Common Sense and Disciplined Investment Strategies

 

The stock market rang out the year in celebratory style, cheered on by a “Phase 1” mini trade deal between the United States and China. This is in sharp contrast to last year when the stock market tumbled 15% from November to Christmas Eve. The climb in the first part of January was later negated with the fears of the Coronavirus spreading.

2019 was the best year in the stock market since 2013. The S&P/TSX index rose 22.9%, including dividends. The S&P 500 climbed by 31.5% in US dollars, including dividends, but only 25.1% in Canadian dollars as the Canadian dollar rose 4.3% over the year (the Canadian dollar ended the year as the best performing major currency against the US dollar). Other major market indices, rose as well. Expressed in Canadian dollars, the Dow Jones Industrial Average rose 16.6% before dividends, the MSCI World Index, which covers 23 countries in the developed world, gained almost 21.9%, and the MSCI Index of emerging markets gained 12.9%.

Your calendar year returns are largely in line with these numbers, with a very modest capital gains tax distribution —the capital gain tax distribution was less than 3% in the funds. So big gains, little tax, more money retained in your pocket. A good year!

Was any of this expected at the beginning of the year? Every December, we hold our annual forecast meetings with institutional investors. As we do every year, we ask them to predict how the market will do over the coming twelve months. In December 2018, none of the approximately 40 people polled in Montreal and Toronto thought the market would rise more than 10%, and a few thought the market would be down. On balance, they expected a hum drum year at best.

As we enter 2020, people are becoming increasingly optimistic that the global economy will snap out of its trade-induced slowdown and that sluggish earnings growth will improve. Analysts are seeing more room for stocks to run this year, but at a slower pace than in 2019. These estimates range from a year-end target for the S&P500 of 3,300, a 2% gain, to 3,500, a gain of 8.2%. The average target of 3,330 represents a gain of about 4% from the year end, according to a survey of Wall Street strategists taken by CNBC.

History shows that these market professionals are no more accurate than their Canadian counterparts. Their median forecast for each of the last 20 years was that stocks would rise every year; the market actually fell in six of those years. Not only did the consensus incorrectly forecast the magnitude of the change, they got the direction of the market wrong 30% of the time. These results are even more scandalous given that they did not predict a decline in any year.

The biggest surprise of 2019 was interest rates. In December of last year, the question was not whether interest rates would rise or fall in 2019, but rather how many rate hikes there would be. The result was of course that the US Federal Reserve cut interest rates three times during the year; the Bank of Canada held rates steady. So what is the value of forecasting?

While these results are not scientific, they clearly highlight that forecasting the future is inexorably inaccurate and is therefore a poor foundation upon which to build your financial future.

Many publications, financial or otherwise, have reported that everybody got 2019 wrong. Yet those very same publications report the forecast of those very same people for the coming year. If they were so wildly wrong last year, why would we care about their next forecast? But for some reason people keep asking for predictions of the coming year.   

That is the first question everyone asks as we enter a New Year, a new decade: What will the market do next year? The chart below shows the annual calendar returns of the US stock market, an admittedly arbitrary measurement period. Three things are readily apparent from this chart:

  1. There are many more up years than down years.
  2. The ups are larger on average than the downs, by quite a bit.
  3. There is no discernible pattern about when the up or down years occur.

 

At Kingwest, we do not make forecasts of the economy or of the market. Why? For information to be valuable, it must be both important and knowable. Knowing what will happen in the future is clearly important. But, the future is unpredictable; it is unknowable. It is not that these macro factors do not matter, but rather that they are just too hard to predict with any accuracy or consistency. Therefore, they are of little help in achieving investing success.

Our strategy is based on fundamental principles of finance and common sense supported by historical experience. If you know that you cannot make an accurate short term prediction, don’t make one. Similar to staying away from forecasts of the economy or the market, we have not adjusted the portfolio for the current Coronavirus events. It is unlikely we could outsmart the virus and stay ahead of the market when the depth of the virus’s spread and timing of its containment remain unpredictable. While the virus may impact a quarter or a few quarters of corporate results, there is no indication that it could impair the long run profitability of any company in our portfolios. Gambling on volatile quarters risks the fruits of a long term investment strategy.

Nevertheless, in order to craft a financial plan, we need to use forecasts of market returns because without any view on how much stocks, bonds, and other asset classes are able to return, it is impossible to know how much one needs to save and for how long. So what should you expect from the market?

