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The study is based on a theory that Professor Berk helped develop several years ago, about how flows among mutual funds affect their subsequent returns. This theory is unlike many that come out of academia, because it is based on the idea that many managers have genuine stock-picking ability. The reason that so few mutual funds beat the market over the long term is that investors shift too much money into the successful ones, or so the theory goes. As a result, these funds’ managers quickly become swamped with more money than they can invest profitably, causing performance to suffer. A helpful analogy, Professor Berk said in an interview, is to the so-called Peter Principle, which predicts that employees will be promoted until they reach their level of incompetence. Similarly, a mutual fund manager who beats the market will continue to attract more assets until he can no longer beat the market. The theory deals with averages and probabilities. Professor Berk doesn’t deny that lots of other factors besides cash inflows — including luck — can play large roles in a particular fund’s performance. And he concedes that it’s possible for a top-performing fund manager to continue beating the market for a number of years, even after his fund receives a huge influx of new cash. But the theory nevertheless predicts that the probability is very low that a top-ranked fund will remain top-ranked for very long. The data certainly provide strong support for this prediction: The mutual funds that have beaten the market in the recent past will rarely be able to keep doing so for longer than a few more months. This theory has been less successful, however, when applied to the worst-performing mutual funds. Less-able managers should become competitive once their portfolios become small enough, because, according to Professor Berk, it is easier to beat the market with a smaller portfolio than with a larger one. So, as investors shift money out of a lagging fund, its size should stabilize at whatever lower level is necessary to give its manager a fighting chance of beating the market. If this part of the theory were right, the worst performers would be no more likely to stay bottom-ranked than top performers to remain top-ranked. But that is not the case, according to the professors. A low-ranking performer, in fact, has a significantly greater chance of continuing to be a low-ranking performer than a top-ranking performer does of staying at the top. In the new study, the professors determined the source of the theory’s failure: Many investors just won’t sell their funds, regardless of how badly they are performing. By not selling, this loyal group prevents poor performers from becoming small enough that their managers can become competitive again. In their study, the professors did not analyze who these loyal investors might be, or why they would refuse to sell in the wake of poor performance. But Professor Berk says that their motivation may be as simple as an aversion to “playing the game” of constantly monitoring mutual funds’ rankings and transferring money away from the losers and into the winners. After all, he said, this task can take much time and energy. Whatever the motivation of these loyal investors, Professor Berk argues that their existence means that the rest of us have to stay on our toes to avoid holding one of worst-performing funds. As a rule of thumb, he says that at least once a quarter, investors should determine how their funds rank in trailing 12-month returns. They should consider transferring their money out of any fund that is ranked in the bottom 20 percent and into a fund in the top 20 percent, assuming that they will incur very low transaction costs when doing so, he said. Professor Berk acknowledges that such an approach runs the risk of unfairly selling a fund whose bad performance is only temporary. Nevertheless, he says that this rule of thumb “keeps you out of the dogs” — which he says is of paramount importance if you invest in actively managed funds. If all of this sounds like too much work, he recommends that you stick with index funds. Above all else, he says, you shouldn’t buy and hold actively managed funds without checking on them, because you run the risk of holding a fund that will consistently lag behind the market.
Since 1945, the S&P500 has gained just 1.6%, on average, during that stretch. The best six months for the S&P have been the period that’s coming to an end: November through April. Since the end of World War II, the S&P500 has shot up 7.1%, on average, during these months. This phenomenon has been just as strong in recent years. Since 1990, stocks have gained 7.8% from November to April, on average, but only 2.1% from May to October. Chris Orndorff, head of equity strategy at Payden & Rygel, says he doesn’t usually pay much attention to seasonal differences. “But these numbers are quite compelling,” he said. Why such a disparity in performance? Theories abound. Jeffrey Hirsch, editor of The Stock Trader’s Almanac, says investors may be “operating on a summer vacation schedule” during this six-month window. Investors usually don’t have as much money to put to work in the market in the middle of the year. By the time May rolls around, some people are done funding individual retirement accounts, and many have already spent or invested year-end bonuses. That may explain why mutual fund sales tend to slow noticeably during that six-month period. In fact, since 2000, net new inflows into domestic stock funds from November to April have been three times as big as those from May through October, according to data compiled by the Investment Company Institute. To be sure, the 1.6% gain for the S&P during this stretch is only an average. Health care stocks have risen 5.7%, on average, during those six months, while consumer staples have gained 5.3%. In a number of midyear stretches, the index has fared much better. From May to October of 2006, the S&P500 advanced 5.1%. From November 2005 to April 2006, the gain was 8.6%. While the May-to-October window is typically frustrating, two of the best months for equities — July and August — fall within it. And October has turned out to be the best one for domestic stocks since 1998, on average. The May-to-October period has outperformed the November-to-April stretch in almost a third of the years since World War II. So it may be far too simplistic — and risky — to just “sell in May and go away.” The fact is, “you’d prefer not to sell in May,” said Sam Stovall, S&P’s chief investment strategist.
