Better alternative to crazy predications

While watching TV over the weekend I came across yet another infomercial that is predicting the end of the financial world in 2016. It’s been predicted each year for the last five years or more, so I guess if they keep it going they will eventually be right some day?!

This particular infomercial asked viewers to go to crashingbanks.com and watch a video. The video is your typical doomsdayer, sprinkling in half truths and fabrications with faulty comparisons. Of course if you do a little research you can find that the creator is also the author of a handful of “end of the world” books over the last 13 years. The S&P 500 is up some 200%+ since his first book was published in 2003 (entitled “Financial Reckoning Day”) so his timing might be a bit off. Maybe he’ll elaborate on the exact date of implosion going forward. (sarcasm)

But with the ever increasing amounts of noise like this out there. How can investors keep the blinders on? Is there a rational and unbiased way to face these fears? We know that bear markets in stocks do happen from time to time. They have in the past and they will continue in the future. So how do investors way through the nonsense predictions like these?

recessions

JP Morgan Asset Management came out with another great “Guide to the Markets” slide show. This one slide above captures every bear market on record since 1926. There have been 10 bear markets in the S&P 500 stock market average since 1926 (bear market is defined by 20% or greater decline from the prior market high).

They break the causes of these bears markets down into four components (Recession, Commodity spike, Aggressive Fed, Extreme valuations). These happen to be the main reasons that people will use to predict an upcoming bear market.

valuations

Extreme valuations are always a cause for concern, as you can buy even a good company, but at a bad valuation it can still turn into a bad investment. Valuations is one aspect I’ve been hearing about with recent bear market predictions. First note that of the last 10 bear markets, 5 came during extreme valuations (so 50%, or a coin flip). The markets crashed in 2000 and 1987 off of extreme valuations, but also crashed in 2008 off of fairly valued levels.

Personally I don’t feel that historical valuations are that helpful to begin with. As they don’t take into account inflation and interest rates and how can you compare margins and business models of this digital age to the industrial age. Things are changing so rapidly, how can we honestly make an apples to apples comparison of valuations over 20 years, nevermind 100 years.

However there are many smart people who truly believe in historical valuations (those infinitely smarter than myself) so I will differ to their expertise. However as the above slide shows,  valuations on a variety of different metrics are still at or near their 25 year average. And when you couple in low inflation expectations and interest rates, I don’t see the current environment as being overall bubbly at all.

expansions.png

The other aspect is the length or duration of the expansion. I do believe in this as a gauge but it is hardly an exact science. As you can see the current expansion is the 4rth longest since 1900 and almost double the length of the average. This really means nothing though as who is to say the advance can’t go on to match the longest on record.

The other aspect for bear markets is an aggressive Fed. I believe this may have been part of the reason 2016 got off to a such a bad start. The Fed projections of 4 rate hikes this year was ridiculous. Cooler heads prevailed and we will continue to get a very gradual pace of increases. But even this indication was relevant to only 4 out of the 10 bear markets, for a 40% hit rate.

Another aspect is spiking commodities prices, which was seen in 4 out of 10 bear markets as well (40%). It’s ironic how the theory changes. In 2000 and 2007, 2011 it was the oil spikes that was hurting the markets. Now oil prices are at multi decade lows and that is supposedly what is causing the markets decline as well.

Lastly the aspect with the highest hit rate was an economic recession, for obvious reasons. The hit rate was 80%, 8 out of 10. Now keep in mind that not every recession produced a bear market, but 80% of bear markets were caused by a recession. The outliers being the 1987 and 1962 bear markets which occurred without a recession.

So even though we have a reasonably reliable indicator  to a bear market (recession), it’s not perfect either. We can’t say for sure that the next bear market will come during the next recession, because it might not. And we can’t say for sure that the next recession will cause the next major bear market, because it might not.

What we can say is that history suggests the highest odds of the next bear market will occur during the next recession. I know, it’s very simplistic in nature, but it’s always good to take a step back and look at the big picture.

So what can investors do? They can either find a competent advisor that understands these dynamics and can make subtle tactical changes when financial risks elevate. It’s not an exact science and it’s not an exact timing strategy, but staying on top of the main data points such as yield curve, financial stress levels, employment, PMI’s, corporate profits and retail sales, can really help you avoid the noise. The data is objective and unbiased, we humans aren’t.

Another strategy is to simply diversify your assets among a variety of different asset classes in line with your own time horizon and risk tolerance. Of course a competent advisor will be able to do this for you as well.

2016-04-19_1430.png

This chart says it all. During the worst climate for equity returns, a well diversified investor would have been able to weather the storm with the rest of these asset classes while the S&P 500 would go back to total return outperformance from 2009 to present. Diversification isn’t easy, as it pretty much guarantees you will be holding one or more underperformers at a time.

The bottom line is that there is a much better way for investors to navigate through the difficulties of investing, then by listening to the crashing banks of the world. The media has made investing sound much crazier than it really is. One can be as aggressive or conservative as desired. There is an abundance of options that don’t require 24/7 monitoring of investment news.

Sources:

JPM Asset Management

Ritholz Wealth Management

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