Investment Factoids
Advice, Analysis, and Lessons for the Do-It-Yourself Investor

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Q2-08
Roses Among the Wallflowers
Mark Hulbert, NY Times 6-29-08
    Pay close attention to stocks that attract so little interest that they don’t trade — not even a single share — on at least one day of the year. There are more of these neglected stocks than you might think: on major exchanges in the United States, according to a new study. And though they occupy a sleepy corner of the market, at least some of these stocks are worth studying closely. Many aren’t very impressive, at least in part because little is known about them, but a few perform extraordinarily well.
    These are the implications of a study entitled “Information Diffusion Based Explanations of Asset Pricing Anomalies,” written by Athanasios Bolmatis, an investment strategist at Fulcrum Asset Management, a hedge fund in London, and Evangelos G. Sekeris, a financial economist in the supervision and regulation department of the Federal Reserve Bank of Boston. A version has been circulating in academic circles as a working paper for more than a year.
    The researchers were interested in the quality of information about a company that is available to investors and the speed with which it is disseminated in the marketplace. They believe stocks that occasionally go an entire market session without trading are those for which information is generally of lower quality and is slower to circulate.
    Relatively few investors follow such companies, and few, if any, stock analysts look at them closely. That’s important, the researchers argue, because — at least in theory — a neglected stock will need to promise a higher return in order to compensate investors for the lower quality and quantity of information.
    Consider two hypothetical portfolios the researchers put together. The first owned just those stocks that traded each market day of the previous year, while the second held those stocks that had at least one no-trade day. From the beginning of 1962 through 2003, according to the researchers’ calculations, the second portfolio outperformed the first by an annualized average of eight percentage points.
    That’s a big gap. By contrast, the average small-cap stock outperformed the average large-cap issue during that period by only 2.9 percentage points, annualized, according to the researchers. And the typical value stock beat the average growth stock by 5.5 points a year.
    From those numbers, the odds would seem to be in your favor whenever you invest in the stocks that don’t always trade. But in an interview, Mr. Sekeris said that this strategy was not without sizable risk. The key to beating the market with such stocks is finding those whose relative obscurity is about to end. That’s because new money tends to rush in as Wall Street discovers such stocks, bolstering their performance. Without that newfound attention, many of those stocks would continue to languish — and be mediocre performers at best.
     The study did not focus on how an investor might go about researching neglected stocks. But it is clear that before buying, an investor needs to be particularly confident in the information he uncovers. Without compelling information, it’s much safer to just invest in an index fund.

Are Small-Cap Stocks Signaling a Recovery?
Paul Lim, NY Times 6-22-08
    In times of economic uncertainty, investors don’t usually flock to volatile assets like small-company stocks. Instead, they tend to favor havens like bonds or shares of stable, industry-leading blue-chip companies. But have you seen how small-capitalization stocks have been performing lately?
    Despite all the bad news surrounding record-high oil prices, mounting job losses, and continuing troubles in housing, the Russell 2000 index of small stocks has soared 12.7% since mid-March. By comparison, the S&P500 index of large stocks is up by a more modest 3.5%. For investors, this surprising situation raises an important question: Are small stocks signaling that the worst of the economic storm is behind us?
    Historically, a small-stock rally during an economic slowdown has often foreshadowed better times ahead. Ned Davis Research studied economic downturns since the end of World War II and found that large-cap stocks tended to lose their momentum to small stocks six months after the start of an official recession. The typical recession has lasted about 10 months, so these turns often take place during the economic slump — not after one. To be sure, no official recession has yet been declared this time around. But if, as some economists believe, a recession started in December, it wouldn’t be surprising that small stocks have begun to excel.
    The recent surge in small-cap stocks “fits with many other economic and stock market indicators suggesting recovery,” said James W. Paulsen, chief investment strategist at Wells Capital Management. He points out that not only are small stocks generally doing well, but also that the most economically sensitive sectors of the small-cap universe have performed best of late. They include energy stocks in the S&P600 small-stock index, which are up more than 40% since the start of April; the technology sector, up more than 9%; and industrial stocks, up more than 8%.
    Bradford Evans, co-portfolio manager of the Heartland Value fund, which specializes in small stocks, says that other signs also support this optimistic view of the economy. For example, he said, “I would look to the yield curve as confirmation that the economy is possibly staging a stealth recovery.”
    Last year, the yield curve — the spectrum of interest rates paid by bonds of various maturities — was inverted. In other words, a two-year Treasury note was paying out more than a 10-year note, even though the 10-year Treasury locked you into a longer commitment. Historically, this has signaled economic troubles ahead. Today, the yield curve is sloped normally, with 10-year Treasuries paying substantially more than two-year notes. This typically signals economic growth ahead.
    Still, not all market watchers are convinced that the small-cap rally is an all-clear signal for Wall Street. “I would say it’s too soon to tell,” said Samuel S. Stewart Jr., chairman of Wasatch Advisors, an asset manager based in Salt Lake City that specializes in investing in small and medium-sized companies. Tim Hayes, chief investment strategist at Ned Davis, agrees. “I’m playing it cautiously until I can be confident in saying that the stock market has bottomed,” he said. “And we can’t say that yet.”
