The S&P Has a Habit of Bouncing Back

November 8, 2012

As much as investors appear to dislike stocks right now, Bob Carey of First Trust points out that the S&P; has a habit of bouncing back. The gist of his argument is contained in a nice graphic and a few paragraphs of commentary. Here’s the relevant chart:

Source: Bob Carey, First Trust (click on image to enlarge)

Although this picture is probably worth a thousand words too, his commentary is especially on point. Here’s what you are looking at:

  • The time periods featured in the chart depict the annualized returns for the S&P; 500 from the index’s lowest price point following a crisis situation.
  • Those crisis situations were as follows: 1973-74 (Oil Embargo); 1981 (Hyperinflation); 1987 (Crash/Black Monday); 1990 (S&L; Failures/LBOs); 2002 (Internet Bubble Burst); and 2008 (Subprime/Financial Crisis).

Amazing, isn’t it? If you had the nerve to buy during each crisis, you racked up big returns over the long run. (The recent returns have been exceptionally strong, but the time period is much shorter and hasn’t had time to include any additional bear markets.)

I find it extraordinary that the market managed 8% annual returns if you bought after the tech wreck in 2002, even after holding it all the way through the most recent financial crisis. American business is remarkably resilient and our financial markets reflect that. Even at the depths of a crisis—especially at the depths of a crisis—it makes sense of buy shares in growing businesses. Headlines and negative investor sentiment shouldn’t necessarily deter you from buying productive assets.

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Stock Market Perception vs. Reality

September 21, 2012

It’s no secret that investors have had a fairly negative outlook toward the stock market lately. Their negative perception shows up both in flow of funds data and in our own advisor survey of investor sentiment.

One possible—and shocking—reason for the negative sentiment may be that the public thinks the stock market has been going down!

Investment News profiled recent research done by Franklin Templeton Funds. Here is the appropriate clip, which is just stunning to me:

One surprising finding shows that investors are likely so consumed by the negative economic news, including high unemployment and the weak housing market, that they haven’t even noticed the strength of the stock market.

For example, when 1,000 investors were asked whether they thought the S&P; was up or down during each of the past three years, 66% thought it was down in 2009, 48% thought it was down in 2010, and 53% thought it was down last year.

In fact, the S&P; gained 26.5% in 2009, 15.1% in 2010, and 2.1% last year.

That blows me away. I have never seen a clearer case of the distinction between perception and reality. This data shows clearly that many investors act on their perceptions—that the market has been declining for years—not the reality, which has been a choppy but steadily rising market.

The stock market is ahead again year-to-date and money is continuing to flow out of equity mutual funds. I understand that the market is scary sometimes and difficult always, but really? It amazes me that so many investors think the stock market has been dropping when it has actually been going up. Of course, perhaps investors’ aggregate investment decisions are more understandable when it becomes clear that only a minority of them are in touch with reality!

Advisors obviously have a lot of work to do with anxious clients. The stock market historically has been one of the best growth vehicles for investors, but it won’t do them any good if they choose to stay away. Some of the investor anxiety might be lessened if advisors stick with a systematic investment process using relative strength—and least that way, the client is assured that money will only be moved toward the strongest assets. If stocks really do have a long bear market, as is the current perception, clients may be somewhat shielded from it.

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The Refrain of the Pessimists

August 29, 2012

Chuck Jaffe wrote a nice article for Marketwatch, pointing out that fund investors are actually more intelligent than they are given credit for. It’s worth pointing out because nearly every change in the industry is greeted with skepticism by the pessimists. His article ends with a nice summary:

“The knee-jerk reaction to almost all of the advances we have seen has been ‘Oh my goodness, what is going to happen to the industry?’ and ‘Investors will blow themselves up with this,’” said Geoff Bobroff of Bobroff Consulting, a leading fund industry observer. “Surprise, surprise, the world hasn’t come to an end yet and, in fact, the fund world has gotten better for each of these developments.