The chart clearly shows that the market almost invariably goes up over groups of a few years. So the sensible thing is focus on the longer term where up is the name of the game. If you can do that, you will be very well rewarded. The market has delivered a compound annual return of about 10% over the past 70 years. So the best practice is to understand your investment horizon. Are you investing for a number of years? If so, focusing on the longer term returns rather than the annual returns will be the most beneficial.

When we speak of the longer term, the standard reply is: “I don’t have a long term”. The good news is that you do! We are all living longer. At age 65, there is a 90% chance that one of a married couple will live to be over 80, and a 50% chance that one will live over 90, according to SSA 2016 Life Tables. These are US statistics; Canadians have an even longer life expectancy. At Kingwest, we are very fortunate to have happy and healthy clients who have celebrated or are about to celebrate their 100th birthday this year!!

We know that looking long term can be uncomfortable. To say you will not try to anticipate the down swings in the market, which you know are inevitable — they happen 30% of the time — is tough and uncomfortable.

But it is important to keep top of mind that the market rises 70% of the time. If you are investing for years, stay with the market. While it may be unpredictable in any given year, it is very predictable over multiple years and those generate the attractive returns discussed above.

Three Things You Need to Know About Stock Market Corrections

Despite the fact that the market seems to vacillate 1% or so every day, there are three statistics about stock market corrections that you need to know that should calm your nerves.

  1. Corrections happen frequently.

Since 1950, there have been 35 separate occasions when the US market declined at least 10% from its recent high. Even though corrections are relatively frequent, they tend to catch investors off guard because unfortunately, when they will occur is highly unpredictable.

The stock market does not adhere to averages. We could go years without a correction — there wasn’t a single double-digit correction between 1990 and 1997 — or we could suffer two corrections in the same year, as occurred in 2018. Then look at what happened in 2019 — up more than 20% in Canada, 30% in the US. Occasional downdrafts in the stock market should surprise no one.

  1. Corrections do not last long.

Two-thirds of the corrections for the S&P 500 since World War II lasted four months or less. More serious but much less frequent bear markets (>20% decline) last 13 months, and recover relatively quickly. In the last forty years, only two corrections have lasted more than one year.

For example, the US stock market peaked in October 2007, declined modestly until May 2008, and then fell 41% over the next ten months. The market recovered dramatically thereafter, going up 3.6 times from the March 2009 low point until today.

To illustrate, if you had invested at the October 2007 peak and suffered the full brunt of the decline, you would still have more than doubled your money as of today — an annual return of about 9% including dividends from the 2007 peak. Still a very good return!

Of the 35 corrections since 1950, each one was completely erased and put into the rearview mirror by a subsequent market rally. In most instances, it took just a few months to do so.

  1. Long-term investors bat 1,000.

Almost all businesses increase in value over time. This is why the stock market, even with these numerous hiccoughs, rises most of the time. The variable you need to focus on most is time, not volatility. If you give quality investments the time to blossom, you will outperform inflation and generate substantial returns over the long run.

There is a sound economic rationale for this. Companies average a return on their capital of about 12% per year. They pay out about 40% of those earnings as dividends and retain 60% in the company to be reinvested in productive assets earning about 12%. In actuality, they reinvest a little more because companies borrow another 30% of their capital at very low cost, on average. The result is their earnings improve by about 10% per year. More profits, more value. That very simplified model is why companies become more valuable over time, and the stock market tracks it, albeit over longer time frames.

Simply, you have nothing to fear from a stock market correction if you have a long term mindset.

If you can do that, you will be very well rewarded. The market has averaged a 10% return over the past 70 years.

The best practice is to understand your investment horizon. If you are investing for a number of years, focusing on longer term returns rather than annual returns will be the most beneficial.

We know that is an uncomfortable strategy, saying you will not fuss over swings in the market that you know are inevitable.

It is important to keep top of mind that the market rises 70% of the time and if you have a longer investment horizon, stay with the market. While it may be unpredictable in the short run, the market has returned on average 10% over the long term. A good return!

Basing your investments on sound principles that have stood the test of time is the most sensible policy and gives us the confidence to continue following it.

One more thing. This year starts a new decade, so we thought we would go back and look at what has happened in each decade over the last 90 years.

First, the bad news is that over a 10-year period from 1930-39, the market declined 1% per year — a loss of 10% over the decade. Not surprising, those were the depression years. The same decline happened again in 2000 to 2009 when the Great Recession hit.

The good news is that over the rest of the decades, the market rose quite a bit. On average, including the bum decade, you should expect 2.9 times as much money at the end of a decade as you had at the beginning. That is building wealth.

Be patient. Do not let short term market swings change your long term investment strategy. Common sense and a disciplined investment strategy will do better than the market return can produce.