The Investment Scientist

Confusing volatility and risk could cost you a bundle. Let’s take a look at returns on an investment of $1000 over 50 years from 1958-2007 in five asset classes.

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

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

Why small cap value is the best long-term investment

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

Table: How would $1 investment become?

Safety paradox

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

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

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

“Volatility does not measure risk.” -Warren Buffet

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

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

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

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

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

Richard Conniff of MSN Money wrote about “How fear can make you loss millions.”

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

Bob Klosterman explained life insurance in wealth management.

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

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

Are you bullish, bearish, or neutral?

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

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

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

How does bearish investor sentiment relate to stock market return?

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

Data sources: AAII, Kenneth French data library

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

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

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

6/22/2007 After Bear Stearns’ hedge funds blew up, Jim Cramer said on CNBC’s Stop Trading:

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

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

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

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

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

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

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

I said the common stock was worthless on Friday.

Chinese stocks are hot. Taiwanese stocks are not. That’s about to change.

Taiwan will hold its presidential election on March 22nd. Barring an extraordinary electoral surprise, Ying-jeou Ma, the candidate from the pro-business and less China-averse KMT will win the election. (Currently Ying-jeou Ma is leading with 63% in Taiwan’s political futures market.)

The relationship between China and Taiwan is best seen as a broken marriage. China wants to reconcile the rift on its own terms, and threatens consequences if that should not happen. Taiwan, on the other hand, suffers from multiple personality disorder. One part of it wants an outright divorce. The other wants to stay separated with the option of eventual reconciliation.

For the last eight years, Taiwan has been ruled by a president who favored outright divorce. His government has been responsible for hampering economic interactions between China and Taiwan. As the result, Taiwan’s economy languished exactly when China was making a great leap forward. Taiwanese stock market is basically where it was eight years ago. But many emerging economies have seen their stock markets double or even triple during that time. It’s likely we’ll see a catch-up rally once the dust settles after the election.

Even a surprise win by DPP candidate Frank Hsieh wouldn’t be that bad for Taiwanese stocks. He’s seen as a pragmatist within his party. Rhetorically, he would still want the divorce. Economically however, he wouldn’t mind sleeping with China.

Inclusion, if you want a small piece of China in your retirement investment portfolio, you can still have it cheap with a Taiwan ETF (EWT) or some Taiwan ADRs.

Related symbol: EWT
Disclosure: I own EWT

Jim Cramer:

What I’m saying is that there are bargains right now, there are stocks right now that if you’re shrewd enough, you will be able to buy them at the opening today and you’ll make money in a year from now.

It has been a year since Jim Cramer made his many picks in Mad Money Lighting Round last January. Undoubtedly, many people followed his advice buying his stock picks. To get an idea of how much money they made, I decided to do a little research.

The research is straightforward enough. I looked up the recap of Mad Money Lighting Round at SeekingAlpha.com and tabulated Jim Cramer’s bullish and bearish calls. I then calculated one-year returns from the second (market) day he made the calls.

Bullish: If a bullish call has a one year return higher than that of the S&P 500, it is a right call. If not, it’s a wrong call.

Bearish: If a bearish call has a one year return lower than the S&P 500, it is a right call. Otherwise it’s a wrong call.

I calculated the accuracy of his calls by this formula: Accuracy = right call/all calls. I also determined what return a loyal Cramer follower would have made if he/she had bought all of his bullish calls and sold all of his bearish calls.

In January of 2007, Jim Cramer made a total of 194 bullish calls and 123 bearish calls. Out of the 194 bullish calls, 60 are right calls. Out of the 123 bearish calls, 53 are right calls. The accuracy of Jim Cramer’s bullish calls is 30.93% and that of his bearish calls is 43.1%. The combined accuracy is 35.6%.

During the one-year period after Jim Cramer made his calls, the S&P 500 fell an average of 3.72%, his bullish calls on average fell by 3.33% but his bearish calls actually increased by 3.11%.

The table below shows Jim Cramer’s calls on 1/3/2007 and their subsequent one year returns. You may request a complete report of all of his January 2007 calls from MZ Capital.

Data source: SeekingAlpha.com
Research assistance: Ivy Cui

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Janice Revell of Money Magazine makes a good case that inflation is more of a threat to your retirement than a recession.

Bob Klosterman asks if you are undermining your financial independence by overly risk-averse.

James Hamilton writes scholarly about predicting recession and stagflation.

Talking about inflation, we can’t ignore China’s role. Ebn Esterhuizen has an essay on that.

Last month, the Fed took a drastic step to cut rate twice by a total of 125 basis points. And with a drop of 225 basis points since last fall, what does this say about likely stock returns? Let’s look at the historical data.

Since 1950, the Fed cut more than 200 basis points 11 times in attempts to simulate a faltering economy. Economists believe it takes six months for the rate cuts to take effect which should last for as long as three years. Therefore I examined the one- and three-year returns of the S&P 500 Index and the Fama/French Small Cap Value benchmark portfolio for each rate-cut period.

After cuts of 200+ basis points, the average one-year return for the S&P 500 was 13.5% with two negative-return periods. The average three-year returns for the S&P 500 was 31.8% with one negative-return period.

However, the Fama/French Small Cap Value benchmark portfolio fared better. The one-year average return is 34.5% with no negative returns. The three-year average return was 100.5% with just one negative-return period.

Data sources: Federal Reserve, Kenneth French data library

It’s apparent from historical data that Fed rate cuts don’t guarantee making money in stocks. However, they do increase the odds of doing so— particularly with small cap value stocks. (Note: the odds of losing money with the S&P 500 index in any given year is about 30%.)

Martin Zweig once said:

Don’t fight the Fed!

That could be a very wise counsel!

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We’re already in a recession. Or, that’s what the pundits say. They may well be right. But what will you do about it? Will you follow common wisdom and seek relative safety of large cap stocks? After all, large cap stocks are safer— right?

That’s what I had thought too, until I studied the S&P 500 and the Fama/French Small Cap Value benchmark portfolio in all nine recessions going back to 1950.

My study looked at time periods of one year and three year returns into a recession. Surprisingly, results show small cap value stocks to have both higher returns and lower risk than the S&P 500.

Here’s what happened in the one-year period from the start of all nine recessions. The S&P 500 declined three times. Yet in the same period, the Fama/French Small Cap Value benchmark portfolio was down only once.

Three years after the start of all nine recessions, the S&P 500 was under water one time. However, the Fama/French Small Cap Value benchmark portfolio fared much better by being firmly on dry land.

One-year average return after the start of recessions in our study was only 2.95% for the S&P 500 while the Fama/French Small Cap Value benchmark portfolio returned a healthy 13.21%.

For the three-year period, the average return was 28.20% for the S&P 500 vs. 76.21% for the Fama/French Small Cap Value benchmark portfolio.
While the future may not be like the past, we think small is beautiful. And if common wisdom is all for investing in large cap stocks in these rocky times, you might just need some uncommon wisdom for your long-term investing success.