Monthly Archives: July 2019

Last Week Today. Minutes from the European Central Bank’s June meeting showed an improvement in Eurozone consumption. However, due to geopolitical factors and weakening global trade the ECB bankers are considering injecting stimulus via interest rate cuts and/or relaunching their $2.9 trillion bond-buying program. Not sure how taking the interest rate more negative (the official interest rate is already -0.4%) will have a net positive effect on the economy, but I guess they know what they’re doing. | In two days of Congressional testimony, Fed Chair Jerome Powell had ample opportunity to tamp down market expectations of a rate cut at the end of this month. He didn’t, so if the Fed doesn’t cut rates following their July 30/31 meeting, it will be “Look out below!” for financial assets as both the Fed and Chair Powell will lose considerable credibility. | China’s economy is slowing. The June data showed exports fell by -1.3% year-over-year, imports tumbled -7.3%, and GDP grew at 6.2% — the slowest quarterly growth rate in almost 30 years.

Financial Markets. Powell’s confirmation of an imminent rate cut during his congressional testimony boosted markets. The S&P 500 and Dow stock indices rose to record levels, and fixed-income investors were forced to adjust their stance quickly. All told, it wasn’t a huge week for equities, but stocks had already gained nearly +2% following the Fed’s meeting in the first week of July when they hinted at cutting rates. Powell’s push maintained the momentum and the S&P 500 closed above 3,000, while the Dow soared over 27,000. International equity markets did not rally with domestic stocks and finished the week down about -0.5%.

Powell’s dovishness, and the prospect of rate cuts, also caused the yield curve to steepen. While the yield curve remains inverted (i.e., bonds with longer-dated maturities have lower interest rates than bonds with shorter maturities), the total amount of yield curve inversion declined last week. For example, one week ago (depicted by the gold line), U.S. Treasury bonds maturing in 3 months had an equivalent yield to that of bonds maturing in 17-18 years. As of Friday, 3-month bond yields were roughly equal to bonds maturing in 10 years. Not only were the yield curve changes dramatic in absolute terms, but the move also nearly undid the critical 10-year/3-month bond inversion, which historically has been a reliable indicator for impending recessions.

For specific weekly, month-to-date and year-to-date asset class performance, please click here.


Source: Bloomberg LP and Covenant Investment Research.

Confessions. Q2 earnings season kicks into gear this coming week with 56 corporate management teams scheduled to confess results. Consensus earnings estimates for Q2 are less than rosy, with analysts calling for a -2.7% year-over-year decline. Some of analysts’ pessimism is surely the result of management teams guiding analysts towards conservative estimates to lower the bar for reporting better than expected results. Yet, Q2 economic growth was slower than in Q1 and U.S./China trade tensions boiled over in May, both of which likely hurt second quarter corporate earnings. Having said that, management teams’ forecasts of the business environment over the next few quarters will likely prove more relevant for the direction of equity markets than if companies “beat” or “missed” analyst expectations last quarter.

Timing. As global equity markets are pushing higher and setting new records this year, retail investors are fleeing the market. Indeed, investors pulled $25 billion from domestic mutual funds and ETFs in the week before the July 4th holiday. Year-to-date investors have removed nearly $90 billion from global equity investments, $71.8 billion of which is from U.S. equity markets which have subsequently gone on to set new highs.


Retail flows are generally considered a contrarian indicator, as retail investors seldom get the timing right on when to put money into, or pull money from, the stock market (see last week’s Behavioral Finance entry referencing Fidelity’s Magellan Fund for a prime example). While anything can happen, we’d be more concerned if there were massive flows into equities when markets are hitting new highs, all else being equal, than when people are rushing for the exit, as the current behavior does not resemble unbridled euphoria.

How the Mind Works Against Successful Investing – Endowment Effect

(Entry #4 in a series on Behavioral Finance)

In theory, the price a person is willing to pay for a good should equal the price a person will accept to sell the same good. But guess, what? “In theory, there is no difference between theory and practice. In practice, there is.” (Thank you for the quote Yogi Berra).

In practice, the price a person is willing to pay for a good tends to be less than the price they would be willing to accept to sell the same good.  This overarching reality is the Endowment Effect in action, and it describes the irrational premium people place on items we own or for which we have a feeling of ownership.

