“Ben Graham, made an observation to me that really stuck in my mind,‘ You can get in a whole lot more trouble in investing with a sound premise than with a false premise.’“
What do Warren Buffett, Carl Icahn, David Einhorn, and Bill Ackman all have in common? They all have long term track records that trounce any index you could pit them against. They all take large positions in companies they consider to have strong long term prospects and are considered somewhat contrarian investment managers. They are all preaching caution against what they consider bubbles that may be forming. They also all underperformed the Dow and S&P 500 indexes last year and early this year.
These managers long term performance records range from 16.5% per year to almost 30% per year on average with Buffett and Ichan’s records dating back to 1957 and 1968 respectively. Prior to last year these track records were much stronger. So what happened to make them all fall from grace? It seems the last few months of 2015 and the first few months of 2016 the concept of finding quality undervalued diamonds in the rough fell out of favor. Many of these investment “gurus” are reminding us how bubbles have formed in the past and certain types of investments have continued to gain favor to the point where owning them made little to no sense to those who think independently.
Carl Icahn has been preaching lately, along with other key business leaders that the government needs to focus on more infrastructure spending and corporate tax reform. "I do believe in general that there will be a day of reckoning unless we get fiscal stimulus (more government infrastructure spending)," he said, pointing to the Federal Reserve’s maintaining low interest rates, and potentially creating "tremendous bubbles."
How much attention should we be paying to these “low interest rates”. Pimco Founder and "bond guru" Bill Gross warned that global bond yields are at their lowest in “5000 years of recorded history”. He cautioned that record-breaking low yields and negative interest rates emerging in places like Japan and parts of Europe could have explosive implications. And not in a good way for global markets, as he stated, “This is a supernova that will explode one day!” As sovereign debt with negative yields surpassed $10 trillion for the first time in May, global stimulus is on track to create bubbles in bond markets and potentially stock markets much like what we have seen in the U.S. over the last few years. It’s just that Japan and parts of Europe are willing to take things further than the U.S. Federal Reserve ever has in its history.
No other developed country’s stock market has seen the type of recovery that the U.S. has experienced over the last few years. Some would say that Bernanke accomplished his objective by masterfully organizing Federal Reserve policies to keep us out of a deeper recession and stimulating our economy while avoiding both deflation and rampant inflation. Many are more concerned about inflation today than they have been in recent years but others believe that some of these actions have encouraged other types of bubbles.
Some Believe there is a Bubble in Index Funds
Bill Ackman in his letter to shareholders at the beginning of the year warned, “If the index fund trend continues, and it looks likely to do so, what happens when index funds control Corporate America? Courts have often deemed shareholders to be in control of a corporation with as little as 20% of the ownership of a company. At current rates of asset inflows, it will not be long before index funds effectively control Corporate America and the corporations of many foreign countries.”
“The Japanese system of cross corporate ownership, the keiretsu, has been blamed for decades of Japanese corporate underperformance and economic malaise. Large passive ownership of Corporate America by index funds risks a similar outcome without the counterbalancing force of large active investors…”
The thought of corporate America turning Japanese should be enough to make even the biggest proponent of indexing pause for a moment.
Ackman says that the “greatest threat to index fund asset accumulation is deteriorating absolute returns and underperformance versus actively managed funds” because of money flowing into these funds with no consideration of value. This has been the major rationale for the movement toward other types of “smarter indexes”. We will get to one of these types later.
As Ackman espouses, when you invest outside of the mainstream, you will have returns that are outside of the mainstream. That means that there will be plenty of years when you underperform. Even hedge fund masters of the universe lose money some years. But if you’re a good investor, it also means that there will be years where you massively outperform. Much of this we wrote about last month in the blog Is Warren Buffett Giving Contradictory Advice? Buffett wrote a great article on how thoughtful investors can perform well over a long period of time in Superinvestors of Graham and Doddville over three decades ago. The same concepts he touches on in this article still apply today.
What's Working and What's Concerning?
David Einhorn, founder of Greenlight Capital, has been betting against what he considers a new technology bubble for over two years now. He has publicly expressed that he believes the valuations of technology darlings like Amazon, Facebook, Netflix and the like have gotten out of hand. It takes a lot of fortitude to go against the grain with companies that are so popular with investors and consumers, but he believes that investors should pay more attention to the price they pay regardless of how much they believe in the company in question.
