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Re-Examining Emerging Markets Equity (copy)

twistadmin — Thu, 13 Sep 2018 13:58:57 +0000

In a look at both the long-run and the current market data, Jared Kizer offers five lessons that reinforce some of the reasons investors should remain committed to a long-term emerging markets equity allocation.

Emerging market equities have substantially underperformed the S&P 500 Index in 2018, with the S&P 500 up 6.5 percent and emerging markets down 4.4 percent through July. As I detailed in a recent post on international developed market equities, remaining committed to a globally diversified portfolio can be challenging during extended periods of underperformance relative to the U.S. market. In this post, we’ll look specifically at emerging markets by examining five lessons from long-run and current market data that reinforce some of the reasons investors should remain committed to emerging markets equity investing.

1. Over the long term, the evidence indicates that emerging market equities have outperformed U.S. equities.

From 1988 (the earliest data we have for emerging markets) through 2017, the S&P 500 earned average annual returns of 12.2 percent per year, while the MSCI Emerging Markets Index averaged 16.3 percent per year. In financial jargon, this difference in returns of roughly four percentage points would be referred to as a “risk premium,” indicating that markets have tended to reward long-term emerging markets investors with additional return compared to U.S. equities. This is a sensible result since emerging market equities clearly possess risks that U.S. equities do not. Emerging market investments could expose an investor to currency risk (the risk that emerging markets currencies as a group depreciate relative to the U.S. dollar), heightened geopolitical risk and lower market liquidity when compared to U.S. equities. Markets are aware of these additional risks and appear to have priced them appropriately.

2. Good news: While additional risks are associated with emerging markets investing, those risks are not perfectly correlated to U.S. equity market risk.

The three risks emerging markets investors face (outlined above) are either absent or lower for U.S. equities, but for globally diversified investors there’s a silver lining: Those risks are not perfectly correlated with the performance of U.S. equity markets. To visualize this, let’s look at a scatter plot of the annual returns of the U.S. and emerging equity markets.

Figure 1: MSCI Emerging Markets vs. S&P 500 Annual Returns (1988–2017)

Source: Thomson Reuters Lipper

Because the points are fairly scattered and not on the line, this indicates an imperfect relationship between the returns of the two markets, indicating that owning both adds diversification to your portfolio.

3. Historically, a portfolio that included emerging market equities in addition to U.S. equities has had higher risk-adjusted returns than a U.S.-only portfolio.

We can also ask the question of what allocation to emerging markets has been historically optimal for an investor with a 100 percent allocation to equities who wanted to maximize risk-adjusted returns. In the investing world, this means we want to find the portfolio that provided the most return for the volatility it experienced. This is admittedly a theoretical exercise since we can’t go back in time and experience this portfolio (and we certainly can’t expect the future to be identical to the past), but it does give us a general indication of how useful emerging markets have been historically. Over the period 1988–2017, the optimal allocation was about 80 percent to the S&P 500 and 20 percent to emerging markets. This result doesn’t necessarily mean you should allocate 20 percent of your equity to emerging markets (that’s a conversation to have with your advisor regarding your comprehensive financial plan), but it is useful in showing an allocation of zero percent likely doesn’t make sense either.

4. As with international developed market equities, emerging market equities represent a sizable fraction of the world’s equity market wealth.

As of year-end 2017, emerging markets equities were a bit more than 12 percent of the world’s equity market value with total market capitalization of almost $7.2 trillion. As with the analysis above, this doesn’t necessarily mean your allocation should be 12 percent of your equity portfolio, but this is a reasonable starting point. As a very general rule, if the market’s allocation to an asset class is meaningful, then yours likely should be, too.

5. While emerging markets can be a valuable component of a diversified portfolio, be prepared for volatility and potentially long periods of time where it underperforms U.S. equities.

The first four points lay out the case for a long-term allocation to emerging markets. That said, over the shorter term, emerging markets will inevitably have periods when it dramatically outperforms the U.S. equity market and periods when it spectacularly underperforms the U.S. equity market. For investors who are tempted to look at relative performance over shorter periods of time, it helps to understand what you should expect to see. Let’s first look at year-by-year maximum drawdowns of the S&P 500 and the MSCI Emerging Markets. The maximum drawdown is the largest peak-to-trough loss an investment earns over a particular period of time. If we say that the maximum drawdown of the S&P 500 was –20 percent in 1993, that means there was some period of time in 1993 when the S&P 500 declined 20 percent. Figure 2 plots the maximum drawdown in each year from 1988–2017 for the S&P 500 and emerging markets.

Figure 2: S&P 500 and MSCI Emerging Markets Maximum Drawdowns (1988–2017)

Source: Bloomberg

A few things stand out. First, in most years, the MSCI Emerging Markets Index has a drawdown of at least –10 percent and a significant number of years of at least –20 percent. Second, in most years, the maximum drawdown for emerging markets exceeds that of the S&P 500 (although they usually occur at different times during the year). This means investors with an allocation to emerging markets must remember it’s extremely volatile and will inevitably experience periods of substantial underperformance compared to the S&P 500. Let’s now look at rolling five-year returns for the S&P 500 and the MSCI Emerging Markets. Figure 3 presents this data.

Figure 3: Rolling 5-Year Annualized Returns (1988–2017)

Source: Thomson Reuters Lipper

The first five-year period goes through 1992 and the last goes through 2017. I’ve specifically highlighted two of the five-year periods above to give a sense of the magnitude by which U.S. equities have outperformed emerging markets over a five-year period and vice versa. For the five-year period through 1999, the S&P 500 was up 28.6 percent per year, while emerging markets were up just 2 percent per year. Conversely, for the five-year period ending 2007, the S&P 500 was up 12.8 percent per year, while emerging markets were up 37.5 percent per year. These results are even more mind boggling when you remember that, over the entire period of 1988–2017, emerging markets outperformed the S&P 500 by an average of about 4 percent per year. This just goes to show that short-run results (though five years may feel long for some investors) can diverge from long-run results.

This commentary originally appeared September 6 on MultifactorWorld.com

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The post Re-Examining Emerging Markets Equity (copy) appeared first on West Loop Financial LLC.

Current Valuations, Forward-Looking Returns and Disrupted Expectations (copy)

twistadmin — Wed, 15 Aug 2018 17:24:09 +0000

Current equity valuations may present some significant challenges for investors using historical return assumptions to plan their retirement. Larry Swedroe on what today’s market indicates for forward-looking returns, and what you can do in response.

The first half of 2018, like in any year, contained many challenges and surprises for investors. For example, investors were confronted with certain threats to equity returns, specifically, the Federal Reserve raising interest rates and tightening liquidity by starting to unwind its balance sheet, rising oil prices and threats of a global trade war, which also led to collapsing prices in some commodities.

Surprise!

