Notes, Views, and the Occasional Provocation November / December 2010 

One of the dangers of reading a great book like Christopher McDougall's Born to Run in two sittings is that you want to accost everyone you meet and start talking about it. I resisted that temptation here, but did draw upon some of McDougall's colorful descriptions of evolutionary biology.

Our predilection for attempting to use macroeconomic data to guess where the markets are headed next appears rooted in our ancient need to track down a quickly fleeing meal. While we come by this honestly, for our portfolios' sake, it's time to give up some old bad habits.

Warm regards,

Milo Benningfield


 
The Modern Persistence Hunt
That Homo sapiens eclipsed the Neanderthals in the evolutionary race is one of the most surprising come-from-behind stories the world has ever seen. But success, as they say, often sows the seeds of its own destruction, and many investors attempting to track the markets today are perilously trapped in their past. more

BFA Media Quotes
Recent media quotes. more




The Modern Persistence Hunt
According to the Running Man theory, Homo sapiens won the race against our stronger, faster and more intelligent cousins the Neanderthals because we could run long distances, sometimes for days, and literally chase animal prey to death. During the two million years before we learned to make spears and still had to catch meat with our bare hands, this was an important skill to have.1

But so-called "persistence hunting" required more than just stamina and, as it turns out, the ability to sweat. It required a keen ability to read half-smeared tracks in the dirt, find them again after they'd disappeared on hard ground, while remaining aware of other signs around you — a scratched post, a fallen feather — that might provide clues not only to where an animal had been, but to where it was going.

Given how essential our tracking skills were to our survival, it's no wonder that so many investors today love to scrutinize telltale macroeconomic signs for where the markets might be headed next. Having solved the meat (and the fries and soda) problem, we've moved on to more abstract levels of tracking, replacing spoor on the ground with brightly lit computer screens filled with macroeconomic graphs and data points on our quest to project where the markets are going.

As a recent Wall Street Journal article noted, there are ever more clues to study:

They come out like clockwork — dozens of government and private economic reports, covering everything from bond sales to mortgage approvals. Traders, politicians and, yes, the media fixate on them, often enough to move the markets as they react to employment numbers or consumer-confidence surveys.2

And with the usual macroeconomic spoor so well-covered, investors seeking an edge turn to ever more exotic data:

Stats like the price of the obscure metal rhodium, the number of people quitting their jobs and the number of ships using the Port of Los Angeles are being scrutinized like never before. While there's no consensus, there is a growing belief among some pros that such figures track the economy more reliably than better-followed data.3

The problem is, the global economy and its capital markets are, no disrespect intended, a lot more complex than a herd of kudu. Small inputs on one end of the system lead continually to unpredictable outputs on the other. What often seems commonsensical and true about the markets turns out to be a mirage on the horizon.

Take, for example, the recent concerns that rising debt levels in many countries will likely lead to poor stock returns. This seems to make sense. After all, aren't company earnings and thus share prices tied to how many goods and services they can sell?

In fact, it's this belief that makes so many economists fall out of their chairs when they see the chart below, which shows that today many developed countries have debt-to-GDP levels above 70% and others have debt that exceeds their economic output:

Before you rush to sell your shares, however, consider this: ample evidence suggests there's actually a weak relationship between a country's economic growth and its stock-market returns.

As one example, in a recent study Dimensional Fund Advisors looked at developed countries in the MSCI universe and compared a country's GDP growth to equity performance in subsequent years. What they found was that there was no "statistical difference between the annual returns of equity markets in high-growth versus low-growth countries. In fact, low-growth countries had slightly higher average returns than high-growth countries."

The graph below illustrates this relationship in terms of a dollar invested in high- versus low-GDP growth portfolios from 1971 to 2008. The low-GDP growth portfolio's higher annual return would have generated slightly more wealth for the period. The chart details the average annual return and real GDP growth for both groups.

DFA then applied the same methodology to the MSCI emerging-market countries and found an even greater return difference, although the data period is much shorter (2001 to 2008). The return of the high-growth country portfolio averaged 19.77% (with 2.5% GDP growth), versus 24.62% for the low-growth portfolio (-4.94% GDP growth).

An even more dramatic example of the often inverse relationship between economic growth and market returns is China. Despite a GDP growth rate of more than 9% over two decades, "between 1993 and 2008, investors actually lost 3.3 percent in Chinese stocks, even with dividends reinvested."4

Why this disconnect? Several factors may contribute:

  • With globalization, a multinational company's stock price in its home market may not reflect economic conditions in other countries.
  • In many countries, public companies must share the fruits of economic growth with a host of other non-public businesses and private investments.
  • In many cases, risk, not economic growth, determines a stock's expected returns.

Regardless, what it means is that investors intending to use their biological predilections to good advantage may end up wandering aimlessly in the desert, switching strategies at precisely the wrong time, looking futilely for the next macroeconomic spoor that will give them a reliable edge over everyone else.

Successful long-term investing, by contrast, is much more straightforward, relying on some simple truths:

  • Stocks are risky animals and precisely for this reason offer higher expected returns than other more stable assets like cash and bonds.
  • Knowing when these higher returns will actually materialize is anybody's guess, but capturing them is more a function of long-term discipline and patience than fancy footwork.

In other words, by employing a more modern version of persistence, one that relies more on mental and emotional fortitude than physical stamina, investors stand a far better chance of capturing the returns they seek. In doing so, we former ninety-pound weaklings can once again assert our superiority and avoid having our financial selves go the way of the Neanderthals:

[T]he Neanderthals were the mighty hunters we like to imagine we once were; they stood shoulder to shoulder in battle, a united front of brains and bravery, clever warriors armored with muscle but still refined enough to slow-cook their meat to tenderness in earth ovens and keep their women and children away from the danger.

Neanderthals ruled the world — till it started getting nice outside. . . . About forty-five thousand years ago, the Long Winter ended and a hot front moved in. The forests shrank, leaving behind parched grasslands stretching to the horizon. The new climate was great for the Running Men [following the antelope herds]. The Neanderthals had it tougher; their long spears and canyon ambushes were useless against the fleet prairie creatures . . . . Smothered in muscle, the Neanderthals followed the mastodons into the dying forest, and oblivion.5

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BFA Media Quotes
Reuters, December 3, 2010
Milo was quoted in a Reuters Special Report by Aaron Pressman, "What Did You Do in the ETF War, Daddy?" The report discusses the ascendance of The Vanguard Group as a provider of exchanged-traded funds (ETFs) over other products such as Blackrock's iShares. Milo noted his reasons for a growing preference for Vanguard's products:

Adviser Milo Benningfield in San Francisco said he has been steadily phasing out iShares funds as Vanguard has broadened its line-up. "When Vanguard offered only a handful of ETFs, I was happy to hold iShares products longer-term," Benningfield said. "But then they had some tracking error and were less tax efficient than I'd hoped."

Read the article.

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

Best regards,

Milo Benningfield




1 Born to Run, Christopher McDougall (Knopf 2009), Chapter 28.

2 "How's Business? Where the Pro's Go to Find Out," Wall Street Journal, December 12, 2010.

3 Ibid.

4 The Investor's Manifesto, William J. Bernstein (Wiley 2010), p. 28.

5 Born to Run, pp. 228-29.

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