A brutal first week of September was a reminder not to underestimate the impact of the seasons on investor sentiment. It’s natural to become more susceptible to negative signals like last week’s disappointing US jobs report.
The glass-half-empty view looks something like this: the economy is finally slowing after two years of rate hikes; valuations are high after 23 months of share price gains since 2022’s downturn; the US Federal Reserve (Fed) has stopped worrying about inflation and is rightly focused on growth - it may cut interest rates by half a percentage point next week; bonds and gold are outperforming shares as recession looms; oh, and it’s September - the next two months are historically the worst of the year for investors.
If you are looking for a more technical reason to worry, the relationship between the yield on short-term bonds and longer-dated ones has also raised a red flag. For two years short rates have been higher than long ones, which is what happens when central banks are squeezing the economy with high interest rates to rein in inflation. This ‘inverted yield curve’ is the classic sign that a slowdown is on its way. Last week, short and long rates flipped over, in anticipation of what’s expected to be a change of direction from the Fed next week. Short rates are now lower than long ones. That ‘un-inversion’ of the yield curve typically happens when the slowdown has actually arrived.
No surprise then that the days following the Labor Day holiday in America were the worst start to a month all year. The S&P 500 fell 4 per cent and the growth-sensitive Nasdaq was 6pc off. The shares most exposed to a slowdown, and particularly those that have benefited from the artificial intelligence (AI) growth story, bore the brunt of the sell-off. Nvidia fell 20 per cent in three weeks.
The technology sell-off has played into the hands of the seasonal pessimists because it has disguised a healthier market than the drop in the headline index level might suggest. The Magnificent Seven have underperformed the equal-weighted S&P 500 index by nearly 10 per cent over the past three months. At the same time, smaller companies have broken out upwards from a two-year slumber. Nearly three quarters of shares are in an uptrend. Earnings forecasts for 2024 as a whole continue to look for near double digit growth.
We find ourselves in the curious situation where the market indices that we all watch closely could be falling even as most shares are still grinding higher. It’s easy to be blinded by the headline level of the market and to miss the opportunities lurking below the surface. As they say, it’s a market of stocks not a stock market.
Which raises a broader question about why the pessimistic view of the market is so seductive. Or, as Morgan Housel says in his excellent book The Psychology of Money, ‘pessimism holds a special place in our hearts. It sounds smarter. It’s intellectually captivating and it’s paid more attention than optimism, which is often viewed as being oblivious to risk.’
Pessimism sounds clever. But it only rarely makes sense for investors. The progression of stock markets over the long haul has rightly been labelled by investment historians Elroy Dimson, Mike Staunton and Paul Marsh as ‘the triumph of the optimists’. As Housel also said, ‘if you want to do better as an investor, the single most powerful thing you can do is increase your time horizon’. One of the underappreciated reasons Warren Buffett got so rich is that he started young and is still going strong in his nineties.
So, why do we fall for the pessimists’ fallacy? A few reasons. First, there’s a good evolutionary reason to see danger all around us. As Daniel Kahneman, author of another great book on behavioural investing, Thinking, Fast and Slow, says: ‘organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.’ But what kept us alive on the savannah, also encourages us to be over-cautious investors.
Second, pessimism has the edge over optimism when it comes to money because when something bad happens in the financial world it affects us all, unlike say a weather event or a motorway pile up, which can be catastrophic for some but leave the rest of us completely unaffected. Even if you don’t own shares, a drop in the stock market may lead to you or someone in your family losing their job in due course. Fewer than 3 per cent of Americans owned shares in 1929 but the market crash triggered the Great Depression.
Third, pessimism can be self-feeding because of our tendency to extrapolate in straight lines. We forget that the economy is always adapting. Take oil production, which rose from five million barrels a day in America in 2008 to 13 million by 2019. The reason was that the oil price, which had been US$20 a barrel in 2001, rose to nearly US$140 in 2008. The incentives changed and, as a consequence, the arithmetic of supply and demand did too.
Finally, pessimism trumps optimism because positive change is often slow and imperceptible while bad things happen in a rush. Housel points to a 70 per cent drop in deaths from heart disease in the 50 years from 1965. ‘We could have a Hurricane Katrina five times a week, every week and it would not offset the number of annual lives saved by the decline in heart disease.’
It’s easy to focus on what could go wrong. But it’s not an investment strategy.
Tom Stevenson is an investment director at Fidelity International. The views are his own.