One of the most widely cited proofs of the Endowment Effect is a research experiment conducted by Behavioral Finance pioneers Daniel Kahneman, Richard Thaler, and Jack Knetsch. In “The Mug Experiment,” the researchers arbitrarily divided a group of participants into Buyers and Sellers, and the Sellers were given a coffee mug as a gift. The researchers then independently asked the Sellers how much they would sell the mug for and the Buyers how much they would pay to purchase the mug. Results from the experiment (based on median values) showed the Sellers placed a significant premium on the mug, valuing it at $7.12, while Buyers were only willing to pay $2.87.


Source: Kahneman, D., Knetsch, J., & Thaler, R. (1991).  “Anomalies: The endowment effect, loss aversion, and status quo bias”.

This experiment highlights that “value” is conditional. People generally assign a higher value to goods they possess (condition = ownership) as opposed to goods they don’t own but might acquire (condition = non-ownership). The Endowment Effect is related to another bias called Loss Aversion (discussed in Entry #2). Loss Aversion results from the psychological effect that the pain of losing is about twice as powerful as the pleasure of gaining. Hence people in possession of an object view selling it as a “loss” and place a higher value on the good than someone seeking to acquire the same object.

For investors, the Endowment Effect most often results in holding onto assets longer than makes sense and ignoring new investment opportunities. Whether an investor inherits assets or purchases assets, once in their portfolio, the investor will likely assign greater value to it than an impartial third party. Hence investors systematically overestimate the value of their holdings and are unwilling to sell them at market prices. As a result, investors often miss opportunities to shift their portfolio to investments with higher potential returns.

The Endowment Effect is a powerful psychological force, but there are ways to address it. For example, investors can be intellectually honest and ask themselves the following questions about their investments:

  • Would I buy it today? If you are unwilling to purchase the investment at today’s price, consider selling it.
  • What was my original investment thesis? If conditions no longer support your thesis, sell the position. For example, if you acquired stock in a company because they planned to expand internationally, but the new CEO is focused on domestic sales, consider selling.
  • What is the expected return of existing investments vs. available alternatives? Don’t fall in love with your portfolio, even if it has had excellent past performance. The past is irrelevant; the future is what matters.

A particularly effective counter to the Endowment Effect is hiring an experienced financial advisor. Professor John A. List conducted research that led to publishing a seminal paper entitled “Does Market Experience Eliminate Market Anomalies?” While Professor List’s research subjects traded sports memorabilia, the findings are relevant to investors seeking to maximize portfolio returns. Specifically, with regards to the Endowment Effect, Professor List found “sharp evidence that suggests market experience matters” and that “the endowment effect becomes negligible” for investors with deep trading experience. While this is not a blanket endorsement of all financial advisors, a well-trained and experienced professional can help investors view their portfolio with a less emotional, more clinical perspective.

Be well,


Last Week Today. On June 29th President Trump and Chinese President Xi Jinping agreed to reinitiate trade negotiations – an outcome hoped for by the market, but evidently not fully priced as the S&P 500 reached a new record level last week. | The European Parliament nominated France’s former finance minister and current managing director of the International Monetary Fund, Christine Lagarde, to replace Mario Draghi as the first female President of the European Central Bank. | President Trump announced two nominees for empty seats on the Fed’s board of governors. Christopher Waller is a research director at the St. Louis Fed and former mentor to current St. Louis Fed President James Bullard. Judy Shelton has the academic qualifications to make the cut, but controversially she is an outspoken critic of the institution. Both nominees appear to advance the President’s desire for a more accommodative Federal Reserve. | June’s nonfarm payroll report (released Friday) was stronger than anticipated, reducing the impetus for the Fed to cut interest rates proactively.

Risk Rewarded. Global equities pushed higher in a U.S. holiday-shortened week. Domestic stocks led the way once again, as the S&P 500 gained +1.7%. International developed markets rose by +0.5%, and emerging market equities gained +0.7%. At approximately the halfway mark, it has been an excellent year for equity investments: S&P 500 +20.6%, International developed markets +15.1%, and emerging markets +11.5%. Taking a closer look at sector performance within the S&P 500, Information Technology has been shining in 2019, but even Healthcare, the worst-performing sector, is up nearly double digits.


