You may have heard the news.  Between October 1st and December 31st, the stock market delivered its worst quarter since 2008 to culminate its worst year since 2008.  It was the stock market’s worst December since 1931. 

What caused the stock market selloff?  

As we say often, there is rarely ever a definitive answer to this question.  Persistent global trade tensions, Brexit uncertainty, a government shutdown, Federal Reserve interest rate policy, and recession fears were all possible factors.  It could simply be that stocks traded at lofty valuations and that hints of a slowdown precipitated a market correction.  Or it could just be that this is what stock markets do.  They go up.  They also go down.  Sometimes, a lot.  When asked, nearly a century ago, whether he thought the stock market would go higher or lower, investor J.P. Morgan is famously said to have responded, “The market will fluctuate.”

Wall Street and Main Street 

One thing that often gets ignored by financial media – perhaps intentionally because it makes for better ratings – is the very wide gap between Wall Street (stock returns) and Main Street (economic data).  These two things are not the same.  Not even close.  Next month’s employment report, retail sales data, or GDP report (if the Bureau of Economic Analysis ever reopens for the date to be calculated and reported) all look backwards.  It is usually several months into a recession before we know from the economic data that we’re in a recession.

The stock market, in contrast, discounts forward-looking expectations of corporate profits.  Consider these important words, working from right to left:

  • Corporate Profits.  The stock market is not a measure of job creation, GDP, consumer spending, or economic growth.  The stock market reflects corporate profits – how much companies make less what they spend.  Adding further separation from the economy, the stock market does not reflect corporate profits for the trendy bakery on the corner, the massively popular technology start-up, or the local bowling alley.  Rather, the stock market represents corporate profits for a fraction of the economy – large, publicly traded companies.  And when the flawed and terribly outdated Dow Jones Industrial Average is the barometer of stocks, the stock market effectively represents corporate profits of just 10-15 domestic public companies.  This alone can obviously create huge disconnect between the stock market and the economy.
  • Forward-Looking Expectations.  Again, economic data reflects the past.  The stock market reflects expectations about the future.  Past results and future expectations are obviously different things.  But many investors still fail to appreciate the difference.  Consider that you knew in advance, before anyone else, that Company XYZ will announce 110% profit growth versus last quarter when they report earnings.  This is clearly a strong measure of historic results.  But this information alone would arguably give you zero trading advantage from which to profit.  In order to benefit from this information, you would need to understand the expectations.  Is Company XYZ currently expected to grow at 200% for the next several quarters to where 110% would be disappointing and cause the stock to fall?  As we explain here, stocks often win on bad news and lose on good news because it’s the expectations that matter.
  • Discounts.  The stock market “discounts forward-looking expectations of corporate profits.”  The first word here – ‘discounts’ – may be the most important word because stock prices don’t just reflect forward-looking corporate profits of public companies.  Stock prices reflect these anticipated future profits discounted back at some interest rate.  And this “discount rate” is overwhelmingly important in the valuation of stock prices.  Changing the equity discount rate by just a small amount can have a huge impact on stock prices.  This means that no change in expected corporate profits is required to move stock prices.  Just a positive or negative change in investor sentiment – which sometimes swings as wildly as the mood of a pubescent teenager – will cause huge stock market movements.  If you’re looking for an explanation as to how the S&P 500 Index can crumble the on Christmas Eve, losing 2.7%, and then rocket the day after Christmas, gaining 5.0% without any new data points, this is a big part of that explanation.   

Snowfall in Finland is above average this winter so I don’t know why the Knicks keep losing

It should be clear by now that there is a rational disconnect in statements such as, “Economic data this month has been really strong so I can’t figure out why stocks are declining.”  One might similarly surmise, “Snowfall in Finland is above average this winter so I don’t know why the Knicks keep losing.”

But perhaps you are not convinced of the large divide between economic forecasts and stock returns and still seek someone who can make successful economic forecasts to profit off those forecasts.  Let’s assume for a moment that you find a financial advisor who can project the economic future better than nearly everyone else in the history of economic forecasting – far better that the smartest and most successful professionals.  While the best investors and forecasters in the world tend to be correct in their economic forecasts roughly 55% of the time, we will assume that is child’s play for your advisor.  He or she trades on economic surprises with an astounding 75% success rate, almost certainly making your advisor the best economic forecaster of all time.

How much of a fee should this financial advisor charge for this historically unprecedented forecasting prowess?  Fees approaching 20% per year like the most successful hedge fund investor of all time?  According to a recent whitepaper, your omniscient advisor may be of no added value.  The paper, which uses historical economic data and stock market returns from 1992 – 2018, indicates that predicting economic surprises with a 75% success rate and then trading on them would have produced returns similar to that of a buy-and-hold investor who did absolutely nothing other than rebalance.  From the paper’s concluding paragraphs:

“Do short-term surprises hint at long-term risk-reward dynamics that can inform strategic asset allocation decisions?  In a word: no.  Surprises don’t matter for long-term returns…Our analysis of the relationship between economic surprises and asset returns yields two insights: First, the odds of successfully trading on surprises are low.  Second, what can seem consequential in the short run is irrelevant to the long-term investor.”

What should you be doing now

Like many fee-only financial advisors, we create an investment policy statement (IPS) for every client and occasionally update this IPS, as warranted by changes in a client’s life.  The investment policy statement is intended to guide the investment actions of both us and our clients. 

Not a single IPS describes a plan to raise cash when political uncertainty causes nervousness and then stay in cash until we feel better about the political climate.  Not one suggests that we shift the investment risk level based on what the “trusted” or “expert” prognosticators are saying.  There is nothing about changing the asset allocation based on what a neighbor, work colleague, college roommate, or Uber driver are doing with their own portfolios.

An IPS describes how the portfolio will remain prudently diversified across asset classes, styles, and risks in an attempt to reduce overall volatility.  It lays out a targeted risk level that is individually designed based on things like risk appetite, financial objectives, time horizon, and anticipated cash flow needs.  The IPS uses the important term of ‘discipline’ to describe the investment approach.  

On this note, Fidelity Investments published a study last year of more than 6.5 million workplace retirement plan and IRA account holders.  The report titled “Ten Years Later” compared the investment returns of investors who sold all their stocks in 2008 to those who stayed invested.  Investors who maintained an allocation to stocks during the bear market saw their retirement account balances grow by 240% from pre-crisis levels at the beginning of 2008 to the end of 2017.  Those investors who moved to cash at some point during the market decline of 2008-2009, even if only for a few days, experienced gains of just 157% during the same time 10-year period.  The study highlighted a similar result when comparing those who stopped contributing to their retirement accounts during the bear market versus those who continued contributing despite market losses. 

The market will fluctuate

In hindsight, it is easy to speak about the benefits of maintaining a discipline during unsettling periods.  Losing hard-earned money in the stock market is not fun.  It is scary. Many investors understand the benefits of long-term discipline but the evidence suggests that few practice it.  

In a world of instant gratification, maintaining a discipline is difficult.  But the empirical evidence overwhelmingly falls on the side of maintaining a discipline over tactical trading based on news, speculation, or emotion if the objective is to achieve long-term financial success.  Subsequently, this is precisely why we believe that one of the most important things we can do to help our clients achieve their financial goals is to establish a portfolio that is allocated according to objectives and personal risk appetite and then to adhere to that discipline. 

The stock market will fluctuate.  Up and down.  And employing an appropriately allocated, disciplined plan is the best way we know to achieve financial success through those inevitable ups and downs.

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