Stock volatility returned this week after a pretty steady summer and market indexes reaching all-time highs. Many cautious investors have been waiting for the market to fall again which is a natural emotion when we have recently experienced a 34% decline. Besides the shock of getting over the recent drop, there is a general distrust in the validity of the market recovery. I regularly get asked the question, “Why is the market performing so well right now with everything that is going on?” With Covid, unemployment, trade tensions, high stock values and a looming election, many wonder where the market will go from here. While none of us know what the market will give us in the coming months, this post will discuss what this stage of the economy can mean for our investments.
Following the Business Cycle
We use the business cycle to evaluate how to position investments to capitalize on economic activity. Typically, we find that certain sectors and industries will lead during different parts of the business cycle. During the last few months of recession, it has been a story of the “stay-at-home” sectors like technology experiencing a remarkable recovery while the “re-open” sectors like energy and financials are still depressed.
Our economy is beginning to turn around, and many analysts say that we are now in the early cycle of business recovery. Dirk Hofschire, SVP of asset allocation research with Fidelity says, “ Household and corporate spending has improved as the economy has been reopening, albeit fitfully, with support from extraordinary fiscal and monetary policy.”
It may be difficult for some to believe that we are out of a recession at this point, but that is normal at this stage of the cycle. In fact, the early cycle really doesn’t look that much different than recession. We still expect to see high unemployment and struggling businesses. During this time, corporations are typically trying to evaluate what difficult decisions to make in order to recover and often there is muted corporate spending and additional layoffs. The chart below shows that there is often a disconnect between the economy and the stock market at this stage because stocks tend to recover faster than economic indicators.
This period can create opportunity for investors. Going back to 1962, stocks have typically delivered their highest performance during the early cycle. Economically sensitive sectors like financials, consumer discretionary, and real estate tend to outperform at this stage due to low interest rates. However, this period requires discipline as we don’t typically see a smooth upward ride. There is a high risk of short-term reversals and sell-offs as consumers build confidence in an economy that is trying to find momentum.
Are We in a Bubble?
No matter the level of skill or experience, it is extremely difficult for any investor to know if they are in a bubble when they are in it. We have seen the best of the best make mistakes over the years. Recently, there have been comparisons of this run in tech stocks to the Dot-Com Bubble of the late 90s. While there may be some stocks that are overvalued, the long-term trend is in our favor right now. The great bull market that started in 2010 ended this year, however some suggest that we are still in a “Secular Bull Market” or long-term bull market similar to what was experienced by the stock market through the 50s and 60s or 80s and 90s. The chart below shows the S&P 500 return compared to the long-term trend. Look at where we are now in relation to the trend compared to the market peak in the late 90s that led to the bubble bursting. This may help put our current market valuations into perspective.
The popular CNBC TV host, Jim Cramer, starts his show with, "There is always a bull market out there somewhere...". I like this because it reminds us to look for what opportunities that the current situation is presenting us with. Right now we may see high valuations in certain companies or sectors, but there other parts of the stock market that may be a good value still.
Monetary Policy is Keeping us Afloat
There is no doubt that the economy is stabilizing due to government stimulus. The Fed recently announced a new stance against inflation that indicates that they will do what it takes to accommodate economic growth. This means that we should expect low interest rates and monetary support to continue. This situation coupled with a low dollar valuation typically would create a headwind for stocks and assets like gold and real estate.
Mistakes typically get made when we become overly optimistic or pessimistic. We are definitely in a unique time and lessons from history or other business cycles can only go so far in helping us with what we are dealing with now. Since this is an election year, there is an added level of anxiety. However, there is always uncertainty when it comes to the stock market and it is better to rely on good fundamentals and stick to an investment plan than to let our emotion take over. Allocating your investments properly and maintaining diversification will help you find the opportunities that present themselves in the market.