Four Steps to Cope with Market Madness

After hitting one record close after another in 2021, the stock market responded to geopolitical uncertainty, spiking inflation, and the prospect of a much more aggressive Federal Reserve by dropping – a lot.

And that was before Russia invaded Ukraine.

The sanctions being imposed on Putin’s Russia and his oligarchs are more robust and require more concerted effort than anything attempted to date. While countries are trying to insulate their economies as much as possible, the fallout will be inevitable, and volatility will continue to increase.

Where does that leave the U.S. economy and you? How can you achieve the right mindset to ride out volatility and keep your plan intact? First, let's review some market and economic indicators, and then we'll dive into getting your reactions and your head right.

We dive into all the nooks and crannies.

First, What’s Been Happening in the Markets

Before the invasion of Ukraine, markets had been pricing in the uncertainty around inflation and the Federal Reserve’s policy response. The equity markets responded to the Fed’s intention to remove liquidity from the markets by selling off the assets held on their balance sheet. The Fed’s $8.5 trillion balance sheet was amassed throughout the pandemic as the central bank moved to provide liquidity and keep interest rates low.

In addition to raising short-term interest rates, selling off these assets would have the effect of raising rates along the entire yield curve. The increase in long-term rates is one thing worrying the equity markets, as capital to fuel growth would become more expensive. The market has seen some version of worry over this for the last year, as the shift to value stocks became a staple positioning.

Despite spiking inflation that went from the Fed’s categorization as a “transitory” problem to the Fed’s acknowledgment that aggressive measures would be needed to contain it, stock earnings continued to hit records.

The Q4 2021 earnings season that began in January 2022 is largely wrapped up, and it didn’t disappoint. Of the 472 companies in the S&P 500 that have reported earnings to date (February 28) for Q4 2021, 76.9% have reported earnings above analyst estimates. This compares to a long-term average of 65.9% and prior four quarter average of 83.9%. Q4 2021 year-over-year revenue is expected to be 14.9%. Excluding the energy sector, the growth estimate is 10.6%.

Earnings are the foundation of stock prices. Over the long-term, which is what most investor horizons are, stocks that consistently grow earnings see price advances. In other words, over the long-term, the market historically goes up.

The Federal Reserve has been very careful to be exceedingly transparent as to its intentions, even going so far as to have Governor Brainard and NY Fed Chairman Williams correct market perceptions that the March interest rate increase would be 50 basis points, instead of 25.

This is to allay market fears and help markets avoid volatility. As the Fed parses the data, and the new complications of the sanctions on Russia, we can expect they will hold to this line.

Where We’re At

The S&P 500 index fell 3.15% in February. The 2022 year-to-date decline to the end of February of over 8% is the largest two-month decline since March 2020. The CBOE volatility index has remained above 30 since the Ukrainian invasion. A reading above 20 indicates additional volatility is expected.

Investors will need to be prepared for a period of extended volatility in markets and the potential that things will get worse before they get better. Given the deep, committed, and combined efforts of the EU and U.S., a potential resolution is possible, but sanctions won’t likely go away anytime soon.

Creating Your Own Calm When we perceive a threat, whether it is a saber-toothed tiger in a prehistoric jungle or a drop in the Dow, our brain floods our bloodstream with hormones such as adrenaline, which sets off a chain of physical responses that gets us ready to fight to defend ourselves, to run away, or to freeze in place until the threat goes away. While this works great in the jungle, it wreaks havoc in our financial lives. This response is the primary reason we engage in self-destructive financial behaviors. When we are scared or excited enough about the economy or our finances, our animal brain takes over, and we do one of three things: we fight, we flee, or we freeze. People stuck in a financial fight reaction may react with anger and blame. In a subconscious effort to avoid taking personal responsibility, they may blame others for their problems: the government, a bad stock tip, predatory lenders, greedy bankers, short-sellers, etc. When we are stuck in a blame cycle we miss out on opportunities to examine and change our own financial beliefs and behaviors, dooming us to repeat our mistakes. I have seen people sell all their stock holdings at record lows in the past few years, only to buy gold at record highs. This selling low and buying high pattern underlies all stock market bubbles and crashes. A common freeze reaction is to feel so overwhelmed we "play possum" with our financial lives. We put our heads in the sand and avoid thinking about our finances, stop looking at our bank statements, shy away from conversations about money, and ignore recommendations from our financial advisors. So, what can you do if you find yourself stuck in a financial fight/flight/freeze reaction? Here are four steps to help you calm down and make better, rational financial decisions.

• Step 1: Recognize that when you are emotionally keyed up- either afraid or excited- you are inclined to act irrationally. When we are emotionally charged, we are rationally challenged. Remind yourself that financial decisions made in the heat of emotion are almost always ill advised. Prior to acting, it is essential to calm down and get your rational brain back online. Delay making any decisions until you are calm.

• Step 2: Take a few deep breaths. When we are stressed, we take shorter, shallower breaths. Taking several deep breaths can initiate a relaxation response. With each breath, repeat in your mind a comforting word or phrase, such as "relax" or "take it easy." This helps bring the rational brain back online.

• Step 3: Evaluate the accuracy of your thinking. Just because it pops in your mind doesn't mean it's true. What is the evidence that supports your assumption? What is the evidence against it? Is there a better explanation? What is the worst thing that could happen if your assumption proved true? Could you live with that? What is the most likely thing that will happen? What advice would you give a friend who was in a similar situation?

• Step 4: Don't do anything! Don't make any rash decisions. Put some time between your emotional reaction and whatever action you take in response. When we are upset, it takes about twenty minutes of calming thoughts to quiet the animal brain enough to allow the rational brain to retake control. Even then, we can still be swayed by our emotions, so consider seeking professional financial advice before making big financial decisions.

Whether the market is screaming up or plummeting downward, whatever you do, don't let your animal brain take control of your finances.