News

“Ideology is the antithesis of reason.”
McCartney summarizing Charlie Munger

“You see, one thing is, I can live with doubt and uncertainty and not knowing. I have approximate answers and possible beliefs and different degrees of certainty about different things… It doesn’t frighten me.”
Richard Feynman

The efficient market hypothesis is just “a model”, Fama stresses. “It’s got to be wrong to some extent.” “The question is whether it is efficient for your purpose. And for almost every investor I know, the answer to that is yes. They’re not going to be able to beat the market so they might as well behave as if the prices are right.”
Gene Fama Interview, Financial Times, 8/30/2024

The third quarter was another nice quarter for the markets. Below are the indices we track.

Our friends at Dimensional summarized the 3d quarter as follows:

”US stocks built on a strong first half, with many market indices at or close to record levels as the third quarter neared an end. But those gains came amid a spike in volatility unseen since the COVID pandemic. Fulfilling expectations that had been building for months, the US Federal Reserve in September cut interest rates—another thing investors hadn’t seen since 2020—as core inflation eased. Developed equity markets outside the US rose, and emerging markets were slightly higher for the quarter. In the bond market, US Treasuries posted price gains, sending the benchmark 10-year yield below 4%.”

Playing with Artificial Intelligence

I decided to do something different for this newsletter.  I took 11 very influential academic papers and articles (which I will list at the end of this newsletter with appropriate links, in case anyone wants to dig further), and I uploaded those into the artificial intelligence “AI” engine ChatGPT. ChatGPT allows you to upload research. I then posed the following query to ChatGPT.

“Can you summarize the lessons from the uploaded papers for investors, including how to structure a portfolio for the long-term? Please write the memorandum combining the knowledge contained in the papers uploaded, and give a good argument why artificial intelligence will not lead to improvements in investing based upon the knowledge contained in the papers.”

I hope you enjoy it.  It was illuminating how quickly the memorandum was prepared, and I do believe ChatGPT did a good job of summarizing the papers. We are always happy to discuss further. I included the most cited paper ever in the history of finance, Portfolio Selection, by Harry Markowitz, as well as several papers by Eugene Fama, who is considered the possibly the most cited Finance professor ever because of multiple papers, a list of which you can find here.  Eugene Fama vitae  One may quibble with the papers uploaded, but it is hard to argue against Markowitz, Fama, Sharpe, Black (of Black-Scholes fame who would have won a Nobel prize if he was alive) and the other authors uploaded, as well as their contribution to finance and investing.  I am always willing to listen to counterpoints.

I did slant my question against AI.  Next quarter, I will ask the same tool what it envisions as the benefits of AI for investing now and in the future.  Remember, this is ChatGPTs output regarding the papers uploaded at the end of this newsletter, and not mine or Emily’s.  However, I have to admit that the advice is sound.

Memorandum: Lessons for Long-Term Investors and AI in Investing

Key Insights on Long-Term Portfolio Structuring

1. Embrace Passive Management: Fama and French’s research repeatedly shows that, after accounting for costs, active management generally underperforms passive strategies. Active management is often a zero-sum game, where winners and losers offset each other, and once fees are included, most funds fail to outperform passive benchmarks​​. Sharpe’s “Arithmetic of Active Management” further reinforces this, showing that after costs, the average actively managed dollar performs worse than a passive dollar​. Therefore, a long-term investor should focus on a low-cost, passively managed, diversified portfolio to maximize returns over time.
2. Diversification is Essential: Jim Davis emphasizes that effective diversification significantly reduces portfolio risk. His work shows that increasing the number of stocks in a portfolio to a very high level (up to 11,000 stocks) lowers portfolio volatility to market levels​. Building a globally diversified portfolio, across asset classes and geographies, helps mitigate the risk of underperformance from any single asset class.
3. Incorporate Value and Momentum Factors: Asness et al.’s research on “Value and Momentum Everywhere” highlights the consistency of value and momentum return premia across asset classes​. These factors can be complementary, offering diversification benefits even within factor investing. Combining value (buying undervalued stocks) and momentum (buying stocks with strong recent performance) can yield a balanced portfolio that performs well across various market conditions, reducing risk and improving long-term returns.
4. Consider Profitability as a Core Factor: Novy-Marx’s work introduces profitability, measured by gross profits-to-assets, as a factor that rivals book-to-market in predicting returns. Profitable firms tend to outperform less profitable ones, and controlling for profitability improves the performance of value strategies, especially for larger stocks​. A long-term investor should look to incorporate this factor into their portfolio for an additional performance edge.
5. Market Efficiency and Random Walk Hypothesis: Fama’s work on market efficiency suggests that markets reflect all available information, making it hard for investors to consistently beat the market​. Similarly, Fischer Black’s analysis of the Random Walk Hypothesis supports the idea that stock prices move randomly, making market timing ineffective​. Therefore, attempting to time the market is generally futile for long-term investors.
6. Stick to a Buy-and-Hold Strategy: Studies show that active trading not only incurs costs but often leads to lower performance​​. Long-term investors should adopt a buy-and-hold strategy with periodic rebalancing to maintain their target asset allocation. This minimizes transaction costs and takes advantage of compounding over time.

Argument Against AI Improving Active Investing

While artificial intelligence (AI) holds promise in many fields, there are fundamental reasons why AI is unlikely to dramatically improve active investing returns in the long run:

1. Active Management’s Structural Limits: According to Sharpe’s arithmetic and the research by Fama and French, active management remains a zero-sum game. AI’s advanced data analysis may help some managers make better predictions, but it cannot change the underlying market dynamics where the outperformance of some investors is balanced by the underperformance of others​​. AI cannot alter the cost of active management, and after fees, active strategies will still likely underperform passive strategies over the long term.
2. Efficiency of Markets: AI may process vast amounts of data quickly, but markets are highly efficient, especially in developed economies. The Efficient Market Hypothesis (EMH) suggests that prices already reflect all available information​. AI might detect short-term pricing inefficiencies, but these are likely small, fleeting, and eroded by competition. Furthermore, transaction costs and market impact from frequent trading can diminish any small advantage AI might generate.
3. Behavioral and Liquidity Risks: As shown by Asness et al., value and momentum strategies perform consistently across various asset classes because of fundamental economic drivers like liquidity risk​. AI could exacerbate these risks, particularly in times of market stress, as many algorithms may trigger similar trades simultaneously, amplifying market volatility and reducing the benefits AI might offer in normal market conditions.
4. Complexity of Financial Markets: AI might improve short-term predictions, but financial markets are influenced by complex, unpredictable macroeconomic factors, geopolitical events, and human behavior. As demonstrated in the studies on market anomalies and behavioral biases, these factors are difficult to model, even with advanced AI​​. Human oversight and judgment will still be necessary to interpret these broader market influences.

In conclusion, while AI might provide some incremental improvements in certain aspects of portfolio management, the fundamental advantages of passive investing, diversification, and long-term buy-and-hold strategies—rooted in decades of academic research—suggest that AI will not significantly alter the structural limitations of active investing. Therefore, for most investors, a well-constructed, diversified, and passive portfolio remains the optimal strategy for long-term success.

Recommendations for Portfolio Construction:

• Use Passive Index Funds: Invest primarily in low-cost index funds across various asset classes.
• Diversify Globally: Include a mix of equities, bonds, and potentially alternative assets (e.g., REITs).
• Incorporate Factors: Consider adding value, momentum, and profitability strategies within the passive framework.
• Stick to Long-Term Investing: Rebalance periodically, avoid market timing, and stay invested through market cycles.

This approach maximizes your chances of achieving consistent, risk-adjusted returns while minimizing costs—key tenets of sound long-term investing.

Papers Referenced

Luck versus Skill in the Cross-Section of Mutual Fund Returns – Eugene Fama and Ken French

The Arithmetic of Active Management – William Sharpe

The Loser’s Game – Charles Ellis

Portfolio Selection – Harry Markowitz

Value and Momentum Everywhere – Asness, Moskowitz and Pedersen

Implications of the Random Walk Hypothesis for Portfolio Management – Fischer Black

The other side of value: The gross profitability premium – Robert Novy-Marx

Dissecting Anomalies with a Five-Factor Model – Eugene Fama and Ken French

Are Markets Efficient? | Chicago Booth Review

Embrace Passive Management Already | Chicago Booth Review – Eugene Fama

Effective Diversification and the Number of Stocks – Jim Davis

__________________________________________________

Until next time,

Mike and Emily

“In today’s rapidly changing economy, even the strongest and best-managed companies face the risk of a decline in competitive position and stock underperformance over time,” said Thomas E. Faust Jr., chief investment officer of Eaton Vance Management, regarding the collapse of Enron. His advice was old- fashioned: “Don’t put all of your eggs in one basket.”
The Atlanta Journal – Constitution; Atlanta, Ga.. 08 Feb 2002

“Economist Joseph Schumpeter argues in “Capitalism, Socialism, and Democracy” that capitalism is never stationary and always evolving, with new markets and new products entering the sphere. He is perhaps most known for coining the phrase “creative destruction,” which describes the process that sees new innovations (and companies) replacing existing ones that are rendered obsolete over time.”
Schumpeter’s Theory of Creative Destruction, Carnegie Mellon, 2019

“Part of the never-ending story of competitiveness is creative destruction: many new businesses end up displacing incumbents who were at one time leaders themselves. We monitor this creative destruction in a number of ways. As shown in the first chart below, there is a constant drumbeat of companies removed from the S&P 500 due to business distress. Furthermore, more than 40% of all companies that were ever in the Russell 3000 Index experienced a “catastrophic stock price loss”, which we define as a 70% decline in price from peak levels which is not recovered.”
“The Agony & the Ecstasy: The Risks and Rewards of a Concentrated Stock Position JP Morgan, 2022.”

The US equity market posted positive returns for the quarter and outperformed non-US developed markets, but underperformed emerging markets.  Value underperformed growth, and small cap stocks underperformed large caps for the quarter.  Below are some of the indices we follow.

Magnificent 7 Stocks

We have been getting questions on Nvidia and the “Magnificent Seven” for a bit now.  While Nvidia and the “Magnificent Seven” (Apple, Microsoft, Alphabet, Amazon, Meta Platforms, and Tesla) have been market leaders, concentrating your entire portfolio on them carries significant risks. Investment theory emphasizes diversification as a core principle and argues that by spreading investments across uncorrelated assets, you can reduce overall portfolio risk without sacrificing returns. Even within the “Magnificent Seven,” a downturn in one sector, like technology, could disproportionately impact your holdings.  Below is a graph from Apollo showing how the Mag 7 has performed since January of 2023 compared to the other 493 stocks in the S&P 500.

Nvidia and the other companies in the Mag 7, despite the impressive performance, are subject to company specific risks such as competition and regulatory changes. Over-reliance on these stocks could lead to significant losses if they underperform.  As Bank of America showed this week, large cap growth relative to small cap value is at its highest valuation since the tech bubble in 2000.

We are not saying that we can time these things. However, tilting to factors such as value, profitability and small cap further supports diversification. Financial research suggests that market returns are driven by factors beyond just the overall market movement. These factors include size (small vs. large companies), value (cheap vs. expensive stocks), profitability, and investment (companies that invest heavily vs. those that don’t). Diversifying across these factors gives the potential of long term gains without exposing yourself to concentration risk.

