The market recovery has been one for the history books, and investors have been noticeably optimistic through some tough economic times.
These past few years have helped retail investors become more engaged, build their resilience to volatility and, at times, see market dips as potential buying opportunities. That’s the good news: The adage that retail investors “buy high and sell low” is less true now. They are more practiced.
But now, the mindset has switched from “What could go right?” to “What could go wrong?”
Within that context, investors are getting increasingly anxious about what’s coming around the corner, whether it be a policy change or an inflation scare. That was evident last week, when the S&P 500 dropped 1.3% in the span of an hour on reports that President Biden was considering raising the capital gains tax for select individuals.
As an investor, sticking to your investment plan is important in good times and bad. But so is being flexible and opportunistic because the markets will inevitably throw some surprises your way.
State of the Market
Bulls have several reasons to be upbeat right now.
First, the U.S. has administered about 240 million vaccine doses, which has helped pave the way for the re-opening of more areas of the country. The positive impact has been clear in recent economic data, like historic jumps in consumer confidence and 6% gross domestic product (GDP) growth last quarter. Analysts now think S&P 500 earnings grew 34% year-over-year last quarter, the highest growth in 10 years.
Then again, all that news is already known, and the market seems to have factored it in. The devil is potentially in the details of what hasn’t already been reported.
With that in mind, here are our top three wild cards we’re watching out for:
1. An Inflation Scare
Prices have been moving higher. We’re seeing it all around us. Everyday commodities, such as crude oil, are back above pre-pandemic levels. Other important markets, such as lumber and iron ore (a key component of steel), are at record-high prices.
Long-term bond yields have also moved sharply higher since the beginning of 2021. Yes, part of that is to reflect improved economic growth. But what makes inflation a wild card is that it can quickly shift from being a positive sign of business recovery to an economic obstacle.
Data shows that prices are rising quicker for businesses than for consumers. That said, businesses may try to recoup some of those higher costs in the second half of this year, which could directly impact shoppers’ wallets.
The Federal Reserve (Fed) believes that inflationary pressures will be temporary and are likely to disappear over the next year, but what if that proves to just be wishful thinking?
2. The Fed’s Plans
Speaking of the Fed, its next shift in strategy will likely be less accommodative to financial markets. In the early days of the pandemic, the Fed cut rates to historic lows and started buying $120 billion of bonds each month.
The Fed reiterated on Wednesday that rather than inflation, its primary focus is to return the U.S. labor market to pre-pandemic levels. That would require adding another 8 million jobs. That said, the U.S. added 916,000 new jobs in March 2021. At that pace, the pandemic-related labor deficit could be eliminated early next year.
However, the latest “dot plot” survey of voting Fed members suggests that rates may not move higher until 2023 or later. In other words, a lot of investors could be surprised if it happened sooner.
Even if short-term interest rates stay near zero, the Fed has said that it would likely wind down bond buying first. When that happened in 2013, it was dubbed the “taper tantrum” because financial markets were scared by what the lack of Fed support would mean. From May to June, the S&P 500 fell 5.8% and the 10-year yield rose from 1.6% to 2.6%.
Then again, any market reaction when (and if) the Fed changes plans could be short-lived. Since 1950, the S&P 500 has gained an average of 4.1% in the 12 months after the Fed started raising rates.
3. The Chance for More Stimulus
Wild cards don’t have to spell doom and gloom for investors. Government spending programs, such as the $2 trillion infrastructure and $1.8 trillion American Families plans, could directly benefit both business and household spending.
These strategies will likely face more scrutiny than the first $5 trillion of economic relief doled out during the COVID-19 pandemic, which was primarily seen as a lifeline to struggling individuals and small businesses.
Even so, the infrastructure bill could potentially impact more than just bridges and roadways. It also could direct funds toward technology, healthcare and clean energy projects. And even if the American Families plan is offset by raising taxes on wealthier individuals, placing more money in the hands of consumers could give the economy and market an extra boost.
The Bottom Line
The market mindset is shifting again, and investors are paying more attention to potential barriers on the horizon. In a way, the cautiousness is healthy and rational. We’d rather see investors wary of risks than blind to them because they could be more prepared when bad news does come out. At any rate, this seems like an environment that could reward the fundamental investor over the passive investor.
It’s wise to know the risks, even when it seems like everything is going right. Investors need to be able to anticipate and adapt to wild cards that will occur from time to time. In this environment, that may mean keeping some cash on hand if buying opportunities arise while staying invested according to your goals.
Sign up to receive the Weekly Viewpoint and other top market insights delivered to your inbox.
Callie Cox, senior investment strategist, contributed to this article.
During her tenure as president of Ally Invest, Lule led Ally Invest Securities, Ally Invest Advisors and API business lines. She also authored several articles about the investing industry and investor behaviors. Lule has a passion for agile product development and an appreciation of design thinking in shaping user-centric experiences. An advocate for financial and retirement solutions that rely on a mix of digital and human guidance, Lule believes in empowering individuals, especially women and minorities, to independently drive their own financial futures.