“Joe Six-Pack is going to do exactly what he has always done,” Bobroff added. “He is not going to change, just because the technology exists for him to do something different. He will adapt, and over time become comfortable with the newer products and newer ways. That doesn’t mean he will always make money; the market won’t always work for Joe Six-Pack, but that won’t be because the fund industry is evolving, it will be because that’s just what the way the market is sometimes.”

The article addresses the concern expressed by many that investors will blow themselves up with ETFs because of their daily liquidity. (John Bogle has expressed this view frequently and loudly.) Mr. Jaffe pulls out some data from a Vanguard (!) study that shows, in fact, that’s not how investors are acting.

Over the years, we’ve heard the same refrain about tactical asset allocation: investors will never be able to get it right, they’ll blow themselves up chasing performance, etc., etc. In fact, tactical allocation funds have acquitted themselves quite nicely over the past few years in a very difficult market environment. For the most part, they’ve behaved pretty much as advertised—better than the worst asset classes, and not as well as the best asset classes—somewhere in the middle of the pack. That kind of consistency, over time, can lead to reasonable returns with moderate volatility.

Reasonable returns with moderate volatility is a laudable goal, which probably explains why hybrid funds have seen new assets this year, even as equity funds are seeing outflows.

In markets, pessimism is almost never the way to go. It’s more productive to be optimistic and to try to find investment strategies that will work for you over the long run.

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The Truth About the “Impending” Recession

August 15, 2012

Doug Short at Advisor Perspectives performs a very valuable public service. He presents very clear charts of major economic indicators without a lot of heavy interpretation and spin. Pundits who have forecast a recession—and therefore have a vested interest in a recession occurring—often pick and choose their indicators. There’s always some part of the economy that’s lagging, and with the right spin you can probably make it look like the sky is falling.

Here is Mr. Short’s brief comment:

Official recession calls are the responsibility of the NBER Business Cycle Dating Committee, which is understandably vague about the specific indicators on which they base their decisions. This committee statement is about as close as they get to identifying their method.

There is, however, a general understanding that there are four big indicators that the committee weighs heavily in their cycle identification process. They are:

  • Industrial Production
  • Real Income (excluding transfer payments)
  • Employment
  • Real Retail Sales

The weight of these four in the decision process is sufficient rationale for the St. Louis FRED repository to feature a chart four-pack of these indicators along with the statement that “the charts plot four main economic indicators tracked by the NBER dating committee.”

Bear in mind that the NBER dating committee identifies recessions after the fact. These are not leading indicators, but rather coincident indicators. Only after they have turned down solidly can the NBER agree that a recession has started.

So, what do the indicators actually look like? There are more charts in Mr. Short’s indicator update, but this chart summarizes it nicely.

Are these indicators going up or down?

Source: Advisor Perspectives/Doug Short (click to enlarge)

I highly recommend reading the entire article, but even a cursory inspection of this chart shows no current evidence of a recession. The stock market is one of the leading indicators in the LEI also, and it is near the high for the year. Our global tactical allocation accounts hold a lot of domestic equity because that’s where the strength has been. (Despite, or maybe because of, investors’ reluctance to own stocks, the market is having a decent year so far.) Instead of freaking out about an impending recession, maybe you could just look at the primary source data.

It’s not impossible that a recession is on the way, of course, but you’d have to present data that the NBER is not using. Anything can happen, but it’s pretty tough to make the recession argument from the data in this chart.

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Moving Averages and RS…By the Numbers

June 22, 2012

Investors frequently rely on market indicators, such as moving averages, to decide when to buy, sell, or hold a stock. In fact we hear all the time of the magical powers of the moving average indicator, which has the mystical capabilities of keeping you out of trouble during market downturns, while making sure you are along for the ride on any rallies.