Though the exact reason for the disparity isn't clear, the performance of these oil-related funds has been hurt by the run-up in oil futures, which has increased the sums they need to shell out each month to roll over their futures contracts. Greg Drake, a Claymore Securities executive, says occurrences like these are expected occasionally in the funds, though "it's not what we desire." An official at Alameda, Calif.-based Victoria Bay declined to comment. Such issues are arising in only a small number of ETFs, but they may mark a crucial shift in an investment sector long known for its predictable performance. At a time when ETFs are establishing themselves as a staple in Americans' portfolios, investors may need to consider that some new funds are coming to market with new risks and the potential to deliver unexpected results. One recurring problem: Some newer ETFs are diverging from their hypothetical rates of return. The indexes on which ETFs are based are routinely "back tested" to see how they would have performed in previous years. That back-tested data is then often used to market the funds to investors. Back-tested data for the WisdomTree High-Yielding Equity Index shows average annual returns outperforming the Russell 1000 Value Index for several time periods, including by more than three percentage points for the 10-year period ending in March. However, from June 2006 through the end of March, the ETF based on the WisdomTree Index trailed the Russell 1000 Value Index by more than 0.50 percentage point. Other ETFs issued by New York-based WisdomTree Investments and PowerShares Capital Management of Wheaton, Ill., have fallen behind their back-tested data in similar ways. Sixteen of the 20 ETFs launched by WisdomTree last June were outperforming their benchmarks as of the end of last month. "WisdomTree was happy with that performance," says Luciano Siracusano, the firm's director of research. He adds that "short time periods are not indicative of longer market cycles." The company's Web site states that "no representation is being made that any investment will achieve performance similar to those shown." PowerShares offers similar disclaimers. ETF advocates say new funds like these are an important investment tool because they often give small investors access to markets or strategies that traditionally have been tricky to invest in, ranging from gold, oil and other commodities to international real estate. That's partly why Victoria Bay's U.S. Oil Fund ranks among the most successful new ETFs, amassing more than $900 million in assets since its inception last April. The oil fund is designed to track the movements of light, sweet crude oil, a type of investment generally considered too cumbersome and complex for most individual investors. The fund's portfolio includes crude-oil futures contracts and other oil-related securities. However, since its inception, shares of the fund have declined more than 25%, while the oil price it is supposed to follow has fallen just 10%. Victory Bay portfolio manager John Hyland points to regulatory filings about the product that explain such potential discrepancies in returns. Among other issues, the filings state that because the fund invests in a broad array of sophisticated futures contracts and other instruments, it can stray from its benchmark. Two oil-related funds from Claymore, based in Lisle, Ill., have seen particularly striking discrepancies. The two funds -- the Claymore MACROshares Oil Up Tradeable Shares and Claymore MACROshares Oil Down Tradeable Shares -- let investors bet on oil prices rising or falling, respectively. But in recent months, their shares have sometimes moved in reverse of what they're supposed to. One day earlier this month when the relevant price of oil increased seven cents a barrel, the "Up" ETF's price dropped 25 cents. The two funds' shares also frequently close at big premiums or discounts to the value of their underlying holdings. On some days this month, for instance, shares in the "Up" fund were priced more than 8% above the value of its assets. The "Down" shares traded more than 9% below their asset value. These discrepancies highlight how tough it can be to design ETFs and related products like these for narrow or esoteric investments. "You never know what to expect with a new product," says Claymore's Mr. Drake. Overall, he says, the funds' underlying value has done "a fabulous job, compared to the alternatives, in tracking the price of oil." Another emerging issue relates to taxes. Holders of ETFs generally have been able to avoid the capital-gains taxes that often plague investors in conventional mutual funds. That's because a conventional mutual fund often has to sell some of its holdings when investors want to leave the fund; if those holdings have increased in value since they were purchased, it may have a capital gain. By contrast, ETF shares change hands in the market; the underlying securities don't have to be sold off when an investor wants to sell out. These days, however, more ETFs are making capital-gains distributions. About 6% of ETFs paid out capital gains to investors last year, compared with 3% in 2005, according to fund researcher Morningstar Inc. Among them was ProShares Ultra QQQ, which paid holders the equivalent of about 6% of its share price in gains last year, and the ProShares Ultra S&P500, which paid about 4%. The two funds seek to double the daily returns of the Nasdaq 100 Index and the S&P 500, respectively. To do that they buy not only the stocks in those indexes, but also futures and other derivatives, seeking to magnify their returns. ProShares says the two ETFs could be "less tax efficient than plain-vanilla ETFs" due to their investment strategy.
A weak U.S. dollar has aided exports although the boom in overseas sales is not so much about currency as about what American multinationals bring to the table, said David Goerz, chief investment officer at HighMark Capital Management Inc. "They're operating from a U.S. base and they're going overseas and being very competitive with high-end goods and services," Goerz said. "And that's really the key -- that they are the providers of high-end goods." Growth abroad, driven by urbanization and industrialization in emerging markets, is spurring greater purchases of U.S. goods, especially at the high end, Goerz said. The U.S. trade balance will improve faster than most people think, he said.
In the study, “Causes and Seasonality of Momentum Profits” by Richard Sias, a professor of finance at Washington State University, the momentum effect was concentrated in just four months of the year: March, June, September and December. For each month from April 1984 through December 2004, he calculated the difference between the average performance of two groups of stocks: the 10% with the best returns over the previous six months, and the 10% with the worst. He defined the momentum effect as the difference between these two average returns. In the average quarter-ending month over this two-decade period, Professor Sias found that the momentum effect averaged 3.1%. That’s equal to nearly 44%, annualized. But among all the other months of the year, on average, the relationship reversed, with the group of stocks containing the previous winners underperforming the group containing the previous losers. This marked seasonality suggested to Professor Sias that institutional investors were playing a large role. At the end of each quarter, he pointed out in his study, such investors often sell stocks that have performed poorly and buy those that have done well — in order to project a more favorable impression in their lists of holdings in end-of-quarter reports. This window-dressing causes previous winners to keep performing better than they otherwise would, and causes previous losers to perform worse. Professor Sias said the seasonal fluctuations of the momentum effect could also be caused by something else that some mutual funds do at the end of a quarter. Known as “marking the close,” funds sometimes place buy orders in the last moments of a quarter on stocks they already own. This is done, he said, to push those stocks’ prices higher, in turn bolstering the fund’s quarterly or yearly ranking. The momentum effect in the stock market has strengthened over the years, Professor Sias said. Consider what he found when comparing the effect’s magnitude in two periods: the first from mid-1963 to March 1984 and the second from April 1984 to the end of 2004. The momentum effect was much stronger for quarter-ending months and weaker for other months during the later period. This is exactly what we should expect, Professor Sias said, given the growth in the institutional share of stock ownership and trading. In 1950, he said, institutions owned just 7% of the total market capitalization of stocks listed on the NYSE. That figure grew to 28% by 1970 and is near 50% today. Institutions’ share of trading volume has also grown, Professor Sias said; they now account for some 70% of all trades. The study suggests a strategy for investors. First, momentum investing works best during quarter-ending months. Second, momentum investors should concentrate on stocks with high levels of institutional trading.
