About this Blog

Market Correction or Bear?

Sun, 2 Sep 2007 10:08:01 -0400

Do you know the difference between a market correction and a bear market? Do you know when a correction becomes a bear?

Technically speaking a market correction is defined as a market that losses 10 percent or more. From July 19 to August 14 the market tumbled by 9.4% based on the S&P 500 closing prices. Hence technically speaking, the market is not yet in a correction.

Lots of investors claim that it has already reached a market correction because if you count the intra-day highs and lows of the market and not just the closing prices, then the decline in the S&P 500 reached 12% from July 19 to August 16.

So there is some disagreement, but the fact remains that the market dropped by approximately 10%. Since August 16, the market has rallied back, but has yet to return to its previous high. If the market does not rally to its previous high and continues to drop, when would it turn into a bear? Technically speaking a bear market is reached when the market drops by 20% or more.

Based on the S&P 500 index there have been 10 bear markets and 16 market corrections since 1946. Those bears have erased on average nearly one third of the market’s value. The market corrections since 1946 have driven the S&P500 down by about 14% on average.

Taking a longer time horizon: there have been 87 market corrections and 23 bear markets since 1928. Historically, market corrections have lasted only about a third as long as bear markets. The market corrections since 1946 have lasted on average only 148 days.

Since I was born in 1946, I do not have as long an investment record as the shortest one described here, but my records go back more than 20 years and hence allow to reflect on how well I personally sustained market corrections. In the period since I started investing in 1982, there has been only one bear market using the annual returns on the S&P 500. This was in 2002. That year I outperformed the S&P 500 by 6.4%, which still left me with a drop of 15.8% in my portfolio for that year.

There have been three market corrections since 1982, specifically, 1990, 2001, and 2002. My personal records show that I outperformed the market in one, broke even in another and lost against the market in the third.

What is important, besides keeping track of year-to-year market returns in absolute as well as relative terms, is to monitor you overall investment score.

For example, assuming you have been invested for a reasonable number of years, if 70% of the years that you have been investing you are up on average 20% per year, and 30% of the time you have been investing you were down by 10% or less, then your overall investment performance shines compared to many investment managers.

If you keep such statistics – which is quite easy to do in a simple spreadsheet – you will be less worried whether at present we are in a market correction or the beginning of a bear market, because your entire focus will be on keeping your average losses down.

In nutshell, forget what the experts are saying about the markets or where they may be heading; keep you eyes on your own investment score and don’t let any wild swings disturb you track record.

Lester Thurow on a Chinese Century

Tue, 21 Aug 2007 13:51:23 -0400

In Sunday's New York Times, Lester Thurow argued that China is unlikely to surpass the United States in GDP in absolute or relative terns anytime soon. He went as far as claiming that "a Chinese century will be in the 22nd century"; hence in this interesting article he casts doubts about the ability of China catching up with the US in this 21st century. The math behind his reasoning does however not provide a convincing case.

As a starting point Lester Thurow assumes that China's inflation adjusted GDP is $1,000 per capita which would make China at present only a 1.3 trillion economy . This is way below every figure that has been published, even lower than what the World Bank estimates. 15 years ago Larry Summers estimated that the Chinese economy was already at at $3,000 per capita. In December 2005 the Herald Tribune reported that the Chinese economy in 2004 was 2 trillion and the sixth largest in the world. If the Chinese economy in 2004 was 2 trillion then it is closer to 3 trillion or more today. Hence the starting point from which Lester projects the Chinese economy is way off. Dean Baker of the Center for Economic and Policy Research in Washington wrote that China is bigger than Japan's economy and likely to surpass the size of the US economy in less than a decade.

Apart from the starting point Lester assumes that the US will grow in the future at the same rate it has grown in the past 15 years i.e. 3% -- which would be an incredible high growth since we have gone to the most rapid economic expansion ever recorded in US history in just the last seven years--. It would be more realistic to assume that the US will drop to 2-2.5% .

