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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.
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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.
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What you need to know now the recession is here
Do you ever get that feeling that you’d rather just stay in bed? This morning was one of those mornings. We woke up to the painful news of stock market collapses across Asia and Europe. And then, more surprising, a sudden action by the Fed cutting the interest rate by three-quarters of a percentage point (75 basis points). We never know for sure whether we’re in a recession until National Bureau of Economic Research (NBER) makes it official. That could take up to six months. But the only conclusion I can draw from the immediacy of reaction from the Fed is that if we are not in a recession right now, it’s about to happen.
So what can we expect the stock market to do during a recession-and after it? I may not have a crystal ball to see the future, but I have made an in-depth study of all nine recessions since 1950. Even if history won’t repeat itself, looking at the past half-century should give us some perspective.
Things look gloomy now, but the future is not
How long does the average recession last?
Since 1950, a typical recession lasted for ten months. The shortest one lasted for six months and the longest one lasted for 16 months. (See column 2, Table 1 below.)
What have been typical returns during past nine recessions?
Five of the nine recessions saw the S&P 500 index increased during the downturn (See column 3, Table 1 below). The average index return during recessions was 3.14%.
One year into the start of a recession, the S&P 500 index, on average, increased an anemic 2.95%. (See column4, Table 1.) Yet there are only three instances during this period when the index dropped, and the largest of these was by a painful 27%. However, the remaining six first-year periods saw the index increase. The best of these was by 25%.
By the third year of the start of a recession, the S&P 500 index on average increased 28%, which is slightly below the normal rate of return for the index. There was only one instance when the index was below the start of the recession. (See column 5, Table 1.)
Ten years into the start of a recession, the S&P 500 index on average increased 139.6%. There were no instances of the index being below the start of such a long recession. It’s worth noting 139.6% for ten years is still below the normal rate of return for the S&P 500 index. (See column 6, Table1.)
Table 1: S&P 500 returns during and after recessions
| Recessions | # of months | During R | 1 year | 3 year | 10 year |
| Jul 1953 – May 1954 | 10 | 17.94% | 25% | 100% | 179% |
| Aug 1957 – Apr1958 | 8 | -3.94% | 6% | 26% | 107% |
| Apri1960 – Feb 1961 | 10 | 16.68% | 20% | 28% | 50% |
| Dec 1969 – Nov 1970 | 12 | -5.28% | 0% | 28% | 17% |
| Nov 1973 – Mar 1975 | 16 | -13.13% | -27% | 6% | 73% |
| Jan 1980 – Jul 1980 | 6 | 6.58% | 13% | 27% | 188% |
| Jul 1981 – Nov 1982 | 16 | 5.81% | -18% | 15% | 196% |
| Jul 1990 – Mar 1991 | 8 | 5.35% | 9% | 26% | 302% |
| Mar 2001 – Nov 2001 | 8 | -1.80% | -1% | -3% | |
| Average | 10 | 3.14% | 2.95% | 28.20% | 139.16% |
| Current recession started Dec 2007 | 18 | -34.8% | -39.2% | -9.9% | ? |
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Small cap value stocks will do better, if history repeats itself
I’ve used the Small-Cap Value Index constructed by Fama and French to study the effect of recession on small cap value stocks for the last nine recessions since 1950.
On average, the Small-Cap Value Index returned 11.39% during a recession. During those recssion periods, the returns of the Small-Cap Value Index ranged from barely dropping (-2.17% in the ’69 recession) to strongly rallying (38% in the ’81 recession). (See column 2, Table 2 below.)
One year into the start of a recession, the index on average returned 13.21% with only one instance of index decrease. (See column 3, Table 2.)
Three years into the start of a recession, the index on average returned 76.21%with 31% being the worst return. (See column 4, Table 2.)
Ten years into the start of a recession, the index on average returned 506.26% with 312% being the worst return and 1183% being the best. (See column 5, Table 2.)
The reason I recommend my long-term approach and staying with small cap value stocks is because of these results.
