Earlier this week, we began discussing what the markets taught us in 2017 about prudent investment strategies. We tackled lessons one through three then, so today we’ll resume with lessons four through seven.
Lesson 4: Don’t make the mistake of recency. 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 buy yesterday’s winners (after the great performance) and sell yesterday’s losers (after the loss has already been incurred).
This causes investors to buy high and sell low—not exactly a recipe for investment success. This behavior explains the findings from studies that show investors can 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 to one’s plan doesn’t mean just buying and holding. It means buying, holding and rebalancing—the process of restoring your portfolio’s asset allocation to your plan’s targeted levels.
Using DFA’s passive mutual funds, the following table compares the returns of various asset classes in 2016 and 2017. As you can see, sometimes the winners and losers repeated, but other times they changed places.
For example, the best performer in 2016, U.S. small value, fell to 11th place in 2017; the sixth-best performer in 2016, emerging markets, rose to first place in 2017; and the 12th place performer in 2016, international small stocks, moved up to fourth place in 2017. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends DFA funds in constructing client portfolios.)
Lesson 5: Volatility can stay low for longer than expected.
While the VIX’s long-term average has been about 20, we entered 2017 with the volatility index well below that, at about 14. The historical evidence shows that volatility is negatively related to returns. The logical explanation is that volatility tends to spike when markets receive bad news, which tends to occur at unexpected times, when so-called black swans arrive. On the other hand, good news doesn’t tend to suddenly break out.
The VIX being well below historical levels led some gurus to believe investors were too complacent and overconfident, especially in light of very high U.S. stock valuations and a political environment that created a lot of uncertainty insofar as tax policy, health care and budget deficits. In addition, potential ill winds were blowing on the geopolitical front from Russia, North Korea, Iran and the Middle East in general.
Despite a dysfunctional political environment at home and these ill winds abroad, the VIX remained below 16 throughout the year. Evidence of last year’s low volatility can be found in the fact that there were only eight days in 2017 of 1% moves in the S&P 500 (four up and four down).
Looking back at the historical data, the year that had the lowest number of days with a 1% or greater move in the market was 1964, when there were three. In contrast, 2013 saw 134 such days. The record for days of a move of 1% or more was 199, which came in 1932. And with this low level of volatility, the market delivered strong returns.
Lesson 6: Ignore all forecasts because 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 will 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 investors a lesson about ignoring all forecasts, including the ones that happen to agree with their own notions (that’s the nefarious condition known as confirmation bias at work).
We’ll begin with the March 10, 2017 warning from David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates as well as frequent guest on CNBC. The S&P 500 Index stood at 2,372. Rosenberg gave 10 reasons to be cautious about stocks as major indexes hovered near record highs:
- Stocks were expensive relative to their historical average.
- Margin debt stood at a record level.
- Private clients had “thrown in the towel,” plowing nearly $80 billion into equity funds since the November 2016 election—a classic sign of a market top is when “dumb money” chases gains.
- There was very narrow leadership.
- Investors were complacent with volatility at very low levels.
- The Fed would raise rates three times in 2017.
- Inflation would roar.
- Stocks were over-owned: 21.1% of household assets were in stocks, and he argued that “only five times in the past 156 years has the share been this high or higher—42% above the norm.”
- Credit markets were frothy (spreads were very narrow).
Such concerns are enough to scare many investors, and likely they did, especially those who shared them. However, the market ignored all those reasons, with the S&P 500 adding about another 13% for the year, not including dividends.
We turn now to the April 2017 warnings from some leading hedge fund managers. At a Goldman Sachs conference, billionaire and legendary hedge fund manager Paul Tudor Jones warned that years of low interest rates have bloated stock valuations (as measured by market cap to GDP) to a level not seen since 2000, right before the Nasdaq tumbled 75% over two-plus years.
Jones wasn’t alone among hedge fund managers who were warning investors. Guggenheim Partners’ Scott Minerd said he expected a “significant correction” in the summer or early fall. Philip Yang, a macro manager who has run Willowbridge Associates since 1988, saw a stock plunge of between 20% and 40%. Legendary value investor Seth Klarman, who runs the $30 billion Baupost Group, told investors in a letter that corporate insiders have been heavy sellers of their company shares. To him, that’s “a sign that those who know their companies the best believe valuations have become full or excessive.”
