Does dollar cost averaging really work better in a volatile equity market?

Say that your equity market outlook assumes that one of two scenarios is true.  Either:

1. You expect equity markets to be volatile over the next 10 years or,
2. You are convinced that neither you nor anyone else knows what equity markets are going to do over the next 10 years!

but you still expect equities to outperform other asset classes over this term.

In this kind of environment a program of drip-feeding funds into the market makes sense as most research seems to suggest that market timers usually do worse than a more unemotional dollar cost averaging process. 

What is dollar cost averaging?

Dollar cost averaging refers to the process of investing the same amount to some regular timescale. When the price of the equities is low you will acquire more, and when high you will acquire less.

It may seem obvious, but is still worth stating, that dollar cost averaging essentially delays investing, which means that broadly as prices tend to rise over time this may reduce your returns…

Dollar cost averaging however itself has two problems aside from the implied delay element:

1. There are transaction costs
2. Can it be automated?

Transaction costs of dollar cost averaging

Ostensibly the transaction costs do not seem that high. You can download a very simple Excel model where you can put your own portofolio figures in here: Dollar cost averaging share purchases transaction costs.  

On the basis of $150k portofolio spread out over 10 sectors asset allocation sectors, with 10 trades per sector (100 trades in all), at $32 per trade (eTrade’s costs in Australia to private investors) you are looking at a transaction cost of around 2.13% on the whole portfolio using a dollar cost averaging strategy in establishing your portfolio:

Can you fully automate dollar cost averaging?

In an ideal world many time-poor private investors would prefer to set up a plan in advance e.g. ‘complete my dollar cost averaging plan over the next 2 years’, for example.  

This raises the question of whether share purchase orders set ‘at market’  or ‘at best’ can be poorly priced, whether deliberately or accidentally by the broker?

The short answer is the jury is out …. there didn’t appear to be any easily identifiable research and presumably it differs on a broker by broker basis.

However a common-sense approach might suggest that low liquidity shares with bigger bid/ask spreads might be more at risk of mispricing than broadly traded shares or ETFs.   

Know better? Comment below.

Posted under investment strategies, market timing

In the old (pre-internet) days to create a market rumour you actually had to go to the trouble of making a phone call to a broadsheet journalist. As a university prank we rang a major newspaper’s Property columnist, told him we were from the (fictitious) “Real Estate Institute” and did he know if there was any truth to the market rumour that there was a Sheikh in town with $200m to spend on property?

Unsurprisingly (because we’d just made it up) he didn’t know if there was any truth to it but that didn’t stop him printing it prominently the following day, “the real estate scene is abuzz with the rumour that there is a Sheikh in town with $200m to spend on some property acquisitions…” (I have no idea whether or not that benefited someone flogging property over the succeeding couple of weeks, if it did please forward me a cheque care of this blog). 

[PS Don’t try this sort of thing at home, it’s too easy to succeed, and probably illegal into the bargain.]

These days you don’t need to even get someone on the other end of a phone. Last Monday you could watch the internet equivalent of  this sort of rumour-mongering playing out in the blogosphere and email world and it’s interesting to take a closer look at how the rumour spread and why.

The Rumour

On Wednesday I received the following item forwarded by email:

“Monday, April 20, 2009
Stress Test Results Leaked

Posted by [name omitted] at 8:08 AM
Turner Radio Network out with a shocker on what they claim are the leaked Stress results. We paraphrase:

The Turner Radio Network has obtained “stress test” results for the top 19 Banks in the USA.

The stress tests were conducted to determine how well, if at all, the top 19 banks in the USA could withstand further or future economic hardship.

When the tests were completed, regulators within the Treasury and inside the Federal Reserve began bickering with each other as to whether or not the test results should be made public. That bickering
continues to this very day as evidenced by this “main stream media” report.

The Turner Radio Network has obtained the stress test results. They are very bad. The most salient points from the stress tests appear below.

1) Of the top nineteen (19) banks in the nation, sixteen (16) are already technically insolvent.

2) Of the 16 banks that are already technically insolvent, not even one can withstand any disruption of cash flow at all or any further deterioration in non-paying loans.

3) If any two of the 16 insolvent banks go under, they will totally wipe out all remaining FDIC insurance funding.

4) Of the top 19 banks in the nation, the top five (5) largest banks are under capitalized so dangerously, there is serious doubt about their ability to continue as ongoing businesses.

