Even Balanced Portfolios Correlate Strongly to Stocks

Wednesday, August 1st, 2012

Although the following commentary from Dorsey Wright Money Management is pointed, it draws an interesting conclusion that a 60/40 balanced portfolio is by no means a fully diversified portfolio, given that its correlation to the S&P 500 has been 0.99 for the past 15 years. Their presentation (for advisors only) worth a look.

via Dorsey Wright Asset Management, Systematic Relative Strength

Those investors looking to build a portfolio with low correlation to the stock market are going to have to do more than just add bonds. BlackRock points out that the correlation of a 60/40 balanced portfolio and a 100% equity portfolio has been 0.99 over the past 15 years!

It is important for investors to understand the sources of risks in their portfolios. Take the traditional 60/40 portfolio as an example. Even though 40% of this portfolio is invested in bonds, almost all of the risk in the portfolio is equity risk. This chart shows that over the last 15 years, the correlation of returns between a 60/40 portfolio and a 100% equity portfolio was 0.99, meaning that they were almost perfectly correlated. Even a portfolio that is exceptionally overweight bonds shows a similar trend. A 30% stock/70% bond portfolio had a 0.82 correlation to a 100% stock portfolio. To us, that says that a long-only stock and bond portfolio isn’t full diversification.

However, when you also add commodities, currencies, and real estate into the portfolio it is a different story.  Click here to learn how we incorporate a broad range of asset classes into our Global Macro portfolio (financial advisors only).

To receive the brochure for our Global Macro strategy, click here.  For information about the Arrow DWA Tactical Fund (DWTFX), click here.

Click here and here for disclosures.  Past performance is no guarantee of future returns.

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Whither Global Stocks? Be Sure to Track This Data

Wednesday, August 1st, 2012

by Russ Koesterich, Chief Investment Strategist, iShares

Sometimes, either weak economic numbers or strong economic numbers can point to a surge in US and global equities. This could be one of those weeks.

Two important sets of data are due out this week: the US Institute for Supply Management (ISM) — which is broken into two parts: the manufacturing survey on Wednesday and the non-manufacturing survey on Friday — and the US non-farm payroll report which comes out on Friday.

If the numbers are weak, they may be positive for global equities because they may increase the odds of more monetary stimulus on the part of the US Federal Reserve. Numbers showing a rebound in economic growth would also be a positive for the stock market.

On the other hand, if July numbers are like June’s, they would be a negative for stocks as they would suggest slow economic growth, but not so slow as to merit further monetary easing.

Here, then, is what I expect from this week’s data:

• ISM: I’m looking for a modest rebound in the Purchasing Managers’ Index services component of ISM and in new orders from manufacturers. Both would confirm my thesis that the economy won’t be entering another recession. While falling numbers may lead me to revise down my second-half US growth estimate to below 2%, they could in turn be read by investors as making Fed action more likely.

• Non-Farm Payroll: I’m also watching Friday’s non-farm payroll report, especially net new job creations, which I believe will strongly influence the Fed. If the number comes in below 70K to 80K, a third round of quantitative easing (QE3) is likely before year’s end.

In the meantime, I’m maintaining my preference for equities, particularly mega caps, high dividend producers and minimum volatility exposure. For investors looking for global exposure, I would suggest the iShares MSCI ACWI Index Fund (NYSEARCA:ACWI), the iShares MSCI All Country World Minimum Volatility Index Fund (NYSEARCA:ACWV), or the iShares S&P Global 100 Index Fund (NYSEARCA:IOO).

My preferred vehicles for yield are the iShares High Dividend Equity Fund (NYSEARCA: HDV), given its low beta and quality screen, and the iShares Dow Jones International Select Dividend Index Fund (NYSEARCA: IDV).

Source: Bloomberg

The author is long IOO, HDV and IDV

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.


Investing involves risk, including possible loss of principal. In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavourable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Narrowly focused investments typically exhibit higher volatility.

There is no guarantee that dividends will be paid.

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Why Another China Stimulus Package is Not Coming

Wednesday, August 1st, 2012

When might the government roll out another stimulus? Have local governments already announced major stimulus? Will the economy grow at a much slower pace than targeted by the government if no new stimulus is adopted soon? Could the country/industries/companies survive without another stimulus? These are some of the recent more frequently asked questions.

