Swedroe: More 2015 Investor Lessons

January 27, 2016

Earlier this week, we began discussing 10 important lessons that the markets taught us in 2015 about the prudent investment strategy. In lessons one through three, we explored active management as a loser’s game, the “conventional wisdom” about the correlation between the economy and the stock market, and the “Sell in May” myth. Today we’ll pick up with lessons four through seven.

Lesson 4: Inflation Wasn’t, and Isn’t, Inevitable

One of the most persistently asked questions that I’ve received since 2009 has been some version of the following: What should I do about the inevitable rampant inflation problem we’re going to face because of the huge fiscal and monetary stimulus that’s been injected into the economy?

While the risk that massive budget deficits, a zero-interest-rate policy and the Federal Reserve’s bond-buying program would translate into rising inflation certainly did exist in 2015, this outcome wasn’t (and still isn’t) inevitable. Since 2008, we haven’t had a single year in which the CPI exceeded 3%. In fact, 2011 was the only year when it exceeded 2%, and 2015’s rate was less than 1%.

A related myth persists among many investors as well. I frequently hear concerns about the exploding growth rate of our nation’s money supply. This belief likely has been fueled by certain commercials—you know, the ones that recommend buying gold because central banks are printing money like we’re experiencing Weimar Germany all over again.

The fact is that M2, a broad measure of the money supply, hasn’t been growing at rates that would suggest rampant inflation should be expected. For the seven-year period from Dec. 8, 2008 through Dec. 7, 2015, the Federal Reserve Bank of St. Louis reports that the rate of growth in M2 was 6.1%.

Since, as Milton Friedman, one of our greatest economists, noted, “Inflation is always and everywhere a monetary phenomenon,” the factual data doesn’t support the view that we should have expected rampant inflation. In fact, despite the fears of many investors who seem certain that we will see massive inflation, neither the bond market nor professional economists are expecting anything of the kind.

We can at least get an estimate of the market’s forecast for inflation by looking at the difference between the approximately 2.3% yield on 10-year nominal bonds and the roughly 0.7% yield on 10-year Treasury inflation-protected securities (TIPS). The difference is just 1.6 percentage points.

Clearly, investors—in aggregate—don’t appear concerned about rampant inflation. As for economists’ expectations, the Federal Reserve Bank of Philadelphia’s Fourth Quarter 2015 Survey of Professional Forecasters has a 10-year forecast of inflation averaging just 2.15% at an annual rate. Again, they don’t believe rampant inflation is likely, let alone inevitable.

But don’t get the wrong idea. The risk that inflation could increase dramatically is still very much present. It hasn’t happened so far because, even though the monetary base has been increasing rapidly (as the Fed’s balance sheet expanded through its bond-buying program), the velocity of money (as measured by M2) has fallen pretty persistently from about 2.0 at the end of 2007 to about 1.5 at the end of 2015, a drop of approximately 25%.

That said, there remains the risk that if or when the velocity of money begins to rise, inflation could increase. Of course, the Fed is well aware of this risk, and would likely take action—reverse its bond-buying program and raise interest rates—to prevent inflation from taking off.

Lesson 5: Ignore All Forecasts—All Crystal Balls Are Cloudy

In January 2015, The Wall Street Journal surveyed economists, asking them to forecast what the federal funds (FF) rate would be at the end of the year. The average projection called for a rate of 0.89%. The Fed’s target rate remained unchanged at 0.00-0.25% until Dec. 16 and ended the year at 0.25-0.50%.

Investors paying attention to such forecasts likely would have kept their bond allocations either in cash or in very-short-term instruments, and paid the price in terms of lost opportunities. Last year, Vanguard’s Short-Term Bond Index Fund (VBISX) returned 1.2%, underperforming its Intermediate-Term Bond Fund (VBIIX), which returned 1.8%. However, its Long-Term Bond Index Fund (VBLTX) lost 2.4%.

Here’s another important reminder. Despite what many investors believe, the Fed’s decision to raise the federal funds rate does not mean that longer-term rates will rise. The reason is that the yield curve reflects the market’s expectations for future short-term interest rates. As an example, on Dec. 16, 2015, when the Fed raised rates, the 10-year Treasury yield was 2.30%. It ended the year slightly lower, at 2.27%.

Lesson 6: Last Year’s Winners Are Just as Likely to Be This Year’s Losers

The historical evidence demonstrates that individual investors tend to be performance chasers. They watch yesterday’s winners and then buy (after the great performance), and they watch yesterday’s losers and then sell (after the loss has already been incurred).

This causes investors to buy high and sell low—not exactly a recipe for investing success. It also explains the findings from studies showing that investors actually underperform the very mutual funds in which they invest.

