Archive for the ‘Economics & Markets’ Category
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.
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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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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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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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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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An Overdue Correction
Posted on: June 5, 2007
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!
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On a recent air trip to China, I found myself sitting next to a Japanese. As our conversation turned to real estate, I opined that the Japanese real estate market had finally turned the corner after 16 years of falling prices, and it might be a good time to buy. He immediately disagreed with and went on to give me a litany of reasons why the Japanese real estate prices would keep on falling. His reasons include that no Japanese nowadays would think that the real estate prices will ever go up again.
In 1991 when the Japanese market was at its peak, banks were lending to home buyers without any down payments, people were taking out interest only loans, and everybody was expecting the real estate prices, already the most pricey in the world, to keep on rising. Does that sound familiar? Was it like what we saw two years ago in some hot markets in the US?
The excess in their real estate market took the Japanese 16 years to unwind. During this time, their real estate prices fell by an average of 60%. Counting inflation, real values have fallen by more than 80%.
Could the US real estate market experience a long recession like what had happened in Japan? I can’t give a definite answer. However, judging by how relatively optimistic people are with real estate, I believe there is still a long way to go before the market turns around. I think when I don’t see real estate investors around me, when I don’t see people talking about real estates as the best investment, better yet, when I see people in the US speak like the Japanese I met on the trip, I can then reasonably conclude the bottom has been reached.
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The title is a question posted to me by email, and the following is my answer.
In 2003, for a very short period of time, I achieved that type of return.
That was when Sarbane-Oxley Act went into implementation w.r.t. insider trading reporting. Before the implementation, company insiders (CEO, COO, CFO etc) had two month time to report their inside trades, and by paper; after the implementation, they had to report within two days electronically. At that time, I created a program to query the SEC insider trade database. As a result, I was able to follow the insider purchases as soon as they were reported. One or two weeks later, when the insider purchase news hit the wire (Dow Jones or Wall Street Journal), the stock prices would jump and I would exit with a tidy profit. At one point, I was making 30% monthly returns. In less than 6 months however, websites were popping up left and right offering real-time insider trading information, and my strategy became obsolete.
The point I want to make is: if there is a way to make 10% monthly return, it won’t last very long if there is no barrier of entry. That’s why in my current investment management practice, I do something others can not easily mimic.
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On May 13th, the Shanghai Stock Exchange Composite Index (SSEC) for the first time crossed the 4000 level. In just this February, when the index crossed the 3000 level for the first time, it promptly dropped 9%, causing a worldwide correction in stock prices. Who would have thought, in the short 3 months that followed, it would have crossed another milestone.
Indeed the whole country of China is swept into stock investment hysteria. By the end of April, there were 96 million brokerage accounts in the country, three times the number there were last April. New brokerage accounts are opened at the rate of 1 million every 3 days. If you get into a taxi in Beijing or Shanghai, you will likely get a free lecture on stock investment along with the ride; street vendors will offer you free stock tips as you shop and even grandmas and grandpas can’t resist dabbling in and out of stocks with their life savings. (The picture below is a grandpa before a screen of stock prices. The coloring convention is the opposite of the US. Red means profits and green means losses.)
Miracle stories abound as well. There are the usual overnight success stories of somebody (names published in newspaper) who made over a million dollar in one day. There are even stories of chronically sick patients who recovered after winning big in the market.
These anecdotal stories of mania are worrisome enough, they are further corroborated by the unsustainable high average P/E ratio of over 50 in the Chinese stock market.
That’s why I see dark clouds gathering even while many people still see green. Stock market crashes of significant magnitude (> 40%) are never caused by economic problems alone, they are usually preceded by a period of unbridled optimism. The optimism in China now is at a hysterical level and it is unlikely to abate leading up to the 2008 Olympics. What I am afraid will happen is that after the 2008 Olympics or shortly before that, smart money will exit the market. A massive exit could trigger a run in the Chinese market that would spread globally.
What can we in the US do about it? First, don’t panic. The ship that is the US financial system is very solid and resilient, storms (even one coming out of China) will shake it but will not sink it. Second, it would be prudent to raise the cash level of your investment leading up to the Olympics. In case you don’t know, the opening ceremony will be on 8/8/2008, still 445 days away. Third, it is wise to invest in defensive stocks.
As a matter of fact, it is always wise to invest passively.
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