The Ego, The Market, and The Mania

Since 2008, economic uncertainty and market volatility have tested the staying power of investors around the world. Many people fled equities during the worst months of the global financial crisis, while others waited for signs of a turnaround before investing more. Their emotional reactions may have exacted a large price on their wealth.

The graph below documents investor behavior during the stock market downturn in 2008 and subsequent market rebound. It offers a few key lessons about investing in turbulent markets.

Figure 1: Quarterly Equity Mutual Fund Flows

Industry vs. Dimensional Relative to S&P 500 Index Performance

January 2008–June 2011

For illustration purposes only. Industry net new cash flow data for US-domiciled equity funds provided by Investment Company Institute ©2011. Quarterly cash flows are estimates that are adjusted to represent industry totals, based on reporting covering 95% of industry assets. Dimensional’s figures are based on net new cash from financial advisors in US-domiciled funds. Industry and Dimensional data reflect investment in US and international equity markets and do not include funds of funds. S&P 500 Index performance is based on monthly returns data. The S&P data are provided by Standard & Poor’s Index Services Group. The S&P 500 includes 500 US stocks chosen for market size. Past performance is no guarantee of future results.

Reading the Graph

First, look at the shaded graph in the background, which plots the performance of the S&P 500 Index (measured by growth of a dollar) over this three-and-a-half-year period. The market began falling in late 2008 and hit bottom in early March 2009. It then reversed sharply and began a long climb through June 2011.

Now consider how mutual fund investors responded to the stock market’s downturn and recovery. The orange line plots quarterly net cash equity flows for the US mutual fund industry over the same period. (Net cash flow is the difference between redemptions and purchases of shares in a mutual fund. A net cash outflow occurs when redemptions exceed purchases.) Equity fund flows were cumulatively negative over the period. Investors were redeeming more shares than they were buying, and on a net basis, capital was leaving mutual funds.¹

Note that these fund industry outflows followed the stock market downturn, and net flows stayed negative even after the market rebound. Investors were reacting to the falling stock market by either redeeming their fund shares or delaying the purchase of additional shares.² When the stock market suddenly rebounded in March 2009, investors who had reduced their exposure to equities missed a good part of the recovery.

This apparent lack of discipline is well established over longer time periods too. Industry analyses and academic research suggest that investors tend to focus on recent performance and make decisions that compromise long-term returns in their portfolio.³

Recent history illustrates why the average fund investor may fail to earn returns comparable to those of the average fund or market index. Markets change quickly, and investors must be in their seats to capture returns. Unfortunately, many investors let their emotions get in the way of participating in long-term market performance.

Now consider the upward-sloping blue line, which plots quarterly net flows into equity strategies offered by Dimensional Fund Advisors. These flows were cumulatively positive throughout the entire period, suggesting that shareholders in Dimensional’s funds continued to purchase shares during the 2008–2009 market decline and after the March 2009 rebound.

As a group, these investors did not flee stocks en masse. In fact, they did the opposite by adding to their portfolios. Their discipline positioned them for the market rebound.

A mutual fund’s net cash flows also may reveal the collective discipline—or lack of discipline—among its shareholders. In fact, the direction of net flows can impact portfolio management and performance, especially for funds invested in less liquid markets. Large net redemptions typically increase the direct and indirect costs of a mutual fund, which compromise fund returns.⁴ The assorted costs are not borne by redeeming shareholders but by the shareholders who remain in the fund.⁵ Therefore, consistently positive net cash flows are helpful to a fund’s expenses, strategy, and performance.

Summary

The large net cash outflows from US-based mutual funds since 2008 document investor reaction to market volatility, while Dimensional’s stable and positive net fund flows suggest disciplined behavior. So why would shareholders in Dimensional’s funds behave differently? One reason might be the education, encouragement, and discipline offered by their financial advisor at that difficult time, underscoring the value of sound investment advice.

An advisor’s steady hand helps investors apply discipline in all types of markets, which can positively impact individual performance over time. Moreover, when advisors influence the collective decisions of shareholders in a fund, the greater cash flow stability can prove beneficial to the fund’s strategy, cost management, and returns.

Endnotes:

1. Mutual fund investors redeem their shares by selling them back to the mutual fund and receiving cash proceeds based on the net asset value (NAV) of the shares at day’s end. Redemption is a normal activity in a mutual fund, and liquidity is one benefit of owning fund shares. A fund manager may use inflowing cash to cover the redemptions or keep cash in a “liquidity reserve” for this purpose. When cash balances do not suffice, the manager may execute trades to raise the cash.

