Goldman Sachs is in agreement with the consensus that 2020 will be mildly bullish. Their use of the Sharpe index to pick individual stocks is what is most interesting.
David Kostin, chief U.S. equity strategist for Goldman Sachs, is forecasting more of the same for stocks next year, although the consensus is that growth in stocks will be a lot more modest in 2020, somewhere in the range of 5%. Kostin has this pegged at 6%, based mostly on the solid macroeconomic conditions continuing to shape things in a positive way.
While these predictions may end up erring on the side of modesty, as this would actually be a below average performance for stocks, especially during this bull run, this should at least help allay the fears of many investors that this run is about to end and especially may be more likely to end than not.
Even if we had such a prediction, we’d still want to see enough confirmation from the market to act on these beliefs, as there is a fair amount of guesswork involved and we don’t want to be doing too much guessing. This is especially true with investors, who generally want to be in stocks unless there is a really good reason not to, and there have been no significant ones so far over the last 10 years.
Along the way, there have been plenty of concerns about this long bull market ending, with none thus far panning out. These calls really picked up earlier this year, but the only thing that the modest pullbacks that ensued accomplished is to drop off the scared money at lower prices and then just resume going higher.
We’re likely to get our best year in stocks in 2019 since all the way back in 1997, during the heady days of the tech bubble where the frenzy to pile on stocks got so out of hand that we required a huge correction to rebalance things. We don’t want things accelerating too fast though or this can happen. Think a lighter version of the Bitcoin boom and bust where everyone scrambles to grab their big profits before they disappear, and when this many people do that, a crash is the only thing that is possible.
We’re nowhere near such a thing though and the real difference is to compare the mood 20 years ago with today’s mood. Fear was well in the air back then, with the strong belief that recent growth simply wasn’t sustainable. Market beliefs translate into reality easily and naturally because once you actually do get to a point where things reverse in this scenario, this causes things to reverse very hard as we believed that it would.
With today’s much more positive outlook, this is far likely to happen, and we’ve taken the pullbacks this year very much in stride, believing overall that the storm will pass, and then seeing this belief manifest as it usually does.
Trying to predict stocks for the coming year based upon data is a difficult process at best, and investors who mostly intend to be in stocks but may consider exiting if really warranted need to keep things simple. Keeping tabs on the overall mood of the market and their beliefs about the future is a simple and easy way to look to avoid acting too hastily, as a lot of people did this year for instance, but also providing the level of safety that they seek, to avoid the worst of it if the worst does happen.
Seeing outlooks such as that of Goldman’s and others should tell us that we are nowhere near that point, and while there are always bears out there, and you can always find reasons why a bull market may end, we always need to be considering the whole picture and weigh the good with the bad, and the good is clearly ahead right now.
Taking your profits here not only risks giving up next year’s probable gains, but you also need to be concerned about where you are going to put your money instead, and stocks not only still look bullish but are still a better bet than alternative investments such as bonds or gold.
Bonds are particularly bearish right now, and while gold does look mildly bullish, we simply cannot rely on gold making money in 2020 anywhere near as much as we can count on stocks over this time. Investing is all about focusing on probabilities, even though we may do so in a very casual fashion, but casual is really enough since these comparisons are so broad and the differences between them, like in this case, aren’t minor.
The Growth Numbers People Are Using Are on the Conservative Side
The 6% that Goldman is seeing is based upon their macroeconomic predictions, and given how economists calculate things, this does tend to understate the potential since it does not factor in the biggest force in the stock market, which is called momentum. What we end up doing with stocks is multiplying the effect of positive economic change, and if we do not account for this multiplication enough, if the predictions about the economy are indeed right, the market will take this data and make it larger.
2019 is a good example of this, as these folks certainly weren’t predicting a 30% gain, especially after a pretty dismal 2018. The difference between 2018 and 2019 can actually serve to enlighten us as far as how powerful monetary policy is to stocks, and the fact that we saw a mediocre 2018 but a very strong 2019 just didn’t coincide with a change in mood at the Fed from hawkish to dovish,
it actually was the major force behind this change. The economy actually was better last year, but the removal of the worry that the Fed may put them up again combined with their putting rates down later in the year easily trumped this slowdown.
