Bogus Effect

This time of year, we often find ourselves reading about the "January Effect," which is sometimes described as a predictable way to forecast returns, and sometimes as a way to know whether this is, or is not, a good year to invest and make some money.

Unfortunately, most of this reporting is nonsense.

Let's start with the predictable part. Wouldn't it be nice if, even for just one month of the year, we

could know whether the market is going to go up or down? That's what market pundits are implying in their January Effect reporting: that markets have a strong tendency to rise in January. Why? The explanation, first offered in 1942, is twofold:

1) Stock investors tend to harvest their tax losses at the very end of the year, selling any stocks that happen to be below the price they paid for them, and, of  course, claiming the loss on their tax returns. This selling activity depresses the prices of stocks generally in late December (Why do we not hear about a negative "December Effect?"), but when those investors buy back into the market in January, the additional buying demand pushes up prices.

2) Mutual funds, who are the biggest stock investors, have to report their holdings as of the end of the year. If they made an embarrassing mistake and purchased a stock which subsequently dropped like a stone, the portfolio manager engages in an exercise known as "window dressing:" she conveniently sells that stock right before December 31, and then reports a portfolio that doesn't include the losing investment. This is a great way to prevent reporters from asking pointed questions about what they might have seen in that dog stock when they purchased it in the first place. And it makes it look like, despite what might have been poor performance throughout the year, the fund is strangely only invested in stocks that went up.

Of course, the cash position is only temporary; the fund will put the money to use in January. Just like the tax harvesting activity, these sales in December and purchases in January, we are told, have a wind-at-the-back impact on share prices in the first month of the year.

So why is this nonsense? Back in 1942, and for some years afterwards, it might have made sense to do all your tax loss harvesting once a year as the holiday decorations were being taken down at the malls. Today, with modern software tools, professional investors can check daily to see if there are portfolio losses they can harvest, so the buying and selling is spread out through the year. Also, today's mutual funds report the contents of their portfolios quarterly, rather than annually, so the window dressing activity (which still goes on), happens each fiscal quarter, rather than all at once at the end of the year.

Moreover, a quick glance at history suggests that returns in the month of January have been pretty random for this century's investors. The S&P 500, in the calendar month of January since January 2000, has delivered returns of -4.18%, +6.45%, -2.12%, -5.87%, +2.04%, -1.73%, +0.89%, +1.53%, -4.74%, -11.37%, -5.22%, +1.12%, +2.77%, +2.44% and -0.77% last January. If you can see a pattern there worth betting on, chances are you're also a genius at the racetrack.

The other January Effect says that if stocks rise in January, they will be up for the year, and if they fall in January, then the market will deliver losses through December. Of course, any time you give the market a head start in either direction, there will be a slight tendency for the rest of the year to follow suit--similar to if you saw an Olympic sprinter break out of the blocks ahead or behind the pack, you would notice a tendency to finish ahead or behind. Not a guarantee, you understand, but a tendency.

Looking at the historical record, when stocks finish the first month down, they finish the year down 58% of the time--almost exactly what you would expect within the statistical probabilities of randomness. Researchers have actually determined that--probably also due to random factors--the returns in September have historically been the best predictor of returns for the year as a whole.

The truth is, none of us have a way to predict even a week, much less a month or a year of market returns. Whenever we read about the Super Bowl winner predicting the market, or the month of January or September or the winning party in the Presidential election, we should recognize that the article is being written purely for entertainment, giving us a chance to fantasize that, somehow, we can, for a moment, know the unknowable future and maybe even profit from it.

A YEAR TO REMEBER!

The U.S. stock market punctuated an extraordinary year with gains on the last trading day, moving many of the American indexes to record highs on the final trading day for only the sixth time in history.  Despite all the uncertainties that we faced (the government shutdown, Boston bombings, the ongoing Syrian uprisings, debt ceiling debates, NSA revelations, the lingering economic aftershocks of superstorm Sandy, nuclear standoff with Iran) people will look back at 2013 as one of the most profitable years for investors on record.