2. According to the Investment Company Institute, mutual fund flows do not offer a good measure of total demand for equities since funds hold only about 20% of the total US equities outstanding, with the balance held directly by individuals, institutions, and governments. Academic research offers some evidence that mutual fund flows do not drive market returns but reflect investor reaction to markets. (Roger M. Edelen and Jerold B. Warner, “Aggregate Price Effects of Institutional Trading: A Study of Mutual Fund Flow and Market Returns,” Journal of Financial Economics 59, no. 2 (2001): 195–220.)

3. A Morningstar study compared the dollar-weighted returns of the average investor in a fund with the fund’s published total return for the ten-year period ending Dec. 31, 2009. In US equities, the average investor in all funds earned 0.22% annualized, compared with 1.59% for the average fund. (Russel Kinnel, “Bad Timing Eats Away at Investor Returns,” Morningstar.com, February 15, 2010.) Lack of investment discipline also is documented among individual investors who hold common stocks directly. Those who trade frequently pay a tremendous performance penalty for their actions. (Brad M. Barber and Terrance Odean, “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” The Journal of Finance, April 2000.)

4. Direct transaction costs include commissions, bid-ask spreads, and price impact incurred when a fund makes trades in response to shareholder redemptions. Net outflows also may generate indirect costs on a fund by forcing its manager to alter the target asset allocation or make disadvantageous, uninformed trades to raise cash. See Qi Chen, Itay Goldstein, and Wei Jiang, “Payoff Complementarities and Financial Fragility: Evidence from Mutual Fund Outflows” (white paper, February, 2007).

5. Mutual funds typically meet a redemption based on the NAV at day’s end but may execute a trade to raise cash on the following day. The redeeming shareholder cashes out at an NAV that does not reflect the trade, and the resulting costs are borne by remaining shareholders. See: “On the Run: Examining Patterns in Mutual Fund Redemptions,” Knowledge at Wharton,http://knowledge.wharton.upenn.edu/article.cfm?articleid=2133, accessed September 27, 2011.

Disclaimer:

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Diversification neither assures a profit nor guarantees against loss in a declining market. Past performance is no guarantee of future results. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services.

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and charges and expenses of the Dimensional funds carefully before investing. For this and other information about the Dimensional funds, please read the prospectus carefully before investing. Prospectuses are available by calling Dimensional Fund Advisors collect at (512) 306-7400 or at www.dimensional.com. Dimensional funds are distributed by DFA Securities LLC. 

Since the onset of the financial crisis in late 2007, the Federal Reserve has used interest-rate cuts and other policy tools in an effort to fuel economic growth. Economists can debate the effectiveness of these policies, but everyone can agree that today’s low interest rates are a two-sided coin.

Consumers, businesses, and government all benefit from low borrowing costs. But on the other side, savers and investors earn almost nothing on their cash balances. This has been the case in most months since 2008, when the Fed cut short-term interest rates to near zero. Worse yet, investors are actually losing wealth in real terms. The inflation-adjusted yields on short-term Treasury securities have been negative in most months since October 2010. (Nominal yields reflect the stated interest rate, while real yields are adjusted for inflation.)

Earning negative real yields on short-term fixed income is not unprecedented, as shown in Figure 1. In fact, inflation has exceeded nominal interest rates in several post-war periods. This graph plots nominal and real yields of one-month Treasury bills, which are considered the equivalent of cash. The gap between the two lines is the inflation rate.

Figure 1: One-Month Treasury Bills
Nominal vs. Real Yield
April 1953–June 2011

The real (inflation-adjusted) yield is computed using trailing 12-month changes in the Consumer Price Index. Source: Federal Reserve Economic Data

Negative real yields have occurred during periods of high interest rates (early 1980s) and during periods of low interest rates (2010–11). Regardless of the scenario, negative real yields cause investors to lose purchasing power. Keep in mind that the graph shows yields only and not total return, which also would reflect price changes resulting from interest rate movements.

You may note that some negative real yields have occurred during recessionary periods, when the Fed was cutting interest rates to spur a recovery. These times also may be when investors are most tempted to flee the capital markets for the perceived safety of cash. Investors may have a host of reasons for their flight—some might want to avoid economic uncertainty or stock market volatility, while others might fear that impending higher interest rates will cause bonds to lose value.

