Investors are fascinated with the possibility of bear markets, and they are often fixated on attempting to predict when the next one will occur. The notion of declining stock prices tends to dominate more investment conversations than anything else. This occurs irrespective of where the market may be at any given point in time. It typically does not matter if we are witnessing record highs, or if stocks remain in the depths of a bear market, most investors almost always anticipate further downside. There is a tremendous amount of behavioral finance research that can help explain why this occurs, and it can often stem from the perceived notion that declining prices are associated with measurable losses. Investors tend to associate a short-term drop in prices as an actual monetary loss. Although that’s true on paper, monetary losses can only be realized when an investor exits equity market participation (i.e., decides to sell). Such a dichotomy in understanding was evident during the equity market events that transpired in the early part of 2020 amidst the COVID bear market. Our internal approach to such conversations remained adamantly objective in attempting to educate investors, yet there are always limitations to all attempts. Behavioral finance research shows us that investors do not react rationally when presented with solutions to their observed biases. This occurs partly because one’s own biases never seem to be an issue (to themselves) and partly because humans (as a species) are not wired to extrapolate into the future after a potential traumatic event. A sudden equity market decline of -30% can almost certainly be defined as a short-term traumatic event when we take into consideration the perception of paper losses versus actual realized losses. This is a main reason why working with a team of professionals tends to help investors attain more desirable long-term results. The rational oversight that is available by advisors, in addition to their subject matter experts (investments, advanced planning, service team…etc.), provides measurable value that has been proven over the long-term. With that in mind, and considering the current state of global equity markets, let me tie this into the purpose of this week’s commentary.
I want to start by acknowledging that market events never transpire simply because the masses expect them to. It is really that simple. This means that expectations of short-term market movements, or economic developments, carry no direct basis that allows them to truly materialize. Stated differently, every investor across the globe has horrific market timing capabilities. No one can do it, professional or not, despite the confident rhetoric that can encompass a judgement call. For example, assuming that the equity market must enter into a correction due to its record-high stance is an irrational judgement call. It sounds plausible from a conventional wisdom standpoint, but it is not something that makes objective sense, and it is often a non-quantifiable expectation. Historical occurrences of volatility have taught us a lot on the topic of downside, with the main takeaway being that it can often be defined as a shock, which is an unforeseen event. They often occur when no one is expecting them. Such shocks carry a minimum of a -10% correction and Figure 1 illustrates the nature of how such a relationship has worked over the long-term. In its simplest form, the data simply reaffirms the dire need for investors to maintain control of their behavioral biases because the absence of shocks will almost never be the norm. This may be difficult to accept, yet it may likely be the key to a successful retirement.
We believe the current environment has defied the odds of relevant historical market movements, yet it has also substantiated such a path to the upside in a way that has rarely occurred in the past. Consumer strength has flourished amidst a backdrop that lacks definitive systematic issues. An argument could be made that volatility maintains no objective reasoning in the current environment, but we continue to believe that’s not the appropriate response. The mere fact that volatility provides for a healthy backdrop within capital markets has been a recently neglected fact, one that deserves attention. This isn’t to say that we should fixate on the lack of short-term downside volatility; rather, the main takeaway is that we must gauge all capital market movements (or lack of movements) with a risk management lens that can help answer whether an event is appropriately validated.
On that note, we remain highly constructive on equity market participation over the next 12-months because we maintain both validation and rationality in macroeconomic data and overall trends. Most importantly, however, it remains difficult to build an argument that bets against consumers.
Edison Byzyka, CFA – Chief Investment Officer – Credent Wealth Management
Investment advice offered through CX Institutional, a registered investment advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted.
All other data, including returns, soured from Bloomberg, through the release of monthly figures from the Department of Labor, Bureau of Economic/Labor Statistics, U.S. Census Bureau, or from the Federal Reserve and any of its affiliated regional locations.
Small Business Optimism sourced through NFIB. Small business hiring plans sourced through NFIB. Consumer sentiment sourced through the University of Michigan.
Earnings data sourced through Bloomberg Intelligence and through Bloomberg’ earnings analysis composites. Interest rate cut/rise probabilities are sourced from Bloomberg’s tracking of futures contracts tied to the Federal Funds interest rate.
Economic Policy Uncertainty data sourced from Bloomberg via The Baker, Bloom, and Davis Index.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changed in the aggregate market value of 500 stocks representing all major industries.