Beware of Negativity Bias as Markets Go on Sale

Steve Brice

I have had two instances in the past few weeks when members of a live audience shared their strong conviction in a bearish stock market outlook. One member gave a very precise 10-year forecast for the S&P 500 index (-2% per annum), while the other was more vague in terms of time horizon or the specific equity market he was referring to.

I have two issues with this, both of which are related to the conviction they held in their views. First, people with high conviction are very persuasive and compelling. Negativity bias – whereby we tend to attach a higher weight to negative information or views – merely exacerbates this. As such, they may have an outsized impact on the audience’s investment decisions. In the negative views are wrong, it would undermine investors’ ability to achieve their financial goals.

Second, people with high conviction infer that they know what is going to happen, which is definitively not the case. The outlook is probabilistic and not known by anybody ahead of time – you, me or other esteemed finance professionals.

Of course, this is not to say they will be proven wrong. I can paint a scenario whereby equities lose value over the short run. This could go as follows: the lockdown in China extends through the rest of the year, while Europe decides to disengage from Russian energy supplies. This would keep supply-side inflation elevated, which, together with tight labour markets fuelling wage pressures, could force dramatic monetary policy tightening around the world.

Even without a recession, this could be challenging for markets as history shows that equity market valuations (eg. price-earnings ratios) are lower during periods of high inflation and interest rates. If you were to add in the chance of a recession, as the central banks tighten policies too aggressively, earnings would be hit dramatically, and equity markets could decline even further in the short run.

Making a case for a 10-year decline in equities is harder, in my opinion, as earnings tend to rise over the course of the cycle and companies pay out dividends during that period. High inflation would likely be reflected in higher earnings as well, especially over longer time horizons. Of course, there have been instances when 10-year periods generate negative returns, but it is very rare and is usually very sensitive to the start and end dates i.e., if you move the start and the end date by a year, the outcome is usually very different.

Of course, an alternative scenario is if inflation peaks. This would buy time for the Fed, enabling it to slow the pace of expected policy tightening to allow the effects of tighter policy to feed more gradually into the economy. This would also allow time for the economy to slow – something that was likely to happen regardless of Russia’s invasion of Ukraine. Such a scenario would see a slowdown in job creation, reducing the pressure on wage inflation. There are some initial signs that inflation may be peaking, but it is certainly too early to be definitive about this outlook.

The challenge for investors is factoring in this uncertainty and making an investment plan. So how do we go about it? The first piece of advice is selling after sharp declines is not usually the optimal course of action. For investors, staying invested requires great fortitude, but timing the exit and re-entry into markets, even for finance professionals, is even more difficult. Indeed, our experience is that many individual investors who sell their equity holdings often take years to

invest back in the markets. This dramatically reduces their ability to meet their financial objectives.

The second piece of advice, for those with cash on the sidelines and great discipline, is to gradually feed money into markets. This can be even more challenging as it is difficult to be greedy when everybody else is so fearful, but a gradual approach to buying into assets that are on sale is likely to bear long term fruits.

This begs the question as to what to buy. The default setting would be to first ensure that your purchases are diversified so that you plan for different scenarios – after all one of the challenges this year has been that both bonds and equities have sold off together. Looking at it opportunistically, both bonds and equities are ‘on sale’. Within this, particular areas of value, in our view, are Asia ex-Japan equities and USD-denominated bonds, private credit and shorter- dated areas of the bond market.

(Steve Brice is Chief Investment Officer at Standard Chartered Bank’s Wealth Management unit)