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Saturday, June 2, 2012

Bizarro Redux

Yesterday was an ugly day in global equity markets, with the S&P 500 down 2.5%.  Markets are again gripped by fear over the economic situation in Europe.  The last few weeks remind me of a post I made last Summer called Bizarro World, which I recommend re-reading.

I think that at times like this, when daily market activity is driven by emotion and overreaction, it's always good to step back and look at some numbers.
  • The original Bizarro World post was on August 10th, 2011.  From then until May 31st 2012 the DFA Core Equity II fund was up 17%.  (DFA Core Equity II is an example of a well-diversified  domestic mutual fund owned by many of our clients). Now, int'l stocks were down over the same period, but the DFA Int'l Core Equity fund was only down 5%.
  • Yesterday, the yield on the 10 Year Treasury Note dropped to 1.4%.  (Here is a good post from Greg Mankiw about Treasury yields.)  According to Morningstar, the dividend yield on the DFA Int'l Core Equity fund was 3.57%.  This is very important information, so let's review.  If you panic and put your money into a 10 year US Treasury note, you are guaranteed a return of 1.4% per year.  This return will very likely lose to inflation.  If you were to put your money into the DFA Int'l Core Equity fund over the same 10 year period instead, you would earn more than twice the return of the Treasury note, assuming the prices of the stocks in the DFA fund are flat over the next decade.
Clearly, this is not an apples-to-apples comparison.  The prices of the stocks could decline over the coming decade and you could lose money.  The companies could decide to stop paying dividends, and the yield could go away.  But the fact remains that we don't know of any other period in the past when dividend yields on a well-diversified portfolio of profitable companies (think BP, Vodafone, Mercedes, Toyota, etc.) were more than twice the yield of US Treasuries, as they are at the present time.  To some people, this screams opportunity, as shown by this Wall Street Journal article about US Hedge Funds heading to Europe looking for bargains.

To be clear, I am not saying that everything is great or that there aren't real economic problems in the world.  I am not saying that stock markets won't decline further. What I am saying is that reacting to fear and panic are not good investment strategies.  As usual, it is best to remain well-diversified, calm and rational.