Noah Solomon: It’s all fun and games until rates go up
Markets ended the first four months of the year on a particularly sour note.
The MSCI All Country World Stock Index fell 12.9 per cent. High-quality bonds provided no relief: the Bloomberg Global Aggregate Bond Index fell 11.3 per cent. Proving there was nowhere to hide, even a classic balanced portfolio of 60 per cent global stocks and 40 per cent global bonds suffered a loss of 12.3 per cent. Markets have entered a new phase.
Let’s assume a “normal” return for any 12-month period is something between a 20 per cent loss and a 20 per cent gain. On that basis, the S&P 500 Index behaved “normally” during 65.7 per cent of all rolling 12-month periods between 1990 and 2021.
Of the remaining 34.3 per cent of periods, 29 per cent were great (above 20 per cent), and 5.4 per cent were awful (a loss of more than 20 per cent).
During normal periods, there isn’t a significant difference in average returns between the S&P 500 Index, the Bloomberg U.S. Aggregate Bond Index, and a balanced portfolio consisting of 60 per cent of the former and 40 per cent of the latter.
It is another story entirely during the 34.3 per cent of the time when bull and bear markets are in their most dynamic stages. The good news is that there are some key signals and rules of thumb that offer decent probabilities of catching respectable gains in major bull markets, while avoiding the devastation from the worst phases of major bear markets.
Don’t fight the Fed
The trend in interest rates is the dominant factor in determining the stock market’s major direction.
When central banks are cutting rates, it’s a good bet that it won’t be long before stocks deliver attractive returns. In late 2008 and early 2009, central banks responded to the collapse in financial markets by aggressively cutting interest rates. This spurred a rapid recovery in asset prices. Similarly, to offset the economic fallout of the COVID-19 pandemic, monetary authorities flooded the global economy with money, which acted as rocket fuel for stocks.
Conversely, when central banks are raising rates, the effect can range from benign to causing a full-fledged bear market. Once the United States Federal Reserve began hiking interest rates in mid-1999, it wasn’t long before stocks found themselves in the throes of a vicious bear market that cut the S&P 500 Index in half over the following couple of years. Similarly, when the Fed raised its target rate to 5.25 per cent in mid-2006 from one per cent in mid-2004, it set the stage for a nasty collapse in debt, equity and real-estate prices.
It’s all fun and games until rates go up, which ultimately causes things to break.
Never fight the tape
The importance of not fighting major movements cannot be overemphasized. Fighting the tape is an open invitation to disaster.
Investing legend Marty Zweig compared fighting the tape and trying to pick a bottom during a bear market to “catching a falling safe.” Zweig, who died in 2013, stated: “Investors are sometimes so eager for its valuable contents that they will ignore the laws of physics and attempt to snatch the safe from the air as if it were a pop fly. You can get hurt doing this: witness the records of the bottom pickers on the street. Not only is this game dangerous, it is pointless as well. It is easier, safer, and, in almost all cases, just as rewarding to wait for the safe to hit the pavement and take a little bounce before grabbing the contents.”
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Only geniuses and/or liars buy at the lows preceding major uptrends and exit at the very top before bear markets begin. Realistically, you can only hope to catch (or avoid) the bulk (rather than all) of the big moves.
It doesn’t matter whether you are an aggressive or conservative investor, so long as you are a flexible one. Conservative portfolios tend to remain defensive, regardless of the market environment. Similarly, aggressive portfolios tend to stand pat through thick and thin.
Neither approach is sound by itself. Being aggressive is OK, but there are times to be a wallflower. By the same token, there are market environments in which even conservative investors should be somewhat aggressive.
A slap hurts less than a pummelling
The only consistent way to make money in the market is to run with profits and cut losses. A slap in the face, as represented by a 15-per-cent price decline, should be neutralized rather than allowed to metastasize into a severe pummelling. Such a slap is easier to recover from than a bear market beating that can leave you in a poor position to pursue future gains once markets begin to recover.
The economy has little to do with stock prices
Even if market strategists could predict economic growth for the next one to four quarters, this does not mean they could predict bull or bear markets. Over the near term, profits and stock prices don’t have much to do with each other.
If you want to forecast the economy, look at the stock market. Equities always look ahead, peaking well before the economy does and bottoming far in advance of recessionary troughs.
Where we stand today
Markets have been, and may very well continue to be, in one of those rare periods when portfolio positioning can result in dramatically different outcomes.
In a world of high inflation, rising interest rates and falling stock prices, it would be prudent for defensive investors to remain so and for aggressive investors to dial down their risk. Also, in an environment where price gains become scarce (or nonexistent), high-flying, growth-oriented companies tend to underperform their value-oriented peers. In a similar vein, dividends (which are far less volatile than prices) take centre stage in terms of their share of contributions to overall portfolio returns.
Source: Financial Post