Can a Market Decline Be a Good Thing? + Financial market Update + 7.20.21

Can a Market Decline Be a Good Thing? + Financial market Update + 7.20.21

FINANCIAL MARKET UPDATE 7.20.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

CAN A MARKET DECLINE BE A GOOD THING?

The market has experienced some volatility over the last week, as concerns that the Delta coronavirus variant could impact economic growth have increased. The large-cap stocks of the S&P 500 have declined nearly 3% over the last three trading days. Cyclical ‘reopening’ stocks that were hit especially hard during the height of the pandemic have fared even worse, and the small-cap stocks of the Russell 2000 briefly hit correction territory (defined as a 10% decline) on Monday.

While inflation has generally been the prevailing worry in recent months, there is evidence to suggest those fears have taken a back seat. If inflation were driving the recent equity market moves, you would expect bond yields to be rising. This would likely occur to compensate investors for a fixed rate of interest that now delivers less purchasing power. Instead, the yield on the 10 Year Treasury bond has declined more than 0.20% over the last week. Such a move is more consistent with an expectation for a slower rate of growth.

Is this volatility a precursor to a larger drawdown? The answer, of course, is impossible to know in advance. The market opened higher and is rallying fairly strongly as of this writing. Perhaps the recent selloff was just a blip on the radar? Or perhaps stocks are beginning to buckle due to their lofty valuations. Only time will tell.

Something we do know is periodic volatility in the equity market is normal. The chart below illustrates the frequency of drawdowns for the S&P 500 going back to the 1940s. As you can see, a decline of -5% or more has occurred fairly regularly, about three times per year on average. Over halfway into the year, we have not had a pullback of this degree yet. Larger declines of more than -10% have occurred surprisingly frequently as well. Referred to as a ‘correction,’ they have historically happened about once a year. Finally, a decline of -20% or more has historically occurred every 6 to 7 years. Large declines of this magnitude are referred to as a ‘bear market’ and are often accompanied by a recession.

Sources: Capital Group, RIMES, Standard & Poor’s. Assumes 50% recovery of lost value. Length measures market high to market low.

The point of showing this chart is not to suggest that stocks are due for a pullback simply because we have not had one in a while. Rather, it is to remind investors that volatility is a normal and healthy feature of investing in the stock market. Selloffs can reset valuations, temper excessive optimism and speculation, and provide the market with a stable foundation for future growth. Taking this lesson to heart when times are good can give investors the strength to stay disciplined when they inevitably aren’t.

WEEK IN REVIEW

  • Earnings season got underway last week, with 8% of S&P 500 companies reporting results thus far. Year-over-year earnings growth was expected to be 63% as of June 30th. Blending the growth rate of companies that have reported with the estimate for companies that have not yet reported, estimated earnings growth has increased to 69.3%.
  • This week will be fairly quiet on the economic data front. On Thursday, we will get jobless claims and the Index of Leading Economic Indicators. On Friday, we will get a flash reading of manufacturing and services sector activity. Last week initial jobless claims sank to a post-pandemic low of 360,000. Retail sales, meanwhile, surprised to the upside, increasing by 0.6% MoM, vs. expectations of a -0.4% decline.
  • Bitcoin has spent most of today trading below $30,000, after falling over 50% from its mid-April peak.

ECONOMIC CALENDAR

Source: MarketWatch

HOT READS

Markets

  • It’s Official: The Covid Recession Lasted Just Two Months, the Shortest in U.S. History (CNBC)
  • Used Car Supply is Improving (Axios)
  • Meme Stocks Mired in Longest Losing Run Since Frenzy Began (Bloomberg)

Investing

  • 90% of Personal Finance is Just Spend Less than You make, Diversify, and be Patient (Morgan Housel)
  • How the Stock Market Works (Ben Carlson)
  • The 7 Best Investing Podcasts for 2021 for Serious Investors (Investor Place)

Other

  • The Rose Bowl Throws a Wrench in College Football’s Playoff Expansion Plan (SI)
  • An ‘Airbnb for Pools’ Is Making a Splash This Summer (WSJ)
  • Jeff Bezos Reaches Space on Blue Origin’s First Crewed Launch (CNBC)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

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ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 12+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. He is also responsible for portfolio trading, research and thought leadership as well as analytics and operational efficiency for the Firm's Financial division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