Table 2: Small cap value returns during and after recessions
| Recessions | During R | 1 year | 3 year | 10 year | |
| Jul 1953 – May 1954 | 10.11% | 21% | 100% | 362% | |
| Aug 1957 – Apr 1958 | -0.56% | 18% | 63% | 517% | |
| Apr 1960 – Feb1961 | 21.72% | 32% | 46% | 343% | |
| Dec1969 – Nov 1970 | -2.17% | 7% | 31% | 312% | |
| Nov 1973 – Mar 1975 | 17.81% | -13% | 86% | 1183% | |
| Jan 1980 – Jul 1980 | 3.11% | 15% | 96% | 499% | |
| Jul 1981 – Nov1982 | 38.29% | 0% | 95% | 387% | |
| Jul 1990 – Mar 1991 | 5.52% | 9% | 83% | 448% | |
| Mar 2001 – Nov 2001 | 8.68% | 31% | 86% | ||
| Average | 11.39% | 13.21% | 76.21% | 506.26% | |
How shall we learn from history?
We can take the short view. In the last six months, the S&P 500 has dropped more than 15%. The Small-Cap Value Index has dropped more than 25%. Should we conclude that at this rate, all investment in stocks will be lost in two to three years?
Should you panic now?
The answer is no. But that’s precisely what many investors are doing now by taking money out of the market or rotating them to stocks they perceive to be safer. There is a better way to learn from history.
Take the long view
If you want to sleep well while building your wealth for the long term, you must take the long view of history. Then you’ll be more like Warren Buffet and John Bogle who see the current market madness as normal and transitory. William Shakespeare could well have been talking about the emotional turmoil of the market when he wrote,
It’s like a tale told by an idiot, full of sound and fury, but signifying nothing.
Sleep well, take the long view.
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By the end of 2006, Small Cap Value stocks had completed a historical 7 year run of outperformance relative to Large Cap Growth stocks. According to Prof Kenneth French’s data library, during this 7 years, Large Cap Growth returned a total of -10.35% while Small Cap Value returned a total of 266%!
2007 however saw a drastic reversal. In the first 10 months alone, Large Cap Growth has outperformed Small Cap Value by a whopping 18%! If you are a Small Cap Value investor and you are nervous, you are not alone. How much longer and how much more will Small Cap Value uncerperform? To get a handle of these issues, it is helpful to get a historical perspective.
Based on the data on Fama/French benchmark portfolios in Prof. French’s data library, and by comparing the yearly performances of the Small Cap Value portfolio and the Large Cap Growth portfolio since 1960, I obtained the following results:
1. 75% of the years, Small Cap Value outperformed; 25% of the years, Large Cap Growth outperformed.
2. $1000 invested in Small Cap Value on 1/1/1960 would grow to $1.7mm on 12/31/2006! In comparison, $1000 invested in Large Cap Growth on 1/1/1960 would grow to only $66k.
3. There are 8 occurrences of Large Cap Growth outperformance. 3 lasted for one year, 3 lasted for two years and 2 lasted for 3 years.
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Amid the deafening din of recession talks, the Business Roundtable released its quarterly CEO Economic Outlook Survey. The survey shows that the nation’s CEOs are quite upbeat about the economic outlook for the next 6 months, a stark contrast to the financial markets.
To the question “How do you expect your company’s sales to change in the next 6 months?” 70% answered “increase”, only 13% answered “decrease”.
To the question “How do you expect your company’s employment to change in the next 6 months?” 78% answered “increase” or “no change”, only 22% answered “decrease”.
Business Roundtable companies represent a third of the total US stock market value. Their CEOs clearly don’t see a recession in the horizon. Do they see something the financial market don’t see?
Here is the link to the Business Roundtable press release.
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What a difference one month made! When I left for vacation one month ago, the Sub-Prime Crisis appeared to be a spent force; when I returned, all talks are about recession. I am sure you have many questions (if you are like me): Will there be a recession? Will the stock market and the US economy survive a recession? What shall we do now? To answer those questions, I am burning late night oil now to review all past recessions after 1950 and how the stock market fared. History will not repeat itself exactly, but history is nevertheless a very useful guide.
Please look at the first chart. The chart depicts the S&P 500 since 1950 in logarithmic scale. Periods of recession are yellow highlighted. Now what impression do you get? … My take is: if you investment horizon is 5 years and beyond, a recession is but a bump, you should just sit tight and ignore all the talks about recession. In fact, in all but one instance, the market returned to its pre-recession high within 3 years.
The Deepest Recession
The deepest post-war recession started in the last quarter of 1973 and lasted for 6 quarters. The recession was global in scale. It was triggered by the Arab-Israeli War and the subsequent Arab Oil Embargo. The S&P 500 dropped just over 40%. The current geopolitical and macro-economical landscapes are quite different. The global economy is very strong and the Arab and the Israeli are suing for peace.
The Most Similar Recession
The recession that has the most similar characteristic is the 1990 recession. It started in the second quarter of 1990 and lasted for 4 quarters. The recession was caused by a credit crisis from the Savings and Loan Debacle. The Savings and Loan Debacle is similar to the current Sub-Prime Crisis in that both are the result of imprudent lending and both cause a credit crisis. During this recession, The S&P 500 dropped just shy of 14% from peak to trough. It recovered very strong though. By the end of the recession, the market is higher than the beginning of the recession.
Will We Have a Recession?
Dr. Paul Samuelson famously said: “The stock market has accurately predicted 9 out of last 5 recessions.” Just because the market is very scared of a recession doesn’t mean one is coming. The world economy is very robust, and the drag caused by the contracting housing sector is more than made up by surging exports. The silver lining is consumer spendings, which account for 70% of the economy. The alarmists argue that the tumbling housing price and the surging oil price will kill off consumer spendings. The optimists argue that the job market is still very robust and pays are still increasing. The jury is still out.
Recession’s Impact on Different Sectors
If indeed the domestic consumption driven recession comes to pass, the most affected sector is likely to be Consumer Cyclical. The sectors that are most insulated are Technology and Capitals Goods. Both are driven by robust foreign markets and made more competitive by the falling dollar.
Be Cautious About Emerging Markets
Emerging Markets have done extremely well over the last few years. In the last two years alone, the Chinese market went up 400% and the Indian, the Brazilian and the Russian markets went up only slightly less. On November 5, Petro China was listed in the Shanghai Stock Exchange. It instantly became the largest company in capitalization in the world, doubling the capitalization of second place Exxon Mobile. (Petro China’s earning is about a quarter of Exxon Mobile’s.) As a matter of fact, 5 of the top 10 market cap stocks in the world are Chinese stocks. That’s pure magic! China is a land of opportunities for rough and tumble, hand on entrepreneurs with the right connections. For us armchair investors, we rely on an independent legal system, a solid accounting system and a fair disclosure system to safeguard our interests. I am afraid China and many emerging economies have none of the above yet.
What to do next?
If your investment horizon is more than 3 years, you should tune out the cacophony of market punditry. If your investment horizon is less than 3 years, some adjustments to your portfolio might be necessary. If your investment horizon is less than a year, you shouldn’t be in the market in the first place.
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Academics have found out that stock returns are driven by several factors: size, valuation, fundamental, seasonal and momentum. I’ve covered the seasonal factor quite extensively in previous communications. At some point I will talk about the momentum factor as well. In this article, I will primarily talk about three very important factors: size, value and fundamental. Our investment strategy MDVFS is designed to take advantage of these three factors. These three factors are risk factors, meaning that they have their own risk/reward characteristics. By understanding these factors, you will come to grasp the risk/reward characteristics of MDVFS.
Size Factor
“Size matters” – we heard that a lot. Usually that means ” the bigger the better.” In the arena of investment however, it could mean “small is beautiful.” Based on the data in professor Kenneth French’s online library, between 1963 and 2006, small cap stocks on average outperformed large cap stocks by 3.76% a year. However, small cap stocks don’t always outperform. Out of those sample years, small caps stocks outperformed 57% of the time and large cap stocks outperformed 43% of the time. As a matter of fact, we are in a period of small cap underperforming now. In the past 12 months, small cap stocks have underperformed by about 3.61%.
Value Factor
Stocks’ valuations have very strong predictive power regarding their prospective returns as well. Though Wall Street prefers P/E as a valuation measure, academics have found P/B to have the most predictive power. Value stocks are defined to be stocks with the bottom 30% P/Bs and growth stocks are defined to be stocks with the top 30% P/Bs. Between 1963 and 2006, value stocks on average outperformed growth stocks by 6.51% a year. Value stocks don’t always outperform though. Out of the sample years, value stocks outperformed growth stocks 70% of the time and growth stocks outperformed value stocks only 30% of the time. As a matter of fact, we are not just in a period of small cap underperforming, we are also in a period of value underperforming now. In the past three months alone, value stocks have underperformed growths stocks by 7.29%.
