Everybody Panic for Recession -- No, Wait: Keep Calm and Invest On

So the stock market has been a bit "moody" over the past month, with 10 of the past 15 sessions closing down, including some rather alarming "big red candles" on July 18th and 24th, and August 1st -- and again looking to do the same today, August 7th. More distressing than the S&P 500's downward trend have been the days of 5% or more losses for the tech-heavy NASDAQ index, and the 20%+ sell-off of Bitcoin and Ethereum. Of course anytime there are a series of losing days in our investments, we start to get a bit anxious. After all, we've made a commitment to taking part of our hard-earned paycheck and investing it in the hope of long-term profit and wealth.

But deep down that feeling of panic has less to do with the daily drop in the stock market and more to do with the feelings of uncertainty and doubt that we feel about what's going on. "Stonks only go up", right? So when we see losses in our TSP balance or stock portfolio in our brokerage app with Vanguard, Fidelity, Schwab, or E*Trade, it doesn't make sense compared to our expectation. We are now in the weird world of emotions, aka Fear, Uncertainty, and Doubt, or FUD.

FUD is no mindset for making decisions about something as important as our retirement, future financial stability, or dreams of Financial Freedom, yet we make FUD decisions anyway. Should we? How can we stop it? What should we do? What's really going on?

Understanding the Basics

If you really like this first topic, Google "efficient market hypothesis" and dive in as deep as you want to go. But for most, that is way too "academic" for trying to understand the stock market and investing in stocks, mutual funds, or even bonds. But we still have to understand some basic concepts if we're ever going to overcome the animalistic FUD response, stick to our strategy, and build wealth.

First, stock price movements are random. They move up or down at basically the rate of a coin toss, with 53% of stocks closing higher and 47% lower over about a billion trading days. Those movements up or down happen to both the best of companies (Berkshire-Hathaway) and worst (Enron), so that should tell you right away that just because a stock -- or the stock market -- goes down it doesn't mean it's a bad investment. And if it's NOT a bad investment, why would you ever sell it?

Second, stock prices are said to be "efficient," which means that at any given moment they are the right price given everything we know from the past, and all the information we predict about the future. So long as things like earnings, profits, product launches (think Apple Day), etc. continue to follow our expectations, the stock will steadily rise over time. It's only when there are surprises (good or bad) that people didn't expect or predict that a big change in the stock or stock market can happen. Everyone sets new expectations, buys or sells based on that, and the price changes.

Because the professionals and big banks and institutions get this information before we do, they start trading first. That causes a sudden and rapid rise or fall in the stock price or stock market -- and that is the first signal you or I have that something is going on. But it has already happened! We are too late to do anything about it, because we don't have access to the insider and "pay-to-play" information and reports that the big traders do. Not even your Financial Advisor who's only been out of college for 7 years knows what's coming (and that's why only 1% of them ever actually beat the market).

In reality, as a result of the randomness, the lack of information, and the fact that millions of more powerful traders beat us to the punch every day, reactionary trading or making investment decisions based on FUD is almost always going to result in a worse result than just sticking to your guns.

The Economy and the Stock Market

Now in the summer of 2024, we're seeing crazy movements in the stock market in reaction to news about the U.S. and global economy -- not headlines about the specific stocks we own. So a report comes out that says unemployment rose from 3.1% to 4.3% in one year and we must certainly be in a recession, so AI-darling and chipmaker NVIDIA's stock tanks 10% in one day? But NVIDIA is hiring more people, signing new contracts, and making more money! Does that make sense?

Traders react to economic headlines just like they do to updates on individual companies: they made guesses before on what would happen, and then they change their guesses. But nothing about that makes the stock, stock market, or their investments better or worse.

Consider the headlines of July 2024 that resulted in stock market losses: President Joe Biden withdraws from the presidential race and a glitchy global security patch from CrowdStrike paralyzes airports, hospitals, and other organizations. People panicked about these things, and the stock market went down. After a couple of days, all was recovered.

Similarly, the big early August sell-off followed a very weak jobs report and news of rising unemployment. Several indicators based on this suggest the U.S. economy is already in a recession, which typically results in a downturn of the stock market. That happens because in a recession corporate profits fall and unemployment rises; if companies make less money, they're worth less, and if people make less money, there's less to invest. Naturally the stock market would follow downward.

But what's really required to show we're in a dangerous economic situation? A recession technically should show two consecutive quarters of GDP decline; in 2024, the first quarter GDP grew +1.4% and the second quarter grew +2.8%. These are not recessionary numbers. In a recession, you also have rising unemployment -- but only if that's because people are losing their jobs. Unemployment doesn't only go up when people lose jobs, it also goes up when more people are looking for jobs. A quick look at the jobs report for 2024 shows that each month we continue to have more people working, and that the unemployment rate is only going up because more people are looking for work, not because people are getting laid off!

(SOURCE: https://fred.stlouisfed.org/series/PAYEMS)

And what about inflation? It seems to be stabilizing, bouncing between 3.1% and 3.5%. This is pretty close to the 114-year average in America of 3.1%, despite the "target" of 2% set by Federal Reserve Chairman Jerome Powell ("J-Pow") and the Federal Open Market Committee (FOMC).

In other words, if we step back and look at the overall economy, while there are certain things that aren't great, there are a lot of measurements and indicators that remain strong. It's important to not allow daily headlines or single "not-good" reports distract you from the bigger picture.