UBS: Don’t Hold Your Breath for another Stimulus in China

Indeed some market participants seem to be eagerly anticipating or hoping for another stimulus in China, and each day that has passed without a big policy announcement seems to have depressed the market further. While the Chinese government has been very concerned about the economic slowdown and has taken policies to support growth, we would not be holding our breath for another big stimulus. The previous stimulus in 2008-09 did lift growth much higher than otherwise would have been, but the excessive credit expansion also worsened the imbalance in the economy and left serious negative consequences which are still been dealt with today. Chinese government has clearly recognized this and is keen to avoid making a similar mistake this time. Of course, the slowdown in export and in the overall economy is also much milder compared with 2008-09. Importantly, the lack of labour market distress so far has made it less urgent to come up with any big stimulus.

This is not to say that the government has done little or will do little to support growth. Indeed macro policies have changed to supportive of growth since early this year and this has intensified since mid-May. The policies taken so far include fiscal (tax cuts for small businesses, subsidies for some appliances, pension increase, and more spending on social housing), monetary (increase of base money supply through RRR cuts and reverse repos, increase of banks’ lending quota, and 2 interest rate cuts), and credit and quasi-fiscal (easing of lending to the property sector, local government platforms and some sectors, approval and launch of more government investment projects). Among all these, we continue to believe that the measures to increase public investment, to be financed largely by bank credit, will be the most important ones in the near term.

The government has also been trying to encourage private investment in energy, utility, transport and service sectors including by promising easier entry and access to credit, but we think it may take some time before such investment can take off. Most recently, the State Council announced on July 30 that the government will support industrial upgrading including by providing interest subsidies for enterprises to invest in new technology and techniques, more advanced equipment, energy saving process and materials, and advanced information and automation systems. Banks are also encouraged to increase lending to such investment projects.

What about the many “regional stimuli”, including in Changsha and Guizhou? Should we tally up the regional investment plans and count these as stimulus? Not really. While the central government is clearly trying to support growth and investment in the inland regions, we think the many regional stimuli are largely wishful thinking of local governments. The realization of such ambitious investment plans depends crucially on sufficient financing, but banks have been more cautious this time and the overall credit policy is still closely managed by the central government. In addition, the central government’s insistence on not relaxing the property policies wholesale has put limited local governments’ ability to use land/property to finance ambitious investment projects.

Nevertheless, with the continued implementation of the existing pro-growth measures we think GDP growth can still be close to 8% in 2012. In the coming months, we should see bank lending to expand at a steady pace, with the share of medium and long term loans rising gradually, which should help support a modest and investment-led recovery in Q3 and Q4 2012. Industrial profits are down and may continue to be depressed for 1-2 quarters with the ongoing decline in some prices and inventory adjustments, and some companies may not survive this cycle, but we do not foresee major macro risks because of this. Some adjustment and industry consolidation in an economic downturn may not be bad, and many listed companies may emerge from this cycle stronger and more efficient. The ride, of course, may not be pretty.

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Jeremy Grantham: Investment Outlook (Q2 2012)

Wednesday, August 1st, 2012

GMO Quarterly Q2 – July 2012

Welcome to Dystopia!¹
Entering a long-term and politically dangerous food crisis²

by Jeremy Grantham, GMO

“Them belly full but we hungry …
… A hungry man is a angry man …
… A hungry mob is a angry mob.”
—Bob Marley, “Them Belly Full”

“Anyone who believes exponential growth can go on forever in a finite world is either a madman or an economist.”
—Kenneth Boulding, Economist

Summary of the Summary

We are five years into a severe global food crisis that is very unlikely to go away.  It will threaten poor countries with increased malnutrition and starvation and even collapse.  Resource squabbles and waves of food-induced migration will threaten global stability and global growth.  This threat is badly underestimated by almost everybody and all institutions with the possible exception of some military establishments.

Summary

1. Last year we reported the data that showed that we are 10 years into a paradigm shift or phase change from falling resource prices into quite rapidly rising real prices.

2. It now appears that we are also about five years into a chronic global food crisis that is unlikely to fade for many decades, at least until the global population has considerably declined from its likely peak of over nine billion in 2050.

3. The general assumption is that we need to increase food production by 60% to 100% by 2050 to feed at least a modest sufficiency of calories to all 9 billion+ people plus to deliver much more meat to the rapidly increasing middle classes of the developing world.