Fundamental Factor
Fundamental factor is the strongest of all. According to professor Piotroski’s research, fundamentally strong stocks on average outperformed fundamentally weak stocks by an astonishing 18.3% a year. Despite overwhelming historical evidence, it should not be taken as axiomatic that strong stocks always outperform weak stocks. Strong stocks only outperform to the extent the market is surprised by their strengths and weak stocks only underperform to the extent the market is surprised by their weaknesses. Because large cap and domestic stocks tend to be better covered by analysts relative to small cap stocks and foreign ADRs, the fundamental factor has the best predictive power among small cap stocks and foreign ADRs.
Even the fundamental factor is not without risk. Historically, one out of seven years, fundamentally weak stocks actually outperformed fundamentally strong stocks! It is helpful to recall that during the height of the internet bubble in 98/99, people shunned solid brick and mortar stocks in favor of .com stocks without any sales. Warren Buffet was laughed at because he did not subscribe to the idea that profits don’t count any more for .com stocks. He suffered ridicules for two long years and now it’s clear to us that his patience and discipline paid off.
Conclusion
MDVFS picks fundamentally strong stocks among deep value stocks, it is therefore exposed to the value and fundamental factors by design. In portfolio composition, MDVFS assigns equal weighting to large cap stocks and small caps stocks, the resulting portfolio is also exposed to the size factor.
MDVFS is most appropriate for patient investors who do not care to follow the market, since over the long run, we almost surely will benefit from exposure to the size, value and fundamental factors. In any given moment however, these factors may not necessarily work to our favor.
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Do you know that the top three one-day drops in Dow Jones happened in October? On the 19th of October 1987, Dow Jones fell nearly 23%, making the day the worst day in the US stock market history. It was followed by the 24th and 29th of October 1929, when Dow Jones fell 13.5% and 11.5% respectively, ushering in the Great Depression. These events are commonly remembered as the crash of 29 and the crash of 87.
Despite boasting the top three worst days in the market history, October is not the worst month for the stock market. That distinction belongs to September. (See Chart) In fact, summer (from June to mid October) is usually the most volatile and least productive season for stocks. Economists can not quite account for it, but this seasonality is very persistent. So much so that there is a Wall Street folklore that says “buy in November and sell in May”.
The title of my June Newsletter is “Stock Market Seasonality “. This is a good starting point to understand the “What” of this topic. In this article however, I will attempt to discuss the “Why” of stock market seasonality through the prism of Nobel Laureate Daniel Kahneman’s behavioral theories.
Information Accessibility
Some information is more accessible to human minds than others. For instance, visual images are more accessible to human minds than statistics. Deers kill approximately 600 times more people in the US than alligators. Yet if you ask people which of the two animals is more dangerous, nearly all would pick the alligator. Why so? Because alligators look more dangerous and the Chinese said:”An image is worth a thousand words.”
In the case of those big stock market crashes, the most accessible information to ordinary investors is the calendar information – in October they happened. The reasons, the dynamics and the consequences of the crashes are simply quite difficult to comprehend. Take the crash of 87 for example, dynamic hedging and program trading were the culprit. Because the crash was not triggered by economic fundamentals, the market recovered very quickly. Teaching of dynamic hedging belongs to PhD curriculum. It is just too difficult for ordinary investors to understand.
Anchoring
In the words of Kahneman and Tversky, “people rely on a limited number of heuristic principles which reduce the complex task of accessing probability and predicting values to simpler judgments.” One of the heuristic principles is anchoring, which is relying on the most salient or accessible information, rightly or wrongly. In the case of the crashes, the most salient and accessible information is that they both happened in October, and ordinary investors may intuitively judge that to be the plausible cause of the crashes. More thoughtful investors may suspect that both crashes happening in October is a mere coincidence, and they may mentally attempt to correct the initial intuitive judgment. According to Kahneman and Tversky, however, “the correction is likely to be insufficient, and the final judgment is likely to remain anchored on the initial intuitive impression.”
