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For the first time in decades, Wall Street strategists are collectively pessimistic about the stock market over the coming year, according to Bloomberg. Prior to the dot-com and financial crisis collapses (2000, 2001, 2002 and 2008), Wall Street strategists predicted stock gains for the following year. Predictions of gloom are indeed rare.
Does this mean those strategists are super bad at prognostication and this is a contrarian indicator (time to buy)? Or is this a good reason for investors to position portfolios cautiously? By framing the question in terms of probabilities and consequences, investors can get a clearer path.
Over the past year, my firm conducted surveys with investors and advisors that addressed market bubbles and bear markets. The results of these surveys unearthed some fascinating findings:
We cannot always see what is in front of us.
Only 52% of advisors and 42% of investors thought we could expect to experience a bear market within the next 12 months. In fact, we were in a bear market five days after the survey was conducted1.
Clients are worried about the future and advisors may not always be aware of the depth of their concerns, expectations, and anxieties.
Almost one-third of clients (30%) somewhat or strongly agreed that they were concerned about outliving their money. Only 31% of advisors correctly identified the scope of the concern; fully 44% said that fewer clients were concerned.
Seventy-eight percent of investors expressed some level of concern that a bear market may cause them to outlive their money, and 84% of advisors thought that clients should be concerned.
Eighty-three percent of investors said they experience some level of anxiety when thinking about their investments. Twenty-one percent of clients said that their level of anxiety is “very high.”
A relatively small percentage of clients felt they had a clear plan of action in the case of a bear market.
Fifty-two percent of investors reported that their advisor has shared a formal plan of action in the case of a bear market.
Developing a plan has a significantly positive impact on client confidence.
Eighty-four percent of investors reported that they are somewhat or significantly more confident that they will reach their financial goals as a result of having a plan to address a bear market. Advisors were even more optimistic at 99%.
Like Wall Street, investors are not adept at predicting markets. Many feared for their livelihoods and were potentially set up for poor decision-making as a result. This brings us back to the first part of my approach to framing the markets: probabilities.
After reading the above, you may wonder: Who cares what people think the probabilities of further decline are?
My analysis suggests that there are good reasons to be skeptical about stock gains this year. Valuations remain high, so further erosion in prices is possible even before considering the prospect of declining earnings, which many suggest are inevitable. Also, valuations have been a decent predictor of stock returns. At nearly 20-times trailing earnings on the S&P 500, we are still well above mean historical level of 16-times earnings, meaning that valuations may act against rather than in favor of strong returns. Although inflation appears to be ebbing, high inflation in the U.S. has historically lasted between four and nine years over the past century. There may be a self-fulfilling logic at play here that is eluding investors. If inflation declines and causes markets to gain, the wealth effect could increase consumption, improve employment, and spur inflation. The sad conclusion may be that the Fed will be forced to put further downward pressure on the economy and financial assets to find a durable solution to inflation.
Alternatively, stocks can gain in 2023. If people are willing to pay infinity times (no) earnings for bitcoin, why can’t they pay 25- or 30-times earnings for legitimate companies? Ideally, inflation may have been tackled, creating an “all-clear” sign for stocks to advance.
Stocks may advance, but there is some probability – let’s say for arguments sake it is between 25% and 50% – that stocks lose ground in 2023.
Consequences of further declines
In my firm’s investor survey, we asked investors about how far stocks declined during the Great Depression, the 2008 financial crisis, and the COVID pandemic. Only about a quarter of investors could correctly identify the range of losses during any period. Similarly, investors likely fail to understand that losses can stretch for multiple years, especially since bear markets over the past 20 years have only lasted as long as 16 months. But negative consequences for investors are amplified when large percentage declines occur over long durations. During such periods investors can lose faith in the possibility for returns, but they may also be forced to liquidate assets at losses to meet living needs. People near or in retirement may not be able to retire or may have to reduce their standard of living.
This is the real economic risk to investors. For advisors, another year of losses in stocks and bonds – similar to what we saw last year – would create significant challenges to investor retention and revenue. While the probabilities of further declines may be debatable, the consequences would be severe.
Despite all of this, many continue to bet on only the optimistic scenario: Stocks will eventually recover, and one should just wait it out. I have great respect for Eugene Fama and agree that markets are generally efficient and that yes, ultimately, stocks will recover. However, if the consequences of further declines are too great for investors to bear in some cases, it pays to build contingency plans. There are multiple way to accomplish this, including hedging your bets through options contracts or hedged equity funds and adopting an adaptive, unconstrained fixed income approach to address possible further losses in bond portfolios.
Phillip Toews is the CEO and co-portfolio manager for Toews Asset Management in New York. Toews has spent the last three decades avoiding a majority of the bear markets by specializing in hedging strategies and behavioral finance. Toews also founded the Behavioral Investing Institute, which offers coaching programs to help financial advisors manage investor behavior through market challenges.
1The study was conducted between March and April of 2022, and was released in February 2023.
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