Cracks In The Crystal Ball

The last few years have been anything but predictable. This is tough to stomach for investors; with markets volatile our investment portfolios have been constantly moving up and down.

Yet uncertainty is an inescapable part of investing, one which investors are compensated for accepting. Throughout all of these uncertainties, markets continue to deliver, with the S&P 500 nearly at all-time highs following a poor start to 2022.

During 2020 we reckoned with COVID, lockdowns and economies grinding to a halt. This year also brought negative oil prices for the first time in history.

In 2021 we had the Gamestop fiasco, Crypto crashes, the Suez Canal obstruction and the beginning of the Evergrande property crisis in China.

2022 brought the Ukraine invasion, the assassination of Shinzo Abe, Queen Elizabeth's passing, Liz Truss's record short 44 days in office and the beginning of extensive rate hikes.

The start of 2023 also delivered, with the collapse of Silicon Valley Bank, First Republic Bank and Signature Valley Bank. We continue to wrestle with inflation and the rising interest rates.

And yet markets trudge on. It would have been impossible to predict these events at the beginning of each year. History has shown it is also impossible to predict how they may impact markets. Luckily, with a diversified investment strategy, we don't have to make predictions. We can sit tight and be assured that markets deliver long-term.

Despite this, predictions make great headlines and articles. It is important to see these as entertainment and not investment information. Even the most knowledgeable commentators cannot accurately predict the future.

The article below is by Dimensional's Jim Parker. As the Australian financial year comes to a close, he revisits the predictions made in the media for the previous year. Unsurprisingly, it has proven tough to hit a moving target.


Cracks in the Crystal Ball

By Jim Parker Vice President

A standard media device at the start of a financial year is a “lookahead” on the outlook for the coming 12 months. As a reflection on the anxieties of the day, these articles are usually reasonably accurate. But as a forecast of the future, not so much.

The financial year outlook articles are put together by journalists based on interviews with market economists and analysts, who are asked to provide estimates for economic growth, inflation, interest rates, shares, bonds and currencies in a year’s time.

The resulting stories are usually an interesting read. But there is a fundamental problem with this approach in terms of its reliability: The economists’ forecasts rest on a whole bunch of assumptions that can quickly exceed their use-by date when events change or when at least one of the variables undershoots or overshoots their expectations.

One only has to look at the past three years or so to see examples. Carefully made projections for 2020 were made quickly redundant by Covid. Two years later, Russia’s invasion of Ukraine upended another set of economic and market assumptions. And remember when we were told that the upsurge in inflation was likely to be a transitory phenomenon?1

Making accurate predictions is tough at the best of times, but nailing year-end forecasts for interest rates, shares, currencies and other variables in the face of wars, pandemics and the biggest inflationary breakout in four decades is a nigh-on impossible ask.

Just how hard can be seen by looking back at the forecasts published in the Australian media this time a year ago.

The Conversation academic website each year surveys a panel of academic, market and industry economists for their outlook for a series of economic and market variables for the coming year. In mid-2022, the panel comprised 22 experts.2

The consensus forecast for the Reserve Bank of Australia’s official cash rate was a rise from its then rate of 0.85% to peak at 3.1% by August this year. Well, we’re now in July and the rate is already at 4.1%, with market expectations of one or two further increases by year end.3

For headline inflation, the panel on average expected it to moderate to 4.8% by the end of the 2022/23 financial year. The most recent monthly inflation indicator for May from the Australian Bureau of Statistics had annual inflation at 5.6%.4

On the economic outlook, the panel saw a 40% chance of a recession in the US in the coming two years and a 20% chance of one in Australia, most likely starting in August 2023. While the US economy has slowed, authorities there recently upgraded estimates of GDP growth for the first quarter of this year from 1.3% to 2.0% - still a fair way from recession.5

In Australia for the same period, annual GDP growth was 2.3%, a marked slowdown from 2.7% at the end of 2022, but still well short of recession.6

Unemployment was also seen by the panel as likely to increase over 2022/23 from 3.9% to 4.2%. In actual fact, the jobless rate has fallen in that period to be at 3.6% by May this year.7

On financial variables, the consensus was a slow and modest recovery in the Australian dollar to around 72 US cents. In fact, the currency declined over the financial year from around 69 US cents in mid-2022 to close to 66 cents by June 30 2023.8

On equity markets, the panel expected the Australian share market to fall 2% over the financial year. The reality was the Australian market, as measured by the S&P/ASX 300 index on a total return basis, climbed by more than 14% in 2022/23.

