Swedroe: Lessons From 2016, Part Two

January 25, 2017

Earlier this week, we began discussing nine important lessons that the markets taught us in 2016 about prudent investment strategy. In lessons one through three, we explored active management as a loser’s game—the fact that so much of returns tend to come in short and unpredictable bursts and the propensity for events to occur that no one predicted. Today we’ll pick up with lessons four through six.

Lesson 4: Ignore All Forecasts; All Crystal Balls Are Cloudy

One of my favorite sayings about the market forecasts of so-called experts is from Jason Zweig, financial columnist for The Wall Street Journal: “Whenever some analyst seems to know what he's talking about, remember that pigs will fly before he'll ever release a full list of his past forecasts, including the bloopers.”

You’ll almost never read or hear a review of how the latest forecast from some market “guru” actually worked out. The reason is that accountability would ruin the game—you would cease to “tune in.”

But I believe forecasters should be held accountable. Thus, a favorite pastime of mine is keeping a collection of economic and market forecasts made by media-anointed gurus and then checking back periodically to see if they came to pass. This practice has taught me there are no expert economic and market forecasters.

Here’s a small sample from this year’s collection. I hope they teach you a lesson about ignoring all forecasts, including the ones that happen to agree with your own notions (that’s the deadly condition known as “confirmation bias” at work).

  • In July 2015, Charles Robertson, Renaissance Capital’s global chief economist, predicted that U.S. stocks could crash 50% within the next 12 months.
  • In January 2016, economists at the Royal Bank of Scotland warned that investors faced a “cataclysmic year” in which stock markets could fall by up to 20% and oil could drop to $16 a barrel. The advice was to “sell everything” except safe bonds.
  • In May 2016, legendary investor Carl Icahn warned that “a day of reckoning” was coming for U.S. stock markets unless the federal government stimulated the economy with greater spending. He certainly was putting his money where his mouth was, as shortly before his prediction of a big crash, Icahn Enterprises had announced in SEC filings that it had a net short position of 149%.
  • Also in May 2016, Savita Subramanian, Bank of America Merrill Lynch's head of U.S. equity and quantitative strategy, appeared on BloombergTV to warn of a "vortex of negative headlines" (doesn’t that sound scary?) coming in the following month that could push the S&P 500 down to 1,850 (a level back near its February lows). The factors she cited to support this prediction were the then-upcoming Brexit vote, the June decision from the Federal Reserve and the U.S. election.
  • Again in May 2016, John Hussman of Hussman Funds wrote: “Prevailing market conditions continue to hold the expected stock market return/risk profile in the most negative classification we identify. That profile reflects not only extreme valuations on the most reliable measures we’ve tested across history, but market internals and other features of market action that remain unfavorable. …. In any event, looking beyond the near-term horizon, I doubt that any shift in market action will meaningfully reduce the likelihood of a 40-55% loss in the S&P 500 over the completion of the current market cycle.”
  • In August 2016, UBS warned of an imminent crash in the S&P 500. The bank predicted there would be a major correction within the next two months.

 

As poor as the preceding forecasts turned out to be, this one is my personal favorite: Just six weeks into 2016, Goldman Sachs announced that (whoops!) it had abandoned five of its six recommended “top trade” calls for the year, having gotten them wrong.

One might ask: If they got those wrong, why ever would we think they’ll get it right this time? Of course, Goldman Sachs was just as confident of its new trade calls as it was when it made its old forecasts. Overconfidence is an all-too-human trait.

To be fair, there were surely some forecasts that turned out right. The problem is that you can’t know ahead of time which ones to pay attention to and which ones to ignore. What my experience has taught me is that investors tend to pay attention to the forecasts that agree with their preconceived ideas (again, that pesky confirmation bias) while ignoring forecasts that disagree. Being aware of our biases can help us overcome them.

Lesson 5: Even With A Clear Crystal Ball …

Imagine you had a crystal ball that allowed you to foresee the economic and political events of 2016, but not stock prices. Surely that would be of great value in terms of investment decisions—or would it have been?

Would you have been a buyer of stocks if you knew that the first few weeks of 2016 would produce the worst start to a year since the Great Depression? The S&P 500 Index closed 2015 at 2,043. By Jan. 20, it had fallen to 1,859, a drop of just more than 9%.

Would you have been a buyer of stocks knowing that Great Britain would vote to exit the European Union, creating great uncertainty for the global economy and financial markets? Within three days, the S&P 500 Index fell from 2,113 at the close on June 23 to 2,001 on June 27, a drop of more than 5%.

Would you have been a buyer of stocks if you knew that, once again, the economic growth rate would disappoint, with growth failing to reach even a tepid 2%? Most of the world’s developed economies were basically stagnating, bordering on recession.

Finally, would you have been a buyer of stocks knowing that Donald Trump would win the presidential election? Be honest now, especially if you happen to lean Democrat. Within moments of his victory becoming clear, the DJIA fell more than 800 points and S&P futures had sunk more than 5%.

With the benefit of hindsight, we now know that, in each instance, the market recovered, and relatively quickly. The lesson here is that, even with a clear crystal ball (which no one has), it’s very difficult to predict stock markets. Thus, you shouldn’t try. It’s a loser’s game.

 

Lesson 6: Last Year’s Winners Are Just As Likely To Be This Year’s Dogs

The historical evidence demonstrates that individual investors are performance-chasers—they watch yesterday’s winners, then buy them (after the great performance), and watch yesterday’s losers, then sell them (after the loss has already been incurred).

This causes investors to buy high and sell low, which is not exactly a recipe for investment success. This behavior explains the findings from studies showing that investors actually underperform the very mutual funds in which they invest.

Unfortunately, a good (poor) return in one year doesn’t predict a good (poor) return the next year. In fact, great returns lower future expected returns, and below-average returns raise future expected returns. Thus, the prudent strategy for investors is to act like a postage stamp. The lowly postage stamp does only one thing, but it does it exceedingly well: It adheres to its letter until it reaches its destination.

Similarly, investors should adhere to their investment plan (asset allocation). Sticking with one’s plan doesn’t mean just buying and holding. It actually means buying, holding and rebalancing (the process of restoring your portfolio’s asset allocation to your investment plan’s targeted levels).

Using passive asset class funds from Dimensional Fund Advisors (DFA), the following table compares the returns of various asset classes in 2015 and 2016. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.) As you can see, sometimes the winners and losers of 2015 repeated their respective performances, but other times the winners became losers and the losers became winners. For example:

We will conclude our series on what the markets taught us in 2016 later this week, when, in lessons seven through nine, we address the “sell in May” myth, persistently poor hedge fund performance and the danger of letting your political views influence your investment decisions.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

 

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