A long time ago as a young Army officer, I learned a lesson that has stuck with me during stressful times. It was during my training as a newly commissioned 2nd Lieutenant where we were being taught the basics of commanding an infantry platoon. We had been out in the Piney Woods of Georgia for a few days when a cold front blew in, turning what had been a fairly routine field exercise into something much less comfortable. Our platoon was on a mission of some sort that involved walking for several miles through the woods at night with just a map and a compass for navigation. We had stopped to crawl under a rain poncho so that we could use a dim light to try to figure out where we were on the map. We were cold, wet, tired, hungry, lost, and behind schedule. The senior officer in charge of us was not happy and I, unfortunately, had been chosen to lead the mission. As a result, I was the primary recipient of the Captain’s ire.
Shortly after a very direct mostly one sided conversation with the Captain, the Sergeant that was assigned to our platoon pulled me aside and asked me if I was having any fun yet.
“Fun,” I asked"?
“Yes sir, fun,” he replied.
“I fail to see any humor, Sergeant,” I said.
“That’s because you haven’t embraced “The Suck”, Sir,” he exclaimed!
And with that, he pulled the pin on a CS (tear gas) grenade and tossed it into the group of us that were huddled together looking at the map. If it hadn’t sucked prior to that moment, it really did after getting a face full of chemical irritants and having to don a clunky gas mask that made it virtually impossible to see anything. But instead of hanging my head and wondering, “Why me?’, I started laughing.
I then asked my shivering colleagues if they could think of anything else we could do to screw this up any worse. Soon, we were all laughing at our misery as we realized that things weren’t going to get any better by feeling sorry for ourselves. We weren’t going to get any sleep, food, or warmth until we completed our mission. So we collectively embraced “The Suck”, figured out where we were, and started putting one foot in front of the other in the direction of our target. A similar attitude towards investing can help when crazy markets get us disoriented and fatigued.
So far in 2020, the economy, the stock market, and life in general during Covid-19 has largely been “The Suck”. Yet in spite of record joblessness and grim tallies of fatalities and numbers of infections leading the news, the stock market has recently rallied.
How can bleak economic reports about sickness, death, record unemployment and business failures be accompanied by a positive surge in the stock market? The last few weeks have produced many examples of the oftentimes stark contrast between stock market performance and economic indicators. So why the apparent disconnect?
Markets have historically moved in anticipation of events. In other words, stocks fell before there were any real apparent economic impacts of the Covid-19 shutdown. When investors in aggregate begin expecting the economic environment to change the cash flows of businesses, stock markets tend to follow those expectations well in advance of those changes being reported. The downward direction of the stock market in March suggested that investors feared that the shutdown could lead to a economic disaster. While the expectations of a slowdown have largely proven true, it may not be as bad as was expected. So while the news may be poor, it can be greeted with a positive stock reaction. The markets seem to embrace “The Suck”, often times when things seem to be at their worst. What is actually happening is that investors are not focused on how bad things are today but instead how they may look months or even a year plus from now. This phenomenon is explored in the following excerpt taken from a recent Dimensional Funds article titled “Under the Macroscope: When Stocks and the Economy Diverge”.
LOOKING AHEAD
We can see this anticipatory nature of markets in action by looking at the relation between US gross domestic product (GDP) growth and equity premiums, or stock market returns in excess of one-month US Treasury bills. When annual US equity premiums are plotted against GDP growth for the same year (top panel of Exhibit 1), there is no discernible relation between the two. Changes in GDP have not been strongly related to simultaneous stock market returns. It’s important to note that this result does not imply financial markets ignore macroeconomic data. After all, GDP encompasses several measures of the economy, not just corporate profits. However, while GDP may be an imprecise representation of the activities that ultimately drive stock prices, further analysis shows that is not the sole cause for the lack of relation between GDP growth and simultaneous equity premiums. Plotting GDP growth against the previous year’s equity premium (bottom panel of Exhibit 1) reveals a noticeable relation. The positive trend in the data suggests market prices have in fact reacted to changes in GDP but have done so in advance of these economic developments coming to fruition. This result is consistent with markets pricing in their expectation of economic growth.
Exhibit 1. Plot Development
US equity premium vs. GDP growth, 1930— 2019
Past performance is not a guarantee of future results. Annual GDP growth rates obtained from the US Bureau of Economic Analysis. GDP growth numbers are adjusted to 2012 USD terms to remove the effects of inflation. Annual US equity premium is return difference between the Fama/French Total US Market Research Index and One-Month US Treasury Bill. Equity premium data provided by Ken French, available at mba.tuck.dartmouth.edu. Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP. “One-Month Treasury Bills” is the IA SBBI US 30 Day TBill TR USD, provided by Ibbotson Associates via Morningstar Direct.
MARKETS AT WORK
Macroeconomic variables and investment decisions are like frozen turkeys and deep fryers—caution should be exercised when combining the two. The results presented here are consistent with markets aggregating and processing vast sets of macroeconomic indicators and expectations for those indicators. By incorporating this information into market prices, we believe public capital markets effectively become the best available leading macroeconomic indicator.
If embracing recent market behavior is proving to be easier said than done for your plans, perhaps you should get in touch for a review. The sooner you get oriented back to your goals and objectives, the sooner you can accomplish them.