The Road to Failure is Paved with Past Successes

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Recently, a number of people—both clients and non-clients—have been asking why their accounts didn’t match the performance of the S&P 500 in 2013, when this widely-followed index shot up +32.3%. The answer is always the same: your accounts don’t contain just S&P 500 stocks, but are far more diversified, with other US stocks, foreign stocks, bonds from both the US and overseas, and other types of securities. Last year, it was hard to beat or even match the S&P 500 because it was one of the very best performing assets classes in the world. So the natural question becomes: Why not invest everything in the S&P 500 all the time? Today, we attempt to answer this question.

First we want to clarify that we are not recommending that you purchase or sell any specific security, index or asset class. In fact, we consistently recommend a (professionally) diversified portfolio appropriate for your cash flow needs, investment time horizon and risk tolerance. If you aren’t sure what this means, or whether your portfolio is properly diversified, please contact us.

Past Performance is No Guarantee of Future Results

These words are printed in virtually every prospectus, SEC filing, research report or other securities-related email or publication. The idea that past performance does not guarantee future results may seem obvious to you, but throughout history investors have forgotten this crucial concept and repeatedly flocked into “hot” assets near their top, while simultaneously shunning underperformers trading at bargain prices. Why is this? It has to do with the way our brains are wired: we tend to believe that a trend will continue indefinitely. In reality, most trends reverse, a phenomenon called “reversion to the mean.”

We see reversion to the mean in all areas of life, not just investing. Take competitive sports, for example. Even the best team loses periodically, and all winning streaks eventually come to an end. The recent college basketball upset, with UConn beating top-ranked Florida, is a prime example. Nothing is forever, neither a winning team nor a winning stock.

To fight the urge to “chase performance” and load up on investments (such as the S&P 500) after a long winning streak requires counter-intuitive behavior. Warren Buffett explained how to do this when he said, “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.” [Emphasis ours.]

At a recent CFA event, prominent bond manager Jeffrey Gundlach posed the following: “The S&P 500 outperformed every other major asset class last year. Why didn’t you have 100% of your assets and your clients’ assets invested there?” “Better yet,” he went on, “Why didn’t you have your entire portfolio in Tesla stock?” Clearly, a man whom Barron’s calls “The King of Bonds” was not asking the question seriously. Rather, he was making a point about diversification and why you don’t chase past performance, as assets and asset classes tend to experience mean-reversion over time. In addition, you only would have experienced the outsize return of the S&P 500 or Tesla if you had known ahead of time that they would be among the best performers in the subsequent year (or far more likely, you just got lucky).

Mean reversion is why professional portfolio managers rebalance accounts periodically to align the actual weighting of each asset class to its target weight. For example, if you target an allocation of 25% large-cap US stocks, after a year like 2013 they might make up over 30% of your portfolio. Amateur investors chase past performance, and would hesitate to sell some of their large-cap US stocks for fear of missing out on future gains. Instead, many investors did just the opposite in early 2014, either increasing their exposure to US stocks or buying stocks for the first time after years of sitting on the sidelines. The better move is to (counter-intuitively) decrease your large-cap US stock exposure back toward the 25% level and buy some underperforming assets in their stead.

A graph of greed and fear

The graph below shows the performances of the iShares MSCI Emerging Markets Index ETF (blue line), S&P 500 (red line) and Vanguard FTSE Europe ETF (green line) from September 2008 (just prior to Lehman going bankrupt) through March 31, 2014.

S&P-VGK-EEM 2008-2014


Equities worldwide were clobbered towards the end of 2008 by what we now know as “The Lehman Moment.” Selling begat more selling and in less than 3 months, equity portfolios were down a shocking -45%! This was perhaps the example of typical investor behavior—being fearful when everyone else is fearful.

In 2009 investors were still incredibly bearish on equities, which dropped even lower by March of that year. When markets finally turned around, they did so with a vengeance. The best asset class in 2009 was emerging market stocks, which recovered all their losses and more by the summer of that year. By 2010 investors started to notice this outperformance and, chasing it as usual, piled into emerging markets. What happened? As of today, your early 2010 investment in emerging markets has gone nowhere, while US and European markets have continued to gain ground.

In the fall of 2011, markets were again hit by the European debt crisis. Not surprisingly, the US was less affected than European markets, as our economy is somewhat removed from that debacle. European stocks finally bottomed in June of 2012, having dropped -30% over the prior year (the US had recovered most of its 2011 losses by then). With Europe relatively cheap compared to the US, were investors buying? Of course not: Who would buy stocks of companies in countries whose debt levels were out of control and whose currency might cease to exist? In retrospect, this was a great buying opportunity, and people who realized that investor fears were overblown made a lot of money by being greedy when others were fearful.

Today, investors are finally flocking to European equities (and bonds) as well as US stocks. While the party may not be over, this is yet another case of investors flocking to asset classes after a period of outsized returns, when such assets may no longer be cheap.

Emerging Markets: The greedy have left the building

By any fundamental valuation, emerging market stocks are cheap relative to other major asset classes. A lower valuation on emerging markets is not unjustified, as political instability and inflation are greater threats than they are to developed economies. But the discount today is larger than it has been in decades, similar to what it was in the days when countries such as Brazil and China were more like banana republics than the economic powerhouses they are today. And if you ask professional and amateur investors alike, either through surveys or casual conversation (as we have done often over the past year), no one likes these markets. Fear (or disgust) has definitely overtaken greed for this asset class.

There are convincing pro and con arguments for the major emerging markets (e.g., Brazil, Russia, India, China) as well as for the asset class as a whole. The pro arguments include faster growth rates than developed economies, cheap valuations, political risks that are not as extreme as advertised, stabilizing economies and in many cases, massive currency reserves. Increased consumer spending should also serve as a boost to many emerging nations. Emerging market cynics point to increasing levels of debt relative to GDP (not that developed markets are in such good shape here), political unrest and impending asset bubbles. Slowing growth in China (where slowing means +7% annual GDP growth) is also a concern.

We believe emerging markets are an example of an asset class where the potential rewards outweigh the risks, where the greedy have moved on to more expensive assets. Clearly we do not know what the future holds, but the combination of cheap valuations and general distaste of an asset class is usually a positive signal for investors.

Turning Fear into Profits

So what is KCS doing now? As most of our clients are overweight to US stocks after their strong performance in 2013, we’ve been trimming those positions in favor of less pricey and unloved stocks. These include companies based in Europe, Asia and Latin America: developed and emerging markets that have lagged over the past couple of years. Similarly, we’ve been trimming some of the better-performing sectors, such as industrials and healthcare, in favor of laggards such as energy and materials.

One equity sector that’s done well but which we haven’t trimmed is consumer discretionary. But even here, we’re favoring companies in emerging countries like Brazil, Argentina, China, India and even Russia. Consumers there have a long way to go before they even begin to approach the buying habits of Americans, making this a long-term trend that could take quite a few years to revert to the mean.

Warren said it best: Be fearful when others are greedy and greedy when others are fearful.

Happy Easter, Passover or whatever you celebrate in April,


Dr. Ken Waltzer MD, MPH, AIF®, CFA, CFP®
Founder and President – Kenfield Capital Strategies (KCS)

Adam Bragman
Director of Business Development – Kenfield Capital Strategies (KCS)

Kenfield Capital Strategies℠ (KCS) is a registered investment adviser. Our services include discretionary management of individual and institutional investment accounts, along with comprehensive financial, estate and tax planning services.

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