This still requires that we look at the economic data that they look at, especially when it comes to perceiving the risk of tightening, but it’s blue skies ahead on both counts next year and this alone should have us continuing to stay in stocks until things get to the point where we may wish to rethink this.
Whether we get 6% or 30% doesn’t really matter to the decision to stay or go, because at the lower end of this, stocks simply win. Seeing them win more is nice, but as far as the role this plays in our decision making, it is just a bonus.
Goldman Sachs also has some stock predictions for us as well, and we can certainly benefit by changing horses when it is desirable to do so, when we can improve our overall returns by switching horses and looking to get off the slower ones and get on faster ones.
Kostin’s picks are based upon using the Sharpe ratio to calculate which stocks have the best risk-adjusted return, which is in itself a nice-looking idea provided that we actually calculate things out properly. While we tend to be too conservative with taking on risk, basically ignoring the benefit of avoiding risk by just being on the right side of longer-term trends, we still need to pay attention to such things, even though Sharpe’s approach does indeed overstate the impact of risk and have us watering down our returns too much.
The reason why this happens is that it modifies returns by way of volatility, in a way that approaches it in a purely negative way. Kostin actually uses implied volatility from options, which actually takes us further in the wrong direction as it is quite normal to see this go up in good times where such a thing is a clear good, even though this also goes up in bad times as well, the thing that we do need to pay attention to.
If we imagine two stocks that mostly zig up but also zag down along the way, if one both zigs up and zags down more than the other but goes up quite a bit more on a net basis, we do not want to penalize it for zigging up more and use this to understate its potential. We do need to be aware of the higher risk of the better stock but we also need to be careful not to overstate it too much.
Since it is risk that we are concerned about here, a better approach, and the one we use, is to compare the magnitude of pullbacks across stocks and use that as our risk control. Once you have this, you can’t just look at it in isolation either, like a tech stock being too risky because it may give back twice as much during a pullback, as we also need to account for the fact that it gained more prior to the correction and where we end up correcting to on a net basis is what really matters.
We therefore need a more dynamic approach to risk with stocks, one that incorporates both the good and bad side to volatility, and not just use greater volatility against a stock. Some might argue that the Sharpe ratio already does that, since it compares return with volatility, but it does use volatility itself to rein in returns and this is where the fear of volatility gets puffed up like a cat’s tail can when they are nervous.
Even doing something like toning down the effect of volatility in the formula would help, perhaps dividing it by half since at least half of this is to our benefit. We also need to further discount this effect by having this match our time frames more and approaching this on a longer-term perspective than just something like a year, where we see hot stocks be more volatile to the downside in the shorter term, in a manner that we can easily withstand in this timeframe, making these moves far less significant to us than they would be to a position trader for instance.
This Formula Only Works if the Return Numbers are Valid
The much bigger question if we’re going to use Sharpe ratios to pick stocks is what we are going to use for the return in the calculation. We would normally want to look at past performance for this, and while it’s always better to look ahead rather than back if we can, looking ahead with any degree of accuracy over a time frame such as a year is notoriously difficult to quantify, so much that we should not even consider attempting such a thing, as being off too much is going to destroy the validity of our calculations.
We can calculate what has already happened though, and this is actually the bedrock of any good stock picking strategy, where picking here also means choosing to stay in or not after we are already invested in something. From there, we can further refine the potential of a stock in a general way, where we might see a stock like Amazon which has delivered good results lately but has petered out in the second half of the year being less favorable than a stock that grew as much but has achieved this gain more in the second half.
Kostin’s idea of looking at the price targets of analysts for the return part of this formula might seem reasonable on its face, until we realize that these predictions aren’t really that reliable, and anyone who believes they are neither understands the process in which these targets are obtained nor has looked at how this has worked out in the past.
