6 things that will happen in the financial markets in 2020

There are no guarantees in the world of investing… or are there? Here are six things about investing that I'm certain will happen in 2020.

THERE WILL BE SOMETHING HUGE TO WORRY ABOUT IN THE FINANCIAL MARKETS

Peter Lynch is the legendary manager of the Fidelity Magellan Fund who earned a 29 per cent annual return during his 13-year tenure from 1977 to 1990. He once said:

"There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of the newscasters. Sell a stock because the company's fundamentals deteriorate, not because the sky is falling."

Imagine a year in which all the following happened: (1) The US enters a recession; (2) the US goes to war in the Middle East; and (3) the price of oil doubles in three months. Scary? Well, there's no need to imagine: They all happened in 1990. And what about the S&P 500? It has increased by nearly 800 per cent from the start of 1990 to today, even without counting dividends.

There will always be things to worry about. But that doesn't mean we shouldn't invest.

2. INDIVIDUAL STOCKS WILL BE VOLATILE

From 1997 to 2018, the maximum peak-to-trough decline in each year for Amazon.com's stock price ranged from 12.6 per cent to 83.0 per cent.

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In other words, Amazon's stock price had suffered a double-digit fall every single year.

Meanwhile, the same Amazon stock price had climbed by 76,000 per cent (from US$1.96 to more than US$1,500) over the same period.

If you're investing in individual stocks, be prepared for a wild ride. Volatility is a feature of the stock market - it's not a sign that things are broken. 

3. THE US-CHINA TRADE WAR WILL EITHER REMAIN STATUS QUO, INTENSIFY, OR BLOW OVER

"Seriously!?" I can hear your thoughts.

But I'm stating the obvious for a good reason: We should not let our views on geopolitical events dictate our investment actions.

Don't just take my words for it. Warren Buffett himself said so. In his 1994 Berkshire Hathaway shareholders' letter, Buffett wrote (emphases are mine):

"We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.

Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8 per cent and 17.4 per cent.

But, surprise - none of these blockbuster events made the slightest dent in Ben Graham's investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices.

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Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital.

Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them.

If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results."

From 1994 to 2018, Berkshire Hathaway's book value per share, a proxy for the company's value, grew by 13.5 per cent annually.

Buffett's disciplined focus on long-term business fundamentals - while ignoring the distractions of political and economic forecasts - has worked out just fine.

4. INTEREST RATES WILL MOVE IN ONE OF THREE WAYS: SIDEWAYS, UP, OR DOWN

"Again, Captain Obvious!?" Please bear with me. There is a good reason why I'm stating the obvious again.

Much ado has been made about what central banks have been doing, and would do, with their respective economies' benchmark interest rates. This is because of the theoretical link between interest rates and stock prices.

Stocks and other asset classes (bonds, cash, real estate etc.) are constantly competing for capital.

In theory, when interest rates are high, the valuation of stocks should be low, since the alternative to stocks - bonds - are providing a good return.

On the other hand, when interest rates are low, the valuation of stocks should be high, since the alternative - again, bonds - are providing a poor return.

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But if we're long-term investors in the stock market, I think we really do not need to pay much attention to what central banks are doing with interest rates.

There's an amazing free repository of long-term US financial market data that is maintained by Robert Shiller. He is a professor of economics and the winner of a Nobel Prize in economics in 2013. 

His data includes long-term interest rates in the US, as well as US stock market valuations, going back to the 1870s.

The S&P 500 index is used as the representation for US stocks while the cyclically adjusted price earnings (CAPE) ratio is the valuation measure.

The CAPE ratio divides a stock's price by its inflation-adjusted average earnings over a 10-year period.

The chart below shows US long-term interest rates and the CAPE ratio of the S&P 500 since 1920:

Contrary to theory, there was a 30-plus year period that started in the early 1930s when interest rates and the S&P 500's CAPE ratio both grew.

It was only in the early 1980s when falling interest rates were met with rising valuations. 

