When in Doubt, The Magic 8 Ball has all the Investment Advice Answers

“Probability Theory Is Nothing More Than Common Sense Reduced to Calculation”
Pierre Simon Laplace

One of my fondest memories of Christmas was getting a Magic 8 Ball in my stocking when I was younger – times were simpler. I spent hours (admittingly one to many) asking questions to the large plastic ball, only to turn it over to reveal the written answer which appeared on the surface. Recently, I was cleaning out my storage unit (my parents’ house) and I came across my trusted childhood toy. I thought to myself, could the Magic 8-Ball help us answer questions relating to the market. As of time of writing, global equity markets have rallied approximately 9%, 10% and 9% as measured by the S&P 500, S&P/TSX and MSCI World year to date. Perhaps it doesn’t feel like it but believe it or not we have gained over half of the losses experienced in the correction. Let’s ask our trusty Magic 8 Ball the questions that our team has received most often during the past couple of weeks.

Will a new dollar invested today be worth more a year from now?

Signs point to yes.

Over the past thirty years, the S&P 500 has experienced six bear markets (a drop of 20% or more) in a calendar year. Of those, markets were positive all but once one year later with an average return of 18% from that initial drop of 20%. The same analysis is similar for corrections. Our work suggests that since 1987 there have been 25 corrections in a calendar year (as measured by a drop of more than 10% from the previous peak). There were 11 instances of the 25 when the forward 1-year return was negative from the initial drop of 10%. 9 of those occurred either leading into or during a recession. In our 2019 Outlook published earlier in the year, we highlighted that despite the slowing global economy, the risk of a global recession continued to be low. Investing is a probability-based decision and when pullbacks occur, history tells us that investors have been well served to take advantage of the volatility if it occurs in non-recessionary periods.

Calendar Year Date @ -20% 1 Year Forward Return from initial -20% drop Peak to Trough Date Peak to Trough
1987 10/19/1987 23% 12/4/1987 -31%
1990 10/11/1990 29% 10/11/1990 -20%
2001 9/17/2001 16% 9/21/2001 -26%
2002 7/10/2002 7% 7/23/2002 -32%
2008 10/7/2008 6% 10/27/2008 -35%
2009 3/3/2009 61% 3/9/2009 -22%
Average 18% -28%

In 2010, a paper titled “the equal importance of asset allocation and active management” written by Ibbotson, Xiong, Idzorke and Chen studied 10 years of returns from more than 5,000 mutual funds in order to measure the relative importance of asset allocation. They found that three quarters of a typical fund’s variation of performance comes from general market movement, with the remaining portion split roughly between the specific asset allocation and active management.

Our work suggests that a material driver in the relative performance of asset classes is valuation. One metric we use is a market’s earnings yield relative to its country’s inflation rate (which is a proxy for fixed income). When we look at the earnings yield of the S&P 500 relative to inflation, it paints a positive story for the S&P 500’s 2 year forward compound annual growth rate (CAGR) as illustrated below. Our US inflation model forecasts inflation, as measured by the Consumer Price Index (CPI), to moderate around 2% into 2019 which would likely lead to a S&P 500 CAGR in the mid to high single digit over the next couple of years.

The FED Model looks at it another way where it measures the S&P 500’s Earnings Yield relative to 10 Year U.S. Treasury Bonds. What the dot plot below shows is historically that a yield gap above 3% has very rarely been associated with negative returns in the following 12 months. The median return since 1962 was approximately 14%.

INV MMF Invest note magic 8 ball

Source: https://repsourcepublic.manulife.com/wps/wcm/connect/8ee59d4d-90db-49b8-8295-eb67a413ba9f/inv_mmf_investnotemagic8ball.pdf?MOD=AJPERES&CACHEID=ROOTWORKSPACE-8ee59d4d-90db-49b8-8295-eb67a413ba9f-mA6d1xD