Among the “surprises” were that, even though many investors had declared the size premium dead, U.S. small-cap stocks outperformed. For instance, using data from Morningstar, the Vanguard S&P 500 ETF (VOO) rose 2.7% this year through June 30 and the Vanguard S&P Small-Cap 600 ETF (VIOO) climbed 9.3%. That recent outperformance follows poor performance over the seven-year period 2011 through 2017. Using Fama-French data from Dimensional Fund Advisors, the annual size premium in the U.S. was negative in five of those seven years, with returns of -6.0%, -1.2%, 7.3%, -8.0%, -3.9%, 6.6% and -4.8%, respectively. The annualized premium was a negative 1.4%.

Another such “surprise” to many was the poor performance of developed international and emerging market stocks given their lower valuations and thus higher expected returns.

As just one example, GMO, whose chief investment strategist is the oft-quoted Jeremy Grantham, in its latest seven-year forecast stated: “To us, the opportunity set for equity investors looks pretty clear: favor non-U.S. markets, especially value stocks in emerging markets.” While, as I previously mentioned, Vanguard’s S&P 500 ETF, VOO, rose 2.7% over the first six months of 2018, and again using Morningstar data, the Vanguard FTSE Developed Markets ETF (VEA) lost 2.7% and the Vanguard FTSE Emerging Markets ETF (VWO) lost 7.2%.

A third “surprise” for investors was that the first half of the year saw strong returns to the U.S. momentum factor. If that performance holds up for the full year, Fama-French data shows it will be the seventh year of positive returns to the momentum factor over the last nine (only 2012 and 2016 showed a negative premium). Since 2010, the annualized premium has been about 4%.

Forward-Looking Returns: What Should Investors Expect?

Research on the expected equity premium, including Aswath Damodaran’s paper, “Equity Risk Premiums (ERP): Determinants, Estimation and Implications,” has found that the best predictor of future equity returns is current valuations—whether using measures such as the earnings yield (E/P) derived from the Shiller CAPE 10 (or, for that matter, the CAPE 7, 8 or 9) or the current E/P—not historical returns.

His review of the evidence led Damodaran to conclude: “Equity risk premiums can change quickly and by large amounts even in mature equity markets. Consequently, I have forsaken my practice of staying with a fixed equity risk premium for mature markets, and I now vary it year to year, and even on an intra-year basis, if conditions warrant.”

With that in mind, let’s examine the earnings yield (the inverse of the commonly used price-to-earnings, or P/E, ratio) based on the CAPE 10 ratio as of June 30, 2018, for three equity indexes pertinent to our discussion thus far: the S&P 500 Index, the MSCI EAFE Index and the MSCI Emerging Markets Index.

Earnings Yield & CAPE 10

The E/P provides an estimate (which should be treated only as the mean of a wide potential dispersion of potential outcomes, not as a predetermined, inevitable or even a likely outcome) for the real returns to equities in these three markets. According to data from AQR Capital Management, the earnings yield was 3.2% for the S&P 500 Index, 5.2% for the MSCI EAFE Index, and higher still at 6.6% for the MSCI Emerging Markets Index.

In each case, and again based on data from AQR, the earnings yield was up slightly from its year-end 2017 figure—0.1 percentage points higher for the S&P 500 Index and MSCI EAFE Index and 0.3 percentage points higher for the MSCI Emerging Markets Index, as weaker performance of emerging markets raised expected returns the most.

To get the nominal expected return, my firm, Buckingham Strategic Wealth, adds in the difference between the current yield on the 10-year Treasury and 10-year TIPS, currently about 2.1%. That produces nominal expected returns of just 5.3% in the U.S., 7.3% in developed non-U.S. markets, and 8.7% in emerging markets. Each of these is well-below their respective historical returns.

Before moving on, it’s important to note that higher valuations of U.S. equities reflect the view that, in the collective wisdom of investors, the stocks of other developed nations are riskier, and the stocks of emerging market countries are riskier still. In other words, the higher expected returns of international stocks does not mean they are better or more attractive investments, just more risky ones. It does mean, however, that because current valuations represent the best estimate of future returns, investors seeking the safety of U.S. stocks are accepting lower expected returns.

The bottom line is that current valuations present problems for investors relying on historical returns in their retirement plans.

Depressed Yields

Creating further problems is that bond yields remain depressed. The five-year Treasury bond, for instance, is yielding about 2.8% as I write this. Let’s see what these estimates mean for a “traditional” 60% stock/40% bond, U.S.-centric investor.

The traditional 60% stock/40% bond portfolio, using publicly available, low-cost mutual funds, performed extremely well over the last 36 years—a period that included two of the worst bear markets in U.S. history. From 1982 through 2017, a period that begins with a bull market and a peak in interest rates, a portfolio allocated 60% to the S&P 500 Index and 40% to five-year Treasury bonds returned 10.4% a year with volatility of 10.2%. Note that 10.4% return was almost 2 percentage points per year higher than the portfolio’s 8.5% return (with volatility of 12%) over the full, 90-year period 1928 through 2017 (the longest time frame for which data was available).

Unfortunately, simple mathematics makes it clear that today’s investors (including pension plans and endowments) are faced with a harsher reality. Those returns, from what might be called a “Golden Era,” are not likely to be repeated. The reason is that returns benefited from three favorable tail winds (stock valuations rose, profit margins rose to record levels and bond yields fell), none of which is likely to recur. Meanwhile, the risk of mean reversion exists.

With an expected return of 5.3% for U.S. stocks and a 2.8 expected return on five-year Treasury bonds, a 60/40 portfolio has an expected return of about 4.3%. That’s more than 6 percentage points below the return over the prior 36 years and more than 4 percentage points below the 90-year results.

Investors can increase their expected returns by adding exposure to small-cap and value stocks to capture those premiums, and by increasing exposure to international developed markets and emerging markets stocks. However, there’s no way they should expect to earn returns similar to those earned over the prior 36 years. As I mentioned previously, this reality creates problems for those counting on historical returns when designing their investment plans.

On that note, I recently spoke to a financial professional who asked my thoughts on a client’s retirement plan. The advisor was using historical return assumptions in his Monte Carlo analysis. I told the advisor that doing so presented an overly optimistic view of likely outcomes and created a dangerous situation, in this case because the client was withdrawing 6% and had a significant chance of running out of money. That conversation spurred me to write this article. Forewarned is forearmed.

Summary

Those retiring today have benefited greatly from the tail winds I discussed. However, those now planning for retirement face much greater challenges. That likely means many will have to save more, plan on working longer, and should at least consider increasing their equity exposures to factors that historically have provided premiums and can also provide diversification benefits. Such investors may also consider increasing their exposure to international equities, perhaps overcoming a home-country bias.

