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The real estate market is…

Market Sentiment At Its Lowest In 10 Months

Market Sentiment At Its Lowest In 10 Months

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With The Market Overpriced, Here's What To Do

Don't you wish it was easier to figure out where to invest your money? I certainly do. But, to the contrary, experience tells us it can be incredibly hard to arrive at your specific decisions on which funds/ETFs you should go with. Certainly, if there were a "quick and easy investing formula," most fund investors would jump on it.

Well, guess what? For many people, that "quick and easy investing formula" has now been discovered - although whether it is the panacea hoped for needs to be evaluated further - and it goes something like this:

Invest primarily in index funds since it appears, by and large, that fund managers have far too little ability to deliver returns that surpass index funds. Which specific funds should one choose? Two of the best candidates are a fund that matches the "total" US stock market and one that indexes the rest of the developed world. One or two other index funds might be thrown in for good measure such as an S&P 500 index fund (although this overlaps highly with the first fund) and one that provides exposure to the emerging markets. On the bond side, along the same lines, invest in an index fund that mimics the "total bond market."

The highly difficult challenge posed by having to choose from among so many available but divergent funds, along with the apparent failure of the majority of more costly managed funds to do better than the above index funds, has apparently led to the adoption of the above "quick and easy investing formula" which focuses on no hocus pocus, plain vanilla, across-the-board market index funds.

In fact, according to one source, the Vanguard 500 Index (VOO) was the fastest-growing ETF over the three years ended December 31, growing to $27.6 billion in 2014 from $2.4 billion in 2011. Over a nearly identical 3 year period, the Vanguard Total Stock Market Index (VTSMX) has gone from $185 billion in assets to $405 billion, while the Vanguard Total International Stock Market Index (VGTSX) has climbed from $66 billion to $147 billion. Currently, the largest 4 stock funds/ETFs are all of this broad index variety. (Incidentally, the same type of phenomenal growth can be seen in index funds/ETFs investing in the unmanaged "total" bond market.)

These days, the majority of investors are definitely exhibiting less and less confidence in fund managers, or in themselves for that matter, in being able to select somewhat narrower segments within the markets that could potentially outperform and thus be able to help them add materially to their own portfolio's long-term performance.

More and more, the argument goes, we should just put our money into these broad, unmanaged funds and not expend the effort trying to figure out where the real value within these markets might lie. As proof, these advocates seem to focus on this: During the last 5 years or so, one could not have done much better than investing in the above broad stock and bond index funds or ETFs. Such funds have delivered mostly better returns than comparable managed funds, or investors' more "sliced and diced" market category choices regardless of whether indexed or managed.

But does what has happened in the recent past tell the whole story? Observing that the stock market right now is perched at a very high level (with recent gains of more than 200% in the S&P 500 since March 2009), one should look back not that long ago when the market was exhibiting a similar profile. At that time, it would have made an absolutely huge difference where you chose to invest, and more specifically, whether you held most of your investments in the

  1. aforementioned broad indices and even managed funds hew closely to these broad indices,

--OR--

  1. found some other types of undervalued funds considerably less likely to suffer (or to suffer as much) in the periods following when the overall market proved to be overvalued.

By not having to ponder too much and merely keeping your money in the Vanguard Total Stock Market Index back in Jan. 2000, a time when the overall market was terribly overvalued, your return one year later would have been minus 10.6%, with the return on the Vanguard Total International Stock Market Index even worse at minus 15.6%. However, if you had invested a portion in three well known managed funds as well a real estate index fund that I researched and recommended at that time, your one year returns for each would have varied between about +26.3% to about +8%, averaging +18.9%. You read that right - losses in the range of 10 to 15% vs. gains averaging close to 20%. Such gains, instead of losses, in even a modest portion of your portfolio, would have gone a long way toward smoothing out your returns in the first year of the ensuing bear market.

But it turned out this was not just a one-year anomaly. By the end of 5 years (Jan. 2000 to Dec. 31, 2004), while returns for the total market as well as international indices hovered around minus 1.0 annualized, returns on the above managed funds and real estate index fund varied between about +21 to about +3% ann., averaging +12.9%.

But here's perhaps the biggest surprise: If one looks at how these same four funds have done over the last 15 years, the investor who had identified them and held them steadily through bull and bear markets, would have done far better than merely holding the two aforementioned broad indices. Apparently, holding an overvalued fund as opposed to an undervalued one can continue to place an impediment on the returns of the former one for many, many years to come.

