Are Financial Markets Getting Even Less Predictable in the Near Term?

Earlier in my investment management career it was not uncommon for me to raise a fair amount of cash, say 10-20%, in client accounts when I thought the equity market was overheated. The idea was that I would have plenty of firepower when prices dropped and bargains were abundant. Over the years the data suggested that such a move was rewarding, at best, half the time. Too many instances, though, resulted in prices rising enough before they fell that the cash positions at best offered no alpha.

Don’t get me wrong, I have always been in the camp that market timing in the near term is difficult (hence I would never go to 50, 75, or 100 percent cash), but I learned that mean reversion, while a real thing, could not really be consistently exploited profitably even on just a small part of a portfolio. As a result, cash balances in my managed accounts now reflect the number of interesting investing opportunities I see out there, rather than overall market levels.

As I have spoken with clients this year, I think 2021 has solidified the argument against market timing even more, if that’s possible. Profits for S&P 500 companies this year are currently on track to come in roughly 30% above 2019 levels. And that result has not happened because the pandemic suddenly waned. In fact, we are seeing a lot of data that would suggest corporate profit headwinds; retail supply constraints, a lack of qualified labor, and a chip shortage - to name a few - all of which are profit margin-negative.

Despite such strong profit growth, interest rates remain very low with the 10-year bond yield hovering below 1.5%. The end result is an S&P 500 that fetches 23 trailing earnings after surging for most of the year. Who would have been able to predict that? It seems to me even fewer people than would have done so in more normal economic times.

The current inflation story reinforces the point even more; that short-term market movements are getting even less predictable than in the past. And that’s certainly saying something. We just learned today that consumer prices rose by more than 6% in October, a 30-year high. Remember how one of the main jobs of the Federal Reserve is to raise interest rates to keep inflation subdued? Would any short-term investment strategist suggest that 6% inflation would not result in higher interest rates and thus lower stock valuations? And yet, here we sit with the Fed Funds interest rate sitting at zero. Not just an average rate. Not just a below average rate. But zero.

I didn’t come into 2021 trying to predict the economy and the markets and thank goodness for that. For those who still do try that sort of thing, I think 2021 has taught us that a very tough job is getting near impossible, if it wasn’t there already.

So what to do? Throw up our hands, of course. But in conversations with clients I find myself saying “I have no idea” more often than ever. Some may find that disappointing, especially coming from an industry professional, but if my track record predicting stock prices, interest rates, or other economic metrics six months out was unimpressive before the pandemic, imagine how subpar it would be now. I much prefer to just sit back and try to invest in undervalued companies regardless of the macro backdrop and I think my clients are best served by that as well.