Where Does The Market Go From Here? What Does History Tell Us About Managing Risk?

Check the headlines, and you’ll likely see the following themes: “The market is hitting all time highs, it must come down!”, “(Insert hedge fund manager) predicts a huge market crash!”, “Inflation is coming to eat all your gains away!”, “The Federal Reserve is raising rates soon, run for the hills!”

As an investor how do you digest all of this? As an advisor it’s even more difficult. After all, we are responsible for our clients’ financial success. Our clients have trusted us to be the caretaker of their money, and that is not a task we take lightly.

As much as I would love to have a crystal ball that tells the future so I can buy and sell the right stuff at the right time for my clients, the reality is that nobody does. Not even the folks on social media posting their trades that they somehow always time perfectly! Sarcasm aside, the crystal ball simply doesn’t exist. If it were easy to time the market then nobody would make money by doing so, because everyone would be doing it.

Now that I’ve dispelled the myth that timing the market is easy, how do we move forward with conviction? The concerns highlighted in the media are not unmerited, and there are plenty of smart folks in finance who are rightfully concerned about the current market conditions. The real question is: should you (and I) be? And how do we gameplan for adverse conditions?

The answer, as I’m sure you’ve guessed, is complicated. In finance (and in life, probably) our best teacher is the past. I took a dive into our current inflationary environment, how inflation affects us as investors, and how fed policy affects the markets.

Inflation?!?

At the forefront of concerns causing some headwinds in the markets this year is the CPI (Consumer Price Index) numbers we’ve seen over the past few months. There are a couple of very important things to note regarding CPI numbers which I believe are being overlooked.

First, what exactly is CPI? Simply put, it is an aggregate of the last 12 months’ worth of increases in prices to consumer goods almost everyone purchases: food, housing, gas, vehicles, etc. It is generally used as a measurement of the purchasing power of our dollars as we buy everyday items.

So what do I think is being overlooked? The first thing would be the elephant in the room that is affecting all of our lives in so many ways: the continued fallout of COVID-19 and the measures taken to try to slow the spread of it. Prices were artificially depressed heavily during the first few months of the pandemic as the lockdowns created a standstill in economic activity. Because CPI looks back 12 months we have been seeing an exaggerated increase in prices as the economy has slowly returned to a more normal state. This will likely even out as we get further removed from the first few months of the pandemic, and the July CPI numbers released today (8/11) are beginning to reflect that.

While the above may be a bit more obvious to folks, there is another aspect of the pandemic/lockdowns that is affecting prices: supply chain interruption. Supply chains don’t work like water faucets; you can’t simply turn them off and turn them back on expecting immediate results. As we get supply chains back up and running the good ole principles of Econ 101 should come into effect: more supply will be able to meet the demand we are seeing and bring prices lower. We have been feeling the effect of this in commodities such as lumber, oil/gas, food, and other energy/building materials. The process will be gradual for many reasons: production, re-staffing, transportation, etc. will all have to recover and be smoothed out before we can anticipate a return to pre-pandemic supply levels. Don’t just take it from me--there’s a report in this article from a London-based global supply chain intelligence firm called BSI you can see for yourself.

This report from the IMF also details how the pandemic (and other factors) have caused food prices to rise.

The bottom line: inflation should not be dismissed as a concern, but it is likely overstated given the current economic conditions. This probably explains the Fed’s lack of urgency to raise rates to combat inflation.

What Do Rate Hikes Mean For My Portfolio?

Before we discuss Fed policy, let’s go to school real quick and learn a little about Quantitative Easing and Tightening.

Quantitative easing: the Fed lowers interest rates and pumps new money into the economy. Simply put, there is more money in the system and it is cheaper to borrow money. This strategy is employed to support the economy in recessions/other economic crises, and is the current strategy of the Fed due to the pandemic. Generally speaking, periods of QE accompany growth in the stock market because companies are able to access more money to grow their businesses through borrowing. Investors also have more cash to put into the market, and are more inclined to invest in stocks as opposed to bonds/bank savings because bonds and bank interest do not provide adequate returns when interest rates are low.

Quantitative tightening: the Fed raises interest rates and begins to take money out of the money supply. This has the opposite effect of QE, and asset prices tend to become more depressed than in periods of QE.

These are very basic definitions, and it is not my intention to dive into the intricate details of Fed policy. What I want to address, and what you are probably wondering, is how this affects the way one should invest.

The stock market is an interesting animal. Its general nature is to define public companies’ value according to where they are at today and what their future holds. We only have about a 12 year history of how modern Fed policy affects the markets, and there is no doubt there is a correlation between the two. This chart from Huygens Capital illustrates how the market has performed during periods of QE and tightening (up until late 2018).

