Anyone studying the long-run history of American business cannot help but observe how many of the prominent firms of one era fail to make it to the next. Free-market economies are characterized not only by intense competition but also by disruptive change. Sometimes a company’s toughest competitor turns out to be a firm it has never heard of selling a product or service that didn’t exist until recently. The list of companies that once dominated their industry but have fallen on hard times is lengthy enough to give every thoughtful investor reason for sober reflection.

Among many possible examples, a number of firms come to mind that were once highly regarded but later encountered serious or even fatal problems.

• Bethlehem Steel pioneered the steel I-beam, which launched a skyscraper boom in cities across the country. Its engineering expertise supplied the steel sections for the Golden Gate Bridge. But growing competition and a changing marketplace eventually took their toll, and the firm filed for bankruptcy in 2001.
• In 1973, Eastman Kodak held a seemingly impregnable position in the lucrative market for photo film and chemicals, enjoyed a reputation for innovation and astute marketing, and boasted a market value even greater than oil giant Exxon. Kodak shareholders had been favored with an uninterrupted stream of dividends dating back to 1902. Today the company is struggling to reinvent itself as the film business shrivels, the dividend has been suspended, and the share price is limping along under $3.
• A Fortune article profiling Pfizer in mid-1998 praised it for having “one of the richest product pipelines in the Fortune 500.” A Wall Street analyst enthused that “some of my clients refer to Pfizer as the best company in the S&P 500.” In early 1999, a Forbes cover story sounded a similar note, crowning Pfizer “Company of the Year” and observing that “the people who brought us Viagra have more blockbusters on the way.” Thirteen years later, the Viagra boom has subsided, patents are expiring on highly profitable products, and the gusher investors expected from the research pipeline has slowed to a trickle. The share price has slumped over 50% since year-end 1998 compared to a 3% loss for the S&P 500 Index.

Some companies almost single-handedly create new industries but still find it difficult to turn innovation into a permanent advantage. Pan Am (air travel), Kmart (discount retailing), Polaroid (instant photography), and Wang Laboratories (word processing) all had impressive initial success and provided handsome rewards for their investors. Alas, neither Pan Am nor Polaroid survives today, and Kmart shareholders were wiped out when the firm emerged from bankruptcy in 2003. (Kmart, Polaroid, and Wang Laboratories were all cited as examples of “excellent” companies in the 1982 bestseller In Search of Excellence.)

Evidence of this “creative destruction” appears all around us. For example, the Wall Street Journal reported that shares of Minnesota-based Best Buy Co. slumped Wednesday to their lowest level since 2008 after reporting a 30% drop in quarterly profits. For most of its life, Best Buy has been the toughest kid on the block, vanquishing rivals such as Highland Superstores and Circuit City on its way to becoming the nation’s leading electronics retailer.

Will Best Buy fall victim to even tougher competitors such as Amazon.com or Walmart? Or is this current downturn just a speed bump on the road to even greater success? No one can say. For every riches-to-rags story, we can find another tale of decline followed by dramatic recovery. According to some accounts, for example, Apple was only a few months from bankruptcy when Steve Jobs returned to the company in 1997. Now it vies with ExxonMobil for the number one spot in a ranking by market cap. And who would have imagined that a floundering New England textile firm with a low-margin business that sells suit-lining fabric would one day become a financial colossus known as Berkshire Hathaway?

The thrill of owning a great growth company during its most lucrative phase is a powerful incentive to search for the Next Big Thing. But almost every company with a highly profitable position is under constant attack from competitors seeking to garner a portion of those hefty profits for themselves.

As a result, the search for firms destined to generate greater-than-expected profits for many years into the future is fraught with peril and likely to end in frustration. Most investors will be far better off harnessing the forces of competitive markets and putting them to work on their behalf by holding a diversified portfolio. As Nobel laureate Merton Miller once observed, “Above-normal profits always carry with them the seeds of their own decay.”

Author Weston Wellington is a Vice President with Dimensional Fund Advisors

Miguel Bustillo and Matt Jarzemsky, “Best Buy Gets Squeezed” Wall Street Journal, September 14, 2011.

David Stipp, “Why Pfizer Is So Hot,” Fortune, May 11, 1998.

“Pfizer: Company of the Year,” Forbes, January 11, 1999.

Standard & Poor’s Stock Guide, 1974.

Thomas Peters and Robert Waterman, In Search of Excellence (HarperCollins, 1982).

