Clearing Up Common Market Misconceptions
Most investors feel like they have a general understanding of what does, or should, move markets – but the realities are quite often very different. This week we touch on a few common misconceptions people have about markets that can be quite costly when acted on.
FIVE THINGS YOU SHOULD KNOW
- Equity Markets – were mixed this week with U.S. stocks (S&P 500) up 0.83% while international equities (EAFE) fell -0.28%
- Fixed Income Markets – fell this week with investment grade bonds (AGG) down -0.76% while high yield bonds (JNK) dropped -0.68%
- Debt Ceiling Extended – After weeks of gridlock the Senate voted 50-48 this week to extend the nation’s debt limit through early December. The House plans to vote on the agreement on Tuesday before it is sent to the President for final approval. Reports are that the ceiling was increased by $480 billion, in-line with the amount the Treasury department told congress they would need to get through Dec. 3rd.
- Mixed Jobs Data – While the economy only added 194,000 jobs in September (the smallest gain on the year and well below expectations), the unemployment rate continued its decline to 4.8%. This sends a strong signal that an increasing number of Americans are leaving the labor force, further amplifying recent struggles across industries to bring in new hires. As of now there is no indication that the underwhelming report will impact the Fed’s timeline of tapering before year-end.
- Key Insight – [VIDEO & ARTICLE] Most investors feel like they have a general understanding of what does, or should, move markets – but the realities are quite often very different. This week we touch on a few common misconceptions people have about markets that can be quite costly when acted on.
INSIGHTS for INVESTORS
I don’t know of many industries that have more associated cliches or unfounded “rules of thumb” than investing. Below is a list of some common misunderstandings, with links to articles that I’d encourage you to read that cover each point in more detail.
- Mr. Market is NOT like You – One general misunderstanding I wrote about in depth on January 8th of this year, is that people falsely believe the Market should/will act like they would – hint it doesn’t. If you missed this article, may I humbly encourage you to read it here. In short, the market is a ruthless counting machine that cares not for feelings or humanity but solely profit. It’s not “bad”, it’s just the way it works.
- The Stock Market is NOT the Economy – I’ll defer to Brian Wesbury’s great article below, but in short many confuse their market outlook with the current state of the economy, for better or worse, and fail to account for the key differences between the two, as well as the fact that the market is much more forward looking than a reflection of current realities.
- You Care about Politics and Headline News, and think the Market Does Too, It Doesn’t – A related point in some ways to #1 above, but worth a stand-alone point. Every four years half the country believes the world has ended and feels compelled to trade those emotions. But as we’ve covered every election year, the market doesn’t really care who is in power. In fact, it doesn’t care about most things that make headlines. Numerous studies have been done, as we discussed and cited to in our June 22nd, 2018 Commentary here, that show that "[m]acroeconomic news ... explains only about one fifth of the movements in stock market prices." In fact, they even noted that "many of the largest market movements in recent years have occurred on days when there were no major news events." They also concluded that "[t]here is surprisingly small effect [from] big news [of] political developments ... and international events."
- Markets Move off Expectations and Rates of Change, Not Absolutes – As people, we tend to be a bit too black and white when it comes to how we talk about money, the market and/or the economy. Many conclude at any given moment that things are either bad or good. You may not want to hang out with someone who is just getting “less bad”, but the market will absolutely rally around a stock or economy that may still be in a bad way but is showing positive change. Europe’s economy may not grow as fast as China’s, but that alone isn’t actionable without knowing what relative expectations are being priced in for each country and their growth trends. A stock that makes a profit of $1 million a year for five straight years might be a better company to personally own than one that goes from losing a million to making a million over that same time frame, but the former likely wouldn’t be the better stock to own because there is no positive growth.
- People Don’t Understand How to Think Through Risk and Return – What’s a good return? 5%, 7%, 10%? The truth is, to really know the answer to that question one needs to also know, and be able to quantify, how much risk they took and what the market should have rewarded them for over a set period of time. Why? Only such an analysis can help you know whether your results were about luck, proper allocation or simply too short of timeframe to judge. Knowing that will help you to know whether it’s time to rebalance or stay the course, etc. Such information allows you to act (or not) based on actual information likely to repeat over time as you try to build wealth. Such an analysis is what the efficient frontier is all about. Not only does it help you set proper expectations, but also determines if your portfolio is optimized for the long haul, not just over an arbitrary time frame. The efficient frontier also helps one conceptually grasp that just adding risk doesn’t automatically mean there will be more return – another common misconception of their relationship.
- Misguided Signals to Evaluate True Systemic Risk – If people are honest with themselves they anticipate future market movements, outside of politics, based on some combination of; a) what they/or others are “feeling” (e.g., “the market feels likes its due for a correction or crash”) and/or b) what amounts to the fallacy of “recency bias” whatever has been happening will continue (e.g. “it feels like it’s just going to keep dropping”).