P: 402.827.2300 | F: 402.827.2319 | E: contact@lutzfinancial.com | 13616 California Street | Suite 200 | Omaha, NE 68154

All content © 2017 Lutz Financial  | Important Disclosure Information |  Privacy Policy

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The Inflation Debate Continues + Financial Market Update + 7.13.21

The Inflation Debate Continues + Financial Market Update + 7.13.21

FINANCIAL MARKET UPDATE 7.13.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

THE INFLATION DEBATE CONTINUES

Inflation continues to be one of the main storylines gripping the markets in 2021. The question isn’t if we will see sharp price increases or not, as they have been spiking higher for months. Rather the debate centers on whether the increases result from transitory factors, or if they will persist. The answer may have a significant impact on the economy and the markets. The Federal Reserve has maintained a view that the elevated inflation readings will be temporary. Their reasoning relates to labor market issues, supply chain disruptions and a misleading comparison of current prices with those of the weak economy a year ago. Other economists, however, think elevated inflation is here to stay. If the latter camp is correct, the Federal Reserve may be forced to tighten monetary policy sooner than expected, which would dampen economic activity and likely pressure stock and bond prices.

This morning, the Bureau of Labor Statistics published the Consumer Price Index (CPI), a popular inflation measure, for the month of June. While economists surveyed by the Wall Street Journal were expecting a modest slowdown from the May figure, the published data came in notably higher. On a year-over-year basis, prices increased by 5.4%, which is the fastest increase since the summer of 2008 when oil pushed to $150 per barrel. Core CPI, which strips out the volatile food and energy components, increased by 4.5%, making it the fastest pace since 1991.

On the face of it, the updated data appears to support the idea that rapid inflation is here to stay. Still, some factors suggest it’s too early to begin worrying. For example, used cars and truck prices have been rising rapidly due to a chip shortage that has choked off the production of new vehicles. The price for used autos has increased by 45% over the last 12 months and accounts for roughly a third of the overall inflation figure. Additionally, significant pent-up demand for travel and other services has been unleashed as the nation’s vaccination program continues. This has put upward pressure on the price of everything from fuel to airline tickets. Finally, the ‘base effect,’ or the comparisons between current prices and those of last year when the economy had just exited widespread lockdowns, should begin to fade away as we enter the fall.

At its most recent monetary policy meeting, members of the Federal Open Market Committee (FOMC) published their updated ‘Summary of Economic Projections.’ The projections aggregate the independent view of each member. While these projections do not represent an actual consensus forecast, they still provide some information on what the committee is thinking. The inflation measure included in the projections is the Personal Consumption Expenditures (PCE), which is the Fed’s preferred gauge. As you can see in the below table, the Fed expects inflation to run above its 2% target for 2021 and then decline in subsequent years. Again, this reflects the Fed’s view that inflation will be temporary.

Source: Federalreserve.gov, released on 6/16/2021. Yellow highlight added by me.

Investors in aggregate seem to be subscribing to the Fed’s view. Market-based measures generally suggest inflation will average just above the Fed’s 2% target in the coming years(1). Other data series that previously spiked but have since declined include the M2 money supply and lumber prices. Finally, even after the CPI data was published this morning, bond yields remain more or less unchanged. Generally, you would expect yields to rise with inflation fears.

It’s impossible to know how this plays out. The Fed seems to have convinced the market that inflation pressures are temporary, or at minimum, it has the tools to tame it if it’s not. The inflation debate will likely continue to garner headlines in the coming months.

1. The 10-Year Breakeven Rate, a common market-based measure of inflation expectations was at 2.33% as of 7/12/2021, per the FRED database.

WEEK IN REVIEW

  • Earnings season gets underway this week with a few major US banks reporting results. Earnings estimates for the S&P 500 currently reflect a staggering YoY growth rate of 64%, largely due to economic weakness at this time last year. If these estimates prove to be accurate, it will be the fastest YoY growth rate since Q4 2009, when the economy was recovering from the Financial Crisis.
  • Mortgage rates have followed the 10-Year Treasury yield lower. According to Freddie Mac, the national average 30-year fixed-rate mortgage rate declined to 2.9% last week. That is the lowest level since February.
  • Economic data to watch for this week includes jobless claims, industrial production and capacity utilization on Thursday. On Friday, we will get an update on retail sales, business inventories and consumer sentiment.