Unfortunately, a good (poor) return in one year doesn’t predict a good (poor) return in the next year. In fact, above-average returns lower future expected returns, and below-average returns raise future expected returns. The prudent strategy for investors is to act like a postage stamp. The lowly postage stamp does only one thing, but it does it exceedingly well—it adheres to its letter until it reaches its destination.

Similarly, investors should adhere to their well-crafted investment plan (asset allocation). Sticking to one’s investment plan doesn’t mean just buying and holding. It means buying, holding and rebalancing (the process of restoring your portfolio’s asset allocation to your plan’s targeted levels).

The following table compares the returns of various asset classes in 2014 and 2015 using passive asset class funds from Dimensional Fund Advisors (DFA). As you can see, sometimes the winners and losers of 2014 repeated their performance, but at other times, they change places. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)

For example, in 2014, DFA’s International Small Company Fund (DFISX) was in 12th place, and its International Small Cap Value Fund (DISVX) was in 10th. However, in 2015, DFISX was the best performer, and DISVX finished second.

On the other hand, the first- and second-best performers in 2014, DFA’s Real Estate Securities Fund (DFREX) and the firm’s U.S. Large Company Fund (DFUSX), repeated their relatively strong performance. They finished in third and fourth place, respectively, in 2015. And finally, the DFA Commodity Strategy Fund (DCMSX) repeated its last-place finish.


Fund 2014 Return (%)/
Rank
2015 Return (%)/
Rank
DFA Real Estate (DFREX) 31.1/1 3.2/3
DFA U.S. Large (DFUSX/S&P 500) 13.5/2 1.4/4
DFA International Real Estate (DFITX) 11.1/3 -3.6/8
DFA U.S. Large Value (DFLVX) 10.5/4 -3.5/7
DFA U.S. Small (DFSTX) 4.4/5 -3.3/6
DFA U.S. Small Value (DFSVX) 3.5/6 -7.8/10
DFA Emerging Markets (DFEMX) 3.0/7 -15.8/12
DFA Emerging Markets Value (DFEVX) -4.4/8 -18.8/13
DFA Emerging Markets Small (DEMSX) -4.7/9 -8.7/11
DFA International Small Value (DISVX) -5.0/10 4.0/2
DFA International Large (DFALX) -5.2/11 -2.9/5
DFA International Small (DFISX) -6.3/12 5.9/1
DFA International Value (DFIVX) -6.9/13 -6.3/9
DFA Commodity Strategy (DCMSX) -14.6/14 -23.9/14

Lesson 7: The Road to Riches Isn’t Paved With Dividends

Over the last few years, we’ve seen a dramatic increase in investors’ interest in dividend-paying stocks. This heightened attention has been fueled both by hype in the media and the current regime of interest rates, which are well below historical averages.

The low yields available on safe bonds have led even once-conservative investors to shift their allocations from such fixed-income investments into dividend-paying stocks. This is especially true for those who take an income, or cash flow, approach to investing (as opposed to a total return approach, which I believe is the right one).

How did that strategy work in 2015? Equal-weighting the 417 dividend-paying stocks within the S&P 500 Index returned -3.1%. By contrast, the 83 nondividend payers returned -1.3%, an outperformance of 1.8 percentage points.

In 2014, the dividend payers also underperformed (14.0% versus 14.4%). They underperformed in 2013 (40.7% versus 46.3%) as well. And for the eight-year period from 2008 through 2015, the dividend-paying stocks within the index provided a total return of 68.7%, underperforming the 92.8% total return provided by the nondividend payers by 24.1 percentage points.

Admittedly, these results are for a relatively short time period. And economic theory, and the evidence, suggests that all else equal—meaning the same exposure to factors that explain returns, such as market cap (the size factor) and price-to-earnings (P/E) and book-to-market (B/M) ratios (the value factor)—dividend-paying equities should have the same expected returns as nonpayers.

However, seven years of historically low rates on safe bonds have led many investors to pursue dividend-paying stocks as a way to generate more cash flow. This increased demand, in turn, drove up prices (and price-to-earnings and price-to-book ratios) on dividend-paying stocks, and lowered their expected returns.

In general, dividend strategies continue to have relatively higher valuations than strategies that don’t consider dividends as a factor in fund construction. As one example, Morningstar categorizes both the SPDR S&P Dividend ETF (SDY) and the Vanguard Value ETF (VTV) as large value funds. The P/E and the P/B of SDY are 20.0 and 2.5, both quite a bit higher than the 16.2 and 1.9 figures, respectively, for VTV. Thus, SDY has lower expected returns.

We will conclude our series on what the markets taught us in 2015 later this week, when we cover risk premiums, discipline and tax-loss harvesting in lessons eight through ten.


Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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