March 2021 Market Update
We’ve had many questions from clients about recent market volatility. Over the years, we’ve occasionally used the term “frothy” to describe market behavior. Certain stock sectors are definitely starting to feel frothy, with growth stocks in particular reaching unusually high valuations, e.g., Price/Earnings (PE) and Price/Revenue ratios. Another recent concern is the potential for an up-tick in inflation, as more people who have received COVID-19 vaccinations begin returning to less restrictive lifestyles.
Investors who make decisions based on emotion fall victim to two fears. The first is “FOL”—fear of loss. This causes many people to sell stocks after prices have dropped—late in bear markets, or even after sharp short-term declines. They panic and sell (often at a loss) because they can’t bear to possibility that their portfolio value might fall even further. You sometimes see this referred to as part of the “Fear/Greed” cycle. “Greed,” on the other hand, refers to times when emotional investors buy after stock prices have risen dramatically—often near market high points. Since few people are actually greedy, however, a more apt term is “FOMO”—fear of missing out. Having sold stocks at low points due to FOL, emotional investors watch stocks rise and rise, and FOMO (on further gains) causes them to buy back into stocks…at relative high points. The end result is “buying high” and “selling low,” the exact opposite of what we should do.
The outstanding recent performance of the stock market (most indexes reached all-time highs just days ago) has drawn in more and more of these emotion-driven FOMO investors. They buy, but then quickly sell again when the market drops sharply (FOL), as it has also done in recent days. None of this emotional buying/selling means that the bull market (for long-term investors) is over, but—in conjunction with high PE and other valuation measures—it certainly contributes to a volatile, frothy market.
DON’T FIGHT THE FED
One of the oldest investment adages, “Don’t fight the Fed,” relates to Federal Reserve Board monetary policy. This reflects the fact that, when the Fed is accommodative, e.g., when the Fed is reducing or holding short-term interest rates low and credit loose (to stimulate the economy), the stock market has historically been strong.
Thus, investors have done well to have higher than average equity (stock) exposure at such times, as we do currently in our Viridian strategies. Conversely when the Fed raises interest rates and tightens credit (normally in an attempt to limit inflation), stocks tend to perform worse, so investors do better by reducing stock exposure.
For context, the historical average effective Fed Funds rate (on overnight loans between banks) was 4.70%. The current effective Fed Funds rate is 0.07%—about as close to zero as possible. This is most obvious in everyday life in very low-yielding bank savings rates, and very low consumer loan rates on everything from car loans to home mortgages.
The Fed has made clear that it has no intention of raising rates, but its hand could be forced if inflation picks up meaningfully. We would expect to see near “full employment,” i.e., an unemployment rate of 3% or less (versus 6.7% in January 2021) and inflation rising to around 2% (versus 1.4% for the 12 months ended January 2021), before the Fed would raise rates.
One of the primary transitions between no Fed rate hikes and rising rates would be a reduction in asset purchases (e.g., of treasury notes) by the Fed. But tapering asset purchases can take quite some time. In 2014, for instance, it took over 10 months to slow asset purchases by a meaningful $85 billion. To put that into perspective, the Fed is currently buying about $120 billion of treasury notes and agency mortgage-backed securities (MBS) every month. It would be reasonable to expect meaningful tapering of those purchases to take 12 months or more.
If GDP continues to pick up, with more consumers getting the COVID-19 vaccines and—aided by further COVID relief payments—returning to more traditional spending habits, and if we therefore see inflation increase and unemployment fall, it would make sense to expect Fed asset purchases to slow later in 2021 and in 2022. It is interesting to note that the last time a Fed chairman (Ben Bernanke in 2014) suggested tapering asset purchases, bond yields (which are controlled by market forces, not the Fed) spiked higher—from 2% to 3%**. That makes sense, since markets are always trying to price in today economic conditions 6-12 months from now. Once tapering began, however, rates actually fell. So, it is reasonable to expect that bond yields will spike higher if/when current Fed chairman, Jerome Powell, suggests that tapering of asset purchases is on the horizon, and yet see rates fall somewhat once tapering actually begins.
Our investment philosophy is always centered around the idea that we want to let the weight of the evidence lead us in the right direction. We will continue to watch metrics/indicators (those related to the topics above, and many others), and let the evidence lead our decision making. We avoid emotion-based investing—FOL and FOMO—and instead use a disciplined, reasoned approach.
Your Viridian financial advisor should have your investments allocated in such a way that your stock exposure is appropriate for your goals and time horizon—allowing you to participate in rising markets, without fear of having to sell while stocks are down in order to satisfy liquidity and living expense needs. If your situation or goals have changed, be sure to revisit your asset allocation with your advisor.
For the time being, we are comfortable with allocations that are overweight stocks and underweight bonds. You might also have noticed a shift over the past quarter in the types of bonds we are using in our fixed-income allocations. Specifically, we have increased the allocation to inflation-protected notes and adjustable-rate bonds/bank loans in our strategies.
We remain vigilant as the world emerges from COVID-19, and economic and market indicators reflect a return to more normal conditions. This is a truly dynamic time in history, and we will continue working to deserve the trust and faith you place in us.
**10 year Treasury Yield
Behavior chart – Fear/Greed by Carl Richards
Reference source: NDR – Ned Davis Research