Image: Nelson still remains bullish. We wouldn’t be surprised to see the markets make new highs as they have done time and time again over the stock market’s storied history of bull and bear markets, crashes and rip-your-face off rallies, and economic booms and recessions! There are myriad risks, but we’re not overthinking this market. We like stocks for the long haul.
“The active versus passive over-benchmarking plague is hurting investor returns, and flawed measures of risk are disguising the underperformance.” — Brian Nelson, CFA
Dear members:
Latest thoughts on Meta Platforms >>
Latest thoughts on Alphabet >>
One of the hardest parts of investing is keeping your head when others around you are running for the exits. That’s exactly what we did for members (we don’t manage money), and the stock market has come roaring back since the mid-June bottom! Anyone who has read our book Value Trap knows that the rapid fall in the 10-year Treasury yield to ~2.8% today from the mid-3% range in mid-June has helped support this stock market advance (due to a lower cost of capital in discounted cash-flow models — enterprise valuation is the key driver behind stock market performance, in our view, as it has been revealed time and time again). After calling the COVID-19 crash when others doubted the impact that the coronavirus would have on the markets, and then calling the tremendous bull run that followed, we still remain bullish on these markets, and the simulated newsletter portfolios have done fantastic on a relative basis so far this year. See here >>
Helping investors sort through “noise” about the key drivers behind stock prices and stock returns is an important mission of our firm, to help investors out of the statistical weeds and spurious correlations and back into enterprise valuation (the discounted cash flow model). Frankly, we think investors should be tired of the statistical “garbage-in, garbage-out” analysis (i.e. book equity) and spurious correlations out there (i.e. historical stock/bond correlations), particularly after the huge underperformance of the statistical style small cap value the past decade and just how terrible the 60/40 rebalanced stock/bond portfolio has performed during the most recent bear market, adding to the portfolio’s tremendous weakness during the past decade–a decade that has included all parts of the economic cycle, a once-in-a-lifetime pandemic, and more. This “stuff” was supposed to work over time, right? Clearly, something is not adding up in “quant land.”
According to data from Morningstar, the Vanguard Balanced Index (VBINX), which is the rebalanced 60/40 stock/bond portfolio, is down nearly 12% so far in 2022, while the SPDR Dow Jones Industrial Average ETF (DIA) is down less than 10%. During the past 10 years, the VBINX is up ~130%, while the DIA is up 150%+ — data from Morningstar. You’re going to have a hard time convincing us that statistical-based asset allocation has helped investors the past few cycles. Let’s think about this: The most commonly-used rebalanced stock and bond portfolio has done worse that the plain-vanilla Dow Jones Industrial Average during the bear market of 2022 (when it was supposed to cushion the blow), and it has underperformed during the past decade, too (leaving return on the table)! For investors seeking generational wealth (as most generally should be), what’s the value in hurting returns across almost all market environments?
“Empirical,” “evidence based” and “data driven” statistical analysis and backward-looking correlations, as in quant-based factor investing and modern portfolio theory, have simply fallen short by a huge margin in recent history. Investors that were attracted to the backtests of the quant small value factor that uses book equity, for example, have been particularly hurt, as the area of large cap growth has outperformed considerably thanks to the rising value of intangibles the past 10 years (i.e. tremendous free cash flow generation on asset-light entities)–something that enterprise valuation, or the discounted cash-flow model, picks up but traditional quant analysis that uses accounting book equity doesn’t. The Schwab US Large Cap Growth ETF (SCHG), for example, has advanced over 300% the past 10 years, while small cap value, as measured by the iShares Russell 2000 Value ETF (IWN), has advanced just 115% — all data sourced from Morningstar. Quants and “backtesters” have had it completely backwards the past decade, expecting the opposite (i.e. small value to outperform large growth).
