# The Investment Scientist

## Archive for the ‘Stock Market’ Category

### Tracking the performance of Jim Cramer’s Jan 2007 stock picks

Posted on: March 6, 2008

Jim Cramer:

What I’m saying is that there are bargains right now, there are stocks right now that if you’re shrewd enough, you will be able to buy them at the opening today and you’ll make money in a year from now.

It has been a year since Jim Cramer made his many picks in Mad Money Lighting Round last January. Undoubtedly, many people followed his advice buying his stock picks. To get an idea of how much money they made, I decided to do a little research.

The research is straightforward enough. I looked up the recap of Mad Money Lighting Round at SeekingAlpha.com and tabulated Jim Cramer’s bullish and bearish calls. I then calculated one-year returns from the second (market) day he made the calls.

Bullish: If a bullish call has a one year return higher than that of the S&P 500, it is a right call. If not, it’s a wrong call. Bearish: If a bearish call has a one year return lower than the S&P 500, it is a right call. Otherwise it’s a wrong call.

I calculated the accuracy of his calls by this formula: Accuracy = right call/all calls. I also determined what return a loyal Cramer follower would have made if he/she had bought all of his bullish calls and sold all of his bearish calls.

In January of 2007, Jim Cramer made a total of 194 bullish calls and 123 bearish calls. Out of the 194 bullish calls, 60 are right calls. Out of the 123 bearish calls, 53 are right calls. The accuracy of Jim Cramer’s bullish calls is 30.93% and that of his bearish calls is 43.1%. The combined accuracy is 35.6%.

During the one-year period after Jim Cramer made his calls, the S&P 500 fell an average of 3.72%, his bullish calls on average fell by 3.33% but his bearish calls actually increased by 3.11%.

The table below shows Jim Cramer’s calls on 1/3/2007 and their subsequent one year returns. You may request a complete report of all of his January 2007 calls from MZ Capital.

 Date Bullish Calls 1y return Bearish Calls 1y return 1/3/2007 CVX 38.46% XOM 31.17% MPEL -50.53% MOT -20.97% NYX -11.22% NOK 86.41% EBAY 3.96% HSY -20.94% SPG -14.71% NXG -1.89% AUY 25.53% KRY -32.88% DELL -9.64% WFC -17.58%

Data source: SeekingAlpha.com
Research assistance: Ivy Cui

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### What do Fed rate cuts mean to your stock portfolio?

Posted on: February 27, 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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### Small (cap) is beautiful in a recession

Posted on: February 21, 2008

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.

### After deep sell-offs, follow sharp rallies?

Posted on: February 4, 2008

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.

### Not Without Risk: Factors Driving Stock Returns

Posted on: October 22, 2007

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.

### Do You Use any Stock Monitoring Software?

Posted on: July 10, 2007

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.

### 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.

### What is the Best Way to Make 10% per Month in Stock Markets?

Posted on: May 23, 2007

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.

### The Unbearable Lightness of Chinese Stocks

Posted on: May 15, 2007

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.