    But even if the economic and market storm is continuing, small caps don’t necessarily have to start underperforming large-company stocks. Small-stock earnings have held up surprisingly well during this slowdown. In the first quarter, as profits for companies in the S&P500 sank 17% versus the same period a year earlier, earnings for the S&P600 small-stock index fell less than 9%, according to Merrill Lynch. And Wall Street analysts are forecasting that S&P600 earnings this year will grow just as fast as large-cap stock profits — by around 8%, according to S.& P. “On average, earnings for the companies we own are coming through reasonably well,” Mr. Stewart said.
    Moreover, with inflation fears heightened, there is a growing sense that the Federal Reserve, which meets this week, won’t cut interest rates again. That should be good for small stocks. Standard & Poor’s studied the performance of large and small stocks after various series of Fed rate cuts going back to 1954. On average, in the six months after the last rate cut of a series, the Russell 2000 index advanced 14.9%, versus just 9.4% for the S&P500. And 12 months after the last rate cuts, the small-cap advantage persisted. Small stocks surged 25.2%, on average, in the year after the Fed stopped trimming rates, versus 18.9% for large-cap shares.
    Of course, what if the biggest threat isn’t a slowdown, but inflation? Don’t worry, Mr. Paulsen said. Historically, small stocks have typically outpaced large stocks during periods of accelerating inflation. In the 1970s, for example, as inflation was running at an average annual rate of 7.4%, small stocks gained 11.5% a year, on average, versus 5.9% for large stocks. Similarly, in the 1940s, when inflation was 5.4%, on average, small stocks doubled the performance of big stocks.
    Why? Mr. Paulsen argues that just to compete, many small-cap companies must run more efficiently than industry-leading large caps. “If you’ve got companies that are operating extremely lean,” he said, “and they’re now able to raise prices, more of that increase will fall to their bottom line.”
Inflation? Stick with Stocks
Paul Lim, NY Times 6-08-08
    With inflation running higher than it was a year ago, investors are faced with a host of uncertainties. First and foremost, is inflation bad for stocks? The simple answer is, not necessarily. To be sure, inflation devalues corporate earnings, a major driver of stock prices. But the mere presence of inflation also suggests that many companies are successfully passing along price increases to customers, said Alan F. Skrainka, chief market strategist at Edward Jones. And that’s good for profits.
    Moreover, while periods of high inflation typically reduce stock returns, they have been much harder on bonds. In the 23 calendar years between 1926 and 2007 when inflation measured more than 4%, stocks returned 6.9% on average, versus just 2.8% for long-term government bonds, according to Ibbotson Associates.
    A separate analysis by Merrill Lynch, meanwhile, found that in inflationary periods — as measured from troughs to peaks — going back to August 1972, some 6 of the 10 market sectors in the Standard & Poor’s 500-stock index actually gained ground, on average. This explains why stocks — even though they’re hurt by rising prices in the short term — may be an investor’s best long-term hedge against inflation.
    Of course, this isn’t to say that high inflation is welcome. The mere fact that inflation can cut into returns, sometimes significantly so, is enough for investors to be worried. So stock investors may want to consider several factors in the coming weeks and months:
    The 4% Threshold     Is inflation running at 4% or more? “That seems to be the line in the sand,” said Sam Stovall, chief investment strategist at Standard & Poor’s Equity Research. Mr. Stovall studied past periods of inflation going back to 1960, using the overall — or “headline” — CPI as a gauge. Stovall found that when the CPI was rising at no more than a 4% annual pace, the S&P500 gained about 1% a month, on average. But when the price index grew 4% to 6% annually, stocks lost an average of 0.3% a month. Stocks fared even worse at higher rates of inflation.
    According to the Labor Department’s most recent assessment of consumer prices, based on April data, the price index was growing at a 3.9% clip. That’s just under the 4% threshold and still within what Mr. Stovall calls the sweet spot for inflation: the 2% to 4% range.
    A Matter of Direction    Which way is inflation headed? “There’s a big difference in the level of inflation and the direction of inflation,” said Jeffrey N. Kleintop, chief market strategist for LPL Financial. For example, when inflation is painfully high but falling, stocks can do quite well, Mr. Kleintop said. In 1980, the CPI rose by more than 12%, but stocks still gained more than 32%, according to Ibbotson Associates. Why? Perhaps because in 1979, inflation was even higher, at more than 13%.
    And while the average rate of inflation throughout the 1980s was an uncomfortable 5.6%, it still turned out to be a great decade for stocks: the S&P500 rose by an average of 12.6% a year. The key may have been that inflation was declining throughout the decade. In periods of low-but-rising inflation, stocks can feel a pinch. Ned Davis Research recently studied the performance of stocks between Q1-1926 and Q1-08. In periods when inflation accelerated, stocks gained less than 0.5% a year, on average, Ned Davis found. By comparison, in periods when the inflation rate fell, stocks soared by an average of nearly 10%.
