Sunday, February 14, 2010

Who's afraid of a sideway market?

George Soros appeared on the Bloomberg interview recently giving his economic outlook. He thinks the shape economy should look like an inverted square root --

"In 2010 there might some (recovery)... Whether you have a recovery depends on how deep you go. I think that for the US economy... What I expect is an inverted square root sign. In other words, you hit bottom you automatically rebound some. But then you don't come out of it in a V shape or anything like that, but you settle down.. Step down."

I'm in an opinion that we are going for a strong V shape recovery. The biggest premise is the government will quickly rush in for another round of stimulus the moment financial markets showing weaknesses or job markets are not recovering.

However, assuming I'm wrong, we are going for a stagflation that causing the market going nowhere. What should be the investing strategy? Legg Mason has an interesting piece: Who's afraid of a sideway market?

The key points was stock pickers are the winners, growth-based strategy will do OK but momentum players and passive index investors the worst. Click on this link on the detail of their arguments

We decided to study the behavior of the last sideways markets after recalling the exceptional investment performance generated between 1975 and 1982 by Warren Buffett at Berkshire Hathaway and Bill Ruane at the famous Sequoia Fund. Over these seven years, the book value of Berkshire Hathaway and the net asset value of Sequoia Fund generated cumulative total returns of 676% and 415%, respectively, and average compound annual returns of 34% and 28%, respectively. Remember, Buffett and Ruane were not traders. They bought and held outstanding companies.

Our Research Team examined the performance of the 500 largest stocks in the stock market between 1975 and 1982, and what we discovered surprised even us.

When we looked for doubles--stocks that increased in price by more than 100%--we found that, on average, 3% of the 500 largest stocks doubled (or more) over the course of any calendar year. Put differently, on average, only 16 out of 500 stocks doubled in any one year. When we extended the time horizon to rolling three-year periods, we found that, on average, 18.6% of the stocks doubled; 93 out of 500. When we extended the time horizon to rolling five-year periods, the results were eye popping. On average, an astonishing 38% of the stocks went up more than 100% or more; that’s 190 out of 500.

Momentum strategies work best once the direction of the market has been established. Momentum strategies also are closely aligned with investor sentiment. In sideways markets, sentiment sloshes back and forth largely because the trajectory of the economic recovery is unknown. At times, the data may indicate the economic recovery is gaining strength, leading to a short blast in stock prices, only to be followed by weak economic readings which causes sell-offs. In this environment, momentum investors find themselves constantly whipsawed.

So…..who should be afraid of sideways markets? With no long-term trend in place, it will be tough for momentum investors to produce sustainable profits. Index investors could also be in for a rough time. If the price of the index is little changed in the coming years, the most index investors can hope for is a paltry 2% annual dividend.

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