On July 12, The Wall Street Journal reported coffee prices were soaring due to drought in Brazil, the world’s biggest coffee producer. With the prospects of coffee demand exceeding supply, it would seem readily apparent that coffee prices will continue to climb. Or will they?
I must admit I’m not a coffee achiever. My morning intake consists solely of milk tea with ginger followed later by a raw cocoa drink with some supplements — no food. But, I’m a supporter of happy people and the prospect of low supply and higher prices for coffee makes me a little uneasy about the overall emotional well-being of the world.
But this is a good opportunity to look at markets and how prices are set. If you looked at the spot price of coffee (or gold or Bitcoin or any other commodity based on supply and demand), would you think it is undervalued, overvalued, or correctly valued? Everyone will have a different opinion, and everyone will think their opinion is correct, so who’s right? Enter an interesting illustration based on voluntary participation at a client event hosted by a financial advisor in August 2013, with the results audited by the advisor. A jar of jelly beans was set on a table; of course, we’ll call it a jar of coffee beans. The audience was asked to guess how many beans were in the jar. The highest guess was 5,365, while the lowest was 409.
This is a big range, and each person who guessed thought they were right — but no one was. Now here’s where it gets interesting. The average of all the guesses was 1,653, which was very close to the actual number of beans in the jar: 1,673. Considering this the “coffee bean market” illustrates the power of collective information and how difficult it is to beat the market.
This is actually very similar to how the stock market works and was described in Nobel Prize winning-economist Eugene Fama’s pivotal research with “The Efficient Market Hypothesis.” It essentially states that stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices — so it should be impossible to outperform the overall market through expert stock selection or market timing. Commodities are different from stocks, as in addition to supply and demand, a company’s stock price will also be affected by the estimated future cash flows of that company, something a commodity in and of itself will not give you.
Rather than get into the intricacies of stock valuation, the point is that there is a huge amount of collective data reflected in the price of each stock listed on the various stock exchanges around the world. These markets reflect the combined knowledge of all participants. In 2018, the daily average trading value was $462.8 billion.1 You may bet against the collective knowledge of the market and I sincerely hope you get lucky, but as I tell my clients, luck is not a strategy we want to count on for their financial well-being.
1 In US dollars. Source: Dimensional, using data from Bloomberg LP. Includes primary and secondary exchange trading volume globally for equities. ETFs and funds are excluded. Daily averages were computed by calculating the trading volume of each stock daily as the closing price multiplied by shares traded that day. All such trading volume is summed up and divided by 252 as an approximate number of annual trading days.
2021 Q2 Index Review Through June 30
Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio. “BB=Bloomberg Barclays”. Market segment (index representation) as follows: US Stock Market (Russell 3000 Index), International Developed Stocks (MSCI World ex USA Index [net div.]), Emerging Markets (MSCI Emerging Markets Index [net div.]), Global Real Estate (S&P Global REIT Index [net div.]), US Bond Market (Bloomberg Barclays US Aggregate Bond Index), and Global Bond Market ex US (Bloomberg Barclays Global Aggregate ex-USD Bond Index [hedged to USD]). S&P data © 2020 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. MSCI data © MSCI 2020, all rights reserved. Bloomberg Barclays data provided by Bloomberg.
Q2 was another great quarter for stocks, and it was actually the U.S. and global REIT indexes that led the charge with 11.94% and 10.43%, respectively. As a matter of fact, all listed indexes were positive for stocks and bonds, which is a good scenario for globally allocated investors with bonds in their portfolios.
The stock market has had a very robust recovery since the pandemic and you might think it’s self-evident we might be at a high and headed for another downturn. I’m sure you will read analysis or talk to folks who will suggest a reallocation away from equities because of this. Well, they might be right and it could happen, but history suggests otherwise. The following table looks at the average annualized returns of the S&P 500 after new market highs from January 1926 to December 2018 and you’ll note robust returns one, three, and even five years out from market highs.
In U.S. dollars. Past performance is no guarantee of future results. New market highs are defined as months ending with the market above all previous levels for the sample period. Annualized compound returns are computed for the relevant time periods subsequent to new market highs and averaged across all new market high observations. There were 1,115 observation months in the sample. January 1990–present: S&P 500 Total Returns Index. S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. January 1926– December 1989; S&P 500 Total Return Index, Stocks, Bonds, Bills and Inflation YearbookTM, Ibbotson Associates, Chicago. For illustrative purposes only. Index is not available for direct investment; therefore, its performance does not reflect the expenses associated with the management of an actual portfolio. There is always a risk that an investor may lose money.
The moral of this story is to come up with a strategic allocation that fits a well- thought-out financial plan. Outguessing markets is more difficult than many investors might think. While favorable timing is theoretically possible, there isn’t much evidence it can be done reliably, even by professional investors.
The positive news is investors don’t need to be able to time markets to have a good investment experience. Over time, capital markets have rewarded those who have taken a long-term perspective and remained disciplined in the face of short-term noise. By focusing on the things that can be controlled (like having an appropriate asset allocation; diversification; and managing expenses, turnover, and taxes) you may be able to position yourself to make the most of what capital markets have to offer.
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