In an internet age it is easy to find information on just about anything, but often it can be difficult to determine what’s fact and what’s fiction. Here we will discuss 5 myths about the market today.
1) The market is Near its All-Time High
2) Timing the market results in higher returns
3) History Repeats Itself
4) October is a Bad Month for Investing
5) Good Companies Always Have Good Stocks
Myth #1: The Market is Near its All-Time High
Despite the novel coronavirus ravaging the world since the beginning of this year, we have observed a sharp recovery of major indices, including the TSX and S&P 500, to the point where they are now nearing their all time highs. This has perplexed many investors who are left asking the question, how can the market be at an all-time high amidst major economic shutdowns and soaring rates of unemployment? Or more simply put, why is there such a disconnect between “Main Street” and “Wall Street”? To answer this important question, we first need to deconstruct the index so we can analyze what is driving it higher. Indices such as the TSX and the S&P 500 are market cap-weighted indices. What that means is each constituent security of the index carries a weight in the index commensurate with its market capitalization (outstanding shares times price per share). Therefore, a company like Apple that carries a market cap of nearly 2 trillion U.S. dollars and was the most valuable holding in the S&P 500 Index as of September 30th, 2020 carries a far greater weight in the index than say a company like Bank of America which had a market cap of $216 billion as of the same date. Since the lows of March 23rd this year, many of the securities that displayed the most impressive recovery have come from the technology and communications spaces, companies like Apple, Microsoft, Facebook and Alphabet (Google’s parent company) to name a few. These are also the companies that carry some of the largest weights in the cap weighted index. So why is this important? Well, many people look at the index as a proxy for how well the stock market is doing as a whole. The issue right now is that a handful of companies that happen to carry a large weight in the index are doing very well, while a much greater number of companies are struggling, but only represent a small combined weight in the overall index. As a result, the index is displaying, disproportionately, the characteristics of these few companies that are not indicative of what is happening to the entire stock market. So how can we adjust for this disproportionate representation in these indexes? There could be several ways, but for purpose of simplicity we will stick to one which involves adjusting the weights of each constituent security from market weight to equal weight. Therefore, each constituent security contributes equally to the performance of the index. To illustrate the impact of this change we will continue to observe S&P 500. As of October 31st, 2020, the S&P 500 Index was positive year-to-date by a little more than 1%, yet over the same period the S&P 500 Equal Weight Index was negative by 7%, a differential of over 8% percent! By giving each security an equal weight, we paint a clearer picture of how the majority of the index is performing. The key takeaway here is to understand the methodology used to calculate returns.
Myth #2: Timing the Market Results in Higher Returns
It is true that if you could consistently time the market such that you bought securities at their trough and sold them at their peak you would earn higher returns, so why is this a myth? To answer this question, we can look at several variables. To start let’s examine the length of the business cycle. If we can predict the length of the business cycle or better yet the length of each phase in the business cycle, then we will know when we are at the peak (and therefore should sell) and when we are at the trough (and therefore should buy). In the U.S. we can observe that the average length of the typical business cycle is 4.7 years, but varies greatly from cycle to cycle, with the standard deviation of the average cycle length being 2.2 years. (Marmer, 2016) With most cycle durations deviating up to 47% away from the mean, it becomes very difficult to predict each cycle length with any real accuracy. To compound this problem the average stock market cycle in the U.S. is 7 years long with a standard deviation of 3.1 years. (Marmer, 2016) With both the business cycle and stock market cycle having differing, and highly variable durations it becomes nearly impossible to consistently predict how long each phase will last in order to sync up your trades to maximize profits. We can also observe the difficulties of market timing on a more granular level. During 2019 the TSX had a price return of 19.1%, which is a figure you may have seen discussed in the media as we entered the new year. What you might not know is that of the 251 trading days on the TSX in 2019, the 19 best days account for just over 94% of the annual return. Obviously, it would be next to impossible to predict which of the 19 days of the year would yield these returns. Instead of timing the market its better to develop a disciplined strategy to be in the market that considers both your willingness and ability to take risk. We know that markets go up over the long run so don’t let your portfolio suffer by potentially missing the relatively few days (in this case 19) of the year that can drive your overall return.
