The Unpredictable Nature of Investor PsychologyOctober 28, 2019 9:54 am
One of the standard topics at our meetings with clients is our market outlook. Recently I have noticed that clients are more attentive than usual to what we say. I attribute this to all the noisy headlines that do more to confuse than clarify where the economy is headed. Clients are feeling they have a lot at stake when it comes to the timing of the next downturn; reassurances are more important than ever.
Before giving our latest outlook, let me start with a caveat that was reinforced by a presentation I attended last week. It was a reminder that investing is a humbling business. Even the most carefully researched theories are subject to unpredictability.
Former WSJ and Motley Fool columnist, Morgan Housel’s premise, at the presentation, was that market valuations are determined as much by psychology and human behavior as by hard data. While investment managers, like us, tend to focus on data, indicators and trends to make our portfolio decisions, investor behavior in the marketplace is often not nearly as analytical. According to Housel’s research, investor behavior is more dependent on personal experience (such as the market environment when investors came of age, or what happened to them in the last market rout) than investment history and data points. Thus, an understanding of what drives market sentiment and behavior can help us, at StrategicPoint, define market risks for our clients.
Our Market Outlook
The facts and indicators we are looking at, with the support of independent research, are telling us that the economy will experience slow growth – with low probability of a recession — in the next 6-9 months. This is the “muddle through” scenario where the economy is strong enough (labor markets, consumer confidence, low inflation and interest rates) to outweigh weakness (earnings, trade war fears and sluggish global growth).
We have been in this slow growth/no recessionary environment for most of the recovery with the exception of 2018 and the beginning of 2019 when tax cuts and increased government spending temporarily boosted economic growth. As the stimulus faded this year, we have seen businesses profits fall, begging the question, “Is there a cushion to keep most businesses afloat and profitable?” We believe that the Federal Reserve along with the vast majority of global central banks and their recent policy of interest rate cuts, are providing that cushion. The Federal Reserve is clear that it wants to keep this expansion going. Most recessions are triggered by the Fed raising rates, not lowering them.
So what about investor psychology? Should that be part of our outlook? Back to Morgan Housel. He cited research showing very few economic indicators having predictive value when followed for three years. What got in the way were changes in consumer and business sentiment as well as investor reactions involving greed and fear.
In addition to deciphering the data, we feel it is important to follow how both consumers and businesses are feeling when creating our market outlook. People and companies will spend (and invest) based on whether they believe the future is positive.
At the moment, businesses, which represent approximately 30% of the economy, are wary. They have pulled back on their spending, including business investment and share buybacks, due to the global slowdown and trade uncertainties. This doesn’t bode well for the markets if confidence can’t be regained. (We are trusting that the Trump administration will find a way to get a trade deal done going into the 2020 election year).
Consumers, which represent approximately 70% of the economy, on the other hand are feeling pretty good. They haven’t lost confidence in the expansion and continue to spend.
If consumer sentiment turns negative, or if businesses start to cut back on workers, then we are likely to alter our economic outlook and adjust risk in the portfolios accordingly. Conversely, if the global recovery starts to rebound and a decent trade deal is signed, then businesses confidence should rebound. In that case we are likely to form a more optimistic view of the economy and tweak the level of risk in response.
But how do we control for the unpredictable nature of human investors as they flirt with fear and greed? Our response: we offer a buffer (cash and bonds) in each of our portfolio models to help our clients ride out short term volatility caused by investor psychology.
Investing is all about managing risk and ensuring that you don’t take on more risk than you need or want to. With some risks being more predictable than others, we monitor the risks we feel we can control and protect against the risks we can’t.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.