History provides stark reminders of the dangers of concentrated portfolios. The tech crash of 2000 serves as a prime example. Back then, Cisco was a darling of the tech world, its stock price soaring to an all-time high of over $80 per share in March 2000. Investors piled into the company, believing its dominance in networking equipment was unassailable.

The tech bubble burst in early 2000 as investor sentiment shifted. Companies with inflated valuations, like Cisco, were particularly vulnerable. Cisco’s stock price plummeted, losing a staggering 89% of its value and reaching a low of $8.60 in October 2002. Here is what the well-known financial publication Barron’s had to say in its February 14, 2000, edition, weeks before the correction started.

“Fans of Cisco were trumpeting its potential to become the first $1 trillion company in market value following its blow-out profit report on Tuesday.

Cisco rose 9 13/16 to 131 last week after hitting a record high of 136 1/4, giving the company a market value of $475 billion. Cisco last week became No. 2 in market capitalization after overtaking General Electric, which has a value of $440 billion. Microsoft has the largest market cap at $554 billion.

Cisco, which is up more than 400-fold from a split-adjusted price of 31 cents a share at its initial public offering exactly a decade ago, now has to roughly double again to hit the magic $1 trillion mark. Considering that Cisco rose 131% last year after gaining 150% in 1998, another double doesn’t seem like such a stretch.

Cisco now is deemed a better bet than Microsoft to hit $1 trillion first because its profit momentum is stronger. Cisco had pro-forma profits of 25 cents in the quarter ended January 31, up 47% from 17 cents a year earlier, on a 53% rise in revenues. Microsoft’s profits per share were up a sizable 31% in the fourth quarter.”

Sounds familiar, huh?  Cisco’s dramatic decline highlights the perils of overconfidence in any single stock, no matter how strong the company appears.  We do not know where things are going. However, we do know single stock risk is real.

While Cisco survived the crash and remains a major player in the networking industry, its stock price has never fully recovered. As of July 2024, it trades at around $47 per share, well below its 2000 peak 24 years ago. This is a significant reminder that even seemingly invincible companies can experience long-term declines.

BlackBerry, a pioneer in mobile phones, couldn’t adapt to the rise of Apple and Android smartphones and its stock price plummeted by over 80% in 2011.  Lehman Brothers, a major investment bank, collapsed during the 2008 financial crisis.  AIG, another financial giant who was only one of a handful of companies with the highest AAA credit rating, required a government bailout after suffering massive losses. Anheuser-Busch reached a peak of over $130 per share in September of 2016, while trading today just below $60 per share, 8 years later. These cautionary tales are but a few that exist highlighting the dangers of concentrating your portfolio in a few seemingly invincible companies.

Diversification allows you to benefit from growth in different sectors and asset classes. By spreading your investments among different asset classes and geographies, you create a more resilient portfolio less susceptible to the fortunes of any single company or sector.

It’s important to remember that even the “Magnificent Seven” may not maintain their dominance forever. New technologies and business models can disrupt established industries, as shown by the plight of Blackberry above.  Diversification allows you to participate in future growth opportunities beyond the current market leaders, thereby benefiting from creative destruction and capitalism.

Meir Statman, a renowned finance professor from Santa Clara University, wrote a nice piece for Avantis Investors, one of the fund companies we use.  Diversification vs. Concentration in the Era of the ‘Magnificent Seven’  Here are some useful thoughts.  The entire piece is worth reading.

Students “note their surprise at the large role of luck in the outcomes of their portfolios. Some stocks they thought would do well performed poorly, and some they thought would do poorly performed well. Some stocks chosen after careful analysis did well, but others performed poorly, and some chosen at random did well, but others performed poorly…”

“Much of the benefit of diversification comes from the fact that the overall positive returns of stocks come from a few winners. Indeed, the returns of most stocks lag those of the U.S. Treasury bill. Moreover, the identities of the winning stocks vary over time, with technology stocks in 2023 and energy stocks in 2022.

A portfolio diversified among all stocks, technology, energy, and all other industries would likely include the winning stocks, even if their identities were unknown in foresight. A concentrated portfolio would likely miss them.

A portfolio concentrated in technology in 2023 and energy in 2022 would have made investors winners, but a portfolio concentrated in energy in 2023 and technology in 2022 would have made them losers.

Wise investors holding diversified portfolios are likely to do well over the long run, even if not over the short run. However, investors holding concentrated portfolios are likely to do poorly over the long run, even if they do well over many short runs.”

Below are returns for the Nasdaq and S&P 500 for the decade starting January 2000 and ending December 2009.  As you can see, if you had all of your money in Nasdaq, your $1,000,000 turned into approximately $557,600 at the end of the decade.  Being diversified in large value, small, small value and international helped portfolios tremendously during that decade.

While Nvidia and the “Magnificent Seven” are impressive companies, a diversified portfolio is essential for long-term investment success. As Peter Bernstein and Aswath Damodaran wrote in their book Investment Management,

“Staying rich requires an entirely different approach from getting rich.  It might be said that one gets rich by working hard and taking big risks, and that one stays rich by limiting risk and not spending too much.”

Election 2024

The election season is upon us.  After last weekend, we know there will be increased scrutiny and coverage.  We want to reiterate that although in the short-term there could be volatility in the market, we believe taking a long-term view should not impact our diversified approach.  Below is some information to keep you rational in a time of uncertainty and emotion.

How Much Impact Does the President Have on Stocks?

Until next time,

Mike and Emily

“But to say the record of their transactions, the price chart, can be described by random processes is not to say the chart is irrational or haphazard; rather, it is to say it is unpredictable.”
Benoit Mandelbrot

“The scientist has a lot of experience with ignorance and doubt and uncertainty… we take it for granted that it is perfectly consistent to be unsure—that it is possible to live and not know. But I don’t know whether everyone realizes that this is true.”
Richard Feynman

“There’s so much uncertainty involved in the outcomes from investing that it’s difficult to extract the signal from the noise.”
Eugene Fama

“Unfortunately, skill in evaluating the business prospects of a firm is not sufficient for successful stock trading, where the key question is whether the information about the firm is already incorporated in the price of its stock. Traders apparently lack the skill to answer this crucial question, but they appear to be ignorant of their ignorance.”
Daniel Kahneman

“We are far too willing to reject the belief that much of what we see in life is random.”
Daniel Kahneman

1st Quarter 2024

The first quarter was a good one, as shown by the indices we follow below.

The US equity market posted positive returns for the quarter and outperformed both non-US developed and emerging markets.  Developed markets outside of the US also posted positive returns for the quarter and underperformed the US market, but outperformed emerging markets. Emerging markets posted positive returns for the quarter and underperformed both US and non-US developed markets.

Understanding Knightian Uncertainty and Risk in the Stock Market – The Importance of Uncertainty, Risk, Elections and War

In the world of finance and economics, two concepts often come up when discussing investment decisions: risk and uncertainty. These terms were formally distinguished over a century ago by economist Frank Knight in his 1921 book, “Risk, Uncertainty, and Profit“. According to Knight, risk applies to situations where we do not know the outcome of a given situation but can accurately measure the odds.  For instance, if a coin is flipped, we don’t know whether it will land on heads or tails, but we know the probability for each outcome is 50%.

On the other hand, Knightian uncertainty, or “true uncertainty,” applies to situations where we cannot know all the information to set accurate odds in the first place. This is a situation where the possible outcomes are not known, or where it’s impossible to assign probabilities to them. An example of Knightian uncertainty is the potential impact of a completely new and unknown technology or market disruption. Understanding uncertainty reminds us the world is complex and helps us set realistic expectations about what data can and cannot tell us.

When investing, we encounter both risk and uncertainty. The risk in an investment can be quantified using historical data and statistical models. For instance, we can calculate the average return and volatility of a stock based on its past performance. However, the future performance of the stock market also involves Knightian uncertainty. Factors such as changes in market sentiment, unforeseen events like pandemics, war, or sudden regulatory changes can drive unforeseeable changes in stock returns. It is a reason why we (or anyone else) cannot answer definitively the question “where is the market going” for any given period.

So, how can an investor navigate through this landscape of risk and uncertainty? This is where the research of Harry Markowitz and others come into play. Markowitz introduced Modern Portfolio Theory (MPT), which revolutionized the way we think about investments. Instead of focusing on individual stocks, MPT emphasizes the importance of portfolio diversification by eliminating single stock (bankruptcy) risk as well as holding domestic and international stocks and bonds. By holding a diversified portfolio, investors can try to optimize their returns for a given level of risk.

Markowitz’s theory was later built upon by other researchers such as Bill Sharpe, leading to the development of the Capital Asset Pricing Model (CAPM). This model provides a method to determine the expected return of an asset based on its systematic (market) risk. It suggests that by investing in a mix of a risk-free asset and a market portfolio, investors can achieve an optimal balance between risk and return.

Eugene Fama and Kenneth French then expanded upon the Capital Asset Pricing Model (CAPM) by adding two more factors to the “market” factor: size and value in the Fama-French Three-Factor Model.  The size factor, referred to as “Small Minus Big” (SMB), is the return spread between small- and large-cap stocks. The value factor, known as “High Minus Low” (HML), measures the return spread between high book-to-market (cheaper) and low book-to-market (more expensive) stocks. This model acknowledges that small-cap and value stocks tend to outperform the market, and it adjusts for this tendency, making it a more effective tool for evaluating manager performance. More recent research has added two more factors, investment (the return spread between companies that invest conservatively and those that invest aggressively) and profitability (the return spread between companies with high versus low operating profitability), to their factor model.

Robert Merton also advanced the CAPM by introducing the Intertemporal Capital Asset Pricing Model (ICAPM).  This model extends the traditional CAPM by considering that most investors participate in markets over multiple years and are interested in developing a strategy that shifts as market conditions and risks change over time. ICAPM assumes that investors hedge risky positions and construct dynamic portfolios over time. It considers how investment opportunities might shift as expectations of risk change, resulting in situations in which investors may wish to hedge, especially as they may have to live off their portfolio after retiring and no longer having a salary.

While the stock market presents both risk and Knightian uncertainty, theories and models developed by economists like Frank Knight, Harry Markowitz, Bill Sharpe, Gene Fama and Bob Merton provide valuable tools for investors to navigate such risk and uncertainty. By understanding the difference between risk and uncertainty, and by using strategies such as portfolio diversification and asset pricing models, investors can make more informed decisions and better manage the inherent risk of the market.

Elections, Markets and Uncertainty
Speaking of uncertainty, elections can create great uncertainty in both the political world and markets. The impact of elections and the governing parties on stock market returns in the United States is a topic of significant interest to investors. Research shows that while elections do influence the stock market, the specific political party in control most likely does not significantly affect the market’s long-term performance.

Below are several other graphics depicting S&P 500 returns under different regimes.

It’s important to note that market returns are influenced by many factors, including political, economic and inflation trends such as actions of foreign leaders, interest rate changes, changing oil prices and technological advances; rather than strictly election results. While elections may introduce short-term volatility due to policy uncertainty, their impact on medium-to-long-term stock market performance appears to be minimal.

