Because I don’t want to end up like Larry Kudlow, I don’t make claims about whether the stock market is going to go up and down. I mean, sure, I expect stock prices to tend to go up over the long run as they roughly track the growth of the economy. I own stock mutual funds, so I’ve put my money where my mouth is on this view. But I don’t make claims about whether the stock market is currently “overvalued” or “undervalued,” or about whether a particular stock market rally or decline is rational, or about whether now is an especially good time to buy — not on television, not to my friends, and not even to myself. If I knew in advance what the stock market was going to do, I wouldn’t be writing this article; I would be self-quarantining on my private island.
Since I don’t think I can outsmart the market, my usual investing strategy is just to take the money I don’t need to use right now and park it in low-fee, broad-market equity index funds; set it and forget it, knowing the equity markets are likely to be a lot higher when I retire than they are now. At least that was my approach until the Friday before last, when I sold about a third of my stock funds.
Here is my thinking. I am still unwilling to make claims about the future level of the S&P 500, but I am willing to make claims about the standard deviation of its likely future levels. The coronavirus crisis means tremendous uncertainty for the U.S. economy, with possible outcomes ranging from relatively benign to calamitous, and those outcomes all have implications for the financial markets. At this point, I can easily envision the Dow above 25,000 in a year and also below 15,000, and so can other market participants. This uncertainty is why stocks have been so volatile of late. When we have a clearer picture of the impact of this crisis, I expect stock prices to become more stable, but I don’t know whether they will stabilize at a high or low level. The uncertainty will only be reduced when we have locked in a good outcome or a bad one.
Like essentially all Americans, my financial position is tied to the fate of the U.S. economy for reasons unrelated to investing. My human capital — the wage and salary income I can expect to earn in the future — is closely correlated to U.S. economic performance, and my earning outlook has therefore gotten more uncertain in recent weeks just as the outlook for stocks and the human condition have gotten more uncertain. And like most Americans not at or near retirement age, my ability to earn money in the future is my primary store of wealth, exceeding my current financial investments. There are ways to insure future labor income against idiosyncratic risks (disability insurance, life insurance) but there is no good way for me to hedge it against broad economic risk. This makes me feel overexposed to U.S. economic growth, and I wanted to rebalance away from that risk in the only places I can: my investment account and my retirement accounts.
By selling some of my stock holdings, I have given up some of the upside I might enjoy if the stock market bounces right back. But if the stock market bounces right back, that probably means the damage from coronavirus has been less severe than feared and my future professional outlook is therefore less impaired. Conversely, if the stock market continues to crater, I will have preserved assets at a time when I most need them.
Alas, I used the money I took out of the stock funds and bought bond funds, which has been an unfortunate choice so far. The idea was to diversify my risks by buying something that would not move in line with the stock market. Returns on U.S. Treasury bonds have typically been inversely correlated to returns on stocks, since investors who sell stocks out of fear often buy the safest bonds — government bonds — as they seek a stable investment. Investment-grade corporate bond prices are typically only somewhat correlated to stock prices; both depend on the financial health of corporations, but bondholders are ahead of stockholders in line to be paid, so bonds do not get beat up as badly as stocks when corporate finances weaken. Municipal bonds are barely correlated to stocks at all. I bought funds with diverse exposure to many classes of high-quality bonds, hoping to be significantly less exposed to the market gyrations. Unfortunately, over the last few days, pretty much every kind of investment has fallen in value simultaneously: stocks, corporate bonds, Munis, even Treasury bonds.
“When stocks and Treasuries both sell off, it only means one thing: Everybody’s trying to get their hands on cash,” said Josh Brown, the CEO of Ritholtz Wealth Management and a panelist on CNBC’s Halftime Report. He compared the situation to October 2008, when investors were selling not to adjust a risk mix but to meet urgent cash needs. Investors are selling not what they especially want to sell but whatever they can sell. It’s a sign of significant economic distress.
“I’m always surprised that people are surprised that there’s not this consistent negative correlation between bonds and stocks,” said Allison Schrager, a financial economist who focuses on risk. “Whenever you have tail events, those correlations always start reversing, because people are looking for cash or they’re worried about inflation in the future — there’s always a million reasons why. All we know is those correlations are not reliable at all.”
I was surprised as I researched this column: Most of the experts I spoke with offered the view that the stock market has gone down too much. Usually, this view came unsolicited — I don’t call people up and ask them if stock prices are too low because I don’t think anybody really knows the answer. Nonetheless, Mark Dow, an investment manager who writes the Behavioral Macro blog, told me he sold equities back in February, because he thought markets were pricing in “zero risk” from coronavirus when there was at least some risk (he was right) but now that prices have crashed he thinks they have gone down too much and he is buying again. Schrager — who describes herself as a “militant efficient markets person” and therefore should not really have a view on whether stocks are too high or too low — also told me she thinks stocks are too low. Andrew Biggs, a pensions expert at the conservative American Enterprise Institute, told me he’d moved a small amount of money out of Treasury bonds into stocks in an effort to “buy the dip.” But Michael Strain, also of AEI, seemed to consider stocks to be oversold and undersold at the same time. He told me he thought stocks had fallen more than was reasonable — but then admitted to me that he was holding cash out of the market that he’d previously intended to invest in stocks, because he thought he would be able to buy later at a lower price.
Strain’s internal conflict of opinion reinforced my view that I should not form an opinion about whether stock prices are higher or lower than they should be. But I also realized, several days after I sold stocks, why I had done so without any particular conviction that their price was too high. It wasn’t a hard-headed calculation about portfolio allocation. After all, as Schrager pointed out to me, it was kind of dumb to think I’d be able to rely on bonds moving independently from stocks in a crisis. But the trade worked as a psychological mechanism: I wanted to feel myself asserting control over some kind of risk in a world that has become much scarier than it was a few weeks ago, and I found an opportunity to do so in my brokerage account. It made me feel a little better. At least until bond prices started falling.