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Fourth Quarter 2021 Newsletter

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Fourth Quarter 2021 Newsletter

Beware The Financial Fortune Tellers

Sarah K. Charles, CSRIC™, AIF® / Director of Business Strategy

Did you know that you can predict the future by observing a rooster pecking at grain (alectryomancy)? Or by studying patterns in melting wax (ceromancy)? Watching what happens to molten metal after it’s dumped in cold water (molybdomancy) is another method for fortune telling. So is watching parakeets pick up fortune cards (the aptly named parrot astrology).  Divination has been practiced by many cultures for millennia, and the future can be foretold using everything from scattered salt (alomancy) to the sediment at the bottom of a wine glass (tasseography) to the movements of an ax placed on a post (axinomancy).

I confess: when I was in high school I purchased a deck of tarot cards as I hoped that learning to read them (cartomancy) would confirm that something better was waiting for me beyond my teenage angst.  Seeking answers to what life holds in store is human nature. We desire clarity.

The financial media knows this, which is why they like to kick off each new year with scads of stories telling you what stocks to pick and what the markets will do.  While this falls under the heading of journalism, I prefer to call it something else: financial fortune telling. And it doesn’t serve investors well. 

Are the prognostications and predictions offered by analysts and strategists gazing into their crystal balls (crystallomancy) any more accurate than predicting the future based on the shape of an animal’s shoulder blade (spatulamancy) or drawing arrows at random from a container (belomancy)?

I think not.

It’s 2022. So What?

Unless you believe in divination to determine the favorable time for action (chronomancy), the idea that there’s something special you need to do with your investments because we flipped a page in the calendar and it’s now 2022 instead of 2021 is ludicrous.  What happens in any one calendar year or any twelve-month period for that matter is trivial when you’re a long-term investor. I am a whole lot less interested in what’s going to happen in the next year than I am in the next 50. Why? Because that’s roughly the length of my investment horizon. And while your timeline may be longer or shorter, I don’t think that anyone reading this newsletter believes they have only one year in front of them as an investor. And if you do? Then you shouldn’t have much market exposure to begin with. 

Changing your investment strategy because it’s a new calendar year makes as much sense as consulting the clouds (nephomancy) or relying on what you read in a fortune cookie (aleuromancy).  Investing is profoundly personal, which is why the decisions you make when it comes to your portfolio including how you’re allocated and the level of risk you’re taking, should be driven by your Strategic Life Plan, and reflect your individual goals.  

Market Predictions Are Useless

As investors, we tend to seek confirmation of our existing beliefs – it’s called confirmation bias. Feeling pessimistic about the future of the market? You will likely congregate with like-minded bears. And if you’re a cockeyed optimist you will find your fellow bulls. Whatever your sentiment about the future of the market, there’s a forecast out there to affirm it and 2022 is no exception.

In mid-November, Morgan Stanley and Goldman Sachs released their 2022 target predictions for the S&P 500 one day apart.  Morgan Stanley is calling for the S&P 500 to end 2022 at 4400 which is a ~ 6% decline from where the index was when the prediction was made, and almost 8% less than where the index ended 2021. 

Meanwhile, Goldman’s forecast is that the S&P 500 will end 2022 at 5100 which represents ~ 9% growth. 

Feeling confused by the wildly disparate predictions from two of the most prominent banks on Wall Street? Perhaps The Wall Street Journal can shed some light on the right answer. 

In the January 3rd WSJ Wealth Advisor Briefing (a daily email available to subscribers) the lead story painted a rather gloomy picture:

“Stocks Face Rockier Path in 2022: The double threat of an unpredictable pandemic and looming interest-rate increases is tempering investors’ optimism heading into 2022, a contrast to their vaccine- and stimulus-fueled enthusiasm of a year ago."1

Sounds like a case for the bears. Time to find a cave and settle in. Except this was the very next story:

“Cheaper Stocks Boost S&P 500’s Prospects in New Year: Wall Street forecasters predict rising markets in 2022 thanks to lower valuations, an expanding economy and ultralow interest rates."2

And suddenly we’re back out of hibernation.

Although the modern-day methodologies employed by each strategist and analyst make more sense than walking in a circle until falling from dizziness and then prognosticating from the place of the fall (gyromancy) or studying the livers of sacrificed animals (haruspicy), there is still a high degree of subjectivity to market analysis – otherwise there wouldn’t be such a wide range of outcomes.  

The back and forth can be exhausting.  Who’s right? Who knows? Furthermore, who cares? At DHGWA we aren’t market timers, and we don’t build portfolios based on “what the market is doing.” Our investment philosophy is rooted in academics and driven by Modern Portfolio Theory, a Nobel-prize winning methodology, which means we’re more interested in the long-term performance of global markets and what the financial science teaches us than we are in the price target on a single index (e.g., the S&P 500 at 4400 or 5100).

