Beginning in the summer of 1997 a number of southeast Asian countries experienced a financial crisis that would wreak havoc on their currencies and the broader emerging markets in general. Countries like Thailand, Indonesia and South Korea all experienced a severe depreciation in their currencies.

The MSCI Emerging Markets Index proceeded to get chopped in half over the next year or so, dropping 56% from August 1997 to August 1998. U.S. markets brushed off the turmoil for the majority of this period. From August 1997 to June 1998, the S&P 500 was up 21% while emerging markets fell 40%.

Then in August of 1998, the Russian government was forced to devalue their currency and default on their debt as their own problems came to light. Hedge fund Long-Term Capital Management blew up in the process and markets everywhere were affected.

The losses were swift and unforgiving for stock markets around the globe as you can see the damage done in just two short months:

S&P 500 -15.4%

Small Caps (S&P 600) -25.5%

Mid Caps (S&P 400) -21.8%

Emerging Markets (MSCI EM) -26.7%

Foreign Stocks (MSCI EAFE) -11.5%

The crazy thing is that stocks recovered relatively quickly following the dramatic fall. These were the total returns from September 1998 through March 2000:

S&P 500 +59.8%

Small Caps (S&P 600) +48.4%

Mid Caps (S&P 400) +81.2%

Emerging Markets (MSCI EM) +113.9%

Foreign Stocks (MSCI EAFE) +49.0%

This was the last leg higher before the tech bubble burst and the S&P 500 was eventually cut in half over the ensuing 2-3 years.

Some market observers seem to think that we may have experienced our own 1998 moment in the latter part of 2015 and early 2016. Here were the returns in those same markets in that time:

S&P 500 -15.3%

Small Caps (S&P 600) -22.3%

Mid Caps (S&P 400) -23.2%

Emerging Markets (MSCI EM) -39.8%

Foreign Stocks (MSCI EAFE) -25.5%

Anything is possible, but it doesn’t feel like the recent downturn had the same type of macroeconomic backdrop as its 1998 counterpart. Here’s Peter Bernstein on the 1998 affair:

We now digress briefly to discuss an important instance of high macro volatility in August 1998, when stock prices fell by over 14 percent, the largest one-month decline since the famous crash of October 1987. A monetary crisis had been moving across Asia for some months, but on August 17, without warning, the Russians abruptly defaulted their government bonds, devalued the ruble by 25 percent, and declared a three-month moratorium on foreign obligations of Russian banks. The Russians had issued $3.5 billion of euro-denominated debt as recently as July 24. The most shocking feature of this debacle was in the default on bonds denominated in rubles as well as in foreign currencies; defaults on bonds denominated in foreign currencies have been all too frequent in financial history, but defaults on obligations in a country’s own currency have been rare. Financial markets worldwide responded to the shock with steep price drops in price.

I guess you could say oil falling roughly 80%, the potential for a huge slowdown in China and negative interest rates around the globe set the stage for this latest bear market, but it hardly seems as bad as the 1998 episode.

Regardless, it makes sense for investors to understand risk from a historical market perspective. People seem to assume that market volatility has been far above average since the financial crisis, but swift market downturns are not a new phenomenon. Markets have always had air pockets that get filled to the downside (and the upside as well). It’s best that investors remember this now as we continue to inch closer to new all-time highs in stocks.

There is always a risk of an uncertain event throwing a wrench into your best laid plans. I don’t think it’s necessary for investors to constantly shy away from volatility, but it’s worth remembering that unexpected shocks come with the territory when investing in risk assets.

Source: Capital Ideas Evolving

Further Reading: Even Bull Markets Aren’t Easy

——-

This post from Ben Carlson (@awealthofcs) originally appeared on A Wealth of Common Sense.

The trouble with evaluating the success or failure of an asset allocation model over a short period of time – or in real-time – is that one of the primary benefits to the strategy involves non-correlated assets – and correlations aren’t constant.

A given asset class, like emerging market equities or corporate bonds for example, will display an oscillating amount of correlation to any other given asset class over any multi-year period. And then, in the next multi-year period, that correlation could change markedly once again.

Consider that REITs and Treasury bonds could either move in lockstep, move in opposite directions or switch back and forth in completely random cycles. However, when the lens is widened and you take several steps back, the non-correlated nature of two asset classes often begins to shine through – thus demonstrating the free lunch concept and its virtues for a retirement-bound investor.

We want non-correlated assets over the long term because their differences in performance allow us the opportunity to rebalance from winners to losers and pick up potential premiums that other, more short-term oriented investors are dropping at our feet. This is a logical, sound and proven strategy – but it is a strategy that many have a tough time sticking with.