Additionally, in April 2018, I discussed how using alternative investments such as reinsurance and marketplace lending can improve the odds of achieving your goals while providing diversification benefits.

For those interested in learning more about investing in factors, I recommend my book, “Your Complete Guide to Factor-Based Investing.”

This commentary originally appeared August 6 on ETF.com

The post Current Valuations, Forward-Looking Returns and Disrupted Expectations (copy) appeared first on West Loop Financial LLC.

twistadmin — Wed, 01 Aug 2018 12:50:14 +0000

The bond market is less transparent in pricing and trades less frequently than equity markets. Blerina Hysi explains how a trusted advisor can help navigate these market inefficiencies and prevent you from suffering excessive mark-ups.

The post appeared first on West Loop Financial LLC.

twistadmin — Tue, 20 Mar 2018 15:52:28 +0000

The post appeared first on West Loop Financial LLC.

The Differences Between the Equity and Fixed Income Markets

twistadmin — Mon, 12 Mar 2018 14:34:39 +0000

A quick take on bond markets. Blerina Hysi on navigating fixed income’s lesser transparency and trading frequency.

The post The Differences Between the Equity and Fixed Income Markets appeared first on West Loop Financial LLC.

Active Management Fails in Fixed Income (copy)

twistadmin — Mon, 12 Mar 2018 14:11:07 +0000

Larry Swedroe explains why active bond fund managers not only fail to outperform, but may also offer investors only the illusion of portfolio diversification.

There is a myth that active bond fund managers want and need you to believe. It goes something like this: “Sure, active stock picking isn’t likely to work, but in fixed income, active management really shines.” This is a strange argument to make, because:

1. Active management is a zero-sum game before expenses (and a negative-sum game after expenses). Thus, you have to be able to exploit the mistakes of others to generate alpha.

2. Even more so than in equity markets, trading activity in bond markets is dominated by large, institutional investors. Thus, it’s hard to identify a likely supply of the necessary victims to exploit.

3. The academic research has found that the vast majority of returns to fixed-income portfolios are well-explained by two common factors: term (duration) risk, and credit (default). In other words, any outperformance by active managers against benchmark indexes is likely to come from simply having greater exposure to these two common factors—not from security selection or market timing (two sources of true alpha).

With the sharp cyclical decline we have experienced in interest rates since the global financial crisis, active managers could claim to outperform a benchmark by constructing a portfolio with more duration than the declared benchmark.

Of course, you don’t need active management to have longer duration. Just increase your allocation to longer-duration indexes and invest in lower-cost, passively managed mutual funds and ETFs. The term premium (the difference in returns between long-term U.S. government bonds and one-month Treasury bills) from January 2009 through December 2017 was 4.1% per year. In contrast, over the prior period 1926 through 2008, the term premium was 2%.

The same is true for credit risk, which also has been well rewarded since 2009. The credit premium (the difference in returns between long-term corporate bonds and long-term U.S. government bonds) from January 2009 through December 2017 was 3.1% per year. In contrast, over the prior period from 1926 through 2008, the credit premium was 0%. The default premium over that same period was about 11.6% per year (based on the Bloomberg Barclays US Corporate High-Yield Index).

Again, if you desire exposure to credit risk, you can obtain it in lower-cost, passively managed mutual funds and ETFs. In other words, you don’t have to pay the typically high fees of active management to gain exposure to these factors.

Making matters worse is that the primary reason for investing in fixed income should be to dampen the overall risk of the portfolio to an acceptable level, and while safe bonds offer effective diversification from the equity risk that dominates most investors’ portfolios, credit risk is more highly correlated with equities. The lower the credit rating, the higher the correlation becomes.

The Evidence

Fortunately, we have plenty of evidence to help dispel the myth that active management is likely to generate alpha in fixed-income markets. The most recent comes from S&P Dow Jones Indices, which has published its S&P Indices Versus Active (SPIVA) scorecards, comparing the performance of actively managed mutual funds to their appropriate index benchmarks, since 2002. The 2017 midyear report, the latest available, includes 15 years of data on the performance of active bond funds.

Following is a summary of the results:

The worst performance was in long-term government bond funds, long-term investment-grade bond funds and high-yield bond funds. In each case, just 2% of active funds beat their respective benchmarks. On an equal-weighted (asset-weighted) basis, long-term government bond funds underperformed by a shocking 3.5%age points (3.0%age points), long-term investment-grade bond funds underperformed by 2.6%age points (2.2%age points) and high-yield bond funds underperformed by 2.3%age points (1.7%age points).
For domestic bond funds, the least poor performance was in intermediate- and short-term investment-grade funds, where 76% and 71% of actively managed funds underperformed, respectively. On an equal-weighted basis, their underperformance was 0.5 percentage points and 0.7 percentage points, respectively. However, in both cases, on an asset-weighted basis, they outperformed by 0.3 percentage points. This result possibly could be explained by the funds having held longer maturities (that is, taking more risk) than their benchmarks.
Active municipal bond funds also fared poorly, with between 84% and 92% of them underperforming. On an equal-weighted (asset-weighted) basis, the underperformance was between 0.6 percentage points and 0.7 percentage points (0.2 percentage points and 0.4 percentage points).
Actively managed emerging market bond funds fared poorly as well, as 67% of them underperformed. On an equal-weighted basis, their underperformance was 1.4 percentage points. On an asset-weighted basis, their underperformance was 0.4 percentage points.

We even have evidence from a 1993 study, which covered a period when, arguably, the markets were less efficient than they are today. Christopher Blake, Edwin Elton and Martin Gruber, authors of the study “The Performance of Bond Mutual Funds,” which appeared in the July 1993 issue of the Journal of Business, examined the performance of 361 bond funds and found that the average actively managed bond fund underperforms its benchmark index by 0.85% per year.

In addition, Kevin Stephenson, author of the study “Just How Bad Are Economists at Predicting Interest Rates?”, which appeared in the Summer 1997 issue of the Journal of Investing, found that only 128 out of 800 fixed-income funds (or 16%) beat their relevant benchmark over the 10-year period he covered.

Is Past Performance Predictive?

Being a loser’s game does not mean there aren’t some winners, offering the hope that somehow we can identify the few winners ahead of time. Unfortunately, the evidence suggests that believing this is possible in a reliable way would be the triumph of hope over experience.

For example, in his 1994 book “Bogle on Mutual Funds,” John Bogle studied the performance of bond funds and concluded that “although past absolute returns of bond funds are a flawed predictor of future returns, there is a fairly easy way to predict future relative returns.”

He continues: “The superior funds could have been systemically identified based solely on their lower expense ratios.” Other studies on the subject, including those on municipal bond funds, all reach the same conclusions:

Past performance cannot be used to predict future performance.
Actively managed funds do not, on average, provide added value in terms of returns.
The major cause of underperformance is expenses; there is a consistent one-for-one negative relationship between expense ratios and net returns.

