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Sound Advice: October 14, 2020

“I like the dreams of the future better than the history of the past.”

                                                                            Thomas Jefferson

History is a useful, though not infallible, guide to what lies ahead. Invariably, excess in one direction is followed by offsetting movement in the other direction.  Strength is followed by weakness and vice-versa.  Within the universe of investments, there are those that do better than the averages and those that do worse.  When interest rates are low and credit is loose, the stage is set for an acceleration of growth.  When interest rates are climbing and credit gets tighter, the brakes are being applied to economic advances.

Stocks tend to rise when investors expect earnings to rise.  They weaken when the view ahead is less rosy.  Bonds rise when interest rates are dropping. Typically, this takes place when monetary policy eases or when investors’ fears prompt a flight to quality.  As business conditions improve, monetary policy tends to tighten, causing bond prices to fall and bond yields to rise.  As interest rates change, the impact on prices is greatest on bonds with the longest maturities and least on those maturing in the near future.

At all times, the issue is what lies ahead, not what has already happened. More specifically, what investors do today reflects what they expect to happen tomorrow. The reality that follows is often quite different from what was expected. Changes in investor psychology, and their impact on market prices, tend to be far greater than the fluctuations in underlying fundamentals they are supposed to be reflecting. 

A company with an unblemished record of annual advances may be viewed as one with below average risk and above average earnings predictability, but that history will do little to dampen the impact of the speed bumps that loom ahead. Companies with checkered records will generally be accorded leaner valuations, primarily due to the increase in perceived risk.

One of the better examples of the need to look ahead is cyclical companies. Those are companies that regularly move through periods of lean and rich results. Those that produce raw materials such as steel, paper, and fertilizer are of this type. When their profits are in a trough, their shares tend to receive the richest valuations (price-earnings multiples) since investors are aware that profits are atypically low and will rise during the next boom cycle. Conversely, when profits of these companies are peaking, valuations will be low, reflecting the likelihood that a downturn will soon follow.

N. Russell Wayne, CFP®



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