For long-term investors, the best course of action during an election year is to stick with a sound long-term investment plan based on individual investment goals. This means staying fully invested throughout the year per your plan or investing consistently per your plan.  Investors should avoid market timing around politics. While it can be tempting to make investment decisions based on the potential impact of election outcomes, as shown above historical data suggests that the party running the country makes no clear difference for the stock markets in the long-term.

Shareholders invest in companies that focus on serving their customers and growing their businesses and profits, regardless of who is in the White House. Long-term investors are typically better off sticking to their investment plan and not making drastic changes based on election outcomes.

Until next time,

Mike and Emily

PS.  The last 2 quotes at the beginning of the newsletter are a nod to one of the deepest thinkers ever, Danny Kahneman, who passed away on March 27.  He had a profound impact upon understanding how humans behave, including investors.  As a psychologist, he won a Nobel Prize in Economics, and by some accounts, is one of the most cited academic psychologists ever.  Good obit here. The Nobel citation commended Kahneman “for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty.”

“A good process produces good results.”
Nick Saban

“Goals can provide direction and even push you forward in the short-term, but eventually a well-designed system will always win. Having a system is what matters. Committing to the process is what makes the difference.”
James Clear, Author, Atomic Habits

“If you can’t describe what you are doing as a process, you don’t know what you’re doing.”
W. Edwards Deming, Quality Control Expert

Well, the fourth quarter was a good one, despite most economic forecasters’ predictions. Below are the indices we track.

The Nick Saban Way to Investing: Why Process Trumps Results (and How It Can Grow Your Portfolio)

As some of you may know, Emily and her 2 sisters attended the University of Alabama, so we have been somewhat influenced by Nick Saban since 2011.  Have you ever wondered what Alabama’s legendary coach and a solid investment strategy have in common? Surprisingly, both hinge on a powerful principle: prioritizing the process over the outcome.

Saban’s relentless focus on meticulous preparation, execution, and constant improvement has propelled Alabama to six national championships. Similarly, in the uncertain world of investing, chasing short-term returns can lead to impulsive decisions and emotional rollercoasters. Imagine trying to make decisions based upon the daily stock moves as shown in the graph below.

Instead, focusing on a well-defined process, grounded in research and evidence, gives an investor a higher probability of achieving their long-term financial goals.

This isn’t just wishful thinking. Nobel laureate Eugene Fama and Professor Kenneth French, whose work on risk factors like size and value underpins Fama-French portfolios, have shown that systematic, process-driven investing outperforms market timing and impulsive decisions. And Harry Markowitz, another Nobel laureate, championed diversification as a cornerstone of risk management, a principle that forms the bedrock of any sound investment process.

At McCartney Wealth Management, we believe in the power of process. We work with clients to develop personalized investment plans that leverage these proven principles. We employ evidence based research such as Fama-French factor-based strategies to tap into returns that investors get for taking compensated risk.

For example, Fama and French found that systematic factors beyond just market risk significantly influence stock returns and can be harnessed to build more effective portfolios. Let’s dive into these factors and their statistical significance:

1. Size Premium (SMB): Small-cap stocks have  historically outperformed large-cap stocks. This may be due to their higher growth potential, lower liquidity, or higher risk, which demands a higher expected return.

2. Value Premium (HML): Stocks with high book-to-market ratios – “value stocks” – tend to outperform “growth stocks” with low book-to-market ratios. This could be due to mean reversion in valuations, where undervalued assets eventually catch up to their intrinsic worth.

3. Profitability Premium (RMW): Companies with high operating profitability, as measured by profitability ratios like operating margin, have historically generated higher returns. This aligns with the idea that better-managed companies deliver superior returns over time.

Statistical Significance: The empirical evidence for these factors is robust. Numerous studies have confirmed their existence and significance using various statistical tests like T-statistics and P-values. For example, the average T-statistics for SMB and HML in Fama and French’s original paper were well above 3, indicating strong statistical separation from random chance (at a P-value < 0.01). Subsequent research has further validated these findings.

Further, we diligently diversify portfolios across asset classes and geographies, including international and emerging markets, to mitigate risk. This structured approach, based on research and not hunches, aims to navigate market volatility and steer your portfolio towards long-term success.  As you can see below, it is impossible to identify in advance which asset class is going to be the best or worst performer in any given calendar year.

But focusing on process doesn’t mean ignoring results entirely. Regular portfolio reviews and performance monitoring are crucial to ensure your strategy stays aligned with your evolving needs, risk tolerance and financial plan. This iterative approach allows you to fine-tune your process, making adjustments as needed while maintaining a steady focus on the long game.

Remember, the market is a marathon, not a sprint. By focusing on the process, on disciplined execution and evidence-based strategies, you’ll be well on your way to achieving your long term financial goals. So, the next time you find yourself tempted to check the scoreboard, take a page from Coach Saban’s playbook, and focus on the process, trust the system, and watch your long-term success unfold.

WE’RE MOVING

We hope you and your families had a Happy New Year! As we look forward to 2024 there are a few changes that are coming to McCartney Wealth management that we want to make you aware of.

We’re Moving! We have loved being in the Webster area since I started MWM in 2010. As we plan to grow and hire a Client Services Representative/Admin this year we are outgrowing our space (and Emily is ready for a door), it is perfect timing that our lease is up on March 31st. Beginning April 1 we will be in offices in the Pierre Laclede building in Clayton, MO. We will be sure to update you when we have our official address and office suite numbers. We look forward to meeting with you in our new offices in the second quarter.

We are also making a technology move and migrating to a different portfolio management software company, Advyzon. You are familiar with our current portfolio management system, Pulse, through your quarterly reports. Pulse (formerly Assetbook) has been a great, trusted provider and was the only cloud based system at the time I started in 2010. Since then, technology has advanced and other competition has moved into the RIA space. We have researched and met with many portfolio management software companies and we are confident that Advyzon will allow us to better serve you as our client. Advyzon has top notch security, more back end functions to optimize our back office and better integrations with the other software we already use, including Schwab. There is no action needed from you at this time. From your point of view the main difference you will notice will be a slight difference visually in the quarterly reports. We will be sure to communicate more details when the migration is complete.

Please reach out with any questions or concerns. We do not make changes light heartedly and believe these will allow us to continue to serve you and your families even better in 2024. We are very grateful to work with you and for your continued business and support.

All the best,

Mike and Emily

“Persistence beats timing. Execution beats luck. Not immediately, but eventually.”
Naval Ravikant

“Over a long enough time horizon, positioning beats predicting.”
Shane Parrish

“I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.”
Warren Buffett

Below are the indices we track for this newsletter.

Stock markets gave back some of the gains from earlier in the year this last quarter.  The US Stock market posted negative returns for the quarter and outperformed international developed markets but underperformed emerging markets.  International developed markets also posted negative returns for the quarter and underperformed both US and emerging markets. Emerging markets posted negative returns for the quarter and outperformed both US and international developed markets.  Finally, interest rates increased across all bond maturities in the US Treasury market for the quarter.

The Perils of Market Timing in the Stock Market

Introduction

The stock market is a place where many go to grow their wealth. With recent headlines of a possible recession, a government shutdown and consumer savings waning, some are advocating getting out of the market.  Some believe they can outsmart it by “timing” their buys and sells perfectly to make even more money. Nobel laureates such as Markowitz, Sharpe, Fama, Tobin, and Merton have done extensive research on this topic. Their findings? Trying to time the market is risky and usually doesn’t work out.

1. What is Market Timing?

Market timing means attempting to buy stocks (and other securities) at their lowest points and sell them at their highest points, based on predictions about future market movements. This might sound smart in theory, but in practice, it’s very difficult.

2. Why is Market Timing a Bad Idea? Extensive research has led to the following theories:

• • Random Walk Theory (Fama): Eugene Fama‘s research suggests that stock prices move unpredictably and follow a “random walk”. This means today’s stock prices are not based on yesterday’s prices and predicting the market’s next move is almost impossible.  Below is a graph of daily returns of the S&P 500 for 30 years through Oct 3, 2023.

• • Risk-Reward Relationship (Markowitz and Tobin): Harry Markowitz‘s research on portfolio theory and James Tobin‘s work on the “separation theorem” highlight that higher returns come with higher risks. By trying to time the market, investors might miss out on high-returning days, meaning they could end up with lower overall returns.  Tobin suggested managing and lowering the risk of the portfolio by combining Markowitz’s diversified stock portfolio with safe, cash-like investments, such as short term treasuries or safe bonds.
  • Efficient Market Hypothesis (Fama): Fama’s theory suggests all known information about a stock is already reflected in its price. If true, this means it’s impossible to buy undervalued stocks or sell overvalued ones consistently because there are no “hidden secrets” in stock prices.  Further, prices adjust quickly, as shown below.

• • Luck versus Skill: Fama and Ken French researched luck versus skill in investing in their paper Luck Versus Skill in the Cross Section of Mutual Fund Returns by comparing the returns of professionally managed funds to returns one would expect by chance or luck.  They found that professional money managers do not beat the market once fees and expenses are considered.  The paper suggests that it is challenging to find a manager who will consistently outperform the market in the future.

3. Real-world Challenges

• • Emotional Decision Making: Fear, loss aversion identified by Danny Kahneman, and greed can influence decisions. When the market drops, fear might make someone sell their stocks. And when it rises, greed might make them buy. This emotional cycle can cause people to buy high and sell low – the opposite of what’s profitable. 

• • Increased Costs: Trying to time the market involves more trading. More trading means more fees and taxes, eating away at potential profits.

  • Missing the Best Days: Research by Bill Sharpe and others have shown that a significant portion of stock returns come from just a few of the best trading days. If an investor is out of the market on these days, they might miss out on essential gains.

• • Stay Invested: Over time, historically, the market has trended upwards. By staying invested, one can benefit from this long-term growth.

  • Diversify: Instead of putting all money into one stock or sector, spread it out. This reduces risk and provides a smoother ride.

Conclusion

The collective wisdom from these Nobel laureates, and Warren Buffett above, tells us that trying to time the market is more of a gamble than a guaranteed strategy. It’s filled with risks, costs, and challenges. For most people, a more reliable approach is to stay invested, diversify their portfolio, and think long-term. The stock market isn’t a game to be outsmarted; it’s an opportunity to grow wealth over time.

Citations

• Random Walk Theory (Fama)
  • Fama, E. F. The Behavior of Stock-Market Prices. The Journal of Business, 38(1), 34-105.
• Risk-Reward Relationship (Markowitz and Tobin)
  • Markowitz, H. Portfolio Selection. The Journal of Finance, 7(1), 77-91.
  • Tobin, J. Liquidity Preference as Behavior Towards Risk. The Review of Economic Studies, 25(2), 65-86.
• Efficient Market Hypothesis (Fama)
  • Fama, E. F. Efficient Capital Markets: A Review of Theory and Empirical Work. The Journal of Finance, 25(2), 383-417.
• CAPM and Return Concepts (Sharpe)
  • Sharpe, W. F. Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. The Journal of Finance, 19(3), 425-442.
• Continuous-time finance (Merton)
  • Merton, R. C. Theory of Rational Option Pricing. The Bell Journal of Economics and Management Science, 4(1), 141-183.

