Corrections are an Emotional Process for Investors

These were the market headlines this morning. The Wall Street Journal
stated, “Stocks, Oil Fall as Russia Said to Continue Its Troop Buildup.” CNBC
wrote, “Dow drops more than 500 points as Russia-Ukraine tensions weigh on
markets.” CNN Business said, “Stocks slide again as Russia-Ukraine invasion
fears resurface.” Hostile military actions do tend to make people nervous, so
this certainly has a negative impact on investors. However, these headlines often
mask what is really happening beneath the surface of the markets. There are
always issues and concerns. Therefore, it is important to understand which issues
are important and which are not. At this time, there are two major issues that are
affecting the stock and bond markets. The fundamental factor facing investors is
that the Federal Reserve is pivoting from easy money to raising interest rates and
reducing liquidity. For almost two years now, it is like the Fed has been forcing
fuel into the economic engine to make sure it kept on humming in the face of a
global economic shutdown. Now, it is like the Fed is changing course to just
letting the fuel flow into the economic engine at a normal rate.

It is important to understand that the Fed and other central banks are not trying
to slow down the economy. They are just trying to bring conditions back to
normal again. Interest rates and liquidity are key variables for stocks, bonds and
the economy. So, when there is an important shift like this, there is often a period
of adjustment.

There is also the emotional factor that is affecting stocks and bonds, which the
headlines often gloss over. A lot of optimism has built up after the strong advance
from March 2020 until late 2021. That is not healthy. As was mentioned in last
week’s Update, it takes time for this optimism to dissipate. For example, we go
through an emotional process when a relationship ends, when there is a divorce,
or when we experience the death of a loved one. We all go through similar stages
when we are separated from someone we are close too. We cannot rush through
this process of accepting a loss no matter how hard we try. The only thing we can
do is take it one day and one step at a time.

I remember when my oldest daughter left our home to move into the dormitory
for her first year at Trinity University. It seemed like she had died for close to six
weeks after she moved out of our home. After six weeks, I was able to accept it
and I felt better again. It felt like normal again. I have heard other parents go
through the same experience.

In the same way, it takes time to remove excess optimism from the minds of
investors. This is often accompanied by volatility too. Since inflation is rising, this
might be a good time to review what the Fed had to do to eliminate the
inflationary psychology in the early 1980’s.

Wages, product prices and commodity prices had been rising steadily in the
1970’s. Conditions had escalated to the point that workers were constantly
demanding higher wages to keep up with the cost of living. Businesses kept
raising prices as their costs rose. It did not make sense to save up to buy
something because by the time you had saved up enough to buy it, you could not
afford it because the price has increased so much. Since prices were often rising
more than the cost to borrow, people were borrowing more and more. Central
bankers who knew their history were aware this would end very badly if it
continued. Fed Chairman Paul Volker raised short-term interest rates from 9% in
August 1979 to 15% by the end of February 1980 to shock the financial system in
an effort to reverse the trend of spiraling inflation. Stock markets fell 20% in
March 1980 and people were concerned. The Fed then lowered rates back to 7%
by June 1980 to see if the strategy had worked. It didn’t. Consequently, Volker
raised interest rates back up to 15% and kept them there until August 1982. Some
interest rates reached 19% to 21%. This put a choke hold on the economy and
created a recession so severe that by the summer of 1982, 500 US companies were
declaring bankruptcy every week! This strategy did succeed in eliminating the
inflationary psychology, but it came at a very high price. Many new homeowners
lost their homes as interest costs doubled seemingly overnight. My generation was
scarred forever by this experience.

Although it was a brutal course of action, it paved the way for the decades of
low interest rates and low inflation that have followed. Eliminating spiraling
inflation also enabled the US economy and stock markets to experience
tremendous growth until now. This is a memorable example of how important it
was to allow enough time to change the emotional mindset of the public. Please
see a chart of interest rates from 1930 to the present below.

The above chart is from Federal Reserve Economic Data or FRED.

 

Thankfully, we are not in a situation like that today. Innovative growth stocks
did get ahead of themselves and they have been a bear market for a year now, so
time is getting rid of the over-optimism in that sector.

However, interest rates are still extremely low. It would take a major increase
in interest rates to put this bull market and economic growth at risk. This is one of
the reasons why the S&P 500, DJIA, S&P 400 and S&P/TSX have held up fairly
well in recent months.

Sentiment has become even less optimistic in the last week as there are now
only 5.8% more optimists (bulls) than pessimists (bears). (See the chart below
from Investors Intelligence.) You can observe that sentiment has only been this
bearish two other times. At the start of 2019, the Fed announced that they were
reversing course and were not going to raise interest rates as planned after the
S&P 500 fell 20%. In March 2020, the Fed announced all sorts of measures to add
liquidity to the financial system as Covid-19 shut down the global economy. The
S&P 500 fell 34% at that time.

There is no need for the Fed to act now. This is just a normal correction so far.
We don’t need to be experts in global politics or military strategy to determine
what will happen to stock prices. No one knows exactly how things will play out
in the Ukraine. In the medium term, the issue in the Ukraine is just providing
another excuse for what was going to happen to stock prices anyway.

 

I believe if we focus on the process, we will have the best idea of how markets
will react in the future. Looking at the sentiment of investors is very useful,
although it does not give us an idea of the precise timing of an eventual
turnaround. We will need to see many more stocks advancing than declining and
many more stocks making new 52-week highs while far fewer are making 52-
week lows. A reversal may coincide with positive news of some kind. On the
other hand, a reversal may simply occur when stocks have just sold off too much
or sentiment has stayed negative enough for long enough.

Analyzing markets does not have to be complicated if we understand the forces
that drive it. I hope this information helps you to understand how markets actually
function so that you can have confidence in our investment strategy. I hope you
have a wonderful long weekend!

Please see the photo below of a hike I went on with some friends near
Palm Springs. The barber of one of my friends retired a while ago ☺