Future Stock Returns

As Mark Twain once said,  "Prediction is difficult - especially about the future." And while investors would wish otherwise, predictions about the stock market are especially difficult. Many investors will use historical returns as an estimate of future returns. However, the job of an analyst is to make stock market predictions based off additional evidence. Recently, Vanguard, one of the largest mutual fund companies in the world, released its 10-year annualized forecast for financial markets. Vanguard is estimating only a 4.7% to 6.7% annual return for large-cap U.S. stocks and a 5.0% to 7.0% annual return for small cap stocks. So will the stock market achieve its historical average return over the next 10 years, or is Vanguard correct? Check back with us in 2033!

Rockin' In The Free Markets

Investors have been looking for alternative investments and will be able to invest in a guitar from an alternative metal band. Gibson is using Rally to sell ownership of collectible guitars. The company recently sold 13,000 pieces of a guitar owned by Guns N' Roses guitarist Slash for $5 each. Of course, the company did not cut up the guitar, but sold a fractional share. Other guitars by Tony Iommi of Black Sabbath and Adam Jones of Tool are scheduled for sale. Of course, as with any collectible market, it appears that guitars that are not especially rare are having prices plucked up with the prices of rare guitars. The real question is will investors fret over the investment in the future or will it turn into real Money?

Identifying A Ponzi Scheme

If you are not familiar with a Ponzi scheme, it is generally a fraud in which early investors are paid out from contributions made by later investors. The Ponzi scheme usually ends when new investments dry up. A recent article on CFO.com highlights how to avoid a Ponzi scheme. We would like to make sure you read one particular concept, that is, "high returns with little or no risk." As we discuss extensively in the textbook, the only way to a higher return is with increased risk. Although we would all like higher returns with little or no risk, centuries of investment history show that such an investment is not possible. If it were, investors would flock to that investment, driving the return down. 

The Market Beats Robots!

A recent article highlights a retirement issue, "lost" 401k accounts. It is estimated that 24 million accounts containing $1.35 trillion in assets have been left in 401k accounts when someone leaves an employer. And while these can be claimed easily, we want to make sure that you don't forget about a retirement account. You can often leave a 401k account with an old employer if you like the options and costs available, but you can also roll over the account tax-free into an IRA. We did want to point out one sentence in the article:

Those robo accounts have returned almost 9% annually over the past three years, while popular S&P 500 ETFs have seen annualized returns of nearly 14% over the past 10 years.

Over the past three years, it is even worse for robo advisors as the S&P 500 has returned about 18 percent over that period. One important caveat is that robo advisors likely have a more diversified portfolio, including bonds and money market accounts. This would reduce the risk of robo advisor accounts, but, as you see, can also reduce the return.

 

I Bonds

While most people are familiar with EE savings bonds, fewer are familiar with I bonds. A recent article in the Wall Street Journal highlights I bonds and the advantages of these bonds. One major advantage is that I bonds are yielding an currently very high interest rate of 3.54 percent. This is impressive when you consider the bonds are virtually risk-free. By way of comparison, 30-year Treasury bonds are yielding about 2.25 percent. I bond yields are based on the inflation rate and can change every six months. You cannot redeem I bonds for 12 months, and if you redeem within five years, you pay a penalty of the last three months of interest. You can buy electronic I bonds at www.treasurydirect.gov in any amount from $25 to $10,000, or paper I bonds in $50, $100, $200, $500, or $1,000 as a tax refund. One way to tell that I bonds are good investments is that the government caps the annual electronic purchase at $10,000 per individual, with another $5,000 possible through the tax refund purchase.

Morningstar Stock Valuation

So how do analysts value a stock? A recent video from Morningstar, one of the most trusted independent sources for stock values, discusses the methodology it uses. If you watch the video, you will hear a lot of methodology similar to what we discussed in the textbook, especially discounted cash flow analysis. Similar to what we discussed, the value of the stock increases by the capital gains yield and will change as new information is received. Notice an important point: Morningstar only recommends a stock if it believes that is fair value is significantly above the current market value, which implies Morningstar does not believe the market is semistrong form efficient.

