Markets, Economy

Weekly Kickstart (06/01/2020-06/05/2020)

6/1/20 8:00 AM

iStock-626627280.jpgStocks continued higher last week, as the S&P 500 rose by 3.01 percent to 3,044.31. That left the benchmark index down just 5.77 percent 2020-to-date, and 36.06 percent above the March panic low (closing basis). Given how sharp and relentless the rebound in the market has been many investors may be worried that the likelihood of another large correction has increased. Such concerns are understandable since there are indeed many potential catalysts for equities to pull back in the near-term, e.g. elevated uncertainty still surrounding COVID-19, the economic recovery, and U.S.-China trade relations. However, the depth of any immediate drawdown could be limited, save another exogenous shock, thanks in part to the unprecedented financial support provided by Congress and the Federal Reserve that removed a lot of the downside tail risk that existed in March when the coronavirus crisis was just getting started. Further, there is a long history of the probability of something happening in the market and the severity of what actually does occur being overestimated by regular investors, according to a well-known academic study.


Indeed, on October 19th, 1987 the S&P 500 plunged by over 20 percent, the largest single-day drop on record. Ever since then the researchers have been polling investors on the perceived odds of a similar market event happening within the next six months. Over the roughly three-decade sample period respondents have typically assessed the likelihood of a comparable crash as being around 10-20 percent. Given that there have so far been zero “Black Mondays” since 1987 (even including the recent market tumult), investors were clearly overestimating the probability of a repeat occurrence. This exaggeration was found to be even greater when an adverse event was being widely covered by the financial media, e.g. surveyed investors would often assign a significantly higher crash likelihood if asked during or soon after a big down day in the market. That is just one of the many examples of how investors will frequently rely on easily-recalled information to estimate the probability of something occurring. The researchers also found that crash assessments can negatively influence equity flows (exacerbate the flight to and from risk assets), especially when investors give excessive weight to short-term fluctuations in the market. Such irrationality can lead to people having too low a portfolio allocation in stocks simply because equities have been under pressure, and too high an allocation after a favorable period for the market. Altogether, this study is yet another reason why regular investors should stay focused on the long-term, refrain from making emotion-based trading decisions, and maintain a portfolio that is appropriate for their risk tolerance, nearness to retirement, and other unique circumstances. As always, we are here to help with any questions you may have.


To recap a few of the things we learned about the economy last (holiday-shortened) week, the positives included that mortgage purchase applications climbed for the sixth consecutive week, home values continued to rise, new home sales increased, inflation pressures remained nonexistent, regional manufacturing activity stabilized, initial jobless claims fell for the 8th straight week, and continuing claims declined for the first time since February. As for the negatives, the nation’s trade deficit (in goods) widened, consumer spending collapsed, and gauges of Americans’ optimism sent mixed signals. Put simply, the prevailing theme in the recent data continues to be that the backward-looking April figures are terrible but the incoming reports for May have improved or are at least less terrible, supporting our argument that economic activity likely bottomed in Q2. This week the pace of data picks up with several important reports on credit, construction, manufacturing, service sector activity, and employment scheduled to be released, including the potentially market-moving May job report from the U.S. Labor Department due out on Friday.


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Sources: Econoday, Yale SOM, FRBSL

Post author: Charles Couch