How Worried Should You Be about the Stock Market?

How worried should people be about the stock market? Every day’s news reminds us of unusual risks on the economic horizon. The fiscal cliff, which CBO projects as a $600 billion depressant on 2013 GDP, is looming. The European economies are sagging once again, and there is no lasting resolution yet in sight for the euro currency problem. China’s spectacular growth has slowed. And the upcoming presidential election adds to uncertainty about what lies ahead. Should one be in stocks in this environment?

Let’s start with the election. Taking a really long view, Wharton’s Jeremy Siegel calculated the annual return on equities averaged 9.6 percent between 1888 and 2006. The return averaged 10.9 percent under Democrats and 8.6 percent under Republicans. Such a difference gave rise to the slogan “If you want to live like a Republican, vote like a Democrat.” But the main message is that stocks have been a good long-term investment regardless of which party occupied the White House.

In the short run, down stock markets often accompany bad economic shocks. How damaging are today’s global developments likely to be to the U.S.? The Chinese slowdown has been apparent for several quarters. It has come mainly from the end of its construction boom and weaker exports to the slumping advanced economies. The slowdown has cut into China’s imports of raw materials but otherwise had only a modest impact on the U.S. economy.

Europe is a major market for U.S. exports so a deep recession there would have a bigger impact on the U.S. economy through trade. However many in Europe, along with the IMF, have concluded that fiscal austerity is having a large depressing effect , pressuring governments to back off. So the deep recession risk should lessen. The U.S. financial sector is more insulated from Europe’s than it was a few years ago, so spillovers from banking problems there should be manageable. And a messy breakup of the eurocurrency zone is not likely any time soon. In short, while the situations could turn worse, it now seems that problems in Europe and China will not derail the U.S. recovery.

As for impacting the U.S. stock market, the European situation has been evolving for years and has roiled markets as the crisis risk alternately worsened and subsided. Short-term traders have reacted repeatedly to these changing prospects, and those who are still solvent should have more opportunities in the coming weeks and months.

For the U.S., the bigger potential risks come from the fiscal cliff, which is the large swing to higher taxes and lower spending that occurs next year if current laws are not changed. To review how it came to this, here are three main elements: The Bush tax cuts were originally set to expire in 2010 to avoid exceeding the ten year budget limits that Congress had imposed on itself. They were extended through 2012 because of the recession. The alternative minimum tax has been temporarily amended for decades to avoid its affecting too many taxpayers. And the sequestration of $800 billion of defense and nondefense spending effective next January was created by the present Congress as a kind of doomsday machine to exert pressure for long run deficit reduction.

Nobody can have confidence about how this strange situation will play out. Right after the election the changes scheduled for January 1 might be pushed to mid-year to give time for a new Congress and the president to act. Or the changes might be allowed to kick in, inviting the risk of renewed recession in order to pressure both sides to find a compromise on long run budget issues. One reason this might be helpful is that discussions with the new Congress would start with substantially higher tax revenues which could then be reduced as part of any compromise. Or–and this seems less likely–they might be as unwilling to compromise as ever and allow the worst to happen.

So how worried should people be about the stock market? Nothing now on the horizon suggests that money invested in stocks today will look like a bad investment five years from now. But it would not be too surprising if stocks fell in this environment. Anyone who cannot afford a decline because they have a near term need for their capital should realize they are risking losses in stocks. They always are.

But now seems as good a time as any to be in the market for long term investors, like those who are saving for college or for retirement. Even such long term investors will be tempted, at times, to get out of the market temporarily. That is understandable but it risks reducing long term performance. As Warren Buffet has observed, nobody is likely to invest well based on what he reads in the paper each morning. And the economic risks discussed here have been, and will be, in the papers daily.

And what is most important: in order to time markets well once, you have to be right twice. First, knowing when to get out, and then knowing when to get back in.