Notes, Views, and the Occasional Provocation January / February 2016 

A well-known investment cartoon shows a TV anchor delivering the business news. "Everything that was good for the market yesterday is no good for it today," the announcer deadpans.

That pretty much sums up market sentiment right now, and no wonder. The first two weeks in January was the worst start in history for the S&P 500 Index, and the market swings haven't let up.

Many investors are questioning their strategies. When this happens, they tend to study historical investment returns in deciding whether to switch or stay the course. As the article below discusses, this exercise contains as many pitfalls as the markets themselves, and historical returns alone provide a perilous basis for making long-term investment decisions.

We shared much of this content earlier with clients, but thought it worth one more pass. We hope you find it helpful during these volatile days.

Best regards,

Milo Benningfield




With Investment Data, Begin With the End in Mind
Investors are admonished to focus on the long-term investment climate, not the yearly weather. But even a decade of past returns can mislead in making investment decisions, depending on where you start. more


With Investment Data, Begin With the End in Mind
A Wall Street Journal headline this week declared, "Winning Bets Become Losers." "Some of the hottest trades on Wall Street have gone ice-cold," the article stated, with bets on banks and large tech firms souring. "New sectors, such as value shares and small-and-midcap stocks, could take the market's baton from growth companies and large-cap shares."

For diversified U.S. investors, this would be a welcome shift. Over time, investors expect riskier stocks such as small and value stocks to compensate with higher returns than the market generally and larger growth stocks, in particular. But as the chart below shows, large growth stocks have now outperformed their riskier brethren over the past decade. We have to go out twenty years to see large and small value outperforming the S&P 500 Index:

What happened to small and value stocks over the past ten years? The answer lies with three main culprits:

  • Financial Crisis: small and value stocks were hit harder than large growth stocks during the recent financial crisis, so had a bigger hole to climb out of.
  • Low Inflation & Interest Rates: small and value companies tend to blossom during periods of rising inflation and interest rates, but rates have been low for a while.
  • Luck of the Draw: just because there's risk doesn't mean it will be rewarded at all times. The S&P 500 Index itself underperformed cash for fifteen years from 1966 to 1981.

More recently, the S&P 500 Index returned -1% from 1999 through 2009, while a globally diversified equity portfolio emphasizing small, value and international stocks earned more than 8%. Afterwards, the trend reversed so that international is now underperforming:

Currency fluctuations explain much of the international underperformance for U.S. investors. The US dollar is at a thirteen-year high compared to other currencies and rose 25% in the past two years alone. Last year, this meant that while the MSCI Europe Index returned 8.22% in euros, it returned -2.84% in US dollars.

Looking at the charts above, it's tempting to conclude that the S&P 500 Index is a superior choice to small, value and international stocks. But these charts are "snapshots" of historical data and provide a perilous foundation on which to make long-term investment decisions.

To illustrate, we can compare two ten-year investment periods, one starting in 2003, and the other starting not long after in 2006. If you were constructing your portfolio based on the 2003-2012 snapshot, you likely would have favored small and value stocks over the S&P 500 Index.

Three years later, the relative positions of growth stocks versus small and value had reversed:

We see the same shift between the same ten-year periods with international stocks and the S&P 500:

These shifts in average investment performance starting a few years apart illustrate a concept known as "endpoint sensitivity." Where you start and stop a data series often dramatically influences the results you see.

Even if you have some assurance that you've framed the data in a useful way, the investment climate changes too quickly for any historical snapshot to tell us what will happen next. Sometimes, in fact, the investment climate changes in a matter of months as it did with value stocks in the late 1990's.

At year-end 1998, value stocks had underperformed growth stocks over the previous one, three, five, 10, 15, and 20 years. To many investors, it seemed foolish to hold "old economy" stocks like Caterpillar while "new economy" stocks like Yahoo! Inc. were the future.

By early 2000 value had underperformed growth by 5.6% per year over the previous decade. It seemed that value stocks would need a lifetime to catch up, if they ever could.

It took less than a year. From April 2000 to February 2001, value outperformed growth by almost 40%. This brief run of outperformance meant that suddenly value stocks had outperformed growth over the previous one, three, five, 10 and 20 years.

Historical data and recent performance are necessary, but not sufficient to make long-term investment decisions. We also need an economic rationale for selecting our portfolio components. For example, we need to understand the risks inherent in small and value stocks, to explain the higher returns they provided over growth stocks in past decades and to provide a reasonable expectation that the premiums will continue.

In addition, we need to understand how portfolio components will likely work together under varied conditions—relationships that will always be changing as markets and economies evolve. We can use historical returns to test our theories about these relationships, but should remain skeptical about the ability of the data alone to confirm them.

In the end, the only real assurance we have from the historical record by itself is that the markets will become volatile from time to time. When that happens, panicked investors will sell based on what's happened recently. Disciplined investors will take the longer view, understanding how quickly the climate can change and how difficult it is to predict what's next.

Thank you for reading. Please look for our next newsletter in April.

Best regards,

Milo Benningfield

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