5) Five large U.S. banks have credit exposure related to their derivatives trading that exceeds their capital, with four in particular – JPMorgan Chase, Goldman Sachs, HSBC Bank America and
Citibank – taking especially large risks.

6) Bank of America`s total credit exposure to derivatives was 179 percent of its risk-based capital; Citibank`s was 278 percent; JPMorgan Chase`s, 382 percent; and HSBC America`s, 550 percent. It gets even worse: Goldman Sachs began reporting as a commercial bank, revealing an alarming total credit exposure of 1,056 percent, or more than ten times its capital!

7) Not only are there serious questions about whether or not JPMorgan Chase, Goldman Sachs,Citibank, Wells Fargo, Sun Trust Bank, HSBC Bank USA, can continue in business, more than 1,800 regional and smaller institutions are at risk of failure despite government bailouts!

The debt crisis is much greater than the government has reported. The FDIC`s “Problem List” of troubled banks includes 252 institutions with assets of $159 billion. 1,816 banks and thrifts are at risk of failure, with total assets of $4.67 trillion, compared to 1,568 institutions, with $2.32 trillion in total assets in prior quarter.

Put bluntly, the entire US Banking System is in complete and total collapse.

More details as they become available. . . . . .” 

Spreading a Rumour

There were two other interesting features about the email aside from the fact that it took two whole days (!) to get to us.

Email Your Market Rumour

Firstly, my contact had had this email to him on Tuesday by a large investment banking house which I won’t name whose employee noted that “I am sharing this not to create undue panic but simply to let you know what is out there right now” and who also noted that he was sending this to his “valued clients and friends”.

One could argue that in a sense it’s this professional investor’s job to send round stuff like this if it, a) creates a reason to do a trade (!) and b) to let his clients know what rumours are doing the rounds in the rest of the market. Of course one could also argue that there is a bunch of people out there who could also use the those relatively unknown tools available like Google to check  the truth of what they’re disseminating.

The second thing that I thought was interesting was the speed this rumour spread at and how it spread.  In email terms there were already 3 headers from three different on-forwarders on the version of this story I sent.  Assume, for example, that each person in those 3 ‘layers’ forwarded it to 10 people then that’s 1000 individuals (10 X 10 X 10). Clearly some would have not forwarded it at all and some might have forwarded it to more or less than 10 but you get my drift (and it makes the math trivial).

Blog Your Market Rumour

Bloggers receiving this email unaware (maybe) or at least not bothering to check what was on the web just posted it verbatim on their blogs (actually they had been sent by email the full text of a blog post that was already up). In what NPR’s must-listen-to “On the Media” refers to as the “echo chamber of the blogosphere” it spread quickly, with on Wednesday there being about 96 web pages posted repeating the item verbatim, and when I did this search today (Saturday) there were 441 web pages repeating it. If you’re familar with Google you will also realize that Google’s PageRank system regards a link as a ‘vote’ for the importance of a website (whether your link actually says “here’s a bunch of crap” or “hey look at this item I think is a permanent and unique truth”).

So if you’re trying to spread a bear market rumour you need to realize that a blog post may not be enough: you really need to use email as a mechanism to get it out there (because bloggers reading the email may assume that the item is only being circulated by email and therefore that if they post it quickly on their blogs they may be amongst the first to break it on the web).

What Makes a Market Rumour Work

The best kinds of rumours ride the concerns already out there. This rumour was probably helped by two things: Bank of America’s results happened to also come out on Monday and they weren’t good (a 41% leap in non-performing assets) and of course the general concerns swirling around about banks anyway.

The best kind of spam also circulates effectively because it references an ‘authoritative source’.  The ‘Turner Radio Network’ from the email sounds pretty authoritative doesn’ t it?

Well errr… actually it’s totally unrelated to Turner Broadcasting and as is a blog run by a guy called Hal Turner and hosted using Blogspot’s free hosting service (I’m not going to link to it because PageRank does what it does and I’d merely be driving more traffic to it).

A $527m Market Rumour

Mr Turner himself seems to have been pretty impressed with the results:

“When the U.S. Stock Markets opened, Bank stocks were immediately impacted by folks spreading my report. Bank stock values plunged by eleven percent within 6 minutes. On the S&P 500 alone, bank stock values plunged by about $527 million dollars.”

