Market Returns in 2007, Changing Growth/Value, US/Int'l, SmallCap/LargeCap

2007 Stock Market Returns
Returns from December 29, 2006 to December 28, 2007:

1. DIA: [US]: Dow Jones Industrial Average ETF: +9.05%
   
2. $NDX: [US]: Nasdaq 100 Index: +19.93%
   
3. $COMPQ: [US]: Nasdaq Index: +10.73%
   
4. SPY: [US]: S&P 500 ETF (Large Cap): +5.06%
   
5. MDY: [US]: Midcap 400 ETF (Mid Cap): +8.04%
   
6. IWM: [US]: Russell 2000 ETF (Small Cap): -1.91%
   
7. EFA: [Int'l]: Developed International Market ETF: +10.64%
   
8. EEM: [Int'l]: Emerging International Market ETF: +34.96%
   
9. IVE: [US]: S&P 500 Value ETF: +0.17%
   
10. IVW: [US]: S&P 500 Growth ETF: +8.55%
    
11. IJJ: [US]: Midcap 400 Value ETF: +0.96%
    
12. IJK: [US]: Midcap 400 Growth ETF: +13.15%
    
13. IWN: [US]: Russell 2000 Value ETF: -11.08%
    
14. IWO: [US]: Russell 2000 Growth ETF: +7.42%
    

Observation 1: 2007 International Returns Trounce US Domestic Returns

The Returns of International Markets, including those from the Developed World (mostly Western Europe, Japan, and Australia) and the Emerging Markets (including China, Brazil, Russia, Mexico, India, Taiwan, South Korea) are doing much better than the US markets. The Emerging Markets (EEM) have done much better than the Developed International Markets.

Observation 2: Outperformance of International Markets is Part of a Multi-Year Trend

The outperformance of International markets, especially Emerging markets, is part of a multi-year trend, where Globalization is a key trend.

1. 2007 US SPY (S&P 500 ETF) Return: +5.06%
   
2. 2006 US SPY (S&P 500 ETF) Return: +14.70%
   
3. 2005 US SPY (S&P 500 ETF) Return: +5.13%
   
4. 2004 US SPY (S&P 500 ETF) Return: +9.04%

1. 2007 Int'l EFA (Developed Int'l ETF) Return: +10.64%
   
2. 2006 Int'l EFA (Developed Int'l ETF) Return: +25.28%
   
3. 2005 Int'l EFA (Developed Int'l ETF) Return: +13.94%
   
4. 2004 Int'l EFA (Developed Int'l ETF) Return: +20.56%

1. 2007 Int'l EEM (Emerging Int'l ETF) Return: +34.96%
   
2. 2006 Int'l EEM (Emerging Int'l ETF) Return: +31.15%
   
3. 2005 Int'l EEM (Emerging Int'l ETF) Return: +34.19%
   
4. 2004 Int'l EEM (Emerging Int'l ETF) Return: +26.25%

Observation 3: 2007 Small Cap Returns lagged Midcap and Large Cap

Small Cap Returns, as represented by the IWM ETF, lagged midcap and large cap returns in 2007.

Observation 4: Small Cap Underperformance is a new trend, breaking multi-year trend

From April 11, 2003 to April 5, 2006:

1. S&P 500 (Large Cap) Return: +54.77%
   
2. Midcap 400 (Mid Cap) Return: +94.98%
   
3. Russell 2000 (Small Cap) Return: +113.11%

From April 7, 2006 to December 28, 2007:

1. S&P 500 (Large Cap) Return: +16.52%
   
2. Midcap 400 (Mid Cap) Return: +9.77%
   
3. Russell 2000 (Small Cap) Return: +2.99%

For many years, Small Cap stocks have outperformed Large Cap stocks. These trends tend to remain for many years, and we have recently seen the pendulum swing from favoring small cap stocks, to large cap stocks.

Observation 5: 2007: Growth Outperforms Value

In 2007, Growth outperforms Value through all US asset classes.

