When the person with arguably the greatest influence over the economy in the world opines that stock valuations are “quite high,” as Federal Reserve Board Chair Janet Yellen told an IMF conference last month, should investors take heed?
The answer quite simply is “No,” according to advisor and investment analyst Eric Nelson, whose latest post warns that we’ve seen this show before and already know it ends badly.
The Servo Wealth Management principal is referring to former Fed Chairman Alan Greenspan’s famous testimony about the stock market’s “irrational exuberance” in December 1996.
However high valuations were at the time, or whatever “potential dangers” (another Yellen comment last month) may have existed, the stock market more than doubled in the nearly three and a half years between Greenspan’s comment and the ultimate market crash in March 2000.
Investors who restructured their portfolios based on the revered Fed chief’s forecast would have achieved significant losses. How severe was the penalty for market timing, and how great the reward for steadfastness?
In his usual thoroughgoing fashion, Nelson quantifies the cost of acting on the Fed chair’s tip by viewing stock returns through three time perspectives: from January 1997 to March 2000, the period between Greenspan’s comment and the dot-com bust; from the same start time through the ensuing bear market’s conclusion in September 2002; and from the same start time until the end of the end of this May.
In that first three-and-a-half year period, the S&P 500 climbed just shy of 26% on an annualized basis.
That not only trounced the Greenspan comment’s implied investment alternative, cash, which delivered a 2.3% annualized return (using 1-month T-bills as a proxy), but it also beat Nelson’s preferred small- and value-tilted U.S stock portfolio (16.9%) and even more preferred small- and value-tilted global stock portfolio (13.3%).
Broadening the perspective to include the period of the subsequent crash that Greenspan’s remarks anticipated, we see that the S&P 500 did indeed suffer during that six-year stretch, delivering an annual average performance of 3%, which is indeed less than the 4.5% average annual performance of T-bills in that period.
But the small- and value-tilted global stock portfolio matched exactly the return of T-bills, whereas the small- and value-tilted U.S. stock portfolio handily beat cash, delivering a 6.3% annual average return.
Elongating the perspective to bring us to the end of last week, we can see that the large-growth oriented S&P 500 delivered a respectable if slightly depressed 7.7% annual return — certainly way ahead of the cash investor saw just 2.3% nominal return on his money these 18 years.
But investors in small- and value-tilted U.S. and global portfolios saw average annual returns of 9.9% and 9.4%, respectively — way ahead of the S&P 500.
Nelson tallies the results thusly:
An investor who held onto the S&P 500 after Greenspan’s comment saw an almost fourfold increase while the global small and value investor achieved an over fivefold increase and the U.S. small and value investor came near to a sixfold increase. What’s more, the S&P 500 investor enjoyed a 5.4% annual advantage over the cash investor.
The Servo Wealth principal says the payoff for this kind of discipline is virtually identical to return results from the longer preceding period between 1928 and 1996. And the small-value 2.2% premium above the S&P 500 similarly matches the 1928-96 period.
For a still broader perspective, ThinkAdvisor reached Nelson to ask of the fate of investors frightened by the 2008 market crash who have scurried to gold, rather than cash, as an alternative investment.
Nelson characterizes such wealth preservation strategies as misguided at best.
“I would submit one example,” he says. “In August of 2011, as the U.S. credit rating was downgraded for the first time in our country’s history, GLD [the SPDR Gold Trust ETF] closed the month at about $178. Investors were piling in assuming that we’d be one of the PIGS in no time, the U.S. dollar would collapse, etc.
“At the end of last month, GLD closed at about $114,” he continues. “That is a 36% decline over this 3 year and 9 month period. That is as bad a total loss as investors experienced on the S&P 500 in 2008 — the worst year for stocks since the 1930s! So by trying to avoid a repeat of 2008 (or worse), investors fleeing to gold to protect their wealth wound up experiencing the very decline they were trying to avoid the entire time!”
What this all implies is the need for a bit of humility on the part of investors (and Fed chairs and politicians), says Nelson, who offers two reasons for this.
First, only unknown information drives future stock prices, and second, no one person can know all that information.
“[That’s] why ‘I don’t know’ is a totally legitimate and honest answer to investor questions about current events or the short-term future of investment markets. And also why ‘…and I don’t care’ is not derogatory or lazy in any way. It’s very nuanced and grounded in evidence and reality. And more importantly, it frees you up to focus on other things you do know and should care about and…investors should be aware of,” he says.
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