Market Commentary April 2012
Equity markets got off to an outstanding start in 2012. Returns for the first three months represented the best yearly sta
rt since 1998, as the S&P 500 was up 12.6%. As you can see in the chart, equity markets were generally up 11%-13% with emerging markets up 14%. The broad bond market essentially broke even for the quarter, while riskier bonds, like high-yield corporates, were up as much as 5%.
Equity returns exceeding 10% would be welcome for the year, say nothing of the quarter. Some fear that we are now due for a correction, as the markets have risen too rapidly. We try never to predict future market movements, but it is worth noting that the S&P 500 index, ignoring dividends, reached 1530 back in March 2000. It got back to 1560 in the fall of 2007 before retreating, and it is now hovering around 1400, meaning that the value of the 500 largest U.S. companies is still well below the level first attained twelve years ago, and earnings continue to improve. So while a correction is always possible, there seems equal opportunity for further upside.
It is also interesting to note how much less volatile markets have been in the last quarter as the debt crisis in Europe generates fewer alarming headlines, and other economic news has taken on a positive tone. The European debt crisis seems far from solved, and yet just the absence of bad news has had a surprisingly positive effect on global equity markets.
Should Passive Investors Feel Bad About Getting a Free Ride?
The efficient market allows passive investors to get a free ride – market returns at minimal cost while others do the work. Diligent, hard working analysts and active managers are determining the true value of individual stocks and bonds, and driving prices toward those values in an auction market. Meanwhile, index funds come along and buy a market basket of securities at the market price without doing the work to determine if the prices are fair.
But What Happens When Everyone Buys the Index? Who Keeps the Market Efficient?
As a believer in the advantages of index funds, I have been asking these questions since before we started an investment advisory firm in 1991. By that time, index funds had been available to institutional investors for a few years, but they were just beginning to take off with smaller investors using mutual funds. The new products allowed us to utilize institutional money management strategies for small investors, and it seemed clear that everyone should adopt the new innovation that allowed anyone to get market returns at low cost. Alas, not everyone saw the world as we did, and they probably never will.
Nonetheless, we now see growing talk of passive management dominating markets, and having a detrimental effect on market function. In fact it has become the topic of serious research.
The latest issue of the Financial Analyst Journal includes an article, “How Index Trading Increases Market Vulnerability” (Sullivan and Xiong, March/April 2012). It reports that, “the authors found that the rise in popularity of index trading – assets invested in index funds reached more than $1 trillion at the end of 2010 – contributes to higher systematic equity market risk.” The implication is that traders are buying and selling the whole market basket without regard to the merits of individual stocks. I have seen presentation materials from at least one active manager using this argument to help explain why it has been so difficult for them to outperform the market.
On the other hand, Jack Bogle, the founder of Vanguard often credited as the father of index funds, sees the growth of passive investing as a triumph. About 25% of mutual fund assets are now invested in index funds. Also, ETFs (Exchange Traded Funds) which typically track an index but trade throughout the day, now represent about 30% of trade volume in U.S. equity markets, having grown from essentially zero in 12 years. Appearing at a recent conference, Bogle said that in the last five-plus years, index funds have gained $600 billion in assets, while active managers have lost $400 billion. He says that investors have to be persuaded by the growing evidence that index funds work.
So, will the dominance of passive investing destroy the free ride? I am not worried. I believe there will always be plenty of people willing to pay smart analysts to keep the market efficient. My latest evidence of this was published in the New York Times on April 1, 2012 in an article entitled, “Public Worker Pensions Find Riskier Funds Fail to Pay Off.” The article reports on public workers’ pension funds across the country, increasingly turning to riskier investments in private equity, real estate and hedge funds…“but while their fees have soared, their returns have not.”
It goes on to explain that the states using more of these alternative, actively managed investments have incurred higher fees and worse performance, compared to the states that stuck with a more traditional mix of stocks and bonds. Yet the Oklahoma Teachers Retirement System, which has done well over the past five years with a mix of stocks and bonds, is putting 10 percent of its fund into private equity and real estate funds. When asked about the higher fees, the fund’s executive director said, “We believe the outperformance from moving into these categories can justify the additional fees,” demonstrating that hope springs eternal, and that Mr. Bogle is an optimist to think that investors will be persuaded by the facts. I think passive investing has a bright future, and I will be happy to continue taking that free ride.
Lessons From 2011
ONE- Stock market returns are seldom what we expect.
The S&P 500 index was up 2% for the year, after being up 8% at the end of April and down 12% at the beginning of October. Large stocks did better (Dow up 7%); small stocks did worse (Russell 2000 down 4%); and international stocks did much worse (EAFE down 12%).
It is unusual for the S&P 500 to move so little from one year to the next, but it is also unusual for it to behave the way we “expect” it to behave. Since 1926 the average annual return has been about 11%, and yet over those 86 years, the annual return has fallen between 8% and 13% only 6 times. The range has been -43% to +54%.
