Wow, the stock market is starting off 2018 with a bang. The S&P 500 index increased over 6% in less than a month and it is not slowing down. Investors are euphoric. Everyone is sure the stock market will keep going up and we don’t want to miss out. I’m not immune to this feeling. I just maxed out our 2018 Roth IRA contributions ($11,000) and put it all in the US stock market. The S&P 500 index will push through 3,000 this year for sure. Financial Samurai said this is the final stages of a blowoff and I completely agree. Let’s see what the blowoff stage is about and how we can prepare for it.
What is a Stock Market Blowoff?
If you’re a new investor, you probably haven’t gone through a market blowoff before. This final phase of the bull market is characterized by a steep increase in price follow by a steep drop in price and volume. In the mania phase, investors feel exuberant about stocks and they don’t think they can lose. Nobody knows where the top is, though.
To me, this feels like 1999. Everything is going up and everyone keeps talking about the stock market. I went out to lunch with Mrs. RB40 last week and I overheard 2 conversations about stocks. Everything is just going too well so investors are very bullish. Check out the steep rise of the S&P 500 index over the last 2 months. Here are some of the reasons why the stock market is going gangbusters.
- The US and global economy are very healthy. Consumers are buying and almost every economy grew at a healthy pace in 2017.
- US unemployment rate is at its lowest point since 2000. Consumers feel confident about their income so they aren’t afraid to spend.
- The US tax reform will put money in everyone’s pocket. Employees will have more income to spend. Businesses will have more money to invest. The tax reform will give a great short term boost to everyone.
- The interest rate is slowly climbing, but it is still very low. This is good for consumers and businesses.
- Valuation doesn’t matter. Stocks are going higher and nobody wants to miss out. The PE ratio is approaching the dot com bubble territory. However, it doesn’t matter because stock will keep going up due to investor confidence. Tesla has 0.2% of the US automobile market, but it is worth more than Ford. Amazon’s PE ratio is 360. These numbers are somewhat unreasonable. The Shiller PE ratio for the S&P 500 is getting very high.
- Credit card debt is at an all-time high. Consumers are confident about their finances and they are borrowing money to buy stuff. This is great for businesses in the short term.
- Margin debt is also at an all-time high. This means a lot of people are borrowing money to invest. I had a margin account when the Dot Com bubble blew up and it didn’t turn out well. That’s why I don’t use a margin account today. However, a lot of investors think they can’t lose and they are driving the margin debt balance to new record high every month. This is a bad idea at this stage of the bull market.
- Investors are exuberant. See the AAII Investor Sentiment Survey. Most investors are feeling bullish. This result is for week ending 1/24/2018. Note that it was even higher in the previous week.
Preparing for the blowoff
Stock prices can’t keep outpacing the earnings. Eventually, the valuation will revert to historical means. During the Dot Com boom, investors thought the stock market was entering a “new paradigm” because of the internet. Profitability and earnings didn’t matter as long as the business was growing. Everyone was caught up in a mass hallucination. Unfortunately, the new paradigm didn’t last and the bubble burst.
I predict that the stock market will crash by the end of 2018, but it’s just a stab in the dark. Nobody knows what the stock market will do. The S&P 500 index could increase 30% before we see a crash. If you’re really conservative, you might think cashing out before a crash is the way to go. However, that’s the wrong move. You’ll miss out on a lot of gains in the mania stage. You have to ride the wave up and brace for the downside too.
Here are some steps to prepare for a stock market blowoff.
- Keep investing. You have to keep investing no matter what happens. We kept investing through the last financial crisis and it turned out very well. People who stopped investing missed out on much of the recovery. Experts predicted the end of this bull market for years now. If you listened to them, you’d miss out on a ton of gains.
- At least 18 months COL fund. It’s a bad idea sell stock when the market is crashing. This COL fund does not have to be in cash. It just needs to be somewhere you can access after a crash (not in stocks.) Unemployment usually increases after a stock market crash so you need to be prepared. If you have a COL fund, then you won’t need to sell stocks to pay your bills. We have over $400,000 in bonds and that will cover our cost of living for many years.
- Figure out your target asset allocation. This is the easiest way to get through any market. Once you figure out your target asset allocation, you can just stick to it and ignore everything else. Our target asset allocation is 70% equities, 20% bonds, and 10% alternatives. If the US stock market crashes tomorrow, I would be fine with it. I’ll just rebalance and get my asset allocation back on target. If you need help figuring out your target allocation, here is my post on How to Figure Out Your Asset Allocation.
- Check your asset allocation. It is also important to keep an eye on your asset allocation periodically. The stock market did very well in 2017. That might have thrown your asset allocation out of balance. The easiest way to check your asset allocation is with Personal Capital. Once you’ve added your accounts, the asset allocation is available at a click of your mouse. You can see a sample of a report below.
- Be a bit more conservative if you have life changing events coming up. Life events can have a major financial impact on your household. It’s best to be cautious if you’re going to retire, have a kid, buy a house, get married, or send a kid to college. I suggest reducing your stock allocation for a while. Mrs. RB40 wants to retire by 2020 so we should reduce our equity exposure at some point.
So that’s what I’m doing to prepare for this stock market blowoff. I’m not doing anything drastic like getting out of stocks. The world economy is doing very well and I think the stock market still have some legs. We are in our mid 40s so we will be invested in the stock market for many years to come. At this point, it’s best to keep investing and stick with our target asset allocation. Going a bit more conservative for a few years would be okay too.
What about you? Are you prepared for a stock market blowoff? What’s your plan?
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