The Big Disconnect
Stocks notched record highs in August with the MSCI All World Stock Index rising 6.1% for the month. The U.S.-based, now tech-heavy S&P 500 index climbed 7.2% during the same period. As we write, high-flying tech stocks are leading a pullback in stocks, a reminder that enthusiasm can overshoot from time-to-time.
Taking a step back, imagine yourself at the start of 2020 with a crystal ball. You see that within weeks a novel virus will emerge that will shutter much of the global economy. The virus spreads like the common cold or the flu via airborne particles. Medical science offers no vaccine or other cure. Businesses will close, travel will grind to a halt and sporting events will disappear from the calendar. Tens of millions of Americans will lose their jobs. A flood of information about the virus and its impact erases any hope for certainty.
Given this knowledge, would you think it’s a good time to buy stocks? Probably not. But what is the alternative? Attempting to time the market? Without a reliable crystal ball, any efforts invariably prove elusive.
Investment decisions seem even more complicated because of the disconnect between the economic impact of the virus and swift recovery in stock prices over the course of the pandemic. How does this make sense? It’s the most frequent topic of conversation with clients.
We see four principal drivers:
The financial markets are forward looking, while economic statistics reflect the past. The markets are anticipating what the economy will look like twelve to eighteen months ahead and “discounting” that future back to the present. The so-called market we refer to is really the syntheses of millions of investors’ opinions regarding the future. Right now, the markets indicate a decidedly optimistic view of COVID-19 vaccines and treatments.
The world’s central banks rescued investors. In March, the U.S. Federal Reserve responded to a potential credit crunch with lending guarantees and bond purchases on a scale heretofore unimaginable, driving the benchmark 10-year Treasury bond yield from an already low 1.6% to 0.6% today. Are there longer-term implications from all of this “new money printing”? Maybe, but for now it has soothed troubled markets by lowering the discount rate used to determine the present value of a future stream of corporate earnings.
In August, Federal Reserve Chair, Jerome Powell, announced a shift in Fed policy to target average inflation over time, as opposed to the absolute value at any given time, reassuring markets that interest rates will stay low for a long time.
Despite the pandemic, Americans have shown themselves to be the world’s consummate consumers. In addition to boredom driven by online shopping, historically low interest rates have juiced new home sales, home improvements, and car sales.
While not on as large a scale as the Federal Reserve’s intervention, businesses and individuals have undoubtedly benefited from a range of government programs, from the Cares Act to the PPP Program and enhanced unemployment benefits.
At the end of the day, the stock market’s rally from March lows can be viewed as a hopeful message for the economy. Do the markets have a better grasp of the financial and economic dynamics of a post-pandemic world than many nervous consumers? Do the markets always get it right? Obviously no, but the long-term upward sloping return curve for stocks indicates they are right more than they are wrong.
All this is not to say that we are not nervous, or that it will be smooth sailing from here. We fully expect much rougher seas and most likely a correction in stocks prices along the way. Human nature, in our experience, tends to overshoot 10-20% on both the upside and the downside for stocks.
WHAT IT ALL MEANS
A financial market characterized by very low interest rates and a challenging macro-backdrop has resulted in a handful of companies driving the returns in the market. But the TINA - “There Is No Alternative” – strategy of buying large technology stocks because of the absence of other options can be dangerous. Mistakes are made when investors extrapolate too much success too far in the future. It happened before, and it can happen again.
At times like these, it is important to stay grounded in a diversified strategy, regardless of the temptation to pile into whatever is going up the most. We believe exposure to stocks should be broad-based, not just large technology companies and not just companies in the S&P 500. A diversified strategy should also include small company stocks and shares of international companies too.
Sticking to a disciplined strategy can be a challenge in a highly uncertain time. Whether you are in an accumulation phase of life or drawing on an existing nest egg, don’t be distracted by the constant noise of today’s news. As always, a strategy you can stick to will fit your life and your needs.
Contact us at 865-584-1850 or info@proffittgoodson.com
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