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Don’t be Fooled: Complacency is a Danger to Investors

The U.S. economy itself appears to be doing well, but we see many end of cycle signs, including less than 4% unemployment, rising interest rates, emerging consumer inflation, a strained housing market, slowing growth worldwide, and huge instability now developing in the emerging market space including Argentina, Turkey, Brazil, Indonesia, and Thailand. However, what scares us the most is the level of investor complacency.

Because of the Fed’s and other major central banks’ easy money policies, asset prices, like those of equities and real estate, appear to be inflated. We had the Greenspan, Bernanke, and Yellen puts – meaning whenever any market trouble arose, the Fed would come to the rescue. Judging by the Fed’s recent moves and by Powell’s current and past comments, it appears that this Fed Chair and the current set of voting members of the Federal Open Market Committee have a different mindset.

Over the past nine years, all an investor had to do was be passive and buy the market index. This has manifested itself in the belief that passive market investing is superior to active portfolio management. But, while true of the recent past, long-term data suggests something different. During periods where the economy has issues, active portfolio managers significantly outperform the passive indexes.

As a result of this nine year trend of low volatility and passive outperformance, Wall Street has developed robo-portfolio management, where pre-programmed computers now make the investment decisions. Why not? Since computers don’t demand pay increases, don’t need medical coverage, and work 24/7, Wall Street can offer this at a very low price. Analysts are now being laid off (new college grads now prefer tech to financial careers). In the end, like everything else Wall Street does, it is about their profits; the investing public is of secondary concern. The real issue here for the average investor is that this new paradigm has not yet been stress tested. It will be interesting to see how it fares as the investing environment shifts.

In fact, we had a taste of what is surely to come on May 29th, the day after Memorial Day in the U.S. On Sunday, May 27th, Italy’s President, Sergio Mattarella, blocked the formation of a new government when he rejected economist Paolo Savona, who was picked by the coalition of the 5-Star (liberal) and League (conservative) parties as their choice for Economy Minister (equivalent to the Secretary of the Treasury in the U.S.). This is an especially important role given Italy’s precarious public finances and weak banking system. Savona is a “Eurosceptic.” That term pretty well conveys what his policies would have been toward the European Union (EU). The financial markets immediately jumped to the conclusion that this meant new elections in Italy in September, and markets assumed that the two extreme parties (5-Star and League) would emerge with an even larger mandate as “populism” has been on the rise worldwide, but especially in the southern European economies (Greece, Italy, and Spain) which have still not fully recovered from the worldwide recession. The markets assumed the worst and believed that, at best, Italy would end up disregarding the fiscal rules of the EU (regarding the size of its fiscal deficit), and, at worst, would repudiate its debt and exit the EU.

As a result, on Tuesday, May 29th, Italy’s two-year note rose 145 basis points or 1.45 percentage points. Its banking index also cratered. Charts of these events really drive home the fact that these are unusual/extreme occurrences. When the U.S. markets re-opened on Tuesday, May 29th, there wasn’t a flight to quality – there was a stampede. The U.S. 10-Year Note fell 15 basis points (0.15 percentage points) in the Tuesday trading session, an episode that falls into the realm of three standard deviations.

As it turns out, the markets’ assumptions were quite inaccurate. The Italian coalition government picked another Economy Minister, Giovanni Tria, who soothed market angst by promising to keep Italy in the EU and promised to address the country’s debt issues. (Time will tell if this was just talk to calm markets or true policy positions.) The point is that the markets tend to shoot first and ask questions later.

Unanticipated events are inevitable. Certainly, the Lehman Brothers bankruptcy was such an event in September, 2008. Markets sold off 32% over the next 31 trading days. The question is: Will today’s new passive investment paradigm work in a more uncertain and volatile environment? To phrase the question differently: In the likely event of a significant unanticipated situation (Long-Term Capital Management comes to mind), will the computer programs controlling those passive investment strategies direct everyone to the exits at the same time, causing real market panic and significant price degradation?

The volatility that was exhibited in the fixed income markets due to Italian politics and that has recently emerged regarding trade and tariffs should be taken seriously by investors. In particular, investors in life stages where they don’t have the time horizon to endure a significant market drawdown should actively take control of their portfolios and move toward more conservative asset allocations.

Robert Barone, Ph.D.

Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com .

He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone Financial Unconstrained Medium-Term Fixed Income ETF (FFIU).

Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.


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