Certainly, Fed rate cuts stimulate the stock market in certain periods — after the economy is already clearly in a recession and stock values have already come down. In such cases, “by the time the Fed eases there’s a great deal of room for price-to-earnings multiples to increase, he said.“ When P/E multiples climb, stock prices generally rise. But at the moment, stocks are already fairly expensive - the P/E ratio of the S&P500 stands at 17 even as corporate earnings have risen to record levels. History shows that when the P/E ratio of the S&P500 is at least 17 — and when overall corporate earnings have surpassed previous levels — Fed rate cuts generally do not take the stock market higher. (Mr. Hussman calls the P/E in such times the “price-to-peak-earnings ratio.”) In fact, in periods since 1955 when the P/E of the S&P500 has been 17 or more, stocks, on average, have declined by 2.3%, annualized, in the six months following the first Fed rate cut in a market cycle. After that initial decline, however, the market has generally recovered: stocks have returned 6.2%, annualized, over the 18 months after the first Fed rate cut. Conditions in the bond market make the current prospects for the stock market worse than these figures suggest, Mr. Hussman said. At the moment, there is an inverted yield curve. Historically, when all of these bond and stock market conditions are combined, as they were when the Fed first cut rates in 1968 and 2001, stocks have been especially weak. In the first six months after cuts in those years, they declined by an average of 6.8%, annualized. And over the 18 months after the first cuts, they lost an average of 9.3%, annualized. Mr. Hussman says he is not convinced that the Fed, still concerned about inflation, will ease interest rates anytime soon. And if it doesn’t, he said, the outlook for stocks may be worse yet. “In my view,” he said, “the stock market risk/reward ratio is not appealing at this time.” But his bearish assessment of the stock market’s prospects is not universally held. Laszlo Birinyi, president of Birinyi Associates, says he expects the stock market to rise this year, whether or not the Fed cuts rates. Private equity firms have accumulated a huge reservoir of capital that they will continue to deploy to acquire publicly traded companies, he said, and that should buoy the markets. “I think we’re in a bull market,” he said. “It will continue for the rest of the year. The market is going to do well, with interruptions and bumps along the way.” He acknowledged that the growth rate for corporate earnings is declining, a development that has generally been a drag on the market. But he said that analysts’ estimates had already “come down so sharply” that further bad news on that front wasn’t likely to have much market impact. In early January, analysts tracked by Thomson Financial were forecasting an 8.7% increase in first-quarter earnings for the S&P500 companies. But since then, the aggregate forecast has been ratcheted all the way down to 3.4%, said David Dropsey, senior research analyst at Thomson. Since January, the forecast for full-year earnings growth has been trimmed to 6.2% from 9.3%. Joe Battipaglia, chief investment officer at Ryan Beck, is not sure that companies can match even the current earnings growth forecasts. “Earnings growth expectations for the S&P500 may be too high,” Mr. Battipaglia said. Noting that net new borrowing by consumers was down 38% in Q3-06, versus the period a year earlier, he sees the prospect of a “consumer-led pullback” for the first time in 15 years. This would hurt the stock market, he said, with the S&P dropping 5% or more.
This covers the majority of people in today’s stock market. Whether you got the idea to buy from SmartMoney Magazine, your uncle, or your favorite primate’s stock-picking service, most people don’t understand stocks. So they usually buy a stock when someone tells them to. This might work sometimes - heck, it works a lot of the time - but there are a few problems with this strategy. A lot of people might be “listening” to the story. The guys on CNBC can move stock prices. That’s not necessarily because they picked a great investment, but because people that listen often buy. But if everyone listend to the same guru, who would profit? You might not understand the story. Are you familiar with the company’s business? Do you know how they make their widgets, and how their business could be affected by everything in the news? There might be “cracks” in the story. Your resource might have analyzed the company’s discounted cash flow or noticed that it was highly leveraged. There might be things about the company you don’t know. Take the advice of someone else and you will have no idea why you purchased the stock in the first place. And this will make you feel helpless. I mean, I’m not even making your own mistakes. You're making someone else’s mistakes. If the story changes - when will you find out? Who is keeping their finger on the pulse of your investment? Do you keep an eye on these factors? And, if you follow someone else’s advice - do they? Since you may not understand why the stock is a good buy, you might have even more difficulty understanding it if you see it drop in price. If you are overcome by fear, you might unload it just before the market sends it soaring. Can you handle the idea that you might never feel calm and confident about what is happening to your investments? When do you sell? If you don’t understand the company and its business, you might never know when things are too good. If you wait until the folks on TV tell you, you’ll probably be selling too late. Some investors wait until it drops, and others sell when they believe it is overvalued. But if you buy just because someone else tells you to, you’ll probably never know when to sell - because you never understood why to buy in the first place. #2: People Buy Stocks Based on Trends, Momentum, and Technical Indicators. This could mean it has an upward trend, its candlestick charts look great, it is below its moving average, or that an alphabet soup of technical indicators all point to the stock. The big picture is the same - some people invest based on what they believe the market is telling them about one particular stock. This also works - hedge funds and day traders make a living of this type of analysis. But there are a few problems, too: The indicators can change quickly. Hundreds of millions of shares trade each day. Most active traders are tuned in to the market continuously. To excel, you must really understand it. If you want to work with candlestick charts, you need to understand the reversal patterns, what they are telling you, and which ones are more reliable than others. If you look at price and volume data, you need to understand what the data is telling you so you can take immediate and decisive action if necessary. That is not impossible - plenty of people make money doing this type of analysis - but it will take time and effort. You’ll spend more in fees. Depending on the data you’re looking for, you might need access to additional market data. You’ll also be trading stocks more often. This will cost you more; but it is a moot point if you’ll be making more money. The more trades you make, the more mistakes you are likely to make. Let’s say that you were the world’s greatest investor, and that every time you made a trade, there was a 99% chance you were right. That also means there is a 1% chance you were wrong per trade - and, after five trades, it multiplies to a 5% chance you were wrong. This statistical probability of error can build quickly if you are trading every day. #3: People Buy Stocks Based on Price versus Perceived Value. This applies to anyone that looks at a stock, understands it enough to think it is worth more than its current price, and then buys on that reasoning. Some people perform in-depth analysis of discounted cash flow, and some people just look at the P/E ratio. Some people focus on industries that they understand - like restaurants, or pharmaceuticals, etc. It helps if you understand the industry or have some inside knowledge into the companies. A pharmacist should invest in pharmaceuticals businesses because they have inside info Wall Street doesn’t have: they know what customers are buying, what pills have bad reactions, and the ‘latest drug’ that area doctors are prescribing. With that kind of industry information staring them at the face every day, why should a pharmacist buy stock in Cisco systems? Other people use screens to come up with a starting list of stocks. John Dorfman screns for stocks with the lowest P/E values. This is “Value” investing. It takes the idea of investing and makes it academic instead of emotional. The whole goal here is to buy stocks at a discount to their value - things the market has not figured out yet. This is the style that Warren Buffett, his mentor Benjamin Graham, and a large number of successful money managers use. Warren Buffett has argued that it is the most successful style of investing. There are problems with picking stocks this way, too: There is a lot to read and understand. Not everyone can or is willing to commit the time to it. You have to read company filings, look at their balance sheet and cash flow statements, and make sense out of them. This is not easy - but, once you know what to look for, it really isn’t that hard, either. Depending on how you come up with your “perceived” value - you could be wrong. Of course, you could be wrong no matter how you pick a stock - unless you buy with a margin of safety. Successful value investors buy things when they are out of favor - so if you don’t have time to think about what could be out of favor, perhaps you shouldn’t be investing? Buying stocks is about taking the time to make clever and educated decisions weeks, months, or years before the chumps on Wall Street come to the same conclusion. At the end of the day, each of us is on his or her own path. No one knows where we will all end up, but they will all be different places.
