Joseph H. Davis, Ph.D., principal and global chief economist of the Vanguard Group, Inc.. … [+]
Vanguard Global Chief Economist Joe Davis rolled out a 50% probability “forecast” of a 2020 stock market correction. Instead of exhibiting wisdom, he simply reminds us of the old economist joke in action: “On the one hand, …, but on the other hand, ….”
While this flip-a-coin, 50/50 “forecast” should be laughable, it is a serious disservice to investors. He bases his conjecture on investors shifting from recession worries to reflation enthusiasm. So, just when is this excitement supposed to take place? More importantly, when will it top out? After all, it is from that point investors and the media will measure a correction. If the market rises 20% before dropping the 10% correction amount, we will miss out by selling now. Worse, what if the other 50% probability happens and the good news continues to lift the market further?
Or, most likely, what if that 50% guesstimate is simply a reaction to economists’ flawed recession forecasts? It’s a common result among those who forecast incorrectly — they either double down, believing the unexpected rising market is even at higher risk of a reversal, or they switch gears, changing the list of problematic issues that will cause the market to fall.
Bad statistical analysis where no relevance even exists
Then there is the comparison to show higher risk. Davis says that normally there is only a 30% chance of a correction. However, that number is unsupportable. In fact, even his suggestion that such a number exists is wrong. Any study of past stock market behavior shows that the there is neither a “normal” correction probability nor a link between corrections. (The graphs below will show how past data does not contain some magic vision of the future.)
Even worse, he points at volatility (VIX) as being “unsustainably low.” That is a ridiculous suggestion. Yes, the level of volatility will rise and fall over time, but it is a very short term measure that only shows what the market is doing at that particular moment. It has no relationship to what it will be doing. Yes, if a correction does occur, volatility will rise, but only at the same time – not in advance. Think of volatility as being like a plane’s altimeter, not radar.
What this forecast does signify: The stock market analytical approach is changing
This forecast shows the futility of the past analytical trend that now is dying: top down economy/investor/index analysis (versus bottom-up company, industry analysis). The generalized “stock market” view is appropriate when there is some general economic condition (e.g., recession) or investor attitude (e.g., the late 2018 emotional sell-off) at work. However, today, without such whole-market condition or attitude, analytical focus is on specific economic measures and the stock market’s components (sectors, industries and, most importantly, individual company stocks).
Want more proof of the Vanguard’s “forecast” inaccuracy?
For chart readers, here are three 1950-2019 views of how the proffered 30% “normal” does not exist.
1. The annual returns for each year (previous year’s close to the current year’s close), with those down 10% or worse being labeled “corrections”
1950-2109 S&P 500 annual corrections (from close to close)
2. The year-by-year returns from the previous year’s close to the current year’s lowest level – in other words identifying the corrections that took place within the year from the previous close
1950-2109 S&P 500 annual corrections (from close to lowest point in year)
3. The same as #2, but moving ahead only month-by-month and calculating the lowest return over the next twelve months gets rid of the December forecast fixation
1950-2109 S&P 500 rolling 12-month corrections (from close to lowest point)
From those three series, we can see the percentage of occurrence is volatile and does not support Vanguard’s 30% normal statement.
The bottom line
Vanguard’s chief economist has made an unsound “50% stock market correction probability” forecast. For the reasons above, label it flawed and ignore it. However, the damage is done for many investors, who will decide to underweight stocks even as conditions continue to support gains ahead.
While that flawed advice helps other investors buy at attractive prices – and postpones any unhealthy over-optimism – it is a serious disservice to those who rely on such guidance.
One final admonition
Compared to previous market periods, today’s heavy flow of frightening and frothy investment articles makes an investor’s task all the harder. To then have a large, trusted investment firm start promoting sloppy analysis and worrisome, but baseless, scenarios is both misleading and detrimental.
For those of you in the investment advisory business, it is important to call out such misinformation. To succeed, investors must learn to navigate the investment world with a proper amount of caution and questioning, even of those they trust.