“New normal” is one of those phrases that was so overused during the pandemic that it practically lost its meaning. While this term became part of our shared language more recently, people have always been hardwired to assume that any new status quo will continue indefinitely.1 Humans simply aren’t great at envisioning a future that is different than the present.
We know that the economy goes through cycles, and yet each recession feels like the end of the world with headlines wondering whether the economy will ever recover. Despite being proclaimed as a new normal, the covid virus and the masks we all wore no longer dominate our daily life. In sports, it’s easy to assume that the team that won the championship in the prior season will be back at the top in the following season — it’s rarely that simple, even though we’re still holding out hope for the Warriors to make another run this year. It is human nature to assume the present landscape will continue unchanged. This straight-line thinking can impede our ability to make decisions about a future that is constantly in flux.
In the world of investing, “recency bias” is the tendency to overemphasize the importance of recent experiences or the latest information when estimating future events. Recency bias often misleads us to believe that recent events give a clear indication of how the future will unfold.
Last year, the S&P 500 was down -18.1% and bonds had a historically bad year. An investor could easily draw the conclusion that markets would continue to decline based on the persistent experience of the prior twelve months. Instead, the S&P 500 has grown by +8.2% to start the year and bonds have resumed their normal role in portfolios and are up +3.0% in 2023. History has repeatedly proved that recent performance should not be interpreted as a clear indication of where markets are going next, despite its prominence in the minds of investors.
This phenomenon can tempt investors to sell when markets are declining, out of fear that the trend will continue unabated. Conversely, investors often pile into a stock or cryptocurrency when prices are rising based on the irrational belief that the trajectory of growth can and will continue uninterrupted. What’s important to remember is that, over time, each area of the market has its moment in the sun: internet stocks in the late 90s, commodities and real estate in the early 2000s, large-cap tech stocks through the low-interest rate period of the 2010s. Seasoned investors understand this and regularly rebalance portfolios to a long-term investment allocation, rather than chasing recent trends, in order to proactively address the risks of recency bias.
A Calm Moment in the Market
Expecting the status quo to continue can lull investors into a false sense of predictability. For example, looking only at the past month, an investor could develop the perspective that price volatility is not a current risk. Stocks have been trading in a tight range and volatility — as measured by the CBOE Volatility Index, more commonly called the VIX — has come down dramatically since March’s bout of regional bank-inspired uncertainty.
The VIX is Wall Street’s so-called “fear gauge” and uses options pricing to measure implied volatility going forward. The index has fallen by -21% over the past month, taking it to 15.8, which reflects a relative calm in the overall market.
Despite the temptation to assume that placid markets will continue, a longer view would indicate that the status quo won’t be permanent. Renewed volatility could come from further deterioration of corporate earnings, a surprise from the Federal Reserve at its May meeting, or a resolution of contentious debt ceiling negotiations. Regardless of what sparks the change, investors should expect the road ahead will include unexpected turns.
Second Crisis for First Republic
Another headline that highlights the risk of status quo thinking are the challenges facing First Republic Bank. After being caught up in the regional banking crisis in March, First Republic re-entered the headlines this week after it announced Q1 earnings. The bank lost more than $70 billion in deposits over the first three months of 2023, and its advisory business — a core revenue driver for the company — has seen more than 20% of its assets under management leave the bank.2
One challenge that First Republic faces is its mortgage portfolio. The bank issued a significant number of mortgages at ultra-low rates, assuming that the status quo interest rate environment would persist. Instead, when the Fed increased rates dramatically last year, it was left with a loan book that was only yielding 3.24% at the end of 2022.3 With the Fed Funds rate near 5%, there isn’t a big incentive for another bank to swoop in and buy these 3% mortgages without a significant discount to their original value.
If deposit outflows continue, the bank may be taken over by the Federal Deposit Insurance Corporation. At that point, the regulator would try to find a buyer for the whole entity or sell its assets in pieces. We wrote about that process here. While it seems likely that First Republic is heading toward failure, a dwindling number of pathways may still exist for the company to remain independent.
Change is the Constant
Rather than the static nature of a “new normal”, assuming a combination of uncertainty and change is more valuable when envisioning the future. Changes in technology, demographics, and geopolitics all mean that today doesn’t look like yesterday, and tomorrow is likely to look different as well. If the past few years have reminded us of anything, it is that flexibility and adaptability are vital traits for businesses, consumers, and communities alike.
Change is part of life, and similarly, it is part of market cycles. We support our clients as market and banking conditions shift, and more importantly, as factors in their own life necessitate shifts to their risk tolerance or need for liquidity. Recent events can’t provide a perfect roadmap for investors, but a better understanding of our human nature can offer useful perspective as we navigate forward.
1 Status Quo Bias in Decision Making. Harvard
2 $1.3 Billion Team Quits First Republic, Jumps to JPMorgan Barrons
3 First Republic’s Options May Be Dwindling. What’s Ahead for the Troubled Bank. Barrons
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