    The Core Rate     A big complaint these days is that economists don’t understand how painful inflation is to the average family, because they tend to focus on core inflation, which strips out the volatile prices of food and energy. But in measuring the macro economy, said Mr. Skrainka at Edward Jones, core inflation is a “better indicator of long-term trends because it tells us if higher energy and food costs are feeding through to the rest of the economy.”
    Investors also need to pay attention to core inflation because the Federal Reserve Board does. And “if inflation pressures remain high or rise to the point where the Fed is forced to raise interest rates, then you’ll see a direct negative impact on stocks,” said James B. Stack, editor of the InvesTech Market Analyst, a newsletter.
    There’s another reason to be mindful of core inflation. “There’s a perfect inverse relationship” between core inflation and stock market valuations, said Liz Ann Sonders, chief investment strategist at Charles Schwab. Ms. Sonders has discovered that since 1960, whenever core inflation has hovered between 2% and 3%, the average price-to-earnings ratio of the S%P500 has been 19.7, based on trailing 12-month earnings. But when core inflation jumps to between 4% and 5%, the average P/E falls to 14.8. Where is core inflation now? The government says it’s running at an annual pace of about 2.3%. That’s the good news — at least so far.
Behavioral Economics Shows That When It Comes to Investing, People Aren't That Smart
Jon Roemer, AP-24-08
    Four months ago, judging myself to be the next Warren Buffett, I logged on to my Charles Schwab account and did something that in hindsight was astonishingly stupid, even for my own very long roster of financial screw-ups. I clicked over to the trading page and bought shares of Citigroup.
    The company, like most of the big Wall Street banks then staring down the subprime meltdown, was limping along. The headlines were bad. The chatter on CNBC was pessimistic. I saw a bargain. I saw a company whose credit card bills and offers show up in millions of mailboxes every day. Just as soon as the banks got their write-offs out of the way, optimism would return to the sector. There would be more buyers of the stock than sellers. I would profit. Now here I am today: My investment is down 22%. And I'm still holding on to the stock. Am I, as my wife and closest friends sometimes insist, the dumbest man walking the Earth?
    "You are human," said Russell Fuller, chief investment officer of Fuller & Thaler Asset Management. His firm uses behavioral economic theories of Nobel Prize winners and university economists to profit from the mistakes made by everyday investors and the pros on Wall Street. Humans, no matter how hard we try, act in ways that cause us to make the wrong investment decisions almost all the time.
    We are absurdly overconfident about what we think we know. We are reluctant to part with our losers, even though the tax code rewards us for doing so. We sell winners too soon, then we buy stocks that perform worse than the ones we sold. We get anchored on certain opinions about stocks and react too slowly to information that should change those beliefs. We believe things will happen based on how easily we can think of recent examples. (A hurricane just hit. Another one will come soon.)
    The world of the behavioral economics, which melds psychology, finance and emotion, seeks to explain and sometimes exploit why we do what we do when it comes to investing. It is a field that has become more accepted lately, particularly since 2002, when Princeton University psychologist Daniel Kahneman was awarded the Nobel Prize in Economics for, as the Swedes put it, integrating "insights from psychology into economics, thereby laying the foundation for a new field of research."
    Kahneman is a director at Fuller & Thaler, a firm whose other namesake is Richard Thaler, a prominent University of Chicago behavioral economist and a frequent collaborator with Kahneman. Two of the funds the firm manages that use behavioral methods have beaten Russell benchmarks from their inception through the first quarter of this year. Not surprisingly, Fuller & Thaler is not the only firm using such techniques. Firms ranging from J.P. Morgan to AllianceBernstein say they seek to capitalize on the faulty investor mind.
    For instance, Fuller & Thaler likes to pay close attention to analysts who may be anchored on a stock, not raising their earnings-per-share estimates enough even though positive information has come out about the company. Fuller & Thaler's investment team pounces before the analysts realize they were wrong. As Kahneman said in an interview, "I think that betting on mistakes of people is a pretty safe bet." Good for them. My interest in talking to the likes of Kahneman, Thaler and other behavioral economists and personal finance advisers -- besides confirming that I am not dumb -- was to understand these mistakes and what there is to do about them. "I don't think you can fix what's in your head," Thaler said. "What you can do is train yourself to say, 'This is a risky situation, and this is the kind of situation where I get fooled.' "
    I asked Kahneman what fools us most frequently. That was simple, he said: overconfidence. "It's the idea that you know better than the market, which is a very strange idea," he said. "Individual investors have no business at all thinking they can do better." Why do we? "It's because we have no way of thinking properly about what we don't know," Kahneman said. "What we do is we give weight to what we know and then we add a margin of uncertainty. You act on what you think will happen." That's what I did by buying Citigroup. But Kahneman added, "In fact, in most situations what you don't know is so overwhelmingly more important than what you do know that you have no business acting on what you know." Oops.
