“Things never go the way you expect them to. That’s both the joy and frustration in life. I’m finding as I get older that I don’t mind, though. It’s the surprises that tickle me the most, the things you don’t see coming.” - Michael Stuhlbarg
Curse you Josh Brown and Michael Batnick! Ever since I went on The Compound & Friends podcast in late February 2020 to brag about my sure-fire surprise forecasting formula, I have successfully predicted only two of six surprises in 2020 and 2021. As a reminder, each January for the past six years, I have reluctantly predicted three surprises for investors. My overall track record is a respectable 12 of 18 (67%), but the last two years have been a disaster.
Some friends, colleagues and clients have gone so far as to take pity on me by offering the highly unusual pandemic plagued years as an excuse for my recent prediction failures. Their kindness speaks to the strange unspoken agreement between writer and reader of this article. Despite mountains of evidence exposing so-called experts’ inability to consistently make accurate forecasts, we both guiltily embrace our behavioral biases and agree to suspend disbelief for a few fleeting moments, allowing hope to triumph over experience.
The Boston Red Sox broke the Curse of the Bambino in 2004. The Chicago Cubs ended the Curse of the Billy Goat in 2016. In January, the Cincinnati Bengals won their first NFL playoff game in 31 years, ending the Curse of Bo Jackson. And, now, I must break the Curse of the Compound in 2022.
While investors hope to find a hidden gem investment idea in my surprises, the most important lesson from this article is the annual reminder that investment outcomes are always highly uncertain. However, a consistent, disciplined and repeatable investment process is firmly within investors’ control. A thoughtful approach combined with a little luck provides investors the best opportunity for long-term success.
I have consistently applied the same simple repeatable formula over the past six years. Each year I forecast just three surprises. Predicting a small number of high conviction surprises has aided my results. Too many predictions reduce accuracy as correct and incorrect forecasts cancel each other out.
My forecast period is the calendar year. Attempting to identify surprises over longer time horizons adds to forecasting folly.
And perhaps the most important ingredient to my surprise forecasting formula is identifying unloved assets with compelling valuations where a lot of bad news is already priced in and investor sentiment is decidedly one-way. When these dynamics are in place, the potential for a surprise is at its peak.
Applying this forecasting framework, let’s explore this year’s three surprises:
Chinese stocks plummeted 21.6% last year, massively underperforming both US and global stocks by 49% and 43%, respectively.1 China’s zero-COVID policy combined with regulatory crackdowns in the technology, for-profit tutoring and property sectors cooled economic growth. As a result of these harsh policy shifts, a growing number of investors are asking, is China still investable? This is a sharp change in sentiment from a year ago.
Wall Street firms, the World Bank and many others have been slashing their China GDP forecasts for this year. But, more recently, the People’s Bank of China has been cutting lending rates and loosening monetary policy to spur sluggish economic growth. In addition, China’s finance ministry vowed to roll out a number of fiscal policies earlier than usual in 2022 to revive the country’s economy. And, according to Barron’s, China racked up a record $676 billion trade surplus last year, a 60% jump from the pre-pandemic year of 2019.2 Easier monetary policy, fiscal stimulus and the country’s still strong export machine are likely to result in some unexpected upside surprises in China’s economic growth this year.
Meanwhile, Chinese stocks trade at a forward price-to-earnings (P/E) multiple of 12.1x, suggesting that a lot of bad news is already priced into the market. Compared to US and global forward P/E multiples, Chinese stocks trade at a 46% and 38% discount, respectively,3 likely creating a compelling relative value opportunity for investors.
China celebrated the Year of the Tiger on February 1, offering investors in Chinese stocks a promising sign. The tiger symbolizes strength in Chinese folk tales and it’s known for warding off disaster. After a challenging 2021, investors would welcome a rebound in Chinese stocks. That’s why for my first surprise, I’m predicting that Chinese stocks will outperform global stocks.
Gold gained 18% and 25% in 2019 and 2020, respectively, but delivered a disappointing loss of 4.3% last year.4 Rising interest rates from the pandemic lows, anticipation of tighter monetary policy and a strong US dollar trumped gold’s benefit as a hedge against inflation in 2021. Funds tracking the price of gold suffered notable outflows last year.