It’s frustrating to an unsophisticated investor when three quarters of their portfolio is going up and one quarter is going down. The response is almost always something along the lines of “Why can’t we just own the stuff that’s going up now?”

LPL is out with a mid-year outlook piece that has lots of interesting information in it, but I especially liked this portion about how the benefits of non-correlated asset allocation sometimes don’t show up…

However, despite the near universal acceptance of the importance of diversification, having a diversified portfolio does not automatically mean investors will outperform or gain value in risk reduction.

This was best demonstrated in 2014, when despite a sixth consecutive year of stock market gains, some investors might have lagged, as most segments of global financial markets failed to keep pace with many of the popular domestic stock market indexes. The broad S&P 500 Index and the Nasdaq Composite Index finished the year up 13.7% and 14.8%, respectively, and solidly outperformed other diversifying asset classes, like small cap or international stocks, by wide margins. Investors taught not to keep “all their eggs in one basket” and diversify their portfolios were left wanting more, as their investment performance trailed these broad U.S. benchmarks.

And 2014 is not a sole outlier, as diversification failed to benefit investors twice more in recent years. In fact, the S&P 500 Index has outperformed an equal weighted portfolio of the most common equity asset classes used to diversify (mid cap, small cap, developed foreign, and emerging market stocks) by a combined average of roughly 5% in three of the past four years. Not since 1998 and the Asian Crisis, when international stocks suffered and small and mid cap stocks also underperformed, has such a large performance gap between the S&P 500 Index and the other segments of the global stock market existed.

So why not just invest in large cap stocks or the S&P 500 and abandon the notion of diversification? Simply put, to do so would be a mistake of overvaluing a short term phenomenon over a long-standing investment axiom that benefits more than it hurts. In fact, over the past 20 years, the S&P 500 has only outperformed all other major asset classes (including small, mid, foreign developed, and emerging markets) 30% of the time, and it was the worst performing asset class 25% of the time. This demonstrates the importance of investing in at least several different types of investments. Diversification has historically worked and it remains the core tenet of portfolio strategy.

And here’s a table showing both non-correlation to the S&P as well as “batting average” against the S&P for a few asset classes over various time frames:

Josh here – it’s interesting how easily investors can focus on the recent underperformance of EM stocks vs the S&P 500 (a 25% batting average) and forget about the outperformance in a prior, longer period of time (58% batting average in the decade ending 12/2012). This obsession with recency and forgetfulness of longer term results is the opportunity for patient investors to pick up.

Source:

LPL Financial Research – 2015 Mid-Year Outlook

Before you go out and load up on small-caps, it’s important to first consider yourcurrent asset allocation. If your portfolio already has a sizable allocation(25% or more), then it probably won’t make sense to bulk up even further. If you own much less than that, then you’ve got some reading to do (below).

3 Reasons I Think Small Caps Could Outperform This Year Historically, small-cap stocks tend to outperform large-caps in the early stages of bull markets. The reason is that the early stage of a bull market typically corresponds with a v-shaped economic recovery, which tends to favor cyclical, commoditized industries that benefit most from rapid growth off the bottom. And that’s where small-cap companies thrive. But as a bull market ages, leadership starts to change, cyclical industries start to feel the pinch of slower growth rates and tighter financing, and investors start to lean towards more defensive, well-established and cash-rich large caps/multinationals. Those types of companies are better able to weather economic downturns. Which begs the question: isn’t this bull market technically in its “maturation phase,” i.e., the twilight years? And, wouldn’t that imply that large caps should outperform? Generally speaking, yes, it would imply that large caps should do better. But, it’s important to remember that just because large caps typically outperform late in bull markets, it does not mean they’ll always outperform. Indeed, even as recently as the 2003 – 2007 bull market, we saw that small-caps can lead all the way through. I’m not implying that small-caps will outperform large-caps for the remainder of this bull, however I do think conditions dictate they could have a good run in the medium term. Here are 3 reasons why: 1) A Stronger Dollar Hurts U.S.-Based Multinationals – a stronger dollar implies weaker foreign currencies, which means it’s progressively becoming more expensive for foreigners to buy US goods. US corporates reported over $18 billion in negative currency impact in Q4. With the Fed set to hike rates this summer, while other central banks loosen, the dollar could get even stronger. Multinationals could experience weaker foreign sales as a result, which could pinch share prices. 2) The U.S. is Leading the World Economically – small caps generally tend to benefit from a strong domestic picture, and when you consider an improving labor market, lower gas prices and the fact that consumer spending saw its fastest growth from Q3 to Q4 last year since 2006, it looks ripe for small-caps to do well. 3) Mean Reversion – small-caps significantly underperformed large-caps over the last year. I think small-caps could make up some of that ground from here. Bottom Line for Investors 

I’m a firm believer that just about every well-constructed, diversified portfolio should have a reasonable (10% - 20%) allocation to small-cap stocks. Over long periods of time, history tells us that the expected return from small-caps is higher than the expected return of large-cap stocks. Of course, small-caps won’t outperform their larger peers every year, but on average they should generate a stronger rate of return over time. 