Lester assumes an inflation adjusted growth rate for China of 4% . He gets from 11% nominal to 4% real by taking the 6.5% inflation that was recently reported for select set of products. Even if China's real growth rate is (say) between 7 and 8%, projections starting from a more realistic baseline puts it ahead of the US in about 25-30 years. If you take 3 to 4 trillion economy and grow it at say 7.5% over 30 years (26 to 40 trillion) and you compare that with an 11-12 trillion US economy growing at 3% (more likely 2-2.5%) -- becomes 26 trillion -- then you find that China will bypass the US in the next 25 to 30 years! At least in absolute size.

Lester argues that in absolute terms China will not surpass the US in the next 93 years. If he had used a more realistic baseline he would have found that this claim can not be correct. Whether China is at present the third or fourth largest economy (let stand the second largest) is besides the point. A check against history tell us that it may have taken Japan 150 years to reach standards of living comparable to the US, but it took Korea less than half of that time, it will take China probably half the time it took Korea, e.g. about 30 years.

Now the tricky thing in L.T's article is that he throws in some population projections, which he admits you should never do! He assumes no growth in China (1.3 billion population) and he assumes 1% growth in the US. Even if you take these assumptions 300 million US becomes 384-404 million in 25-30 years. If we apply the same to China (1% growth instead of 0%) then China will have 1.6 - 1.75 billion people in 25-30 years. Both of these projections are however subject to many questions.

Questions not raised in L.T's article is how you account for 1/ the rural areas in China and 2/ the immigration in the US. Are 20-25 million illegal aliens counted in the per capita figures? what growth is projected for rural China? Can a totalitarian system keep population in control (meaning no change to 1 child per family)? Can a democracy really control its borders? Depending on the answers the above population projections may be way off. Zero population growth in China is definitely most unlikely.

L.T.'s entire argument that China will NOT surpass the US thus rests on these kind of speculations, which just like global warming are impossible to predict.

In the 70's working for W.H.O. I recall that we tried to predict the population of Bangladesh. Armed with the best research and tools from Harvard and MIT we projected then that the country would grow from 70 to 90 million; a real catastrophe for a country as poor as Bangladesh. Twenty years later I learned that our wildest projections were 20 million too low and at present population in Bangladesh is not 110 but over 143 million. Lessons learned from real life experience confirms what L.T. suggested, one should never try to make a population projection. Hence, there is nothing one can claim as to relative or per capita accomplishments of either the US or China.

As to absolute measures, the lessons to be learned from this are: check you baseline before you make a projection; base projections on a variety of assumptions; provide ranges and when something sounds like crazy, consider that it just may be crazy (because results could be derived from absurd claims, like an underestimation of the baseline). As for you the reader, never take anything for granted least of all articles in the NYTs or signed by famous economists.

Should you take the week after pill?

Sat, 18 Aug 2007 10:16:40 -0400

The volatility in the stock markets has been huge in the past week. Now that the markets are closed, you got a weekend to reflect on what has happened and decide what to do next…

From early June till the middle of July the S&P500 had been in a trading range between 1484 and 1540. A trading range may be an euphemism in this case for the markets had been zig-zaging. It was difficult to make money, but there was no particular reason to get out of the stock markets. On July 12 the market rally continued and zoomed to 1556. Then on July 18 came a first warning sign: the S&P500 crossed its 10 day moving average and got as low as 1533. On July 24 the S&P 500 crossed its 50 day moving average and went all the way down to 1508. That was a second warning. The third signal came on July 26; a huge drop brought the S&P500 down to 1465.

Assume you missed all three signals and stayed in the market. If you were not into financial or energy and were parked in technology stocks you probably could sustain this relatively minor correction relative to the gains made in the past months.

A week ago on Friday the S&P500 closed at 1453. Then this week it dropped to a low of 1406 and recouped by Friday’s close back to 1445. Simple division tells you that from 1556 to 1406, the market corrected by 10.6%.

