The Little Stuff Matters

In Search of the Lost Decade

For several years analysts have been complaining about a “Lost Decade” for stocks. Judging by the big U.S. stock market indices, the market has been flat for 13 years. But the Dow Jones Industrial Average and the Standard & Poors 500 reflect primarily the performance of large companies. 

The picture is much different if one looks at the broader stock market. According to an analysis by Standard & Poors, over the 10 year period from March 24, 2000 (the peak of the tech boom) to December 2, 2011, the S&P 500 declined by 19 percent. 

As we’ve noted, the index counts big companies more heavily. Just 10 of the 500 companies account for 20 percent of the performance.

If instead you weight each company in the index equally, the index would have climbed by 66 percent. To put this in actual dollar terms, if you had invested $10,000 in the S&P 500 on March 24, 2000, you would have had only $8,100 left at the end of the decade. If you had put equal amounts into each of the 500 stocks included in the index, your investment would have grown to $16,600 --- more than double the $8100 if invested in the S&P 500.

This isn’t an esoteric discussion about constructing indices. It points out the dramatic benefits of diversification.  Most people acknowledge that no one can predict the future. If that is so, no one will know whether to hold big companies or small ones, U.S. banks or Asian telephone companies.

Investing with wide global diversification increases the chances that the investor will own the stocks that do best. Over time owning the winners helps more than owning the losers hurts. Often, a small sector or a few individual stocks can greatly influence a large portfolio over a decade.

In the recent decade, an analysis by Bloomberg showed that energy and resource stocks appreciated dramatically. After a twenty year bear market for oil stocks from the 1980 peak, energy stocks rallied by 242 percent in the five years after October 2002 while material producers appreciated by 162 percent.

Meanwhile some of the biggest companies, which had done the best in the 1990s, suffered throughout the decade. General Electric, once the most valuable company in the world, dropped by 67 percent during the decade. Cisco Systems, a miraculous growth stock in the 1990s, at its peak was also the most valuable company in the world and appeared to be heading to be the first “trillion dollar company.”  Cisco has dropped by 82 percent over the decade to $100 billion.

Most U.S. investors, whether by design or chance, now tie their fate to the largest U.S. companies. According to S&P, some $1.3 trillion is indexed to the S&P 500 while $5.6 trillion is benchmarked to the S&P 500, one-third of total U.S. stock investments. If one counts “closet indexers,” the totals are even higher.

It could be that big U.S. stocks have been in the dog house long enough. Their valuations appear much cheaper than those of smaller companies. Small companies have had a good run and nothing lasts forever.  Perhaps Emerging Markets or other international companies will take the lead. Energy stocks might drop or precious metals might pick up the mantle.

But the clearest lesson from this data is that by placing all your eggs in one basket, whether it’s the largest U.S. stocks or precious metals, investors can end up with egg on their face. True diversification means participating in wide sectors of the global economy. Some funds buy thousands and thousands of different stocks spread out around the globe.  Over time, being widely diversified has typically lowered risk and given greater appreciation.   

(Calculations by Standard & Poors, http://www.standardandpoors.com/home/en/us; Bloomberg.com, Dec. 5, 2011, “No Lost Decade for Equal-Weight S&P 500,” http://www.bloomberg.com/news/2011-12-05/no-lost-decade-for-s-p-500-as-market-value-bias-masks-66-rally-since-2000.html)

Reasons for Optimism

 The Big Picture

Would you be frightened if someone told you that the stock market would drop one quarter of one percent this year? Of course not, but that’s the record for the Dow Jones Industrial Average after the latest 250 point drop. The headlines are scary and the future looks bleak. It’s hard to look beyond the Great Recession and it’s easy to list overwhelming problems. The reasons for optimism are more elusive. While the stock market was disappointed in the outcome of the Supercommittee, consider this: the non-partisan Congressional Budget Office now estimates that in the current fiscal year the budget deficit will drop by $300 billion (one fourth), and in the following two years by $460 billion and $235 billion. By that year, 2014, the deficit will reach 1.6 percent of domestic output --- below the long-run average --- under current policy, even assuming a weak recovery. Certainly our future depends on more than the Federal budget deficit; Europe’s fate looms large. But investors shouldn’t get fixated on the problem de jour. Instead they should focus on the big picture.  The U.S. economy remains dynamic and diverse and given time is positioned to overcome policy errors and other disasters.

Stock Market Logic

 The End is Near

The stock market works on its own logic and smart people who apply normal logic to it do so at their own peril. Most people have been fearful about the market, despairing about the economy and disgusted with the government. So what did the market do? The Dow Jones Industrial Average rose more than 1,000 points in little over a week in early October. Did the outlook suddenly improve dramatically? Not at all. It’s true the world didn’t end. Most of the time it doesn’t.  In the ashes of bear markets and terrible recessions, great bull markets are born. The light at the end of the tunnel always seems a long way off but we get there at unexpected times and sometimes with surprising speed. Beneath the gloomy headlines, some positive news lurks. Major banks have reported strong lending for the first time in four years, the Federal budget deficit dropped $300 billion from the original estimates because of higher revenues and lower spending and it is expected to drop another $300 billion next year, according to the U.S. budget office. Eventually the economy will heal and employment will improve and the stock market will lead. No one knows when that will happen but it doesn’t pay to despair.

