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I referenced a study published in the Social Science Research Network (SSRN) in my March 27, 2023, “Capital Ideas” column. The SSRN website has become a favorite new geek of mine. On it, I found a study published by Hendrik Bessembinder, Michael Cooper, and Feng Zhang called “Mutual Fund Performance at Long Horizons” (MFP@LH).
I’ve previously cited reports, primarily by Dalbar, which illustrated how unlikely it is for professional and individual investors to outperform the broad market consistently. The MFP@LH study supports that notion, so I’ll spare you redundancy and highlight mostly the fun nuances and augmentations.
It is important to note that numerous books (including “The Psychology of Money”) support the notion that investment performance should be a tool, not a goal.
Mutual funds are an excellent tool for data collectors because their information is publicly available. Mutual funds are run by well-staffed professional teams with access to technology, resources, instant information, and corporate management that we regular folks cannot utilize. If any investments beat the market, it would be mutual funds. But they don’t, not regularly. So, shouldn’t it stand to reason that instead of relying on superior returns to fund our retirement, we should A) avoid catastrophic mistakes, B) reduce taxes as much as possible, and C) continuously monitor our overall financial plan to be sure we achieve A and B?
If your aim is to outperform the market, that’s awesome. I won’t suggest you shouldn’t do that—I don’t know you. Your circumstances might advocate that you take a more considerable risk. However, you may not need the highest returns possible to ensure you don’t run out of money in retirement. In that case, you can decrease your chances of making a catastrophic mistake by investing like me—a boring, old person who doesn’t want to lose money.
You know the gist of the Mutual Fund Performance at Long Horizons report—most mutual funds don’t beat the S&P 500 over monthly, annual, or decade-long horizons. The study tracked 7,800 U.S. stock funds from 1991 through 2020. Individual fund investors (ordinary people using mutual funds as investments) experienced returns 10 percent less than those underperforming mutual funds due to the natural human tendency to buy high and sell low.
But what about those investment managers who argue that they’ll just put money into their best ideas? Other studies have shown that the fewer stocks a fund owns, the lower its returns. It would be prudent to diversify risk to reduce the chance of a significant loss while simultaneously increasing the chances of a better investment return.
The Calm Before Even More Calm?
In last week’s column, I cited the high degree of complacency by stock market investors. Specifically, I argued that although many pundits contend that a low VIX (aka the “volatility index,” aka the “fear index”) was a sign of a stock market crash to come, it doesn’t predict much more than a 10 percent correction.
If I had to scramble to find the good news in a stock market correction, I contended that such a drop would happen as “1) stock prices already priced in a recession, 2) inflation is being tamed, 3) corporate earnings stabilized and are moving up, 4) and the Fed is no longer raising interest rates.”
However, if the stock market doesn’t drop 10 percent, it’s not just because it’s looking past an economic downturn. The stock market is embracing the idea of a recession.
The stock market is trading near the top end of its two-year range, seemingly ignoring the growing risks of a recession. Why? Because every recession for the last half century has cured the problems companies face today.
Profit margins for S&P 500 companies for the first quarter of 2023 should be about 11 percent. While that’s near the pre-pandemic high, it’s also declined from about 13 percent throughout the last five quarters. Lower margins should slow corporate hiring, and stock prices should embrace those cost controls. Prior to the pandemic, businesses hired when they were forced to because employees stretched to the limit of declining productivity per worker. Whether good or bad in other ways, that approach kept wage expenses under control. Since 2021, U.S. companies have gone from a “just in time” hiring mode to a “hire everyone we can” attitude.
Businesses hired and gave little attention to the return they would have on that human capital. That pushed U.S. labor force productivity growth to the negative for the last three quarters of 2022. For context, labor force productivity went negative for two consecutive quarters only twice during the previous three decades (Q3/Q4 1993; Q3/Q4 2011). We have to go back to the recessions of 1974 and 1982 to find other three-quarter stretches of declines. Labor force productivity has grown at an average of 2.0 percent annually since 1960. After the last eight recessions, it has increased at an average rate of 5.4 percent because companies will lay off less productive workers.
A more productive workforce, and better cost control, puts companies in a position to expand earnings growth as the economy accelerates. New highs in net income might not occur right away. But that is OK for the stock market because it tends to reflect the path of bad-to-good and not absolute levels.
A recession would also push down inflation, causing the Federal Reserve to pause its interest rate hike campaign. The Fed could even act as it often does during a recession and cut rates. This would support stock prices.
An economic contraction would not necessarily raise the stock market to record highs in quick order, but it would clear a path by eradicating some headwinds. This is a good case for holding equities even if there is a meaningful chance of a 10-percent correction.
However, I am no Pollyanna. The decline in quarterly earnings from its 2022 peak to Q1 2023 is only about 11.2 percent. It isn’t unusual for S&P 500 earnings to drop about 20-25 percent during a recession, yet stocks are near their two-year highs. Talk about complacency! I’ll remain invested in stocks—holding my hedges—but I’ll keep watching to be sure we don’t make a catastrophic mistake.
Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
