Beware of Whipsaw
There was a time, before the global financial crisis, when the central banker's job was relatively simple. The main goal was simply to keep inflation under control and if it stayed around the 2% to 4% level, everyone was happy. Interest rates around 4% were acceptable. By the time the Federal Reserve officially set its inflation target in early 2012, even 2% inflation was considered a bit spicy. By then, in the wake of the GFC, US interest rates, of course, were at 0.25%.
This was part of the Federal Reserve's effort to support the economic recovery from the Great Recession and help stimulate economic growth. Now the task was to control inflation and grow the economy. It didn't stop there. With the luxury of stubbornly low inflation, something that was considered problematic at the time, the Federal Reserve regularly held their commentary on levels of borrowing, the housing market and job creation.
The central banks of the UK and the Eurozone were also aligned with low interest rates and similar inflation targets. Of course, it wasn't all smooth sailing. There was the minor issue of the Greek debt crisis in the Eurozone that had to be dealt with and various shocks, both economic and geopolitical, that shook the markets.
But the point to make is that when it comes down to it, with markets staring into the abyss, the Federal Reserve has always capitulated and eased monetary policy. However, it's also important to remember that these various crises almost always came at the end of a Federal Reserve tightening cycle, i.e., a period of rising interest rates that caused something to pop in the first place: the Latin -US debt in the 1980s, the stock market crash of 1987, Asia '98, dot.com, 9/11...
The Fed's latest tightening cycle, which began in March 2022, was surprising in scope and speed. The need to contain double-digit inflation was widely understood, but the rise in the post-pandemic rate from 0.25% to 4.75% in 11 months was always going to cause problems. Since the other central banks were generally forced to follow suit, it was unlikely that these problems would be limited to the US.
And so it happened that the sudden bankruptcy of Silicon Valley Bank, followed by New York-based Signature Bank, sent banking stocks down around the world. Exactly how Credit Suisse suffered a humiliating collapse in such a short time will be debated for years to come, though its various difficulties and failures have been well documented over the years. Nevertheless, as one of the top thirty systemically relevant banks, the fall is alarming and brings back memories of the fall of Bear Stearns and Lehman Brothers in 2008.
It is precisely in this environment, characterized by large swings in stocks and bonds, where trying to time the entry or exit of markets can go horribly wrong. A good example is Credit Suisse's Swiss rival, UBS, which took over Credit Suisse this weekend, backed by a series of eye-watering financial backstops and guarantees from the Swiss government and central bank.
As markets digested the news, shares in UBS fell sharply by 15% when the stock market opened Monday morning. By lunchtime, they were up 1%. How many investors who panicked and sold everything in the morning would now have the courage to reinvest at a higher level than if they had done nothing?
A long-term investor might also wonder if it's wise to get out of the UK's FTSE100 index, heavily laden with banks and financials that sold off last week and put the money in the bank for a while.
However, the UK index has already fallen from its peak of 8,000 at the end of February to around 7,400, even though the market was pretty much down most of the summer last year. Unless you really think dividend cuts are coming to market, walking away from a 4.4% yield, both current and forecast, for the safety of 4% on deposit isn't immediately appealing.
The truth is that historical long-term returns on stocks are much higher than on deposits. Investors who try to time the market by investing and liquidating portfolios based on short-term fluctuations are unlikely to outperform those who remain invested for the long term. Even missing some of the best performing days in the market can significantly reduce an investor's overall return.
One study found that between January 1, 1999, and December 31, 2018, an investor who remained fully invested in the S&P 500 index would have earned an average annual return of 5.6%. However, if that investor missed just the 10 best performing days during that period, just 10 days out of a decade, his average annual return would have dropped to just 2%.
When markets go through a period of volatility, the dips can be an excellent starting point for the portfolio – especially for gradual investments – and provide opportunities for risk-controlled tactical gains. But liquidating entire portfolios for reinvestment at a lower level can go horribly wrong.