Research Associates See Dismal Decade for Large Caps
When we look to predict the future, the assumptions we make will determine what the future will hold. Research Associates have used theirs to predict a dim outlook for large caps.
In spite of all the advancements that modern civilization has made, some things remain in a pretty nascent stage, and our understanding of the stock market overall is one of these areas, at least among the vast majority of our population. We might think that we have developed a good or even intimate understanding of this topic, but for whatever reason most people are stuck in the era where the world is still flat.
The curious thing about trying to predict future stock prices is that you need at least a basic understanding of how these things work before you can even pretend to make valid predictions. If the assumptions that you make are faulty, so will be the data, as it essentially flows from these predictions.
We don’t just miss this by a little, as for whatever reason, the common view is so far off base that it may even be seen to be dead wrong, the complete opposite of the truth. Being pointed in the exact wrong direction than we need to be going in is no way to achieve success.
Stocks aren’t so hard to understand if we can only step away from the common beliefs out there about them and merely think about the issue. When we do, we clearly see models that are widely practiced that end up widely misunderstanding what actually goes on and seeks to replace reality with their confused conception of it.
There are two main things to look at when we examine the movement of stocks, which are the overall outlook for a stock, and over-expressions of this outlook in the shorter term. An outlook of a stock may improve and we often may be too overenthusiastic and take the price too far. This also happens on the downside when the outlook deteriorates and we take it down too far.
In both of these situations, we overextend the price and we move towards equilibrium. The level of demand at the peak just isn’t sustainable, and after the eager beavers all get in, those left aren’t as eager and demand drops down to a more normal level, and together with supply increasing due to the higher price and a concern that a reversal may be in order, this produces a correction.
The first essential principle to grasp is that it is only the overexuberance that needs to be corrected here, not the whole move. As obvious as this should be, there are many who instead think that the whole thing is on the line, both the improved outlook and the excesses, and this really isn’t going to paint an accurate picture at all about what is going on because it ignores the improved outlook itself, which is what we actually need to be trading.
The story of how we could ever end up in a place is an interesting one, and arises by our looking to fix benchmarks on stock prices that do not correspond with reality or do not even seek to describe what really goes on.
What we end up doing is assuming that anything above the average future outlook for stocks is excessive, and in need of correction, and this includes a lot of the genuine future value that becomes expressed, which we need to account for in the positive way that it has manifested, not consider it something that is bound to be magically removed by the forces of the universe.
The Brighter the Future, the Better the Stock Price, and Bright Futures are Preferable
Stock prices are forward looking by nature, and the current price of a stock does not represent the current state of the company, it instead represents beliefs about the future value of the stock. Deviations with current and this perceived future value represent the public’s perception of where they see the stock going, where the more deviation we have, the better the future outlook is.
This benchmark will produce various degrees of outlooks, from terrible to fabulous. There is an average amount of this, not just currently but historically, and this becomes the benchmark for those who are looking to use such a scheme to predict stock prices.
This leads to our discounting not only any overextension with the outlook of the better stocks but the whole move over average. Companies that have a better outlook than average will have us not only ignoring this but making the assumption that it will reverse, without any real reason or basis to assume this.
Conversely, those whose outlook is below average will be assumed to have the wherewithal to turn things around, even though, once again, there is no basis to assume this. Even worse, both of these assumptions are not only unfounded but are contrary to what actually happens generally.
If we are seeking stocks that will continue to have a positive outlook over time, our best chance will be by selecting stocks that do have a positive outlook now, and it is certainly not to be done by seeking those with a poor outlook.
We may say that strategies involving this sort of reversion to the mean are dead because this has been shown to fail, but reversion to the mean investing is very much alive and well and widely practiced by anyone who takes a “value” approach to investing, or even allow this to influence their views at all.
Where this approach really leaves the road is when they look at a company’s future valuation versus its present valuation, and assume this reversion to the mean with this, where we even end up classifying positive future valuation in a negative light and something that will end up being corrected.