ECONOMIC CALENDAR

Source: MarketWatch

HOT READS

Markets

  • ‘This feels like 1999’: Global Start-Up Funding Frenzy Fuels Fears of a Bubble (CNBC)
  • Earnings Season Starts With Sky-High Stock Prices and Sky-High Expectations (CNBC)
  • Consumer Price Index Summary (BLS)

Investing

Other

  • The Uneven Odds for Promotions With Hybrid Work (WSJ)
  • The Invisible Addiction: Is It Time To Give Up Caffeine? (The Guardian)
  • Bezos and Branson are Going to Space! Or Maybe Not (Wired)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Do you want to receive financial market updates in your inbox? Sign up here! 

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 12+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. He is also responsible for portfolio trading, research and thought leadership as well as analytics and operational efficiency for the Firm's Financial division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

P: 402.827.2300 | F: 402.827.2319 | E: contact@lutzfinancial.com | 13616 California Street | Suite 200 | Omaha, NE 68154

All content © 2017 Lutz Financial  | Important Disclosure Information |  Privacy Policy

FORM CRS RELATIONSHIP SUMMARY

Can a Market Decline Be a Good Thing? + Financial market Update + 7.20.21

Average Returns are Rare + Financial Market Update + 6.29.21

FINANCIAL MARKET UPDATE 6.29.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

AVERAGE RETURNS ARE RARE

Over the last century, the US stock market has been a wealth-creating machine. With an average annual return of just over 10%, a buy-and-hold investor should have seen their money double roughly every seven years. $1,000 invested at the start of 1926 and held through the end of last year would now be worth more than $10 million!¹ Unfortunately, most mortal investors don’t have a century-long investment horizon, but compounding returns are still a very powerful force, even over shorter periods.

Investing in the stock market requires the investor to assume some risk. While stocks have generally earned a 10% return over time, one should not expect to earn that consistently from one year to the next. In fact, as the chart below shows, stocks rarely earn anything near their average return during a given year.  The green band illustrates a +/- 2% band around the long-term average of 10%. In the 95 years since 1926, the annual return has only fallen within the band on six occasions! Most years oscillate between very high returns and the occasional sizable loss.

Source: Morningstar Direct. Annual returns are from January 1926 through December 2020, and are based on the IA SBBI US Large Stock TR USD Index.

The famous investor, Howard Marks, has my favorite description for this pattern:

The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward the extreme itself that supplies the energy for the swing back.

Investment markets make the same pendulum-like swing:

  • Between greed and fear,
  • Between optimism and pessimism,
  • Between risk tolerance and risk aversion,
  • Between credence and skepticism,
  • Between faith in value in the future and insistence of concrete value in the present, and
  • Between urgency to buy and panic to sell.

This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at the “happy medium.”

Recent experience has certainly been consistent with Marks’ analogy of the pendulum in investor phycology. The S&P 500 returned over 30% in 2019, and optimism was high at the end of the year following the easing of trade tensions with China. In early 2020, the market experienced a significant drawdown as the pandemic and associated lockdowns caused panic among investors. Optimism returned fairly quickly, and the period that followed has generally been characterized as frothy, with substantial speculative activity within meme stocks, SPACs and cryptocurrencies.

It is critical for investors to understand the degree to which investor phycology can influence the market. The goal, however, isn’t to anticipate the swings in emotion in an effort to profit from them. The events that trigger the reversals are often completely unexpected. Instead, investors should simply recognize that these large swings are normal and are destined to repeat in the future. The challenge is to stick to your plan while others are being swept away in the currents of fear and greed. A difficult task to be certain. Those that are able to do this successfully put themselves in the best position to harness the wealth-creating ability of the stock market.

1. Based on the IA SBBI Large Stock TR USD Index

WEEK IN REVIEW

  • Last week new data showed that shipments of “core” non-defense capital goods excluding aircraft, a key component of business investment used to calculate GDP, increased by 0.9% in May (on pace for a 9.7% annualized rate in Q2). While this figure has slowed from the blistering growth rates upon exiting the pandemic lockdowns, it is still a very good reading.
  • On Friday, Personal Consumption Expenditures (PCE), the Fed’s preferred inflation gauge, was published. The figure showed a 3.9% YoY increase in prices, which is the fastest rate since 2008. The Core PCE figure, which strips out the volatile food and energy components, increased at a 3.4% YoY rate.
  • Economic data to be published this week includes an update on manufacturing sector activity and jobless claims on Thursday. The headliner for the week will be the Jobs report on Friday.

