Investment

» SteveT - Is It Time to Abandon U.S. Stocks?

By MARK HULBERT

RISK IN THE STOCK MARKET is dangerously high right now.

That is the unmistakable message of a stock-market timing model that its author claims to be "best cyclical timing indicator in existence."

Normally, of course, I would take a jaundiced view of any adviser with the chutzpah to claim that a particular model was the "best in existence," and for that reason probably discount the message of that model as well.

But in this case I believe we should take it seriously, not only because of who the adviser is but also because of the model's long-term real-time track record.

The adviser in question is Norman Fosback. I can think of few investment advisers who are more qualified than he to rigorously study the statistical properties of various market-timing indicators, or who have actually tested as many as Fosback has.

Fosback is perhaps best known as the editor of a number of newsletters that were published from the 1970s through the 1990s by the Institute for Econometric Research -- the most famous of which probably was Market Logic. Time Warner bought those newsletters in the late 1990s and then folded them. Fosback now edits a newsletter called Fosback's Fund Forecaster.

The market-timing model that Fosback claims is the best in existence is based on the amount of cash owned by mutual funds. Like other advisers who focus on mutual funds' cash level, Fosback interprets this ratio in a contrarian way. So he considers it to be bullish if mutual-fund managers are bearish on the stock market and hold lots of cash -- and bearish if managers are very bullish and hold very little cash.

Nevertheless, according to Fosback, the mutual funds' cash-to-assets ratio, a widely known measure, is not the indicator to use in getting a proper read on fund cash levels and their implication for the general direction of stocks. It's just too simple to be useful.

This indicator erroneously assumes that fund managers have a constant predisposition to hold cash. According to Fosback, however, fund managers actually are more inclined to hold cash in some situations rather than others, for reasons having nothing to do with their opinion of the stock market as a whole. So the mutual funds' cash-to-assets ratio is liable to issue false signals.

What non-stock-market-related reasons are there for why fund managers vary their cash levels? One major one is interest rates. Other things being equal, Fosback argues, fund managers are more inclined to invest in cash when interest rates are higher. Another factor is that funds' cash needs are higher during periods when there are lots of fund-redemption requests. One therefore should factor interest-rate levels and redemption activity out of the equation when interpreting mutual-fund cash levels.

The econometric model that Fosback developed to do that he calls the Fosback Index. It calculates the difference between the average stock fund's actual cash holdings and the amount of cash that we would expect its fund manager to be holding, given interest rates and recent redemption activity. The result, in Fosback's opinion, is a purer reflection of the average fund manager's opinion of stocks' prospects.

The proof of the pudding is in the eating, of course. And, according to Fosback's calculations, this model has had unprecedented success in forecasting the stock market's intermediate and longer-term trends.

Note carefully, furthermore, that Fosback is not simply reporting back-tested results in reporting his model's stellar record. He created an early version of his model in the 1970s, in fact. This early version relied on just one of the two factors that the current model adjusts for -- interest rates, and not recent redemption activity.

But enough by way of background. Where does the Fosback Index stand now?

According to Fosback, the Fosback Index is close to record low levels currently, which means that fund managers are close to being more bullish than they've ever been. Only twice previously, according to Fosback, did the Fosback Index get as low as where it is right now: "At the peak of the glamour stock frenzy in 1972 and at the broad top of the tech bubble six years ago."

Is there any way of wriggling out from underneath the bearish implications of that? Only barely, it would appear, and not for long.

First, Fosback reported in his book Stock Market Logic, which was published in 1976, that the earlier version of his Fosback Index had a better record at identifying market bottoms than it did market tops. That's because, as he wrote at the time, "funds usually work down to a low cash position far in advance of the market peak."

Though the modified version of the Fosback Index no doubt has better back-tested performance than the earlier version, even it is guilty of prematurely calling bull-market tops. For example, the newer version of the Fosback Index fell to well-below-average levels in 1996 and 1997, two to three years before the breaking of the Internet bubble in early 2000.

So there may be at least some consolation in the possibility that the final top of the bull market that began in October 2002 is still ahead of us -- even if, in light of the stock market's rout in recent days, that is certainly looking less and less likely.

Secondly, Fosback argues that we should never base our market timing on just one indicator, no matter how good its track record. Fosback himself has devised a comprehensive model that takes into account a whole host of indicators in addition to the Fosback Index -- and that model, while currently not bullish by any means, is not calling for a crash.

For example, Fosback's omnibus model currently is projecting that the S&P 500 index will produce only a 2% annualized return over the next five years, far below the stock market's long-term average of between 10% and 11% annualized.

The bottom line may be the same, however, whether or not you pay attention to Fosback's more comprehensive model or just to his Fosback Index alone. Either way, the clear implication is that we should reduce our equity exposure significantly, or even to get out of stocks altogether. After all, money-market funds currently are paying upwards of 5%, more than double the projected returns of Fosback's more optimistic model for the S&P 500.

Mark Hulbert is founder of The Hulbert Financial Digest. He is a senior columnist for MarketWatch.

Comments? E-mail us at online.editors@barrons.com

URL for this article:
http://online.barrons.com/article/SB1149...

