Is it a good idea to drive your car looking in the rear view mirror?  Probably not, unless you want to get in an accident.  Why then do many people invest their money the same way – looking in the rear view mirror at performance?

The answer is grounded in hindsight bias.  People adapt to the circumstances they have experienced and then are surprised when the future is different than the past.  Because the US large cap sector, in particular, the S&P 500, has done so well over the past few years, most people expect the outperformance to continue and hence invest more money in the same sector.  But this logic goes against the historical cycles of growth versus value, domestic versus international and so on.

Recently, we had a very conservative client say to us “I want to invest in something safe – the S&P 500 Index”.  This type of comment feels eerily similar to prior times of complacency (i.e. 1999).  This person is not the only investor being lulled into US large company stocks because of their recent outperformance.  In our opinion, equity valuations show that large company US stocks offer the least amount of upside potential compared to other investment options.

US large company stocks, as measured by the S&P 500 Cyclically Adjusted P/E Ratio (“CAPE”), currently stands above 30x.  This mark has only been eclipsed two other times in the past – in 1929 and 1999.   By comparison, the CAPE ratio for emerging market stocks is anywhere from 11x to 15x, depending on which index you use.  This divergence is one factor in why we are overweight international stocks (with a higher exposure in emerging markets) and underweight US large company stocks today.  This is in contrast to our position in 2009. At that time, we had minimal exposure to international stocks and no exposure to emerging markets and were overweight US large company stocks.  However, it is important to recall that in 2009 the media was touting Brazil, Russia, India, China and South Africa – the so-called (“BRICS”) – to supplant the United States economically.

The following chart shows the annual returns for the past nine years ending June 30th, 2017 for US large company stocks, emerging market stocks and developed international stocks.  It depicts the pitfalls of investing looking in the rearview mirror:

Index 6/2008-6/2017 6/1999-6/2008
S&P 500 Index 9.71%  0.88%
MSCI EM (emerging markets) 1.62% 13.81%
MSCI EAFE (developed Int’l) 2.41%   5.63%

Source: Thomson Reuters

Why was everyone touting the BRICS in 2009?  Hindsight bias!  Stocks in those countries had appreciated 13.81% annually over the previous nine years when US stocks were up only 0.88% over the same time period.  It did look like they were taking over the world.  We see the opposite occurring today with the S&P 500 up 9.71% annually over the past nine years while emerging markets were up only 1.62% during this same time.

Congratulations to Jimmy Stechschulte!

Please join us in congratulating Jimmy for passing the third (and final) level of the Chartered Financial Analyst exam.  Jimmy has devoted much of his free time over the last several springs to studying for this exam and he deserves a lot of credit for his desire and dedication to making it happen.  The knowledge he has gained from the program will prove invaluable for all of you moving forward.

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