Cautiously Optimistic

Introduction – What the Heck am I Talking About?
In spite of some ominous current headlines, I remain cautiously optimistic with perhaps a short-term tilt towards caution. To put it in financial jargon: a near-term pullback in stocks is most likely cyclical and doesn’t derail the long-term structural trend, while medium-term returns could trend sideways, skewing portfolios towards total return, individual stocks, and alternatives. What the heck am I talking about here?

Defining Structural vs Cyclical Trends
Structural. The structural trend refers to the long-term trajectory of a set of data. In this graph of the Dow Jones Industrial Average (a “price-weighted” average of 30 stocks), if you took a pencil and drew a line connecting the two ends of the graph, you’d have an upward-sloping line from lower left to upper right. That line would be close to the long-term structural trend for that time period.

Cyclical. But there’s variability along the slope of this structural trend. Take a look at that pencil line you just drew; some of the index is above the line and some below. These shorter-term fluctuations are the “cyclical” surges and pullbacks that happen to stocks in response to things like the rise and fall of the business cycle or the shock and recovery from the COVID pandemic. Short-term movement can be confusing, even alarming, when people mistake a temporary cyclical downturn for a change in long-term structural trend. Emotional decision making can lead to regrettable investments.

Short-Term Caution
At the time of this writing, stock indexes are pulling back from (or dropping) all-time highs. If you’re inclined towards caution, now is a good time to lean into that. A short-term cyclical pullback should surprise exactly no one right now. Sometimes, stocks need to blow off steam, and reset levels. There are several reasons or catalysts for such a pullback:

High Valuations. They say stocks were priced to perfection heading into earnings season. This means that earnings will have to be as good as the best predictions if they’re going to be able to justify high valuations. If earnings disappoint, then stocks could fall to levels that reflect lower earnings. Remember, stock prices are just a prediction of where future earnings will be. Lower earnings should mean lower stock prices.

Falling Yields. This means that people are buying into bonds, which bids up the price of bonds and therefore drives down the related yield. People go into bonds when they are fearful and want to protect their money. Traditionally, low yields can signal that many people are expecting bad news. When people expect bad news, in theory they move their money to safety.

Inflation. As the economy reopens and recovery picks up momentum, supply chains are realigned and demand rises for inputs like materials, consumer goods, and resources. This can cause shortages and shortages can cause prices to go up. We’re seeing shortages in many sectors such as building materials, hourly labor, microchips, used cars, etc. The question is how long this will last. My own guess is that prices even out as suppliers catch up with demand.

COVID. As good as things are relative to several months ago, the pandemic is proving more stubborn and persistent than most of us would like to believe. Rising infections, hospitalizations, and deaths due to the new variant(s) are scary. And the refusal (or inability) of many to become vaccinated speaks to all sorts of micro and macro risks.

Sideways Trending in the Medium Term
In thinking about the potential direction of the markets, it is often helpful to look to history for guidance. There have been periods in the past when market indexes have trended sidewards for many years. For example, if you look at the Dow Jones index chart again, you can see that from the 1960s through the 1970s, stocks went essentially nowhere.

I’m not saying the circumstances of today are an exact match. There are important similarities and differences between today and the 60s-70s. Rather, I’m reminding us that stocks don’t have to be in a strong upwards (bull) or downwards (bear) market. Stocks can just drift sideways. The “malaise” of the 1970s was very damaging to wealth because slow growth was also met with inflation. In real (inflation-adjusted) terms, people’s wealth painfully declined.

In the next several years, we could well move into a sideways market. If we do, passive index investing could lead to little or no growth. We may have to work a little harder for returns.

Money can still be made, but some changes in approach may have to be adopted. Three strategies come to mind:
Seek Total Return. Stock returns comes from two things: increase of the stock price, plus the dividend produced. Say you receive 3% annual growth from a stock, plus you reinvest a 2% – 3% dividend payment, you could end the year up some 5% to 6%. This isn’t what you got in 2020, but it’s way above zero.