    Barbara Warner, a financial planner with Warner Financial, said she sees a lot of overconfidence among two groups of people: relatively new investors to the market, particularly recent business school graduates, and retirees. The latter group can be exceptionally frustrating. "Now they have entirely too much time on their hands to devote to CNBC and Money magazine," she said. "People suddenly think they are smarter than they used to be because they have more time to pay attention to it."
    That's a disastrous situation, Kahneman said: "The more closely you pay attention, the more you do things. And the more you do things, the worse off you will be." For proof, he pointed to groundbreaking research done by one of his former students, Terrance Odean, now a professor at the University of California at Berkeley. Odean has written that "overconfidence gives investors the courage of their misguided convictions."
    He has gathered trading records from discount brokerage houses for hundreds of thousands of investors, and in several published studies, he has shown that when people had a choice of two stocks to sell, more often than not they sold the stock that did better in the future and held on to the one that did worse. And when they bought something new, they tended to buy a stock that did worse than the stock they just sold. As Kahneman once told Odean, "It is expensive for these people to have ideas."
    It is particularly curious when investors hold on to losing stocks, as I have done with Citigroup. This is a function of something called loss aversion, a discovery that helped Kahneman win the Nobel Prize. Thaler, Kahneman's close colleague, put it this way: "Loss aversion refers to the fact that we're wired in such a way that losing money hurts more than getting money feels good." So let's say a hundred bucks falls out of my wallet, lost forever. Under loss aversion, this hurts a lot more than it feels good to find $100 that somebody else lost.
    When it comes to trading, this helps explain why we would want to hold on to losers. Selling the loser, even though it gives us a tax write-off, causes us to admit we have lost. So we do something that makes us feel better: We sell the winners. This feeds our overconfidence. But as Odean's research has shown, we often sell winners that still have some winning to do. That puts stocks with upward momentum on the market for less than they are really worth long-term, allowing savvier investors to snap them up. "What I believe is that individual investors probably as a group create the dynamics by which they lose money and institutions make money," Odean said. "They create mispricings."
    Along with several co-authors, he has published a somewhat depressing study about just how much wealth can be lost by everyday investors just because they trade. Looking at data from every trade made by all investors in Taiwan from 1995 to 1999, Odean discovered that the "aggregate portfolio of individual investors suffers an annual performance penalty of 3.8 percentage points," which includes trading costs. If investors had simply bought the index and not traded at all, they would have done about 3.5 percent better. The amount of money lost was equivalent to 2.2% of Taiwan's gross domestic product.
    So what should mere humans do about all of this? Like most things human, it depends on which one you ask. Odean said he saw two options: Be dumb and let others make money off you, or just buy a no-load index mutual fund and stop focusing on beating the market. Kahneman said there was no one-size-fits-all advice, but he liked the idea of having one sure thing and one long shot. The personal finance planners say investors should stick with them -- they get paid to understand this stuff, and to win. Of course, they are humans too, which means they could be prone to the same problematic behaviors.
    As for me, I'm taking some responsibility for myself, which is probably where everyone should start. Earlier this week, I logged in to my Schwab account. I sold my Citigroup shares, at a loss. I'm going to push the money into an index fund. The move felt bad, no doubt about it. I didn't fix what was in my head, but I did fix what my head had done.

An Alarm Is Blaring: Time to Buy
Mark Hulbert, NY Times 5-18-08
    Market timing — trying to jump into or out of the stock market just before rallies and declines — is notoriously difficult. Most investors would probably be better off sticking with a buy-and-hold strategy. Nevertheless, anyone trying to beat the odds may be interested in a market indicator with an excellent track record — and it has just flashed a buy signal. Of course, it is just one signpost, so proceed with caution. But it may help shift the weight of market evidence toward the bulls.
    Called the Recession Buy Indicator, it was devised by Norman Fosback, who was editor of Mutual Funds magazine in the 1990s and the author in the mid-1970s of the popular investment textbook “Stock Market Logic.” He currently edits Fosback’s Fund Forecaster, an investment newsletter. The indicator is based on the notion that it is darkest just before the dawn — that when the economic news becomes bad enough, the stock market’s likely subsequent direction is up. Because the stock market is forward-looking, Mr. Fosback said in the most recent issue of his newsletter, it “has little use for yesterday’s, or even today’s, crises.” “The focus,” he added, “is always on the future — how will business be six months, or a year or two, from now?” When the economy appears to be on tenuous ground, as it does today, he said, “stock investors looking well out to the future are able to perceive the seeds of the next economic expansion.”
    It is one thing to appreciate this market cycle from a conceptual point of view, but quite another to come up with a market-timing system based on it. Mr. Fosback’s indicator focuses on the four business barometers that together make up the federal government’s index of coincident economic indicators. These four focus on industrial production, manufacturing and trade sales, nonfarm payrolls and personal income. The Recession Buy Indicator is triggered when — as is the case today — each of these four gauges is below its level of six months earlier. On such occasions, Mr. Fosback considers the economy to be in a recession or very close to it.