Source article

Generally speaking the market hasn’t grown at the same rate during periods of tightening versus periods of easing. However, there are other factors which affect market performance which are unrelated to Fed policy. Because the chart ends at the beginning of 2018 it excludes 2019, which was an excellent year for the market while tightening was still going on.

What Do I Do With This Info?

As individual investors I hate to break this to you: you and I are simply minnows in a sea of sharks and whales. Ultimately the games being played at the macro level do affect us, but we generally have to rely on what works for most ordinary folks to benefit from what happens in the financial markets.

There are many, many examples of folks in the media, finance community, and general public who believed the initial wave of QE beginning in 2008-09 would be the death of our financial markets. The doomsday predictions still linger to this day.

Now think of a normal investor like yourself who really needed their assets to grow from 2008 until now, but decided to listen to the noise and liquidated their investments at that time. Hypothetically speaking, let's say they had exactly 100k invested in the S&P 500, and they liquidated it all. They also never invested another dime in the market because they believed it was going to collapse. As of this blog’s writing the S&P 500 is sitting at about 3x the level it was at prior to the 2009 collapse. So that 100k would’ve presumably grown into about $300k today. Using Nerdwallet’s return calculator, the money sitting in cash at the bank earning about 2% interest (which is pretty generous for this time period) would be worth about $127k today. Also consider the opportunity cost of never investing again.

There are some hypotheticals here-timing isn’t always exact, but we are assuming our hypothetical investor liquidated on fears that QE was going to destroy the market. This would have placed the time of liquidation sometime in late 2008/early to mid 2009. The above calculation is actually pretty rosy in comparison to what reality probably would have been-it assumes liquidation at the absolute high before the drop, which is probably not realistic.

Regardless, the above example is meant to illustrate a point: we simply do not know what is going to happen and if we play crystal ball with our money it could cost us dearly. I do think it is important to pay attention to market conditions, and it is my job as an advisor to do so. But ultimately as normal people we are never going to know in advance when crashes or corrections are coming. Is the market going to perform slightly worse when the Fed begins to raise rates? The brief history we can observe tells us yes, kind of.

I say kind of because we had a big catalyst (tax cuts) during a period of quantitative tightening. If you liquidated simply because of tightening, guess what...you missed out on the tax cut run up! We also saw some drops during tightening thanks to tariffs and tweets, so my point is that Fed policy alone does not dictate how the market moves. Trying to time investments based on Fed policy speculation is a dangerous game.

ONCE AGAIN, WE JUST DON’T KNOW WHEN THE CATALYSTS UPWARDS OR DOWNWARDS ARE GOING TO BE, OR WHERE THEY’RE COMING FROM. So how do we win? History has shown us that if we invest diligently over a long period of time in the broad market we can participate in the overall growth of the market. Obviously risk management comes into play when we are talking about the time frame of your money, when you plan to retire, etc. But time is your best friend as a normal investor because while it’s a bumpy ride, the market has historically appreciated over time. As an advisor I do my best to put clients into portfolios that are not only appropriate for them, but appropriate for current market conditions.

My final point is actually a question: in an inflationary, low to moderate interest rate environment, where are you going to put your long-term investment money if you panic and take it out of the market? If inflation is 4-5% and your bank is giving you half a percent on your cash, what sense does it make to add to that cash balance and see your long-term investment money lose purchasing power in the bank? The reality as we see it is that the stock market is your best option to try to outpace inflation with your hard-earned money.

Is there risk involved with stocks? Of course there is. Your money can’t go down in principal value at the bank, but it can in the stock market. That is why you invest appropriately and know what your time horizon for your money is. If you have time to be aggressive then the noise of market conditions shouldn’t get to you. History has shown that time is your best friend. One thing I tell my clients (and I use to stay invested and block out the noise): if the financial markets are truly a house of cards that will inevitably come crashing down, money will be the least of our worries if that happens. Basic survival skills will be worth more than a 100 million dollar portfolio!

If you need help with figuring out where to invest your money, how much should be exposed to the markets, and general financial planning, we suggest working with an advisor! As usual I’ll plug our blog regarding choosing the right advisor for you if you are looking for guidance in that process. We are a fee-only financial planner who can provide guidance and help you invest your money appropriately. We don't accept commissions and we are only paid by our clients.

Cheers!

All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed. All economic and performance data is historical and not indicative of future results. All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC.

IMPORTANT: ALL ASSUMPTIONS OF GROWTH RATES DISCUSSED IN THIS PLAN AND/OR SHOWN ON ANY CHARTS ARE HYPOTHETICAL AND NOT A GUARANTEE OF THE FUTURE PERFORMANCE OF ANY ASSET.