ECONOMIC CALENDAR

Source: MarketWatch

HOT READS

Markets

  • What Investors Can Learn From the History of Inflation (WSJ)
  • ‘Great Resignation’ Gains Steam as Return-to-Work Plans Take Effect (CNBC)
  • Home Prices Surged in April at a ‘Truly Extraordinary’ Rate, S&P Case-Shiller Says (CNBC)

Investing

Other

  • The Apple-Microsoft Tech War Reignites for a New Era (WSJ)
  • The RoboTaxi Era Will Require a Rethinking of Vehicle Safety (Axios)
  • Apple Daily’s Closure Marks a Dark New Chapter in Hong Kong (The Atlantic)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Do you want to receive financial market updates in your inbox? Sign up here! 

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 12+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. He is also responsible for portfolio trading, research and thought leadership as well as analytics and operational efficiency for the Firm's Financial division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

P: 402.827.2300 | F: 402.827.2319 | E: contact@lutzfinancial.com | 13616 California Street | Suite 200 | Omaha, NE 68154

All content © 2017 Lutz Financial  | Important Disclosure Information |  Privacy Policy

FORM CRS RELATIONSHIP SUMMARY

Can a Market Decline Be a Good Thing? + Financial market Update + 7.20.21

Common Behavioral Biases and How to Overcome Them + Financial Market Update + 6.15.21

FINANCIAL MARKET UPDATE 6.15.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

COMMON BEHAVIORAL BIASES AND HOW TO OVERCOME THEM

As investors, we are often our own worst enemy. We may believe we are making rational decisions, but we frequently take mental shortcuts or allow emotions to cloud our judgment. Generally referred to as ‘behavioral biases,’ these tendencies lead investors astray in predictable fashion. The problem is so pervasive that a field of study (behavioral finance) was spawned to identify and categorize these common errors. The challenge to avoid behavioral biases exists for both novice and professional investors alike.

Behavioral biases are generally grouped into two categories. The first group is referred to as cognitive biases. These are mental errors that occur when analyzing and interpreting information. Dozens of cognitive biases have been identified in academia. The world is extremely complex, and even mundane decisions would be utterly exhausting if we carefully analyzed every variable and potential outcome. To function with any degree of efficiency, people rely on mental shortcuts. Often referred to as ‘heuristics,’ these shortcuts help people to avoid analysis paralysis but can also lead to poor decisions.

The second category is referred to as emotional biases. As the name implies, these biases stem from emotional impulses rather than analytical error. Often times fear and greed are the primary drivers here. Below are a few examples of prevalent cognitive and emotional biases and how they manifest themselves in investor behavior.

Confirmation Bias

This cognitive bias reflects the tendency to seek out evidence that confirms existing beliefs and discount any evidence to the contrary. It is related to ‘cognitive dissonance,’ or the pain one feels when forced to reconcile new information that challenges existing beliefs.

Confirmation bias can lead to holding concentrated positions in certain companies and/or sectors. Negative information that might be a warning an investor should reduce their concentrated position and diversify may be ignored, exposing the investor to increased risk. Additionally, positive information about a particular asset class or strategy could also be ignored if it contradicts existing beliefs. This could lead to a missed opportunity to enhance returns.

Availability Bias

This cognitive bias refers to the tendency of people to estimate the probability of a particular outcome based on how easily those outcomes come to mind. People tend to believe that recent and/or easily recalled cases are more likely than those that are difficult to remember or understand.

This bias can cause investors to overreact to recent news or market conditions. It can also lead people to make investments based on something they recently heard, as opposed to investing on the basis of thorough analysis.

Loss Aversion

This emotional bias highlights the fact that people feel the pain of losses more acutely than the pleasure of gains. In fact, studies have shown that people feel the pain of loss twice as intensely as any enjoyment from gains.