This will end up steering us away from the stocks with the most potential and toward stocks with measurably less potential. We may still churn out positive returns in a bull market, but this will serve to reduce those returns over better selections and even the market. If our strategy is below average, we will not beat a random selection such as a stock index.
Any time we do not beat the market, a random selection of stocks, we need to immediately abandon our approach or at least look to improve it such that it even beats pin the tail on the donkey. Instead though, we tend to stubbornly cling to our faulty ideas and sit back and wait for a day where reality reverses itself and our predictions will finally align with it. This may be madness but the realm of stock analysis is mad enough that we fit in.
When we see predictions such as large cap stocks only expected to return 0.5% annually over the next decade, we may immediately expect that a reversion to the mean strategy is being used. As it turns out, the firm that has come to this particular conclusion is Research Associates, who designed the value-focused RAFI approach to investing.
The paper ends up telling us that U.S. small cap stocks will do better but still only deliver a very disappointing 1.9% average return over the next 10 years. International stocks are predicted to rise by 5.3% adjusted for inflation.
The word pricy comes up here, and you only need to understand a little about Research Associates’ approach to stocks to understand how they could hold a more bearish view of U.S. stocks and large U.S. stocks in particular.
When a value investor uses the word pricy, this means that more of the perceived value of a stock lies in the future. We could assign a multiple of what this future value consists of compared to the present, where above average becomes understood as overvalued.
Large cap stocks tend to be pricier than small cap ones, which we can translate into the outlook overall with large cap stocks is better, which is certainly true but can even be measured by comparing valuations. This just isn’t optimism in general that we are measuring, it is a quantitative representation of this optimism within a stock’s price.
Goodness Portends More Goodness More than it Portends Badness
U.S. stocks in general have more optimism built into their prices, so if you compare them to stocks in other countries, and you see this as a bad thing and something that you somehow believe will naturally revert, this can indeed have you forecasting much better potential for international stocks.
The conclusion is that we are supposed to invest in international stocks if we want to get any sort of decent return at all over the next 10 years. U.S. stocks are pricier and we should prefer less pricy options.
This claim is made in the face of the fact that economic fundamentals in the United States remain preferable. If you think that the value of stocks corresponds to economic conditions, then better conditions should be expected to provide better results, not poorer ones.
It is simply the case that prospects for U.S. stocks overall are superior to international stocks, and if the goal were to be to select the worst outcomes, an approach such as the one that Research Associates uses would steer us in the right direction by chasing underperformance.
That’s not what we want though. Research Associates describe themselves as contrarians, but we want to be careful with what we seek to run contrary to, including such things as common sense.
This is on the opposite side of right, to the degree that we can just invert it and arrive at the right conclusion. In this case, with U.S. big cap stocks being the most preferable, followed by U.S. small cap stocks, with international stocks lagging the field.
We can therefore derive value from their approach and recommendations, even if this means just turning them on their heads. Unfortunately, very few people get this and some may follow this pied piper off the cliff, those who choose to let others do the thinking for them and end up choosing the wrong horse, the one riding in the opposite direction from success.
International stocks have indeed lagged U.S. ones, but the reason isn’t due to the gods smiling less on these foreign stocks thus far and due to change their mind and allow them to catch up, in pursuit of cosmic fairness, as there are factors of cause and effect at work that create and maintain these divergences.
If we had data suggesting that economic factors will cause the U.S. to suffer while other countries prosper more, there may be a case for making this claim, but we don’t have anything of the sort and the outlook is for the U.S. to maintain its advantage. If your model suggests otherwise, for no better reason than your assuming that success breeds failure and failure breeds success by way of some invisible hand that is completely unworthy of belief, you have already fallen flat on your face, whether you notice it or not.
Chief Editor, MarketReview.com
Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.
Contact Ken: ken@marketreview.com
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