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Lessons of a pandemic year

That notorious misprediction warns us against trying to forecast equity returns. It’s one I should have heeded this time last year, when I wrote that lead indicators pointed to 2020 being a dull year, with the All-Share index rising only slightly.

That was, of course, hopelessly wrong. Mistakes, though, are learning opportunities. So what might we learn from that?

One possibility is: nothing. These lead indicators pointed to a one-in-three chance of the market falling and around a 10 per cent chance of it falling as much as it has. Such chances do turn up quite often. My indicators therefore warned us not to bet heavily upon shares, and to diversify.

What’s more, these lead indicators have been wrong before, only to be correct later – for example in 2002-03. And the pandemic was a genuinely exogenous event that economists could not have foreseen last year. In this sense, this year’s fall is very different from previous ones, which were caused by economic events such as crises, recessions or over-valuations; it is these, not exogenous events such as pandemics, that lead indicators have successfully predicted.

Such a view might, however, be too complacent. Another interpretation is that the world is even more unpredictable than we want to think. Maybe Covid-19 was a once-in-a-century event; its nearest comparator is the Spanish flu pandemic of 1918-20. But we don’t know this for sure. Perhaps increasing cross-border travel, antibiotic resistance and climate change are all increasing the danger of economically disruptive illnesses. And the pandemic is only one type of surprise that could disrupt the relationships we use for forecasting. There are others – ones we can’t describe in advance, but which are only understandable with hindsight.

Perhaps, therefore, this year’s events remind us of a point made by Richard Bookstaber, author of The End of Theory. We live, he said, in a world of “uncertainty that cannot be expressed or anticipated”. If this is so, then we should just shut up about the future: we just don’t know anything about it. We must be humble. In this respect, I failed abjectly last year.

But, but, but. There are at least two big facts that have remained true even in this most disruptive of years.

One is that simple diversification works. In January I wrote a piece called 'How not to lose money' wherein I showed that a simple portfolio (50 per cent in MSCI’s world index, 20 per cent in gilts and 10 per cent each in gold, sterling cash and US dollar cash) lost only 5 per cent in the first three months of the year and has now made 9 per cent so far this year. If you were to look only at this portfolio’s performance, you’d never guess that anything strange had happened this year.


The other big fact is that economists’ approach to stock-picking has worked well this year.

There are two strategies that have proven to beat the market over time. (In fact, if you’re looking for decades of evidence from around the world, only two.) One is momentum investing. My no-thought momentum portfolio (comprising the 20 biggest risers in the last 12 months) has risen over 25 per cent this year while the FTSE 350 has fallen almost 10 per cent. The other is defensive shares. And my portfolio of these has risen 8 per cent so far. Research shows that the success of these strategies is robust to varying definitions of momentum and defensive; my portfolios are merely specific instantiations of a general principe.

Granted, these outperformances are flattered by the fact that half of the fall in the market is due to just four companies (Royal Dutch Shell, BP, HSBC and GlaxoSmithKline) and any stock-picker who avoided these should have done relatively well. But even allowing for this, the fact is that momentum and defensive investing have both done better than their betas would predict. They’ve continued to deliver (Jensen’s) alpha.

Again, if you were to look only at the relative performance of defensive or momentum portfolios, you’d not see anything unusual about 2020 – except perhaps slightly better performance than usual.


The success of simple diversification and of momentum and defensive investing cast doubt over the idea that 2020 proves the ubiquity of radical uncertainty. If the world really had become fundamentally uncertain, we’d not have seen such previously successful strategies continue to work. From an investor’s point of view, the only oddity about this year has been the unpredicted fall in the All-Share index.

So, we just cannot tell whether this year’s events refute or not the notion that markets are often predictable.

Luckily, though, we have a test here. If the market has become unpredictable then our lead indicators have stopped working and so will not predict the All-Share in 2021.

Investors should hope this is true, because they are now pointing to the market falling more than 10 per cent next year.

This is because two indicators are sending a bearish message.

One is that in the last 12 months non-Americans have bought $234.5bn of US shares, the largest amount ever. In the past, such buying has been a sign of excessive exuberance and hence a predictor that shares would fall around the world in the following few months. The two biggest falls in the All-Share index before this year – the tech crash of 2000-01 and the financial crisis of 2008-09 – both followed big foreign buying of US shares.

The other is that the ratio of the money stock to share prices in developed economies is still below its long-run trend, thanks to the recovery in global stock markets since March. This implies that investors now own more shares than usual and less cash. In the past, this has led to investors trying to rebalance their portfolios away from equities and towards cash, causing prices to fall. It was this indicator that sent a bearish signal a year ago.

Against this, we have one bullish indicator. This is that momentum is on the market’s side: the All-Share index is above its 10-month average. And we have one neutral indicator: at 3.4 per cent the dividend yield on the All-Share index is around its post-1995 average.

Net, these indicators point to the market falling next year. Of course, even if past relationships continue to hold, there is still a margin of error around this forecast. It implies there’s around a five-sixths chance of a fall and a one-sixth chance of a rise.

Which gives me some dilemmas.

One is whether to believe this. There are good reasons not to.

For one thing, foreign buying of US equities might no longer be a sign of exuberance but of its opposite. Insofar as foreigners are buying Amazon and Microsoft they are seeking the security of familiar stocks. That’s a sign not of high sentiment but of low. If so, it points to equities rising.

And for another, it is rare for shares to fall when economies do well simply because upturns increase investors’ appetite for risk. Even fully-foreseen recoveries can have this effect because investors don’t anticipate that better economic times will change their taste for risk.

And, thirdly, we have a bullish indicator. The ratio of retail sales to the All-Share index is above its average. Historically, this has predicted good returns because there is wisdom in crowds; consumers only spend a lot if they expect better times. Granted, retail sales overstate the strength of consumer spending, but even allowing for this we have a mildly encouraging indicator. This isn’t included in my model, because it usually predicts returns over longer horizons than just 12 months.

Such doubts, however, only give me another dilemma: should we trust my judgment? I’m honestly not sure. On the one hand, these doubts feel reasonable. But on the other, my instinct is to discount our judgments because they are prone to countless biases and errors. I prefer algorithms.

But there’s a third dilemma: how should we interpret the claim that the All-Share will fall 10 per cent next year? You could read it as simply advice to sell – subject to the caveat that there is a margin or error around that forecast. But I’d rather not. Instead, I’d see it as a test of the hypothesis that a small set of well-defined lead indicators can predict returns at least as well as unaided judgment.

In this sense, forecasts are not the same as advice. The advice I’d offer is that you should have a balanced portfolio that’s resilient to surprises – something that’s been easy to achieve in the past. But then, this is the advice I’d have offered last year, and the year before. Good investment strategies do not rely upon forecasts.