What is happening in markets and what you should do now
The market appears to be going through a fit of irrationality. Investors would be wise to steer clear of letting an unpredictable market dictate their next move.
I don’t often write about short-term market movements. I find the whole thing exhausting. On most days the market goes up or down some fraction of a percent which is followed by commentators making up some reason to explain it. We are told the market dropped 0.08% because of “profit taking” and go back to whatever it is that we were doing.
The last few days have been a bit more dramatic. And this is where market movements impact something I do care about – investing. Investing is the process that we all go through to take our savings and grow them to achieve a goal. And it is the consistency and patience we exhibit during that process that is the biggest driver of results. At times like this our emotions make this harder. And that is when we make mistakes which can have a large impact on our outcomes.
A brief overview of what has happened provides a backdrop for the challenges investors are facing. It has been a rough couple days in share markets around the world. We can start with Japan where the Nikkei plunged 12.40% on Monday which was the biggest drop since 1987. This followed a fall of 5.8% on Friday. It was just last month that the Nikkei hit a record high. The index is down 25% since.
In Australia the ASX 200 dropped 3.70% on Monday. That followed a rough Friday session as the index has dropped close to 5.5% in the last two trading days.
Much of the turmoil began in the US. First there are concerns about the commercialisation of AI off the back of earnings from the tech giants. And then there was the jobs report which showed weakening conditions and set off the panic alarm that the US economy was headed for a recession.
The Nasdaq has been hit hardest and entered correction territory with a 10% drop from recent highs. Over $1 trillion US has been shaved off the market caps of the magnificent seven. As I write this early Tuesday morning the US market is down again with the S&P off by around 3.00% and the Nasdaq is down close to 4%. The headlines are far more dramatic than the run of the mill explanations we are used to.
How should investors react?
If you’ve been paying attention to markets over the past week you are probably feeling like you need to do something. This is natural. We humans have an action bias. When confronted with something scary we go into fight or flight mode. And we’ve been presented with something scary as the media has painted an ugly picture.
At times like this I think it is beneficial to take a step back and try to rationally assess if the facts have changed or if sentiment has changed. And this is where I like to turn to Ben Graham’s personification of investors as “Mr. Market”. There are a lot of quotes about Mr. Market from a lot of famous investors. I think the following quote by Charles Ellis fits the current situation nicely:
“Ben Graham and Warren Buffett have talked about a charming, seductive manic-depressive gentleman named Mr. Market. Every day he shows up on your doorstep offering to do business with you, When he's manic, he'll offer to buy your stocks or sell you his for absurdly inflated prices. When he's depressed, his prices go ridiculously low. The mistake most people make is answering the door just because Mr. Market knocks. You don't have to let him in. Why should you buy just because he's excited? Why should you sell just because he's down in the dumps? A long-term investor shouldn't care about market prices.”
There is a reason that Ellis describes Mr. Market as “manic-depressive”. He is diagnosing the market with a disease that involves intense mood swings. And that is what we’ve been seeing the last couple days. I want to be clear that in no way do I think this depressive state of Mr. Market has made share prices go ‘ridiculously low’. Maybe that will come. Maybe it won’t. My point is the dramatic actions of the last few days are the result of a mood swing that can’t be justified by facts alone.
Have the facts about AI changed?
Investor worries about AI commercialisation has been mentioned as an explanation of the drop in the major tech shares that have driven the US rally over the past couple years. This shift in sentiment on AI is a good symptom to start with to see if Mr. Market has fallen into a depressive state.
The trigger for this sentiment shift has been investor fears that tech companies are spending too much money on AI and that the opportunity to commercialise these investments will take longer than thought.
The tech companies are spending a lot on AI. CEO Mark Zuckerberg originally said that Meta would spend $30 billion US on AI related tech infrastructure in 2024. During first quarter earnings he announced they would spend $35 billion US. Last week he said it would be at least $37 billion and that the company would spend even more next year.
Not to be outspent Alphabet splashed $145 million US per day on AI infrastructureduring the second quarter. This is a lot of spending and I do think investors should be concerned. The spending also seems to be accelerating. This can happen if a company sees a great opportunity. It can also happen if a company sees a mortal threat.
In the case of Meta and Alphabet I think it is the later. They both have near monopolistic control of social media and search respectively. Neither of them charges for these basic services but use them to sell advertising. AI is existential threat. Being the best at searching the internet for the right answer is less valuable when AI will just tell you the answer. The ability to generate an additive feed to get people to scroll through dog videos for hours on end is less valuable when AI can personally curate content for each person. Both companies need AI to defend their turf.
Is the market rationally assessing these concerns which has sent Meta shares down close to 12% in the past month and Alphabet shares down close to 15%? I don’t think so. None of this information is new. The business model for Meta and Alphabet hasn’t changed. Spending was high. It is still high.
If the concern was tech companies overspending it would make sense for the beneficiaries of that spending to be flying high. That is AI poster child NVIDIA. Most of this spending is on new data centres as AI requires a lot of computing power. And the more AI computing power used the more chips sold to support it. Despite this orgy of spending NVIDIA shares are down 20% over the past month.
I don't think any of us know how AI will impact companies and how it will impact the world. Who will be the beneficiaries? The companies that create the technology? The companies that provide the inputs to AI? The companies that use AI to operate existing business models more efficiently? I think we can confidently say AI will have a large impact on the world. I also think it is hard to know exactly what that impact will be. None of these questions have been answered in the last month.
