It has been nearly 11 years since equity markets bottomed during the financial crisis, and the ensuing years have been lucrative for investors. The first table shows the major North American indices and their compound annual returns in (Canadian dollar terms) over the decade ending last month. With the exception of the S&P/TSX Composite, these are all double-digit returns.
Source: RBC Capital Markets Quantitative Research
These post-recession returns haven’t just been high, they have been consistent. The next chart shows the normalized price of the S&P 500 during each of the bull markets since WWII. The current bull market, shown in red, is the longest by over a year.
Taken in combination, these two charts suggest that never in history have investors had it this good. There is currently a young generation of investors who has never seen a bear market. This generation is also the one that has embraced online investing and ETFs. Their major concern has been minimizing fees, since performance hasn’t been an issue: many ETFs have mirrored the impressive returns in the table above.
This type of investing landscape has the potential to breed complacency. Recency bias – the human tendency to more easily remember recent versus older events – means that many investors aren’t even contemplating the possibility that a bear market could occur, let alone the impact a prolonged selloff would have on their own investment decisions.
This brings us to the title of this post. It’s a quote from Mike Tyson, who was once the most feared heavyweight boxer on the planet. We’ll let “Iron” Mike expand upon what he meant when he dropped that quote:
People were asking me [before a fight], “What’s going to happen?” They were talking about his style. “He’s going to give you a lot of lateral movement. He’s going to move, he’s going to dance. He’s going to do this, do that.” I said, “Everybody has a plan until they get hit. Then, like a rat, they stop in fear and freeze.”
Time and time again investors have exhibited similar behaviour when they get punched in the mouth by a bear market. That is, they become fearful and make decisions they (likely) know are bad, but seem right emotionally. The following chart shows monthly fund flows for U.S. equity ETFs (blue bars) and monthly changes in the S&P 500 index (red line). Note what all of the negative blue bars have in common: they occur either in the same month or the month after a market selloff. This suggests that ETF investors are quite fearful when punched in the mouth, as they waste no time selling when the market is down.
Source: Bloomberg, Investment Company Institute
So far in the current bull market, this irrational behaviour by ETF investors has not had any long-lasting repercussions for them, as all of the market selloffs have rebounded quickly. In other words, they haven’t yet been punched hard. But we believe it’s foolish to think that there will never be another haymaker coming.
When will we be hit?
From our point of view, we would certainly welcome more of this type of irrational behaviour from ETF investors. Historically, the highest returns have occurred when capital is scarce, and vice versa. And over the latter stages of this bull market we have been competing with an unprecedented amount of capital flowing into the public markets via ETFs.
What could bring an end to the abundance of capital? Higher interest rates are an obvious possibility. A punch in the mouth from a market selloff would hurt investors much more if the cost to borrow their investment capital is also increasing. And what could drive interest rates higher? Inflation is the main driver for most central banks. But so far in the U.S., inflation has remained muted. In December it was up 2.3% year-over-year, but as shown in the following chart, this was driven mainly by just two components: rent of shelter and health insurance. So inflation pressure isn’t exactly widespread. At least not yet. Our plan for anticipating when we will be punched includes watching inflation trends closely. And as we have demonstrated during previous market selloffs, we won’t stop in fear and freeze when the inevitable bear market comes.