The Price of Mispricing

June 11, 2017

In an April 2016 Gallup poll  52% of Americans said that they had some stocks in their portfolio. In this annual survey, the two decade high occurred in 2007 when 65% of those surveyed said stocks were a part of their savings. Asked what they thought was the safest long term investment, surveyed respondents answered: stocks/mutual funds. The stock market hit a high in the fall that year.

Turn the dial to April 2008. The market had declined 10% from its October 2007 high but there was still five months to go till the onset of the financial crisis in September. Americans surveyed by Gallup said that savings and CDs were the safest (Poll ). At that time, a 5 year CD was paying 3.7% according to Bankrate . What happened to turn sentiment from rather risky stocks to safe cash and CDs? The decline in the SP500 might have been responsible. A more likely cause was the recent headlines concerning the failure of the investment firm Bear Stearns. The Fed provided a temporary bailout, then arranged a sale of the firm to JPMorgan Chase.

When real estate prices were rising in the early 2000s, people thought real estate was the safest long term investment. Each of us should ask ourselves an honest question. Do I treat relatively short term shifts in asset pricing as though they were long term trends?

Here’s another thought. Do we mentally treat changes in asset pricing as though it were cash income? If I see that the value of my stock portfolio has gone up $10,000 since my last quarterly statement, do I think of that as kind of a dividend reward for my willingness to take a bit of a risk? The statement confirms that I’m a prudent investor. Do I mentally “pocket”  that $10,000 as though someone had sent me a check?

On the other hand, if my statement shows a decrease in value, I have not only lost money but now I may question my prudence. Am I taking too much risk? I might even think that “the market” is wrong. Can I trust a market that could be wrong? What if there’s another financial crisis? Should I sell my stocks and put the money in CDs? A 5 year CD is only paying a little bit above 2% but at least I won’t lose any money.

Let’s crawl out of our heads and into the pages of history. In the early 1950s, two people published ideas that have come to dominate the investment industry.

In 1951, John Bogle wrote his Princeton college thesis “The Economic Role of the Investment Company.” The paper was an in-depth analysis of mutual funds, a product that was less than 30 years old. (Excerpts). At that time, only 8% of individual investors owned stocks.

Two decades later, Mr. Bogle would go on to found Vanguard, the giant of index mutual funds.  Contrary to the founding principle of Vanguard, Bogle’s 1951 paper did not champion indexing.  In Chapter 1, he objected to the portrayal of a mutual fund as settling for the average returns of an index of stocks.  Bogle touted the active management that a mutual fund provided to an investor.  In a quarter century after he wrote the paper, Mr. Bogle’s conviction in the superiority of active management shifted toward passive indexing. Indexing is the averaging of the decisions of all the buyers and sellers in a particular marketplace.

When Bogle wrote his paper, two types of funds competed for an investor’s attention. The earliest funds were closed end (CEF) and date back to the middle of the 19th century. The Adams Diversified Equity Fund was founded in 1854 and continues to trade today under the symbol ADX. After the initial offering a CEF is closed to new investors. The shares continue to trade on the market like a company stock but investors can no longer buy or redeem shares with the company that manages the fund.

A mutual fund is an open end product, meaning that the fund is open to new investors and investors can redeem their shares at any time. The early mutual funds touted this feature but it was not statutory until the enactment of the Investment Act of 1940.

When Bogle wrote his thesis, the market was still in what is called a secular bear market. The beginning of this period was marked by the brutal crash of 1929 and would not end till 1953, when the price of the SP500 finally rose above the highs set in 1929. The 1920s had been a decade of rapid growth in the new radio industry and manufacturing. The automobile and stock markets were fueled by easy credit. In response to this short era of explosive growth, investors elevated their long term expectations. From 1926 to 1929 the stock market doubled in price, a rapid mispricing that finally corrected in the October crash of 1929.

In 1951, Bogle summarized the previous two decades:
“The depression and the great capital losses to investors which resulted from it caused a greater desire for safety of principal, but gradually confidence in stocks (and especially in a diversified group of them) returned, and during the same period bond rates fell. The combination of high income and safe principal thus shifted in favor of the common stock element. In spite of the fact that many funds urge that part of the investor’s capital should be devoted to bonds, after he has cash reserves and insurance needs filled, it seems doubtful that this advice has been widely followed. “[my emphasis]

In his analysis, Bogle identified several metrics that gave open-end mutual funds superiority over closed-end funds: prudent management to keep the fund attractive to new investors, diversification, liquidity, and income.

