BENEFITS OF STUDYING THE PAST
Quarter 3 | 2023
Author: Jason Kirchhoff
One of the highlights of my summer was getting together with our interns for a reading club. We met monthly to discuss various white papers and articles that I selected to provide a different perspective on markets and investments than what they were getting from their college classes. Many of the research papers focused on the history of markets and how investor exuberance or structural economic shifts can change decades-long relationships. My goal in reviewing these papers was to convey the importance of appreciating the history of long-term cycles and their impact on investment returns. These cycles can seem to be entrenched and often evoke the phrase “this time is different,” but most trends eventually come to an end and the cycles start all over again. There are a couple of current cycles that have been around for a while that are especially meaningful to long-term investors.
1. S&P 500 Dominance
The past 10+ years have been great for investors in large U.S.-based companies. It’s hard to argue against the innovation and growth that has occurred in some of the largest most well-known U.S. companies. While their earnings have increased, their values have increased much faster with the assumption that their growth will continue well into the future. However, one of the reasons we see these types of cycles (great returns followed by poor returns) repeat again and again is because they almost always sow the seeds of their own destruction. Investors often chase what has done well in the past which leads to higher prices, which creates a self-reinforcing cycle that typically ends in a quick reversion to less expensive valuations. Reviewing the performance of the S&P 500 since 2001 is a good example of what these cycles can look like in retrospect.
2. Diversification Benefits of Bonds
Over the past twenty years, the correlation between stocks and bonds has been persistently negative. This has been beneficial for simple stock-bond portfolios as the value of bonds often increased when stocks dropped. However, the past twenty years are an outlier as the long-term historical relationship shows a slight positive correlation. While the relationship between stocks and bonds has many factors, one of the key drivers is the level of inflation. Higher Inflation tends to cause the correlation to be positive and removes some of the diversification benefits of holding bonds. The pace of inflation has been dropping this year, but it is still at a level that is causing this correlation to be higher than at any time since the 1990’s.
We don’t pretend to have the ability to call the tops and bottoms of these various cycles, but we want to build portfolios that take them into account. This can be done by maintaining broad global diversification, allocating to strategies beyond just stocks and bonds, and tilting to undervalued asset classes that have higher expected returns. Building resilient portfolios requires an appreciation of history and the ability to question current trends (even very long trends).
* ANNUALIZED RETURNS ARE MEASURED BY THE GEOMETRIC MEAN OF A GIVEN PORTFOLIO, WHICH TAKES INTO ACCOUNT THE SEQUENCE OF RETURNS OVER A GIVEN PERIOD OF TIME AND MORE ACCURATELY SHOWS THE PORTFOLIO’S PERFORMANCE OVER THAT PERIOD OF TIME AS COMPARED TO A SINGLE AVERAGE.
ALL DATA IS FROM MORNINGSTAR DIRECT. ALL RETURNS ARE TOTAL RETURNS.
THE S&P 500 INDEX IS A CAPITALIZATION-WEIGHTED INDEX OF 500 STOCKS. THE S&P 500 IS DESIGNED TO MEASURE THE PERFORMANCE OF THE BROAD DOMESTIC ECONOMY THROUGH CHANGES IN THE AGGREGATE MARKET VALUE OF 500 STOCKS REPRESENTING ALL MAJOR INDUSTRIES.
THE OPINIONS EXPRESSED ARE THOSE OF MCGILL JUNGE WEALTH MANAGEMENT AS OF THE DATE STATED ON THIS COMMUNICATION AND ARE SUBJECT TO CHANGE. THERE IS NO GUARANTEE THAT ANY FORECASTS MADE WILL COME TO PASS. THIS MATERIAL DOES NOT CONSTITUTE INVESTMENT ADVICE AND IS NOT INTENDED AS AN ENDORSEMENT OF ANY SPECIFIC INVESTMENT OR SECURITY. PLEASE REMEMBER THAT ALL INVESTMENTS CARRY SOME LEVEL OF RISK, INCLUDING THE POTENTIAL LOSS OF PRINCIPAL INVESTED. INDEXES AND/OR BENCHMARKS ARE UNMANAGED AND CANNOT BE INVESTED IN DIRECTLY. RETURNS REPRESENT PAST PERFORMANCE, ARE NOT A GUARANTEE OF FUTURE PERFORMANCE AND ARE NOT INDICATIVE OF ANY SPECIFIC INVESTMENT. DIVERSIFICATION AND STRATEGIC ASSET ALLOCATION DO NOT ASSURE PROFIT OR PROTECT AGAINST LOSS.
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