Loss aversion often leads investors to hold on to bad investments rather than lock in a loss by selling. Conversely, it can also cause investors to sell their winners too early. Additionally, ‘myopic loss aversion’ is related to the fact that the more an investor looks at their portfolio, the more likely they are to see small and transitory investment losses. Since investors feel the pain of loss twice as much as the pleasure of gains, investors may take less risk than they would otherwise be able to. In doing so, they may lower the likelihood of achieving their long-term goals.

Overconfidence Bias

This emotional bias leads people to overestimate their abilities when it comes to investing. They believe they are smarter, more capable, and have access to better information than they really do.

This bias can lead to investors holding insufficiently diversified portfolios, underestimating risk, and trading excessively.

Unfortunately, awareness alone is not enough to insulate investors from the damaging effects of behavioral biases. Daniel Khaneman, a Nobel Laureate and one of the founders of the behavioral economics field, once said in a speech that he had 40 years of experience studying biases and still commits them!  So if the person responsible for identifying many of the biases can’t avoid them, what hope do investors have?

A powerful tool investors can use to avoid these critical mistakes is a financial plan. A major pillar of the planning process is the establishment of a long-term investment strategy, referred to as a strategic asset allocation. The key is to establish the strategy in advance, ahead of the inevitable market swings, and then stick to it. By doing this, investors can avoid the need to make those stressful decisions that are ripe for damaging behavioral biases in the first place!

WEEK IN REVIEW

  • The Federal Reserve kicked off its two-day FOMC meeting today, which will culminate with the publication of a written statement at 1 PM CT Wednesday afternoon. The statement will be accompanied by an updated ‘dot plot’ and economic projections and will be followed by a live press conference beginning around 1:30 CT. The market is expecting the Fed to signal that it will soon begin discussing a strategy to unwind its asset purchase program, which includes the $120 billion of Treasury and mortgage bonds purchased each month.
  • May CPI data published last week showed headline inflation accelerated to a 5.0% YoY pace (fastest since 2008), and core inflation inched up to 3.8% (fastest in 30 years). While the Fed maintains its belief that recent inflation pressures are transitory, some expect the dot plot to reveal more Fed officials penciling in a rate hike in 2023.
  • Data published this morning showed retail sales declined MoM as the effects of the stimulus payments begin to wane. May retail sales were up 18% compared to the last month prior to the onset of the pandemic, which suggests retail activity remains strong in general. Additional data to be published this week includes capacity utilization, industrial production, jobless claims, and the index of leading economic indicators.

ECONOMIC CALENDAR

Source: MarketWatch

HOT READS

Markets

  • Markets Are Leaving Little Room for the Fed to Be Wrong on Inflation (WSJ)
  • Consumer Prices Jump 5% in May, Fastest Pace Since the Summer of 2008 (CNBC)
  • A Full Rundown of What to Expect From the Federal Reserve on Wednesday (CNBC)

Investing

  • You Can’t Invest Without Trading. You Can Trade Without Investing (Jason Zweig)
  • Getting the Goal Posts to Stop Moving (Morgan Housel)
  • Why I’m Not Worried U.S. Household Debt is at Record Highs (Ben Carlson)

Other

  • How the L.A. ’84 Olympics Changed Everything (SI)
  • How Humans Think When They Think As Part of a Group (Wired)
  • The Coming Boom in Travel Credit Card Rewards (Ben Carlson)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Do you want to receive financial market updates in your inbox? Sign up here! 

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 12+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. He is also responsible for portfolio trading, research and thought leadership as well as analytics and operational efficiency for the Firm's Financial division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

P: 402.827.2300 | F: 402.827.2319 | E: contact@lutzfinancial.com | 13616 California Street | Suite 200 | Omaha, NE 68154

All content © 2017 Lutz Financial  | Important Disclosure Information |  Privacy Policy

FORM CRS RELATIONSHIP SUMMARY

Can a Market Decline Be a Good Thing? + Financial market Update + 7.20.21

The Return of Meme Stock Mayhem + Financial Market Update + 6.8.21

FINANCIAL MARKET UPDATE 6.8.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

THE RETURN OF MEME STOCK MAYHEM

A handful of companies that had previously garnered a devoted following of individual investors are once again making headlines. Back in January, these ‘Meme Stocks’ saw their share prices rocket to dizzying heights. By early February, many of the highest flyers had given up much of their gains. In recent weeks, some of these same companies have again launched higher. While these stocks have been generating significant buzz, are they actually worth your attention?

