The Best of Times, the Worst of Times

For the twelve-month period ending May 31, 2011, equity investors around the world enjoyed the equivalent of blue skies and bright sunshine while the economic news was partly cloudy at best. Among forty-five developed and emerging-country stock markets tracked by MSCI, all but four had double-digit total returns (in US dollar terms), and twenty-six had returns of 30% or more.

If someone had told us a year ago that global markets would stage such a broad-based rally, we would have been inclined to think that trends in employment, housing, and financial distress were about to take a pronounced turn for the better. It seems hard to argue they have done anything of the sort. Somehow, despite gloomy financial page news that keeps repeating itself, equity prices marched substantially higher.

The moral of the story? Investors should be skeptical of their ability to predict future events and even more skeptical of their ability to predict how other investors will react to them.

Last Year's Headlines	This Year's Headlines
"Europe Crisis Deepens as Chaos Grips Greece" Sebastian Moffett and Alkman Granitsas. Wall Street Journal, May 6, 2010	"Greek Woes Fuel Fresh Fears" Marcus Walker and Hannah Benjamin. Wall Street Journal, May 10, 2011
"Fearful Investors Are Pulling Out" Adam Shell. USA Today, May 20, 2010	"Fear Wins: Stocks Resume Long Slide" Adam Shell. USA Today, June 16, 2011
"Housing Prices Remain Weak" Sara Murray. Wall Street Journal, May 26, 2010	"Home Market Takes a Tumble" Nick Timiraos and Dawn Wotapka. Wall Street Journal, May 9, 2011
"Fear Returns—How to Avoid a Double-Dip Recession" Cover story. Economist, May 29, 2010	"The World Economy—Sticky Patch or Meltdown?" Cover story. Economist, June 18, 2011
"Spill Tops Valdez Disaster—Deep Trouble: There Was 'Nobody in Charge'" J. Weisman, G. Chazan and S. Power. Wall Street Journal, May 28, 2010	"Japanese Nuclear Crisis Is Ranked at the Level of Chernobyl" Mitsuru Obe.Wall Street Journal, April 12, 2011
"Discouraging Job Growth Batters Stocks" Don Lee. Los Angeles Times, June 5, 2010	"Jobs Data Stoke US Recovery Fears" Robin Harding, S. Bond and M. Mackenzie. Financial Times, June 4, 2011
"Economic Outlook Darkens" Jonathan Cheng and Justin Lahart. Wall Street Journal, June 2, 2010	"Stocks Plunge Amid Fears That Global Economy is Slowing" Christina Hauser. New York Times, June 11, 2011
"Bond Fund Managers See Signs of a Bubble" Sam Mamudi. Wall Street Journal, June 8, 2010	"Why Are Investors Still Lining Up for Bonds?" Jeff Sommer. New York Times, May 29, 2011
"Rapid Declines Rattle Even Optimists" E.S. Browning. Wall Street Journal, June 14, 2010	"Investors Shaken by the Fear Factor" James Mackintosh. Financial Times, June 18, 2011

Past performance is no guarantee of future results.

A Few FAQs

In layman's terms, what is the Efficient Market Hypothesis?

The Efficient Market Hypothesis says that market prices are fair: they fully reflect all available information. This does not mean that prices are perfect; some prices may be too high and some too low, but there is no reliable way to tell. In an efficient market, investors cannot expect to earn above-average profits without assuming above-average risks. Market efficiency does not suggest that investors can't "win." Over any period of time, some investors will beat the market, but the number of investors who do so will be no greater than expected by chance.

Can any single industry—for example, the high-tech sector—assure investors above-average returns?

Detailed research into the sources of investment returns (Fama, Eugene F. and Kenneth R. French. "Industry Costs of Equity." Journal of Financial Economics 43 (1997), 153-93.) concludes that industries, or companies' products, are not a factor in expected stock returns. Industry effects can influence prices, but in a seemingly random, short-term way that can be mitigated in a diversified strategy. Therefore, industry effects, though they pose risks that are worth taking into account, are not a primary variable on which to sort securities for investment purposes.

Firms developing new technologies have no assurance of earning above-average long-run profits. The competitive forces in a free market work constantly to disperse the benefits of innovation throughout the economy. The retailer using new high-speed computers to cut inventory costs, for example, may reap greater economic rewards than the company who developed them. And if competition pressures the retailer to pass the resulting savings along in the form of lower prices, the ultimate beneficiary is the consumer. Even if one could correctly predict technological trends, identifying the winners from an investment standpoint becomes an elusive exercise.

Consider the birth of the personal computer industry in the early 1980s and its subsequent explosive growth. Industry pioneers IBM and Apple Computer were responsible for many innovations, yet shares of both firms have lagged the broad stock market: total return for the 20-year period ending December 2001 was 333% for Apple Computer, 1360% for IBM, and 1606% for the S&P 500 index (Center for Research in Security Prices, University of Chicago; Ibbotson Associates).

