Investment Commentary – January 13th, 2016
Market Indices as of Market Close January 13th, 2016
Dow 16,151 (-7.31% YTD)
S&P 1,890 (-7.52% YTD)
NASDAQ 4,526 (-9.61% YTD)
Global Dow 2,151 (2,145 52 week low /2,644 high)
10-year Treasury 2.09 (1.64 52 week low /2.50high)
Gold 1,086 ($1,045 52 week low /high $1,306)
Oil $30.80 ($32.10 52 week low /high $65.50)
Thought of the week
It has been the worst start to the year for equity markets since 2008. Risk-off sentiment swept the U.S. market despite positive signs for the economy including a solid employment print, a growing services economy, and more evidence that the Fed will remain dovish through the early stages of the rate hiking cycle. A confluence of global factors triggered the market drop of 5% in the first week of 2016, including a sell-off in Chinese equities, new lows for oil prices, and lowered estimates for global growth in 2016. Investors wonder if the early stumble in the market this year foreshadows a difficult year for markets. The chart of the week shows that January returns do not always predict full year returns, and 60% of the time that January returns are negative, the full-year return is positive. Although blockbuster equity
returns associated with earlier stages of the business cycle are likely behind us, consumer strength should continue to fuel growth in the U.S. throughout the year, possibly pushing equities higher and putting the initial market hiccup behind us.
U.S. Stocks: A Bad Time for Market Timing
The impulse to sell during market pullbacks has often resulted in lower long-term returns.
Volatility is up markedly, and forecasters already are reining in their projections for the market’s performance in 2016. It may be tempting for investors to panic, bail out, go into U.S. Treasury bonds or cash, and be done with equities altogether. So it couldn’t be more fitting to see that January 7 marked the thirty-fifth anniversary of newsletter pundit Joseph Granville’s epically doomed “sell everything” call on equities. As a recent Bloomberg article noted, the famous Granville newsletter was at the height of popularity at the start of 1981, with thousands of subscribers, when it flipped decidedly negative on the prospects for U.S. equities. Adherents of this market-timing call missed out on one of the greatest episodes of wealth creation in history, an almost 1,500% rise in the S&P 500 over the next 20 years.
In the history of market prognostication, failure like the episode described above is more the rule than the exception. One has to look no further than the 2015 estimates by top bank economists for oil prices and the year-end level of the S&P 500. A Reuter’s survey of 33 economists and analysts at the end of 2014 forecast North Sea Brent crude would rise to $74 a barrel in 2015, after ending 2014 at around $60. (Spoiler alert: Oil did not go up in 2015.) Meanwhile, a survey of top strategists by Barron’s, in early 2015, expected the S&P 500 to return 10%. Yet, the S&P 500 was essentially flat over this period. The tendency for experts’ calls to miss by a mile isn’t anecdotal. It’s almost an inevitable outcome when trying to forecast macroeconomic and market data subject to untold and unknown variables.
These experts are the best in the business. They have years of experience in the field. They have top-tier educational credentials. They have access to the vast analytical and research capabilities of major financial firms. They get paid very well for their efforts. Yet their records are abysmal. So why do financial advisors and nonprofessional investors think they can do better with market timing?
I can think of three reasons:
Overconfidence—many studies have shown that people overestimate their ability to forecast future events. When study participants are asked to specify a 90% confidence interval around estimates of specific quantities, they nearly always set that range too narrow. Hit rates are often as low as 50%,1 implying that people often think their knowledge is meaningfully more accurate than it actually is. This overconfidence can lead to irrational selling when we read a negative article on the prospects for the stock market or when we “get a bad feeling” in volatile markets.
Loss aversion—Prospect theory, which describes how people make choices between different options or prospects based on probable outcomes, has given rise to many experiments to estimate loss aversion. From these, it’s often summarized that people experience—that is, they feel—losses with around two times greater severity than they experience when they earn gains. There are a number of real-life constraints and psychological biases that contribute to this tendency. So it’s natural (though not necessarily rational) that we pull the trigger on sell orders a little quicker in volatile times.
Recency bias—another well-documented phenomenon is that we tend to extrapolate what has happened in the recent past when forming beliefs about what will happen in the future. For example, investors may assume that the U.S. dollar will continue to appreciate versus other currencies this year simply because it has been going up recently. In reality, the spot price of the dollar today is almost certainly the best estimation of the future value of the dollar because it already includes estimates about the future. But professional economists and the layman are often guilty of this bias. So when markets go down, people often assume further declines are in store.
THIS DAY IN FINANCIAL HISTORY
January 13th, 2000: Scoffing at Alan Greenspans cautious speech one day earlier, the Dow Jones Industrial Average closes at a new record high of 11,722.98, and the NASDAQ closes at a near-record of 4064.27. People are starting to look ahead to the second half of the year, says Ned Riley, chief investment strategist at State Street Global Advisors in Boston. Look again: By year-end, the Dow has sagged to 10,786.85 and the NASDAQ has been crushed down to 2470.52.
The views presented are not intended to be relied on as a forecast, research or investment advice and are the opinions of the sources cited and are subject to change based on subsequent developments. They are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.