FINANCIAL MARKET UPDATE 6.2.2020

STORY OF THE WEEK

GETTING OUT IS THE EASY PART

Famous studies conducted by Daniel Kahneman and Amos Tversky in the late 1970s described how individuals assess potential gains relative to losses. From that research, they developed what is known as Prospect Theory, which challenged existing views on how people make decisions. Daniel Kahneman would later receive the Nobel Prize in Economics in 2002 for the work.

Among the conclusions from the research was the fact that people feel the pain of a loss twice as intensely as the pleasure they feel from a gain. While we may not need a Nobel Prize winner to tell us people disdain losing money, the asymmetry in how people experience gains versus losses helps to explain why they go to great lengths to avoid the latter. This has been on full display in 2020. As the stock market decline deepened during the 1st quarter, many investors wanted out of their investments to avoid further losses.

I have written in the past about how impactful missing a few of the best days in a year can be on investment performance. An unfortunate reality is that many of the best days in the market seem to follow many of the worst days. So, if you liquidate your portfolio during a volatile period, you are likely to miss some strong rallies. The table below illustrates the average annual return on the S&P 500 going back thirty years (11.45%). It also shows what happens to the average annual return if the best days each year are stripped out.

  • If the best day of each year is missed, the average return declines by a third to 7.72%.
  • If the two best days are missed, the return is more than cut in half.
  • If an investor were to miss the four best days each year, the average annual return over the thirty-year period becomes negative!

Despite the high cost of being out of the market, the decision to get back in is very challenging. Some people will try to time the market on reentry, which is another (impossible) challenge. The recovery begins only after the market reaches its lowest point, presumably when expectations about the future are the grimmest. It requires a lot of courage to invest at that moment, and there is always the risk that things deteriorate further.

Others want the dust to settle and for things to calm down before they are ready to dip their toes back in. The problem with this approach is that by the time things are “calm,” the market has already rallied substantially. This appears to be the situation we find ourselves in currently.

The day after the S&P 500 hit the low, the market jumped more than 9%. Within three days, the market was up nearly 17%. As of June 1st, the S&P 500 has gained 36%. Even after this blistering rally, many are still not convinced we are out of the woods. It’s easy to see how people end up waiting so long that they are forced with the prospect of buying back in at a higher price than where they sold. That is a tough pill to swallow and can result in an investor remaining out of the market indefinitely.

There is no way to know if the rally will continue, or if we will end up retesting the low from March. What we DO know is that it is critical to be invested during those “best days,” because they ultimately drive a substantial part of a portfolio’s performance. Our instinct is to try to avoid losses, but getting out is the easy part. Investors must also consider the challenge of getting back in.

WEEK IN REVIEW

  • There were a handful of key data releases over the last week. 1st quarter GDP was revised lower from -4.8% to -5.0%. Personal consumption expenditures excluding food and energy (the Fed’s preferred inflation gauge) fell from 1.7% in the previous month to 1.0%. Business investment fell roughly 6% in April, which is bad, but much better than the forecast 15% decline. Finally, data published yesterday from the Institute for Supply Management (ISM) showed that the U.S. manufacturing sector continues to decline, but at a slower pace than the previous month.
  • Since 1997, when the United Kingdom returned control of Hong Kong to China, Hong Kong has enjoyed a favorable trading relationship with the United States under the “One Country, Two Systems” framework. This special relationship looks to be in jeopardy following a new Security Law that has been imposed on Hong Kong from China. It has led the U.S. to conclude that Hong Kong no longer has enough autonomy to continue the special relationship. This will have many consequences, potentially including more restrictive measures applied to about $66bn in goods traded between the two nations.  
  • Later this week, we will get an update on the labor market, with the ADP payroll report on Wednesday, initial jobless claims on Thursday, and the Nonfarm payrolls report on Friday.

HOT READS

Markets

  • Why the Stock Market is Up Amid Chaos in the Streets (CNBC)
  • What It Means For Investors if Hong Kong Loses its Special Status with the U.S. (CNBC)
  • All of the World’s Money and Markets in One Visualization (Visual Capitalist)

Investing

  • Latest Memo from Howard Marks: Uncertainty II (Howard Marks)
  • This is the Thing the Bears Hate the Most (Josh Brown) There is no good or bad, its better or worse
  • Why We’re Blind to Probability (Collaborative Fund)

Other

  • Hong Kong’s Security Law: What China is Planning, and Why Now (WSJ)
  • How Sleep Has Changed in the Pandemic: Insomnia, Late Bedtimes, Weird Dreams (WSJ)
  • Coronavirus Pandemic Claims Another Victim: Robocalls (AP)

ECONOMIC CALENDAR

Source: MarketWatch

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

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JOSH JENKINS, CFA + SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

Josh Jenkins is a Senior Portfolio Manager & Head of Research at Lutz Financial with over nine years of investment experience. He is responsible for assisting clients in the construction, selection, and risk assessment of their investment portfolios. In addition, Josh will provide on-going research and trade support.

AREAS OF FOCUS
  • Asset Allocation & Portfolio Management
  • Investment & Market Research
  • Trading
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst (CFA)
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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