In this week's Accountable Update, we take a look back at 2016. First, I share an Issue Brief that addresses whether stocks hitting new highs give us any clues as to when to sell them. The answer may surprise you.
Then, we'll look back at a year that started off as the worst year ever for major US indices and finished with a huge rally. This in spite of Britain voting to leave Europe[1], much to the chagrin of geographers everywhere. Then, when you thought it couldn't get any crazier, the candidate with the most votes (according to everyone but the winner[2]) lost the US presidential election. There's a reason we prefer to look back instead of trying to predict what is going to happen, as you can't make this stuff up.
As always, if recent market events have you questioning how you are invested, get in touch for a free portfolio review.
[1] NY Times Op-Ed from Richard Cohen on June 27,2016, "Britain to Leave Europe for a Lie".
[2] Donald Trump Tweet on November 28, 2016
New Market Highs and Positive Expected Returns
There has been much discussion in the news recently about new nominal highs in stock indices like the Dow Jones Industrial Average and the S&P 500.
When markets hit new highs, is that an indication that it’s time for investors to cash out? History tells us that a market index being at an all-time high generally does not provide actionable information for investors. For evidence, we can look at the S&P 500 Index for the better part of the last century. Exhibit 1 shows that from 1926 through the end of 2016, the proportion of annual returns that have been positive after a new monthly high is similar to the proportion of annual returns that have been positive after any index level. In fact, over this time period almost a third of the monthly observations were new closing highs for the index. Looking at this data, it is clear that new index highs have historically not been useful predictors of future returns.
Given that the level of an index by itself does not seemingly have a bearing on future returns, you may ask yourself a more fundamental question: What drives expected returns for stocks?
Exhibit 1.
S&P Total Return Index Highs: 1926–2016
Percent of Months With Positive Return Over Next 12-Month Period
From January 1926–December 2016, 319 months, or approximately 29% of monthly observations, were new closing highs.
Note: 1,081 monthly observations. The S&P data is provided by Standard & Poor's Index Services Group. For illustrative purposes only. Index is not available for direct investment. Past performance is no guarantee of future results.
POSITIVE EXPECTED RETURNS
One way to compute the current value of an investment is to estimate the future cash flows the investment is expected to deliver and discount them back into today’s dollars. For an investment in a firm’s stock, this type of valuation method allows expectations about a firm’s future profits to be linked to its current stock price through a discount rate. The discount rate equals an investor’s expected return. A simple, but important, insight we glean from this is that the expected return from holding a stock is driven by the price paid for it and what its investors expect to receive.
Stock prices are the result of the interaction of many willing buyers and sellers. It is extremely unlikely that in aggregate, those willing buyers apply negative discount rates to the expected profits of the firms they are purchasing. Why? Because there is always a risk that expected profits will not materialize or that the price might decline because of unanticipated future events. If investors apply positive discount rates to the cash flows they expect to receive from owning a stock, we should expect the price of that stock to represent a level such that its expected return is always positive. Unless the expected cash flows are persistently biased downward or upward, we can expect this to be the case.
There is little evidence, though, that the aggregate expectations of investors that set market prices have been persistently biased downward or upward. Many studies document that professional money managers have been unable to deliver consistent outperformance by outguessing market prices. In the end, prices set by market forces are difficult to outguess. The market does a good job setting prices, and we can assume that the expected return investors have applied when setting prices are not biased.
Therefore, it is reasonable to assume that the price of a stock, or the price of a basket of stocks like the S&P 500 Index, should be set to a level such that its expected return is positive, regardless of whether or not that price level is at a new high. This helps explain why new index highs have not, on average, been followed by negative returns. At a new high, a new low, or something in between, expected returns are positive.
EXPECTED RETURNS, REALIZED RETURNS, AND HOLDING HORIZONS
Today’s prices depend on expected returns and expectations about future profits. If either expected returns or expectations about future profits change, prices will also change to reflect this new information. Changes in risk aversion, tastes and preferences, expectations about future profits, or the quantity of risk can all drive changes in expected returns. All else equal, an increase in expected returns is reflected through a drop in prices. A decrease in expected returns is reflected through a rise in prices. Thus, realized returns can differ from expected returns.
