Covenant Weekly Market Synopsis for July 12, 2019

July 15, 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.

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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.

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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.

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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,

Justin