Bogle concluded his thesis with a caution that is timeless: “That the market will fluctuate is certain, and merely because it has experienced a general upward trend in the decade of the investment company’s greatest growth may have made many investors fail to realize that the share value, like the market, is liable to decline.”

He looked toward the future of mutual funds, and expressed what would become the business plan of Vanguard: “perhaps [the mutual fund industry’s] future growth can be maximized by concentration on a reduction of sales loads and management fees.”

In the past 15 years, only 15% of active large cap managers have beat the returns of the SP500 index.  The performance is even weaker for small cap stock managers.  Only 11% beat their index.  Individual investors have withdrawn money from actively managed funds and put that money to work in their passive counterparts.  As more money flows to index funds, the danger is that those funds will be averaging the decisions of a smaller pool of active managers. That objection is raised by advocates for active management but it seems unlikely that the pool of active managers will diminish to the point that a few remaining managers will essentially control the direction of the market.  Although recent flows of money have favored passive indexing, actively managed mutual funds and ETFs still control two-thirds of all assets (Morningstar).

In the following year, Harry Markowitz, a graduate student at the University of Chicago, wrote a paper titled “Portfolio Selection” which proposed a systemic approach to diversification called Modern Portfolio Theory. Bogle had noted the prudent rule of thumb that an investor should devote some capital to bonds as well as stocks to stabilize a portfolio. Markowitz mathematized this rule of thumb. The key to portfolio stability was a strategy of asset selection that minimized risk in the face of uncertainty. Any two assets, not just stocks and bonds, that were normally non-correlated would provide stability. When one asset zigged in value, the other asset zagged. Both assets could be risky but if one asset responded opposite the other, then the net effect of owning both assets was to lower the risk.

The key word in any talk of historical correlation is “normal.” There is no theory which can explain investor trauma, a total lack of confidence in most assets. In October 2008, every asset but one fell. Both stocks and gold fell 16%, commodities sank 25% and REITs fell a whopping 32%. Even bonds, a safe haven in times of uncertainty, fell 3%. In a world where every asset class was losing value, investors bought short term Treasuries, which rose 1%, but avoided long term Treasuries, which declined 2%. There was no safety to be found outside of the U.S. Emerging markets fell 26%, European stocks sank 23% and international real estate nose dived 32%.

But the correlation in normally non-correlated assets could not last. During the following two months, bonds rose 9%, and gold shot up 20%. Stable or defensive stocks like health care continued to lose value but at a slower pace. Some investors stepped in to pick up quality stocks at bargain prices. The stock market continued to stagger to a bottom until the passage of the American Recovery and Reinvestment Act in February 2009, soon after the inauguration of Barack Obama.

50% market repricings are relatively infrequent. That we experienced two such events in less than a decade in the 2000s caused millions of investors to abandon risky assets entirely. The SP500 index did not recover the ground lost till January 2013, more than five years after the high set in October 2007. The recovery after the dot-com bubble burst in 2000 lasted a similar time, 5-1/2 years.

When was the last time we had back to back severe downturns? We need to turn the dial back to the fall of 1968 when the market began a 1-1/2 year decline of 33%. After a few years of recovery, stocks fell again. Provoked by the Arab-Israeli war, the oil embargo and high inflation, the market began a repricing in 1973. The recovery lasted almost seven years.

In 1975, Bogle founded Vanguard, what some called “Bogle’s Folly.”  Four years later, the SP500 was barely above its high in 1968. Investors had so little confidence in stocks as a long term investment that, in August 1979, Business Week declared that stocks were dead. Since that declaration, the price of the SP500 has gained about 8-1/2% annually.  Add in 2 – 3% in dividends and the total return exceeds 10% annually.

Bogle and Markowitz have had a profound influence on the investment industry by developing two deceptively simple ideas for investors who can’t know the future.  Bogle’s thought: don’t bet on which chicken can lay the most eggs.  The complimentary idea from Markowitz: don’t put all your eggs in one basket.

Next week – what’s so special about market averages?  They’re not your average average.

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