Equity markets closed out 2020 in style with the S&P 500 Index gaining 12.4% in the fourth quarter to finish the year up 18.4%. From its trough on March 23, the S&P 500 has remarkably rallied more than 65%. The S&P 500, Dow Jones and Nasdaq indices all finished 2020 at or near all-time highs.
What’s more is tell-tale signs of pervasive enthusiasm, optimism and “risk on” sentiment—which had largely been absent or muted during much of the bull market that began in 2009 and which was abruptly halted this past spring before ultimately resuming anew—are beginning to become readily apparent. While not an exhaustive list, during the last year we witnessed:
- Massive rallies in highly speculative—and in some instances bankrupt—companies,
- Record IPO issuance, a significant portion of which was for SPACs which are speculative in nature,
- Multiple IPOs that registered eye-popping day one price appreciation,
- A frenzy of retail trading both in individual stocks as well as in call options, a considerable portion of which was from novice investors on popular trading apps such as Robinhood,
- A significant increase in the use of margin debt which reached an all-time high in November,
- Enormous rallies in cryptocurrencies; and lastly
- Regular media attention given to—and often lionizing—day traders and other investors who realized outsized gains from all of the above.
It’s worth stressing that my point is not to confidently declare that all of the above is demonstrably irrational and completely detached from reality and will ultimately blow up on investors. Many of the stocks that experienced significant rallies last year may prove to be long-term winners. Similarly, many of the IPOs that came to market could very well go on to establish themselves as the leaders in their respective industries in the years to come. And it’s quite possible that one or more of the cryptocurrencies that saw exponential price appreciation last year may firmly entrench themselves in our future financial ecosystem. My point is that the current investing environment is one where optimism, risk tolerance and greed are in the driver’s seat while skepticism, risk aversion and fear have largely been relegated to the back seat.
In such an environment, using history as a guide, I believe the chances of experiencing a pullback and bouts of volatility has increased.
A natural next step might be to try to anticipate a market top. Many investors (possibly more aptly described, traders) may be tempted to take some money off of the table or move out of stocks entirely, wait for the “inevitable” pullback and swoop in and “buy the dip” later. While the rationale behind the strategy makes logical sense, I advise investors to think twice before dramatically altering their investment plans or getting carried away with market timing. We know that market timing rarely works and over time tends to impair rather than improve investment performance.
At the end of the day, no one can truly know when the stock market will experience a significant pullback. Investors well versed in investing history know that volatility and drawdowns are an inherent and routine part of stock market investing. They are what I like to describe as “the price of admission” for participating in the market’s long-term rewards. Remember, without risk, there is little opportunity for return.
Unfortunately, we do not—and cannot—know with certainty when these drawdowns will occur, how significant they will be, how long they will last and perhaps most importantly for those with a market timing itch to scratch, when they right time to get back in will be. Anyone who tries to say they know for sure is either lying to you or to themselves.
Given the speed and magnitude of the current market rally, the overall “pulse” of the investing environment and the uncertainty ahead on multiple fronts, I absolutely think the chances of the market experiencing a 10-20% pullback in 2021 are higher than normal. That said, I still don’t believe the proper course of action is to sell out or take similar dramatic portfolio action.
Consider that if the market were to rally another 20%, it would take a 17% decline to fully wipe gains from such an advance. A further 30% rally would require a 23% drop to get back square one. In an environment that can reasonably be described as “risk-on” or “frothy” a 20%-30% advance is eminently possible as momentum-driven rallies have a way of feeding on themselves. If such a rally were to occur, even if the duly anticipated pullback were to follow, in order for market timing to work the market timer would need to possess both the patience to sit out the rally and the fortitude to buy back in on the dip. It’s quite easy to see how market timing could go wrong if: (a) the initial rally is exceptionally strong, (b) the pullback isn’t as significant as anticipated or (c) the bottom is missed by just a few days or weeks. This is why I’m generally skeptical of and guarded about attempts to time the market. As the legendary Peter Lynch stated: “Far more money has been lost by investors trying to anticipate corrections, than lost in the corrections themselves.”
For those that remain unconvinced, my advice is this: be sure to appropriately calibrate the magnitude of any actions you take to your portfolio with the degree of confidence you possess in your ability to predict the future. At Kathmere, we believe we’re appropriately humble about our short-term market forecasting capacity. That’s why we’ll continue with our current approach of moving forward with caution. Overall, we believe investors should be favoring defense over offense right now and we’ve positioned our portfolios accordingly.
Kathmere Capital Management (Kathmere) is an investment adviser registered under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply any level of skill or training. The information presented in the material is general in nature and is not designed to address your investment objectives, financial situation or particular needs. Prior to making any investment decision, you should assess, or seek advice from a professional regarding whether any particular transaction is relevant or appropriate to your individual circumstances. This material is not intended to replace the advice of a qualified tax advisor, attorney, or accountant. Consultation with the appropriate professional should be done before any financial commitments regarding the issues related to the situation are made.
The opinions expressed herein are those of Kathmere and may not actually come to pass. This information is current as of the date of this material and is subject to change at any time, based on market and other conditions. Although taken from reliable sources, Kathmere cannot guarantee the accuracy of the information received from third parties.
The S&P 500 Index or the Standard & Poor's 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies.