Swedroe: The Cost Of Perfect Crystal Balls

January 20, 2015

 

This article is the second of a four-part series containing 12 lessons that prudent investors could learn from the markets in 2014. The first article appeared here.

 

Last week, we discussed the first three of a total 12 lessons that the markets taught us in 2014 about prudent investment strategies. Today we’ll cover lessons Nos. 4 through 6.

 

Many of these lessons appear year after year. But a lot of investors simply fail to learn from them, and instead repeat the same mistakes. That’s why—as I’ve observed before—one of my favorite sayings is that there’s nothing new in investing, only investment history you don’t yet know.

 

Lesson 4: Sell in May and Go Away is the Financial Equivalent of Astrology

 

One of the more persistent investment myths is that the winning strategy involves selling stocks in May and then waiting to buy back into the market until November.

 

While it’s true that stocks have provided greater returns from November through April than they have from May through October, since 1926 there has still been a demonstrated equity risk premium from May through October.

 

From 1927 through 2013, the “sell in May” strategy underperformed the S&P 500 Index by more than 1.5 percent per year. And that’s even before considering any transaction costs, let alone the impact of taxes. The tax impact of this strategy matters because it entails converting what would otherwise be long-term capital gains into short-term capital gains, which are taxed at the same rate as ordinary income.

 

How did selling in May and then going away until November work in 2014? Well, the total return to the S&P 500 Index for the period from May through October was 9.0 percent. During this period, safe, liquid investments would have produced virtually no return. In case you’re wondering, 2011 was the only year in the last six when the “sell in May” strategy would have worked.

 

The most basic tenet of finance is that there’s a positive relationship between risk and expected return. To logically believe stocks should produce a lower return than Treasury bills from May through October, you would have to be convinced that stocks are less risky during those months—a nonsensical argument.

 

Lesson 5: Even With a Clear Crystal Ball ...

You might think an investor with the ability to know the news (though not stock prices) with 100 percent certainly could easily generate market-beating returns. But is that really the case? If you knew on Jan. 1, 2014, that the market would face the following hurdles, would you have invested in stocks?

  • Real GDP in the United States would fall 2.1 percent in the first quarter.
  • Economic growth in the eurozone would slow to a crawl, creating the risk that European economies could slip into their third recession since 2007.
  • The Japanese economy would slip back into recession.
  • Economic growth in China would decelerate faster than expected.
  • There would be no resolution to the Iranian nuclear situation.
  • Russia would first invade, and then eventually take over, Crimea before creating a threat in Ukraine and increasing geopolitical risk, as well as danger to European economies.
  • A series of crises would develop in the Middle East, including problems created by an expanding ISIS. These crises would impact Syria, Israel and Iraq, among others. All of them could have the potential to threaten energy supplies, or worse.
  • The Federal Reserve would end its bond-buying program, threatening a rise in interest rates.
  • The U.S. dollar would rise significantly, especially against the Japanese yen, reducing the value of foreign earnings posted by U.S. multinational companies. This would make our exports more expensive while creating more competitive pressure from lower-priced imports.
  • An Ebola epidemic would spread in West Africa and threaten to disrupt world trade.
  • There would be major problems with the implementation of the Affordable Care Act, creating uncertainty for the economy.
  • Congress would be unable pass favorable trade legislation.

These are just some of the many hurdles the market had to overcome in 2014. Yet the S&P 500 Index rose 13.7 percent for the year.

 

Lesson 6: Inflation Wasn’t, and Isn’t, Inevitable

One of the most consistently asked questions I’ve received since 2009 has been, “What should I do about the inevitable problem we are going to face with rampant inflation as a result of the huge fiscal and monetary stimulus injected into the economy?”

 

There certainly was a risk that massive budget deficits, a zero-interest-rate policy and the bond-buying program would translate into rising inflation. But this outcome wasn’t inevitable.

 

I also frequently hear that the growth rate of our money supply is exploding. That belief has probably been fueled by those commercials that recommend buying gold because central banks are printing money like it’s Weimar Germany all over again. The fact is, “M2,” a broad measure of the money supply, hasn’t been growing at rates that would suggest rampant inflation is brewing.

 

For the six-year period from Dec. 8, 2008 through Dec. 8, 2014, the Federal Reserve Bank of St. Louis reports that the rate of growth in M2 was about 6.1 percent.

 

 

 

Where’s The Inflation?

Since, as Milton Friedman, one of our greatest economists, noted, “Inflation is always and everywhere a monetary phenomenon,” the factual data don’t support the view that we should have expected rampant inflation last year.

 

In fact, despite the opinion of many who seem certain we will see massive inflation, neither the bond market nor professional economists are expecting anything of the kind. We can at least get an estimate of how the market is forecasting inflation by looking at the difference between the roughly 2.2 percent yield on 10-year nominal bonds and the roughly 0.5 percent yield on 10-year TIPS. The difference is just 1.7 percentage points. Clearly, investors in the aggregate don’t appear to be concerned about rampant inflation.

 

Regarding the forecast of economists, the Fourth Quarter 2014 Survey of Professional Forecasters from the Federal Reserve Bank of Philadelphia has a 10-year inflation forecast of just 2.2 percent.

 

Again, it doesn’t believe rampant inflation is likely, let alone inevitable.

 

No Velocity Of Money Right Now

Don’t get the wrong idea. There’s certainly risk that inflation could increase dramatically. The reason it hasn’t is because, even though the monetary base has been increasing rapidly as the Fed expanded its balance sheet through its bond-buying program, the velocity of money has been falling sharply.

 

The velocity of M2 has fallen from about 2.0 at the end of 2007 to around 1.5 at the end of 2014, a drop of about 25 percent.

 

With that said, the risk remains that if or when the velocity of money begins to rise, inflation could increase. Of course, the Fed is well aware of that risk, and thus will likely take mitigating action—such as reversing its bond-buying program and raising interest rates—that would prevent inflation from taking off.

 

History Suggests QE Has Worked

It’s worth noting history does provide us with examples of quantitative easing (QE) programs similar to the Fed’s. In the 1990s, Sweden’s central bank, the Riksbank, more than doubled the country's monetary base during the Nordic banking crisis, but inflation remained moderate during and after the expansionary period. Even as the monetary base jumped from 1994 to late 1996, inflation did not follow suit and, in fact, remained flat before falling in 1996.

 

And Sweden was not an isolated case. The Federal Reserve Bank of St. Louis looked at past expansionary periods over the last two decades in the U.K., Switzerland, Japan, Australia, New Zealand and Iceland. 

 

The Fed’s researchers concluded that QE is a useful policy tool, and that doubling or even tripling a country's monetary base doesn’t lead to high inflation if  the public views the increase as temporary and expects the central bank to maintain a low-inflation policy. In fact, they found little impact in terms of increased inflation from such expansions.

 

They also noted that the key to successfully implementing a policy of QE is, when the crisis has passed, for the Fed to promptly unwind its balance sheet. That does mean extending maturities isn’t without risk. But the pricing of that risk is embedded in today’s yield curve. In other words, extending maturities today would result in a negative outcome only if interest rates rise more than already expected.

 

No Substitute For A Good Plan

Since there are no clear crystal balls, a well-developed investment plan should incorporate the possibility of greater-than-expected inflation and address that risk through the asset allocation process. For example, the more you are exposed to the risk of unexpected inflation, the more you should consider holding TIPS and short- to intermediate-term nominal bonds, avoiding long-term nominal bonds. 

 

That’s it for lesson six. In our next post, we’ll tackle lessons Nos. 7 through 9, which include some pretty convincing data on performance chasing and dividend strategies.


Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.

 

 

 

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