Economist Paul Samuelson is famously quoted as saying that the stock market has predicted nine out of the last five recessions. While somewhat satirical, this quip demonstrates how poor investors and economists are at predicting the timing, depth, and duration of recessions.
It is also not enough to “simply” predict these outcomes as legendary bond investor Howard Marks often illustrates with his comments on second level thinking. To generate outsized returns, an investor must accurately predict the macroeconomic conditions and how businesses and then investments will respond to this environment. Marks believes this is exceptionally difficult (perhaps impossible) to do on a regular basis–a view that is consistent with other highly successful investors including Warren Buffett and Peter Lynch.
Year of the Rabbit Begins With Negative Omens
The year began with a host of negative commentary regarding a potential recession late in 2023. There was a range of factors given, including the fastest rate of interest rate increases in history and their expected impact on investment and consumer spending, inflationary pressures devastating consumers’ cost of living, the roll-off of financial and fiscal stimulus from the pandemic era, rising geopolitical tensions, and a weak reopening of China’s economy following severe pandemic restrictions. Doom and gloom predictions were everywhere.
Most of these predictions have not borne fruit, supporting Buffett’s belief that “forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” Europe has managed an incredible transition away from Russian gas following the war in Ukraine, the United Kingdom has avoided a recession (despite more extreme inflationary pressure, particularly around energy costs), and locally, both house prices and gross domestic product (GDP) have continued to grind higher–albeit at a modest pace. The world’s largest economy, the United States, even recorded GDP growth of 4.9% year-on-year (YoY) in the third quarter–the fastest pace since 2021!
Negative News Sells…
Dire economic forecasts and predictions of market crashes attract sensationalist headlines. Unfortunately, human nature is attracted to the drama of periodic recessions and stock market crashes (that are a natural part of the economic cycle), rather than the slow-moving but positive move upwards that the share market typically makes. There are, however, very few headlines that say “market went up slowly but steadily again today.” It certainly doesn't make the evening news.
It’s similar to how journalists would find it difficult to attract readers to articles describing a healthy diet and relaxed lifestyle compared to those about the hidden risks of life that may cause a premature death.
…But It Pays to be Positive in the Long Run
It is often said in investing that investors that are both short (betting that a stock will go down in price) and long (betting that a stock will go up in price) can be right–depending on the time frame.
According to Charlie Bilello, since 1928, the S&P 500 has been in a drawdown over 71% of the time (using monthly data that includes the returns from dividends). Yet according to Investopedia, the average annualised return since 1957 (when the 500 stocks were adopted as an index to measure against) was approximately 10.15% through the end of 2022.
The long-term return trends are clear and compelling. Yet the fear of loss can often deter or even overwhelm people from choosing to invest or staying invested. This is known as “loss aversion” (or occasionally Prospect Theory), and relates to the fact that investors feel the pain of losing a dollar more than they feel the pleasure of gaining a dollar of profits. This is one of several reasons why the average investor often underperforms the market.
Mind the Gap
In fact, Morningstar releases an annual “Mind the Gap” study that estimates the return of the average dollar invested in funds and ETFs (the “Investor Return”) compared to the average fund’s total return. In the decade ending December 31, 2022, Morningstar showed that the average investor returned 6% annually versus an average fund return of 7.7% annually. That is, investors in the same funds returned 1.7% per year less than the return of the fund. Morningstar’s conclusion: “timing costs are a persistent drag on the returns investors earn.”
To be more explicit, Morningstar says that “investors are using price changes as signalling mechanisms to make changes to their portfolio. This is at the heart of why these poor decisions are made.” Or as the so-called father of value investing Ben Graham once said, “the investor’s chief problem–and even his worst enemy–is likely to be himself.”
In particular, Morningstar highlights that while a strong and growing economy is good for company profits, share prices often rally significantly in anticipation of a better economy. This can create “cognitive dissonance” for investors, meaning that it is hard for them to meld these two ideas.
It is also important to remember that a share price reflects the total discounted cash flows for a company for the rest of its existence. One particular year of profits can be important (particularly in the event of a huge loss or cash flow crunch), but it may also represent a fraction of the company’s worth–particularly if it is growing at a healthy clip. Unfortunately for investors, there is a long lead time between decisions and results, and the feedback loop isn’t particularly clear (unlike receiving an annual bonus at work, for example).
Markets Climb a Wall of Worry
Investors face a host of psychological challenges when investing in the share market. The future is inherently uncertain, the predictions of experts are often conflicting and confusing, the world is constantly changing, and there is a long and unclear feedback loop on the decisions an investor makes–just to name a few.
Yet one of the most damaging can be negativity and the fear of loss that prevents someone from investing or causes them to zig and zag at exactly the wrong time. We have seen how devastating this can be on returns with the demise of Hamish Douglass at Magellan, who took an extremely conservative view at the onset of the coronavirus pandemic.
On the contrary, Buffett has held an almost ever-optimistic view about the future of America and the benefits of long-term share ownership. He focuses on the long-term increases in productivity and standard of living that continually drive the market higher and accepts the volatility that comes from inevitable recessions and market drawdowns. Buffett uses any moments of market pessimism to increase his long-term ownership of his favourite businesses.
In fact, when the market is fuelled with optimism (as it was during 2021 when “meme stock” trading was in vogue), this can often signal a short-term peak in valuations. The economy is strong, profit margins are high, and there are a host of new buyers for each stock as participation in the share market hits new highs–that is, the environment is about as good as it can get.
Conversely, it’s often said that the share market “climbs a wall of worry” in the early and mid stages of a recovery. The market continues to grind slowly but steadily higher amidst a host of negative news, before surging late in the cycle as optimism once again returns. Bank of America last week noted that ETF inflows surged, with the largest inflows in 11 months. When the negative headlines are busy generating clickbait, it’s important to keep in mind that the long-term trend of the share market is up.
Markets & Commentary
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