-- posted by SteveT

» Normxxx - Old Formula; New Worry

An Old Formula That Points to New Worry

By MARK HULBERT | 18 June 2006

BAD news, stock investors: the market is likely to underperform garden-variety money market funds through the end of next year.

<img Width="560" src="http://graphics8.nytimes.com/images/2006/06/18/business/18strategies-graphic.gif">
Click Here, or on the image, to see a larger, undistorted image.

That gloomy forecast comes from a market-timing model that, while not perfect, has had an impressive track record over the long run.

The model arose from research conducted some 15 years ago by William Reichenstein, a professor of investments at Baylor University, and Steven P. Rich, a finance professor there. They reported their results in an article in the summer 1993 issue of The Journal of Portfolio Management.

The model is quite simple, especially when compared with many econometric models. It has just three ingredients: the stock market's dividend yield, the interest rate on 90-day Treasury bills and the median of projections from analysts at Value Line, the investment research firm, of how much the 1,700 stocks they monitor will appreciate over the next three to five years. The first two numbers are readily available at many financial Web sites, and the third is published weekly in the Value Line Investment Survey. The formula for combining the three pieces of data can be easily figured with a spreadsheet program or a calculator.

Despite the model's simplicity, the professors found in back testing over the period from 1968 through 1989 that its periodic readings had done an impressive job of forecasting the stock market's gains and losses over the subsequent six calendar quarters.

To be sure, the model has had a mixed record in the 13 years since their study appeared. Though the model has performed well in the current decade, its record in the 1990's was poor. Through much of that decade, it projected below-average performance for the stock market, thereby greatly underestimating equities' actual returns.

[ Normxxx Here:   Apparently, the model is not euphoria-proof! ]

The model's failure in the 1990's, however, may be the exception that proves the rule. In an interview, Professor Reichenstein contended that the stock market's outsized returns in that decade were in large part attributable to investor "irrationality," and that the model should therefore not be faulted for failing to forecast them. The model aims to forecast what the market's level would be if investors were rational, and "no model built on rational pricing is able to explain irrational behavior," he said.

A study by The Hulbert Financial Digest provides further support for the notion that the model's failure during the 1990's was an anomaly. The study focused on its performance from 1968 through 2006— a period that includes the 22 years covered in the professors' original study and the 17 years since. Even after the incorrect forecasts in the 1990's are taken into account, the model's overall record is good enough to be statistically meaningful and not likely to be mere luck.

So what does the model say about the current state of the stock market? Unfortunately, the message is pessimistic. In fact, it has been more bearish only 15 percent of the time since 1968. Specifically, it projects that the total return of the Standard & Poor's 500-stock index over the next six quarters will be one percentage point below that of riskless 90-day Treasury bills. Because those bills, at current rates, are to produce a 7.5 percent return over the next six quarters, that would mean a total S.& P. 500 return of around 6.5 percent— equal to about 4 percent, annualized.

Professor Reichenstein emphasized that because so many factors would influence the stock market over the next six quarters, we should not place too much weight on the exact number of his model's forecast. But, based on its current low reading, he said, he is confident in forecasting that the stock market's return from now to the end of next year will be "well below average."

One investment adviser who bases his market timing in part on this model is Dan Seiver, who publishes a newsletter called the PAD System Report; he is also an emeritus professor of economics at Miami University of Ohio and is now a visiting professor of economics and finance at San Diego State University and the University of San Diego. Professor Seiver writes that the model's recent level "matches the reading for the second quarter of 1987 (before the crash), and is fairly close to the reading for the fourth quarter of 1968 (before a six-year punishing bear market)."

He also points out that the model's current reading is far lower than it was at the beginning of bull markets. In the second half of 1982, for example, before the great bull market of the 1980's, it projected a six-quarter equity return that was 15 percentage points higher than today's forecast. The projection from late 1974 was more than 30 percentage points higher than today's.

"You can draw your own conclusions, but these numbers make us very afraid," Professor Seiver writes. "Expect weakness or worse over the next year."

Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch.

______________


The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

-- posted by Normxxx

» SteveT - The Irrational Allure of Growth Stocks

Thursday, July 6, 2006
By MARK HULBERT

WHICH DO YOU FIND MORE INTOLERABLE?

Losing money when the market declines, or not making as much as the market when it rises?

In my experience, most investors are quick to answer that it is the first of these two scenarios that they would have a harder time enduring. After all, who likes to lose money?

But, according to almost all money managers I talk to, it is the second scenario that -- when push comes to shove -- investors actually can't stand.

This became particularly evident in the late 1990s, when value strategies seriously lagged the overall stock market for several years running. That era was dominated by growth stocks in general and high-tech and Internet-related issues in particular. Money managers reported that it was the very rare client who was willing to tolerate making only a couple of percents per year while the most popular growth stocks were rising by 20%, 30% and more.

Those value-oriented advisers who were willing to stick to their guns enjoyed the last laugh during the 2000-2002 bear market, of course, when their stocks held their own -- or even produced handsome gains -- while the overall market dropped like a rock.

