The Investment Scientist

Archive for July 2007

Someone asked:”Do you know of any researches/studies carried out that help predict possible upward/downward movements of equity markets?” The following is my answer.

Investors are driven to a large extent by greed and fear, and usually they are driven to the wrong directions. Warren Buffet once said:”Be fearful when everyone else is greedy; and be greedy when everyone else is fearful.” In real life, not many people can do that.

Professor Baker of Harvard and Wurgler of NYU did a study relating investor sentiment and future stock returns. They found when investors are optimistic, the subsequent one year returns are lower; when investors are pessimistic, the subsequent one year returns are higher. (See Chart) They also found small cap stocks are more influenced by investor sentiment than large cap stocks, extreme value stocks and extreme growth stocks are also more sensitive to investor sentiment. Here is their paper – http://www.people.hbs.edu/mbaker/cv/papers/sentiment.pdf

stock-market-sentiment-return.gif

Last week, I went to the Washington Area Money Manager meeting where the keynote speaker was former Fed Governor Larry Meyer. Governor Meyer gave a brief prepared speech on the macro state of the US economy and he spent significantly more time taking questions from the audience.

As it turned out, the audience’ concerns about the economy are very similar to mine. Readers of my past posts may still remember I talked about the housing bubble and the risk that it might deflate in a bad manner, leading to a prolonged recession like the one in Japan during the 90s. Just two months ago, I talked about the equity bubble forming in China and the potential consequence.

Governor Meyer characterized the current state of the economy as “Concentrated Drags, Resilient Elsewhere.” (See Chart) The drags refer to the rapidly falling residential investment. For instance, in Q4 of 2006, residential investment fell nearly 20% compared to Q4 of 2005. Since residential investment accounts for about 5% of total economic activities, this 20% contraction translates to about 1% reduction in GDP growth. However, GDP growth in that quarter was a robust 2.5%. This is due to the 4.2% growth in consumption and the 3.4% growth in government expenditures. In short, in spite of the housing correction (or recession), the overall economy is very resilient.

Governor Meyer also pointed out that the drags from the housing correction are diminishing. The residential investment contracted 15.4% in Q1 of 2007, and 7.6% in Q2 of 2007. The rate of contraction is expected to reduce further to 6.2% in Q3 and 0.9% in Q4 of 2007. At the same time, other segments of the economy remain very robust. In light of this, Governor Meyer sees very little risk of recession in the next two years.

drags.gif

Many in the audience expressed concerns about the equity bubble in the Shanghai Stock Exchange, and that the risk that its popping might start a global domino like the Asian Contagion of 1997 (that was started in Thailand and reverberated throughout Asia and beyond). Governor Meyer shared with the audience that Beijing is his most visited city and he found the financial officials there are quite capable and “they are certainly not burying their heads in the sand …” Governor Meyer concluded the risk was probably overblown.

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

Most stock market movements are best characterized as “market noise”. Market noise reduces the clarity of our judgments so it is better to be avoided. I review my own portfolio and my clients’ portfolios every quarter. In the review, stock prices play only a small role, fundamentals of the companies are the more important factor. So the straight answer to your question is no. I don’t think any “noise” monitoring software useful and I don’t use them.


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.



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