- Stock and bond market returns surprised everyone in 2019
despite what seemed like constant concerns
about a coming recession, the MSEI all country
world index finished the year up 20.19%
and the Bloomberg Barclays global aggregate bond
index hedged to Canadian dollars
finish the year up 7.4 3% both in Canadian dollar terms.
At the beginning of every year, including last year
and this year analysts make often gloomy forecasts
about short term expected returns and economic conditions.
There are two big problems with these forecasts.
They often make investors nervous and they're usually wrong.
I'm Ben Felix portfolio manager at PWL Capital.
In this episode of common sense investing.
I'm going to tell you what to expect
from the stock market in 2020.
There is no reliable approach
to predicting future stock market returns.
And the consistently poor accuracy
of stock market forecasts are enduring proof.
Every year, since 2010 Larry Swedroe
the chief research officer for the BAM Alliance
has compiled a list of sure thing predictions
made by the financial media and other investors.
He diligently tracks those predictions throughout the year
and reports on the results.
The predictions are things that most investors
will be familiar hearing.
Strengthening or weakening of currencies,
economic growth rates, market returns
and asset class returns to name a few.
Swedroe tallied up a total of 69 sure thing predictions
from 2010 through the end of 2018
only 32% of those predictions materialized as expected.
Of course, a sure thing should materialize 100% of the time,
not 32%.
The value of forecast was also studied
a bit more formerly in a 2018 paper
titled "Do Financial Gurus Produce Reliable Forecasts"
where the authors examined a 6,627 forecast
made by 68 forecasters.
They gave more weight in the analysis
to longer term and more specific forecasts.
They found that 48% of the forecast examined were correct
and 66% of the forecasters had accuracy scores
less than 50%.
Listening to humans making forecasts about the market
probably isn't useful
but there are some quantitative measures
that have historically been useful in forecasting
future returns and economic conditions.
These measures might even show up as evidence
to back up the usually incorrect market forecast
that people make.
The Shiller cyclically adjusted price earnings ratio
has been a particularly reliable indicator
where higher stock prices tend to be followed
by lower future stock returns.
As it stands right now US stock prices are high
based on the Shiller Cape.
This might lead to a lower return expectation for US stocks
but it's not information that can be used
to time Investment decisions.
A paper from AQR titled "Market Timing, Sin, A Little"
examined the Shiller Cape as a market timing tool.
They built a market timing strategy
that adjusted the weights in stocks based on valuations.
They tested the strategy on data from 1900 through 2015.
For the full sample the timing strategy
did add a bit of value to returns
but it underperformed from 1958 through 2015.
The paper suggest that this may be due to stocks
becoming more or less cheap for very long periods of time.
In other words, from 1900 through 1957
stocks were generally cheap relative to their past
resulting in the timing strategy being aggressively invested
in stocks for most of the time period.
From 1958 through 2015
stocks were generally expensive relative to the past
resulting in the strategy being under invested
for most of the time period.
The paper sums this up as follows.
Valuations can drift higher or lower
for years or decades making it difficult
to categorize the current market confidently
as cheap or expensive without hindsight calibration
and therefore difficult to profit from such categorizations.
The other thing to keep in mind
as a properly diversified investor
is that the us stock market is not the world.
Stocks in Canadian and international markets
are not currently as expensive as measured
by Shiller price earnings
and emerging market stocks are cheap by the same measure.
In either case it doesn't really matter
because we can't use the Shiller Cape to time the market.
But when you hear that the market is expensive
or overvalued an appropriate response might be which one.
The other measure that is often cited and making forecasts
is the US yield curve.
The chart of us treasury yields that plots
the yield on the y-axis and the maturity
is on the x-axis.
A normal yield curve is upward sloping
where longer maturity treasuries have higher yields
than shorter maturity treasuries.
An inverted yield curve when the shorter term treasuries
have higher yields than longer term treasuries
has been really good at predicting US recessions.
There have been nine a US yield curve inversions
including the one that occurred in late 2019
and seven US recessions since 1966.
An inverted yield curve has successfully forecasted
within six quarters, six of those recessions.
There was one false positive in 1966
when an inversion was not followed
by a recession within six quarters.
We are currently sitting within the six quarter window
that of recession has historically occurred
following an inversion, spooky stuff.
I'm not forecasting a recession, but even if I was
it wouldn't be a reason to change your investment strategy.
In a 2019 paper titled "Inverted Yield Curves
And Expected Stock Returns",
Eugene Fama and Ken French built a market timing model
that moves out of equities and into treasury bills
when the local yield curve is inverted.
They acknowledged that there is strong empirical evidence
suggesting that inverted yield curves
tend to forecast future recessions.
But they set out to answer how this relates
to stock returns.
They analyze three different portfolios
from the perspective of a US investor.
The US market the world ex US market and the world market.
The analysis was designed to test whether
or not an actively managed strategy
that shifts out of equities and into treasuries
based on yield curve inversions adds value
to portfolio returns.
