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Taking Flak

As advocates of passive investing, MASECO takes a lot of flak from an industry predicated on selling false promises to investors. Many times, our competition has claims of being able to time markets or have superior insight into selecting equity investments which will greatly outperform the market. While there is certainly no dearth of academic literature on the ability to time to equity markets (or lack there of), that doesn’t mean it isn’t worth trying. If it has potential to increase returns in a systematic, non emotional manner, it is worth finding out whether the tactic has merit.

With that being said, we have tested everything from economic indicators such as GDP growth and ISM PMI readings, to fundamental metrics such as P/E and dividend yield, and everything in between. None of the common metrics have proved to have any predictive power over about 52% (P/B being the best metric and also a building block of the Fama & French three-factor model), which is why we are such strong advocates of not trying to time the market and letting asset allocation dictate your risk level.

Recently the good folks at Vanguard wrote a paper talking about this same topic entitled Forecasting stock returns: What signals matter, and what do they say now? We highly encourage you to read the entire article, but it is quite lengthy so we have provided some bullet points for your review.

  • “We confirm that valuation metrics such as price/earnings ratios…have had an inverse or mean reverting relationship with stock market returns, although it has only been meaningful at long time horizons and, even then, P/E ratios have explained only about 40% of the time variation in net-of-inflation returns.”
  • “…stock returns are essentially unpredictable at short horizons. As evident in the R2s, the estimated historical correlations of most metrics with the one year ahead return were close to zero. The highest correlation…was 0.12.”
  • “…many commonly-cited signals have had very weak and erratic correlations with realized future returns even at long investment horizons. Poor predictors include…trailing dividend yields and economic growth, corporate profit margins, and past stock returns.”
  • “In fact, many popular signals had a lower correlation with future real return than rainfall – a metric few would link to Wall Street performance.”
  • “…higher government debt levels have been associated with higher future stock returns, at least in the United States since 1926.”
  • “…forecasting stock returns is a difficult endeavor and essentially impossible in the short term. Even over longer time horizons, many metrics and rough “rules of thumb” commonly assumed to have predictive ability, have had little or no power in explaining the long-run equity return…”
  • “…the future is difficult to predict…we encourage investors not to focus on…various forecasting models and instead turn their attention to the distribution of future outcomes.”
  • “Diversifying equities with an allocation to fixed income assets can be an attractive option for those investors interested in mitigating the “tails” in this wide distribution and thereby treating the future with the humility it deserves.”

We could not agree more with the findings of this article. The full article can be found here for your review.

Happy investing!

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