![Learn to profit from uncertainty](https://www.evidenceinvestor.com/wp-content/uploads/2019/10/TEBI-Dimensional-Perspectives.jpg)
As an investor, there’s no escaping from uncertainty. Right now, for example, there’s uncertainty around inflation, how long prices will carry on rising for, and the impact that will have on the economy and equity returns. But as WESTON WELLINGTON from Dimensional Fund Advisors explains, a look at headlines from the past 50 years shows the difficulty of timing markets around inflation expectations. Investors may be better served sticking to a long-term plan.
How quickly things change.
Two years ago, the New York Times reported, “Federal Reserve officials are increasingly worried that inflation is too low and could leave the central bank with less room to manoeuvre in an economic downturn.”1 More recently, a Wall Street Journal article presented a sharply different view, with a headline that likely touched a raw nerve among investors: “Everything Screams Inflation.” The author, a veteran financial columnist, observed, “We could be at a generational turning point for finance. Politics, economics, international relations, demography and labor are all shifting to supporting inflation.”2
Whither inflation?
Is inflation headed higher? In the short term, it has already moved that way. With many firms now reporting strong demand for goods and services following the swift collapse in business activity last year, prices are rising—sometimes substantially. Is this a negative? It depends on where one sits in the economic food chain. Airlines are once again enjoying fully booked flights, and many restaurants are struggling to hire cooks and waiters. We should not be surprised that airfares and steak dinners cost more than they did a year ago. Or that stock prices for JetBlue Airways and The Cheesecake Factory surged over 150% from their lows in the spring of 2020.3
Do such price increases signal a coming wave of broad and persistent inflation or just a temporary snapback following the unusually sharp economic downturn in 2020? We simply don’t know. But future inflation is just one of many factors that investors take into account. The market’s job is to take positive information, such as exciting new products, substantial sales gains, and dividend increases, and balance it against negative information, like falling profits, wars, and natural disasters, to arrive at a price every day that both buyers and sellers deem fair.
To hedge or not to hedge?
Let us assume for the moment that rising inflation persists into the future. Some investors might want to hedge against higher inflation, while others might see it as a market-timing signal and make changes to their investment portfolios. But for the market timers to do so successfully, they would need a trading rule that directs exactly when and how to revise the portfolio — “I’ll know it when I see it” is not a strategy. A trading rule based on inflation estimates, however, is just a market-timing strategy dressed in different clothes. A successful effort requires two correct predictions: when to revise the portfolio and when to change it back.
It’s not enough to be negative on the outlook for stocks or bonds in the face of disconcerting information regarding inflation (or anything else). Current prices already reflect such concerns. To justify switching a portfolio, one needs to be even more negative than the average investor. And then outsmart the crowd once again when the time appears right to switch back. Rinse and repeat.
The evidence of success in pursuing such timing strategies — by individuals and professionals alike — is conspicuous by its absence.
The example of 1979-80
To illustrate the problem, imagine it’s New Year’s Day 1979. The broad US stock market4 produced a positive return in 1978 but failed to keep pace with inflation for the second year in a row. Your crystal ball informs you that the next two years will see back-to-back double-digit inflation for the first time since World War I.
What would you do? You have painful memories of 1974, when the inflation-adjusted total return for US stocks was –35.05%, among the five worst returns in data going back to 1926.
We suspect many investors would sell stocks in anticipation of significantly lower security prices over the subsequent two years. The result? Most likely a failure to capture above-average returns from both the equity and size dimensions, as shown in Exhibit 1.
Some of the recent concern regarding inflation appears linked to substantial increases in government spending and the US debt load. Determining the appropriate level of each is a contentious public policy issue, and we don’t wish to minimise its importance. But the news items in Exhibit 2 suggest these concerns are not new, and the expected consequences of these issues are likely already reflected in current prices.
Profiting from uncertainty
The future is always uncertain. But as economist Frank Knight observed 100 years ago, willingness to bear uncertainty is the key reason investors have the opportunity for profit.6 Investors will always have something to worry about, and the possibility of unwelcome or unexpected events should be addressed by the portfolio’s initial design rather than by a hasty response to stressful headlines in the future. As recent research from Dimensional highlights, simply staying invested can help investors outpace inflation over the long term.
FOOTNOTES
1Jeanna Smialek, “Fed Officials Sound Alarm Over Stubbornly Weak Inflation,” New York Times, May 17, 2019.
2James Mackintosh, “Everything Screams Inflation,” Wall Street Journal, May 5, 2021.
3Sourced using Bloomberg security returns. Low for Cheesecake Factory was April 2, 2020, and low for JetBlue was March 23, 2020.
4As measured by the CRSP 1-10 index.
5S&P data © S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.
6Frank H. Knight, Risk, Uncertainty and Profit (Boston and New York: Houghton Mifflin Co., 1921).
7Headlines are sourced from various publicly available news outlets and are provided for context, not to explain the market’s behavior. This material is in relation to the US market and contains analysis specific to the US.
INDEX DESCRIPTIONS
DIMENSIONAL US SMALL CAP INDEX: Compiled by Dimensional from CRSP and Compustat data. Market-capitalisation-weighted index of securities of the smallest US companies whose market capitalisation falls in the lowest 8% of the total market capitalisation of the eligible market. The eligible market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: non-US companies, REITs, UITs, investment companies, and companies with the lowest profitability and highest relative price within the small cap universe. The index also excludes those companies with the highest asset growth within the small cap universe. Profitability is defined as operating income before depreciation and amortisation minus interest expense divided by book equity. Asset growth is defined as change in total assets from the prior fiscal year to current fiscal year. The index has been retrospectively calculated by Dimensional and did not exist prior to March 2007. Accordingly, the results shown during the periods prior to March 2007 do not represent actual returns of the index. Other periods selected may have different results, including losses. The calculation methodology for the index was amended in January 2014 to include profitability as a factor in selecting securities for inclusion in the index. The calculation methodology for the index was amended in December 2019 to include asset growth as a factor in selecting securities for inclusion in the index.
DISCLOSURES
The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.
WESTON WELLINGTON is a Vice President of Dimensional Fund Advisors.
This article first appeared on the Dimensional blog, Dimensional Perspectives.
MORE FROM DIMENSIONAL
David Booth on 50 years of indexing
Stressing about rising inflation achieves nothing
Ken French on the danger of false positives
Booth and Fama on rising inflation
Are YOLO traders undermining efficient markets?
Should a top-heavy stock market worry us?
PREVIOUSLY ON TEBI
Institutional investors vs individuals: Who wins?
Indexing has saved Americans $357 billion since 1996
Specialised ETFs: high fees, poor performance
Does momentum investing make sense?
Why and how systematic strategies decay
Where are you looking for information?
FIND AN ADVISER
Investors are far more likely to achieve their goals if they use a financial adviser. But really good advisers with an evidence-based investment philosophy are sadly in the minority.
If you would like us to put you in touch with one in your area, just click here and send us your email address, and we’ll see if we can help.
© The Evidence-Based Investor MMXXI