This psychological perspective on investing helps to explain what otherwise is a mystery: Why growth stocks continue to be so much more popular than value stocks. (Indeed, the lion's share of investment newsletters in this country focus on growth stocks.)

Value strategies historically have produced higher long-term returns than growth strategies, while at the same time losing a lot less during bear markets. On paper, at least, that would appear to make following value strategies a veritable no-brainer.

The missing ingredient that resolves the mystery is a psychological factor that might be called "keeping up with the Joneses." Because of this factor, investors find value strategies to be significantly riskier than growth strategies.

Why doesn't "keeping up with the Joneses" work against growth strategies during bear markets, when value strategies typically are performing much better? It may to some extent. But investors tend to stay quiet about their losses, and only brag when they are making the big bucks. It's easier to lose money when others are losing than it is to lag the market when everyone else appears to be winning big.

This is what John Maynard Keynes had in mind when he wrote that it is better for one's reputation to fail conventionally than to succeed unconventionally.

Quantifying this psychological dimension is not easy, however. But earlier this month I came across an intriguing way of doing so: Focus on how a strategy performs in those months when the overall market is performing the best.

This approach was discussed in the June 30 edition of the "Investment Review" that is published by Ford Equity Research. This advisory service falls closer to the value end of the growth-versus-value spectrum than most of the newsletters tracked by the Hulbert Financial Digest (HFD).

Indicative of this orientation is its performance since the beginning of 2000, close to the top of the bull market: Over the six and one-half years from then until mid-June, according to the HFD, its recommended stocks produced a gain of 10.6% annualized, versus a total return of just 0.3% annualized for the Dow Jones Wilshire 5000 index.

In its latest issue, Ford Equity Research focused on just those months over the last decade in which the average stock rose by at least 5%. They presumably were those months in which the "keep up with the Joneses" factor would have been felt the most strongly.

Ford Equity Research then measured how each of a number of different stock selection strategies performed during these months. Not surprisingly, momentum stocks shone. Such stocks are those that, at any given time, have performed the best over the trailing several months, of course, and they tend to continue outperforming for a while longer -- to exhibit momentum, in other words. In 97% of these months on which Ford focused, momentum stocks outperformed the overall stock market.

No wonder momentum strategies are so popular. They almost always perform well during those periods when investors' psychological desire to beat the market is strongest.

At the opposite end of the spectrum, consider stocks picked according to Ford Equity Research's value strategy, which is proprietary. They outperformed the overall market in fewer than half the months in which the market was strongest. In fact, on average, stocks picked according to Ford's value model actually lost money during these months in which the overall market performed so well.

Despite performing so poorly during these months, however, value stocks performed wonderfully over the entire period that Ford focused on in its study. In fact, they had the best overall performance of any strategy that Ford measured. That's because momentum stocks performed particularly poorly when value stocks did well.

So there's the trade-off: On the one hand is a momentum strategy that performs extremely well when the market is hot, but requires followers to tolerate big losses when the market is falling. And on the other is a more value-oriented strategy that produces mediocre returns at best when the market is hot but shines when the market is falling.

My 26 years of tracking investment newsletters has inclined me to believe that neither approach is better than the other. Choosing between them depends on taking this crucial psychological dimension into account.

If you are someone who finds it intolerable not to "keep up with the Joneses" when the market is hot -- and there is no shame in admitting that this is the case -- then you should be a growth-stock investor.

But if, in contrast, you are someone who is willing to be a market laggard when the market as a whole is going crazy, then value investing is probably the way to go. You most likely will be rewarded with superior long-term results.

Mark Hulbert is founder of The Hulbert Financial Digest. He is a senior columnist for MarketWatch.

Comments? E-mail us at online.editors@barrons.com

URL for this article:
http://online.barrons.com/article/SB1152...

Steve Thompson

-- posted by SteveT

» jjMcCoy - The Irrational Allure of Growth Stocks

In response to The Irrational Allure of Growth Stocks posted by SteveT:

Old Wall Street Saying:

Riding down in a bear market is unforgetable..
Missing a bull market is unforgivable...

-- posted by jjMcCoy

» SteveT - A discouraging farewell

By Mark Hulbert, MarketWatch
Last Update: 12:01 AM ET Jul 21, 2006

ANNANDALE, Va. (MarketWatch) -- This is my last column before taking a two-week vacation.
I wish I could be more upbeat as I bid adieu, but I'm afraid that recent sentiment trends are not encouraging.
I base this cautionary assessment on two factors.
The first is the latest reading of the Hulbert Stock Newsletter Sentiment Index (HSNSI), which reflects the average recommended stock market exposure among a subset of short-term stock market timers tracked by the Hulbert Financial Digest. As of Thursday night's close, the HSNSI stood at 18.8%.

