By Justin Pawl, CFA, CAIA
In this week’s edition:
- Last Week Today. News impacting financial markets and the economy.
- Heads and Tails. Timing the market is a fool’s errand.
Last Week Today. U.S. economic data releases were weak, with one big exception. The November Non-Manufacturing Purchasing Managers Index and Manufacturing (PMI) report, in particular, were both softer than expected. Nonetheless, the October jobs report was a humdinger, showing 266,000 new jobs added (vs. 180,000 consensus estimate), and the prior two months were revised higher by 44,000 jobs. It was a strong report, but the “internals” were less impressive as the manufacturing sector added few jobs outside of the returning GM strikers (consistent with the weak Manufacturing PMI report), and many of the other positions were added in education, healthcare, and leisure sectors. The good news is that the labor market is healthy overall, which should support the all-mighty U.S. consumer. | President Trump announced he is reinstating 25% tariffs on Brazil and Argentina steel and aluminum. | Aramco (the world’s largest oil company) held the biggest initial public offering (IPO) in history. Though the IPO’s capital raise of $25.6 billion fell short of Saudi officials’ original hopes of raising $100 billion, the $1.7 trillion valuation makes it the world’s most valuable publicly-traded company (ahead of Apple’s $1.15 trillion). | OPEC agreed to cut oil production by another 500,000 barrels a day, bringing OPEC-related production cuts to 1.7 million since October 2018.
Global equity markets began the week on shaky ground when another round of He Said-Xi Said put the trade deal on shaky ground. By Wednesday, however, the trade mood had brightened and, bolstered by the strong jobs report, the MSCI All Country World Index rallied to close the week up +0.3%. Emerging market equities were the clear winner for the week, rising 0.9% aided by a 1.3% rally in Chinese equities. Gains in developed market stocks were less robust, but beneath the surface, Value stocks gained +0.5%, while Growth stocks declined by -0.2%. Commodities, outside of precious metals, rallied on hopes of a trade deal and oil (+7.3% to $59.20 per barrel) received an extra boost from OPEC’s agreement to reduce production. For more detail on weekly, MTD, and YTD financial market performance, click on the table below.
Heads and Tails. Most investors dream of finding an investment strategy that avoids the worst days in the market and captures the returns from the best days. This Aladdin’s Lamp of a strategy would, by definition, require an investor have specific knowledge to move deftly in and out of the market with precision, putting capital at risk only when the risk of losing money was low if not zero. This approach to investing is called “market timing,” and it has a long history of unfulfilled promises. Sure, there have been cases where a portfolio manager can time the market for a short period, but the number of successful market timers over a long horizon can likely be counted on one hand. The challenge for market-timers is two-fold: you must correctly predict when to divest AND when to invest. Each of these decisions is difficult enough on its own, but when a successful trade requires being correct twice in a row, the odds are cut in half. Over a long time horizon, the probability of success becomes infinitesimal.
To illustrate this point, consider flipping a coin and correctly choosing whether it will land as a head or a tail. On your first flip, you have a 50% chance of being correct – not great odds, but better than Vegas. On the second flip, you have a 25% of making two good choices in a row – uh oh, this is getting harder. By the time you get to 10 flips, you only have a 0.10% chance of making ten correct choices in a row. You can see the problem, especially when you consider your retirement savings could be on the line.
On that note, Fidelity compiled data on market timing that shows the portfolio impact of missing the best days in the market. Remember, to successfully time markets, you must not only correctly choose when to sell, but also when to buy. According to Fidelity’s data, if you had invested $10,000 in the S&P 500 in 1980 and held your investments through good times and bad, your investment would have grown to just over $700,000. However, if you had missed the best 5 days of market performance, you would have missed out on 35% of the gains. Missing the top 10 days, and your portfolio value would be cut by more than 50%.
Source: Fidelity Investments
This is not to suggest that the best investment approach is to buy and hold stocks. There are, of course, a myriad of other considerations when it comes to putting hard-earned money at risk in the market. For example, Fidelity’s study does not consider the different investment horizons to which each investor is subject. Consider individuals who retired in late 2000 or late 2007 and needed to withdraw capital from their portfolio to pay for living expenses. Their net worth would be dramatically lower than what is illustrated above simply because the withdrawn money would not be available to appreciate in the market recoveries following the devastating losses of the Dot.com-bust and the Financial Crisis. Moreover, the data above does not consider individual risk tolerances, that may cause individuals to sell during the exact wrong times when markets were down, but about to move higher.
The point here is that trying to time the market is a fool’s errand. Concentrating your portfolio in stocks is not a realistic solution either – even university endowments that have a theoretically infinite time horizon populate their portfolios with multiple asset classes. The middle ground is building a diversified portfolio of investment assets (stocks, bonds, real estate, commodities, alternative investment strategies, etc.) with unique return drivers that complement one another.
A diversified portfolio is a good starting point. From there, diligently researching the global economy and financial markets can help identify outright dislocations and pockets of opportunity, where it makes sense to overweight a portion of one’s portfolio. Keep in mind that certain assets will perform well in some environments, while others will lag or even lose money. Said differently, by definition, a diversified portfolio will never perform as well as its best performing allocation, but it will also never perform as badly as its worst-performing allocation.
In a properly diversified portfolio, there is always a holding or two that will frustrate you because it (or they) are not performing as well as the other positions. That’s OK because you don’t want all the assets moving in the same direction with the same level of performance simultaneously. Indeed, that type of pattern would be a good indication that you are not diversified at all. Instead, combining a diversified portfolio with disciplined rebalancing (buying assets that haven’t performed well, while selling assets that have appreciated) keeps the portfolio “fresh” and can help compound growth at a pace consistent with your risk tolerance and investment horizon.