At its heart, investment is a game of prediction: buying or selling securities based on a degree of confidence they will behave a certain way over a certain time frame. But what happens when those predictions turn out to be wrong? Volatility and doubt prevail, eating away at investor returns creating a self-reinforcing cycle of unpredictability.
“Bit by bit, we are coming out of the long., dark tunnel. We now have more ‘normalised’ macro-economic and investment markets, making the market a little bit more predictable.”
Robert Quinn
Despite all the talk of ‘New Normal’ and markets disconnected from fundamentals, the temptation to make future predictions based on historical analysis is too hard to resist, especially given the strong start to equity markets this year. But, if we are truly in a new world, can predictions based on ‘Old Normal’ principles really be relevant? What happens if predictability becomes unpredictable?
The January Barometer
By the end of January, markets were full of hope for a strong 2013. The S&P 500 jumped 135.98 points or 9.53% during the first month, resulting in a stream of citations of the “January Barometer” coined by Yale Hirsch in 1972, which hypothesises that stock market performance in January predicts its performance over the year. Research from Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, shows the index has moved in the same direction as January in 61 of the last 84 years.
That gives the January Barometer a predictive accuracy of about 73%. Interestingly, when January is positive, the predictive value is even stronger, rising to around 80% (since 1929 markets have risen 54 times in January, the year subsequently ended higher 43 times). At the time of writing, the Barometer was bearing fruit: on 31 July 2013, the S&P 500 index closed at 1685.73, up 259.54 or 18% for the year-to-date. S&P’s July global market performance data showed 63% of 46 global markets tracked by its Broad Market Index were in positive territory year-to-date.
New Normal?
But, as so many investment experts have stressed, we are in a ‘New Normal’ world where many assumptions of the past have been questioned to their core. Research from Lipper into equity mutual funds shows the January Barometer’s predictive accuracy more recently leaves much to be desired.
In 2009, 2010 and 2011, the direction of markets in January was opposite to the year-end. Most significantly, 2009 saw the worst January equity fund losses over the 50-year period covered by Lipper’s analysis, but the full year posted some of the strongest returns over the period. The same directional mismatch occurred in 2010. In 2011 however, a positive start to the year turned into losses by yearend. This was the only time in that 50-year history when the January Barometer failed for three consecutive years.
Mirko Cardinale, head of strategic asset allocation at Aviva Investors, says: “Historical analysis should be taken with a pinch of salt. In the short term its predictive reliability breaks down and it is more important to understand how markets react to news, and the momentum in the market.”
In April 2009, Pimco investment gurus Bill Gross, founder and co-chief investment officer (CIO), and Mohamed El-Erian, chief executive and co-CIO, coined the phrase ‘New Normal’ to explain the breakdown of the old growth pattern where economic growth and higher asset prices were almost invariably a natural evolution. The ‘Old Normal’ (otherwise commonly known as The Great Moderation), had been characterised by a period of reliable growth of around 6-7% nominal GDP, which meant companies could gear themselves to “take advantage of that predictability in order to produce returns and return on equity”.
The subsequent breakdown, caused by de-leveraging, de-globalisation and re-regulation, created an environment where, as El-Erian said in May 2013, “large companies, showing less exuberance and confidence than financial investors, have yet to expand aggressively”.
Expectation
Predictability and confidence are inextricably linked and are critical drivers of human behaviour. Being able to predict anything assumes relationships (or correlations) between two or more factors – in the Old Normal, if the economy grew, equity markets grew. However, predictions based on correlations between any indicator and markets could effectively be useless, because they fail to reflect the most important factor in determining market performance – expectation.
“It all depends on one magical factor,” says Jeff Molitor, CIO at Vanguard, “and that is what is already priced in.”
China posted annual growth of 7.5% in the second quarter, an impressive figure in itself, but disappointing when markets are expecting more (the International Monetary Fund forecast growth of 7.75% in early July). HSBC’s share price fell 0.6% the next trading day, but when the bank reported a 12% fall in revenues and cited slowing growth in China as a key factor, the stock fell 4.4% in one day.
“Price changes reflect the gap between expectations and what actually happens,” Molitor says. “One of the toughest challenges in investment management is knowing what value is already priced in.”
Volatility
If markets move based on whether expectations priced in to securities are realised, then it follows that volatility would remain low if the investment world was good at predicting future outcomes.
If volatility is high, or is itself volatile, the investment world is therefore going through a period of being bad at making predictions because they are pricing in expectation that is not being met. Volatility is, after all, a measure of uncertainty, which is defined, according to Dictionary.com, as unpredictability. So markets are less predictable during times of stress.
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