US stocks got off to a choppy start in 2015. The S&P 500 ended January down 3% and some took it as an omen for the year ahead. But the market bounced back 6% in February and is now up 2.88% for the year. So much for the “January Barometer?”
Whether you use them or not, the reality is that many of the common heuristics for predicting market movements just don’t work — not reliably anyway. Typically, these mental shortcuts are market artifacts that stem from select instances when, once upon a time, they appeared to have predictive powers.
However, observed from a proper perspective, that is objectively and over adequate time periods, they tend to fall apart as random events without statistical significance. This is true even for some of the most popular rules of thumb.
Take the widely-followed “Fed Model” for example — namesaked after the Federal Reserve which often refers to the model as a tool for relative valuation between stocks and bonds. The basic thinking is when the earnings yield on stocks is higher than the yield on bonds, then stocks are relatively more attractive, and stocks should perform better (and vice-versa).
There were stints in time, in the 1990’s for example, when this seemed to be accurate. However, over longer periods, there’s actually little to no significant correlation between relative earnings yields and future market performance. Why then are investment managers, Fed Chairmen/women, and amateur investors alike so drawn to the implications of this predictably flawed model?
Well, that has less to do with financial models and more to do with human psychology. The burgeoning field of Behavioral Finance has long recognized that people are prone to making sub-optimal (even irrational) financial decisions due to innate mental biases.
In the case of relying on flawed models, people in general, prefer some kind of explanation over none. It can be quite stressful for an owner of financial assets to accept that financial markets are random and sporadic. So it’s just convenient to believe that there is some method (however flawed) and not just madness ruling over outcomes.
Fortunately, for those who value simple rules for their own financial well-being, there actually is an effective one. And guess what? It has nothing to do with bond yields or financial models. It really boils down to focusing on what you can control to improve results — regardless of what else does or doesn’t happen.
For example, you can’t control what the markets will do (no matter how sophisticated your modeling gets). However, you can absolutely control how much you defer to your 401(k). You can absolutely control your exposure to market risk. You can absolutely control whether to liquidate your investments at a market bottom (assuming you don’t need the funds).
The point is this. We all get inundated with financial information telling us what we should be doing with our investments on any given day. And while it may be tempting to follow fancy models and indicators, most of us are better off just filtering out the noise, and focusing on correctly carrying out the limited number of things we can actually control.
Will February’s market performance set the tone for the year ahead — becoming a new February Barometer? Honestly, I don’t know, I don’t care, and most likely neither should you.
Victor K. Lai, CFA
This blog is for informational purposes only. Nothing on this blog represents advice. Investing is inherently risky and involves the potential for loss. Victor Lai does not own any of the securities referenced in this posting. Clients of Bellwether Capital Management LLC may own shares of the securities referenced in this posting.