The Investment Scientist

July 30, 2008

Bear market: how long will it last?

Posted by investmentscientist under Investment, Investment Risks, Small Cap Value Investing, retirement investment, stock market predictions
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It’s official. On July 9, US stocks slid more than 20% from their October high, sending the S&P 500 into bear market territory. Even earlier this month the NASDQ and Dow Jones turned bearish following the Russell 2000, an index of small caps, which lead the decline.

How long will this bear market last?

Well, I don’t have a crystal ball, but I do have a rear view mirror.

Since 1960, there have been ten bear markets (see Table). The worst bear market took one-and-a-half years to reach bottom. Four reached bottom within a month. The remaining five hit bottom between one and ten months. On average, it took 4 months to reach bottom.

Date of entering bear market	Months to bear bottom	1 year return from entry	3 year return from entry
2/26/2001	19 months	-11%	-8%
10/8/1998	< 1 months	38%	12%
10/17/1990	< 1 months	33%	59%
10/19/1987	2 months	3%	13%
3/1/1982	5 months	34%	63%
3/6/1978	< 1 months	13%	49%
12/10/1973	10 months	-32%	9%
1/26/1970	4 months	10%	35%
10/3/1966	< 1 months	28%	24%
5/28/1962	1 month	20%	51%
*Average*	*4 months*	*14%*	*31%*

Data source: Moneycentral.com

Now that we are in a bear market, shall we move to cash?

I don’t recommend it. Here’s why. From the day the S&P 500 entered a bear market, on average it returned 14% in one year and 31% in three years.

Let’s look at the distribution of returns. This is important. Among the ten one-year returns, two were negative, yet three were over 30%. As for the three-year returns, only one was negative but three were over 50%!

I don’t know about you, but I like those odds.

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July 9, 2008

Is P/E ratio a useful stock valuation measure?

Posted by investmentscientist under Investment, retirement investment, stock market predictions
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Warren Buffet said: “Price is what you pay and value is what you get.”

Wall Street uses the price-to-earning ratio, or the P/E ratio in short, to determine whether one gets what one pays for when buying a stock. Is this ratio just a myth? Or is it a useful valuation measure?

To answer this question, I examined the whole stock market data for the past 50 years from 1958 to 2007. For each year, I separated stocks into three portfolios: the top 30% P/E portfolio, the middle 40% P/E portfolio and the bottom 30% P/E portfolio. (Stocks with negative earnings are all in the top 30% P/E portfolio.)

If I had invested $1 in each of the three portfolios at the beginning of 1958, by the end of 2007, the top 30% P/E portfolio would have grown to $91; the middle 40% P/E portfolio would have grown to $322 and the bottom 30% P/E portfolio would have grown to $1698! (The chart below shows the growth of $1 in the three different portfolios in logarithmic scale.)

In fact, in the past 5 decades, there was not a single decade in which the bottom 30% P/E portfolio did not outperformed the top 30% P/E portfolio. The decade spanning 1968 to 1977 was especially eventful: two global recessions, the Arab-Israeli war and the Arab oil embargo. The returns of the three portfolios in that decade are as follows:

Top 30% P/E portfolio: 31%

Middle 40% P/E portfolio: 61%

Bottom 30% P/E portfolio: 137%

It is safe to conclude that the P/E ratio is a very useful valuation measure for long-term stock investment. The lower the P/E ratio, the higher is the expected long-term return. That does not mean that low P/E stocks outperform every year though. In the last 50 years, there are 12 years in which the top 30% P/E portfolio outperformed the bottom 30% P/E portfolio. Take 2007 for example, the top 30% P/E portfolio outperformed the bottom 30% portfolio by more than 13%.

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June 11, 2008

Retirement Investment Bookmarks

Posted by investmentscientist under Chinese Stock Market, Investor Psychology, Retirement Investment Bookmarks, retirement investment
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Why is oil closing on $138? James Hamilton has an answer.

William Engdahl argues “60% of today’s oil price is pure speculation“.

J.D. of Get Rich Slowly explains why it pays to ignore financial news.

Newsweek has a piece on the Great Leap Downward of Chines stocks. Did I tell you this last year?

May 29, 2008

Small cap: is the pain worth the gain?

Posted by investmentscientist under Investment, Investor Psychology, Small Cap Value Investing, retirement investment
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Over the last 60 years, the simple average annual return of the Fama/French benchmark small-cap portfolio* was 16.3%. For the same period, the large-cap portfolio* was only 12.76%. Do you think small cap beat large cap by a wide margin? I put my mathematician’s hat on to find out.

Volatility shrinks the return difference

The small-cap portfolio return volatility for this period was 26%, and 16.4% for the large cap. Taking into account the drag to return by volatility , I calculated the geometric mean return for both portfolios. My results showed 12.9% for small cap, and 11.4% for large cap. Mathematically, the return advantage of the small-cap portfolio is significantly reduced by its volatility.

The odd favors small cap … somewhat

For most investors, long-term investing means holding a stock for three to five years. What is the odds of the small-cap portfolio beating the large-cap portfolio? Not by much.

