The Investment Scientist

Archive for February 2008

Last month, the Fed took a drastic step to cut rate twice by a total of 125 basis points. And with a drop of 225 basis points since last fall, what does this say about likely stock returns? Let’s look at the historical data.

Since 1950, the Fed cut more than 200 basis points 11 times in attempts to simulate a faltering economy. Economists believe it takes six months for the rate cuts to take effect which should last for as long as three years. Therefore I examined the one- and three-year returns of the S&P 500 Index and the Fama/French Small Cap Value benchmark portfolio for each rate-cut period.

After cuts of 200+ basis points, the average one-year return for the S&P 500 was 13.5% with two negative-return periods. The average three-year returns for the S&P 500 was 31.8% with one negative-return period.

However, the Fama/French Small Cap Value benchmark portfolio fared better. The one-year average return is 34.5% with no negative returns. The three-year average return was 100.5% with just one negative-return period.

    Periods of 200+ bp rate cuts S&P 500
    1 year return
    Small Value
    1 year return
    S&P 500
    3 year return
    Small Value
    3 year return
    Oct 1957 – Mar 1958 32% 64% 55% 106%
    Apr 1960 – Jan 1961 11% 23% 25% 47%
    Apr 1970 – Nov 1970 8% 12% 10% -1%
    Jul 1974 – Oct 1974 21% 34% 25% 149%
    Apr 1980 – May 1980 -19% 46% 46% 175%
    Jan 1981 – Feb 1981 -14% 10% 20% 131%
    Jun 1981 – Sep 1981 4% 25% 143% 141%
    Apr 1982 – Jul 1982 52% 96% 78% 174%
    Aug 1984 – Nov 1984 24% 31% 41% 39%
    Sep 1990 – Mar 1991 8% 29% 19% 89%
    Sep 2000 – May 2001 -15% 19% -11% 57%
    Average 13.5% 35.4% 31.8% 100.5%

Data sources: Federal Reserve, Kenneth French data library

It’s apparent from historical data that Fed rate cuts don’t guarantee making money in stocks. However, they do increase the odds of doing so— particularly with small cap value stocks. (Note: the odds of losing money with the S&P 500 index in any given year is about 30%.)

Martin Zweig once said:

Don’t fight the Fed!

That could be a very wise counsel!

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We’re already in a recession. Or, that’s what the pundits say. They may well be right. But what will you do about it? Will you follow common wisdom and seek relative safety of large cap stocks? After all, large cap stocks are safer— right?

That’s what I had thought too, until I studied the S&P 500 and the Fama/French Small Cap Value benchmark portfolio in all nine recessions going back to 1950.

My study looked at time periods of one year and three year returns into a recession. Surprisingly, results show small cap value stocks to have both higher returns and lower risk than the S&P 500.

Here’s what happened in the one-year period from the start of all nine recessions. The S&P 500 declined three times. Yet in the same period, the Fama/French Small Cap Value benchmark portfolio was down only once.

Three years after the start of all nine recessions, the S&P 500 was under water one time. However, the Fama/French Small Cap Value benchmark portfolio fared much better by being firmly on dry land. (See return table below.)

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In the three month period between Oct 19th, 2007 and Jan 18th, 2008, the S&P 500 index fell 14.1% and the Russell 2000 Value Index fell 19.5%. To understand what is likely to happen next, I studied the top 10 worst three-month-sell-offs since 1950. These sell-offs ranged between -13% to -30%. I found that in 8 out of the 10 occasions, the S&P 500 index rebounded by more than 20% in one year. Small Cap Value stocks did even better. The Fama & French Small Cap Value Index rallied more than 30% in one year in 8 out of the 10 occasions. In the other two occasions, it increased 6.6% and 24.1% respectively. (See Table below.)

A market sell-off is not a risk

As Demonstrated by history, most of the worst market sell-offs were followed by a substantial rally within a year. Many investors panicked and fled to cash at the nadirs of the sell-offs. By the time they mustered enough courage to get back in, they had missed the rallies. If you want to achieve long-term investment success, treat a market sell-off as an opportunity, instead of a risk.

Table: One-year returns after the worst 3-month sell-offs

3-month period ending 3-month decline Subsequent S&P 500
12-month return
Subsequent Small Value
12-month return
Nov 1987 -30% 23% 32.7%
Sep 1974 -25% 38% 42.4%
Jun 1962 -21% 31% 37.9%
Jun 1970 -18% 42% 55.4%
Sep 2002 -17% 24% 41.4%
Sep 2001 -15% -20% 6.6%
May 1962 -14% 23% 30.6%
Oct 1990 -14% 34% 49.6%
Oct 1957 -13% 30% 50.5%
Nov 2000 -13% -12% 24.1%

Data sources: Fidelity MARE group, Prof. Kenneth French data library.


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.

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