Saturday, April 16, 2022

It’s different this time!

The four most dangerous words in finance and economics are “it’s different this time.” It’s not; it never is, though there are always those who want to force a set of facts to fit their outlook.  

I often look to history as a guide to what might happen next. And yet we find ourselves at a unique time in history. We are emerging from a global pandemic; there is an active war in Europe, inflation is at multidecade highs, and the Federal Reserve is raising interest rates when the economy shows signs of slowing. Parts of the bond yield curve have inverted, there are recession fears, and yet companies have more job openings than we have people. We have experienced all these conditions at times in the past and can glean insight from what happened next, but we’ve never had a time when all these conditions coincided.

Part of what makes finance and economics so interesting is that it sits at the intersection of the unyielding constant of mathematics and the predictable unpredictability of people. Mark Twain said, “The past does not repeat itself, but it rhymes.” So, where can we find the rhymes?

We are headed for a recession! That sounds scary, but the reality is that we are always headed towards a recession. The economy naturally expands and contracts. We want to know where we are in that cycle and the financial impact of the next contraction. Previous recessions have been preceded by an inversion of the bond yield curve. We saw a short-lived inversion of the yield between the two-year Treasury and the ten-year Treasury, which has preceded some recessions by six to twenty-four months. We are now watching the spread between the three-month Treasury and the ten-year Treasury for confirmation of an inverted yield curve. This inversion has not yet happened and is now showing signs of steepening. If this part of the yield curve inverts, I would expect a recession is on the horizon. I see the risks of a recession in 2022 as low. The low unemployment rate means that people have the income to spend on goods and services in the economy. It would be difficult to experience a significant contraction during a period of such low unemployment. We also need to remember that many of those employed contribute to an employer-sponsored retirement plan. Every month we see inflows to markets from payroll deferrals.

I’ve shared that I thought the first half of the year would be more volatile than the second half. Increased volatility should be expected when the Federal Reserve changes monetary policy. The war in Ukraine adds to the economic uncertainty and may extend the period of volatility, and we’ve yet to see the impact of the mid-term elections.

I expect the S&P 500 to trade between 4000 and 5000 for the remainder of the year. The most pessimistic analyst I follow is Morgan Stanley which expects the S&P 500 to finish the year at 4400. Morgan Stanley Chief Markets Strategist Mike Wilson warned of a market downturn for some time; his 2021 forecast was for the S&P 500 to end 2021 at 4000, which was incorrect. One of the most optimistic analysts I follow is Brian Belski, BMO Capital Markets investment strategist, who sees the S&P 500 finishing the year at 5300. His 2021 target was 4800. The S&P 500 finished 2021 at 4766. Brian Belski was almost spot on with his outlook for 2021; perhaps he will be for 2022.

Summary: I do not see a recession in 2022. There will be increased volatility as market participants contemplate all the economic variables. I am not aware of any market analysts predicting the S&P 500 will finish the year lower than where it is now. The average of the most pessimistic and most optimistic S&P 500 targets would have the S&P 500 gaining 10% from current levels finishing the year with a small gain. I am never anchored to an outlook or opinion, and if the facts and data change, I will adjust my view.

Wednesday, April 6, 2022

Recency Bias

A powerful bias in investing is Recency Bias. Recency bias is the tendency to think that things that have happened recently are more likely to happen again or that a current trend will continue despite data and information to the contrary. Recency Bias can show up in many areas of our lives. People who have been in a serious automobile accident may drive more cautiously for a time. Someone who had a winning lottery ticket may be more inclined to buy more lottery tickets. Recency bias can be based on life experiences and our emotions. Following news of an airplane crash, some will choose not to fly despite evidence that flying is the safest form of transportation. People may be apprehensive about going into the ocean if a shark attack has recently occurred, even if the attack occurred hundreds of miles away. As time passes, if there are no more airplane crashes or shark attacks, the emotions and effects of recency bias fade.

Investors often underperform their investment benchmarks due to Recency Bias. During a bull market, investors may ignore data that suggests they should reduce their equity exposure, preferring to believe that the current upward trend will continue. Investors may also ignore positive economic data during periods of market weakness out of fear that the recent downward trend will continue. The best time to reduce equity exposure would be when markets are at highs, but that doesn’t feel comfortable. The best time to reengage with equity markets would be when markets are at their lows, but that won’t feel comfortable either. The SEC disclosure “Past performance is no guarantee of future results” cautions investors against relying on Recency Bias. Experience has taught me not to try to guess about market highs or lows and to pay more attention to the data and less to my feelings and hunches.

Recency Bias can affect our decisions even when events aren’t so recent. When made aware of a coming hurricane, people who live in the affected areas may choose to evacuate or not evacuate based on their experience with previous storms when they should evaluate the risks of the current storm based on the available data and information. When recession and inflation are in the news, people reflect on their most recent experiences during earlier times of recession and inflation though the economic fundamentals and ultimate outcomes may differ.

We can’t eliminate biases from our decision-making processes, but being aware of them and considering how much weight to give them will help us make better life and investment decisions.