In 1960, some 55 years ago, stocks on average were held for an average of eight years. Today, the average stockholding ownership period is about five months.
The investment question is: are investors doing better by trading their portfolios almost twenty times more often than 1960? The answer is no. Market returns over the last decade have been lower than in 1960. While other factors enter into this (industry marginalization, credit quality, etc.), one of the more pronounced reasons for the erosion of returns is the cost of trading. As people treat stocks less like part ownership of companies and more like casino chips, and hedge funds play chicken with the direction of the market. The average investor finds himself in a situation where information overload causes people to react by buying or selling shares in unison. Thus, the stock market becomes increasingly volatile, and people become afraid of it.
The rise of mutual funds and electronically traded funds (or ETFs) has contributed to this trend. When people held individual stocks and bonds, they had some sense of what they owned. When packaged investment products became popular, the focus was less on ownership and more on return. Portfolio managers of actively traded funds felt the need to constantly buy and sell, so as to keep abreast of their competitors over increasingly shorter time frames. The idea of buying and holding a stock for three to five years became a recipe for underperformance and loss of job, given that at some point, the portfolio would inevitably underperform. Managers were expected to put on a floor show for their clients by rapidly buying and selling, as an indication of portfolio activity and oversight. The basis of the buying and selling was the day-to-day information available on stocks and the market in general. As information became more widespread via cable TV, the demand to “do something” increased as well.
Into this situation stepped John Bogle, the head of Vanguard Funds. If you cannot beat the market, buy the market. Thus the rise of index funds, managed by computers, which reflected their associated index.
Indexing has not stopped portfolio volatility. As indexes gyrated, people began dumping index funds in response to news headlines advocating the same. Indeed, one can make a case that volatility has increased with the popularity of indexing, not the other way around.
Add to this mix the rise of computerized trading, where managers try to use patterns of stock movements to get into and out of a stock, all in the matter of seconds, and volatility was set to increase once again.
The underlying theme of all the strategies is, in essence, greed. People want a high return on their investments, and they want it now. The idea of buying and holding something because you believe in its future has become, to those who do not practice this type of investing, quaint. Better to get in and out and leave someone else holding the bag.
In the transition of the stock market from a place to raise capital and make investments to a “casino”, no one is asking the central question. Who is better off over time, the speculator who holds for brief periods, or the investor with a longer time frame? There is data to support the idea that, at least among stocks with value attributes, outperformance comes from holding over time. This superior return comes from two sources. The recognition of the value of an investment, along with the lower trading cost that comes from holding something for longer, and the ensuing lower tax rate accrued.
This is not to say outperformance occurs for each and every period for the value investor, or for each and every investment. For the greedy, who want to get rich quick, waiting for an investment to bear fruit is like watching paint dry. But get rich quick investing has its risk. It has so much risk that, in fact, it seldom works out. Were this not the case, all investors would adopt this strategy.
Warren Buffett used to be fond of describing the stock market as short-term, a voting machine and long-term, as a weighing machine. By this he meant that a stock can be high on any given day simply due to more buyers than sellers. Over time, the company has to generate profits to justify its stock price going up. If you are buying and selling in rapid-fire order, what the company does or will do is of little consequence. However, at some point, such matters do weigh on the stock’s price. Whether it supports the stock or sinks it, depends on the value at hand.
Lost in all the market turmoil of the past three weeks is the fact that the US Economy continues to expand and gain momentum. Last week, second quarter GDP was revised upwards to 3.7%, from 2.3% previously. At the same time, the index of inflation used by the Fed edged down to 1.2% annualized, from a 1.3% rate previously.
There are several reports to be released by the Government this week, but none are as important as the estimate of U.S. Non-farm Payrolls for August, due out on Friday. The consensus is for 220,000 jobs to be added to the labor rolls in August, with the unemployment rate declining to 5.2%. A higher number would support an increase in interest rates sooner rather than later.
The parlor game of when interest rates will rise continues. There was a consensus that rates would rise modestly in September, but international financial market instability seems to have pushed that back to later this year.
The strength of the US dollar over foreign currencies may provide the Fed with some cover in raising rates. As rates rise due to the Fed’s withdrawing of funds from circulation, the higher rates could attract foreign money that would keep the increase at a modest level. As the economies of other countries improve, the funds would flow out of the US again, but presumably at that point the US economy would be strong enough to attract domestic savers again, offsetting the foreign funds outflow.
While inflation numbers are still benign, we are approaching the anniversary of oil’s collapse one year ago. As we enter the new year, much of oil’s decline will be past, and inflation will more likely reflect the dynamics of a stronger economy, and justify higher interest rates in the process.
The Stock Market
In spite of all the gyrations, domestic stocks as a group are off about ten percent year-to-date, although down almost 17 percent from the highs set earlier in the year.
Given the confusion and anxiety generated by various media outlets, many investors are focusing more on the negatives than the positives. For example, growth in China is expected to decline, but to a rate of 7 percent, down from 10 percent per year previously. While decelerating, this is hardly a negative number.
While commodity prices in general are still down sharply, the rally last week in oil caught some people by surprise. Stability in energy prices, or even a rebound, would help to change the tone of the market greatly.
Warren M. Barnett, CFA August 31, 2015