The Market's Response to Crisis

By Arianna Capital

This slide shows performance of a balanced investment strategy following a few historical crises. Each crisis is labeled with the month and year that it occurred or peaked. The subsequent one-, three-, and five-year annualized returns start from the first day of the month following each crisis.

Although a global investment strategy would have suffered losses immediately following most events, the financial markets recovered over time, as indicated by the positive three- and five-year annualized returns. Negative events such as these may tempt investors to flee the financial markets. But diversification and a long-term perspective can help investors apply discipline to ride out the storm.

Composition of the Normal Balanced Strategy:

Index Percent
S&P 500 Index 12%
Fama/French US Large Cap Value Index 12%
Fama/French US Small Cap Index 6%
Fama/French US Small Cap Value Index 6%
Dow Jones Wilshire REIT Index 6%
Fama/French International Value Index 6%
International Small Cap Index 3%
International Small Cap Value Index 3%
MSCI Emerging Markets Index 1.8%
Fama/French Emerging Markets Value Index 1.8%
Fama/French Emerging Markets Small Cap Index 2.4%
Merrill Lynch One-Year US Treasury Note Index 10%
Citigroup World Government Bond Index 1-3 Years (hedged) 10%
Lehman Brothers Treasury Bond Index 1-5 Years 10%
Citigroup World Government Bond Index 1-5 Years (hedged) 10%

Japan Quake Shows That Thoughts Should Be on Those Affected, Not on Investment Plans

By Larry Swedroe

The images of the devastation caused by the earthquake in Japan have been nothing short of shocking and heart-wrenching. My thoughts and prayers go out to those affected by this tragedy.

While I certainly don’t want to minimize or trivialize the magnitude of this situation, the economic impact of such as occurrence is something that must always be considered. The response from the global economy has been swift. As the Wall Street Journal noted, “Global companies in industries ranging from cars to technology started trying to assess the impact of the giant earthquake in Japan as operations were disrupted.”

Overwhelming crises like this happen far too frequently and are obviously unforeseen. These types of events are why Joseph Mezrich noted that, “Surprise is a persistently important factor in stock performance.” You can’t specifically plan for such an event to occur, knowing that you need to get out of the stocks of European reinsurers, which have been taking a significant hit on fears of losses resulting from the quake.

What you can do is plan for these types of events — whether they’re environmental like this one, political like the situation in Libya or economic like the situation in Greece last year — by diversifying your portfolio according to your plan and sticking to it, no matter how nervous the images in newspapers and on TV and the Internet may make you. You can also make sure your plan addresses the things you can control:

* The type and amount of risk you take
* The diversification of those risks
* The costs and tax efficiency of your portfolio

Then, you can stop worrying about how this will affect your investments and start thinking of much more productive, helpful and fulfilling things, such as how you can help during a tragedy like this.

Why Scary Announcements Are Great for Your Portfolio

By Larry Swedroe

One of the basic tenets of investing is that investors must be offered risk premiums to invest in riskier assets, as most investors are risk averse. The larger the risks, the greater the premium demanded. Thus, it would stand to reason that risk premiums should be even greater on days when stock markets are facing greater risk. Thanks to a recent study, we can see that this, indeed, appears to be true.

While some information about the economy arrives randomly over time, certain important macroeconomic news is released on regularly scheduled preannounced dates. While you may not have a crystal ball telling you what the news will be, you do know the announcement dates. Given the potential for surprises in the information, it would seem logical that the risk of investments will be higher around announcements — and investors will therefore demand a premium for taking increased risk. In other words, expected returns should be higher on announcement days.

The authors of the study “How Much Do Investors Care About Macroeconomic Risk?” studied the period from 1958 through 2009 and found that the evidence is consistent with economic theory. The following is a summary of their findings:

* On days when big news such as inflation, unemployment or interest rate numbers are announced, the average U.S. stock market returns and the Sharpe ratio are significantly higher.
* The average announcement day excess return is 0.11 percent versus 0.01 percent for all the other days — a figure statistically indistinguishable from zero.
* While announcement days make up just 13 percent of trading days, they account for more than 60 percent of the cumulative annual equity risk premium.
* Despite the significantly greater risk premium, the volatility of daily stock market returns is only 4 percent higher on announcement days.
* The Sharpe ratio is 10 times higher on announcement days.
* Even Treasury securities are affected by major announcements. Treasuries with maturities over one year behave similarly to the stock market, with higher excess returns, similar volatilities and significantly higher Sharpe ratios on announcement days.

As theory would suggest, the authors also found that the risk-free rate is lower on announcement days. The average holding period return on 30-day U.S. Treasury bills is 0.015 percent on announcement days, while it averages 0.017 percent on all days. Once again, the evidence is consistent with theory.

The authors concluded that “that the major component of the equity premium is compensation for exposure to news about the state of the economy: macroeconomic risk.” While this finding shouldn’t be surprising, what is surprising is both the magnitude of the risk premium on announcement days and the 10-fold improvement in the Sharpe ratio. The data seems to be telling us that investors have an incredibly high aversion (virtually implausible) to the risk of surprises in economic data.

The bottom line is that this study provides clear evidence that the winning strategy is to stop worrying about bad news coming on announcement days. This is especially true during bear markets — when investors fear and panic become prevalent emotions — when the already-large risk premium increases much more. And since any surprises will be incorporated into prices virtually instantaneously, you’re better off not “tuning in.” That will allow you to instead focus your attention on things that actually add value.

The next time you’re tempted to sell before the announcement of economic data — either because you fear a negative surprise or you were alarmed by an economist’s forecast — keep the evidence from this study in mind.