To be sure, this reading does not suggest there is too much bullishness among newsletter editors, so at least to that extent, there are no outright contrarian-based sell signals to report.
But recent trends are worrisome: So far in July, the HSNSI has increased by 6.2 percentage points while the Dow Jones Industrial Average has declined by 222 points. It is rare, and bearish, for advisers to become more bullish in the face of a market decline.
These recent trends reflect a marked shift in mood on the part of the average newsletter editor. Most newsletters quickly exited from stocks in the wake of the market's decline that began in mid-May, suggesting that this decline was more likely a mere correction than the beginning of a major bear market.
But rather than continuing to view the market's glass as half empty, editors are gradually beginning to view that glass as half full. If this trend persists, it would suggest that the stock market must decline a lot more before there is enough skepticism to support a more sustainable rally.
The second factor suggesting caution is not based on a contrarian analysis of newsletter sentiment, but is based instead on a contrast between the best- and worst-performing newsletters. The theory behind this way of looking at newsletter sentiment is that the past's top performers are more likely to be right than the past's worst performers.

Unfortunately, the top performers are becoming less bullish while the worst performers are becoming more so.
Consider first the average recommended stock market exposure among those select newsletters that, according to the Hulbert Financial Digest, have beaten a buy-and-hold in the stock market over the last decade on a risk-adjusted basis. That's a high hurdle. Right now, the newsletters that are able to jump over it are recommending that subscribers allocate 62% of their portfolios to U.S. stocks.
Not only is this a relatively low number, it is down from 67% a year ago, reflecting a gradual erosion in recommended exposure to the U.S. equities among the market beating newsletters.
At the same time, the average newsletter that has failed to beat a buy-and-hold has not become any more bearish and, if anything, has become more bullish.
As a result, there is now no appreciable difference in the average exposures of the top and bottom performers -- and no basis in that contrast to forecast a higher stock market.
To be sure, the top performers are not more bearish than the bottom performers, so this contrast by no means supports an outright sell signal. Again, however, as with the first factor discussed in this column, the trends are not encouraging.
I hope my discouraging assessment is proven unfounded. I'll reassess in my next column, scheduled for Aug. 8. End of Story
Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.

Steve Thompson

-- posted by SteveT

» SteveT - Backdating Options Hurts Investors

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Thursday, September 7, 2006
By MARK HULBERT

THE BULK OF THE ATTENTION that so far has been paid to the option-backdating scandal focuses on how outrageous it is for executives to so audaciously steal wealth from their shareholders.

And, indeed, it is outrageous.

But there are profound investment implications as well, and a new study helps us focus on what those may be.

The study, "The Economic Impact of Backdating of Executive Stock Options," began circulating in academic circles earlier this week. Its authors are M. P. Narayanan, Cindy A. Schipani, and H. Nejat Seyhun, all from the Stephen M. Ross School of Business at the University of Michigan.

Option backdating, for those one or two of you who have remained blissfully unaware of this brewing scandal, involves after-the-fact setting of the strike prices of the options granted to an executive.

That strike price, of course, represents what that executive must pay to acquire shares of his company's stock. Provided that the strike price is equal to the stock's market price on the day the options are granted, such options have no immediate cash-in value -- are not "in the money," so to speak. But if that strike price is set equal to some lower price in the past, as is the case for backdated options, the options would be "in the money" on the day that they are granted -- and, therefore, worth a lot more to the executives.

None of this would be scandalous if companies were to disclose that the options that they granted to their executives had strike prices well below the current prices of their stocks. But, for a variety of accounting and tax-related reasons, companies don't want to do that.

To secure the most favorable accounting and tax treatment of those options, for example, for both the companies themselves as well as for the executives individually, the options' strike prices must be equal to the market price on the day the options are granted.

So that's where the scandal comes in: Companies are lying about when they actually granted the options in order to secure more favorable accounting and tax treatment. If they were to tell the truth, the companies would have to take a bigger deduction against current earnings, and the executives receiving the options would have to pay more in taxes.

This discussion hints at the tax and accounting implications of companies' backdating. But there are many legal consequences as well. The authors of this new study discuss the high probability that companies involved in backdating have violated a number of federal securities laws, as well as state laws dealing with fiduciary responsibility to shareholders. Corporative governance questions also are raised about the oversight (or lack thereof) that these companies' boards of directors were exercising.

Last but not least, executives who received backdated options were given less incentive to do a good job than executives of other companies that did not engage in any backdating. To the extent that pay-for-performance actually leads to markedly better performance on the part of corporate executives -- and the executives receiving backdated options often make this argument -- then companies involved in backdating should be poorer performers than those that did not engage in the practice.

All told, therefore, there are many reasons to expect that, other things being equal, a company that backdated options is significantly less attractive than another company that did not.

To estimate how less attractive such a company would be, the authors of this new study constructed a database of 48 firms that have already been implicated in this scandal. They then compared the average returns of these 48 companies' stocks to that of the S&P 500 index over the 21-trading-day period beginning 10 trading days prior to the company's public announcement that it was implicated in this backdating scandal.

The professors found that, on average over these 21 trading sessions, these 48 firms' stocks performed 8% worse than the S&P 500. Given these firms' market capitalizations prior to being implicated in the options-dating scandal, this 8% translates into an average loss of around $500 million per firm.

These are big numbers. Is it possible that the stock market overreacted? Of course. But it is not easy to make such a case.

To make it, you would have to argue that you know more than the market knows. Even though the stock market is not completely efficient, it usually is more right than any one of us individually. Furthermore, the courts typically rely on the markets' reactions when estimating how much investors have been harmed by various instances of corporate malfeasance.