Enough with volatility as a measure of risk, right? It’s counter-intuitively hurting investors as bear markets remain too brief. Enough with backward-looking correlation analysis and poor asset allocation decisions, right? It’s causing investors to leave too much return on the table. The financial industry with its arguably-warped benchmarking analysis has investors completely confused, too. Imagine comparing the Schwab US Large Cap Growth ETF–SCHG–to another identical, but slightly better performing, holdings-based large cap growth index and then concluding the SCHG is not “good enough” relative to the benchmark based solely on this holdings-based analysis–and then instead of buying the SCHG, one employs something like the rebalanced stock/bond VBINX, which massively underperforms the SCHG by nearly a couple hundred percentage points during the past 10 years. What’s really not good enough, right?
The active versus passive over-benchmarking plague is hurting investor returns, and flawed measures of risk are disguising the underperformance. The reality is that it’s okay to actively underperform a stock index with a collection of equity securities if it means you’re managing risks in doing so, as long as you’re still outperforming traditional asset allocators that rebalance stock/bond portfolios. Those underperforming stock/bond portfolios, which use stock and bond allocations to manage risks instead of active stock selection, often come with additional fees levied on them. They are THE benchmark — they are the opportunity cost for investors to beat with their own hands-on risk-management strategy, whether all-equity or not. From my perspective, one should not be using a holdings-based benchmark of the same or similar stocks that one already holds to assess how well you’re doing, as is the present line of industry “logic,” but rather, one should have a benchmark consisting of stocks and bonds that measures your personal opportunity cost, or what you would have achieved with a stock/bond portfolio after netting additional hypothetical management fees you would have paid to outsource that portfolio, had you not pursued your present do-it-yourself strategy, whatever that may be.
Quite simply, it shouldn’t matter if “active” is underperforming, if the alternative is to do much, much worse as those falling into the academic statistical traps consisting of often-expensive and flawed asset allocation models. Common sense, right? Just look at the numbers and returns in this article (i.e. compare the SCHG vs. the VBINX, for example). The answer to us continues to be as simple as it is clear: Stocks for the long haul! Always work with your personal financial advisor, of course, but I truly feel that we all are lucky to be able to see the light, and not be blinded by the failed (data) science and over-benchmarking that has troubled investors with stock and bond allocations, arbitrary value versus growth indices, and flawed measures of risk, all the while these same investors struggle to grasp why the markets have soared the past month on the back of a falling 10-year Treasury yield. Enterprise valuation pointed to large cap growth as the clear winner the past decade, not because of backward-looking statistical analysis but because of the key drivers behind enterprise valuation. It’s been a fantastic ride with considerable exposure to large cap growth these past 10 years, and one that we’re still on. The image below, taken from our book Value Trap, provides some of the key drivers of stock prices and stock returns for your convenience.
Image: Everyone, please read the second edition of the book Value Trap for insights on what moves the market.
Now, what do we think about this market? Well, quite simply, we’ve never been more bullish on stocks for the long run. This is not the Great Financial Crisis or the COVID-19 meltdown. This is a run-of-the-mill stock market pullback, with temporary elevated levels of inflation, in our view. We expect large cap growth to lead the market out of this pullback, too, as it already has started to do. Meta (META) and Alphabet (GOOG) remain two of our favorite ideas for consideration. Please have a read of our work on them in the article links that follow.
Latest thoughts on Meta Platforms >>
Latest thoughts on Alphabet >>
The latest industry report update is the Industrials industry, published today here. We’re monitoring the developments in the payments industry as it relates to PayPal (PYPL) and Visa (V) here, and we have thoughts on Exxon Mobil (XOM) and Berkshire Hathaway (BRK.B) in the queue. Stay tuned. The Exclusive publication is up next, to be released tomorrow August 8, in accordance with its modified publishing schedule. Going forward, please expect the Exclusive publication to be released on the 8th of each month, instead of the first Saturday. This will allow us to better serve your needs! All in all, what a great time to be a stock market investor for the long run!
Brian Nelson, CFA
President, Investment Research
Valuentum Securities, Inc.
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Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, BITO, and IWM. Valuentum owns SPY, SCHG, QQQ, VOO, and DIA. Brian Nelson’s household owns shares in HON, DIS, HAS, NKE. Some of the other securities written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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