What happened? The economists undershot their expectations for inflation, GDP growth, interest rates and share markets, while overshooting expectations for unemployment and the Australian dollar. In essence, they underestimated the strength of the economy.

To be fair, it’s a tough business, forecasting, even for the experts. So much can go wrong if one variable (like inflation in this case) turns out to be stickier than assumed. But it’s a reminder to the rest of us not to put too much weight in these articles about the year ahead for economies and markets.

It’s also a reminder that basing your investment strategy on these forecasts is unlikely to be a successful or sustainable strategy. Instead, accept that the market already does a pretty good job of incorporating all those opinions and expectations for the future and that as events occur, market prices will change.

No-one can predict the future and there will always be uncertainty. The potentially higher returns on offer from shares and other assets are the trade-off for the uncertainty.

At the end of the day, having an appropriate asset allocation for your own risk appetite and personal goals, staying diversified and remaining disciplined are the best alternative to relying on a cracked crystal ball.

FOOTNOTES

1‘Recent Trends in Inflation’, RBA Governor Philip Lowe, 16 November 2021.
2‘How the Conversation’s Panel Sees the Year Ahead’, The Conversation, 30 June 2022.
3ASX 30-Day Interbank Cash Rate Futures Implied Yield Curve, as of 30 June 2023.
4Monthly Consumer Price Index Indicator, Australian Bureau of Statistics, 28 June 2023.
5‘US Weekly Jobless Claims Post Biggest Drop in 20 Months as Economy Shows Stamina’, Reuters, 30 June 2023.
6Australian National Accounts, Australian Bureau of Statistics, 7 June 2023.
7Labor Force Australia, Australian Bureau of Statistics, 15 June 2023.
8Historical Exchange Rate Data, Reserve Bank of Australia.

The Stock Market Vs. Stocks In The Market

We've certainly had a bumpy start to the year. While the S&P 500 has made great gains following 2022, markets have been volatile. But this volatility is par for the course when investing in shares and patience has rewarded long-term investors.

With a number of bank collapses, starting with Silicon Valley Bank and now First Republic Bank, it is natural to be concerned about markets. However, we must separate the stock market from stocks in the market. Below is a short article from Dimensional founder David Booth discussing how diversification avoids the risk of individual shares.

Before the article, I have included a link to Dimensional's Fund Landscape report. Similar to Standard & Poor's Index Vs Active (SPIVA), this compares the performance of active managers to the market index. The 2023 report brings no suprises, with the majority of active managers failing to beat their benchmarks over 10, 15 and 20 year periods.


Fund Landscape - How Mutual Funds Have Performed Against Their Benchmarks

You will probably by now be familiar with SPIVA, Standard and Poor's regular study regarding how active managers fare against their benchmarks. The Fund Landscape is Dimensional's own take on this topic.

The document linked above clearly shows three important truths about investment management:

  1. Less than half of actively managed funds survive for 20 years and even fewer outperform over this time.

  2. There is no evidence to suggest funds doing well now will continue to do well, making consistently picking winners impossible.

  3. High costs and fees are directly related to poorer performance.

Dimensional has addressed these points clearly with supporting data and charts. The evidence displayed here is key to our passive-leaning investment philosophy.


The Stock Market vs. Stocks in the Market

By David Booth, Dimensional Chairman and Founder

The collapse of First Republic Bank is a harsh reminder that any stock can go to zero, no matter how established a company is, or how loyal and wealthy its customers are. The failure of what many considered to be a rock-solid regional bank should serve as powerful evidence of the importance of diversification, what I consider to be one of the first principles of investing. 

If your wealth is highly concentrated in any one individual stock, take this opportunity to learn an important lesson: While many people think they know more than other investors, none of us knows more than the market.

Many years before he became a Nobel laureate, my friend and mentor Merton Miller used to say, “Diversification is your buddy.” Diversification is the practice of spreading investments across a variety of assets. It’s a time-tested strategy to mitigate risk. Children learn about it early in life with the phrase “Don’t put all your eggs in one basket,” but all too often, grown-up investors forget.