The study looked at the idea of “mutual fund herding” — meaning an abnormally high level of mutual fund purchases or sales — involving particular stocks in a quarter. The research found that, though prices of typical stocks bought by herds of funds shot up immediately, these stocks were barely able to beat the return of the overall market over the next year. By contrast, the price of the average stock dumped by fund herds was beaten down severely, then bounced back. The study, “Analyst Recommendations, Mutual Fund Herding and Overreaction in Stock Prices,” has circulated since late last year in academic circles. Its authors are Nerissa Brown, an assistant professor of accounting at the University of Southern California; Kelsey Wei, an assistant professor of finance at the University of Texas at Dallas; and Russell Wermers, an associate professor of finance at the University of Maryland. A version is at http://papers.ssrn.com/sol3/papers.cfm?abstract-id=972731. To determine whether herding occurred for a particular stock in a calendar quarter, the professors first calculated the percentage of fund transactions involving the stock that were purchases. They compared that percentage to similarly calculated averages for all stocks that mutual funds bought or sold in that quarter. Herding was said to occur when a stock’s proportion deviated significantly from that overall average. Consider Motorola stock in the second quarter of 1997 According to the professors, 76% of mutual fund transactions in that stock were purchases during that quarter — far higher than the 55% average for all stocks bought or sold by funds. Not surprisingly, Motorola shares soared during the quarter, gaining 26% — equivalent to more than 150 percent, annualized. Over the next four quarters, however, the stock lost more than 30%. As an example of a stock dumped by a fund herd, the professors offer Ascend Communications in the fourth quarter of 1997. More than 82% of all mutual fund transactions involving Ascend in that quarter were sales, versus an average of 43% for all stocks that funds bought or sold. The stock plunged 24% during that quarter, but recovered smartly over the next year, gaining more than 160%. Herding behavior was particularly pronounced among managers of funds whose recent performance was quite poor. These managers are presumably those most worried about keeping their jobs, Professor Wermers said in an interview, so they aren’t inclined to go out on a limb and buy when everyone else is selling. This appears to be a wonderful illustration of John Maynard Keynes’s view that “it is better for reputation to fail conventionally than succeed unconventionally.” Though the professors suspect that herding occurs on many different occasions, they focused on funds’ reactions to changes in Wall Street analysts’ consensus ratings of stocks. An example is found in funds’ reactions from mid-1994 to 2003 to analysts’ consensus upgrades of small stocks — defined by the professors as the 20% of stocks followed by Wall Street analysts that had the smallest market capitalizations. Mutual funds bought 3.4% more shares of stocks with such upgrades, compared with the average stock that they traded during the same quarter. The herding was even more pronounced on the sell side after downgrades of stocks, with funds selling 8% more shares than the quarterly average. Herding had a marked effect on the prices of the stocks. Consider two hypothetical portfolios built by the professors — the first containing the stocks that were most heavily bought by fund herds, and the second owning those that were most heavily sold. First, the professors calculated the portfolios’ returns for the quarter when the herding occurred. On average over the nine and a half years through 2003, they found that the portfolio of stocks bought by herds beat the heavily sold portfolio by an astounding 117%, annualized. Unfortunately, the professors hasten to add, an investor would have no way to capture this huge return regularly. That’s because mutual funds must divulge their holdings only quarterly, and even then with a several-week delay. As a result, we can’t be immediately sure that herding has occurred. But that’s not all. Once the quarter has ended, the professors found, the two portfolios took much different paths. Over the next 12 months, the portfolio of the heavily sold stocks outperformed the overall market by 4.5%. It also fared markedly better than the portfolio of heavily bought stocks, which beat the market by just 0.5% in the year after the quarter when herding occurred. Individual investors could capture that 4.5%, since the strategy relies on publicly available information. You may consider buying the most beaten-down shares, betting that they will soon recover. And if you own any of the stocks that have been bid up the most, you may want to sell them, because it is unlikely that they will keep beating the market. Analyst Recommendations, Mutual Fund Herding and Overreaction in Stock Prices Brown, Wie & Wermers - March 2007 We find the first evidence that mutual funds appear to overreact when they herd in their trades [simultaneously trade in the same direction] - stocks heavily bought by herds tend to underperform their size, book-tomarket, and momentum cohorts during the following year, while stocks heavily sold outperform. These reversal patterns are even stronger when herds of mutual funds (especially funds with poor performance records) follow analyst recommendation revisions. An investment strategy that accounts for the direction of both analyst revisions and mutual fund herding generates a return (adjusted for size, book-to-market, and momentum) exceeding six percent during the following year. Several researchers examine patterns in stock returns to find evidence suggestive of large groups of investors exhibiting irrationality, such as Narasimhan Jegadeesh and Sheridan Titman, 1993, "Returns to buying winners and selling losers: Implications for stock market efficiency", who find evidence of investor underreaction, and Werner DeBondt and Richard Thaler, 1985, "Does the stock market overreact?", who find evidence of overreaction. Institutional investors are well known to receive correlated information (see Joshua Coval and Tobias J. Moskowitz, 1999, "Home bias at home: Local equity preference in domestic portfolios") and to exhibit correlated trading patterns (see John Nofsinger and Richard W. Sias, 1999, "Herding and feedback trading by institutional and individual investors", and Sias "Institutional herding" (2004)). In addition, the scale of trading by institutional managers magnifies the effect of any correlated trading patterns that may exist, relative to the small trades normally placed by individuals. Russ Wermers ("Mutual fund herding and the impact on stock prices", 1999) finds that mutual funds tend to exhibit high levels of “herding” (simultaneous buying or selling) in growth stocks, small stocks, and high past-return stocks during 1975 to 1994. In addition, Wermers (1999) finds that trading