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Predictions vs Statistics

Posted on: April 21, 2012 |

In this report:

We look at the recent market returns and look at predictability of returns for 2012.

We are asking you to please take an independent survey.

We look at how a small percent of stocks influence market performance.

Barron’s magazine warning and other foibles.

The song pick for 2012?

 

The First Quarter of 2012

This year started off with a bang. The markets worldwide had generally positive returns. Even Greece (plus 7%) and Ireland (plus 12%) got into the plus return column. The big winners were Germany (up almost 18%), Pakistan (plus 20%), Russia (plus 19%), and India (plus 13%). The S&P 500 index rose close to 12%.

Some markets pundits have opinions that we have gone too far too fast. Others say this is the start of something great. Historical analysis reveals that past first quarter performance does have some bearing on the return predictability for the remainder of 2012.

During the past 55 years (the S&P 500 index originated in 1957) there have been eight other years whose first quarter returns were better than what we just experienced. Those eight years had an average 16% first quarter return, nearly twenty five percent higher than first quarter 2012.­

In every one of those eight years, except the big October market meltdown year of 1987, the markets continued adding positive returns. Even 1987 ended up nearly 6%. Excluding 1987, the average return for quarters two through four was slightly over 10%, and the average annual return for those seven years, excluding 1987, was nearly 27%. If we include 1987, the average return was just a tad over 24%.

We know that many factors influence market performance on a day to day basis and that market opinion-casters can hand pick any data to back their bias. Statistics, not opinions, are at least in our favor. During the past 55 years there has not been a losing year when the first quarter was up greater than 3%. The historical bias is toward the upside!

 

Please Take the Survey

In 1981, three years after I started the business, I conducted a client satisfaction survey. There were fewer clients then and I came up with some dozen questions, a space for a comment, and sent them out with a return envelope. I hoped for some responses that would help guide the direction of the business. The result of that survey was the basis of our operating as a partnership with our clients. You indicated that you wanted someone you could confide in and who would be there for you. We built the firm slowly on modest personal capital and there was no outside factor or loan payments driving our decisions, just what we believed was best for you.

Now we are undertaking a “strategic review” run entirely by an independent outside firm. The firm is Advisor Impact. They will be putting together a questionnaire, mailing (or emailing) them to you and they will analyze the results and give us a report. You’ll have the opportunity to express a preference for keeping your comments either anonymous or having them attributed to you.

The reason for this survey is you. We want to close any gaps in our services to you. We care about your feedback and especially what is important to you. We want to serve you better. Normally only about 20% of folks who are surveyed ever respond. With Advisor Impact, the response rate jumps to 40% and we ask you to please take that percentage higher.

The survey will begin sometime this quarter. In future newsletters we’ll share with you what we learn about serving you better.

 

Market Performance Influenced by a few Stocks

The following graph ought to scare the pants off the active stock picker or active stock picking mutual fund manager. Perhaps this is why the overwhelming majority of individuals and fund managers don’t beat the indexes. The graph shows that only a few outperforming stocks account for a disproportionately large share of the US market’s total return in a given year. From 1926 to 2011, the broad US stock market provided a 9.6% compound average annual return. If the top/outperforming stocks were excluded, the market’s return would drop to 6.2% annualized. Excluding the top quartile (the top 25%) of outperformers each year would reduce the market’s average annual return to a negative 0.7%. Since it is impossible to reliably identify winners before the fact, the most prudent approach is to maintain broad diversification and consistent exposure across asset classes. This improves the likelihood that a portfolio will capture the outperforming securities.

2012 Q1 Quarterly Report and Commentary april2012-page-002

Why We Don’t Believe Press Predictions

“And you thought 2011 was tough?” So went the headlines in December as media and market pundits, reflecting on a miserable year, saw no respite for investors in 2012. But markets have a funny way of confounding expectations. That’s why we don’t rely on news reports to drive our investment decisions.

To be sure, the reasons to be anxious were piling high as the year turned, with European politicians dithering over how to tackle a tottering mountain of sovereign debt, policymakers in the US running short of options, and emerging markets not providing the cushion that many investors had hoped for. The general view, as expressed through the media, was that there would be more muddling through in early 2012. “Buckle up!” warned the respected Barron’s magazine. “For investors frightened by the stock market’s volatility in the past six months and tired of worrying about places in Europe once given little thought, 2012 promises scant comfort—at least in the first half.”1

Europe was the epicenter of concerns for much of the past year, has jumped out of the blocks in 2012. The Euro Stoxx 50 was up by nearly 12% over the first two months of the year, with the German market rising by close to 20% in US dollar terms.

The renewed buoyancy extended to Asia, where the MSCI Asia Pacific Index has registered ten consecutive weeks of gains, its longest uninterrupted winning streak since 1988, and powered by strength in energy stocks. Australian stocks have firmed as well, to be up 12.5% year to date in US dollar terms—although in local currency terms, the gain has been less stellar at just over 7%.

Why the change in mood? There are several catalysts for the turnaround in markets so far in 2012.

First, by the end of last year, market participants were discounting a lot of bad news, including a couple catastrophic scenarios. Fears of mass defaults in Europe and a possible breakup of the euro were seen as entirely possible.

While Europe can hardly be described as being out of the woods yet, the agreement by creditors on a new round of official funding for Greece has eased nerves, as has the European Central Bank’s provision of another half-trillion euros in cheap funding to financial institutions.

Second, there have been signs of a turnaround in the US economy, at least compared to the view the market was taking a few months ago. At that time, another recession was seen to be in the cards. Since then, data has shown an improvement in the labor market, a rise in manufacturing orders, and a climb in consumer confidence.

Third, central banks are pumping out massive amounts of cheap cash—essentially printing money—to provide liquidity to the financial system and to support the recovery. As well as the ECB’s latest cash injection, Japan and Britain have recently extended their so-called “quantitative easing” programs, while China has cut the reserve requirements for its banks.

Of course, just as it was wrong to extrapolate the pessimism of last year into 2012, it would be foolish to forecast that the rest of this year will resemble the first two months in tone. No one knows how markets will perform going forward, because that requires an ability to forecast news. You can always guess, of course, but we tend to think that’s not a sustainable investment strategy.

The point of this is to highlight the virtues of discipline and the tendency of markets to absorb news very, very quickly and to look forward to the next thing. Unless you know what the next thing will be, you are wise to stay in your seat.

1. “Buckle Up!” Barron’s, December 19, 2011.

 

The Song Pick for 2012

Sometimes we have a musical theme to our quarterly report. Last quarter it was, “What a Diff’rence a Day Made.” I’ve been humming several tunes based, in part, on the first quarter positive economic news.

What I’m not humming is The Wall Street Blues. The first phrase, “They took your money and your shoes and now you’ve got the Wall Street Blues” just doesn’t fit, we don’t believe, the current national mood.

The theme from Rocky which is Trying Hard Now, with only 30 words in the lyrics, starts out “Gonna Fly Now” That may be overkill! We would prefer a slow grinding longer term advance than a pulsing, surging explosion in the market.

Happy Days Are Here Again was written in 1929 and was later adopted by the Democratic party as their unofficial song. It was also thought by many to reflect the joy of the people due to the repeal of prohibition. We choose to express neutrality in the political arena and are definitely not promoters of alcohol consumption.

For now, a song by Bobby McFerrin from 1988 is the song of the day and expresses our outlook for 2012, Don’t Worry Be Happy.

We wish all of you a most enjoyable Spring.

 

John, Derek, Dawn, & Sue

 

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