What do you think the market will do?
I get that question all the time, especially this time of year. And it’s reasonable to ask someone who makes his living dealing with the ups and downs of the Dow and interest rates whether he thinks next year’s markets will behave like Santa Clause or the Grinch.
In the long-run, markets are moderately predictable. Bonds are actually very predictable. If you buy a 10-year Treasury bond at a yield to maturity of 2.9%, you can confidently expect that you will receive about 30% over 10 years. (That extra 1% is due to reinvesting the coupon payment.) Low yields lead to low returns. Conversely, high yields lead to high returns.
How about stocks? The data is less decisive, but still indicates that valuation matters. Cyclically adjusted earnings yield is positively associated with returns—especially when the market is at an extreme—as it was in 2009 or 2007. But even in times of normal valuation—which is what I would maintain we are in right now—there’s a positive correlation. But the data is messy. Equities are a residual claim on a volatile earning stream, and subject to manias and panics. Still, low valuations lead to higher returns, and vice-versa, over the medium to long run.
But what do I think the market will do next year? Short-term data are much less dependable. Stay diversified! Diversification is the compliment that humility pays to uncertainty. We don’t know the future. We can only plan for volatility.
Douglas R. Tengdin, CFA
Chief Investment Officer