“Oh, that is quite normal!” a friend told me last week, "there is no reason to panic" he continued in his usual self-assured voice. He is right, a ten percent correction in a market rally after a decent market up trend is indeed quite normal and not something to panic about. Actually, "panic" is not something anyone in the market should ever do. But then again, I was not talking about "panic", I was merely asking him how he re-assessed the market trends in light of the high volatility.

The day after our conversation, I wrote my friend that he is dead wrong on calling this "a normal correction". Why? As you may have gathered from various articles and radio/TV news programs during the past week, the Federal Reserve has found it necessary on several occasions to put more cash into the market.

On Friday it lowered the discount rate by 75 basis points. The effects of that on consumer and mortgage loans is nil ( if the Fed were to decide to lower the Fed fund overnight rate then interest on loans maybe affected but only after some considerable time...). What the infusion of cash and the lowering of the discount rate does, is it affects the rate at which banks can borrow money from the Federal Reserve and the amount of money banks can count from the Fed on for short periods (all the way from one day to 30 days).

You may also have heart about the unwinding of the "yen carry trade", meaning in simple terms, hedge funds who borrowed in yen and invested in bonds with higher interest rates in the US, Australia etc, are now reversing those investments. This puts more pressure on the markets.

What does all of this mean for you or for us small investors ? What does it mean for those who started to invest just about at the peak of the market? Well, there is Warren Buffet’s rule number one of investing: Don’t loose capital, and rule number two, Don’t forget rule number one. I do not a reminder of Buffet’s rules; when working in the investment department of the world bank, I had a Director, who was, let's put it mildly, "obsessed" with not loosing money. It's hard to forget the valuable brainwashing he provided. Thanks, Bernie!

If you invested your portfolio about at the peak of the market (June/July) -- the worst possible case -- then after a decline of 7% you should have gotten out (because that is one of the ten rules for better investing that have been advocated on this site -- a rule adopted from O’Neil’s 20 rules for investment success --. If you followed this rule you avoided most of last week’s volatility.

If you were fully invested from the beginning of the last market rally, maybe you could let some of your paper gains evaporate, but don’t test this to the extreme. If your paper gains are already cut in half, ask yourself, do you really want to test whether the market will climb up again before all your gains are gone?

What is next? No one knows, least of all the talking heads on TV. The best you can do in the present circumstances, is to be on the sideline, preserve capital, cash is king. Let the markets tell you where they will go next and only when they provide a firm signal that they are back in a rally mode --and confirm that signal maybe a couple of times -- would it be wise to step back in the market.

If you still are 100% invested in the market, your week-end should best be spend reading about market episodes like 2000-2002, 1992, 1987 etc. History repeats itself, is the common belief, but those who do not know history are bound to relearn some hard lessons from history.

Market plunges forces reflection

Sun, 12 Aug 2007 10:55:55 -0400

If you were on vacation all week long last week, you probably came back and wondered: “what has happened”? “did I miss something”? The easy answer is “ not much! “. The market went down, dropped like we have not seen in a long time and yesterday recovered some of its losses. If before going on vacation your portfolio was up about 7 or 8% for the year, it is now probably closer to 2 or 3%, assuming you are mainly invested in the U.S.

If you follow the markets day-in-day-out you might have been differently affected by the market volatility of last week. Maybe, you panicked, got out of some stocks and took some losses. That’s OK, Uncle Sam allows you to deduct those losses from your gains or if you do not have gains that exceed those losses, from your income.

Maybe you did not move an inch and rode the whole market volatility -- what has already happened and what is still to come -- out. Good for you! Market swings of the kind we just experienced ought not to deter you from reaching your goals.

Whatever may have been the case, market plunges forces investors to reflect.
One of those days last week while I was sitting tight and not allowing my “feelings” to get in the way of rational market moves, I went back to my portfolio records and reflected on what I have been doing in the past ten years.