Source for image: https://cdn.gamerant.com/
The last five years have reminded us of the markets in the late 1990s. Many do not see the technology bubble that Einhorn has been betting against because it does not seem as prevalent as before. But many companies have seen their stock prices climb without any regard to actual financial results. Just recently Nintendo has seen their stock double in less than a month on the heels of the Pokemon Go. How they are going to translate this application’s recent popularity into long term profits is still a mystery. Momentum investing has become more popular. Much like the late 1990s, many are paying very little attention to how richly valued companies have become in relation to actual earnings.
One strategy that has become more popular is the advent of low volatility investing. Many studies that have become more mainstream lately have shown that stocks with less price fluctuations over the previous year tend to outperform those that have higher fluctuations. When you consider that large fluctuations in price typically occur when prices are moving against us, this makes intuitive sense. The chart below shows the outperformance of the least volatile areas of the S&P 500 versus the S&P 500 over the last ten years.
As these “low volatility strategies” have become increasingly more popular, we start to be more concerned. We started incorporating these into our mutual fund models many years ago and have recently utilized these in lower cost and more tax efficient ETF models last year. While this has been helpful in working to reduce risk and improve returns for us recently, we are somewhat concerned that as these strategies become more popular, more “low volatility” strategies may fail. For this reason we believe in continued use of “Value” and “Quality” oriented strategies as a complement to low volatility strategies when they move out of favor.
Should we abandon diversification and only invest in U.S. large companies?
Again, the last few years reminds us much of what we experienced in the late 1990s. Those who piled into technology companies in those years saw their portfolios rise greatly in value followed by a bursting of the bubble once the infrastructure build up leading to the year 2000 was past. Lately we have seen the S&P 500 outperform most other indices much like the late 1990s and speculation is more rampant. The primary difference is the popularity of the “low volatility” strategies which has some merit. What we would caution against is “un-diversifying” portfolios like many did in the late 1990s. Those who “un-diversified” suffered greatly during the “lost decade” of the 2000s. What is interesting is that those who stayed diversified saw their portfolios steadily increase during this time while the rest suffered, thinking they were well positioned in the S&P 500 index or even further concentrated in the Nasdaq 100 index.
Data from Morningstar Investor 12/31/2015
The chart above shows how a more diversified all equity index portfolio would have performed in the decade of the 2000s and every other decade back to the 1950s. It is interesting to note that this portfolio owning small US and non-US companies, large US and non-US companies, REITS and other equity holdings outperformed in all decades except for the 1990s and the last five years. Those who have only considered investing in the S&P 500 index may be doing themselves a favor by studying this chart.
Recently, publicly traded real estate companies have become more popular and have been outperforming most other investments over the last 3 years. Soon these companies will be included in their own separate sector within the S&P 500 index at the end of August instead of being lumped in with financial companies. Many are looking to add these into portfolios before the index funds so they can benefit from the additions next month. After these additions are made there may be little reason to add these to portfolios, especially considering this has been one of the best performing asset classes for the last three years. This momentum tends to continue until we see a speculative spike or a catalyst that sends the sector into a downturn. The presidential election could be a factor for real estate over the next few years. The election of a real estate tycoon such as Trump could encourage more real estate speculation, but a Clinton victory could could spell the end for this trend.
The last five years the S&P 500 has appreciated approximately 3% faster than its long term trend. Over a two and a half year period ending on June 30th, commercial real estate has continued to appreciate almost 5% faster than its long term trend. While it is possible that momenutm will continue for some time, we believe that covering our bases is a more prudent approach and caution against piling into the most recent fad.
When comparing portfolios against the S&P 500 or the Dow, investors would do well to remember the late 1990s. Those who over-concentrated their portfolios during this period did not enjoy the next decade.
“Speculative bubbles do not end like a short story, novel, or play. There is no final denouement that brings all the strands of a narrative into an impressive final conclusion. In the real world, we never know when the story is over.”
Joe D. Franklin, CFP is Founder and President of Franklin Wealth Management, a registered investment advisory firm in Hixson, Tennessee. A 20+year industry veteran, he contributes guest articles for Money Magazine and authors the Franklin Backstage Pass blog. Joe has also been featured in the Wall Street Journal, Kiplinger's Magazine, USA Today and other publications.
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