The stock market’s recent moves have a lot of people confused.
On one level, it’s easy to understand the -34% plunge from February highs – the stock market was pricing-in the steep, pandemic-driven global economic downturn that engulfed the world during the spring months. But since March 23, which was still early days for the pandemic and economic crisis, stocks abruptly switched into full rally mode. The “v-shaped” bounce caught many investors by surprise, as did the -5.9% wallop to the downside last week. The end result has been a lot of confusion about where this market is actually headed.
This confusion has been playing out in investor sentiment metrics. According to the American Association of Individual Investors survey in May, 53% of respondents cited being bearish for the next six months. Following a few more weeks of sustained rallying, the bearish number dropped to 38% a two weeks ago.1 But following the steep one-day selloff last week, the number ticked higher again – all underscoring the investor confusion. Fund managers increased their investments in global stocks last month as well, but their overall equity allocations still remain far below long-term averages. No one is quite sure what to make of this market.
These topsy-turvy shifts in investor sentiment bring to light an age-old question that investors consistently grapple with: if today is a big up day for a stock, what does that tell us about tomorrow’s performance? Or, if this month/quarter was a strong one for the stock market, what can we assume or forecast about performance in the next month/quarter? Generally speaking, there are three points of view in answering these questions.
The first point of view is held by ‘momentum’ investors and traders. It says that the move from today or this month will carry into tomorrow or next month, especially if there is a high volume supporting the trend. A second point of view is the belief that market timers are likely to swoop in to buy the dip or sell the rally to take profits, essentially reversing the price direction for the stock from one time period to the next. In this point of view, the strong rally in recent weeks must mean that “what goes up must come down.”
The final point of view – which is the camp I’m firmly in – is that stocks are not serially correlated to any meaningful degree. In other words, what happens today, or this month, or this quarter has little-to-no influence or predictive power over what will happen tomorrow, or next month, or next quarter. Market returns are independent over time.
My concern today is that too many investors are basing their outlook for stocks on past performance. In my view, this explains why so many investors are becoming less bearish as the market rallies, and more bearish following steep, one-day declines like we saw last week. It’s a signal that investors are using past performance as an indicator for future returns – which I advise against.
Ask yourself this question: has the recent market rally got you wondering if you should take profits off the table now? Or maybe you’re thinking that now is a good time to sell-out of stocks, so as to ensure you at least “break even” as this pandemic and crisis continue to unfold? If the answer to either of these questions is yes, then you’re using past performance as a predictor of future returns. Again, not advisable.
Bottom Line for Investors
In my view, the worst possible outcome happens when a person changes their asset allocation (usually by reducing their equity allocation) because they think a market rally was too strong, too fast, or unfounded. I see this happening a lot today, but I think it’s evidence that investors are basing decisions on technical indicators and past performance versus fundamental drivers.
I strongly believe the only reason to change your portfolio’s asset allocation is if your financial situation and/or long-term goals have changed. For many, the pandemic and economic downturn may have triggered personal financial changes that warrant portfolio adjustments. But for most, it probably hasn’t, and any portfolio changes happening now could be happening for the wrong reasons.