The results of a December 2004 study by Morningstar’s Russel Kinnel, “Time to Clear Out the Dead Wood,” further demonstrate the importance of costs and that the past performance of actively managed funds is a poor predictor of future performance. Kinnel tested funds with strong past performance and high costs against those with poor past performance and low costs. He writes: “Sure enough, those with low costs outperformed in the following period.”

Latest Research

AQR Capital Management contributes to the literature with their December 2017 study, “The Illusion of Active Fixed Income Diversification.” The firm’s researchers studied the performance of institutional fixed-income managers from 1997 through 2017.

AQR extracted monthly manager and benchmark returns that belonged to three categories: global aggregate, core-plus (U.S. aggregate credit index-benchmarked portfolios with allowance for out-of-benchmark exposures) and unconstrained bond (go-anywhere) funds. They limited themselves only to funds within a category that had a benchmark clearly mirroring the category. In addition, they required the base currency to be U.S. dollars.

For global aggregate managers, they were able to find 89 bond funds in their database, and ended up with 53 funds that had the global aggregate index benchmark as well as sufficient returns data for the analysis. For core-plus managers, the same filtering criteria yielded 115 funds. For unconstrained bond managers, it yielded 27 funds.

The funds they eventually used represented 70% of the number of eligible funds available on eVestment in these three categories (and 69% of the assets under management).

Following is a summary of their findings:

On a returns basis, active fixed-income managers have outperformed their benchmarks. However, the majority of active returns for fixed-income managers can be explained by exposure to credit markets, not security selection or market timing. For example, active returns for all three categories have a very strong correlation with high-yield excess returns: 0.76 for global aggregate, 0.95 for core-plus and 0.82 for unconstrained bond.
Credit tilts are consistently positive and do not vary significantly over time. Inasmuch as managers adjust their exposure to credit, they tend to vary between long and very long (they tend not to take short positions). To the extent that there are deviations in credit tilts, they only weakly predict future credit returns. In other words, there is scant evidence of timing ability.
Most active fixed-income returns are a result of the credit risk premium, which is related to the equity risk premium. The resulting diversification loss can dampen the risk-adjusted performance of an investor’s overall portfolio. And this has been the case.

These findings led AQR to conclude that “a significant portion of [fixed income] manager active returns comes from being overweight, structurally and permanently, sources of return that are highly correlated with [high-yield] credit.”

They also warned that “there is a downside of this effective credit overweight to overall strategic allocations, namely a reduction in overall portfolio diversification.”

AQR’s researchers showed that, while over their full sample the U.S. aggregate credit index has tended to provide excellent diversification to equities, realizing a -0.33 correlation with the S&P 500 Index, an equal-weighted portfolio of core-plus managers has actually realized a correlation to equities of 0.05 over the full sample, changing the sign of the correlation of fixed-income returns to equity returns from negative to slightly positive.

This effect has been even stronger since 2008, when active fixed-income managers across categories have tended to have an even higher effective credit exposure. During this time period, the correlation of U.S. aggregate credit index returns to the S&P 500 Index was -0.22, while an equal-weighted portfolio of core-plus managers had realized a correlation of 0.33.

Making matters worse is that the correlation tends to turn strongly positive at exactly the worst time, when equities are crashing, increasing portfolio drawdowns.

Bottom Line

The bottom line is pretty simple: There is an overwhelming body of evidence that active management in fixed-income markets is even more of a loser’s game than it is in equity markets.

The winning strategy for investors is the same for both stocks and bonds: Decide how much exposure you desire to common factors, and then implement the appropriate allocations using the lower-cost, passively managed mutual funds and ETFs that give you the most effective exposure (considering not only expense ratios but also fund construction rules and trading strategies) to those factors.

This commentary originally appeared March 2 on ETF.com

The post Active Management Fails in Fixed Income (copy) appeared first on West Loop Financial LLC.

twistadmin — Thu, 22 Feb 2018 18:51:39 +0000

Larry Swedroe tackles performance, international equity valuations and the perils of recency bias.

For the 10-year period 2008 through 2017, a very wide dispersion in returns has existed in markets. As the following table shows, U.S. stocks far outperformed international stocks, and growth stocks outperformed value stocks.

Given these results, it’s no surprise I have been getting lots of queries from investors about their international equity investments. Any time an asset class does poorly—even for a few years, let alone a decade—a significant number of investors will question why they own that asset.

One particular inquiry I received involved the fact that international equities not only had underperformed domestic equities since 2009, but they crashed in 2008. Just when the benefits from diversification were needed most, they failed to materialize. As a result, the investor in this case doubted the reason for including international equities in his portfolio.

Recency Problem

Among the errors discussed in my book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” is one called recency. Recency is the tendency to overweight recent events/trends and ignore long-term evidence.

This leads investors to buy after periods of strong performance (when valuations are higher and expected returns are now lower) and sell after periods of poor performance (when prices are lower and expected returns are now higher). This results in the opposite of what a disciplined investor should be doing: rebalancing to maintain their portfolio’s asset allocation.

The problem created by recency is compounded when international stocks underperform, greatly increasing the risk that an investor will commit a mistake. This occurs because of another common error: confusing familiarity with safety, which leads to the well-documented, global phenomenon known as home-country bias.

To address questions about where the benefits of international investing can be found, we don’t have to look too far back in time. The problem is that investor memories can be very short, often much shorter than is required to be a successful investor. The period we’ll examine is the five years from 2003 through 2007, the period just before the Great Financial Crisis.

As you can see, results in this period (2003-2007) were just the reverse of what they were in the period following it (2008-2017), with international stocks far outperforming U.S. stocks and value stocks outperforming growth stocks. As Spanish philosopher George Santayana famously warned, “Those who cannot remember the past are condemned to repeat it.”

In general, dramatic outperformance (underperformance) is accompanied by rising (falling) valuations, which generally leads to reversion in returns—higher valuations predict lower future returns, and vice versa.

Forward-Looking Return Estimates

The academic research shows that, while valuations are poor predictors of short-term returns (and thus should not be used to time markets), they are the best predictor we have of future returns. At year-end 2017, the Shiller CAPE 10 earnings yield, as good a predictor of future real returns as any available, was 3.1% for the U.S., 5.1% for non-U.S. developed markets and 6.3% for emerging markets.

There are other valuation metrics we can observe. The table below shows the current price-to-earnings (P/E) ratio and price-to-book (P/B) ratio for three of Vanguard’s funds—Total (U.S.) Stock Market ETF (VTI), FTSE Developed Markets ETF (VEA) and FTSE Emerging Markets ETF (VWO)—and three Dimensional Fund Advisors (DFA) international value funds—International Value (DFIVX), International Small Cap Value (DISVX) and Emerging Markets Value (DFEVX).

