Despite trade worries and recession fears, global stocks are up a surprising 16% for the first half of 2019. Bonds are also positive, with the broad US bond market registering a 6% total return. After last year’s selloff in stocks and an additional 5% pullback in May, it’s hard to believe stocks have returned so much this year. The ride has certainly felt rougher than the end result.
Lower interest rates supported the stock market’s recovery in June. US stocks continue to lead, as the S&P 500 reached new highs in June and is up 18.5% for the year. Much of the move to lower rates is based on expectations the US Federal Reserve will reverse course and cut rates. This anticipation of lower rates now places a greater burden on the Fed to follow through with actual rate cuts.
The last twelve months have been a rollercoaster. Most of 2019’s strong gains are efforts to climb out of the slump felt at the end of last year. The 2018 market drop was precipitated by a potential trade war and a follow-on recession – concerns the stock market now seems to discount.
The drop in long-term interest rates also indicates that the bond market has a different recession view. Over the last twelve months, broad bond indices have outpaced stocks, with the US bond aggregate returning 7.9% versus a 5.7% gain for the global stocks. Whether you feel good about the strong gains across this year depends on your perspective.
While the returns for stocks and bonds are sending conflicting signals about the economy, the current expansion marches on and now exceeds a decade. As worries about the next recession grow louder, it still pays to be patient during these times. We believe long-term investors will continue to be rewarded for a sensible level of stoicism.
How did everyone get it so wrong?
At the beginning of the year, results of a survey by the Wall Street Journal concluded that economists collectively expected the yield on the 10-Year Treasury to nearly reach 3.0% by June. The lowest estimate of the lot was 2.5%. Naturally, the market proved them all wrong as the 10-year Treasury yield dropped to 2.0% – half a percent below the most pessimistic forecast. As Yogi Berra quipped, “it’s tough to make predictions, especially about the future.”
How can supposedly informed professionals get it so wrong? Economists are human and subject to the behavioral biases that are ingrained in all of us. Research in behavioral economics suggests we anchor our beliefs to arbitrary reference points, perhaps fearing sticking our neck out too far from the pack. We are also overconfident in our estimates, assigning a high degree of certainty around too tight a range. We also place too much emphasis on information that is readily available, either overweighting today’s headlines or extrapolating recent trends too far.
By any measure, this year’s stock and bond returns have exceeded most reasonable forecasts. While few have foreseen the strong returns to both stocks and bonds, it’s important to always be prepared for the unexpected.
Being wrong can have more severe consequences than eating some humble pie for a bad call. That’s the biggest difference between a long-term investor and an economist. If you believed economists’ forecasts this year for bonds and adjusted your portfolio to hold more cash, you left money on the table. If you sold stocks before the 2016 election, you missed a 40% gain in stocks.
The dangers of overconfidence in one’s views can be as perilous as ignorance or recklessness. Coupled with a focus on a fickle news flow, it’s easy to make short sighted decisions based on emotions.
Should you even worry about normal recessions and the resulting downturns in stocks? Throughout history, appropriately allocated investors have weathered periodic shocks and survived to take advantage of higher long-term returns. In his book “Deep Risk,” financial historian and writer William Bernstein argues that investors should really only worry about four big, potentially catastrophic risks.
Hyperinflation. There are extreme cases of hyperinflation in history. In Wiemar Germany in 1923, prices doubled over 3.7 days. In Zimbabwe in 2008, prices doubled every 24 hours! Less extreme situations can also pose severe problems. The inflation rate recently reached 22% in Turkey. In the US, inflation hit 23% in 1920.
Prolonged deflation. Historically, prolonged deflation is even more rare. But despite its low likelihood, the consequences of a debt/deflation spiral are severe. Falling prices and income, combined with stable debt loads, can lead to financial ruin.
Devastation (wars or geopolitical disasters). Wars and the associated devastation wreak havoc on asset values. Historically, two large oceans have protected the United States, but that protection, arguably, may have shrunk in modern times.
Government confiscation. If desperate enough, governments have seized assets from its citizens. Confiscation can happen in other ways too – through extremely high taxation and through policies that lead to inflation.
What It All Means
Bernstein’s “deep risks” all have a very low likelihood of occurrence but have severe consequences if they do. Insuring against any and all deep risks is impossible but having the right plan in place can help.
Ensure your assets are properly diversified. This can mean a host of things – diversified across assets, across countries, across strategies, and across currencies. Spreading equity risk across countries significantly reduces the chance of severe stress in any one country (including the US) impacting your portfolio. Inflation-protected bonds can help protect a bond portfolio from unforeseen inflation, while conventional US Treasuries can help in a deflation scare. Careful estate, tax, and insurance planning are also critical parts of mitigating the impact of deep risks.
We believe proper portfolio and wealth management is about preparing for a range of scenarios, most of which will be hard to predict.
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