    Fosback came up with this indicator in 1979, and since then it has set off four buy signals (not counting the current one). On average over the 12 months following those signals, according to his research, the average stock on the New York Stock Exchange had a total return of 37%. And in the three years after such a signal, the average gain was 106%. These gains are triple the stock market’s long-term average. (Mr. Fosback has also backtested this indicator to the late 1940s, the earliest period for which data on the coincident economic indicators were available, and it performed just as well from then until the late ’70s as it did in more recent decades.)
    Not everyone draws the conclusions that Mr. Fosback does. Ned Davis Research has extensively studied the stock market’s performance during and after United States recessions since World War II. Like Mr. Fosback, the firm’s analysts found that the stock market typically hit bottom six months after a recession began, and that at such times the stock market was a “table-pounding buy.” But, in an interview, Ed Clissold, the firm’s senior global analyst, cautioned that this conclusion was based on an average, and that on some past occasions the stock market’s actual bottom came much later.
    That is one reason, he said, that his firm doesn’t mechanically issue a buy signal six months after the economy begins to turn downward. Instead, it prefers to await confirmation from a number of its other indicators that a bottom has been formed. In the current market, that confirmation has not yet come, he said, and his firm has a policy of not trying to predict when it will.
    The advantages of not automatically jumping into the market six months into a recession were clear the last time the Recession Buy Indicator flashed: in February 2001, a year and a half before the low of the 2000-2 bear market. In his latest newsletter, Mr. Fosback acknowledged that this particular signal was “the poorest performing of the 10 signals” since World War II. Even so, he argued, the average stock was still higher three years later. He agreed that many people might be wary of plunging into the market when the economic news is so bad. But, he added, his indicator is a classic illustration of the virtues of contrary opinion: “When everything seems gloomy, it’s time for the smart money to buy.”
How to Tell if a Rally Is Real
Paul Lim, NY Times 5-11-08
    In fits and starts, blue-chip stocks have been climbing higher since mid-March. But many market watchers aren’t convinced that the worst of this market storm, which began in October, is behind us. “This was certainly a market bottom, and a pretty good market bottom,” said Duncan W. Richardson, chief equity investment officer at Eaton Vance. “But I don’t know if it was the bottom.” For that, investors will have to look for signposts in the future — not the past. For instance, if stocks are rallying on the belief that the economy is indeed on the mend, investors will need to see signs that it is actually strengthening. “There’s been a lot of stimulus put into place, and you’ve got to look for evidence that that’s working,” Mr. Richardson said.
    One important gauge will be corporate earnings — namely, profits among companies outside the financial services sector. “The world has figured out that the financial sector has serious problems, but the assumption is that the rest of corporate America seems to be doing O.K.,” said Ben Inker, director of asset allocation at GMO.
    While overall earnings of the S&P500 index are expected to fall nearly 6% in the second quarter, profits for the nine nonfinancial sectors are predicted to rise nearly 8%. But can investors count on this trend continuing? “It’s our significant worry that corporate profits in the nonfinancial part of the system are likely to be weak over the next couple of years,” Mr. Inker said. “If we’re right, and corporate profits are going to start to deteriorate outside the financials, it will cause another round of problems.” Here are some other factors to watch in coming weeks:
    Small-Stock Perfromance     An indication that investors are gaining courage after a market scare is a renewed willingness to own speculative assets. Small stocks generally perform better than large-capitalization shares in the first few months of market recoveries. Since 1979, for example, the median gain for small stocks in the three months after market bottoms, has been 19.6%, according to a study by Ned Davis Research. By comparison, big, blue-chip shares have risen more modestly — by 13.6%. Since March 17, the S&P600 index of small stocks has gained 9.3% while the S&P500 index of large stocks is up 8.8%. Continuing strength in small stocks through June could offer confirmation that this rally is for real.
    Growth VS. Value     As markets recover from severe downturns, “growth stocks eventually come back into favor,” said Robert E. Turner, chairman and chief investment officer at Turner Investment Partners. Because growth stocks are considered a more aggressive bet than dividend-paying value shares, a growth rally is an indication that “the sellers are done selling and the buyers are ready to come in,” Mr. Turner said. Since mid-March, growth stocks in the Russell 1000 index of blue-chip stocks are beating their value counterparts — but by less than a percentage point. So this indicator is sending mixed signals for the moment.
    Sensitive Sectors    If markets are rallying because the economy is on the mend, it stands to reason that the most economically sensitive stocks should fare best after a market bottom. The two sectors that have historically led market recoveries are technology and consumer discretionary stocks. On average since 1974, the tech sector has gained 27.7% in the three months after a market bottom and consumer discretionary stocks have risen 23.3% in the same period, according to Ned Davis. Since March, technology has been one of the best performers, but consumer discretionary stocks are trailing the overall S&P. A surge in the consumer sector would be expected, if the market has hit rock-bottom.
    Strength of the Dollar    A climb in the dollar against the euro for the remainder of this year would suggest that the Fed was nearly done trimming interest rates and that the economy was truly on the mend. A strengthening dollar would also tell global investors that this could be a good time to invest in United States stock markets. “If people get a double benefit because our markets are rising and our currency is improving,” Mr. Turner said, “it will only add interest in U.S. equities.” And that, in turn, would provide yet more support for a market rally.