Observation 6: Growth Outperformance is a New Trend, Breaking Multi-year Trend

From July 28, 2000 to April 4, 2006:

1. S&P 500 Value ETF: +31.08%
   
2. S&P 500 Growth ETF: -24.2%
   
3. MidCap 400 Value ETF: +132.78%
   
4. MidCap 400 Growth ETF: +29.07%
   
5. Russell 2000 Value ETF: +140.68%
   
6. Russell 2000 Growth ETF: +7.29%

From April 7, 2006 to December 28, 2007:

1. S&P 500 Value ETF: +13.47%
   
2. S&P 500 Growth ETF: +17.63%
   
3. MidCap 400 Value ETF: +5.76%
   
4. MidCap 400 Growth ETF: 12.6%
   
5. Russell 2000 Value ETF: -2.13%
   
6. Russell 2000 Growth ETF: +7.4%

This makes sense. In the 1990s, Growth stocks prevailed and value lagged. From 2000 to sometime around 2006, Growth stocks suffered, and value stocks reigned supreme. Now that the value stock cycle has run its course, we are at the beginning of a multi-year growth stock run.

Observation 7: In 2007, the Large Cap Nasdaq Stocks outperformed

In 2007, the Nasdaq 100, 100 of the largest Nasdaq stocks (which is heavy in high tech stocks) outperformed the Nasdaq thanks to the performance of the larger capitalized stocks such as Apple (AAPL) and Google (GOOG).

Observation 8: The outperformance of Nasdaq stocks may be the start of a new trend.

From January 4, 1999 to July 21, 2000:

1. Nasdaq 100 Index: +110.78%
   
2. Nasdaq: +85.44%
   
3. S&P 500: +20.06%

From July 20, 2000 to December 19, 2006:

1. Nasdaq 100 Index: -55.32%
   
2. Nasdaq: -41.94%
   
3. S&P 500: +0.10%

From December 18, 2006 to December 28, 2007:

1. Nasdaq 100 Index: +17.65%
   
2. Nasdaq: +9.81%
   
3. S&P 500: +4.81%

During the different periods, we see the Nasdaq outperform the S&P 500, then underperform the S&P 500 for many years. Recently, we've seen it change, and the Nasdaq is starting to outperform the S&P 500.

Typically the Nasdaq 100 seems to lead the Nasdaq either up or down. During the last period starting December 18, 2006, we notice that the Nasdaq 100 Index is leading the Nasdaq up.

Prediction over next several years:

If we assume that style trends tend to be multi-year trends, then over the next few years, we can predict that:

1. Large Cap will outperform Small Cap Stocks (Early stages)
   
2. Growth Stocks will outperform Value Stocks (Early stages)
   
3. Nasdaq stocks and Nasdaq 100 stocks will Lead once again (Early Stages)
   
4. International Markets will continue to outperform US stocks (Early to Middle Stages)
   

Effects of Falling Rates and Inflation on the Stock Market

In a previous article, we examined the historical Price to Earning Ratios of the US large cap index, the S&P 500.

Now, let us examine how a falling interest rate environment or low inflation situation affect stocks, stock performance, and sector performance.

Effect of Inflation on Stock Performance

Crestmont Research provides very interesting information on Inflation and Price to Earnings Ratios from 1900 to 2006.

When we look at Inflation (as measured by CPI) ranges, we see the average PE:

1. CPI Range (less than 0%): Average PE = 14
   
2. CPI Range (0 to 0.99%): Average PE = 16
   
3. CPI Range (1 to 1.99%): Average PE = 17
   
4. CPI Range (2 to 2.99%): Average PE = 22
   
5. CPI Range (3 to 3.99%): Average PE = 19
   
6. CPI Range (4 to 4.99%): Average PE = 16
   
7. CPI Range (5 to 5.99%): Average PE = 15
   
8. CPI Range (6 to 9.99%): Average PE = 13
   
9. CPI Range (10% or more): Average PE = 8
   

During times of low inflation, especially in the range of 2 to 2.99%, the US equity market supports a high PE ratio of 22. As we have deflation, or very high inflation, the average PE ratios are much less. The historic average PE ratio of the S&P 500 is 14 or 16 depending on how you calculate it.

In addition, the link above shows the general inverse relationship between inflation and stock prices. As inflation rises, stocks tend to fall. And as inflation drops from high levels (so long as there is no deflation), stocks tend to rise.

As of July 2007, the Inflation rate (through CPI) is 2.36%. Based on the chart above, this is a good inflation rate for Price to Earnings multiple expansion. As long as inflation remains contained, the outlook for US equities remains bright.

Effect of Falling Interest Rates on Stock Prices

The Fed, according to Fed Funds Futures, is likely to start cutting the Fed Funds Rate, currently at 5.25%.