Merton Miller, “Is American Corporate Governance Fatally Flawed?” Journal of Applied Corporate Finance, Vol. 6, No. 4, Winter 1994.

What if you had a magic newspaper and were able to read tomorrow’s economic news today? Do you think you could successfully invest with that information?

It would make investing a lot easier, right? Well, maybe not.

Super investor Warren Buffett famously said, “If (Federal Reserve Chairman) Ben Bernanke whispered in my ear exactly what he’s going to do tomorrow, it wouldn’t change anything I’m going to do today.” The problem is it’s difficult to know how the market will interpret any given piece of information.

Take oil prices as an example. If we whispered in your ear that oil prices would fall $2 per barrel tomorrow, do you think that would be bullish or bearish for the stock market? In reality, it probably depends on the reason for the fall.

Generally speaking, falling oil prices are good for the economy because it lowers the cost of gas and may allow consumers to spend more money, which could lead to higher corporate profits. With that backdrop, if oil prices fell due to oversupply, it might be bullish for the stock market because consumers would have more money to spend.

However, if oil prices fell due to a slowing economy, some believe the stock market might sell-off because some consumers would lose their jobs and reduce spending.

So, even if you knew what was going to happen to oil prices tomorrow, you’d still need to know the “why” behind the price change to predict its impact on the stock market.

And oil is just one of many examples.

Think about the myriad of economic indicators, corporate announcements, political wrangling, regulatory actions, and other things that happen each week that could affect the stock market.

Trying to track all these factors and accurately discern their impact on the market would be futile.

Bit by bit, the recovery from the traumatic stock market slump in 2008 and 2009 continues.

Although broad-market indices in the U.S. have yet to regain their previous peaks, the gap is narrowing as some industries and companies regain strength more quickly than others.

The S&P 500 Index and Dow Jones Industrial Average remain below their all-time highs by 13.4% and 10.4%, respectively, but a growing list of stocks are not only recovering but setting all-time record highs, including widely held firms such as Costco Wholesale, Cummins, Honeywell, IBM, Union Pacific and W.W. Grainger in yesterday’s trading alone [April 27th].

For small company stocks, the comeback is complete: the Russell 2000 Index established an all-time record high of 858.31 on April 27th, eclipsing its previous peak of 855.77 set on July 13, 2007. Through April 27, the index is up 150% from the darkest days of March 2009, and total return from March 2009 through February 2011 was 117.4%, the strongest 24-month period since inception of the index over thirty years ago.

We don’t know if the current strength in stock prices is an indication of even higher prices in the near future. But if recent performance reflects a so-called “new normal” pattern for the economy and the equity markets, it looks to us a lot like the “old normal”—dramatic changes in prices that confound most investors in their efforts to predict them.

Turn on the TV or the blogosphere and they’re filled with experts who make predictions about what’s going to happen in the economy or the financial markets. Generally, these experts have deep knowledge about a particular area and strong convictions in their forecasts and predictions.

Unfortunately, their accuracy is no better than dart-throwing monkeys, according to Philip Tetlock, a professor at UC Berkeley and author of the 2005 book, Expert Political Judgment: How Good Is It? How Can We Know?Tetlock conducted a long-term study of 284 experts who made their living “commenting or offering advice on political and economic trends.” Over the course of two decades, he tracked the accuracy of the 82,361 forecasts made by these experts.

The results are startling.

Here are some of the highlights as reported in an article by Louis Menand in The New Yorker:

• The better known and more frequently quoted an expert is, the less reliable their guesses about the future are likely to be.
• People who stay up-to-date on current events through regular reading and watching the news can guess what is likely to happen about as accurately as the experts quoted in the papers and on the news shows.
• Experts tend to fall in love with their ideas and display a double standard, i.e., they accept information that supports their position much more easily than information that contradicts their position.
• After the fact, experts tend to claim a higher degree of accurate forecasting than they actually achieved.

While experts may not be so “expert” after all, there is hope. Tetlock discovered that when it comes to making predictions, it’s better to know a little about a lot than a lot about a little.

He said people who had a broad understanding about many things tended to be more flexible and willing to stitch together diverse information to reach an opinion.

By contrast, experts tended to try and expand their deep expertise in one area into other areas that were not really relevant.

The New Normal.

By now, you have probably read that you should prepare yourself for a New Normal in the stock market. The 2008 global market crisis and the struggling economy have left many investors fatigued. Despite two years of strong equity returns, some investors have been slow to regain market confidence. And by now, many are accepting the talk about a “new normal” in which stocks offer lower returns in the future.

