The Economy, Markets, and Your 401(K) Portfolio, Pt. 3 of 4

In Part 2 of The Economy, Markets and Your 401(K) Portfolio, I explained the five patterns of the economic cycles (also known as the "business cycle") and generally how the economy is influenced, whether by the monetary policies of the Federal Reserve, corporate earnings, and inflation.

Understanding Event Risk

World history is comprised of noteworthy events that have impacted lives, shaped economies, and either established or destroyed empires and governments for thousands of years. Thankfully, in this edition of The Economy, Markets and Your 401(K) Portfolio I am not interested in covering world history. However, I am interested in events that have had a direct impact on the U.S. markets since World War I, to the present.

Again, while not attempting to cover every major event that has impacted the United States since WWI, it is important to note that largely unexpected events will have an initial impact on the Market whether or not the economy is also impacted. As an investment advisor, my responsibility is to discern the nature of the event at hand, whether it represents an investment risk or a buying opportunity. In other words, should I completely reallocate our model portfolios, or back the truck up by doubling down and buying more of the same shares that are already in our client's portfolios?

Knowing whether a particular type of risk (e.g., terrorism, pandemic, geo-political, wide-spread corporate malfeasance resulting in moral hazard, etc.) presents an investment opportunity, or not can be the difference between considerable losses that could take years to break even from, or it may result in substantial investment gains. Market declines are inevitable because they could be influenced by profit-taking after a prolonged Bull Market, or it may be the result of a corporation such as Microsoft or Apple, reporting a lower-than-expected earnings report. Markets also rise and fall based on political gains or losses of a major candidate during an important national election.

Is There an Economic Impact?

Threats to the economy that have the potential to cause significant socio-economic harm to the American way of life may result in some form of government intervention to "save the day." For example, as horrible as the terrorist attack on September 11, 2001, was from an investment perspective that day merely presented a buying opportunity in the markets. The stock market declined a week later when the markets opened and two months later, the market recovered from the sharp decline that it experienced on the first day of trading after September 11th. In short, 9/11 was an event, but just not the type of event that resulted in a risk to the economy, hence, government intervention in the form of financial aid was non-existent.

By contrast, there was government aid in response to the economic risks related to The Great Depression, i.e., The New Deal. There was government aid in response to the Great Recession which resulted in the housing crisis, i.e., the Toxic Asset Relief Plan (TARP). In 2020, during the Coronavirus Pandemic, the Federal Reserve responded quickly by first investing in Exchange Traded Funds that were comprised of Corporate Bonds, followed by making large investment purchases directly in corporate debt. Talk about a wonderful time to have corporate bonds in your portfolio! Following what amounted to a cash infusion for corporations.

The White House followed suit when President Biden announced the Paycheck Protection Plan (PPP) Loans, and the Coronavirus Aid, Relief, and Economic Security Act, also known as the CARES Act, a $2.2 trillion economic stimulus bill passed by the 116th U.S. Congress. If the risk is so great that the government must get involved as it has in the past, then it is very unlikely that the market is going to recover as quickly. Therefore, a complete portfolio reallocation may be necessary to reduce market losses and potentially generate positive returns.

Uncertainty is a bad word in the stock market and for good reason. The market wants to quickly quantify the results of a particular event risk and move on. During the Pandemic, more than 1.1 million Americans died which is a staggering number by any measure. However, the most pressing question to the market was, “When will there be a vaccination?” Again, the market was chiefly concerned with being able to see a significant decline in the number of lives lost to Covid. Once the fog of uncertainty begins to break, signs of recovery in the market begin.

Event risk is the great outlier that can either result in quick profits or considerable losses. Outside of the uncertainty of an unexpected event, the economic cycle of Peak, Recession, Trough, Recovery, and Expansion, will follow somewhat of a predictable pattern.

If you understand which asset classes are likely to perform best throughout the five cycles of the economy, the next thing you must understand is whether an event that has the potential to cause the markets to fall significantly will ultimately require some form of a bailout from the legislative or executive branch of the Federal Government and/or the Federal Reserve, and if so, then modify your investment portfolio accordingly. If a government bailout isn't necessary, then the market might be saying that NOW is the time to back up the truck and double down on your portfolio by investing more!

If you have questions or would like to schedule a meeting by phone or Zoom, the following button will allow you to book a time on my calendar that is convenient for both of us.

In Pt. 4, the conclusion of "The Economy, Markets and Your 401(K) Portfolio", our topic is Asset Class Diversification.

I am going to briefly summarize Pt. 1 - 3, as the foundation that Pt. 4 is built upon as it frames the context of this series on asset class diversification. The art and science of selecting the appropriate index investments by asset class, and building the model portfolio based on the present, and most probable direction of the economy.

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