- In the short term, the market is heavily influenced by new information and noise.
- In the long term, there are clear trends that can give you an edge to beat the market.
- We’ll discuss a few trends that are clear but that will take time to develop.
Some argue that the market is efficient and prices always reflect available information. The Efficient Market Hypothesis (EMH) was developed by Chicago School of Economics Professor Eugene Fama who was also awarded a Nobel prize for his findings in 2013. Implications of the EMH are that it is impossible to beat the market consistently on a risk-adjusted basis since market prices only react to new information or changes in discount rates.
As markets—and especially stocks—are very volatile, the EMH was met with a lot of criticism when the first major bubble after its publication burst, the dotcom bubble, with many papers finding that fundamentals have an impact on investment returns and risk. One of the most influential opponents of the EMH is another Nobel prize winner and Yale professor Robert Shiller, who, among other reasons for opposing the hypothesis, simply states that fundamentals have a significant influence on the market.
A look at PE ratios shows how long term investment returns are much lower after period of high market PE ratios than when valuations are low. In the past when PE ratios were at the levels they are now, stocks didn’t deliver positive 20-year returns. Perhaps if the S&P 500 stays at these levels we will have the first positive returns as PE ratios were much higher toward the end of the 1990s, but we’ll have to wait a few years to see about that.
Figure 1: 10 Year PE ratios vs 20-year real return. Source: Sitka Pacific Capital Management.
Fama replied to behavioral researchers like Shiller in 2010 with his article titled Luck Versus Skill where he proved that aggregate returns on actively managed funds are close to the market portfolio and therefore it isn’t possible to beat the market. This is logical as the aggregate of actively managed funds is actually the market. Therefore, the main conclusion is to be better than the average.
On one side you have people that look at historical valuations and returns to estimate future returns, and on the other side people that say the current market values are fair because interest rates are low and information is positive. I would say they are both right, and then focus on how to be better than average in order to have the best possible returns for the minimum amount of risk and perhaps even beat the market in the long run.
Let us first take a look at what’s going on in the market at the moment and how information affects asset prices in the short term.
Winners Become Losers
This year is a very interesting year. We started the year with a market bottom in January based on fear of a Chinese slowdown. The slowdown never happened and stocks climbed to new historical highs. The interesting thing is that sector returns in the same period vary enormously.
The best performing stock of the S&P 500 up until August was Newmont Mining (NYSE: NEM). But since August it has been one of the worst performing stocks in the market.
Figure 1: Newmont mining year to date. Source: Nasdaq.
We have to look at fundamentals and new information in order to see if the stock is under the influence of the EMH or irrational forces. As NEM is a gold miner, gold prices will probably explain much of the change. Gold prices bottomed in December 2015 and peaked in August 2016 and NEM’s price moved accordingly.
Figure 2: Gold prices. Source: Bloomberg.
From a fundamental perspective, NEM didn’t do much as it has only slightly improved its fundamental factors in the last two years.
Figure 3: NEM’s fundamentals. Source: Morningstar.
So it all boils down to the questions: are gold prices rational or irrational and do short term fluctuations matter more than long term trends?
Similarly to the gold prices issue, a look at dividend yielders will lead us to question the rationality of current dividends as those companies had a similar performance as gold.
The S&P 500 telecom sector was up 22% in the first half of 2016 and is down 10% since then, utilities were up 21% and are now down 10%, REITs were up 9% and are now down 8% since the end of June. As asset prices move according to information about yields and potential revenues, the question leans toward forecasting yields and future revenues.
Forecasting Yields & Revenues
In order to beat the market we have to estimate future revenues and invest accordingly. Can we estimate future revenues that are under the influence of gold prices, interest rates, new technologies and millions of other factors better than the market does? In the short term, definitely not, and if there are those among us who can do that, you can count them on one hand.
But, in the long term, and this is why investing is often compared to watching paint dry, by doing lots of research, being prepared and increasing our knowledge, we can create small advantages that will result in big portfolio gains in the long term.
One example is yesterday’s article on India. With certain short term ups and downs, there is a very high probability that India will continue on its growth path for the next few decades and reach a population of 1.7 billion in the next 50 years.
Another example comes from the recent decision of the German Parliament to push for a ban of gasoline and diesel powered engine registrations from 2030 onward. This will be detrimental for oil in the long term and therefore you can use this information to protect your portfolio. As the market is thinking mostly in the short term it will take some time for this to sink in, but as more similar decisions will be made, related assets will decline. So don’t wait too long.
Similar facts and decisions give us an indication of future trends. The point isn’t that you immediately jump into or out of such investments with everything you’ve got, but as there are plenty of years for the trends to develop, you can seize the opportunities that will arise from other future certainties like a U.S. recession. By preparing yourself to invest more in a recession, you can grasp the benefits shown in figure 1 where low market PE ratios beat high market PE ratios.
The greatest investor of all time, Warren Buffett, makes it all look so easy. The point is that it is easy if you call discipline, self-control, proper risk assessment, sticking to what you know, being greedy when others are fearful and fearful when others are greedy, easy.