The concept of a new normal is anything but new. In fact, throughout modern history, periods of economic upheaval and market volatility have led people to assume that life had somehow changed and that new economic rules or an expanding government would limit growth. What they could not see was how markets naturally adapt to major social and economic shifts, leading to new wealth creation.

Let’s look at other periods when investors had strong reasons to give up on stocks, and consider the parallels to today:

1932: The US stock market had just experienced four consecutive years of negative returns. A 1929 dollar invested in stocks was worth only 31 cents by the end of 1932. Hopes were sinking during the Great Depression, and many people felt as though the economy had permanently changed. Many investors left the market, and some would not return for a generation. Amidst what is considered the roughest economic time in US history, the markets looked ahead to recovery.

US Stock Market Performance after 1932*
Annualized
5 Years: 15.35% – Growth of $1: $2.04
10 Years: 10.07% – Growth of $1: $2.61
20 Years: 13.19% – Growth of $1: $11.92

All stock market returns based on CRSP 1-10 index.

*Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

1941: World War II was raging, and the US had just entered the conflict. The US stock market had experienced two consecutive years of negative performance, and the economy had shown signs of sliding back into depression. Although conversion to a wartime economy would revive industrial production and boost employment, investors struggled to see beyond the conflict. Many expected rationing, price controls, directed production, and other government measures to limit private sector performance.

US Stock Market Performance after 1941*
Annualized
5 Years: 18.63% – Growth of $1: $2.35
10 Years: 16.67% – Growth of $1: $4.67
20 Years: 16.29% – Growth of $1: $20.47

1974: Investors had just experienced the worst two-year market decline since the early 1930s, and the economy was entering its second year of recession. The Middle East war had triggered the Arab oil embargo in late 1973, which drove crude oil prices to record levels and resulted in price controls and gas lines. Consumers feared that other shortages would develop. President Nixon had resigned from office in August over the Watergate scandal. Annual inflation in 1974 averaged 11%, and with mortgage rates at 10%, the housing market was experiencing its worst slump in decades. With prices and unemployment rising, consumer confidence was weak and many economists were predicting another depression.

US Stock Market Performance after 1974*
Annualized
5 Years: 17.29% – Growth of $1: $2.22
10 Years: 15.92% – Growth of $1: $4.38
20 Years: 14.89% – Growth of $1: $16.07
5 Years 10 Years 20 Years

1981: The stock market had delivered strong positive returns in five of the last seven calendar years, and the two negative years (1977 and 1981) were only moderately negative. Despite these results, investors were weary from stagflation, which was characterized by high annual inflation, anemic GDP growth, and unemployment, and from fears of another economic downturn. In late 1980, gold climbed to a record $873 per ounce—or $2,457 in 2010 dollars. (By comparison, spot gold reached $1,256 per ounce in 2010.) Memories of the 1973–74 bear market lingered. A 1979 BusinessWeek cover story titled “The Death of Equities” claimed inflation was destroying the stock market and that stocks were no longer a good long-term investment.

US Stock Market Performance after 1981*
Annualized
5 Years: 18.82% – Growth of $1: $2.37
10 Years: 16.58% – Growth of $1: $4.64
20 Years: 14.54% – Growth of $1: $15.11

1987: On “Black Monday” (October 19, 1987), the Dow Jones Industrial Average plummeted 508 points, losing over 22% of its value during the worst single day in market history. The plunge marked the end of a five-year bull market. But in the wake of the crash, the market began a relatively steady climb and recovered within two years. The effects of the crash were mostly limited to the financial sector, but the event shook investor confidence and raised concerns that destabilized markets would increase the odds of recession.

US Stock Market Performance after 1987*
Annualized
5 Years: 16.16% – Growth of $1: $2.11
10 Years: 17.75% – Growth of $1: $5.12
20 Years: 11.89% – Growth of $1: $9.46

2002: By the end of 2002, investors had experienced the stress of the dot-com crash in March 2000, the shock of the September 11 attacks, and the early stages of wars in Afghanistan and Iraq. Although October 9, 2002, would ultimately mark the market’s low point, investors had endured three years of negative performance and an estimated $5 trillion in lost market value. A younger generation of investors had experienced its first taste of old-world risk in the “new economy.”