This is the case for many individual investors and professional money managers today. They are reportedly shifting their portfolios to money market funds and other cash instruments with the intent to return to stocks and bonds when the economy shows signs of improvement.1 The problem with this strategy is that no one can consistently time markets, and the signs are never clear. So while investors sit in cash, their purchasing power quietly erodes.

Investors may have good reasons to hold cash—for example, to keep a portion of their assets liquid. But they should understand that holding cash has a price in real terms. Investors ultimately may lose wealth even as they try to protect it.

Endnote:
1. Jonnelle Marte, “The New Cash Hoarders: Smart or Not-So-Smart?” SmartMoney, June 29, 2011.

Disclaimer:
Past performance is no guarantee of future results.

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.

As government spending hits record levels around the globe, some politicians, economists, and pundits are warning that rising indebtedness may drag down economies and financial markets. This issue has raised concern among investors who assume that a government’s fiscal policy is closely linked to the country’s economic growth and market returns.

The graph below shows the projected state of indebtedness around the world.1 Over half the Organization of Economic Co-operation and Development (OECD) member countries expect to have debt-to-GDP levels above 70%—and the US, Canada, and the UK project debt levels exceeding 80% of their economic output.

Government efforts to stimulate these economies out of recession may partly explain this level of borrowing, which is high compared to historical levels. But longer-term trends such as aging populations, expanding public pensions, and rising health care obligations are compounding the fiscal challenges of these countries.

Global investors may be particularly concerned about the economics of government spending in countries around the world. So how does public debt affect economic growth and market returns? The evidence might surprise you. Although rising levels of government debt create headwinds for economic growth, a country’s deficit and debt levels do not seem to adversely impact capital market returns.

Let’s explore these issues by addressing a few popular questions about sovereign debt:

Do rising deficits drive up interest rates?
Yes. As borrowing increases, a government must offer higher interest rates on its debt to compete for capital. The public sector consumes savings and investment that may have otherwise fueled private sector growth—a displacement of resources known as the “crowding out effect” in economic theory. Additionally, as debt levels rise, market concerns about higher default and inflation risks put additional upward pressure on interest rates.

Consistent with this theory, our analysis shows that current interest rates reflect expectations of future deficits2 but that current government deficits and debt do not predict future interest rates or bond returns.3 So, long-term interest rates rise when the market expects future deficits to increase. However, today’s interest rates and bond prices already reflect information about current government spending, and markets quickly incorporate new information.

Do higher deficits hamper economic growth?
It depends on a country’s debt level. Using World Bank data from 1991 to 2008, we compared current deficits to future GDP growth in sixty-seven countries and found an increasing interactive effect between deficits, debt, and economic growth. High-debt countries that run deficits are more likely to experience lower economic growth over the next three years. But numerous forces may affect a country’s economic direction, and deficits explain only a small fraction of the variation in future GDP growth. The combination of high debt and deficits can create headwinds for economic expansion, but slower growth is not guaranteed.

So investors are justified in having some economic concern about higher government spending and borrowing. But the impact on investment returns is less clear. Let’s now consider the potential effect on equity markets.

Does low economic growth result in diminished equity returns?
No. This relationship can be tested by comparing a country’s GDP growth to its equity market performance in subsequent years. We conducted this analysis using all the developed countries in the MSCI universe, divided each year into high-growth and low-growth “portfolios” based on growth in real GDP. There was no statistical difference between the annual returns of equity markets in high-growth versus low-growth countries. In fact, low-growth countries had slightly higher average returns than high-growth countries.
The graph below illustrates this relationship in terms of a dollar invested in high- versus low-GDP growth portfolios from 1971 to 2008. The low-GDP growth portfolio’s higher annual return would have generated slightly more wealth for the period. The chart details the average annual return and real GDP growth for both groups.

Applying the same methodology to the MSCI emerging market countries shows an even greater return difference, although the data period is much shorter (2001 to 2008). The return of the high-growth country portfolio averaged 19.77% (with 2.5% GDP growth), versus 24.62% for the low-growth portfolio (-4.94% GDP growth).

Other research has confirmed a weak relationship between a country’s economic growth and its stock market returns.4 Several factors may contribute to this decoupling effect. For one, with globalization, a multinational company’s stock price in its home market may not reflect economic conditions in other countries. Also, the fruits of economic growth do not accrue exclusively to public companies, but also to income earners, non-public businesses, and private investments.

