What To Do When Stocks Decline

First, see it as an opportunity.

From “You Knew This Was Coming, So Why Worry?” in Chapter 7 of The Neatest Little Guide to Stock Market Investing:

From all your reading to this point, you should be well aware that the market fluctuates. Always, friend. It won’t stop because your money has finally arrived there. In fact, from your vantage point it will start fluctuating more than ever. It won’t of course, but somehow the numbers mean more when it’s your money on the line.

Money you invest in stocks shouldn’t be money you need for groceries next month or college tuition next year. If you define your goals clearly and invest by those goals, you’re geared for whatever comes. The money you do need for groceries is safely deposited in a bank account. The money you do need for college tuition next year might also be in a bank account or perhaps a conservative mutual fund. The money you have earmarked for long-term goals such as retirement or a new home can withstand any short-term market fluctuations, and even profit from them if you react intelligently.

And here we are, living through a real-life moment of downward market fluctuation.

No matter how well you’ve prepared for this inevitable development, it might still rattle you. You may wonder how much of a setback you’re in for, like the guy on the left:

In this report, I’ll examine what’s going on and offer thoughts on how to react. With a little perspective, you can be like the guy on the right.

Tariff Tempest

To paraphrase Democratic consultant James Carville’s 1992 observation when leading Bill Clinton’s successful election campaign:

It’s the tariffs, stupid.

President Donald Trump’s tariffs against America’s trading partners have raised fears of price inflation. Tariffs are fees on imports that usually get passed along to consumers, making them a consumer tax in most cases. The concern is therefore valid. It comes at a particularly bad time for America’s economy, which has been trying to shake off inflation for three years.

Let’s look at that, starting with the way inflation is measured.

Core PCE

America’s central bank, the Federal Reserve, has spent the last three years working to reduce inflation to its 2% target but is struggling with the final stretch.

The Fed’s preferred inflation metric is core PCE (Personal Consumption Expenditures), which provides a stable, accurate view of underlying price trends. The 2% target refers to year-over-year growth. The Fed aims for a situation where prices rise no more than 2% from the same month one year earlier.

What does core PCE measure?

It measures price changes in goods and services that consumers buy, excluding volatile food and energy prices. That’s the “core” part, making this measurement a subset of the broader PCE index, which tracks actual consumer spending patterns. The full PCE index includes food and energy prices, while the core subset strips these out.

The following qualities make core PCE appealing to the Fed:

• Less Volatility – Food and energy prices fluctuate due to supply shocks (oil prices, weather events), making headline inflation less reliable for long-term policy decisions. Prices without them offer a clearer look at the general trend.
  

• Accurately Reflects Consumer Behavior – The PCE index adjusts for how consumers shift spending when prices change (substitution effect), offering an accurate picture of inflation. More below.
  

• Aligned with Policy Goals – It tracks the broadest range of expenditures and aligns with the Fed’s 2% inflation target.

From the Sunday, March 3 Kelly Letter:

That middle bullet, about substituting goods and services, is an often overlooked superior characteristic of Core PCE. A more famous measure of inflation, the consumer price index (CPI), monitors a fixed basket of goods and does not adjust for substitution as dynamically.

So, what is substitution?

Consumer behavior that adjusts spending by switching to cheaper alternatives. If the price of beef soars, people might buy chicken instead. If brand-name cereal gets expensive, they might switch to a store-brand alternative. If airfares increase, travelers might drive or take a train.

The PCE Price Index accounts for these shifts, making it a more accurate reflection of consumer behavior than the CPI. The PCE draws on data from businesses and government reports that track what consumers actually spend their money on. If consumers shift from beef to chicken due to rising beef prices, the weight of chicken in the index will increase, while beef’s weight will decrease.

By focusing on core PCE, the Fed gets a clearer signal of persistent inflation trends, which helps in setting interest rates.

Core PCE’s Last Mile

Despite the Fed’s best efforts and what looked like a darned good trend last spring, core PCE refuses to go down without a fight. Getting it over the last mile to the Fed’s year-over-year 2% target has proven difficult.

Here’s a five-year chart, from YCharts:

Pandemic supply-chain interruptions sent the measurement soaring to 5.6% in February and September of 2022, when higher interest rates from the Fed finally starting weighing it down. It fell steadily to 2.6% last June. The trajectory looked set, and celebrations began early. One prediction you may recall was for inflation to a be a “Pomeranian by Christmas,” as reported here last May.

Well, it wasn’t. Instead of continuing its merry descent toward 2%, core PCE flattened out — then started heading higher last fall. Here’s a zoom on that:

Here we are, eight monthly reports later, still above that 2.6% zone. The latest table from the Bureau of Economic Analysis (BEA) shows the recent stuckness:

Not good, and especially concerning for investors because it could delay the Fed’s ability to lower interest rates. Let’s look at that.

Stalled-Out Interest Rates

Fed officials have been grousing about persistent inflation for months.

They’d been on a path of reducing their key interest rate, the Fed funds rate, which is among the most investor-friendly moves they can make. “Hip, hip, hooray!” cheered investors as the rate declined last fall. Here’s the chart, from FRED:

Now, it’s going sideways again because inflation refuses to fall. The Fed thought its policies had reached a good resting point, allowing the Fed funds rate more time to weigh on core PCE. The assumption was that core PCE would finally drift down to 2%, at which point the Fed could cut rates further, invigorating the economy and keeping stocks rising.

Then, double trouble rolled into town: the two Ts of Trump and tariffs, complicating the Fed’s situation. If tariffs reignite a fire under inflation, the Fed funds rate might need to stay at its current level longer — or even rise again. But if tariffs weaken the economy through uncertainty and lower business investment, the Fed funds rate should go lower to boost results. This tradeoff was a focal point in the Sunday, March 9 Kelly Letter, from which:

…recessionary hues paint the “stag,” as in stagnant, half of a stagflation picture. The inflation side would stem from higher prices caused by the trade war. Stagflation is particularly tricky for the Federal Reserve because its key tool, the Fed funds rate, can ease one problem while exacerbating the other. Lowering rates can help revive the economy but risks fueling inflation. Raising rates can curb inflation but drags on economic activity.

BCA Research Chief Global Strategist Peter Berezin reiterated Thursday that he thinks there is a 75% chance the US enters a recession, likely beginning in the next three months. “Conventional estimates understate the likely impact on economic activity from the trade war and DOGE cuts,” he wrote. “This implies that growth will slow more than expected.”

Then, last week, Trump unveiled sweeping tariffs more broadly than anyone anticipated, igniting a global trade war. The Financial Times called it “one of the greatest acts of self-harm in American economic history.”

What’s a central banker to do? Wait and and worry, evidently. That was the message last Friday from Fed Chair Jerome Powell, shorthanded on Wall Street to JPow, so frequently does his name surface in money discussions.

At a conference of business editors and writers in Arlington, Virginia, he acknowledged that inflation progress had already slowed, and now “higher tariffs will be working their way through our economy and are likely to raise inflation in coming quarters.” Then, the doozy:

While uncertainty remains elevated, it is now becoming clear that the tariff increases will be significantly larger than expected. The same is likely to be true of the economic effects, which will include higher inflation and slower growth. The size and duration of these effects remain uncertain. While tariffs are highly likely to generate at least a temporary rise in inflation, it is also possible that the effects could be more persistent.

Market Fallout

Well, the stock market doesn’t like this state of affairs one bit.

Investors are ticked off that inflation won’t just go away, interest rates won’t just fall to something like 3%, and profits can’t just be left alone to soar. As if the Fed didn’t have its hands full enough with persistent inflation, Trump had to come along and set fire to an economy that was doing perfectly well, thank you very much.

After peaking on February 19, back when tariff threats seemed like mere negotiating bluster rather than realistic policy, the S&P 500 donned its swan diving suit:

From Friday’s “Detonation Donald” market report:

Dodging trade-war missiles and economic shrapnel of every shape, size, and stupidity, investors dove into the fallout shelter for a second straight day.

Level Change 4/4/25 (%)
– – – – – – – – – – – – – – –
-5.5 Dow
-5.8 Nasdaq
-6.1 Nasdaq 100
-6.0 S&P 500
-4.8 S&P 400
-4.2 S&P 600

The Nasdaq entered official bear-market territory, dragged down by Tesla (TSLA -10.4%) doing its best impression of a luxury lead balloon, with the S&P nipping at its heels. Since February 19, the indexes have surrendered 22% and 17%, respectively.

What To Do

Which brings us back to the way we entered this report: You knew this was coming, so why worry?

No, you didn’t know specifically what would unfold — nobody did, or could — but you knew that at some point, stocks would fall again. Fluctuation is the core characteristic of stock prices: it’s what they do. So far, there’s nothing particularly noteworthy about this correction.

The stock market follows a volatile path upward over time. There’s a correction (decline of 10% or more from a recent high) roughly every 22 months, and a bear market (decline of 20% or more from a recent high) roughly every 56 months. Of course it’s not clockwork, but on average that’s their frequency, according to S&P Dow Jones Indices. So, you knew this downward volatility was inevitable in the course of events, specifics unimportant. If it hadn’t been tariffs, it would have been something else.

You also know how the math of investing works: buy low, sell high.

Sounds great — pithy and wise — but it’s hard to put into practice because low prices arrive with bad news, and high prices arrive amid good news. This works against our psychology. The last thing we want to do is buy when the news is bad and we’re promised it’ll never get better, or sell when the news is good and we’re promised sunny skies to eternity. But doing what you least want to do is a proven method for stock investors. It ain’t easy, though.

I recommend buying into this price weakness. It’s what my plans did. They operate on a quarterly schedule, come fire or flood, issuing signals in response to how prices changed in the quarter. Down a little? Buy a little. Down a lot? Buy a lot. Same in the other direction too.

Now, automating this with a set of rules is my preferred approach (and I’d love to welcome you to our community of intrepid stock profiteers at The Kelly Letter, where we view the market through precisely this lens), but if you can muster the gumption on your own to react appropriately to a stock sale, have at it.

You need to reset your perspective — get excited when prices fall, and cautious when they rise. As Warren Buffett famously put it: “Be fearful when others are greedy and greedy when others are fearful.” It’s easier said than done, but most worthwhile things are.

Something that helps my subscribers and me is breaking from mainstream financial media tradition, which displays falling prices in red and rising ones in green. We reverse the colors to signal the appropriate reaction to price changes. These were our indicators last weekend:

When the prices of our stock funds fall sufficiently below our quarterly targets, the indicators enter a green buy zone. When prices rise sufficiently above our quarterly targets, the indicators enter a red sell zone. Framing fluctuation in this manner guides emotions toward the right action in chaotic environments.

Keep this in mind through recurring tariff threats and multiplying recession forecasts. Stocks are sure to remain jumpy. You know what to do with them.