Ignoring the Siren Call of Market Forecasts

21 March 2016 | by Sean Stannard-Stockton, CFA

With the S&P 500’s year to date return turning positive with last week’s rally, it is important for investors not to forget the fear that gripped the market back in January. Remember the newspaper headlines exclaiming that the first week of 2016 represented the worst first week of the year since 1928? The implication at the time was that the rapidly declining market was a sign that further declines were on their way.

Back on January 11, we took on this false narrative and pointed out that other years that had started out with sharp declines had subsequently produced both positive and negative returns over the rest of the year and that the observations about the first week’s decline were “trivia masquerading as insight”. Note, however, that we did not predict that the market would bounce back. The fact is that we had no idea what the market would do next, nor do we have any insight today as to how the rest of the year will play out. While it would great to have this sort of foresight, short-term market movements are not predictable, nor is this foresight needed to produce strong investment returns over the long-term.

Coming to terms with the unpredictability of short-term market movements is one of the hardest and most important milestones in the development of becoming an investor. It is extremely frustrating that the market is not more predictable. But the fact is that there is no evidence that supports any systematic approach to predicting short-term market movements.

So if we can’t predict where the market is going to go next, what should investors focus on? Finding great companies and buying their stock when it trades at a discount to intrinsic value. In many ways, this advice sounds quaint and so very old school. In a world of high-frequency trading, 24-hour global markets, exotic financial instruments and computer programs that can scan and analyze the entire universe of investable stocks in seconds, surely the approach that worked for Phil Fisher, Warren Buffet, and Peter Lynch in the 1950s, 60s, 70s and 80s no longer applies today?

But the truth is that while the world has changed in many ways, it has also stayed the same. The market has become no more predictable, the value of a business remains the amount of cash it can distribute to shareholders over time, and stock prices continue to oscillate around a fair estimate of their intrinsic value — being efficiently priced on average, but deviating significantly from fair value across time.

We, of course, are not the only investors to believe that this approach is timeless. Many of the great investors of our time such as Seth Klarman, Mohnish Pabrai, Donald Yacktman and Mason Hawkins have accumulated outstanding returns over the last decade or two by focusing primarily on individual company analysis while eschewing attempts to time the market.

The best defense against the siren song of thinking you can guess which way the market will move next is by preparing yourself during periods of calm markets for how you will behave during the next sharp selloff or parabolic bull run. It is a truism that during periods of market volatility, human psychology leads investors to expect the recent market trend to continue. It isn’t possible to turn off the part of our brain that warns of danger after the market tumbles or spikes the levels of risk-encouraging dopamine after the market rallies. But it is possible to build and follow a disciplined approach to investing that you can turn to for strength when other investors are dumping stocks or scrambling to buy.

Back in mid-January, when we warned against fear-mongering headlines about the worst start to the year since the Great Depression, many other people were writing similar pieces. We revisit this important point today after the market has recovered because our point was never to suggest that investors always remain bullish during downturns, but instead to come to terms with the unpredictable markets in which investors must operate. The recovery in the stock market does not mean that the rest of 2016 will see further market gains. Instead, whether the market is falling, stable, or rallying, the key focus for investors should be tracking the intrinsic value of the companies in which they are invested and looking for opportunities to add to these positions when market values trade at a discount or reduce their exposure as market values approach or exceed fair value.

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