4. It is also widely assumed that at least the lower end of this target will be achieved.  I believe that this is substantially optimistic.  At very best, if we reach that level we will not be able to hold it.  Much more likely, we will not come close because there are too many factors that will make growth in food output increasingly difficult where it used to be easy:

- Grain productivity has fallen decade by decade since 1970 from 3.5% to 1.5%.  Quite probably, the most efficient grain producers are approaching a “glass ceiling” where further increases in productivity per acre approach zero at the grain species’ limit (just as race horses do not run materially faster now than in the 1920s).  Remarkably, investment in agricultural research has steadily fallen globally, as a percent of GDP.

- Water problems will increase to a point where gains from increased irrigation will be offset by the loss of underground water and the salination of the soil.

- Persistent bad farming practices perpetuate land degradation, which will continue to undermine our longterm sustainable productive capacity.

- Incremental returns from increasing fertilizer use will steadily decline on the margin for fertilizer use has increased five-fold in the last 50 years and the easy pickings are behind us.

- There will be increased weather instability, notably floods and droughts, but also steadily increasing heat. The last three years of global weather were so bad that to draw three such years randomly would have been a remote possibility.  The climate is changing.

- The costs of fertilizer and fuel will rise rapidly.

5. Even if we could produce enough food globally to feed everyone satisfactorily, the continued steady rise in the cost of inputs will mean increasing numbers will not be able to afford the food we produce.  This is a key point that is often missed.

6. On the positive side, scientists are now very optimistic that they will be able to engineer more efficient photosynthesizing “C4” genes (corn belongs to that family) into relatively inefficient but vital “C3” plants such as rice and wheat, in 20 to 30 years.  If successful this would increase output up to 50% and would buy time for a less painful transition to a sustainable population.

7. Many of these increasing difficulties were reflected in the original 2008 food crisis and the 2011 rebound. The last six weeks’ price rise is more threatening because it occurred despite very much larger plantings than were available in 2008. Global demand is now so high and rising so fast and reserves are so low that price sensitivity to weather setbacks has become extreme.

8. It seems likely that several countries dependent on foreign grain imports have in fact never recovered from the 2008 shock.  Countries like Egypt saw the percent of their consumer budget for food rise to 40%.  At this level, social pressures may be at an extreme and probably have already contributed to the Arab Spring. Any price increases from here may cause social collapse and a wave of immigration on a scale never before experienced in peacetime.  Another doubling in grain prices would be catastrophic.

9. Strong countermeasures to prevent a food crisis would be effective in curtailing the current crisis and preventing the development of a much greater crisis, but these measures will likely not be taken.  This is because the price signals for the rich countries are too weak – they can afford the higher price – and there is inertia in all parts of the system. Also, the problems of malnutrition in distant countries are not generally felt as high-order priorities in the richer countries.

10. If food pressures recur  and are reinforced by fuel price increases, the risks of social collapse and global instability increase to a point where they probably become the major source of international confrontations. China is particularly concerned (even slightly desperate) about resource scarcity, especially food.

11. The general public, the media, the financial markets, and governments badly underestimate these risks.  Only the military of some countries, including the U.S. and the U.K., seem to appreciate them appropriately.

12. Natural gas supply increases buy some time, mainly for the U.S., but seem more likely to create complacency and continued dependence on hydrocarbons.  The energy situation is less pressing globally in the short term than is the food problem.  Supplies are sufficient to cause merely a slow and erratic price increase.  The main problem with oil is in its contribution to the food problem through higher farming costs and generally increasing cost pressures on poorer countries.

13. In the longer term, in contrast, energy costs and absolute shortage in the case of oil form a serious problem second only to food shortages and will result in prices so high that they will impact global growth and even the viability of modern, rather fragile, economies.

14. On paper, though, the energy problem can be relatively easily addressed through very large investments in renewables and smart grids.  Those countries that do this will, in several decades, eventually emerge with large advantages in lower marginal costs and in energy security.  Most countries including the U.S. will not muster the political will to overcome inertia, wishful thinking, and the enormous political power of the energy interests to embark on these expensive programs.  They risk being left behind in competiveness.

15. Availability of metals is, in contrast, a minor problem in the next few decades.  The prices will steadily rise but the consequences will be less.  In the long run though, metals are the most intractable problem.  There is no brain-intensive solution as there is for agriculture (i.e., organic farming), nor is there any capital-intensive or technology-intensive solution as there is for energy.  We will just slowly run out and prices will rise.

16. The results of these problems will be felt mainly as price pressure in rich countries.  The need to obtain adequate resources will squeeze national budgets, profit margins, and economic growth.  For poor countries, though, it is literally a matter of survival.

