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Stock Market PerformanceStock Market PerformanceLessons from HistoryLessons from History

(that we never seem to learn)(that we never seem to learn)

© 2006-2009, Gary R. Evans. This material may be used for non-profit educational use only without permission of the author,

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61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 08

Dow Jones Industrial Averages: Dow Jones Industrial Averages: 1961 1961 -- NowNow

2.03%

15.6%

11.4%

Shown are continuous annual growth rates. Turning points are July 1982 December 1999, and October 2007.

8.8%

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Bull/Bear MarketsBull/Bear Markets

• Bull market defined to have ended when stocks fall about 20% from peak

• Average duration this century: 27 months• Very high variance, however• Bull market of 1990s lasted more than 10

years• Can't predict from this statistic alone.

Stock Market PerformanceStock Market PerformanceWhat seems to matter ...What seems to matter ...

• The stock market likes– High growth in earnings or expectations of high

growth in earnings– Meeting those expectations– The River of Money– Price stability– Momentum– Enthusiasm from foreign investors

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Stock Market PerformanceStock Market PerformanceWhat seems to matter ...What seems to matter ...

• The stock market does not like– Missed earnings or performance expectations– Inflation– High interest rates

• The stock market seems indifferent to– mild recessions, but not major recessions

The importance of earnings ...The importance of earnings ...Generally, the stocks that make up the S&P 500 Index respond to the earnings growth rates of the companies.

The anomaly in 2002 was because the stock marker crash, or the worst of it, was in tech and dot.com companies that were not in the S&P500.

The relationship is robust, with the market leading earnings by about 2 quarters, although that relationship is variable cycle to cycle.

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DividendsDividends

• Dividends will supplement yields• 388 of the S&P500 paid dividends in 2004• Dividend yield averaged 1.8%.• The larger the company, the more likely

they are to pay dividends, tech and growth companies don't like to pay dividends.

• Trend is rising because of favorable tax break initiated in 2003 (15%)

Dividends (cont)Dividends (cont)

• Historically dividends much more important– Since 1926, 41% of S&P500 yield– Sharp decline in 1980s and 90s

• Sharply higher overseas– New Zealand 4.1%, Australia 3.7%, Italy 32.%

• Big utilities and income stocks often pay hi– Entergy LA

Source: WSJ Jan 18 2005

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Yield ComparisonsYield Comparisons

Data assembled by Richard Shaw for the source above.

DJIA - The Inflation Years1971 - 1982

71 72 73 74 75 76 77 78 79 80 81 820

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Stocks don't like inflation ...Stocks don't like inflation ...

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DJIA - Moderate Growth1955 - 1982

1955 1960 1965 1970 1975 19800

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84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Stock Mutual Funds All Mutual Funds

The River of MoneyThe River of MoneyNet New Cash Flow to Mutual FundsNet New Cash Flow to Mutual Funds

Source: Investment Company Institute

$ billions, 1984 - 20082008 is YTD to Nov 2008

Excludes Money Market Funds

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The River of Money (stocks cont)The River of Money (stocks cont)

Note the severe decline in 2001/2002

... and decline in 2007 and collapse in 2008

StockYear Mutual Funds84 5.985 8.586 21.787 19.088 -16.189 5.890 12.991 39.992 79.093 127.394 114.595 124.496 217.097 227.198 157.099 187.700 309.301 32.302 -27.803 152.804 177.805 135.806 159.407 92.408 -215.6

Loss of confidence after the 87 crash.

When we see the timing of these down-turns, we may conclude that this is a public reaction to a market drop rather than a cause (although it makes the cycle longer).

Data at the ICI show that flows into long-term mutual fund IRAs fell from $171b in 2007 to 0 in 2008 Q2.

A complication: U.S. investments in A complication: U.S. investments in foreign stocks through foreign stocks through ETFsETFs and and

mutual fundsmutual funds

Once global investment funds, both mutual funds and ETFs, became the rage, then increasing percentages of new equity fund contributions were directed to overseas markets through these funds. This began in 2005 and continued through 2007, but in 2008 and early 2009 the trend has reversed, with those funds now losing cash.

