"Why Are Most Investors Mostly Wrong Most of the Time?" was the title of Dr. Marc Faber's October Market Commentary. It's a great question and one that deserves at least an attempt at answering. But perhaps you disagree with the basic assumption of the question? Are most investors mostly wrong most of the time? The data would strongly tend to support that belief. Take a study by Dalbar, a Boston research firm, that was released a few years ago. Dalbar found that individual stock mutual fund investors earned an average return of 5.23% per annum from 1984 to 2000 - a period during which the unmanaged S&P 500 returned 16.3% per annum on average. The average fixed income (bond) investor earned 6% per annum on average during that period while the Lehman Brothers Long-term Bond index returned 11.83%. Mind boggling isn't it? Anyone care to calculate how much wealth individual stock mutual fund investors managed to leave on the table during one of the greatest secular bull markets of all time? I'll save you the trouble - $1,060,000 in foregone profit on a $100,000 initial investment. Incredible! A $100,000 investment in the S&P 500 index in 1984 would have grown to $1,301,000 by the end of 2000. Meanwhile, the typical individual investor's $100,000 would have grown to a whopping $241,000. Yikes!
Okay then, most individual investors are mostly wrong most of the time, just as Dr. Faber contends - but why? Well, the field of behavioral finance offers us some clues. Behavioral Finance is the study of how human psychology effects decision making in the investment arena, and it has produced some very intriguing findings over the years. One commonly observed tendency is for individual investors to place a much higher probability on an investment outcome than is warranted. High levels of (undeserved) certainty lead many investors to pursue concentrated investment portfolios lacking sufficient diversification. Certainty also leads investors to dive into and exit markets at the wrong time. For instance, investors seem to gain confidence the longer a trend is in place, leading them to load up on an investment at just the wrong time. Individual investors were fully invested in stocks and real estate in 2007, seemingly convinced that stocks and home prices had nowhere to go but up, despite strong evidence that prices had disconnected from the real economy. Likewise, many investors bailed out of the stock market in the spring of 2009 at a time when the S&P 500 was demonstrably undervalued and likely to deliver well above average returns going forward.
Currently, investors seem to be buying into the notion that deflation is the greatest risk out there - how else to explain the huge demand for bond mutual funds in 2009? Well, perhaps it is simply the fear of owning stocks that is forcing people into bonds by default, rather than a conscious fear of deflation. Regardless of what is driving investors to load up on bond funds in 2009 and ignore stock funds, it is likely that most individual investors will be mostly wrong once again. Year to date U.S. bond funds have attracted net inflows of $357 billion while stock mutual funds had outflows of $11 billion, according to Barrons (stock mutual funds currently hold about $4.5 trillion in assets while bond funds hold about $2 trillion). Furthermore, according to Morningstar, nine of the year's ten best selling mutual funds invest in bonds. A disconcerting development for all of those folks who chose to buy bond funds in 2009, thus missing a $4 trillion dollar increase in the value of the S&P 500 from the March lows (to put that number in perspective the U.S. economy currently produces $14 trillion in goods and services annually). Put another way, individual investors chose to buy bonds, which have a superb 10 and 20-year trailing track record, apparently on the assumption that the long-running trend will continue. They bought bonds despite the fact that every time the 1-year rate of return of the Ryan index of 30-year Treasury bonds was above 30% the subsequent return was negative - the return in 2008 was 41%! They bought bonds near record low yields even while stocks were available at a sharp discount to any reasonable estimate of fair value (the S&P 500 companies probably have the ability to earn $60 per share in "normalized" earnings, which means the index was available for 11x earnings in March at the 666 low). They chose to buy bonds despite huge government borrowing needs, and despite a U.S. dollar that is likely to continue to fall in value over the long run (circumstances which will normally lead to rising yields and inflation, and falling bond prices), instead of buying stocks at a time when the 10-year compound annual total return is the worst ever - by a HUGE amount. In fact, except for a brief period of time in the late 1930s, trailing 10-year compound returns had never been negative, going all the way back to 1827. As of February 11 2009, the 10-year compound annual total return was minus 4%!
