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Markets in a Minute

The Psychological Pitfalls of a Market Cycle

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This Markets in a Minute Chart is available as a poster.

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This Markets in a Minute Chart is available as a poster.

The Psychological Pitfalls of a Market Cycle

When making investment decisions, investors have a wide variety of tools at their disposal.

For example, fundamental analysis can be used to estimate a stock’s intrinsic value. Technical analysis, on the other hand, requires an investor to analyze price movements to identify trends.

While these tools can form the basis of a sound investment thesis, their effectiveness is limited by one’s emotions. In today’s Markets in a Minute chart from New York Life Investments, we illustrate how sentiment can get in the way of rational decision making.

The Mentality of the Herd

Allowing emotions to dictate decisions is a common mistake made by many investors, yet they may not even realize it.

Herd mentality, which refers to an individual’s tendency to be influenced by his or her peers, often leads to heightened emotions and less rational decision making. In the context of investing, this tendency becomes particularly troublesome—market developments can be sensationalized in the media, by online blogs, or through word-of-mouth.

Mapping the Sentiment Cycle

Similar to how markets move in a series of patterns and cycles, the behavior of the investor herd tends to follow a continuous “sentiment cycle.”

1. Market Recovery
Today’s chart begins at the recovery stage of a market cycle, and assumes that emotional investors have recently suffered losses.

Although a support level has been clearly established, the herd is likely too afraid to act. Their fear of making another mistake causes them to miss the optimal window to re-enter the market.

2. Market Peak
Only after prices have substantially risen does the herd begin to take notice. Many of these investors will experience the fear of missing out (FOMO), and overzealously begin buying. Valuations at this point are likely no longer attractive.

3. Market Decline
What comes up must come down, and prices eventually peak as demand weakens. Investors who become too emotionally attached can find it difficult to cut their losses early.

4. Market Trough
By this point, the sentiment cycle has run a full course. Investors who followed the herd have likely sold at a loss, and will be reluctant to re-enter the market again.

Navigating Rough Waters

Investors are prone to falling into the sentiment cycle at any time, but especially when things get rough. So-called black swan events, such as the COVID-19 pandemic, can bring volatility to markets on short notice. In these situations, it’s common for investors to flock to safe-haven assets.

Since COVID-19 was classified as a global pandemic, money market funds have been in extremely high demand:

Money market flows

While this dramatic shift does have its merits—equity markets have seen deep selloffs—it may be a tad drastic. Governments around the world are making serious commitments to providing economic stimulus. In the U.S., the CARES Act amounts to a massive $2 trillion, and provides direct payments to families as well as support for both the private and public sector.

Keeping a Clear Mind

Now that we’ve outlined the psychological pitfalls of a market cycle, what can one do to break away from the herd?

A good start is becoming aware of the cognitive biases we commonly exhibit when investing. These biases can be linked to many of the emotions outlined in today’s chart. Finally, maintaining a growth mindset and learning from our past mistakes can also help us make better decisions in the future.

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Markets in a Minute

Visualizing S&P Performance in 2020, By Sector

Who were the big winners of 2020? We rank the S&P performance of 11 sectors—and provide possible explanations on why the market had a strong year.

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s&p sector performance charts

Visualizing S&P Performance in 2020, By Sector

With 2020 finally over, many are breathing a sigh of relief.

Investors faced a tumultuous year. Still, the S&P 500 finished strong with a 16% gain, outpacing its decade-long average by 4%. Many sectors that provided the new essentials—like online products, communication software and home materials—outperformed the market. It was, of course, a challenging year for other sectors including energy.

This Markets in a Minute graphic from New York Life Investments ranks the 2020 performance of every sector in the S&P 500 using data from S&P Global.

S&P Performance By Sector

As the world coped with devastating losses and uncertainty, how resilient were S&P 500 sectors?

Here’s how every sector performed, from top to bottom.

S&P 500 Sector2020 Price Return2019 Price Return10-Year Annualized ReturnsP/E (Trailing)*
Information Technology42.2%48.0%18.9%31.6
Consumer Discretionary32.1%26.2%16.0%48.1
Communication Services22.2%30.9%5.6%27.5
Materials18.1%21.9%6.6%40.4
Health Care11.4%18.7%13.8%25.3
Industrials9.0%26.8%9.6%28.9
Consumer Staples7.6%24.0%8.7%25.1
Utilities-2.8%22.2%7.2%21.1
Financials-4.1%29.2%8.6%15.3
Real Estate-5.2%24.9%6.6%36.3
Energy-37.3%7.6%-5.6%N/A
S&P 50016.3%28.9%11.6%31.2

*Trailing P/E measures market value divided by the last 12 months of earnings

As no surprise, technology came out on top with over 42% returns for the year.

COVID-19’s economic impact benefited the sector as activities, from work to socializing, moved online. In 2020, the tech sector’s returns were more than double its 18.9% average over the last decade.

Consumer discretionary was also one of 2020’s top sectors. Home to online marketplace giants along with electric vehicle companies, it posted a 32.1% return—surpassing its 2019 gains.

