Bespoke’s Commodity Snapshot: Year-to-Date Change

Monday, March 1st, 2010

Friday, February 26, 2010 at 12:54PM

Below we highlight the year-to-date change for ten key commodities.  As shown, orange juice has gotten off to a nice start (+13.15%), while natural gas has once again resumed its seemingly perpetual decline (-13.75%).  Platinum is the second best performing commodity shown with a gain of 5.34%, followed by gold at +1.59%, and oil at +0.34%.  While gold and platinum are up in 2010, silver is down 2.69%.

Below we provide our trading range charts for the ten commodities highlighted above.  For each chart, the green area represents between 2 standard deviations above and below the commodity’s 50-day moving average.  As shown, oil has been trading sideways between about $85 and $70 for a few months now, and it is currently closer to overbought levels than oversold levels.  Natural Gas is once again in extreme oversold territory, and the same goes for coffee.  After reaching oversold territory, gold, silver, copper, wheat, and corn have all seen nice bounces.  Platinum remains in a nice uptrend.  Along with the the recent outperformance of stocks like Ford (F), Sirius XM (SIRI), and Johnson Controls (JCI), is the solid performance of platinum (used in catalytic converters) another sign of an auto recovery?

Tags: 2 Standard Deviations, Auto Recovery, Bounces, Catalytic Converters, Commodities, Commodity, Gold Silver, Jci, Johnson Controls, Moving Average, Natural Gas, Orange Juice, Outperformance, Range Charts, Silver Copper, Siri, Sirius, Uptrend, Xm, Year To Date
Posted in Markets | No Comments »

The Problem of Persistence

Friday, February 26th, 2010

By Michael Nairne, Tacita Capital

On January 1, 2000, Jim Smith invested with Manager X. Jim had done his homework: he had compared Manager X’s performance over the prior decade against the relevant benchmark. Although Manager X stumbled in 1990, his returns had beaten the S&P 500 every year after that. This outperformance is illustrated in the following graph. $1.00 invested with Manager X on January 1, 1990 was worth $7.05 on December 31, 1999 (see green), far in excess of the $5.32 earned by the S&P 500 (see red).

Jim had dug even deeper and reviewed several years of analysts’ reports. They were unanimous. Manager X’s performance warranted a role as core equity holding. Jim also hired his own financial analyst to analyze Manager’s X’s performance from a risk–adjusted perspective. Again, Manager X came through with flying colours. Although his returns were more volatile than the S&P 500, his higher returns more than compensated for the bumpier ride. With his homework done, Jim confidently selected Manager X as his core U.S. equity manager and allocated him a sizeable portion of his portfolio.

Fast forward to December 31, 2009, and Jim is ruefully assessing the results of his selection decision. Although Manager X’s performance had outstripped the S&P 500 through the first half of the decade, he suffered massive losses in the market meltdown. Every $1.00 Jim invested with Manager X in 2000 was worth 72 cents (see green) at the end of the decade, more than 20% less than the 91 cents yielded by the S&P 500 (see red).

Analysts’ reports now say this manager is too volatile to be a core holding. Jim’s own financial analyst ran the numbers and now concludes that Manager X’s recent risk-adjusted performance is poor. Jim wonders where he went wrong.

Jim’s experience highlights the critical question of persistence in manager performance – whether a manager’s past performance is predictive of his or her future performance. Certainly, considering the avalanche of media articles on top winning funds and the endless sales pitches to investors trumpeting “best in class” managers, one would assume that there is some reasonable level of persistence in performance.

Fortunately, we can garner insights based on empirical evidence, not puffery. Over the past half a century, there have been over 100 academic studies on the question of persistence in managed money performance. In 2003, the Fund Management Research Centre undertook a sweeping review of 49 of the most recent or robust of these studies from the U.S., U.K. and Australia in a report
to the Australian Securities and Investment Commission.

The report’s major conclusions provide serious investors with some clear answers:

1. Good past performance is, at best, an unreliable and weak predictor of future good performance over the medium to long-run. Approximately 50 percent of the studies found no correlation at all between good past performance and good future performance. Where persistence was found, it tended to be short–term, i.e. only one to two years.
2. In those studies that found some level of persistence in positive performance, the outperformance tended to be small and in many cases, would be swamped by the cost of swapping between funds.

The report’s authors hypothesized some reasons for the lack of persistence in past performance – style cyclicality; the erosion of competitive advantage as managers battle it out for better staff and methods, and; the negative impact of large capital inflows on outperforming managers.

The implications for investors are clear. An analysis of past performance alone is not sufficient for the selection of an investment manager. The chance of a given outperforming manager repeating this performance is almost random. An investor might as well use a dartboard if he or she is selecting managers solely on past return numbers.

