The Investment Scientist

The Premium
The small cap value premium is a Nobel Prize-winning discovery about the stock market by Eugene Fama and Kenneth French. (Only Fama was awarded the Nobel Prize in 2013.) The original paper “The Cross-Section of Stock Returns” was published in the Journal of Finance in 1992. Using stock market data from 1963 to 1990, Fama and French found that small cap stocks outperform large cap stocks (small cap premium) and value stocks outperform growth stocks (large cap premium). Collectively, they are referred to as the small cap value premium.

Since the paper was published, many researchers have done out-of-sample studies and they found that this market feature persists in the data from 1928 to 1963, in the data from 1990 to as late as 2010, and even in foreign stock markets. So in academic jargon, this is a very robust feature of the market. (See chart below.)

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3__L3__001.pngToday the Oxford University Business School arranged a webinar in which my  macro-economics professor, Oren Sussman, explained to us the economic impact of the Coronavirus. I will summarize the key takeaways below. 

The capitalist system is characterized by periodic crises. The last one was the 2007 housing crisis. Even without the Coronavirus outbreak, we were on borrowed time. The long expansion since the last crisis was very much fueled by easy money from the Fed and imprudent fiscal policy from the federal government. As a result, the whole economy is overly leveraged (that is to say,  having too much debt.) An economy without too much debt is like a pond of water. A stone thrown at it will create ripples that will eventually dissipate. An economy with too much debt is like a pane of glass. A stone thrown at it can break the whole thing. Prior to the Coronavirus outbreak, our economy was already like a pane of glass. Read the rest of this entry »

 

240_F_119564777_rEkf9eOoPwdUrMeRlzSKmO6eKokHwbvd.jpgLet me start with my usual disclaimer that I can not predict the market. Like the similar article I wrote four weeks ago, this article is simply an exercise in which I think through possible scenarios for the market. 

When I wrote “Will The Stock Market Give Us a 30% Discount?” the market had already fallen 19%, and I was thinking through the scenarios under which it would fall through 30%. One of the scenarios unfortunately came true: some US states have lost control of the Coronavirus situation, and the market did drop all the way to 36% before recovering to 23% down as it stands now.

Now with Europe finally turning the corner and the rapid spread in the US beginning to decelerate, will the market discount disappear quickly or will there be more shoes to drop that could  cause the market to give us even deeper discounts? Could it hit 40% or more?

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envelopes.jpgAllow me to indulge in a bit of fancy. I would love to be remembered as the person who invented the oxymoron “Intelligent Ignorance.” By the end of this essay, I hope to convince you that intelligent ignorance can make you a better investor.

Like the other oxymorons “jumbo shrimp”, “pet peeve”, “bloody awesome” etc., this one needs a story as well. It all started with Nobel Prize winner Daniel Kahneman’s discovery that we humans experience joy when making money and pain when losing money – Duh!  Hold on, keep on reading, there’s more. The pain is usually twice as intense as the joy even if the amount of money lost or gained is the same. This means that if you pay too close attention to a volatile market, it could be a hell of bad experience. Bad experiences lead to bad judgments and before long you are making bad trades.

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28_base-rate-neglect.jpgAllow me to ask you a seemingly unrelated question: what do you think the most common hair color in Ireland is? If you answered red, you are like the majority of people, but you are also wrong. The most common hair color in Ireland is dark brown (80%.) 

As you answered that question, what went through your mind? What mechanism caused you to arrive at the wrong answer? How is it relevant to stock market investing? I will answer these questions one by one in the space below.

If you answered red, you were using a mental shortcut called the representative heuristic to answer the question. What is the representative heuristic, exactly? It essentially says we humans tend to erroneously equate what is representative to what is likely. Indeed, red hair is representative of Irish people. Just under 10% of the Irish are redheads, compared to 1% of the rest of Europe. So the typical Irish in your head is a redhead, probably wearing green clothes and holding a pint of Guinness. Since you can easily recall a redhead Irish in your mind, you think therefore that the Irish are more likely to be redheads.

