Distinguishing between noise and signals in volatile markets (Part 2)
Part 2: Equities
by Sandy McIntyre, Co-Chief Executive Officer, Sentry Investments
In talking with financial advisors over the past few months, there’s been a consistent theme: they are overwhelmed with the amount of financial information and opinion that is available. They are struggling to separate the signals from the noise. They are struggling to determine which inputs to their investment decision-making process are working and which opinions they should trust.
In Signal to Noise, part 1, we looked at fixed income. In this commentary, we’ll be looking at equities and what we should be using to filter noise from true signals.
Signal-to-noise ratio (SNR)
The signal-to-noise ratio is sometimes used informally to refer to the ratio of useful information to false or irrelevant data in a conversation or exchange (Wikipedia). The calculation is as follows:
SNR = Power signal/Power noise
In my view, investors should only listen and respect those signals that challenge their long-term investment objectives and be prepared to adjust their portfolios when those objectives are not a likely outcome. Unfortunately, too often, investors listen only to the signals that confirm their outlook (known as confirmation bias) and ignore the ones that challenge it.
When investors are stress-testing their long-term objectives, they should ask, “Is the return I anticipate receiving worth the risk that I am taking to obtain that return?”
Is past performance a true signal or is it noise?
For most investors, answering this question involves looking at past performance of major asset classes and extrapolating that performance into the future.
If past performance can be expected to be replicated given current circumstances, then it is a signal. However, if the performance cannot be replicated, then it is noise. If it’s noise, the information should not influence investors’ thought process.
This concept will likely relegate most media inputs into the noise category: they do not speak to the investors’ long-term objectives and are too frequently caught up in the flow of short-term news events.
Can past equity performance be replicated?
Like we did with fixed income in part 1, we should establish some key measures to judge if the risk of equities can be justified at this time: can past performance be replicated from this starting point?
Valuation is the main measure to consider; however, we’ll also be reviewing these other measures in this commentary:
- Current position in the business cycle and earnings growth trend: Where are we in the business cycle? What is the correlation between the business cycle and bull and bear markets?
- Relative market valuation — P/E ratios: Are current multiples indicating that the market is too expensive? What is the effect of adjusting P/E ratios for inflation?
- Liquidity and impact of central bank activity: What are the U.S. Federal Reserve’s intentions in terms of monetary tightening and quantitative easing? What is the impact of the U.S. Federal Reserve adding or taking money away from the system?
- Liquidity and margin debt: What is the current amount of liquidity in the market? Are investors using cheap money to buy long-term assets?
- Capital formation and allocation: Where are funds flowing? What implication will demographics have on capital allocation and fund flows?
Business cycle and trend in earnings growth