the decline. What makes this tremendous rally unusual is that it is occurring during one of the most extreme periods of decline in economic growth, employment and corporate profits. It has been a relief to investors – particularly those who may not have managed the initial decline. However are stock prices justified at these levels? Perhaps.

Stock markets have an uncanny way of “discounting” future economic and profit growth – today’s market reflects tomorrow’s reality. Hence the reason stocks historically fall before the economy bottoms and tend to rise before it actually gets better. What we may be witnessing is the stock market discounting better days ahead for economic, employment and corporate profit growth. That may make sense in hindsight and serves a reminder to investors of the cost of being out of the market for the past two months. However, what if the market’s rosy vision of future growth becomes clouded by unforeseen events connected to COVID-19, civil discord or some other unknown negative headwind? In that more negative scenario stocks would be vulnerable to more than just a correction at these levels.

Essential Tools – Flexible Stock Allocation, Sector Management & Stop Loss Orders
Stock markets have always been risky and may be even more so today. It is nearly impossible to predict with accuracy the future direction of stock prices from these levels. We are always operating within the unknown – but perhaps now more than ever with the pandemic wreaking havoc on the economy. For this reason we stand prepared for any significant downside by having a flexible approach to your allocation to stocks, careful exposure to different economic sectors and the use of intentionally placed stop loss orders. Together these risk management tools complement each other to ward off the possibility of a catastrophic decline in one stock, a sector of stocks or the whole stock market. They worked effectively in 2008 and in the recent “crash.”

We hope the market’s recent and significant strength is correctly discounting the better days ahead as the economy opens up. Hopefully “the curve” remains flat, but we just wanted to remind you that we are prepared should that rosy outlook not come to fruition.

If you have colleagues, friends or family members who are relieved that stocks have recovered, but are worried about a redux of the March crash we would be happy to share some thoughts and guidance with them. In the meantime let’s enjoy this great recovery while it continues to last and see if “Superman” can avoid any oncoming kryptonite!

Your Team at Main Street Research