Waiting Until the Sky is Clear

Earlier this year, we wrote about how markets are always lined with red flags giving investors cause for concern. So far, 2022 has been a dismal year for investors as both stocks and bonds have been pummeled thanks to:

• Inflation
• Russia / Ukraine
• Slowing GDP
• Rising mortgage rates
• Supply chain issues
• Rising energy prices
• Oh yeah…..and a whole bunch more

Clients that have cash on the sidelines have been asking one simple question:

“Is now a good time to invest or should we wait???”

As advisors we can choose 2 routes; one is to go with our gut instinct and two is to look at the data and determine what the best action going forward would be.

Concern: I want to wait until things look better in the economy before investing.

Fact #1 – By the time things look clear, markets have already recovered

July 2022 was the 8th best month for the S&P 500 index going back to 1985.

Outside of March 2009, which was the bottom of the Great Financial Crisis, every preceding month in our sample period produced strong negative returns just before the best months since 1985. Investors who avoid investing cash based on past market price movements are forgetting one important principle: The stock market is forward looking!

Concern: The markets recent sell-off is a sign of things to come and we are heading for a recession.

Fact #2 – Past market returns do not predict future market returns

Looking at figure 1 we can clearly see why the SEC is so adamant about advisors and investment professionals stating, “Past performance is not indicative of future results.” If recent returns predicted future returns, we would clearly see a linear pattern on the chart above. The randomness in returns is a clear signal that markets are doing their job by efficiently incorporating current information into prices so that no “free lunch” exists throughout time.

What about the bond market you ask?

Let’s overlap those two charts to see if any pattern exists from one quarter to the next:

Again, we see randomness amongst the returns from one period to the next even within the bond markets.

Time “in” the market > timing the market

Concern: Economic data is pointing to a recession so markets will struggle the rest of the year.

Fact #3 – The stock market DOES NOT equal the current economy

This is China’s Gross Domestic Product growth since 1980:

China’s stock market since 1992:

We can clearly see that despite more than 30 years of rapid economic GDP growth, the price index for the Chinese stock market is below where it started in 1992. From December 2010 to December 2020, the nominal GDP of Asia (excluding Japan) grew almost 4.5 times faster than global nominal GDP – but Asian equities (excluding Japan) underperformed Global equities by 25% over that period.²

“I know Scott, China has multiple geopolitical issues that have hampered it’s stock market over the years…..what about the US and other developed markets??”

Great question! Plenty of academic research illustrates that economic growth and stock markets are uncorrelated over time. In 1998, Jeremy Siegel noted that between 1970-1997 the correlation of stock markets and GDP growth was -0.32 for 17 different developed markets and -0.03 for 18 emerging markets.³ Later on, Elroy Dimson and colleagues recorded the correlation between real equity returns and GDP growth as -0.27 from 1900-2000 and -0.03 from 1951-2000 across 16 different countries.⁴

GDP growth is a net positive for society; however, it does not always translate into positive returns for the providers of capital.

Conclusion

Is now a good time to invest cash into the markets?

• Fact #1 – By the time things look clear, the markets have already recovered
• Fact #2 – Past market returns do not predict future market returns
• Fact #3 – The stock market does not equal the current economy

All crystal balls are cloudy when it comes to future market behavior. Every investor would love to have a clear reliable crystal ball and the ability to time markets. All the gain without the pain is what any rational person would seek. Unfortunately, the facts tell us that pursuing such an endeavor will likely produce sub-optimal results.

Investors should manage their risk by:

• Developing a target allocation that plans for future drawdowns
• Understand their targeted return and risk tolerance
• Not letting short-term distractions interrupt long-term success

Remember, not all cash must go into the stock market and even within the stock market, we can diversify where we invest. Including alternative asset classes that move independently of equity and bond markets can provide the needed confidence investors need to remain invested in markets throughout time. The role of a good financial advisor is not to maximize returns but to manage risk, expectations and provide clarity.

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¹Data from 7/1/1926 – 4/30/2022. The market is represented by the CRSP U.S. Total Market Index. Source: Avantis Investors. Past performance is no guarantee of future results.

²The Man Group, “Never mind the economics! There’s more to markets than GDP” – Steven Desmyter, Andrew Swan and Ed Cole

³Siegel, Jeremy J., 1998. Stocks for the Longs Run, Second Edition. McGraw-Hill

⁴Dimson, Elroy, Marsh, Paul, Staunton, Mike, 2002. Triumph of the Optimists: 101 Years of Global Investment Returns. Princeton University Press, Princeton.