Myth #3: History Repeats Itself
To quote Mark Twain; “history doesn’t repeat itself, but it often rhymes”. These wise words from Mr. Twain were meant to capture the subtlety that while no two events on the historic timeline are the same, there are often patterns we can identify. Perhaps the best way to prove this theory is to look at real world examples, so for the purpose of this segment we will review some of history’s greatest asset bubbles to both debunk this myth, and prove Mark Twain’s famous quote. It may be hard to believe today, but in the 1600s there was an asset bubble in the Netherlands that drove up the prices of tulip bulbs, some of which would sell for the price of a house during that era, and many that would sell for the equivalent of the annual wage of a skilled craftsman. The prices spiked from December 1636 as people speculated what their potential value could be, until their peak in February 1637, after which they would crash down to their pre-bubble prices in May of 1637. (Roos, 2020) While this bubble did not have the widespread impact of others we will review, it is perhaps the most obscure asset on the list, with one quickest rallies to its peak. We note that the duration of the rise in prices lasted less than 3 months, with some bulbs experiencing 12-fold price appreciation over that time. The crash that brought prices back to a normalized level that lasted about 3 months as well. (Roos, 2020) Fast-forward a few centuries and we arrive in 1990s, and with the it rise of the dot-com bubble. As many of you might remember from the mid-90s through our entry into the new millennium there was a whirlwind of dot-com companies emerging left, right and centre, many of which quickly went public. From January 1995 when the Nasdaq composite index opened at 751, we witnessed the Nasdaq index rise over 600% until it reached its peak on March 24, 2000, when it recorded a daily high of 5079. During that time, dot-com stocks flooded the market and these newly founded tech stocks comprised over 20% of the S&P 500 names (Isbitts, 2020). Many of these companies had no substantial revenue to speak of, let alone positive earnings. In 1999 there were 117 IPOs that more than doubled on their first day of trading and an additional 77 IPOs that did the same during the year 2000. To put this in perspective, during the combined 24 years prior, only 34 IPOs were able to boast triple digit percentage first-day returns. (Ritter, 2020) But as we know it all came crashing down, with the Nasdaq market dropping over 68% from its peak in March 2000 to early April 2001. Fast forward a few more years and we observe the U.S. housing bubble, fueled by low interest rates, sub-prime lending, an increased use of financial derivatives and heightened levels of leverage, due, in-part, to relaxed capital requirements for some banks. As a result, homeowner equity rose to nearly 100% of GDP in the United States in 2006 versus an average range of 50–70% during the second half of the 20th century. Many of us remember all too well how that story ended as housing prices fell to just 40% of GDP in 2009. (Taylor, 2016) The point to take away is that all three of these asset bubbles shared some characteristics such as greed, speculation, and deviation from fundamentals, yet other characteristics were completely different. To start, the assets were different. We can probably all agree that is it unlikely we will ever experience a tulip bulb bubble again. And not only did the size of these bubbles differ, but so did their durations, ranging dramatically from just a few months to several years. History may not produce exact replicas, but there are some patterns we can learn from. Human behavior remains fairly constant over time, with people rushing to jump on the bandwagon of the latest profit making machine and driving asset prices higher, to the panic that eventually ensues when the bubble bursts, causing a sharp retreat to reality.
Myth #4: October is a Bad Month for Investing
This myth is likely rooted in history and has carried forward decades later. As many may recall, on October 19th, 1987, investors experienced one of the most devastating stock market crashes in history. The U.S. equity market declined 22% in just one day. It is perhaps for this reason that October is deemed by many to be a poor month for investing. To test this hypothesis, we analyzed historical returns from the S&P 500 Index for the month of October from 1980 to 2019, a 40-year period. What we found was that the average return in October over that period was 1.14%, including the devastating October of 1987. Perhaps a more compelling statistic to consider is that 65% of the time over those 40 years, returns during the month of October were positive. Not a circumstance to shy away from, especially considering the strong seasonal trends of the last months of the year. As Sir John Templeton famously said, “the best time to invest is when you have the money”, starkly simple advice from an investment legend.
Myth #5: Good Companies Have Good Stocks
Many people believe that if a company has a great product or service and strong brand recognition that their stock, by definition, carries with it, similar value. This thinking contradicts the value analysis we all conduct in our every-day lives. Imagine visiting your favourite restaurant to enjoy a meal only to discover that all the prices on the menu have tripled. Same great food, BUT WOW, do you want to break the bank? This represents the type of valuation analysis that we conduct many times every day, whether it is at the restaurant, or in a clothing store, or buying a car. We’re relatively comfortable doing this analysis because we have, through life lessons, grown comfortable in our analysis of the commodity we’re purchasing, and as such can assign what we consider to be a fair price. But we also know the saying, “one person’s trash is another person’s treasure”, and that is what makes a market. Same in the stock market. For every buyer there is a seller, and a difference of opinion. Investors often run into difficulty because they don’t have the knowledge, experience or confidence to analyze the commodity that is being priced, in this case the company. Investment firms specialize in that analysis, so they are just as comfortable assigning relative value to a company as they are buying a jacket or a pair of shoes. Investors, whether through their own efforts or by retaining an investment advisor, must do their due diligence through fundamental, quantitative, and technical analysis. Without that your risk of loss rises dramatically.
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