Behind the Curtains

So why do these things trigger such swings in the stock market and leave all of us feeling uneasy, anxious, and fearful, ready to abandon our strategy and sell our good investments? There are often things that have absolutely nothing to do with anything that result in big daily swings.

For example, the "carry trade" in which big banks and institutions borrow money in cheap currencies like the Japanese Yen to buy U.S. stocks. So long as interest rates in the U.S. stay high, they do this -- but once they think interest rates will come down, it's no longer as profitable. So they start selling, paying back the loans, and preparing for lower interest rates in the U.S.

Another case is "open interest" on options, which are not actual stocks but just contracts for stocks to buy or sell in the future. Every once in a while you get what's called a "triple-witching" or "quadruple-witching" day when a bunch of these contracts expire or come due at the same time. The major banks and hedge funds that made bad bets have to suddenly buy or sell a bunch of stocks, in the billions of dollars, causing one-day changes in the market. Again, nothing is actually wrong. Just pay attention to the following 1-3 days and you'll see everything gets back to normal.

There are numerous other factors that cause one day changes in the market. Your mission is to remember to pause and take a look at the bigger picture: if nothing is actually going wrong with the economy or your investments, there's no reason to do anything.

The Penalty of Panic

Trying to follow the herd and sell after a big drop, or trying to guess what will happen next and "time the market" actually costs the average retail investor like you and me dearly. 

From 1993 to 2013, the S&P 500 endured two significant crashes: the Dot-Com Bubble and the Great Recession. When the Dot-Com Bubble burst, the S&P 500 lost 50% and the NASDAQ lost 78%; in the Great Recession of 2007-2009, the S&P 500 again lost 57%. Yet over that 20 year period, the average annual return on the S&P 500 was 9.2%! 9.2% is enough for you to get 8% Total Real Return, aka adjusted for inflation, and stay on track for your investing goals of doubling your wealth every decade.

In other words, 2+ really, really, REALLY bad years out of 20 still were totally overwhelmed by the recoveries and "bounces" that followed. Anyone who stuck to their strategy, didn't sell, and kept investing month after month won big-time. But the reality for the average American retail investor and pensioner was that over this period they only averaged 2.6% per year -- because they panicked!

(SOURCE: https://econompicdata.blogspot.com/2015/05/no-investors-have-not-underperformed.html)

As soon as the crash happened and they were down 30%, 40%, 50%, or more, they sold. They realized, or "locked-in" their losses. Then they waited to see signs that the stock market recovered before buying back in. They also missed the massive profits of the recovery. There are only two ways to win in this market: gain access to expensive institutional data (like a $30,000 a year Bloomberg terminal and subscription) or insider information -- or stay consistent and don't panic sell.

This 20-year period makes it clear the benefit of having a solid strategy that you consistently execute with a 10-year vision and no concern for the headlines: you will earn 9.2% instead of 2.6% per year, or in other words Confident and Consistent You will do 253% better than Fearful You. After 20 years, the difference between 9.2% and 2.6% on a starting portfolio of $10,000 is almost 4x as much money, $62,525 compared to $16,800. (Not to mention that 2.6% is worse than a High Yield Savings Account and fails to keep up with inflation!)

In dollar terms, we saw the same thing happen yet again in 2020 and the COVID Pandemic crash. As a result of panicked selling by the average retail investor, over $5 TRILLION dollars of wealth was lost by retail investors -- and gained by the richest investors and banks. This was one of the largest "wealth transfers" in history, and could have totally been avoided if folks like you and I didn't panic.

Keep Calm and Invest On

So what to do? Well, if the market is down 5% and there's no reason you can figure, just forget about it and watch it bounce back. Something happened, you missed it, so just keep going as if nothing happened at all. If the move is bigger, remember that 10% down is a "correction", meaning the "big money" is just moving around to take new positions, and things will return to normal: the market needs to drop 20% or more to be in a technical recession.

You can automate "stop-loss limit orders"  to sell if your investment drops too much. But this is not clear-cut, and can realize a loss while stopping you from benefitting from the recovery. The amount of drop you can tolerate before you want to sell has to depend on the individual stock or investment, so you'll have to do your own research. A 10% stop-loss on an S&P 500 index fund might make sense, but a 10% stop-loss on Bitcoin or Twitter/X stock could happen every day!

Also remind yourself of the penalty paid for selling when the market is down, which means you lock in your losses of 20%, 30%, 40% or more. It's about 1,000,000:1 that you'll be able to guess when the crash is finished, and far more likely that you'll miss all the massive profits of the bounce and recovery to make up for the initial loss. In other words, if you didn't have a stop-loss to catch your fall at a reasonable level, the worst thing you can do is sell and lock in even bigger losses.

Using 10-year periods, the U.S. stock market has always averaged out at 10.2% per year, and using 30-year periods it averages 10.8%. So long as you stay consistent with your strategy, don't panic sell, and keep investing even when the market is down -- way down -- you will end up earning 10% on your investments in your lifetime. The only way to ruin this (or to "kill the goose that lays the golden eggs") is to constantly react to FUD and panic-sell, then buy back in when it's too late.

Automating your investments can save you from this. Take a 10-year view of your investment strategy, automate monthly deposits and investments, and don't mess with it. Once you get to within 3-5 years of your goal, whether that's to withdraw $50,000 in 2030 to buy a house, or to retire with a $2.5 million nest egg in 2060, start to move your investments out of stocks into safer assets. Beyond that, just leave it alone and trust in the numbers, which are on your side.