Current Top Performing Stock Funds Often Have One Big Problem

By Tom Madell

In attempting to help investors achieve excellent returns, a frequent theme in my Newsletters has been to remain vigilant for instances in which otherwise excellent funds seem to have become "overvalued." If a given fund can be classified as overvalued, the chances are that, sooner or later, its returns will tend to underperform a fund that is not currently overvalued, or, is even undervalued. This is the same principle that applies to the stock market as a whole: If the stock market is overvalued, sooner or later, it can be expected to underperform. Of course, the phrase "sooner or later," being as inexact as it is, likely tends to cloud the essential truth. So long as an overvalued fund, or, the overall market, keeps going up, which they often do, many investors are willing to take their chances, riding the positive momentum, all the while putting the risks on the back burner.

Another way of looking at it is this: Fund or stock market performance moves toward the future on two different tracks. In the relatively shorter term, the best predictor of performance is a continuation of the same magnitude of performance (that is, over- or under-) it has been showing in over the last several years. However, in the relatively longer term, the best predictor of performance is indeed valuation, with overvalued assets likely to underperform and undervalued ones more likely to do better performance-wise.

While the term "overvaluation" is essentially a conceptual one, with no one absolute definition, there are certainly some guideposts that can point in the direction of overvaluation that investors can make use of. One easy one to spot is merely realizing that stocks have gone up, on average, by greater than 15% annualized over a period of 5 years or more. This information is available and updated regularly on morningstar.com. (Note: In an earlier version of this article, I incorrectly stated that if a fund or the overall market goes up 200% in 10 years or less, this means that gains would have averaged at least 20% per year. Thanks to feedback from an obviously well-versed reader, this erroneous statement has now been removed.)

As recently as the summer 2014, stocks were averaging even bigger gains, that is, 20% per year annualized, over the prior 5 year period. Since then, stocks have slowed the pace, but not by an extreme amount, with major indices averaging about 13% a year over the last 5 years. But the "slowdown" has been enough to perhaps say that stocks are now "only" in the upper range of what might still be considered "fair" valuation, and therefore, perhaps not quite as overvalued as before.

I myself do like to use exceeding a 15% figure over a five year period for average performance of a fund or the stock market as a whole as my guidepost for when overvaluation is setting in. The stock market tends to be quite volatile so that a 5 year return appears to indicative of what is actually going on while still being focused long term. And, it happens to correlate highly with other better known valuation measures such as P/E ratios. Of course, the longer the 15% annualized return continues past 5 years and the higher it gets, the more overvalued you should consider the fund or the overall market to be.

Preceding the above mentioned summer of 2014, back in mid-Oct, 2013, stocks in general reached this 15% annualized level. While they continued to rise for another year and a half, beginning around May 2015 they pretty much went nowhere until the election of Donald Trump, a year and a half later. While the election seemed to inject a new dynamism into investors who began banking on better, business friendlier conditions and a higher rate of growth, we still can't be sure when, and if, these optimistic assumptions will reach fruition.

To summarize what I've said thus far, momentum is an important factor leading many investors to pick and stick with funds with current outstanding prior performance. Outperformance can last for a number of years which is why investors can sometimes turn a blind eye to the long-term implications for funds that have become overvalued. While we are probably not currently in an obviously overvaluation situation for the majority of funds, we are still in the upper range of normal valuations and close to that arbitrary, but likely real, "borderline" that separates reasonable, but high, valuations from overvaluation.

In the remainder of this article, I will provide some stark evidence that overvalued funds tend to underperform in subsequent years. In the April 2015 issue of this Newsletter (on page 7), I listed 11 funds, in a variety of fund categories, that had what I considered to be excessively high returns. For the reasons stated above, I predicted at that time they would likely underperform in the years ahead. It should be noted that at the time, most stock funds were about in the same range of high, but probably not excessive, valuation as they are today. But the 11 funds I listed each had cumulative returns in excess of 100% over the previous 5 years, or over 20% annualized, and were therefore, to my way of thinking, highly overvalued. Each had outperformed the S&P 500 index by at least several percent each year on average.