Let’s start with some background. The term ‘meme stock’ generally refers to a company whose shares are exhibiting significantly higher than normal volume as a result of the stock being hyped on social media. Prominent examples include GameStop, AMC Entertainment and Blackberry.  Reddit’s WallStreetBets forum, which has grown to over ten million users, is generally considered the launchpad for the meme stock phenomenon. Individual investors using this platform have been able to coordinate enough buying power to move the share price of certain small stocks significantly higher. This activity garnered significant attention in late January but later fizzled out to a degree. Over the last few weeks there has been a resurgence in some meme stocks. As of Monday’s close, the year-to-date gain on GameStop and AMC had risen to approximately 1,400% and 2,500%, respectively.

After observing such massive share price gains, the fear of missing out (FOMO) can easily take hold. In fact, FOMO supplies much of the fuel required for share prices to blast off the way they have. A virtuous cycle can be created after the initial share price gain attracts attention, enticing more buyers, which increases demand, elevating prices further, drawing in additional buyers, resulting in ever-increasing prices. While this may appear to be an easy path to riches, it is important to understand that there are significant risks.

Perhaps the largest risk is the stretched valuations. Many of the meme stocks were negatively impacted by the pandemic lockdowns. AMC Entertainment, the nation’s largest chain of movie theaters, was nearly forced into bankruptcy late last year. As the economy reopens, it would seem reasonable that these companies and their share prices would recover. According to YCharts, the value (market cap) of AMC’s business was about $752 million at the end of 2019. As of yesterday’s close, the business was valued at $27.6 billion. You would be hard-pressed to justify such a massive increase in AMC’s value over its pre-pandemic level. The stock’s price has completely detached from fundamentals, with its share price being driven by a massive supply and demand imbalance.

The fear of missing out can be replaced by the ‘fear of losing everything’ in the blink of an eye. A small price decline can push a few investors to the exits, and their selling causes the price to fall further, spreading the fear and creating more sellers, which pushes the price even lower. The once virtuous cycle becomes a vicious one that destroys wealth as fast as it was created. This type of abrupt sentiment reversal was on full display during a roughly two-week span ending February 9th. During that time, AMC lost over 70% of its value, while GameStop lost over 85%.

Share dilution is another major issue that meme stock owners should be concerned about. When there is significant demand, the market is extremely efficient at providing supply. With the massive rally in meme stocks, largely a function of coordinated investor demand, it shouldn’t be a surprise that some of these companies have taken advantage and issued new shares. While this is a great deal for the issuing company, it’s generally a bad deal for their investors. The ownership interest of existing shareholders declines as the number of shares issued increases (unless a shareholder purchases additional shares).

AMC again provides us a great example of this. The company’s shares outstanding increased late last year and has more than doubled in 2021. While this proved to be a useful lifeline to help the company get through a challenging period, it left its existing shareholders with a significantly lower ownership interest in the business.

Some buyers of meme stocks fully understand that the prices they are paying are astronomical. To the extent that their main goal is to profit from the trade, they believe the momentum can continue and that they can hop along for the ride. There are several issues with this.

For starters, to the extent that the momentum does not last long, a successful sale will incur a high short-term capital gains tax. This means a good chunk of the benefit from taking a substantial risk will go to Uncle Sam rather than remain in the investor’s brokerage account. Even doing that assumes the investor will know when the right time to sell arrives. The problem, of course, is nobody knows for certain, and many will be wrong. For every investor that sells near the top, there must be a buyer on the other side. For those poor souls that ultimately do buy at the top, I am sorry. After quick gains of 1,000%-2,000% (or maybe more), it’s an awfully long way back down to earth.

WEEK IN REVIEW

  • Last week the BLS published the jobs report, which generally disappointed. The economy added 559k jobs during May, while Forecasters surveyed by MarketWatch were anticipating a gain of 670k jobs. The unemployment rate declined from 6.1% to 5.8%, while the participation rate (share of adults working or looking for work) declined to 61.6% versus 63.3% pre-pandemic. Additionally, updated data published last week from both the services and manufacturing sectors showed activity continues to grow at an accelerating pace.
  • Over the weekend, the G-7 announced a (non-binding) agreement to update the global-corporate tax system. Before the agreement can be implemented, each member country will have to pass their own local laws in order to actually implement the agreement (no easy task). There are two main pillars to the agreement. The first would change the longstanding principle that profits should be taxed where value is created, which generally meant where the company was located. This was easily implemented when it came to factory production but is more challenging now, given the increased importance of intellectual property. The updated framework would allow at least a portion of profits to be taxed where the goods and services are consumed. The second component would be a 15% minimum tax on the global income of multinationals.
  • All eyes will be on the May CPI data to be published this Thursday. A high reading on the April inflation report generated some volatility as the market questioned the Fed’s view that the accelerating pace of price increases is transitory. Recent Fed speakers have begun to signal there will likely be a discussion about how/when to begin tapering the asset purchase program at the FOMC meeting next week. A surprise in the inflation data would likely dominate the headlines and weigh on those discussions.

HOT READS

Markets

  • The Fed is in Early Stages of a Campaign to Prepare Markets for Tapering Its Asset Purchases (CNBC)
  • Higher Interest Rates Would Be Good for the Country, Treasury Secretary Yellen Says (CNBC)
  • Is There a Labor Shortage? What the May Jobs Report Tells Us (CNBC)

Investing

  • How To Do Long Term (Morgan Housel)
  • Crypto Frauds Target Investors Hoping to Cash in on Bitcoin Boom (WSJ)
  • The Stock Market vs. Earnings Growth (Ben Carlson)

Other

  • Rampant Pitch-Doctoring in MLB is Pumping Pitchers and Deflating Offenses (SI)
  • What Can You Do to Lower Your Risk of Alzheimer’s Disease (WSJ)
  • Normandy Commemorates D-Day with Small Crowds, but Big Heart (Military.com)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

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ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 12+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. He is also responsible for portfolio trading, research and thought leadership as well as analytics and operational efficiency for the Firm's Financial division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

P: 402.827.2300 | F: 402.827.2319 | E: contact@lutzfinancial.com | 13616 California Street | Suite 200 | Omaha, NE 68154

All content © 2017 Lutz Financial  | Important Disclosure Information |  Privacy Policy

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Can a Market Decline Be a Good Thing? + Financial market Update + 7.20.21

Why a Pause in Market Gains is a Good Thing + Financial Market Update + 5.25.21

FINANCIAL MARKET UPDATE 5.25.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

WHY A PAUSE IN MARKET GAINS IS A GOOD THING

Stocks have been on an absolute tear following the pandemic-related selloff. The S&P 500 is up over 90% since the market bottomed on March 23rd of last year. By August, the index had fully recovered its losses and pushed to a new all-time closing high on 41 trading days since. Over the last month, however, the pace of gains has slowed dramatically. While some investors may fear this apparent loss of momentum, it would probably be a good thing for the stock market to take a breather.

Investors must understand that the stock market is forward-looking. Prices reflect current conditions but also incorporate expectations for how conditions will evolve in the future. This feature was on full display during the pandemic. The stock market selloff began in February, several weeks before cases accelerated and local officials began instituting lockdowns. Conversely, the market began to recover before the economic data even began to reflect the damage caused by the shutdowns. In each case, the market repriced itself ahead of forthcoming changes to the business environment.

Today, most traditional measures of valuation (how cheap or expensive the market is) suggest the stock market is richly priced. Evidence of this can be found in the chart below from JP Morgan. The grey line represents the forward P/E ratio, which divides the market’s current price by the estimated earnings for the next twelve months. The ratio indicates how many dollars an investor must shell out to participate in the earnings generated over the next year. The higher the grey line, the more expensive the market is. When the grey line resides above the highest dashed line (as it has for several months), the market is often considered overvalued.

S&P 500 Index: Forward P/E Ratio

In addition to the forward P/E ratio, the table at the top center summarizes how various other traditional valuation measures compare to their long-term averages. The majority of the measures offer the same conclusion: the market is expensive.

There are a variety of factors that may be contributing to the market’s high valuation. One reason may be that the market expects earnings growth to be higher than the forecasted earnings used in the forward P/E ratio. Recent evidence could potentially justify this expectation. According to an analysis published by FactSet, earnings growth during the 1st quarter of 2021 was dramatically higher than the initial estimates. Investors could be justified in paying a higher price for stocks today if they anticipate businesses will continue to outperform Wall Street estimates. In doing so, investors are pulling future returns to today. Businesses will then need to knock it out of the park in the coming quarters just to justify today’s price. If results end up being good, but not as good as investors are anticipating, prices would likely fall.

