Swedroe: More Investing Lessons From 2018

January 23, 2019

Every year, the markets provide us with lessons on the prudent investment strategy. Earlier this week, I covered lessons one through three. Today, I’ll tackle lessons four through seven.

Lesson 4: Volatility doesn’t stay low forever. Your discipline will be tested.

While the VIX’s long-term average has been about 20, we entered 2018 with the Volatility Index well below that, at about 11. In addition, it had mostly remained below its historical average for the prior six years, a period of strong equity returns—as 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.

In terms of daily volatility, 2018 was the most volatile since 2011, according to data from S&P Dow Jones Indices. In 2018 (2011), the S&P 500 Index saw a price change of at least 2% 38 (68) times, 3% 16 (24) times, 4% five (10) times and 5% one (five) time(s).

After hitting a high of 36 on Dec. 24, the VIX closed at 25.42, well above its historical average. Once again, the increase in volatility was accompanied by poor equity returns. This served as a needed reminder that equities are risky, and investors should never become complacent. They should anticipate periods of poor returns, building them into their plans, as history teaches us that large losses are not that unusual. For example, from 1948 through 2017, the Dow Jones industrial average fell at least 15% about once every three years. It also fell by 20% or more about once every six years.

The historical evidence demonstrates that today’s 35-year old investor needs to plan on having to live through only about 10 more bear markets over his or her lifetime, and 20 more periods of losses of at least 15%. Experience has taught me that the only way you are likely to be a successful investor, surviving those periods, is to have a well-thought-out plan that anticipates these events. Forewarned is forearmed.

Lesson 5: The stock market and the economy are two very different things.

It was the best of times, it was the worst of times. The U.S. economy continued to grow at a strong pace throughout the year, with second-quarter GDP growing 4.2%, third-quarter growing 3.4% and fourth-quarter growth expected to come in at 2.6%.

On the other hand, Christmas Eve saw the S&P 500 come very close to closing in bear market territory, putting the index down 19.8% from its Sept. 20 closing high of 2930.75. Clearly, the market and the economy were on divergent paths. What may surprise investors is that this is not unusual.

As Ben Carson pointed out in his October 2018 column, the S&P 500 has had 20 bear markets (down 20% or worse) and 27 corrections (down 10% but less than 20%) since 1928. The average losses saw stocks fall 24% and last 228 days from peak-to-trough. Carson noted that, of those 47 double-digit sell-offs, 31 occurred outside of a recession and didn’t happen in the lead-up to a recession—about two-thirds of the time, the market experienced a double-digit drawdown with no recession as the main cause. Of those 31 that occurred outside of a recession, the losses were -18% over 154 days, on average. This also demonstrates that the stock market is not a good indicator of a recession (Carson cited the old joke that the market has predicted nine of the last five recessions). In other words, there is nothing unusual about the recent performance of the market.

Carson also showed that, on average, the S&P 500 has been up 1% in the three months prior to the start of the 14 recessions since the one that began in August 1929. For those investors worried that the market’s recent drop foretells bad economic news, which might tempt them to abandon their plan and sell equities, the evidence should convince them that this is not likely to prove to be a good strategy.

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). Note, I collect mainly the ones calling for really bad things to happen—with history demonstrating that far fewer bad things happen than are predicted by gurus.

We’ll examine four predictions, beginning with the Jan. 4, 2018 forecast by legendary investor and billionaire hedge fund manager Ray Dalio of Bridgewater Associates. He warned that the bond market had slipped into a bear phase and that a rise in yields could spark the biggest crisis for fixed-income investors in almost 40 years. There was no bear market in bonds in 2018, with even Vanguard’s Long-Term Treasury Index ETF (VGLT) losing just -1.5%, while the Vanguard Intermediate-Term Treasury Index ETF (VGIT) returned 1.4% and the Vanguard Short-Term Treasury Index ETF (VGSH) returned 1.6%. Strike 1.

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