So, here is a reality check on how these 11 funds have done in the two years since I wrote that article. For comparison, the S&P 500 returned 9.1% annualized over the 2 year period, as of approximately two weeks ago.

As noted above, while each of the 11 funds had beaten the S&P 500 over the previous 5 years, by two years later none of them had. In reality, it should be noted that the S&P 500 has been extremely hard to beat in the last few years. But of the above 11 previously exceptional performers, 6 currently show annualized performance of at least 3.5% below that of the index, with most considerably below that figure. Further, when we look at how each fund has been performing against the competition in its own category over the last year, 8 out of the 11 funds now fall in the lower half against funds with the same objective, since a Morningstar rank above 50 shows exactly that.

In terms of the present, a sample of some of today's top performing, but likely overvalued funds, might include:

• Vanguard Capital Opportunity Inv (VHCOX)
• Dodge & Cox Stock (DODGX)
• T. Rowe Price Global Technology (PRGTX)
• Fidelity® Select Biotechnology (FBIOX)
• Vanguard Consumer Discretionary Idx Adm (VCDAX)

New Model Portfolios for Apr. 2017

Overall Allocations to Stocks, Bonds, and Cash

As mentioned above, the overall stock market remains near overvalued levels, although, in my estimation, it will take a little bit more of a surge to cross from being highly valued to overvalued. At the same time, neither bonds nor cash are yet offering much to entice investors, other than just the prospect of not losing money in the event of a correction, rather than really making any. In the meantime, investors willing to venture into some down-trodden areas of the stock market, such as emerging markets, foreign markets in general, and energy stocks may have the best opportunities to see the biggest gains.

For Moderate Risk Investors

Model Stock Portfolio

So far in 2017, our Model Portfolio selections, both stocks and bond (with several notable exceptions), are off to a very good start to the year, with the majority ahead of the index funds I use as benchmarks. More on the past performance of our Model Portfolios will be presented in the next Newsletter.

Note: Most investors will not have investments in all of the Model Portfolio funds. However, I recommend they have at least one fund from each fund category mentioned which would produce a portfolio of at least 6 stock funds. While this may still seem like a lot of funds to some, the goal is a high degree of diversification while allowing for the inclusion of those fund categories which currently seem to have the best longer term potential.

Notes:

1. A stock or bond fund shown with (C), (M), or (A) indicates it has characteristics that may make it most suited for Conservative, Moderate, or Aggressive investors, respectively.
2. Vanguard ETFs (exchange traded funds) are often practically identical to similarly named Vanguard "Investor" index funds with even lower expense ratios and without the higher minimums required for the "Admiral" funds. Therefore, these ETFs can be substituted for any Vanguard stock or bond index fund shown in tables. E.g. Vanguard FTSE Pacific ETF (VPL) can be substituted for VPACX; Admiral funds can also be substituted when available, e.g. VPADX.

Model Bond Portfolio

Notes:

1. When possible, select PTTRX; HABDX is only recommended if you cannot meet PTTRX's minimum.
2. The two funds are the same but have different minimums; select DBLTX if possible because of lower expense ratio.
3. Muni bonds are only suitable for taxable accounts. Invest in a fund with bonds specific to your own state, if available, for the greatest tax savings.

Thank You to All Readers Who Responded to My Request for Feedback

Many readers answered my somewhat urgent request for feedback within the last month and what they had to say was quite helpful as well as gratifying.

I had intended to answer each and every person who responded, but before I could complete this, I ran into the very problem I had previously mentioned - no longer having enough time to do as much as I have in the past. While I still haven't resolved this problem, and only time will tell if I can get past it, let me personally thank the readers that I didn't have enough time to reach.

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