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crowdsource.jpgYesterday I wrote about this little mental quirk called the “availability bias” that could cost you a lot. I gave you an example, based on my conversations with clients and their propensities that I had to suppress. If an investor sold his portfolio four days ago at the bottom of the market based on his experience the prior week, and bought back yesterday because he was inspired by the 3-day 20% rally, he would have owned 20% less productive assets.  This is even though the total dollar amount is the same, since what he bought was 20% more expensive than when he sold it.

But most likely, this person won’t sense any loss, since after all, he owns the same dollar amount of stocks. How cool is that? He loses 20% of his wealth, his future income will be 20% less, and yet he barely notices it. It turns out there is another mental quirk that is playing games with him. It is called the “saliency bias.”

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drawing-chart-going-up.jpgAfter three days of the stock market rallying, I have noticed a change of tune among my clients who have been calling me. Three days ago, a few of them were asking if they should get out of the market altogether and wait until things turned the corner. Three days and 20% higher in the Dow, they want to increase their investment in stocks. But why? Why are stocks so bad when they are 20% cheaper and so good now that they are 20% more expensive!?

There is a little mental quirk that has been playing games with us. This quirk was discovered by Nobel Prize winner Daniel Kahneman, together with his trusted collaborator Amos Tversky who died too young to share the Nobel Prize. This quirk is called “availability bias.” That is when we assess the probability of a future event, we try to recall that event from our memory. If the event can be easily recalled, we subjectively judge it to be more likely. Read the rest of this entry »

 

Now that the panic has abated a little, many financial advisors (FAs) are advising their clients to buy strong stocks on sale. None other than Jim Cramer made the same proclamation, he even mentioned ten stocks by name. (Just FYI, he did the same in 2008 – and I did a study afterward – 8 out of the 10 underperformed the S&P 500 index that year.)

So what are the strong stocks to own? Are they industrial titans like Boeing or GE? They were strong stocks but are they still? Are they Wall Street banks too big to fail like JP Morgan or Citibank? But how do we know they’re not just another Lehman Brothers? Is it a consumer tech giant like Apple? How can we be sure it won’t go the way of Sony, which was the previous consumer tech giant. How about Netflix? When we are stuck at home social distancing, you’ve got to watch Netflix right? But what if Amazon, Apple and the other big boys jumping in the streaming market eat its lunch?

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1.jpgPrior to the market’s open yesterday, the Fed announced unlimited asset purchases that also include corporate bonds, municipal bonds and securities backed by consumer loans.

Wow!

There is a long-term downside of taking this measure. I am not going to write about it until the market calms down. Today I am going to write about the short-term upside for the economy, for the market and for investors like us.

Whether it is called QE (quantitative easing), asset purchases, or balance sheet expansion, it means the same thing: the Fed is creating new money. Just ten days ago, the Fed announced they would create $1.5T new money, but the market pretty much ignored that. Now the Fed is essentially saying that they will create as much money as possible to back-stop this financial crisis.

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018443422de7644a788fd5f9daa27e3a.jpgOver the weekend, a client of mine sent me a news report about how Senator Richard Burr, head of the Senate intelligence committee, sold his stocks before the coronavirus market crash. This maneuver is called front-running the market. Simply explained, if you possess superior information that the market does not have yet, you can massively profit from this superior information by positioning your portfolio ahead of the anticipated impact the information will have on the market once it becomes public.

There is a whole body of academic studies on who has superior information. They are the usual suspects: lawmakers and company executives. Regarding company executives, research shows that CEOs and COOs have the best inside information, followed by CFOs. After that, information superiority drops off quickly. The information possessed by company directors is rarely superior. Research also shows that legislators are able to position their portfolios as they make laws. The difference between lawmakers and company executives is that the latter’s actions are heavily regulated and the former’s are not.

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MW-DB025_balaci_20141208133245_ZQ.jpgBy the close of the market yesterday, the Dow was discounted by 32% from its peak just three weeks ago. This level of discount happens once a decade. The last two times were during the 2000 dotcom bubble burst and 2008 financial crisis. 

I have been busy rebalancing portfolios for myself and my clients. What is a rebalancing? Imagine a client has a target allocation of 60/40, that is, 60% in stocks and 40% in bonds. After the last round of discounts, the allocation becomes 45/55. To get back to the target, I must sell bonds worth 15% of the portfolio and use the money to buy stocks.

All investors set out to buy low and sell high, but when the market is giving them a 30% discount, most of them freak out and want to sell every stock instead. There are a few human judgement heuristics and biases at play here that were studied by Nobel Prize winner Daniel Kahneman, like representative bias, base rate neglect, availability bias, anchoring and framing heuristic. When I have time, I will write about those heuristics and biases.

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unnamed (11).jpgYesterday, what got lost in the panic selling was the Federal Reserve’s announcement that $1.5T will be injected into the banking system. 

Nowadays, money is created not through Treasury’s printing press, but through the Fed’s central bank balance sheet expansion. I won’t bore you with the mechanism. Suffice to say that yesterday, $1.5T of new money was created, and this new money has to go somewhere.

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discount_30_large.jpg

Let me start with my usual disclaimer that I can not predict the market. This article is an exercise in which I think through possible scenarios for the market. Also, while the media and common folks like to use “crash”, “tumble”, “fall,” etc to describe the market, I prefer to use the term“discount”. The former signifies danger while the latter signifies opportunity. 

As of the market close yesterday, after dropping 2000+ points, the Dow is right at the edge of correction territory (meaning down barely 20%.) The 2000+ point drop was the result of the double whammy of coronavirus out of control in Italy, and oil prices dropping 30% because of a price war between Russia and Saudi.

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Predicting the market is a dangerous business, but there are enough people asking me this question that I thought I’d give it a try.

First things first, Covid19 is not a Pandemic yet.  It is primarily in China and even within China, 88% of the cases and 95% of deaths are in Hubei province which has 60mm people. The second worst-hit province is Guangdong (my hometown). There are 586 existing cases and 7 deaths there as of this writing and this goes up by one or two cases every day. Guangdong has a population of 113mm people. So my sense is that outside of the epicenter province, the situation is under control within China.

That said, the virus has spread beyond  China and infected hundreds of people in Japan, Korea, Italy, and Iran. The first three countries are unlikely to implement draconian measures limiting movements of people, the latter country does not have the medical resources to detect and fight the virus. The chances of Covid19 becoming a pandemic are increasing. So asking how that will affect your investments is a reasonable question.

The best way to answer the question is to study close historical precedents. The most recent, I believe, is the H1N1 swine flu pandemic. We have the added benefit that this virus was first detected in the U.S., which took the worst economic hit. Covid19 has barely reached the U.S. shores yet. Whatever impact it will have economically, it should be less than H1N1.

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Part of Wall Street analysts’ job is to make earning forecasts of covered firms so as to guide investors’ actions. In 1996, Professor Rafael La Porta discovered an interesting phenomenon: the better the forecasts, the worse the returns! Twenty years have passed since his last paper, now we have two more decades of data. Does the new data confirm or contradict his original discovery? Well, see this graph, which I lifted right from his new paper.

unnamed (8).jpg

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Before we discuss the cost of advanced taxation (or the benefit of deferred taxation,) I need to first introduce the concept of time value of money. That is to say, $100 a year from now is different from $100 today.

Let’s say I owe $100 in taxes due to be paid next year, but for some tricky reason, the IRS wants me to pay that now. How costly is this advanced taxation to me? Well, if I didn’t have to pay the tax today, I could invest the $100. Let’s also assume the return is 8%, so by next year, I would  have had $108. I could pay the $100 tax and get to keep the remaining $8. If I have to pay $100 today, I forgo that $8. That’s the cost of advanced taxation. 

With this concept established, now let me run an experiment with the following assumptions:

  • The investment cycle is 20 years.
  • The investment return per year is 8%.
  • Of  the 8%, 2% is dividend distributions that are taxed at a 50% marginal income tax rate.
  • The remaining 6% is the capital gain. Capital gain distributions (“CGD”) range from 0% to 5%, and they are taxed at the long-term capital gain tax rate of 20%.

The study is about how changing the CGD rate affects the investor’s tax liability as a percentage of initial principal investment.

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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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