Investors: How to handle this downturn ... and prepare for the next
WEST LAFAYETTE, Ind. What's a battered investor to do in a volatile stock market that has left many investment and retirement portfolios in ruins?
Nothing, say two Purdue University finance professors, if you plan to keep your money "working" in the market for 10 to 20 years.
"You especially shouldn't try to time the market," says Michael J. Cooper, assistant professor of management at the Krannert School of Management. "You do, however, need to hold stocks that will do well in recessions."
Cooper says what tends to do well in recessions are value stocks, precisely those depressed-price, stodgy Old Economy industrial, materials and consumer-product companies that investors jettisoned during the technology run-up of the past several years. But the point is not to add value stocks when the market turns down. You need to have these stocks in your portfolio all the time, says Raghu Rau, also an assistant professor of management at the Krannert School.
"In any year, there are 10 to 15 days that account for almost all of a stock's returns," he says. "If you try to time the market, you'll miss those days and outsmart yourself."
Growth stocks do well in expansionary times when value stocks do worse. The lesson for investors: Diversify, diversify, diversify. A simple diversification method, says Cooper, is to put one-third of your holdings into S&P 500 stocks or funds, one-third in value funds and one-third in international stocks. Rebalance your portfolio annually to keep the 33 1/3 percent diversification, but don't chase the market.
"For the long-term investor, the concept of 'flight to safety' that television commentators talk about is a bad idea," Cooper says. The point for the canny investor is to buy and hold both growth and value stocks and mutual funds all the time, not to jump in and out given a day, a week or even a year's worth of news, Cooper says.
There is an curious mystery in value stock investing, though. Cooper says in both the academic literature and plain old logic, value stocks' going up in recessionary times is counterintuitive. Why should beaten-down stocks do well when the economy heads south? Shouldn't the value stocks do even worse in bad times?
The answer is no. They do better.
"In many cases, value stocks are small companies whose share prices have gone way down," Rau says. "You can look at them as being undervalued, especially compared to their high-flying technology and communication brethren, because the value stocks are closer to bankruptcy.
"But given macroeconomic forces such as a credit crunch or a drop in consumer spending, value stocks tend to bounce up."
Cooper runs the numbers. "In expansionary periods, value stocks gain an average of 0.37 percent per month relative to growth stocks. But in contractionary periods, they gain 0.85 percent per month relative to growth stocks."
Rau says a very practical reason to hold value stocks is that people get laid off in recessions. A one dollar gain means a great deal more for a laid-off person with a portfolio of $5,000 than the dollar gain in a $50,000 portfolio in good times.
There are simple and subtle indicators when the markets are making transitions from expansionary to recessionary investment environments. Still, the experts counsel the way to play the market is to buy and hold.
Take for example P/E (a stock's price compared to earnings) ratio strategy which says to buy stocks when the market's P/E is below the historical P/E average. When the P/E is above average, buy bonds.
The long-term results: This strategy underperforms a buy-and-hold approach by 1,000 percent.
Finance professors also do fancy regression studies that show how big and small stocks react given various indicators, such as U.S. Treasury bond yields, as well as esoteric measures such as Fama-French factors, t-statistics and R-squares. And, indeed, these measures do function as fairly reliable indicators of the future behavior of stocks.
The rub? "Just because you can predict what is going to happen with different types of stocks does not mean that you are not taking on more risk," Cooper says.
Rau says the reason is that you cannot predict changes in the macroeconomic environment in which stocks exist. In lay terms, it goes back to the futile effort of trying to time the buying and selling of stocks in a marketplace that has an economic mind of its own.
"The pros mutual fund managers, analysts and hedge fund managers can't time the market," Cooper says. They may beat the market for a quarter or a year, but the research shows there are very few persistent winners over time. There are, however, losers.
"It is perhaps an anomaly that while no one can consistently beat the market over time, there are many investors who consistently underperform the market," Rau says.
Sources: Michael J. Cooper, (765) 494-4438, firstname.lastname@example.org
Raghu Rau, (765) 494-4488, email@example.com
Writer: J. Michael Lillich, (765) 494-2077, firstname.lastname@example.org
Purdue News Service: (765) 494-2096; email@example.com
"Investing in size and book-to-market portfolios using information about the macroeconomy: some new trading rules"
Michael Cooper, Huseyin Gulen and Maria Vassalou
We propose new trading strategies that invest in size and book-to-market (B/M) decile portfolios. These trading strategies are based on a forecast model that uses mainly business-cycle-related variables as predictors. Extensive out-of-sample experiments show profitable predictability in the returns of the decile portfolios. In particular, the proposed strategies outperform passive investments in the same deciles, as well as SMB- and HML-type of strategies. A key characteristic of the proposed strategies is that the long and short positions can be invested in different decile portfolios across time. This is in contrast to the traditional SMB-and HML-type of strategies that always go long and short on the same portfolios. Active strategies that involve the market portfolio, SMB and HML are examined. A significant level of predictability is identified for SMB. Our results suggest that time variation in SMB and HML is linked to variations in aggregate, macreconomic, nondiversifiable risk. Thus, our results most closely support a risk-based explanation of SMB and HML.