How Behavioral Investing Can Explain Stock Market Disconnects

How Behavioral Investing Can Explain Stock Market Disconnects

The American College of Financial Services
July 23, 2020

Throughout the current COVID-19 crisis, financial analysts have noted a surprising disconnect: while the economy continues an uneven pattern, the stock market is performing significantly better than expected. For advisors charged with portfolio management and client decision making, this can result in a difficult bind: which numbers should you believe, markets or the real economy?

Participants in the stock market today face the double-edged sword of risk: while chances are good that economic conditions could worsen and corporate earnings will weaken, damaging market prospects, there could be an equal problem with being underweight in equities and therefore missing out on a market rally. We've already seen investors who panicked and sold off stocks when the stock market was in its March free-fall lock in those losses when stock values recovered during April and May. This in turn can create a feedback loop of confirmation bias, whereby investors pour more money into equities despite the downside risks.

Understanding behavioral finance and loss aversion is key to learning why markets and the economy seem at odds, and one of the many factors governing today's uncertainty is that the stock market, by nature, is forward-looking, whereas the economy anchors to the past and bases projections on backward-looking data like GDP figures.

In the chart below, you can see the difference in decision making on full display. The S&P 500 declines along with the spike in job losses as one would expect, but then turns around and starts rising well ahead of any improvement in unemployment claims. This movement reflects expected future developments, not current data. Along with the government jumping quickly into action to try to stop the economic bleeding, who doesn't want to believe in a fast recovery?

The stock market also doesn't respond to the actual levels of economic indicators, but more often than not, their performance relative to expectations and trends. Even though unemployment remained high by historical standards in late April and May, it was lower than many economists predicted, and as a result, investor behavior reflected hope for a quick rebound: what practitioners call a "V-shaped" recovery, and initial data had pointed toward this conclusion in some ways. However, the US Federal Reserve and other organizations still urge caution and are predicting a slower period of growth over time, or a "U-shaped" recovery. The moral of the story is that wealth management professionals and advisors need to counsel their clients to prepare for either situation and not take market trends or economic figures alone as gospel.

 

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In the midst of a historic financial crisis, you need the tools to answer the questions clients are asking about their investments, the markets, and their future. The key is a combination of behavioral finance and market research brought to you by our faculty and thought leaders at The American College of Financial Services.

To learn more about the disconnect described here, download our latest article “Are Markets and the Real Economy Disconnected?” for the information you need to make informed investment decisions for clients during an unprecedented financial upheaval.

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