As soon as the Federal Reserve delivered an expected rate cut in July, the White House kicked up trade tensions with further tariffs on Chinese goods. Subsequent retaliation put the markets on edge, with stocks giving back most of July’s gains in the first few days of August.
The latest trade escalation suggests neither side is willing to concede, questioning if anyone has a real strategy or willingness to strike a deal..
Monetary easing is back in favor as New Zealand, Thailand, and India followed the global trend in cutting rates and global yields continue to plummet. Adding to that, President Trump is back tweeting for the Fed to cut rates “bigger and faster.”
The Fed downplayed the latest economic weakness that a rate cut typically signals, choosing to call their move a “mid-cycle” policy adjustment. That would be a rare policy move if it turns out to be the case. Of course, even the Fed doesn’t know what the future will bring. Will a few rate cuts keep the recovery going or will this be perceived as caving to political pressure? Regardless, we can expect interest rates to remain near historically low levels as long as inflation stays lower than the Fed’s 2.0% target.
Meanwhile, global stocks attempt to hang on to year-to-date gains, while the domestic economy remains resilient against a weakening global backdrop.
As the economic recovery hits new records, investors want to know whether the stock market can sustain recent highs. Unfortunately, we have no crystal ball into the future.
What we do know is that investor skepticism can feed the stock market. The market often reaches new highs when investors are most worried. Consequently, high stock prices alone do not necessarily suggest an overly exuberant investor base.
Some typical signs the sentiment may be extra high are when:
Greed overtakes fear
Valuations are historically high
Everyone generally believes that things will get better
Companies have little challenges accessing capital markets
The media is undoubtedly positive
Risk is perceived to be low.
In other words, as long as people are worried, the market is generally okay. When everyone gets on board, including the financial press, then watch out below.
When skepticism is high, rallies in stocks can continue longer than most expect. No one knows when the next shock to the economy will arrive. As investors wait for more clarity, a pullback, or some other sign to buy, the markets steadily climb the proverbial “wall of worry.”
Your Own Worst Enemy?
Dalbar, a Massachusetts research firm, has been studying the behavior of mutual fund investors since 1994. Dalbar’s Quantitative Analysis of Investor Behavior Study (“QAIB”) has consistently found that the average investor earns much less than market indices. In their latest report, they analyzed the results achieved by actual investors in mutual funds. As it turns out, investors can be their own worst enemies.
In the 20 years ending December 2018, the average bond mutual fund investor earned 0.22% annually. The broad bond market, as measured by the Barclays Aggregate Bond Index, returned 4.55% annually. If investors had simply held an index fund, such as the Vanguard Total Bond Market Fund, they could have captured most of the market’s return.[i]
Not many people did that. Most bought higher-cost, actively-managed traditional mutual funds and then, to compound matters, proceeded to overreact to current events and market turmoil, buying and selling shares at the wrong times.
How about domestic stock mutual fund investors? They did marginally better. For the past 20 years they underperformed the S&P 500 stock index by 1.74% annually. The opportunity cost of that performance on a $100,000 portfolio over 20 years was $84,344. Ouch.
The Dalbar data leads to the conclusion that many investors, left to their own behavioral biases, often bungle the investment process. Put simply, they tend to buy high and sell low. Most would be better off with a simple three step approach: 1. Have a plan, 2. Buy low-cost stock index funds with long-term retirement funds and bond index funds to cover short-term needs and 3. Stay invested.
What It All Means
Skepticism towards good times and high stock prices may be a lasting legacy of the 2008-09 Great Recession. It’s not just investors that have been more cautious. Central bankers have also learned lessons as well, taking care not to smother the recovery.
We expect the stock market volatility to continue as investors look for signs the economy is teetering. We believe those who stick with a well-balanced, long-term plan will be rewarded for accepting short-term gyrations.
A good strategy is one that you can stick with through normal market ups and downs. It’s better to re-evaluate your risk tolerance now, with a 5-6% pullback from highs, than after a 20-30% drawdown.
Let us know if we can help find the right strategy for you.
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[i] Jeff Sommer, “You Can’t Predict the Future. Neither Can I”, The New York Times, July 28, 2019; also, “A buy and hold strategy can serve investors well,” Dalbar investing study by the Capital Group, 2019