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A Gambler's View | Market Insights Thumbnail

A Gambler's View | Market Insights

Key Points:

  • Will the bear be back this year?
  • What excessive valuations tell us about future returns.
  • How financial trauma can skew our perceptions.
Doug Johnson CFA

If someone tried to describe the markets in 2020 in a statistical sense, the term “highly improbable” would fit well.  Yet when looking at all the things that have happened up to this point, many investors feel that 2020 still has more surprises to offer.  Schwab’s Chief Investment Strategist Liz Ann Sonders published a great piece recently outlining the aspects of this market that have many investors concerned.  I have provided the link below and I would encourage everyone to read through her piece…hopefully right after they finish this!

High Hopes: S&P 500 Hits All-Time High Amid Pandemic/Recession

Poker Hands, Outcomes, and Probability

The chart above shows the probabilities of getting a series of poker hands playing exclusively with 5 poker die.  Each of the five die has playing card images-Ace, King, Queen, Jack, Ten and Nine, on the six faces of the die.  The die are rolled at the same time and the images that come up on each dice are used to make the best poker hand.  For those not familiar with poker, a Straight represents 5 images in running order(A,K,Q,J,10 or K,Q,J,10,9) and a Full House represents a 3 of a kind paired with a 2 of a kind in the same hand.  A Bust represents a hand that has no combinations of any kind.   The biggest takeaway from this table is the probability column on the right side.  Not surprisingly, the chance of getting 5 of a kind or the exact same symbol on each dice is less than .10% or 1 out of 1,296 rolls.  On the other end of the spectrum, the chance of getting 1 pair is around 46% or 1 out of 2.17 rolls.  Obviously, a player has a much better chance of getting a pair than 5 of a kind.

Why Do We Care?

So what can this chart tell us about the current market environment?  To be honest, probably not a whole lot.  But it can tell us about how people are likely to react to the current environment.  When reading through Liz Ann Sonders piece, you will see that only a handful of stocks are dominating the return profile of the indices.  In addition, valuations remain extremely elevated.   Historically, the combination of high valuations and high index concentrations have lead to a high probability of lower than average returns on a forward looking basis.  So, we have a high probability of knowing the ultimate outcome; the problem is that no one knows exactly how we will get there.  The path could be poor returns in the next few years followed by unusually good years, the exact opposite, or simply a string of below average years with no big spikes or troughs.  Point being, long-term is another way of saying, even though we know the most likely outcome, it doesn’t have to happen right now.

Now back to our poker odds.  Most skilled gamblers would conclude from the chart above that getting 5 of a kind is a highly improbable event (a bad bet).  Yet highly improbable doesn’t mean “impossible”.  The bear/bull market of 2020 was a highly improbable event before it happened.  The thought of having an 18 day bear market followed by an almost immediate bull market surge in the face of a global pandemic and depressionary economic numbers is something most Hollywood studios would have laughed at.  Yet, the market just rolled a 5 of a kind, maybe even twice in row.  

Now that we have lived through a highly improbable event, it has been seared into our memories.  Think about almost any highly improbably event that has happened during your lifetime (JFK shooting or the Columbia Space Shuttle Disaster) and chances are, you can recall, with striking detail, where you were when you heard the news and the circumstances surrounding it.  These events can change a person’s perspective, often in irrational ways.   Any kind of traumatic experience may cause one to fear that activity; while any big positive surprise may lead that person to, incorrectly, believe that it has a high probability of happening again.  Las Vegas exists because of humans’ inability to correctly interpret probability.  

Markets are no different.  Now that we are 6 months removed from both a market crash and a massive rally, investors have both bad and good memories to choose from.  Behavioral finance tells us that we are more likely to expect a re-occurrence of a significant financial event when we have just experienced it first hand.  That experience tends to make us believe that our interpretation of the situation, and its potential to happen again, is correct.   This is one of the reasons that as a firm, HCM depends on objectively interpreting data in thinking about the probabilities of various outcomes.  

The same way when an ill-informed gambler bets on rolling a nearly impossible 5 of a kind and wins, their silly wager is easily forgotten because the outcome was favorable. They may even view that event as a skillful bet, when in fact they were just lucky.  The tech bubble of the 2000s shares a lot of similarities to the price action of the NASDAQ today.  At the time, most people were told that it was a low probability bet, but the successful outcomes in the moment were enough to make many investors ignore the risks, until the NASDAQ was cut in half.

The landscape of today’s market remains as challenging as any I can recall in my career.  But we must remember that not everything exists in extremes, and we must be careful not to misinterpret the probabilities based on the recent 2020 investment experience.   HCM remains concerned about the froth in certain areas of the market, along with the economic headwinds that, albeit are slightly improving, will likely continue to present a very challenging environment.  We believe the Fed’s commitment to providing liquidity remains the primary driving force behind current rally and until that support is removed, there is potential for the rally to continue, with periodic bouts of volatility.  While some are concerned that another crash is imminent and others are fearful of missing out (FOMO) on further gains, we remain positioned in a balanced fashion respectful of the rally, concerned about valuations, and objective in our efforts to balance them both.

Weekly Focus – Think About It 

“Life can only be understood backwards; but it must be lived forwards.”

  • Soren Kierkegaard

Market Activity

Performance last week for the four major asset classes were:

  • U.S. Stocks – Russell 3000 (IWV) – Gain of 0.73%
  • Developed Foreign Markets (EFA) – Loss of -0.59%
  • Emerging Markets (EEM) – Gain of 0.09%
  • Fixed Income (AGG) – Gain of 0.41%

 (Note: performance is based on the change in price plus dividends)

Last Week’s Headlines

  • The S&P 500 advanced for the fourth straight week, with technology stocks leading the index to a new record high
  • Economic data and corporate profits released last week showed the recovery is progressing, yet it remains uneven
  • Optimism surrounding FDA approval of a new COVID treatment involving blood plasma from recovered patients

Eye on the Week Ahead

  • The Fed will be the main focus as Jay Powell is expected to give an update of the current inflation target, with some speculating an possible increase to the historical target of 2%

If you have questions about the recent market conditions, please contact a member of HCM’s Wealth Advisory Team:

 Any tax or other advice contained in this document, including any attachments, is not intended and cannot be used for the purpose of avoiding penalties under Internal Revenue Code. No action should be taken on any information contained in this message without first consulting with your tax/legal advisors regarding the tax/legal consequences for your circumstances.

Additional Notes:

  • The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general.
  • Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance.
  • Past performance does not guarantee future results.
  • You cannot invest directly in an index.
  • Consult your financial professional before making any investment decisions.

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