What is Driving Stock Market Performance

Many media pundits have claimed that the stock market is being propped up by the easy money policy of the Federal Reserve Bank.  They claim that the stock market is on a “sugar high” and will surely crash when the hangover sets in.  While it is hard to determine the influence the Fed’s unprecedented actions have had on the economy, one thing is for sure…economic indicators have gotten much better over the past few years, and I would submit that the stock market’s performance is largely due to these fundamentals.  Below is an interesting chart that plots the inverse of weekly unemployment claims (blue line) against the S&P 500 (red line):

FRED Graph

What you see is that there has been a fairly tight correlation between layoffs and the stock market.  Intuitively this would make sense.  When the economy is weakening, companies would lay off workers.  When the economy is improving, layoffs would subside.  The idea that the Fed is creating a bubble in the stock market does not take into account the improvement we are seeing in the economy.  While we have seen significant improvement in the labor market over the past 3 years, it is not the only indicator moving in the right direction.  GDP, retail sales and corporate profits have all surpassed their 2007-08 highs.  While the unintended consequences of the Fed’s low interest policies may still be an issue in the future, the stock market’s performance over the past 4 years looks like it has been driven by improving fundamentals. 

Challenging Conventional Wisdom on Your House as an Investment

Every now and then I will have a client tell me how their home has been their best investment (well, not as much recently!).  We have data we can review to see how this has really been a myth in most cases.  Below is a chart compiled by the Yale Professor Robert Shiller on home prices:

In computing the figures here are some of the details:
Nominal return of home prices (1890-2012):  3.00%
Inflation (CPI- 1890-2012):  2.83%
Real Return of home prices:  0.17%

Because housing tends to be the largest purchase an individual will ever make, most tend to look at the dollars and not the returns.  For example, let’s use a recent conversation I had with a client.  This client purchased a home in 1980 for $150,000 and it is currently worth $500,000.  On paper, this looks like a great investment…a $350,000 gain!  When we dig into the numbers, here is what everyone misses:  there are substantial carrying costs with a home that are often overlooked (real estate taxes, maintenance, repairs, closing costs, insurance, etc).  Second, when you calculate the returns (even without those costs) it comes out to 3.83% per year.  As a comparison, over that same period, the S&P 500 averaged 11.2% per year.  Had the $150,000 been invested into the stock market it would be worth over $4.4 million. 

I am not saying that homes should not be purchased, but that you should be leery of conventional wisdom that says your personal residence(s) will be good investments over time.  The data just does not support that argument. 

Does Active Management Work Better In Inefficient Markets?

A commonly held belief in the investment world is that active management works better in inefficient markets where there is less information available (e.g. small cap, international, emerging markets, etc.).  The theory usually suggests that this market inefficiency creates opportunities for managers, through superior security selection, to achieve outperformance.

First, we know of no statistical or empirical data that supports this commonly held belief.  Here is a discussion with Kenneth French (economics professor at Dartmouth) where he discusses this very topic.

In addition, if this argument were true, you would expect to see Small Cap, International and Emerging Market managers outperform their benchmark indices due to the perceived inefficiencies in these markets.  Here is the actual data from the Mid-Year 2012 S&P Indices Versus Active Funds Scorecard (SPIVA):

SPIVA Data

 

 

 

 

Interestingly, the best performing asset class against its benchmark index was large cap US stocks.  Since most would consider this to be the most efficient asset class of the four, the argument that active management is desirable within inefficient markets is not supported by the data.

 

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.