Around this time last year a client of mine challenged me over whether it made sense to continue to own stocks when one could earn a “safe” 5% in fully liquid cash funds.
“The yield curve is inverted. That’s a pretty reliable recession indicator.” He told me.
Yes, it is.
“You even told me you think there’s a good chance of a recession.”
That’s correct.
“Equity valuations are very high relative to history, which seems even more unsustainable as interest rates remain high.”
Um hm.
“A recession combined with a rerating to lower equity multiples would be terrible for stocks.”
Agreed.
“So either we have a recession, and equities come down. Or the economy keeps growing, inflation persists, and interest rates go up… putting further pressure on stocks.”
Yep. One of those two outcomes seems to be likely. I wouldn’t bet on the Fed threading the needle here, allowing us to maintain economic growth while bringing down inflation.
“Given all of this, is it worth the risk to own equities?”
Yes, I think it is.
“How can you say that?”
Because we could be wrong.
As it turns out, we were both right. But we were also both wrong. There was no recession, but economic growth surprised to the upside. Corporate profits have generally remained strong. And as a consequence, inflationary pressures persist. The interest rate cuts investors were betting on have not yet materialized. In fact, this past week’s equity storm can be at least partially attributed to a strong inflation report and the realization that investors may not get the interest rate cuts they had been counting on. Some commentators are even whispering that the next move in interest rates might have to be… gulp… up.
We were right about all of this! But the decision to sell stocks would have been the wrong one. Markets are up strongly over the past 12 months, defying even the most optimistic predictions. The S&P 500 is up almost 24%! That “safe” 5% isn’t looking so hot in retrospect. In fact, taking that safe return would have cost you a significant amount of purchasing power in a world where inflation rages on.
What is going on? In my experience, in financial markets, when everyone is in agreement on something so obvious, it’s almost always wrong. Because when everyone agrees on a likely outcome, it’s priced in.
Investing is hard enough. Identifying quality assets to own is hard work, and mistakes will be made. But adding a timing element to the exercise makes it that much more difficult. Last year it was “obvious” to almost everyone that the equity markets were vulnerable to a significant correction, and instead, they tripled their average annual return in a single 12 month period.
One of the things I talk about in Low Risk Rules is the need to simplify your portfolio and reduce the number of variables at play. Part of that is giving up on the idea that you can time markets.
What other things do you take to be “obvious” today that you might be wrong about?