Stocks, and even to some degree bonds, seem to be defying gravity, holding up at levels which are surprising many people, me included. No matter what news about the economy comes out, some of it at times troubling, investors seem to think that so long as the Fed doesn't actually start raising interest rates, the bullish markets thus far in 2014 will keep investors showered with decent if not quite spectacular returns.
One might expect investors, even those with a positive bent, would, at best, be in a holding mode. And those who were more cautious to actually have been doing some selling, not out of fear but to protect already earned profits.
Some investors are likely reducing their stock exposure, but probably very few. If so, such a joint dynamic should mean an essentially flat stock market. But on more days than not in the last several months, the stock market is going up. This means that, on balance, a great number of investor dollars are on the buy side rather than in a holding mode, or selling much of anything.
I would argue that this appears to reflect something about human nature: There are plenty of investors out there who are mainly focusing backward on the great returns since 2009, and more recently, the increasingly positive trend this year. But are these investors taking into account the whole picture? How investors wind up making out has to do with forward looking prospects as opposed to backward looking ones. While forward prospects are always unclear as compared to looking backward, the history of stock investing along with mathematical probability suggest that what goes up beyond historical norms must eventually come back down toward those norms.
It's one thing to be in holding mode given the positive current trend to see how much further we can go, or just because one intends to hold their funds for many years so that even a moderate setback shouldn't necessarily be permanently damaging. But it's quite another to be buying at this stage where a significant drop might hold future returns achieved to a low level for years to come.
And the types of funds that these investors apparently with blinders on seem to be buying this year are the very ones that have in many cases advanced so much already: specialized funds such as health care, real estate, and long-term bonds to name a few.
In trying to make sense out of this, I must keep reminding myself that, yes, we still are in a bull market. And one that has carried stock prices to extraordinary heights. Many investors are entranced by the gains, and even attracted to those categories of funds that have gained the most, assuming perhaps that there's more "easy" money to be made. And even if the market goes down, they assume, as investors always have, that they will be able to anticipate the worst of the fall and get out quickly before too much damage has been done. (These assumptions have long been made by overly optimistic investors in the past and nearly always have turned out to be false.) But making money in the stock market, while it sometimes looks easy, hardly ever is.
Dare I suggest that buying stocks (or likely, most bonds) now is exactly the equivalent of deciding to buy a house after prices have gone up 50% or 100% over say a half decade, or so. The hypnotized buyer sees further dollar signs; the prudent buyer, one who isn't required to buy a house for his/her family as a result of finding a job in a new city, more likely steps back and thinks about waiting a year or two for a better buying opportunities ahead.
It doesn't take any special expertise to recognize what has already been doing well. But sorting out what has been doing well vs. what likely will do well in the future involves a whole different skill set.
A Reminder: S&P 500 Up Another 25% Without a 10% Correction
Less than a year ago, in our Aug. 2013 Newsletter, we discussed the fact that investors who a) sold some of their stock position after a 25% gain occurred in the S&P 500 index in the absence of a 10% correction, and b) bought additional stock after a 10% correction had occurred wound up outperforming the S&P by 6.2% a year over the 3 1/2+ years examined between Jan 2010 and July 2013. You can review the article here. (Similar results for the entire 2000 through 2009 decade were also reported in my Feb 2010 Newsletter.)
Bringing the data from the 2013 article up to date, we still haven't had a 10% correction since June 1, 2012. Looking at the S&P numbers, we have gone from 1267 on that date to over well 1900 which we recently surpassed, or over a 50% gain. If you were following the strategy, you would have sold some stock in April 2013 after the first 25% rise. The strategy now suggests doing the same for the second 25% rise.
Many of Our Prior Longer-Term Projections Have Gone As Predicted
I have generally found that an investor who has a longer-term approach to spotting under- and over-valued areas of the markets must be prepared to wait a minimum of one year to see results from this approach.
In our July 2013 Newsletter, we discussed the importance of your percentage allocation to international investments in determining how your overall portfolio performs. While at the time, international stocks appeared undervalued as compared to US stocks, we recommended keeping one's allocation to international stocks at a moderate 27.5% level because we were not convinced that such stocks were yet ready to fully break out of the malaise they had encountered over the prior five years.
Fund investors, on the other hand, continued directing a majority of their investments internationally as opposed to domestically. According to one source, net cash flow estimates into domestic equity mutual funds were just over $20 billion vs. foreign-focus equity mutual funds at $143 billion. And the trend toward favoring international investments continued in the 1st quarter of 2014.
It turned out our hesitancy on adding to international stocks proved correct. Over the last year, while most domestic funds continued to do extremely well, many international funds were weighed down by middling returns especially in Asian and emerging markets.
