Be on the Lookout For the Next Change in Trends

Investors need to be wary of the “recency effect,” which regularly costs people a lot of money.

Under the recency effect, people tend to remember best the facts and ideas to which they’ve most recently been exposed. In investing and economics, people believe the future will be very similar to the recent past. It’s a variation of “What have you done for me lately?”

The recency effect is why we have bubbles in markets and why few people will buy investments at the bottom of bear markets. It is one of the reasons many investors buy high and sell low.

It appears to me that most investors have been in the thrall of the recency effect. Market prices and investor surveys indicate investors believe the next few years will be very similar to the last few years. They’re very complacent and expect very low interest rates, little change in inflation, steady economic growth and rising prices for most investments. The U.S. economy and stock indexes are expected to remain the world leaders for several more years. We see the complacency in measures of volatility, such as the VIX index.

Yet, policies have changed, and that is leading to changes in economies and markets.

The Federal Reserve stopped its quantitative easing policies in 2014. Then, it implemented a long-term plan to raise interest rates. I believe interest rates and inflation reached long-term low points in July 2016. In the meantime, the European Central Bank (ECB) accelerated its monetary policy and many emerging markets began to recover from the economic downturn and bear market that began in 2011.

We started to see the effects of these policy changes in the economy and markets in 2016 and changed our portfolios accordingly.

The U.S. economy continues steady, sustainable growth. I see that continuing as long as the Fed doesn’t tighten monetary policy too much or there aren’t other policy mistakes.

But economies outside the United States are improving, and many are or soon will be growing at least as fast at the United States. The shift to higher growth outside the United States likely is still in its early stages.

Stocks outside the United States have had higher returns than the domestic market for most of the last year, and I expect that to continue. Stocks, of course, are helped by aggressive monetary policies. Also, there is much higher growth potential, barring policy mistakes or economic shocks, because international economies and stocks are starting from much lower levels than in the United States.

Most investors still aren’t aware of these shifts, so they aren’t priced into the markets.

For the last few years, I’ve said the greatest risk to the markets and economy is that the Fed might raise interest rates too far, too fast. While that’s still a risk, recent statements by Fed leaders give me the impression it’s a low risk.

A greater risk, but still not a high probability, is that the ECB might tighten its monetary policy too soon. The ECB’s in a more difficult position, because the different economies in Europe are in different stages of the cycle. Germany’s economy is strong and normally would be due for tighter monetary policy. But others, especially France, Italy and Spain, still need a lot of help. The ECB indicated it will tighten policy in 2018, so we’ll have to watch carefully to see if it tightens more than the economy can handle.

We’ll continue to monitor the factors that matter to the markets over time. Because policies matter so much these days, we’re also watching closely central bankers, politicians and other policy makers. We want to respond early to the next change in trends.