After a relatively jarring August, as measured by volatility, the markets have started September off with some optimism.
Many will point to the news that the US and China expect to meet in October and the expectation of further Fed monetary easing. Those are certainly catalysts, but there are also some things that trends and investor behavior tell us which also give some insight.
On a long-term basis the stock market is in uncharted territory. We are in the longest business expansion cycle in American history. This is, of course, is a great thing however, we are potentially overextended. Over the past 100 years there have been numerous recessions. Some of them are more notable than others.
- 1929 was the historic market crash that led into the great depression.
- 1966 markets peaked and then drifted sideways for nearly 10 years.
- 2000 gave us the tech crash.
- 2008, the freshest in most investor psyche, was the financial crisis.
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In all of these recessions, there are some shared characteristics to what we observer today. In all of these cases:
- There was pain in the market following a peak
- All of the peaks were well above the long-term trend-line of the market; and
- When we measure the deviation from trend-line, we find that within all four recession cases, market prices were in the top quintile of positive deviation from trend
On a shorter-term basis, markets tell a different story. It might be better to think of these types of indicators as a thermometer that gauges how overactive the market can be to headline risks. Over the past year we have had a whipsawing short-term trend. When investor psyche stretches so much it tends to snap faster, creating volatility. Add in excessive optimism, and it is difficult for the market to move upwards.
Trends vacillate between excessive optimism and excessive pessimism. In August, markets became excessively pessimistic on trade, inverted interest rates and Fed-paralysis. Thankfully, though there may be excessive pessimism, absent a bad situation like a recession or financial crisis, markets tend to move higher swiftly (think of January and June 2019).
Many economic realities tend to come to fruition before we observe recessions and prolonged bear markets. Nevertheless, investor psyche tends to get stretched as we deviate further and further to the upside. Much like a rubber band stretched until it breaks. This can help explain the seemingly violent reactions to bad news that investors should expect under these conditions.
I do think that the macroeconomic is telling us that recession is growing more and more likely in the intermediate term, but conditions are more indicative of short-term volatility than they are likely to come crashing down into recession immediately. We are definitely late cycle and extremes are likely to be observed many times even before a recession strikes.
All this information could lead to bad decisions if investors are not disciplined in their approach to managing whipsawing emotions driven by both fear and greed. Understanding how emotion can contribute to wild swings can be helpful when trying to understand strategy and how to manage risk. It can also help to calm nerves that can get frayed at times!
Understanding markets, your own propensities and your needs helps to make sure that you are prepared when recession finally does develop. Do you know what your strategy is for all market conditions? Talk with your advisor to make sure that you are in the best strategy for you. The last thing you want to do is be a victim of market psyche.
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