Good Luck Finding a Needle in a Haystack

Had the stock market existed in Ancient Greece, I suspect the Oracle of Delphi would have been a stock picker given headlines like:

“Barron’s Best Income Investments for the New Year”3

“The Housing Boom Could Last for a Decade. Buy These Stocks.”4

“Barron’s 10 Stock Picks for 2022”5

“How Our Tech Stock Picks Fared in 2021—and What’s Worth Buying Now”6


Because at their core, these stories are nothing more than 21st century prophecies promising to help investors find a needle in a haystack. But as Warren Buffet once said: “Predicting rain doesn't count, building an ark does.” Which makes prophecies – whether derived from eggs (oomancy), rodent behavior (myomancy), or quantitative algorithms – ineffective.   

Moreover, there is a giant fundamental flaw with the “finding a needle in a haystack” approach of stock pickers. Over time most stocks perform in-line with Treasury bills which makes stock picking a poor approach to building long-term wealth.

I know what you’re thinking: I mistyped that last sentence. Everyone knows stocks outperform Treasury bills over the long-term. Just look at Exhibit 1.

EXHIBIT 1: Growth of a Dollar, 1926–2020 (compounded monthly)

Source: Dimensional Fund Advisors. In USD. US Small Cap is the CRSP 6–10 Index. US Large Cap is the S&P 500 Index. US Long-Term Government Bonds is the IA SBBI US LT Govt TR USD. US Treasury Bills is the IA SBBI US 30 Day T-Bill TR USD. US Inflation is measured as changes in the US Consumer Price Index. CRSP data is provided by the Center for Research in Security Prices, University of Chicago. S&P data © 2021 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. US Long-term government bonds and Treasury bills data provided by Ibbotson Associates via Morningstar Direct. US Consumer Price Index data is provided by the US Department of Labor Bureau of Labor Statistics. 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.

Don’t misunderstand – the stock market has indeed rewarded investors with meaningful growth of wealth over time.  But here’s what this chart doesn’t show: which specific stocks are driving the outperformance.   And as it turns out, according to research by Hendrik Bessembinder, the best 4% of listed companies explain the net gain for the entire US stock market since 1926. The other 96% have collectively matched Treasury bills.7

Jason Zweig explains this phenomenon perfectly: “The average return of the stock market, and the return of the average stock in the market, are nothing alike.”8

Are you surprised? You’re not alone. And subsequent research from Bessembinder has found that while the stock market investments have increased shareholder wealth on net by $47.4 trillion between 1926 and 2019, the majority of individual stock investments led to decreased wealth in the long run, and aggregate shareholder wealth creation is concentrated in a relatively few high performing stocks.9

One thing driving this phenomenon is that individual common stocks have an average lifespan of 7½ years. In The Psychology of Money, Morgan Housel shares the story of one of them:

“[Carolco] produced some of the biggest films of the 1980s and 1990s, including the first three Rambo films, Terminator 2, Basic Instinct, and Total Recall.

Carolco went public in 1987. It was a huge success, churning out hit after hit. It did half a billion dollars in revenue in 1991, commanding a market cap of $400 million—big money back then, especially for a film studio.

And then it failed.

The blockbusters stopped, a few big-budget projects flopped, and by the mid-1990s Carolco was history. It went bankrupt in 1996. Stock goes to zero, have a nice day. A catastrophic loss. And one that 4 in 10 public companies experience over time. Carolco’s story is not worth telling because it’s unique, but because it’s common.”

What Bessembinder’s research implies is that “undiversified portfolios selected at random will underperform the overall market more often than not, a fact that reinforces the desirability of low-cost and broadly-diversified strategies for many investors.”10 It’s why DHGWA preaches the gospel of diversification.  When you own the entire haystack, it’s going to include the winners. 

Considering that only a handful of names are driving shareholder wealth creation in the market over time, you have as much chance as identifying those winners from a magazine article as you do from observing a flight of birds (ornithomancy) or basing your picks on chance events or occasionally uttered words (cledonomancy).  

It can be tempting to turn to predictions and prophecies for glimpses into what the future might hold. Just ask my 15-year-old self. But fortune-telling in any form isn’t the answer, and in some places, it’s actually illegal.11 Instead, turn to your DHGWA Strategic Life Plan to help answer meaningful questions like:

  • Am I on track to achieve my goals?
  • Am I using my resources to live the life I want?
  • Do I have financial clarity and peace of mind when it comes to my personal financial situation?

And if you are guided by your plan, then I don’t need to check my Magic 8 Ball to know that “without a doubt, the outlook is good.” 

