This was an excellent quarter for the stock market. Demonstrating its unpredictable short-term nature, the market shrugged off any and all bad news and applauded the good news. I’ll start with the bad news. Europe continues to struggle with its monetary union, as the election in Italy and the bailout in Cyprus remind us. The European crisis is easing, but I do expect it to drag on for some time. In the U.S., the federal government continued to play at brinksmanship. And worse, it allowed the federal sequester to take effect. As I’ve mentioned before, the sequester does not pose any great threat to the economy, but it will slow down GDP and counter some of the positive forces that are gearing up.
Now for the good news. The economy continued its strengthening trend from late 2012. Job numbers have been better than expected, and consumer demand looks good. Housing continues to gain traction, to the point where it is becoming a significant contributor to economic growth (it’s been a detractor for the past five years).
I hedged client accounts with a 20% cash position this quarter. I chose a much less aggressive hedge than during the last debt ceiling stand-off, and that change proved very helpful as the markets continued their climb. It was the strengthening economy, and the lower probability of a significant negative outcome, that contributed to the smaller hedge. I will now look for an attractive entry point to reinvest the hedge. My expectations for some market volatility following the sequester were confounded by the markets current euphoria. For now, patience is the key, and a market correction is likely as we move forward. I don’t expect to be able to time the correction (of course, market timing is impossible), but I will look for slightly better valuations before eliminating the hedge.
Most people intuitively expect markets to behave rationally. There are many reasons why markets do not, at least in the short-term, behave rationally. I’ve written before about the problematic incentives for fund managers, the counterproductive approaches of day traders, and the basic investor psychology of greed and fear. Recently, I read an SEC study that explains another dimension of this phenomenon: a lack of knowledge by investors.
As part of the Dodd-Frank Act, lawmakers directed the SEC to figure out how much average investors know about the stocks and mutual funds that they hold. In a 182 page report, the SEC found that American investors “lack basic financial literacy,” and that they generally do not understand even “the most elementary financial concepts, such as compound interest and inflation.”
It’s important to note that the SEC didn’t question all Americans, they asked people who are already investing. One might expect that this set of Americans would have a greater level of financial acumen than those who are not investing. The survey participants, however, were consistently tripped up on questions like “what is a stock?”
The SEC found that one of the reasons that investors lacked basic knowledge was due to the producers of securities documents. Survey participants were tasked to read a summary prospectus from a mutual fund. Not surprisingly, many found the document poorly written and user-unfriendly. The test results for reader comprehension of these documents were dismal. Many of those document producers, however, find it in their best interest to keep investors in the dark.
As I’ve noted in the past, the average mutual fund investor trails the performance of the funds he or she holds substantially by virtue of buying and selling at the wrong times (Of course, the temptation to time the market extends into the ranks of professional traders too). Financial illiteracy is costly to the investor when it leads to attempted market timing or other counterproductive trading strategies, but generates greater commissions for the institutions. Fund fees are another area where institutions do whatever they legally can to obfuscate investors. Indeed, if investors fully understood mutual fund fee structure, we would probably see a mass movement from mutual funds to ETFs.
Investor knowledge is just one part of the market’s irrational puzzle. All these issues, and many more, create an irrational market in the short-term. It is this irrationality that allows us to find value and prosper in the long-term.