Speaker 1: Stock and bond market returns surprised everyone in 2019. Despite what seemed like constant concerns about a coming recession, the MSCI All-Country World Index finished the year up 20.19%, and the Bloomberg Barclays Global Aggregate Bond Index hedged to Canadian dollars finished the year up 7.43%, 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 Swedrow, 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. Swedrow 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 forecasts was also studied a bit more formally in a 2018 paper titled, Do Financial Gurus Produce Reliable Forecasts, where the authors examined 6,627 forecasts made by 68 forecasters. They gave more weight in the analysis to longer term and more specific forecasts. They found that 48% of the forecasts 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, U.S. stock prices are high based on the Shiller CAPE. This might lead to a lower return expectation for U.S. 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 suggests 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 the stocks for most of the time period. From 1958 through 2015, stocks were generally expensive relative to the past, resulting in the strategy being underinvested 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 in making forecasts is the US yield curve, the chart of US treasury yields that plots the yield on the Y-axis and the maturities 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 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 a 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 acknowledge 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 analyzed 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 sacrifice 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, Aswath Damodaran 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. While 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 works 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 3.22%. 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%. An expected 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 Market's 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 any more 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 averaged 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 averaged 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 forecasts in this video, so I apologize if that's what you were looking for. The only forecasts worth paying attention to are those that have been proven as useful in the data, like the Shiller price earnings. And even then, forecasts 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 Investing videos to watch, you can tune in to weekly episodes of the Rational Reminder podcast, wherever you get your podcasts. ♪MUSIC♪