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Greetings!
Welcome to the latest edition of The Financial Fortnight That Was.
In this edition we:
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consider the 3 Factor Model,
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take a look 11 surprising stock market indicators,
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provide a summary of the movements in markets over the past fortnight including 3, 5 and 10 year return history,
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look at why we should be careful about being pessimistic about Australian share dividends,
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provide a link to Scott's latest Eureka Report article,
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highlight the latest Monday's Money Minute Podcast,
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discuss the Commonwealth Seniors Health Care, and
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provide an update to the Dimensional Trust performance graphs - the 3 factor model in practice.
Enjoy the read!! |
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A Quote for Consideration
"Returns are the result of risk compensation, not price speculation"
Mark Hebner
President & Founder of Index Fund Advisors (IFA)
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Financial Topic Demystified
The 3 Factor Model
Some investors are starting to pop their heads out of the trenches to look at alternatives regarding growth asset investments going forward. This is almost being forced on investors as they see that the income from sitting in cash is not particularly appealing. In the current climate our firm would suggest that any investment into growth assets should be done in a measured way to reduce the possible down side if growth asset markets were to fall further.
If the decision is made to invest in growth assets, particularly shares, our research suggests an investment approach based on the 3 Factor Model. So what is this model?
The following explanation is taken from our latest book - Your Guide to Being a Successful CEO of Your Life.
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This chapter explores the 3 factor model, an academic model that says that within investment markets not only is the average return a source of returns, 'small' and 'value' companies outperform the average market return.
There are many people for whom the index investing story does not provide a strong enough value proposition to entice them to take action. Somehow it is not compelling enough. The application of the 3 factor model to investment portfolios makes a passive approach to investing more compelling, as it allows investments in small and value companies, which provide a higher expected return for portfolios.
Fama and French, researchers and finance professors from the United States, found that investing in companies with specific attributes could provide an expected return above that of the index. Indexing was the exciting innovation of the 1970's, and Fama and French's research provides the more recent and exciting innovation.
The previous chapters have outlined the benefit of taking index positions, over time. This chapter asks:
- Is there potential to tweak this model to produce slightly higher returns?
- Are there market segments that consistently outperform according to their risk, over time?
Some leading academic research, initiated by Fama and French's research, suggests that there are possible positions that can be taken by investors to achieve premiums above the expected index return.
How Do We Apply This?
In a nutshell, the three factor model suggests that the only way to outperform or under-perform the investor next to you (and the market) is to invest in companies with more or less size and / or Higher Value (BtM) risk.
The power of this is that investors can now build a passive portfolio that, through exposure to small companies and value companies can outperform the simple index. This method does not require investment skill, expensive research or tax ineffective trading.
What are the expected benefits?
On a standard 40 / 60 portfolio (40% cash & fixed interest, 60% Australian shares, international shares and property) the small, value and emerging markets factors would be about 25.4% of the overall portfolio value. If we were to achieve an out-performance over the market of say 2.5% for this part of the portfolio, this provides extra returns of 0.63% per annum compared to a standard index based portfolio with the same weightings.
A word of caution, the 3 factor model is all about understanding risk in relation to investing. Holding small, value and emerging market exposure is riskier than holding a simple broad based index fund. Therefore there are periods where these areas of the market will under-perform the broader market exposure. We should only expect to see out-performance over a long time frame.
To see how we apply this model to our portfolios please take a look at our Building Portfolios page on our website.
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Fascinating Financial Fact
11 Surprising Stock Market Indicators
Last edition we looked at the Baltic Dry Index which some believe is a lead indicator of future economic performance. This week we take a look at an article recently published on CNBC.com. It highlights eleven indicators of future stock market performance:
- Hemline / Skirt Length Indicator
- This theory suggests that the direction of the economy can be predicted based upon the average length of hems in that year's new fashion lines. If skirts are short, markets are on the rise. Conversely, if skirts are long, markets are heading down.
- The Boston Snow Indicator
- A white Christmas in Boston means a rise for stocks the following year.
- Super Bowl Indicator
- A championship for an AFC team predicts a decline in the stock market for the coming year, and a win for the NFC means the stock market will be up.
- Billboard Top 100 Indicator
- Songs with high beat variance - individual tracks that shift tempo throughout the song - are preferred in times when market volatility is low. When volatility is high, people tend to prefer songs that have a more consistent beat.
- Lipstick Indicator/Lipstick Effect
- When individuals feel uncertain about the future, they turn to less-expensive luxuries, most notably vanity items such as lipstick. The trend suggests that lipstick sales increase during a recession or times of economic uncertainty.
- Harvard MBA Indicator
- It looks at the percentages of Harvard Business school graduates entering into various market-sensitive jobs, such as investment banking, private equity and securities trading. The indicator signals investors to exit the market if more than 30 percent of graduates take these jobs, while investors should go long if less than 10 percent of graduates move into these fields.
- January Effect
- A phenomenon since 1925, where small cap stocks outperform the broader market as well as mid and large cap stocks in the month of January. There is also the idea that according to the direction that the market takes in January, the rest of the year will follow. "As goes January, so goes the year."
- Aspirin Count Indicator
- When times are tough, headaches abound... and aspirin sales go up! The idea is that, as a lagging indicator, stock prices and aspirin sales are inversely related. So, when the sales of aspirin go up, the market goes down.
- Sports Illustrated Swimsuit Cover
- There is an indicator based upon the nationality of the cover model. It suggests that when the cover model is from the United States, the S&P will show a return for the year above its historical rate. With a non-American cover model, the S&P 500 will underperform for the year.
- Pallet / Cardboard Box Indicator
- The higher the demand for corrugated boxes and shipping pallets - necessities when shipping products to customers - the higher the demand for the products being shipped.
- The Big Mac Index
- The Economist magazine suggests that in the long run, the exchange rate between two countries should reach equilibrium, and the ability to buy the same items in each country should remain in-sync.
To find out more about these indicators please go to - www.cnbc.com/id/29257460
These eleven indicators remind me of one of the key aspects of our firm's approach to building portfolios - the importance of scientific / academic research that underpins our approach to investing and not an approach based on data mining. Some of the above indicators have some economic rationale but most are pure acts of data mining. The example we use on our website showed that the production of butter in Bangladesh explained 75% of the variation in US stock market returns. The production of butter in Bangladesh and the US; the sheep population in Bangladesh and the US; and the production of cheese in the US explained 99% of the variation in US stock market returns. Sound plausible?? For more information on our approach please take a look at Our Research Based Approach pages on the website.
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Market News
ASX P/E Ratio and Dividend Yields
The P/E ratio is a common broad indicator of the price of shares. It is a calculation of the price of shares compared to expected earnings. A higher ratio indicates that share prices are more expensive. The historical P/E ratio for the ASX has been between 14 & 15. The dividend yield is the calculation of dividend payments divided by the market capitalisation of the company or index. The historical average in Australia is around 4%.
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