If active managers are to be used in a portfolio, extensive investigation far beyond a simple review of past performance is required. A recent study, for example, suggests that analysis of a manager’s portfolio holdings and the extent of their deviation from the benchmark as well as historic returns might point the way to managers who are more likely to exhibit positive performance persistence. However, once adjusted for style, size and momentum factors, much of this positive performance disappears and hence, more research is needed to validate these findings.

Finally, since managers as a group underperform the market by their fees and costs, the absence of positive performance persistence by active managers in general suggests that low cost, tax efficient index funds should form the core of a portfolio and that active managers, if included, should be used in a satellite role. Jim Smith wishes he had taken this approach in 2000.

February 25, 2010

www.tacitacapital.com

Tacita Capital Inc. (”Tacita”) is a private, independent family office and investment counselling firm that specializes in providing integrated wealth advisory and portfolio management services to families of affluence. We understand the challenges of affluence and apply the leading research and best practices of top financial academics and industry practitioners in assisting our clients to reach their goals.

Tacita research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it and is not intended to replace individually tailored investment advice. The asset classes/securities/instruments/strategies discussed may not be suitable for all investors and certain investors may not be eligible to purchase or participate in some or all of them. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Tacita recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor.

Tacita research is prepared for informational purposes. Neither the information nor any opinion expressed constitutes a solicitation by Tacita for the purchase or sale of any securities or financial products. This research is not intended to provide tax, legal, or accounting advice and readers are advised to seek out qualified professionals that provide advice on these issues for their individual circumstances.

Tacita research is based on public information. Tacita makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete. We have no obligation to inform any parties when opinions, estimates or information in Tacita research changes.

All investments involve risk including loss of principal. The value of and income from investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. There may be time limitations on the exercise of options or other rights in securities transactions. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. Management fees and expenses are associated with investing.

Tags: Amp, Benchmark, Core Equity, Critical Question, December 31, Equity Manager, Financial Analyst, Flying Colours, Homework, January 1, Jim Smith, Manager Performance, Manager X, Market Meltdown, Massive Losses, Outperformance, Persistence, Selection Decision, Sizeable Portion, Tacita
Posted in Markets | No Comments »

Correction Characterized by Typical Risk Aversion Patterns

Sunday, January 31st, 2010

The past week’s performance of the major asset classes is summarized in the chart below - a set of numbers indicating heightened risk aversion on the back of growing concerns about sovereign debt issues, the longevity of the global economic recovery and Chinese policy tightening. The only asset classes to end the week in the black were the US dollar (+1.5%) and Treasury Inflation-Protected Securities (TIPS) (+0.3%).

Source: StockCharts.com

The chart below, obtained from the Wall Street Journal Online, also includes the performance of a few other financial markets during the past week.

Source: Wall Street Journal Online, January 29, 2010.

On the topic of risk aversion, and more specifically as far as equity markets are concerned, a number of indicators make for interesting reading.

Stock market leadership

It is interesting that since the start of the nascent US stock market correction on January 20, cyclical sectors such as the Materials SPDR (XLB), Technology SPDR (XLI) and Energy SPDR (XLE) have been leading the market lower. Traditionally defensive sectors such as Consumer Staples SPDR (XLP), Health Care SPDR (XLV) and Utilities SPDR (XLU) also declined, but to a lesser extent than the S&P 500 Index as a whole (-6.6%) and the cyclical sectors.

Source: StockCharts.com

Emerging markets

The chart below shows the relative performance of the MSCI Emerging Markets Index versus the Dow Jones World Index. After strong outperformance by emerging markets since November 2008, the relative performance has been moving sideways for the past three months, with emerging markets underperforming since early January.

Source: StockCharts.com

Small caps

Small-cap stocks have strongly outperformed large caps since the start of the March rally (see chart below). The relative line has been volatile since October, but it would not come as a surprise if small caps are heading for a bout of underperformance (i.e. a declining line).

Source: StockCharts.com

The above are some of the patterns one would expect typically to emerge during a correction phase. These will be on my radar screen in an attempt to assess the magnitude of the nascent correction.

Tags: Asset Classes, Chinese Policy, Consumer Staples, Debt Issues, Emerging Markets, Energy Spdr, Inflation Protected Securities, Market Leadership, Msci Emerging Markets, Msci Emerging Markets Index, Outperformance, Relative Performance, Risk Aversion, Small Cap Stocks, Small Caps, Stock Market Correction, Treasury Inflation Protected Securities, Us Stock Market, Wall Street Journal, Wall Street Journal Online, Xlu
Posted in Markets | No Comments »

Good Things Come in Small Packages

Thursday, December 17th, 2009

One of the most important findings of modern finance is that small companies, on average, have higher returns than large companies. This size premium is evident from the following graph which illustrates the growth of $1.00 U.S. invested in small company stocks (in red) compared to large company stocks (in green) from January 1926 to November 2009.

The investment in small company stocks grew to $11,253 - more than four times the $2,537 of the large company stocks.

The size premium is not restricted to the United States. A number of researchers have confirmed its presence in most other countries around the world. In a study spanning seventeen countries, Hawawini and Keim found that small company stocks outperformed large company stocks in every country except Korea.

The size premium is unique in a number of respects. First, the relationship between return and size applies across the complete spectrum of firm sizes. Returns become progressively higher as one moves from large to medium to small to micro companies (see Table I at the end of the Commentary). Risk also grows commensurately since the smallest stocks are more than twice as volatile as the largest stocks.

Second, the size premium is a highly streaky phenomenon. The following graph, which depicts the cumulative size premium (i.e. small company returns – large company returns) since 1926, shows that outperformance by small company stocks was concentrated in the mid-1930’s, the early to mid-1940’s, the late 1960’s, the mid-1970’s to early 1980’s, the early 1990’s and the earlier part of this decade.

As can be seen, the periods of outperformance by small company stocks have frequently been punctuated by lengthy spans of underperformance. Accessing the size premium therefore requires patience.

One of the more remarkable elements of this firm size effect is that it seasonal. Virtually the entire size premium occurs in January, an outsized month for small company returns. This excess performance is evidenced in the following bar graph which depicts the average monthly return of U.S. small company stocks from 1926-2008.

Source: Tacita Capital, based on Ibbotson Associates SBBI Small Company Stocks

40% of the average annual return of small company stocks has occurred in January. Two theories have been advanced for this “January effect”. The first attributes the effect to tax-loss selling where losers that were disposed of in the prior year are re-acquired bidding up prices in January. The second attributes the effect year-end “window-dressing” by fund managers who rid their portfolios of losing stocks before year-end thereby depressing prices which bounce back in January.

One of the enduring myths about small company stocks is that they represent a spectrum of the market where, on average, active managers add value by outperforming small company indexes. The evidence refutes this belief. In a comprehensive study

of U.S. mutual funds from 1965-1998, Davis found no evidence of positive, abnormal returns in actively managed small stock funds. More recently, Standard & Poor’s found that small stock funds as a group underperformed their benchmarks in both of the past five-year market cycles including the bear markets (see Table II at the end of the Commentary).

Small company stocks offer patient investors an opportunity to enhance performance. Their “streakiness”, however, means that a strategic, long-term commitment is essential to realizing on this opportunity. Also, given the volatility of this asset class, portfolio allocations must be consistent with the risk profile of the individual investor. This isn’t a free lunch – extra helpings bring extra risk.

December 17, 2009

www.tacitacapital.com

Source: Ibbotson SBBI 2009 Classic Yearbook

Source: SPIVA Scorecard: Active Management Myths;

http://www2.standardandpoors.com/spf/pdf/index/SPIVA_2009_UPDATE.pdf

Tacita Capital Inc. (”Tacita”) is a private, independent family office and investment counselling firm that specializes in providing integrated wealth advisory and portfolio management services to families of affluence. We understand the challenges of affluence and apply the leading research and best practices of top financial academics and industry practitioners in assisting our clients reach their goals.

Tacita research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it and is not intended to replace individually tailored investment advice. The asset classes/securities/instruments/strategies discussed may not be suitable for all investors and certain investors may not be eligible to purchase or participate in some or all of them. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Tacita recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor.

Tacita research is prepared for informational purposes. Neither the information nor any opinion expressed constitutes a solicitation by Tacita for the purchase or sale of any securities or financial products. This research is not intended to provide tax, legal, or accounting advice and readers are advised to seek out qualified professionals that provide advice on these issues for their individual circumstances.

Tacita research is based on public information. Tacita makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete. We have no obligation to inform any parties when opinions, estimates or information in Tacita research changes.

All investments involve risk including loss of principal. The value of and income from investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. There may be time limitations on the exercise of options or other rights in securities transactions. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. Management fees and expenses are associated with investing.

Tags: 1940, Company Stocks, Countries Around The World, Cumulative Size, Decade, Good Things Come In Small Packages, Graph, Investment Stocks, Keim, Korea, Micro Companies, Outperformance, Patience, Periods, Phenomenon, Presence, Remarkable Elements, Respects, Spans, Spectrum, Volatile Stocks
Posted in Bonds, Markets | No Comments »

Donald Coxe: $1,100 Gold is a Warning Sign

Friday, November 13th, 2009

In his November 6, 2009 weekly conference call, Don Coxe of Coxe Advisors discussed gold, the economy and commodities.

Coxe says that there are a host of reasons for the recent outperformance of gold, the least of which is the crumbling dollar. As long as interest rates are at zero, the carry trade in the US dollar will continue to flush liquidity into the markets and into gold, and as that involves shorting the dollar the dollar will continue to slump.

It also means that all assets could blow off together should there be any reversal in monetary policy resulting in a rate hike. That may still be a while coming as central bankers have stated a willingness to wait until next summer to revisit rates.

On a supportive note for gold, India and Sri Lanka have bought much of the IMF’s 430-tonne overhang of gold inventory, and China is said to be buying the rest.

However, Coxe says, don’t be fooled by the fact that gold and equities are doing well at the same time. The rise and outperformance in gold is also due to the appetite of large investors betting on long term prospects for inflation, now.

Good economic news from around the world last week, as well as promising news from the US, is a serious threat to the economy, the market. We had very positive news, for example, coming from India and China that growth would be better than expected, and their commodity demand continues to be sustainable. In the US, while capacity utilization still remains slack, wage demands have remained stable. Unemployment in the 10% range may be understated by the BLS though because of the way they account for part-time employment, says Coxe. Do-over economists have stated that unemployment could be 16-20%. The BLS has quietly said that there could be inflation in food prices.

Coxe said, “Those of us who accept David Dodge’s view that this has been a rebound, and not yet a recovery; a rebound from a dramatically oversold territory where it looked liked the world was coming to an end, to some optimism that things were going to get better, and pricing in how good things would be, then what it does, is put enormous pressure on central banks not to feed inflationary fears.”

“What we learned from the 70s, is once the inflationary fears start to work into peoples decisions, then all sorts of non-economic decisions are made which makes the inflation forces develop a life of their own. Specifically, changes in inventory policies, such as people buying now, rather than later, because they expect the price to go up, those kinds of things.”

“One of the things central bankers learned is that they must move before the surveys of inflation expectations start to show a sustained rise. Its when people predict that there’s nowhere for inflation to go but up, and its going up, that then its very difficult to hold off the inflation that occurs. What you have to do then [central banks] is dramatically raise rates.”

“So, we’ve seen those go past 20% in the US before, and those inflation expectations got crushed, and in the process the economy got crushed too.”

Good economic news from around the world, and domestically is actually bad news for investors and for the economy, as it means that we could end up in a situation similar to the mid-1970s when we had high unemployment coupled with interest rate hikes. If interest rates remain zero for too long, then the problem may end up being bubble-like economic conditions artificially enhanced by zero interest dollars, and could cause a central bank move swiftly, then, to reign in overheated conditions.

$1,100 gold is a sign that this could be happening. Coxe says that if commodity demand continues to strengthen and wage demands prove to be stickier than expected, the combination could be very bad as it would intensify inflation, and cause policymakers to raise rates at a time when there is high unemployment. That will choke off the fragile recovery and it will choke off the easy money.

Either way, Coxe says that you want to be in gold. You’re better off in gold has it will hold its value better than other “risk” assets. $1,100 gold is a warning sign; not a sign of a really good bullish environment to be investing in. Coxe finishes by saying, “Its the outperformance of gold that should give investors pause.”

Coxe goes out of his way to make sure he’s understood that commodity ETFs that invest in commodity futures are not a effective way to partake in the commodity trade, because of contango/backwardation effects. One way to go, and he makes his disclosures, as advisors is to the way of Coxe Commodity Strategy Fund, and otherwise, via the stocks of the commodities producers as he has discussed on a regular basis in the past.

Coxe also discussed crops, saying that while the warmer November weather was good for farmers, and crop prices came off as a result, they still had not accounted for crop blight.

Tags: Bank Move, Bls, Capacity Utilization, Carry Trade, China, Commodities, Conference Call, David Dodge, Don Coxe, Donald Coxe, Economic Conditions, Economic News, Emerging Markets, ETF, Food prices, Gold, Imf, India, Interest Rate Hikes, liquidity, Mid 1970s, Monetary Policy, Outperformance, Overhang, Part Time Employment, Positive News, Rate Hike, Term Prospects, Wage Demands, Warning Sign
Posted in Gold, Markets | No Comments »

Goldman Recommends Companies with High Sales Exposure to BRICs

Friday, October 9th, 2009

Goldman Sachs recently put out a report, and continue to follow it up, in which they aggressively recommend overweighting US companies that have high sales exposure to BRIC economies, as they have been outperforming the market and are expected to continue to do so.

The basis of this is Goldman’s outlook for growth in the BRICs next year. GS expects BRICs combined GDP to grow by 8.7% vs. the consensus 7.2%, with China and India leading the way. For China and India, Goldman’s outlook for growth is also more aggressive with China registering 11.9% and India 7.2% in 2010.

Goldman’s BRICs hit list of 50 companies makes the case, with Year-To-Date performance of 43% vs. 17% for the S&P 500. Its hard to argue with Goldman, given that they rule the BRICs trade, and to their credit, coined it themselves.

Goldman said:

We favor exposure to Brazil, Russia, India and China (BRICs) over developed markets given the significantly higher GDP growth outlook. We believe investors should use this basket to identify stocks with high exposure to emerging market growth. Long/short investors should consider buying this basket against the S&P 500 to gain exposure to higher growth in the BRICs countries versus slower growth in developed regions.

In its morning notes yesterday GS said:

BRICs-exposed companies outperform during earnings season Our basket of 50 stocks with high sales exposure to BRICs economies has posted stronger sales growth and surprises than the S&P 500 during the past 10 earnings seasons. We believe this outperformance will continue.

Here is Goldman’s list:

Download the GS Slideshow: goldman-research-where-to-invest.

Tags: Advertisement, Amp, Brazil, BRIC, BRICs, China, Consensus, Countries, Earnings Season, Emerging Market, Emerging Markets, GDP, GDP Growth, Gold, Goldman Sachs, Growth Outlook, High Exposure, India, Investors, Leading The Way, Outperformance, Russia, Stocks, Surprises
Posted in Emerging Markets, Gold, Markets | No Comments »

David Rosenberg: Yesterday’s action was telling

Thursday, September 3rd, 2009

David Rosenberg’s Breakfast with Dave newsletter just came in - here is the synopsis that accompanied the report:

YESTERDAY’S ACTION WAS TELLING

The damage was done yesterday. The U.S. 10-year Treasury note yield broke below the interim lows (as did the long bond) and this is very likely going to set up a retest of the 3.00% level. Government bond yields are at a seven-week low. Corporate bond risk, as measured by CDS, has risen to a six-week high. The Canadian dollar has slipped to a two-week low - even gold/silver prices ripped (best session in five months) and generated a further huge outperformance between Canada and the U.S.A. Meanwhile, gold is rallying on the safe-haven bid because other commodities like oil (down to a two-week low) and copper dropped on cyclical concerns. (China’s decision to diversify into IMF notes to the tune of $50 billion also likely helped bolster the gold price). Welcome to the real post-bubble credit collapse world where the initial earthquake is followed by intermittent aftershocks - as market chatter now turns towards the next possible financial problem.

BUYING POWER, WHERE ART THOU? According to TrimTabs, corporate insiders were net sellers of their stock to the tune of $6.3 billion in August - the selling/buying ratio was a huge 30.7x (insiders bought only $210 million). Not only that, but share buybacks slowed to a trickle in August too - $3.6 billion, which was the third lowest tally in the past two years.

EMPLOYMENT BACKDROP … STILL THE MISSING LINK

The government has managed to pull rabbits out of the hat when it comes time to stimulate housing and autos - though not indefinitely - but obviously has no such magical show for the labour market. As the ADP data showed, there were 298k private sector jobs lost in August (but isn’t that a green shoot next to -360k in July and, -433 in June, -461 in May and -518k in April?).

Not only that, but the slack in labour markets across the U.S.A. have hit truly extreme levels. Fully 19 metro areas now have unemployment rates above 15%, and there are locales in California where the numbers are north of 30%.

To get the report, you have to register with Gluskin Sheff to receive them. They’re well-worth reading.

Tags: 7x, Aftershocks, Bond Yields, Canada, Commodities, Corporate Bond, Corporate Insiders, David Rosenberg, Gold, Gold Price, Gold Silver, Government Bond, Labour Market, Labour Markets, Level Government, Market Chatter, Missing Link, oil, Outperformance, Retest, Safe Haven, Share Buybacks, Silver Prices, Year Treasury Note
Posted in Gold, Markets | No Comments »

Beating the Market

Thursday, July 30th, 2009

By Michael Nairne, Tacita Capital

For many investors, beating the market is the holy grail of investing. In fact, google the phrase “beating the market” and you get 14 million hits, more than seven times “passive investing”. Yet, beating the market over the long-term is extremely difficult. By definition, the market includes all stock owners and hence, investors as a group earn the market return – for every winner there must be a loser. In confirmation, a litany of studies has found that fund managers in aggregate achieve market-like returns less fees and costs.

However, the potential to beat the market does exist. Over the past several decades, the painstaking examination of historic stock performance in numerous countries has pointed the way to outpacing the market. The findings indicate that value stocks - those low-priced in relation to earnings, dividends and book value - have higher expected returns than growth stocks - those high-priced in relation to earnings, dividends and book value. Over the long-run, value investors are the winners; they earn a premium to growth investors who are the losers.

This premium is evidenced in the following graph which illustrates the growth of $1.00 U.S. invested in large value stocks (in red) compared to large growth stocks (in green)

and to the S&P 500 (in blue) from August 1927 to May 2009. The investment in value stocks grew to $4,454 - more than four times the $868 of the growth stocks and nearly three times the $1,578 of the S&P 500 which, although growth-tilted, contains both value and growth stocks.

The historic outperformance of value stocks is not restricted to the U.S. market. In a study on the United Kingdom stock market from 1900-2000, Dimson, Marsh and Staunton (DMS) found that value stocks achieved an annual return of 11.5 percent, a 2.9 percent premium to the 8.6 percent return of growth stocks and a 1.4 percent premium to the market overall. They conclude that “over the long term, the historical record of value investing has been positive … we now know that value stocks did better than growth stocks in the earlier as well as later parts of the twentieth century.”

In fact, in a sweeping review of the research on the value premium in international markets, DMS found that value stocks outperformed growth stocks in thirteen out of fourteen countries including Canada. Italy was the only exception. The value premium is therefore a global phenomenon.

But this begs the question … why? Without a meaningful explanation, it is possible (although not probable given the length and breadth of its occurrence) that the value premium is a statistical fluke or worse, an historic anomaly now widely known, avidly pursued by knowledgeable investors and hence as prices are bid up, no longer available to future investors.

Economic theory offers us two explanations for the value premium. First, behavioural finance experts argue that cognitive biases hardwired into the human psyche often lead to the systematic mispricing of value stocks. David Dreman, a leading apostle of this view, believes that investors routinely overreact to recent news concerning a given stock. If it is good news, they tend to project a continuance of this favourable trend and bid up the price of the stock. When bad news confronts investors, an opposite reaction is triggered. Believing a negative trend to be firmly in place, investors either hold or sell and the stock price subsequently languishes. Yet, inevitably, some negative event occurs to cause the higher-priced growth stocks to tumble while conversely, enough positive surprises occur to send the value stocks spiralling upwards.

Investors appear to naively extrapolate recent earnings trends and only adjust their expectations slowly as recurrent surprises occur. One study by Fuller, Huberts and Levinson

found that while high-priced glamour stocks initially have much stronger earnings growth rates than low-priced value stocks, after five years or so this difference becomes negligible. As the market slowly adopts scaled-down earnings expectations as the new norm, value stocks enjoy superior returns as their price moves up at a relatively faster pace than that of the slackening growth stocks.

Another behavioral view holds that investors often confuse the characteristics of a good company (e.g. powerful brand, positive image, superior growth) with the elements of a good stock (i.e. a price that is low in relation to discounted future cash flows). One study found that the stocks of companies considered “excellent” according to the standards outlined in the best-seller In Search of Excellence materially underperformed the stocks of “unexcellent” companies!

The second explanation for the value premium comes from the efficient market school of thought. Under the efficient market hypothesis, the prices of stocks reflect all available information and hence, higher expected returns must rationally reflect higher risk. Originally, efficient market supporters did not believe there was sufficient evidence of a value premium. Then, in a 1992 landmark study covering the period 1963-1990, Professors Eugene Fama and Ken French found that value stocks outperformed growth stocks by a statistically significant margin. In 2000, a second study covering 1929-1963 contributed strong out-of-sample confirmation of the existence of a value premium.

According to Fama & French, however, value stocks are generally shares of companies that are in comparatively worse financial shape than companies whose shares are growth stocks. Investors demand a higher return for their investment in value stocks because of the greater risk the company will deteriorate financially or even go bankrupt. This is no different from bankers or bondholders who charge a higher rate of interest to companies in poor financial shape. The poor performance of value stocks during the Great Depression may be indicative of this risk.

Both the behavioral and efficient market explanations for the value premium are compelling. In academia, a vociferous debate exists as to which is the foremost cause of the value premium. From an investor’s perspective, however, the critical aspect of both explanations is that each supports an enduring value premium that is unlikely to disappear. However, the exploitation of the value premium rests on one key characteristic – patience - since the premium is highly volatile and can disappear or even go negative for years.

This volatility is evidenced in the following graph which depicts the 36-month rolling average annual return of the Fama-French Large Value Premium (i.e. the return of large value stocks minus large growth stocks) for the U.S. market for the period August 1929 to May 2009. Although value stocks outperformed growth stocks by an average annualized 3.24 percent, there are intermittent periods where growth stocks outperformed, sometimes by a significant margin, and some of these periods can persist for a number of years, such as occurred through much of the 1930’s and 1990’s.

To the thoughtful investor, the volatility of the value premium is reassuring. A premium which showed up with any regularity would disappear almost immediately since it would be arbitraged away by traders. Instead, the value premium is available to patient, long-term investors who are interested in beating the market. Impatient investors will need to look elsewhere.

July 23, 2009

www.tacitacapital.com

Tacita Capital Inc. (”Tacita”) is a private, independent family office and investment counselling firm that specializes in providing integrated wealth advisory and portfolio management services to families of affluence. We understand the challenges of affluence and apply the leading research and best practices of top financial academics and industry practitioners in assisting our clients reach their goals.

Tacita research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it and is not intended to replace individually tailored investment advice. The asset classes/securities/instruments/strategies discussed may not be suitable for all investors and certain investors may not be eligible to purchase or participate in some or all of them. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Tacita recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor.

Tacita research is prepared for informational purposes. Neither the information nor any opinion expressed constitutes a solicitation by Tacita for the purchase or sale of any securities or financial products. This research is not intended to provide tax, legal, or accounting advice and readers are advised to seek out qualified professionals that provide advice on these issues for their individual circumstances.

Tacita research is based on public information. Tacita makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete. We have no obligation to inform any parties when opinions, estimates or information in Tacita research changes.

All investments involve risk including loss of principal. The value of and income from investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. There may be time limitations on the exercise of options or other rights in securities transactions. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. Management fees and expenses are associated with investing.

Tags: Aggregate, Canada, Dividends, Dms, Fund Managers, Google, Growth Investors, Growth Stocks, Holy Grail, Investment Stocks, Litany, Loser, Losers, Marsh, Outperformance, S Market, Seven Times, Stock Market, Stock Owners, Stock Performance, Tacita, Value Investors, Value Stocks
Posted in Markets | No Comments »

Goldman: Past the Worst?

Wednesday, May 27th, 2009

The debate rages on regarding whether the global business cycle has started to stabilize, with most of the “green shoots” arguments based on softer data such as Purchasing Managers Indices (PMIs) appearing “less bad”. Although this is not the same as “good”, one should be aware of the fact that a bottoming process of the economic cycle has commenced. Importantly, different countries will experience dissimilar rates of recovery that, in turn, will impact asset allocation decisions.

An interesting analysis by the Goldman Sachs Global Economics team suggests that every major economy has possibly already seen its worst rate of GDP decline, either in Q4 of last year or Q1 of this year (see graphs below). “Emerging markets are likely to see a return to trend growth about six months, on average, before advanced economies. Similarly, emerging markets on average will close their output gaps – the difference between actual growth and trend growth – about two years before advanced economies,” said the economists.

Although the Goldman team are not under the elusion that they will be entirely correct on the timing of these events, they do feel more confident about the relative order in which countries/regions will reach the above milestones. The analysis leads them to the following market implications as summarized in the report:

• Equity markets have most likely bottomed and volatility should start diminishing.
• Countries that get back to trend growth sooner will tighten monetary policy sooner.
• Countries that get back to trend growth sooner should see their currencies strengthen.
• As the output gap will take many years to close, there should be limited pressure on prices and wages. Deflation will still be a greater concern in the short term than inflation.
• Emerging markets, particularly Asia, should offer more opportunities for outperformance for equities and forex, and could support commodity prices, especially industrial metals.

Source: Peter Berezin and Alex Kelston, Goldman Sachs - Global Economics Weekly (via Fullermoney), May 20, 2009.

Tags: Asset Allocation Decisions, Business Cycle, Commodity Prices, Debate Rages, Economic Cycle, Economics Team, Elusion, Emerging Markets, Gap, Global Business, Global Economics, Goldman Sachs, Industrial Metals, Market Implications, Metals Source, Monetary Policy, Outperformance, Output Gap, Output Gaps, Prieur, Purchasing Managers, Q1, Q4, Volatility
Posted in Emerging Markets, Gold, Markets | No Comments »

Jeremy Siegel: Outlook for Government Bonds

Friday, May 15th, 2009

Jeremy Siegel, on his outlook for government bonds:

40 years ago [US] treasury bonds were yielding over 6.3 percent, about twice their yield today. It is mathematically impossible for government bonds to come close to matching those 12 percent returns in future decades. Stocks, on the contrary, can easily repeat their returns over the past four decades, since those returns were near their
historical average…

For the 55-year period from December 1925, when the well-known Ibbotson stock and bond series begins, through January 1982, total real government bond returns were negative. This means that, by rolling over in long-term government bonds, reinvesting all the coupons, and thereby taking no income, investors’ bond portfolios were sinking in value.

Most strikingly, for the 40-year period from 1941 through 1981, government bond investors lost a whopping 62 percent of their value after inflation. A loss in purchasing power over this long a period has never happened in stocks. There has never even been a 20-year period when real returns in stocks have been negative. In fact, the worst 30-year real return for stocks is plus 2.6 percent per year, just slightly below the average real return investors earn with government bonds.

Looking at today’s markets, the forward-looking prospects for government bonds are very poor. Yields on 30-year inflation-protected bonds are 2.3 percent, and yields are only 4 percent on 30-year Treasuries. In contrast, after stocks have fallen 50 percent from their previous high, as they did in March of this year, their subsequent 30-year real returns have always been in excess of 10 percent per year.

The 40-year outperformance of government bonds over large stocks has ended.

As a addendum, Robert Arnott, of Research Affiliates opined about bonds vs. stocks in Bonds: Reversion Cuts Both Ways?

Tags: 1941, 30 Year Treasuries, Addendum, Bond Investors, Bond Portfolios, Bond Returns, Bond Series, Bonds Vs Stocks, Contrary, Government Bond, Government Bonds, Ibbotson, Inflation Protected Bonds, Jeremy Siegel, Outperformance, Poor Yields, Prospects, Purchasing Power, Research Affiliates, Robert Arnott, Stocks Bonds, Us Treasury Bonds
Posted in Bonds | No Comments »

Stock markets: reversal time?

Tuesday, May 12th, 2009

I indicated in Sunday’s “Words from the Wise” review that “the speed and sheer magnitude of the rally argue for markets to either consolidate or retrace some of the past nine weeks’ gains prior to moving higher”.

Is the rally about to be reigned in? While most major stock market indices are encountering resistance at their 200-day moving averages and/or at the early January highs, a few other indicators also warrant our attention.

Two sectors that have been leading the overall market higher during the rally that commenced on March 9 - small caps and technology - have reversed their outperformance, as seen from the turnaround in the relative performance. The first chart plots the Nasdaq Composite index relative to the NY Composite Index, while the second compares the performance of the Russell 2000 Small Cap Index with that of the S&P 100 Index (large caps). A rising relative strength line indicates outperformance and a declining line underperformance.

Source: StockCharts.com

Source: StockCharts.com

I will keep a close eye on these two charts as relative weakness of small caps and technology will not be a good sign for an overall market that is overbought and looking exhausted after its monumental rally over the past nine weeks.

Another interesting-looking chart is that of the S&P 500 Index’s Bollinger Bands. Although a close below the 20-day moving average (dotted blue line) is required to confirm a correction, the fact that the price is touching the upper band indicates a short-term overbought condition. Also, the black line in the bottom section of the chart - measuring the width of the Bollinger bands - has turned up and is signaling expanding bands. This usually points to rising volatility and lower prices, similar to those experienced at the January and February lows.

Source: StockCharts.com

For those who missed the item over the weekend on Adam Hewison’s (INO.com) technical analysis of the S&P 500’s most likely direction and important chart levels, click here to access the video presentation.

I still maintain that US and other mature stock markets are in the process of mapping out a base development formation which probably means toing and froing between policy tailwinds and economic headwinds. It is only natural (and necessary) that profit-taking should set in after the strong advance; a pullback should not be too much cause for concern, provided the levels from which the rally commenced on March 9 hold.

Tags: Bollinger Bands, Bottom Section, Cap Index, Chart Plots, Lows, Moving Averages, Nasdaq Composite Index, Nine Weeks, Outperformance, Relative Performance, Relative Strength, Relative Weakness, Russell 2000, Sheer Magnitude, Small Cap, Small Caps, Stock Market Indices, Stock Markets, Turnaround, Volatility
Posted in Markets | No Comments »

Signs The Economy is Stabilizing

Wednesday, April 15th, 2009

The global economy appears to be stabilizing according to a research report by the Goldman Sachs Global Economics team. To monitor whether economic data are indeed improving they have developed a simple diffusion index, recording whether a particular data series has increased or decreased relative to its previous reading. Thirty-four monthly economic data points from the US, Europe, China, Japan, Brazil, Russia, Korea and India are analysed, including manufacturing and non-manufacturing surveys, consumer confidence indices, industrial production, retail sales, jobless claims, housing data and some credit-related data.

After having languished below 50 since the spring of 2007, the Diffusion Index increased above 50 in February and March (March doesn’t yet contain all 34 indicators, though). Any reading between 0 and 50 indicates the data are deteriorating, whereas above 50 implies improvement.

When looking regionally, the economists believe the worst of the cycle has been seen in the US and the UK, but this does nor appear to be the case in Euroland and Japan.

The team concludes: “Some of our other proprietary indices are picking up. Our Global Leading Indicator has improved in March and momentum has been improving for the last three months. Our Financial Stress Indicator also improved. If these signs of improvement really set in we should expect:

• stronger performance from equities;
• cyclical sectors to outperform;
• softer performance from government bonds;
• strong outperformance of equities versus bonds, and
• higher commodity returns, particularly industrial metals (copper).”

Source: Binit Patel and Kamakshya Trivedi, Goldman Sachs - Global Economics Weekly, April 8, 2009.

Tags: China Japan, Commodity, Consumer Confidence, Diffusion Index, Economic Data, Economics Team, Economists, Emerging Markets, Euroland, Financial Stress, Global Economics, Global Economy, Goldman Sachs, Government Bonds, India, Industrial Metals, Jobless Claims, Leading Indicator, Outperformance, Retail Sales, Simple Diffusion, Trivedi
Posted in Bonds, Credit Markets, Economy, Gold, Markets, Outlook | No Comments »