We've heard questions from many clients about why the market is doing so well right now given how bad the economy is, and whether we will see the lows of March 2020 retested.

They're good questions, but there might not be clear-cut answers for those who want certainty. We'll discuss three points embedded in investors' questions.

Key takeaways

  • Markets are unpredictable, especially in the short term. This means we should be prepared to see many different outcomes, including what we've seen in recent months.
  • Markets predict the economy, not the other way around. Don't expect the economy to improve because the stock market has risen.
  • What is a market? An index's performance can hide the idiosyncrasies of underlying sectors and types of stocks.
  • In our view, stocks that have fallen more or recovered less often have greater potential for future gains.

Point 1: Markets are unpredictable in the short-term

This point is perhaps obvious, yet there seems to be no end to the appetite for predictions from investment managers. It's not just investing—anyone who watches sports on television fully knows that a) the unpredictable seems to happen a lot, b) humans' ability to predict any short-term outcome is very limited, and c) we still love to hear and make predictions.

In the short term, one should be prepared for a wide range of outcomes in markets. Yet, we are often surprised at what markets do. Being surprised implies a level of confidence in our expectation that is probably misplaced. So, not only are markets unpredictable in the short term, we are also overconfident in our or others' ability to predict.

With investments, we try to keep a humble confidence about the long-term path of markets. History has shown time and again that market declines are eventually repaired by rebounds and that the general direction of stocks in aggregate is up, as long as their underlying companies are profitable, and managements continue to allocate capital so that its growth compounds. The path, however, is far from smooth and even.

We do find that market prices will depart from market fundamentals, or the aggregate cash flows produced by companies. When a price is below what we think a stock is worth, all else equal, we'll typically find that to be an attractive investment. This doesn't require accurate short-term predictions.

Point 2: Markets predict the economy

Bill Miller, the famous value investor who was chairman of Legg Mason Capital Management and later founded Miller Value Partners, observed that markets predict the economy rather than the economy predicting markets. Economic data is historical—it's backward-looking—while markets are forward-looking. This explains why markets typically rebound before a recession is over, but it certainly doesn't mean markets are always right.

Is it true today? Have markets correctly seen that the economic impact from the coronavirus will be less than thought in March? We just don't know.

We do believe, however, that buying assets when they're attractively priced is usually well-rewarded. Also, doing so removes the need to be right about predictions. Even if markets test new lows, we think they'll eventually recover and assets bought at attractive prices will do well—regardless of whether they were bought at the most attractive price or not.

Point 3: A market is more than an index

The idea of "the market" is a tricky one, and what we say about a market can depend on how it's defined. So, it's important to understand what's within an index before you talk about it—or invest in it.

Exhibit 1 illustrates how the headline performance number for an index that's meant to represent US stocks, like the S&P 500, doesn't tell the full story about the investable universe. Small-cap value stocks have lagged large-cap growth stocks by a wide margin year to date, and the S&P 500 has well outpaced international stocks, represented by the Morningstar Global Markets ex-US Index.

YTD returns have diverged for US large growth, small value

Also, the S&P 500 itself is an agglomeration of other markets, one that changes over time. The composition of the S&P 500 has become increasingly dominated by stocks that are doing well in the current environment because they benefit from work-from-home consumers or are Internet-related, have strong balance sheets, benefit from globally diversified revenues, or their businesses are defensive by nature (meaning demand for their products is less dependent on the strength of the economy).

Most other stocks are down, some by a lot. So, while it feels like some parts of the market are doing too well currently, other parts are pricing in some negative outcomes for energy companies and banks and outright disaster for airlines, hotels, and cruise lines.

The flaw of averages

This is another example of "the flaw of averages." When you add market-cap-weighting—or the fact that larger companies make up more of the total worth of a market—it's the flaw of averages on steroids.

The flaw of averages is illustrated by the man who sticks his feet in the freezer and his head in the oven so he can feel comfortable, on average. To give you a sense of the "the oven" in the US stock market, Exhibit 2 shows the weighting in the S&P 500 of five big tech stocks: Facebook (FB), Amazon.com (AMZN), Microsoft (MSFT), Apple (AAPL), and Alphabet (GOOG). We think all these firms benefit from the positives being rewarded by today's markets mentioned earlier—internet-based and global businesses that are benefiting from the work-from-home environment, and they all have strong balance sheets. Even though they're technology stocks, not defensives, investors aren't treating them as cyclical stocks.

Tech giants' share of S&P 500 is approaching 20 per cent

What does this mean for portfolios?

While we will never have a satisfactory answer to the question of what is driving the market, we do think one can respond to the prices and opportunities presented.

The market is facing a wide range of possible economic outcomes with more uncertainty than usual. In the wisdom-of-the-crowd model, accuracy is driven by the diversity and accuracy of individuals' guesses. We don't see anything to suggest a greater diversity among guessers, and most investors would say their guesses have a wider range than normal, so the average accuracy may be much lower than normal.

This means the market's accuracy may be hindered, and the crowd's wisdom may have lost a few IQ points. We think it also could mean opportunity for investors willing to be different from the crowd.

For those businesses whose stock prices are higher than they were at the end of January 2020, one has to wonder whether this environment should call for higher valuations. Mark us as sceptical, but there are still select opportunities.

We find those opportunities through our valuation-driven investment approach. Our valuation research leads to calculations of the returns we think an asset class will experience over each of the next 10 years, averaged and adjusted for inflation.

As shown in Exhibit 3, US small-cap value stocks are poised for much higher returns—according to our valuation-based, forward-looking return estimates—than US large-cap growth stocks.

Our estimates show far better expected returns from small value than large growth

We chose to show these valuation-implied return forecasts for US small value versus US large growth to stick with the theme above. We're also seeing similar gaps between US and international stocks and among sectors, with the energy and financials sectors being priced for the best returns, according to our calculations.

In our opinion, market-timing is not possible, however, we think the returns for value, international, and energy stocks in US dollars at current prices look attractive for a long-term US investor. 

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