by John Goltermann, CFA, CPA, CGMA
September 20, 2017
If the short-term direction of the stock market were in any way predictable, there would be trillionaires among us. Since there are no trillionaires, by logical extension, we must assume that the stock market is, in fact, unpredictable. And if that is the case, why then is so much mental energy, analytical firepower, press coverage and cocktail party conversation spent trying to make stock market predictions. I have wondered the same thing throughout my career. Perhaps, it is like musing about winning the Powerball -- it’s just fun to think about.
For investors, instead of making predictions it is far more productive to understand the type of investment environment we are operating in because one’s macro surroundings are a bigger determinant of investment success than micro efforts. In other words, if the tide is strongly against you, it doesn’t matter how hard you swim against it. Not that understanding the investment environment provides any advantage through more predictability, it may, however, provide guidance on how much, and what types of risks to take.
Today, we have one of the most volatile and controversial executive branches in history, but we still have a generally buoyant stock market and historically low price volatility. This has confounded many investors. The buoyant market may be explained by Trump’s inability to unite the GOP and get any of his agenda through, including tax reform. And combined with an over-indebted economy, paradoxically, the Fed could easily continue to suppress interest rates for longer than expected, keeping the stock market buoyant – for now.
Today’s environment, however, can change quickly for any number of random, unpredictable reasons. Therefore, in considering the investment environment is important to note whether we see any extremes. The stock market is priced at an above average valuation (as a multiple of earnings), but it is not at an extreme. Nor is the bond market at an extreme: 10-year treasury bond yields stayed below 3% for 20 years starting in the mid 1930s. Interest rates seem extremely low because we are at low levels not seen in most people’s investment lifetimes
No -- the extreme today is most likely in stability. Daily price swings in the market have been much smaller than average in the 8-year period since 2009. But long periods of low volatility generally predict periods of greater volatility. Greater price swings aren’t necessarily a bad thing – they just provide more frequent periods of opportunity and risk. It all depends on how one approaches it.
As the enthusiasm over Trump’s pro-business agenda fades, as the Fed looks to normalize (increase) interest rates (and shrink its balance sheet) despite deflationary economic pressure, we could easily see more instability in financial markets. With this in mind, it may be prudent to consider European and emerging market stocks, which are far cheaper than their US counterparts.
But no matter the investment strategy, one of the most important things to do is to reflect on your own investment temperament, your goals and how potentially bigger price swings may impact you – not only emotionally, but financially. It is time well-spent to prepare for a change in market conditions in advance of the actual change. Doing so will provide a much better chance for success by not being caught off-guard, by thinking through scenarios, and being ready to take advantage of the irrational behavior of the unprepared. Considering the investment environment is not the same as making successful predictions, hence it won’t make you a trillionaire. But being prepared may help your returns enormously and give you peace of mind when things get tougher.