So even if the markets overreacted, it is likely that in the class-action lawsuits that undoubtedly will be filed against companies involved in this scandal, the damage claims will be based on this 8% number.

One investment implication of this new study, therefore, would be to avoid, or even sell short, those companies that have not yet been implicated so far in this options-dating scandal but which you suspect are guilty of the practice. Identifying these companies is not easy, however, since by the time it is obvious that they soon will be implicated, their stocks most likely will already have suffered.

Indeed, the professors found from their study that much of the market-lagging return of companies involved in this scandal was experienced over the several trading sessions prior to a public announcement that they were implicated. "This finding suggests that some insiders or hedge funds may be receiving word of the likely filing of backdating complaints and either selling or shorting the stock in advance," the professors write.

A broader investment implication has to do with the importance of a strong corporate-governance structure and, in general, of a corporate culture in which shareholders are taken seriously. Investors, oriented to the short term as so many are these days, tend to pooh-pooh the importance of corporate governance and corporate culture, on the grounds that their impact is subtle and over the long term. But the options-dating scandal shows that corporate governance and culture can have a big impact over the short term, too.

Mark Hulbert is founder of The Hulbert Financial Digest. He is a senior columnist for MarketWatch.

Comments? E-mail us at online.editors@barrons.com

URL for this article:
http://online.barrons.com/article/SB1157...
.

-- posted by SteveT

» PEIC - Why All Those Frowns Should Make You Smile

September 24, 2006
Strategies
Why All Those Frowns Should Make You Smile
By MARK HULBERT

MANY investment newsletters have been fretting about the stock market — and that suggests that the market will rise.

At least that’s the conclusion you would reach if you followed the market-timing theory that is known as contrarian analysis. It owes its name to the observation that investors, as a group, are usually wrong about the direction of the stock market. At the peaks of bull markets, for example, when people ought to be getting out of stocks, optimism tends to be widespread — and the prevailing belief is that happy days are here to stay. At bear-market bottoms, by contrast, the mood is often gloom and doom, even though investors’ best course would be to jump back into the stock market with both feet.

Put simply, contrarian analysis works because investors tend to become more optimistic as the stock market rises and more pessimistic as it declines. That means that optimism will be at its peak at market tops and at its lowest level at market bottoms. The Hulbert Financial Digest, which tracks investment newsletters, has found that the stock market, on average, has performed significantly better after periods when newsletter editors were very bearish than when they were exceptionally exuberant.

Optimism about the market becomes particularly clear when newsletter editors refuse to give up on their equity positions even as the stock market moves against them; such enthusiasm in the face of a market decline often signals that stocks have much further to fall. By the same token, increasing pessimism in the face of a market rally defines the so-called “wall of worry” that bull markets like to climb, in the classic contrarian view.

Over the last couple of months, market sentiment has been a textbook illustration of a wall of worry. During several of the stock market’s recent rallies, the average investment newsletter editor responded to market strength by becoming even more bearish. This suggests a powerful undercurrent of skepticism in the market right now. In the contrarian view, that is a good omen for stocks.

Consider the average recommended stock market exposure among a subset of several dozen newsletters that focus on short-term market timing, as calculated by The Hulbert Financial Digest. During the four-week rally from mid-July to mid-August, for example, as the Dow Jones industrials tacked on more than 400 points, the average recommended exposure fell 15 percentage points. And earlier this month, in the wake of a one-week rally that added more than 200 points to the Dow, the average recommendation dropped more than 12 points.

As a result, even though the Dow is within shouting distance of its record high of 11,722.98, reached on Jan. 14, 2000, the recommended exposure among short-term market-timing newsletters is relatively low. Though the recommended level, now 47 percent, is higher than it was during the summer, it is still some 33 percentage points below the all-time high of 80 percent.

This climate of skepticism has been particularly evident among market-timing newsletters that focus on the Nasdaq. On average over June, July and August, for example, the editors of these services were recommending that their subscribers allocate a quarter of their portfolios to going short the market — an aggressive bet that Nasdaq stocks would decline. Though the average Nasdaq-oriented market-timing newsletter is no longer recommending a short position, it nevertheless is suggesting that subscribers keep about 70 percent of their portfolios in cash.

Investment newsletter editors are not alone in greeting recent market strength with heightened skepticism. Consider an indicator constructed by the American Association of Individual Investors, a nonprofit educational organization with about 175,000 members.

Members who visit its Web site are invited to indicate whether they are bullish, bearish or neutral on the stock market, and the organization publishes weekly averages. Over the first half of September, when the Dow rose by some 150 points, the percentage of respondents who were bearish rose by 12 points, to 38 percent from 26 percent.

Other than concluding that the market is likely to rise, contrarian analysis does not try to forecast the size of the rally, or how long it might last. But the analysis does focus attention on what is likely to signal the eventual end of a rally: a sharp rise in optimism and, even more tellingly, bullishness that is stubbornly held even as the market starts to decline.

Neither of these early warning signals prevails today. So, for now at least, contrarian analysis concludes that the path of least resistance for stocks is upward.

Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail: strategy@nytimes.com.
http://www.nytimes.com/2006/09/24/busine...

-- posted by PEIC

» SteveT - The Best Way to Play Momentum

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By MARK HULBERT

NOLOAD FUND*X has consistently been one of the best performing newsletters tracked by the Hulbert Financial Digest.

For example, it is in first place for risk-adjusted performance over the past 25 years among the handful of services the HFD has tracked over this period. And it is also in first place for performance among the larger number of services for which performance data exist for the past 10 and the past 15 years.

Not surprisingly, such stellar performance has attracted a lot of attention, including that of more than just a few copycat advisers who want to exploit NoLoad Fund*X's approach themselves. This column analyzes one such attempt at imitation.

NoLoad Fund*X's approach is almost a pure play on momentum. No-load funds that have performed the best over the recent past are considered the best bets for continued outperformance. This approach is relatively short term, furthermore, since the typical fund's momentum lasts just a few months.

How about a momentum strategy that switches between investment newsletters? If momentum is a genuine feature of the investment markets, shouldn't such a strategy work just as well as NoLoad Fund*X's approach, if not better?

To find out, I constructed a hypothetical portfolio that each month invested in the newsletter model portfolio that had made the most money over the 12 months through the end of the previous month. My tracking of this hypothetical portfolio began on June 30, 1981, the point at which the Hulbert Financial Digest first had 12 months of newsletter track records.

The portfolio's performance was, well, awful: Through the end of this past October, this hypothetical portfolio lost 11.9% per year on an annualized basis. Over this same period, NoLoad Fund*X produced a 14.3% annualized gain.

Why did a momentum strategy that work so well when applied to mutual funds perform so poorly when applied to investment newsletters? At least two major factors appear to be at work.

First, momentum strategies seem to perform the best when switching between relatively conservative funds or advisers, and the newsletter portfolios that typically come out on top for trailing 12-month returns typically are incredibly risky.

Even prior to my study, this pattern was already evident -- at least somewhat -- in the performances of the three of the portfolios of funds maintained by NoLoad Fund*X. These three portfolios' performances are inversely related to the riskiness of the funds in which they invest.

Here are the data. Between June 30, 1980, and Oct. 31, 2006, the NoLoad Fund*X portfolio that switched between aggressive stock funds produced a 12.7% annualized return. The newsletter's second portfolio, which invested in only moderately risky stock funds but otherwise employed the identical methodology, gained 16.7% annualized over this same period. And the newsletter's third portfolio, which invested in still more conservative stock funds, produced a 17.7% annualized return.

The investment implication of both NoLoad Fund*X's performance as well as of the momentum strategy involving investment newsletters: When pursuing momentum strategies, switch between relatively conservative strategies; ignore the riskiest ones.

The second reason why momentum strategies may work so much better for mutual funds than investment newsletters has to do with transaction costs. Consider two momentum portfolios that invest in the identical stocks, the only difference being that one of the portfolios invests directly in those stocks themselves while the other invests in a mutual fund that owns those stocks. The second of these two portfolios will perform significantly better.

To understand why, it's helpful to review how mutual funds calculate their net asset values, which are the prices investors can buy into, or sell out of, no-load funds. Funds in almost all cases calculate those NAVs on the basis of the closing prices of the stocks that they own. On average, researchers have found, those closing prices fall halfway between those stocks' bid and offer prices.

What this means: A no-load mutual fund enables investors to buy and sell the stock holdings of that fund at the midpoint of those stocks' spreads. If an investor wanted to buy and sell those stocks directly, of course, their purchase prices would be closer to the offer side of the spread and their sale prices would be closer to the bid.

Believe it or not, research shows that these transaction costs can eliminate much, if not all, of the theoretical profit that is otherwise associated with momentum strategies. Perhaps the best known of such studies was conducted by Donald Keim, a finance professor at the Wharton School of the University of Pennsylvania, titled "The Cost of Trend Chasing and the Illusion of Momentum Profits1."

One of Professor Keim's key findings is that momentum investors must pay much higher transaction costs than other types of investors. Those higher transaction costs aren't due to brokerage commissions, which presumably are the same regardless of whether one is buying a stock that is hot or one that is out of favor. Instead, momentum strategies' higher transaction costs can be traced to bid-asked spreads and the price impact of the trades themselves.

Both of these factors work to the disadvantage of momentum investors because there are so many other investors who inevitably are trying to buy and sell the same stocks at the same time. Lots of investors will want to jump on the bandwagon of a stock that has outperformed the market in the recent past, and by the same token, many will try to jump off the bandwagon of a stock that has been a recent serious laggard. This bandwagon effect not only causes momentum stocks' bid-offer spreads to significantly widen, but also makes it more likely that momentum investors' purchases will occur at or near the offer side of the spread and sales to occur near the bid.

Professor Keim's conclusion? "The returns reported in previous studies of simulated momentum strategies are not sufficient to cover the costs of implementing those strategies." The implication is that momentum traders who invest in mutual funds are being subsidized by the longer-term shareholders in those funds themselves.