Sources: Bloomberg LP and Covenant Investment Research

The question on everyone’s mind is “Can this continue?”  The answer is that it most likely can in the intermediate term, but not at the same pace and with more volatility than witnessed thus far.  With the usual caveat that this outlook excludes the potential for exogenous events like natural disasters (you hear me California?) or geopolitical risks, it also assumes the Federal Reserve does not commit a monetary policy mistake, and that trade tensions remain at a low simmer rather than a rolling boil. One reason is that the economy remains relatively stable. Yes, the global economy is slowing and the domestic economy is retreating from the unsustainable pace of 2018, but so long as consumer confidence remains high and they continue to spend, our “Good but not Great” growth scenario can stay intact. Current data shows domestic GDP growth slowing materially in the second quarter (among other things, the build-up in inventories from Q1 needs to be worked off), but a return to the post-Financial Crisis 2% average growth rate is reasonable. The second important factor supporting equities is the return of “TINA.” With the yield on domestic bonds pushing lower to levels last seen in 2015/2016 and more than $13 trillion of bonds with a negative yield globally, for many investors There Is No Alternative to equities.

How the Mind Works Against Successful Investing – Overconfidence

(Entry #3 in a series on Behavioral Finance)

The next Emotional Bias we explore is “Overconfidence.” Psychological research has convincingly demonstrated that humans tend to have an inflated view of their decision-making abilities. As such, this human frailty affects nearly all aspects of our lives. Famously, when people are asked to rate their driving ability compared to other drivers, most rank themselves in the top third of the population. Obviously, this is mathematically impossible, as 50% of all drivers’ abilities are at or below average.

Overconfidence’s successful twin “confidence” can be described as a belief in one’s self and one’s ability to succeed. This type of positive thinking has been critical to the evolution of the human race. For example, if our ancestors were not confident in the future, there would have been no incentive to take risks or to defer gratification. But too much confidence can blind you to otherwise obvious obstacles.

Striking a balance between confidence and overconfidence is challenging, and there is often only a thin, red line separating the two. In finance, Overconfidence is an extremely dangerous bias as actions taken from an overly confident mindset may be the most harmful to your wealth.

In simple terms, investors commonly believe they are more intelligent and have access to better information than they actually do. As a result, investors tend to be overly optimistic about their estimates and attribute successful decisions to their skill and poor outcomes to bad luck. Overconfidence destroys wealth through the following emotionally-charged, risk-seeking, investment errors:

  • Mistaken belief in one’s own ability to outsmart the market
  • Excessive Trading
  • Underestimating downside risks
  • Concentrated portfolios

Often investors commit two or more of these errors simultaneously. To illustrate this point, let’s review the average investor’s experience with Fidelity’s wildly successful Magellan Fund. Peter Lynch earned a reputation as a legendary portfolio manager racking up a 29% annualized return (10% better than the market) when he was responsible for managing the fund from 1977 through mid-1990. The fund was not available to the public until 1981, but even from that point forward, Lynch generated an annualized performance of approximately 23% through 1990 vs. 16.5% for the S&P 500. However, according to Fidelity’s calculations, the average investor in the Magellan Fund only earned around 7% per year.

The paltry performance of the average investor was not Fidelity’s fault, but rather because the average investor repeatedly committed the first two errors listed above. When the fund would experience an inevitable setback, investors would redeem from the fund. Then, when performance improved, investors would rush back into the fund, missing a big part of the recovery. Overconfident bets about the future direction of the market and the associated trading provoked the average investor to buy high and sell low over and over again. As a result, those investors not only missed out on Magellan’s market-beating performance, but they also earned less than 50% of the broader market’s gains. Ouch!

Investors suffering from the Overconfidence bias may also underestimate investment risks and/or concentrate their portfolios in a few investments. Together or independently, the market often teaches investors committing these mistakes an expensive lesson. For example, during the bubble, those investors that did not trim their winners or diversify their portfolio into non-technology stocks, suffered catastrophic losses when the bubble popped, and the Nasdaq Index declined by 78% from March 2000 – October 2002.

How to address the Overconfidence bias:

  • Consider downside scenarios and assign a probability, or likelihood, that those scenarios come to fruition.
  • Maintain a properly diversified portfolio, based not on the number of investments in the portfolio, but the types of return drivers for those positions.
  • Recognize that both good results and bad results typically come from decisions you made previously. Most people attribute good results to their competence and poor outcomes to bad luck. There’s no doubt luck plays a role in investing, but it balances out over time, whereas your decisions are a constant input to the outcome.
  • More information does not necessarily make for a better decision. Research studies show that investors are more confident in their forecasts when they have more information, but the reality is their forecasting accuracy was little changed regardless of the amount of information provided. Typically, a successful forecast hinges on only a handful of data points, therefore do not confuse quantity with quality of information you are evaluating.

Be well,