Is the market narrative shifting again?

Don't get stuck on the story

It feels like the market narrative is starting to shift again.

Between January 2022 and October 2022 the markets were getting hammered by aggressive policy tightening and out of control inflation. Market pessimism was through the floor as an impending recession was a foregone conclusion.

After October, the narrative changed. Inflation began to moderate, employment remained strong and many now expect a soft landing. People are starting to believe (rightly or wrongly) the Fed can actually pull this off. Consequently, markets have risen substantially, pricing in the end to Fed Funds rate hikes. Many have suggested the October low was the bottom.

This week it feels as though the market is taking a harder look at its own assumptions. Once again, the market narrative might be changing.

What could cause the market narrative to change?

This week, CPI and PPI data came in hotter than expected while manufacturing data weakened more than expected. I’m not trying to cherry pick data to fit a story, but I believe more investors are seeing this information and realizing there is a non-zero probability that while the economy weakens inflation could remain stickier than expected.

Note that there also remains a non-zero probability that the economy lands hard and deflationary forces overwhelm markets. Yet, until now markets have chosen to ignore the risks and are pricing in the goldilocks scenario.

Future paths are unknown, so investing is always a game of assigning probabilities to multiple potential outcomes. Understanding the downsides to each of these outcomes can help investors understand the risks to incorrect forecasts.

Put it this way, the probability of getting into a car accident on the way to work is very low but the downside of that risk is potentially catastrophic. So you prepare for that minimal risk by wearing your seatbelt.

What’s the probability of a stagflationary outcome? 10%? 25%? 50%? Who knows, but if this were to occur the impact to markets could be deadly. A Fed that pauses and then resumes its rate hikes because it lost control of inflation - again - would likely kill the market.

It comes down to psychology (and math). Disappointment is more painful when hopes are high.

Someone once said the key to happiness is to keep your expectations low. Right now, the market seems to have high expectations for a soft landing, disinflation and declining bond yields.

Maybe the market is right, maybe the market is wrong. That’s not the point.

The point I’m trying to make is investors should not attach their decisions to the prevailing market psychology because that psychology can quickly shift. Instead, investors should have a plan and continuously stress test that plan with “what if” scenarios.

I’m also saying that market psychology - and financial experts - can be wrong, despite the reassurance of the masses. In 2007, for example, financial pros were forecasting a soft economic landing, the Fed was confident on housing and pundits were promoting the standard brand name stocks.

The FOMO is real. I get it. Markets have risen significantly over the past couple months. But if you’re an investor - and not a speculator - building wealth over your lifetime requires a clear assessment of the range of probable outcomes and your tolerance for risk. This is a key element of a solid long-term financial plan.

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Very few financial pros saw the Global Financial Crisis, despite the warning signs

Below is a video of Peter Schiff facing off against market pundits in 2006/2007. You don’t have to like, respect or agree with Schiff, but what this video shows is how difficult it is to argue against mass psychology backed by ‘experts’. There is comfort in crowds, so investors tend to base their decisions on what everyone else is thinking.

I don’t think there will be another financial crisis like in 2008/2009. This is simply an extreme example of how mass psychology can color investor perception.