Emerging market funds example of why not to rely on past performance

By DAVID MOON, Moon Capital Management, LLC
January 29, 2012

A year ago, the most popular investments included stocks in foreign countries, especially developing economies. China, India, Brazil and Taiwan dominated the news. I halfway expected Wal-Mart to introduce a new store concept, the “Emerging Market,” where they would only sell products made in the US.

Emerging market funds increased 18 percent in 2010. Conventional wisdom suggested these areas would continue to be profitable in the coming year.

Conventional wisdom is usually either conventional or wise, but seldom both.

Despite a continuation of the extraordinary economic growth in most of those countries, emerging market funds declined 16 percent in 2011.

Why was there such a disconnect between the performance of the underlying economies in those countries and the performance of their stock markets? And how could so many financial experts miss it?

The second question is the easiest. Most investors, both professional and the do-it-yourself kind, usually expect a continuation of the most recent past. A momentum investment strategy is wonderfully simple to employ, while also lending itself to an illusion of esoteric analyses that professional advisers can use to impress their clients. However, Newton’s first law of motion (“a body in motion tends to stay in motion…”) is excellent physics, but it is a terrible investment strategy.

The stock and economic performance of a country can differ over a period of months – or even a year or two - for the simple reason that the economy is not the stock market.

In the past 80 years, the US experienced 14 officially declared recessions. The Dow Jones Industrial Average increased during eight of them.

Valuations are more important in determining investment returns than whether or not GDP increases or decreases a percentage point. When stocks are inexpensive relative to earnings or some other objective, tangible measure, they are more likely to produce positive returns in subsequent periods.

Any effort an investor spends extrapolating past investment performance or trying to predict immediate changes in the economy is wasted. That is, unless the investor’s goal is to produce cocktail party banter.

From 1996 to 2006 US residential real estate prices increased an average of 8.9 percent annually. Inflation averaged 2.5 percent. Investors who simply assumed a continuation of that trend borrowed and bought. They flipped. They became day traders of houses.

They prospered – at least until they didn’t. And then they crashed.

What they missed in the interim was that real estate prices had increased well beyond what increases in the general cost of living would suggest or support.

They ignored the prices they were paying.

Smart investors are the ones who are now buying houses for a third of their selling prices only five years ago. They do not simply expect a continuation of the trend. They recognize a disconnect between the prices and values of these properties and are willing to buy at what they think are bargain prices, even if they are early and have to wait a bit to realize their profits.

Comedian Marty Allen was right. A study of economics usually reveals that the best time to buy anything is last year.

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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