 And he’s not alone on this anway: CNBC notes that the “Select Sector SPDR Financial ETF was down 5.4 percent after the blog post was widely disseminated by at least two third-party news services” and that a Treasury spokesman actually had to publically say the Treasury didn’t have the Stress Test results.

On one point it looks pretty clear Mr Turner is right, a good market rumour spread by people who don’t fact check carries its own momentum. As he noted on Monday night:

“Sorry guys, but whether the Turner Radio Network has the real results or not is no longer material.”

If you’d read this item from Mr Turner and immediately gone out and shorted US bank stocks (and maybe even forwarded it along ,and filed it a few times yourself as comments on articles on prominent financial sites) you also wouldn’t care whether it was right or wrong.

Posted under investment strategies, market timing

I received this in an email this morning – don’t know where it originated but it is a good laugh with more than a grain of truth in it.

“I am going to leave you with 21 reasons to buy some beaten up equities.
1.        Good news is taken as bad news (the market is totally glass empty)
2.        Every guest on CNBC is talking about buying US T Bills at record low yield
3.        Every other guest on CNBC is talking about buying gold at a record high (in A$)
4.        Marc Faber was just on CNBC
5.        CBA, the strongest bank in the world right now, struggles to get a placement away at a 15% discount despite the fact they bought a good asset very cheaply from a distressed seller
6.        Volatility is unprecedented
7.        Hedge Funds are massive forced sellers of everything
8.        Central Banks and regulators are pumping more liquidity than at any time in history
9.        Cash rates are going sharply lower; cash will be an underperforming asset class
10.        Equity risk premiums are enormous meaning that real investment risk is low.
11.        The credit markets have bottomed
12.        Fear is the no.1 investment factor
13.        Every headline in the mainstream press is about the equity market
14.        The coffee shop guy kindly asked me today “Charlie are you ok?”
15.        We are all addicted to CNBC: ie we are all focused on the extreme short-term.
16.        Commentators who have predicted 10 of the last 2 recessions are all over the press
17.        Main St now gets we have a problem (ie it’s a known known)
18.        Stocks and currencies are being sold irrespective of fundamentals
19.        The Oil price is down $62 from its high.
20.        Inflationary pressure is dead
21.        Even my Labrador is bearish”

Posted under market timing

When is it worth stepping back into the US market as a foreigner (in a broadly diversified drip-feed way)? With the S&P 500 now sitting 50% below its peak you could be forgiven for thinking there might be a bargain out there.

Here are some things it might be worth taking into account:

• market valuations
• currency risk
• appropriate indicators like risk aversion 
• average length of recessions

Not on this list are technical indicators – apologies, basically we are not amongst the true believers.

Market Valuations on the S&P 500

Market valuations on the S&P 500 had it on a forward concensus PE of around 12 at the end of September putting it around 11. Since then it has dropped another 10%+ (end of September S&P 1099, today Oct 9th  984). However some estimates have it on a forward basis of 15 or even 19 or higher (at the $48 a share earnings estimate mentioned in this article on the Big Picture blog) on the basis that analysts have been known to be over-optimistic about earnings …

15 actually might well be the long run average but in previous recessions PEs have actually got down to 10 (see this article to see historical PE fluctuations) implying a further fall might be entirely possible.

Currency Risk on US Equities

One would think that in the medium term the $700 billion bailout last week is not good news for the US dollar (for example, it will represent a 24% increase in the 2008 US Federal Budget):

“total government commitment and proposed commitments so far in its current and proposed bailouts is reportedly $1 trillion compared to the $14 trillion United States economy” [Wikipedia]

 However in the short term there has been a flight to US dollars in relation to UK sterling and Australian dollar by around 12% and 30% (!) respectively (it is likely the A$ has been punished by the fall-off in commodity prices as well as general risk aversion).

At the risk of trying to predict the future of currencies (a mug’s game as everyone from Warren Buffett to your neighbour Frank can tell you) one would have to wonder when the immediate perceived risk related to bank solvency starts to decline whether the $US is in for a fall – essentially this bailout has given everyone a new reason to dislike it.

How risk averse are equity investors at the moment?

Very averse … The VIX volatility index aka ‘the fear gauge’ which measures the cost of options hit a record high yesterday (Oct 8th) and this kind of VIX level has previously been associated with market bottoms.

Average Length of Recessions

The ‘average’ recession is about 12 months but on the plus side it does seem that recessions have become both less frequent and milder (see NBER study information in previous link). Is the current credit squeeze different – almost certainly – but equally there are many other things that are different in 2008 as well, ranging from technology to world trade.

