Insights from Omar Aguilar
CIO, Equities and Multi-Asset Strategies
Global equity markets rallied during the first quarter of 2017, as the current U.S. bull market celebrated its eighth birthday. Enjoying one of the longest runs in modern history, U.S. stocks have recently benefited from ongoing labor market improvements and hopes for a correspondingly faster pace of U.S. economic growth. Another factor that we believe has supported stocks early in 2017 has been a carryover from the final quarter of 2016: the overconfidence bias. I explained this behavioral finance influence in my previous quarterly insights, titled “Confident to a fault.” The overconfidence bias is a cognitive bias, but one with emotional overtones.
A purely cognitive bias—and an especially common one, at that—is the anchoring bias, a behavioral finance factor that can affect experienced and inexperienced investors alike. Anchoring involves creating a mental reference point that influences our appraisal of subsequent conditions, and this influence can assume particular gravity in our decision-making processes when we confront uncertain environments. In some ways, anchoring highlights a pervasive and natural human desire for shelter, springing up like a self-defense mechanism to help us cope with the unknown.
From an investment standpoint, an anchor can be as straightforward as the purchase price of a stock, or even the expected rate at which the U.S. economy is projected to grow. The number of forecasted interest rate hikes by the Federal Reserve can also serve as an anchor, as can presidential campaign promises. Yet even though anchors often have little direct relevance on where a data point should currently reside, they nevertheless influence our perceptions of reality and can take concerted effort to raise once they have become firmly secured.
Anchoring is one of the factors that we believe helped U.S. stocks continue to rally for much of the first quarter.
Anchoring is one of the factors that we believe helped U.S. stocks continue to rally for much of the first quarter. Confident that President Trump would deliver on his campaign promises, anchored investors enthusiastically pushed U.S. equities sharply higher late last year and into this year, expecting a flurry of economically stimulative measures that would ultimately drive up corporate profits.
This behavior is reflected in the chart below, which illustrates how the U.S. dollar, the S&P 500® Index, and the S&P 500 Banks Industry Group1 rose sharply from Election Day through well into the first quarter of 2017. This is an updated version of the chart from my prior quarterly Insights, highlighting how investor enthusiasm surged in the post-election environment, driving up select U.S. stocks and the dollar in the process.
With this backdrop in mind, consumer and investor confidence rose to their highest levels in years during the first quarter. These confidence measures reflect survey-based findings, and are often described as “soft data.” Such gauges usually serve in a predictive capacity, pointing toward the direction in which the economy might be headed, provided that conditions remain essentially the same. The chart directly below demonstrates this enthusiasm, revealing that earlier this year, the Conference Board Consumer Confidence Index® reached its highest levels since 2000.
With the new administration failing to find sufficient support in the House of Representatives to repeal the Affordable Health Care Act in late March, doubts have emerged regarding the president’s ability to deliver on his other campaign promises.
Although not specifically undertaken to fuel a faster pace of economic growth, a repeal of the Affordable Health Care Act stood prominently among President Trump’s campaign promises. With the new administration failing to find sufficient support in the House of Representatives to repeal the Act in late March, doubts have emerged regarding the president’s ability to deliver on his other campaign promises.
In light of this political setback, will robust confidence levels continue? Perhaps. However, the unexpected political challenges could be starting to exact a toll on investor enthusiasm, which might explain why equities began to tread water by late March.
Unlike soft data, hard data is generally backed by quantitative figures and can be proven. Inflation-adjusted gross domestic product, or real GDP, is one of the most frequently cited pieces of hard economic data, and information regarding the rate of U.S. growth in recent years is depicted in the chart below. Although a lagging economic indicator by nature, GDP is nevertheless a useful economic gauge.
During the fourth quarter of 2016, real U.S. GDP slowed from the preceding quarter, coming in at a 2.1% annualized pace. This slower pace of growth reflected downturns in governmental spending, increased imports, and less nonresidential fixed investment. Unfortunately, activity during the first quarter of this year fell further still to an initially estimated 0.7% annualized rate of growth. As a result, even though a tightening labor market and recently supportive levels of business, consumer, and investor confidence may bode well for the near-term outlook, the hard data currently seems considerably less encouraging than the soft data.
Baby boomers seem particularly susceptible to anchoring. This generation has historically been inclined toward the early adoption of major trends for fear of missing out. Moreover, boomers have a generational propensity to take calculated risks, making many of them predisposed toward overconfidence regarding their insights and future possibilities. Research shows that boomers may also have been instrumental in voting President Trump into office, which increases the probability that this generation has an anchored belief that he will yet deliver on any outstanding campaign promises. To the extent that the president fails to deliver on corporate tax reform, reduced regulations, and increased economic growth through fiscal stimulus measures, equities could prove vulnerable. This is particularly true for areas that have benefited the most from the post-election rally.
The largest living generation, millennials appear to be much less at risk from the effects of the anchoring bias than baby boomers. The millennial generation is a social one, driven by data, generally well educated, and tech-savvy. As a result, millennials appear far more predisposed toward weighing hard data with objective scrutiny, and placing more relevance on these figures than on soft data findings. In addition, millennials’ tendency toward skepticism makes them more likely to view the current political landscape objectively, rather than to accept prevailing enthusiasm without asking critical questions.
As the unprecedented economic and political landscape continues to unfold in 2017, we believe that investors would be wise to carefully monitor whether the hard data begins to find a convergence point with the soft data. To the extent that the data remain disconnected, equity market volatility and intermittent sell-offs remain very real possibilities. There are objective reasons to be optimistic, including ongoing labor market improvements—underscored by falling unemployment and underemployment rates, as well as solid job growth—combined with the Federal Reserve’s expectations that conditions will permit further interest rate hikes this year as it continues to move toward policy “normalization.” However, President Trump’s ability to deliver on his outstanding campaign promises could have a notable effect on where equity markets—in the U.S. and internationally—go from here. With these points in mind, we believe that investors would be well served by examining data objectively and by trying to suppress any anchored biases when shifting fundamental conditions require a new course of action.
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1. The S&P 500 Banks Index is a capitalization-weighted index, developed with a base level of 10 for the 1941–43 base periods, with a parent index of the S&P 500 (Industry Group) Index.
Omar Aguilar is Chief Investment Officer (Equities and Multi-Asset Strategies) of Charles Schwab Investment Management Inc. (CSIM), subsidiary of The Charles Schwab Corporation. Aguilar joined CSIM in 2011 and is responsible for equity and asset allocation mutual funds, ETFs, and separately managed accounts. Aguilar has more than 20 years of broad investment management experience in the equity markets, including managing index, quantitative equity, asset allocation, and multi-manager strategies. Aguilar received a BS in actuarial sciences and a graduate degree in applied statistics from the Mexico Autonomous Institute of Technology (ITAM). He was a Fulbright scholar at Duke University’s Institute of Statistics and Decisions Sciences, where he earned his MS and PhD.
Past performance is no guarantee of future results.
The opinions expressed are not intended to serve as investment advice, a recommendation, offer, or solicitation to buy or sell any securities, or recommendation regarding specific investment strategies. Information and data provided have been obtained from sources deemed reliable, but are not guaranteed. Charles Schwab Investment Management makes no representation about the accuracy of the information contained herein, or its appropriateness for any given situation.
Some of the statements in this document may be forward looking and contain certain risks and uncertainties.
The views expressed are those of Omar Aguilar and are subject to change without notice based on economic, market, and other conditions.
Indices are unmanaged, do not incur fees, and it is not possible to invest directly in an index.
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