Arcon Wealth Management, LLC does not believe in "picking stocks," so how do you decide which stocks to buy?
Buying stocks inside the funds is a detailed process but can be described in general terms. An eligible universe of all traded stocks of real operating companies is created. Filters are then applied to exclude stocks that do not fit the asset class of the fund or that have specific pricing or trading concerns. The remaining stocks are eligible for purchase and are subject to rough market-capitalization target weights. Trading in the market place is regularly monitored with real-time checks for current news that may impact prices, such as a looming takeover. Other than that, we're generally indifferent among the stocks in the eligible universe, which allows us to trade opportunistically and take advantage of liquidity premiums that benefit client returns. For additional information regarding the investment strategies of each fund, please read each fund's prospectus and statement of additional information carefully.

Isn't the success of indexing in recent years mostly due to a "self-fulfilling prophecy"? Index funds appear to push up prices of a handful of big company stocks simply because they're included in the S&P 500 index.

Some critics of indexing assert that mechanical buying from index funds creates a "self-reinforcing trend" in a handful of large company stocks and that their price behavior is dictated by cash inflows to index managers, not fundamental business conditions at the underlying companies.

Evidence to support this assertion is difficult to find. Arcon Wealth Management, LLC believes a more plausible explanation of pricing suggests it is the active money managers who dictate prices to indexers, not the other way around. As an example, an analysis of trading activity in General Electric Corp. stock (the largest component of the S&P 500 index) found that programmed buying from index funds in January 1997 accounted for approximately 1.3% of total GE monthly trading volume (Strategic Insight Mutual Fund Overview, February 1997). The notion that 1.3% of trading attributable to passive investors possessing no useful information determines the price-discovery process for the remaining 98.7% of market participants is far-fetched.

Advocates of the "self-fulfilling" viewpoint must also confront a wide disparity in performance of individual issues. If the behavior of large company stocks is primarily attributable to passive investors buying without regard to fundamental developments, it is difficult to explain why Coca-Cola shares appreciated only 1.3% in 1998 while Wal-Mart Stores soared 108.0% (Standard & Poor's "Stock Guide," January 1999).

If everyone followed an indexing strategy, would markets still be efficient?

This question has come up repeatedly ever since indexed strategies first appeared in the mid 1970s. Critics of indexing assert that markets would be less efficient if all investors adopted a market-fund investment approach. One can accept this theoretical viewpoint and still embrace indexing with enthusiasm.

If the adoption of indexed strategies became so pervasive that market efficiency were impaired, Arcon Wealth Management, LLC believes it would be a self-correcting process. Mispriced securities would create opportunities for investors to earn profits in excess of their research costs, and their activity would drive prices back to equilibrium levels. We will never know how much information and liquidity are required for an efficient market. Markets for consumer durables such as homes or autos appear to be at least reasonably efficient, despite very poor liquidity, high search costs, and the absence of perfectly fungible assets. This behavior suggests a shift to passive investing would have to be very pronounced to have any effect on market efficiency.

Even if all professional investment managers adopted a passive approach, other market participants would continue to provide price-setting information. Sources of such information could include corporate stock buybacks, acquisitions, and the investment activities of officers, employees, competitors, and suppliers.

Despite the impressive commercial success of indexed investing strategies over the last twenty-five years, they still represent only a small percentage of total stock market wealth. The assets of all US equity index mutual funds* were approximately $695 billion as of December 31, 2010, or roughly 5% of the nation's total stock market value.

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*US-domiciled equity index funds in Morningstar database, and which reported fund assets for December 31, 2010.

If academic research demonstrates that value stocks have higher returns than growth stocks or market portfolios over time, why not put 100% of the equity allocation in value stocks?

For investors who define risk solely as the variability of returns, such a strategy might be appropriate. Whether such investors actually exist is debatable. Most investors are probably sensitive to the risk of being different from the market, even if overall variability is no higher. Value stocks do not outperform market portfolios regularly or predictably—if they did, they would not be riskier. To the extent an investor is likely to be disappointed with performance that differs from a market portfolio, a tilt toward value stocks should be undertaken cautiously!

The Advice Remains the Same: Defensive Strategies Won't Protect You

(Note: This item is part three of a series on why you shouldn’t alter your investment strategy during booms or busts.)

If the perception of risks are high, which they are during bear [or weeks of down] markets, so must be the expected return. And the historical evidence is that investors persistently demonstrate a pattern of buying high and selling low when acting on their own. This destructive behavior is evidenced by the fact that investors typically underperform the very mutual funds in which they invest.

“Defensive” strategies

Investing history is filled with examples of strategies that try to benefit from observable patterns of past market performance. Unfortunately, the realized returns haven’t matched the promise.

In their article “Noisy Signals: A Challenge to Tactical Strategies,” Joseph Davis and Christopher Philips of Vanguard examined the performance of several different signals based on “conventional wisdom” to see if they actually translated into better risk-adjusted returns.

For example, they examined selling in the presence of an inverted yield curve (short-term interest rates exceeding long-term rates), which is a well-documented leading indicator of recessions. Vanguard found that the yield curve signal is “noisy.” For the period 1952 through 2006, the yield curve inverted 19 times, but the U.S. economy lapsed into recession only nine times.

