reminder that the economy and the market are different

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reminder that the economy and the market are different

Postby larryswedroe » Wed Dec 26, 2012 12:50 pm

http://www.cbsnews.com/8301-505123_162-57560311/great-economies-dont-usually-mean-great-returns/

Hope this is helpful.

It's one of the most common errors investing make, confusing the two

Best wishes
Larry
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Re: reminder that the economy and the market are different

Postby Index Fan » Wed Dec 26, 2012 1:18 pm

The market is highly efficient at processing information. That means everything knowable about stocks is already incorporated into prices. Thus, if the market expects China's economy to grow faster than Europe's, that's already reflected in prices. What matters to future returns is how the actual outcome differs from the expectation.


Excellent point, Larry- overweighting China seems to be a popular thing to do these days.
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Re: reminder that the economy and the market are different

Postby nisiprius » Wed Dec 26, 2012 1:28 pm

Larry, in the last few years there's been a sort of meme on the rise to the effect that one should overweight certain classes of stocks on the grounds that certain classes of business are underrepresented in the stock market relative to their weight in the economy. This argument has been made about:

a) Domestic REITs (real estate is underrepresented in the stock market relative to the real economy)...
b) Domestic small-company stocks (small companies that don't issue stock are collectively a big part of the economy)...
c) Emerging markets (their stocks are underrepresented because of state-owned oil companies, etc. that don't issue stock)...

It's never quite explained why one's stock portfolio ought to mirror the economy instead of the stock market. It's a perfect example of begging the question in the proper meaning of the phrase. They just say "your portfolio doesn't mirror the real economy," as if everyone took it for granted that it should. You need to buy extra stocks in market segment X to compensate for all of the X businesses that don't issue stock.

Can I take it that you reject that approach?
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Re: reminder that the economy and the market are different

Postby bertilak » Wed Dec 26, 2012 3:14 pm

nisiprius wrote:Larry, in the last few years there's been a sort of meme on the rise to the effect that one should overweight certain classes of stocks on the grounds that certain classes of business are underrepresented in the stock market relative to their weight in the economy...

It will be interesting to hear what Larry has to say about this.

I overweight REITs not to match the economy, but to participate in more of the total investable market. This is something bigger than the stock market. There may be other things that are part of the total investable market which I do not attempt to invest in. This is for one or more of several reasons:
  • I don't know what they all are.
  • I don't understand their market.
  • I don't know how to easily make a well-diversified investment in their market.
  • I don't consider anything to be a true investment if it doesn't produce a return (earn an income), thus leaving out things like commodities and collectables.
I think real estate passes those tests and REITs provide the mechanism for simple, well-diversified, participation in the market.

Note again, this is not a matter of trying to match the "economy," except perhaps coincidentally. Or maybe it is just a matter of terminology. Maybe the total investable market IS the economy. But I think if one was trying to match the economy then one would weight things by their contribution to the GNP.
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Re: reminder that the economy and the market are different

Postby larryswedroe » Wed Dec 26, 2012 3:24 pm

Nisiprius
Well, few thoughts.
1) I agree you don't want to mirror the economy but the investable market. At least as starting point
2) I think you can thus make argument for overweighting REITS, not sure that's true for small caps (you have exposure to the industries they are in)
That's my short answer
Best wishes
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Re: reminder that the economy and the market are different

Postby Occupier » Wed Dec 26, 2012 3:32 pm

Larry: I remember reading a study that did indicate a relationship between the American Stock Market and economic performance. The conclusion was that the stock market was a good predictor of economic performance 14 months later. I don't trade (I just rebalance), so I don't really use the study. But it indicates to me that your rejection of a relationship between market returns and economic performance is a bit over broad. I am not saying this critically, but I was looking for a little caveat in there about investors buy stocks to share in future economic earnings the companies they invest in might obtain, and that is related to the growth in the economy. Dave
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Re: reminder that the economy and the market are different

Postby asset_chaos » Wed Dec 26, 2012 4:29 pm

I'll guess that the finance industry already knows that the economy and stock market are different. Otherwise there would already be exchange traded notes or swap agreements linked to changes in GDP. Such notes could be a direct---well derivative---investment in total economic activity. With all the other wacky things "investable" via ETNs, now that you've put the thought in my head, I'm surprised that GDP ETNs don't already exist. Maybe the finance industy considers such a product too boring to be marketable or that investing in total economic activity is just not that rewarding or that GDP numbers are too rubbery to host a marketable product.
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Re: reminder that the economy and the market are different

Postby larryswedroe » Wed Dec 26, 2012 8:30 pm

Occupier
The stock market is in fact a leading indicator, one of I believe the 9 the government uses in its index of leading indicators. Best wishes
Larry
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Re: reminder that the economy and the market are different

Postby TJSI » Wed Dec 26, 2012 9:19 pm

For those interested in this topic there is a very good paper by Jay Ritter (http://bear.warrington.ufl.edu/ritter/JACF_2012.pdf) titled Is Economic Growth Good for Investors? in the Journal of Applied Corporate Finance. Looking at data from 1900 to 2011 for 19 countries there is a negative corellation between the growth rate in per capital GDP and real stock returns. This is a cautionary note for those investors looking to rapidly growing economies for good returns.
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Re: reminder that the economy and the market are different

Postby Spades » Thu Dec 27, 2012 10:39 pm

Interesting article, what about overweighting REITs to take advantage of ROTH accounts to avoid taxes?
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Re: reminder that the economy and the market are different

Postby larryswedroe » Fri Dec 28, 2012 11:36 am

Spades, check out my blog on REITS today (note there is an error in this paragraph as the fund I used to show SV was Bridgeway's which has a P/C of 3.4 --they wanted Vanguard as more well known and we used the Vanguard REIT fund--so it should read 5.9 in the paragraph below

While no metric is a great predictor of future returns, the best predictors are valuation metrics like P/Es and P/Cs. And high valuations tend to predict low future returns. Personally, I would much prefer paying 3.4 times cash flow than 16.7 times cash flow.

Best wishes
Larry
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Re: reminder that the economy and the market are different

Postby Spades » Tue Jan 01, 2013 10:23 am

Larry,

Interesting article. So why is that REITs trade on the P/C ratio? Is it because their return on investment is mainly in the form of dividends and thus the more cash coming in the more return on investment? Also, buying REITs at 16.7 P/C could be similar to buying a 5% high risk bond (1/16.7) correct?

I completely agree with your last paragraph that investors should not be chasing returns and that bubbles can obviously occur in the REIT market.

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Re: reminder that the economy and the market are different

Postby larryswedroe » Tue Jan 01, 2013 11:27 am

spades
P/B and P/E doesn't mean very much when you have depreciation like you have in RE. It's the cash flow that investors are buying.
And they really trade on what is called FFO, or funds from operations, that is the metric that is used. We are working with a fund family to create a value REIT as the evidence shows that when ranking by FFO there is a value premium just as you would expect when you buy a low price to anything asset
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Re: reminder that the economy and the market are different

Postby ourbrooks » Tue Jan 01, 2013 12:17 pm

Very much the same observation is true for emerging markets. I suspect that lots of investors buy emerging market stocks because they hear about the rapid growth of emerging market economies. Alas, emerging market stock funds are capitilization weighted, so that they hold, mostly, the stocks of large market cap companies, which also usually are large in terms of sales. In what countries will there be large sales? Countries with a lot of money, which, by definition, are developed economies. Most of the leading "emerging market" companies, in fact, do a large portion of their sales in developed economies, so emerging market stocks are even less likely to reflect their home economies.
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