Investors sometimes drawn to past winners

By DAVID MOON, Moon Capital Management, LLC
November 14, 2010


Everybody loves a winner. Unfortunately, we tend to be attracted to past winners, not future ones. It may make us feel good at the time, but it can be a pretty dangerous investment strategy.

A little more than ten years ago, a common theme in investment circles was the invincibility of the S&P 500. Although the price/earnings ratio on the popular stock index was more than twice its historic average, folks argued that valuations were irrelevant - if for no other reason, because of the amount of money flowing into index funds from 401(k) plans.

The argument was that this flow of money had created a perpetually new valuation metric. Earnings were less relevant than momentum. Investing was, according to the then-popular stock mantra, a popularity contest.

It was also about this time that homeowners and lenders decided that traditional debt metrics were no longer relevant and folks could carry much greater mortgages, total debt and monthly debt service than once believed. After all, home values would perpetually increase faster than the rate of inflation. "They're not making any more land" became the new real estate mantra.

The S&P 500 produced an average annualized return of negative 2.72 percent during the next ten years. The home mortgage mess is even more well-known.

Looking at today, where might be the bubbles of the next ten years? That is, what asset classes are popular primarily based on their past performance?

The most obvious answer is gold. I understand and share people's concern about the value of the dollar and the Fed's irresponsible attempt to micromanage just a tad of inflation into the economy. But we are not going to return to the gold standard. The gas pumps at Pilot are not going to begin accepting small blocks of bullion.

Gold is popular today because since January 1, 2000 it has increased almost 400 percent. People can concoct reasons to justify their gold fever, but if gold was still $290 an ounce few people would be gold bulls.

If you don’t believe me, look at the returns of stocks and gold prior to 1990.

From 1989 to 1999 the S&P 500 increased 15.3 percent a year. Gold declined 3.12 percent a year. No wonder people preferred stocks to gold in 1999 – at exactly the wrong time.

In the past three years investors have moved money from stock mutual funds into bond funds. Is it a coincidence that during the past ten years the bond market increased an average of 7.39 percent a year?

Is there a bond bubble brewing?

Another area that is popular today is emerging markets. According to the Morningstar mutual fund data, the average diversified emerging markets equity fund increased 9.21 percent annually from 1999 to 2009. Given that investors are basing much of their confidence on their ten year performance, does it concern anyone that the average tenure of the manager in these funds is only 3.9 years?

Once again, investors are betting on the winner of the last war, not trying to logically predict the winner of the next one.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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