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Why you should be grateful for the market freakout

The stock market had a long overdue freakout Monday. Be grateful.

As an investor, protracted stretches of prosperity should make you nervous. We've seen that in the globally dominant U.S. stock market, where the S&P 500 stock index of big companies averaged returns of almost 16 per cent annually over the five years to Dec. 31 in U.S. dollars. That's pretty much double what the optimistic experts expect for the years ahead.

The market plunge Monday shows people are getting appropriately worried about all this good fortune. The official explanation for the sudden afternoon implosion was that investors are concerned about the risk of rising inflation bringing a jolt of higher interest rates. But what really happened was this: Investors have begun to contemplate the end of the current bull market and they panicked.

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Don't make the same mistake yourself. The markets are likely to be ornery for the next while, but there's no need for radical surgery on properly diversified portfolios of stocks, bonds and cash that you're holding for the long term. Think about strategically adding stocks, not subtracting. After any big market decline, put a little money into quality stocks or exchange-traded funds and mutual funds that hold them.

Monday afternoon was one of those scary days when the stock market loses hundreds of points with every click of the refresh button on your web browser. We haven't seen the likes of it since the winter of 2009.

There are some similarities between that period and today, but don't get carried away with the past-is-prologue narrative. We've had some speculative excess lately, exemplified by bitcoin and marijuana stocks. But the underlying economy and global financial system today is improving, not decaying like it was in the later 2000s.

The usual trigger for a bear market in stocks is a recession. So why are stocks falling when we have the opposite conditions in the economy? It's because investors are starting to realize what a growing economy means – rising inflation and rising interest rates.

Rates fell to historic lows in the financial crisis and have only recently started to rebound in a serious way. Low rates make investors turn away from bonds and guaranteed investment deposits, and embrace stocks. With rates rising, stocks are less attractive. Rising rates also increase the cost for companies raising money by selling bonds, and that will weigh on the profit increases investors demand.

The Canadian stock market got off somewhat more lightly than the big U.S. indices on Monday, but that's only because domestic stocks have massively underperformed in recent years. The resource stocks that make up about 30 per cent of our market have been holding us back with their weak returns. Ironically, the inflation threat that so rocked the markets on Monday could actually be good for commodity prices.

Two lessons for investors emerge from all of this uproar. One is that in a market rout, the blue-chip dividend stocks gulped down by so many people in recent years get savaged like anything else. In the S&P/TSX 60 index of big blue-chips, banks were among the biggest losers on Thursday.

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Another lesson is that the outlook for bonds is a lot more complex than people have thought lately. Rising rates have been turning investors against bonds, because the price of bonds and bond funds falls as rates move higher. But in the stock market plunge, money flowed into both U.S. and Canadian government bonds.

Cash is arguably the best safe harbour for money now. With rates rising, it's possible now to get 1.15 per cent on an investment savings account that you can buy just like a mutual fund for most any investment account. Overall, that's lame. But if you want a safe vantage point from which to drop money into future market declines, cash makes some sense right now.

To be clear, cash is for new money. Don't sell quality stocks and funds that have served you well in hopes of skipping market carnage ahead. If that's your inclination, there is absolutely no way you're going to have the fortitude to buy stocks as they topple.

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