This means there is a probability that the realized return on any stock, an index like the S&P 500, or the market as a whole can be negative even when expected returns are positive. But what can we say about the relation between the probability of a negative realized return and an investor’s holding horizon?
Exhibit 2 shows rolling 10-year performance of the equity market premium (equity returns minus the return of one-month US Treasury bills, considered to be short-term, risk-free investments). In most periods it was positive, but in several periods it underperformed.
Exhibit 2.
Historical Observations of 10-Year Premiums
Market minus one-month Treasury bills: US markets
Information provided by Dimensional Fund Advisors LP
In US dollars. The 10-year rolling equity premium is computed as the 10-year annualized compound return on the Fama/French Total US Market Index minus the 10-year annualized compound return of the one-month US Treasury Bill. Fama/French indices provided by Ken French. Index descriptions available upon request. Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.
There is uncertainty around how long periods of underperformance like this may last. Historically, however, the probability of equity returns being positive increases over longer time periods compared to shorter periods. Exhibit 3 shows the percentage of time that the equity market premium was positive over different time periods going back to 1928. When the length of the time period measured increases, so does the chance of the equity market premium being positive. So to answer our question from before: as an investor’s holding period increases, the probability of a negative realized return decreases. This is why it is important to choose a level of equity exposure that you can stay invested in over the long term.
Exhibit 3.
Historical Performance of Equity Market Premium over Rolling Periods
US markets overlapping periods: January 1928–December 2015
Market is Fama/French Total US Market Index. T-Bills is One-Month US Treasury Bills. There are 877 overlapping 15-year periods, 937 overlapping 10-year periods, 997 overlapping five-year periods, and 1,045 overlapping one-year periods.
Information provided by Dimensional Fund Advisors LP. Based on rolling annualized returns using monthly data. Rolling multiyear periods overlap and are not independent. This statistical dependence must be considered when assessing the reliability of long-horizon return differences. Fama/French indices provided by Ken French. Index descriptions available upon request. Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP. Indices are not available for direct investment. Past performance is not a guarantee of future results.
CONCLUSION
By themselves, new all-time highs in equity markets have historically not been useful predictors of future returns. While positive realized returns are never guaranteed, equity investments have positive expected returns regardless of index levels or prior short-term market returns. The collective wisdom of market participants and their competitive assessment of expected returns and risks allow investors to rely on the information contained in prices to inform their investment decisions and assume positive expected returns from stocks. Historically speaking, over longer time horizons, the odds of realized stock returns being positive have increased. This is one reason why investors should consider investing a long-term commitment: Staying invested and not making changes based on short-term predictions increases your likelihood of success.
Source: Dimensional Fund Advisors LP.
Past performance is no guarantee of future results. There is no guarantee an investing strategy will be successful.
All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.
2016 Market Review
In 2016, the US market reached new highs and stocks in a majority of developed and emerging market countries delivered positive returns. The year began with anxiety over China’s stock market and economy, falling oil prices, a potential US recession, and negative interest rates in Japan. US equity markets were in steep decline and had the worst start of any year on record. The markets began improving in mid-February through midyear. Investors also faced uncertainty from the Brexit vote in June and the US election in November.
Many investors may not have expected global stocks and bonds to deliver positive returns in such a tumultuous year. This turnaround story highlights the importance of diversifying across asset groups and regional markets, as well as staying disciplined despite uncertainty. Although not all asset classes had positive returns, a globally diversified, cap-weighted portfolio logged attractive returns in 2016.
Consider that global markets are incredible information-processing machines that incorporate news and expectations into prices. Investors are well served by staying the course with an asset allocation that reflects their needs, risk preferences, and objectives. This can help investors weather uncertainty in all of its forms. The following quote by Eugene Fama describes this view.