Mutual Funds Underpform...Again

In our discussion of market efficiency, one trait of an efficient market is that it is difficult for investors to outperform the market. The results for mutual funds for 2020 are in and it appears that the market won again. For large-cap equity funds, 57.1 percent underperformed the S&P 500, the 11th straight year less than half of large-cap funds outperformed the S&P 500. Over a 20-year horizon, only 4 percent of large-cap funds outperformed the index, while 10 percent of mid-cap funds and 6 percent of small-cap funds could make that claim. It appears that the market is tough to beat.

Women Outperform Men

Who are better investors, women or men? A recent interview with proprietary trader Kathy Donnelly discusses reasons why the evidence suggests that women tend to outperform men as investors.

A Short Squeeze

A short sale occurs when an investor sells a stock they don’t own to hopefully buy it back later at a reduced price. Recently, Gamestop and AMC have seen a short squeeze. When you short a stock, if the stock price increases, you must make a margin deposit, that is, make an additional deposit of cash into your account, or repurchase the stock and take the loss. In a short squeeze, a group of investors buy the stock, forcing short sellers to make more deposits or take a loss. In the past two weeks, Gamestop has gained about 1,800 percent, which in our opinion, means the stock is in a bubble.

McRib Investing

Although many people love the McRib, an even more important discovery has been made: You can make money investing in the stock market by investing in the McRib! Surely we jest, and we do. A recent article highlights the McRib effect, that is, the stock market as a whole has a higher return when the McRib is avialable. While this is a fact, as the article points out, there is an important distinction between causality and correlation. And while the McRib anomaly may tickle your ribs, it does highlight that many market analysts will tell you why the stock market rose or fell on a particular day. Most, if not all, are inferring causality when only correlation is present. 

COVID-19 Stock Trading

In a positive announcement in the fight against COVID-19, on Monday, Pfizer announced a vaccine that is more than 90 percent effective. That day, Pfizer's stock rose about 10 percent. But a strange thing happened: Albert Bourla, the CEO of Pfizer, sold $5.6 million of the company's stock. The stock sale was part of a 10b5-1 plan. A 10b5-1 plan allows company executives to prearrange stock sales with a broker to avoid the appearance of insider trading. In Bourla's case, the 10b5-1 plan was put in place on August 19. However, some have scrutinized Bourla's plan as on August 20th, the company had a press release announcing new Phase 1 testing date. 

An Interview With Eugene Fama

Recently, an interview with Nobel laureate Eugene Fama, who laid the foundation for the efficient markets hypothesis, was published by The Market/NZZ. The wide-ranging interview covers topics from the problems with growing government debt, stock market bubbles, the efficient markets hypothesis versus behavioral investing, the reason for negative oil prices, and negative interest rates. Professor Fama also discusses his belief that the power of central banks is much more limited than many believe. The interview is definitely worth a read.

Universities And Pensions Underperform

We recently discussed the underperformance of Harvard's endowment fund, but it appears that Harvard is not alone. A recent article shows that the endowment funds of major universities have underperformed the market by abut 1.6 percent per year. What is so interesting about that 1.6 percent? That is the average management fee paid by the endowment funds! In other words, the overall investment performance is the same as the market, but once fees are accounted for, performance lags the market. Of course, public pension funds have performed slightly better, only underperforming the market by about 1 percent.

Market Trounces Harvard

So how hard is it to beat the market? From 1993 to 2008, the portfolio managers of Harvard’s endowment fund beat the S&P 500 by almost five percent per year. A major contributor to that performance was a hugely successful investment in timber. Since then, things have not been so rosy (or even Crimson). Using the analysis in the article, the Harvard endowment fund has underperformed a blended portfolio of stocks and bonds by one percent per year over the past 20 years. Based on the current endowment value of $42 billion, this means the endowment potentially lost out on $420 million in growth per year, or roughly $8.4 billion dollars of growth over this period. It is tough for the best and brightest to beat the market.