Report Earnings, and Watch the Stock Fall
Mark Hulbert, NY Times 5-04-08
    Momentum investing — a bet that what has gone up will keep going up — is risky at any time. But it is especially so during earnings season, when stocks often move up and down very abruptly; in fact, the top-performing stocks are particularly vulnerable during these periods. And a new study has found that these highfliers tend to fall immediately after their companies announce their earnings — whether those earnings are good or bad. The study, “Limited Attention and the Earnings Announcement Returns of Past Stock Market Winners,” has been circulating for several months in academic circles. Its authors are David Aboody and Brett Trueman, both professors of accounting at the University of California, Los Angeles, and Reuven Lehavy, a professor of accounting at the University of Michigan. Their findings serve as a warning about the risks of buying stocks whose prices have been pushed unjustifiably high by mass enthusiasm.
    The professors looked at stocks that had been the very best performers over 12-month periods. Such stocks — those whose trailing 12-month returns were in the top 1% of stocks traded on American exchanges — tend to rise quite predictably in the days leading up to their companies’ earnings announcements — and then to abruptly give up all of those gains. The professors reached this conclusion after studying each earnings season from January 1971 through September 2005.
    The patterns they found were quite pronounced. Consider two hypothetical portfolios that the professors built from this group of stocks. The first bought each stock five business days before its earnings were to be announced, and sold each one just before the actual announcement. The second portfolio bought each stock immediately after the earnings announcement and held the stock for five business days. The first portfolio beat the market by an annualized rate of 47 percentage points, according to the professors, while the second lagged the market by an annualized rate of 43 percentage points. (These rates of return reflect the effect of bid-asked spreads. Though they don’t take brokerage commissions into effect, the professors say the portfolios would still beat or lag the market by large margins even after such costs.)
    The professors did not find nearly as pronounced a run-up and drop-back among stocks whose 12-month performance was only slightly behind that of the stocks that led the momentum hit parade. Why was this pattern concentrated among such a small group of top performers? The professors surmise that this is the answer: As earnings season begins, these stocks receive a disproportionate share of attention from small investors, no doubt largely because they are at the top of the leader board for 12-month returns. This appears to lead many of those investors into bidding these stocks even higher, to levels that may be unsustainable. The stocks decline when reality sets in — after the excitement of a positive earnings report ebbs, or, more sharply, after an earnings report disappoints the market.
    These results would seem to illustrate a hazard of momentum investing — that it works only as long as it works. When momentum reverses itself, a stock may plummet. Another option for momentum traders would be to avoid altogether the stocks at the top 1% of the rankings, betting instead on those that have performed just slightly behind those leaders — and thus were less likely to be magnets for some small investors. As a result, Professor Trueman said, their prices will be less likely to be thrown out of whack. Over all, though, the study suggests just how risky momentum strategies can be. Stocks that rise sharply may fall in just a few days’ time. And they most definitely are not for the weak of heart.
A Market That Dashes Assumptions
Paul Lim, NY Times 4-27-08
    Investors entered the year sure of one thing — that the economy was bound for recession, or at least for a severe downturn. And based on that assumption, they drew several conclusions. There was widespread agreement that growth stocks would likely trounce value stocks this year, because investors typically seek out companies with dependable earnings growth during times of dwindling profits.
    Large-capitalization stocks were expected to handily beat small-company shares, as investors tend to seek the safety of larger, blue-chip investments during a market storm. And defensive-minded industries like health care were expected to hold up significantly better than economically sensitive sectors like consumer discretionary stocks.
    Nearly a third of the way into the year, the economy looks as if it’s in or bound for a severe slowdown. Yet none of these other predictions have come to pass — at least not the way the “smart money” anticipated. “It does seem that logic has been turned on its head,” said Christopher N. Orndorff, head of equity strategy at Payden & Rygel.
    To be sure, growth and value stocks have been running neck and neck this year. But that is rather remarkable. After all, the growth shares were supposed to perform so much better, and value investing has been weighed down by huge losses in financial stocks (a classic value sector). Small-cap stocks are actually holding up slightly better than big, blue-chip shares. Since the start of the year, the Standard & Poor’s 600 index of small stocks has lost 3.5% of its value, while the S&P500 is down 4.8%.
    And the health care sector has lost nearly 11%, on average, since the start of the year. Consumer discretionary stocks, on the other hand, have lost less than 3%. “It is puzzling to me that the consumer discretionary part of the S.& P. 500 is beating the index,” Mr. Orndorff said. “We are in a recession and consumer spending is slowing, so it should stand to reason that these stocks would do poorly.”
    What’s going on? A growing school of thought says that stock markets are acting rationally. “The economy simply has not turned out as bad as most feared,” said James W. Paulsen, chief investment strategist at Wells Capital Management in Minneapolis. Consider corporate earnings. In the first quarter, earnings for the S&P500 companies were forecast to have fallen 14.1%. But virtually all of these declines can be attributed to just one sector: the financials.
