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Rekenthaler Report

3 Questions That Stump Investment Experts

They can guess, but they do not know.

Tricky, Tricky
By now, even casual observers realize that stock market forecasts are bogus. They’re as accurate as when former NFL players predict the next Super Bowl winner, but less entertaining. Knowing the direction of stock prices, never mind the magnitude, is beyond human ability--even with computer assistance.

Less appreciated is that even knowledgeable investment professionals do not understand basic aspects of the stock market. Analyzing its workings is surprisingly difficult. For one, the forces that move equity prices cannot be directly observed. For another, stocks do not lend themselves to scientifically controlled experiments. We cannot rewind history to test how equities would have behaved had something been changed.

Rational Considerations
The biggest mystery is whether the stock market is rational.

We largely understand the market’s degree of efficiency. With occasional exceptions, most stocks have sensible relative prices. If they did not, the better investment managers would regularly outperform their benchmarks, and indexers wouldn’t dominate U.S. equity-fund inflows. But the better managers do not consistently achieve that feat, and indexers most certainly do dominate flows. That matter is settled.

We cannot judge, however, whether the stock market’s overall level is accurate. As I write this sentence, the Dow Jones Industrial Average is 29,305. Is that broadly correct? Framing the problem another way: When last decade began, the country was early in an economic expansion and the Dow Jones was barely over 10,000. Looking back, U.S. stocks were a bargain. Should shareholders have realized that stocks were cheap? Were they collectively misguided?

Normally, I dismiss hindsight analysis. But I can’t shake the memory of Black Monday. On Oct. 19, 1987, U.S. stocks plummeted 22%, with no major news. They did not reach their previous day’s closing price for almost two years. That behavior, as our British cousins would say, was mad. Equities should not have dropped that dramatically, nor required so long to recover. They suffered from a prolonged panic. That may have been the only mass investor confusion during my lifetime. I can find defenses for all other stock market upheavals, including the 1973-74 bear market, the rise, fall, and re-ascent of New Era technology stocks, and the 2008 crash. However, it only takes one. The example of Black Monday demonstrates that those defenses might be wrong. We just don’t know.

Who's the Alpha Dog?
It is commonly believed that retail shareholders are poor investors because they chase trends. They trade too frequently, thereby incurring costs and risking the possibility of buying high and selling low. This makes them the “dumb money.”

There is precious little evidence for this contention. A brokerage could calculate its customers’ aggregate performance, but it would struggle to find the appropriate benchmarks. Even if that task could be accomplished--which I doubt--the outcome would describe but one investor group among many.

By this argument, investment professionals are the winners. The sheep get sheared, while the shepherds receive the wool. The argument appeals to the heart, but it fails the head. Mutual fund managers, obviously, haven’t profited from individual investors’ losses. Neither have pension and endowment funds, which have been penalized since 2008 for being diversified into alternative asset classes. A recent paper, for example, reported that the average nonprofit endowment fund trailed a simple 60/40 mix of U.S. equities and Treasury bonds by more than 4 percentage points per year from 2009 through 2017.

It may be objected that the paper’s figures are insufficient because they don’t show how skilled the endowment-fund managers were at security selection. Instead, they merely show that those funds were not helped by their long-term asset allocations. That protest is valid. We don’t know the aggregate alphas for pension funds. We don’t know any investor segment’s alphas. We can only guess.

I once made the attempt, which I immodestly regard as being as accurate as anybody else’s, and maybe better. I found--which I stated more confidently than I should have--overseas buyers to have been the U.S. stock market’s winners. The rest of us were its losers. Accompany that conclusion with a heavy dose of salt.

Fund Flow Indicators
Cash flows into mutual funds have long fascinated, and sometimes horrified, institutional investors. Morningstar’s Ben Johnson forwarded me a page from Business Adventures by John Brooks, the premier chronicler of the investment '60s. In 1962, reports Brooks, mutual funds had built up the “staggering total of twenty-three billion dollars in assets.” When stocks dropped sharply that spring, many believed mutual funds to be at least partially responsible.

Writes Brooks, “A thoughtful broker named Charles J. Rollo” ... recalled that the threat of a fund-induced downward spiral, combined with general ignorance as to whether or not one was already in progress, was so "terrifying that you didn’t even mention the subject.’” General ignorance is an apt term, then and now. We can measure fund flows precisely, but understanding how they affect equity prices is another matter altogether. That remains, at best, a black art.

Ironically, domestic-equity funds accounted for 5% of U.S. stock market capitalization when Rollo was so worried, yet more than 20% today, when observers are relatively sanguine. The wolf has been decried many times since 1962, in particular when 401(k)s inflows became large, but it has yet to arrive. Consequently, most market observers have become sanguine.

Someday, perhaps, the concerns will prove to have been merited. Certainly, fund inflows could become outflows, and the industry appears to be large enough to cause major damage if fund redemptions were high. But once again, this concern is mere conjecture. The concept isn’t supported by hard numbers; nobody has figured out how to write the equations.

Editor’s Note
A few paragraphs up, for convenience’s sake, I used investment jargon: “alpha.” Most definitions of this word are eye-glazing. For example:

A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha.

In practice, however, investment professionals tend to use the term loosely and intuitively. In the industry, “alpha” effectively means “any aspect of the fund’s performance that can be credited to, or blamed on, the investment manager.” In contrast, “beta” refers to “whatever is outside the manager’s control.”

The latter version reflects my intent. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.