Stock Market Forecasts - YouTube

- Stock and bond market returns surprised everyone in 2019

despite what seemed like constant concerns

about a coming recession, the MSEI all country

world index finished the year up 20.19%

and the Bloomberg Barclays global aggregate bond

index hedged to Canadian dollars

finish the year up 7.4 3% both in Canadian dollar terms.

At the beginning of every year, including last year

and this year analysts make often gloomy forecasts

about short term expected returns and economic conditions.

There are two big problems with these forecasts.

They often make investors nervous and they're usually wrong.

I'm Ben Felix portfolio manager at PWL Capital.

In this episode of common sense investing.

I'm going to tell you what to expect

from the stock market in 2020.

There is no reliable approach

to predicting future stock market returns.

And the consistently poor accuracy

of stock market forecasts are enduring proof.

Every year, since 2010 Larry Swedroe

the chief research officer for the BAM Alliance

has compiled a list of sure thing predictions

made by the financial media and other investors.

He diligently tracks those predictions throughout the year

and reports on the results.

The predictions are things that most investors

will be familiar hearing.

Strengthening or weakening of currencies,

economic growth rates, market returns

and asset class returns to name a few.

Swedroe tallied up a total of 69 sure thing predictions

from 2010 through the end of 2018

only 32% of those predictions materialized as expected.

Of course, a sure thing should materialize 100% of the time,

not 32%.

The value of forecast was also studied

a bit more formerly in a 2018 paper

titled "Do Financial Gurus Produce Reliable Forecasts"

where the authors examined a 6,627 forecast

made by 68 forecasters.

They gave more weight in the analysis

to longer term and more specific forecasts.

They found that 48% of the forecast examined were correct

and 66% of the forecasters had accuracy scores

less than 50%.

Listening to humans making forecasts about the market

probably isn't useful

but there are some quantitative measures

that have historically been useful in forecasting

future returns and economic conditions.

These measures might even show up as evidence

to back up the usually incorrect market forecast

that people make.

The Shiller cyclically adjusted price earnings ratio

has been a particularly reliable indicator

where higher stock prices tend to be followed

by lower future stock returns.

As it stands right now US stock prices are high

based on the Shiller Cape.

This might lead to a lower return expectation for US stocks

but it's not information that can be used

to time Investment decisions.

A paper from AQR titled "Market Timing, Sin, A Little"

examined the Shiller Cape as a market timing tool.

They built a market timing strategy

that adjusted the weights in stocks based on valuations.

They tested the strategy on data from 1900 through 2015.

For the full sample the timing strategy

did add a bit of value to returns

but it underperformed from 1958 through 2015.

The paper suggest that this may be due to stocks

becoming more or less cheap for very long periods of time.

In other words, from 1900 through 1957

stocks were generally cheap relative to their past

resulting in the timing strategy being aggressively invested

in stocks for most of the time period.

From 1958 through 2015

stocks were generally expensive relative to the past

resulting in the strategy being under invested

for most of the time period.

The paper sums this up as follows.

Valuations can drift higher or lower

for years or decades making it difficult

to categorize the current market confidently

as cheap or expensive without hindsight calibration

and therefore difficult to profit from such categorizations.

The other thing to keep in mind

as a properly diversified investor

is that the us stock market is not the world.

Stocks in Canadian and international markets

are not currently as expensive as measured

by Shiller price earnings

and emerging market stocks are cheap by the same measure.

In either case it doesn't really matter

because we can't use the Shiller Cape to time the market.

But when you hear that the market is expensive

or overvalued an appropriate response might be which one.

The other measure that is often cited and making forecasts

is the US yield curve.

The chart of us treasury yields that plots

the yield on the y-axis and the maturity

is on the x-axis.

A normal yield curve is upward sloping

where longer maturity treasuries have higher yields

than shorter maturity treasuries.

An inverted yield curve when the shorter term treasuries

have higher yields than longer term treasuries

has been really good at predicting US recessions.

There have been nine a US yield curve inversions

including the one that occurred in late 2019

and seven US recessions since 1966.

An inverted yield curve has successfully forecasted

within six quarters, six of those recessions.

There was one false positive in 1966

when an inversion was not followed

by a recession within six quarters.

We are currently sitting within the six quarter window

that of recession has historically occurred

following an inversion, spooky stuff.

I'm not forecasting a recession, but even if I was

it wouldn't be a reason to change your investment strategy.

In a 2019 paper titled "Inverted Yield Curves

And Expected Stock Returns",

Eugene Fama and Ken French built a market timing model

that moves out of equities and into treasury bills

when the local yield curve is inverted.

They acknowledged that there is strong empirical evidence

suggesting that inverted yield curves

tend to forecast future recessions.

But they set out to answer how this relates

to stock returns.

They analyze three different portfolios

from the perspective of a US investor.

The US market the world ex US market and the world market.

The analysis was designed to test whether

or not an actively managed strategy

that shifts out of equities and into treasuries

based on yield curve inversions adds value

to portfolio returns.