The initial impact was to fuel overseas markets. The current effect is to impede their growth.

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Overseas Investors and InvestmentsOverseas Investors and InvestmentsThe depreciation of the dollar complicates this issue: as the dollar depreciates the effective yield to overseas investors buying U.S. stocks and bonds falls. For example, if the dollar to Euro exchange rate rises from $1.10 to $1.20 (this is a dollar depreciation --- the dollar is worth less, the Euro more) then a European investor investing in U.S. stocks would have paid .91 Euros per dollar when buying, but receiving only .83 Euros per dollar if cashing out a year later.

When the $ depreciates his should discourage overseas investments in the U.S. But in 2004, when the dollar was depreciating, foreign capital continued to flow in. This appeared to be due to perceptions of quality and safety in a troubled world.

Also, when the dollar is thought to be near it's trough, U.S. investments are seen as "on sale," spurring more overseas inflows. This appeared to be happening in early 2005 when the dollar was at $1.33 to the Euro.

Obviously, $ depreciation increases yields on U.S. investments made in foreign stocks, but again, at it's trough, these investments are expensive.

1.07

0.920.90

0.95

1.13

1.24 1.24 1.26

1.37

1.56

1.29

0.60

0.80

1.00

1.20

1.40

1.60

1.80

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Value for 2009 is for Jan 20

Dollar to Euro Exchange RateDollar to Euro Exchange Rate… the cost of a Euro in $$

This is a $ devaluation

This would add to the yield of U.S. investments in European ETFs, reduce yield on European investments in US stocks.

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The 1987 program trade crashThe 1987 program trade crash

1,500

1,700

1,900

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2,900

Oct 1987

Dec 1985

July 1989

Momentum marketsMomentum marketsSubstantial excess speculation can push stocks up at exponential rates into ranges that economically make no sense. This can happen for an individual stock, an entire industry, or an entire market. For the stock market as a whole, such a cycle usually begins when stocks are truly undervalued, justifying a rapid rise, which begins to happen. Then heavy and immediate capital gains produces a market euphoria where speculative investments, in part from unsophisticated investors (even institutional investors) blows the market higher and higher. In the final phase of the market explosion, the only operative variable is momentum. The clear, obvious, and well-publicized profits being made attracts more money which, results in more demand, which causes prices to accelerate. Sometimes the rise is exponential in the final phase before the correction, which is sometimes a collapse.

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NASDAQ Composite 10 year performanceNASDAQ Composite 10 year performance

Source: bigcharts.com

Looking at recent cycles:Looking at recent cycles:

The millennium selloff

DJIA 10 year performanceDJIA 10 year performance

Source: bigcharts.com

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S&P 500S&P 500

Full recovery (compare to NASDAQ)

... then collapse.

The Millenium (2000) The Millenium (2000) SelloffSelloff• NASDAQ has spectacular rally in Q1• Selloff begins with Micro Strategies warning• NASDAQ falls 39% for year, 50% from peak• Selloff gets stronger in Nov/Dec because of tax

related selling.• S&P 500 more or less holds its own• Huge DotCom casualties – the Tulip Bulb scandal

revisited

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EToysEToys

VentroVentro

Ventro was a B-to-B play. Company never had profits, virtually no revenues, CEO was 24 years old and bought a corporate jet. Jet was repossessed and in 2001 he was booted.

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The 1998 darling: The 1998 darling: TheGlobe.ComTheGlobe.Com

This stock IPOd in November 1998 and rose 600% on its first day of trading to $87 (it later split). The company was founded in a Cornell dorm room in 1994 by Todd Krizelman and Stephan Paternot. They were fired in August 2000. This stock was was delisted in late 2000. On August 6, 2001, the stock was trading for 6 cents per share.

