Tom Madell, Ph.D. Copyright 2002
Look at the following graph of the 3 year performance of the S&P 500:
The graph shows that prior to March 2000, the index was in a sustained uptrend. Beginning in early March 2000, however, it appeared that the trend might be starting to reverse although this was not more clearly evident until about 6 months later. As you can see, the index fell from a March high of over 1500 to below 1000 in late 2001, a loss of over 33%.
Since the S&P 500 is one of the main stock indexes, it would be easy to assume it could be used to represent the trend for most or all stocks. However, such an assumption can turn out to be an unfortunate error. Since the S&P 500 consists only of a blend of large cap stocks, it usually tells us very little about the performance of growth stocks, value stocks, or small cap stocks.
As mentioned in many of our previous Newsletters, during the bull market of the late 90s and continuing through the onset of the bear market, most fund investors had selected large growth funds as the place to put the majority, if not all of their investments. Unfortunately, they placed a relatively small amount of their funds in other types of funds such as value funds or bond funds.
Let's break up the S&P 500 into its large cap growth and value components. These components can be represented by the performance of the Vanguard Growth Fund Index and the Vanguard Value Fund Index respectively. Shown below is a graph of how each of these two components did over the same period as shown above for the S&P 500:
Note: None of the graphs showing specific funds in this artcile (nor those generated by software in general) take into account adjustments to share prices as a result of dividends and capital gains distributions. If adjusted for, such "ex-dividend" price drops, would have the effect of raising the trend line.
By examining these graphs, you can see that the Growth Index fell even more significantly than the S&P 500. Instead of falling by about a third as the S&P 500 did, the Growth Index fell nearly 50% from the low 40s in March 2000 to the low 20s in late 2001. The Value Index, however, while still falling during the same overall period, fared far better: It actually rose during the 12 months after March 2000 and fell only about 25% from March 2000 to its 2001 low.
Now let's go back to the beginning of 2001. What if you, after noticing the apparent unsustainable overperformance of the large cap growth category were considering switching some your investments from this category to potentially undervalued categories. You note from a table listing fund category performance over the 3 years prior to 2001 the following performance figures:
Note: All data in the example are real.
Sounds like such a switch might work, but how can you be more certain?
The potential successfulness of the move might be clarified by examining the category performance data more closely. Upon so doing, you note the following one year category performances:
As you can see, in each case, the magnitude of the longer-term trend has shown signs of changing away from large cap growth and toward the other categories. Such a change in each catgory's trend seems to suggest that these non-large cap growth categories have the potential to outperform. Large cap growth, however, seems likely to be falling back to more normal rates of return.
Trends can best be spotted by examining a graph showing long-term results. However, even if you don't have access to the Internet or other software where you can locate or interactively create such graphs, you can still roughly get the same information, as above, by examining tables of category performance available in many publications that show results over different time intervals.
We have already shown in earlier Newsletters how things would have turned out had an investor put some of his fund assets into the undervalued categories identified above. Needless to say, it would have proven to be a very smart move during the entire bear market that followed.
The following graph shows the performance of the Vanguard Small Cap Value Index over the same period as shown in the 3 graphs above:
You can see that this index fund, which is often used as an average for its category, almost immediately began rising in March 2000. And except for several short-term reversals, it rose for the remainder of the period. In fact, between March 2000 and late 2001, unlike for each of the other graphs, the return remained positive. And for the remainder of the period, the price continued to rise rather dramatically!
And what about the performance of bond funds, which data show held only a very small percentage of investment dollars during the preceding bull market, and even later during the height of the bear market? The following graph shows the performance of the Vanguard Total Bond Market Index over the identical period as for the other graphs.
If you look closely, you will see that the performance of this fund, which can also be used as an average for the entire bond fund category, is almost an exact mirror image of the graph for the S&P 500. Thus, had you recognized the potential overvaluation in stocks and switched some of your investments into bonds, you would have clearly offset some of your losses during the bear market.
Finally, had you invested in the typical real estate equity fund, the results would have been quite similar to those shown in the graph for the small cap value category. In fact, between its March 2000 low and the end of the charted period, the Vanguard Real Estate Investment Trust (REIT) Fund was up an annualized 24.5%!
You might think that these deep divergences between large cap stocks (especially growth) and other fund categories were largely a one time occurrence. However, past studies have shown that you can find similar patterns when the market does poorly. Therefore, if you want to improve your investment performance during shaky periods for stocks, you can use the above methods of identifying patterns of potential overvaluation, and then target a portion of your investments into categories that appear undervalued.
And regardless of when we are talking about, or the overall market climate, some categories will probably have been doing well yet beginning to show the potential for being overvalued. The above methods will help you avoid the crowd psychology of piling into the winning categories. It will also help you spot potentially good choices for some of your future investments.
Tom Madell, PhD
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