July 10, 2022
Sid Roy
This is a follow-up to last month’s article on investing discipline in market volatility. This was a very relevant topic considering the current market and what is happening to bonds and stocks. We covered a lot of ground in last month’s session. We talked about the two things that trip up even a model investor – risk capacity and risk tolerance. If you have not read that article, it is here.
In today’s article, we go a bit deeper into the root of the problem. Many of us have started with a thoughtful investment strategy and are trying hard not to lose faith. But we do feel uneasy about the market. There are lots of things that are changing in the market, the broader economy, and the world. Let’s try to make sense and retain perspective as an investor while pondering some of these issues.
For starters, inflation is at the highest level it has been in a long time. Many of us have not seen this kind of inflation. This is causing the Federal Reserve to raise interest rates rapidly. Due to the rise in interest rates, stocks and bonds both have been losing value. And we are in a bear market now. Added to this above, the war in Ukraine is also affecting supply of energy and agricultural products, which in turn is having an impact on inflation. Pandemic-related issues continue to affect supply-chain, causing a reconfiguration of certain productions and businesses in response to geo-political realities.
This is also a sharp contrast to the situation a year back and it is understandably unsettling. There is probably one positive aspect to the bear market. It indicates that valuations of stocks are not completely irrational anymore and they reflect a more pragmatic view. The swinging back and forth of the pendulum is reassuring in that sense.
If you have been observing the movement of asset prices, you might have noticed how bonds and stocks are moving in the same direction – lower. Obviously, this can cause you to question what you know about correlation of assets. Bonds and stocks are supposed to go in opposite directions. The insight here is that asset prices tend to follow each other over short durations during times of crisis.
It is hard not to acknowledge inflation and its effect on one’s savings though. There is also no clear horizon on when the inflation will go down and how much the interest rate will have to go up to tame inflation. If, however, one looks at the long-term horizon say the last twenty years or so, overall inflation does not seem too scary. Inflation has historically tended to be high in short bursts while remaining around 2-3% for the most part. This should give us some perspective as well.
The third scary part is the reconfiguration of the international orders and the supply chains. Some of these changes might seem like once-in-a-lifetime disruptions. However, if we step back and take a broader view – changes have been happening all the time, sometimes quite rapidly. For example, if we go way back, the globalization wave created opportunities for China due to its cheaper manufacturing cost, and it came at the cost of large-scale reduction in blue-collar jobs in the West. As China’s economy took off and its labor costs rose, other countries became more attractive, and manufacturing bases changed to become a highly interconnected and optimized process across geographical boundaries. With the pandemic-related closures in various geographical pockets, and the geopolitical issues at hand now, we might see some more changes with more near shoring happening in some industries.
However, companies have grown and made money amidst all such changes. In fact, such changes are happening to make sure that the global economy wakes up to certain realities and adapts to the new world. The only difference is that new companies have come up, some existing ones have survived and thrived, while some others did poorly and are facing extinction. While the fate of an individual company may be uncertain, stability and growth of the global economy is inevitable. Companies will find a way to optimize, and the current volatility will recede eventually. But that stability will again be short-lived, until the next black swan event strikes. And then the cycle will repeat itself. In short, these cycles are expected though it appears to be new and unprecedented.
That brings us back to first principles. If we aren’t spending our energy in vain to pick individual winners and losers in an uncertain environment, or taking impulsive investment decisions in futile market timing, we don’t have much to worry about. As long-term investors with a well-diversified portfolio aligned with our financial goals, we should see stability and growth in due time. This assurance should be enough to cope with the rollercoaster ride we are on, instead of questioning sound investment principles.