Four market myths that continue to mislead but motivate investors

A question: what do the following statements all have in common? Rising earnings are good for stock markets, as are improving economic growth figures. Two heads are better than one, which is why investment clubs deliver better returns. The best investors are those who successfully forecast the financial markets.

Answer: each statement sounds like a statement of the obvious, but is in fact completely untrue.

Myth 1

Rising earnings drive equity returns

Rising earnings are good for stock markets; declining earnings spell declining returns. Additionally, stock markets perform better when indices trade on low earnings multiples.

This seems like common-sense advice, but the relationship between earnings and markets is not nearly that simple. Examining 65 years of market data, trader and Practical Speculation author Victor Niederhoffer found that earnings rose on 43 occasions and saw 22 annual decreases.

Markets rose an average of 4.9 per cent during the rising years, compared to 14.2 per cent in years of declining earnings.

Similarly, while commentators will often justify their bullish or bearish position by pointing to one year price/earnings valuations, these have no predictive merit. At the beginning of 1929, prior to the market crash, US markets traded on less than 18 times trailing earnings.

They traded for 17 times earnings in 1933, a year which saw indices soar 50 per cent, the first year of a strong cyclical bull market.

Markets also traded on a higher price/earnings ratio in 2003 (the early stages of a five-year bull market) than in 2000 (just prior to a bear market that saw indices halve).

In January 2007, prior to the global financial crash, the S&P 500 traded for 17 times earnings; it traded for 71 times earnings in January 2009, near the bottom of the global bear market.

As Niederhoffer notes, earnings fallacies have “an appealing, superficial plausibility”, but these neat little nuggets are more likely to mislead than to enlighten.

Myth 2

Investment clubs deliver the goods

If two heads are better than one, then surely investment clubs are a source of education and juicier returns – right?

Well, no. The investment club concept gained popularity in the 1990s, when the US-based Beardstown Ladies – an investment club mainly made up of 70-something women – released a bestselling book detailing how they apparently beat the market over a long period. It later emerged that they got the maths wrong and had in fact substantially underperformed the market.

So do most clubs. One study, Too Many Cooks Spoil the Profits, examined the performance of 166 investment clubs between 1991 and 1997, and found club members overtraded, favoured volatile growth stocks and ultimately underperformed the market by almost four percentage points per year.

Even worse, they underperformed individual investors by two percentage points per year. The club members would have been better off on their own.

Discussing groups in general, investment strategist James Montier writes that the “eternal hope” is that they will “come together, exchange ideas, each bringing something different to the discussion”.

However, members tend to “abandon their individual information, choosing to agree with others, because they think they know more”, and ultimately groups “amplify rather than alleviate the problems of decision-making”.

Of course, investment clubs, as the aforementioned study concluded, have their uses. “They encourage savings. They educate their members about financial matters. They foster friendships and social ties. They entertain. Unfortunately, their investments do not beat the market.”

Myth 3

Economic growth is crucial to stock returns

Fast economic growth is good for stock returns; slow growth is bad.

One might assume that to be true, given the acres of newsprint given over to the subject, but one would be wrong. In the 20th century, if you had always invested in the 20 per cent of countries with the fastest gross domestic product growth over the previous five years, you would have earned 6 per cent annually. Investing in the slowest growers, however, would have led to annual returns of 12 per cent.

The relationship between economic growth and stock returns was analysed in the Global Investment Returns Yearbook in 2005 and again in 2010. Essentially, it was found that market fluctuations predict changes in GDP, but movements in GDP do not predict stock returns.

Revisiting the subject in 2014, the authors acknowledge that “common sense suggests that what is good for the economy is good for the stock market, and vice versa”.

However, it’s not that GDP growth is irrelevant. In fact, anyone who can perfectly predict future growth rates can earn outsized returns, the authors said. However, growth predictions are already priced into markets; to prosper, one must “reliably outguess the consensus of other investors”. Such a strategy, however, “is sadly not implementable, except by a clairvoyant”.

Myth 4

Investing is all about forecasting

The financial markets are, it appears, full of gifted clairvoyants. The soothsayers tell us where the stock market will be in 12 months, and whether the euro will rise against the dollar in 2015, and why stronger-than-expected GDP growth in one corner of the world will neutralise the impact of declining sales in some other corner of the world for some company or another, thereby helping it to beat analyst earnings estimates and likely leading to a stock price of €19.35 before the end of August.

Naive folk who think investing is all about successful forecasting should listen to author William Bernstein, who says there are ultimately two types of investors: those who don’t know where the market is headed, and those who don’t know that they don’t know.

He’s right. One study of more than 100,000 12-month analyst price targets found that, on average, their forecasts are 35 per cent too optimistic. Another found that the odds of analyst earnings estimates being within 5 per cent of actual results for four consecutive quarters are 1 in 170.

Another examined over 60 national recessions in the 1990s, and found that 97 per cent of the time, economists failed to predict it a year in advance. Studies of tips found in financial magazines, investment newsletters and internet forums all confirm they are worthless.

According to the CXO Advisory website, which analysed 6,582 forecasts made between 1998 and 2012, analysts’ directional markets calls were right 47 per cent of the time – slightly worse than chance. The most high-profile market gurus, the ones who appeared most frequently in the media, tended to be only average to well-below-average in terms of accuracy.

Warren Buffett’s approach is the best one: “We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.”