The Wilshire 5000 index--the broadest measure of U.S. stocks and bonds--rose 33.07% in calendar 2013, with 10.11% of the gains coming in the final three months of the year.  The comparable Russell 3000 index gained 33.55% in 2013, posting 10.10% returns in the final quarter.

Large cap stocks, represented by the Wilshire U.S. Large Cap index, gained 32.33% this past year, with 10.22% gains in the fourth quarter.  The Russell 1000 large-cap index returned 33.11% for the year, up 10.23% for the last quarter, while the widely-quoted S&P 500 index of large company stocks gained 29.60% in 2013, with 9.92% returns in the year's final quarter.

The Wilshire U.S. Mid-Cap index index rose 36.78% in 2013, buoyed by an 8.69% rise in the final quarter.  The Russell midcap index was up 34.76% for the year, with 8.39% gains in the final three months of the year.

Small company stocks, as measured by the Wilshire U.S. Small-Cap, gained a remarkable 39.01% for the year; 9.10% of the returns came in the final quarter.  The comparable Russell 2000 small-cap index rose 38.82% in 2013, posting an 8.72% gain in the year's final three months.  The technology-heavy Nasdaq Composite Index gained 38.32% for the year, after posting 10.74% gains in the last quarter of the year.

By any measure, these returns were remarkable.  The S&P gains were the highest since 1997, and the 3rd highest since 1970.  The small cap returns are the 3rd highest since 1980, and the Nasdaq returns were the seventh-highest ever.  What makes the year even more remarkable was that nobody was predicting a rampaging bull in 2013, and many economists and pundits didn't think returns like these would be possible.

If anything, the five-year gains since the market downturn have been even more extraordinary.  The Wilshire 5000 has posted an average 18.58% gains over the last 60 months, and the midcap (23.08%) and small cap (23.86%) indices have fared even better.  Investors who got out of stocks during the market crisis of 2008 and worried ever since have missed out on one of the best 5-year bull market runs in American history.

IS this a bull market?  Commentators, investment strategists and economists don't agree on whether we are experiencing a temporary rise in the midst of a long-term bear market, like we experienced during the Great Depression, or the strong early stirrings of a long-term bull like the one which started in 1982.  The truth is, nobody knows, just as nobody knew that the U.S. stock markets would reel off such strong returns after the near-collapse of the global economic system.

Long-term investors can be compared to farmers, who plant seeds with no foreknowledge of the weather during their growing season, and no belief that what happened this year has any impact on what will happen in the next one.  There will be bad years, and good years, but over time, the good years have tended to outnumber bad ones, which is why it makes economic sense to continue planting the seeds each Spring--or staying invested in the stock market when each coming year is a mystery. 

Around the world, the harvest was mostly excellent in 2013, even though returns lagged the booming U.S. market.  The broad-based EAFE index of developed economies rose 19.43% in dollar terms in 2013, aided by a strong 5.36% return in the final quarter.  European stocks were up 21.68%, giving them a strong year despite the constant threats of sovereign debt default and internal trade imbalances. 

Emerging market stocks were a very different story.  In 2013, the EAFE Emerging Markets index of stocks in Latin America, the Middle East, Eastern Europe, Africa, India and Russia was down 4.98% for the year, despite a 1.54% rise in the year's final quarter. 

Other investment categories also lagged their long-term averages.  Real estate, as measured by the Wilshire REIT index, gained just 1.86% for the year, after a modest 0.83% drop in the last three months of 2013.  Commodities, as measured by the S&P GSCI index, experienced a price collapse, losing 26.73% in 2013.  Gold investors, meanwhile, experienced the precious metal's worst annual loss in 32 years, dropping 28% in value over the past 12 months. 

Bond yields remain low by historical standards, but a slow rise in rates caused bond holders to experience paper losses.  Investors in the Barclay's Global Aggregate bond index lost 2.60% in 2013, and 2.02% in the U.S. Aggregate index.  Investment grade corporate bonds are currently yielding an aggregate 3.87%.