Note: There are several factors for investors to keep in mind going forward. European stock funds have been doing quite well over the last 12 months, aided by the strong euro vs. the US dollar. This week the European Central Bank eased credit which may well pump up European equities even more. However, there is a good chance that as a result the euro will weaken, detracting from most returns for US investors. We think funds that emphasize the European region and "hedge" out a possible weaker Euro such as TBGVX (see below) will continue to do well. If the Japanese yen continues to weaken as it has over approximately the last year and a half, this will likewise hurt returns for US investors in funds that have holdings in the Japanese stock market. Therefore, aggressive investors in Japan might want to invest in a fund that hedges out this yen effect. One such fund is the WisdomTree Japan Hedged Equity ETF (DXJ).
In our June 2013 Newsletter, I introduced what I called a "simple test" of a bond fund's prospects. Based on that test, we ventured that for a typical bond fund such as the Vanguard Total Bond Market Fund (VBMFX), "the odds would appear to favor a continuation of ... low returns and also suggest that returns could even be less than 2.0 over the next 12 months." While returns for many bond funds have been doing better in 2014 than last year, the one year return for VBMFX as well as many similar bond funds has indeed been a little less than 2% (1.9% for VBMFX) over the last 12 months. (Note: all results cited are as of June 6.)
We also pointed out then that using that simple test, a favorite bond fund of ours, Loomis Sayles Bond Retail (LSBRX), appeared posed to do well. In the elapsed one year, LSBRX has returned approximately 7.4%, making it one of the better performing bond funds since.
When applying the simple test to project the performance of the S&P 500 index, we argued that the test pointed to "highly favorable prospects." Since then, the 1 yr. return for the index has been 22.5%. Of course, we did point out that at a certain point, stocks could become what we consider overvalued, and at that point, chances are that within the following 12 months, they will likely suffer. That point was reached in mid-Oct. 2013. If correct, the clock may ticking down for the current rally.
So my simple tests were very accurate when applied last June. But that was then. What would the same simple tests show today?
Using VBMFX as a proxy for plain vanilla bond funds, the 1, 3, and 5 year annualized returns of 1.9, 3.1, and 4.9% are still suggestive of potentially low returns ahead for bonds. Of course, if stocks falter, which we still consider highly likely within the next 4 or 5 months or so, this could provide a basis for support for such bonds as investors flee to safer grounds.
Using LSBRX as a proxy for riskier high yielding bonds, prospects also look unfavorable according to the simple test, although relatively speaking, performance may continue to outpace many other categories of bonds. However, if there is a correction in stocks, one can expect high yield bonds to suffer as well.
Unfortunately, right now the simple test reveals little information about the prospects for stocks in general, using VFINX as a proxy. However, we remain convinced that most categories of US stock funds remain seriously overvalued.
In our May 2013 Newsletter, we said we believed there were much better long-term prospects for the Large Cap funds going forward as compared to Small and Mid-Cap funds. When tracked over the 12+ months since then, the meager edge the smaller categories held for most of the period appears that it may be breaking down. In fact, when looked at since the beginning of this year, Small Caps especially have indeed started to tail off while the Large Caps have typically held on to their gains. We also believe this trend will continue, and if the overall stock market does drop 10 or more percent as we expect, the Small/Mid-Cap categories should drop to an even greater degree. Note that Small Caps have already recently dropped 10% from their highs on an inter-day basis during May.
We recommended investors consider Tweedy, Browne Global Value Fund (TBGVX) in the international category. Here the same type of pattern is playing out. While TBGVX trailed many other international funds for the remainder of 2013, it is now outperforming a more typical international fund like Vanguard International Growth (VWIGX) 5.5 vs 2.5% since the start of 2014. Once again, we expect the outperformance to continue.
Also in the May '13 Newsletter, we also repeated our recommendation for Financial Services funds. These funds, as a group, have had a good 12 mos. average return of 19.3%, but have tapered off considerable to 3.2% in the last 5 mos.
Our recommendation against owning emerging market funds in that Newsletter has been proven wise in that the average such fund has returned only a moderate 7.5% over the last 12 mos. while most other categories of international stocks have done considerably better. For example, the average fund in the broad international category has returned 19.9%.
Our recommendation for Yacktman Service Fund (YACKX) as an alternative to other large blend funds such as VFINX has thus far not proven successful. VFINX has actually done better than YACKX over the last year by close to 8 per cent (approximately 22.5 vs. 14.6%), but YACKX has been closing the gap a little so far this year. If, however, there is a market correction, YACKX will likely be a better place to be than VFINX. (Note: YACKX is closed to new investors).
We devoted our March 2013 lead story to presenting why we thought Large Value funds/ETFs would likely outperform Large Growth in the years ahead. We pointed out that outperformance by either growth or value tended to run in cycles with an average length of 6 years. While Large Growth has indeed outperformed Large Value over the last 6 years, the tide now appears to be turning.
Large Value has pulled into the lead this year by about 2.5% (6.2 vs. 3.7%). In fact, we said "Large Value should likely be your best place to be for at least the next several years within the universe of stock funds/ETFs." Not only is Large Value ahead of Large Growth this year, but it is now the 2nd best performing category within the Morningstar "3 by 3 grid" of nine major fund categories, behind only Mid-Cap Value by a small amount.