When in doubt, the Magic 8 Ball has all the investment advice answers

One of my fondest memories of Christmas was getting a Magic 8 Ball in my stocking when I was younger – times were simpler. I spent hours (admittingly one to many) asking questions to the large plastic ball, only to turn it over to reveal the written answer which appeared on the surface. Recently, I was cleaning out my storage unit (my parents’ house) and I came across my trusted childhood toy. I thought to myself, could the Magic 8-Ball help us answer questions relating to the market. As of time of writing, global equity markets have rallied approximately 9%, 10% and 9% as measured by the S&P 500, S&P/TSX and MSCI World year to date. Perhaps it doesn’t feel like it but believe it or not we have gained over half of the losses experienced in the correction. Let’s ask our trusty Magic 8 Ball the questions that our team has received most often during the past couple of weeks.

Signs point to yes.

Over the past thirty years, the S&P 500 has experienced six bear markets (a drop of 20% or more) in a calendar year. Of those, markets were positive all but once one year later with an average return of 18% from that initial drop of 20%. The same analysis is similar for corrections. Our work suggests that since 1987 there have been 25 corrections in a calendar year (as measured by a drop of more than 10% from the previous peak). There were 11 instances of the 25 when the forward 1-year return was negative from the initial drop of 10%. 9 of those occurred either leading into or during a recession. In our 2019 Outlook published earlier in the year, we highlighted that despite the slowing global economy, the risk of a global recession continued to be low. Investing is a probability-based decision and when pullbacks occur, history tells us that investors have been well served to take advantage of the volatility if it occurs in non-recessionary periods.

In 2010, a paper titled “the equal importance of asset allocation and active management” written by Ibbotson, Xiong, Idzorke and Chen studied 10 years of returns from more than 5,000 mutual funds in order to measure the relative importance of asset allocation. They found that three quarters of a typical fund’s variation of performance comes from general market movement, with the remaining portion split roughly between the specific asset allocation and active management.

Our work suggests that a material driver in the relative performance of asset classes is valuation. One metric we use is a market’s earnings yield relative to its country’s inflation rate (which is a proxy for fixed income). When we look at the earnings yield of the S&P 500 relative to inflation, it paints a positive story for the S&P 500’s 2 year forward compound annual growth rate (CAGR) as illustrated below. Our US inflation model forecasts inflation, as measured by the Consumer Price Index (CPI), to moderate around 2% into 2019 which would likely lead to a S&P 500 CAGR in the mid to high single digit over the next couple of years. 

The FED Model looks at it another way where it measures the S&P 500’s Earnings Yield relative to 10 Year U.S. Treasury Bonds. What the dot plot below shows is historically that a yield gap above 3% has very rarely been associated with negative returns in the following 12 months. The median return since 1962 was approximately 14%. 

Cannot predict now.

We have come across several sell side reports that are calling for a re-testing of the lows set in December. These forecasts are through the lens of technical analysis. While we have healthy internal debate within our team regarding the merits of technical analysis, we all agree that for every ‘re-test’ thesis we have also seen ‘no retest’ from other technical analysts. Who do you listen to? At this time based on fundamentals and valuations markets are attractive. We could dip lower but, in each example, highlighted in sell side reports of a retest (1998, 2011 and 2016) the markets ultimately marched higher. Will we ever have the ability to time it perfectly? Absolutely not! Could we move lower? Absolutely! But that doesn’t stop our team from recognizing the attractiveness today. As Philip often says “the markets will move higher from these or lower levels”.

My sources say no.

Recency bias is a powerful cognitive error that tricks you into believing that what has happened will continue to happen. We believe that it’s one of the single greatest cognitive biases that helps explain the difference between the market return and that of a typical retail investor. It is this dynamic that makes me challenge those advisors that want to ‘wait’ for the ‘potential’ retest before investing.

If we were to retest the lows, what are the odds of investors actually investing? Sure, some investors will follow their investment plan, but the majority of investors become paralyzed with doubt during severe sell offs and practice recency bias by sitting on their hands. Quite often, the market rallies quickly and investors are stuck sitting with cash only to invest later at higher levels making them worse off than if they had stayed invested. The chart below illustrates this phenomenon which tracks S&P 500 1 year returns vs. net flows into equity and fixed income mutual funds and ETFs – the message is clear; investors’ decisions are based on prior market conditions and not on future prospects, leading them to selling when they should be buying and buying when they should selling. We believe those who fear negative short-term market moves are better off to allocate capital using a dollar-cost averaging strategy. History would show that despite potential short-term pullbacks, more often than not the markets are positive one-year later. As the Ibbotson study illustrates, the most important decision an investor can make is ‘being’ in the market.