How does a Falling interest rate environment affect stocks?

The Business Week magazine has an article showing the effect of falling rates and rising stock prices.

Since World War 2, the Fed has started rate cutting programs 10 times, and in the six month period after the first cut, the S&P 500 advanced by an average of 11%, two percentage points better than the average of 9% price increase in all years since 1945.

In the 12 months after the first rate cut, the S&P 500 gained an average of 18.6% and posted an increase in 9 out of 10 cases.

So for the most part, except for a few cases (such as the big drop in 2000-2002 due to excessive valuations of Nasdaq and S&P 500 stocks), falling interest rates are good for stocks.

Effect on Different Indices in a Falling Interest Rate Environment

Since 1945, during a falling interest rate environment, Growth and Blend methodologies in the S&P 500 returned 11%. Value stocks in the S&P 500 returned 7.9%. During a falling interest rate environment, large capitalization US growth stocks outperformed large capitalization US value stocks.

The small capitalization stocks as represented by the Russell 2000 or the S&P SmallCap 600 returned 7.8% six months after first interest rate decrease. However, this still underperforms the US Growth S&P 500 Index during a falling interest rate environment.

During a Falling Interest Rate Environment, it would be a good idea to invest in large cap growth stocks.


Effect on Sectors in a Falling Interest Rate Environment

Which sectors outperform and underperform during a falling interest rate environment?

According to Standard and Poors and the Business Week Article, these sectors performed in the six months after the first rate reduction (since 1945). The average percent change is listed:

1. Information Technology: +21%
   
2. Consumer Discretionary: +18%
   
3. Industrials: +17%
   
4. Consumer Staples: +14%
   
5. Energy: +12%
   
6. Health Care: +11%
   
7. Materials: +11%
   
8. Financials: +10%
   
9. Utilities: +7%
   
10. Telecom Services: +4%
    

During a Falling Interest Rate Environment, it would be a good idea to overweight Information Technology (Growth), Consumer Discretionary, and Industrials and underweight utilities and telecom services.


How I reallocated a portfolio to take advantage of the Falling Interest Rate Environment

The Warren Buffett Challenge (and Index Funds)

Warren Buffett, in the 2007 Annual Berkshire Hathaway Conference, has some interesting comments.

Warren Buffett even offered a challenge:

Name at least ten hedge funds that will beat a low-cost index funds.

His point? For "a know-nothing investor, a low-cost index fund will beat professionally managed money." But you might ask why didn't Mr. Buffett take his own advice on index funds? Warren Buffett said that he thought could beat the S&P by a couple of percentage points, "just not a whole lot better."

Other gems selectively taken directly from a Leslie McFadden Article from BankRate.com:

1. Read and think before you invest. When a 17-year-old who was attending his 10th consecutive Berkshire annual meeting asked how to become a better investor, Buffett offered some simple but golden advice. Read everything on investing you can get your hands on and fill up your mind with various competing thoughts. After doing that, it's time to get started, as investing on paper and dealing with real money is like "reading a romance novel and doing something else."

He added that when you think about buying shares in a company, think about why you might buy the whole business. If you couldn't write an essay about it, then you shouldn't buy any shares.

2. Risk is tied to the type of business and ignorance of the investor. One investor from Los Angeles asked about using volatility as a measurement of an investment's risk. "Volatility does not determine the risk of investing," Buffett said, adding that risk comes with certain kinds of businesses and not knowing what you're doing. A better approach would be to understand the economics of the business you're investing in, he said.

3. What can be done about shorting stocks? "I have no problem with shorts," says Buffett. He added that he didn't think shorting stocks poses any threat to the world. He would be fine with it if someone wanted to short Berkshire stock.

4. Better to invest in businesses tough for competitors to enter. Asked about his interest in investing in Taiwanese high-tech companies, Buffett remarked that "change is wonderful, but not necessarily for investments." In terms of predicting how a business will perform, he said it's much easier to look at consumer behavior and businesses that have big barriers to entry, citing Gillette as an example of a company with a 70 percent market share for men's razors.

5. Value investing -- what else is there? One person asked about whether Buffett's value investing strategy would apply in South Korea. Buffett said investing is all about value. "What other kind of investing is there?" he asked. "Are we going to have nonvalue investing? Are we going to have tipster investing … dream investing? I've never understood what the alternative is."