It goes without saying this has been a wild year in the stock market. On March 23rd, the Russell 3000 was down 35% from all-time highs but is in the midst of rallying 46% from that point. VIX, the market “fear gauge,” went from a normal reading to its highest reading ever in 18 trading days. But the volatility goes both ways. There were no daily gains of 4% or more in the S&P 500 from 2015-2019. There have been eight so far this year.
The stock market’s furious fall and rise is occurring in the backdrop of a global pandemic that killed more than 100,000 Americans and resulted in millions more being out of a job.
The recent positive stock market news contrasts sharply with the negative economic reality across the country. Investors are understandably confused and questioning if the stock market has risen too fast too soon. Maybe, maybe not, but that is exactly the type of question investors have gotten wrong all year long. 2020 is a master class in the perils of market timing but offers lessons that can benefit investors moving forward.
1: Trying to predict the short-term moves of the market is a bad idea
As the bull market surged past 10 years in duration, it was common to look for some economic or structural reason for its demise. Few saw an exogenous shock like a global pandemic coming. Even as the crisis was unfolding, there was plenty of discounting the impact of the virus in January and February and plenty disbelieving the recovery in April and May.
Now, many are arguing that the stock market is wrong. Earnings reports have been ugly this quarter and many companies aren’t offering forward guidance given the uncertainty. Investors who went to cash in March and April cost themselves the large gains we’ve seen in the stock market recovery but struggle to get back into the market at current levels. Investors who stayed invested might be wondering if it is time to cash out. After-all, aren’t we likely to see a resurgence of cases this fall?
The stock market is a forward-looking discounting machine that values the future earnings stream of publicly traded companies. The market crash was rational because of the amount of uncertainty surrounding the virus and the shutdown of the country. It needed to account for a very wide range of possible outcomes. Since then, epidemiologists, doctors and policymakers have gotten a better handle of the situation. Might there be a resurgence of cases in the fall? Yes, but the stock market knows that. Futures betting on the level of VIX are highest in October, showing that the chance of a fall resurgence is accounted for in current stock market prices.
It didn’t seem like such a quick recovery was possible in March, yet here we are. No one knows what the stock market will do the rest of the year, but the good news is you don’t have to.
The stock market attracts the confident and humbles them quickly.
— Morgan Housel (@morganhousel) June 8, 2020
2: This was the ultimate test of your true risk tolerance
A typical financial planning process will include some assessment of an investor’s risk tolerance level. You can try it for yourself here. Questions are asked that aim to get a feel for the level of risk the investor is willing to take, such as:
Which potential risk/return tradeoff would you choose with a $100,000 investment?
- Chance to earn $2,000 but risk $0
- Chance to earn $9,000 but risk losing $5,000
- Chance to earn $20,000 but risk losing $13,000
- Chance to earn $31,000 but risk losing $21,000
These questions are well thought out, scientifically validated and tend to do a good job at predicting risk tolerance levels in normal times. The problem is we typically take the assessment in what psychologists call a “cold state.” That is, we take the assessment when we are calm and able to think clearly. But humans are bad at predicting their own actions when they are in a “hot state” (hungry, angry, stressed, in pain, etc). So, we sometimes learn that the amount of risk we think we can stomach when times are good is not the actual amount we can stomach when stocks crash.
If you had trouble sleeping in March because of the stock market, couldn’t stop staring at your investments or considered going to cash, now is a good time to revisit your asset allocation while the experience is fresh. If you have a financial plan but your fear level was high, it’s time to revisit your plan. If you don’t have a financial plan, it’s time to create one.
3: The economy is not the stock market
The economic numbers are ugly.
- The unemployment rate is in the double digits
- Second quarter GDP is projected to decline as much as 53%
- The NBER officially announced the economy went into a recession
So, how is it possible that the S&P 500 erased all its losses for the year yesterday?
There are no shortages of articles telling you that the stock market is not the economy. Still, it can be difficult to square the negative news with the surging stock market. The key thing to remember is that economic data is backwards looking while the stock market is forward looking. The moves of the stock market typically make sense in hindsight but rarely make sense in the moment.