17. We are badly designed to deal with this problem:  regrettably we are not the efficient species of investment theory, but ill-informed, manipulated, full of inertia, and corruptible.  Only once in a blue moon – like World War II – do we perform anywhere near our theoretical capabilities and this time the enemy is amorphous and delivers its attack very, very slowly.  But the stakes globally are very high indeed.  We must try harder.

18. The following comments on this topic are mine personally and reflect my Foundation’s portfolio (and a total lack of career risk!).  These comments are based on a time horizon of 10 years and beyond.  The portfolio investment implications are that investors should expect resource stocks – those with resources in the ground – to outperform over the next several decades as real prices of the resources rise.  Farming and forestry, though, are at the top of the list.  Serious long-term investors should have a very substantial overweighting in a resource package.  I suggest for long-term investors a resource position of at least 30%.  Another relative beneficiary of resource pressure is the quality group of equities.  Resources are a smaller fraction of final sales than average and higher profit margins make them more resilient to margin pressures.

19. Perhaps more importantly, the resource squeeze, coupled with other growth-reducing factors (to be discussed next quarter), is likely to reduce the return from the balance of the portfolio. P.S. A 24-minute video of similar material from a recent interview at University of Cambridge, Programme for Sustainability Leadership, can be accessed at www.gmo.com; however, only those qualified investors with client IDs will be able to access it.

You can read or download the complete quarterly letter in the slidedeck below:

GMOQ2Lettern – Jeremy Grantham – Welcome to Dystopia

Footnotes:

1  Dystopia:  a society characterized by human misery, disease, oppression, and overcrowding.

2 This report is an update and extension of “Time to Wake Up,” April 2011 and “Resource Limitations 2: Separating the Dangerous from the Merely Serious,” July 2011.  Each is available with registration at www.gmo.com

Tags: agricultural
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Investor Sentiment: The Bernanke Put Won’t Die Easily

Wednesday, August 1st, 2012

by Guy Lerner, The Technical Take

There certainly is a lot of belief in the Bernanke put.  And that belief exists whether you are bullish or bearish on the markets.  If you are bullish, you acknowledge the “put” and buy knowing Ben has your back.  If you are bearish, you acknowledge the “put” and sit on the sidelines knowing that the music is likely to stop at anytime.  The Bernanke “put” is no longer rumor.  Everyone believes in it and it would seem likely baked into the market.  This belief existed 8 weeks ago when the market sold off and the belief in the mantra “Ben has your back” is even stronger today as the market has worked its way back towards the recent cyclical highs.  From this perspective, this sets up a “buy the rumor, sell the news” scenario when the Fed announces its next bold plan to “save” the economy this week.

But the belief in the “put” won’t die easily as investors seem to be fixated on the fact that central bankers can fix the economy.  We know they can try and likely will because that is their job, but each intervention seems to produce less and less an effect on the markets and on the economy.  It isn’t like these stewards of the economy have discovered the financial fountain of youth.  Furthermore, there is always a new data point of hope just on the horizon that will always prompt investors to believe that the next big liquidity operation is just around the corner.

As discussed previously, the investor sentiment picture remains consistent with a market top.

The “Dumb Money” indicator (see figure 1) looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investors Intelligence; 2) MarketVane; 3) American Association of Individual Investors; and 4) the put call ratio. This indicator is neutral.

Figure 1. “Dumb Money”/ weekly

Figure 2 is a weekly chart of the SP500 with the InsiderScore “entire market” value in the lower panel. From the InsiderScore weekly report: “Market-wide insider sentiment continued to be Neutral last week as insider trading activity remained near a seasonal low-point. The number of unique non-10b5-1 plan buyers and sellers was the third-lowest in our 446-week (dating back to January 1, 2004) tracking period, bested only by the prior week and the third week of April this year. Activity will begin to pick-up late this week/early next week and transactional volume will increase significantly as insiders at the first-round of earnings reporters are free to buy/sell again.”

Figure 2. InsiderScore “Entire Market” value/ weekly

Figure 3 is a weekly chart of the SP500. The indicator in the lower panel measures all the assets in the Rydex bullish oriented equity funds divided by the sum of assets in the bullish oriented equity funds plus the assets in the bearish oriented equity funds. When the indicator is green, the value is low and there is fear in the market; this is where market bottoms are forged. When the indicator is red, there is complacency in the market. There are too many bulls and this is when market advances stall. Currently, the value of the indicator is 69.12%. Values less than 50% are associated with market bottoms. Values greater than 58% are associated with market tops. It should be noted that the market topped out in 2011 with this indicator between 70% and 71%.

