There’s something odd going on in the housing market. Mortgage rates are appreciably higher than they were a year ago, but home prices—on average—have yet to fall. In recent months, house price increases have slowed, but as of the most recent reading, prices are nonetheless still increasing on a year-over-year basis. It reminds me of the cartoon character Wile E. Coyote, who experiences a delayed reaction every time he runs off the edge of a cliff. It’s only after he looks down that he realizes he has a problem.
What’s going on with home prices? One explanation is that higher rates cut both ways. In theory, higher rates should result in downward pressure on prices. But there’s another, more subtle factor at play: Many existing homeowners who had been considering selling now feel “stuck” in their homes. The problem is that if they move, they’ll have to take out new mortgages, which might be prohibitively expensive. The result: Fewer homeowners are putting their homes on the market. And that reduction in supply is putting upward pressure on prices at the same time that higher rates are applying downward pressure.
Ultimately, prices might come down. The key point, though, is that the impact is hardly straightforward. This dynamic illustrates something important about investment markets, which is that they tend to move in ways that, on the surface, often defy logic and expectations. Consider the bond market, for example. In normal times, bonds with longer maturities offer higher yields than shorter-term bonds. This makes intuitive sense: If you’re going to tie up your money for longer, you’ll want to be compensated for it. But that isn’t the case today. In normal times the yield curve is characterized by a smooth upward slope, but today its shape is entirely different. It looks a bit like a molehill. Rates are more or less the same across one-year, 10-year and 30-year bonds, but with a slight peak around the one-year mark.
Why is that? After each of its meetings, the Fed’s rate-setting committee issues a set of interest rate forecasts, and these forecasts carry a clue that can help investors understand today’s unusual interest rate situation. Bond investors, it turns out, are simply mirroring the Fed’s own thinking. In their most recent forecast, committee members projected that rates will peak this year, then drop by half in the longer term.
The Fed, of course, has been steadily raising rates for about a year, and this week reiterated its expectation that further increases will be required to bring inflation under control. But at the same time, investors are looking beyond today’s challenges and see rates dropping in the future. The lesson: If you’re building a bond portfolio, it may be worthwhile to allocate a portion to intermediate-term bonds to lock in some of today’s higher rates before they fall. However, because rising rates can impact intermediate-term bonds more than shorter bonds, you’ll want to do this judiciously. In other words, because rates might go higher and then go lower, you’ll want to balance both risks.
While not nearly as quantitative, stocks also follow a logical though counterintuitive pattern. In Mastering the Market Cycle, investor and author Howard Marks notes that today’s stock prices rarely represent a company’s current financial condition. Rather, today’s prices represent a combination of two other factors: investors’ expectations for a company’s future financial results and investor psychology. In mathematical terms, a company’s stock price equals its projected earnings multiplied by a price-to-earnings ratio. That latter figure represents the psychology element—how investors feel about the company.
That emotional component follows a well-known pattern, cycling over time between fear and greed. In normal times, when those two sentiments are roughly in balance, most types of stocks, on average, will tend to rise. But over time, as the market cycle progresses and prices continue to rise, investors will start to crowd into the fastest-growing, most attractive stocks. In recent years, that’s been companies like Apple, Amazon, Netflix and the like.
In the final stage of a market cycle, as prices rise yet further, some investors throw caution to the wind—often, as Marks notes, because they see their friends getting rich and can’t stand sitting on the sidelines. That’s when investor sentiment tends to cross over from investing to speculation. We saw this in the latter part of 2020 and in 2021, when companies with no earnings, SPACs and crypto “currencies” captured investors’ imaginations.
As we all know, periods of extreme investor behavior always come to an end. And when they do, investors retrench and reset to the other end of the spectrum, opting for the most conservative stocks, such as those in healthcare and consumer staples. The cycle then starts over again.
This poses a problem for investors: It means that risk is highest at precisely the point when everything looks most rosy. And by the same token, the opportunity for profit is greatest at the point when investors are feeling most downbeat.
This conundrum is unlikely to ever go away. As Marks notes, it will likely always repeat because it’s driven by human nature. What, then, can you do to protect your finances from this regular boom-bust cycle? I recommend this approach:
First, while it sounds simplistic, diversify. Structure the stock side of your portfolio such that you’re not overly vulnerable to any one particular type of stock. Hold some growth stocks, some value stocks and some international stocks. That way, you’ll always have some part of your portfolio that’s in relatively good shape, regardless of whether investors are in a greedy mood or a fearful one. An easy way to do this is with total-stock market funds.
Second, avoid trying to guess when the cycle will turn, because that’s a nearly impossible task. Instead, insulate yourself from unpredictability by aligning your portfolio with your needs. Hold enough assets outside the stock market to carry you through a downturn along the lines of the ones we’ve seen in recent history. I use five years as a rule of thumb. If you’re early in your career and only adding to your portfolio, this is less of a concern. But if you’re approaching retirement or making withdrawals for tuition or other expenses, I recommend this five-year set-aside.
Third, decide on an asset allocation—for example, 70% stocks, 30% bonds—then rebalance when it deviates significantly from those targets. This is a nearly automatic way to take advantage of the market’s inevitable ups and downs without trying to guess when they’ll occur.
In my opinion, those first three steps are sufficient. Howard Marks, however, suggests one more. While he acknowledges that investors can’t predict the future, he does offer this analogy: The future, he says, is like a bowl filled with lottery tickets. Some are winners and some are losers. If you reach in and take one, there’s no way to know which it’ll be. However, he says, informed investors tend to have a better sense of the mix in the bowl. In other words, no one knows exactly when the cycle will turn, but careful observers will have a better sense of how close to a market top or bottom we might be.
While I like this analogy, it’s still too susceptible to error, in my view. As I’ve noted before, even economists have a hard time predicting recessions. So do corporate executives. In announcing significant layoffs, CEOs including Mark Zuckerberg have acknowledged that they misjudged economic trends and mistakenly over-hired in recent years. The best solution, then, is to structure your portfolio so you’re prepared at all times for whatever might be around the corner.