Since January 3, 2022, the stock market has taken an unfriendly turn to investors. Initially, 40-year high inflation and the fear of higher interest rates pushed prices lower. Then, on February 24, Russia invaded Ukraine, compounding the concerns of a broader military escalation and of a recession caused by skyrocketing energy and food prices.
Admittedly, even the most unemotional investors may be hard-pressed to maintain their composure under these conditions. So why should investors not sell out of their stocks? There are at least three compelling arguments for not selling.
Time in the Markets and Not Timing the Markets
Investing in the stock market is a long-term exercise in compounding. Compound interest is one of the most misunderstood mathematical marvels in finance. The growth of a dollar invested and reinvested over the years (10, 20, or 30 years) can turn into a substantial figure, just by getting a return on the profit previously accumulated in addition to the original principal.
This mathematical principle works wonders. However, if you miss even a handful of the best market days, the compounding may be severely impaired. As it happens, the best market days almost always occur in in the proximity of the worst ones. They are clustered. The good and the bad come together. As a result, the price for strong capital accumulation is enduring short-term drawdowns and volatility.
Financial markets work in inter-related cycles. They are all essential. They should be followed and understood: the corporate profit cycle, the interest rates cycle, the credit cycle, and so on. One cycle that is often neglected but very important is the investors' psychology cycle.
Investors' moods often swing from euphoria to sheer panic. Regardless of all other factors, times of euphoria are bad times to buy stocks, while times of panic are great ones. Luckily, today we have access to several quantitative metrics to measure market sentiment.
Research firm Bespoke Investment Group runs a composite of three sets of indicators to determine the mood of different types of investors: a) the individual investors (American Association of Individual Investors, AAII) b) institutional investors (Institutional Investors, II) c) active fund managers (National Association of Active Investment Managers, NAAIM).
The most recent reading of these surveys points to an extremely elevated level of fear and pessimism. In context, these metrics are where they were in March 2020 when the world was shutting down because of Covid-19. In other words, we are in a "maximum pessimism" situation in which nobody sees a way out.
From such levels of extreme bearishness, the S&P500 has historically seen strong returns 6 and 12 months after, with a high frequency of occurrences. Staying invested in stocks now, despite the gloom and doom, may be statistically advantageous for the next 12 months.
Cash Balances on the Sidelines
Some analysts recently estimated that the United States may be sitting on a cash pile of $19T between accounts of private individuals and companies. These cash balances are unlikely to remain unused, with interest rates significantly below the inflation rate.
Individuals will consume their dollars and support the economy or invest them in riskier assets to generate returns. Likewise, companies will buy back shares, pay dividends, or invest cash in future growth opportunities. Either way, all of the above are supportive of the markets.
The wall of cash on the sidelines is one of the best reassurances that we won't have a financial meltdown. Buyers will likely jump in as soon as they start to feel more comfortable.
The Bottom Line
Last week we mentioned that we are not buying the dip, because of an increased probability (very far from a certainty) of a commodity-led recession. At the same time, for investors who are invested adequately with a plan suitable for their age, conditions, and risk profile, we strongly advise against giving into fears and abandoning their investment program.
Market history has been very unkind to those making decisions dictated by fears, even when times look bleak and no reasonable path out seems evident.