The fact that it is hard to find a rational explanation for these dramatic market moves is an indication that Mr. Market’s mania over AI has turned into a depressive episode. That makes the next move extremely unpredictable.
The chances of a US recession
A jobs report on Friday in the US showed that in June fewer new jobs were added and the unemployment rate rose to 4.3%. This set off the plunge in the US at the end of last week which has carried into trading on Monday. Investors are worried that the US is headed to a recession.
Until Friday, stock investors had taken any news of a softer economy as proof that there would soon be room for the Federal Reserve to cut interest rates. This has been a continuation of the strange situation we’ve been in for the last couple years. The market was so fixated on rate cuts that bad economic news was cheered on by the market because it was thought that it would eventuate in lower interest rates.
Now apparently bad news is bad news. Chief US economist at Morningstar Preston Caldwell explored the jobs report and cited the “Sahm Rule” as one of the reasons the US market is spooked. This is the first time I’ve heard about the Sahm rule. But I did some research. It was named after a former Federal Reserve economist named Claudia Sahm in 2019.
The press is breathlessly reporting that the Sahm rule has never been wrong. This is a generous interpretation of the facts. The Sahm rule was cited in a paper she wrote arguing that government stimulus should be applied at signs of a recession. She deliberately searched for an indicator of previous recessions. It was designed to explain every previous recession by back testing different variations of a rule until one was found that explained them all. Describing it as never being wrong is a bit of a stretch.
Maybe we should hear what Sahm has to say about her rule. She said "The Sahm rule is an empirical regularity. It’s not a proposition; it’s not a law of nature. I created the Sahm rule to send out stimulus checks automatically. The idea was to act fast to make the recession less severe and help families. The star was always the stimulus check, not the indicator that other people named after me.”
The Sahm rule just seems to be a bit of drama inserted into the situation to drive Mr. Market into a depressive state. The US economy does look to be slowing. Then again, the Federal Reserve has been trying to slow the economy to control inflation. And it looks like there is a lot of good news on the inflation front and interest rates may come down. On balance things look pretty good economically.
Yet I can’t help but think that after years of having interest rate cuts as the holy grail for the market it is strange how quickly things have turned. Strong economic readings used to make the market go down. Poor readings made it go up. This seems to me to be another indication that Mr. Market has simply switched from a manic to a depressive phase. When the Mr. Market is depressed he finds reasons to be depressed and ignores the good things going on. That seems to be what is happening.
Is this a unique set of events?
The question is if investors should do anything after the last couple days. Are we entering a bear market? Nobody knows. Most of the people we see quoted in the press about what the market will do next are wrong. I can confidently say that because they are always mostly wrong. It is just too hard to predict the future over the short-term to make most pronouncements anything more than a guess.
Imagine a scenario where an investor made changes to their portfolio based on changing consensus views of economic conditions. That would have been a lot of changes over the past couple years. It is hard to remember each time the consensus about interest rates have changed. It is hard to remember each market reaction. It was all just noise.
In 2022 the S&P 500 corrected four times which is a drop of 10% or more. In 2023 there was one market correction. Since 1980 the S&P 500 has dropped 5% to 10% 4.5 times a year. It happened 12 times in 2022 and 3 times in 2023.
I’m not trying to minimise what you are feeling right now. It is natural. I am just trying to provide some context. This happens all the time. The explanations in the media don’t hold up to scrutiny. Market sentiment can switch quickly.
The fact that these moves are based on emotions that turn so quickly shows how unpredictable the market is right now. That unpredictability makes it foolish for an investor to try and act in anticipation of the next move. Chances are anything you do now will diminish the outcome you achieve over the long-term.
What is the cost of emotionally driven trading?
There is ample research that the average investor underperforms by 1.00% to 1.50% a year due to emotional selling. Morningstar’s former head of behavioural science Steve Wendell conducted a study showing those results. Researchers Friesen and Sapp (2007) estimate that emotional selling decreases investor returns by about 1.50% per year. Vanguard also places it at about 1.50% annually (Bennyhoff and Kinniry 2013). Morningstar's Mind the Gap study has shown how investors have underperformed the investments they bought and sold by up to 1.70% a year.
This is a profound difference in outcomes over the long-term. This is the difference between financial independence and just scrapping by. It is the difference between achieving your goal and having to compromise.
Final thoughts
My advice is simple. If you don’t have an investment strategy now is a good time to create one. If you do have a strategy, then follow it. Control what you can control. Make sure your asset allocation remains appropriate for the returns you need to achieve your goals. Focus on saving money and investing it according to your plan.
Do your best to control your emotions. Guard against your action bias creating justifications to do something. The future market moves aren’t any more predictable than what has happened in the last few days.
If you feel the urge to take action put some effort into slowing down the decision making process. Write down all the reasons why the move you are contemplating is the right thing to do. Write down all the reasons it isn’t. Call up a mate and talk through what you are considering. Shoot me an email at [email protected] – I can’t tell you what to do but might be able to point you towards some resources that will make you think.
It is understandable if you are feeling nervous about what is happening. It is up to you to control how you react.
Here are some additional resources to help you understand what is going on and to stay focused on the long-term.