by herds of mutual funds moves stock prices in a stabilizing manner—that is, fund herding tends to bring stock prices closer to their fundamental values, and, if anything, mutual fund herds appear to underreact to information. It is almost certain that equity mutual funds tend to play a much bigger role in setting stock prices today than during the period covered by Wermers (1999). Specifically, mutual fund equity holdings, which now total about $4 trillion, have more than doubled relative to the total capitalization of equity markets since 1994 — from 12.5% to over 27% of all outstanding shares of U.S. equities. In addition, turnover by U.S. mutual funds has substantially increased during this time period; together, these statistics indicate that mutual funds are responsible for a much larger share of trading volume today than just 10 years ago. We analyzed quarterly stock trades by the universe of U.S. equity mutual funds following the recommendation revisions of sell-side analysts, across all U.S. stocks from 1994 to 2003. We found clear evidence that mutual funds herd on analyst recommendation changes, and that this trading impacts stock prices in a manner consistent with overreaction by funds to the consensus signal provided by analysts. Stock Selection Based on Mutual Fund Holdings: Evidence from Large-Cap Funds Robert A. Weigand, Susan Belden & Thomas J. Zwirlein Heavily-weighted stocks in mutual funds perform no better than, and sometimes significantly underperform, the most lightly-weighted stocks. Ellis (2000) asserts that professional investors should no longer expect to “beat the market” because this intelligent, well-educated and highly-skilled group has become “the market” — over 90% of the trading volume on the NYSE is now generated by professional investors. Behavioral finance also offers explanations regarding the underperformance of professional investors. Odean (1999) contends that investors trade too much due to overconfidence, and that professionals probably suffer from greater overconfidence than individuals. Bauman and Miller (1997) assert that experts make habitual cognitive errors, such as focusing on and overusing predictors of limited validity. They present evidence that professional investors tend to herd into stocks with strong recent earnings growth in the mistaken belief that this earnings growth will continue.
Certainly, a growth rate of 6.3% is nothing to sneeze at. In fact, Mike Thompson, managing director of global research at Thomson Financial, points out that this would be fairly close to the historical earnings growth rate of about 7%. And this rate of growth, he added, “is far more sustainable than the double-digit rates we’ve seen lately.” The mere fact that profit growth is slowing isn’t necessarily a disastrous development for stocks. Sam Stovall, chief investment strategist at S&P, looked at past periods of slowing earnings growth from 1966 to 2000 and in 4 of the last 10 such periods, the S&P500 lost value. But this means that in a majority of cases, stock prices still managed to climb in the face of slowing profits. In fact, the average gain for the S&P500 during these slowing periods was a respectable 7%. Still, the pace of earnings growth is an important variable for investors to consider. Many market strategists believe that earnings have a bigger influence on the stock market than the overall economy does. Mr. Ablin put it this way: “If you told investors that the economy would grow by only 1% but profits would continue to grow at a double-digit pace, you’d find the market would continue to climb higher.” What’s important is not just the rate of earnings growth, but also the underlying trends. When earnings growth is low but on the upswing, it’s often a good time to invest, said Tim Hayes, chief investment strategist at Ned Davis Research. That’s because investors are anticipating better times to come. But periods when the earnings growth is high but falling tend to be challenging for the market, Mr. Hayes said. It’s during these periods that “the market begins to question the sustainability of earnings growth.” And “the market becomes vulnerable to disappointments,” he added. Despite the swoon in stock prices in late February, the markets haven’t come close to pricing in the coming earnings slowdown, in the view of Richard Bernstein, chief investment strategist at Merrill Lynch. “What’s happening now is an odd situation where earnings growth looks like it’s slowing, but people are hesitant to make that bet because every time they’ve made that bet in the recent past, earnings have surprised to the upside,” Mr. Bernstein said. For the last 15 of the last 16 quarters, analysts’ estimates for earnings growth have turned out to be too pessimistic. And Mr. Thompson added that analysts have recently underestimated actual earnings by around 3%. “It’s now almost become a Pavlovian response,” Mr. Bernstein said, where investors immediately bet on better-than-expected earnings once analysts post their forecasts. But is it safe to keep counting on analysts being too pessimistic? These misses tend to come in distinct cycles. From 2001 to 2003, analysts consistently overestimated the earnings capacity of corporations. Before that, in 2000, they routinely underestimated profits. And in the late ’90s, their outlooks were again too rosy. To be fair, at least a couple of forces could help earnings exceed expectations this time around. For starters, corporations are continuing to buy back stock at a record pace, in effect reducing the supply of shares on the market. This could improve earnings per share without bolstering the profits themselves. Furthermore, the dollar continues to weaken, Mr. Bernstein said. And this could improve the profit outlook of American companies that do business abroad. Still, it’s important to consider which earnings are slowing the most. For example, at the start of the year, earnings in the energy sector were predicted to grow 13% for Q1. Now, they’re expected to fall by 3%. At the same time, profits for consumer-discretionary companies are predicted to drop 10% in the first quarter. Mr. Thompson argues that the expected drop in consumer-discretionary earnings is largely attributable to weakness in the home-building sector as well as at the Ford Motor Company. Nevertheless, it’s clear that the sectors driving these downward revisions are predominantly economically driven ones like industrials, basic materials and technology. In fact, technology earnings, which at the start of the year were expected to grow 17% in Q1 and 20% in Q2, are now forecast to increase by just 10% and 12%, respectively. What does it all mean? Perhaps investors who have been studying the economy to gauge the outlook for future earnings growth should look in the opposite direction. The already slowing profit picture indicates that the economy has been weak for some time and may be weaker than some people have assumed. And if that’s the case, investors may start to question what exactly is propping up the current bull market.