Chart Of The Week: Shutdown Showdown

Goldman Sachs sent an email on Oct 2, 2023, discussing the potential government shutdown.  They stated: “Government shutdowns since 1980 have lasted, on median, 4 days, but a shutdown in 2023 may last 2-3 weeks. We expect annualized growth to decline by –0.2pp for each week that a shutdown lasts but believe those losses can be recovered in subsequent months, in part due to back-paying government salaries. Historical market impacts have been relatively muted: since 1980, the S&P 500 has delivered a median return of 0.75% during government shutdowns.”

Some food for thought on the impact on markets.

All the best,

Mike and Emily

“Time horizons are the bases of our decisions – and of our regrets.”

“We can improve our outcomes by understanding the effect of time and variance on our choices.”

“In investing, losing your capital means that you lost both your capital and all future returns that it could have generated…Any form of “game-over” nullifies future gains, bringing the average down.”

Luca Dellanna, Ergodicity (3rd Edition)

“The greatest successes are explained by the establishment of clever arrangements for the reduction of risks rather than by excessive risk taking.”

From Predators to Icons: Exposing the Myth of the Business Hero

Below are the returns for the indices we follow.  Overall, it was a good quarter.

Artificial Intelligence and Investing

There has been a lot of discussion on how AI is going to change many things going forward. One aspect that has been touted is how AI is going to improve investing. Can AI make better investment decisions? Dimensional Fund Advisors recently asked the question and used an existing AI Exchange Traded Fund for an analysis.

“Can AI be used to identify mispriced securities?”

Active investors have long attempted to get an informational edge on markets by using artificial intelligence (AI) processes to retrieve and process data. For example, tools that gauge sentiment from social media or scrape text from company financial reports predate ChatGPT by many years.

Material information gleaned from running AI processes is very likely a subset of the vast information set known by the market in aggregate and reflected in market prices. If new information is obtained, the process of acting on that information incorporates it into market prices.

Another reason to question AI’s role in helping with market timing is limitations with its predictions. AI’s forecasting ability fares well when assessing patterns that are relatively stable. The market is fantastically complex. So much so that no one knows exactly how much a particular piece of information impacts a price, because there are so many other simultaneous inputs. AI trying to predict market prices is like self-piloting cars trying to read stop signs with words, shapes, and colors that differ every day.

As an example, consider the AI-Powered Equity ETF (AIEQ), launched in 2017. It employs IBM Watson’s AI to analyze publicly available information to pick US stocks that will outperform the US market (Exhibit 1).

Exhibit 1: AI Powered Equity ETF vs. Russell 3000 Index and S&P Technology Select Sector Index

Cumulative returns, November 1, 2017–May 26, 2023

Source: FactSet. Sample period begins with the first full month of returns for AI Powered Equity ETF. Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. S&P data © 2023 S&P Down Jones Indices LLC, a division of S&P Global. All rights reserved.

While Watson can outwit an individual, its intelligence pales in comparison to the aggregate wisdom of the millions of individuals trading in stock markets each day. It is perhaps unsurprising then that the Watson-powered ETF has lagged the broad US market and, by a wide margin, the US technology sector since its inception.

Sure, AI can help the execution of trades. But the market is powerful and ensures a price is the most accurate current representation of the value of a stock or bond. There’s no reason to think that AI should fundamentally influence the way people think about stock prices anytime soon.”

Here is a different comparison I pulled off of Vanguard’s tool using Morningstar data.  I compare AIEQ to SPY (an Exchange Traded Fund tracking the S&P 500 Index) and 2 large cap funds we use, DFAC and DFLVX.  It seems that artificial intelligence struggles when it comes to long-term investing.

A key point in the piece above is whether AI would be better at predicting the future in a complex system.  The future contains unknown surprises.  The market prices in all known information according to the Efficient Markets Hypothesis (EMH). When new unknown information occurs, AI will be just as surprised as anyone else. The picture below that AIEQ shows on their website with all of their “signals” appears to be just noise.

Ergodicity

I read the book titled Ergodicity last quarter.  Ergodicity is the study of how payoffs scale over time and space. Below is a discussion the author, Luca Dellanna, had with Econ professor and podcaster Russ Roberts on Roberts’ podcast. The points made regarding variance and risk of ruin are highly relevant in our investment approach, as we manage risk as well as return.  Irreversible losses are important to avoid, and diversification is one way to minimize the risk of those losses.

“Russ Roberts: How can I reduce the variance? How can I reduce the risk of ruin? How can I push my own returns–not the market’s, but my own–closer to the average? And of course, I said that, as I was saying it, I’m thinking of index mutual funds. Index mutual funds are a way to avoid the kind of ruin that occurs if you pick a handful of stocks, even if you’re a genius, because you could be wiped out.

Luca Dellanna: Exactly. And, I make an example on a use case which I discussed a few times. Someone that works in tech in a startup tells me that they have a lot of stock options in their company, which are worth a lot because the company looks very good and maybe will become the next Google or something like that. And, they say that they know that they should diversify, but they tell me that for them it doesn’t make sense to diversify because any other investment will have a lower expected return. Which on one side is true.

But, the question is, what’s the distribution of the average expected return? Because, if you keep all your money in the stock options of your company–which by the way also provides for your salary–what happens is that you have a certain number of possibilities where you become a millionaire or maybe even a billionaire, and then you have a certain other number of possibilities where you lose almost everything.

Conversely, if you take half of your stock options and you invest them, and you find some way to diversify them with an index fund, you reduce your average expected returns, but the distribution of those returns is such that almost certainly you will end up a millionaire.

And, the question is, what do you really want? And, for most people the answer is, ‘Yeah, actually I want to make sure that I end up very comfortable with almost certainty.’ And, that’s another example why you do not want to look at the average, but you want to look at the distribution of outcomes.”

As Dellanna says in his book, “it is not the best ones who succeed. It is the best ones of those who survive…distinguish between calculated risks whose consequences you can recover from and recklessness whose consequences might permanently debilitate you…Similarly, in investing, losing your capital means that you lost both your capital and all future returns that it could have generated.”  “Any form of game-over nullifies future gains, bringing the average down.”

We rigorously try to avoid “game over” scenarios, while trying to follow the financial science on both risk as well as return.

Here are a few other good pieces that we saw this quarter.

Are Things Getting Worse?

Does Higher Inflation Hurt Stock Market Performance? (Video)

Valuing time over money is associated with greater happiness.

If you have any questions, please feel free to reach out.

Best,

Mike and Emily

“Active managers think the market is inefficient when they buy but efficient when they sell. How do they know they won’t go to their grave being the only one who knew the right price of Cisco?”
The late Dan Wheeler, Dimensional Fund Advisors

“An extreme return on a portfolio of many stocks is much less likely than an extreme return on an individual stock.”
Fischer Black and the Revolutionary Idea of Finance (Mehrling, Perry)

“I have come to understand that few things are harder to predict accurately than the timing and magnitude of financial crises, because the financial system is so genuinely complex and so many of the relationships within it are non-linear, even chaotic.”
Niall Ferguson

If you would have told me we would have had 3 bank failures in the first quarter and the US stock market performed as well as it did, I would have fallen over laughing.  However, here is how the market indices we follow did in the first quarter.  Not bad at all.

Normally, I draft most of the newsletter.  However, whenever I get a piece that I believe is very good and worth sharing, I share!  Below is a question and answer that Michael Perry of Dimensional Fund Advisors sent out.  I thought it was particularly interesting and enlightening, especially with everything going on in the financial markets and banking world in the first quarter.

Should I be worried by the recent banking turmoil’s impact on the stock market?

“March 2023 has been a significant month for banks in the US and globally. On March 10th, Silicon Valley Bank (SIVB) succumbed to a phenomenon called a “bank run” resulting in the largest failure of a US bank since the 2008 global financial crisis. Two days later, a second regional US bank, Signature Bank, was shut down. The developments don’t stop just in the US. Switzerland’s largest bank, UBS, agreed to buy its rival, Credit Suisse, in a rescue deal to help ease concerns in the global financial markets stemming from the turmoil facing some American banks.

All this to say: investors might be worried and eyeing their exposure to these regional and global banks. While it is natural to worry about the sensational news headlines being published these days, it is important to also step back and look at the bigger picture. Regardless of if a bank, or any other company for that matter, falters or not, your investment plan shouldn’t.

An easy but often underestimated tool to help avoid concerns about individual companies is to diversify globally and across sectors. Thanks to financial innovations in the form of mutual funds and ETFs, investors can now access thousands of securities diversified across countries and sectors at low costs. While not all risks can be diversified away, such as the risk of an economic recession, diversification is still a powerful tool to reduce the risk that any one company, industry, or country might face. For instance, as of February 28, SIVB was just one of more than 9,000 companies in the MSCI All Country World IMI Index (MSCI ACWI IMI) and represented a mere 0.03% of the index. As of the same date, regional banks in total represented only 1.15% of the index, with the largest at 0.10%. Incorporating diversification in your investment plan might help you avoid some of the pitfalls that concentrated portfolios face.

It is also important to remember that uncertainty is nothing new and that investing inherently comes with risks. When we consider what events have taken place in the last three years alone – a global pandemic, the Russian invasion of Ukraine, spiking inflation, and the fear of a recession – there’s been plenty of causes for concern regarding the state of the world and the markets. Despite these events, for the three-year period ending on February 28, 2023, the Russell 3000 Index (a broad market-cap weighted index of public US companies) returned 11.79% annualized, outperforming its average annualized return of 11.65% since inception in January 1979.

Having a sound financial plan can help investors weather through periods of uncertainty. Also important to the experience is having the discipline to stick with that plan through uncertain periods, rather than trying to predict or make sudden movements as a reaction to them. Investors that do are generally able to reap long-term benefits while also maintaining their peace of mind through the inevitable ups and downs that come with investing in the markets.”

Echoing Michael’s thoughts above, below are several charts showing the long term trend of the stock market.  As Dimensional has pointed out in the past, “markets around the world have often rewarded investors even when economic activity has slowed. This is an important lesson on the forward-looking nature of markets, highlighting how current market prices reflect market participants’ collective expectations for the future.”

Additional Thoughts

It is important to remember that there are many influences on market prices, including:

1. Supply and Demand
2. Economic Indicators
3. Government Policies
4. Political Instability
5. Natural Disasters
6. Consumer Behavior
7. Market Sentiment
8. Corporate Performance

The stock market is a complex system.  As Nassim Taleb has written, “the main idea behind complex systems is that the ensemble behaves in ways not predicted by its components.”  All of the above influences are dynamic and are constantly changing.  To believe that our individual information is better than the markets takes some hubris.  Robert Merton was recently interviewed on the Rational Reminder podcast, and he stated:

“I want to point out very clearly that the market has information, very important information that no one has. No sovereign wealth fund, no central bank. We all have pieces of it…The market encapsulates that aggregate information from all of us that none of us have. The first point to make is the market is a very important source of information. It has information that no one has, okay? Now, the question is, how good is that information? That has to be measured relative to the information you have…Whenever you’re assessing an investment decision, you have to always ask, if the market is disagreeing with me, or if the market doesn’t seem to be aligned with me, that could be that I know things the market doesn’t. It also could be, the market knows things that you don’t [my emphasis]…Market efficiency, and we’ve been testing that formally for more than a half century, by and large, it’s pretty darn hard to beat the market.”

