The stock market ended 2015 with a whimper and began the new year with a shudder. Even before Wall Street showed up for business Monday morning, stocks fell 7 per cent in China, and the turmoil that started in Asian markets cascaded around the world.
The stock market in the United States fell 1.5 per cent that day, based on the Standard & Poor's 500 index. In the face of troubles in the Chinese markets and a flare-up of geopolitical worries, including news of a North Korean nuclear test and heightened tensions in the Persian Gulf, the American stock market was shaky for much of the week, ending down.
That unsettling start could have a salutary effect. It provides yet another reminder that investing in stocks is inherently risky: Unless you are prepared to accept losses, you should not be in the market.
In interpreting the week's news, it's also worth remembering that a few days or even a month of stock returns will not tell us much about where the market will be a year or more from now. In fact, although everyone would like to know where the current gyrations will take us, the unpleasant truth is that there is simply no reliable way of foretelling the short-term path of the market.
You might not know that from the forecasts of major Wall Street investment houses. The start of a new year is the season for prognostication, and many analysts have issued very specific predictions. The consensus on Wall Street is that the S&P 500 will rise 7 percent for all of 2016.
Not everyone has come up with a year-end target for the index, however. Among the reports on the future path of the market, one was perhaps the most useful and certainly honest. Bespoke Investment Group published it. Its three authors, Paul Hickey, Justin Walters and George Pearkes, began their 2016 forecast with this disarming statement: "We have no idea."
This candid disclosure ensured that the authors will not have to eat their words. They acknowledged that their lack of specificity might be unsettling: "That's probably the last thing you wanted to hear from us regarding our views towards the next year in the stock market. In all honesty, though, to try and look out one year from now and tell people what the market will or will not do is a fool's errand."
Yet they had plenty of interesting and skeptical things to say in the 161-page report. They explained why it is possible that the market will soar and finish 2016 with a double-digit gain and why it is also quite possible that the long bull market is coming to an end this year. There is no certainty about either outcome, of course.
What is likely, if not absolutely certain, is that the Wall Street consensus will be wrong.
The Bespoke report reviewed the recent history of Wall Street predictions and found them wanting. Since 2000, it found, the consensus has called for an average yearly increase in the S&P 500 of about 9.5 percent. The actual average annual change was less than 4 percent, however, and consensus predictions were inaccurate in every single year, sometimes by preposterous margins. In 2001, for example, the consensus called for a gain of 20.7 percent. But the index fell by 13 percent. In the horrible year of 2008, the consensus was that the market would rise 11.1 percent. As many investors may recall, it fell by 38.5 percent. Not once since 2000 has Wall Street predicted that the market would decline in a calendar year. Yet the market actually fell in five of those years.
This doesn't mean market analysis is useless. There is evidence, for example, that factors like stock valuations affect overall market returns over periods of five years or more, and that the level of prevailing interest rates influences returns over shorter periods. At the moment, those two factors point in different directions, however.
After years of gains, overall valuations are stretched, by most measures, which may augur poorly for future returns. The price-to-earnings ratio of the S&P 500, for example, ended the year above 18, compared with an average since 1926 of a little over 15. That implies that investors are paying more for stocks than they have in the past. Higher prices often lead to price declines, but there is no assurance that this will happen on a known timetable, or that it will happen at all.
On the positive side, interest rates, both the short-term ones set by the Federal Reserve and the longer-term rates established in the bond market, are extremely low by historical measures. That's the case even though the Fed has begun raising short-term rates. At the moment, for example, the yield on 10-year Treasury notes stands below 2.2 per cent, compared with an average of more than 6 per cent since 1962. With the rates on relatively riskless investments in Treasury notes remaining so low, the stock market may seem attractive as long as the economy grows and companies generate profits, in other words, unless the economy falls into a recession.
On that score, the bond market may offer helpful clues. No recession since 1962 has occurred without an advance signal from the bond market known as an "inverted yield curve." This simply means that short-term rates become higher than longer-term rates, reversing the typical order of things. When that reversal happens, the Bespoke report said, it "represents a belief by the market that current inflation and real interest rates are too high, and that activity will eventually contract, reducing inflation and forcing the Federal Reserve to lower interest rates."
The yield curve right now is rising sharply, indicating that the bond market does not see a recession on the horizon. While the market has often predicted recessions that have never occurred, no recession has occurred without such a prediction. In short, this is a portent of stability. But like other indicators, it is not infallible.
That is worth remembering, too. If there were a single reliable indicator of the market's direction, smart managers would use it and profit handsomely. But systems and methods aimed at ensuring investment outperformance rarely prevail for very long.
The latest evidence of this is to be found in forthcoming data from S&P Dow Jones Indices on the persistence of mutual fund returns. I've written extensively about earlier findings, because the S&P Dow Jones team has conducted this study twice a year since 2002. Aye M. Soe, senior director of index research and design for S&P Dow Jones Indices, shared the new data with me.
It tracked domestic mutual funds through September 2015, and there were no surprises. As in the past, the numbers showed that active mutual funds that performed well in one year were rarely able to sustain that performance in subsequent years. In fact, the statistics indicated that they performed no better as a group than you would have expected if their managers had merely flipped coins. The data suggested, once again, that most people would fail if they tried to predict the direction of the overall market or of particular stocks and bonds.
"I feel the game is rigged against the average investor," Soe said.
People often pay high fees for investment management that produces scant measurable benefit. It's usually wiser, for longer-term investments, to hold them in broadly diversified, low-cost holdings, probably in index funds.
As for where the market is heading this year, you might as well flip a coin.