Explanation of Stock Market Seasonality
The vast majority of investors may very well anchor their understanding of the crashes on the calendar and incorrectly judge October to be the month with a very high likelihood of another crash. To hedge this imagined risk, some of them may take their money out of the market entirely in September or earlier and just wait for October to pass, causing the market to go down in summer and in particular in September. The rest who keep their money in the market would become very vigilant and may tend to interpret information more negatively than it is, causing the market to be very volatile. After October however, money would return and vigilance would be replaced gradually by holiday spirits and we get our usual year end rally.
Reference:
Daniel Kahneman’s Nobel lecture in 2002, “ Map of Bounded Rationality”
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During this correction, the Russell 2000 Value Index tumbled 16.88% based on intra-day data. Comparatively, the peak-to-trough draw-down for the Russell 2000 Growth Index is 12.97%, for Nasdaq 100 12.38% and for S&P 500 11.91%.
This is quite usual! There are a few well-established effects in the stock market. Among them are the Small Cap Premium Effect and the Value Premium Effect. In plain English, small cap stocks outperform large cap stocks, and value stocks outperform growth stocks, in aggregate and over the long run. In the case of the Value Premium Effect, this is not due to risk. Lekonishok, Shleifer and Vishny in one of their researches, investigated how different types of stocks performed during the 25 worst months over the last 30 years. They found overall, value stocks held their value better than growth stocks. During this correction however, this pattern was broken. Why small cap value stocks fell so much, even more than small cap growth stocks? Is it an aberration? or does it portend something new academic researchers have not yet discovered?
I believe there are two reasons to small cap stocks falling more in this correction: exposure to financial sector and hedge fund liquidation.
This correction started with the news that two Bear Sterns hedge funds investing in CDOs (Collateralized Debt Obligations) and CMOs (Collateralized Mortgage Obligations) suffered severe losses and had to shutdown. That sudden event helped focus the market’s attention on that fact that subprime mortgage delinquency has jumped more than 100% in the past year. The market decided to punish all financial stocks, regardless of their subprime exposure. The value sector is over-weighted with financial stocks, mostly small community banks. For instance, 30% of the Russell 2000 Value Index made up of financial stocks. As the result, the Russell 2000 Value Index fell more than the Russell 2000 Growth Index.
The news that three BNP Paribus hedge funds also had to shutdown must have caused a run in hedge fund money that persist to this day. Overnight, Nikkei dropped more than 5% and in the previous night the South Korean Kospi dropped 7%. They do not have any subprime exposure, why punish them? Alas, hedge funds are unwinding their positions everywhere.
The run in hedge funds hit a specific type of funds called quantitative funds as well. The two Goldman hedge funds who got a $3 billion dollar bailout from Goldman Sachs belong to this type. They use long-short strategies to capture the Small Cap Premium Effect and the Value Premium Effect. The long portfolios tend be small cap and value stocks and the short portfolios tend to be large cap and growth stocks. According to a Wall Street Journal report, the two Goldman hedge funds are leveraged up to 6x. Goldman’s Global Equity Opportunities Fund had $5 billion in capital, with 6x leverage, they had $30 billion to play with. To unwind their positions, they were forced to sell their longs and buy back their shorts. With billions of dollar of selling from Goldman’s hedge funds alone, and unknown billions from other quantitative hedge funds, small cap value stocks were hit very hard.
I believe the effect of this sequence of events is transitory and small cap value investing remains fundamentally sound.
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I am an amateur pilot. I remember vividly an episode happened during one of my training classes a few years ago.
That was a very windy day. Up to that point, I had only experience flying in calm weather. As soon as my Cessna took off, I immediately felt the difference. My plane was tugged and pulled in all directions by cross winds. I felt like I was losing control of the plane, and fear swelled up from the bottom of my spine to the top of my head. I sat stiffen in the pilot seat and my sweaty palms grabbed tightly at the control handles like a sinking person grabbing onto a straw.
My trainer sensed my tenseness and she asked: “Are you OK?”. Not willing to acknowledge my fear, I asked her instead: “Is it more dangerous to fly in turbulent weather like this?” The trainer smiled and said: “It is not more dangerous to fly in turbulent weather. The plan was built to withstand any turbulences. But occasionally, an amateur pilot would lose his cool and do something stupid. That’s the real danger.”
