The Investment Scientist

Archive for June 2007

The title is a question posted to me, the following is my answer.

I don’t use stops, there is not any evidence that there are effective stops. (By evidence I mean rigorous and peer reviewed academic research.) To protect against downside risks, I use an “ex ante stop”. OK, this is a term I make up on the fly. What I mean is that I only invest in stocks with P/B less than 1.3 where P is the market value of the stock and B is the book or accounting value of the stock. Presumably, the market value of a stock can not fall below its book value in equilibrium. (It does not work that way all the times, but it works most of the time.) By investing in these type of stocks, I limit my potential losses to less than 25%. Comparatively, S&P 500 stocks have an average P/B of 4.7, which means the average stock price needs to fall over 75% before reaching the average book value. Nasdaq stocks have an even higher average P/B of 8.6. In summary, investing in low P/B stocks is a much more effect way (with a mountain of academic research to back up) to limit downside risks.

Does the stock market have seasonality? Well, if you have abode by the old investment adage “buy in November and sell in May”, you would have done quite well (if you don’t count taxes and transactions costs). This is because stock gains in November through April have typically been stronger than May through October for reasons yet unknown to mankind.

The Stock Trader’s Almanac has demonstrated this by tracking what would happen to a $10,000 investment in the stocks that make up the Dow Jones industrial average. Over 56 years, this money invested in the Dow stocks in the “best six months” and then switched to fixed income in the “worst six months” grew to $544,323. But if the money invested in the Dow in the “worst six” and then switched to fixed income in the “best six” would result in a loss of $272.

Stock market seasonality is not a unique American phenomenon. A scholar at Erasmus University Rotterdam by the name of Wessel Marquering did a rigorous study of the seasonality effect of 5 major stock markets in the US, UK, Germany, Netherlands and Belgium. He found that the stocks perform better in “winter” season than in “summer” season in all 5 markets (see chart).

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How can investors benefit from the seasonality effect? The short answer is “Not much.” Surely one can follow the strategy to “buy in November and sell in May”. This strategy sounds tempting in theory, but jumping in and out of stocks forces the investor to pay transaction costs and short term capital gain taxes. These costs would be more than make up for whatever benefits the strategy might bring about. Using the example referenced above at the Stock Trader’s Almanac, the total capital gain taxes adds up to about $159,000, which is much more that the $272 saved! Further more, I haven’t accounted for the transaction costs yet. Unfortunately, most investors would trade stocks and funds without much regards to the transaction and tax consequences.

Although the seasonality effect can not be exploited directly, the awareness of which could make the investors mentally prepared for the more volatile summer season. My suggestion to you is: stay put, and prepare for a bumpy ride.

The title is a question posted to me. The following is my answer.

The most important thing to look for in a broker is not the explicit commission rate it charges, but the quality of its execution. In the Celent’s execution ranking, there is a $0.3 per share difference between the best execution and the worst execution. If you buy 1000 shares of stocks, that adds up to $300 difference. My own company, MZ Capital, uses Fidelity. It ranked #2 in the chart. I wonder where would Zecco.com be in the chart? One way a zero commission broker can make money is to channel your trades to a particular market maker instead of finding you the best execution. It is possible Zecco.com is doing that. If that’s the case, then Zecco.com would save you a nickel upfront, but would cost you a bundle in the execution.

Yesterday morning, I read the news about the overnight 8.6% drop in Shanghai Stock Exchange Composite Index (SSEC). As I just finished the reading, I got a call from a client of mine who just returned from a trip to Shanghai. Here is what she told me. While she was in Shanghai, her brother, who was (and mostly likely still is) knee-deep in the stock market, told her to dump all her stock investments in the US and move her money to Chinese stocks instead. She was very tempted. Then she got on the flight back to the US, took a long sleep, and got a call from her brother. In addition to making sure she is safe and sound, he also told her that he had just lost 50% of his money in the stock market correction. What a difference 24 hours can make!

Just 20 days ago, I wrote “The unbearable lightness of Chinese stocks“. The article was to make a case that there is a bubble in the Chinese stock market. Chinese investors had the blind faith that the government would not let the market fall leading up to the 2008 Olympics, which will be in Beijing. By then the bubble would be so big, the repercussion of its bursting would be in the same magnitude of the Great Depression. Shortly after I wrote that, 10 days to be exact, Alan Greenspan came out with the same warning. (See the BBC report here.) Apparently, some Chinese officials took heed of Greenspan’s warning and the “stamp” tax for stock transactions was promptly raised to 0.3% from 0.1%, ostensibly to stamp out stock flipping. The action also sent a signal to the market that the government would not necessarily support stock prices leading up to the Olympics. In a country where government intention is still paramount, that signal took the wind out of the sail of the stock market, at least for the moment.

Since the tax hike, SSEC has corrected close to 20%. This is well overdue. As a matter of fact, the sooner the air is taken out of the bubble, the better. A prolonged correction of another 20% might bring some balance to the market and some sense to the investors. Should the market recover lost ground within one or two months, that would be a bad sign. We might have to steel ourself for an eventual 70% to 80% crash!

This reuter news item summarizes nicely my approach to investing. The only difference is I use the approach for buy-and-hold value investing instead of rapid fire trading. In my opinion, buy-and hold is the only proper approach to invest for retirement.


Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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