To me, Shiller's data shows how changes in interest rates alone can't tell us much about the movement of stocks. In fact, relationships in finance are seldom clear-cut. "If A happens, then B will occur" is rarely seen.

Time that's spent watching central banks' decisions regarding interest rates will be better spent studying business fundamentals.

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The quality of a company's business and the growth opportunities it has matter far more to its stock price over the long run than interest rates. 

Sears is a case in point. In the 1980s, the US-based company was the dominant retailer in the country. Morgan Housel wrote in his recent blog post, Common Plots of Economic History:

"Sears was the largest retailer in the world, housed in the tallest building in the world, employing one of the largest workforces.

"No one has to tell you you've come to the right place. The look of merchandising authority is complete and unmistakable," The New York Times wrote of Sears in 1983.

Sears was so good at retailing that in the 1970s and '80s it ventured into other areas, like finance.

It owned Allstate Insurance, Discover credit card, the Dean Witter brokerage for your stocks and Coldwell Banker brokerage for your house."

US long-term interest rates fell dramatically from around 15 per cent in the early-to-mid 1980s to 3 per cent or so in 2018. But Sears filed for bankruptcy in October 2018, leaving its shareholders with an empty bag. In his blog post mentioned earlier, Housel also wrote:

"Growing income inequality pushed consumers to either bargain or luxury goods, leaving Sears in the shrinking middle. Competition from Wal-Mart and Target - younger and hungrier - took off.

By the late 2000s Sears was a shell of its former self. "YES, WE ARE OPEN" a sign outside my local Sears read - a reminder to customers who had all but written it off." 

If you're investing for the long run, there are far more important things to watch than interest rates.

5. THERE WILL BE INVESTORS WHO ARE ITCHING TO MAKE WHOLESALE CHANGES TO THEIR INVESTMENT PORTFOLIOS FOR 2020

Ofer Azar is a behavioural economist. He once studied more than 300 penalty kicks in professional football (or football) games.

The goalkeepers who jumped left made a save 14.2 per cent of the time while those who jumped right had a 12.6 per cent success rate.

Those who stayed in the centre of the goal saved a penalty 33.3 per cent of the time.

Interestingly, only 6 per cent of the keepers whom Azar studied chose to stay put in the centre.

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Azar concluded that the keepers' moves highlight the action bias in us, where we think doing something is better than doing nothing. 

The bias can manifest in investing too, where we develop the urge to do something to our portfolios, especially during periods of volatility.

We should guard against the action bias. This is because doing nothing to our portfolios is often better than doing something. I have two great examples. 

The first is a paper published by finance professors Brad Barber and Terry Odean in 2000.

They analysed the trading records of more than 66,000 US households over a five-year period from 1991 to 1996.

They found that the most frequent traders generated the lowest returns - and the difference is stark.

The average household earned 16.4 per cent per year for the timeframe under study but the active traders only made 11.4 per cent per year.

Second, finance professor Jeremy Siegel discovered something fascinating in the mid-2000s. In an interview with Wharton, Siegel said:

"If you bought the original S&P 500 stocks, and held them until today-simple buy and hold, reinvesting dividends-you outpaced the S&P 500 index itself, which adds about 20 new stocks every year and has added almost 1,000 new stocks since its inception in 1957."

Doing nothing beats doing something. 

6. THERE ARE 7.7 BILLION INDIVIDUALS IN THE WORLD TODAY, AND THE VAST MAJORITY OF US WILL WAKE UP EVERY MORNING WANTING TO IMPROVE THE WORLD AND OUR OWN LOT IN LIFE

This motivation is ultimately what fuels the global economy and financial markets.

There are miscreants who appear occasionally to mess things up, but we should have faith in the collective positivity of humankind.

We should have faith in us. The idiots' mess will be temporary.

To me, investing in stocks is the same as having the long-term view that we humans are always striving collectively to improve the world. What about you?

This article was first published in The Good Investors. All content is displayed for general information purposes only and does not constitute professional financial advice.