Warnings from four highly respected managers were likely enough to scare off many investors. Yet the markets ignored them all.
Shiller Weighs In
We next turn to a Sept. 21, 2017 column in which economist Robert Shiller warned investors about the risks of a bear market. He presented evidence that led him to conclude: “The US stock market today looks a lot like it did at the peaks before most of the country’s 13 previous bear markets.” Coming from a Nobel Prize-winner, that can be pretty scary.
Before going into his reasons for concern, note that Shiller was wise enough to add this caveat: “This is not to say that a bear market is guaranteed: such episodes are difficult to anticipate, and the next one may still be a long way off.” If you don’t provide the timing for an event you predict, it’s hard to say you are wrong. It’s easy to argue that it just hasn’t happened, yet.
Shiller began by noting that not only was the CAPE 10 above 30 (observing that it had been reached only twice before, and both times were followed by severe bear markets), but that while earnings growth was strong (from the second quarter of 2016 to the second quarter of 2017, real earnings growth was 13.2%, well above the 1.8% historical annual rate), it didn’t reduce the likelihood of a bear market.
He writes: “In fact, peak months before past bear markets also tended to show high real earnings growth: 13.3% per year, on average, for all 13 episodes. Moreover, at the market peak just before the biggest ever stock-market drop, in 1929-32, 12-month real earnings growth stood at 18.3%.”
Shiller also noted the “ostensibly good news that average stock-price volatility—measured by finding the standard deviation of monthly percentage changes in real stock prices for the preceding year—is an extremely low 1.2%. Between 1872 and 2017, volatility was nearly three times as high, at 3.5%. Yet again, this does not mean a bear market isn’t approaching. In fact, stock-price volatility was lower than average in the year leading up to the peak month preceding the 13 previous U.S. bear markets, though today’s level is lower than the 3.1% average for those periods. At the peak month for the stock market before the 1929 crash, volatility was only 2.8%.”
The U.S. stock market, as represented by the S&P 500, ignored Shiller’s warning, with the last quarter of 2017 providing a return of about 5.5%.
Finally, we’ll look at two contradicting forecasts from former Goldman Sachs Group and Fortress Investment Group macro trader Michael Novogratz. On Dec. 23, 2017, he announced that he was shelving plans to start a cryptocurrency hedge fund. He predicted that bitcoin may extend its plunge to $8,000. Earlier in the same month, he predicted it could reach $40,000 within a few months. Which one should we have believed?
To be fair, there were surely some forecasts that turned out to be right. The problem comes in knowing ahead of time which ones to pay attention to, and which to ignore.
Here’s what Warren Buffett had to say about the value of forecasts in his 2013 letter to Berkshire Hathaway shareholders. “Forming macro opinions or listening to the macro or market predictions of others is a waste of time.”
He has also warned: “We have long felt that the only value of stock forecasters is to make fortune-tellers look good.” Unfortunately, one of the great ironies is that, while so many idolize Buffett, many of those same people not only ignore his advice, they tend to do exactly the opposite.
My long experience has taught me 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 7: Sell in May and go away is the financial equivalent of astrology.
One of the more persistent investment myths is that the winning strategy is to sell stocks in May and wait to November to buy back into the market. While it’s true that, historically, stocks have provided greater returns from November through April than they have from May through October, since 1926, there’s still been an equity risk premium from May through October. From 1927 through 2016, the “Sell in May” strategy returned 8.4% per year, underperforming the S&P 500 by 1.6 percentage points per year. That’s even before considering any transaction costs, let alone the impact of taxes (you’d be 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 the sell-in-May-and-go-away strategy work in 2017? The S&P 500 Index’s total return for the period May through October was 9.1%. During this period, safe, liquid investments would have produced just 0.5%, providing virtually no return. In case you’re wondering, 2011 was the only year in the last nine when the sell in May strategy would have worked.
A basic tenet of finance is that there’s a positive relationship between risk and expected return. To believe that stocks should produce lower returns than Treasury bills from May through October, you would also have to believe stocks are less risky during those months—a nonsensical argument. Unfortunately, like with many myths, this one seems hard to kill off. And you can bet that next May the financial media will be resurrecting it once again.
We’ll finish up our list of what the markets taught investors in 2017 later this week with lessons eight through 10.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.