The ‘Bottom Line’ – buy the S&P 500 now or wait?

At the moment I am inclined to wait. Mainly because I would like to see the US dollar come off a bit as opposed to any other reason. However the other indicators are looking pretty positive. It is of course impossible to pick the exact bottom but if you were within say 15% of the bottom in 2002 you still would have been up 50% within say two and a half years.

Posted under index trackers, market timing

Having recently lived through the most dramatic trading week in living memory, it seemed like a good time to revisit the impact on long term performance of trying to time the market. Looking at the long term performance of the main investment indices of both the US and the UK stock markets produce similar conclusions.

The compound average annual return of the FTSE from June 1986 to June 2008 was 10%. If you missed the 10 worst days during this 22 year period, your annual compound return would have risen to 13%. A study of the S&P 500 from 1979 to 2004 shows an even more dramatic impact. If you missed the worst 10 days investing the in S&P 500 during this 25 year period, your annual compound return would have risen from10% to 38%!

If you were wise enough to look around you during the last couple of years and realise that booming global economic growth based on the apparently infinitely deep pockets of US consumers was unsustainable, congratulations! Perhaps you were even clever enough to reduce your exposure to sky high asset valuations in both property and equities. In which case you are already well on the way to achieving a much better return than those who believed the party would last forever!

But… even if you believe as I do, that we are at the beginning of a nasty global recession which may last 3-5 years, and which will see substantial rises in unemployment and slowing economic growth from Los Angeles to Beijing, it does not pay to wait for the young green shoots of economic growth to emerge before reinvesting in the equity market.

If you missed the 10 best days of the FTSE during the 22 year period from 1986 to 2008, your annual compound return would have fallen from 9.8% to 7.4%. If you missed the 10 best days of the S&P 500 during the 25 year period from 1979 to 2004, your annualized return would have fallen from +10% to -10%.

Cleary these are idealistic scenarios and nobody gets it right all the time, but given that Thursday 18th September was one of the worst market days in living memory, it’s probably fair to assume it will turn out to be one of the ten worst days this decade. For those brave or crazy enough to buy as the lemmings jumped, Friday 19th September turned out to be one of the best market days in living memory! The FTSE 100 closed up 8.8% – the biggest daily gain in its 24 year history.

Yes, the global crackdown on short sellers was no doubt a catalyst, and the $700 billion dollar promised “temporary asset relief programme” bailout by US Treasury Secretary Paulson had a dramatic impact on short term sentiment. Nevertheless I’m willing to bet that starting to buy on the dips will turn out to be a great long term strategy.

It usually pays to be contrarian. Global markets are likely to fall further and will bounce along the bottom for some time. But with global valuations some 25% below where they were a year ago, the risks have subtly shifted so that there’s probably now more to lose by being out of market than being in!

Posted under market timing

With the problems at Merrill Lynch, AIG, and collapse of Lehmans, there will be some people who have been sitting on the sidelines in cash who may think this is a bleak enough moment to start dribbling cash into the market.

This is not one of those ‘on the one hand & on the other hand’ articles in that I spent 10% of my SMSF cash holdings today on buying 3 (fairly poorly researched) index trackers, but as someone noted to me this evening it is easy to want to get back in too quickly (the possibly apocryphal example given was that of JP Morgan who waited from 1929 to 1939 to start buying again).

The same person noted that that ASX index had now fallen from 6800 to 4799 but that the next support level was at 4200 (confession: I neither believe in or understand charting in anything but a rudimentary sense when it comes to equities).

There was some muttering about if we hit 4200 we would be in for “10 years of poor returns”.

‘Typical bear markets’ fall 25% and that is where we are now in most major markets.

So I went looking today for poor performing markets over the last couple of years where I could start to nibble at low cost index trackers, which had gone on to fall even more after the weekend’s events.

I ended up buying small holdings in 3 iShares trackers that just happen to be in Asia that have not performed very well over the last 5 years and have fallen even further over the last few days (the charts are for the underlying indices and not the tracker):

I am even tempted increasingly by the S&P500 which got to 1500 last year and is now sitting 20% lower just below 1200 (back where it was in 1998!) but wonder if there will be another US dollar fall that might be a better entry point given that I am not a US resident (the USD is up 10% against the $A in the last few weeks).

Posted under index trackers, market timing