    For the second quarter, Wall Street analysts are bracing for a 5.5% decline in corporate profits. But if you strip out financial companies’ results, earnings for the rest of the S&P500 are expected to climb nearly 8%, according to Thomson Financial.
    Sam Stovall, chief investment strategist at Standard & Poor’s Equity Research, has a slightly different take on these trends: Maybe the markets aren’t simply reacting to a less-than-severe downturn. What if stock prices are instead foreshadowing an impending recovery? Mr. Stovall noted that many Wall Street assumptions have come true — it’s just that they did so between the market’s peak last October and mid-March. During that stretch, growth beat value, large caps held up significantly better than small caps, and defensive sectors held up better than economically sensitive stocks. But all that seemed to change in March, when the Federal Reserve made a sixth cut in a key short-term interest rate and helped bail out Bear Stearns from a possible bankruptcy.
    The fact that small stocks and economically sensitive shares have done so well since March 10 — the S&P600 index of small stocks has jumped 10.6% since then, while consumer discretionary stocks have been among the better performers — would seem to confirm that the worst of the equity price decline is over, he said.
    But others aren’t so sure. Jack A. Ablin, chief investment officer at Harris Private Bank, noted that consumers were still stressed by a combination of falling housing values, a worsening job market, the continuing credit crisis and rising food and energy bills. Given that, “it’s too early for stocks to be off to the races,” Mr. Ablin said. He could be right. After all, the markets erred by making wholesale assumptions about how stocks would react to a slowing economy. Investors could be similarly mistaken about a potential recovery rally. This is a reason to ignore market chatter and simply stick with a diversified investing plan that calls for investing some money in large-cap stocks and small-cap shares, in growth and value, and in every sector of the market.
The Odds for a Retirement Nest Egg, Recalculated
Mark Hulbert, NY Times 4-20-08
    Conventional wisdom recommends that investors start with a high allocation of stock in their portfolios when they are young and reduce it as they approach retirement. That makes intuitive sense: In your 20s, you may be inclined to take bigger risks; in your 60s, you may feel a greater need to protect the wealth you have been able to amass. But a recent study of real-world portfolio returns, which fluctuate significantly from month to month and year to year, has found that there is no particular advantage in this approach. You would do just as well, with no greater odds of doing poorly, by simply picking an allocation of stocks and bonds that you can live with for a long while and sticking with it.
    That is the implication of “Hitting or Missing the Retirement Target: Comparing Contribution and Asset Allocation Schemes of Simulated Portfolios,” by Harold J. Schleef, an economics professor at Lewis & Clark College, and Robert M. Eisinger, an associate professor of political science at that institution. It was published last year in the Financial Services Review, an academic journal.
    The professors performed computer simulations for hypothetical individuals investing for retirement. Each earner is 35 years old and trying to amass $1 million (in 2006 dollars) by age 65, in 30 years’ time. They differ in how they divide their portfolios between stocks and bonds. They also differ in how the stock and bond markets perform during their decades of investing. For each year and individual, the professors picked randomly from the 80 years from 1926 to 2006. That means, for example, that the period over which an investor is trying to amass wealth could turn out to be like the 30 years beginning in 1929, a period when the market barely beat inflation — or like the 30 years beginning in 1974, a span when stocks provided stellar returns.
    By running their simulations thousands of times, and by assuming the future will be like the past, the professors calculated the odds that any given strategy would succeed. Consider, for example, an investor whose portfolio at age 35 has 78% allocated to stocks and 22% to bonds, and that the equity portion declines gradually so that, at age 65, it is just 40%. Such a scheme is typical of what many financial planners recommend, and is similar to what has been adopted by the so-called life-cycle funds, or target date maturity funds, that mutual fund families in recent years have created. Assume further that this investor contributes $11,000 each year to this portfolio. This would be enough to enable it to reach $1 million by the time he is 65 — provided the stock and bond markets each year perform exactly in line with their long-term averages.
    Yearly returns aren’t the same as the long-term averages, though. Based on actual market returns, what are the odds that this investor will reach $1 million? Only 29%. The probability of his portfolio being worth at least $750,000 is just 62%. Why such low odds of success? Because of market volatility; the order in which good and bad years occur makes a big difference.
    These findings are sobering enough, but consider what the professors found upon studying another lifetime asset allocation scheme that was just the reverse. It calls for the equity portion at age 35 to be just 40%, and for it to grow to 78% over the next 30 years. The odds of reaching $1 million were 45% and the odds of hitting the $750,000 level were 70%, versus 62% for the original scheme.
    The professors don’t recommend increasing equity exposure as people age. Instead, they advise simply keeping asset allocations fixed — which would give you just as great a chance, if not greater, of hitting retirement targets as the conventional approach, while incurring no greater odds of falling short. One big benefit of the fixed allocation approach, which the professors did not take into account in their calculations, is that it avoids the fees associated with schemes for automatically shifting asset allocations, like life-cycle funds. Some of Fidelity’s life-cycle funds, for example, have annual fees as high as 0.88%. Those fees can compound into a large sum over 30 years.
