Thursday, August 20, 2015

Recent Trends in the US GNP

Looking back on my own experiences going back to 1938 there has been always a concern that good times could not last forever. A profitable stock market will be invariably followed by periods of losses. Investors will nevertheless believe that ultimately an improvement in stock prices will always prevail. Faith in the ultimate growth of the US economy will compensate for the acceptance of short-term losses. Long-term gains will be realized. In the stock markets cyclical bouts of pessimism will alternate with exuberant spurts in optimism.

George Akerlof and Robert Shiller – both winners of the Nobel Prize in economics – wrote about the gyrations in investor attitudes. Accordingly the economy is driven primarily by personal attitudes. We subscribe to that point of view. We view the stock market cycles as an amplification of personal sentiments.

Our approach to investments is influenced by our detection of economic, social and structural anomalies. We look for deviations from what are generally accepted opinions about what are real events. Deviations must be examined for factual and quantitative indicators that anticipate a change in an expected trend.
To examine a significant deviation we will start with an examination of the long-term trends of the GNP. Are there any indications that something unusual may be taking place?
The Gross National Product has grown since 1947 without slowdown and with slight acceleration in 1990. However, something abnormal has occurred recently. According to the Federal Reserve Bank there has been a break in the linear trend of the real GNP per capita in 2007:


The real (e.g. deflated) income per capita rose steadily from $17,582 in October of 1960 to $50,172 in October of 2007. Real personal income of the US population thereby gained 285% in a period of 47 years, or a regular rise of 6.3% per year, without disruption.

Former growth came to an abrupt halt when real personal income rose only to $51,164 since October 2007. In seven years, there has been only a 0.28% gain in GNP per capita per year. These increases took place in a wavering pattern and indicate an increasing uncertainty in the economy.

The year 2007 break in the growth of the GNP suggests that retired investors may have to start reducing their expectations of future investment growth despite prognostications from the financial services industry.

The year 2007 break in the growth of the GNP suggests that retired investors may have to start reducing their expectations of future investment growth despite prognostications from the financial services industry.

The year 2007 break in the growth of the GNP suggests that retired investors may have to start reducing their expectations of future investment growth despite prognostications from the financial services industry.


Sunday, July 12, 2015

Cyclical Investments in Mutual Funds

As far back as we can trace investment have been a cyclical business. Since 1877 there have been five major up cycles. Stock investments appreciated in up cycles while stock investment depreciates during five down cycles.[i]

Five Up Cycles and Five Down Cycles in the US stock market since 1870

If investors had followed only up cycles their total 1949 to 2015 appreciation would have been 1181%. During down cycles they lost -122%, which they could have prevented only through a perfect applications of market timing. Consequently, from 1949 through June of 2015 the inflation adjusted Dow Jones Index delivered only +874% gains. That assumes that the investor remained invested in a DJI fund with very low fees, but it is the best that could be done:
Stock Market Appreciation and Depreciation Since 1949

The question is: what can then an investor do to improve the chances in benefiting from up markets and limiting the damage from down markets? Are there any techniques available that improve investment results under inherently cyclical conditions that are unpredictable?

We have used large and conservatively invested mutual funds as an example to illustrate how investment portfolios can be managed even if upside and downside market prices can deliver different results.

The following is an example of mutual fund valuations from the peak in prices in 6/21/2005 to the peak in 6/20/2015:
Peak-to-Peak Stock Market Valuations for Selected Mutual Funds

This example shows that the S&P index experienced a -53% drop from its peak to the bottom of the cycle. It then recovered +36% to its current levels in June of 2015. 

At the other end of our example Vanguard Health Care dropped only -28% from its peak to the bottom of the cycle. However, it recovered to its prices by gaining +172% in June of 2015.

Other mutual funds, inclusive of Berkshire Hathaway A, show a range in the drop in value between -28% and -53% with peak-to-peak gains between +172% and +36%. We have examined 124 mutual funds in Morningstar designated as “GOLD” and rated better than “4”.[ii] In all cases we found that small drops in value from the peaks of the cycle were associated with higher levels of ultimate peak-to-peak gains.

Our analysis of the consequences of tracking the tops and bottoms of cycles should also receive encouragement from our findings that more stable mutual funds will usually have higher 5-year and 10-year returns. Vanguard Health Care will show 5-year returns of 24.4% and 10-year returns of 13.8%. Respective returns for Vanguard Capital Opportunity will be 17.9% and 10.8%; Vanguard PRIMECAP 16.7% and 10.2%; Vanguard Dividend Growth 15.0% and 9.1%; S&P 500 Index 13.6% and 5.7% and Berkshire Hathaway A 12.1% and 9.9%. 

We conclude that despite the inevitable market cycles it is possible to minimize the effects of cyclical losses on the growth of mutual fund investments. A careful examination of the peaks and the bottoms of the prices of mutual funds over more than two market cycles can give us insights which funds to pick for protection against market fluctuations. 

Whether you call that timing is arguable. But we are satisfied that it may be possible to minimize risks for losses while maximizing the opportunities for gains whenever high quality mutual funds are examined for the patterns of prices shown during stock market several market cycles. Whether such patterns will repeat is unknown, though the down-and-up variations in the market prices of quality mutual funds should be considered as one of the characteristics that reflects the risks taken by the management of each mutual fund.