Q421 Market Perspective

Bill Laird, CFA, CFP® / Chief Investment Officer

Source: Morningstar Direct

Markets in 2021 continued a robust recovery from 2020 pandemic lows with US stocks represented by the S&P 500 returning 28.7% and developed overseas stocks returning 12.6%. Value and Growth stocks traded places taking the lead in 2021 with Growth stocks outpacing Value slightly by year end both domestically and abroad. Small US stocks trailed Large counterparts in both the US and overseas.  Emerging markets declined during 2021, mainly influenced by turmoil in China

Positives included more market breadth (more types of companies participating in the advance), indicating an economy where prosperity is shared among a broad set of industries.  Additionally, markets following earnings and GDP (which eclipsed pre-pandemic levels) indicated that the market advance was driven by fundamentals versus speculation. Exhibit 2 illustrates the long-term influence of earnings as the main driver of stock market advances.

EXHIBIT 2

Interestingly markets did not reward speculation in 2021 in the same way as 2020. There were fewer stories of wealth being created overnight through trading apps, and your friends involved in those efforts likely told you about their diamonds in the rough but neglected to talk to you about the coal most received in their stocking at year end in the form of their statement.  

Exhibit 3 outlines the market’s disinterest in rewarding companies without profit which began near the introduction of the vaccine and has accelerated as the Fed has reduced stimulus provided to the economy.   
EXHIBIT 3

IPOs and SPACs followed a similar pattern relative to established profitable peers, as shown in Exhibit 4.

EXHIBIT 4

Source: Morningstar Direct

Challenges included concerns regarding inflation and Federal reserve policy, and the continued spread of COVID-19. Federal Reserve policy does influence many aspects of the economy, but the beginning of a tightening cycle does not mean that asset values will decline.  Fed tightening and the other measures used to influence the economy are designed to uphold the Fed’s dual mandate of “price stability and maximum sustainable employment.”  That means that the Fed will sometimes need to slow down the economy to keep in line with that mandate and thus will tighten financial conditions.

Exhibit 5 shows that through a number of cycles in the last 25 years (both tightening and easing economic conditions), markets have advanced with only modest correlation between Fed action and market movements. The Shadow Rate illustrates the influence of other Fed actions such as bond buying in addition to the Federal Funds Rate.  

EXHIBIT 5

Longer term observations, as illustrated in Exhibit 6, indicate the market may have trouble digesting the latter part of Fed tightening cycles (where conditions are most restrictive), but that observation was not conclusive as the market advanced in many cases during the latter part of tightening cycle, most likely indicating that Fed action was appropriate and the market was able to adjust to tighter financial conditions.

EXHIBIT 6

Inflation continues to be a concern of the Federal Reserve and market participants. As we’ve illustrated in previous newsletters, inflation and positive stock returns can co-exist. Our portfolios are built in an inflation aware manner and hold many assets that over the long term are designed to preserve purchasing power. We’ll continue to cover this topic in more detail in the future as it is a current topic of high interest.

DHGWA Privacy Statement

DHGWA’s Privacy Statement has recently been updated and can be found on our website here. We encourage you to periodically review this Statement to keep up to date on how we are handling your personal information and our commitment to you to safeguard any nonpublic information we obtain about you. Please contact us at info@dhgwa.com if you have any questions, because your privacy, our professional ethics, and the ability to provide you with quality financial services are very important to us.

* * * * *

Happy New Year! Our crystal ball is out of order, and we have no idea what 2022 has in store for markets and investors. But we’d rather focus on more important things – like helping you have a better investment experience by delivering financial clarity, peace of mind and service beyond the expected. 

Stay safe. Stay healthy. Take care. 

 

1 “Stocks Face Rockier Path in 2022 as Fed Rate Increases Loom,” The Wall Street Journal, January 2, 2022

2 “Cheaper Stocks Boost S&P 500’s Prospects in New Year,” The Wall Street Journal, January 2, 2022

Barron’s, January 3, 2022

4 Barron’s, December 6, 2021

5 Barron’s, December 20, 2021

6 Barron’s, December 27, 2021

7Do Stocks Outperform Treasury Bills?” by Hendrik Bessembinder, Department of Finance, W.P. Carey School of Business, Arizona State University, June 2018

8 “Amazon’s 49,000% Gain: The Most ‘Super’ of ‘Superstocks’ Since 1926,” The Wall Street Journal, May 17, 2017

9Wealth Creation in the U.S. Public Stock Markets 1926 to 2019” by Hendrik Bessembinder, Department of Finance, W.P. Carey School of Business, Arizona State University, November 2020

10Wealth Creation in the U.S. Public Stock Markets 1926 to 2019” by Hendrik Bessembinder, Department of Finance, W.P. Carey School of Business, Arizona State University, November 2020

11 Fortune telling is a Class B misdemeanor in the state of New York punishable by up to ninety days in jail or a $500 fine.

Attachments

  1. FourthQuarter2021_DHGWealthAdvisorNewsletter.pdf 1/12/2022 9:01:57 AM