Figure 3. Rydex Total Bull v. Total Bear/ weekly

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How to Gauge Risk Appetite

Wednesday, August 1st, 2012

by Russ Koesterich, Chief Investment Strategist, iShares

With investor risk appetite often driving market performance these days, it’s important to know where current sentiment is when making investment decisions.

To help with this task, my team has created a new “Risk Appetite Dial” that we’re publishing monthly in our Investment Directions market commentary. Here’s how the dial looks this month:

The bolded arrow shows where we believe current market risk appetite is now versus last month. Since last month, the measure has turned slightly more negative, signaling a more cautious mood in the markets.

So how do we come up with this measure? We determine where risk appetite lies monthly on a scale of -3 (low risk appetite) to 3 (high risk appetite) by analyzing and combining data about equity market returns, corporate credit spreads and expectations for future US economic growth.

Equity Market Returns: We consider equity market returns (as measured through the monthly performance of the MSCI All Country World Index) in our analysis as investors’ risk appetite is heavily dependent on the market prices they are observing.

Corporate Credit Spreads: We also look at the spread between the average yield of Moody’s Aaa-rated and Baa-rated corporate bonds. This spread is widely considered to be one of the most representative measures of how much investors are fleeing for safety by reallocating their corporate credit exposure. When this spread is high, investors are scrambling to exit lower quality corporate debt and vice versa. For instance, over the past 20 years, the average Baa and Aaa yield spread has been roughly at 150 basis points. But at the height of financial crisis in 2008 and 2009, this spread skyrocketed to 350 basis points.

Future US Growth Expectations: Finally, to measure growth expectations, we use the Chicago Fed National Activity Index (CFNAI), which is our preferred real-time gauge of US economic activity. It’s an excellent measure of current quarter US gross domestic product growth and offers a good prediction of next quarter’s GDP growth as well.

When taken together, high equity returns, narrow credit spreads and a good growth outlook tend to coincide with positive investor sentiment and stronger appetite for risky assets, while low equity returns, wide credit spreads and a poor growth outlook tend to mean investors don’t want to take on as much risk.

Currently, risk sentiment is at -0.6 on our dial scale, down from -0.4 last month, as investors have turned more cautious toward risky assets, as indicated by widening US corporate credit spreads and falling expectations for US growth amid heightened macroeconomic uncertainty.

So what does this mean for investors? As I write in the latest Investment Directions, in light of today’s uncertain and volatile market environment, I continue to favor investments that potentially offer some downside protection while still potentially producing a reasonable yield and allowing for participation in market gains. These include:

1.)    Dividend-paying stock funds such as the iShares High Dividend Equity Fund (NYSEARCA: HDV) and the iShares Emerging Markets Dividend Index Fund (NYSEARCA: DVYE).

2.)    Defensive sectors such as global telecommunications, accessible through the iShares S&P Global Telecommunications Sector Index Fund (NYSEARCA: IXP).

3.)    Minimum volatility funds such as the iShares MSCI All Country World Minimum Volatility Index Fund (NYSEARCA: ACWV).

In addition, besides viewing the measure as a helpful guide for tactical portfolio tilts such as those mentioned above, investors can also use the risk sentiment measure to help them on tactical selection decisions such as which countries to invest in. For example, if risk appetite is low, investors may want to consider avoiding more risky countries such as those I recently highlighted in my post, “Where in the World is Risk Today.”

Source: Bloomberg, Investment Strategy Group Research

The author is long HDV and IXP

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

Investing involves risk, including possible loss of principal. There is no guarantee that dividends will be paid.

In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility.  International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. ACWV may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.

Copyright © iShares

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The Price of Glamour

Wednesday, August 1st, 2012

by William Smead, Smead Capital Management

The list of glamorous growth stocks getting hit by what we call “minefield” price declines is getting fairly long. Some of the more influential names which have suffered sharp, swift declines include Nike (NKE), Chipotle (CMG ), Facebook (FB), Coinstar (CSTR), Starbucks (SBUX) and the King of the Glam stocks, Apple (AAPL). Is there a pattern here that matters? If earnings growth is hard to come by, what are the most important themes for long-duration common stock investors?

