By Nick Fisher, Portfolio Manager
A human behavior that magnifies risk during market cycles is Recency Bias. Investors get very excited after a couple of years of great returns. Looking in the rear view mirror of the recent past, they see their neighbor making money and knowing full well that the neighbor is not endowed with any particularly unique intelligence; they too pile into investments they know little about, pushing the prices up and ignoring the underlying fundamentals. And boy have investors piled on!
To illustrate, let us look at S&P 500 returns for the last few years (shown at right). With returns like this, who wouldn’t want to be invested in the highest flying US stocks? This trait is not limited to the average investor, however. Recency bias also impacts pension fund managers. A couple of extreme historical examples: In 1972 the average pension fund was nearly 100% invested in stocks, only to get clobbered over the next two years of the stock market crash. Conversely, in 1981 pension funds had a mere 9% allocation to stocks and missed one of the best opportunities to own stocks. The recent past clouded their objectivity and caused extreme reaction. We caution our clients to remain objective.
History tells us that the market does not go up every year; in fact the market has experienced significant periods of time where very little total return is available. In the 20th century (from 1900 – 1999), for 56 ¼ of those years the market returned a negative total return. Over the 43 ¾ years the Dow Jones Industrial Average went from 66 to 11,000 a 180X total return (turning $1,000 into $180,000). Further, long stretches of time passed where very little if any return was created. Consider from 1900-1921, the market returned 26% (less than 0.5% per year). From 1929-1948, the market returned a negative 52%. From 1965-1981 the market returned virtually zero. As comparison, recalling the headlines in 2009, the “lost decade” doesn’t seem so bad.2
Stock market returns have a very low correlation to economic growth. The economy grew during every decade of the 20th century. In fact, the decade of the greatest economic growth was during one of the time periods of the most dreadful stock market returns (1940s). The simplest explanation for these paltry returns is plainly the starting point of valuations. Extreme, above average valuations are followed by periods of low return.
Someday, the winds of change will again shift. Renowned investor Seth Klarman summed it up very well in one of his recent letters to his investors:
Someday, financial markets will again decline. Someday, rising stock and bond markets will no longer be government policy. Someday, QE will end and money won’t be free. Someday, corporate failure will be permitted. Someday, the economy will turn down again, and someday, somewhere, somehow, investors will lose money and once again come to favor capital preservation over speculation. Someday, interest rates will be higher, bond prices lower, and the prospective return from owning fixed-income instruments will again be roughly commensurate with the risk.3
In the meantime, we search high and low for any semblance of reasonable risk adjusted returns. In contrast to US markets, many markets internationally currently sell for a much lower valuation. We would advocate allocating a sensible amount of capital toward these areas. According to Mebane Faber, US investors currently have very little exposure to international markets and some international markets currently sell for less than half the valuation as in the US (see our recent Chart of The Week: 5/20/2014).
We believe that investors willing to take the unconventional approach of allocating a greater percentage of capital toward international markets (selling at reasonable valuations) will be rewarded with better comparative risk-adjusted returns. This is not to say we will forget about the US market, as the opportunity to invest at lower prices will surely present themselves again, someday.
1 Morningstar and Wikipedia
2 Buffett, Warren. Speech at the University of Georgia.
3 Klarman, Seth. Letter to Investors