Living in the Past

Fundamentals of Market Investing by Adam J. McKee

We all know that it is not psychologically healthy to dwell too much on the past.  We must live in the present and plan for the future.  When it comes to investing, the past can be very, very unhealthy because our assumptions that history is bound to repeat itself is just plain wrong most of the time.  If you are looking at a fund that was up 23% in 2016 and up 26% in 2017, logic and the laws of probability tell us that this recent history is very unlikely to repeat itself.

The SEC requires funds to tell investors that a fund’s “past performance does not necessarily predict future results.”  This can be true for many reasons.  They may be specific to a particular company, a particular sector, the market in general, or the overall economy.  What we do know is that stellar performance in one period is usually followed by mediocre to terrible performance in the next.  Chasing alpha often means that you cannot even achieve beta.  It does seem, however, that very long-term trends are more trustworthy than shorter ones.  Just about everyone, for example, will tell you that you need at least some equity exposure in your portfolio.  Despite all of the corrections, recessions, and depressions of the past, long-term equity returns are positive and tend to beat other asset classes.

Always keep in mind that returns are an output variable.  They are the Y’ of regression analysis—the thing being predicted.  Past performance will be a clear indicator of future performance if we can assume that the inputs are all equal.  Given the dynamic nature of societies and economies, this is a very dangerous gambit.  Even if Amazon can continue its stellar growth trajectory, we must also consider the broader economic climate.

If P/E ratios shrink across the board as bond rates climb with interest rates, then all stocks will suffer, but perhaps those with extremely large P/E ratios will suffer the most.  I freely admit that while I am a huge fan of Amazon and a loyal customer, I have no idea what the common stock will do in the near future.  Traditional wisdom says that nobody deserves multiples that high, and tech is overdue a massive correction.  Prudence, therefore, says we sit on the sidelines and let the risk junkies build positions in high multiple tech companies.

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