The table below shows these four specific funds and their annualized 15 year returns as compared to the total market indices (data as of 4/21/15):

Fund Name 15 Yr. Ann.
Return
Fidelity Low Priced Stock (FLPSX) 12.8%
Vanguard REIT Index (VGSIX) 12.1
T. Rowe Price Value (TRVLX) 8.5
ICAP Equity (ICAEX) 6.5
Vanguard Total Stock Market Index (VTSMX) 5.2
Vanguard Total International Stock Market Index (VGTSX) 4.0
Note: ICAP Equity (ICAEX) now called MainStay ICAP Equity I
and now is only for Institutional investors.

In more concrete terms, an annual return of 5% suggests an investor would have had to wait until nearly the end of the entire 15 year period to have approximately doubled his or her investment. An annual return of 10% would have lead to a quadrupling of an investment over the same period. Obviously, the "quick and easy investing formula" that seems to now be in the limelight as compared to investing that strives to separate the undervalued from the overvalued, while certainly "quick and easy," cannot claim to be the undisputed superior way to invest that many glowingly speak of.

Clearly, then, it may not always be the best option to invest primarily in broad market indices, or even managed funds that closely mirror the broad indices, while choosing to avoid specific market segments (managed or indexed) when making one's investment choices. Note that although I recommended the above four funds based on their undervaluation 15 years ago, each of these funds should no longer be considered undervalued today. The types of funds that currently appear undervalued will be presented shortly.


Why Seek Out the Undervalued?

Are these findings merely a fluke?

Doesn't it make sense to assume that funds/portfolios that tend to be concentrated on what appear to be undervalued stocks will do better than average several years out? This is certainly what some of the world's greatest investors have concluded and propelled their performance ahead of others. Currently undervalued and generally "unloved" stocks, as they gradually become recognized by greater numbers of investors as good opportunities, should eventually show superior performance to those that are considered too pricey. This is in spite of the fact that the terms "undervalued" vs. "too pricey" are somewhat subjective concepts whose definitions are hard to pin down.

Note that undervalued stocks are not necessarily synonymous with "value" stocks. Why not? Value stocks, themselves, can become overvalued. By the same token, so-called "growth" stocks can sometimes be considered undervalued. Some people would even now consider Apple, perhaps the best known growth stock of all, to be undervalued.

Since a total market index fund, by definition, will have a huge mixture of stocks, both undervalued and overvalued, the differential performance of these two segments should cancel each other out, leading to what we have been told to expect of an index fund, that is, "average" performance. But if your fund has a preponderance of undervalued segments, chances are good it can eventually do better than either the broad index or any fund with a preponderance of overvalued segments.


Which Funds Should Be Considered "Undervalued?"

OK, I know what your next question is going to be. How exactly can one recognize funds that are made up of stocks that are predominantly undervalued?

First an admonition: As implied above, the term "undervalued" is a relative one and even "experts" don't agree on how to assess it. And, the term shouldn't suggest or imply that big gains will lie immediately ahead, even when correctly assessed. (Many experts rely on a statistic called the P/E ratio, or price divided by earnings, to define abnormally high or low valuation; unfortunately, many stocks, and stock funds, with relatively low P/E's will continue to underperform, while, conversely, funds with extremely high P/E's can continue climbing even for years. Therefore, even though the statistic for any fund is readily available, such as on sites such as morningstar.com, I wouldn't recommend paying that much attention to it.)

Of course, the opposite is also true. What is "overvalued" isn't always clear either and such funds don't always immediately start to underperform (although my research suggests that when measured as I will present below, they most likely will within a year or two). In fact, I have been saying that most types of funds have been overvalued since late Oct. 2013. Since then, most of these funds have continued to move ahead, although they appear to have slowed down somewhat since the start of this year.

Thus, while the concepts of over/undervaluation are frequently debated by the experts, and there is no absolute "yardstick," I will now give you a guideline that I use to help shape my own investment decisions.

Suppose you own a fund that has returned cumulatively in excess of more than 25% of what might have expected over the past few years. More specifically, stocks, on average, tend to return 9 to 10% a year. For simplicity, let's call that a cumulative return of 50% over 5 years. So if your fund returns 25% more than that, it would return 75% over 5 years. This, then, comes out to an average return of 15% a year.

Unlike a fund, when you own an individual stock, it can literally go to the moon. Once again, take Apple stock. Over the last 5 years, it has returned about 150%, or 30% per year. But over the last 10 years, it did even better - 38% a year, or 380% cumulatively. In other words, there may be nearly no limit to how far up any one stock might go. Of course, a badly performing stock might continue underperforming, inflicting huge losses, perhaps until the company goes out of business or goes bankrupt. Enron stock, a darling of Wall Street from 1996 to 2001, fell from over $90 per share to less than $1 before becoming totally worthless.