First thing that struck me that I had totally forgotten, was that some ten years ago I was fully invested in dozens of mutual funds. The capital I managed was smaller and the number of holdings then was much, much larger. Two things wrong with this: mutual funds are not cheap investment vehicles and over diversification is no protection against market declines.

As I looked back into earlier years I noted that I shifted from managing one portfolio to a set of smaller portfolios, some of which were trust funds. The advantage here is that with multiple smaller portfolios you can test out alternative strategies. For example, some smaller portfolios were managed over time by extreme concentration (meaning I seldom had more than one or two stocks in those portfolios). It so happens that these smaller highly concentrated portfolios outperformed just about all the others, not by “ a mile or two” but by a huge margin. Concentration on one or two stocks is not more risky than holding a widely diversified portfolio; the risk depends on which two stocks you are holding!

The market drop from 2000 to 2002 caused some serious disruption in everyone’s portfolio although on reflection I noted that the impact on my portfolios was less than the market itself experienced. So bigger storms had been faced in the past.

By 2003 the whole decline from 2000 to 2002 was erased.
Anyone who has been fully invested in the stock markets in the past five years, either in the US or abroad, cannot complain. Some decent returns have been realized since 2003 even if you were not a proactive portfolio manager.

In perspective, the market decline of last week should lead to the realization that markets can on occasion experience great volatility. The key in those periods is to stay “cool”, take losses where necessary, shift money to safe(r) investments, wait out the “storm” and invest in the new opportunities (several of which I described in my earlier article).

The day after the market plunged... new big opportunities

Sun, 5 Aug 2007 15:52:51 -0400

Twenty years ago the stock market dropped by 23% in one day. That was on October 19, 1987. Probably few people remember that day or even those who do, like me, may have erased from their memory what it was like to see so much unrealized gains evaporate in one day. I recall I was up 39% for the year when it happened; by the end of the year only 5% of those gains survived. I had been in the markets for several years but October 19, 1987 was my first big down year. Since then there have been other big down days that I can remember and the more of those you see, the more they look a like. Experience teaches that the key thing to do is to ignore “the water under the bridge”; think and act cool i.e. rationally, not panic; and plan for the next big opportunities.

Unless you were on vacation last week, you know by now that last week was the worst week in the markets in years. NASDAQ, NYSE, S&P500 and the DOW all plunged between 4.2% and 5.6%. Will that be the end of the correction? No one knows, just remember that since 2003 the stock market is up by some 65% and that a normal 10% correction would require some further down drafts; a 33% correction could take away one third of the gains made since 2003.

I read several newspapers this morning in which lots of articles try to rationalize last week’s plunge in various ways. Is that really important? Why it happened or what caused the plunge is great material for journalists (and historians) but does not help you.

Real value added can only be achieved by looking forward, not "rear-view mirror driving". Hence after the close on Friday I screened all listed stocks for those that have EPS rankings greater than 90, relative strength rankings greater than 90, an A or B for sales, profit margin and ROE, an A for accumulation, a current price greater than $15, a stock price within 10% of 52 week high and with current 50 day average volume greater than 300,000. The results were 10 stocks, complemented with five names that I watched closely in the past week which did not suffer from the market plunge. At least two of these five actually made me some decent money last week.

Here is my list of ten that meet all the above criteria: SRCL (Stericycle Inc), ISRG (Intuitive Surgical), VSEA (Varian Semi Equipment Assoc.), FFIV ( F5 Networks), AQNT (Aquantive) TPX ( Tempur Pedic), NILE (Blue Nile), CAM (Cameron), BIDU (Baidu), NOV (Nat. Oilwell Varco). And here are five more that I have kept a close watch on: AAPL (Apple), GOOG (Google), WCG (Wellcare Health Plans), SNCR (Synchronoss Technologies) and OMTR (Omiture).

I let you explore each of these stocks and decide for yourself whether the market plunge of last week is a sufficient reason not to consider buying any of these.