Despite last year’s headwinds there are several reasons to remain optimistic about gold’s outlook for 2022. According to Strategas Research Partners, last year was the ninth calmest market since 1950. Historically, the next year is more volatile and that’s particularly true in midterm election years. The messy exit from the pandemic, supply chain disruptions, inflationary pressures and divergent global monetary policies are all likely to lead to greater volatility this year. Rising volatility may prove beneficial for gold as it looks to resume its longer-term bull market which began during the Federal Reserve’s (Fed) previous tightening cycle in December 2015.
Increasing policy rates are not always an obstacle for gold. For example, the Fed raised its target funds rate nine times from December 2015 until it began cutting rates in July 2019 and the gold spot price climbed nearly 35% during that time.5 Real yields may be a more important gauge for movements in gold’s price and the 10-year Treasury real yield is currently -0.71%, creating an attractive backdrop for gold investors.6
Over the last 50 years gold has provided an average annual real return of 12.1% when the Consumer Price Index (CPI) exceeded 5%, compared to negative returns on average for both US stocks and bonds.7 On January 12, the US Bureau of Labor Statistics reported that CPI increased by 7% year-over-year, the largest 12-month increase in 40 years. Investors may seek to increase exposure to gold in response to soaring inflation.
Unexpected US dollar strength dampened gold’s performance last year. The dollar is likely to find short-term support as the Fed begins to tighten monetary policy. However, as the global growth recovery from COVID-19 expands more firmly beyond the US, combined with poor US debt and deficit dynamics, the US dollar may begin to weaken in the second half of this year.
Finally, nosebleed market valuations, historically tight credit spreads, rising geopolitical risks and surging speculation in cryptocurrencies, SPACs and NFTs could lead to heightened volatility, making gold an attractive hedge against a growing list of potential market risks.
So, what about bitcoin? Peter Atwater, adjunct lecturer at William & Mary and the author of an upcoming book on confidence-driven decision-making, wrote a thought provoking op-ed in the January 11 Financial Times. He described popular investor trends like trading in NFTs, cryptocurrencies, Web3 and metaverse as manifestations of a deep-running trend towards extreme abstraction.
Atwater admits that abstraction isn’t something that investors pay attention to. So, he relates abstraction to investor confidence. At peaks in confidence, investors have an insatiable appetite for possibility — they buy dreams at the highest price. He claims that what is most expensive in today’s market is the most extremely abstract — the enterprises that have the greatest “hypotheticality,” the anti-real.
Atwater’s fear is that when we see an inevitable retreat from extreme abstraction, a vicious spiral develops. Not only would investors switch to more “real” investments, like gold, but recent crowd favorites would come under greater scrutiny. He asks, “After years of devouring abstraction, does the crowd turn to more substantive investment themes - a year of getting real?” Atwater further suggests that the transition would be far from smooth.
Keeping it real in 2022, my second surprise is that gold beats bitcoin.
I’m shaking things up in year seven of forecasting surprises. For the first time ever I’m going to repeat a surprise from the previous year. Last year I predicted that aerospace and defense stocks would beat the market. That surprise bombed, pun intended. The S&P Aerospace & Defense Select Industry Index produced a modest 2.7% return in 2021, trailing the S&P 500 Index return by a whopping 26%.8
The annual National Defense Authorization Act (NDAA) that sets policy for the Pentagon was delayed until the end of last year over disputes ranging from the size of the defense budget to whether to force President Joe Biden to impose sanctions over a Russian natural gas pipeline or how to punish China for alleged mistreatment of Uyghur Muslims in its Xinjiang region. The $770 billion act which authorizes military spending finally made its way through Congress in December. However, NDAA uncertainty weighed on aerospace and defense stocks throughout last year.
In addition, Boeing, a bellwether of the aerospace and defense industry, battled production issues with the 787 Dreamliner and faced lingering 737 Max challenges, sending shares lower by roughly 6% in 2021. Regrettably, the delta and omicron variants continued to wreak havoc on the outlook for airline travel.
The prospects for reduced government defense spending, Boeing’s blunders and the pandemic’s negative impact on the airline business were all headwinds for the aerospace and defense industry in 2021. Poor performance combined with a second consecutive year of fund outflows from indexes tracking aerospace and defense stocks make them unloved investments.
