As economic data continues to come in red hot across a wide range of metrics, companies report very strong earnings growth, and investment products start to put up big one year performance numbers, we are reminded of an important phenomenon to keep in mind when looking at it all as an investor.
Its called the base effects.
“The base effect is the effect that choosing a different reference point for a comparison between two data points can have on the result of the comparison. Thinking about the base effect in comparing different numbers or pieces of data means considering the question, “Compared to what?” The choice of the basis for comparison can have a large effect on the apparent result of a comparison. If ignored or misunderstood, the base effect can lead to a major distortion and possibly mistaken conclusions. However, if considered carefully, it can be leveraged to improve an analyst’s understanding of the data and the underlying processes that generate them.”
In other words, if base effects (also known as ‘comps’ or ‘comparisons’) are easy, then what would otherwise be ordinary performance can look like great performance. What would normally be considered good economic data is now great economic data. Indeed, a large part of successful forecasting of the future economic regime that markets are likely to price in and transition to in coming quarters is driven by understanding the base effects. Are the comps getting easier or harder is one of the most fundamental questions to ask when looking forward, either in regard to economic data or company earnings.
Think about where we are right now, and what was happening in the world around 1 year ago. We are getting economic data, earnings growth, and investment performance numbers through as at the end of April. The bottom of the share market fall was in late March 2020. Economic data such as the PMIs bottomed in April last year, just as the mother of all monetary and fiscal rescue packages was getting started.
Therefore, a lot of the year-over-year economic data and company earnings growth numbers are going to look extra fantastic due to the low base effects / easy comps due to the artificial event of the shutdown of the global economy over that prior period. Now, a global economic shutdown is clearly not a normal event, and hopefully not something we ever see again. And it is certainly a fact that not all the uplift right now is due to base effects. Organic growth is absolutely a central player and is benefiting from near zero interest rates and extraordinary fiscal stimulus. However, with abnormally easy base effects it is important to not extrapolate these red hot numbers into the future in a linear fashion. In fact if anything, the ‘comps’ from here start to get incrementally harder as we traverse the next 12 months.
Notice how published performance numbers (especially over 1 year) of investment products (especially share market funds and ETFs) have skyrocketed in the past month or so? Again, its because they are comping against the low point in the market due to the massive COVID inspired selloff in March 2020.
Here is a case in point. Our own Lonsec Emerging Leaders model share portfolio (CLICK HERE for more info), as at the end of March, has a one year performance of 68.69%.
That’s right. 68.9%. That’s not a typo.
However, before we get carried away and pat ourselves on the back, here’s the thing. The small cap index also did 52.15%. The ASX 200 index did 37.47% over the same time frame. So just investing in index ETFs with no stock picking at all still did very, very well, as the base effects were low due to the bottoming out of the market a year ago. At the end of the day, it is the easy base effects due to the March 2020 crash that are providing the vast majority of the uplift in one year performance numbers in share market products and portfolios.
To put it another way, in no way shape or form should anyone think that the above return is normal, or that it can be expected going forward. It just isn’t realistic. The same goes for any other investment product you may be looking at right now, regardless of the asset class. Consider the base effects, look at a longer time frame that encompasses the crash as well as the rebound of the past year, and think about how the base effects change as we move forward from here.
Easy base effects due to the COVID induced events of early 2020 are permeating through nearly all year-on-year data series and performance figures right now, and it is important for investors to be aware of it. In particular, one year performance figures are going to be skewed way outside their normal boundaries and should not be extrapolated into the future.
Author: Graham Parkes
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