Twice before -- in 1999 and 2007 -- we have seen how a strong market taints expectations
2011 started with a January like many in the recent past. Stocks came out of the gate like a group of thoroughbred horses after the bell rings and the gate opens. Yet, there are disturbing trends in the data I am following. In some small way I hope to point out that many investors are on the road to a repeat of what hit them twice in the past dozen years: performance-envy, due to the headline indicators flourishing, and the feeling that they were falling behind.
The S&P 500 has had a strong run since the end of August. Recall that for the first eight months of 2010, the broad stock market indicators went up and down a lot, with the end result being a flat first two-thirds of the year. Then, the market ripped through the remaining 1/3 of 2010 and the run continued in January. In fact, the S&P gained 23.55%. This has put more money in investors’ portfolios, but I also see that it is tainting their view of the markets in ways we have seen before.
Twice in the past dozen years — 1999 and 2007 – an urgent buying of stocks ultimately became a topping process for the market. 1999 was the sixth year of a stealth stock bull cycle that ultimately gave way to the dot-com crash, and 2007 was the fifth year of a similar expansion due in large part to the housing bubble. In what may eventually be known as the liquidity mini-bubble, the concern is that investors have once again chased stocks higher for fear of missing out. In fact, they have already missed out, as the S&P 500 has nearly doubled from its March 2009 trough.
Specifically, if you take that past five months’ return of the S&P 500 (23.55%) and annualize it to a 12 month period, you get 56.53%. That’s the pace the market has been on for the past five months.
Time to load the truck on equities?
I looked at the fund category averages followed by Morningstar, and found that several were in excess of that annualized return and many others were in reach of it. All in all, if the past five months were an indicator of what the next seven would be, its time to load up the truck on equities…or is it?
I am not making market calls in this column, but merely pointing out oversimplifications on the part of many investors, based on talking and reading about the markets for a living, with a very wide variety of people. See: 10 investment ideas that STILL don’t work.
In particular, I note the performance over the past five months of mutual funds in the Long-Short category. By definition, these funds work both sides of the market, trying to buy winners and short losers. This means they will not likely keep up with the S&P when it annualizes 56%. Specifically, Long-Short funds made 7.21% in the five month period in question, which annualizes to 17.29%. While that is nearly double the long-term return of the S&P 500, investors appear to be putting defensive growth investment strategies in the penalty box. Why? Performance envy. 17% annualized is, to hear some describe it, an embarrassment when the “market” is up 56%.
Long-Short funds had company in the penalty box. TIPS, World Bonds, Multi-Sector bonds and others performed worse. But that is not the point. The point is, during market runs like the one we are in now, investors and their financial advisors cannot afford to forget what it is they are investing for. Because the bigger they are, the harder they fall. Performance chasing is a sucker’s bet. Don’t be a sucker when the latest period of dramatically-high returns ends.
Winners and losers
Meanwhile, here is a look back at winners and losers in January. For last month’s winner’s and losers, see: Winter winds hitting bond investors, China takes a pass, alternatives posted strong gains: Morningstar data.
• Equity mutual funds of many types rose in value, with Energy stocks leading all categories (+5.86%). Technology, Industrial and US REITs all advanced more than 3%. Europe, a laggard for much of the autumn as Eurozone economies took turns receiving bailouts, gained 2.67% in January. Within the U.S., Consumer Staples funds were an exception, declining by 2.08% for the month. Their cousins, Consumer Discretionary funds, dropped 1.20%.
• A trio of “Hybrid” categories followed the equity markets higher. High Yield funds gained 2.20%, Convertibles 2.04% and Bank Loan Funds 1.81%. All three of these categories invest primarily in bonds, but in each case the bond is clearly different in character from higher quality bonds like Treasuries and High-Grade Corporates.
High Yield bonds are often issued by up and coming companies and the bonds are viewed more similarly to stocks, in that the companies’ fortunes will ride up and down with corporate growth. Convertibles are a type of bond that may be exchanged into common stock of the same company under certain conditions. This results in the bond price being heavily influenced by movements in the company’s stock price. Bank Loan funds invest in short-term loans to corporations. They are similar to High Yield Bonds, but with much shorter maturities. The flip side of this is that the interest rate the corporation pays on the loan is floating, with terms reset typically every 30, 60 or 90 days.
• At the low end of January’s performance charts were some areas that have paced the markets in recent years. Equity Precious Metals (read: gold stock funds) dropped 11.60%, its worst monthly return in some time. Latin America and Pacific/Asia ex-Japan Stock funds (know more simply as “Southeast Asia”) were hit hard, with losses of 5.35% and 5.14% respectively. This was part of a January that saw Emerging market funds of many types fall while the U.S. generally rose, continuing a pattern from late 2010. While the long-term outlook for January’s laggards would seem to be much brighter than January’s winners based on secular economic trends, any month or series of months can ignore that. Reason: investors tend to ignore a lot of things in the short-run, and tend to react to bad news when it reaches crisis mode.
For Emerging Markets, one month does not tell us the extent to which a new, down trend may develop, but we will certainly continue to follow that in this column.
• Finally in January, Long Government Bond funds lost 2.68%. That spells rising rates, a subtle but increasingly disturbing trend that is developing. High Yield Muni funds dropped 1.66%, indicating that the goodwill investors have toward non-investment grade corporations was not extended to lower-rated municipalities.
Robert A. Isbitts, a 25-year industry veteran, is a newsletter writer, published author, and investment strategist. He is also the lead-manager of asset allocation mutual fund and a global equity mutual fund. For more information on those mutual funds, visit www.easfunds.com. His second book, “The Flexible Investing Playbook” – Asset Allocation Strategies for Long-Term Success” was published by John Wiley & Sons in August, 2010.