With -37.3% returns, energy was the hardest hit of all. Historic demand disruptions, along with OPEC tensions led to sector weakness. Like energy, real estate had a difficult year. Still, after declining 40% in March, by year-end, the sector mostly rebounded with just 5% losses.

Why The Market Had a Strong Year

Looking back, one of the biggest questions baffling investors is: why did the market perform so well? A number of factors, including government stimulus, low interest rates, and vaccine expectations can all help explain some of its behavior.

Government Stimulus

In March, the U.S. government approved a $2.2 trillion CARES-Act relief package, breaking historical records for stimulus. This helped create optimism in the market as individuals, small-businesses and corporations received financial relief.

At the same time, the Federal Reserve extended its “quantitative easing” policies that it introduced in 2008. Quantitative easing is when the central bank buys a number of longer-term securities. This type of measure is designed to boost economic activity through injecting liquidity into the market.

In 2020, the Federal Reserve began purchasing corporate bonds and other assets—on top of treasuries and mortgage-backed securities (MBS)—for the first time ever. In fact, the Federal Reserve is now estimated to 34% of MBS in the U.S. to help protect American homeowners.

Low Interest Rates

Another force that may have contributed to S&P performance in 2020 was the Federal Reserve’s low-interest rate policy.

Low interest rates mean that borrowing costs are low, which can be favorable for business conditions. In September, the Federal Reserve announced a “lower for longer policy”, stating that it won’t raise rates until 2023.

Vaccine Expectations

The promise of a vaccine rollout has contributed to S&P 500 performance momentum, along with expectations that things could return to normal in 2021. It also corresponded with double-digit gains for the health care sector.

Though roadblocks and uncertainties remain, vaccine announcements in November also helped spur an uptick in the energy sector, which will be influenced by global vaccine efforts in the months ahead. This, in turn, will help travel resume to normal and spark oil & gas demand.

S&P Performance: What Comes Next in 2021

With the first year of the pandemic behind us, it’s hard to say how the story will continue.

As countries acquire vaccines, there is hope for S&P 500 performance, and future stimulus measures could prop up the stock market. Of course, both the containment of the virus and people feeling safe will have an outsized impact on S&P sectors in the shift to a post-pandemic world.

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Markets in a Minute

How Do Countries Around the World Compensate for Equity Risk?

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Equity Risk Premiums

How Do Countries Compensate Investors for Equity Risk?

When investors purchase stocks internationally, they are exposed to additional risks. Companies may have higher volatility based on a country’s economic, political, and legal conditions. In exchange for taking on the additional risk, investors demand a higher return potential, known as an equity risk premium.

Which countries have the highest premiums? In this Markets in a Minute from New York Life Investments, we explore equity risk premiums for countries around the world.

Behind the Numbers

The premiums are based on a study by a New York University researcher, Aswath Damodaran. All data is as of July 1, 2020.

Here are the steps Damodaran took to determine a country’s equity risk premium:

StepExample - Brazil
1. Find a country’s credit (bond) risk rating.Credit risk rating: Ba2
2. Based on that rating, determine the credit spread, which is the additional yield over a risk-free investment.Credit spread for Ba2 rating = 3.53%
3. To account for the additional risk stocks carry over bonds, multiply the credit spread by the relative equity market volatility.

This is the country risk premium.
3.53% credit spread x 1.25 relative equity market volatility

= 4.41% country risk premium
4. Add the country risk premium to the mature market risk premium (obtained by using the S&P 500 risk premium).4.41% country risk premium + 5.23% mature market risk premium
5. The resulting value is the country equity risk premium.9.64% country equity risk premium

Premiums will shift over time as a country’s credit rating, credit spread, and equity market volatility changes.

Equity Risk Premiums by Country

Below, we look at how equity risk premiums break down for 177 countries and regions, organized from highest to lowest.