Now the two professors have revisited the subject, examining the reasons for these trends. It turns out that the bulk of these sector differences results from the behavior of just a handful of stocks. If not for these outliers, the long-term returns of the various sectors would not have been appreciably different from those of the overall market. Because it’s hard to pick individual outperformers, it is no less important to invest broadly within stock sectors than it is in the overall market. In the study, the professors segregated all publicly traded stocks into two groups — small and large — according to their market capitalizations. Next they divided each group into value, growth and blend categories. They ended up with six investment styles, which correspond loosely to the categories that Morningstar uses to classify stock mutual funds. The study focused on stocks that shift among these categories, a process the professors call migration. A small-cap value stock that becomes popular among investors may migrate to the small-cap blend or small-cap growth category. And if the company’s market cap grows enough, the stock may move into one of the large-cap styles. Similarly, a large-cap growth stock may fall out of favor and migrate to the large-cap value category and, if it falls on particularly bad times, it may even shift into one of the small-cap categories. Consider the stock of Pier 1 Imports. The professors placed it in the small-cap blend category in the mid-1990s. By 1998, owing to the spectacular run-up in the stock price, it had migrated to the large-cap growth category. In the wake of the stock’s poor performance in more recent years, Pier 1 by mid-2006 had slipped back into the professors’ small-cap value category. The professors found that even though only a minority of stocks migrated from one category to another in a typical year, these stocks had an outsized influence on each style’s overall performance. They reached this conclusion after analyzing a series of hypothetical style portfolios, each of which was rebalanced once a year to include only the stocks that met the style’s definition. The professors compiled a full 80 years of performance data for each portfolio, from 1927 through 2006. Consider their small-cap value portfolio. They calculated that it produced a gain of 22.5% annualized before transaction costs, over the last eight decades, versus a gain of 13.3% annualized for a capitalization-weighted index of the entire stock market. Only one in four small-cap value stocks migrated to another style in the average year during this period. But if the migrating stocks had not been included in the years that they shifted out of the portfolio, it would have underperformed the market — gaining only 13.1% annualized over the eight decades. It’s worth noting that over shorter periods, some styles performed far better or worse than they did over the full 80 years. During the late 1990s, the large-cap growth sector bucked its long-term trend and beat the market. Today, some advisers are arguing that small-cap stocks will not live up to their historical pattern and that the sector will lag. Such shorter-term deviations are of little more than historical interest unless investors believe that they can successfully forecast which styles will be in or out of vogue. But that is a very tough task for anyone, Professor French said in an interview. The professors’ findings don’t mean that you should stop emphasizing particular sectors of the market. After all, if the future is like the past, the small-cap value category will outperform other sectors over the long term. But the professors’ conclusions do suggest that this bright performance will most likely come from just a small number of stocks. And if picking the right stocks is beyond most investors’ abilities, there is another, easier solution: buying a low-cost index fund that is a diversified bet on stocks of a particular investment style. Migration Eugene Fama and Kenneth French - February 2007 Rolf Banz ("The relationship between return and market value of common stocks", 1981) documents a size premium in average returns: small stocks, with low market capitalization, have higher average returns than big stocks. Many papers identify a value premium in average returns: stocks with low ratios of price to book value (value stocks) have higher average returns than stocks with high price-to-book ratios. These papers include [1] Barr Rosenberg, Kenneth Reid, and Ronald Lanstein "Persuasive evidence of market inefficiency" 1985, [2] Eugene Fama and Kenneth French "The cross-section of expected stock returns" 1992, and Josef Lakonishok, Andrei Shleifer, and Robert W. Vishny in "Contrarian investment, extrapolation, and risk" 1994. Fama and French in "The anatomy of value and growth returns" (2005) find that convergence of price-to-book ratios plays an important role in the higher average returns of value stocks. They suggest a simple economic story. Competition from other firms tends to erode the high profitability of growth stocks, and profitability also declines as they exercise their most profitable growth options. Conversely, the price-to-book ratios of value portfolios tend to rise in the years after portfolio formation, as some value firms restructure and their profitability improves. The higher average returns of small stocks are due primarily to one type of migration: small stocks that become big. Big stocks that become small have strong negative average excess returns, but they contribute little to the size premium. Also, without changing size groups, there is little room for growth stocks to improve in type or for value stocks to deteriorate.
The mess in the mortgage market, amid rising defaults by sub-prime borrowers who can't make their payments, was the big shock to Wall Street in the quarter — although some investors might say the only real shock was that anyone would be surprised that many recent home buyers were in over their heads. In any case, the potential for spillover from the ailing housing sector to the rest of the economy became Topic A in markets these past three months. Faith that the U.S. economy in 2007 could achieve a "soft landing," meaning a temporary slowdown that would give way to stronger growth in 2008, began to dim. Fear of a housing-led recession ramped up. That sent some investors into defensive mode, away from high-risk securities and toward stocks and other assets that might hold up well in a contracting economy. Hence, shares of utility companies attracted buyers. Even in a poor economy, "people like their power to stay on," said Jack Caffrey, equity strategist at JPMorgan Private Bank in New York. The Dow utility stock index jumped 9.5% in the quarter. The sector also got a boost from an unexpected $33-billion takeover offer for utility giant TXU from buyout firms Kohlberg Kravis Roberts & Co. and Texas Pacific Group. Jam maker J.M. Smucker also seemed like a safe bet to some people. The Orrville, Ohio-based company's stock rose 10% in the three months, closing Friday at $53.32. U.S. Treasury bonds, the classic defensive investment, were popular. Demand drove the bonds' prices up and their yields down. The yield on five-year T-notes ended the quarter at 4.54%, down from 4.69% at year's end. For bearish investors, the late-February global stock market slump was exactly what they'd been hoping for. It was a giddy moment for "short sellers". The S&P500 dropped 5.9% from Feb. 20 to March 5. The Nasdaq composite index sank 6.8% in the same period. Those weren't dramatic losses, but the bears ran wild anyway. By mid-March the number of New York Stock Exchange shares sold short had rocketed to a record 10.5 billion, from 9.6 billion in mid-February. Some of those short-sellers can't be too happy at the moment. The broader market has recovered most of what it lost in the recent pullback. The S&P 500 inched up 0.2% for the quarter. The Dow Jones industrial average eased 0.9%. For the most part, the flight from risky assets ran its course quickly. Investors soon returned to many of those markets. Mexico's IPC stock index ended the quarter at an all-time high, and up 8.7% for the three months, despite losing 8% from Feb. 27 to March 5. If the U.S. economy is about to crumble, investors shouldn't be buying Mexican stocks, given the links between the two economies. Indexes of U.S. small and mid-size stocks handily beat blue-chip shares in the