Note that the research shows the current P/E has about the same explanatory power as the CAPE 10 ratio. Data is the latest available from Morningstar, with Vanguard data as of December 2017 and DFA data as of November 2017. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends DFA funds in constructing client portfolios.)

Once again, we see that U.S. equity valuations are substantially higher than in developed markets and, especially, emerging markets. Of course, that’s a result of the vast outperformance by U.S. stocks over the prior 10 years. We also see wide spreads between the P/E and P/B ratios of value portfolios relative to market portfolios. Before summarizing, I’ll review an interesting paper on the importance of book-to-market ratios.

Book-To-Market Ratio Importance

Michael Keppler and Peter Encinosa, authors of the study “How Attractive Are Emerging Markets Equities? The Importance of Price/Book-Value Ratios for Future Returns,” which appears in the Spring 2017 issue of The Journal of Investing, provide us with some further insights as to the returns we might expect from emerging markets.

For the period January 1989 through October 2016, they found that the P/B ratio of the MSCI Emerging Markets Index ranged from a low of 0.90 in January 1989 to a high of 3.02 in October 2007 and averaged 1.75. Note the current P/B ratio of VWO is 1.8 and for DFEVX it is just 1.0 (near the very bottom of the range). Keppler and Encinosa then divided the P/B range into three intervals and found:

For 10 observations in the first interval, the P/B ratio was below 1.22. The average annual return in U.S. dollars in the four years that followed was 12.9% and never fell below zero.
For 273 observations in the second interval, the P/B ratio fell between 1.22 and 2.76. The average annual return in the four years that followed was 9.4%.
For four observations in the third interval, the P/B ratio exceeded 2.76. The average annual return in the four years that followed was -5.1%, and was always negative.

Keppler and Encinosa concluded there has been a negative relationship between the P/B ratio and future returns in emerging markets. They also warn investors that focusing on average returns hides a wide dispersion of outcomes.

For example, while the authors’ regression analysis led them to forecast a return of 12% per year for emerging markets over the ensuing four years, data from the previous 28 years indicate that the extreme outcomes lay between an annual loss of 8.8% and an annual gain of 36.9%.

Keppler and Encinosa found the same negative relationship between the P/B ratio and returns over the subsequent four years in developed markets. Over the period 1970 through October 2016, they found the developed markets’ lowest P/B ratio was l.01 in July 1982, the highest was 4.23 in December 1999, and the average was 2.06.

Note the current P/B ratio of VTI is 3 (near the top of the range) and 1.7 for VEA (well below the midpoint). Again, dividing the period into three intervals, they found:

For 169 observations in the first interval, the P/B ratio was below 1.70. The average annual return in U.S. dollars in the four years that followed was 15.4%, and never below zero.
For 319 observations in the second interval, the P/B ratio was between 1.70 and 3.46. The average annual total return four years later was 7.2%.
For 27 observations in the third interval, when the P/B ratio was above 3.46, the average annual return over the next four years was -5.6%, and always negative.

The bottom line is that, currently, expected returns among emerging market equities, particularly emerging market value stocks, are much higher than they are for U.S. stocks (as well as for other developed markets, though to a lesser degree). Additionally, the expected returns of non-U.S. developed-market stocks are higher than they are for U.S. stocks.

With emerging markets now making up more than half of global GDP and about one-eighth of global equity capitalization, an emerging market allocation of one-eighth of your portfolio’s equity allocation is a worthwhile starting point to consider. Non-U.S. developed markets make up about three-eighths of the global market cap. That, too, is a good starting pointing for determining your allocation.

With that said, let’s examine the case for building such a globally diversified portfolio.

Global Diversification Case

Diversification rightly has been called the only free lunch in investing. A portfolio of global equity markets should be expected to produce a superior risk-adjusted return to any one country or region held in isolation. However, the benefits of global diversification came under attack as a result of the financial crisis of 2008, when all risky assets suffered sharp price drops as their correlations rose toward 1.

When that happened, many investors surmised that global diversification doesn’t work, because it fails when its benefits are needed most. That is wrong on two fronts.

First, the most critical lesson investors should have learned is that, because correlations of risky assets tend to rise toward one during systemic global crises, their portfolios should be sufficiently allocated to the safest bond investments (investments such as U.S. Treasury bonds, FDIC-insured CDs and municipal bonds rated AAA/AA). The overall portfolio should reflect one’s ability, willingness and need to take risk.

At the time it’s needed the most, during systemic financial crises, the correlations of the safest bonds to stocks, which average about zero over the long term, tend to turn sharply negative. They benefit not only from flights to safety, but also from flights to liquidity.

The second lesson that many investors failed to understand is that, while international diversification doesn’t necessarily work in the short term, it does work eventually. This point was the focus of a paper from Clifford Asness, Roni Israelov and John Liew, “International Diversification Works (Eventually),” which appeared in a 2011 issue of the CFA Institute’s Financial Analysts Journal.

The authors explained that those who focus on the fact that globally diversified portfolios don’t protect investors from short systematic crashes miss the greater point that investors whose planning horizon is long-term (and it should be, or they shouldn’t be invested in stocks to begin with) should care more about long, drawn-out bear markets, which can be significantly more damaging to wealth.

Diversification For The Long Term

In their study of 22 developed-market countries during the period 1950 through 2008, the authors examined the benefit of diversification over long-term holding periods. They found that, over the long run, markets don’t exhibit the same tendency to suffer or crash together.

As a result, investors should not allow short-term failures to blind them to long-term benefits. To demonstrate this point, the authors decomposed returns into two components: (1) those due to multiple expansions (or contractions); and (2) those due to economic performance.

They found that, while short-term stock returns tend to be dominated by the first component, long-term stock returns tend to be dominated by the second. They explained that these results “are consistent with the idea that a sharp decrease in investors’ risk appetite (i.e., a panic) can explain markets crashing at the same time. However, these risk aversion shocks seem to be a short-lived phenomenon. Over the long-run, economic performance drives returns.”

They further showed that “countries exhibit significant idiosyncratic variation in long-run economic performance. Thus, country specific (not global) long-run economic performance is the most important determinant of long-run returns.”

For example, in terms of worst-case performances, the authors found that, at a one-month holding period, there was very little difference in performance between home-country portfolios and global portfolios.

However, as the horizon lengthened, the gap widened. The worst cases for the global portfolios are significantly better (their losses were much smaller) than the worst cases for the local portfolios. The longer the horizon, the wider the gap favoring the global portfolios becomes.

Demonstrating the point that long-term returns are more about a country’s economic performance and that long-term economic performance is quite variable across countries, the authors found that “country specific economic performance dominates long-term performance, going from explaining about 1% of quarterly returns to 39% of 15-year returns and rising quite linearly in time.”