TWO – Regardless of the returns we realize, markets are volatile.
In other words, we often experience the risk without realizing the commensurate level of return.
2011 certainly felt like a rollercoaster, and the stock market was indeed volatile. Yet was that volatility unusual considering world economic events? The experts at Vanguard say no, and provide evidence in a recent paper. Their evidence is based on a comparison of economic volatility and market volatility, which turn out to be closely correlated. Moreover, they show that the volatility of the economy and markets was higher in the 1970’s than it has been over the past five years. Risk and return are related, but we only observe the correlation in the long run.
THREE- When “everyone agrees” on the likely direction of a market (or prices, or interest rates) they can still be wrong.
At the beginning of 2011 “everyone agreed” that interest rates had to rise from current levels. Bill Gross was one prominent expert who put his money where his mouth was, declaring that U.S. Treasury yields were so low they did not adequately compensate investors. He sold Treasuries out of his portfolio. It turned out to be a spectacularly bad decision as Treasury rates fell further and his fund, PIMCO Total Return, the largest bond fund in the world, underperformed.
What is a reasonable range of expected returns…
We have all read the standard performance disclaimer, “Past performance is no guarantee of future returns.” That warning has rarely been more important or relevant than it is today.
Bond returns have now outperformed stocks over the past ten years. Mutual fund investors continue to pour money into bond funds in response to stock market volatility and, we assume, in part because of attractive past returns.
Vanguard published a paper in November 2011 that tried to answer the question, “What is a reasonable range of expected returns for a balanced portfolio of stocks and bonds based on present market conditions?” For the full paper, click here: https://advisors.vanguard.com/iwe/pdf/ICRLYVE.pdf?cbdForceDomain=true
They present several interesting conclusions including:
• Expected returns for a 50% stock/50% bond portfolio are 4.5% to 6.5% nominal and 3.5% to 4.5% in real terms (after adjusting for inflation). This result is modestly below the average since 1926 (8.2% nominal and 5.1% real) but better than the past decade.
• Expectations for the next decade are driven by the current level of bond yields, which are highly correlated with future annualized returns from bonds.
• The chart below shows expected returns for a more risky portfolio (80% stocks/20% bonds) more consistent with the historical average while the expectation for a less risky portfolio (20% stocks/80% bonds) less likely to achieve historical results.
Real (inflation-adjusted) returns
Notes: Percentile distributions are determined based on results from the Vanguard Capital Markets Model. For each portfolio allocation, 10,000 simulation paths for U.S. equities and bonds are combined, and the 10th, 90th, 25th, and 75th percentiles of return results are shown in the box and whisker diagrams. The dots indicating U.S. historical returns for 1926-2010 and 2000-2010 represent equity and bond market annualized returns over these periods. The equity returns represent a blend of 70% U.S. equities and 30% international equities; bond returns represent U.S. bonds only.
Sources: Barclays Capital, Thomson Reuters Datastream, and Vanguard calculations, including VCMM simulations, and index returns.
• With ten-year Treasury rates below 2%, it is irrational to expect bond returns over the next decade to be anything like the past decade, and nearly impossible mathematically.
• Stocks, on the other hand, appear reasonably priced, capable of providing average historical returns, and quite likely to do better than the past decade, which began with stocks very highly valued (Price/Earnings ratios well above historical averages.)
Conclusions/Take-Aways
1. Expect returns from balanced portfolios to be below historical averages over the next decade due primarily to low bond yields.
2. The incentive to take stock market risk (relative to bonds and cash) may be as high as it has ever been.
3. Chasing the bond returns we have seen over the past decade is ill-advised.
4. Taking more stock market risk may be tempting, but comes with greater volatility.
5. Most investors should stay the course, with a balanced portfolio that reflects their long-term tolerance for risk.
Five Reasons You Should Not Panic in the Face of Market Volatility
1. It is not really “different this time.” Vanguard, in a recent study entitled “Stock Market Volatility: Extraordinary or ‘Ordinary’?”, concludes that recent volatility appears extraordinary compared to the relative calm of the markets in 2010, but is in fact “ordinary” when compared to similar periods characterized by major global macro events – they cite the Asian currency crisis of 1997, the Russian debt default and bailout of Long-term Capital Management in 1998, the tech market bubble (2000-2002), and of course the financial crisis of 2008-2009. Market volatility spiked in similar ways during each of these events as markets tried to re-price risk in the face of startling new information. This time it is political paralysis and the European sovereign debt crisis. So the reason is different, but the market reacts to crisis in similar fashion, over and over again.
2. Diversification provides a remarkable amount of protection from volatility. Information in the charts below is taken from the same Vanguard study mentioned above.
3. The only way to fully participate in the up days is to be able to withstand the down days. Volatility refers to moves in both directions.
4. Remember that you are investing and not trading. “Sitting out” the current volatility is an appealing notion, but timing the market is something better left to speculators and traders. Trying to benefit from correct predictions of short-term moves in the market is not a long-term investment strategy.