The investment morals to draw depend on whether you are a momentum investor yourself. If you are, then you should attempt to exploit momentum through relatively conservative mutual funds rather than individual stocks. And you need to find mutual funds that have no front or back-end load and which do not place any restrictions on relatively short-term trades.

If you are instead a long-term investor who tends more toward the buy-and-hold end of the spectrum, in contrast, you should avoid no-load mutual funds that place no restrictions on short-term traders. Otherwise you will find that your long-term return is lower than it should have been, and that its diminution came from subsidizing the momentum traders.

Mark Hulbert is founder of The Hulbert Financial Digest. He is a senior columnist for MarketWatch.

Comments? E-mail us at online.editors@barrons.com

URL for this article:
http://online.barrons.com/article/SB1162...
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-- posted by SteveT

» SteveT - A Decade After a Big Warning

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HULBERT ON MARKETS
By MARK HULBERT

JEREMY SIEGEL EARLIER THIS WEEK precipitated quite a debate among market theoreticians.

In an op-ed article in the Wall Street Journal, Siegel -- who is a professor of finance at the University of Pennsylvania's Wharton School -- declared that we now have enough evidence to pass judgment on former Fed chairman Alan Greenspan's famous "irrational exuberance" speech.

In that speech, which occurred ten years ago this month, Greenspan expressed anxiety that "irrational exuberance has unduly escalated asset values."

Was Greenspan right to worry? Professor Siegel writes that "the answer is decidedly no."

Consider the data. Over the last ten years, the Dow Jones Wilshire 5000 index has produced an annualized total return of 8.4%, notwithstanding the 2000-2002 bear market. Though in nominal terms this is slightly below the stock market's long-term average return, it's important to note that inflation also has been low over the last decade. In real, or inflation-adjusted terms, therefore, the stock market's return since late 1996 has been right in line with historical norms.

As you might have expected, however, the matter is not quite so easily settled as that. There turns out to be no shortage of market theoreticians who disagree with Professor Siegel's interpretation of what has happened over the last decade. And it's important to understand the source of their disagreement, since the bull market over the last four years has brought the stock market's valuation today back to where it stood when Greenspan voiced his anxiety one decade ago.

What was the source of Greenspan's anxiety? There no doubt were many factors, but it is widely assumed that one of them was a talk that Yale University finance professor Robert Shiller gave at the Fed a few days prior to Greenspan's "irrational exuberance" speech. Professor Shiller reportedly argued that, over the previous 125 years, the stock market's subsequent ten-year returns were well below-average for investors entering the market whenever valuations were as high as they were in late 1996.

Professor Shiller's research, much of which was conducted with Harvard economics professor John Campbell, did not focus on a single valuation measure. But one prominent measure that the two professors employed was a particular form of the price/earnings ratio -- one in which the earnings portion of the ratio represented the average of the previous ten year's inflation-adjusted earnings.

Why did Professors Shiller and Campbell focus on ten-year earnings, rather than the one-year earnings which price/earnings ratios traditionally use? For starters, it turns out that year-over-year earnings are incredibly volatile; another reason, not unrelated, is that P/E ratios based on one-year earnings have only weak predictive power at best in forecasting the stock market's subsequent returns.

But when P/E ratios based on ten-year trailing earnings are used to forecast the stock market's return over the subsequent decade, Professors Shiller and Campbell found an admirable success rate.

Consider a statistic known as the "r-squared," which reflects the degree to which fluctuations in one factor predicts or explains changes in another. The r-squared ranges between 0 and 1, with 1 indicating the highest degree of predictive power and 0 meaning that there is no detectable relationship.

Few of the indicators that the financial press obsesses about have an r-squared that is statistically different than zero, and even among those that are statistically significant, it is rare to find an r-squared above 0.1 or 0.2.

In contrast, the r-squared is around 0.5 when relating P/E ratios based on ten-year earnings and the market's subsequent ten-year return. No wonder that Alan Greenspan was worried in December 1996, since at that time the P/E based on ten-year earnings was higher than 95% of the time since the 1870s.

Note carefully, however, what an r-squared of 0.5 signifies. It means in this case that the P/E ratio based on trailing ten-year earnings explains 50% of the market's return over the subsequent decade. Though fifty percent is a lot better than nothing, it still means that half of the market's ten-year returns can not be explained in terms of where the P/E ratio stood at the beginning of that ten-year period.

It's important to keep this in mind when interpreting the stock market's strength over the last decade. Because no one was claiming that the P/E ratio based on ten year earnings had an r-squared of 1 when predicting ten-year returns, the last ten years strictly speaking don't constitute a disproof of the original analysis.

This was stressed by Professor Shiller in an interview: "We have only one observation of ten-year returns since 1996. One observation is not overwhelming evidence."

To be sure, the stock market over the last ten years was stronger than Shiller and Campbell's model would have led us to expect. So to that extent, the last ten years lessens the r-squared that emerges from the analysis. According to calculations conducted by Clifford S. Asness, managing and founding principal at AQR Capital Management, a Greenwich, CT-based quantitative research firm, the r-squared falls to around 0.32 in the wake of the last decade. That still is higher than the r-squareds that prevail for the vast majority of other stock market models, and is still highly significant.