Acting on our belief that most individual investors are mostly wrong most of the time, I would maintain that stocks are a better buy right now than bonds in the United States. However, the S&P 500 returned more in a shorter period of time between March and October of 2009 than at any other time since the Dow's humongous recover rally in 1933! Furthermore, fair value for the S&P 500 is likely somewhere between 800 and 900 based on that $60 per share earnings estimate, making the index over valued by around 25%. Finally, stock mutual fund investing inflows hit their second highest level of the year in the week ending October 23, after net outflows in August and September (five months after the bottom), indicating that individual investors may finally be ready to embrace a rising stock market (the S&P 500 has essentially moved sideways since October and may be in the process of putting in an intermediate top).
Add it all up and it is more than a little likely then that the stock market will correct, giving up at least some of it's heady 2009 gains. Of course the $64,000 dollar question is when and by how much!
Uncertainty is a fact of life and a fact of investing. Capital preservation should be any investor's first priority. Losing money is an investing sin due to simple mathematics. A 20% decline in one's portfolio requires a 25% gain simply to get back to even. There is a reason that Warren Buffet's first rule of investing is don't lose money and his second is: refer to rule one! Proper diversification is an essential tool in any investor's tool box. We are already on record as liking stocks more than bonds for 2010, but what about cash, given that we will likely see a pullback in the stock market sometime in 2010 (likely beginning in the next few months) that could breach 20% (a common definition of a bear market). Cash is an asset class after all, although one that currently yields a negative real rate of return ( return adjusted for inflation).
The Federal Reserve has increased the monetary base (currency in circulation plus reserves) from approximately $850 billion to around $2.1 trillion since the financial crisis began. Furthermore the Fed has continued to grow the monetary base at an almost 100% per annum rate, indicating that it does not see a quick end to the financial crisis. Our government is basically flooding the economy with paper money and hoping that it will start to circulate sooner rather than later. In very simple terms, the more paper money circulating the more everything will cost in that paper money - inflation is coming! In fact, it is likely that inflation is already here. Actual inflation is currently closer to 6% than the 1% reported by the government (perhaps we'll blog on the government's systematic under reporting of inflation next). Cash then is a wasting asset! It is not holding its value now and is likely to be worth substantially less 10 years from now. Most Americans don't truly understand the pernicious nature of inflation. Inflation has averaged 4.5% post world war II (using the government's own highly distorted metrics). At a 4.5% rate of inflation, a $20,000 car will cost $31,000 ten years from now! We like cash even less than bonds, except in the very short term.
To summarize, we see a correction in the stock market sometime next year that could hit 20% and is likely to occur sometime in the next few quarters. It is likely however that the market will not make fresh bear market lows and that the Federal Reserve and government will support the market, pushing it back toward current levels by year end. Bonds are a disaster waiting to happen, particularly if the Fed ends quantitative easing on schedule in March, leaving the corporate bond market and foreign central banks to absorb some $2 trillion in Federal debt in 2010. Finally, we like cash even less, given the huge increase in the monetary base over the last 18 months and the likelihood of continued irresponsible government spending. It is more than possible, however, that the dollar rallies for a few quarters as it works off its currently oversold state. Any non-dollar assets are preferable once the current dollar rally sputters and dies, including gold.
Our 10-year forecast is for rising inflation, rising taxes, rising interest rates, and rising commodity prices. We do not see stocks advancing much in real terms over the next 10-years, but they might manage to hold their own against inflation, thus preserving your purchasing power. Our favorite investing assets remain commodities, international stocks and international bonds. Our favorite area to invest remains Asia. Our favorite sectors remain Asian consumers, U.S. multinationals, and world infrastructure. We would avoid the U.S. consumer discretionary sector (for example retail and restaurants) unless the purchase price is literally a steal.
However, the future is always uncertain and no one should feel so certain of it that they load up on any one asset class, sector, or theme.
Most individual investors are mostly wrong most of the time. We do not condone market timing or concentrated investing for individuals. Rather we recommend that you build a properly diversified portfolio that makes sense given your individual circumstances and financial goals. Your strategic allocation should change only as your individual big-pictures circumstances change. As far as executing your investing plan... well, we advocate contrarian investing in all asset classes all of the time, and by now you can probably guess why!
