What’s going on with the stock market right now? We started the year with the worst market performance in history.  In February, volatility continued to reach multi-year highs.  As if that weren’t bad enough, the media reported in March that second quarter earnings were expected to be broadly lower. Things were shaping up to be a very bad year for stocks.  Now here we are in April, and all of a sudden the market is reaching new highs.  This seems incomprehensible.  Why isn’t the market behaving more predictably?  And what’s a rational investor supposed to do?

To address the first question, it may help to understand how markets work. In a large, non-rigged, efficient marketplace where everyone has access to the same information, small investors will not have any control over the returns that they will get.  The price of any company’s stock is based purely on supply (which is fixed) and demand.  When the number of investors buying a stock exceeds the number selling it, the price will go up (and vice-versa).  As company performance – which has been shown to affect demand – improves, and as the U.S. population’s investable savings grow, the higher demand for stocks will cause prices to increase.  But investor sentiment also plays a role, which is why in the shorter-term we are constantly being blindsided by unexpected market performance.

Do you recall the Greek election of 2012? It was widely regarded as a referendum on whether or not Greece would accept the austerity measures imposed by the European Central Bank, without which the country would be unable to remain in the European Union (EU).  The pro-austerity party won the election, which was also viewed as a win for stability and for support of the EU economy.  Yet the following Monday European and U.S. stocks fell.  Why?

What about 2013? We began the year with what was called “sequestration,” automatic and significant federal government budget cuts as a result of the Democrats and Republicans unable to agree on a budget for the year.  Museums and other federal agencies were closed or forced to operate on shorter hours with reduced staffs.  Economists were predicting the cuts would shave as much as one full percentage point off GDP.  Yet we ended that year with the S&P 500 growing by over 32%, its best return since 1998. Again, who in January predicted that would happen?

Complicating our decision-making are the tens of thousands of so-called “expert” investment advisors, media pundits, economists, and the like who are in the business of making money by promising you what to expect by doing what they say.   There’s just one problem: they really don’t know.   They can’t know. No one can predict the future.  These experts may utilize historical data together with various statistical tools or look at past price movements to try to spot what they believe to be repeatable patterns when estimating, valuing, figuring, assessing, or (name your verb) presuming future returns for particular stocks or stock funds. Call it what you will, in the end it’s still just a guess.  But we want to believe them, according to Dan Gardner in his book Future Babble, mostly because as human beings we all have a strong aversion to uncertainty.

There was a McKinsey study several years ago that reviewed media analyst predictions about S&P 500 earnings growth for the previous 25 years. They discovered that those predictions had been significantly wrong almost every single year.  Yet year after year the predictions continue to be made and investors continue to listen.

The reality is that the factors that impact stock prices are just too myriad and too complex to allow the creation of a model to predict changes from one day to the next or even from one year to the next. And if someone were somehow able to do so for a particular stock, unless he or she kept it secret (which would be hard to do in an efficient market), everyone would jump in, driving up the price of the stock to a level at which future returns would then become pretty small for anyone that bought-in late.  The only way you could make a good return would be to have made the purchase before everybody else did.  Good luck with that strategy!

Rational investors have to accept that we live in a world of uncertainty. But although we may not be able to control returns, there are some things that we do have control over that will improve our returns over time.  Next blog I’ll address one of these.