As Friedrich Hayek wrote in 1945, “Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people in the same way as subjective values help the individual to coördinate the parts of his plan.”

Fischer Black’s biography by Perry Mehrling contributes to the thoughts above. Black became a big fan of the Capital Asset Pricing Model (CAPM), which is a model that describes the relationship between the expected return and the risk of investing in a security, including stocks.  Once he understood and believed in CAPM, Black “chose more carefully what specific risks to bear” both in life and in investing.  “Risk and time, he said, are the problems that define the modern field of finance…All this was about avoiding risks that do not pay…What about risks that do pay? After learning CAPM, Fischer switched from individual stock holding to mutual funds, and he never switched back.”  Why?  “[B]ecause the risk in the market portfolio comes with a commensurate expected payoff, whereas the risk in an individual stock may not.”  As stated above, “an extreme return on a portfolio of many stocks is much less likely than an extreme return on an individual stock…Modern finance tells us how to reduce risk by diversifying over time.”

Because the timing and magnitude of a financial crisis is so hard to predict, it is better to take a broadly diversified approach to investing based upon the risk that you can bear and consistent with a financial plan that is reasonably related to your goals.  Because time in the market, not timing the market, is important to achieving long-term goals, it is best to avoid the noise and stick to a long-term plan because as with all complex systems, the results of the interactions are not always predictable.

As Ken French has written, “there is a large academic literature on whether market returns are predictable. The general conclusion is that it is impossible to predict the market return with any confidence… “A Comprehensive Look at the Empirical Performance of Equity Premium Prediction,” by Amit Goyal and Ivo Welch (Review of Financial Studies, 2008), is a good summary of the evidence.”

Until next time,

Mike and Emily

“The median forecast of policy committee members calls for 3 quarter-point rate hikes in 2022, followed by 3 more in 2023. The bond market is pricing in a targeted federal-funds rate of 0.75%-1.00% by the end of next year, up from 0%-0.25% now.”
Barrons.com December 17, 2021
(The actual rate hikes in 2022 by the Federal Reserve amounted to 4.25% and they hiked 7 times).

“Your 2022 S&P 500 forecasts: Oppenheimer 5330, BMO 5300, DB 5250, GS 5100, JPM 5050, RBC 5050, Citi 4900, UBS 4850, Cantor 4800, Barclays 4800, Wells 4715, Bofa 4600, MS 4400.”
Jonathan Ferro, Bloomberg TV, January 3, 2022
(The actual close was 3839)

“For a number of years, professors at Duke University conducted a survey in which the chief financial officers of large corporations estimated the returns of the Standard & Poor’s index over the following year. The Duke scholars collected 11,600 such forecasts and examined their accuracy. The conclusion was straightforward: financial officers of large corporations had no clue about the short-term future of the stock market.”
Daniel Kahneman, World Renowned Psychologist and Nobel Prize Winner in Economics

It was a tough year for both stocks and bonds, as indicated by the indices we track below.

The Failure of Forecasts and Predictions

As you can see by the predictions in December 2021 of both the Federal Reserve and the big investment houses such as Goldman Sachs, Morgan Stanley, JP Morgan and Citi, none of them were even close in predicting where both interest rates and the S&P 500 would be at the end of 2022.  Given that it is the Federal Reserve’s job to manage and change the Federal Funds rate, the fact that they were so wrong on where the Federal Funds rate would be at the end of 2022 is somewhat scary.

J. Scott Armstrong wrote a paper titled The Seer-Sucker Theory: The Value of Experts in Forecasting. “One would expect experts to have reliable information for predicting change and to be able to utilize information effectively.  However, expertise beyond a minimal level is of little value in forecasting change.”  As economist John Kenneth Galbraith stated years ago, “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”

Why are forecasts and predictions so hard?  Because no one can predict the future. There is a tremendous amount of uncertainty in the world. Daniel Kahneman has stated, “Inadequate appreciation of the uncertainty of the environment inevitably leads economic agents to take risks they should avoid…An unbiased appreciation of uncertainty is a cornerstone of rationality – but it is not what people and organizations want.”  As Benoit Mandelbrot stated, “there is something in the human condition that abhors uncertainty, unevenness, unpredictability.  People like an average to hold onto, a target to aim at – even if it is a moving target.”  Nassim Taleb adds, “in fact, we saw that the world is too random and unpredictable to base a policy on visibility of the future.”

Further, humans are in general overconfident.  As Kahneman has found, “we are often confident even when we are wrong…Many people are overconfident, prone to place too much faith in their intuitions. They apparently find cognitive effort at least mildly unpleasant and avoid it as much as possible.  It suggests that when people believe a conclusion is true, they are also very likely to believe arguments that appear to support it, even when these arguments are unsound.”

If Forecasting is Virtually Impossible, How Should We Invest?

Fortunately, there is a better way to invest for the long-term instead of listening to the likes of Jim Cramer or some market pundit.  Below are a few pieces of advice from Dimensional Fund Advisors on how to think about investing for the long-term, focusing on the value premium and investing in a rising rate environment.

Value Bounces Back

After more than a decade of underperforming growth stocks, value stocks bounced back over the past couple of years. While “Value’s Rebound Rewarded Investors Who Stayed in Their Seats,” the rally led some to question how much longer its run can last.

“Just like data shows that bull markets often last longer than bear markets, and have higher peaks, value runs are much longer and reach higher peaks than the downturns,” Wes Crill said. “But it is important for investors to balance their enthusiasm for higher expected returns with their tolerance for underperformance.”

Value investing is based on the premise that paying less for a set of future cash flows is associated with a higher expected return. That’s one of the most fundamental tenets of investing. Combined with lengthy historical data on the value premium, our research shows that value investing continues to be a reliable way for investors to increase expected returns.

When It’s Value vs. Growth, History Is on Value’s Side

There is pervasive historical evidence of value stocks outperforming growth stocks. Data covering nearly a century in the US, and nearly five decades of market data outside the US, support the notion that value stocks—those with lower relative prices—have higher expected returns.

Recently, growth stocks have enjoyed a run of outperformance vs. their value counterparts. But while disappointing periods emerge from time to time, the principle that lower relative prices lead to higher expected returns remains the same. On average, value stocks have outperformed growth stocks by 4.1% annually in the US since 1927, as Exhibit 1 shows.

EXHIBIT 1

Value Add

Yearly observations of premiums: value minus growth in US markets, 1927–2021

Past performance is no guarantee of future results. Investing risks include loss of principal and fluctuating value. There is no guarantee an investment strategy will be successful. The Fama/French Indices represent academic concepts that may be used in portfolio construction and are not available for direct investment or for use as a benchmark.  Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment.

Some historical context is helpful in providing perspective for growth stocks’ recent outperformance. As Exhibit 1 demonstrates, realized premiums are highly volatile. While periods of underperformance are disappointing, they are also within the range of possible outcomes.

We believe investors are best served by making decisions based on sound economic principles supported by a preponderance of evidence. Value investing is based on the premise that paying less for a set of future cash flows is associated with a higher expected return. That’s one of the most fundamental tenets of investing. Combined with the long series of empirical data on the value premium, our research shows that value investing continues to be a reliable way for investors to increase expected returns going forward.

How Stocks Respond to Hikes in Fed Funds Rate

Some investors may worry that rising interest rates will decrease equity valuations and therefore lead to relatively poor equity market performance. However, history offers good news: Equity returns in the US have been positive on average following hikes in the fed funds rate.1

We study the relation between US equity returns, measured by the Fama/French Total US Market Research Index, and changes in the federal funds target rate from 1983 to 2021. Over this period of 468 months, rates increased in 70 months and decreased in 67 months. Exhibit 1 presents the average monthly returns of US equities in months when there is an increase, decrease, or no change in the target rate. On average, US equity market returns are reliably positive in months with increases in target rates.2 Moreover, the average stock market return in those months is similar to the average return in months with decreases or no changes in target rates.

EXHIBIT 1

Reliably Rewarding

US equity market returns and fed funds target rate change, January 1983–December 2021

Past performance is not a guarantee of future results.

What about the months after rate hikes? This question may be of particular interest when the Fed is expected to increase the federal funds target rate multiple times. Exhibit 2 presents annualized US equity market returns over the one-, three-, and five-year periods following one or two consecutive monthly increases in the fed funds target rate, as well as following months with no increase. In reassuring news for investors concerned with the current environment of increasing rates, the US equity market has delivered strong longer-term performance on average regardless of activity at the Fed.

EXHIBIT 2

Keep On Keeping On

US equity market returns following consecutive fed funds rate hikes, January 1983–December 2021

Past performance is not a guarantee of future results.

The Fed’s signals and actions will continue to be closely watched by the market. As the Fed often signals its agenda in advance, we believe market participants are already incorporating this information into market prices. While it’s natural to wonder what the Fed’s actions mean for equity performance, our research indicates that US equity markets offer positive returns on average following rate hikes. Thus, reducing equity allocations in anticipation of, or in reaction to, fed funds rate increases is unlikely to lead to better investment outcomes. Instead, investors who maintain a broadly diversified portfolio and use information in market prices to systematically focus on higher expected returns may be better positioned for long-term investment success.

The Importance of Diversification and Focusing on Factors and Dimensions of Return

Hendrik Bessembinder published a paper in 2017 discussing whether stocks outperform treasury bills and diversification.  In his paper, he found:

“Four out of every seven common stocks that have appeared in the CRSP database since 1926 have lifetime buy-and-hold returns less than one-month Treasuries. When stated in terms of lifetime dollar wealth creation, the best-performing four percent of listed companies explain the net gain for the entire U.S. stock market since 1926, as other stocks collectively matched Treasury bills.”

The key is that broad diversification is necessary to have that four percent in your portfolio, as it is virtually impossible to pick those stocks consistently in advance, and those stocks change over time.

In addition to broad diversification, we put a bit more into the following asset classes because they have had consistent return premiums over the long-term.

If you have any questions, feel free to reach out.

Best,

Mike and Emily

“Historically what’s happened is, when there’s a spike [in inflation], the spike persists for a long time. Inflation tends to be highly persistent once you get it.”
Eugene Fama
Nobel Prize Economics, 2013
Distinguished Professor of Finance
University of Chicago

“There is no way of slowing down inflation that will not involve a transitory increase in unemployment, and a transitory reduction in the rate of growth of output. But these costs will be far less than the costs that will be incurred by permitting the disease of inflation to rage unchecked.”
Milton Friedman
Nobel Prize Economics, 1976
Former Professor of Economic Theory
University of Chicago

“Part of the problem is the Fed has gotten involved in a multitude of ways in the financial market. There’s only so much central banks can do. And when they claim they can do more than that, they tend to get into areas where they should not be.”
Raghuram Rajan
Former Governor of Reserve Bank of India
Distinguished Professor of Finance
University of Chicago

Market Review

Below are some of the indices we track. It has been a really tough environment since January 1.

There has been nowhere to hide, although short-term high-quality bonds, as evidenced by the last 2 rows of the returns above, have tempered the larger downturns of the stock market.  What is going on?