quarter. If investors really were afraid that a recession loomed, you'd expect them to favor the relative safety of bigger stocks over smaller issues. Even the late-March jump in oil prices, fueled in part by the seizure of British naval personnel by Iran, failed to rattle global markets much. Crude oil ended Friday at $65.87 a barrel, up from $61.05 at year's end and near a six-month high. There are, of course, plenty of people who are worried enough about the economy to keep their portfolios tilted to the conservative side. One is Christopher Sheldon, investment strategist at Mellon Private Wealth Management. He says the firm got rid of the last of its high-yield junk bonds in the quarter and pared back on emerging-market stocks, seeking to reduce risk. "There is such a thing as a too-slow economy," as opposed to a soft landing, Sheldon said. A rally in gold in the quarter suggested that some people were looking for insurance against economic or other trouble. Gold futures rose 4.4% in the period, to $663 an ounce. Nonetheless, in the stock market cautious investors were overruled in March by those who figured there was still no good reason to doubt the soft-landing scenario, even as housing slumps. "I think the expected path of the economy hasn't changed," said Brian Stine, investment strategist at Allegiant Asset Management. "I'm fairly upbeat." Some economic reports Friday showed why the bulls remained optimistic. U.S. consumers' spending and income rose more than expected in February, as did commercial construction spending. And a Chicago-area index of manufacturing activity rose at a faster-than-expected pace in March. "Incomes are holding up and unemployment is low. That's really a pretty solid underpinning for the market," said Michelle Clayman, chief investment officer at New Amsterdam Partners. Economic bulls also can point to gains in shares of industrial giants such as U.S. Steel, which surged nearly 36% in the quarter. Healthy demand for steel overseas underpinned U.S. Steel's advance and also boosts hope that economic strength abroad will help buttress the American economy. There's still the possibility, however, that February was the last gasp for the U.S. consumer, before housing-market fears deepened. That's why Wall Street will be watching spring spending data carefully. First-quarter corporate earnings reports due this month also will be key to markets' next moves. Earnings in the financial-service sector will be particularly scrutinized, for obvious reason: If more than just sub-prime mortgage borrowers are having difficulty paying what they owe to lenders, that should begin to show up in earnings reports of banks, brokerages and other financial-service firms. Given the importance of financial-company earnings in the benchmark S&P 500 index — that sector accounts for 27.2% of the index's profit, more than any other industry — severe weakness in that business would be no small matter. First-quarter percentage changes in key stock indexes
Returns by Fund Category
Earnings contribution to S&P 500 earnings in 2006, by industry
That may keep investors upbeat about the economy, and keep their appetite strong for corporate junk bonds and other dicey securities. Demand for those issues pushed up their prices in the three months that ended March 30. The result was that high-risk bonds generally produced better returns than lower-risk issues in the period: [1] The average high-yield "junk" bond fund had a total return of 2.6% in the quarter, according to Morningstar Inc. Total return is interest earnings plus or minus any principal change. [2] Funds that own bonds of emerging-market countries such as Brazil and the Philippines gained 2.2% in the quarter, on average. [3] Bank loan funds, which invest in syndicated bank loans often used to finance corporate buyouts, were up 2%. By contrast, lower-risk types of bond funds posted smaller returns. Funds that own long-term investment-grade securities, such as U.S. Treasuries and high-quality corporate bonds, gained 1.2% in the period, on average. Although low-single-digit bond fund returns may not look like much, they beat the 0.6% total return of the blue-chip Standard & Poor's 500 stock index in the quarter. And they topped the average money market mutual fund return of about 1.1%. The yield on an index of 100 junk bonds tracked by KDP Investment Advisors rose from a 20-month low of 7.02% on Feb. 26 to 7.26% on March 5. It was at 7.28% late last week. That modest blip up in junk yields didn't fix what many analysts believe is the basic problem with buying those issues now: "The riskier sectors of the bond market just aren't offering much return for the risk," says Scott Berry, a mutual fund analyst at Morningstar. That has been Wall Street's consensus view of high-risk bonds for the last year or so. But it hasn't stopped investors from piling in. Some fund managers say it's still no contest between a junk bond yielding 7.28% and a 10-year U.S. Treasury note yielding 4.75%, the rate as of Friday. Inflation-protected funds invest primarily in the Treasury's version of those bonds. The funds rose 2.2%, on average, in the first quarter, as the bonds' prices rose — a sign that some investors were fearful about inflation pressures in the economy. Fed officials have continued to warn that inflation is running too high for their comfort. Over the last five years inflation-protected bond funds have gained 6.7% a year, on average, according to Morningstar. That beat the 4.1% annualized total return of the average government bond fund. Monthly Employment Stats
Manufacturing employment continued to trend down over the month. Construction employment increased by 56,000 in March, mostly offsetting a decline of 61,000 in February. Unusually adverse weather likely contributed to February’s decline. Overall, the construction industry has shown no net growth since employment peaked in September 2006. Over this span, job gains in the nonresidential components of construction have been more than offset by losses in the residential components. Within retail trade, employment in general merchandise stores rose by 36,000 in March and by 81,000 in the first quarter of this year. Despite the recent growth, employment in general merchandise stores was little changed over the year. Elsewhere in retail trade, employment in building material and garden supply stores has declined by 15,000 since reaching its peak in October 2006. Food services and drinking places also continued to add jobs in March (+19,000). Over the year, employment in the industry grew by 335,000. Employment in health care continued to increase in March with a gain of 30,000; over the year, the industry added 348,000 jobs. In March, offices of physicians and hospitals added 9,000 jobs each, while nursing and residential care facilities added 7,000. Professional and business services employment was essentially unchanged in March and over the first quarter of 2007. The industry added half a million jobs in 2006. In March, employment continued to expand in computer systems design and in management and technical consulting services, but those job gains were offset by small job losses in accounting and bookkeeping and in employment services. Manufacturing employment continued to trend down over the month (-16,000), with declines in furniture and related products (-4,000), computer and electronic products (-4,000), textile mills (-2,000), and paper and paper products (-2,000). The average workweek for production and nonsupervisory workers on private nonfarm payrolls increased by 0.1 hour to 33.9 hours in March, seasonally ad- justed. The manufacturing workweek increased by 0.2 hour to 41.1 hours, and manufacturing overtime increased by 0.1 hour to 4.3 hours. The index of aggregate weekly hours of production and nonsupervisory workers on private nonfarm payrolls increased by 0.6 percent in March to 107.3. The manufacturing index was up by 0.2 percent over the month to 95.2. Average hourly earnings of production and nonsupervisory workers on private nonfarm payrolls rose by 6 cents, or 0.3 percent, in March to $17.22, seasonally adjusted. During the first quarter of 2007, average hourly earnings rose by 15 cents; in 2006, hourly earnings growth averaged 18 cents per quarter. Average weekly earnings increased by 0.6 percent over the month to $583.76. Over the year, average hourly and weekly earnings grew by 4.0 and 4.4 percent, respectively.