What does all this mean for the bottom line? It means that we have learned something from the last ten years' experience, but not a lot. On the one hand, if you believed 10 years ago that the stock market is almost always a good ten-year bet, as did Professor Siegel, then you will -- like him -- reach the same conclusion today.

But if you thought the stock market was irrationally exuberant ten years ago, then the last decade is not enough reason to keep you from reaching a similar conclusion now.

As Mr. Asness put it in an interview, "Professor Siegel concludes that, because the market was strong over the last ten years, stocks were not overvalued in 1996. But you could just as easily, if not more easily, argue that valuations were high then, became insanely so in 2000, and are now back to being just as overvalued today as then.

"Unfortunately, in this case, 10 years is way too short a period to draw strong statistical conclusions, and I am surprised Professor Siegel does so."

Mark Hulbert is founder of The Hulbert Financial Digest. He is a senior columnist for MarketWatch.

Comments? E-mail us at online.editors@barrons.com

URL for this article:
http://online.barrons.com/article/SB1165...

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-- posted by SteveT

» SteveT - January's Predictive Powers

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By MARK HULBERT

DOES THE STOCK MARKET take its cues from the month of January?

That's what proponents of the so-called January Indicator believe.

To be sure, there is enough evidence in the historical record to prevent the January Indicator from being dismissed out of hand as a mere random fluke.

On the other hand, there are a number of features of that historical record that raise serious questions about the wisdom of investors betting their portfolios on the January Indicator.

Consider first the evidence in favor of the notion that the stock market's direction from February through December is foretold by its direction in January, as presented in the accompanying table. The data in that table reflect the Dow Jones Industrial Average back to the late 1800s, when this benchmark was created.

When the DJIA in Jan... % of time DJIA gained between Jan. 31 and Dec. 31 % of time DJIA declined between Jan. 31 and Dec. 31 Average DJIA gain between Jan. 31 and Dec. 31
Gained 72% 28% 7.84%
Lost 51% 49% 3.70%

The data presented in the table certainly appear to provide compelling evidence in favor of the January Indicator. But there are a couple of significant qualifications to this overall record that you need to keep in mind.

First: Stark as the contrast appears between years in which the stock market gained during January and those in which it declined, it is only marginally significant from a statistical point of view. That's because there is a lot of volatility in those data. One consequence of that volatility is that we cannot conclude at very high confidence levels that the differences are statistically significant.

A second qualification: Regardless of the significance placed on January's ability to foretell the market's direction over the subsequent 11 months, there are other months that appear to have just as good a record, if not better. April and November stand out in this regard, for example. Yet I am not aware of anyone who is proposing that we have an April Indicator or a November Indicator.

Both of these qualifications, taken together, suggest that the importance investors are projecting onto January is well beyond what can be supported by the data alone.

The story doesn't end here, however. It turns out that the attenuated significance my discussion up to this point places on the January Indicator depends crucially on whether the decade of the 1930s is included in the analysis. If that decade is omitted, then the statistical case in favor of January's forecasting ability grows significantly, while the case in favor of the other months simultaneously declines.

I owe this insight to an academic study called "The Other January Effect1," which was conducted several years ago by three finance professors: Michael J. Cooper of the University of Utah, John J. McConnell of Purdue University, and Alexei V. Ovtchinnikov of Virginia Polytechnic Institute.

Their insight provides a strong temptation to devotees of the January Indicator to come up with rationales for why the decade of the 1930s should be ignored. On the surface, at least, they would seem to have little difficulty doing so, since that was the decade of the Great Depression. But a severe economic downturn does not explain why January may be related to the rest of the year in a different way.

In fact, almost all of the rationales I've heard to explain why the 1930s should be ignored remind me of the Just So Stories that Rudyard Kipling wrote about, things like why the leopard has spots: They sound superficially plausible but don't stand up to much scrutiny.

The most plausible argument I have come across for why we should ignore the 1930s is that the capital-gains tax was not inaugurated until the early 1940s. That tax, the argument goes, might give January a different significance in the years since 1940 than it had in the 1930s.

But Professor Cooper, in an interview, points out that this rationale is not particularly compelling. January had a good forecasting record in the decades prior to the 1930s, in addition to the decades since then. And in those earlier decades there was no capital-gains tax. So its adoption in the 1940s can't be the reason why the January Indicator was a failure during the 1930s.

Are there other rationales that are more compelling for why the decade of the 1930s should be ignored, which in turn would increase our confidence in betting on the January Indicator? I am not aware of any, and Professor Cooper says that he and his co-researchers aren't aware of any either.

The bottom line? The statistical basis for the January Indicator ranges from marginally strong to quite strong, depending on the importance placed on the decade of the 1930s.

Mark Hulbert is founder of The Hulbert Financial Digest. He is a senior columnist for MarketWatch.

Comments? E-mail us at online.editors@barrons.com

URL for this article:
http://online.barrons.com/article/SB1167...

Hyperlinks in this Article:
(1) http://papers.ssrn.com/sol3/papers.cfm?a...
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-- posted by SteveT