NewsNews--driven marketsdriven markets(2005(2005--8, for example)8, for example)

"We're in a very day-to-day, news-driven market," said Scott Wren, equity strategist for A.G. Edwards and Sons. "One day we are worrying about inflation. The next day we're worrying about slower growth. The next day it's good earnings. In general there's more good news than bad news, but we are paying attention to the negative stuff for now.

In the words of another analyst, "Right now the market climbs a staircase and descends in an elevator."

And then beginning in the summer of 2006, the market starts riding up in an elevator and descending a staircase. In late 2007 it switches again.

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EventEvent--based pricing reactionsbased pricing reactionsAside from underlying market fundamentals of a commodity, prices will reflect conditions imposed by economic and politicalevents (e.g. FRS policy, the situation in the mid-East, hurricane predictions) and are often very sensitive to news events.

This is especially true of futures prices because they, of course, are based upon expectations of future conditions and future prices.

Look at the performance of the stock market on the next two slides and how it was influenced by international political events.

Also at work sometimes are market-specific forces like momentum and Ricardian events (over-reactions to stressful news).

Prelude to disasterPrelude to disaster

• September 11, 2001, terrorists fly hijacked jets into WTC and Pentagon, killing 4,500.

• U.S. equity markets are closed until September 17. European markets down sharply, U.S. Bond markets are open and show a huge “flight to quality.”

• Economy was showing signs of accelerating decay just in the week before Sept 11; unemployment rate shot up from 4.5% to 4.9% – timing of disaster could not have been worse.

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A A RicardianRicardian Event: Sept 11 Event: Sept 11 –– 20, 200120, 2001

• Dow loses 14.3% of its value, greatest one-week loss sinceJuly 21, 1933.

• S&P loses 11.6%, NASDAQ Comp 16.1%; losses in Europe and Asia are even greater

• Total market volume on Sep 17 was staggering 2.3 billion.

Sept 16;Market closed 11-15

The post 2002 recovery (details)The post 2002 recovery (details)Better earnings, economic

recovery, river of money, then momentum

2003 strong, 2004 early slump, then recovery

2005 tepid

2006-2 strong

Source: Bigcharts.com

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The 2006 bull market comparing two The 2006 bull market comparing two indexesindexes

07May 06

DJIA outperforms Russell 2000

Source: Bigcharts.com

The current bear marketThe current bear market

All-time high mid-October

Credit crunch hits full force

Note the erratic nature (short covering will cause this in part even in a market that remains bullish).

Slide from last year (2007)Slide from last year (2007)

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The current fiascoThe current fiasco• It began, really, in 2005 and 2006 with bad mortgages.• It became apparent in summer 2007 that this might become

a problem because of bank loan write-offs.• By December 2007 bank stocks were slipping and the big

question was "contagion" ... would it spread outside of banking. Gradually it did.

• By spring 2008 generally rising commodity prices and a spectacular rise in oil prices from $60 to $145 per bbl smashed auto sales and compounded the problem

• By spring 2008 we begin to see major bank failures, by fall the world is literally on the brink of complete financial collapse, TARP is created, the stock market plunges and ...

• TO BE CONTINUED

Source: Los Angeles Times, January 28, 2009

The Root of the ProblemThe Root of the Problem

We'll talk more about this, quite a bit more about this, in the lecture on real estate.

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Bears Sterns Last Week of Trade 2008Bears Sterns Last Week of Trade 2008

... and then there was oil ....... and then there was oil ....

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Rapid and accelerating decay of the market ...Rapid and accelerating decay of the market ...

Oct Nov

I bought right here

Note the tremendous daily volatility

October and November 2008 were two of the worst, most frightening months in stock market history, matching equivalent months in 1929 and 1930.

With amazing volatility ...With amazing volatility ...

The VIX index measures the volatility of the stocks that make up the S&P 500. It hit record levels (extreme) when the market was skidding in October and November 2008. That means that stock prices were going up and down wildly, and mostly down.