As it turns out, it is not even possible to predict these returns with anywhere near the accuracy that we need, and while they might still be interesting to look at for a general feel, there are just too many unknowns. This takes information that is very incomplete and sees us using it in a matter that assumes that it is complete.
That’s not even the big problem with this though. Analysts build in strong biases, especially the one that mistakenly assumes a much bigger tendency toward revision to the mean than actually occurs, and we don’t have to look any further than the stock that they found to have the highest Sharpe ratio in the market according to the way they are using it, Diamondback Energy.
Kostin admits that he sees people favoring the dogs more next year based upon his belief that people do that more during good economic times, and the fact that this surely didn’t happen this year nor for a very long time somehow got missed.
Diamondback Energy is simply an ugly stock in an ugly sector and hasn’t even participated at all in the 2019 rally, and even has lost a little money this year. It also has been particularly trending down since last May, and regardless of anything else, if this is going to be a top stock in 2020, it has to at least show us that it is at least heading in the right direction, and continuing to move in the wrong direction does not in any sense qualify.
GM also makes this list, and if you’re betting on GM as well, it’s plain that you just like the beat -up stuff. There’s nothing wrong with keeping your eye on stocks like GM and Diamondback should you believe that they may turn around, but you need them to at least take enough steps that way to want to bet on it, and none cannot possibly be enough.
It doesn’t take much of an understanding of how fundamental analysts think to imagine how these two could achieve such a high predicted return in 2020 to have them sitting at the head of the stock table, as these analysts dislike price growth and will discount it, and will instead add premiums to stocks that have underperformed, whether it makes sense to or not.
This is due to their expectation that higher price growth will revert to being more in line with their fundamentals, and the reverse will happen with low growth ones. The only problem with this is that it is at odds with reality, and enough to allow these two terrible stocks, among others, to magically become not only bullish but enough to elevate them to top 16 overall status, and in Diamondback’s case, number one period.
Making predictions like this over this time frame and obviously ignoring the performance of stocks isn’t just not optimal, it’s completely out of touch. Even if we insist on an approach that fundamentally ignores stock performance, we still need to use this performance as at least a reality check and at least ask if our reasons are sufficient to turn these things around enough such that our predictions are reasonable.
There are no secrets out there even though many investors think that they are. It is not that the market is bearish on Diamondback Energy because they just don’t know how good things look for this company in 2020, and we’re talking plenty good to take it from being a disaster to being a shining star.
If something happens to change this, it hasn’t yet, because the market sees the same things that the analysts see, with the difference being that the analysts are making some assumptions about what we do know that are beyond what the market sees right now. If the company’s foreseeable future was so bright, it wouldn’t be down 17% over the last 7 months while the market has risen by 13%.
If we go a little longer out, since July 2018, this also paints an ugly picture, with Diamondback down 33% over this period, and the S&P being up 18%. We might think that Diamondback Energy is due, but it simply is not showing it and it needs to. A sprinter with a broken leg might win a gold medal one day, but not while the leg is still broken.
We might hope that it might heal someday, but we need to see them start walking again before we can expect them to run and especially run fast.
It’s not that all the stocks on their list are so misaligned with performance, as they also have some pretty good ones in there such as Amazon and Comcast, which have at least been pulling their own weight lately, but any formula that could possibly include distressed stocks that still are very much distressed reveals some big failings. We can use such a list but we do not want to just swallow it whole and ingest a lot of dirt with our meal, and need the presence of mind to take a closer look at what we are going to eat and pick the bad stuff off our plates before we dine.
The Sharpe ratio may have its failings, but can add to our understanding when used properly, and this is simply a great example of when it is not. Like with any formula, the quality of its results is entirely dependent on the quality of its assumptions and data, and like the saying goes, garbage in, garbage out. When garbage even becomes preferred over the good stuff as a matter of strategy, like it is with the approach of the analysts who define the data, this will not surprisingly be wanting us to prefer to invest in the garbage, which cannot be the real goal.
Maybe Diamondback Energy, GM, and their other allegedly high risk-return ratio stocks that just don’t deserve these accolades will end up leading the market in 2020, as anything is possible. Just don’t bet on it.