Inflation

In this newsletter, we are going to focus on inflation and its impact on the markets.  As Professor Nicholas Li states, “inflation refers to a general increase in prices and the resulting decline in the purchasing power of money.”  When the prices of goods and services increase over time, consumers can buy fewer of them with every dollar they have saved.  Therefore, keeping pace with inflation is an important goal for investors.  When the rate of increase is larger and faster, the resulting decline in purchasing power is more painful.  Below is a graphic explaining how money today buys less tomorrow.

In US dollars. Source for 1916 and 1966: Historical Statistics of the United States, Colonial Times to 1970/US Department of Commerce.  Source for 2017: US Department of Labor, Bureau of Labor Statistics, Economic Statistics, Consumer Price Index—US City Average Price Data.

We have become somewhat spoiled over the past 20 years, as inflation has remained subdued prior to late 2021.  However, concerns have been building for a while.  In my newsletters sent on June 12, 2020, and July 12, 2021, I expressed concern about the rapid rise in the money supply in the United States, as evidenced by what is known as M2.  I tried to explain what economist Milton Friedman stated years ago:

“Economist Milton Friedman was quoted as saying “inflation is taxation without legislation.” Thinking of inflation as a tax is useful because the reality is that inflation erodes your purchasing power. Said differently, $1 was able to buy more things in 1947 than it can buy today. Figure 2 shows how the purchasing power of $1 in 1947—the longest history available at the BLS website—has declined through time. Today, that same dollar buys about 8 cents’ worth of goods.”

Friedman stated that inflation “is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”  Or as Professor Aswath Damodaran of NYU states in his May 24,2021 blog post, “too much money chasing too few goods.” Professor John Cochrane wrote in May, “where did inflation come from, is question number one, and Charlie Plosser gave away the answer in his nice preface to this session: The government basically did a fiscal helicopter drop, five to six trillion dollars of money sent in a particularly powerful way. They sent people checks, half of it new reserves, half of it borrowed. It’s a fiscal helicopter drop.”  Hence, a “more rapid increase in the quantity of money than in output.”

Tyler Cowen, professor of economics at George Mason University, recently wrote:

“Consider the recent spurt of 8% to 9% inflation in the US. The simple fact is that M2 — one broad measure of the money supply — went up about 40% between February 2020 and February 2022. In the quantity theory approach, that would be reason to expect additional inflation, and of course that is exactly what happened.

The quantity theory has never held exactly, one reason being that the velocity (or rate of turnover) of money can vary as well. Early on in the pandemic, spending on many services was difficult or even dangerous, and so savings skyrocketed. Yet those days did not last, and when the new money supply increase was unleashed on the US economy, there were inflationary consequences.”

In addition to the monetary phenomenon, additional supply shocks have occurred due to both Covid in 2020 and the Russian invasion of Ukraine.  As Cochrane eloquently states, “while supply shocks can raise the price of one thing relative to others, they do not raise all prices and wages together.”

How does the Federal Reserve slow inflation?   According to Friedman by an increase in unemployment, and a reduction in the rate of growth of output.  One way the Federal Reserve does this is by raising the Federal Funds Rate, which is the target rate at which commercial banks borrow and lend their excess reserves to each other overnight.  That rate, which is considered the “risk free” rate, influences other short-term rates.

In the short term, a rapid rise in the risk-free rate, all else being equal, will cause asset prices to adjust downward because stocks are essentially valued by discounting their estimated future cash flows by an interest rate. The rate includes both the “risk free rate” that the Federal reserve is raising as well as a risk component, which can be described as the “equity risk premium,” which is also rising.

According to Damodaran in his September 26, 2022, blogpost:

“There are two things that stand out about equity markets in 2022. The first is the surge in the equity risk premium from 4.24% on January 1, 2022, to 6.05%, on September 23, 2022, an increase on par with what we have seen during market crises (2001, 2008 and 2020) in the past. The second is that as equity risk premiums have jumped, the treasury bond rate has more than doubled, from 1.51% on January 1, 2022, to 3.69% on September 23, 2022. In contrast to the afore-mentioned crises, where the treasury bond rate dropped, offsetting some of the impact of the rise in equity risk premiums, this inflation-induced market reaction has caused the expected return on stocks to rise from 5.75% on January 1, 2022, to 9.75%, on September 23, 2022; that increase of 4% dwarfs the increases in expected returns that we witnessed in the last quarter of 2008 or the first quarter of 2020.”

The good news is that expected returns going forward are greater than they were in January.  Professor Fama advises not to get out of the market now, because “if you bounce in and out of the market in response to variation in volatility, you are likely to be in when expected returns are low and out when expected returns are high.”  Since expected returns are higher now, an investor would want to stay in the market to try and capture those expected returns. It does not mean that we will not experience volatility.  As uncertainty lingers, so will volatility. Predicting volatility is virtually impossible.  Fama states “bouncing in and out only makes sense if you can forecast increases and decreases in volatility before they occur, so you can miss the price declines associated with the onset of high volatility and profit from the increases associated with the onset of low profitability. I doubt that anyone is that good at predicting changes in volatility.”

Unless one can predict the future increases and decreases in volatility and price, the better approach is to have an asset allocation that one can stick with during good times and bad.  As our friends at Dimensional have written, “inflation is an important consideration for many long-term investors. By combining the right mix of growth and risk management assets, investors may be able to blunt the effects of inflation and grow their wealth over time. Remember, however, that inflation is only one consideration among many that investors must contend with when building a portfolio for the future. The right mix of assets for any investor will depend upon that investor’s unique goals and needs.”

David Berns, author of Modern Asset Allocation for Wealth Management and co-founder of Simplify, takes a consistent approach to Dimensional and Fama above by stating that “a slightly lower utility portfolio adhered to is better than a portfolio with higher utility that is not adhered to, if your goals can handle such accommodation.”  His thoughts are consistent with Fama advising not to get out of the market, as timing is virtually impossible to be right on getting back in the market again, especially on a consistent and persistent basis.  It is most likely better to be invested in a more conservative portfolio (which is less volatile) that you can stick with versus an aggressive one (which is highly volatile) that you cannot.

Our friends at Avantis Investors have written recently:

“What stands out is that the below-average returns we’ve seen historically during times of recession have been driven by significantly negative returns during the first half of the recession. In the second half of recessions, returns have been strongly positive and far above the average monthly return. Good times have historically continued during the first and second halves of expansions…

It would be great if we could get out of the market at the start of a recession before stocks typically experience a downturn and then get back in as prices go back up. The issue is that we can’t say with certainty when economic peaks and troughs will start and end until after the fact — and trying to time these events can have detrimental effects on investors if they get it wrong.

Considering where we are today, we’ve already seen U.S. stocks decline significantly. We can’t know for sure, but it may be that we are currently experiencing the disappointing returns often seen during the first half of recessions. The market seems to have already priced in a lot of bad news and the potential for turmoil. The risk of fleeing the market today is that investors may leave when the bad news is priced in and miss out on the historically positive returns typically seen in the second half of recessions.”

We hope the above helps understand a bit more about what is going on. There are many different factors impacting the markets. Inflation is one factor.

The Real Thing

Annual inflation-adjusted returns of S&P 500 Index vs. inflation, 1992–2021

Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Copyright 2022 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.

History shows that stocks tend to outpace inflation over the long term—a valuable reminder for investors concerned that today’s rising prices will make it harder to reach their financial goals.  And one last chart on market rebounds.

Please don’t hesitate to reach out with any questions.

Until next time,

Emily and Mike

*Market declines or downturns are defined as periods in which the cumulative return from a peak is -10%, -20%, or -30% or lower. Returns are calculated for the 1-, 3-, and 5-year look-ahead periods beginning the day after the respective downturn thresholds of -10%, -20%, or -30% are exceeded. The bar chart shows the average returns for the 1-, 3-, and 5-year periods following the 10%, 20%, and 30% thresholds. For the 10% threshold, there are 29 observations for 1-year look-ahead, 28 observations for 3-year look-ahead, and 27 observations for 5-year look-ahead. For the 20% threshold, there are 15 observations for 1-year look-ahead, 14 observations for 3-year look-ahead, and 13 observations for 5-year look-ahead. For the 30% threshold, there are 7 observations for 1-year look-ahead, 6 observations for 3-year look-ahead, and 6 observations for 5-year look-ahead. Peak is a new all-time high prior to a downturn. Data provided by Fama/French and available at mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Fama/French Total US Market Research Index: 1926–present: Fama/French Total US Market Research Factor and One-Month US Treasury Bills. Source: Ken French website.

The efficient markets hypothesis is “a very simple statement: prices reflect all available information…It’s a model, so it’s not completely true. No models are completely true…I don’t know any investors who shouldn’t act as if markets are efficient.”
Eugene Fama, Nobel Prize Economics 2013, Robert R. McCormick Distinguished Service Professor of Finance – University of Chicago

The effects of noise on the world, and on our views of the world, are profound.  Noise in the sense of a large number of small events is often a causal factor much more powerful than a small number of large events can be.  Noise makes trading in financial markets possible, and thus allows us to observe prices for financial assets.  Noise causes markets to be somewhat inefficient, but often prevents us from taking advantage of inefficiencies.  Noise in the form of uncertainty about future tastes and technology by sector causes business cycles, and makes them highly resistant to improvement through government intervention.  Noise in the form of expectations that need not follow rational rules causes inflation to be what it is, at least in the absence of a gold standard or fixed exchange rates.  Noise in the form of uncertainty about what relative prices would be with other exchange rates makes us think incorrectly that changes in exchange rates or inflation rates cause changes in trade or investment flows or economic activity.  Most generally, noise makes it very difficult to test either practical or academic theories about the way that financial or economic markets work.  We are forced to act largely in the dark.
Fischer Black, Mathematician and Originator of Black Scholes Option Pricing Model 

I think being educated about both the empirical evidence and theoretical rationales for anything, they can help sustain patience in bad times. And I suggest some practical tips, such as viewing your portfolio broadly and rarely.
Antti Ilmanen, Principal at AQR and PhD from University of Chicago

“The most important, and rarest, trait of all: The ability to live through volatility without changing your investment process.  This is almost impossible for most people to do; when the chips are down they have a terrible time not selling their stocks at a loss. They have a really hard time getting themselves to average down or to put any money into stocks at all when the market is going down. People don’t like short-term pain even if it results in better long term results. Very few investors can handle the volatility required for high returns.”
Mark Sellers, Hedge Fund Manager
Author of Article “So You Want to Be the Next Warren Buffett?”

Below are returns from indices we track. It has been a rough 6 months.  In fact, it has been the steepest first-half decline for the S&P 500 since 1970.

Market Summary

Stocks fell for another straight quarter, with the MSCI All Country World IMI Index dropping nearly 16% and major indices entering bear market territory in June. Inflation fears dominated headlines even as it seemed investors eased back their expectations for inflation with the 1-year breakeven rate ending the quarter at 4.3%, after peaking at over 6% in late March. US stocks were particularly hard hit, with international markets, especially emerging markets, faring a bit better. Aside from China, which was up 3.3% for the quarter, all developed and emerging markets posted negative returns. Value exposure cushioned the blow with the MSCI All Country World IMI Value Index outperforming the growth index by over 8%.

Although the drop in the markets has been significant, it is actually not uncommon.  Since 1987, there have been 9 years where there have been intra-year declines greater than 20% for the S&P 500, as shown in the figure below.