US Stock Market Performance after 2002*
Annualized
5 Years: 13.84% – Growth of $1: $1.91
10 Years: - – Growth of $1: -
20 Years: – - Growth of $1: -

2008–Today: The market slide that began in 2008 reversed in February 2009—gaining 83.3% from March 2009 through 2010. Despite two years of strong stock market returns, memories of the 2008 bear market and talk of the “lost decade” have led many investors to question stocks as a long-term investment. But earlier generations of investors faced similar worries—and today’s headlines echo the past with stories about government spending, surging inflation, deflationary threats, rising oil prices, economic stagnation, high unemployment, and market volatility.

Of course, no one knows what the future holds, which brings the concept of “normal” into question. What exactly is the status quo in the markets?

Since 1926, there have been only four periods when the stock market had two or more consecutive years of negative returns. In addition, annual returns are rarely in line with the market’s 9.67% long-term average (annualized). The most obvious normal may be that, over time, stocks offer expected returns reflecting the uncertainty and risk that investors must bear.

What’s new about that?

By now, you may have noticed that consumer financial magazines such as Money, Smart Money and Fortune have published their 2011 Investor Guides.  These guides provide you with all the needed information to make informed decisions with your investments and outsmart the markets.

If only that were the case. Let’s rewind the clock and review their results for 2010.

Money Magazine told us that small company stocks would suffer, since they perform better in the early stage of a bull rally. Because of this, Money urged readers to focus on high quality blue chip stocks.

And the 2010 results were:

• Russell 1000 index (large stocks): 16.10%
• Russell 2000 index (small stocks): 26.85%

Contrary to Money Magazine’s prediction, small stocks outperformed large stocks in 2010 by a wide margin.

Money also recommended ten large company stocks to capitalize on the upcoming outperformance. Unfortunately for the readers who followed the advice, the picks had an average price-only return of 6.3% versus 16.10% for the Russell 1000 index.

Smart Money also picked up on this trend, recommending large stocks over small stocks. They offered 12 stock picks to take advantage of the trend.

Smart Money’s 12 stock picks produced an average price-only gain of 7.5% for the year versus 16.10% for the Russell 1000 index.

Fortune Magazine had a different outlook claiming, in their words, “Making judicious stock selections will be crucial in what is likely to be a topsy-turvy year.”

Fortune recommended ten different stock picks for their readers. And, although Fortune had a great performer in Salesforce.com (up 78.9%), the average price-only return for their picks was 1.75% versus 16.10% for the Russell 1000 index.

That’s not what we would call judicious stock selections.

Comically, in the same issue of Fortune there was a useful article on the appeal of a simple index fund approach: “Stock picking, whether you do it yourself or pay a pro to do it for you, is a mug’s game,” they wrote. “You’re better off buying and holding a cheap, diversified, and consistent index fund, which passively invests in the stocks listed on a broad market benchmark.”

Good advice, but we know it won’t be long before catchy cover stories such as “Top Ten Stocks for the Year Ahead” are crowding the magazine racks once again.  To be sure, last year’s results offer another example of how easy it can be to miss the rewards the capital markets have to offer.

“5 Wall Street Heavyweights say it’s time to GET BACK INTO STOCKS.”

That was a recent headline from the USA Today. These “heavyweights” want you to get back into stocks. NOW!

My immediate question is, why didn’t this headline run in March, 2009, before the S&P 500 index advanced 77.84% (03/01/2009 through 12/31/2010)? Shouldn’t these “heavyweights” have let us know this was going to happen? They can predict with certain accuracy the future movement of markets, right?

Wrong! No one can predict the future! But the “heavyweights” want you to think they can. So does the financial media.

We think it borders on the ridiculous that articles like this go to print year in and year out.  Perhaps USA Today forgot about the 2008 edition, when the paper asked the “best minds” in the financial services industry for their thoughts on how the S&P 500 would perform during the year.

In 2008, all nine experts predicted the S&P 500 would increase – meaning none of them managed to predict even the relative direction of the index, much less the exact year-ending value. And, not a single one predicted the financial meltdown.

Two of the “experts” from 2008: Abby Joseph Cohen (Goldman Sachs) and Richard Bernstein (Merrill Lynch) reappeared on the USA Today 2010 expert forecasting panel.

In 2008, Cohen predicted the S&P 500 would close at 1,675 and Bernstein predicted it would close at 1,525.  To give you an idea of how wrong they were, the S&P 500 began 2008 at 1,468 and ended at 885.  Cohen predicted an increase of 14.2%. The S&P 500 declined -39.7%.