CountryEquity Risk Premium
Sudan27.14%
Venezuela27.14%
Yemen, Republic27.14%
Algeria22.86%
Argentina22.86%
Guinea22.86%
Haiti22.86%
Korea, D.P.R.22.86%
Lebanon22.86%
Liberia22.86%
Somalia22.86%
Syria22.86%
Zambia22.86%
Zimbabwe22.86%
Ecuador19.92%
Congo (Republic of)18.46%
Cuba18.46%
Iran18.46%
Libya18.46%
Malawi18.46%
Mozambique18.46%
Sierra Leone18.46%
Barbados16.25%
Belize16.25%
Congo (Democratic Republic of)16.25%
Gabon16.25%
Guinea-Bissau16.25%
Iraq16.25%
Angola14.79%
Belarus14.79%
Bosnia and Herzegovina14.79%
El Salvador14.79%
Gambia14.79%
Ghana14.79%
Madagascar14.79%
Maldives14.79%
Mali14.79%
Moldova14.79%
Mongolia14.79%
Myanmar14.79%
Nicaragua14.79%
Niger14.79%
Pakistan14.79%
Solomon Islands14.79%
St. Vincent & the Grenadines14.79%
Suriname14.79%
Tajikistan14.79%
Togo14.79%
Ukraine14.79%
Bahrain13.32%
Benin13.32%
Burkina Faso13.32%
Cambodia13.32%
Cameroon13.32%
Cape Verde13.32%
Costa Rica13.32%
Egypt13.32%
Ethiopia13.32%
Guyana13.32%
Jamaica13.32%
Kenya13.32%
Kyrgyzstan13.32%
Nigeria13.32%
Papua New Guinea13.32%
Rwanda13.32%
Sri Lanka13.32%
Swaziland13.32%
Tunisia13.32%
Uganda13.32%
Albania11.84%
Bolivia11.84%
Cook Islands11.84%
Greece11.84%
Honduras11.84%
Jordan11.84%
Montenegro11.84%
Tanzania11.84%
Turkey11.84%
Uzbekistan11.84%
Armenia10.52%
Bangladesh10.52%
Côte d'Ivoire10.52%
Dominican Republic10.52%
Fiji10.52%
Macedonia10.52%
Oman10.52%
Senegal10.52%
Serbia10.52%
Vietnam10.52%
Azerbaijan9.64%
Bahamas9.64%
Brazil9.64%
Croatia9.64%
Cyprus9.64%
Georgia9.64%
Namibia9.64%
Guatemala8.90%
Morocco8.90%
Paraguay8.90%
South Africa8.90%
Trinidad and Tobago8.90%
Hungary8.46%
India8.46%
Italy8.46%
Kazakhstan8.46%
Montserrat8.46%
Portugal8.46%
Romania8.46%
Russia8.46%
St. Maarten8.46%
Andorra (Principality of)8.03%
Bulgaria8.03%
Colombia8.03%
Curacao8.03%
Indonesia8.03%
Philippines8.03%
Sharjah8.03%
Uruguay8.03%
Aruba7.58%
Mauritius7.58%
Mexico7.58%
Panama7.58%
Slovenia7.58%
Spain7.58%
Thailand7.58%
Turks and Caicos Islands7.58%
Laos6.99%
Latvia6.99%
Lithuania6.99%
Malaysia6.99%
Peru6.99%
Bermuda6.48%
Botswana6.48%
Brunei6.48%
Iceland6.48%
Ireland6.48%
Malta6.48%
Poland6.48%
Ras Al Khaimah (Emirate of)6.48%
Slovakia6.48%
Chile6.26%
China6.26%
Estonia6.26%
Israel6.26%
Japan6.26%
Saudi Arabia6.26%
Belgium6.12%
Cayman Islands6.12%
Czech Republic6.12%
Guernsey (States of)6.12%
Hong Kong6.12%
Jersey (States of)6.12%
Macao6.12%
Qatar6.12%
Taiwan6.12%
Abu Dhabi5.96%
France5.96%
Isle of Man5.96%
Korea5.96%
Kuwait5.96%
United Arab Emirates5.96%
United Kingdom5.96%
Austria5.81%
Finland5.81%
Australia5.23%
Canada5.23%
Denmark5.23%
Germany5.23%
Liechtenstein5.23%
Luxembourg5.23%
Netherlands5.23%
New Zealand5.23%
Norway5.23%
Singapore5.23%
Sweden5.23%
Switzerland5.23%
United States5.23%

Venezuela, Sudan, and Yemen are tied for the highest equity risk premium. While Venezuela battles hyperinflation, Yemen is suffering from a humanitarian crisis and Sudan has high perceived corruption.

In the mid-range, emerging countries such as Brazil, South Africa, and India carry moderate risk. However, they may also provide investors with higher returns than can be expected in mature markets.

On the low end of the scale, countries such as the United States, Singapore, and Germany have AAA credit ratings and the lowest premium of 5.23%.

Applying Risk Premiums to Companies

How can investors determine the equity risk premiums for individual companies?

One method is to assume that all companies incorporated in a country have equal exposure to that country’s risk. However, this is a simplified approach and does not account for the fact that a company’s operations may extend into other markets.

Alternatively, investors can calculate a weighted-average premium based on the location of a company’s revenue or production. For example, a consumer products business may weigh exposure based on the location of their revenue. An oil and gas company, where true risk lies in their reserves rather than where they sell, may instead be weighted by production.

Here’s a hypothetical example for an oil & gas company that has reserves in the United States, Saudi Arabia, and Venezuela:

CountryProduction (in kboed)*% of TotalEquity Risk Premium
Total300100%14.41%
U.S.6020%5.23%
Saudi Arabia12040%6.26%
Venezuela12040%27.14%

* Kilobarrels of oil equivalent per day.

The weighted-average equity risk premium is 14.41%.

Importantly, even countries headquartered in mature markets have international risks if they carry out operations in other countries.

Risk Vs. Potential Reward

Every country presents varying degrees of risk based on local conditions. As investors look to diversify internationally, it’s critical to consider two factors:

  • The additional risk
  • The potential additional return

Equity risk premiums serve as a guide that can help investors compare country risk, and the additional return potential they should expect for tolerating that risk.

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