At Flexible Plan, one of the many benefits of being in the markets for nearly 40 years is that we get to look back and test many of the constructive ways that would have best served our investors’ interests. Looking back through market history, it is easy to see that markets change and so should market tactics. Therefore, successful investors need to employ strategies that adapt effectively to market conditions we know will change over time.
The markets by decade
Let’s think through this. In the 1970s, I was in my 20s and only knew an inflationary life and high interest rates.
In the 1980s, life was good. Interest rates were declining and the economy was growing. Unemployment was declining and mortgages were only 6%–10%.
In the 1990s, all I had to do was buy stocks with a ticker symbol and it seemed I could make money. We lived through and enjoyed the tech craze when any publicly held company seemed worthy of a multi-billion-dollar valuation whether it earned money or not. Well, until the crash of 1998 when irrational exuberance, the impeachment of a U.S. president, and the failure of one of the world’s most highly regarded hedge funds woke everyone up from their rising-markets trance.
The thud of the 2000s made us feel vulnerable—excruciatingly so on the unforgettable day of September 11, 2001. But that was not the whole challenge for the financial markets. It took us a decade to work through the excesses of the 1990s. We recognized and re-recognized that equity markets can get ahead of themselves by building in great expectations. So, we had two declines of more than 50% just to keep the market in line.
In the second decade of the 21st century, we’ve had to figure out what to do with zero interest rates—or even negative interest rates. This phenomenon has wreaked havoc on traditional equity pricing models and made it difficult for insurance companies and pension plans to meet their respective obligations.
All of this would seem alarming if one were in the business of forecasting, but we at Flexible Plan are not. We simply respond to markets as history suggests we should. This tends to bias our portfolios in favor of equities in good economic times and to favor fixed income and alternatives in bad economic times.
At Flexible Plan, we have thrived—and will continue to thrive—through good and bad times because we do not try to predict them. We manage our way through them as they occur. We do not react, but we do respond. We take action when action is warranted.
Lessons on market patterns and investor behavior
One of the interesting observations we have seen through the years is the stair-step market process. This is evident in all markets and in nearly all time frames. More importantly, this cycle appears to drive many investors’ lack of patience to let good processes happen in good time.
Investors like to invest only in good times. We understand that. But those good times are generally not predictable. What we do know is that the “good times” can follow the frustrating sideways times. This pattern repeats even on a shorter-term time frame. In the following chart, we can see this pattern over the past 100 years.
A closer view of the past 30 years shows an equally dramatic perspective. In the following chart, we can see the advance followed by the sideways period of the early 2000s followed by the advance of the past 10-plus years.
While this pattern is interesting, let’s think about this in the context of our portfolio management. Markets do tend to move in this stair-step pattern. Identifying when a market (stocks, in this case) are in a sideways market continues to be a challenge. It is also not hard to see how there could be decades of frustration for the passive investor.
For active investors, these frustrating sideways periods can become periods of potential opportunity. Note, I am not saying every up and down in the market is exploitable. I am saying that meaningful advances and declines in the market present potential opportunities to be offensive and defensive.
It gets more interesting. Because we manage and monitor approximately 20,000 investor accounts, we have the ability to see how many investors respond to their investment performance. The responses aren’t surprising, but they are very human.
Based on our fairly extensive experience, here are three things we believe investors have in common:
- Individuals sell near market (performance) lows.
- Individuals will wait a long period of time before initiating a new account or adding to an account.
- (Here is the big one!) Individuals have demonstrated that they have only about a two-year window of patience to work through a sideways market. This is a sad fact since good things generally happen following periods of sideways activity. This performance behavior is also true of individual securities, actively managed strategies, and portfolios as a whole.
What can investors learn from market history?
Based on our experience, we believe one should invest more money during periods of a drawdown, not get overly enthusiastic after long periods of rising markets, and stay the course after periods of boredom or stagnation if the investment is still sound.
While I am on the subject, let’s take this one step further. Investors speak with their financial advisers with a long-term objective in mind. However, their behavior is often not aligned with their long-term objectives. Let’s look at a real case comparing an actively managed portfolio solution with an appropriate benchmark (see the following chart).
We see the same stair-step pattern of up markets following lengthy sideways markets. Keep in mind that both of these market conditions present unique opportunities for risk management as well as profit.
It is also worth noting that there is a tendency for a significant rise in high-profile, crosscurrent news flow during the periods of sideways markets as compared to periods of steadily uptrending markets.
The news headlines in the 1970s were about inflation. In the 1980s, they were about declining interest rates and the explosion of the internet and personal computers. During the 1990s, it was the “tech bubble.” During the 2000s, it was easy mortgages and the financial crisis. In the second decade of the 21st century, the news has been dominated by trade issues and low/negative interest rates around the world.
Despite the constant streaming of headlines that leans in one direction and then the next, the long-term driving force behind markets is almost always rooted in economics. Our methods measure and respond to how markets react to economic developments. That objectivity allows us to maneuver our way through the tidal wave of news headlines that seem to reverse course nearly every week.
Market update by FPI Research
Equity markets traded right below all-time highs set over the summer but closed the week slightly down. The Dow Jones Industrial Average was down 1%, the S&P 500 lost 0.5%, and the NASDAQ finished down 0.7%. Last week, as expected, the Fed decided to lower its benchmark federal funds target rate by 25 basis points. There was no substantial change in language compared to their prior meeting. Most noteworthy is that three members of the Federal Open Market Committee (FOMC) dissented from the policy move. This was the largest number of dissenting votes from policy makers since 2016. Two voters favored no change in interest rates, while one felt the cut should have been 50 basis points. With a lack of consensus about the direction of monetary policy among FOMC members, geopolitical issues, and continued trade uncertainty (Chinese trade negotiators canceled their U.S. farm visit), the markets have traded cautiously within a fairly narrow range for the past two weeks.
The “recession” word has been thrown around quite a lot over the past year, especially during the inversion of the Treasury yield curve. Estimates for the next recession have ranged from as early as this year to as long as five years from now. Leading indicators for August were released on Thursday, with no signal yet of a recession on the horizon. The headline index was unchanged, whereas expectations were a decline of 0.1%. As is visible in the following chart, a warning signal for an impending recession has been a downturn in the leading/coincident indicators ratio. The ratio is not currently in a decline, which has historically been seen leading up to past recessions. What the current snapshot is signaling is not an economy on the verge of entering a recession in the very near term, but one that is traversing through some difficult times, but doing so fairly well.
With the markets hovering around all-time highs in a range-bound fashion, we’ll take a look at one of our trend-following strategies as well as a strategy designed to perform well during mean-reverting market environments. QFC Classic, one of our main beta plays, is a trend-following strategy that employs risk management when volatility rises/markets decline. It has remained fully exposed to equities and declined 0.47% after fees last week. QFC S&P Pattern Recognition, designed to perform during sideways market environments and complement a well-diversified portfolio, was up 0.11% after fees last week. For comparison, the S&P 500 closed the week with a loss of 0.5%. Both strategies were developed to respond accordingly if markets break through new highs or see lower trading levels due to economic and geopolitical uncertainty.
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. Inherent in any investment is the potential for loss as well as profit. A list of all recommendations made within the immediately preceding twelve months is available upon written request. Please read Flexible Plan Investments’ Brochure Form ADV Part 2A carefully before investing. View full disclosures.