The New Normal

In the NYT, Paul Lim explains why investor optimism may be a red flag:

It’s worth remembering that even though a strong year-end surge has pushed the Standard & Poor’s 500-stock index up 20 percent since the start of September, it’s just part of a tremendous rally over the past two years.

Since the bull market began in March 2009, the S.& P. 500 has climbed more than 86 percent. And investments that are considered riskier than blue-chip domestic stocks — such as emerging-market equities or shares of fast-growing but volatile small companies — have done even better during this stretch. Both the Russell 2000 small-stock index and the Morgan Stanley Capital International Emerging Market index have gained 130 percent.

“We were told that this was supposed to be a ‘new normal’ era where investors should expect lower returns and shouldn’t take much risk as a result,” says James W. Paulsen, chief investment strategist at Wells Capital Management. “But the performance of risk assets over the past 18 months shows that this was anything but a new normal.”

Risk-taking hasn’t been rewarded over just the last 18 months. Despite all the talk about what a “lost decade” this has been for investors, risky asset classes have actually produced sizable gains over the last 10 years. For instance, though the average fund that invests in large-capitalization domestic stocks gained just 1.5 percent, annualized, in that period, small-stock funds returned nearly 7 percent a year. And emerging-market stock funds returned nearly 15 percent, annualized, during that stretch, according to Morningstar.

Risk-taking was also well rewarded in the fixed-income markets. While safe government bond funds gained 4.8 percent, on average, for the past decade, slightly riskier investment-grade corporate bond funds gained 5.4 percent, annualized, and high-yield bond funds — even riskier — returned nearly 7 percent a year.

In general, the more risk you took in asset allocation, the greater your relative performance over the past decade, says Jeffrey N. Kleintop, chief market strategist at LPL Financial.

But that can’t go on forever. Sam Stovall, chief investment strategist at S.& P., looked at how bull markets have unfolded historically since 1949. He found that while the S.& P. has soared 35 percent, on average, in the first 12 months of a new rally, those gains have slowed to an average of 17 percent in the second year of a bull market and just 5 percent in the third year.

Posted by on December 27th, 2010 at 11:14 am


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