The Temptation to Panic

            The Most Dangerous Month of the Year

            August was the most dangerous month of the year for investors. That’s not because the world stock markets dropped precipitously. It’s not because of alternate drops and spikes of hundreds of points in the major averages. It’s because of the temptation to panic.
            None of us can control what happens to the world economy or the stock markets. What we can do is control our reaction to those events.
            We’ve all heard that investors alternate between greed and fear. But in relation to the stock market, what exactly does this mean?
            When the stock market starts to drop, investors tell themselves that it’s only temporary and they stand pat. But the sky continues to darken. The news gets bleaker and the problems begin to look intractable. Eventually the news is overwhelming. There is no way out. The economy will never recover. Our way of life is ending.
            The pressure keeps building and there is only one way out. The investor must sell. He must act before it is too late. And he does. He sells. He sells everything. He salvages a portion of his assets and he feels better. For a time. Perhaps a few days, maybe a few weeks. Enough of these seesaw markets. He can’t take the pressure but he doesn’t have to and he sells. Volume surges on the markets and the television shrieks more shrilly.
            But the satisfaction doesn’t last long. Strangely, for no apparent reason, the stock market slide comes to an end. Still, for no good reason, it spikes upward and keeps going. It’s strange. The problems are still there. The economy is still a mess. Our leaders have yet to don their superhero costumes. But there it is – the stock market races up and our investor is on the sidelines waiting for signs that the economy is improving and the market moves without him.
            I know it is not you. I know you would not panic or let greed drive you in a bull market. I know that even though “buy and hold investing” has become a dirty word, you stay the course.  I know this is just a function of cable television. But many other people did do this. Stock volume surged this August. Somebody was selling at low prices. Somebody was panicking. Someone was looking to end the pain.
            There is a book called “One Way Pockets: The Book of Books on Wall Street Speculation” by Don Guyon. It was written in 1917 by a broker who analyzed customer accounts. He found that they owned the right stocks but bought them too late in the bull market and waited too long into the bear market to sell. They owned the right stocks but still lost money.
            Investor behavior never changes. The headlines do, at least a little bit. At one point every year, the world is ending. What should an investor do?
            The advice doesn’t change either. Don’t try to outguess the markets. Have a plan for yourself and stick to it. Build a diversified portfolio. Determine a risk level that you can live with for the long haul. Keep your eye on the long-term and stay off the roller coaster.
            Don’t try to guess what will work. The hero of the last bear market was John Paulson. He is a hedge fund manager who was lionized in the book “The Best Trade Ever.” He made billions spotting the problems in the subprime mortgage market and acting on it. Recently Bloomberg reported that Paulson’s fund is down 34 percent for the year while the Dow Jones Industrial Average was down 1 percent.
            A study by JP Morgan Chase & Co. showed that mutual funds are trailing their benchmarks by the most since 1998. At the same time, Fidelity Investments studied their investors’ 401-Ks and found that those who exited stocks in the heart of the last bear market were up only 2 percent through the cycle while those who stayed in stocks were up 50 percent.
            The lessons are clear. Don’t take big bets and try to predict the market or the economy. Acting on your emotions does serious damage to investors year after year. Being an active trader may be exciting and it may seem like the thing to do but in the end cooler heads prevail. A sound, well balanced approach is the surest path to investment success year after year.  

Saving Social Security

Social Security is for Real

Lately Social Security has been pilloried in the news. For years people have said it’s bankrupt and won’t be there when the Baby Boomers retire. I believe that nothing could be further from the truth. Each year Social Security pays out hundreds of billions of dollars in retirement benefits. According to the Social Security Administration, even without changes, it will be able to pay out 75 percent of retirement benefits for generations.  Inevitably there will be changes but changes are phased in gradually. The last major revamping of the program began under the Greenspan commission in 1983 and their changes will be fully implemented by 2017 --- some 44 years later. As people live longer, the full retirement age will likely be pushed up a few years although there will still be early retirement options. The wages subject to Social Security taxes likely will rise and the way inflation is calculated may change. These changes amount to small cuts in benefits but are intended to preserve the program much as we know it now. Social Security is completely integrated into the fabric of American life and will probably outlive us all. Anyone planning their retirement would be foolish not to incorporate Social Security into their thinking.

A Gigantic Casino?

 A Winning Hand

Some people think of the stock market as a gigantic casino and worry about getting ripped off. Part of the reason is that they act as if it is a casino. In the short term, the stock market goes up and down a lot, often for no apparent reason. Over the long term, the market moves with the economy and is much more stable, particularly if your portfolio is widely diversified. If you hold one stock or a handful of stocks or trade a lot, you are taking big bets. If you spread the risk among thousands of companies around the world, the risk of an unfavorable outcome drops dramatically. One of the biggest mistakes people make is trading in and out of the market based on today’s headlines. If you trade aggressively or if you hold only a few stocks, you may win big. A lottery ticket will also pay off for someone. But do you really want to trust your future to a game of chance with slim odds? Why not use a thoughtfully designed portfolio instead? Skip the casino with your investments and the chances of a winning hand will be much better.