Finally, consider that risk, not economic growth, determines a stock’s expected return. Research indicates that this principle also applies to a country’s stock market.5 Similar to value and growth stocks, markets with a low aggregate price (relative to aggregate earnings or book value) have high expected returns, and markets with a higher relative price have lower expected returns. Consequently, while holding a “growth market” may be a rational investment approach, investors should not expect to earn higher returns by tilting their portfolios toward countries with high expected GDP growth.

Do fiscal deficits lead to currency depreciation?
No. It is commonly believed that large fiscal deficits and high debt cause a currency to depreciate as the government borrows more from foreign sources, and investors who are concerned about inflation and default risk flee the currency. Although recent developments in the US would seem to support this relationship, there is less convincing long-term evidence that deficits affect currency rates. During the 1970s and 1980s, the dollar strengthened while the government increased deficit spending.6 This observation is consistent with academic studies concluding that exchange rates appear to move randomly, and there are no models to date that can reliably forecast currency returns.7

Conclusions

Some economists claim that developed market countries are moving into an era of high government deficits and lower market returns. While higher deficits and debt may impact a nation’s interest rates and economic growth to some extent, the investment implications are not easily discerned. History does not offer strong evidence that current deficits predict future bond or equity returns in a country’s financial markets, or anticipate short-term currency movements.

Investors should assume that stock and bond prices reflect all that is currently known and expected about government spending and debt, economic growth, risk, and other issues affecting performance.

Endnotes

1.  The Organization of Economic Co-operation and Development (OECD) is an international economic organization of thirty-three countries founded in 1961 to stimulate economic progress and world trade. It defines itself as a forum of countries committed to democracy and the market economy.

2. Today’s interest rates reflect expectations of future deficit levels. The analysis compared five-year US deficit projections (as a percent of GDP) to yield spreads (five-year US Treasuries minus three-month US Treasuries) from 1992 to 2010. The yield spread increased 29 basis points for every one percentage-point increase in projected deficits. Data sources: Baseline projected deficits from the Congressional Budget Office; yields from Federal Reserve Bank of St. Louis.

3. Today’s deficits do not predict tomorrow’s interest rates or bond returns. Regression results show that current deficits do not reliably predict changes in the five-year US Treasury yield spread (1982 to 2009) or future bond returns (1947 to 2009). Data source: Federal Reserve Bank of St. Louis.

4. MSCI Barra Research Bulletin, “Is There a Link Between GDP Growth and Equity Returns?” May 2010.

5. Clifford S. Assness, John M. Liew, and Ross L. Stevens, “Parallels between the Cross-Sectional Predictability of Stock and Country Returns,” Journal of Business 79, no. 1 (March 1996): 429–451. Their research uncovered strong parallels between the explanatory power of aggregate book-to-market and aggregate earnings-to-price ratios for country stock markets.

6. Another common assumption is that current account deficits and currency appreciation are related. (The current account balance is the difference between a country’s receipts and payments to the world. This account is composed mostly of the balance of trade, with net income and foreign aid playing a smaller role.) Academic research yields equivocal results on whether this relationship holds.

7. Richard A. Meese and Kenneth Rogoff, “Empirical exchange rate models of the seventies: Do they fit out of sample?” Journal of International Economics 14, no. 1 (February 1983): 3–24. Kenneth Rogoff and Vania Stavrakeva, “The Continuing Puzzle of Short Horizon Exchange Rate Forecasting” (National Bureau of Economic Research working paper No. 14071, June 2008).

Disclaimer

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Diversification neither assures a profit nor guarantees against loss in a declining market.

Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.

The 2008 global market crisis and the struggling economy have left many investors fatigued. Despite two years of strong equity returns, some investors have been slow to regain market confidence. Many are accepting the talk about a “new normal” in which stocks offer lower returns in the future.1

The concept of a new normal is anything but new. In fact, throughout modern history, periods of economic upheaval and market volatility have led people to assume that life had somehow changed and that new economic rules or an expanding government would limit growth. What they could not see was how markets naturally adapt to major social and economic shifts, leading to new wealth creation.