Thoughts on Volatile Times

As the late Fischer Black says above, there is a lot of noise in markets (and in the world in general).  Below is a graph showing the daily movements of the S&P 500 since January 1, 2000.  This is evidence of a lot of noise.  It is very hard to determine a discernible pattern in the graph below.  This is why I have a hard time telling you where the market is going in the short term.

However, when we look at the return of the S&P 500 Index from January 1, 2000 – June 30, 2022, here is what the graph looks like.

The S&P 500 has returned 6.3% annualized from January 1, 2020, through June 30, 2022.  In other words, $1,000,000 has turned into approximately $3,950,000 in that Index.  We are playing a long-term game.  As Antti Ilmanen recommends above, to have a better investment experience, one should view their “portfolio broadly and rarely.”  Why is that?  Terry Odean and Brad Baerber found in their paper Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment “that men trade 45% more than women, and such trading reduces men’s returns by 2.65 percentage points a year as opposed to 1.72 percentage points for women.” Trading less and looking less is better for long-term returns.

In addition, Odean and Baerber found in  The Behavior of Individual Investors “that individual investors (1) underperform standard benchmarks (e.g., a low cost index fund), (2) sell winning investments while holding losing investments (the “disposition effect”), (3) are heavily influenced by limited attention and past return performance in their purchase decisions, (4) engage in naïve reinforcement learning by repeating past behaviors that coincided with pleasure while avoiding past behaviors that generated pain, and (5) tend to hold undiversified stock portfolios.” Advisors can help investors stick to the long-term during times of market volatility and stress.  And as both Gene Fama says above and as his colleague Ken French also says, “almost all of us should act as if prices are right” and that markets are efficient.

Marlena Lee at Dimensional has provided some guidance recently on how to think about investing.  Below are her thoughts.

Three Crucial Lessons for Weathering the Stock Market’s Storm

By Marlena Lee, PhD Global Head of Investment Solutions

Investors can always expect uncertainty. While volatile periods like the one we’re experiencing now can be intense, investors who learn to embrace uncertainty may often triumph in the long run. Reacting to down markets is a good way to derail progress made toward reaching your financial goals.

Here are three lessons to keep in mind during periods of volatility that can help you stick to your well-built plan. And if you don’t have a plan, there’s a suggestion for that too.

1. A recession is not a reason to sell

Are we headed into a recession? A century of economic cycles teaches us we may well be in one before economists make that call.

But one of the best predictors of the economy is the stock market itself. Markets tend to fall in advance of recessions and start climbing earlier than the economy does. As the chart below shows, returns have often been positive while in a recession.

All the dots in the upper left quadrant in the chart below are years where the US economy contracted but US stocks still outperformed less-risky Treasury bills. It’s a great illustration of the forward-looking nature of markets. If you’re worried, other investors are too, and that uncertainty is reflected in stock prices.

Whether accompanied by recessions or not, market downturns can be unsettling. But over the past century, US stocks have averaged positive returns over one-year, three-year, and five-year periods following a steep decline.

A year after the S&P 500 crossed into bear market territory (a 20% fall from the market’s previous peak), it rebounded by about 20% on average. And after five years, the S&P 500 averaged returns over 70%.1

2. Time the market at your peril

When stocks have declined, it might be tempting to sell to stem further losses. You might think, “I’ll sit out until things get a bit better.” But by the time markets are less volatile, you’ll have often missed part of the recovery. Yes, it stings to watch your portfolio shrink, but imagine how you’ll feel when it’s stuck while the market rebounds.

Big return days are hard to predict, and you really don’t want to miss them. If you invested $1,000 in the S&P 500 continuously from the beginning of 1990 through the end of 2020, you would have $20,451. If you missed the single best day, you’d only have $18,329—and only $12,917 if you missed the best five days.2

History shows the stock market tends to rebound quickly. The same can’t be said for individual stocks or even entire sectors. (How many railroad stocks do you own?) So, while investing means taking on some risk for expected reward, investors should mitigate risks where they can. Diversification is a top risk mitigation tool, along with investing in fixed income and having a financial plan.

3. It may be a good time to reassess your portfolio and your plan

We saw many fads crop up through the pandemic, from baking to puppy adoption. Did you experiment with one of the pandemic investment fads—FAANGs or meme stocks or dogecoin? If so, it may be time to put those fads in the rearview.

Do you know the names of all the stocks you own? Then you probably own too few. How much of your portfolio sits outside the US? Because about half the global market is comprised of foreign stocks. If you only invest in the S&P 500, you’re missing half of the investment opportunity set. A market-cap-weighted global portfolio is a better starting point than chasing segments of the market that have outperformed in the past few years.

And if you want to outperform the market, allow decades of academic research to light the way. Portfolios focused on small caps, value stocks, and more profitable companies have had higher returns over the long run. The portfolio I use is invested across more than 10,000 global equities in over 40 countries.

Beyond a well-designed portfolio, one of the best ways to deal with volatile markets and disappointing returns is to have planned for them. A financial advisor can help you develop a plan that bakes in the chances you’ll experience some market lows. And they can help you find the confidence to weather the current storm and get to the other side.

A sound approach to investing—through a plan, a well-designed portfolio, and an advisor—is the ultimate self-care during these rough markets. Your future self will thank you.

This piece first appeared in MarketWatch with the title “Follow these 3 crucial lessons for weathering the stock market’s storm.”

David Booth, Founder of Dimensional, constantly preaches that it is important to have a plan.  “Different people are comfortable with different levels of risk. This is one of the reasons I encourage everyone to talk to a financial advisor before investing. Investing is inherently complex. Dealing with that complexity is the job of a professional advisor. They figure out a long-term strategy that considers both your goals and your risk tolerance. If you’re comfortable, it’s easier to stay the course through both good and bad times.”  This is consistent with Mark Sellers’ quote above that “the ability to live through volatility without changing your investment thought process” is the rarest trait of all of great investors. Hopefully, during these volatile times, we can stay true to your plan to increase the odds of your long-term investing success.

Until next time,

Mike and Emily

“A big challenge for an advisor is to help clients understand that this was a normal outcome and that, ‘No, we don’t need to adjust our portfolio because this quarter it went down. This was in the range of perfectly reasonable outcomes.’”
Kenneth French
Professor of Finance, Dartmouth

“I define risk as uncertainty about lifetime consumption broadly defined. People invest because they want to use their wealth in the future. Some might plan to spend all the money on themselves for things like food, shelter, travel, recreation, and medical care. Others may plan to spend some of their wealth on political contributions, charitable donations, or gifts and bequests to their children. My definition of lifetime consumption includes all these and any other anticipated uses of wealth. Investors like a high expected return because it increases the expected wealth that will be available to spend or give away. And everything else the same, risk averse investors prefer less uncertainty about their future wealth.”
Kenneth French
Professor of Finance, Dartmouth

“Staying rich requires an entirely different approach from getting rich.  It might be said that one gets rich by working hard and taking big risks, and that one stays rich by limiting risk and not spending too much.”
Aswath Damodaran and Peter Bernstein

Below are the returns of some of the key indices we follow.  As you can see, it was a tough quarter, as the Russian invasion of Ukraine and inflation both caused some angst in the marketplace.

We expect markets to be volatile in the intermediate term, as the Russian invasion of Ukraine has raised the level of uncertainty.  The invasion, combined with rapid inflation, has left investors a bit unsettled.

We have received questions on how to deal with both the uncertainty and how to invest in this market climate.  Dimensional has put out a couple of pieces that we think are helpful, and I am incorporating them into the Newsletter below.  In addition, Nobel Laureate Gene Fama was interviewed by the New York Times after the Russia – Ukraine war broke out. The interview was published March 9, 2022.

Jeff Sommer asked Fama “What message, if any, have the markets been imparting since the start of the coronavirus pandemic, or, now, during the war in Ukraine, when stocks rise and fall with no discernible regard for human life?”

The markets aren’t telling us much, he said. Some people interpret efficient markets as the source of “the wisdom of crowds”. This is the idea that, together, through the mediation of markets, crowds of people come up with answers about important questions that are much smarter than the conclusion of any one individual. But there’s no great wisdom evident now.

The markets are struggling to come up with prices for stocks, bonds, commodities, all kinds of things, Fama said. They aren’t necessarily conveying any deeper meaning.

“Basically, we’re in a period where we have had an injection of uncertainty into the world, so speculative prices are going to go up and down in response,” he added. “People are continuously trying to evaluate information. But it’s impossible for them, given the amount of uncertainty that’s out there, to come up with good answers.”

“But that doesn’t mean the market is inefficient,” he added. “Markets can be rational without politics being rational or people always being rational. The problem with pricing is a question of how much is knowable right now. How’s this Russia thing going to work out? Who knows?”

He then further stated that “there is always risk in the stock market, always. It never goes away. People have to remember that”. And, he said, it’s impossible to know which way the market is heading. “My whole life’s work says you can’t answer that question.”

Do Downturns Lead to Down Years?

Dimensional Fund Advisors – Apr 12, 2022

Stock market slides over a few days or months may lead investors to anticipate a down year. But a broad US market index had positive returns in 17 of the past 20 calendar years, despite some notable dips in many of those years. Even in 2020, when there were sharp market declines associated with the coronavirus pandemic, US stocks ended the year with gains of 21%.

Volatility is a normal part of investing. Tumbles may be scary, but they shouldn’t be surprising. A long-term focus can help investors keep perspective.

How to View Risk

Ken French, Gene Fama’s prolific co-author on many academic papers, wrote an essay recently on 5 Things I Know About Investing. The link is here. https://www.dimensional.com/us-en/insights/five-things-i-know-about-investing

The first of his 5 Things had to do with how to view risk. I thought it was worth repeating below.

1. Risk is uncertainty about lifetime consumption.

“Most investors are risk averse. Given the expected return, they prefer lower risk, and given the level of risk, they prefer higher expected return. Most investors understand that the expected return on an investment is essentially the best guess of what the return will be. There is a lot more confusion about risk. When I ask students, investors, and friends what risk means I get conflicting answers. Some say it is the potential for loss. Others suggest it’s the volatility of the return. And others say it’s beta, from the CAPM. Good portfolio design requires a clear understanding of risk.

I define risk as uncertainty about lifetime consumption broadly defined. People invest because they want to use their wealth in the future. Some might plan to spend all the money on themselves for things like food, shelter, travel, recreation, and medical care. Others may plan to spend some of their wealth on political contributions, charitable donations, or gifts and bequests to their children. My definition of lifetime consumption includes all these and any other anticipated uses of wealth. Investors like a high expected return because it increases the expected wealth that will be available to spend or give away. And everything else the same, risk averse investors prefer less uncertainty about their future wealth.

If people don’t like uncertainty about future wealth, shouldn’t we measure each investment’s risk by its potential for losses or the volatility of its returns? No. Those definitions miss important interactions within an investor’s portfolio and, even more important, between the portfolio return and the investor’s other sources or uses of future wealth.

My goal is a portfolio I can justify to myself today, based on the information available now. Because unexpected returns will dominate the outcome, I won’t judge my choice on what the portfolio delivers tomorrow.

