QUESTION: Stock markets are volatile so far this year as inflation persists and the Federal Reserve warns that interest-rate increases are coming; so how do I know when it’s time to take some gains and pull some of my money out?
ANSWER: Even though the market is off its highs by a few percentage points, it’s still up considerably over the past few years, so cash some in if you want. But there is a lot more to consider than just taking profits. America appears to be experiencing a real change in market conditions that might require investors to look at a broader rebalancing.
Stocks are valued by looking at their earnings, cash flow, sales and other measures of success, and then multiplying that number by a factor. For example, a stock with $1 of earnings per share might get multiplied by 18 to determine its value is $18 a share. Investors determine this multiple based on earnings growth, interest rates and general economic conditions. Recent years have seen low interest rates and high earnings growth, which leads to high multiples and therefore higher stock prices. However, the United States appears to be moving into a time of higher inflation and lower earnings growth, which will likely decrease multiples.
Ever since March 2009—the market low after the 2008 financial crisis—investors have seen the multiplier increase (save for few hiccups like the pandemic’s early months) thanks to tremendous economic growth coupled with very low interest rates and little inflation. However, inflation is back, and the Federal Reserve has signaled a willingness to hike interest rates to tamp it down. That means markets are likely to rethink that multiplier, and investors might see stock prices drop relative to their earnings.
So, should the savvy investor sell? Well, maybe. They recognize there will be a period of greater volatility and risk. They consider taking some risk off the table by selling and reaping profits. But they also understand that many companies make money in difficult environments and not all stocks will be impacted the same.
Prudent individuals rotate their portfolios to take advantage of the market disruption. They sell investments with high multiples (typically growth stocks) and buy ones with lower multiples (typically value stocks). Many consider purchasing foreign stocks and investing in real estate or other alternative asset classes that are less impacted by multiples and more impacted by actual performance. These could diversify away some risk from domestic investments and serve as an inflation protection.
Smart investing takes courage. Talk to your advisor about how to best position your portfolio for the coming year.