At Smead Capital Management (SCM), we are not surprised by the struggles of the high expectation stocks. Our first premise as money managers and stock pickers is that valuation matters dearly. In the talk we’ve done at many CFA Societies across the US and the Far East, we shared the following charts from GMO’s top-notch research director, Ben Inker. The first chart below shows that Wall Street Analysts (called so even though many aren’t working in Manhattan) are actually very good at figuring out who will produce the best earnings growth in the next twelve months:

The second chart gives us a clue as to why many of today’s great growth stocks are stumbling. Even though they produce superior one-year earnings growth, they underperform the index as a group in the next twelve months. Looking back to the first chart, the poorest performing companies on forward earnings saw more than a 20 percent contraction in earnings. However, a quick look below shows that you get index outperformance from the group of low PE stocks which saw earnings contract.

There could be other forces at work as well. In a column at barrons.com in May, Mark Hulbert pointed out that growth stocks as a category had outperformed value the most in the last five years than all but two other five-year periods in the last ninety years. One of the only similar stretches of outperformance was the five years from 1995-2000. Here is how Hulbert explained it in his column entitled, “Don’t Give Up on Value Stocks”:

Take heart, value investors!

Every other time over the last nine decades when your patience was as sorely tested as it has been in recent years, your sector was on the verge of an incredible comeback.

Over the last five years through March 30, a portfolio of value stocks has lagged a growth portfolio by 4.7 percentage points per year, on average, according to data compiled by Eugene Fama and Kenneth French, two finance professors at the University of Chicago and Dartmouth College, respectively.

Most investors define value based on PE ratios and price-to-book value ratios. This growth stock popularity of the last five years presents a problem to the low turnover investor who started with a stock at a value price and has held it into the stage where investors are considering the security glamorous. For this reason, it is good to keep track of the stock market’s thermometer, the market for initial public offerings (IPOs).

Here is how we use the thermometer of the stock market. First, companies go public when the stock market is most receptive. Secondly, the stock market is most receptive when growth stocks are popular in comparison to value stocks. We have seen a number of multi-billion dollar IPOs in the last year from LinkedIn (LNKD), Zynga (ZNGA), Pandora (P), Groupon (GRPN) and Facebook (FB). Third, when those IPOs aren’t met by a warm reception the first six months of trading, we believe it tends to be a sign that the over-pricing of growth stocks is in the process of being unwound.

Mark Hulbert shared in his article what history would tell us about what happens after growth stomps value for five years like it has recently. He first shared what is the historical norm over long-term stretches in the stock market.

Professors Fama and French have studied value and growth stock performance going back to 1926. To show their relative returns, they constructed two portfolios that, at the beginning of each year, invested in those stocks that then had the lowest P/B ratios (in the case of value) or the highest (in the case of growth).

Over the last 86 years, they found that the value portfolio outperformed the growth portfolio by an average of 3.9 percentage points per year.

It is normal for value to beat growth in the long run and that is why valuation matters dearly to us at SCM. Hulbert points out that it matters even more at extremes of popularity like the last six months.

But what’s important here is not how rare recent experience has been, but how the value portfolio came roaring back following that period in the 1930s when it lagged growth by as much as it has recently. For the five years ending in mid-1945, in fact, according to the professors’ findings, the value portfolio outperformed growth by an extraordinary 130.7%—more than 18% per year, on average.

This pattern was played out in spades during the Internet bubble. Over the five years through the peak of that bubble, for example, when the highest-flying stocks often were Internet start-ups with little book equity whatsoever, value stocks were out of favor. Over that five-year period, the value sector lagged growth by 36.3%, or nearly 9% per year on average.

Though many value investors lost faith in their approach and threw in the towel, subsequent events proved their impatience to have been just as ill-timed as it was in the late 1930s. Over the five years through mid-2005, value outperformed growth by more than 139%, or nearly 20% per year on average. So impressive was value’s return to grace, in fact, that the professors’ value portfolio actually made money during the 2000-2002 bear market.

Therefore, the dismal performance of IPOs and the “minefield” declines in glamorous high-PE stocks are symptoms of what you’d expect as value reasserts itself over the next five years. The irony of this is the institutional and financial advisory community is moving toward indexing in a big way just as the thing which historically helps stock pickers relative to stock indexes reasserts itself. When growth is popular, the index is loaded on a capitalization basis with growth stocks and under-weighted in the depressed value stocks.

Wayne Gretsky was great because, “he skated to where the puck is going to be.” If the recent action in the stock market is any guide and Mark Hulbert’s historical work is accurate, value will be the place to be for quite awhile.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Only SBUX described in this missive is currently recommended for suitable clients as of the date stated in this missive. We do not and have not recommended any of the other securities for our clients. It should not be assumed that investing in any of these securities was or will be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

Copyright © Smead Capital Management

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