Swedroe: More Investing Lessons From 2018

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.

Dalio added: “The Federal Reserve will tighten monetary policy faster than they have signaled.” The Fed did tighten four times, as expected. Strike 2. He also stated: “It feels stupid to own cash in this kind of environment. It’s going to be great for earnings and great for stimulation of growth.” While he was right about corporate earnings and economic growth, cash turned out to be about the best investment in 2018. Strike 3.

That Dalio was right about corporate earnings and economic growth, yet so wrong about his market forecasts for both stocks and bonds, demonstrates how difficult it is for forecasters to get it right. That is why Buffett’s advice is to ignore all forecasters because their forecasts tell you more about them than they do about the market.

Next up is the June 1, 2018 prediction by “Bond King” Bill Gross. Gross forecasted that the Federal Reserve’s expected rate hike in June would be its last for the year. On June 13, the Fed raised its target for the federal funds rate to between 1.75% and 2%. However, that was not to be the last increase. In fact, there were two more. It raised rates at its September meeting to a range of 2-2.25%, and then again at its December meeting, ending the year with the target between 2.25% and 2.5%.

Our third forecast is the July 26, 2018 prediction by David Rosenberg, chief market strategist of Gluskin Sheff in Toronto, who predicted that the day’s GDP report was infested with “fake data.” While he acknowledged that the second-quarter GDP report would be strong (the final second-quarter growth rate was 4.2%), Rosenberg believed it would be the last good quarter in the cycle, as the Fed's quantitative tightening would kick in just as the stimulus from tax cuts wound down.

Rosenberg was clearly wrong on his economic forecast, as economic growth continued strong despite the continued tightening by the Fed and the tariffs imposed during the trade war. Third-quarter GNP growth came in at 3.4%, and the Philadelphia Federal Reserve’s Fourth Quarter Survey of Professional Forecasters calls for fourth-quarter growth of 2.6%.

It’s also worth pointing out that in March, Rosenberg predicted we would have a 20% stock market correction (we got to 19.8% for the S&P 500 on Dec. 24). However, that was based on his outlook for an economy heading into a recession within the next 12 months (he has three more months to get that one right, though it seems highly unlikely with the Philly Fed’s latest forecast calling for first-quarter GNP growth of 2.4%. The fact that Rosenberg was wrong on his economic outlook but accurate in his call for a bear market shows how difficult a task it is to forecast the stock market. It’s just one of the reasons active management is the loser’s game.

Finally, given the cryptocurrency mania that had infected many investors, no review of forecasts would be complete without one on bitcoin. In an interview with the Motley Fool in November 2017, David Drake, founder of LDJ Capital, asserted that bitcoin would hit $20,000 in 2018. “There’s a fixed supply of it, but growing demand,” he said. “When that happens, the price rises.” Bitcoin closed the year at about $3,700.

To be fair, some forecasts turned out right. For example, at the end of July, Morgan Stanley warned that a correction worse than February’s was looming. The problem comes in knowing ahead of time which forecasts to pay attention to, and which to ignore. Long experience has taught me that investors tend to pay attention to the forecasts that agree with their preconceived ideas (that pesky confirmation bias) while ignoring forecasts that disagree. Being aware of our biases (including political ones) 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 buy back into the market until November. Let’s look at the historical evidence. Using Ken French’s data library, since 1926, it is true that stocks have provided greater returns from November through April than they have from May through October. That may be the source of the myth. The average premium of the S&P 500 Index over one-month Treasury bills averaged 8.4 percentage points per year over the entire period. And the average premium of the portfolio from November through April was 5.7% compared to just 2.5% for the May through October portfolio.

In other words, the equity risk premium from November through April has been more than twice the premium from May through October. Furthermore, the premium was negative more frequently for the May-through-October portfolio, with 34% of the six-month periods having a negative result compared to 27% of the six-month periods for the November-through-April portfolio.

From 1926 through 2017, the S&P 500 Index returned 10.2% per year. Importantly, the May-through-October portfolio had a positive equity risk premium of 2.5% per year, which means the portfolio still outperformed Treasury bills on average. In fact, a strategy that invested in the S&P 500 Index from November through April, and then invested in riskless one-month Treasury bills from May through October, would have returned 8.3% per year from 1926 to 2017, underperforming the S&P 500 Index by 1.9 percentage points per annum. That’s even before considering any transactions 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).

Let’s see how the strategy performed in 2018. Even though October was a rough month for equities, with the S&P 500 Index losing 6.8%, the S&P 500 Index returned 3.4% from May through October, outperforming riskless one-month Treasury bills (which returned 0.9%) by 2.5 percentage points.

What’s perhaps most interesting is that the last year the “sell in May” portfolio outperformed the consistently invested portfolio was 2011. Yet you can be sure that, come next May, the financial media will be raising the myth once again.

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, as with many myths, this one seems hard to kill.

That’s it for now, but later in the week, we’ll finish up with lessons eight through 11.

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