CAPITAL IDEAS: Stock market heat

“I gotta hold on to my angst. I preserve it because I need it. It keeps me sharp, on the edge, where I gotta be.”—Vincent Hanna

Question: Hey, Allen, the stock market has been hot, and now it’s overvalued. Why do you remain invested?

That’s a question I was asked recently. And by recently, I mean almost every week for the last few months.

When asked that question, I actually want to answer a different question. I don’t want to answer “why,” I want to answer “how.” The answer is “apprehensively.”

Today the stock market reminds me of the two times I jumped out of an airplane (which was enough, thank you). I knew I would be okay and I knew, once the parachute opened, I was going to have fun. But I was not looking forward to the intimidating part — the initial drop.

That’s probably the worst analogy I can come up with for feeling apprehensive about the stock market in the short term when I still feel comfortable with the long term. Like, we don’t stop falling once we jump out of the plane. But you get my point — even if you know you’re going to ultimately be okay, life can be scary.

Okay, so now that you helped me with my impromptu therapy session, let’s get back to the original question — “why” do I remain invested? The question of “why” can be interpreted in a couple of ways.

First, it can be interpreted as, “why don’t you try to time the market?” The quick answer to that interpretation of the question is “because I’m not smart enough.” Naïve people seem to think there’s some way to do that. Most people, I think, understand that there’s no way to consistently and reliably time the peaks and troughs of those run-of-the-mill corrections. That’s true for the 5 percent corrections the stock market experiences, on average, three-and-a-half times per year. It’s true for the 10 percent correction that happens every 14 months. And it’s true for larger pullbacks.

But don’t take my word for it. Dalbar has been analyzing investor behavior and actions for 27 years. I won’t drag you through the details; you can purchase their annual Quantitative Analysis of Investor Behavior (QAIB) report to see all the nitty-gritty. The bottom line is that we all suck at timing the market. The 2020 QAIB report states that “since 1984, approximately 70 percent of ‘average investor’ underperformance occurred during only ten key periods in which investors withdrew their investments during periods of crises.”

Stated more plainly, people wrongly get freaked out and sell their investment positions when the market goes down. And then they don’t get back in. That’s a reason why, according to the same study, the average equity fund investor underperformed the S&P 500 by a margin of nearly 30% for the last 20 years.

Dalbar may measure the “average” investor, but make no mistake, we professionals aren’t much better when it comes to investment returns. According to Morningstar’s report How Long Can a Good Fund Underperform Its Benchmark, funds that “outperformed their benchmarks (in the years from 2003–2017) had also trailed that benchmark for an average of nine to twelve years.”

The underperformance of stock pickers isn’t new information. Still, the point is that all investors are pretty lousy at what they are trying to do. Some are a little less lousy than others, for sure, but they still aren’t mystical rock stars. As someone offering you investment advice in the form of this column, I consider my value to you to be, at least, two-fold. Firstly, it’s a form of insurance. I try to protect your portfolio (and mine) by determining when to get conservative. Secondly, I go through the pain with you, especially when it’s scary. I try to keep you invested in the stock market instead of both of us freaking out when the market goes down and selling at the wrong time. Being scared is okay. I’ve got to hold onto my fear. I preserve it because I need it. It keeps me sharp, on the edge, where I gotta be.

The second interpretation of “why” to remain invested in an over-valued stock market is, “what’s your rationale?” Throughout the last couple of months, I’ve cited evidence to support the prudence of my stance. Allow me to update some of the evidence suggesting that it’s the right move to stay invested right now, even if the stock market is overvalued. Answering that question now is particularly timely given the recent weakness in the Technology Sector. Stock market leadership ebbs and flows, but Tech has been the undeniable leader for several years. Since the Tech sector has ballooned to more than 27 percent of the S&P 500 index, according to State Street Advisors, its pullback feels that much more threatening. It feels like I’m about to jump out of a plane. I need some surety that the chute will open.

My stock market parachute is stitched together with various other risk appetites. Investors are not shunning risk, as evidenced by the strength in small-cap stocks, junk bonds, and emerging market stocks. That high-risk appetite is significant because the stock market’s price-to-earnings multiple can get bigger if driven only by investor sentiment.

Still, as I’ve said, I remain apprehensive regarding the short-term stock market path. That short-term concern needs to be weighed against longer-term risks and rewards. I want to feel comfortable that a stock market correction is just a correction. I can stomach a correction if I know my parachute is going to open. But I don’t want to go through something like the three 40-50 percent pullbacks the stock market has experienced throughout the last couple of decades. I don’t think the next correction will be the start of one of those monster crashes.

More COVID-19 vaccine inventory will enable the economy to reopen and allow for continued growth. Also, the short-term pullback that Tech stocks, and some other stocks, experienced was due largely to a quick rise in bond yields. But let’s consider a couple of things. Let’s consider why bond yields jumped; and let’s compare current yields to past yields.

Bond yields rapidly rose in response to strong economic growth and some higher inflation expectations. More economic growth and more money movement is not a bad story for supporting stock prices.

Still, rising bond yields can cause some consternation for the stock market. Higher bond yields retard economic growth and slow earnings acceleration. However, some perspective may help you understand why I remain invested when the stock market is trading at high valuations.

According to the above chart from MRB Partners, real bond yields (“real” means “adjusted for inflation”) on the 10-year Treasury are negative. And while the roughly 3 percent average mortgage rate was a move higher from recent lows, it’s still much lower than the 5 percent level reached in late 2018. The 5 percent mortgage rate level slowed the housing recovery at the time. Bond yields are low enough, and the Federal Reserve is accommodative enough, for me to remain invested in equities even as stocks appear overvalued.

Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing investments of more than $500 million. Unless specifically identified as original research or data-gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable. Full disclosures. Direct inquiries: [email protected].

This article originally appeared in The Berkshire Edge on March 8, 2021