5. “The market has been volatile and just dropped dramatically – what do I do now?” This is a bad question and bad questions do not lead to good investment decisions. A better question would be, “Am I still taking an appropriate amount of risk considering my goals and time horizon?”
Sticking to your disciplined investment strategy is a better response than panic. When stock prices tumble and bond prices soar, it provides an opportunity to rebalance your portfolio by taking some profits from the bonds and buying stocks at reduced prices.
Market Analysis
Renewed fears of a double-dip recession, policy paralysis across the U.S. and Europe, and the looming threat of a financial crisis in the euro zone combined to create very volatile markets and a devastating quarter for equities.
Equity Markets
The third quarter of 2011 saw the value of small stocks and international stocks fall more than 20%, which is generally considered a bear market correction. Large domestic stocks (S&P 500) did a bit better but fell nearly 14% in the quarter, dropping into negative territory for the year at -8.7%.
Fixed Income
Government bonds, on the other hand, had a stellar quarter, defying logic and many experts’ expectations, by rising in value after S&P downgraded the U.S. Government debt rating. The broad bond market index, which is dominated by government securities, rose 4.7%. The value of TIPS (Treasury Inflation Protected Securities) rose even more than the general bond market, as hope for economic recovery diminished, and action by the Federal Reserve drove expectations for real interest rates further into negative territory. Based on the pricing of Treasury securities, and TIPS, the market now expects inflation to average less than 1.8% over the next ten years with ten-year government bonds providing a return above inflation of a meager 0.20% on average. Government bonds of shorter maturities are expected to provide returns less than inflation, so investors’ purchasing power will diminish.
Return Expectations
We cannot predict future returns, but it can be instructive to examine assumptions built into current market pricing. As mentioned above, the expected return on ten-year government bonds is barely above the expected rate of inflation, driven by dismal expectations for economic recovery, extremely accommodative monetary policy, and fear of another financial crisis coming out of the euro zone. This is well below the long-term average, which is about 2% above inflation.
Stocks on the other hand appear priced to provide future returns more consistent with their long-term risk premium of 6-8% above inflation. The S&P 500 index is at a price level first achieved in 1998, but since that time the Price/Earnings Ratio for the index (price paid per dollar of expected earnings) has fallen dramatically. So today’s price reflects a lower, and perhaps more realistic, assumption of growth in dividends and earnings.
Evaluating Your Social Security Options
As retirement age approaches many questions arise about Social Security including the following:
- Should I start drawing benefits as soon as possible or postpone?
- If I do postpone, how long should I wait?
- If I am married or divorced, how can that impact my decision?
- When will I “breakeven” on my decision to postpone?
Rules of Thumb:
If you are expecting death in the near future, or do not have sufficient savings to postpone claiming Social Security, it is advised that you begin receiving Social Security at age 62, the earliest available time.
- If you must claim benefits at age 62 but continue to work and are able to pay the money back at age 70 it will be as if you never filed for benefits and at age 70 you will receive the 8% increase that you would have received if you never filed for benefits in the first place.
OTHERWISE…
- If you have enough saved, and are able to postpone receiving Social Security until age 70, this will result in an approximate 8% increase for every year you postpone. If you postpone until age 70 and live past the age of 80, your total gains from Social Security will be larger than if you began taking Social Security at age 62.
The decision to postpone results in several different options to maximize benefits:
- One strategy for married couples is called the “Start-and-Suspend” strategy; this should be used if one spouse has a much larger income than the other. The first step of this process is for the spouse with the larger income to file for Social Security benefits when they reach full retirement age, age 65-67 (depending on date of birth), and then immediately suspend their benefits. After this is done the spouse with the smaller income can file for benefits based on their spouse’s salary, and they will receive 50% of the benefits. If the spouse with the higher salary suspends his/her benefits until age 70 they will continue to receive the 8% increase even though their spouse is receiving benefits based on their salary.
- Another strategy for couples is claiming “spousal benefits”, which should be used when the incomes of each spouse are approximately the same. This strategy is carried out by one spouse filing for Social Security when they have reached full retirement age, age 65-67. After they have done this the other spouse can file for spousal benefits, which means they will receive 50% of the benefits from the other spouse’s income. This will allow the second spouse to continue receiving an 8% increase on their benefits while they are receiving benefits based on their spouse.
- If you are divorced you can claim benefits on your former spouse’s earnings, as long as the marriage lasted 10 years or more. However, if you remarry before age 60 you can no longer claim benefits on your former spouse, and are only eligible to claim benefits on your current spouse.
Resources:
- http://www.ssa.gov/retire2/whileworking.htm
- http://www.forbes.com/2009/04/03/social-security-benefits-personal-finance-retirement-wait-until-70.html
- http://www.foxbusiness.com/personal-finance/2010/10/01/apply-social-security/
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