Picking the Forest or the Trees
Mark Hulbert, NY Times 4-06-08
    The ability to find top-performing industries is a crucial factor in determining mutual funds that are likely to perform best in the future. In fact, according to a new study, a manager’s success in emphasizing sectors in a portfolio is a far better forecaster of performance than his ability to pick individual stocks. The study, “Mutual Fund Industry Selection and Persistence,” has been circulating as a working paper. Its authors are Jeffrey A. Busse, an associate professor of finance at Emory University, and Qing Tong, a Ph.D. student there.
    An illustration involving two hypothetical mutual funds can help explain the new study’s findings. Imagine two funds with identical track records that differ only in whether their managers are better at picking industries or stocks within industries. The manager of the first fund has done a stellar job of choosing industries but a poor job of choosing good stocks within them, while the manager of the second fund has done the reverse. According to the researchers, the first fund is a much better bet for future performance.
    The researchers reached their conclusion after analyzing virtually all actively managed domestic equity mutual funds from 1980 to 2006. Because they wanted to explore the relative importance of industry selection and stock picking, they eliminated sector funds from consideration. All told, their database was just shy of 4,000 funds.
    To determine a manager’s industry-selection ability, the researchers put together a hypothetical portfolio that replaced each stock in the manager’s fund with an index for that stock’s industry. (If, for example, the manager bought Microsoft for his fund, the hypothetical portfolio would instead buy an equal dollar amount of an index representing “prepackaged software companies.” If the hypothetical portfolio beat the market, the manager was judged to be skillful at industry selection. Using a similar logic, the researchers determined whether this manager’s stock picks added value, by comparing the actual return of his fund to that of the hypothetical portfolio. Repeating this analysis for each fund in their database, the researchers found that industry bets were responsible for about half the margin by which the average fund beat or lagged behind the market. Stock selection was responsible for the other half.
    By themselves, these findings wouldn’t cause investors to focus only on a manager’s industry selection. That implication emerged only when the researchers looked at which skill was most likely to persist. That’s when they found that an adviser with good industry-selection ability was a good bet to continue his winning ways. By contrast, an adviser with good individual stock-selection ability was far less likely to repeat the feat.
    Why would one kind of selection ability persist and another not? The researchers suspect that a big part of the answer lies in the problems that funds face when large amounts of new cash pour into them. If a manager doesn’t have good industry-selection abilities, according to the researchers, he will be more inclined to invest that new cash in stocks he already owns. Unless those stocks are extremely liquid, the very investment of that new cash will disrupt their trading and lead to a diminution in the fund’s future returns. By contrast, fund managers with good industry-selection abilities will have plenty of other stocks within their favored industries in which to invest the new cash. As a result, according to the researchers, such managers will be more likely to continue performing well as their funds grow.
    Tantalizing as the study’s results are for a fund investor, it is hard for an individual to act on them right now. While managers’ industry-selection records can be assembled, as the researchers did, using a computer and the requisite software, they are not readily available right now, and it would be very difficult for individuals to complete all the necessary calculations themselves. But Professor Busse said in an interview that a firm with a large mutual fund database — like Morningstar or Lipper — would have no trouble completing those calculations. He urges them or similar firms to begin doing so.

Quick Facts, Stats & Opinions

    Mutual funds are selling stocks and hoarding cash just as trading surges to a record and prices grow more volatile than at any time since the Great Depression. Forty-three percent of managers surveyed this month by Merrill Lynch moved more money into cash than their funds stipulated, the highest percentage since the New York firm began compiling the data in April 2001. Their cash relative to total assets also rose to a five-year high. Mutual fund managers raised the cash they held to 4.9 percent of client assets this month, according to Merrill. The last time the level was higher was in March 2003, after the S&P 500 had lost almost half of its value from its 2000 peak.
    Daily changes of 1 percent or more in the Standard & Poor's 500-stock index, the benchmark index for American equities, have occurred on 54 percent of trading days this year, according to S&P. That's the most since 1938. One consequence is that volume on the New York Stock Exchange has ballooned to an average 1.75 billion shares a day, the highest on record and 11 percent above last year's figure. {Eric Martin and Alexis Xydias, Bloomberg, 3-30}

    After declining for a few years, mutual fund fees are starting to climb again. From 2003 to 2006, the average expense ratio edged down to 0.9 percent from 1 percent, according to Morningstar. A fund's expense ratio is the percentage of assets an investment company deducts each year for a variety of management and administrative costs. The fees chip into a fund's overall performance. Any rise is "bad news," said Morningstar's director of fund research, Russel Kinnel, "because we've found that costs are the best predictors of future returns." Last year, the average expense ratio was unchanged at 0.9 percent, according to the April edition of Morningstar's FundInvestor report. Kinnel pointed out that the absence of further declines on top of a rise in costs in some broad classes such as balanced and municipal-bond funds indicate that the trend toward lower costs is ebbing. (Washington Post 4-20)

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