“If three or five years of returns are going to change your mind [on an investment], you shouldn’t have been there to begin with.” ―Eugene Fama
The chart above highlights some of the year’s prominent headlines in context of broad US market performance, measured by the Russell 3000 Index. These headlines are not offered to explain market returns. Instead, they serve as a reminder that investors should view daily events from a long-term perspective and avoid making investment decisions based solely on the news.
The chart below offers a snapshot of non-US stock market performance (developed and emerging markets), measured by the MSCI All Country World ex USA Index (in USD, net dividends). The headlines should not be viewed as determinants of the market’s direction but as examples of events that may have tested investor discipline during the year.
World Economy
2016 Market Perspective
Equity Market Highlights
After a rocky start, the US stock market had a strong year. The S&P 500 Index logged an 11.96% total return and small cap stocks, as measured by the Russell 2000 Index, returned 21.31%.
Overall, performance among non-US markets was also positive: The MSCI World ex USA Index, which reflects non-US developed markets, logged a 2.75% return and the MSCI Emerging Markets Index an 11.19% return.[1]
Global Diversification Impact
Overall, US equities outperformed equities in the developed ex US markets and emerging markets. As a result, a market cap-weighted global equity portfolio would have underperformed a US equity portfolio. Investors generally benefited from emphasizing value stocks around the world, as well as US small cap stocks.
Returns at the country level were dispersed. In developed markets, returns ranged from –24.87% in Israel to +24.56% in Canada. In emerging markets, returns ranged from –12.13% in Greece to +66.24% in Brazil.
Strong performance in the US placed it as the 17th best performing country out of the 46 countries in the MSCI All Country World Index (ACWI), which represents both developed and emerging markets. Although the S&P 500 Index had a positive return in 2016, the year was not in the top half of the index’s historical annual returns.
Brazil offers a noteworthy example of market prices at work and the difficulty of trying to forecast and time markets. Despite a severe recession, Brazil was the top performing emerging market country in 2016. Brazil’s GDP was projected to shrink 3.4% in 2016, according to the OECD in November, yet its equity market logged strong performance. The lesson is that prices incorporate a rich set of information, including expectations about the future. One must beat the aggregate wisdom of market participants in order to identify mispricing. The evidence suggests that this is a very difficult task to do consistently.
Volatility
In 2016, equity market volatility, as measured by the CBOE Volatility Index (VIX),[1] was below average. There were, however, several spikes—as you might expect—as new information was incorporated into prices. The high was reached in early February, and spikes occurred following the Brexit vote in June and again in November preceding the US election.
Premium Performance
In 2016, the small cap and value premiums[2] were mostly positive across US, developed ex US, and emerging markets, while the profitability premium varied by market segment.[3] Though 2016 marked a generally positive year, investors may still be wary following several years of underperformance for value and small cap stocks. Taking a longer-term perspective, the premiums remain persistent over decades and around the globe despite recent years’ headwinds. The small cap and value premiums are well-grounded in financial economics and verified using market data spanning decades, but pursuing those premiums requires a consistent, long-term approach.
US Market
In the US market, small cap stocks outperformed large cap stocks and value stocks outperformed growth stocks. High profitability stocks outperformed low profitability stocks in most market segments.[4] Over 2016, the US small cap premium marked the seventh highest annual return difference since 1979 when measured by the Russell 2000 Index minus Russell 1000 Index. Most of the performance for small caps came in the last two months of the year, after the US election on November 8. This illustrates the difficulty of trying to time premiums and the benefit of maintaining consistent exposure. Through October, US small cap stocks had outpaced large company stocks for the year by only 0.35%. By year-end, the small cap premium had increased to 9.25%, as shown below.
US value stocks outperformed growth stocks by 11.01% following an extended period of underperformance. Over the five-year rolling period, the value premium, as measured by the Russell 3000 Value Index minus Russell 3000 Growth Index, moved from negative in 2015 to positive in 2016.