- Investor Sentiment - As to the first, studies will show you that investor sentiment isn’t something to be followed but faded (e.g., bet against). It’s why we correctly cautioned patience against buying during the run of late 2019 (see 12/13/19’s conclusion here) or stated our conviction in buying a number of what proved to be “lows” when we saw extreme sentiment such as Christmas of 2018 (see 12/21/18 here) or March 20th of 2020 here.
- Recency Bias – While this certainly applies to chasing stocks higher, let’s focus on the issue of investors worrying that market losses are likely to continue indefinitely. Every time the market falls 5%, I hear from many investors worried (spurred on by the media) that this is the beginning of the next big one. The reality is that at any given time there is only a 20% probability that a loss of 5% of more will double (e.g., 5 to 10%, or 10% to 20%). Some quick math shows you that the odds of a 5% drop becoming a 40% crash is less an 1%.
- Real Signals to Watch – While most investors cite declines in Dow points (please don’t do that) actual analysts and managers looks to more reliable signals to try to probability weight systemic risk (e.g., credit and/or high-yield spreads, treasury yields, the TED spread, defensive positions (treasury/gold/utilities) vs. risk-on assets (tech, financials, small caps), investor sentiment and/or standard deviations off of recent moving averages are just a few examples. If such signals are a part of your process, it’s likely that your process won’t be of much help to you.
CNBC doesn’t often discuss these types of items because they are confusing and/or boring and thus are bad for ratings. Your average broker/advisor doesn’t delve into them either – perhaps for the same reasons, but it’s also quite likely that they are more focused on making sales and less focused on being a practitioner of their craft.
Ultimately, if you want a customized portfolio that can succeed over time, you need a robust and repeatable process built on a solid understanding of where edges can actually be gained as opposed to just simple stories that can be told.
We love what we do in all respects from crafting solid portfolios, building personal plans that empower our clients’ goals, along with all the communication that goes into each of those aspects to help improve our clients’ clarity and thus confidence in staying the course on the way to achieving their dreams.
Have a wonderful weekend,
Tim and the team at TEN Capital
Stocks Versus the Economy
Brian S. Wesbury, Chief Economist
Robert Stein, Deputy Chief Economist
If you've read our two most recent Monday Morning Outlooks, you know we raised our forecast for the S&P 500, but lowered our forecast for real GDP growth. How can that be?
The first thing to recognize is that when we say we're bullish on stocks that doesn't mean we think the stock market is going to go up every day, every week, or even every month. It won't. Nor does it exclude the possibility of a correction in equities, which based on historical frequency is past due.
We take a fundamental approach, valuing time in the market over trying to time the market. Corrections will happen from time to time, and we don't know anyone who can accurately forecast them on a consistent basis.
Without digging deeply into our capitalized profits model which estimates a fair value for stocks as a whole, we remain bullish for three main reasons. First, long-term interest rates are low and are likely to remain relatively low for at least the next year. Second, corporate profits are very high and will remain relatively high even if they pull back from record highs as the amount of government "stimulus" wanes.
Third, even if real (inflation-adjusted) GDP growth falls short of consensus expectations in the next few years, nominal GDP (which includes both real GDP growth and inflation), should remain robust due to the Federal Reserve's overly loose monetary policy – see point one above – which will remain extremely loose even as the Fed starts tapering later this year and ends quantitative easing around mid-2022.
The key problem for real GDP is that the massive and unsustainable fiscal stimulus and income support that happened during COVID pushed retail sales well above the pre-COVID trend. Retail sales in July were 17.5% above the level in February 2020. To put that in perspective, in the seventeen months before COVID, retail sales were up 5.1%. There is only one way retail sales can grow 3x its normal rate while millions are unemployed and the economy was locked down – the government pulled out the credit card.
Those handouts are now slowing down and retail sales likely dropped in August (official data to be reported Thursday morning) and are likely to moderate from the 17.5% peak growth rate, on a trend basis, for at least the next year.
Retail sales make up about 30% of GDP. So other sectors of the economy will need to pick up the slack – replenishing inventories, home building, and the consumption of services, such as travel and leisure activities. But, after such massive artificial stimulus, it will be difficult for real GDP to keep growing as it has in the past nine months.
GDP includes revenues that are earned by publicly traded companies, but it also includes Main Street businesses that are not listed. It is those latter businesses that have been hurt the most by lockdowns. That's one reason listed-company profits and their stock prices have outperformed the economy.
The bottom line is that we are bullish for now, but fully recognize that we have been in a pristine environment for stocks. A slowdown in GDP will likely slow profit growth, while rising inflation will eventually lift long term interest rates. Tax hikes are still a threat, as are tougher COVID-related restrictions that limit a service-sector recovery. However, with the Fed as easy as it is, the tailwinds from easy money remain strong. The market is not overvalued, but it is not as undervalued as it once was.
This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.