The Investment Scientist

Archive for the ‘Economics & Markets’ Category

In a previous article, I used the Quantity of Money equation to explain what the Fed had done to rescue the economy from imminent collapse at the onset of the Pandemic. Today I will explain why doing that caused inflation and why that inflation is not unlikely to be transitory unless certain things happen.

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I learned this “Quantity of Money” equation during my Oxford program and it has greatly helped me understand Fed’s actions and their implications.

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I am writing this article one hour before today’s market close. If there are no surprises, the S&P 500 will end the day in a bear market, meaning the index is giving us a 20% discount  from its peak. As a comparison, the Nasdaq is already giving us a 30% discount. 

As savvy investors, many of my clients and readers want to know: will the discount get deeper? And how long will the discount last? Well, like I always say, nobody can predict the future, but we surely can learn from history. That’s why I have done a study of all twelve bear markets since 1950. The table below illustrates my findings:

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If you bought a bond fund three months ago, you may have seen your fund go down about 10% in value! What the heck is going on? Aren’t bond funds supposed to be safe? In today’s newsletter, I will explain what’s going on, I will explain why you should still consider your bond funds safe, and I will even give you some hidden upsides of bond funds going down in value.

What’s Going On?
Last month we saw interest rates rallying. Bonds are essentially fixed future promised payments.  The current value of a bond is the sum of all fixed payments discounted by interest rates. When interest rates go up, it stands to reason that, applying the mathematical formula, the current value of the bond will  go down. This mathematical logic applies to all bond funds. 

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From the peak, Nasdaq is down about 24% and the S&P 500 is down about 14%. I am sure when you read your investment statement, you will feel queasy and wonder if you should stay invested. I think this is a good time to review my wardrobe theory of investment. Here is what I wrote in December 2018:

Treat your investment portfolio the same way you would treat your wardrobe…

For simplicity’s sake, let’s say you acquire your entire wardrobe from Neiman Marcus. If Neiman Marcus had an across-the-board 50%-off sale, would you throw up your hands in despair and say, “Darn it, my entire wardrobe just lost half of its value. I better sell it all at the flea market or I will lose everything?”

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The US inflation numbers for March just came out – it’s 8.5%, another 40-year high. I am afraid that, with the Ukraine War still raging, inflation will get worse before it gets better.

Shortly after the Russian Invasion of Ukraine, the West adopted the “Nuclear Option” of economic sanctions – expelling Russia from the SWIFT system. SWIFT is the payment system that undergirds international trades. Now that  Russia is no longer part of this, it can not sell its energy and agricultural products to the world market. 

How Would That Affect Global Commodity Prices?
Russia is one of the top three exporters of the following commodities: oil and gas, wheat, maize, sunflower seeds, sunflower oil, and fertilizers. On average it accounts for about 15% of world supplies. When these supplies are pulled out of the global market, the price of these commodities will skyrocket as they already have. Since these are basic commodities, and many products use them as inputs. The price shock is going to filter through downstream products as well. 

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In the face of rising uncertainties and the prospect of persistent inflation, today I investigated the historical performance of stocks and gold relative to inflation. Here is what I found:

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Over the last few days, I have begun to sense that a number of my clients are worried since the S&P 500 has dropped 13% and Nasdaq, about 20%. 

I would like to argue, if you are going to worry about something, please worry about the inflation rate, which just went up to 7.9% in February even before Russia’s invasion of Ukraine. 

Why is inflation so much more damaging?
You could have kept your money in a safe, and yet you still lost 7.9% to inflation in one year. If this level of inflation keeps going for ten years, you will lose 79% of the value of your money. That’s basically a wipeout.

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Last Thursday when the news reported that Russia had just launched an invasion of Ukraine, the market opened down nearly 800 points. A client called to ask if we should move to safety, but I was able to persuade him to stay put. I did that without knowing that the stock market would end the day slightly positive, followed by the BEST rally since 2020 on Friday. Such is the unpredictable nature of the stock market. Today I am gonna show you, missing the best days of the market can be extremely costly

Below is research from JP Morgan that I found on the internet. You can see that between 1995 and 2014, the annual return of the S&P 500 is 9.85% if invested through the whole duration. But missing just the 10 best days would drop the annual return to only 6.1%. Missing the 20 best days would drop the annual return to 3.62%. Missing the best 30 days would further drop the annual return to only 1.49%. 

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Yesterday, when I had a lunch meeting with the chief scientist at Fannie Mae, our conversation quickly turned to inflation.

My view of that is more pessimistic than the Fed and most mainline economists. Somehow, these economists seem to have forgotten a basic economic tenet – the rational expectation theory. This theory, to put it in layman’s terms, basically says that on aggregate, what people expect to happen will happen. That’s why Fed officials have long been extremely careful about what they say that could change people’s expectations. 

Today’s Fed under Jerome Powell has been much less careful. Here are the three acts of the current Fed that have crushed the expectation that inflation will stay low and stable. 

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I asked my assistant to do an updated stock market seasonality study.

The data we used was the S&P 500 index from 1927 which we found in Nobel Prize winner Robert Shiller’s database.

We assumed that at the beginning of each year we invested $1 in the index, and we observed how the investment fluctuated over the year. Then we took the average over three different periods of time: the last 20 years, the last 50 years, and the last 86 years.

Here is the chart we got: Read the rest of this entry »

images-75Yesterday I received an email from a doctor client of mine telling me how he had a conversation with some fellow doctors, and all of them are pulling their money out of stocks because they feel that with the market breaking new high after new high, a crash is imminent. He wanted my opinion.

First of all, while all of his doctor friends might feel a market crash is imminent and certain, there is simply no such thing as certainty in the stock market. All we can work with are odds. The following are the odds of market corrections:

Magnitude of market decline Frequency of occurrence (out of 64 years from 1950-2013)
>5% Every year (94%)
>10% Every two years (58%)
>20% Every five years (20%)
>30% Every ten years (10%)
>40% Every fifty years (2%)

My study also shows that the market breaking a new high does not substantially change the odds of returns. In other words, the odds of the market dropping over 20% in the next twelve months are still about one in five; the odds of the market dropping over 30% in the next twelve months are still about one in ten.
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Ken French

Professor Kenneth French

Last month I did a study to understand why equally weighted the S&P 500 index RSP has outperformed value weighted S&P 500 index SPY by almost 3% a year since its inception. My conclusion is that it’s mostly due to Fama French risk factor loading.

However, my research also found after removing the effect of risk factors, RSP has a slight alpha advantage over SPY. I conjecture this alpha advantage is due to the fact that RSP requires annual rebalancing and SPY does not. In other word, this could be the so-called “rebalance bonus.”

To test its robustness, I extended my study to six pair of Fama French “indices.”

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ImageAccording to Nobel Laureate Eugene Fama, there are three major risk premiums.

1. Equity premium is the additional “wage” one can earn from taking stock market risk over not taking stock market risk.

2. Small cap premium is the additional “wage” one can earn from taking small company risk over taking large company risk.

3. Value premium is the additional “wage” one can earn from taking non-growing company risk over taking growing company risk.

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images-58In the arena of academic finance, the debate over whether a rebalancing “bonus” exists or not has become somewhat of a religion!

Those who are ardent believers of an efficient market such as Nobel Prize winner Eugene Fama usually believe all returns should be the result of taking risk and that simple actions like rebalancing periodically should not produce additional returns.

Those who believe the market is emotion-driven, such as Nobel Prize winner Robert Shiller, believe in a rebalancing “bonus”. Since the market is either over-priced or under-priced from time to time, rebalancing allows us to take advantage of this market mispricing.

The return differential of RSP vs SPY provides an excellent control experiment to test whether this illustrious rebalancing “bonus” actually exists. SPY and RSP invest in the same 500 largest stocks of the US. SPY being a cap-weighted fund, does not require rebalancing, while RSP being a equally weighted fund requires periodic rebalancing.

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ImageSince its inception on March 9, 2003, RSP has returned 193%. At the same time, SPY has only returned 97%. This is extremely puzzling as both RSP and SPY hold the same S&P 500 stocks.The only difference is that SPY is a cap-weighted fund and RSP is an equally-weighted one. This begs the question, is RSP’s outperformance normal; and more importantly, is it likely to continue?

To answer the question I asked my intern Nahae Kim to run a regression based on the Nobel Prize winning Fama-French Three Factor Model.

R(x) – rf = alpha + beta1*(Rmkt – rf) + beta2*SML + beta3*HML

Where R(x) is the return of the selected fund, x being either RSP or SPY, alpha is the “skill” of the fund, beta1 is the market risk loading, beta2 is the small cap risk loading and beta3 is the value risk loading.

Here is what I got from the two regressions.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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