Based on their analysis, Fama and French conclude

that the results should disappoint investors

hoping to use inverted yield curves

to improve their expected portfolio return.

We find no evidence that yield curve inversions

can help investors avoid poor stock returns.

They go on to explain their interpretation of this finding.

The simplest interpretation

of the negative active premiums we observe

is that yield curves do not forecast the equity premium.

This interpretation implies

that investors who try to increase their expected return

by shifting from stocks to bills after inversions

just sacrificed the reliably positive unconditional

expected equity premium.

In simple terms

while the yield curve may forecast economic activity

it does not forecast stock returns and trying

to time the market as usual results in a better chance

of losing out on good returns than missing bad ones.

All right, so the experts don't know what they're talking

about when they make specific market or economic forecasts

and the best quantitative forecasting tools that we have

for the stock market and the economy do not help

in making better investment decisions.

I need to qualify that statement a little bit.

The Shiller Cape may not be useful

for making portfolio timing decisions

but it has been a useful tool

for estimating future long-term stock returns.

In the 2019 version of an annually updated paper

on equity risk premiums asks what the motor

on demonstrated that the current implied equity risk premium

is the best predictor of the future equity risk premium.

It's still far from perfect

but it is the most reliable metric that we have

for forecasting future stock returns.

Well, this is not useful in making market timing decisions.

It is useful

in making long-term financial planning decisions.

After a year of great returns like 2019

it might make sense to reduce your expected returns

for financial planning purposes.

The way that the implied equity risk premium work

is by taking the earnings yield,

earnings divided by price, and then adding inflation

to estimate the nominal expected return.

For example, if the Shiller Cape

for US stocks is currently 31.31,

we take one divided by 31.31

to find the implied equity risk premium.

This gives us a result of a 3.2, 2%.

To estimate inflation we take the spread between

the Canadian nominal and real return long-term bond yields.

This difference in yield

is the market's current inflation expectation.

This figure is currently 1.37%.

We now have a nominal expected return for US stocks of 4.6%.

If you have been using historical market returns

as financial planning inputs

you might start to notice that what I'm saying is important.

The S&P 500 has returned over 11% per year

in Canadian dollar terms since 1926.

It should be obvious that there are dire implications

for basing a financial plan on an 11% return

when a more reasonable expectation might be 4.6%.

As low as that expected return for US stocks is

it's important to look around the rest

of your portfolio before getting discouraged.

Following the same methodology

Canadian stocks have an expected nominal return of 5.9%.

International developed stocks have

an expected nominal return of 6.4%.

And emerging markets are at 8.6%.

Unexpected return is not a short-term forecast.

It is the long-term return that you expect to earn

on an asset based on its riskiness.

Now, I know that some of you might be thinking

that it makes sense to move

out of the lower expected returning regions

and into the higher ones,

but the data are a little too messy

for that to work consistently.

In a 2012 paper by Cliff Asness titled

"An Old Friend The Stock Markets Shiller PE"

Asness confirmed that future returns fall consistently

as the Shiller price earnings

at the start of the period increases.

Higher Shiller price earnings,

lead to lower future returns on average.

The problem though is

that there is still a large distribution of future outcomes.

Higher prices shift the distribution as a whole

but they do not make future returns anymore certain.

Asness looked at the distribution of future returns

for the S&P 500 when the Shiller price earnings

was at various levels.

Remember it was 31.31 when this video was recorded.

When it was historically below 9.6

10 year real forward returns average 10.3% annualized

in US dollar terms.

For context, the average annual return for the S&P 500,

going back to 1926 has been 7.3% annualized

also in US dollar terms.

So when the Shiller price earnings has been low

market returns have been well above average.

The best 10-year real return while the Shiller PE

was below 9.6 was 17.5% annualized.

While the worst was 4.8%.

There was a difference of 12.7 percentage points

between the best and worst decade

when the Shiller PE was below 9.6.

At the other end of the spectrum

when the Shiller PE has been at historic highs above 25.1

the real returns in the following decade average 0.5%.

The best decade had a real return

of 6.3% annualized while the worst was negative 6.1%.

There was a difference of 12.4 percentage points

between the best and the worst decade

when the Shiller PE was above 25.1.

This should illustrate why making asset allocation

decisions based on the Shiller PE

would not be wise.

Shifting in and out of equity markets

based on the Shiller PE could easily lead

to a bad outcome.

Sticking to an asset allocation through time

allows you to maintain exposure

to the reliably positive equity risk premium.

I know I didn't give you any exciting forecast

in this video so I apologize

if that's what you were looking for.

The only forecast worth paying attention to

are those that have been proven as useful in the data

like the Shiller price earnings.

And even then forecast should only be used

to tweak your expectations for financial planning purposes

not to make short-term changes to your investment strategy.

Thanks for watching.

My name is Ben Felix of PWL capital

and this is common sense investing.

If you enjoyed this video,

please share it with someone who you think

could benefit from the information.

Don't forget if you've run out of common sense

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of the rational reminder podcast

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