Many investors believe markets to be cyclical and search for signs of cycles in an attempt to predict which investment styles are coming into and out of favour.
People have a tendency to see patterns where they do not exist. Do a Google image search for "#iseefaces" and you will understand what I mean. This can be a problem for investors because it is one thing to interpret a startled expression in a bowling ball or a light switch, and another to think that historical stock market data can help predict the future.
Many investors believe markets to be cyclical and search for signs of cycles in an attempt to predict which investment styles are coming into and out of favour. Rolling stock returns are like a Venus flytrap for these investors, luring them to the illusion of a pattern where one may not exist. Multi-year returns expressed over overlapping, rolling periods appear cyclical because consecutive observations share many data points. For example, a five-year rolling return computed at the end of June has 59 out of 60 data points in common with the end-of-July five-year return.
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A recent news item reported that Frederick Smith intended to step down as Chairman and Chief Executive Officer of FexEx Corp., the largest air freight firm in the world.
As a Yale undergraduate in 1965, Smith wrote a term paper for his economics course outlining an overnight air delivery service for urgently needed items such as medicines or computer parts. His professor was not much impressed with the paper, but after a stint in the Air Force, Smith sought to put his classroom idea into practice. He founded Federal Express (now FexEx) in 1971, and one evening in April 1973, 14 Dassault Falcon jets took off from Memphis airport with 186 packages destined for 25 cities.
In retrospect, it was not an auspicious time to launch a new venture requiring expensive aircraft consuming large quantities of jet fuel. Oil prices rose sharply later that year following the Arab states' oil embargo, and the US economy fell into a deep recession. Most airlines struggled during the 1970s, and Federal Express was no exception.
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At some point over the past year, the financial media's inflation coverage transitioned from, "Will this high inflation persist?" to, "Here's how to cope with inflation that's here to stay!" It seems some investors have resigned themselves to a new normal of high inflation following decades of below-average consumer price changes. However, financial market data tells a different story, one of potentially softening inflation.
Breakeven inflation (BEI) rates offer a window into the market's inflation expectations. Defined as the difference between yields on nominal and inflation-protected bonds of the same maturity, BEI represents the inflation rate at which investors would be indifferent between the two. If actual inflation were to exceed BEI rates, investors would be better off with the inflation-protected bond; if inflation were less than BEI, the reverse would be true. BEI is therefore commonly interpreted as the average annual inflation rate expected over a given time horizon.
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Investors can always expect uncertainty. While volatile periods like the one we're experiencing now can be intense, investors who learn to embrace uncertainty may often triumph in the long run. Reacting to down markets is a good way to derail progress made toward reaching your financial goals.
Here are three lessons to keep in mind during periods of volatility that can help you stick to your well-built plan. And if you don't have a plan, there's a suggestion for that too.
1. A Recession is Not a Reason to Sell
Are we headed into a recession? A century of economic cycles teaches us that we may well be in one before economists make that call.
But one of the best predictors of the economy is the stock market itself. Markets tend to fall in advance of recessions and start climbing earlier than the economy does. As the chart below shows, returns have often been positive while in a recession.
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We are living in a time of extreme uncertainty and the anxiety that comes along with it. Against the backdrop of war, humanitarian crisis, and economic hardship, it's natural to wonder what effect these world events will have on our long-term investment performance.
While these challenges certainly warrant our attention and deep concern, they don't have to be a reason to panic about markets when you're focused on long-term investing.
Imagine it's 25 years ago, 1997:
- J.K. Rowling just published the first Harry Potter book.
- General Motors is releasing the EV1, an electric car with a range of 60 miles.
- The internet is in its infancy, Y2K looms, and everyone is worried about the Russian financial crisis.
A stranger offers to tell you what's going to happen over the course of the next 25 years. Here's the big question: Would you invest in the stock market knowing the following events were going to happen? And could you stay invested?
- Asian contagion
- Russian default
- Tech collapse
- 9/11
- Stocks' "lost decade"
- Great Recession
- Global pandemic
- Second Russian default
With everything I just mentioned, what would you have done? Gotten into the market? Gotten out? Increased your equity holdings? Decreased them?
Well, let's look at what happened.
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