Developed ex US Markets
In developed ex US markets, small cap stocks outperformed large cap stocks and value stocks outperformed growth stocks. Over both the five- and 10-year rolling periods, the small cap premium, measured as the MSCI World ex USA Small Cap Index minus the MSCI World ex USA Index, continued to be positive. The five- and 10-year rolling periods for the small cap premium have been positive for the better part of the past decade.
Value stocks outperformed growth stocks by 9.26%, as measured by the MSCI World ex USA Value Index minus the MSCI World ex USA Growth Index. Similarly to US small caps, most of the outperformance occurred in the fourth quarter, reinforcing the importance of consistency in pursuing premiums. Despite a positive year, the value premium remains negative over the five- and 10-year rolling periods.
Emerging Markets
In emerging markets, small cap stocks underperformed large cap stocks and value stocks outperformed growth stocks. Despite the underperformance of small cap stocks, small cap value stocks fared better than small cap growth stocks and performed similarly to large cap value stocks. Investors who emphasized small cap value stocks over small cap growth stocks benefited.
Fixed Income
Both US and non-US fixed income markets posted positive returns. The Bloomberg Barclays US Aggregate Bond Index gained 2.65%. The Bloomberg Barclays Global Aggregate Bond Index (hedged to USD) gained 3.95%.
Yield curves were generally upwardly sloped in many developed markets, indicating positive expected term premiums. Indeed, realized term premiums were positive in the US and globally as longer-term maturities outperformed their shorter-term counterparts.
Corporate bonds were the best performing sector, returning 6.11% in the US and 6.22% globally, as reflected in the Bloomberg Barclays Global Aggregate Bond Index (hedged to USD). Credit premiums were also positive in the US and globally as lower quality investment grade corporates outperformed their higher quality investment grade counterparts.
While interest rates increased in the US, they generally decreased globally. Major markets such as Japan, Germany, and the United Kingdom all experienced decreases in interest rates. In fact, yields on Japanese and German government bonds with maturities as long as eight years finished the year in negative territory.
In the US, interest rates increased the most on the short end of the yield curve and were relatively unchanged on the long end. The yield on the 3-month US Treasury bill increased 0.35% to end the year at 0.51%. The yield on the 2-year US Treasury note increased 0.14% to 1.20%. The yield on the 10-year US Treasury note closed at a record low of 1.37% in July yet increased 0.18% for the year to end at 2.45%. The yield on the 30-year US Treasury bond increased 0.05% to end the year at 3.06%.
Currencies
The British pound, euro, and Australian dollar declined relative to the US dollar, while the Canadian dollar and Japanese yen appreciated relative to the US dollar. The impact of regional currency differences on returns in the developed equity markets was minor in most cases. US investors in both developed and emerging markets generally benefited from exposure to certain currencies.
“There’s no information in past returns of three to five years. That’s just noise. It really takes very long periods of time, and it takes a lot of stick-to-it-iveness. You have to really decide what your strategy is based on long period of returns, and then stick to it.”
―Eugene Fama
[1] All non-US returns are in USD, net dividends.
[2] The VIX is a measure of implied volatility using S&P 500 option prices. Source: Bloomberg.
[3] The small cap premium is the return difference between small capitalization stocks and large capitalization stocks. The value premium is the return difference between stocks with low relative prices (value) and stocks with high relative prices (growth).
[4] Profitability is measured as a company’s operating income before depreciation and amortization minus interest expense scaled by book equity. The profitability premium is the return difference between stocks of companies with high profitability over those with low profitability.
[5] Profitability performance is measured as the top half of stocks based on profitability minus the bottom half in the Russell 3000 Index.
[6] A yield curve is a graph that plots the interest rates at a specific point in time of bonds with similar credit quality but different maturity dates.
Sources:
Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Dow Jones data provided by Dow Jones Indices. MSCI data © MSCI 2017, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2017 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Bloomberg Barclays data provided by Bloomberg. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Eugene Fama is a member of the Board of Directors for and provides consulting services to Dimensional Fund Advisors LP.
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.