This has been a year of contradictions. The second quarter saw one of the strongest equity rallies of the past half century against the backdrop of U.S. GDP declines rivaling the worst of the Great Depression.
The volatility begets two temptations. The first is to dismiss market performance as a crapshoot. The optics certainly lend themselves to skepticism. The second is to try to unlock the secret of why the markets are performing the way they are. Armed with this special “knowledge”, you can get ahead of the markets to the tune of short-term gains.
I have written elsewhere that economic data and markets don’t necessarily move together. Economic data tend to look backward while markets tend to look forward. From employment levels to corporate earnings, to individual, corporate and government debt levels, to international trade, every economic metric is estimated to remain below end of 2019 levels through 2021.
The markets are bucking conventional wisdom
Conventional wisdom is that the market looks out six months. Through the lens of this conventional wisdom, the markets are behaving erratically. But there is another explanation. Simply put, the markets are looking out much further.
How so? One argument is that the market is responding to positive developments in the fight against COVID-19. For a brief period, market gains did seem to dovetail with positive headlines on that front. However, the market has continued to hold strong despite recent upticks in infection rates. Given the consensus regarding the possibility of resurgence in the fall, it would seem that positive coronavirus news is not the driving factor.
Another hypothesis is that the economy is recovering. This is true so far as it goes. After a steep decline in economic activity in the second quarter, even a modest increase in activity seems relatively significant.
However, while the data show the economy is recovering, it is unreasonable to expect 2019 levels of economic activity until consumer spending and corporate investing return to normal. Again, this will require strong, permanent, positive developments in the fight against COVID-19.
That leaves one other major source of support for equity markets, the Federal Reserve.
The Fed has been active
Interest rates for short-term loans have functionally been at 0% since March and longer-term loans to the government are at negative real rates if you assume 2% inflation over the holding period. This obviously makes bonds less attractive. Who wants to loan the government money for free or even at a loss? This has pushed investors into riskier assets, like stocks, to get the same level of return they used to get from safe bonds.
At the same time, the money supply has exploded since March. That money is in banks, in the form of demand deposits, but can be used to finance and collateralize loans. That cushion of cash is supporting equity markets in unprecedented ways.
So the markets are behaving rationally, after all. But are they behaving predictably? That’s more complicated.
Timing the market requires compounding predictions
You’ve heard the phrase “don’t try to time the market”. The axiom holds true here, but for different reasons. 2020 hasn’t seen a market beholden to headlines. Even if you could predict the news (in this of all years) you wouldn’t necessarily be able to predict the markets. Further, a market driven by Fed action is less reactive to narratives around growth and earnings.
And the Fed has been transparent about its intentions. It seeks to keep the cash flowing freely for the next 12 to 24 months. Will the market keep climbing as a result? Maybe, maybe not.
It is not sufficient, then, to simply predict what the Fed will do. You have to predict how the market will respond. Strategies that monetize the economy, such as flooding it with cash as we have seen recently, have pitfalls. It could lead the markets to become mistrusting of the Fed, or rampant inflation, or both.
In order to successfully “time the Fed”, you need to get these compounding predictions just right. This is something virtually no investor has been able to do successfully and consistently.
You’ve resisted the obvious temptations, so what do you do?
Given the long road to recovery that lies ahead, it’s easy to be pessimistic about the markets and the high valuations we are seeing. But that shouldn’t impact your long-term equity allocations. The economy and the coronavirus follow rules and logic, but the markets beat to a different drum.
The simple truth is that markets are immune to would-be sleuths cracking the code. Market unpredictability is a self-fulfilling prophecy. Once the code is cracked, the market will adapt, and you’ll be back at square one, if you’re lucky.
So this is the time to cast aside cynicism and overconfidence. Your long-term plan, designed to ensure that you make enough money and have it when you need it, is still the best course of action, even in these contradictory times.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.
This article was originally published on Forbes.com.
Series 7 & 24 Securities Registrations,1 Series 66 Advisory Registration † Jim brings significant financial services experience along with the investment management industry’s best thinking and best practices to his role as Chief Investment Officer of Wealth Enhancement Advisory Services. Throughout his professional career, Jim’s philosophy on investing has centered on providing clients with...Read More