The old saying, ‘As January goes, so goes the market’ may be a harbinger of things to come this year in the markets. Let’s just say that the market was rough the first month of 2022, so if the old adage is true, it could be tough sledding in the months ahead (more on in sec). Now that we’re in February and we are gaining three minutes of daylight every day, I’m going to try and point out some things that you may not be aware of.
In fact, according to Ryan Detrick of LPL Financial, the “January effect” has not worked in nine out of the last 10 down Januarys. I like those odds, and certainly hope they continue in 2022. But do we know how it will play out? Certainly not – and that’s what we want to focus on in today’s piece. What do we do when markets give us a scare like we saw in recent weeks? How should we react, and what processes are in place to boundary our reactions?
Volatility was certainly subdued in 2021 (on the heels of a wild 2020). We never expected that subdued nature to hold for this year. Such expectations would fly in the face of history and market norms. We’ve said this before and it is probably a good time mention it again. We know that every major bear market has been preceded by a 5%-10% pullback in the markets, but not all 5%-10% pullbacks turn into a bear market. So how do you know which pullback you are in? Well, the truth is nobody really knows, but let’s look at what causes bear markets.
Largely what has caused bear markets over the last 40 years has been tight monetary policy. It’s no surprise to you that I’m not a fan of the Federal Reserve and have used my lofty position as frequent writer of this blog to make my point over the years. If my belief holds true, the fact that the FED is in charge of monetary policy means that they have largely been responsible for bear markets by allowing our economy to become too exuberant and then coming in with a tightening policy to slow things down. That tightening causes a recession, which causes corporate profits to go down, which causes the price people are willing to pay for a stock to go down. It’s a downward cycle the FED has usually started, only to come back and loosen monetary policy after it becomes clear that the economy has slowed down.
In this case, we know that for the first time in history we shut down the world economy to combat a global pandemic. The resulting loose monetary policy and subsequent reopening of the economy has created pent up demand, supply chain issues, and a steep increase in the money supply. Taken together, these factors have led to a steep increase in inflation. It’s the classic definition, ‘Too much money chasing too few goods.’
Today, we believe that the FED is looking at past inflation and bottlenecks rather than forward looking indicators that show things slowing from a torrid pace to a more modest pace. This isn’t to say the economy is shrinking (recession), but simply that it’s slowing (likely back to more normalized growth rates). With that, the real risk becomes that monetary policy is tightened too much based on past data rather than current reality, leading the economy to go from slowing (okay) to shrinking (bad). It’s something to keep an eye on, and trust us, we aren’t the only ones watching. The markets will be very tuned in to this dynamic.
Market participants are making their judgments and the ALGOs (algorithmic traders) are trading fast and furious. As long-term investors (I’ll stress INVESTORS), these short-term swings only serve to distract us from our longer-term goals. It doesn’t mean we shouldn’t pay attention to the swings, but we should be mindful that these swings could cause unintended emotional reactions. That’s never a good thing.
Our model is not emotional at all. It is strictly an objective relative strength monitor of where best to place money in any given market environment. Our model has been getting more conservative over the last half of 2021 and continues to get incrementally more conservative for the month of February. That being said, of the asset classes we look at, US stocks continue to be the favored one, followed by our ‘alternative’ asset class. That includes things like gold and silver, energy, and even long-short investments (many investments that can be viewed as hedges).
The important thing to note is that cash and bonds are at the bottom of our rankings at this point, telling us to underweight them relative to US stocks and Alternatives. While it may seem uncomfortable from time to time, keep in mind that our model was not constructed to avoid what we would call ‘the wiggles.’ That is the 5%-10% down periods in the market (remember, on average we would expect 3 or 4 of these wiggles per year). The part that controls early volatility in portfolios is the risk tolerance that you have. How much risk are you willing to take versus how much return do you want/need to meet your financial goals? Those are key questions we ask in the financial planning process and are key drivers in how we allocate risk in your portfolio.
It's important to remember during this time that if you are losing sleep worrying about the ‘market’ then maybe it’s time to review your risk tolerance. The caveat there is to make sure you aren’t letting your emotions get in the way of an accurate assessment of your true risk tolerance.
Let’s take a look at how emotions are affecting investors decision making. The first is one we’ve shown many times before – the AAII Sentiment Index. Keep in mind, this is a contrarian indicator, meaning that when most investors are bearish, that is a good time to be bullish. Remember the Warren Buffett quote, “Be fearful when others are greedy and be greedy when others are fearful.” You can be the judge of which we should be at this time.
Here is the CNN Fear and Greed Index.
Both of these are saying roughly the same thing – investors are fearful (currently). In fact, thanks to our friends at Sentiment Trader, they compile many sentiment surveys into a model that looks at them in aggregate. Here’s what that looks like.
You can see that every time the model hits levels this low, it has been a good time to be buying (or, at a minimum, not selling in fear). Could this time be different? Sure, anything is possible, but we are sticking with the odds.
But what are small options traders doing? They’re buying puts (bets the market will go down) after the market has had a correction. See the chart below.
The extreme doesn’t get this bad very often, but when it does, check out the forward returns.
Does it mean it will give us those types of return this time? Certainly no guarantees! Most of those times are from 2020 when the COVID shutdown was starting (remember, the market was down almost 30% in 16 trading days). But the important thing is the numbers are positive.
I’m not here with rose colored glasses on. I see the risks to the economy and the FED policies. I’m just saying that I think in the short run the market is too negative and it’s too early for long-term investors to make decisions. In the meantime, the model is doing exactly what it’s supposed to be doing. It is getting more conservative, and we will make changes to move further toward a conservative posture should cash or bonds become a relatively better investment option. Until then, doing some mental exercises and making sure we understand what part of our brain is causing our thoughts will help us sort out whether we are making rational decisions or emotional ones.
We know these times can be unnerving. You’re normal if you cringed a bit at the markets in January. We hope our work will help keep you invested towards your long-term goals, even when doing so might feel uncomfortable. That said, if the volatility is keeping you up at night, let’s talk. Perhaps adjustments are warranted so that you can remain focused on the long-term and can see your hard-earned resources help you accomplish your goals. I hope this was helpful. It’s all I’ve got for now, but you know I’ll have more to say before too long. Reach out with questions, comments, or concerns – and have a great rest of the week.