In the Treasury markets, 10-year bonds now yield 3.03%; 5-year bonds are yielding 1.74%.    

What's next?  Who knows?  Long-term, stocks tend to reflect the overall growth of the economy.  One possible reason why so many investors remain nervous about stocks is the persistent--and erroneous--belief that the U.S. economy is still mired in a recession.  You hear words like "sluggish" in the press, but in fact, the total output of the American economy has grown steadily since the 2008 meltdown, and the pace of growth seems to be accelerating.  The Bureau of Economic Analysis statistics show an annualized increase of 4.1% in the third quarter of last year (the most recent period for which we have statistics), following a 2.5% rise in the second quarter.

Other economic signs are also encouraging.  Total corporate profits rose $39.2 billion in the third quarter, following an increase of $66.8 billion in the second.  Individuals and corporations are carrying less debt than in the past; total public and private debt in the first quarter of 2010 was up above 3.5 times U.S. GDP; today it stands at 1.07 times GDP.  U.S. home prices recently posted their largest one-month rise in more than seven years, and some markets have seen housing values reach their pre-recession levels. 

Even so, many investors will continue to wait on the sidelines, looking for "proof" that the market recovery is finally for real, while others will keep their money from working on their behalf in expectation of a crash.  The former will finally get back in when prices have peaked, and will, in fact, be our most reliable indicator that the market has become overvalued.  The latter will miss the next downturn, but also lose out on the positive returns that have, historically, outweighed the losses suffered in bear markets.  The past five years have given us a useful lesson: that you plant your seeds in the expectation that there will be bad crops from time to time, but these unexpected booming years will more than make up for the losses.

The Federal Reserve Taper Begin

The Federal Reserve Board has made its long-awaited announcement that it will begin to scale back ("taper," in Wall Street language) its QE3 stimulus program.  The last time the Fed even mentioned starting to taper back, last fall, global stock markets and bond investors panicked and sent the markets reeling.  Now, the Fed says that instead of buying $85 billion in Treasuries and mortgage bonds per month, it will only buy $75 billion, and more cuts will come as the economy continues its recovery and the jobless rate continues to fall. 

With this announcement, markets went up and investors cheered.  Japan's Nikkei index reached a six-year high, European markets soared and U.S. stocks finished the day at new record prices.

Does any of this make sense to you?

The so-called "taper," and the QE3 stimulus program itself, are somewhat unique in the history of investment markets.  To understand QE3, imagine that at the auctions where investors buy government bonds and packages of home loans, a bidder nine times the size of Gargantua shoulders everybody else aside and insists on paying higher prices (and, therefore, receiving lower interest) than any of the other bidders.  The Fed's stated goal was to stimulate the economy by driving interest rates lower, making it less expensive for large and small businesses to borrow money, so they can build factories, expand their capacity and hire more people.

The problem with this stimulus effort was two fold:

1. Many American corporations were already sitting on tons of cash, and have little need to borrow if they really wanted to go on a building and hiring spree.  The companies in the S&P 500 index reportedly have a record $1.5 trillion in their coffers, up 14% this year alone.  Add in the money stuffed under the mattresses of some smaller companies, and the total may exceed $5 trillion. 

2. The Fed kept interest rates so low that banks did not want to loan money to small businesses and/or people who did want loans.

The Fed's mortgage purchases probably did make mortgage rates a bit cheaper for home buyers, but it's hard to tell how much.  The day after the announcement, 30-year Fannie Mae mortgage rates were up 0.01 percentage point, at 4.42%.  That's higher than the low of 3.31% in November of 2012, but still very low by historical standards.

Savers and long-term investors should breathe a sigh of relief that the Fed is finally easing out of the investment business.  Why?  For one thing, it means that economists at the Federal Reserve Board believe the economy is finally in a self-sustaining recovery mode. 

For another, it means the end of uncertainty.  When investors are unsure what to expect, they tend to expect the worst. Which is why you will read articles saying that the taper could cause interest rates to skyrocket leading to some problems with the value of ETF & mutual fund bond investments currently owned by investors. But admittedly by early indications, no such thing is happening right now, and you can bet that Fed economists are monitoring the situation and will try to nip any such problems in the bud.