Let’s look at other periods when investors had strong reasons to give up on stocks, and consider the parallels to today:

1932: The US stock market had just experienced four consecutive years of negative returns. A 1929 dollar invested in stocks was worth only 31 cents by the end of 1932. Hopes were sinking during the Great Depression, and many people felt as though the economy had permanently changed. Many investors left the market, and some would not return for a generation. Amidst what is considered the roughest economic time in US history, the markets looked ahead to recovery.1941: World War II was raging, and the US had just entered the conflict. The US stock market had experienced two consecutive years of negative performance, and the economy had shown signs of sliding back into depression. Although conversion to a wartime economy would revive industrial production and boost employment, investors struggled to see beyond the conflict. Many expected rationing, price controls, directed production, and other government measures to limit private sector performance.1974: Investors had just experienced the worst two-year market decline since the early 1930s, and the economy was entering its second year of recession. The Middle East war had triggered the Arab oil embargo in late 1973, which drove crude oil prices to record levels and resulted in price controls and gas lines. Consumers feared that other shortages would develop. President Nixon had resigned from office in August over the Watergate scandal. Annual inflation in 1974 averaged 11%, and with mortgage rates at 10%, the housing market was experiencing its worst slump in decades. With prices and unemployment rising, consumer confidence was weak and many economists were predicting another depression.1981: The stock market had delivered strong positive returns in five of the last seven calendar years, and the two negative years (1977 and 1981) were only moderately negative. Despite these results, investors were weary from stagflation, which was characterized by high annual inflation, anemic GDP growth, and unemployment, and from fears of another economic downturn. In late 1980, gold climbed to a record $873 per ounce—or $2,457 in 2010 dollars. (By comparison, spot gold reached $1,256 per ounce in 2010.) Memories of the 1973–74 bear market lingered. A 1979 BusinessWeek cover story titled “The Death of Equities” claimed inflation was destroying the stock market and that stocks were no longer a good long-term investment.1987: On “Black Monday” (October 19, 1987), the Dow Jones Industrial Average plummeted 508 points, losing over 22% of its value during the worst single day in market history. The plunge marked the end of a five-year bull market. But in the wake of the crash, the market began a relatively steady climb and recovered within two years. The effects of the crash were mostly limited to the financial sector, but the event shook investor confidence and raised concerns that destabilized markets would increase the odds of recession.2002: By the end of 2002, investors had experienced the stress of the dot-com crash in March 2000, the shock of the September 11 attacks, and the early stages of wars in Afghanistan and Iraq. Although October 9, 2002, would ultimately mark the market’s low point, investors had endured three years of negative performance and an estimated $5 trillion in lost market value. A younger generation of investors had experienced its first taste of old-world risk in the “new economy.”2008–Today: The market slide that began in 2008 reversed in February 2009—gaining 83.3% from March 2009 through 2010. Despite two years of strong stock market returns, memories of the 2008 bear market and talk of the “lost decade” have led many investors to question stocks as a long-term investment. But earlier generations of investors faced similar worries—and today’s headlines echo the past with stories about government spending, surging inflation, deflationary threats, rising oil prices, economic stagnation, high unemployment, and market volatility.

Of course, no one knows what the future holds, which brings the concept of “normal” into question. What exactly is the status quo in the markets?

The chart below shows the annual performance of the US market, as defined by CRSP deciles 1–10. Since 1926, there have been only four periods when the stock market had two or more consecutive years of negative returns. In addition, annual returns are rarely in line with the market’s 9.67% long-term average (annualized). The most obvious normal may be that, over time, stocks offer expected returns reflecting the uncertainty and risk that investors must bear.

What’s new about that?

End Notes

1. Adam Shell, “‘New Normal’ Argues for Investor Caution,” USA Today, August, 16, 2010. The term “new normal” originally referred to a post-global financial crisis environment characterized by several years of sluggish economic growth, below-average equity returns in developed markets, high market volatility and risk, high unemployment, and a world in which the range of possible financial outcomes is wider than normal and wealth dynamics are moving from developed to emerging economies.

2. Returns for all periods of the CRSP 1–10 Index are annualized. Data provided by the Center for Research in Securities Prices, University of Chicago. Data includes indices of securities in each decile as well as other segments of NYSE securities (plus AMEX equivalents since July 1962 and NASDAQ equivalents since 1973). Additionally, includes US Treasury constant maturity indices.

Disclaimers

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Diversification neither assures a profit nor guarantees against loss in a declining market.

Dimensional Fund Advisors LP (“Dimensional”) is an investment advisor registered with the Securities and Exchange Commission. This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services.

© 2011 Dimensional Fund Advisors LP. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited.