Consider the Dimensions of Higher Returns

Gene Fama

 “equilibrium expected returns can vary through time in a predictable way, which means price changes need not be entirely random.”

–Gene Fama, often sited as the “father of modern finance.”

In 1992, when Gene Fama and Ken French’s paper, “The Cross-Section of Expected Stock Returns” was published in the Journal of Finance [Vol 47, no. 2 (June 1992):427-465], Gene didn’t expect it to become the most cited paper in finance over the last 20 years.

Several of the more cited points in the paper include the dimensions of higher returns.

Dimensions of Higher Returns:

  • Stocks have higher expected returns than fixed income.
  • The stocks of smaller companies have higher expected returns than the stocks of larger companies.
  • Lower-priced value stocks have higher expected returns than higher-priced growth stocks.

Size and Value Dimensions Are Strong around the World

size value graph

Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Lion’s Share U.S. Financial Services and Cambridge are not affiliated. Indices mentioned cannot be directly invested in. Past performance is no guarantee.  When you access other linked websites, you assume total responsibility and risk of the websites you are linking to caveat emptor. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. Article are provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services in Alabama, Florida, Georgia, and Tennessee. No offers may be made or accepted from any resident outside the specific state(s) referenced. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. US value and growth Research index data provided by Fama/French. The S&P data are provided by Standard & Poor’s Index Services Group. CRSP data provided by the Center for Research in Security Prices, University of Chicago. International Value data provided by Fama/French from Bloomberg and MSCI securities data. International Small data compiled by Dimensional from Bloomberg, Style Research, London Business School, and Nomura Securities data. MSCI World ex USA Index is gross of foreign withholding taxes on dividends; copyright MSCI 2013, all rights reserved. Emerging Markets index data simulated by Fama/French from countries in the IFC Investable Universe; simulations are free-float weighted both within each country and across all countries. Asset class filters were applied to data retroactively, rebalanced annually, and with the benefit of hindsight. Asset class returns are not representative of indices or actual portfolios and do not reflect costs and fees associated with an actual investment. Actual returns may be lower. Values change frequently and past performance may not be repeated. There is always the risk that an investor may lose money. Small company risk: Securities of small firms are often less liquid than those of large companies. As a result, small company stocks may fluctuate relatively more in price. Emerging markets risk: Numerous emerging countries have experienced serious, and potentially continuing, economic and political problems. Stock markets in many emerging countries are relatively small, expensive, and risky. Foreigners are often limited in their ability to invest in, and withdraw assets from, these markets. Additional restrictions may be imposed under other conditions. Foreign securities and currencies risk: Foreign securities prices may decline or fluctuate because of: (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets. Investors holding these securities are also exposed to foreign currency risk (the possibility that foreign currency will fluctuate in value against the US dollar).

Betting Against the House.

Weston

It’s New Year’s Day 2012. In addition to overdosing on televised college football, you’re spending part of the holiday working on the family finances. Armed with a laptop and various online financial tools, you’re on the hunt for appealing stock market opportunities. To prune the list of candidates to a manageable size, you decide to focus on firms that are leaders in their respective industries and exhibit above-average scores on various measures of financial strength. As you work your way through the alphabet, you come to the “P” stocks, and another candidate appears. It’s a prominent player in a major industry (good), but operates in a notoriously cyclical industry (not so good), is currently losing money (definitely not good), pays no dividend, and has a junk-bond credit rating of BB-minus. Next! You push the “delete” key and move on.

Congratulations. You just passed up the best-performing stock in the entire S&P 500 Index for 2012.

Shares of PulteGroup Inc., a Michigan-based homebuilder with a 60-year history, jumped 187.8% last year amid strong performance for the entire industry. For the year ending December 31, 2012, all 13 homebuilding firms listed on the New York Stock Exchange outperformed the S&P 500 Index by a wide margin, with total returns ranging from 34.1% for NVR, Inc. to 382.8% for Hovnanian Enterprises, Inc. The Standard & Poor’s SuperComposite Homebuilding Sub-Index rose 84.1% in 2012 compared to 13.4% for the S&P 500 Index.

The point? For those seeking to outperform the market through stock selection, underweighting the market’s biggest winners can be just as painful as overweighting the biggest losers. Investors are often caught flat-footed by stocks that do much better or much worse than the broad market, and the problem is not limited to individuals. Not one of the 10 seasoned professionals participating in Barron’s annual Roundtable stock-picking panel in early January 2012 mentioned homebuilding stocks or any housing-related firms.

The recent surge in housing shares also serves as a reminder that stock prices are forward-looking and tend to rise or fall well in advance of clear changes in company fundamentals.

Investors who insist on waiting for evidence of healthy profits before investing are often frustrated to find that a firm’s stock price has appreciated dramatically by the time the firm begins to report cheery financial results. Shares of Hovnanian Enterprises, for example, rose 580% between October 7, 2011, and December 31, 2012, even though it continued to report losses. Similarly, it is not unusual for a firm’s stock price to decline long before signs of trouble become obvious.

The behavior of the S&P Homebuilding Sub-Index in recent years illustrates the challenge of relying on industry characteristics to provide a reliable guide to the direction of stock prices.

(Note: Index inception was December 31, 1994, at 100.)

Date                                      S&P Homebuilding Sub-Index
July 28, 2005                        1063.19

Index sets a record high, up more than tenfold from its year-end 1994 level of 100.0.

October 9, 2007                   368.13

Index closes 65% below its peak on the same day the S&P 500 sets a record high.

March 6, 2009                     150.21

Index slumps to its low for 2009, and the S&P 500 Index follows suit on March 9.

July 27, 2010                       239.18

“Sales of new homes are near 47-year lows. … Homebuilders, which began buying up land late last year in anticipation of an economic and housing rebound, are stuck with thousands of acres that are prone to lose value as the market struggles.”

Robbie Whelan, “Supply of Homes Set to Grow,” Wall Street Journal, July 27, 2010.

August 25, 2010                  225.23

“Price declines could lead to more delinquencies and foreclosures, and additional subsequent price drops. … ‘You end up in a home-price-depreciation death spiral. It’s not clear there’s enough demand to handle this overhang without another round of price declines.’ ”

Quotation attributed to Laurie Goodman, Amherst Securities. Sudeep Reddy and Nick Timiraos, “Plunge in Home Sales Stokes Economy Fears,” Wall Street Journal, August 25, 2010.

July 11, 2011                        250.23

“The housing decline will be a long, multiyear process, and the multiplier effect across the economy will be enormous.”

Quotation attributed to Doug Ramsay, Leuthold Group. Roben Farzad, “The Housing Horror Show Is Worse Than You Think,” Bloomberg Businessweek, July 11, 2011.

November 10, 2011           220.41

“It will take ‘years rather than months for a proper recovery to get going,’ said Mr. Dales, who predicts home prices nationally won’t mount a sustained recovery until 2014.”

Quotation attributed to Paul Dales, Capital Economics. Alan Zibel, “Home Prices Keep Dropping,” WallStreet Journal, November 10, 2011.

December 23, 2011            236.80

“Simply put, Hovnanian [Enterprises] may soon become hard-pressed to make payments on its groaning load of debt—$1.6 billion, all in the form of bonds … and it has no bank credit lines to fall back on.”

Robin Goldwyn Blumenthal, “Hammered and Nailed,” Barron’s, December 24, 2011.

March 2, 2012                     277.95

“Home prices in most parts of the country appeared to bottom out in the summer of 2009 and to begin a slow recovery. But now they have fallen below 2009 levels in most markets, according to the Standard & Poor’s /Case Shiller index released this week.”

Floyd Norris, “Home Prices Declined to New Lows in 2011,” New York Times, March 3, 2012.

May 14, 2012                      326.18

Excess inventories “are the mortal enemy of prices, and we’ve calculated an excess of 2 million units, over and above normal working levels of inventories of new and existing homes.”

A. Gary Shilling, “Is Now the Time to Buy Your First House? No: The Fall Isn’t Over,” Wall Street Journal, May 14, 2012.

May 24, 2012                      330.55

“Even as a tentative housing recovery … appears under way, a big stumbling block remains: the vast number of underwater homeowners.”

Alejandro Lazo, “Negative Equity Remains a Drag on Housing Market,” Los Angeles Times, May 24, 2012.

July 26, 2012                      362.79

“The broad dynamics are still quite scary. We think housing is still a short.”

Quotation attributed to Michael Feder, CEO, Radar Logic. Peter Coy and Roben Farzad, “Housing: A Long Way from Normal,” Bloomberg Businessweek, July 26, 2012.

September 26, 2012       416.42

“Housing has snapped back this year even as the broader economy and the nation’s employment situation have proved lackluster.”

Jim Puzzanghera and Alejandro Lazo, “US Home Price Index Reaches Highest Level in Almost 2 Years,”Los Angeles Times, September 26, 2012.

January 21, 2013             484.52

“House prices are vulnerable to a new wave of foreclosures now that mortgage modifications have been tried and largely failed.”

A. Gary Shilling, “Prepare for a Stock Market Plunge,” Forbes, January 21, 2013.

January 30, 2013             503.65

“Sharp home price increases—particularly in once-decimated cities such as Phoenix and Las Vegas—are raising concerns among some economists that speculation could return to certain markets if such double-digit gains continue.”

Alejandro Lazo, “Prices Rise, and So Do Fears of a Bubble,” Los Angeles Times, January 30, 2013.

Many observers in recent years predicted that a recovery in the housing industry would be agonizingly slow, and they were right. Many investors in recent years have avoided housing stocks as a consequence, and they’ve been wrong: Housing stocks have outperformed the broad US stock market by a healthy margin from the market low in March 2009 to the present day.

Bottom Line: Markets have 101 ways to remind us of Nobel laureate Merton Miller’s observation: 

“Diversification is the investor’s best friend.”

Merton Miller

Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Lion’s Share U.S. Financial Services and Cambridge are not affiliated. Indices mentioned cannot be directly invested in. Past performance is no guarantee.  When you access other linked websites, you assume total responsibility and risk of the websites you are linking to caveat emptor. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. Article are provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services in Alabama, Florida, Georgia, and Tennessee.

The Importance of Long-Term Discipline

David Booth

The important thing about an investment philosophy is that you have one you can stick with”

— David Booth Chairman & Founder Dimensional Funds Advisors

The importance of Mr. Booth’s quote should not be dismissed lightly. Defining and following a strategy will help ensure you don’t bow to short term pressures, or fear, that can derail potentially higher gains you may have received had you not reacted to short-term swings or sequence of returns in the market. The below chart of the performance of the S&P 500 shows how those stocks performed over longer time horizons far better than US Treasury bills, except for a shorter time period of 14 years. If you look at the first column, the S&P 500 performed far better, relative to those US Treasury Bills, even when including the same 14 years of poorer performance.

Long term jpeg

Equities have provided significant premiums over longer time horizons, yet historical data show lengthy periods when Treasury bills have outperformed stocks.

Equities can reward investors who maintain a long-term outlook. But inconsistent short-term performance may test one’s commitment to a long-term strategy

Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Lion’s Share U.S. Financial Services and Cambridge are not affiliated. Indices mentioned cannot be directly invested in. Past performance is no guarantee.  When you access other linked websites, you assume total responsibility and risk of the websites you are linking to caveat emptor. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. Article are provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services in Alabama, Florida, Georgia, and Tennessee.

“He Called the Crash”

Weston

The investment community lost one of its more colorful characters last week with the passing of Martin F. Zweig, a prominent market pundit, author, and chairman of Zweig-DiMenna Associates LLC, a New York investment firm. His death also marks the close of another chapter in the long-running debate on the virtues of market timing.

Zweig took a keen interest in stocks as a teenager, and after earning a PhD in finance from Michigan State University, he began writing investment newsletters while teaching in New York. He launchedThe Zweig Forecast in 1971 with a handful of subscribers and continued to publish it, with considerable success, for the next 26 years. Zweig loved numbers (including baseball trivia) and was closely associated with statistical measures of monetary policy and market momentum that he combined into what he called a “super model” to assess market conditions. He is credited with introducing the put/call ratio, a measure of investor sentiment, to the toolkit of market forecasters. He transitioned to money management, and in October 1986, he launched the Zweig Fund, a closed-end mutual fund that relied on his analysis of market trends to adjust its exposure to stocks and bonds.

Zweig was a frequent contributor to both print and broadcast media and wrote numerous articles forBarron’s, a weekly publication with a devoted following among those seeking comprehensive market statistics. Perhaps his finest hour was an appearance on the television show Wall Street Week with Louis Rukeyser on Friday evening, October 16, 1987. When his host asked him to comment on assertions from other market commentators that the “bull market is dead,” Zweig replied he was expecting a crash but was reluctant to say so publicly. It was too similar, he said, to shouting “fire” in a crowded theater. Zweig’s prediction proved eerily accurate: The Dow Jones Industrial Average fell by a staggering 29.2% in chaotic trading the following Monday, an even bigger setback than the combined losses from Black Monday and Black Tuesday in October 1929. The Zweig Fund emerged relatively unscathed: According to a profile several years later in SmartMoney, the fund had 58% of its assets in cash leading up to the crash, and experienced a loss of only 6.2% on October 19. Traumatized by the unprecedented market break, many investors sought out advisors or analysts who appeared to have avoided the debacle. Zweig’s reputation as a financial expert soared. For years, he was introduced as “the man who called the crash.” The headline of Zweig’s obituary in theWall Street Journal described him as a “master market timer.”

Zweig was not the only analyst to predict the 1987 crash, but his appearance on Wall Street Weekwas so visible and so perfectly timed that his status as an astute financial guru was greatly enhanced. By the time SmartMoney published its profile in 1995, his firm was managing nearly $4 billion in assets. In 1999, Zweig purchased a multistory penthouse above the Pierre Hotel, the most expensive residential transaction in New York City up to that time.

Should investors seek to enhance their returns by applying Zweig’s statistical timing tools? The evidence is mixed at best. Zweig’s October 1987 market call was on the money, and the Hulbert Financial Digest once reported that The Zweig Forecast ranked first among market newsletters for risk-adjusted performance. Many investors have discovered, however, that making one or two great predictions is often insufficient to generate above-average long run results—you have to be right over and over again to outperform Mr. Market.

Moreover, it appears that achieving excess returns with real dollars is more challenging than making prescient forecasts in a newspaper column. Annualized return for the Zweig Fund from inception in October 1986 through January 31, 2013, was 6.79% calculated from net asset value and 5.84% based on NYSE closing share prices. (The latter figure reflects the difference between the fund’s reported net asset value and the market price of the shares in NYSE trading.) Over this same time period, the annualized return was 9.84% for the S&P 500 Index and 7.90% for a static mix allocated 30% to the S&P 500 Index and 70% to the Barclays Aggregate Bond Index. A tilt toward small cap or value stocks within these indices over this period would have produced even higher returns.

Market timers often acknowledge that their signals do not provide sufficient guidance to outperform a buy-and-hold, 100% equity strategy. Their goal, they say, is to avoid major bear market losses by holding a large fixed-income allocation during market downturns and capturing a meaningful portion of equity market rewards by increasing stock holdings during the upswing. Reducing bear market losses may be a laudable goal, but as this example shows, it can also be pursued with greater simplicity by adopting a lower equity exposure at all times and ignoring the costs and frustrations associated with constant fiddling.

It’s safe to say that no one worked more diligently or enthusiastically than Martin Zweig to tease out tomorrow’s stock prices from today’s data. But the evidence suggests that even the most dedicated student of market statistics is unlikely to meet with long-run success.

Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Lion’s Share U.S. Financial Services and Cambridge are not affiliated. Indices mentioned cannot be directly invested in. Past performance is no guarantee.  When you access other linked websites, you assume total responsibility and risk of the websites you are linking to caveat emptor. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. Article are provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services in Alabama, Florida, Georgia, and Tennessee. No offers may be made or accepted from any resident outside the specific state(s) referenced.