Summary

We live in a world where there are no accurate crystal balls. Thus, the prudent investment strategy is to build a globally diversified portfolio. But that’s simply the necessary condition for success. The sufficient condition is to possess the discipline to stay the course, ignoring not only clarion cries from those who think their crystal balls are reliable, but also cries from your own stomach to GET ME OUT! As Warren Buffett explained, “The most important quality for an investor is temperament, not intellect.”

To help you stay disciplined and avoid the consequences of recency, I offer the following suggestion: Whenever you are tempted to abandon your well-thought-out investment plan because of poor recent performance, ask yourself this question: Having originally purchased and owned this asset when valuations were higher and expected returns were lower, does it make sense to now sell the same asset when valuations are currently much lower and expected returns are now much higher?

The answer should be obvious. If that’s not sufficient, remember Buffett’s further advice to never engage in market timing, but if you cannot resist the temptation, then you should buy when others panic.

This commentary originally appeared February 14 on ETF.com

The post appeared first on West Loop Financial LLC.

twistadmin — Thu, 22 Feb 2018 18:51:39 +0000

Larry Swedroe tackles performance, international equity valuations and the perils of recency bias.

Recency Problem

Forward-Looking Return Estimates

Book-To-Market Ratio Importance

For 10 observations in the first interval, the P/B ratio was below 1.22. The average annual return in U.S. dollars in the four years that followed was 12.9% and never fell below zero.
For 273 observations in the second interval, the P/B ratio fell between 1.22 and 2.76. The average annual return in the four years that followed was 9.4%.
For four observations in the third interval, the P/B ratio exceeded 2.76. The average annual return in the four years that followed was -5.1%, and was always negative.

Note the current P/B ratio of VTI is 3 (near the top of the range) and 1.7 for VEA (well below the midpoint). Again, dividing the period into three intervals, they found:

For 169 observations in the first interval, the P/B ratio was below 1.70. The average annual return in U.S. dollars in the four years that followed was 15.4%, and never below zero.
For 319 observations in the second interval, the P/B ratio was between 1.70 and 3.46. The average annual total return four years later was 7.2%.
For 27 observations in the third interval, when the P/B ratio was above 3.46, the average annual return over the next four years was -5.6%, and always negative.

With that said, let’s examine the case for building such a globally diversified portfolio.

Global Diversification Case

When that happened, many investors surmised that global diversification doesn’t work, because it fails when its benefits are needed most. That is wrong on two fronts.

Diversification For The Long Term

Summary

This commentary originally appeared February 14 on ETF.com

The post appeared first on West Loop Financial LLC.

Yet More Investing Lessons from 2017 (copy)

twistadmin — Wed, 31 Jan 2018 19:22:45 +0000

Larry Swedroe concludes his list with 2017’s lessons eight through 10.

Every year, the markets offer lessons on the prudent investment strategy. So far, we’ve covered what they taught us last year in lessons one through three and four through seven. Today, we’ll finish off 2017’s list with lessons eight through 10.

Lesson 8: Hedge funds are not investment vehicles, they are compensation schemes.

This one has been appearing as regularly as the lesson that active management is a loser’s game. Hedge funds entered 2017 coming off their eighth-straight year of trailing U.S. stocks (as measured by the S&P 500 Index) by significant margins. And investors noticed.

In 2016, poor performance and withdrawals led to the closing of 1,057 hedge funds, the most since 2008. However, even after withdrawals of about $70 billion, that still left about 9,900 hedge funds (729 new hedge funds were started) managing just more than $3 trillion as we entered last year.

Unfortunately, the losing streak for hedge funds continued into a ninth year as the HFRX Global Hedge Fund Index returned just 6.0% in 2017, underperforming the S&P 500 Index by 15.8 percentage points. The following table shows the returns for various equity and fixed-income indexes.

As you can see, the HFRX Global Hedge Fund Index underperformed the S&P 500 and nine of the 10 major equity asset classes, but managed to outperform two of the three bond indexes.

An all-equity portfolio allocated 50% internationally and 50% domestically, equally weighted among the indexes within those broader categories, would have returned 21.3%, outperforming the hedge fund index by 15.3 percentage points. A 60% equity/40% bond portfolio with the same weighting methodology for the equity allocation would have returned 13.0% using one-year Treasuries, 13.4% using five-year Treasuries and 15.3% using long-term Treasuries.

Each of the three would have outperformed the hedge fund index. Given that hedge funds tout the freedom to move across asset classes as their big advantage, one would think that “advantage” would have shown up. The problem is that the efficiency of the market, as well as the cost of the effort, turns that supposed advantage into a handicap.

Over the long term, the evidence is even worse. For the 10-year period 2008 through 2017, the HFRX Global Hedge Fund Index returned -0.4% a year, underperforming every single equity and bond asset class. As you can see in the following table, underperformance ranged from 1.3 percentage points when compared to the Merrill Lynch One-Year Treasury Note Index to as much as 10.0 percentage points when compared to U.S small-cap stocks.

One Year Of Outperformance

Perhaps even more shocking is that, over this period, the only year the hedge fund index outperformed the S&P 500 was in 2008. Even worse, when compared to a balanced portfolio allocated 60% to the S&P 500 Index and 40% to the Barclays Government/Credit Bond Index, it underperformed every single year.

For the 10-year period, an all-equity portfolio allocated 50% internationally and 50% domestically, equally weighted within those broader categories, would have returned 6.2% per year. A 60% equity/40% bond portfolio, again with the same weighting methodology for the equity allocation, would have returned 4.8% per year using one-year Treasuries, 5.9% per year using five-year Treasuries and 7.6% per year using long-term Treasuries. All three dramatically outperformed the hedge fund index.

Finally, you may recall that a decade ago, in 2007, Warren Buffett bet $1 million that an index fund would outperform a collection of hedge funds over 10 years. He has now won that bet, with the big winner being a charity called Girls Inc. Over the course of the bet, his S&P 500 Index fund returned 7.1% per year versus just 2.2% per year for the basket of hedge funds selected by an asset manager at Protégé Partners.

The bottom line is that the evidence suggests investors are best served to think of hedge funds as compensation schemes, not investment vehicles.

Lesson 9: Don’t let your political views influence your investment decisions.

One of my more important roles as director of research at Buckingham Strategic Wealth and The BAM Alliance involves working to help prevent investors from committing what I refer to as portfolio suicide—panicked selling resulting from fear, whatever the source of that fear may be. The lesson to ignore your political views when making investment decisions is one that rears its head after every presidential election, and this time was no different. It seems to have become much more of an issue in 2017 because of the divisive views held by many about President Trump.

