Shifting tides

The stock market is frequently looked at as one amorphous whole.  It’s not.

Underneath the calm surface of aggregate stock market statistics are rip-tides of out- and under-performance.  Small companies beating large, value beating growth, foreign beating domestic, bonds beating stocks, commodities beating bonds, etc. 

What seems to surprise investors is how long these trends can last–years, not months.  Looking at 3 or 5 year performance, investors conclude that because foreign has beaten domestic for that long, it must continue.  Just the opposite is the case.

Mean reversion–the tendency of a prices to move back to average–is one of the most powerful forces in finance.  That which has performed best is likely to reverse over the long run.  Just when investors think the tide has gone out, it comes back in.

I believe this is especially the case today.  Specifically, small companies have trounced large over the last five years, bonds have crushed stocks, foreign has crushed U.S., and commodities have crushed…well…almost everything.  But, that which can’t go on forever, won’t.

In particular, I’ve been surprised at how well small has done versus large.  From April 1999 until December 2010, The Russell 2000 (representing small) has beaten the S&P 500 (large) by over 6% a year!  If that doesn’t sound like much, let me rephrase: it’s the difference between no return over 12 years and doubling your money!

Let me clarify: small usually beats large.  Small companies can grow faster and are more nimble, so it’s normal for small to beat large over the long run.  But, the margin is usually a little over 1% a year, not more than 6%.  It’s the difference between having 12% extra money and having over 100% extra. 

Now, this can not last.  And, it won’t.  Regression to the mean will cause large to out-perform small for several years until historical relationships are restored.  I can’t guarantee that, but it’s as close to a sure thing as you can get with investing.

When will the tide come back in?  I don’t know.  I was heavily invested in small companies from 2000 until 2004, so I enjoyed riding the tide out.  From 2004 until now, I’ve been shifting more and more from small to large in anticipation of the sea change.  What has surprised me is that I expected the tide to come in sooner (as it has historically).

Just because the tide seems to be going out more than I thought doesn’t mean I should try to ride it to the last.  Quite the opposite.  The smart thing to do is switch when it becomes prudent and wait for the inevitable.  I’m patiently waiting, and expect to be riding back in to shore soon enough.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Shifting tides