Market Commentary

(Ir)rational Exuberance

January 2018

"Be fearful when others are greedy, and be greedy when others are fearful" – Warren Buffett

Warren Buffett’s advice in the quote above is rooted in the knowledge of uncertainty; specifically, the uncertainty of the future. Annually in January, of course, market predictions for the future abound. Reading the news in January is thus an exercise in incredulity – about the certainty the prognosticators declare about an inherently uncertain future.

In both 2016 and 2017, top strategists predicted middling single digit returns in the coming year amid then widespread pessimism. In early 2017, the Brexit vote had cast uncertainty on Europe’s economic prospects, and there was overwhelming trepidation about the first year of the Trump presidency. Nonetheless, in both years, the broad stock markets continued to climb.

Again, we find ourselves in early January, with market prognosticators looking at the road ahead. The forecasts couldn’t be more different this time, though: current headlines are almost uniformly optimistic about growth in 2018. Goldman Sachs even went as far as to call this "rational exuberance"¹ in an ominous play on the late 90’s rally in tech stocks.

We lead this quarter’s market commentary with Warren Buffett’s quip about the value of recognizing herd behavior because the broad agreement about market growth in 2018 strikes us as precisely the sort of herd behavior that should give any seasoned investor pause. We see it as an example of a common tendency to assume a continuation of recent trends, referred to as "recency bias."²

As discussed in academic circles, the "recency bias" means we’re inclined to use our recent experience as the baseline for what will happen in the future. Recent information is more easily remembered, and ends up more heavily weighted in a current decision. It can thus lead to expectations of a direct continuation of recent market price performance, when in fact a look at history proves otherwise.

Back in early 2008, who thought there was a risk of a dramatic economic downturn? Analysts who looked back as far as 20 years could see only a 0.04% chance of a 4% quarterly decline in GDP. Such a decline had happened 11 times, however, in the previous 60 years, so if you had a longer timeframe, you could see that even low likelihood events do happen.³

How important is it for us to pay attention to this type of potential negative outcome that only happens intermittently? If you have the goal of preserving and growing your clients' wealth, we argue it is very important. We draw an example from another area of risk and growth in many people’s lives: learning to drive.

When you learn to drive, or are tasked with teaching a teenager to do so, you become familiar with the concepts of defensive driving. Defensive driving doesn’t mean driving slowly, it means an awareness of potential hazards on the road, including other drivers and adverse weather conditions. Investing is similar.

In the short term, we at North Berkeley do see continued opportunity in equities, buoyed by newly lowered corporate tax rates and innovation in technology and renewable energy. Our sense of opportunity is tempered, however, both by the historically high level of prices relative to earnings, and by the potential for inflation and rising interest rates to dampen real growth. We are taking note of shifting conditions on the road, and are looking ahead to determine if we should adjust our speed.

Moving ahead in 2018 we remain focused on protecting and growing our client portfolios, and appreciate the continued trust you put in us to partner with you on this journey. In our clients' lives, we witness unexpected twists and turns, and we work to adjust personal and family plans to ensure financial security as well as flexibility. We do the same with client portfolios, seeking to ensure growth and stability over the long term that can be the financial underpinning for the decisions our clients don’t yet know they’ll face in future.

This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.

1. Barrons: "Market to experience rational exuberance in 2018 – Goldman", November 22, 2017
2. New York Times: "Tomorrow’s Market Probably Won’t Look Anything Like Today," February 13, 2012. https://bucks.blogs.nytimes.com/2012/02/13/tomorrows-market-probably-wont-look-anything-like-today/
3. Esquire: "Nate Silver’s Theory on 'Recency Bias,'" February 8, 2009 http://www.esquire.com/news-politics/a5549/nate-silver-on-economy-0309/