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What's Up With This Market? by John Wightkin, Director of Equity Research Applications, Schwab Center for Financial Research October 13, 2009 Key points
With this behind us, there are many questions. What you should do now? Should you restructure your portfolio? How? Should you stay invested in the market at all? To gain a perspective into these questions, we took a unique look behind the numbers to see what has driven this market rebound and whether these factors can persist going forward. With these insights, you can get a better understand of what's happening to your portfolio. Equally important, you can decide what to do next. Drivers of this rally So what has been driving this rally? Is it growth or value stocks? Small- or large-cap stocks, or perhaps momentum stocks? Or has it been a combination of some these different stock categories? One way to find out is to look at market returns. We divided the market into different groups based on a specific investment strategy and then examined the performance of each of these groups. For example, let's say we want to see if investors are buying value stocks (for example, stocks with the lowest price-earnings (P/E) ratio). By dividing the market into 10 groups based on P/E, we can compare the returns of the stocks in the lowest P/E group (this could be your buy list) to the overall market average. If this lowest P/E group outperforms the market return, we can infer that investors prefer value stocks. For our analysis, we investigated four investment strategies that many investors believe influence stock returns. Table 1 highlights these strategies and the measures we used to define each of them. Table 1: Investment strategies and their explanatory factors
To dissect this market's rally, we broke our research universe, which is the top 1,500 stocks based on market capitalization, into 10 groups (deciles) of 150 stocks each, based on the month-end value for each of the factors in Table 1. For example, for the risk strategy, we sorted the 1,500 stocks by beta, a measure of the volatility of a particular stock compared to the broader stock market. We then put the 150 stocks with the smallest beta into decile 1. The next 150 stocks ranked by beta were put into decile 2. We continued this process until all 1,500 stocks were put into one of the 10 beta groupings. We then calculated the following month's return for each stock and averaged these returns within each group. The excess return is the difference between the group's average return and the average stock return in our universe. We conducted this test monthly from January 1990 through September 2009. To evaluate each strategy's performance during this rally, we focused on the group of stocks that represent the most extreme values. For example, to measure investors' appetite for risk, we examined the returns to the 10th decile from our beta sort which contains the highest-beta stocks. Graph 1 shows the cumulative excess returns to each of the investment strategies from March through September of this year (about the length of this rally). The results Here's what we found (shown in the graph below):
 Source: Schwab Center for Financial Research. Putting returns into a historical context So this rally has been led by high-beta, small-cap value stocks. Surprised? Maybe not, as many market strategists have made similar comments about this rally. What might come as a surprise, however, are the magnitudes of these returns. For this perspective, we looked back over the past 20 years (to December 1989) for similar seven-month cumulative returns. At each month end, we calculate the cumulative excess returns for the previous seven months. We chose seven because it is the duration of the current market rebound. We then counted the number of times each investment strategy had a seven-month cumulative return equal to or greater than the returns from this rally. (For the momentum strategy, we counted the instances where the seven-month cumulative return was less than or equal to the current return.) Table 2 displays these results. Surprised now? You should be. These results show just how extreme the current returns are. In fact, the current average return to the value strategy has never been this extreme. The next closest returns were in 2001 when the most undervalued stocks had an excess cumulative return of close to 28%, about half of the today's cumulative return. The highest-beta stocks had only one other occasion with similar returns—right before the internet bubble popped. We all know what happened to these stocks afterward. The small-cap outperformance has occurred several times in the past, mostly during the economic recovery in 2002. Finally, the magnitude of the recent sell-off of the stocks with the highest price momentum has only occurred twice before, both right after the internet bubble popped and investors aggressively sold all the recent winners. Table 2: Number of periods with similar returns between 1990 and 2009
Moving ahead How can these insights help you going forward? As we've shown, rarely have there been returns like these in the past. Knowing this, we believe it's highly improbable that the market continues to rally on the backs of these current drivers. Should no other factors take over (e.g. high-earnings growth or large-cap stocks), this rally might run into difficult times ahead. From a portfolio standpoint, this might be a good time to sell some of your winners, especially the higher-beta stocks, and move into less-risky, higher-quality stocks. Keep in mind, stocks could continue to go higher bucking historical precedent. With any new purchases, you might want to lean towards the lower-beta stocks that have done the best during the past 12 months. Schwab’s Stock Screener can help you screen for these types of stocks (see Take action box at the top right-hand corner). Schwab Equity Ratings can also help with the rebalancing. Consider selling the best-performing D-rated and F-rated stocks and buying A-rated stocks with low betas. Again, the Stock Screener can help you find these opportunities. Important Disclosures Schwab Equity Ratings use a scale of A, B, C, D and F, and are assigned to approximately 3,000 stocks headquartered in the United States and certain foreign nations where companies typically locate or incorporate for operational or tax reasons. Schwab's outlook is that A-rated stocks, on average, will strongly outperform, and F-rated stocks, on average, will strongly underperform the equities market during the next 12 months. The information provided is for general informational purposes only and should not be considered as an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Past performance is no guarantee of future results. (1009-10468) Return to Top |
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