Investing happily ever after: lessons from fairy tales

The economy: “Goldilocks and the Three Bears”

In the fairy tale “Goldilocks and the Three Bears,” a young girl, Goldilocks, comes across an empty house in the woods where she finds three bowls of porridge, three chairs, and three beds. After trying them all, she finds one of each that suits her perfectly and ends up falling asleep. Her tranquil nap ends when the three bears who own the house in the woods come home, and she runs away, never to be seen again.

Many are familiar with the term Goldilocks economy―it’s used to describe an economic environment that’s not too hot, not too cold, but just right. Some investors used this term at the beginning of the year to describe the state of the global economy; however, we believe that complacency in believing in the notion of this perfect economy can create surprises if we aren’t careful. The global economy has slowed throughout the year, and we believe that the balance of risks remains to the downside.

The S&P Global Purchasing Managers' Indices are monthly economic surveys of carefully selected companies in manufacturing and services. They provide advance insight into the private sector economy by tracking variables such as output, new orders, employment, and prices across key sectors. A reading above 50 indicates that the manufacturing/service output is growing while a reading less than 50 signals contraction.

Entering the second of half of the year, global manufacturing experienced a growth slowdown with output expanding at the weakest rate in a year. This can be seen in the world’s largest economies (the U.S., Europe, and Mainland China) and, at this point, the outlook isn’t likely to improve drastically with new orders declining. Global services, on the other hand, are bucking the trend and have expanded through the past year and a half. Services generally follow the strength of household consumption, and household consumption, in turn, is typically influenced by income growth from employment and wage growth, credit growth, and excess savings. Excess savings built up during the pandemic have been depleted even as banks continued to tighten their credit standard―developments that have led to weaker loan growth. While income and employment growth has been resilient, the cracks that appeared earlier in the summer are becoming deeper. 

Economist Claudia Sahm created the Sahm Rule, which tracks the risk of a recession based on the unemployment rate. According to her rule, the United States is likely to have slipped into the early stages of a recession when the 3-month moving average of the U.S. unemployment rate is 50 basis points or higher than the trough it hit over the previous 12 months. The U.S. unemployment rate rose to 4.3% in July, up from 3.4% in January 2023; in other words, the threshold for the Sahm Rule was breached in July.

While the economy’s recent resilience speaks for itself, we believe investors shouldn’t be complacent; the notion that this perfect economy will continue can create surprises if we aren’t careful.

While the economy does seem to be on solid footing for now, we need to remind ourselves that, like Goldilocks, this fairy tale might not last forever.

Equity: “The Ugly Duckling”

“The Ugly Duckling” is a fairy tale about a baby duck that looks different from the others and is quickly shunned by its siblings and other animals. The duckling spends time searching for acceptance until one day, when he’s fully grown, he joins a flock of swans, and when he sees his reflection in the water, he realizes that he isn’t an ugly duckling at all but was a beautiful swan all along.

We believe that there are similarities between this tale and the current environment for equity investing. The focus on the equity market has been concentrated on a handful of large mega cap names, commonly referred to as the Magnificent 7, while largely ignoring much of the rest of the companies in the S&P 500 Index. In all fairness, some of these companies have performed quite well, and since they’re large components of the U.S. equity market, they’re widely seen as the main drivers of performance. That said, they haven’t been the only companies to do well this year; in fact, over 170 companies have outperformed the S&P 500 Index returns year to date.¹

With a slowing economic environment, as indicated by the Institute for Supply Management’s manufacturing data, we believe there’s likely to be much choppier and varied earnings among companies. We’re of the view that it makes sense to focus more on quality factors—which include high return on invested capital, high return on equity, strong recurring cash flows, and stable margins—as they’re more likely to be rewarded in this type of environment.

In our view, valuations, as measured by trailing price-to-earnings (P/E) ratios, seem to be getting stretched, not only in the United States but around the world. While P/E is only one way to measure value, it’s able to provide a general sense of whether there may be a better relative geographic opportunity. As it stands now, there doesn’t seem to be. 

However, this is a period in which active portfolio managers have the opportunity to shine as they look beyond the main stock indexes to uncover investment opportunities at the individual company level. It’s less about where to invest but rather about what to invest in.

In an environment of weaker economic data, uncertain earnings growth, and elevated valuation, it’s important to look beyond the surface appearance to identify those companies that might at first be cast aside as ugly ducklings—they might actually be swans waiting to reveal themselves. 

Fixed income: “The Three Little Pigs”

The fable “The Three Little Pigs” tells the story of three pigs that each built a house out of different materials (straw, sticks, and bricks) to protect themselves from a wolf determined to blow their houses down. The story illustrates the need to be patient and the importance of building a house (or an asset) that can withstand the test of time.

We believe this story really lends itself to fixed-income investing, which for many hasn’t worked out the way they had expected it to since the end of 2022. While the backdrop of cooling inflation and the expectation of declining interest rates has theoretically set up the case for investing in bonds, the anticipated outcome has yet to play itself out—patience has been necessary. In this context, we find ourselves asking, “How strong is our fixed-income house?”

