”Investors have put more money into stocks in the last 5 months than the previous 12 years combined.”[1]

1. This is the recovery!

For months, we have heard about an economic recovery that is just around the corner. However, since November of last year, capital markets – and thus the economy – have been downright euphoric. Asset prices of risky assets (stocks, real estate, commodities) have risen in advance of what is perceived to be an economic recovery that is waiting just around the corner. But separating asset prices from the economy is very difficult, when largely, they are one and the same. Euphoria in investment markets typically leads to economic improvement, and hence the stock market almost always leads the economy. We believe this time is no different.

Key investor takeaway

Waiting for a recovery? This may be it. It’s likely that the gains we are seeing are both speculative hope as well as investors banking on the future. With performance in risky assets being far beyond historical norms or expectations over the last 6 months, it is also likely that most of the gains from an expected economic recovery have already occurred. From here, we believe the capital markets will patiently wait for the economy to catch up to pricing optimism, and the errors – or simply overestimation – may very well fall on the side of disappointment, as the economy has potentially already recovered.

2. Interest rates rising due to a strong stock market is normal.

In the first quarter, U.S. interest rates reflated, which caused most bond prices to sink. It is quite normal for interest rates to rise during strong upward movements in stock and real estate prices, and especially given the circumstances. First off, interest rates were exceptionally low given the pandemic fears of 2020. Second,  an improving stock market increases the competition for capital as investors move from conservative assets (fixed income and absolute return) to risky assets. Third, strengthening stock and real estate markets normally lead to a better economy and more money chasing goods and services, which can then, in turn, lead to some form of inflation – and inflation is an enemy of interest rates.

But how far will they rise? The answer to that is part an analytical assessment and part a guess. Interest rates across the globe have experienced downward forces for the last 40 years. Most of those forces are still in place, despite the current climate of euphoria.  It is actually surprising that interest rates haven’t risen further, which is a testament to the power of the long-term forces driving interest rates lower. That being said, interest rates are characteristically self-correcting, and the higher they go, the worse off the economy will be – so down they come again. Historically speaking, U.S. interest rates have not risen much more than 2% before the heat is felt in the stock market and the economy. So far, this time around, intermediate interest rates have risen about 1%.

Key investor takeaway

It is always frustrating when the conservative assets in a client portfolio lose value. But in a truly diversified portfolio, stocks are likely performing well when bonds are losing money. This is currently the case.  Stocks like optimism, whereas bonds react to pessimism, and diversification is the art of combining the two in a manner that creates more consistent return patterns than either of the assets alone would. It is almost impossible to reliably manage risk in a portfolio without owning bonds. We at Frontier do not believe that the concept and use of bonds in a portfolio have been impaired. To us, what is occurring in the bond market right now is normal based on historical data.

3. Party Like It’s 1999!

Many astute, experienced market participants have likened the current euphoria in risky assets to what occurred during the late 1990s tech boom/bust. They may just be on to something. To start with, market leadership has been dominated by tech stocks over the last 5 years. In 1999, too, the world was preparing for a catastrophe. The feared Y2K turned out to be under control. Finally, due to frenzy around stock prices, millions of participants entered the marketplace using new technology to day trade – back then, it was online trading; today, it’s fractional share apps on the phone. There are many more similarities, but to jog your memory with the essentials: tech stocks lost 70% of their value in the impending crash and the day traders were wiped out.

Key investor takeaway

Returns of risky assets have been amazing over the past year. At times like this, it seems like everyone is making money, and the new goal is to “keep up.” Investors feel enticed to abandon well-laid plans and logical portfolio structures to join the stock race. Buying more stock is easy, yet it can also be a risky proposition. Investors often choose investments based upon recent past performance. Seeing whatever is currently winning isn’t hard, but remembering that investors do not get past returns seems to be. Investing is not about what has happened – that’s called history. Instead, investing is all about the future and about what is likely to occur going forward. So when you feel that the past returns are a little too good to be true, trust your gut.

History is littered with time periods that go beyond reason or logic for any investor looking for one. Consequently, though, there are equally many periods that show the tide inevitably turning. It is easy to forget the downside of investing when recent past returns have been this good and alluring to start wanting to seize the day and to try to “keep up.” We at Frontier remember that history is not linear but cyclical in nature.

[1] Source: CNBC, “Investors have put more money into stocks in the last 5 months than the previous 12 years combined”, April 9, 2021.