Q2 2021: PFM Quarterly Commentary
Over the last eighteen months, since just before the start of the pandemic, investor sentiment has whipsawed wildly from ebullience following stellar 2019 market returns to nothing short of despair. Now, as COVID-19 related restrictions are eased and the major global economies reopen, positive – if not enthusiastic – investor sentiment is back centerstage. Fortunately, behavioral finance, a well-researched and widely accepted field of study, can in part explain these enormous variations in sentiment. Scholars and practitioners have over time identified the cognitive and emotional biases that aid in an explanation of this phenomenon, and by extension, help us to understand their effects on the markets.
For brevity’s sake, research shows that the impulses, intuitions, and heuristics which helped primitive humans survive often now lead us to make financial decisions that run counter to our long-term interests. Two of these cognitive predispositions, conservatism bias and recency bias, work in tandem to foil investors. Their definitions are simple, but their effects can be disastrous for market participants. Conservatism bias is when we underreact to new information because of the discomfort involved with altering our entrenched views, while recency bias illustrates our species’ inclination toward linear thinking: what is happening today will occur indefinitely (thus significantly if not completely discounting past experiences).
This Behavioral Finance 101 introduction is our attempt to draw your attention to the fact that most people’s current market outlooks are heavily influenced by what is presently happening around them. For example, the feelings of fear stemming from the likes of the Great Recession, the bursting of the internet bubble, and the pandemic induced crash have been largely overwritten by feelings of elation, arising from the easy money made during the bull markets that typically follow major corrections. Put another way, most people’s financial dispositions are the product of peering through a narrow window, which only looks out onto the present moment. Despite market corrections, crashes, and bubbles being commonplace occurrences, the biases outlined above cause most investors to be surprised, panicked, and/or greedy when the current environment changes.
That primer sets the backdrop to this market commentary’s principal topic: inflation. Arguably it is the most widely discussed financial item of interest in the media today. In fact, Google searches for inflation reached their highest level ever in May, surpassing the previous record by nearly a third since the company started publishing search data in early 2004. The sudden panic about inflation is not without merit. The second quarter heralded a bevy of data points indicating a return to inflation rates not seen in nearly a generation. Inflation at the producer level soared 6.6% year over year, its fastest pace on record following thirteen months of consecutive increases. Core consumer prices surged 5.0% year over year, notching the highest annualized increase since 1992. The Federal Reserve’s preferred measure of inflation, the Core PCE Deflator (Personal Consumption Expenditures less food and energy costs) rose 3.1% – now at its highest mark since 1992. For context, the last time inflation increases ran this hot, the then Federal Reserve Chairman and famed inflation hawk Paul Volker raised interest rates to 20.0%.
The Federal Reserve has responded to the inflation data by attributing the spike in prices to “transitory” forces such as supply bottlenecks, feedstock shortages, fiscal stimulus, and a shortage of workers. On the surface this is true, as these forces have undoubtedly contributed to price increases. We are hopeful that some of these price spikes prove temporary, thus providing some relief to producers and consumers alike. However, prices are infamously “sticky” and rarely decline after rising. With few exceptions, once companies are able to raise prices for their goods, there is little economic incentive for them to reduce those prices in the future.
The inflation narrative will ebb and flow in the short term, but in our view, the ingredients for persistently higher prices are in place. Despite a gradual return to normal from the COVID-19 crisis, central banks around the world continue to pump unprecedented amounts of stimulus into the global financial system. Our own Federal Reserve still injects $120 billion into the markets each month. In May, the Biden administration unveiled its ten-year budget plan for the federal government which promises the highest levels of sustained spending increases since World War II. Additionally, lawmakers continue to promote an infrastructure bill ranging from just under a trillion dollars up to $1.7 trillion – with more expenditures undoubtedly to follow. We contend that governments and central banks flooding the financial system with trillions of dollars at the same time pent-up consumer demand is unleashed is not a good recipe for lower prices.
To our earlier point regarding conservatism and recency biases, most folks either never have experienced inflation and simply did not see it coming, underestimated its pervasiveness, and/or will now discount its potential to move even higher. In contrast, Peak has consistently used these pages since late 2017 to discuss the building inflationary pressures, most recently pointing out in our last letter how skyrocketing commodity prices would soon impact official inflation indicators. Actively preparing for inflation when there had been none to speak of for many years does run contrary to the evolutionary predispositions discussed earlier. Fortunately, we have steadily and incrementally been adding “inflation friendly” investments to client portfolios over the last few years.
The investment markets are entertaining because they are unpredictable and at times do what most consider “impossible.” If the last eighteen months have taught us anything, it is that most of our hard-coded behaviors formed over the millennia work great for keeping us alive, but should not be relied upon for negotiating the capricious investment markets. Thinking beyond the moment, remembering the lessons of the past, and allowing for the consideration of seemingly farfetched outcomes are all critical tools which, as stewards of your portfolios, we employ to overcome any inherent cognitive biases.
We always enjoy hearing from you, so please contact us should you have any questions, comments, concerns, and/or if you would simply like to check in.
Peak Financial Management
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