Investors certainly had their share of discouraging economic news in 2012—a continued tepid recovery here in the United States, along with the “fiscal cliff,” ongoing travails within the Eurozone, and a slowdown in several key emerging markets, notably the so-called BRIC countries (Brazil, Russia, India, and China). Yet despite the gloomy headlines, markets generally rewarded investors—particularly those who were broadly diversified and maintained patience and discipline throughout—with relatively robust returns. This may be confounding to many. After all, wouldn’t poor economic fundamentals translate into poor market returns?
Some of you may know the answer to this question, thanks to a recent article in the New York Times by financial columnist Paul Lim, who illuminated the “big disconnect” between the economy and the stock market.1 Citing a well-documented white paper by Vanguard economists,2 Lim asserted that, contrary to what many would expect, “history has shown that lousy economic conditions, or even dismal corporate results, don’t necessarily lead to disappointing stock market returns in any given year—or decade, for that matter.”
Specifically, Vanguard’s study examined 15 commonly cited metrics used by stock forecasters to determine the direction of the market to test which have actually worked over time. The variables included common market-valuation measures, such as the price/earnings (P/E) ratio, growth in GDP and corporate profits, consensus forecasts for GDP and earnings growth, past stock market returns, dividend yields, interest rates, and government debt as a percentage of GDP.
Not surprisingly, Vanguard concluded that stock returns are “essentially unpredictable at short horizons.” Indeed, the predictive power (known as the R² or correlation coefficient in statistical-speak) of most metrics they examined with the 1-year-ahead return was close to zero.
Over the longer term (defined in the study as a 10-year period), many of these commonly cited signals still had very weak and erratic correlations. Interestingly, profit margins and consensus GDP forecasts had even lower predictive power than rainfall (yes, rainfall!), which Vanguard included in the study for additional context.
Bottom line, the only metric that demonstrated some meaningful predictive quality over a 10-year time horizon was valuation (i.e., P/E ratios). More specifically, and as confirmed in other studies, valuation was proven to have an inverse relationship with future stock market returns: the lower the starting valuation, the higher the consequent returns, and vice versa.
The significant upshot is this: It’s not that economic fundamentals are meaningless or ignored by investors. Rather, the study concludes that trends and projections for earnings and economic growth are already known on Wall Street and are priced into the market. In other words, bad or good economic news is important only if the information differs from what the market has already “baked into” asset prices.
On a related note, as we’ve written before, it’s important to bear in mind that investors are ultimately compensated for risk—real or perceived— and not necessarily growth. When expectations are low and risk seems high, higher returns should be expected—though not guaranteed—to follow, as appropriate compensation for bearing this risk. Conversely, when risk seems low—and prices and expectations are correspondingly high—investors should expect commensurately lower future returns.
Moving on to general financial planning matters, here is what is currently in store for 2013:
- As a result of recently passed legislation, the maximum federal tax rate on dividends and long-term capital gains will rise from 15% to 20%, but only for single taxpayers earning over $400,000 and couples earning over $450,000. Investors below those thresholds will continue to pay a maximum 15% rate on dividends and long-term capital gains. However, these figures do not include the 3.8% Medicare tax on so-called unearned income, which kicks in on January 1 for singles earning more than $200,000 and couples earning in excess of $250,000, as mandated previously under the Affordable Care Act. Thus, singles earning more than $400,000 and couples earning more than $450,000 will pay an effective 23.8% rate on dividends and long-term capital gains, while singles with income between $200,000–$400,000, and couples with income between $250,000–$450,000, will pay an effective 18.8% rate.
- Maximum IRA contributions increase to $5,500 for those younger than 50 and $6,500 for those aged 50 and up.
- Eligibility income ceilings for Roth IRA contributions increase, with contributions phasing out at adjusted gross income thresholds of $178,000 to $188,000 for couples and $112,000 to $127,000 for singles.
- The annual contribution limit for 401(k), 403(b), and 457 plans increases to $17,500 for those younger than 50 and $23,000 for those aged 50 and up.
- The limit on defined-contribution plans (Keogh profit sharing and SEP-IRA) increases to $51,000.
- Also a result of recent legislation, the estate, lifetime gift, and generation-skipping tax exclusion per person remains $5 million as indexed for inflation (so, currently somewhere north of $5.12 million). The top tax rate increases to 40% from the prior rate of 35%.
- The annual gift tax exemption increases to $14,000, from the prior threshold of $13,000.
Just as we seek to manage your expectations on the upside, we also try to maintain your equanimity and balance when the going gets rough. We all know it’s been a long, hard slog since the start of the financial crisis five years ago, and we’re certainly not out of the woods. But as we’ve discussed in this letter, and as the market’s strong rebound since 2009 has demonstrated, the market and the economy do not necessarily move in tandem. Furthermore, despite what often seems like a steady drumbeat of disheartening news, even a realist, and not just a blind-eyed optimist, should be buoyed by the significant positives that attest to unrelenting human ingenuity and progress (e.g., continued advances in technology, energy efficiency/self-sufficiency, and health care). Although our challenges may sometimes seem intractable, a realist knows by virtue of history that, when it comes to investing broadly, optimism (healthy optimism, of course) and patience have ultimately been rewarded over time.
We wish you and your loved ones peace and happiness in the new year.
1. Paul Lim, “For Stock Investors, A Big Disconnect,” New York Times, December 16, 2012.
2. Joseph Davis, Ph.D., Roger Aliaga-Diaz, Ph.D., and Charles Thomas, CFA, Forecasting Stock Returns: What Signals Matter, and What Do They Say Now?, Vanguard, October 2012.