How to stop worrying and love a falling stock market

It's natural to be terrified when stocks fall. Photo / 123RF

It's perfectly natural to be terrified. But big losses bring certain benefits, too.

When the stock market falls as far and as fast as it has in the last three weeks, it is perfectly natural to be terrified.

It requires a leap of faith just to place hard-won savings in such an abstract, ephemeral thing as a share of stock or an exchange-traded fund. Instead of spending on something concrete that can be enjoyed immediately, investing means putting money into what is, ultimately, a notation in a brokerage account displayed on a computer screen.

And now, in just a handful of days, a meaningful chunk of it has been wiped out. If your primal brain sees that and wants no part of the stock market anymore, it is completely understandable.

It's also probably a mistake, assuming the question involves long-term savings. People have a tendency to move money out of stocks after steep drops but often fail to jump back in quickly enough when the market finally bottoms out.

There's a way of thinking about stocks that can help you avoid that fate. It's a mental trick that makes it easier to stomach those terrifying days when your 401(k) plunges. And it has roots in the math of what you're buying when you invest in the stock market.

When you buy a share of stock, you are buying a claim on an infinitesimal portion of the profits of that company for the rest of time. When you buy a broad index mutual fund or ETF, you are essentially buying a share of the future profits of all major corporations.

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The way those profits will be delivered to your pocket will vary. Some of it will be paid directly to you in the form of a dividend. Some will be held by the company or used to buy back shares, which materialises in the form of a higher stock price. And some will be reinvested by the company's managers to drive growth.

We may not know exactly how much money big companies will be making in a decade or two, or what technologies and business strategies they will use to make it, or which companies will account for more or less of that total than they do now. We don't know how severe a potential coronavirus outbreak this year will be, or how long it will last, or how it will affect the near-term performance of corporate America.

But if you look over the sweep of history, one lesson is clear: Earnings tend to rise over time, as the world economy grows. However, the price an investor has to pay to get a slice of those earnings can swing wildly, much more so than any plausible forecast of that long-term future does. And rarely has that been more true than in the last three weeks.

"Earnings have been hugging a trend since 1950," said Robert Shiller, a Yale economist and Nobel laureate. "The market tends to be more volatile than the earnings. So there's something going on other than the forecasting of future earnings."

And that something is the cycle of ebullient optimism and abject fear that we often find in financial markets.

Which condition applies at any given moment involves a lot of factors. It's mostly psychology (are people feeling more greedy or more fearful?) combined with some high-level macroeconomics (is there a glut or shortage of global savings?), with some mechanics of financial markets tossed in (are big hedge funds being forced to sell shares to meet other financial obligations?).

The moments when sentiment shifts from optimism to fear, like the last few weeks, are scary when you have an accumulated pile of savings declining in value. But it also means that the value you're getting on any future earnings has increased.

Typically, stock analysts think of valuations in terms of the price-earnings ratio, but it can be clarifying to invert it. So, for example, at the record market high on February 19, this earnings-price ratio was 3.1 per cent for the S&P 500, meaning that every $100 invested in an S&P index fund bought interests in companies that accounted for $3.10 in profits over the previous year.

With the sell-off through Thursday, that number had risen to 4.2 per cent — last year's earnings were unchanged, but it was a lot cheaper to buy a share. In the same span, though, the yields on longer-term Treasury bonds fell sharply. A 10-year bond paid 1.43 per cent on February 19 and 0.45 per cent at Thursday's close.

Put those two together, and you're earning an extra 3.8 per cent a year for putting your money in stocks instead of bonds now compared with just three weeks ago.

Wait, you might say. These are scary times, with the possibility of a recession, widespread bankruptcies and economic upheaval.

This is all true. But those extra 3.8 percentage points are the compensation you are receiving for keeping an even keel and taking a long view — for being willing to ride out whatever disturbances the next year or two may hold.

The fact that stocks are extraordinarily volatile right now, in that sense, isn't a problem with stock investing — it's a feature! If it weren't for these periods of fear, stocks would trade at levels that offer returns more like bonds or cash. The fancy academic name for this is the "equity risk premium," but an ordinary saver can simply think of higher long-term returns as the compensation you receive for tolerating volatility.

It's a good reason not to keep savings that are needed soon in stocks. If you're looking to pay for a house or car in the short term, that money probably shouldn't be in an asset that can lose 10 per cent of its value in a single day, as stocks did Thursday.

But for retirement or other long-term savings, the sensible approach is to set an asset allocation that makes sense for your level of risk tolerance and stick to it. And then think of the sell-off of the last few weeks as the kind of episode that isn't so much something to fear, but a moment of opportunity — even if an unnerving one.

Written by: Neil Irwin
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