The instruction given to me by my trainer is equally valid for investors who are piloting through this turbulent stock market. If you are like all other investors, you would be caught up by fear and anxiety. What should you do? Should you dump stocks and move to bonds? Should you abandon the small cap value style of investing? Should you rotate to “quality” (an euphemism for large cap growth stocks)? If you turn on the TV or open a newspaper, you would be bombarded with advices to do some or all of the above. My recommendation is to do nothing and just stay the course. Anything you do at this time are more likely out of fear than out of reason. If you allow yourself to be driven by fear (and greed), then it is truly to your detriment.
Paraphrasing my pilot trainer, the turbulent market is not more dangerous. Don’t lose your cool and do something stupid. (You can start by stopping listening to the cacophony of market punditry.)
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On July 17th, the S&P 500 reached its peak after breaking a string of records. In a two week time however, both the S&P 500 and the Nasdaq Composite have lost 7.7%. The index that represents smaller stocks suffered a bigger loss of more than 10%. Are you feeling any pain and anxiety? I know I am.
Before I talk about how I deal with the pain and anxiety arising out of the market tumble, I’d like to first talk about the Equity Premium Puzzle and the Myopic Loss Aversion. These are weighty academic terms, but they would help us understand our psychology and how it could drive us to do stupid things.
Let’s suppose that John Doe has a 10 year investment horizon. He has $100k to invest. Should he invest in treasury bonds yielding 5% a year or in a S&P 500 index fund with long term average return of about 11%? If the money is invested in treasury bonds, 10 years later, John Doe will have $163k for sure unless the US government goes bankrupt. If the money is invested in the S&P 500 index, then John Doe can expect to have $284k. However, this is not sure money. He could end up with more or he could end up with less. The volatility of the S&P 500 is about 15% a year, so with 95% probability, John Doe’s money will be between $189k and $379k. There is a less than 2% probability that investing in treasury bonds will yield more in 10 years. If John Doe is rational, he should invest his money in a S&P 500 index fund.
What economists found out however is that the average John Does in America invest more of their money in treasury bond type fixed income securities. The economists call this the Equity Premium Puzzle, which can loosely be translated into “why on earth would any rational person look past the much better stock return to invest in bonds?”
The term Equity Premium Puzzle was coined in 1985. In 2002, psychologist Daniel Kahneman won the Nobel Prize in economics for his Prospect Theory which was developed decades earlier. Prospect Theory is a theory of how humans perceive gains and losses and how human decisions are driven by these perceptions. What Kahneman found was that the pain from losses is much stronger than the joy from gains of the same magnitude. For instance, when a baby is born, no doubt it is a joyful moment for the parents; but when a baby dies, the anguish felt by the parents is much stronger than the joy of birth. For another example, if you make $1000 in the stock market, you will be happy and excited; if you subsequently lose $1000, you will feel worse.
In 1995, Shlomo Benartzi and Richar Thaler used the Prospect Theory to explain the Equity Premium Puzzle. Here is my interpretation of their work. Regardless of his investment horizon, John Doe’s perception is instantaneous. An immediate gain in the stock market (which may not last) will elicit instantaneous joy and an immediate loss (which may not persist) will elicit instantaneous pain that is stronger than the joy. John Doe may be aware that over the long run, he will be ahead with stocks, but that long run result is unlikely to be in his mind. What is likely in his mind is the fear of the pain of losses he might suffer today or tomorrow. This fear is called Myopic Loss Aversion and it drives our investment decisions. For instance in the last two weeks, the 10 year treasury yield has dropped to 4.75% and blue chip stocks have fallen less than the broader market. These are evidences that people are rotating into bonds and blue chips out of the fear.
Do we want our investment decisions to be driven by fear? How do we harness the fear and even turn it to our advantage? Warren Buffet once said:” Be greedy when others are fearful, and fearful when others are greedy.” Daniel Kahneman also suggested that we looked at our investments quarterly instead of monthly. It would serve us well remembering their wisdom.
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Market Sentiment and Stock Returns
Posted on: July 31, 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 – https://pages.stern.nyu.edu/~jwurgler/papers/wurgler_baker_investor_sentiment.pdf
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Larry Meyer: Diminishing Risks …
Posted on: July 12, 2007
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.
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.
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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.
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How to Set Effective Stops?
Posted on: June 24, 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.
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Stock Market Seasonality
Posted on: June 16, 2007
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).
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.
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