That doesn’t imply that it makes sense to build a portfolio entirely composed of small-caps. Doing so could expose your portfolio to greater degrees of volatility and introduce additional risk that you’d be better served to diversify away with other asset classes and styles. 

___________________________________________________________

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.

I recently got my hands on some longer-term market performance data over 15 and 20 year time frames through year-end 2014. I love digging into this kind of long-term data and there were some numbers that immediately stood out to me. Here are those numbers with annual returns over a wide variety of markets and styles:

You can see that U.S. markets have been the big winners over these periods with small and mid caps leading the way. The only place where value didn’t outperform growth was in large cap stocks, but U.S. stocks have some very respectable 20 year return numbers. On the other hand, international markets have been noticeable laggards with the U.S. making up the majority of world equity market gains.

These are long time periods so you would think you could take this data at face value and come to some fairly certain conclusions about the various markets. Anyone that looks at these returns would assume global diversification is a sucker’s bet and that U.S. markets are the only ones that make sense.

For the opposing viewpoint, I decided to look at a handful of these same markets, but changed the end date to 2007, just before the U.S. relative outperformance started. These are the 15 and 20 year annual performance numbers through 2007:

If you would have looked at these same numbers at that time you would have concluded that many of the foreign markets offered much better long-term return prospects than the U.S. markets.

A few thoughts on each set of return numbers:

Neither of these performance numbers are right or wrong. They are what they are. Even over very long time frames investors can expect much different return figures depending on the dates chosen. Even a few years in either direction can drastically change the results as poor years drop off or good years are added on.

Two decades is considered the long-term in my book, but even over 20 year periods you can’t expect to draw any conclusions about financial markets with any certainty. Even shifting this data seven years led to much different return numbers in most of these stock markets.

U.S. markets have recovered much faster than foreign markets and that has played a large role in the performance differentials in the 15 and 20 year numbers through the end of 2014. Mean reversion is a fickle part of the financial markets that can work very slowly over time until you finally look at the numbers and realize the regime change has taken place…or it can occur swiftly and without warning. Always interesting, never easy.

Japan dragged down the MSCI Pacific performance in both periods. It will be interesting to see if that stock market can finally get its act together. We’re now 25 years from the bubble bursting over there, which shows how truly epic it was.

There are going to be subpar periods for returns in nearly every stock market at one time or another. If the returns were always consistent over any one time frame there would be no risk involved. It doesn’t seem fair to take more risk over two decades and still not be rewarded with average long-term returns, but that’s the nature of the beast. This is why stock markets are best suited for patient people.

Historical market data is interesting, but I always say that it does a much better job of helping investors prepare for future risks as opposed to being able to guess what the future performance will be.

Further Reading: Torturing Historical Market Data Caveats on the Long-Term Global Diversification: Accepting Good Enough to Avoid Terrible Not All Markets Have Recovered From the Financial Crisis

This post from Ben Carlson (@awealthofcs) originally appeared on A Wealth of Common Sense.

Based on the MSCI World Index, the U.S. stock market makes up over 50% of global equity markets. We constantly hear updates about the Dow Jones, S&P 500 and even Russell 2000, but rarely pay attention to foreign markets.

This home bias causes many investors to overweight U.S. stocks in their portfolio. As everyone debates the current valuation of U.S. stocks, it’s now easier than ever to diversify globally. And while investors worry about the fact that U.S. markets have run so far so fast, many international markets haven’t kept pace.

The S&P 500 (SPY) passed through its 2007 peak in early 2013:

The S&P 600 Index (SLY) of small cap U.S. stocks broke its previous highs in early 2011:

Now for a list of broad foreign markets that are still well below their 2007 peaks seen before the global financial crisis hit.

The MSCI EAFE (EFA):

Emerging Markets (VWO):

European stocks (VGK):

Asian stocks (VPL):

Latin America (ILF):

There’s nothing that says international markets have to immediately outperform U.S. stocks anytime soon. But for those that are worried about CAPE ratios and profit margins, diversifying globally is one of the best forms of risk management over longer time horizons.

This post from Ben Carlson (@awealthofcs) originally appeared on A Wealth of Common Sense.