Rising rates, bank failures weigh on investors' psyche

Psychology can have a much greater influence on financial markets than one might expect.

We often tell clients that throughout long periods of time, corporate earnings will determine the direction of stock prices more than anything else. In the short-term, however, it's anyone's guess which headline, press release or nugget of economic data might trigger a rally or selloff.

State regulators recently shutting down two publicly traded regional banks (Silicon Valley Bank in California and Signature Bank in New York) led to whipsaw trading in both stocks and bonds as investors tried to digest the news and make bets on the larger economic implications.

In the days after Silicon Valley Bank's demise, the VIX volatility index spiked 30%, the S&P 500 Financials sector fell 10%, and the two-year U.S. Treasury yield shed more than 100 basis points. Moves this extreme are not an orderly repricing of risk. Rather, they are signs of fear driving investor behavior.

There is an entire field of study called behavioral finance that analyzes how psychology impacts market outcomes. This column seeks only to build an awareness of those impacts, but market expectations will obviously affect any future response. "Investor sentiment" is the measurable benchmark that seeks to quantify the herd mentality toward market expectations, however optimistic or pessimistic it may be.

Two important points to remember about investor sentiment: First, market momentum (either positive or negative) matters a lot. During a long stretch of quality returns and low volatility, sentiment will almost always remain positive. Second, the herd is not particularly smart, so sentiment is typically most valuable as a contrarian indicator. As George Costanza from "Seinfeld" might say, "Do the opposite."

What's interesting about current market conditions is investors have a new variable to deal with: the psychology of inflation. Rising interest rates and a rapidly increasing cost of living have put consumers and investors alike in a situation most are unfamiliar with.

Some of the up-and-down action stems from a legitimate lack of economic clarity. But some is also the reality of a "new, old normal" requiring confidence that equities can perform well even without rock-bottom interest rates and an excessively friendly Fed.

History tells us these conditions do not necessitate poor equity performance. From 1991 to 1999, the Fed funds rate ranged from 3 to 6% and the S&P 500 was positive eight times in those nine years. Still, it's a stark contrast to the last decade-plus.

Since March 2009, investors have been conditioned to respond favorably to the Federal Reserve cutting interest rates. The Fed's willingness during that time to keep rates near zero led to the longest bull market in history. Its willingness to repeatedly cut rates at the first sign of market turbulence triggered numerous V-shaped recoveries. Despite economic data that has so far proven impressively resilient to rising rates, investors remain skeptical of the Fed's new religion — even if killing inflation will ultimately bring greater long-term benefits than rate cuts.

Though economic growth has slowed, consumer spending has hardly decreased. It makes sense that if prices might increase tomorrow, there is greater motivation to spend money today. Is that worth celebrating because consumer spending is the single largest driver of U.S. GDP? Or worth lamenting because it means inflation is likely to linger?

These are the questions that have investors less certain about the path forward. That said, compared to the alternatives, a crisis of confidence doesn't sound so bad after all.