Based on their analysis, Fama and French conclude
that the results should disappoint investors
hoping to use inverted yield curves
to improve their expected portfolio return.
We find no evidence that yield curve inversions
can help investors avoid poor stock returns.
They go on to explain their interpretation of this finding.
The simplest interpretation
of the negative active premiums we observe
is that yield curves do not forecast the equity premium.
This interpretation implies
that investors who try to increase their expected return
by shifting from stocks to bills after inversions
just sacrificed the reliably positive unconditional
expected equity premium.
In simple terms
while the yield curve may forecast economic activity
it does not forecast stock returns and trying
to time the market as usual results in a better chance
of losing out on good returns than missing bad ones.
All right, so the experts don't know what they're talking
about when they make specific market or economic forecasts
and the best quantitative forecasting tools that we have
for the stock market and the economy do not help
in making better investment decisions.
I need to qualify that statement a little bit.
The Shiller Cape may not be useful
for making portfolio timing decisions
but it has been a useful tool
for estimating future long-term stock returns.
In the 2019 version of an annually updated paper
on equity risk premiums asks what the motor
on demonstrated that the current implied equity risk premium
is the best predictor of the future equity risk premium.
It's still far from perfect
but it is the most reliable metric that we have
for forecasting future stock returns.
Well, this is not useful in making market timing decisions.
It is useful
in making long-term financial planning decisions.
After a year of great returns like 2019
it might make sense to reduce your expected returns
for financial planning purposes.
The way that the implied equity risk premium work
is by taking the earnings yield,
earnings divided by price, and then adding inflation
to estimate the nominal expected return.
For example, if the Shiller Cape
for US stocks is currently 31.31,
we take one divided by 31.31
to find the implied equity risk premium.
This gives us a result of a 3.2, 2%.
To estimate inflation we take the spread between
the Canadian nominal and real return long-term bond yields.
This difference in yield
is the market's current inflation expectation.
This figure is currently 1.37%.
We now have a nominal expected return for US stocks of 4.6%.
If you have been using historical market returns
as financial planning inputs
you might start to notice that what I'm saying is important.
The S&P 500 has returned over 11% per year
in Canadian dollar terms since 1926.
It should be obvious that there are dire implications
for basing a financial plan on an 11% return
when a more reasonable expectation might be 4.6%.
As low as that expected return for US stocks is
it's important to look around the rest
of your portfolio before getting discouraged.
Following the same methodology
Canadian stocks have an expected nominal return of 5.9%.
International developed stocks have
an expected nominal return of 6.4%.
And emerging markets are at 8.6%.
Unexpected return is not a short-term forecast.
It is the long-term return that you expect to earn
on an asset based on its riskiness.
Now, I know that some of you might be thinking
that it makes sense to move
out of the lower expected returning regions
and into the higher ones,
but the data are a little too messy
for that to work consistently.
In a 2012 paper by Cliff Asness titled
"An Old Friend The Stock Markets Shiller PE"
Asness confirmed that future returns fall consistently
as the Shiller price earnings
at the start of the period increases.
Higher Shiller price earnings,
lead to lower future returns on average.
The problem though is
that there is still a large distribution of future outcomes.
Higher prices shift the distribution as a whole
but they do not make future returns anymore certain.
Asness looked at the distribution of future returns
for the S&P 500 when the Shiller price earnings
was at various levels.
Remember it was 31.31 when this video was recorded.
When it was historically below 9.6
10 year real forward returns average 10.3% annualized
in US dollar terms.
For context, the average annual return for the S&P 500,
going back to 1926 has been 7.3% annualized
also in US dollar terms.
So when the Shiller price earnings has been low
market returns have been well above average.
The best 10-year real return while the Shiller PE
was below 9.6 was 17.5% annualized.
While the worst was 4.8%.
There was a difference of 12.7 percentage points
between the best and worst decade
when the Shiller PE was below 9.6.
At the other end of the spectrum
when the Shiller PE has been at historic highs above 25.1
the real returns in the following decade average 0.5%.
The best decade had a real return
of 6.3% annualized while the worst was negative 6.1%.
There was a difference of 12.4 percentage points
between the best and the worst decade
when the Shiller PE was above 25.1.
This should illustrate why making asset allocation
decisions based on the Shiller PE
would not be wise.
Shifting in and out of equity markets
based on the Shiller PE could easily lead
to a bad outcome.
Sticking to an asset allocation through time
allows you to maintain exposure
to the reliably positive equity risk premium.
I know I didn't give you any exciting forecast
in this video so I apologize
if that's what you were looking for.
The only forecast worth paying attention to
are those that have been proven as useful in the data
like the Shiller price earnings.
And even then forecast should only be used
to tweak your expectations for financial planning purposes
not to make short-term changes to your investment strategy.
Thanks for watching.
My name is Ben Felix of PWL capital
and this is common sense investing.
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please share it with someone who you think
could benefit from the information.
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