Welcome to 2021! In my last post, How to Describe 2020? Unprecedented, I tried to make the case that the sum total of last year’s events made 2020 an “unprecedented” year. Don’t worry – I won’t be using that word again here. Instead, I want to view last year through a somewhat different lens. Despite 2020’s anomalies, there were a number of ways in which the events that unfolded actually did adhere to familiar patterns. It also helped reinforce some important investment-related lessons.
I think it’s generally accepted that markets hate uncertainty. I would expand on that a little to say that markets generally react most sharply to negative surprises. Investors can deal with bad news, particularly if it’s seen as temporary, since they can discount it appropriately when looking forward and valuing assets. However, unexpected bad news is often problematic, since markets must then recalibrate to take this news into account. Add a degree of uncertainty to the mix, and now investors face the challenge of just how much they need to recalibrate. This principle was evident as markets reacted to the worsening news as COVID-19 initially emerged, began to spread rapidly, and then negatively impacted the global economy. The combination of a negative surprise, along with uncertainty about just how severe the impact would be, contributed to a dramatic market selloff during February and March.
During that selloff, we witnessed another market principle concerning the role of fixed income in a diversified portfolio. Bonds don’t always get much love, particularly during the era of ultra-low interest rates. Since bond yields and prices have an inverse relationship, many investors have been lukewarm on the asset class. If rates “have nowhere to go but up,” then the future potential returns for bonds would appear to be quite modest and possibly negative. Those who advocate for not giving up on the asset class (including SEI) argue that the critical role bonds play within a diversified portfolio is to help buffer against equity-market volatility. And indeed, when we saw equity markets plunge during the first quarter, bonds lived up to their billing. High-quality bonds served as an important portfolio stabilizer during the prototypical flight to safety that we witnessed. Additionally, the Federal Reserve’s asset purchase program represented further demand for U.S. Treasury securities, helping to drive this segment’s favorable returns as stocks were getting hit.
Beginning in late March, equity markets rebounded sharply. They frequently seemed to be rallying strongly just as abysmal economic data points were being reported, confounding some investors. These trends actually made sense, though, when markets are viewed as future discounting mechanisms. They don’t always reflect the current state of the economy or corporate earnings, but rather, typically anticipate where these are trending and what they may look like several months or even years from now. Equity market strength appeared to correspond with increasing investor optimism that the historic (I almost used that word that I said I wouldn’t use) monetary and fiscal measures taken in order to revive the global economy would ultimately proved to be deserved. Positive news on the vaccine development front likely also helped investors to look beyond the valley and price in better economic days ahead.
The speed and intensity with which equity markets declined and subsequently rebounded last year offered investors an opportunity to relearn another time-tested lesson: market timing is futile. I wrote a piece on this previously, but in essence, successful market timing requires selling equities or other risk assets somewhere near a market peak and then buying back into them somewhere near the corresponding trough. The selling part is difficult because markets very frequently show head-fake dips that never materialize into bear markets, so by the time you know you’re in a bear market, it’s probably too late to sell. The buying-back-in phase has its own challenges: while objective data may strongly suggest that a market is oversold (especially with the benefit of hindsight), actually investing at this point of high or maximum pessimism is extremely difficult to do. Markets don’t flash an “all clear” buying signal, and if the rebound is strong and sustained (as we saw in 2020), opportunity costs can add up as investors wait on the sidelines for an entry point. As I highlighted in the last paragraph, the discrepancy between economic news and market trends can make this task even harder.
There are, no doubt, other ways in which market behavior during 2020 was more typical than it appeared at first glance. It’s not my intent to create a laundry list of every example I can think of. Instead, I wanted to make a broader point. Yes, 2020 was indeed a strange, odd, unusual, atypical year when many longstanding economic and market rules seemed to be broken. However, there were also some time-tested principles and lessons that were validated. We learned (again) that:
- Markets hate uncertainty and negative surprises
- Bonds can play a valuable role during equity market declines
- Markets are forward-looking and tend to discount the future rather than reflect the present
- And market timing doesn’t work
I actually take some comfort from the idea that even in a year like 2020, certain principles still apply. Hopefully, we won’t be afflicted with another year like 2020 anytime soon. However, we almost certainly will face challenging and trying market environments at some point in the future, and while there are no guarantees, I remain hopeful that these and other principles will continue to serve us and our clients well.
A bear market is a decline of 20% or more in a broad stock market index.
Investing involves risk including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise. Diversification may not protect against market risk.
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