If you’ve been thinking that stock markets have been pretty quiet this year, you are right. Through the first seven months of the year, none of three major stock market indexes has fallen by more than 5 percent. One gauge of market movement, the Chicago Board Options Exchange volatility index, referred to as the VIX, which measures investors’ expectations of the ups and downs of the Standard & Poor’s 500 index over the next month, recently dropped to its lowest level in 24 years. Low readings have tended to be associated with low anxiety and high stock prices.
In this environment, what could go wrong? A number of risks to the United States and global markets persist. These risks do not mean that long-term investors should change their game plans; rather, they are a reminder to guard against complacency and always approach investing with caution.
HERE ARE THE RISKS
THE FEDERAL RESERVE PROCEEDS SLOWLY
In her recent testimony, Federal Reserve Chair Janet Yellen said, “We are watching inflation very carefully” because it remains so low. Although central bankers have attributed the recent slowdown in prices to temporary factors, Yellen acknowledged that because inflation has been running under the Fed’s 2 percent target, “that there could be more going on.”
Translation: Yellen and company are not so sure why inflation is so low, and that lack of clarity might prompt them to keep rates too low for too long.
What’s wrong with low rates? Besides punishing savers, rock-bottom rates can encourage excessive risk-taking, as investors seek greater returns in stocks, higher-yielding bonds or real estate. As these assets rise in value, bubbles may arise — and, as we know from the past decade, bubbles have a nasty way of popping.
CENTRAL BANKS PROCEED TOO QUICKLY
An equally vexing possibility is that the Federal Reserve, the Bank of England, the European Central Bank and the Bank of China all raise rates too quickly. In doing so, officials could cause a global stock and bond market sell-off or even worse, a recession.
Although politics has not impacted markets yet, a ratcheting up of anxiety and uncertainty might very well have a negative impact. That goes for the United States, Britain and its Brexit negotiations with the European Union, and unforeseen events in the rest of the world.
When stocks rise, it tends to make investors forget about the punishing losses that they can inflict. While bear markets can send you into panic mode, tempting you to sell everything and hide under your bed, bull markets can also be a very dangerous time. They can lead to complacency and even may embolden you to think that you can assume more risk than you should.
Rising asset values can cause investors to gloss over basic prudence. In 2006, I met with a then-client whose net worth had jumped because of a combination of a rising stock market and skyrocketing real estate prices. In his mind, he didn’t have to save more money “because markets are doing the work for me!” You probably can guess what happened in the ensuing years.
Markets can go up and down, which is why the best way for you to control your financial destiny is to create a game plan, which puts you on track to save enough money to reach your goals. And, yes, you will need to focus on spending, which, according to Larry Stein, certified financial planner of Disciplined Investment Management, “usually has the biggest impact on a financial plan.”