Think about homeowner’s insurance. If we consider only the policy, this investment is as bad as a lottery ticket. First, there’s lots of uncertainty about the outcome. Typically, the policyholder pays the premium and gets nothing back, but there is always the chance of a big payoff. Second, if the insurance company rationally expects to make money on the contract, a rational policyholder’s expected return must be negative. Why would a risk averse homeowner choose a volatile investment with a negative expected return? Because insurance reduces the uncertainty of his or her lifetime consumption. The probability that a disaster will destroy any specific policyholder’s house is tiny, but if it does, the loss to that homeowner can be catastrophic. Most homeowners are happy to pay the annual insurance premium to eliminate this potential hit to wealth and lifetime consumption.

In that same spirit, it is particularly risky to invest most of your savings in your employer’s stock. As the former employees of Enron might warn us, this can be a remarkably unfortunate way to put all your eggs in one basket. Enron was an energy and trading company based in Houston, Texas. After roughly a decade of phenomenal success, Enron filed for bankruptcy in 2001. Many employees had most if not all their 401(k) in Enron stock and lost their job and retirement savings at the same time. A better understanding of risk might have led them to a retirement portfolio that reduced their uncertainty about lifetime consumption.

Liability driven investing is another way to manage the uncertainty about lifetime consumption. My friend Jeff Coyle is a financial advisor in Southern California who has spoken to most of the classes I have taught over the last 25 years. He describes a client who hired a shipyard in Italy to build a large yacht. The amount and timing of the payments were known, but the obligations were in euros. Jeff took this liability off the table by buying government bonds that delivered the euros needed when each payment was due. Those of us with more mundane obligations can use the same approach. If you are stretching to buy your first home, for example, you might move the savings you will need at closing into a safe money market account today.

The general takeaway here is to think about risk holistically. How will a potential investment vary with your existing portfolio and with your other sources and uses of wealth? More succinctly, how will it affect the uncertainty about your lifetime consumption?”

We know these are uncertain times. When there is uncertainty, there is often more volatility in the market. As Eduardo Repetto, Chief Investment Officer of Avantis Investors and former co-CEO of Dimensional Advisors, has written with his colleague at the time Jacobo Rodriquez:

“Volatility and cross-sectional dispersion bring uncertainty, which in turn brings anxiety. The best way to mitigate that uncertainty is to be broadly diversified within and across asset classes at all times, so that investors need not worry about whether they own the stocks that earn the returns of those asset classes or whether they are fully invested in the markets when they turn.”

By the way, here is a good piece on uncertainty by Allison Schrager, a PhD in economics from Columbia University and former Dimensional employee. It is very good, and distinguishes between risk, which can be managed, and uncertainty, which is all the things you cannot anticipate or measure. Managing Uncertainty – by Allison Schrager – Known Unknowns (substack.com)

Until next time,

Mike and Emily

The one thing you have to avoid is the risk of ruin.
Naval Ravikant

T-bills are a good inflation hedge, producing three- to five-year (simple and robust) correlations with inflation close to 0.5 because short-term interest rates directly reflect expected inflation. However, a good inflation hedge does not necessarily mean an overall high nominal or real return.
Andrew Ang, Asset Management: A Systematic Approach to Factor Investing

Inflation destroys savings and people’s ability to make long-term plans and turns the entire economy into an attempt to spend money as fast as possible before it loses its value.
Socialism Sucks: Two Economists Drink Their Way Through the Unfree World (Lawson, Robert)

Market Summary

Below are some of the indices we track.  I don’t think many would have predicted the returns, especially in the US, with where things were in January of 2021.

As one can see, the U.S. markets performed much better than international and emerging markets.  However, since it is not possible to consistently market time, we believe it is still important to maintain a long-term diversified portfolio, including international and emerging markets stocks.  As people forget, the S&P 500 was negative for an entire decade (2000-2009), and it was emerging markets and small value (Russell 2000 Index below) stocks that carried portfolios then.  If you invested $1 in the S&P 500 on January 1, 2000, you would have had 90.9 cents on 12/31/2009.

Inflation

Inflation is on everyone’s mind lately, as cost increases as measured by both the consumer price index and producer price index have soared to levels not seen since the early 1980’s.  Inflation, if not brought under control, is worrisome as it can erode the value of people’s savings very quickly.  We do believe a well diversified portfolio can protect investors against the ravages of inflation.  Gerard O’Reilly, co-CEO of Dimensional Fund Advisors stated: “The collective best guess of investors as aggregated by market prices is hard to beat as a guide to what the future may hold.  Investors may therefore be best off tuning out the pundits and figuring out how to either outpace or hedge against the inflation that’s already anticipated in market prices.”  It is hard to argue with that.

​Financial advice is a long game. At its core, it’s about ensuring clients have enough money to fund their needs, wants and dreams through the end of their lives.  That involves not only focusing on returns, but also risk. Inflation is one aspect of that.

Weston Wellington, who has been involved with Dimensional for years, wrote a piece on inflation a few months back that we would like to share with you.  We feel it does a great job of addressing the concerns around inflation and what an investor should do about it.

PERSPECTIVES
July 29. 2021

‘Everything Screams Inflation.’ How to Interpret the Headlines.

By Weston Wellington Vice President Dimensional Fund Advisors

KEY TAKEAWAYS

• After last year’s economic shocks, we shouldn’t be surprised to see prices rebounding.
• But the potential for inflation is one among many factors investors take into account when agreeing on a price at which to trade.
• A look at headlines from the past 50 years shows the difficulty of timing markets around inflation expectations. Investors may be better served sticking to a long-term plan.

How quickly things change.

Two years ago, the New York Times reported, “Federal Reserve officials are increasingly worried that inflation is too low and could leave the central bank with less room to maneuver in an economic downturn.”1 More recently, a Wall Street Journal article presented a sharply different view, with a headline that likely touched a raw nerve among investors: “Everything Screams Inflation.” The author, a veteran financial columnist, observed, “We could be at a generational turning point for finance. Politics, economics, international relations, demography and labor are all shifting to supporting inflation.”2

Is inflation headed higher? In the short term, it has already moved that way. With many firms now reporting strong demand for goods and services following the swift collapse in business activity last year, prices are rising—sometimes substantially. Is this a negative? It depends on where one sits in the economic food chain. Airlines are once again enjoying fully booked flights, and many restaurants are struggling to hire cooks and waiters. We should not be surprised that airfares and steak dinners cost more than they did a year ago. Or that stock prices for JetBlue Airways and The Cheesecake Factory surged over 150% from their lows in the spring of 2020.3

Do such price increases signal a coming wave of broad and persistent inflation or just a temporary snapback following the unusually sharp economic downturn in 2020? We simply don’t know. But future inflation is just one of many factors that investors take into account. The market’s job is to take positive information, such as exciting new products, substantial sales gains, and dividend increases, and balance it against negative information, like falling profits, wars, and natural disasters, to arrive at a price every day that both buyers and sellers deem fair. 

The future is always uncertain. But willingness to bear uncertainty is the key reason investors have the opportunity for profit.

Let us assume for the moment that rising inflation persists into the future. Some investors might want to hedge against higher inflation, while others might see it as a market-timing signal and make changes to their investment portfolios. But for the market timers to do so successfully, they would need a trading rule that directs exactly when and how to revise the portfolio—“I’ll know it when I see it” is not a strategy. A trading rule based on inflation estimates, however, is just a market-timing strategy dressed in different clothes. A successful effort requires two correct predictions: when to revise the portfolio and when to change it back.

It’s not enough to be negative on the outlook for stocks or bonds in the face of disconcerting information regarding inflation (or anything else). Current prices already reflect such concerns. To justify switching a portfolio, one needs to be even more negative than the average investor. And then outsmart the crowd once again when the time appears right to switch back. Rinse and repeat.

The evidence of success in pursuing such timing strategies—by individuals and professionals alike—is conspicuous by its absence.

To illustrate the problem, imagine it’s New Year’s Day 1979. The broad US stock market4 produced a positive return in 1978 but failed to keep pace with inflation for the second year in a row. Your crystal ball informs you that the next two years will see back-to-back double-digit inflation for the first time since World War I.

What would you do? You have painful memories of 1974, when the inflation-adjusted total return for US stocks was –35.05%, among the five worst returns in data going back to 1926.

We suspect many investors would sell stocks in anticipation of significantly lower security prices over the subsequent two years. The result? Most likely a failure to capture above-average returns from both the equity and size dimensions, as shown in Exhibit 1.

EXHIBIT 1

Looking Up

Cumulative return, January 1979–December 1980

Past performance is no guarantee of future results. Indices are not available for direct investment.

Some of the recent concern regarding inflation appears linked to substantial increases in government spending and the US debt load. Determining the appropriate level of each is a contentious public policy issue, and we don’t wish to minimize its importance. But the news items in Exhibit 2 suggest these concerns are not new, and the expected consequences of these issues are likely already reflected in current prices.

The future is always uncertain. But as economist Frank Knight observed 100 years ago, willingness to bear uncertainty is the key reason investors have the opportunity for profit. Investors will always have something to worry about, and the possibility of unwelcome or unexpected events should be addressed by the portfolio’s initial design rather than by a hasty response to stressful headlines in the future. As recent research from Dimensional highlights, simply staying invested can help investors outpace inflation over the long term.

EXHIBIT 2

Fears Through the Years

We do not know where asset prices will go in the short term.  We would not be surprised if volatility in the market picks up over the next 6 months if inflation persists and the Federal Reserve sticks to its plan of raising interest rates and quantitative tightening.  However, we believe a well-diversified portfolio designed for your financial plan and risk tolerance is the best long-term solution to a good investment experience.

Until next time,

Mike and Emily

FOOTNOTES

1. ¹Jeanna Smialek, “Fed Officials Sound Alarm Over Stubbornly Weak Inflation,” New York Times, May 17, 2019.
2. ²James Mackintosh, “Everything Screams Inflation,” Wall Street Journal, May 5, 2021.
3. ³Sourced using Bloomberg security returns. Low for Cheesecake Factory was April 2, 2020, and low for JetBlue was March 23, 2020.
4. ⁴As measured by the CRSP 1-10 index.
5. ⁵S&P data ©  S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.
6. ⁶Frank H. Knight, Risk, Uncertainty and Profit (Boston and New York: Houghton Mifflin Co., 1921).
7. ⁷Headlines are sourced from various publicly available news outlets and are provided for context, not to explain the market’s behavior. This material is in relation to the US market and contains analysis specific to the US.
8. ¹Jeanna Smialek, “Fed Officials Sound Alarm Over Stubbornly Weak Inflation,” New York Times, May 17, 2019.
9. ²James Mackintosh, “Everything Screams Inflation,” Wall Street Journal, May 5, 2021.
10. ³Sourced using Bloomberg security returns. Low for Cheesecake Factory was April 2, 2020, and low for JetBlue was March 23, 2020.
11. ⁴As measured by the CRSP 1-10 index.
12. ⁵S&P data ©  S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.
13. ⁶Frank H. Knight, Risk, Uncertainty and Profit (Boston and New York: Houghton Mifflin Co., 1921).
14. ⁷Headlines are sourced from various publicly available news outlets and are provided for context, not to explain the market’s behavior. This material is in relation to the US market and contains analysis specific to the US.

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