At the same time, we can expect interest rates to go up over the next few years. This could be a problem for some bond ETF or mutual fund holders, but it is great news for older Americans who have been living on CD interest rates that are barely higher than what they would get if they stashed their retirement money in a cookie jar. 

For the economy as a whole, there is still plenty of cash to lend to any company that wants it if it becomes profitable to do so, housing is still more affordable than it was before the 2008 meltdown, and inflation is still currently stubbornly lower than the government's preferred target rate. All in all we are ending 2013 on a great note. However, I will personally be moving into 2014 with a little caution.

Behavioral Finance

One of the most interesting areas of financial research these past ten years has come, oddly, not from economists or investment researchers, but psychologists, who are pioneering a branch of study known as "behavioral finance."  This has led to one of the strangest sights in the history of Nobel prizes: the 2002 prize in economics handed out to psychologist Daniel Kahneman for (according to the Nobelprize.org website) "having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty."

The behavioral finance research tells us that most people take mental shortcuts to arrive at decisions, and some of them lead to odd conclusions.  Around the time you make your New Year's resolution to lose weight, do you buy a $500 annual membership to a gym or opt for a $10 per visit pay-as-you-go fee?  Most people who choose the former end up actually going to the gym less than once a month; the flat fee is only a bargain when you assume that the bold post-resolution intention will actually happen, but it's often a terrible deal when a person's actual behavior is taken into account. 

How do you decide whether to be an organ donor when you face the option on your driver's license application?  In countries where the default option is yes (you consent to be an organ donor), 90% of individuals happen to be registered organ donors.  In countries where the default option is no, the percentage ranges from 10% to 30%.

This research is now finding its way into the hands of policy makers, who are pioneering a new governmental role of protecting you against the dangers of your own mental shortcuts.  One recent example is automatic enrollment in a company retirement plan.  Research shows that if people are required to affirmatively opt-into having a portion of their paycheck sent to their 401(k) retirement plan, they will do so at a lower rate (67%) than if they are enrolled by default and have to affirmatively opt-out (77%).  The U.S. government has been encouraging auto-enrollment policies at American corporations, on the theory that workers will be better off if more of them are making regular 401(k) plan contributions.

Another example in Britain came when the government offered tax incentives for people to insulate their attics, reducing energy consumption and the associated pollution from energy production.  But so few people showed an interest in the incentives that the UK government finally had to switch tactics.  It offered the same tax break, but added a loft clearance service that would help people clean out their attic and give them assistance in disposing of (sell or throw away) unwanted items.  The new service tripled insulation participation rates. 

When the city of Copenhagen painted green footprints on the sidewalks leading to  litter bins, littering decreased by 46%.

The idea of applying behavioral economics to political and social initiatives sounds a lot like manipulation to its critics, who worry that we are moving toward a "nanny state" where the government feels compelled to protect us from our own behavioral biases.  Reducing litter on the streets of Copenhagen is relatively noncontroversial, but what about initiatives that try to influence buyers to select more energy-efficient cars?  Or government policies that discourage the consumption of certain foods or beverages?  The New York City ordinance against large soda containers was based on the assumption that people were unable to recognize, on their own, the health risks of soda consumption.

Interestingly, at least one of these behavioral initiatives is now showing evidence of backfiring.  The Center for Retirement Research at Boston College found that companies that have switched to automatic enrollment in their 401(k) plans have been paying for the additional cost by giving their employees smaller employer matches--3.2%, compared with an average 3.5% for plans without automatic enrollment.  At the same time, the Boston College researchers and the Vanguard organization have found that for some workers, the automatic savings rate offered in the default is lower than what many workers would have chosen if they had made an affirmative decision to participate.  Worse, the automated mix of investments (typically target date funds) that is the default option has underperformed the investment mixes that workers have tended to select on their own.  For some workers, at least, the government's behavioral finance nudge will cost them real money.