Is Relying On Stock Markets For Economic Signals A Mistake?

Wouldn’t it be great if investors could navigate the markets like we navigate through traffic- -guided by red, yellow, and green lights? If we had signals that told us with certainty what direction the economy was headed, then we might have an edge in our investment strategy; we would know when it was a good time to invest, when to proceed with caution, or when to put the brakes on.

Unfortunately, the reality is that the market is murky and unpredictable. As the economist Paul Samuelson once put it: “The stock market has called nine of the last five recessions.” The market marches to its own drummer, or rather to many drummers, as it processes information from millions of investors about whether they want to buy or sell a stock.

Earlier this year when US Equities were down 10% many thought this was the first sign of impending doom for the economy. Well, we all know what happened.  By the end of the quarter, the market had recovered from losses and entered positive territory. Although the economy is not without some areas of concern, it turns out wages are rising, corporate profits continue to be healthy, and inflation remains tame.

But if anything could shed light on the future of the economy, wouldn’t the stock market be the most logical place to look?  Shouldn’t we be able to check a benchmark index like the S&P 500, which has come to define the US stock market, and gain some helpful insights?  No, says Julieta Jung , PhD in Economics, who does research to inform policy makers and aid discussion at the Dallas District of the Federal Reserve.

Ms. Jung points out in a recent Economic Letter to the Federal Reserve Bank of Dallas that Indexes such as the S&P 500 are flawed mirrors of the economy and therefore fail to predict GDP. She notes that half of the components in the S&P 500 are manufacturers but when you look at US GDP, service providers account for more than ¾ of GDP output. Also, the stock market and the economy react very differently to shocks. The market can turn on a dime when unanticipated news or events occur until investors digest what has happened. In contrast, households and businesses adjust to the same news much more slowly.

molly blog

So what is an investor to do if she is uncertain about the direction of the economy and not sure if it is a good time to invest? First, understand that the stock market is not the economy and there is no reliable signal that can tell you it is a good, bad, or indifferent time to invest. Second, understand that your portfolio needs to be designed to match your tolerance for risk so you can stay invested through the inevitable ups and downs. Third, and most important, do what we constantly tell our clients to do- -focus on things you can control. We can’t control what the market will do but we can exert some control over certain things such as costs, taxes, investment discipline, and portfolio allocation. Our advice: Focus on these areas that will have a meaningful impact rather than on trying to decipher market gyrations.

2015= Flat Market, 2016= Your Guess Is As Good As Mine

As we get close to the end of 2015, it is fitting to look back and take a pulse of what happened this year in the markets.  The US stock market was especially interesting.  As I write this, the S&P 500 is trading just 50 points below where it started on January 1st this year, amounting to a 2.4% loss (does not include dividends).  Losses are uncommon, but not rare in the market.  In fact, since 1926 the S&P 500 has experienced 24 years with losses, representing 27% of those 89 years.  You would think that losses tend to happen when recessions or very adverse conditions show up in the economy.  While this is true some of the time, it's not always.  This year is a good example.  While we are sitting at a small loss today, it makes some sense to take a look at the fundamentals from these underlying stocks in the index (taken from Standard and Poors earnings and estimate report on 12/17/2015):

  • Q4 2015 operating earnings are estimated to be 8.5% higher than Q4 2014 operating earnings
  • Q4 2015 reported earnings are estimated to be 20.7% higher than Q4 2014 reported earnings
  • Q4 2015 annualized dividends are estimated to be 5.3% higher than Q4 2014 dividends

So, earnings and dividends improved, but the market fell.  How does that happen?  Remember, the market is a forward looking machine.  Buyers and sellers don't care what earnings are or were.  They only care what they WILL BE.  That is why it is so hard to beat the market.  Once the estimates start coming out on earnings for the first or second quarter of 2016, the market has priced that data in to the index value.  In fact, analysts are already predicting what earnings will be for this time next year (Q4 2016)!  Are they going to be right?  Probably not, but the current price of the market is probably the best guess out there.  Also, realize that millions of people, who have done their research are not only trying to answer the earnings question, but a million others like:

  • Where are interest rates going?
  • Will there be another terrorist attack and when?
  • How is the currency fluctuation in Japan going to impact my Norwegian stock holdings?
  • What will the weather patterns look like next year in Brazil?

