Trending
Written by: Nick Williams | AAM
As we reflect on 2023, you might find yourself trying to reconcile the result with the winding path we navigated along the way. The last two calendar years produced abnormal returns, albeit in opposite directions; yet for many of the broad indices we ultimately find ourselves a stone’s throw from where we sat 24 months ago. At the end of 2023, the S&P 500 settled just over 3% from where it finished 2021. (Dividends included) The simple price return was mere basis points from flat.
While we may have landed near the same altitude, the elevation change along the way was nauseating.
As we review our portfolios, we are often reminded of two fundamental, yet critical concepts, that we habitually attempt to challenge. Investors, of course, are human. And human emotions have an uncanny way of dictating behavior. In past decades, research has increasingly focused on behavioral psychology as an integral driver of returns in the world of finance.
In hindsight, behavioral forces are easy to spot. Consider these two fundamental realities that we so often question:
- Regardless of our convictions and the evidence we cite to support them, markets are notoriously unpredictable.
- Financial markets are not linear (in any direction). Not on the way up, nor the way down.
If these seem like rudimentary concepts, it’s because they are, but human emotion often leads us to challenge even the obvious. Recognizing these realities is the first step in making rational, informed decisions, absent of our own cognitive bias. Even if some major events could have been predicted, the market’s response was unlikely to be forecasted as a result. Let’s recall a few of the major headlines from the past year.
To set the stage, the Fed continued down the path it paved in 2022 with their aggressive campaign to combat inflation. After already raising rates over 400 bps (basis points), the Fed kept their foot on the gas with four more hikes bringing the overnight rate to 5.5% and a deep inversion of the yield curve along with it. An inverted yield curve has historically served as one of the strongest indicators that a recession is likely to follow.
The impacts were blunt, and the first quarter started in dramatic fashion. A sudden run on deposits left Silicon Valley Bank (SVB) insolvent, the largest bank to collapse since 2008, stoking fears of contagion across financial markets.
Some of the headlines read:
“Silicon Valley Bank Fails in Largest Bank Collapse Since 2008 Crisis” — The Guardian, March 2023
“Silicon Valley Bank Collapse Signals Trouble in CA Tech” — Calmatters.org, March 2023
“The Banking Crisis Has Only Just Begun” — Forbes, July 2023
“It’s Crystal Clear Now: More Banks Are Going to Fail” — Business Insider, March 2023
Judging by these headlines, a catastrophic year for the financial sector might have seemed inevitable.
You might be surprised to learn that, despite rampant fears of a sequel to the Great Financial Crisis or 1920s bank run, the S&P Financials Sector earned a double-digit POSITIVE return on the year gaining about 12%. Furthermore, with close ties to private equity and technology companies in Silicon Valley, many experts warned the SVB failure would have spillover effects into the tech sector.
Again, not the case. The tech-heavy Nasdaq Composite returned over 44%.
Geopolitical events — often a major catalyst for volatility in financial markets — became the focal point for headlines in the 4th quarter. One of America’s closest allies was brutally attacked reigning chaos throughout the Middle East.
Conflicts in this part of the world are often accompanied by spikes in oil due to the disruption of major global trade corridors. After a brief spike on initial reports, crude oil prices traded lower by more than 10% by year end, and the VIX (Volatility Index) fell by more than half.
These events, and the market’s response, serve as humbling reminders that financial markets are both unpredictable and non-linear. Unpredictable in the direction and magnitude, and non-linear in the path. The path to an impressive 26% return for the S&P 500 was anything but a straight line. The index experienced two significant drawdowns of 8–10% along the way.
As we know, the catalyst for much of this strong performance was an about-face by the Fed later in the year, but judging by the market’s reaction this too was widely unexpected.
The inevitable departure of our expectations from reality demonstrates why maintaining a set of defined principals in our investing endeavors is so imperative. Actively trading on headlines in the past year would likely have proved detrimental.
Lost beneath the major headlines, 2023 also marked the passing of an integral figure in the world of finance. Harry Markowitz was widely regarded as a pioneer for his work involving Modern Portfolio Theory and the Efficient Frontier that now serve as the cornerstone of portfolio management. Markowitz recognized the benefits of diversification and asserted that an optimal portfolio could be constructed that maximized return for a given level of risk. The key tenant to this concept being sufficient (and efficient) diversification.
An investor who is easily swayed by emotion, or their own cognitive bias, is likely to depart from the foundational principals that (should) conveniently serve as guardrails to keep us on course. Even if newsworthy, allowing events to trigger a knee-jerk reaction rarely delivers the results our emotions tell us to expect, and our response rarely improves the likelihood that we will meet our long-term objectives.
We often emphasize that we do not advocate trying to time the market. To be sure, this does not mean that we discourage active management or tactical asset allocation. In fact, deviating from the “market portfolio” is precisely what Modern Portfolio Theory and the Efficient Frontier require in order to construct an ‘efficient’ portfolio that maximizes return for a given level of risk, consistent with one’s acceptable tolerance.
Tactical asset allocation can serve as a vital source of alpha when properly applied. But deviations from our strategic framework should be deliberate and intentional, completely void of our own emotional bias. We believe every investor should have and maintain a set of core principals, with a strategic outline that defines acceptable portfolio parameters. Tactical adjustments can be made, but within a range that keeps our personal views or expectations in check.
For long-term investing, fundamental analysis often serves as the foundation for portfolio allocation decisions. It focuses on financial metrics and economic indicators to offer an assessment of “fair value.” While fundamentals will likely dictate returns over the long run, results can and will run counter in the short run. We must accept that even if our assessment of fair value is correct, the market will often disagree — often by a wide margin, and for long periods of time.
2023 began with rampant pessimism, setting the stage for largely unexpected results. Judging by sentiment, it appears the pendulum has likely swung toward the opposite extreme. A surprising change in Fed policy, easing inflation, and resilience in the labor market have participants expecting the goldilocks scenario of a soft landing. As of now, it looks like they are right. But while these are certainly positive developments, it is possible they have overshadowed some of the risks still lurking beneath the surface. The inverted yield curve, weakening LEI (Leading Economic Indicators), and the possibility of a hitch in our progress taming inflation, to name a few. Our fundamental research indicates that many risk assets have put more weight on the former suggesting a bit of caution may be warranted.
To read more about our outlook for 2024, click here
While we may not know which way the chips will fall this year, we do know that unexpected returns should be expected. No matter how strong our convictions, adhering to a set of principals conveniently serves as a guardrail to keep us on course.
“The key to successful investing is not predicting the future, but managing risk.” — Harry Markowitz (1927–2023)
Related: Inflation Bump Surprises the Market, and Inflationary Threats Loom