We often make mistakes because we are unaware that our decisions are being influenced by our beliefs and biases. The first step to eliminating, or at least minimizing, such mistakes is to become aware of how our choices are impacted by our views, and how those views can influence outcomes.

The 2012 study “Political Climate, Optimism, and Investment Decisions” showed that people’s optimism toward the financial markets and the economy is dynamically influenced by their political affiliation and the existing political climate. Among the authors’ findings were:

Individuals become more optimistic and perceive the markets to be less risky and more undervalued when their preferred party is in power. This leads them to take on more risk, overweighting riskier stocks. They also trade less frequently. That’s a good thing, as the evidence demonstrates that the more individuals trade, the worse they tend to do.
When the opposite party is in power, individuals’ perceived uncertainty levels increase and investors exhibit stronger behavioral biases, leading to poor investment decisions.

Now, imagine the nervous investor who sold equities based on views about a Trump presidency. While investors who stayed disciplined have benefited from the rally, those who panicked and sold not only have missed the bull market, but now face the incredibly difficult task of figuring out when it will be once again safe to invest.

Similarly, I know of many investors with Republican leanings who were underinvested once President Obama was elected. And now it’s Democrats who have to face their fears. The December 2016 Spectrem Affluent Investor and Millionaire Confidence surveys provided evidence of how political biases can impact investment decisions.

Prior to the 2016 election, with a victory for Hillary Clinton expected, those identified as Democrats showed higher confidence than those who identified as Republicans or Independents. This completely flipped after the election. Those identified as Democrats registered a confidence reading of -10, while Republicans and Independents showed confidence readings of +9 and +15, respectively.

What’s important to understand is that if you lose confidence and sell, there’s never a green flag that will tell you when it’s safe to get back in. Thus, the strategy most likely to allow you to achieve your goals is to have a plan that anticipates there will be problems, and to not take more risk than you have the ability, willingness and need to assume. Additionally, don’t pay attention to the news if doing so will cause your political beliefs to influence your investment decisions.

Lesson 10: Just because something hasn’t happened doesn’t mean it won’t.

As we entered 2017, with U.S. stock valuations at historically very high levels, many investors were waiting for a market decline before they would buy equities again. Giving them confidence there would be a bear market (a drop of 20% or more), a “correction” (a drop of 10% or more) or at least a dip was that the S&P 500 had never gone a full year in which there wasn’t at least one month with a negative return. The only year that came close was 1995, which saw a drop of just 0.4% in October.

As it turned out, 2017 set a record, with every month showing a gain, extending the index’s record-setting winning streak to 14 months. This provides a good example of why I consider it a rule of prudent investing to never treat the unlikely as impossible or the likely as certain. In case you’re interested, or are one of those investors waiting for that dip, 1995 was followed by another strong year, with the S&P 500 up 23%.

Investors would do well to remember this advice from Peter Lynch: “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”

Summary

2018 will surely offer investors more lessons, many of which will be remedial courses. And the market will provide you with opportunities to make investment mistakes. You can avoid making errors by knowing your financial history and having a well-thought-out plan. Reading my book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” will help prepare you with the wisdom you need.

This commentary originally appeared January 19 on ETF.com

The post Yet More Investing Lessons from 2017 (copy) appeared first on West Loop Financial LLC.

More Investing Lessons from 2017 (copy)

twistadmin — Wed, 31 Jan 2018 19:18:07 +0000

Larry Swedroe resumes his list with 2017’s lessons four through seven.

Earlier this week, we began discussing what the markets taught us in 2017 about prudent investment strategies. We tackled lessons one through three then, so today we’ll resume with lessons four through seven.

Lesson 4: Don’t make the mistake of recency. Last year’s winners are just as likely to be this year’s dogs.

The historical evidence demonstrates that individual investors are performance chasers—they buy yesterday’s winners (after the great performance) and sell yesterday’s losers (after the loss has already been incurred).

This causes investors to buy high and sell low—not exactly a recipe for investment success. This behavior explains the findings from studies that show investors can actually underperform the very mutual funds in which they invest.

Unfortunately, a good (poor) return in one year doesn’t predict a good (poor) return the next year. In fact, great returns lower future expected returns, and below-average returns raise future expected returns.

Thus, the prudent strategy for investors is to act like a postage stamp. The lowly postage stamp does only one thing, but it does it exceedingly well—it adheres to its letter until it reaches its destination. Similarly, investors should adhere to their investment plan (asset allocation). Sticking to one’s plan doesn’t mean just buying and holding. It means buying, holding and rebalancing—the process of restoring your portfolio’s asset allocation to your plan’s targeted levels.

Using DFA’s passive mutual funds, the following table compares the returns of various asset classes in 2016 and 2017. As you can see, sometimes the winners and losers repeated, but other times they changed places.

For example, the best performer in 2016, U.S. small value, fell to 11th place in 2017; the sixth-best performer in 2016, emerging markets, rose to first place in 2017; and the 12th place performer in 2016, international small stocks, moved up to fourth place in 2017. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends DFA funds in constructing client portfolios.)

Lesson 5: Volatility can stay low for longer than expected.

While the VIX’s long-term average has been about 20, we entered 2017 with the volatility index well below that, at about 14. The historical evidence shows that volatility is negatively related to returns. The logical explanation is that volatility tends to spike when markets receive bad news, which tends to occur at unexpected times, when so-called black swans arrive. On the other hand, good news doesn’t tend to suddenly break out.

The VIX being well below historical levels led some gurus to believe investors were too complacent and overconfident, especially in light of very high U.S. stock valuations and a political environment that created a lot of uncertainty insofar as tax policy, health care and budget deficits. In addition, potential ill winds were blowing on the geopolitical front from Russia, North Korea, Iran and the Middle East in general.

Despite a dysfunctional political environment at home and these ill winds abroad, the VIX remained below 16 throughout the year. Evidence of last year’s low volatility can be found in the fact that there were only eight days in 2017 of 1% moves in the S&P 500 (four up and four down).

Looking back at the historical data, the year that had the lowest number of days with a 1% or greater move in the market was 1964, when there were three. In contrast, 2013 saw 134 such days. The record for days of a move of 1% or more was 199, which came in 1932. And with this low level of volatility, the market delivered strong returns.

Lesson 6: Ignore all forecasts because all crystal balls are cloudy.

One of my favorite sayings about the market forecasts of so-called experts is from Jason Zweig, financial columnist for The Wall Street Journal: “Whenever some analyst seems to know what he’s talking about, remember that pigs will fly before he’ll ever release a full list of his past forecasts, including the bloopers.”

You will almost never read or hear a review of how the latest forecast from some market “guru” actually worked out. The reason is that accountability would ruin the game—you would cease to “tune in.” But I believe forecasters should be held accountable. Thus, a favorite pastime of mine is keeping a collection of economic and market forecasts made by media-anointed gurus and then checking back periodically to see if they came to pass. This practice has taught me there are no expert economic and market forecasters.

