When a Crystal Ball is No Advantage
What is smart investing?
One of the favorite tropes of time travel stories—movies, novels, or TV shows—is the prescient investor. This is a character who becomes fabulously wealthy by traveling to the past and buying high performing stocks before they take off.
It’s a handy way to create a character with limitless resources, but it also fulfills the fantasy of every speculator: picking exactly the right stock again and again.
Knowing what was going to happen in the future, a character could achieve the same result by buying winning lottery tickets, investing in real estate, or betting on sports. But there’s something especially gratifying about beating the market.
But what if your market foreknowledge was only quarterly? Surely you could still profit handsomely.
Writing for Marketwatch, Mark Hubert explores this scenario. He asks, hypothetically, “If you knew the S&P 500’s quarterly earnings per share three months ahead of time, could you beat the market?”
For example, in early April you would be given the index’s average earnings per share (EPS) for the upcoming quarter ending June 30th.
Of course, this kind of knowledge wouldn’t allow you to pick individual stocks. But maybe it would give you adequate warning of a bear market, allowing you to jump out of stocks ahead of any losses.
Hubert writes, “The reason I conducted this study was to provide a reality check on a recent narrative that is gaining traction: the stock market won’t suffer a major decline as long as the U.S. economy and the S&P 500’s earnings per share are growing.”
Analyzing data for the past 150 years, he found a surprising answer. Since 1871 there have been 36 calendar years (24% of the time) in which the stock market declined even though the economy was growing. And over that same period there were 22 years (15% of the time) where the market declined even though inflation-adjusted earnings per share grew.
In other words, market performance does not always correlate with economic growth or earnings per share. These things do affect stock performance, but a bigger factor is the profit investment ratio (PIR).
To test this further, Hubert ran a hypothetical portfolio that switched between the S&P 500 and 10-Year Treasurys, according to whether the index’s quarter-ahead EPS would be higher or lower than its trailing EPS.
Over the past 150 years this hypothetical portfolio would have beaten a strictly passive portfolio by just 0.1%, an advantage that disappears when you allow for transaction costs.
The market has a complexity that makes it difficult to predict accurately even when you are given some information ahead of time.
Knowing this, the prudent investor will instead follow a plan that doesn’t require lucky guesses about future moves. Smart investing means focusing on the things you can control such as risk tolerance, volatility, and your specific time horizon. If you need guidance, we are here to help. Make an appointment for a free consultation today.