Take Advantage of Widening Dispersion. When a stock index is on a very steep up or down trend, stocks can trend very close to the mean, think of a very thin bell curve. For example, with narrow distribution or dispersion, if the index goes up 20%, most stocks go up +/- 20%. However, dispersion can widen if the market drifts sideways. Some companies will find ways to grow and innovate, while others might stagnate and underperform. Investors may have to add careful stock picking back into their allocation strategies.
I’m not suggesting that individual investors should speculate. I am suggesting that a core allocation of mutual funds may have to be supplemented with several carefully chosen stocks.

Alternative Investments. The idea here is to allocate some of your investments to things that aren’t highly correlated to stocks. You’d like to own some things that could do well regardless of whether or not the stock market does well. Examples include investments in real estate (REITs), commodities, and private equity. You have to be a bit careful, because some alternative investments can be expensive contraptions that pay everyone except the actual investor. But when alternatives do what they say they’ll do, they can add real value.

The Long-Term Trend
I’m optimistic about the long-term. I think quite a bit about this. Should I be? History would say yes. Investors who held stocks for the past several decades have been for the most part richly rewarded. They didn’t let events and crises distract them from their long-term goals. And for sure there were many crises that could have distracted a reasonable person, such as world wars, assassinations, social upheaval, Great Depressions and Recessions, stagflation and malaise, and on and on. There’s a lot of human emotion involved in this, so it’s easy to overreact. But the old adage investments often do better than investors implies that people can often buy or sell at the wrong times because they misinterpret a cyclical downturn as a structural downward trend, and sell just before things turn back up.

So why do I think the structural trend is upwards? I’ll never convince the pessimist of this view, and only time will tell. But I put my faith in human brilliance, spirit, and ingenuity. In the decades ahead, we are likely to see fantastic innovations and development in sectors such as biotech, renewable energy, space travel, 5G, smart cars, the internet of things, synthetic biology, and so on. The collective power of billions of people each seeking to care for themselves and their families will, I argue, lead not to a Malthusian bomb, but to a complicated and ultimately better future, one which is as hard for us to imagine as our current day would be for our great grandparents.

How to Evaluate?
We humans are empirically terrible at predicting the future. Most can easily envision catastrophe, but alternate positive outcomes are often very hard for us to describe and predict. This may be an evolutionary condition (i.e., the anxious cave dweller was better at discovering the lurking saber-toothed tiger). To make good long-term investment decisions, we’ll have to make a sober assessment of what the future may hold. And we need to identify and address our own biases and how they cloud our logic. The outcomes of investment decisions are measurable, and they matter. There are many biases to logic, but here are some of the big ones for investors to consider:

Confirmation Bias. We scan information and our surroundings for data that conform to our preexisting viewpoint. We confirm our bias.

Loss Aversion. It hurts to lose something. So sometimes we hold on to delay realizing the pain of a loss.
Framing Effect. How something is presented, or framed, has an impact on what we think. When someone puts a positive spin on something, we’re likely to believe them. The same is true for cynics: Eeyore would find many to commiserate with him.

Bandwagon Effect. Just because many people think something is true, doesn’t mean it is true. Before Galileo, we thought the earth was flat and the sun revolved around us (and now, the flat earthers want us to reconsider our assumptions…).

Dunning-Kruger. As I understand this one: people who have low skills or ability in a certain topic can greatly overestimate their performance or knowledge (and of course maybe in writing this, I’m just confirming my own susceptibility to this bias?).

Conclusion
In summary, when putting money to work, the results are consequential and measurable. We need to try to think clearly and make careful decisions. If you believe in the long-term, as I do, then it’s about managing risk and emotions along the way. Cyclical downturns, even big ones, shouldn’t derail you from long-term goals. And for coming years, it may be best to reduce your overall expectations and make smart tactical adjustments to your allocation approach.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing involves risk including loss of principal.

i Alternative investments may not be suitable for all investors and involve special risks such as leveraging the investment, potential adverse market forces, regulatory changes, and potentially illiquidity. The strategies employed in the management of alternative investments may accelerate the velocity of potential loses. The fast price swings in commodities will result in significant volatility in an investor’s holdings. Commodities include increased risks, such as political, economic, and currency instability, and may not be suitable for all investors.