The dismal outlook for the industry reflects a lot of bad news, possibly creating a compelling value opportunity for patient investors. Fears that government defense spending would decrease proved to be unfounded. In fact, the NDAA increased military spending by about 5% compared to last year and includes $25 billion more than President Biden requested.9 Recent headlines underscore the persistent but evolving threats from Russia, Iran, North Korea and China. Tensions between the US and Russia are particularly high over Russia’s decision to amass 100,000 troops near the Ukrainian border. These potential military hotspots will make certain that defense spending will continue to be a growing portion of government expenditures.
In January, Boeing reported its third consecutive annual loss. The manufacturer also took a $3.5 billion pre-tax charge in the fourth quarter on 787 Dreamliner delays. Could things get any worse for Boeing? Or did Boeing finally throw in everything but the kitchen sink in its earnings results by releasing all its bad news at the same time rather than dripping it out throughout 2022? It likely wouldn’t take much good news to begin to improve investor sentiment for Boeing’s stock.
Finally, the worst may be behind the aviation sector after the pandemic devastated demand for air travel and new planes. Airline executives said in January that they expect international travel bookings to rebound this spring and summer after entry restrictions were lifted in recent months. Airline passenger traffic is expected to return to 2019 levels as early as next year.
For my third surprise, I expect aerospace and defense stocks to rebound this year and outpace the broader market’s return.
Investors always keep score. It’s what we do. My one for three record with 2021’s surprises was depressing. I successfully predicted that the Fed would make a policy mistake. The Fed waited too long to retire “transitory,” falling further behind soaring prices and now it must aggressively tighten monetary policy to tackle stubborn inflation. As a result, the Fed risks popping the financial asset price bubble and possibly prematurely ending the fragile economic expansion. If you have been reading carefully, you already know that I botched the aerospace and defense stocks beat the market surprise prediction. Let’s not relive it here. You probably can’t believe I am predicting the same surprise for 2022. And, finally, I suggested that inflation would undershoot lofty expectations. Oops. My bad. I really thought 2021 would be better than 2020.
Thankfully at the beginning of each year we wipe the slate clean, reset the score totals to zero and move optimistically forward. There is no curse of The Compound & Friends podcast preventing me from successfully forecasting surprises for investors. Just like there wasn’t a lucky rabbit’s foot or other good luck charm that led me to early success in predicting market surprises when I started this annual article in January 2016. And we both know it. The one constant over the past six years is my consistent application of a simple, disciplined and repeatable surprise forecasting formula.
Investment outcomes are random, but a sound process provides investors the best opportunity for long-term results. May all your 2022 investment surprises be positive surprises.
1MSCI Index returns, Bloomberg Finance, L.P., as of December 31, 2021.
2Craig Mellow, “China’s Trade Surplus Hit a Record in 2021. These Stocks Helped Make It Happen,” Barron’s, January 21, 2022.
3MSCI Index returns, Bloomberg Finance, L.P., as of December 31, 2021.
4Bloomberg Finance L.P., State Street Global Advisors. Data as of December 31, 2021.
5Bloomberg Finance L.P., State Street Global Advisors. Data from December 15, 2015 to July 30, 2019.
6 Bloomberg Finance L.P., State Street Global Advisors. Data as of January 31, 2022.
7Bloomberg Finance, L.P., as of December 31, 2021.
8 Bloomberg Finance, L.P., as of December 31, 2021.
9 Patricia Zengerle, “U.S. Senate passes $70 billion defense bill, Biden's signature next,” Reuters. December 15, 2021.
A peer-to-peer digital currency created in 2009 that offers the promise of lower transaction fees than those of traditional online payment mechanisms. Unlike government-issued currencies, Bitcoin is run and “regulated” by its own users using an infrastructure called “blockchain.”
An overall increase in the price of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation — and avoid deflation — in order to keep the economy running smoothly.
The tendency of a market index or security to jump around in price. Volatility is typically expressed as the annualized standard deviation of returns. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.
The S&P 500 is widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
Represents the aerospace & defense segment of the S&P Total Stock Market IndexTM. The Index is modified equal weighted.
The views expressed in this material are the views of Michael Arone through the period ended January 31, 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward looking statements.
Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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