"The US economy is experiencing expansive economic growth as the stock market is setting record highs."
Does that sound like a reasonable statement for the current market condition? It is actually a description of the Roaring 20s that happened almost a hundred years ago. Pretty wild, huh? The 1920s was when the Dow Jones Industrial Average, or simply the DOW (a price-weighted index of 30 prominent companies listed on stock exchanges in the United States) increased six times from August 1921 to September 1929.
We all know what happened after the Roaring 20s, the Great Depression, an economic abyss of restructuring and difficulty for the entire country that lasted over three and a-half years. During the Roaring 20s, more cash chased fewer goods and services, so the result was asset appreciation. The stock market kept going up and up; many people felt they could make more money investing than they could working. How did this happen, and what lessons can we learn from history so it doesn't happen to the same extreme as it did in the 1930s?
The Roaring 20s was a decade of prosperity and dissipations, jazz bands, bootleggers, flappers, bath gins, and marathon dancers. The stock market hit new highs because investors were taking on risks without understanding the risk they were taking on. Many small investors thought prices would keep going up, and they wanted their slice of the American Dream. When investors ran out of cash to invest, they took out loans to further their market mania, many mortgaging their houses. Most took out margin loans whereby they borrowed money securing their current portfolio as collateral to invest more.
As Spokane financial advisors, we know that when too much risk is in the market, all it takes is one significant correction to wipe out gains. If you have a loan tied to a stock portfolio, a short-term market correction can create a domino effect of momentum by forcing investors to liquidate their stocks to meet margin requirements.
Does this all sound familiar? If you think it does, you are not alone. Here we are 100 years later, the new millennium of the Roaring 20s, and we are back to a period of extreme asset appreciation. Many people are throwing money at investments they don't truly understand, like bitcoin, and they think this is their slice of the American Dream.
While it is easy to be drawn into the mania of the market, it is important to understand that this period of nonstop growth cannot go on forever. It is important to know that there will be a market correction. A correction of up to 20% is considered part of the healthy lifecycle of the investment market. However, it is important that you are prepared.
How to Prepare for a Market Pullback
- Understand your debt. If you don't have to go into debt to buy something, consider not doing it. Too often, people get into trouble by taking on debt, and then their cash flow changes. Suddenly they cannot make their loan payments. The banker will come and take your car, house, and stocks if they are collateral to the loan they gave you.
- Expect to pay more. Inflation is here, and most likely, everything will continue to cost more, so although you are happy with your latest pay raise, you may need it to pay insurance and base living expenses. Get a handle on those expenses, so they don't give you difficulty in paying your taxes. Benjamin Franklin said the two things in life you can count on are taxes and death. This huge stimulus package needs to be paid back, and we will all be contributing more towards taxes. You probably like that your house has appreciated, guess what, so will your property taxes on it. Get ready for layered new expenses, whether it is through payroll deduction mandates, high-income taxes for state and federal taxes.
- Risk. How much chance do you have in your investments? When did you last diversify and rebalance? Don't wait for a market correction to do that; now is an excellent time to talk with your financial advisor.
- Liquidity. How much do you have? If you had to come up with cash in a couple of days, can you convert your investments to currency without taking a big discount?
- Live within your means. Don't get caught up thinking you need the latest iPhone when your current one accomplishes everything you need. If you can't pay cash for something, really think hard about whether you can practice delayed gratification for that item.
It's fun to see economic growth when you are on the ride up. Just remember it's not whether a pullback will happen, it's a matter of when and how much. How prepared will you be for this next roar of our current Roaring 20s?
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Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.