While the historical record shows that various sectors tend to outperform during tough times, Vanguard reached the conclusion that, “Even the most reliable indicators have low predictive power when used to execute real-time strategies. Investors seeking to mitigate equity market risks are better served with a strategic allocation to fixed income investments.”

Summary

Noted author Peter Bernstein provided this insight: “Even the most brilliant of mathematical geniuses will never be able to tell us what the future holds. In the end, what matters is the quality of our decisions in the face of uncertainty.” Thus, my advice will continue to be the same, unless compelling evidence, published in peer reviewed academic journals, demonstrates that there is a superior alternative strategy. Until then, my advice remains the same: buy [the market, diversify systematically, minimize taxes and turnover, think long-term, apply discipline, hold low-cost funds and maintain asset allocation].

Article by Larry Swedroe, Wise Investing, April 13, 2009.  Used today by Matt McKinney because the same needs to be said after every downturn in the market and the pessimism (or noise) in the media that follows.

The Advice Remains the Same: Adventures in Market Timing

(Note: This item is part two of a series on why you shouldn’t alter your investment strategy during booms or busts.)

My previous post discussed market efficiency. Now I want to address the fallacy of market timing and why information is not enough for making investment decisions.

As to trying to time the market, take a look at the historical evidence. If you are thinking about getting out until things are clear again, consider that the evidence on market timing is even worse than on stock selection. Mark Hulbert of the Hulbert Financial Digest says his data backs up his 80/20 rule: 80 percent of market timers fail over any reasonable period of time. I don’t like those odds. Neither should you.

One reason that market timing fails is that so much of the market’s return occurs during very brief and unpredictable periods. Another reason is that you have to be right not once, but twice. Deciding to get out is easy compared to deciding when to get back in. If you go to cash, you may be “whipsawed.” You risk getting out after a severe drop, missing a big rally and jumping back in only to experience another severe loss. You would end up worse than if you had simply stayed the course. That is why I believe going to cash is not a winning strategy.

The difference between information and wisdom

Information can be defined as facts or opinions. In terms of investing, wisdom is information that can be exploited to generate excess — above market — profits. When I ask investors why they are so willing to abandon their well-designed plan, they say something like: “Isn’t it obvious that the situation is terrible?” The question they fail to ask is this: If it is in fact obvious, isn’t the bad news already built into prices? After all, that is why prices have already gone down.

They also fail to understand the following: If things are so bad, that must mean the market is perceived as risky. If the market is risky, expected returns are now higher. Why would investors decide to sell now when expected returns are higher than when they originally bought?

If you feel the need to sell, consider that there is a “universe of risk.” Since all stocks must be owned by someone, someone must hold the market risk. For everyone who wants to sell, someone else must be willing to buy at the same price. And they will only buy in a time of distress if they believe the market price fully reflects the high risks.

In my next post, I will conclude by talking about the lack of success of defensive strategies employed by some to ride out the investing roller-coaster.

Article by Larry Swedroe, Wise Investing, April 10, 2009.  Used today by Matt McKinney because the same needs to be said after every downturn in the market and the pessimism (or noise) in the media that follows.

The Advice Remains the Same: Markets Are Efficient

(Note: This item is part one of a series on why you shouldn’t alter your investment strategy during booms or busts.)

Whether the market has gone up (as it has during the past two years) or down (as it has during the past several weeks), my investing advice has not changed: [buy the market, diversify systematically, minimize taxes and turnover, think long-term, apply discipline, hold low-cost funds and maintain asset allocation].

A common refrain from investors has gone something like this: “Yes, that advice has worked in the past. However, this time is different. It obviously isn’t working now! The market just keeps going down and down. There must be a better alternative than to sit and do nothing.”

In the next few posts, I want to explain why my investing advice has not changed, even though many others may believe “this time is different.”

Market efficiency

For us to believe that we should abandon a long-term, buy-and-hold strategy, we would have to be first convinced that markets were no longer efficient. In other words, the market was now mispricing assets and was slow to react to new information.

It is hard to imagine that markets have gotten slower at reacting to news. In fact, markets incorporate news into prices almost instantaneously. After Treasury Secretary Timothy Geithner unveiled the Treasury Department’s plan to clean up toxic assets, the market reacted immediately, as evidenced by several indexes leaping to their highest one-day gains since last fall.

We see no evidence that active managers were able to predict (the then) bear market. In fact, while there was a wide dispersion in individual stock returns (some stocks, like Wal-Mart were actually up), almost every single diversified mutual fund produced large losses. This would not be the case if markets were somehow inefficient. It is also important to note that evidence shows that active managers fail to outperform during bear markets.

We believe that the market was and continues to be highly efficient. It is just that the news has been persistently worse than expected, causing prices to fall. This is what causes bear markets.
In my next posts, I’ll give further explanation of why my investing advice is still valid, including a discussion of market timing.

Article by Larry Swedroe, Wise Investing, April 9, 2009.  Used today by Matt McKinney (italics his) because the same could be said during most if not every downturn in the market and the pessimism (or noise) in the media that follows.