Misconceptions about the markets can be one of the most dangerous obstacles to achieving great returns. They often lead to decisions that may not be in the best interests of investors’ long-term goals. These fallacies about the market tend to persist because the media reports the latest numbers, without actually analyzing them and their repercussions for the future.
Below, we look at 3 misconceptions that are commonly reported on in the mainstream media. To be perfectly clear, we are only analyzing these figures as they pertain to equity market returns, not how they pertain to our current economic situation.
Misconception #1: Weak Consumer Confidence is Bad
The theory: If consumers are not confident, then they will not spend any money, and therefore the economy can’t grow.
The Reality: It is high consumer confidence that has been terrible for the stock market, not low.
In the past, stocks have performed best when consumer confidence has been poor. In her recent article1, Liz Ann Sonders of Charles Schwab shows that when the Conference Board Consumer Confidence Index is below 66, the Dow Jones Industrial Average has averaged close to 15% returns per year. When confidence reaches extreme highs, as it did in the late 1990s, future returns have historically been negative! Why the disconnect? The reason may be that when confidence is low so are expectations about the future, and that allows any positive news to push the market upward. As it stands right now, the most recent figure for the index is 58.5.
Misconception #2: Periods of poor or negative GDP Growth are a terrible environment for investing
The Theory: If the economy is not growing, then corporate earnings can’t grow, so stocks won’t do well.
The Reality: Markets have performed best when current GDP growth is negative.
GDP numbers are backward-looking and revised constantly. This is why when GDP figures are released, the market typically does not react to it with any conviction. The market is a forward-looking mechanism and GDP figures are historical. This table, from O’Shaughnessy Asset Management2, shows the forward real returns on the market when GDP is negative. Returns have been significantly higher when current GDP numbers are negative.
Misconception #3: Inflation is bad, and must be avoided at all costs
The Theory: Higher inflation is a drag because companies can’t pass their cost increases through to customers as quickly as they are rising.
The Reality: Under most levels of inflation, stocks have performed well.
We are not advocating a policy of high inflation, but only looking at historical data to see how inflation has affected markets in the past. This chart, courtesy of JP Morgan Asset Management, does a nice job of showing how various asset classes perform under different inflationary conditions.
Source: JP Morgan Asset Management
As you can see, high and rising inflation produced an average equity return of only 1%, while under other conditions, stocks returned between 12-22%. We are currently in a low and rising environment.
At the beginning of the article, I indicated that misconceptions about the markets can be dangerous. This is because the perceived risks can have an impact on your risk tolerance. A client’s risk tolerance is determined by a combination of their ability and their willingness to take on risk. It is important to make sure that a client’s willingness to take on risk is not affected by misconceptions like the ones listed above. This will allow us to better calibrate your overall tolerance in order to create a more effective portfolio design to meet your goals.
Rush Zarrabian, CFA
1 http://www.schwab.com
2 http://www.osam.com/Pdf/Commentary_Sep17-10.pdf
All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. The Dow Jones Industrial Average is an unmanaged index and is not available for direct investment. Past performance is no guarantee of future results.
Challenging 3 Market Misconceptions – 07/18/2011
Misconceptions about the markets can be one of the most dangerous obstacles to achieving great returns. They often lead to decisions that may not be in the best interests of investors’ long-term goals. These fallacies about the market tend to persist because the media reports the latest numbers, without actually analyzing them and their repercussions for the future.
Below, we look at 3 misconceptions that are commonly reported on in the mainstream media. To be perfectly clear, we are only analyzing these figures as they pertain to equity market returns, not how they pertain to our current economic situation.
Misconception #1: Weak Consumer Confidence is Bad
The theory: If consumers are not confident, then they will not spend any money, and therefore the economy can’t grow.
The Reality: It is high consumer confidence that has been terrible for the stock market, not low.
In the past, stocks have performed best when consumer confidence has been poor. In her recent article1, Liz Ann Sonders of Charles Schwab shows that when the Conference Board Consumer Confidence Index is below 66, the Dow Jones Industrial Average has averaged close to 15% returns per year. When confidence reaches extreme highs, as it did in the late 1990s, future returns have historically been negative! Why the disconnect? The reason may be that when confidence is low so are expectations about the future, and that allows any positive news to push the market upward. As it stands right now, the most recent figure for the index is 58.5.
The Theory: If the economy is not growing, then corporate earnings can’t grow, so stocks won’t do well.
The Reality: Markets have performed best when current GDP growth is negative.
GDP numbers are backward-looking and revised constantly. This is why when GDP figures are released, the market typically does not react to it with any conviction. The market is a forward-looking mechanism and GDP figures are historical. This table, from O’Shaughnessy Asset Management2, shows the forward real returns on the market when GDP is negative. Returns have been significantly higher when current GDP numbers are negative.
Misconception #3: Inflation is bad, and must be avoided at all costs
The Theory: Higher inflation is a drag because companies can’t pass their cost increases through to customers as quickly as they are rising.
The Reality: Under most levels of inflation, stocks have performed well.
We are not advocating a policy of high inflation, but only looking at historical data to see how inflation has affected markets in the past. This chart, courtesy of JP Morgan Asset Management, does a nice job of showing how various asset classes perform under different inflationary conditions.
Source: JP Morgan Asset Management
As you can see, high and rising inflation produced an average equity return of only 1%, while under other conditions, stocks returned between 12-22%. We are currently in a low and rising environment.
At the beginning of the article, I indicated that misconceptions about the markets can be dangerous. This is because the perceived risks can have an impact on your risk tolerance. A client’s risk tolerance is determined by a combination of their ability and their willingness to take on risk. It is important to make sure that a client’s willingness to take on risk is not affected by misconceptions like the ones listed above. This will allow us to better calibrate your overall tolerance in order to create a more effective portfolio design to meet your goals.
Rush Zarrabian, CFA
1 http://www.schwab.com
2 http://www.osam.com/Pdf/Commentary_Sep17-10.pdf
All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. The Dow Jones Industrial Average is an unmanaged index and is not available for direct investment. Past performance is no guarantee of future results.