But with a mutual fund/ETF, the ride should be smoother since the fund hopefully invests in many, many stocks, lessening the impact of any one extreme success or failure. Since we can not know the future for sure, let's just say while, on average, 50% total gains over 5 years for a fund are close to the normal, 75% gains or more are approaching rarified air. A fund with the former result might be considered to have a "fair" or appropriate valuation; one with the latter is probably "overvalued," or approaching what I would consider being overvalued in the near future.

My research has shown that using such a 15% "yardstick," stretched out over time, can be a useful marker of likely overvaluation. Once most funds surpass it based on a 5 year period, one is typically better off investing at least some portion of a portfolio elsewhere, specifically in one or more funds that instead appear "undervalued."

We might think of an "undervalued" category or specific fund as one where its stocks have performed significantly worse than an annualized return of 9-10%. In fact, if the average fund in its category is currently showing only a 5% annualized return over the last 5 years, it may be underperforming an "average" performing fund by 25% cumulatively and an overvalued fund by at least 50% cumulatively (75% minus 25%).

For the short term, the "overvalued" fund, although probably not recognized as such by most investors, might appear the wiser choice. But for the longer term, the undervalued fund would appear to have much more potential for future gains.


Here's What Owning Overvalued Investments Would Have Cost You in the Recent Past

Using my 15% yardstick, the last time stocks were approximately as overvalued as they presently are was in July, 2001. And they were even more so in Oct. 2007. (Note that the 15% yardstick is not quite surpassed as of this writing in late April. But it was as we began 2015 as it was at the beginning 2001. What this means is that while we may be slightly short of 15% annualized gains right now, the period we are in should still be characterized as an overvalued one.)

July 2001

In July 2001, the S&P 500 had returned 14.5% annualized over the prior 5 years. But due to significant drops in many stock prices over the prior 12 months, some fund categories had become close to fair valuation, while others, including International funds. were quite undervalued. If what I have already said were a valid way of helping to decide where to invest, it would have made sense at the time to have chosen one or more the undervalued categories of funds to have a better chance of enhanced portfolio returns.

So how did stocks perform over the following 5 years?

By July 2006, the S&P 500 had returned only +2.5% annualized. And most fund categories followed suit with the exception of some smaller capitalization fund categories that showed close to average returns.

But not all types of funds showed poor to average 5 year returns following the above July 2001 snapshot. By July 2006, the following categories of funds had done exceptionally well: Emerging Markets Natural Resources, Gold, and Real Estate funds.

The table below shows how relatively "undervalued" prior 5 year performance was followed by particularly good long-term results for 3 of the above fund categories; figures shown are the average performance of all mutual funds within the defined category:

Fund Category July '96 -
June '01 Ann.
Performance
July '01 -
June '06 Ann.
Performance
Emerging Markets -4.9%% +20.7%
Natural Resources +7.2 +19.0
Gold -14.4 +32.0

For the fourth category, Real Estate, what I have called "average" prior 5 year performance was followed by particularly good long-term results:

Real Estate +10.4 +19.4


October 2007

In Oct. 2007, the S&P had returned 15.5% annualized over the prior 5 years, but unlike in 2001, no fund categories could be identified as "undervalued." The best strategy, then, following the yardstick approach given above, would have been to lighten up on stocks altogether.

Once again, one can consider how stocks performed in the following 5 years.

By Oct. 2012, the annualized return on the S&P 500 was only +1.1%, but unlike in 2001, only one other category, Health/Biotechnology, with a +7.7% annualized return, managed to do significantly better.


What Funds to Consider In Today's Market

As just described, it appears that today's situation is most similar to back in 2001, with most, although not all, categories of funds in an overvalued pattern. If it turns out that 2001's rather dismal subsequent performances serve as a guide as to what to expect as a consequence of this overvaluation, it would seem that many 5 year fund returns going forward may turn out to be similarly disappointing.

To make the most of today's opportunities, one should be focusing on funds that are most undervalued, or at a minimum, those that are fairly priced. These are International stock/ETF funds (especially Emerging Markets), Natural Resources funds, Financial funds, Energy funds, and Precious Metal funds. Of course, an investor should take into consideration their own level of risk tolerance before investing since some of these categories of investments might "go beyond" what the typical fund investor is comfortable with.


The Bottom Line

Don't sock away the majority of your investments within the overall U.S. market which appears overvalued (or nearly so) right now. Rather, always seek out segments within the markets that appear to be undervalued, or at least, more fairly valued. While the majority of investors may keep crowding into the overall market and therefore keep it afloat for a time, these investors, as time passes and as conditions become perceived as less than ideal, will likely realize they were banking on "dream-like" returns that cannot persist. This will likely cause the overall market to drop significantly more than undervalued categories whose investments are then likely to be re-evaluated as safer, more attractive bets.

 

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