Evidence Investing

A few days ago Fed Chairman Bernanke said this:

"The Federal Open Market Committee has stated clearly that they currently anticipate that very low, extremely low rates will be needed for an extended period." (source: Yahoo)

Well, talk is cheap, as we know.  Lets take a quick look at the evidence of how the Fed has acted on rate hikes in the past:

So, if the past is any guide (as I would argue it is), and if the recent signs of a decrease in unemployment are true, "an extended period" may actually be something more along the lines of "right around the corner."  

It’s been said over and over again…mostly by financial advisors:

You must be in the market all the time to see your portfolio grow to its potential….If you miss the 10 best days, your returns will suffer greatly!

They usually show you something that looks like this:

This quote from Charles Schwab and Company show what I mean: On "importance of being invested…just a few trading days each year…for the ten-year period from 1994 though 2003, only 10 days accounted for almost half of the gain during the period. That's 10 days out of about 2,600."

This is one of the biggest, if not THE all-time biggest, fallacy foisted on unsuspecting unsophisticated small-time investors.

This subject has been address else where on the net, but I really feel like it cant be said enough and it deserves a little more air time.

Let me ask you this:  if you missed your “10 best” job interviews, where would you be?  Not as well off, I would guess.  What if you missed your “10 best” dates?  Not married to the women of your dreams …or at least not as many memories, right?  What about your “10 best” investing plays?  Lower account balance now, maybe?  

Its not rocket science, right?  You miss the best, 10 best, or 50 best of anything and you will be less ‘well off.’  Yet another expensive useless piece of advice from and expert.

In reality, if we look at missing the 10 best days, we also have to look at missing the 10 worst days.   Unless you have some kind of system that makes you miss all the best and keeps you in for all the worst days…  And that means you have much bigger problems. J

In fact with no system at all, you have an equal probability of missing the best days and missing the worst days, right?  And with any kind of worthwhile system, you just tip those odds in your favor and miss a few more bad days than you do good days.
So we need to look at what happens if you miss both best and worst days.

But first a little DETOUR:  Lets just quickly clarify a basic idea in investing and finance ->  participating in percentage gains are not as valuable as avoiding equal percentage losses. [to a degree, of course…we all know you can’t make money without percentage gains]

Here is an illustration:

So you can see that as you gain and loss and equal percentage, your portfolio value slips away.

Now let’s see what percentage we have to gain to stay even after a 25% loss

So from this, we can see that equal losses have a much larger effect on your portfolio than do gains!  This is a basic risk management concept which becomes even more interesting when linked with the “10 Best/10 Worst” concept.

REMEMBER ->  participating in percentage gains are not as valuable as avoiding equal percentage losses, generally speaking.

Ok, keeping this in mind, back to our “10 Best/10 Worst” discussion.

Look at what happens if you miss both best and worst days.   Below are the results from essentially three studies each using different holding periods, for your viewing pleasure.

Note that the return from “Both” is about 3% points HIGHER than the Buy and Hold return.

Here’s another example. During the period analyzed below, the S&P 500 Index yielded annualized return of 7.06% (buy and hold) over the same period of time: 

Note that the return from “Missed Both” is about 1.5% points HIGHER than the Buy and Hold return.

Now look at this:

This looks at a shorter period.  Note that missing the 10 Worst gives you more gain (+1.43% above buy and hold) than the loss you sustain if you miss the 10 Best (-0.84%).  This ties back in to my “Detour concept” above:  you need even MORE of a gain to offset an equal percentage loss…and here, you have LESS of a gain (i.e. even if the 10 Best days were worth +1.43% (instead of +0.84%), that STILL would not be enough to offset the 1.43% savings that occurs when you avoid the 10 Worst days.

I hope that’s clear.   If not, just remember that missing both the 10 Best and 10 Worst days beats buy and hold (as shown above).

Read these few pages for “in other words” look at it.

AND what’s more, I’ve just been looking at the return numbers here.  I haven’t taken into account the affect on psychology that missing some highly volatile days can have on an investor; neither have I addressed the chance that high volatility can totally wipe out your portfolio OR the fact that there are several systems (TAA) that can tilt the ‘missed days’ in your favor!

Keep reading folks, lots more to come!

I'm slammed today, but I just wanted to check in real quick...a little more 'op-ed-ish' than I like for this site, but I think its useful anyway...

I'm going to reach back a few weeks to tie something together for you:

First take a quick look at this post from a few weeks ago about the bubble in Chinese real-estate .  I'm going to repost the graph here:

Now, check out this article from Bloomburg (which I have summarized):

China is in the midst of “the greatest bubble in history,” said James Rickards, former general counsel of hedge fund Long-Term Capital Management. 

The Chinese central bank’s balance sheet resembles that of a hedge fund buying dollars and short-selling the yuan, he said.  “[It] is the greatest bubble in history with the most massive misallocation of wealth.” China “is a bubble waiting to burst.”   Rickards joins hedge fund manager Jim Chanos, Gloom, Boom & Doom publisher Marc Faber and Harvard University professor Kenneth Rogoff in warning of a potential crash in China’s economy.

The Shanghai Composite Index of stocks jumped 80% last year and property prices rose at the fastest pace in almost two years in February, helped by a record 9.59 trillion yuan ($1.4 trillion) of new loans in 2009. The Index is valued at 32 times reported earnings, compared with 52 times at its peak in October 2007. The U.S. benchmark Standard & Poor’s 500 Index trades at 19 times earnings. China’s economic growth quickened to 10.7 percent last quarter. Property prices in 70 cities rose 10.7 percent from a year earlier in February. 