Before we start our fixed-income story, it’s important to quickly revisit the path for inflation moving forward as it’s a factor that will drive interest-rate expectations and bond returns.

Global central banks (with the exception of the People’s Bank of China and the Bank of Japan) began raising their overnight rates aggressively in 2022 to rein in high inflation. Fast forward a few years, and central banks have made tremendous progress in lowering inflation. Global inflation as measured by the Bloomberg World Economy Weighted Inflation Index, which tracks the Consumer Price Index for more than 98% of the global economy, peaked at 10.4% in November 2022 and has fallen by more than half, to nearly 5.0%, as of August 2024. This shows that the global easing cycle is clearly under way, with 35.0% of global central banks cutting interest rates. Taken together, they represent roughly 46.0% of global GDP.¹

The key message for investors here is that the risk of rising rates is behind us and that the path of least resistance for rates is moving downward. While we remain skeptical that central bank rates in the United States and Canada will return to prepandemic levels, it’s likely that we’ll end up somewhere in the 2% to 3% range. We believe this will be a positive catalyst for bond portfolios. 

Our three phases of fixed-income investing thesis looked at the projected opportunity set for bonds moving forward. We described it in three phases: the sweet spot, duration is your friend, and take on risk. It’s evident to us that many economies are in phase two of the three phases, where it could make sense to consider tactically increasing duration to take advantage of falling yields. 

Crucially, there’s room for yields to fall further on the back of a weakening economic backdrop. It’s also worth noting that the average bond prices across various bond indexes are trading below their 5- and 10-year averages.

What this means is that there remain pockets of opportunities in the fixed-income market, but investors need to be more diligent to uncover them. The prudent, patient, fixed-income investor who takes the time to build a portfolio out of the best material, like the third pig in the story, is more likely to see that hard work pay off.

Market volatility: “Hansel and Gretel”

“Hansel and Gretel” is a story of a brother and sister who were abandoned in the woods before being found by a seemingly friendly old woman, but the woman turned out to be a scary witch intent on eating the siblings. Rather than succumb to her fears, young Gretel takes advantage of an opportunity to turn the tables on the witch, enabling her and her brother to escape to safety.

Investors, like the two kids in the story, can often be caught off guard by scares in the market, but they too are better off analyzing the situation calmly and seizing any opportunity that presents itself to get the desired outcome rather than getting paralyzed with fear.

Back in early August, the S&P 500 Index was seemingly priced for perfection as market participants were expecting a soft landing for the U.S. economy. In our view, any key economic data that came in below expectation could have sparked a sell-off.

The somewhat dovish announcement from the U.S. Federal Reserve (Fed), weak U.S. employment numbers, and geopolitical headlines around the world were the perfect ingredients to spark a jump in market volatility.

The Cboe Volatility Index (VIX) is a measure of the fear associated with investing in the S&P 500 Index. VIX breached the 30 level for the first time since October 2022 during the August sell-off (it’s since come back down, trading below its historical average of around 19).¹

While this short period of volatility is now in the rearview mirror, it’s a given that it will return. Unfortunately, like Hansel and Gretel, investors are likely going to be caught off guard as it’s near impossible to predict the exact sources of future risk, much less time it. It shouldn’t surprise anyone that the upcoming U.S. election has been highlighted as a potential trigger for additional market volatility.

Elections, economic growth, and markets all move in cycles. Sometimes they coincide and other times they don’t. While government policies can have an impact on the economy and markets, it’s rarely immediate or profound. Using data that goes back all the way to 1945, on average, we see little difference in the calendar year returns of the S&P 500 Index under either a Democratic or Republican administration. While some may note that the data appears to suggest that the index underperformed slightly under a Republican administration, it’s worth noting that the results were somewhat skewed by global financial events such as the dot-com bubble and the great financial crisis.

Regardless of the source of volatility, it’s important for investors to take a step back and look at the bigger picture. Market corrections are normal and very hard to predict. Since 1980, the S&P 500 Index has fallen an average of ~14.0% in any given calendar year but is positive 75% of the time with an average return of ~10.0%.¹ It may be hard to appreciate in the moment, but periods of heightened market volatility can often translate into opportunities for longer-term investors. Since 1990, the S&P 500 Index has returned, on average, over 22% in the 12 months after the VIX has breached the 30 level. 

Should the markets experience more volatility in the near or long term, we think investors should embrace their inner Gretel: Assess the situation calmly while waiting for the right moment to act rather than let their fear drive them to the wrong decision.

Ultimately, fairy tales are just stories, but it’s the meaning behind the story that really matters. The lessons learned can be applied in many ways, and they’re not just for kids. We believe that there are lessons to be learned and applied in investments as well, and these fairy tales could help pave the pathway to investing happily ever after.

This is an updated version of our previous article, What can fairy tales tell us about investing in today’s markets?

1 Bloomberg, as of August 21, 2024.