In any given three-year period during the last 60 years, the odd of the small-cap portfolio beating the large-cap portfolio were only 51%. It increases to 58% when the investment horizon is 5 years and 72% when the investment horizon is 10 years. For most investors, the odds barely favor small-cap investing.

Investment horizon	1 year	3 years	5 years	10 years	20 years	30 years
Odds of small cap beating large cap	53%	51%	58%	72%	75%	90%

Data source: Kenneth French data library

Emotional accounting

Daniel Kahneman, the 2002 Economic Nobel laureate and the father of behavioral finance observed that the pain from a loss is twice the pleasure from a gain of the same size.

Applying his principle: I assigned one unit of positive emotion to each 1% gain and deducted two units of positive emotion to each 1% loss. So a resulted positive number represents pleasure and a negative number represents pain. The sum of monthly results over the last 60 years showed: -788 for the small-cap portfolio and -482 for the large-cap portfolio. It is clearly painful to invest in stocks, small cap stocks especially. (This also explains why people prefer to put their money in CDs.) Is the pain of small cap investing worth the gain? You decide.

There are ways to reduce the pain and enhance the gain through diversification and valuations. They are the subjects of my future newsletter, which you can subscribe here.

*Fama/French benchmark small cap portfolio contains stocks in the bottom 30% of market capitalization. Fama/French benchmark large cap portfolio contains stocks in the top 30% of market capitalization.

May 16, 2008

Volatility: a drag on return

Posted by investmentscientist under Investment, Investment Risks, retirement investment, stock market predictions
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In my last article, I explained why volatility does not measure risk. It’s an assertion by none other than Warren Buffet himself. I hope the historical data I used convincingly illustrated the point.

If volatility doesn’t measure risk, then what can we learn from it?

Let’s look at this simple example. Let’s say you invest $100 in asset A, whose volatility is 10%. In year one, the asset returns 10%. In year two, it returns -10%. What is the terminal value in year two? If you’re like most of us mortals, you’d call it a wash. You’d guess $100. Not so, the terminal value is $100*(1+10%)*(1-10%)=$99.

Now let’s assume you invest $100 in asset B, whose volatility is 20%. In year one, the asset returns 20%. In year two, the asset returns -20%. What is the terminal value in year two? This time you should get it right, it is $100*(1+20%)*(1-20*)=$96. So, everything else being equal, we can say higher volatility means lower investment return.

Mathematically speaking, volatility is a drag on return.

Steve Shreve, the math professor in my quantitative finance class, would give you this formula:

Reduction in return = ½ volatility²

For instance, if the annual volatility is 20%, then the drag on annual return is ½*(20%)²=2%. This drag on return is not risk, since it is deterministic – there is nothing uncertain about it.

How to reduce volatility drag on return?

This simple answer is diversification. However, diversification requires special care. Blind diversification could do more harm than good. This is a topic best left for another article. If you’d like to receive it, please subscribe to my monthly newsletter – The Investment Scientist.

April 23, 2008

A costly investment mistake: confusing volatility with risk

Posted by investmentscientist under Investment Risks, Investor Psychology, Small Cap Value Investing, retirement investment
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Confusing volatility and risk could cost you a bundle. Let’s take a look at returns on an investment of $1000 over 50 years from 1958-2007 in five asset classes.

Small cap value: $3,750,000
Small cap growth: $81,200
Large cap value: $854,000
Large cap growth: $130,000
CD: $13,800

Isn’t it obvious which is the best long-term investment?

Why small cap value is the best long-term investment

So you don’t have a 50-year investment horizon? Few of us do. How about a ten-year horizon? In any ten-year period from 1958 to 2007, small cap value had much better investment results than a “safe” CD. (See Table below. Green = best result in the given ten years; red = worst.)

Table: How would $1 investment become?

10 year periods	Small Cap Growth	Small Cap Value	Large Cap Growth	Large Cap Value	CD
1958-1967	$5.64	$8.02	$3.22	$5.39	$1.36
1968-1977	$0.97	$2.66	$1.2	$2.64	$1.75
1978-1987	$3.38	$7.84	$3.52	$4.96	$2.41
1988-1997	$2.87	$6.47	$5.38	$5.13	$1.7
1998-2007	$1.53	$3.47	$1.77	$2.36	$1.42
Annual volatility	28.23%	24.05%	17.67%	18.54%	1.7%

Safety paradox

Even though a FDIC guaranteed CD is perceived to be safe, over time, inflation eats away at returns. For the long-term investor - and by that we mean you - small cap value is less risky.

Why do few investors put their long-term investment in small cap value? And, when the going gets rough, why do many small-cap-value investors switch their money to CDs?

Here’s why, small cap value is highly volatile (See last row of Table) and volatility makes us anxious and jumbles our judgments.

“Volatility does not measure risk.” -Warren Buffet

Volatility becomes risk only when the investor can’t stand it anymore, and abandons an otherwise safe long-term investment. Typically, volatility is highest and its impact most painful when the market reaches bottom. Not surprisingly, many investors bail out at the worst possible time.