Some of these may sound silly, but this is the type of analysis that is going on every second by analysts, hedge funds, and wall street investors.  I always chuckle when I hear someone tell me that Apple is undervalued, or that low interest rates are causing a bubble in tech stocks.  Almost unequivocally, they have no idea (though they don't know what they don't know).  They don't realize that there are literally millions of people analyzing all of these outside factors and they have set the price at where it is trading today.  When someone believes that price is not right, in reality, he is saying that he/she knows more than the millions of buyers and sellers out there who have set the price.  We did a small exercise with jelly beans at a client event that showed how the wisdom of crowds is usually a great way to determine the correct price of the market.  

The market looks like it is headed for a flat year.  The only silver lining that we can take away is that fundamentals did improve from a year ago.  Unfortunately, that tells us nothing about the future.  

How Likely Is It That The Stock Market Will Earn 10% in 2015?

A couple weeks ago I wrote that it is now Prediction Time.  As I watched CNBC this morning I was reminded of this again when the anchors asked every guest that came on the show their outlook for 2014 as it relates to the stock, bond and commodities market.  I thought it would be worthwhile to point out that pretty much every strategist, economist and prognosticator predicts a stock market return of around 10% per year.  And why not?  The S&P 500 has generated a return 10.12% from 1926 through 2014.  That seems like the safe bet.  The truth is that these pundits are almost never right when they choose a return around 10% though.  History tells us that returns, while averaging 10% over long periods of time, almost never actually realize that same return over 1 year periods.  Here is a chart showing the frequency of annual returns of the S&P 500 since 1926:

S&P 500 histogram

Here are some really interesting results of this data:

  • The S&P 500 has generated an annual return of between 0 to 10% slightly less than 15% of the last 88 years.  
  • The highest band of frequency are returns between 10 to 20% in a given year
  • You have a higher probability of generating a return between 30 to 40% than to generate a return between 0 and 10%
  • Losses have occurred about 27% of the last 88 years, so while not common, they will happen.  
  • Losses of greater than 30% are pretty rare, happening only about 3% of the time

Next time you hear a pundit talk about predictions, please remember this post.  Almost all will be wrong, and because of that fact, you should avoid making any investment decisions based on these predictions.


Prediction Time!

It's that time of year again…prediction time.  Economists, wall street strategists and pundits have started coming out of the woodwork telling you where to put your money in 2015.  One thing they won't tell you is their track record from last year (unless it was good). One of the overwhelming areas that wall street hated last year at this time were bonds.  In a poll done by Bloomberg about a year ago, 72 out of 72 economists predicted interest rates to rise and bond values to fall.  72 out of 72!  With that amount of conviction, they have to be right.  Blackrock did something similar with all the major investment/research firms.  Again, everyone was underweight bonds.  Click below to see the graphic from their report:


You can guess what happened next.  World stocks (MSCI ACWI) were up 6.72% through 11/30 while long-term treasury bonds (Barclays Treasury Bond Index Long), the asset class that would have gotten hit hardest if these pundits were right, were up 21.59% for the same period.  Predictions may be fun to watch, but you should never make investment decisions based on them.  This is just more evidence that no one knows the future.  

What The Election Results Mean For Your Portfolio

Republicans won the majority in the Senate and solidified their lead in the House of Representatives.  What does this mean for your portfolio?  

Not much.

Investors tend to put too much weight on the impact of politicians on both the economy and the stock market.  Economic trends happen over long periods of time and stock markets are driven by so many different things, of which politics and legislation are a small part.  There are numerous studies that have shown which political party is better for the stock market.  There are two major errors with those studies.  First, there aren't near enough data points for them to be statistically significant.  Second, there are literally hundreds of other variables that are impacting the stock market so it is disingenuous to attribute market returns to an elected official.  George Bush presided over one of the worst stock markets in history.  Is it fair to say that his administration caused this?  Anyone looking at it objectively would have to say no.  The stock market had two decades of growth and was at the end of one of the largest bubbles in history when he took office.  It certainly was not his fault that the bubble burst.  It was bound to happen.  

Conversely, Barack Obama has led the country during one of the best stock markets in decades.  He was lucky enough to take office at the bottom of one of the worst economic periods this country has ever seen.  It would be hard to argue that Obama's economic policies led to these fantastic returns.  As with many things in life, timing is everything.

Next time you hear a politician take credit (or assign blame) for the economy or stock market, tune it out.  They really had little to do with it.

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.