Here’s a small sample from this year’s collection. I hope they teach investors a lesson about ignoring all forecasts, including the ones that happen to agree with their own notions (that’s the nefarious condition known as confirmation bias at work).

We’ll begin with the March 10, 2017 warning from David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates as well as frequent guest on CNBC. The S&P 500 Index stood at 2,372. Rosenberg gave 10 reasons to be cautious about stocks as major indexes hovered near record highs:

Stocks were expensive relative to their historical average.
Margin debt stood at a record level.
Private clients had “thrown in the towel,” plowing nearly $80 billion into equity funds since the November 2016 election—a classic sign of a market top is when “dumb money” chases gains.
There was very narrow leadership.
Investors were complacent with volatility at very low levels.
The Fed would raise rates three times in 2017.
Inflation would roar.
Stocks were over-owned: 21.1% of household assets were in stocks, and he argued that “only five times in the past 156 years has the share been this high or higher—42% above the norm.”
Credit markets were frothy (spreads were very narrow).

Such concerns are enough to scare many investors, and likely they did, especially those who shared them. However, the market ignored all those reasons, with the S&P 500 adding about another 13% for the year, not including dividends.

Others Agree

We turn now to the April 2017 warnings from some leading hedge fund managers. At a Goldman Sachs conference, billionaire and legendary hedge fund manager Paul Tudor Jones warned that years of low interest rates have bloated stock valuations (as measured by market cap to GDP) to a level not seen since 2000, right before the Nasdaq tumbled 75% over two-plus years.

Jones wasn’t alone among hedge fund managers who were warning investors. Guggenheim Partners’ Scott Minerd said he expected a “significant correction” in the summer or early fall. Philip Yang, a macro manager who has run Willowbridge Associates since 1988, saw a stock plunge of between 20% and 40%. Legendary value investor Seth Klarman, who runs the $30 billion Baupost Group, told investors in a letter that corporate insiders have been heavy sellers of their company shares. To him, that’s “a sign that those who know their companies the best believe valuations have become full or excessive.”

Warnings from four highly respected managers were likely enough to scare off many investors. Yet the markets ignored them all.

Shiller Weighs In

We next turn to a Sept. 21, 2017 column in which economist Robert Shiller warned investors about the risks of a bear market. He presented evidence that led him to conclude: “The US stock market today looks a lot like it did at the peaks before most of the country’s 13 previous bear markets.” Coming from a Nobel Prize-winner, that can be pretty scary.

Before going into his reasons for concern, note that Shiller was wise enough to add this caveat: “This is not to say that a bear market is guaranteed: such episodes are difficult to anticipate, and the next one may still be a long way off.” If you don’t provide the timing for an event you predict, it’s hard to say you are wrong. It’s easy to argue that it just hasn’t happened, yet.

Shiller began by noting that not only was the CAPE 10 above 30 (observing that it had been reached only twice before, and both times were followed by severe bear markets), but that while earnings growth was strong (from the second quarter of 2016 to the second quarter of 2017, real earnings growth was 13.2%, well above the 1.8% historical annual rate), it didn’t reduce the likelihood of a bear market.

He writes: “In fact, peak months before past bear markets also tended to show high real earnings growth: 13.3% per year, on average, for all 13 episodes. Moreover, at the market peak just before the biggest ever stock-market drop, in 1929-32, 12-month real earnings growth stood at 18.3%.”

Shiller also noted the “ostensibly good news that average stock-price volatility—measured by finding the standard deviation of monthly percentage changes in real stock prices for the preceding year—is an extremely low 1.2%. Between 1872 and 2017, volatility was nearly three times as high, at 3.5%. Yet again, this does not mean a bear market isn’t approaching. In fact, stock-price volatility was lower than average in the year leading up to the peak month preceding the 13 previous U.S. bear markets, though today’s level is lower than the 3.1% average for those periods. At the peak month for the stock market before the 1929 crash, volatility was only 2.8%.”

The U.S. stock market, as represented by the S&P 500, ignored Shiller’s warning, with the last quarter of 2017 providing a return of about 5.5%.

Contradictory Forecasts

Finally, we’ll look at two contradicting forecasts from former Goldman Sachs Group and Fortress Investment Group macro trader Michael Novogratz. On Dec. 23, 2017, he announced that he was shelving plans to start a cryptocurrency hedge fund. He predicted that bitcoin may extend its plunge to $8,000. Earlier in the same month, he predicted it could reach $40,000 within a few months. Which one should we have believed?

To be fair, there were surely some forecasts that turned out to be right. The problem comes in knowing ahead of time which ones to pay attention to, and which to ignore.

Here’s what Warren Buffett had to say about the value of forecasts in his 2013 letter to Berkshire Hathaway shareholders. “Forming macro opinions or listening to the macro or market predictions of others is a waste of time.”

He has also warned: “We have long felt that the only value of stock forecasters is to make fortune-tellers look good.” Unfortunately, one of the great ironies is that, while so many idolize Buffett, many of those same people not only ignore his advice, they tend to do exactly the opposite.

My long experience has taught me that investors tend to pay attention to the forecasts that agree with their preconceived ideas (again, that pesky confirmation bias) while ignoring forecasts that disagree. Being aware of our biases can help us overcome them.

Lesson 7: Sell in May and go away is the financial equivalent of astrology.

One of the more persistent investment myths is that the winning strategy is to sell stocks in May and wait to November to buy back into the market. While it’s true that, historically, stocks have provided greater returns from November through April than they have from May through October, since 1926, there’s still been an equity risk premium from May through October. From 1927 through 2016, the “Sell in May” strategy returned 8.4% per year, underperforming the S&P 500 by 1.6 percentage points per year. That’s even before considering any transaction costs, let alone the impact of taxes (you’d be converting what would otherwise be long-term capital gains into short-term capital gains, which are taxed at the same rate as ordinary income).

How did the sell-in-May-and-go-away strategy work in 2017? The S&P 500 Index’s total return for the period May through October was 9.1%. During this period, safe, liquid investments would have produced just 0.5%, providing virtually no return. In case you’re wondering, 2011 was the only year in the last nine when the sell in May strategy would have worked.

A basic tenet of finance is that there’s a positive relationship between risk and expected return. To believe that stocks should produce lower returns than Treasury bills from May through October, you would also have to believe stocks are less risky during those months—a nonsensical argument. Unfortunately, like with many myths, this one seems hard to kill off. And you can bet that next May the financial media will be resurrecting it once again.

We’ll finish up our list of what the markets taught investors in 2017 later this week with lessons eight through 10.

This commentary originally appeared January 17 on ETF.com

The post More Investing Lessons from 2017 (copy) appeared first on West Loop Financial LLC.