Therefore, we decided to test performance of Ken French’s High Relative Strength Index (an explanation of this index can be found here) against 50 and 200 day moving averages. We’ve calculated returns based on the assumption that the investor buys or holds when the price of the RS stock is above the moving average, and sells when the price drops below the moving average. So when the index is above its 50-, or 200-day moving average, we are fully invested, and when it’s below, we are out of the index.

Chart 1: Returns from 1963-2012. During this time period, basing buy and sell decisions off of the 50 day moving average is more successful than being fully invested. It is important to keep in mind that this data includes the bear markets of the 1970s and 2000s.

http://i563.photobucket.com/albums/ss73/dorseydwa/MovingAverage-19752007-1.png

Chart 2: Returns from 1975-2007. When we start at a different point in time, the 50 day moving average performs much more poorly. In this dataset, we’ve cut out two large bear markets, and the effect on returns is drastic. In this case, it would have been better to just buy and hold.

Table 1: Annualized Returns by Time Periods. The average annualized returns also vary based on the period of time measured. At certain times, following moving averages outperforms being fully invested; but in other periods the opposite is true. Check out the difference between the two periods of ’83-’00 and ’66-’82. Using a moving average can either make or break your returns.

Charts 3 and 4: Fully Invested Ken French – Use of 50 Day MA (5 and 10 Year Performance). Investment performance based on moving averages varies greatly over time. In some periods, it performs incredibly, while in others it does terribly.

The performance of moving average based investment is directly related to the time period in which it is measured. As shown in Table 1, the returns can be completely different even in periods that partially overlap. The question then becomes not whether or not to use a moving average, but when! If you can predict the future, you’ll easily be able to decide whether or not to use a moving average when holding an index.

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PDP vs. Ken French High Relative Strength

June 12, 2012

In past posts (“Relative Strength vs. Value-Performance over Time” and “Relative Strength, Decade by Decade”), I’ve used the Ken French database’s relative strength portfolio. While this is useful in concept, what solidifies the findings in my previous posts is the similarity between Ken French’s High RS data and one of our ETFs, PDP.

PDP is a PowerShares ETF based on the Dorsey Wright Technical Leaders Index. It has its own proprietary calculation method, which is different than that of the Ken French database. Yet, over the past five years, both have performed very similarly.

Table 1:

PDP has only been on the market since March of 2007. Yet, over those five years, the two indexes have performed almost exactly the same…no small feat considering the stock market over the last few years. Imagine, then, using the Ken French data as a “loose proxy” for PDP going back decades. We’re not saying the two will always perform the same—we’re just pointing out that it’s clear both indexes are exploiting the same factor (RS) in a practical way.

Currently, relative strength growth rates (10-year rolling returns) are at some of the lowest levels since the 1930s; and historically we can see that growth rates often increase once they hit rock bottom. That may bode well for relative strength returns going forward.

Chart 1:

See www.powershares.com for more information about PDP. Past performance is no guarantee of future returns. A list of all holdings for the trailing 12 months is available upon request.

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One Good Data Point

May 30, 2012

This just in. We are now back at 5/25 levels for the S&P; 500. From Tobias Levkovich at Citigroup, as reported by Business Insider:

Last Friday our panic-euphoria model, one of our proprietary sentiment models went into panic, that gives us a very high probability, almost 90 percent probability that markets are up in 6 months, and 96 percent probability that they’re are up in 12 months.

I have no idea how they come up with those probabilities, but it would be nice if it’s true. More generally, other analysts have also found a correlation between very negative investor sentiment and higher markets 6-12 months later.

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Two Rides the Public Missed…

May 7, 2012

Mark Twain once said, “A cat who sits on a hot stove will never sit on a hot stove again. But, he won’t sit on a cold stove, either.” Surely, that applies to investors who have gone through a severe bear market, like 1973-74 or 2008.

Source: The Leuthold Group

Without an investment process that systematically allocates to where the action is, investors may be psychologically incapable of making much money for years to come.

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