Are The Skeptics Right ?

There are still plenty of people who are complete skeptics on the stock market and who still believe the market is going to crash. This is normal for this point in a secular bull market. Investor psychology has gone from a “total fear and loathing” phase in 2008/2009 to a “disbelief, distrust” phase more recently. And we are probably still a long way from the “euphoric stage”. To be fair, it is true that the market could crash at any time for some unforeseen reason or shock, but right now the financial fundamentals still look reasonable.

The fact that many people are still skeptical is actually bullish because of the lack of consensus. Once there is unanimity of opinion, it usually means we are at or near the end of the trend.  The market is kind of a “reverse psychology” animal: many times you have to “fight” the consensus to be successful and this is difficult to do. The ability to approach investing in a systematic and unemotional way is one of the key reasons why great investors like Warren Buffet do so well over long periods.

We all know the market goes through bull and bear phases; that is normal and predictable but these cycles trigger emotional responses. What causes these phases or cycles? Changes in the outlook for corporate profits has a significant bearing on stock prices. When the market perceives or is comfortable that corporate earnings will rise, it will bid the prices of stocks up in anticipation of improving earnings, as it has been doing for some time now. And vice versa, when the market anticipates or becomes concerned corporate profits may slow or decline (such as in a recession), it will bid the prices of stocks down.

Another key driver of stock prices is valuation. A lot of factors go into valuation, such as investor confidence, the outlook for the economy and inflation, Federal Reserve policy, health of foreign economies, geopolitical factors, energy prices, and a myriad other factors. Market cycles can be further exacerbated by “shocks”, such as financial bubbles (think “housing” in 2006/07) or bubbles within a market sector (think tulips in 1637, or technology in 2000). These “bubbles” create imbalances which are eventually normalized through severe market corrections.

So how do we deal with market cycles from a financial planning perspective? Like Warren Buffett, one way is to take “emotion” out of the process. This is accomplished through a sound financial plan. The plan acts as a long-term roadmap for both personal finances and investments and helps the client approach investments in a systematic and unemotional way.  A good plan will help a client “stay in the game” and avoid the temptation to make emotionally-based decisions at the worst possible time.

 

The “New Goldilocks”….. Not

In our last post, we discussed the “new goldilocks” economy. But it may be “goldilocks” for the wrong reason. Why? It may be “goldilocks” (not too hot, not too cold) for investors in financial assets (for a while anyway), but it remains a pretty cold bowl of lumpy porridge for many people who are either struggling to make ends meet or find a new job. The economy is operating well below its theoretical potential because of slow consumption and companies’ reluctance to ramp up new hiring because of this slow growth. In our last blog, we talked a bit about why, in this “new goldilocks” economy, money is shifting to equities from bonds in a search of higher yield. This is raising systematic risk because equities are inherently more volatile than bonds. To the extent more people are relying on higher volatility investments to provide more of their retirement income, the risk of many people falling short of requisite retirement capital is increased.

 So the point is, while it may be a “goldilocks” environment for stock investors right now, it is not “goldilocks” for the economy. We are still mired in a very slow growth environment which is part and parcel of a de-leveraging environment following a massive 30-year credit binge. It’s like a “hangover” and this is the “payback”. In the meantime, as long as global central banks maintain their super-easy money policies (which they appear to be doing), the “goldilocks” environment for stocks will also probably continue as excess liquidity is channeled into higher yielding equity securities.  But it does raise systematic risk and is unlike anything we’ve seen in the post-World War 2 environment. How does one protect themselves in this environment of increased systematic risk? Diversification of investment portfolios by both asset class and market sectors. Diversification provides the insulation or “shock absorber” when markets become more volatile or decline because assets that are not highly correlated to stocks may hold up better or actually increase when stocks decline. Diversification is probably the only “free lunch” in investing; it is one of the ways to obtain portfolio “insurance” without having to pay for expensive hedging or alternative investment strategies.