Some interesting commentary from the Bonddad blog on the state of the American consumer. One of the themes over the past several years has been the continual deleveraging of the consumer. This is one of the main causes of the anemic growth we’ve seen in our economy as consumers have been using their excess income not to buy more stuff, but to pay down debt. Well, that trend may be changing and that could certainly be a tailwind for the economy. The household debt service ratio (blue line) is an estimate of the ratio of debt payments to disposable personal income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. The financial obligations ratio (red line) adds automobile lease payments, rental payments on tenant-occupied property, homeowners’ insurance, and property tax payments to the debt service ratio.
You’ll see that these ratios are at lows we haven’t seen since they kept these records. This is important on two fronts: the share of a consumer’s income going to debt payoff is at all time lows. In addition, this means there is more excess funds available for spending. We have gotten to this place because of two major factors: consumers paying off debt and ultra low interest rates. As these figures stabilize it will stop being a drag on our economy and should help consumer spending in the years to come.
Past performance has no bearing on future results. The famous warning disclosure at the end of every performance report can be repeated by almost any investor…the real question is “do you believe it?”. You see, with most things in life, this statement is just plain wrong. A person who engages in criminal activity has a high probability of continuing that activity. Students who have achieved good grades will most likely continue getting those grades. Athletes who have high batting averages, or shoot under par, or win championship tennis matches tend to repeat these achievements year-after-year. In almost every area of our life, we find that the past is one of the best predictors of the future.
That’s why investing is so hard. We want to find patters in the noise. We want to believe that smart individuals who work hard have an edge over the rest of investors. Unfortunately, this just isn’t the case. Consider these statistics from Barry Ritholtz in his presentation Romancing Alpha, Forsaking Beta:
- Only 20% of active managers (1 in 5) can outperform their benchmark in a given year
- Within that quintile less than half (1 in 10) outperform in 2 of the next 3 years
- Only 3% stayed in the top 20% over 5 years (1 in 33)
- Once we include costs and fees, less than 1% (1 in 100) manage to outperform (net)
- What are the odds you can pick that 1 in 100 manager?
All of these funds are run by extremely smart individuals with pedigrees and teams of the highest quality. Yet, most fail to keep up with their benchmark. The ones that do will almost always fall out of grace shortly thereafter. Once you understand that past performance has no predictive ability on the future, it gives you a whole new outlook on investing. One in which you can no longer be sold an investment product on the merits of it’s track record.
Blackrock is out out with a new research piece on emerging market stocks. They are saying the same thing we have been for quite some time. When you look at emerging markets compared to developed markets (like the US) they look extremely cheap. This is something you would expect as the past three years (ending 9/30/2013) saw US stocks go up 16.76% per year (Russell 3000 index) and emerging market stocks go down -0.33% per year (MSCI EM Index). This is a huge variance and one of the main reasons emerging market stocks are trading at such a discount to their US counterparts:
Now, valuation does not always determine future returns, but it does have some bearing. Emerging markets have their own issues (inflation, rising rates in US affecting capital flows, and falling commodity prices). With all that being said, valuation discounts and the fact that this asset class does not track exactly with the US market are just two of the many reasons this area of the investment universe should not be abandoned.
There is a great post at the Big Picture blog about whether luck or skill are the determining factors to outperforming the market. The short answer: luck is the main determinant. The research has shown this to be the case but there are some other points in the article that are worth reviewing. First, survivor bias. When research is done on this topic, typically the researchers will look at the funds that are available today and determine how many of them outperformed the market over the past one, three, five, ten years, etc. The problem with that method (which many have pointed out) is that all of the really poor performers have probably folded up shop or merged into another fund.
The reason is what statisticians sometimes call the Wyatt Earp Effect. Earp is famous largely for one simple reason: he quite remarkably survived a lot of duels. We only calculate the odds in these highly improbable situations when we already know what happened and are surprised by it. Thus, in terms of predictive value, these instances don’t mean very much at all.
One of the other reasons to be careful reading into outperformance is outright dishonesty:
It’s important to note at the outset that whenever tremendous investment streaks or returns are claimed, there is considerable reason (see here, for example) to doubt the factual basis for the claim. Sometimes the problem is mathematical, sometimes it’s a matter of a faulty memory, and sometimes people are simply dishonest. In the “professional” space, it is commonplace to see survivorship bias as well as phony measurement and benchmarking (for example, asset-weighted performance typically tells a very different story than more traditional performance measures). That’s why, in a discussion of the likelihood of getting “heads” 100 coin-flips in a row (we should expect it to happen once in 79 million million million million million — that’s 79 with 30 zeros after it – fair sets of tosses), the probabilities favor a loaded coin. Barry dealt with this dishonesty among the pros earlier in the year, noting how common it is to hear from “Pinocchio traders.”
But what about some of those traders/investors that have generated outperformance for decades? At what point do you have to attribute some skill to a manager’s outperformance? The author has a story that many of us in the Baltimore area know all too well:
Bill Miller of Legg Mason famously beat the S&P 500 for 15 straight years from 1991-2005. During that time, he was the poster boy of investment skill. Michael Mauboussin calculated the odds against that happening randomly as exceptionally long indeed. Miller himself was much less self-congratulatory. “As for the so-called streak, that’s an accident of the calendar. If the year ended on different months it wouldn’t be there and at some point the mathematics will hit us. We’ve been lucky. Well, maybe it’s not 100% luck — maybe 95% luck.” As Mauboussin points out, such streaks indicate skill, but luck is heavily involved. Indeed, in the five years after the streak ended, Miller lost 9 per cent annually and ranked dead last out of the 840 funds in the same category. He lost 55 percent in 2008. That said, he’s hot again now.
By understanding how statistics can be manipulated along with how lopsided the research points to luck as the determining factor in outperformance, investors are in a much better position to not be “sold” an investment in some hot-shot fund manager or promise of outperformance in a hedge fund. Understanding these simple facts can save you from falling victim to one of the most common sales techniques in the industry : selling performance.
We are continuing our previous theme of debunking the market bubble concern because it still seems to be what everyone is talking about in the media. I found this research from LPL to add some great perspective to the entire debate. Below is a chart showing where we are (from a return standpoint) compared to other periods in time:
The title of the chart says “The Past Three Years for Stocks Was Nothing Unusual”. In fact, you can see these past three years rank in the most frequent range of 3 year returns (10-15% per year) since 1927. Maybe your argument is that the stock market has really just recently exploded higher which is why it’s unsustainable. There’s a chart for that too:
While it is certainly on the higher end of the spectrum, you can see there are many other years that have seen higher returns than this one. Bottom line, there may be reasons to be concerned, but the idea that stocks have generated unprecedented returns over the past few years and therefore can’t continue, is just not true.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.