The market’s massive move off the bottom of March 23 has confounded most observers and probably many of you. This mystery of the market’s puzzles may be due to a perceived disconnect between dismal economic statistics, tens of millions unemployed, many afraid to even leave their homes, and a stock market almost back to where it was before the virus.
The notion that stock market returns and economic data are closely linked seems intuitive, but in reality:
- Stocks are driven by earnings, not real growth in the economy or employment. Some companies can grow earnings even in very troubling times, and their stocks rise.
- The economy many link to the stock market but does not always relate to the United States. Globalization has made it possible for companies to prosper in other geographical areas not affected by a crisis or a bad economy.
- Stock markets are discounting mechanisms or prediction machines in the short term, and typically there will be a six to nine-month lag between markets and the economy.
With that said, many (including us) have been very surprised at the way the market roared back. Even Warren Buffett, who has always preached to “be greedy when others are fearful and fearful when others are greedy,” didn’t do much buying during March. Psychologists have documented that most people can’t tolerate losing and feel pain from a loss twice that of the pleasure of a gain. Therefore, most can’t tolerate the pain of stocks declining and sell and cut their losses.
One of the longest-running adages on Wall Street is, “You can’t fight the Fed.” Since March 23, investors have placed a great deal of confidence in the ability of the Federal Reserve and Treasury to engineer a recovery from the impacts of this virus. The Fed has stepped up in a big way the purchases of bonds, which puts money in the hands of sellers and that money has to be reinvested. The reinvestment process, in turn, drives up the prices of bonds further (and indirectly stocks) while driving down interest rates and expected returns. The lower interest rates go, the lower the discount rate used to calculate a company’s future equity value. This can argue for higher stock valuations. Lower bond yields also offer less competition to stocks. What would you rather have for ten years, UPS stock with a 3.6% dividend or a UPS bond for 1.34%?
But now what? Have we come too far too fast? Have the massive inflows of Fed-driven liquidity acted as steroids for the market? By most measures, the market is quite expensive and momentum is driving things at the moment. Market participants are quite optimistic all of a sudden and may not appreciate the potential negatives that could loom ahead with the reopening of the economy, consumer confidence and the election risks.
Our concern is that volatility will only increase from here. Volatility trading on Wall Street, which we have discussed too many times to mention, has grown so big that trading on expected market moves can itself move markets. We also have concerns about the market “structure,” which refers to the sheer amount of money traded by computers (machines) without rational human involvement. Today’s economic uncertainty means volatility trading, and therefore volatility itself is likely to stay elevated.
An investor who we admire in Charleston, SC, recently referred to what we experienced in March as analogous to a hurricane. He asked if we are in the eye now, or if the storm has passed completely? Shouldn’t we prepare maybe for the backside of the hurricane, which could be worse than the front? Now that we have recovered most of the losses from March, isn’t it time to analyze where you stand? Isn’t it time to revisit your specific goals and objectives for your money and re-check your positioning?
If what we went through in March was too concerning for you, this is the perfect time to reassess your risk tolerance. A little time spent now with one of our experienced certified financial planners might go a long way in helping you suppress the emotional side of investing.
I co-authored the article above with my colleague and co-Chief Investment Officer Bill Coleman. You can read the rest of our Q2 quarterly letter by visiting our website
As a Managing Director and Co-Chief Investment Officer at Live Oak Private Wealth, Frank Jolley co-chairs the Investment Committee and provides insight and direction to the asset management team. He is also involved in asset allocation, investment policy and portfolio management. Frank has over 40 years of experience in the fields of investments and financial analysis. Prior to joining Live Oak Private Wealth, Frank formed Jolley Asset Management, a leading investment advisory firm in Eastern North Carolina.
Live Oak Private Wealth is a subsidiary of Live Oak Bank. Investment advisory services are offered through LOPW, LLC, an Independent Registered Investment Advisor. Registration does not imply a certain level of skill or training. Opinion and thoughts expressed are those of Bill Coleman and Frank Jolley and not Live Oak Bank.