Don’t you see what’s happening? Potter isn’t selling. Potter’s buying! And why? Because we’re panicking and he’s not. That’s why. He’s picking up some bargains. Now, we can get through this thing all right. We’ve got to stick together, though. We’ve got to have faith in each other.
George Bailey – It’s a Wonderful Life

That quote is from one of my favorite movies, and it is very appropriate given the current market environment. In this scenario the hero George Bailey and the bad guy old Mr. Potter prove to be strong investors. They both see the big picture, they see the long-term perspective, neither character panics, and both maintain faith in the future despite a murky present.

As of yesterday the Vanguard Total World Stock (VT) was at -10.33% for the year. Starting this week the S&P 500 was at -7.93% and the MSCI EAFE was at -8.79% for the year. Since the first trading week of 2016 markets have been dropping, and they have been dropping fast.

My recommendation is to be like Mr. Potter and George Bailey. Do not let the emotion of seeing account values fall dictate your actions. If for some reason you have extra cash within your portfolio, put it to work. Price movement alone should never dictate your investment actions.

The current market downswing is one of two things. It is either a correction within a continuing bull market, or it is part of a new bear market cycle. Neither is provable while occurring, we will not know which is occurring with certainty until we are able to look back.

If it is a correction, the play is simple. As investors we should hold our positions confident that our asset allocation is appropriate for our goals, time horizon, and cash flow needs. We should sit back and put our feet up, while the weaker investors weed themselves out and inevitably whipsaw their returns.

If it is part of a bear market cycle, the play to make is more complicated. If this was a bear market that was preceded by over enthusiastic market sentiment with wobbling economics/fundamentals (like what we see in China), then we would have considered going defensive prior to now.

Hundreds of years of market data have proven that an investor can achieve very strong returns while taking the full brunt of bear markets, as long as they do not miss out on the Bull market cycles. When an investor takes a defensive position or takes money out of stocks, they are betting against hundreds of years of data that says “when in doubt, hold and wait.” Investors can predict bear market cycles and position portfolios accordingly. Accurately predicting bear markets can help an investor achieve superior long-term returns, but it is very very difficult. It is also the most dangerous move an investor can make, because the investor risks being wrong and missing out on bull market returns.

I think that we are in a correction and not a bear market, because I do not see material change in the world from three weeks ago. I do not believe the global economy is threatened by slower growth in China or low oil prices. As I see things, the likelihood of a recession in the US or Europe is low.

The USA and international developed economies are still poised to grow at the low but steady level of 2-3%. Exports to China account for less than 1% of US GDP, and exports to China account for less than 1.5% of Eurozone GDP. Volatility and/or a bear market in Chinese equities could lead to a period of heightened volatility globally, but will not lead to a global bear. The equity prices in China were drastically overbought given the fundamentals of the underline companies, and they crashed much like tech stocks in 2000, or all stocks in 1929. There should not be any contagion for global developed stocks or their underline companies.

Low oil prices or low energy costs hit energy companies hard, because they are very price sensitive. Low energy/oil prices act almost as a tax cut for consumers though. Consumer spending is a much bigger portion of GDP among developed economies than energy is. Low oil prices are a wash economically, or perhaps even a net positive.

Of course the market is a master at humiliating investors and maybe I am its next victim. That is why asset allocation, the correct mix of stocks, bonds, and cash is so incredibly important.