Upon learning that he had to sail by the Sirens - the creatures whose beautiful songs could lure him to jump to his death - Odysseus asked his sailors to tie him to a mast. What mast do you tie yourself to? I suggest you subscribe to The Investment Scientist newsletter, where you don’t get up-to-the-minute news, but a monthly dosage of scientific facts.

April 23, 2008

Warren Buffet: Volatility does not measure risk

Posted by investmentscientist under Investment Risks | Tags: risk, volatility, warren buffet |
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Volatility does not measure risk. The problem is that the people who have written and taught about risk do not know how to measure risk. Beta is nice because it is mathematical, it is easy to calculate and it is wrong - past volatility does not determine the risk of investing. In early 1980s, farmland that had gone for 2,000 an acre, went for $600 an acre. Beta shot up. I was apparently buying a riskier asset at $600 than at $2,000. Real estate not frequently traded. Stocks give you the ability to measure this volatility nonsense.

Because people who teach finance use the mathematics that they have learned, they translate volatility into all types of measures of risks — it’s nonsense. Risk comes from the nature of certain types of business, and from not knowing what you’re doing. If you understand the economics of the business that you’re engaged in and you trust the people you are partnering with, you’re not running significant risk.

Volatility as risk has been very useful for those who teach, never useful for us.

April 17, 2008

Retirement investment bookmarks

Posted by investmentscientist under Investment Risks, Investor Psychology, Jim Cramer, Retirement Investment Bookmarks, retirement investment
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Richard Conniff of MSN Money wrote about “How fear can make you loss millions.”

Blind trust in pundits could wipe you out as well. Alice Gomstyn of ABC News asked “Should you stay away from Jim Cramer?” (My answer is yes.)

Bob Klosterman explained life insurance in wealth management.

Greg Mankiw examined Barrack Obama’s tax return, he found Obama is not a fan of retirement saving.

March 27, 2008

Investor sentiment and stock market return

Posted by investmentscientist under Investment, Investment Risks, Investor Psychology, Small Cap Value Investing, stock market predictions
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Investor sentiment is at its lowest since 1990 and second lowest since the American Association of Individual Investors (AAII) sentiment indicator began in 1987. On 2/7/08, the 8-week moving average bull/bear spread reached the low of -25% and has since hovered below -20%. What does it mean for investors that the bull/bear spread stands at -25%? And what is the bull/bear spread?

Are you bullish, bearish, or neutral?

That’s the question asked by the AAII who has been conducting weekly market-outlook surveys of its members since 1987.

The bull/bear spread is the bullish percentage of the answers minus the bearish percentage of the answers. For instance, if 30% are bullish, but 50% are bearish, then the bull/bear spread would be 30%-50%=-20%. Since investor sentiment is very votalile, the 8-week moving averaging is used to smooth out the kinks. The AAII has 20 years of data with which we can study the relationship between investor sentiment and stock market return.

Current low investor sentiment is significant because there were only six instances (excluding this one) when it was below -15%. And only two instances when it was below -20%.

How does bearish investor sentiment relate to stock market return?

I used the small sample of six prior occasions when the bull/bear spread was below -15%. I then studied the subsequent one-year returns by the S&P 500 and the Fama/French Small Cap Value Benchmark Portfolio. The result is displayed in the table below.

Time (8 weeks ending on )	8 week MA bull/bear spread	S&P 500 one year return	Small Cap Value one year return
11/2/1990	-37%	25%	46%
2/7/2008 (this time)	-25%	?%	?%
10/23/1992	-21%	12%	40%
3/13/2003	-18%	40%	82%
7/2/1993	-15%	0%	11%
7/20/2006	-15%	23%	23%
3/16/1990	-15%	9%	-2%
Average	-20%	18%	33%

Data sources: AAII, Kenneth French data library

History shows that the worst decline is over once the indicator shows a reading of -15% or below.

One-year returns for the S&P 500 ranged from 0% to 40%, while those for the Fama/French Small Cap Value Benchmark Portfolio ranged from -2% to 82%. To the extent history repeats itself, the risk rewards of stock investing is heavily skewed toward rewards.

Warren Buffet put it best when he said: “Be greedy when others are fearful.”

March 18, 2008

Jim Cramer on Bear Stearns since last summer

Posted by investmentscientist under Investment Risks, Jim Cramer
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6/22/2007 After Bear Stearns’ hedge funds blew up, Jim Cramer said on CNBC’s Stop Trading:

Buy Bear Stearns! …fund problem won’t spill over.

8/3/2007 According to StreetInsider, Jim Cramer made comments about Bear Stearns, saying he thinks the company shouldn’t have held a conference call to put more bad news into the market …

2/11/2007 Jim Cramer made his Lighting Round bullish calls:

I think you stick with Bear, I think this Justice Department thing will be cleared up.

3/11/2008 Before Bear Stearns’ collapse, Jim Cramer:

Bear Stearns is fine … Bear Stearns is not in trouble. Don’t be silly … Don’t move your money.

3/17/2008 After Bear Stearns’ collapse, Jim Cramer:

I said the common stock was worthless on Friday.