The Current Aftershock

By David Booth

Using an illustrated timeline, David Booth chronicles US stock market performance in four periods since World War II. His review suggests prevailing market sentiment is often wrong and that investors must stay disciplined through all market environments to pursue their long-term goals.

Who Can Market Time?

By Weston Wellington

New York Times columnist Jeff Sommer, acknowledging recently that he found himself in a "buoyant mood" due to the steady rise in stock prices, sought out someone with a gloomier assessment of the financial markets to provide a counterweight to what he feared could be excessive optimism.

He turned to Robert Prechter, a veteran market analyst who has published The Elliott Wave Theorist in Gainesville, Georgia, since 1979. As Mr. Sommer reported last week in the Times, Mr. Prechter's investment outlook is "as bleak as an ice storm." Based on his interpretation of cyclical wave patterns that he discerns in both financial markets and "social moods," Mr. Prechter believes the current rally is only a minor upswing within a much larger, longer, and punishing downtrend that will "lead the unwary to ruin."

Market forecasters are often accused of doubletalk, couching their predictions in such convoluted language that they can later claim success regardless of the outcome. At least there is little doubt where Mr. Prechter stands—he sees disaster ahead and has been saying so for quite a long time.

In an earlier interview with the New York Times in July 2010, Mr. Prechter suggested the US stock market had entered a decline of "staggering proportions" that would likely see the Dow Jones Industrial Average—9686 at the time—fall well below 1000 over the next five or six years. Although the Dow has surged over 27% since that time to close at 12391 on February 18, Mr. Prechter is unperturbed and argues that the outlook is "much more dangerous today than it was last summer."

Perhaps Mr. Prechter will be proven right. But if not, he appears to have ample reserves of both patience and conviction. If his grim vision of deflation and depression sounds familiar, it should—he was making similar arguments in his book At the Crest of the Tidal Wave, first published in 1995.

Mr. Prechter has made some prescient market calls in the past—notably in the 1982–1987 bull market—but success since that time has proved more elusive. If only we could determine when to follow the advice of a market soothsayer and when to ignore it, we could be exponentially wealthier. But timing the market timers appears to be no easier than timing the market itself.

Dollar's Reserve Currency Status and Your Investments

By Larry Swedroe

There’s a lot of talk about the dollar being replaced as the world’s reserve currency. Understandably, many investors are wondering what this would mean for the markets. Fortunately, we’ve seen this before, and everything turned out fine.

It seems like almost every day investors are bombarded with news that scares them. The current list is extensive:

• The continued high rate of unemployment (and even worse, the extremely high rate of underemployment, with many workers so discouraged that they have left the labor force and are no longer counted as unemployed)
• The continued weakness in housing prices
• The crisis with our national debt and the inability of Congress to act to reduce the deficits by taking on the big problems of entitlements
• Iran and/or North Korea saber rattling
• The contagion of crises spreading across the Middle East

Among the reasons that many investors have been scared off of U.S. stocks is all the talk about the U.S. losing its status as the world’s reserve currency. On Wednesday, the Financial Times reported that China had sold billions of dollars in U.S. Treasury bills for the second month in a row. The article also reported that Russia had pared its Treasury holdings for the second month, down to $106 billion from $122 billion.

It seems like this is the latest in a long string of stories and reports about dethroning the U.S. dollar as the world’s main reserve currency. For example, in June 2010, the United Nations released a report calling for abandoning the U.S. dollar as the main global reserve currency, saying it has been unable to safeguard value. The report received support not only from Russia and China, but also from Nobel Prize-winning U.S. economist Joseph Stiglitz.

In November 2010, China and Russia announced they’ll renounce the U.S. dollar and resort to using their own currencies for bilateral trade. China also announced plans to boost cross-border yuan-denominated trade with other countries 10-fold to 20 percent of total trade to reduce reliance on a few reserve currencies.

Then this month, the International Monetary Fund issued a report on a possible replacement for the dollar as the world’s reserve currency, saying that Special Drawing Rights, or SDRs, could help stabilize the global financial system.

If you’re like most investors, you’re probably nervous about how all this talk of replacing the dollar as the world’s dominant reserve currency will affect your investments. And the forecasts of doom and gloom from various gurus contributes to the stress you may be feeling. Fortunately, we actually have historical evidence that suggest that the best thing is to stop worrying and just stick to your plan — which as readers of this blog and my books know is almost always the best advice.

I first discussed the dollar’s status as the world’s reserve currency nearly two years ago. I noted that prior to the dollar taking that role, the British pound was the world’s reserve currency, a status it lost shortly after World War II. Not only that, but Britain’s industrial capacity was devastated because of the war. Given these conditions, you’d think that U.K. stocks would have done poorly relative to U.S. stocks. And you’d be dead wrong.

We have data on the FTSE All-Share Index going back to February 1955. From February 1955 through December 2010, the FTSE All-Shares Index returned 10.9 percent, outperforming the S&P 500 Index, which returned 10.0 percent.

There’s almost always bad news sufficient to scare investors. And the last two years have certainly provided their share. However, despite all the bad news and the plethora of crises, equity markets around the globe have provided spectacular returns since the bottom was reached in early March 2009. Unfortunately, because of the prior bear market and all of the continuing problems, many investors missed all or most of the rally, as it wasn’t until late in 2010 that equity mutual funds began to experience net inflows.

The great tragedy is that investors persistently make the same mistakes, like selling after periods of bad performance (when expected returns are higher) and buying after periods of good performance (when expected returns are lower). Buying high and selling low isn’t exactly a prescription for investment success. The best way to avoid making that mistake is to have a well-developed plan and stick to it, ignoring the clarion cries from the gurus, who don’t know what they don’t know.