Friday, March 1, 2013

Tuning Out the Economic Noise, and Focus On the Fundamentals

“I spend about 15 minutes a year on economic analysis. The way you lose money in the stock market is to start off with an economic picture. I also spend 15 minutes a year on where the stock market is going.” – Peter Lynch

From 1977 to 1990, Peter Lynch ran Fidelity's Magellan Fund.  During that time period, the Magellan Fund compiled one of the best - if not the best - longer term track record in mutual fund history, returning 29.2% per annum to investors.

Lynch started his career as a research analyst, and his passion for learning and understanding companies and stocks was a hallmark of his investing style.  I would occasionally see Lynch at company presentations during the years he ran Magellan, and I was always struck by his modesty and attentiveness.

What Lynch intuitively understood, like so many other great investors, is the need to focus on what they can analyze - company fundamentals - and ignore larger macro predictions for the economy or stock market, where there is very little evidence that anyone has any ability to forecast events with any skill.

Ned Davis of Ned Davis Research had a piece out today on the futility of trying to successfully invest in stocks by looking at the economy.

Here's what he wrote:

One of the most interesting parts of this business is that the vast majority of investors, as well as professional economists and strategists, first try to decide what the economy is going to do, and then they base their investment strategy largely upon their economic outlook.  The fact is there is very little evidence that this logic works.

Davis notes that stocks have historically lead the economy, rather than follow it, so that stocks often have their best performance periods during times of economic weakness, or vice versa.

He goes on to say:

There is, in fact, very little correlation on a year-to-year basis even in terms of direction {of the stock market and economy}. ..the correlation coefficient between nominal GDP and the S&P 500 is just 0.13.  Statisticians would thus say that changes in GDP explain less than 2% of the year-to-year variation in stock prices (on average) going back to 1948!

I was reminded of all of this morning, when I saw the performance data for the broader market indices over the past 10 years.

Imagine if I could have told you, with perfect foresight, at the end of February 2003 what was in store for the world for the next decade*:
  • War in Iraq (2003)
  • Decline in the Dollar (2004)
  • Hurricane Katrina (2005)
  • Rising Gas Prices (2006)
  • Subprime Mortgage Crisis (2007)
  • Credit Crunch (2008)
  • Collapse of Financial Institutions (2009)
  • European Crisis (2010-2012)
  • Downgrade of U.S. Debt (2011)
  • Political Polarization in the U.S. (2012)
*based on a list compiled by Bel Air Investment Advisors  

Knowing all this, your reaction probably would have been to keep your money safe in an insured bank account, or maybe even buy gold.

And yet, this would have been the wrong decision, at least for the past 10 years.

Here's what $1,000 invested at the end of February 2003 would be worth today:
  •  Large Cap Stocks (S&P 500):  $2,207
  • Small and Mid-Cap Stocks (Russell 2000):  $2,881
  • Global Industrialized Markets (MSCI EAFE):  $2,565
  • Emerging Markets (MSCI EM): $4,919
What history would suggest, then, is to tune out the noise, and focus on what is analyzable.

Stocks today are trading at reasonable valuations relative to both historic norms as well as expected growth rates.  Compared to other investment alternatives (i.e., bonds and cash), stocks remain very attractively priced.

The odds continue to favor a significant equity allocation in most portfolios.