Day Trading For Profit?

In our opinion, a negative financial outcome of the COVID-19 pandemic is the rise of day trading. Dave Portnoy, the CEO of Barstool Sports, has named himself "Davey Day Trader" and helped popularize day trading. And although not all are day trading accounts, Robinhood added 3 million accounts during the first quarter of 2020. One new investor, a 20-year old from Nebraska, tragically committed suicide after his account balance showed a loss of over $700,000. In fact, his account balance may have only been temporary until trades settled. It is important to note that short-term investors tend to do worse than longer term investors, and for day traders, the success rate is less than 10 percent, with only 1 percent or so who really make money. We do believe that investing is worthwhile, but do your research, diversify, and make longer term decisions.

Smart Money Versus Dumb Money

The growth of passive investing, that is, investing in index funds, has arisen in large part due to the growing popularity of the efficient market hypothesis. In short, it seems that outperforming the stock market is a difficult, if not impossible, task. As a result, retail investors, sometimes referred to as dumb money, have flocked to index funds. A common belief on Wall Street is that in a severe market downturn, retail investors would flee the market. The 30 percent drop in the market over the past month has been a severe downturn. But, when fund flows, which is the amount of money put into or pulled out of an investment, is examined, the two S&P 500 Index ETFs favored by individuals showed net buying, while the ETF preferred by professionals showed net selling. In other words, the professionals ran and mom and pop actually bought more. With the market up about 5 percent for today, maybe dumb money does know a little more than previously believed.

A Digitized Athlete

Brooklyn Nets sixth man Spencer Dinwiddie signed a contract for $34 million over three years. Now, Dinwiddie hopes to digitize his contract into a digital token. The plan is to pay back investors principal plus interest from his future salary. For investors, an advantage is that the tokens will have little correlation with other financial assets. There are numerous examples of securitizing cash flow from future earnings, from Bowie bonds, physicians who sell part of the future revenue in their practice, to fledgling golfers, who get money from backers in exchange for future winnings. However, these assets are not without risk. In November 2015, Fantex pulled an IPO that planned to sell future earnings for running back Arian Foster. Foster retired from the NFL less than a year later after several injuries.

An ICO Bubble?

A couple of years ago, coins or tokens, were the new frontier of investing. Now, it appears that the fantastic returns offered in this investment were often only temporary, as are most fantastic returns. A recent Twitter post post notes that the median ICO return in U.S. dollars is negative 87 percent and continues to go lower. Although several ICOs have outperformed bitcoin, most have not. Of course, many of these ICOs were likely destined to be poor performers and sold by being hyped to uninformed investors. 

A Flight To Cash

We have discussed risk and return in the textbook, so by now you should have a grasp on the concept of financial risk. A recent article notes that ultra-wealthy individuals have been moving assets into cash or cash alternatives. In the first quarter of 2019, high-net worth individuals held nearly 28 percent of investable assets in cash. And while cash itself is desirable for liquidity and diversification, this number appears high. There is one sentence in particular we would like to point out:

“Yet perception of risk is an emotional thing.”

We can measure an asset’s total risk by standard deviation, or an asset’s market risk by beta. However we measure risk, it is unemotional. But there can be behavioral factors, such as the fear of risk, that can affect an individual’s decisions.  

As a final point, the article discusses a family that moved money into gold bars and buried them and implies this is moving assets into cash. While gold is a physical asset and often performs well in a bad economy, the volatility of gold prices can often be quite high.

Stocks In The Really Long Run

While we discuss stock returns for a fairly long historical period in the textbook, what about the really long run? Global Financial Data has constructed a World Index that extends back to 1601! When evaluated over four distinct economic regimes, total stock returns have varied from 5.05 percent to 9.98 percent and dividends yields have varied widely as well. The equity risk premium has also varied significantly, from .87 percent to 3.02 percent. Over the past 318 years, the equity risk premium has averaged 1.46 percent. Of course, we should caution that this is not a definitive risk premium going forward. For anyone interested in stock market history, we would recommend a look.