Why in the world should readers care what these folks think will happen next year?  We don’t.

Proponents of active investment management believe that skilled managers can outperform the financial markets through security selection, market timing, and other efforts based on prediction.

While the promise of above-market returns is alluring, investors must face the reality that as a group, US-based active investment managers do not consistently deliver on this promise, according to research provided by Standard & Poor’s .

S&P Indices publishes a semi-annual scorecard that compares the performance of actively managed mutual funds to S&P benchmarks.

The report analyzes the returns of US-based stock and fixed income managers investing in the US, international, and emerging markets.

Over the last five years:

• About 60% of actively managed large cap US stock funds did not beat the S&P 500
• 77% of mid cap funds did not beat the S&P 400
• two-thirds of the small cap manager universe did not outperform the S&P Small Cap 600 Index
• Underperformance of active strategies is particularly strong in the international and emerging markets, where trading costs and other market frictions tend to be higher.

Furthermore, across the thirteen fixed income fund categories, all but one manager experienced at least a 70% rate of underperformance over five years.

Proponents of active investment management will simply say buy managers who can outperform the market. Of course, a couple problems occur with this strategy:

• It is impossible to identify managers who will outperform the markets in the future.
• Most managers who have outperformed the markets cannot consistently do so in the future.

The message is clear: As a group, actively managed funds often struggle to add value relative to an appropriate benchmark—and the longer the time horizon, the greater the challenge for active managers to maintain a winning track record.

One outcome of the financial crisis is we have to “live with messiness.”

Instead of a neat and tidy explanation for everything that happens in the markets, humans are sometimes irrational and, as emotional creatures, we occasionally let fear and greed cloud our financial decisions.

After witnessing the current financial crisis, the tech stock bubble and burst from a decade ago, and numerous other financial storms over the past 20 years, it seems that when it comes to money, humans continue to make mistakes with their money and investments.

In a very interesting September 2 New York Times Magazine article, Nobel Prize winner and liberal economist Paul Krugman discussed the development of economic thought over the past 230 years and how the current financial crisis has thrown economic theory into disarray.

Without getting into his political leanings, Krugman makes a case that almost all economists, whether they be conservative or liberal, financial or macroeconomic, missed this crisis.

Despite their impressive-looking mathematical formulas and hundreds of years of history, economists, in general, failed to predict the size and timing of our current worldwide maelstrom, and, worse yet, were generally blind to the idea that a catastrophe of this size could even happen in this (enlightened) day and age.

Krugman says economists, “Will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic ‘theory of everything’ is a long way off.”

In short, he says we have to “live with messiness.”

From a practical standpoint, it reiterates the importance of knowing that the financial markets are not perfectly rational and that they do not always behave in the way that econometric models predict. One could argue that changes in the financial markets are simply a reflection of the sentiments, fears, dreams, and hopes of us – the market participants. The markets are not separate from us – they are us!

Since we humans are, well, human, then the markets may behave in a way that reflects human behavior and that can get quite messy.

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A recent Wall Street Journal article epitomizes the new “conventional wisdom” that asset allocation failed in 2008.

It is true that correlations among major asset classes have increased in recent years giving the impression that asset allocation no longer works.

During the 2008 financial crisis all major equity asset classes experienced severe declines. Even commodities, which historically had exhibited low correlations to equities, dropped dramatically.

This does not mean that diversification and asset allocation failed.

• High-quality fixed income securities, i.e. U.S. Government bonds, of all maturities were a safe haven and had returns ranging from 1.6% to 25.8% percent in 2008.*
• Financial and economic shocks are rare occurrences, and investors must understand that they are part of the risk of investing in equity markets. Correlations historically have increased during economic shocks but returned to more normal levels as economic conditions normalized.
• Asset allocation depends on individual circumstances. If one has a high overall risk tolerance and a very long investment time horizon, accumulating shares during bear markets may be a wise strategy.

The major problem is, so many articles in the financial press are devoted to attempting to avoid investment losses. These articles make it seem that market timing can work for most investors. Many nervous investors needlessly adjust portfolio holdings, usually to their long-term detriment, in an attempt to grab the current “trend.”

In reality, alternatives like market timing, short selling, and stock picking have historically tended not to work as claimed for most money managers.

Your best bet for financial success is to stick to your plan and your appropriate asset allocation.

*Source: DFA Returns 2.0; One-month T-Bills and Long Term Government Bonds, respectively.

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