Why Good Things Sometimes Happen After Bad News
- Created on Monday, 07 July 2014 11:27
Larry Swedroe
One of the secrets to being a successful investor is the ability to keep your head during a bear market while everyone else around you is losing theirs. To do that, you have to understand that bad news doesn’t necessarily mean stock prices will fall.
While this may sound strange, it’s important to understand that whether news is good or bad is totally irrelevant to stock prices. Failing to grasp this basic truth causes investors to become overenthusiastic when news is good, and panic when news is bad. To be a successful investor, you need to understand that what really matters is whether the news is better or worse than what was already expected.
The market price already reflects all publicly available information. When the market is down because the news has been bad, the market can be expected to keep falling only if future news is worse than anticipated. But if future news is no worse than expected, you’ll earn high returns resulting from low valuations. And even if future news is not good, but it’s still better than expected, valuations will rise as the risk premium demanded by the market begins to fall. That’s often how bull markets begin.
The latter scenario is exactly what happened after March 2009. In general, news on the economy since March 2009 hasn’t been very good. We’ve had the weakest recovery of the post-war era. But we also didn’t get the second Great Depression that many had feared and even predicted. So, the market has improved, albeit slowly, not because economic news has been great but because it has been better than many expected.
The following illustration is another great example of why it isn’t the news itself that matters, but whether that news comes as a surprise.
For the commercial real estate industry, 2010 was miserable as mortgage defaults multiplied. In 2008, just 1 percent of commercial loans were delinquent. In 2009, the default rate jumped to 6 percent, and in 2010 it rose again to 9 percent.
Given that horrible news, you might have expected that investors in commercial mortgages would suffer greatly. You might also have expected that investors in equity investments in real estate (REITs) would suffer as well.
Yet despite the dramatic increase in defaults, 2010 was a great year for investors in commercial mortgages as prices soared. Junior AAA-rated bonds went from 30 cents on the dollar to almost par (or 100 cents on the dollar), and equity investors enjoyed the more than a 28 percent rise in the Dow Jones U.S. Select REIT index.
The contrast in this case between the growing default rate, rising value of commercial mortgages and the great returns on REITs seems contradictory at first. The explanation is that prices rose because the default rates, while bad, weren’t nearly as bad as the market had been expecting.
The following historical examples from my first book, “The Only Guide to a Winning Investment Strategy You’ll Ever Need,” will help you learn how to think about good and bad news.
Good news, bad results
On February 4, 1997, after the market had closed, Cisco Systems (CSCO) reported that its second-quarter earnings had risen from 31 cents per share in the prior-year period to 51 cents, an increase of 65 percent. Certainly, no one would suggest that a rise in earnings of that magnitude is bad news. Yet, Cisco’s stock price fell the following day from its prior close of just over $67 to $63, a drop of 6 percent. The market’s reaction to what otherwise seems like good news reflects that investors were anticipating a greater increase in earnings than Cisco reported.
Bad news, good results
A similar phenomenon occurs when a company’s stock price rises after a “bad” earnings report. For example, the day IBM (IBM) released its earnings for the second quarter of 1996, its stock price rose 13 percent. Based on that, one would have thought IBM had announced spectacular results. However, its earnings were down about 20 percent from the same period of the prior year. The stock rose because the market was expecting IBM to announce far worse results.
The bottom line is this: If you want to be a successful investor, you must understand that surprises are a major determinant of stock performance, and by definition surprises are unpredictable. It’s also important to note that happy surprises are just as likely as unhappy ones. In the end, you’re best served by ignoring the news altogether because acting on it is likely to prove counterproductive.
This commentary originally appeared June 18 on CBSNews.com.
Copyright © 2014, The BAM
My Take: In Honor of the World Cup, a Look at Goaaals!
- Created on Monday, 07 July 2014 11:21
Neal Merbaum
Meet Ben, the CEO of a fictional company. One day, he calls his employees into a conference room for a meeting and starts to assign tasks. “Mark, start typing a letter. Marge, create a spreadsheet. Frank, organize a team.” And so on. But Ben doesn’t tell anyone why they’re doing these things or identify the goal.
Most would agree that Ben's actions don’t make much sense.
Now meet Rose, a software developer who just inherited some money and wants to invest it. She understands that it’s good to be diversified, meaning one should invest in both domestic and foreign stocks and in safe bonds. She also understands that she should consider her risk tolerance. She's not sure exactly how much risk she’s comfortable with, but she’s read that she should invest her age in bonds and the rest in stocks.
So she opens an account and buys some domestic and foreign stock index funds (she knows enough to stay away from actively managed funds!) and some low-risk bond funds. Rose has been pretty thorough, right?
Wrong! Rose left out a huge piece of the financial puzzle: her goals. Without identifying her financial goals, Rose is investing the way Ben manages. Just as Ben needs to know what he wants his employees to accomplish in order to give them the proper tasks and direction, Rose needs to know what she wants her investments to accomplish so she can structure her portfolio to meet her objectives.
If you don’t want to make this mistake, then before you develop your investment plan:
- Identify your goals. Typical goals include saving for retirement, leaving money to heirs, funding college for kids or grandkids and leaving money to charity and
- Prioritize your goals. Goals compete with each other. For example, the more you spend in retirement, the less you will have for another goal like leaving money for the next generation. Decide what’s most important.
- Be specific. "Having enough money for a good retirement” is a worthy goal, but it’s not specific. Add some details, and the same goal could look something like this: "I want to retire in 10 years with after-tax income of $60,000 a year in the first year and adjusted for inflation after that.”
Once you’ve identified and prioritized your goals, you’re on your way to constructing a portfolio that will give you the best chance of meeting those goals. Just like a soccer team needs goals to succeed, so does your financial plan!
Copyright © 2014, The BAM
Did You Sell in May?
- Created on Monday, 30 June 2014 12:40
by Larry Swedroe
One of the more persistent investment myths is that it is a winning strategy to sell stocks in May and then wait to buy back into the market around November. The oft-repeated catch phrase is, "Sell in May and go away."
Well, this year if you sold your stocks in May, you would probably have lost out on some nice gains. The S&P 500 rose from 1883.68 to 1923.57 last month, an increase of 2.1 percent. And that doesn't include the impact of any dividends.
Of course, the real test of the sell in May theory requires five more months. I ran some numbers looking at returns from May through October in recent years.
I found that while it is true that stocks have provided greater returns from November through April than they have from May through October, since 1926 it has still been advantageous to stay invested in stocks from May through October. In other words, selling in May and going away hasn't been a good strategy.
In fact, from 1927 through 2013 the Sell in May strategy has underperformed the S&P 500 by more than 1.5 percent per annum. And that's even before considering any transactions costs, let alone the impact of taxes (you'd be converting what would otherwise be long-term capital gains into short-term capital gains which are taxed at the same rate as ordinary income).
The table below shows the returns of the S&P 500 Index for the last five May-October periods, a period when Treasury bills provided almost no return at all.
Note that the average return for the five six-month periods was 5.4 percent, an annualized return of about 11 percent, or greater than the S&P 500's annualized return from 1927 through 2013 of 10.1 percent.
Given this year's 2.1 percent May increase in the S&P 500, what does the rest of the six-month "Sell in May" period? Unfortunately, my crystal ball, as always, is cloudy.
I do know, however, that the most basic tenet of finance is that there's a positive relationship between risk and expected return. To believe that stocks should produce lower returns than Treasury bills from May through October you have to believe that stocks are less risky during those months -- a nonsensical argument.
Copyright © 2014, The BAM