Severe market downturns are never pleasant, but they're the price of admission to participate in the wealth-creation engine that is the stock market. In fact, some of the most uncomfortable periods of market volatility can be the best times to add to stocks. Think December 2018, or March of last year, as just two examples.
That being said, buying just before a huge downturn can be painful, and it could potentially take years to recover – think the tech crash of 2000, or the great financial crisis in late 2008. If one of those scenarios is on the horizon, now may not be the best time to buy into stocks.
I think this is a more garden-variety mini-correction, not the start of a huge crash, so I'm buying stocks. Here's why.
Image source: Getty Images.
What's behind the recent tech wreck?
This sharp sell-off has confused many, given that many companies are currently posting incredibly strong revenue and earnings numbers, often surpassing analysts' expectations. The financial media has mostly targeted one reason: inflation. However, I'd say there was also another reason behind the counterintuitive sell-off: taxes.
First on inflation -- yes, last Wednesday's Consumer Price Index (CPI) number was much higher than what many had expected, rising 0.8% month over month. Stripping away the more volatile food and energy categories, "core" CPI rose an even higher 0.9%. That's the highest monthly increase since 1982. That may have spooked investors who remember the high inflation of the late '70s and early '80s. Inflation could lead to higher interest rates, and higher interest rates are usually bad for stocks.
However, before you panic, it's worth noting that the circumstances around the eventual end of COVID-19 are certainly unique -- unlike anything we've experienced in our lifetimes. Going from an economic standstill in certain parts of the economy to a huge boom is bound to lead to some bottlenecks. When factoring in shortages of semiconductors, chicken, and other items, it's no wonder inflation is shooting up as a critical mass of people are getting vaccinated. For instance, looking underneath the hood for the CPI report, prices for used cars and trucks climbed 10% over the prior month. Transportation services also rose 2.9% over the prior month -- not a surprise at all, given that many people are taking trips as soon as they're vaccinated.
However, there's a big difference between the kinds of bottlenecks and supply-related inflation we're seeing now and the "embedded" inflation of the late '70s. In addition to core CPI, the Federal Reserve Bank of Atlanta also tracks what it deems "sticky" prices, or those goods and services that normally don't change prices very often. That metric came in at 0.45%, higher than the norm of around 0.2% over the past 10 years, but only half of that 0.9% figure. Based on the relatively dovish statements from Fed officials regarding monetary policy, it would probably take several more quarters of inflation, and across a wider array of goods and services, for the Fed to think about raising rates.
Since the great financial crisis, the Federal Reserve has generally fallen short of its 2% inflation target. The last time it raised rates, the Trump administration had just begun the trade war with China and had implemented tariffs. That rate increase proved a mistake, and the U.S. underwent a short industrial recession. This time, it's more likely the Federal Reserve won't raise interest rates too early.
And don't forget taxes
Another factor that may have played a role in last week's sell-off was taxes. In fact, taxes could have played a part in two different ways. First, because of the pandemic, tax day was moved from April to May 17. Thus, many may have used their stock holdings to pay down their tax bills. I also expect many investors may have panic-sold off long-term holdings in last March's epic crash. If that's the case, many may have had large capital gains taxes to pay today.
Speaking of capital gains taxes, at the beginning of this month, President Biden proposed raising the capital gains tax on the highest earners in the country from 20% to 39.6%. Fearing a higher rate in the future, many high earners -- the ones who are likely to have significant stock holdings -- may have chosen to sell off their big long-term winners and rebalance their portfolios to lock in a lower tax rate today. Given the huge gains since the start of the pandemic, this may have seemed like an opportune time to do so.
Image source: Getty Images.
Buying stocks in sell-offs has been the right move over the long term
Since 1950, there have been 26 market corrections in the S&P 500 of 10% to 20%, as well as 10 severe bear markets of 20%-plus drawdowns. That's about one correction of at least 10% every two years.
The good news? The market currently only sits about 1.5% below its all-time highs after Friday's bounce, meaning stocks in general have always recovered from big drawdowns, given enough time.
Of course, the Nasdaq is much further below its all-time highs. The tech-heavy index did in fact go into a 10%-plus correction recently, but thanks to the bounce on Thursday and Friday, it sits only about 5.1% below its all-time highs.
While the severe and long-lasting downturns of 2000 and 2008 linger in many investors' memories, they were brought on by different fears. 2000 was the dawn of the internet and saw many early-stage tech companies with little in the way of revenue and earnings trading at ridiculous valuations. That may be the case with a certain subset of stocks today, but the vast majority of today's major tech names are the real deal, with soaring revenue and robust profitability. And in 2008, the financial system itself was at risk from the fallout of the housing market crash. There is no such systemic concern today. Thanks to regulations, prudent risk management, and government stimulus, the banking system is generally in great shape today.
With very few exceptions, there's usually no reason to deviate from a plan of consistently buying stocks every month or quarter, with the goal of holding for the long term. With the near-term hysteria brought on by fears of slightly higher rates, as well as likely tax-related selling, there's no reason not to pick up shares of your favorite high-quality stocks amid market volatility. Five to 10 years out, I'll bet you'll be glad you did.