I think it’s safe to assume that the total value of the stock market will not go to zero. But the same cannot be said about any individual stock, no matter how promising the future of a company might seem. Why not? Because we cannot predict the future.

The current price of any stock reflects the value of all its future income streams, but it’s no guarantee. Some companies fail. Can anyone predict which ones? Fortunately, there’s no need to. You can have a positive investment experience without knowing what’s going to happen with any individual stock because of diversification. In investing, diversification is the closest thing any of us can have to a free lunch.

Nearly all investing horror stories start with a simple fact: Someone took too much risk. In the case of First Republic, management took too much risk. But investors don’t have to. Anyone who lost their shirt when FRB stock lost its value had too much invested in it. Everyone who invests in the stock market should prioritize diversification in their portfolio. And it’s never been easier to do so, because with mutual funds and ETFs—many of which allow you to invest in a broad range of stocks by buying just one security—you can achieve a high level of diversification with the same number of clicks as buying a single stock. 

In my opinion, when you concentrate your wealth in single stocks, you’re gambling, not investing. And that’s fine, as long as you don’t mind losing what you bet. First Republic has been included as part of the S&P 500 index since 2018. On the day JP Morgan Chase announced that it was taking over the troubled bank, how did First Republic’s dissolution impact the S&P 500?1 When the market closed, the index was down 0.039%2. 

Now do you see why diversification is your buddy?

FOOTNOTES

1“First Republic Bank Is Seized, Sold to JPMorgan in Second-Largest U.S. Bank Failure,” Wall Street Journal, May 1, 2023.
2S&P data © 2023 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Decrease of 0.039% was on May 1, 2023.

Value Vs Growth

To help our clients squeeze the most they can from their investments, we use a long-term, evidence-based strategy. The core of this strategy emerged from Eugene Fama's empirical analysis of stock returns, for which he won the nobel prize in 2013.

Fama showed that nearly all of a portfolios returns are explained by three factors - market risk (the return you get from putting your money in shares vs the bank), company size and value.

Let's look at value. This is a measure of "relative price", or how expensive a company is compared to it's peers. We can measure this by comparing how much the company is worth on the share market (how much would it cost to buy all of it's shares?) vs how much it's assets are worth. What we get is a price-to-book (PB) ratio, essentially the companies market value divided by it's paper value.

Looking at the S&P 500, companies typically have PB ratios between 2-5. However, we do see extreme outliers on either side. At the end of 2021, Tesla had a PB ratio of 35(!) before the price fell significantly in the following year. On the other hand, during 2020, airlines and energy companies saw PB ratios below 1.

These companies with high PB ratios are considered growth companies, as the justification for their high prices is the expectation of high future earnings. Those with lower ratios are considered value companies, as their lower prices are indicative of a riskier investment.

The higher risk of value companies means higher expected returns for investors. When properly diversified, portfolios with a higher exposure to these companies deliver better returns.

With this being said, growth companies soared during the lead up and start of the COVID pandemic. Tech companies, which had already performed well before lockdowns, experienced continued growth. Many commentators during this time spoke of the death of value.

The previous two years saw value companies rebound. More importantly, history shows us value's long track record of successes. Below is a chart showing 45 years of annual Australian stock returns comparing value and growth.


Historically, value stocks have outperformed growth stocks in Australia, and the outperformance in a given year has often been striking.

  • Data covering nearly half a century backs up the notion that value stocks—those with lower relative prices—have higher expected returns.

  • Value premiums have often shown up quickly and in large magnitudes. For example, while the average annual value premium since 1977 has been 5.8%, in years when value outperformed growth, the average premium was over 17%.

  • There is no evidence investors can reliably predict when value premiums will show up. Rather, a consistent focus on value stocks is essential to capturing these outsize value premiums when they do appear.

Logic and history support a commitment to value stocks so investors can be positioned to take part when those shares outperform in the future.


A focus on long-term drivers of returns is essential to our investing strategy. There may be short periods where value lags growth, small companies lag large companies, or even when shares underperform cash in the bank.

The research supporting these factors is incredibly thorough and robust. Long-term, this strategy is proven to deliver better returns for investors.