Another potential justification for higher stock market valuations is the current level of interest rates. The Federal Reserve has an extremely accommodative monetary policy stance, which includes holding short-term interest rates near 0%. In simple terms, when short-term interest rates pay investors next to nothing, there is an incentive to move further out on the risk spectrum in the search for a higher return. The stock market is a common destination for these return seekers and the increased demand results in upward pressure on prices. Going back to the JP Morgan chart, the last valuation measure in the table (top center of chart) illustrates the EY Spread (Earnings Yield Spread), which compares stock market valuation to current bond yields. Because yields (interest rates) are so low today, the EY spread actually makes the stock market look relatively underpriced, despite appearing overpriced by the other measures.

The Federal Reserve has repeatedly stated that it intends to keep interest rates near zero for an extended period of time. This offers a very real justification for the stock market’s current price. Over time, earnings growth should move valuation measures like the forward P/E ratio from over-priced to fairly-priced without the need for a market correction (selloff). If interest rates were to rise sooner than expected, stocks would lose a major justification for their current price level. This helps to explain why the market has been so jittery about recent inflation data. Excessive inflation could force the Federal Reserve to raise rates sooner and/or more aggressively than it has communicated to the market.

Any way you slice it, a slowdown in the pace of market gains is probably a good thing. Most metrics suggest the market looks expensive. If price appreciation continues to outpace business fundamentals, stock valuations could stretch further. Eventually, interest rates will normalize, which would eliminate a major justification for stretched valuations. Valuations can normalize from earnings outpacing price appreciation or by prices falling. Most investors would prefer the former.

WEEK IN REVIEW

  • According to data from FactSet, 95% of companies in the S&P 500 have reported earnings for the 1st quarter. 86% of these companies have reported earnings above analyst estimates, while 76% have reported revenue above analyst estimates. The YoY growth rate for companies that have reported, blended with the estimates of companies that have yet to report, increased to 51.9%. This blended growth rate is dramatically higher than what analysts were forecasting at quarter-end (23.7%) and would be the largest YoY growth rate since 2010 (55.4%). A faster than expected rate of earnings growth is a large positive for the stock market. Absent a commensurate increase in prices, a faster pace of earnings growth should put downward pressure on stretched valuation ratios.
  • Cryptocurrencies have been under significant pressure in recent days, with Bitcoin declining to as low as $32,000 over the weekend. Factors that precipitated the decline include Tesla’s announcement that it will no longer accept Bitcoin as a method of payment for environmental reasons and a crackdown on mining and usage in China. Bitcoin has retraced some of the losses from the recent lows reached on Sunday.
  • Economic data due later this week includes jobless claims and durable goods orders on Thursday and consumer spending and Personal Consumption expenditures (PCE – the Fed’s preferred inflation measure) on Friday. Inflation data will be of particular interest to investors for reasons discussed in the Story of the Week (above).

HOT READS

Markets

  • Don’t Bet Against Beijing’s Efforts to Smother Bitcoin (WSJ)
  • Bitcoin’s Trading Action Lately is Wild Even by Crypto’s Standards (CNBC)
  • The Fed this Summer Will Take Another Step in Developing a Digital Currency (CNBC)

Investing

Other

  • Phil Mickelson, the People’s Champion, Was the Perfect Winner for this PGA Championship (Sports Illustrated)
  • Chernobyl Is Heating Up Again, and Scientists Aren’t Sure Why (ExtremeTech)
  • The Costly Pursuit of Self-Driving Cars Continues On. And On. And On. (NYT)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

Do you want to receive financial market updates in your inbox? Sign up here! 

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 12+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. He is also responsible for portfolio trading, research and thought leadership as well as analytics and operational efficiency for the Firm's Financial division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

P: 402.827.2300 | F: 402.827.2319 | E: contact@lutzfinancial.com | 13616 California Street | Suite 200 | Omaha, NE 68154

All content © 2017 Lutz Financial  | Important Disclosure Information |  Privacy Policy

FORM CRS RELATIONSHIP SUMMARY