Second Quarter 2011 Letter to Clients

Five hundred points.

That is the gain the Dow Jones Industrial Average logged in just four trading sessions the last week of June. An investor who stayed invested 11 of the 12 weeks during the quarter and then bailed out the last week when the news was at its worst would have locked in a 3% loss for the quarter. In contrast, an investor who stuck around that last week finished with a 1% gain.

This is a vivid illustration of how quickly things can turn around in the stock market despite an overwhelming amount of negative news. We have made the point repeatedly that stocks make their gains in short, dramatic, unexpected bursts. Though missing out on a 4% gain like the one we saw in June may not seem like a big deal, if you miss only a few of those bursts over time, your equity premium – the return that stocks earn above the risk-free Treasury bill rate – is gone.

Buried in the midst of all the bad news about the continuing struggles of Greece to get its fiscal house in order was an interesting tidbit about the rally in the Wall Street Journal’s Marketbeat blog on June 30:

“Now, one day doesn’t mean a lot. Four days may not mean much either. But the market is speaking a different language than the stark, grim headlines that continue to dominate. Seems a quiet bid on recovery is underway.”

The word “recovery” has not been seen much in the news stories that have dominated the press in recent weeks (unless it was preceded by the word “anemic”). So why would the stock market rally in the face of such a grim political and economic environment?

As usual, the media misses the broader point: Investing in the “stock market” is really about investing in “companies,” and U.S. companies have been churning out strong profits by running tighter, more productive enterprises during these lean economic times. And when companies with low share prices suddenly begin churning out large profits, their shares will quickly be bid up by investors who want to get in on the action. This, in turn, causes the overall market to rise.

It’s a simple concept, but one that is disconnected from the overall macro-economic environment. Most people assume that a tough economy is also tough for stocks, but the ability of companies to respond to those environments by being nimble in their operations is vastly underappreciated. As a recent article in Barron’s so aptly observed:

“The doubling of the stock market has almost precisely tracked the path of large-company earnings. In 2009’s first quarter, when the Standard & Poor’s 500 bottomed below 700, earnings of S&P companies were $12.83 per share. In the current quarter, the consensus forecast is $24.69. It’s hard to get closer to an exact doubling of Corporate America’s bottom line.” (Michael Santoli, “The Yes-Yes Market,” Barron’s, May 14, 2011)

* * * * *

“You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all—not some—all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”
                                                                                              – Warren Buffett

Leave it to the Oracle of Omaha to put the recent gold craze into practical perspective. It is nearly impossible to turn on a TV or pick up a magazine these days without quickly being bombarded with an advertisement explaining how you – yes, YOU! – can jump in on the ground floor of the incredible opportunity that is gold!

Yet, when you examine the data, the case for investing in gold is hardly compelling. And when you factor in the recent gold mania, investing in gold seems downright insane.

Here are three points to consider about gold as an investment:

1. The price of gold is extremely high by historical standards: Going back to 1914, gold is the highest price it has ever been. Even adjusting for inflation, the current price of gold was exceeded only by the gold bubble of the early 1980s:

Things went badly for those who jumped on the gold bandwagon in the early ‘80s, with gold prices plummeting about 80% (inflation adjusted) over the next twenty years.

2. Gold has historically been a lousy inflation hedge: Many gold investors defend the current high valuations of gold by touting its benefits as an inflation hedge. With all the liquidity that has flooded the global financial system since the 2008 financial crisis, they say, a spike in inflation is not only likely but actually inevitable. And they believe gold will protect them from that scenario.

As we have noted before, individuals who make investment decisions based on “inevitable” things yet to come very often end up making catastrophic mistakes. But, for the sake of argument, let’s assume we are poised for an inflationary spiral in the years ahead. Does gold, in fact, provide the reliable hedge against inflation that most investors assume it does?

The data says no. First, consider the following chart showing gold’s 30-year correlation to inflation (keeping in mind that 1.0 represents a perfectly positive correlation and -1.0 represents a perfectly negative correlation):

Clearly, the correlation between gold and inflation has fluctuated dramatically over the past three decades. Sometimes gold and inflation move inversely to one another, and sometimes they move in lock-step. And that hardly makes for a reliable hedge.

Moreover, as the next chart shows, gold has generated both high and low returns in both high and low inflationary environments. (Note that the pink shaded area indicates the core inflation rate, pegged to the right scale, while the yellow line represents the annual return of gold, pegged to the left scale):

3. Gold has generated poor long-term returns: From its peak price in 1980, gold generated a compound annual return of 2.7% per year through 2010, compared to 3.2% for the Consumer Price Index. In contrast, common stocks, as measured by the S&P 500 index, compounded at an annual rate of approximately 11%, including dividends, over that 30-year period. (Source: Tweedy, Browne Company 2010 annual report).

So, if you are interested in an investment that is a lousy inflation hedge, has historically generated terrible returns, has no intrinsic value other than what mankind arbitrarily assigns to it, and whose price is at historical highs, then by all means turn on the TV and you’ll find no shortage of ways to seize this remarkable opportunity.

Otherwise, we would not recommend it.

* * * * *

The media is full of quotes from active managers – those whose stated goal it is to beat the market – giving investors advice about what moves they should be making based on current conditions in the market and/or the economy. But should we listen to them? Two new studies from Dimensional Fund Advisors (DFA) cast into doubt the ability of active managers to consistently achieve the market-beating returns they claim to deliver.

The first study took a look at the percentage of actively managed mutual funds that failed to beat their benchmark during the decade of the 2000s as indicated by Morningstar (blue numbers), and then compared that to a database that included all the funds that were closed or merged during the decade (red numbers).

As you can see, while at first glance it appears the majority of active managers beat their benchmarks in nearly all categories during the 2000s, once the closed and merged funds were added back to the data set, the opposite was revealed to be the case. The number of funds that failed to beat their benchmark increased dramatically – sometimes more than tripling! In every single category, the majority of actively managed funds failed to deliver any value for their investors above what the benchmark would have given them.

It is one of the great sleights-of-hand in the investment industry that funds that are closed or merged disappear from the industry data. Such funds are usually the worst performers, and fund companies are delighted to be able to remove them from their fund family’s performance history. This allows those fund companies to tout the fact that “all of our funds have a five-year rating of four or five stars” while conveniently omitting the fact that all their underperforming funds were closed or merged with more successful funds.

And what of those successful active managers? Do the few managers that actually do beat their benchmark in a given year maintain that market-beating performance over time? Again, the clear answer is “no”. The following chart shows the percentage of funds that beat their benchmark in 2005, and then continued to beat their benchmark in the years ahead:
Of the original group that beat their benchmark in 2005 – nearly half of the funds studied – less than 10% sustained that market-beating performance for two straight years, and only 1% managed to continue their market-beating streak over the next five years. This clearly raises the question of whether an active fund that beats its benchmark in any given year was good, or merely lucky.