Quick Facts, Stats & Opinions U.S. Economic Ills Aren't as Contagious as Thought David Wessel, WSJ 4-05 An old cliché holds that when the U.S. economy sneezes, the rest of the world catches a cold. Now comes the International Monetary Fund to say that it ain't necessarily so. All five U.S. recessions in the past 30 years were accompanied by recessions elsewhere in the world. Contrary to the cliché, downturns abroad have been considerably smaller than the U.S. recessions or slowdowns in growth. On average, a one-percentage-point decline in U.S. economic growth is associated with a 0.16-point decline elsewhere, though the impact is larger in Mexico and Canada, which are heavily dependent on exports to the U.S. A 1 percentage point decline in the euro area's growth rate coincides with a 0.10 percentage point decline in growth in other countries. A 1 percentage point decline in Japan's growth rate coincides with a 0.11 percentage point decline in growth in other countries. Of course, when two things happen at the same time, it doesn't mean one causes the other. But in the past 20 years or so, economic ills moving from one country to another seem to be playing a more significant role than these common global shocks. Recent research suggests the U.S. plays a key role in propagating financial shocks. One study pins about 26% of the variation in prices of European financial assets of all sorts (and a whopping 50% for stocks) on the U.S. Only 8% of the variation in U.S. asset prices can be traced to Europe. Small Molecules, Big Impact Victor Godinwz, The Dallas Morning News 4-14 The science of small won't be relegated to research labs for much longer, with an array of increasingly exotic products set to hit the market over the next five to 10 years. In March, Congress' Joint Economic Committee published a study titled "Nanotechnology: The Future is Coming Sooner Than You Think." The report outlines the migration of nanotech into the consumer realm, broken into five-year periods. By the 2015 to 2020 time frame, the authors predict, nano robots will be patrolling the human body, repairing damaged DNA and sending you a summary of your physical condition. Richardson-based Zyvex Corp. is working on prototypes of aluminum reinforced with carbon nanotubes, making the metal two or three times stronger than traditional aluminum. Last week, Sony said that it plans to start selling field emission display, or FED, monitors and televisions in 2009. The displays provide the picture quality of standard tube televisions with the thinness of LCD and plasma. As with standard cathode ray tube sets, the FED monitors fire electrons at the back of the screen. But instead of shooting all the particles out of a single, bulky electron gun, FED sets pour the electrons through an array of tiny nanotubes. The scientists at the Georgia Institute of Technology said earlier this month that they created an array of zinc oxide nanowires that can harvest the energy from mechanical vibrations or other movements, such as blood flow, and transform that energy into electricity. "Wage income has begun to rise more rapidly," notes Peter Kretzmer, senior economist at Banc of America Securities. More rapidly, at least, than the snail's pace of increases from 2001 to 2004. Average weekly earnings of U.S. production workers rose 4.4% in the 12 months through March, according to the Labor Department. That was up from a 3.8% increase in the 12 months ended in March 2006 and a mere 2.6% in the period before that. The government's broadest measure of worker incomes showed a 1.1% rise in wages and salaries in the first quarter, the biggest increase in six years, according to a Labor Department report Friday. The rebound in wages is attributed in part to the relatively tight job market. Some companies are having to pay up to get the help they need. (Tom Petruno, LA Times 4-29) An estimated 50 million Americans won't pay any federal income tax this year. That's nearly a third of all adults, up from 18% in 1980. (Kathy Kristof, LA Times 4-15) Between now and 2015, about half the world's new construction will take place in China, with as much as 6 billion square feet of space expected to be added each year. (Ariana Eunjung Cha, The Washington Post 8-14) The financial sector is far and away the largest, representing 21% of the S&P 500 index's stock-market value, up from 17% at the end of 2000. Financial firms' profits, meantime, represented 28% of S&P 500 company profits in 2006, according to Standard & Poor's. One consequence of financial firms' importance and outsized profits is that they are helping the overall stock market look cheaper than it otherwise might, says Banc of America Securities strategist Tom McManus. The S&P 500 trades at 14.9 times 2006 earnings, but without the financial sector its price-to-earning ratio bumps up to 17.2. (Justin Lahart, WSJ 4-10) Daniel Gross sees what’s happening in the world of margin debt and shakes his head, as it has reached levels not even seen in the year 2000. “Anybody remember what happened in March 2000?” he writes. “Anybody care to guess when else in history margin debt, after several years of positive market returns, soared to really high and ultimately unsustainable levels? If you guessed 1927, 1928, and 1929, you’re right.” But Free Exchange, the Economist’s blog, points out that in 1929, it was estimated that more than one-third of the stock market’s value was owned on margin — now it’s about 5%. (David Gaffen, WSJ 4-03) Hedge Fund / Private Equity News Briefs Global hedge assets have surged 30% to $2.079 trillion with three-fourths of that amount managed by the world’s largest hedge funds, according to HedgeFund Intelligence. The survey found that between January 2006 and January 2007, the industry added more than $500 billion to its coffers, and saw the number of hedge funds with more than $1 billion AUM – the so-called Global Billion Dollar Club -- rise to 351. Of that membership, 241 are located in the U.S., with more than 100 in Europe and 35 in Asia. Nearly $1.5 trillion of the total assets reside in the U.S., HedgeFund Intelligence reports, with $1.198 trillion of that amount, or 80% of the total, held by billion-dollar club members in the U.S. (HedgeFund Daily 3-30) Home Page Previous Factoid Top Sites
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