Effect and Cause

The MSCI World index lost 15.7% in the second quarter The ongoing conflict in Ukraine has continued to put pressure on global supply chains and commodity prices. US inflation increased to 8.6%, while the Federal Reserve rate increased from 0.5% to 1.75%. Consensus estimates are for a further 75bps increase at the end of July. There is also talk of a looming recession. So what do these indicators mean for the stock market? As investors, how should we respond to the economic data?

Should we time the market?

For many, the holy grail of investing is to find a reliable leading indicator for the stock market. Let’s say you had $ 10 000 to invest in 1970. Suppose you had a reliable indicator that could tell you in advance whether the stock market would earn a positive return or not in the following calendar year. Your strategy would simply be to hold either stocks or cash for that year depending on the indicator. If this was possible, then today (in 2022) your $ 10 000 would be worth nearly $ 7.3 million. If you’d simply held the stock index your $ 10 000 would be worth $ 800 000. That’s pretty good, but it’s only 1/9th of $ 7.3 million! You can see why the temptation to try and time the market, however futile that may be, is so powerful.

But suppose your indicator was not so accurate. What if it had you switching between stocks and cash a year late each time? Your $ 10 000 would be worth only $ 230 000. (The result would be very similar if you were a year early each time.) If you’re going to try to time the market, you need to be very accurate and herein lies the fatal flaw. An indicator that is a bit too early or a bit too late is worse than useless – it has negative value.

Economic data make poor market indicators

This is why economic data (GDP, unemployment, inflation, interest rates, etc.) are such poor stock market indicators. They’re always late. Yes, there is a causal relationship between the stock market and the economy, but the stock market reflects the expectations of investors looking at the future economic outlook rather than present conditions. The effect comes before the cause! The stock market is a leading indicator for the economy, instead of the other way around, even though the economy is the cause of the stock market’s returns.

A simple analogy is helpful: Roosters typically start to crow before the sun rises. Even though the rooster crows before the sunrise, it doesn’t cause the sun to rise. Instead the coming sunrise causes the rooster to crow. The effect comes before the cause. The rooster is a leading indicator for the sunrise, even though the sunrise is the cause.

Trying to time the stock market using economic indicators is like waiting for the sun to rise and then expecting the first rooster to crow. By the time the economic data comes, you’ve already missed the market move. The stock market is such a leading indicator that by the time expectations of future economic data have changed, you’ve already missed it.

What about other indicators?

So economic data are a no-go for market timing, but what about other indicators? Some clever analysts may run all kinds of back-tests to find indicators that would have been accurate (with hindsight), but the list of successful investors who have built their track records by consistently timing the market is a very short one. Back-tests and reality are worlds apart. The reality is that there simply isn’t a consistently accurate leading indicator that can tell you when the next stock market drop will happen. Despite this, not a year has passed since the last crisis that some prominent investor hasn’t predicted the next one. A broken clock tells the correct time twice a day, but that doesn’t make it useful.

There are however some useful indicators that can tell you whether long-term returns are likely to be high or low. But since even low long-term stock market returns are usually positive, it makes these indicators of little value for market timing. It doesn’t help being right about below average market returns for the next decade, but sitting in cash and earning an even lower return. Time is not your friend when you’re trying to time the stock market. If you’re a long-term investor the stock market is the place to be.

Time horizon vs. timing

The following table shows the history of returns for the global stock market since 1970. The first row of each block shows the annual return for that year. The second row shows the annualized return for the 7-year period ending in that year. While the 1-year returns are volatile and unpredictable, the long-term returns are more consistent. There hasn’t been a negative 7-year return* since the total return data for the MSCI World Index was tracked in 1970.

* Past performance is not an indication of future performance.

Invest in superior businesses through the cycle

So if these long-term indicators aren’t useful for market timing, or even for timing specific stock purchases, then what are they useful for? They can help us identify superior businesses that are priced for superior long-term returns. The strategy is to invest in these types of businesses over the long-term, through the unpredictable market cycle. This means we need to stomach the inevitable volatility along the way and not panic every time the market drops. Instead use these drops as an opportunity to add to your stock portfolio.

The list of successful investors who’ve built their track records this way is a much longer one. People like Warren Buffett spent little time trying to time the market or predict the economy, choosing instead to focus on business valuations, profitability and balance sheets. These are the same factors we focus on at Bellwood.

So what is the best approach to manage the market volatility? Don’t make investment decisions based on economic data. Follow a risk-based approach to asset allocation instead of trying to predict short-term returns and time the market. This means having enough cash and liquidity set aside to meet near-term and contingent liabilities and investing the rest in growth assets for the long-term, through the cycle.

Once you have this strategy in place, the most important thing is to maintain your discipline, especially when markets are falling. Emotional decisions are seldom good decisions. Don’t deviate from your financial plan. We won’t deviate from our investment process.