The Secret to Stock Market Returns
By: Sam Swift, CFA, CFP®
There’s a lot of talk in the financial world about what an election year might mean for stock markets. You’re likely to hear that election years tend to underperform relative to the long-term average and that the real time to be invested is in the pre-election year:
Alas, it appears we’re at the top of the peak and looking forward to relatively poor returns for 2016. Post-election years, as it happens, are no good either so we really don’t have much to look forward to over the next couple of years when you think about it:
Bummer. Well at least we can focus our energy on which party takes the presidency and maybe that can help us out:
Looks like our money should be rooting for the Democrats. On the other hand, if we measure this by control of the Senate…
Okay, so it looks like we’ll probably have a below average next couple of years in the market unless we get a Democratic president and a Republican Senate. Good, got it. But wait. I forgot that we hadn’t factored in turkey weights. I know, just hang with me here. The average weight of turkeys has a very high correlation with the market:
A key signal is whether the market return is above or below the average weight of a turkey. Perhaps we should be worried that the market has climbed back above the average. Unless turkey weights skyrocket soon, it appears a dip is likely.
Okay, so I think we have the start of a pretty good model here, but I’m still not totally sure of whether or not I should save my Christmas bonus right now. Maybe I’m thinking too big picture here. What day of the Lunar Cycle are we in again?
Damn you day 5! I always knew something was fishy there. Hold on, hold on—we’re getting ahead of ourselves. Didn’t we just have a triple crown winner this year?
So that was the reason for the sluggish second half of this year! I knew something had to have offset the good year we should have had pre-election.
Hopefully you’ve gathered by now that this is pretty silly. Correlation does not equal causation. I’d urge you to visit Spurious Correlations, by the way, where you can learn a little more about this concept in a humorous way (I’m partial to the “Number of People who drowned falling into a pool correlates with Films Nicolas Cage appeared in” or “Letter in Winning Word of National Spelling Bee correlates with the Number of People killed by Venomous Spiders”—I knew those kids had ulterior motives!).
These spurious correlations are a major problem in finance where the sheer amount of dollars in play produce unhealthy incentives to find “the secret”—the one variable that will lead you to riches. The point, like usual, is to ignore these proclamations. Stock markets are extremely efficient which means all relevant information is baked into the price immediately.
While it’s clear that turkey weight or the lunar cycle have nothing to do with stock market returns (or do they?), we are often tempted by economic data that seems like it has a more direct relation. For example, the Fed’s decision to raise interest rates indeed has an effect on market prices. It is not the sole reason, however, and we don’t really know how much of the market returns can be explained simply by that one variable. I could have told you what the headlines would be yesterday. If the market went up after rates rose, we’d have been told, “Fed’s rate increase signals strong health of the economy; Markets up”. If the market went down after rates rose, we’d get the opposite, “Markets down on worries that Fed’s rate increase will slow economy”.
It’s not that politics and the economy don’t matter to stock returns—they do—but that they are only a few out of thousands and any variable you isolate can still only explain a very small portion of stock returns in a best case scenario. In a worst case scenario, you’re trying to get a turkey to sit still on a scale or consulting your astrology tables and being suckered by random correlation. To base an investment strategy off of any one variable only sets you up for disaster.