REFER TO ABOVE GRAPH!!!  J

The nation’s “massive monetary stimulus” risks triggering large asset-price increases, a housing bubble, and bad debts from the financing of local-government projects, says the World Bank. 

Harvard’s Rogoff said Feb. 23 that a debt-fueled bubble in China may trigger a regional recession within a decade, while Chanos, founder of New York-based Kynikos Associates Ltd., predicted a slump after excessive property investments. 

Now, there are some economic heavies on the other side, for sure, all of them saying that the Chinese central bankers will raise rates high enough and quick enough.
 
The banking industry has “very low impairment charges compared to what you’d expect this time in the cycle,” HSBC’s Geoghegan said. “I wouldn’t be surprised if there’s a gradual increase in impairments, but long term I’m confident that the structure of the banking industry is very, very sound.” 

I guess we will see, Mr. Geoghegan…but that chart up there is pretty convincing J

 

With oil reaching over $85 a barrel recently and with what is generally considered to be a 'fragile', some people (me) are asking: do what degree will the effect is rising oil prices hamper this burgeoning economy.  So lets turn again to Econobrowser for some enlightenment.

Fact: Ten of the 11 recessions in the United States since World War II have been preceded by a sharp increase in the price of crude petroleum. 

Check out this chart.  {grayed areas are the recessions, the black line is the price of crude}:

Econobroswer goes on to postulate that the truly important aspect of this whole picture is oil shocks.  Shocks have everything to do with perception...supply perception, usually (take the 1970's oil shocks).  Another aspect of this is the relative anchoring of gas prices:   And with retail gasoline prices still a dollar a gallon below what consumers have recently seen, I'm doubtful that gasoline prices have the ability to induce as much consumer anxiety as we observed two years ago. Although recent increases in prices have brought energy expenditures back up as a share of total consumer spending, they're still below the 6% level at which consumers historically have started to make dramatic adjustments. 


Just food for thought...

More evidence on momentum:

#5:  “Momentum Profits, Non-Normality Risks and the Business Cycle” from Applied Financial Economics.

Abstract:      It shows that momentum profits are not normally distributed and, relatedly, that the momentum profitability is partly a compensation for systematic negative skewness (the distribution curve tilts to the right…toward abnormal profits) risk in line with market efficiency. This finding is pervasive across nine trading strategies that combine different holding and ranking periods and is reinforced when time dependencies in abnormal returns and risks are explicitly modeled. The analysis also reveals that the market and skewness risks of momentum portfolios evolve…in a manner that is consistent with market timing and risk aversion. While non-normality risks matter, a large proportion of the momentum profits remains unexplained…

First look at this chart (courtesy of CXO Advisory):

Some salient points from the paper:

All of the nine momentum strategies they examined showed significant abnormal performance advantages for past winners.  Standard deviation is also smaller for past winners (those stocks with momentum) than with past losers. Efficient market theory still cannot explain fully the outperformance of momentum investing…meaning there is something there (with momentum)!



#6:  In a working paper from the Ross School of Business entitled “Momentum Profits, Factor Pricing, and Macroeconomic Risk,” we see:

Abstract:      We study the connection between momentum portfolio returns and shifts in factor loadings on the growth rate of industrial production. Winners have temporarily higher loadings than losers. The loading spread derives mostly from the high, positive loadings of winners. Small stocks have higher loadings than big stocks, and value stocks have higher loadings than growth stocks. Using standard multifactor tests, we present evidence that the growth rate of industrial production is a priced risk factor. In most of our tests, however, the combined effect of factor pricing and risk shifts does not explain a large fraction of momentum returns.


In this paper, they again constructed momentum portfolios using 6 month rankings and 6 month hold periods (more on this lingo soon).  They found:

The average winner-minus-loser shows excess return is 0.85% per month.  Also, winners have temporarily higher average future growth rates of dividends, capital investment and sales than losers and these temporary factors generally match the duration of their momentum effect.

Here's a clue: 

From Econobrowser:

"Congress seeks more information on health care charges AT&T announced last week that it would charge $1 billion against its earnings as a result of the recently passed health care bill. Other companies also announcing charges include Caterpillar ($100 M), John Deere ($150 M), and MMM ($85-90 M). Analyst David Zion of Credit Suisse estimated that S&P 500 companies will rack up a combined $4.5 B charge.

While $4.5 BILLION dollars is small potatos for the government, I wouldn't want to hold stocks that are facing this kind of write down...  Well, it seems unavoidable now.

Here is the second installment (of many) showing the evidence behind the basic concept of momentum.  Remember, this data doesn't yet apply how to trade this or signals and combinations of strategies...it just focuses on the fact that momentum is persistent and real in the markets.   Ok....


#3: Lets take a look at this paper from the Journal of Finance:  
Jegadeesh, N., Titman, S. “Profitability of Momentum Strategies: An Evaluation of Alternative Explanations.” Journal of Finance 56 (2001).  

Abstract:      The evidence indicates that momentum profits have continued in the 1990's suggesting that the original results were not a product of data snooping bias. Our analysis of post-holding period returns sharply rejects a claim in the literature that the observed momentum profits can be explained completely by the cross-sectional dispersion in expected returns.

Here is a chart from the paper which shows the returns of momentum portfolios: