How Now Down Dow?

By Scott Lummer
Chief Investment Officer, mPower

In my January 4 column, I addressed the likelihood of increasing interest rates, heightened stock market volatility, and equity market returns far less than in recent years. Since then the Dow Jones Industrial Average has fallen by 14%. I wish I had talked about the Cubs winning the World Series.

No, I am not prescient. I simply identified likely long-term trends and short-term risks. I did not expect this degree of a downturn -- I just warned that the risk was there. I often warn my children that they will poke an eye out if they don't cease a particular activity (often involving samurai swords), and although they seldom listen, thus far they haven't done any permanent damage.

So we are left with the typical question that should be asked at a time like this (and no, it's not "how could she marry that guy on national television without even knowing him?").

The question is, "what does the decline mean for your investment portfolio?" Before answering that, it's useful to consider why the decline occurred and the breadth of its impact.

Reasons for the Dow decline

The main reason the Dow has fallen is because the Federal Reserve has increased interest rates, and most analysts feel they will continue to do so in the future. The Fed is concerned about the potential for increasing inflation, and although thus far consumer prices and manufacturing costs have not risen as much as many feared they might, the rapid growth rate of the economy suggests that prices might rise in the future.

The way that the Fed tries to control inflation is by increasing interest rates, which tends to slow down economic growth. Consequently, when analysts feel that interest rates will be increased, stock values fall because of the likely impact on corporate growth.

Another reason for the Dow's decline is an increasing focus on stock market sectors not well represented in the index. The Dow is comprised of 30 stocks that are very large companies, many of which focus on traditional businesses. These are the types of companies that will likely be most affected by the slowing economic growth triggered by an increase in interest rates. Many investors have focused more attention on small companies and less traditional businesses, such as Internet, computer, telecommunication, and biotechnology stocks. As a result, the broader market has not done as poorly as the Dow -- the S&P 500 has fallen by 9% and the Nasdaq index has gained 13%.

Consequently, unless you're only invested in stocks in the Dow, it is unlikely that your losses for the year have been 14%. We at mPower have always suggested broad diversification among sectors and types of investments, and since the past 2 months have proved why diversification is important, hopefully you have practiced this as well.

So what should you do? Well, let me mention two temptations you may have, then try to sway you from succumbing to them.

Temptation # 1: Bail out of the stock market

The first is the temptation to bail out of the stock market and reinvest all of your money in bonds and money markets. This would be a big mistake. As I mentioned earlier, all of the risks we have observed were predictable at the beginning of the year. Nothing shocking has occurred. The economy is still very healthy, and corporate profits are strong. Analysts have already accounted for the likelihood of future interest rate increases -- indeed, that is the reason for the drop over the past week.

Consider two facts:

1. Over the past few years there have been several stock market declines of between 10% and 15%, and in all cases, the market has come roaring back. Emblematic of these declines was the 13% drop in the market during the summer of 1998. Over the last four months of that year, stocks rose by 29%.
2. You are investing for a longer time horizon than 2 months. Although the 2-month return on the Dow has been poor, the index has gone up by 6% during the past 12 months (the S&P has risen by 8% over that time).

Temptation # 2: Follow the herd into technology-oriented stocks

It may also be tempting to follow the herd out of the broader stock market and into technology-oriented stocks. Indeed, if your portfolio is entirely concentrated in large manufacturing company stocks ¾ and I hope the person who wrote to me to say that his/her entire portfolio is in a big oil company is listening ¾ I suggest diversifying a portion of your money into funds that focus on smaller and technology-based stocks.

While we at mPower have always recommended diversifying some of your portfolio into these stocks, putting too much money in them would be jumping out of the frying pan and into the fire. Concentrating your portfolio in the high-tech sector will create valuation swings that will be double or triple those of the broader market.

What you should do…and it's not much

So what you should do is … actually, not much. First, check to make sure your portfolio is widely diversified into different sectors. Then verify that any individual stock does not make up too large a portion of your holdings. But don't cause further damage by making unnecessary changes -- you should maintain your overall equity position, and not completely eschew investing in larger companies. In investing, overreacting hurts more investors than underreacting does.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

How Now Down Dow?

By Scott Lummer
Chief Investment Officer, mPower

In my January 4 column, I addressed the likelihood of increasing interest rates, heightened stock market volatility, and equity market returns far less than in recent years. Since then the Dow Jones Industrial Average has fallen by 14%. I wish I had talked about the Cubs winning the World Series.

No, I am not prescient. I simply identified likely long-term trends and short-term risks. I did not expect this degree of a downturn -- I just warned that the risk was there. I often warn my children that they will poke an eye out if they don't cease a particular activity (often involving samurai swords), and although they seldom listen, thus far they haven't done any permanent damage.

So we are left with the typical question that should be asked at a time like this (and no, it's not "how could she marry that guy on national television without even knowing him?").

The question is, "what does the decline mean for your investment portfolio?" Before answering that, it's useful to consider why the decline occurred and the breadth of its impact.

Reasons for the Dow decline

The main reason the Dow has fallen is because the Federal Reserve has increased interest rates, and most analysts feel they will continue to do so in the future. The Fed is concerned about the potential for increasing inflation, and although thus far consumer prices and manufacturing costs have not risen as much as many feared they might, the rapid growth rate of the economy suggests that prices might rise in the future.

The way that the Fed tries to control inflation is by increasing interest rates, which tends to slow down economic growth. Consequently, when analysts feel that interest rates will be increased, stock values fall because of the likely impact on corporate growth.

Another reason for the Dow's decline is an increasing focus on stock market sectors not well represented in the index. The Dow is comprised of 30 stocks that are very large companies, many of which focus on traditional businesses. These are the types of companies that will likely be most affected by the slowing economic growth triggered by an increase in interest rates. Many investors have focused more attention on small companies and less traditional businesses, such as Internet, computer, telecommunication, and biotechnology stocks. As a result, the broader market has not done as poorly as the Dow -- the S&P 500 has fallen by 9% and the Nasdaq index has gained 13%.

Consequently, unless you're only invested in stocks in the Dow, it is unlikely that your losses for the year have been 14%. We at mPower have always suggested broad diversification among sectors and types of investments, and since the past 2 months have proved why diversification is important, hopefully you have practiced this as well.

So what should you do? Well, let me mention two temptations you may have, then try to sway you from succumbing to them.

Temptation # 1: Bail out of the stock market

The first is the temptation to bail out of the stock market and reinvest all of your money in bonds and money markets. This would be a big mistake. As I mentioned earlier, all of the risks we have observed were predictable at the beginning of the year. Nothing shocking has occurred. The economy is still very healthy, and corporate profits are strong. Analysts have already accounted for the likelihood of future interest rate increases -- indeed, that is the reason for the drop over the past week.

Consider two facts:

1. Over the past few years there have been several stock market declines of between 10% and 15%, and in all cases, the market has come roaring back. Emblematic of these declines was the 13% drop in the market during the summer of 1998. Over the last four months of that year, stocks rose by 29%.
2. You are investing for a longer time horizon than 2 months. Although the 2-month return on the Dow has been poor, the index has gone up by 6% during the past 12 months (the S&P has risen by 8% over that time).

Temptation # 2: Follow the herd into technology-oriented stocks

It may also be tempting to follow the herd out of the broader stock market and into technology-oriented stocks. Indeed, if your portfolio is entirely concentrated in large manufacturing company stocks ¾ and I hope the person who wrote to me to say that his/her entire portfolio is in a big oil company is listening ¾ I suggest diversifying a portion of your money into funds that focus on smaller and technology-based stocks.

While we at mPower have always recommended diversifying some of your portfolio into these stocks, putting too much money in them would be jumping out of the frying pan and into the fire. Concentrating your portfolio in the high-tech sector will create valuation swings that will be double or triple those of the broader market.

What you should do…and it's not much

So what you should do is … actually, not much. First, check to make sure your portfolio is widely diversified into different sectors. Then verify that any individual stock does not make up too large a portion of your holdings. But don't cause further damage by making unnecessary changes -- you should maintain your overall equity position, and not completely eschew investing in larger companies. In investing, overreacting hurts more investors than underreacting does.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.