New year. New decade. Exciting stuff. There is something fresh, new and invigorating about turning the page from one year to the next. It grants us the guiltless freedom to put our disappointments and unfinished goals firmly in the rearview mirror while looking forward to the untouched open road ahead. The start of the 2020s magnifies the excitement. A potentially pioneering decade filled with creative innovations and major breakthroughs across many fields. Something about it just feels good — hopeful.
Embracing these powerful start-of-the-new-year emotions, each January since 2016, I have reluctantly — and rather successfully— forecasted three surprises for investors. Over the past four years, I have accurately predicted 10 of 12 surprises. My two teenage kids would call that a humble brag. There will be plenty of time for gloating later. But first, let’s revisit my simple, disciplined and repeatable forecasting process, a seemingly foolproof formula.
Magic Formula: If It Ain’t Broke, Don’t Fix It
There’s really not that much to it. Forecasting a small number of surprises has helped my accuracy. Investors are repeatedly taught that having a larger number of positions in investment portfolios results in the welcomed benefits of diversification. However, when attempting to make accurate forecasts, concentration in a few predictions can lead to better overall results.
A short time horizon is important too. My forecast period is the calendar year. And when it comes to identifying surprises, unloved assets with compelling valuations where a lot of bad news is already priced in and investor sentiment is decidedly one-way produces a profitable environment with plenty of opportunities. That’s the simple formula that has yielded solid results over the past four calendar years.
However, in a classic sign of hubris and stupidity, for 2020, I’m adding a wrinkle to my formula. Run while you still can! With Christmas and New Year’s Day both falling on a Wednesday in 2019, the long holiday break provided ample time for some casual reading. I read two books that while quite different from one another shared a common theme about logic.
A friend recommended The Book of Why: The New Science of Cause and Effect by Judea Pearl and Dana Mackenzie. Pearl is a computer scientist, a recipient of the Turing Award ─ the highest distinction in the field ─ and a philosopher best known for championing the probabilistic approach to artificial intelligence (AI) and Bayesian networks. Mackenzie is a mathematician turned science writer. Admittedly, this book was tough to get through. It read like a college statistics textbook, and I cursed my friend for recommending it.
However, at least one theme stuck with me. At 83 years old, Pearl has dedicated his life to the development of artificial intelligence. He is an AI expert. When he and Mackenzie describe today’s shortcomings, they observe that the algorithms do as they are told. Computers, even smart ones, don’t break the rules of logic. But, here’s the thing: humans do. In fact, some of the greatest creations and innovations are the result of humans’ ability to dream and ultimately defy logic. The authors unexpectedly conclude that until we’re able to teach computers to break the rules of logic as humans do, advancements in AI may continue to be disappointingly gradual.
Speaking of breaking the rules, the second book I read over my holiday break was Rory Sutherland’s Alchemy: The Dark Art and Curious Science of Creating Magic in Brands, Business, and Life. Now, that’s a mouthful. Vice Chairman of Ogilvy Group UK, Sutherland is widely recognized as one of marketing and advertising’s most original thinkers. Thankfully, there weren’t any mathematical formulas in this book. Simply stated, Rory Sutherland is a rule breaker. In the opening pages, he lists “Rory’s Rules of Alchemy.” Here are just a few:
- “It doesn’t pay to be logical if everyone is being logical.”
- “The problem with logic is that it kills off magic.”
- “Test counterintuitive things only because no one else will.”
- “If there were a logical answer, we would have found it.”
Sutherland claims that modern society has turned its back on illogic, which at times can be uniquely powerful. Because reductionist logic has been so effective in the physical sciences, people now believe that it must be applied everywhere, including the messier field of human affairs. He writes, “The models that dominate all human decision-making today are duly heavy on simplistic logic, and light on magic ─ a spreadsheet leaves no room for miracles.”
On the surface, these books have nothing in common, but they remind me of a valuable investing lesson. Perhaps I will label it the “illogic premium.” If everyone is doing it — being logical — then it won't generate a profit for investors. So, in addition to the “magic formula” that I have successfully used over the past four years to forecast surprises, this year I will sprinkle in a little illogic for good measure. Here are my three surprises for 2020:
1. Missing Market Euphoria is Found
It has often been said that this is the least-loved bull market ever. Yet despite all the skepticism, like the Energizer Bunny, it just keeps going and going. Fast approaching 11 years old, this bull market is among the longest in modern history, and at its current trajectory, it’s on pace to be the best performing, too. And although market valuations are elevated, it feels far from the nosebleed levels observed at the turn of the century just prior to the Technology, Media & Telecom (TMT) bubble bursting. C’mon, people! Where is your excitement?
Most investor surveys and Wall Street market outlooks are forecasting modest, single-digit returns for the S&P 500 in 2020. The logic behind those expectations is solid. Last year’s outstanding returns were largely the result of multiple expansions. So it’s not likely that investors will continue to bid up stocks, unless underlying fundamentals begin to catch up to prices. Earnings growth plus dividends are likely to deliver single-digit returns this year. It all fits neatly together. Too neatly. Looking back at historical calendar year returns reveals that it is rare for the S&P 500 to deliver single-digit returns in any given year. Why should 2020 be any different?
Euphoria has been the missing link in the later stages of this long-running bull market, fueling investors’ growing confidence that stocks can continue rallying without it. Don’t be fooled, euphoria is required before the bull market can end. And it is coming in 2020. As a result, the next leg in the markets likely isn’t down, but up. And up considerably. Investors can put aside all those predictions for more modest returns in 2020, because my first big surprise for the year is that a massive market melt up is finally coming.
This prediction may fly in the face of logic, but a growing number of indicators suggest that a more euphoric investing environment is taking hold. The put-call ratio, a widely used gauge of investor sentiment, is signaling extreme bullishness. Technical indicators like the relative strength index (RSI) point out that stocks are likely overbought. There is excessive bullishness in S&P 500 futures positioning. Flows into equity mutual funds and ETFs are off to a hot start so far this year. Stocks are at all-time highs despite a persistent deterioration in fundamentals. And the American Association of Individual Investors (AAII) Investor Sentiment Survey from the week ending January 22 reports that just 24.8% of survey respondents are bearish about the market over the next six months, which is well below the historical average of 30.5%.
Investors may be ditching their skepticism and finally getting more euphoric about this bull market. Oddly, the surprise melt-up that I’m predicting this year may signal that the long-hibernating bear market is finally waking up from its slumber.