Is there a gorilla in our midst?

Posted by on February 24, 2014 @ 9:00 am in Economy & markets

In a famous experiment, psychologists Christopher Chabris and Daniel Simons asked people to watch a video of people playing basketball and count the number of passes. Technically, the answer is 15, but that misses the point of the experiment. 

In fact, the right answer was a question: Did you see that person in the cheap, shaggy gorilla suit walking through the middle of the basketball game? About half the people who watch the video don’t notice the gorilla. They are too busy trying to count the passes.

How can anyone miss a gorilla? The answer is selective attention. The human brain tends not to “see” things it doesn’t expect. Lately, I’ve started to wonder whether the Fed taper has distracted us from froth in global stock markets.

In our 2014 economic and investment outlook, we expressed concern about froth in the equity markets and warned that investors tempted to add stocks to their portfolios should proceed with caution.

We argued that the return of John Maynard Keynes’ “animal spirits” could accelerate business investment that is necessary for the U.S. economy to start growing more quickly than its recent 2.3% yearly average.¹ With strong balance sheets and attractive profit margins, corporate America is certainly well positioned to increase investment, though political uncertainty could act as a brake on new capital outlays.

The return of animal spirits would certainly be positive and, I hope, bring much-needed relief to those who have been suffering without work. But their impact on the financial markets might be a little like the gorilla in that video–the surprise force that we are blind to because we’re focused on something else. Indeed, while many investors were focused on whether a Fed taper would depress bond prices, emerging-market turmoil temporarily knocked 7% off stock prices. ²

We’re already seeing evidence of animal spirits at work in the equity markets, with valuations that we believe are looking a bit frothy. Over the long run, valuations are more relevant to future returns than any other metric, and the chart below shows that current stock valuations are above long-term averages. Increasing valuations reflect a return to risk-taking, a development that is great for economic growth but also suggests a decline in the compensation that investors earn for taking on risk. In other words, increasing valuations are a sign that the chances of muted future returns are increasing as well.

Joe Davis_Is there a gorilla in the midst_StandardDev_012014

Of course, even valuations explain only a modest portion of returns, meaning that a wide range of outcomes is possible in equity investing, even over the long term. This is why Vanguard recommends allocating assets to achieve goals over the long run and sticking to the plan. But we also believe that current stock valuations suggest advisors and their clients exercise caution in making strategic or tactical portfolio changes that increase equity risk. It’s also a great time to consider rebalancing.

It’s important to remember that recommending rebalancing is very different from market-timing. At Vanguard, we believe that trying to call or time the market is likely to reduce long-run returns. In some ways, rebalancing is the opposite of market-timing because it requires setting an asset allocation and sticking to it. Current equity valuations make it likely that many investors’ allocations are out of line with their original plan, increasing the need for rebalancing.

It’s only natural to watch the taper and worry about bond prices, but that doesn’t mean we should take our eyes off equity valuations or abandon our investment plan. Just as watching a basketball game requires watching out for unexpected moves, disciplined investing requires watching out for the gorilla in our midst so that we don’t get distracted from our long-term goals.

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1 Joseph Davis, Roger Aliaga-Díaz, Charles J. Thomas, and Andrew J. Patterson. 2014. Vanguard’s economic and investment outlook. Valley Forge, Pa.: The Vanguard Group.
2 Dow Jones industrial average from Jan. 7, 2014 through Feb. 3, 2014.

Notes:
All investments, including a portfolio’s current and future holdings, are subject to risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.

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