When thinking about investments, the stock market is at the top of most people’s minds. In the following, we explore the most important aspects of stock investments.
Stock Market Indices
When talking about the stock market, we refer to a basket of stocks with a common regionality, exchange, industry, or capitalization. We can represent each of these baskets as a single time series, an index, from the individual stock prices of the underlying basket.
By using these indices, we can eliminate some of the company-specific fluctuations, and create a more general measure of economic health. There are many different indices available. Here are the most commonly followed ones:
- S&P 500: A cap-weighted index of the 500 larges companies listed on U.S. stock exchanges. The S&P 500 is the most-often used benchmark for “large-cap” stocks.
- Dow Jones Industrial Average: An index of 30 large companies listed on U.S. stock exchanges. A committee selects the Dow’s components to gauge the performance of the industrial sector of the U.S. economy.
- NASDAQ Composite. A stock market index of the common stocks listed on the Nasdaq stock exchange. Historically, the NASDAQ heavily leans towards information technology companies.
- Russell 3000. A cap-weighted index that seeks to benchmark the entire U.S. stock market. It measures the performance of the 3,000 largest publicly held companies in America, representing about 98% of the U.S. public equity market.
- Russell 2000. An index of the 2,000 smallest stocks in the Russell 3000 Index. It represents about 10% of the total market capitalization and is the most common benchmark for “small-cap” company shares.
These indices seem to be quite different in their composition and nature. However, as the chart above shows, most of the time, indices of U.S. stocks behave in very similar ways.
It is further worth mentioning that all of the above indices are cap-weighted. As such, larger companies are weighted more than smaller companies. This scheme aligns with the idea that the underlying stock baskets should not require rebalancing, when stock prices fluctuate.
The chart above shows that even across regions, stock markets are highly correlated. The Total World Stock Index shows the exact same peaks and valleys as the U.S. Total Stock Index, or the World Ex-U.S. Index. This should come as no surprise: The largest U.S. companies are also among the largest in the world, and therefore major drivers of these indices.
It is worth noting that the ex-U.S. stocks have a history of higher volatility and slower recovery than U.S. stocks. We can possibly attribute this to additional country risk and currency risk implied by investing in these indices.
Stock Market Versus Economy
The stock market and the economy have a complicated relationship, which we find best described by the following quote:
“There’s an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch. […] But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the dog watchers, big and small, seem to have their eye on the dog and not the owner.”
- Ralph Wagner, fund manager
With the stock market representing the majority of the U.S. economy, it is hard to imagine how either of the two can make significant moves without affecting the other. However, there is an important difference. The gross domestic product is a coincident snapshot of the state of the economy. In contrast to that, the stock market factors in future economic growth. Therefore, the stock market’s moves depend more on the anticipated future than the situation at hand.
When looking at the economy, recessions are of particular concern. These are relatively short periods of economic contraction. Because it is hard to identify recessions in real-time, the National Bureau of Economic Research (“NBER”) employs a business cycle dating committee, which dates recession periods in hindsight. This resulting time series is available through the Federal Reserve’s Economic Database (“FRED”).
Most investors intuitively understand that recessions are challenging times for stock investors. By calculating the S&P 500’s annualized returns independently for growth and recession periods, we can show that the economy and the stock market are indeed intertwined. Here are the results for the 30 years from January 1990 to December 2019:
|Business Cycle||Accumulated Duration||Annualized S&P 500 Return|
|Growth||27.2 years||+13.2% / year|
|Recession||2.8 years||-17.4% / year|
|Average||30 years||+9.9% / year|
We can see quite clearly, how the stock market is, historically, performing better than average during growth periods, and much worse during recession periods. As described above, stock prices tend to lead the economy. Therefore, the stock market cannot be adequately timed with concurrent recession indicators. Because of this mismatch in timing, the stock market’s losses in the table above look much less intimidating than they actually were.
Stock Market Returns
Investing in the stock market is not a smooth ride. While in the long term, the stock market provides attractive growth opportunities, investors should be prepared to experience setbacks. The chart above shows annualized rolling returns over 1, 2, 5, and 10 year periods since 1990. The table below shows the maximum and minimum readings:
|Rolling Period||Minimum Annualized Return||Maximum Annualized Return|
As we can see, even an investment period of 10 years is not a guarantee for positive returns: In March 2009, the 10-year rolling return dipped down to negative 4.7%. Also, growth since 2000 never returned to the outsized profits we saw during the dot-com boom in the late 1990s.
The critical takeaway here is to not take high stock returns for granted. Investing in the stock market is risky, and the best way to reduce this risk is to lenghten the investment horizon.
Stock Market Volatility
Volatility is a measure of the ‘unsteadiness’ of returns. Typically, we express volatility as an annualized price move. We can calculate historical volatility with only a little bit of high-school math. However, this measure, just like most quantitative indicators, is backward-looking. As investors, we are typically more concerned with the future than with the past.
Implied volatility is a measure of expected future price moves, expressed as an annualized percentage. It is captured through the VIX index. As we cannot predict the future, the VIX uses a different methodology to estimate future volatility: the pricing of options contracts. Options are often used by institutional traders to hedge portfolio risks, quite similar to an insurance policy. The VIX calculates implied volatility based on the premiums paid for these options contracts.
Consequently, we can interpret the VIX as the market sentiment among institutional traders. It is worth pointing out that even institutional traders cannot predict the future, and that implied volatility often closely matches historical volatility. Sometimes, however, significant upcoming events, e.g., presidential elections, cast their shadows and drive up implied volatility.
From the chart above, we can see how the VIX spikes in times of market stress. It seems that the stock market’s reaction to bad news is faster and more violent than its response to good news. Therefore, we often refer to the VIX as the "fear index". The following table illustrates the relationship between stock market returns and volatility for the 30 years between 01/01/1990 and 12/31/2019:
|VIX Regime||Accumulated Duration||Annualized S&P 500 Return|
|High (> 20)||10.8 years||-20.2%|
|Low (< 20)||19.2 years||+ 31.6%|
On average, the VIX reads about 19.1. About two-thirds of the time, volatility is ranging below average, with annualized returns far exceeding the average. Only about one-third of the time, volatility reaches above average levels, with profoundly negative returns.
With these properties, the VIX not only measures the risk of our investments in the stock market but also gives a good indication of the road that lies ahead.
Investing in the Stock Market
There are two general avenues for investing in the stock market:
- Funds, mutual or exchange-traded
- Individual stocks
There are hundreds of funds available, which invest in the stock market. Many of these funds have their unique composition, e.g., a specific region, industry sector, or market capitalization. However, and as shown above, many of these funds are nonetheless highly correlated to the S&P 500. The main advantage of investing in funds is their diversification. With just a single purchase, investors can participate in a wide variety of stocks. Further, share prices of these funds are low, allowing investors broad diversification with very modest initial capital requirements.
Stock market funds are available as mutual funds or exchange-traded funds (ETFs). Historically, mutual funds were often associated with high sales loads and other hurdles locking investors into the products. In contrast, ETFs are traded on major exchanges, and investors can enter and exit these products freely. Today’s online brokerages mostly blur the line between these two categories.
Individual stocks allow investors to tailor portfolios to their specific needs. However, this flexibility is both a blessing and a burden: Stock-picking is no simple task and subscribers to the Efficient Market Hypothesis even claim it can't be done. Diversifying across ten or more stocks requires significantly more capital than investing in a fund. However, failure to diversify the portfolio adequately adds concentration risks.
Summarizing, we believe that for most investors, low-fee ETFs are more appropriate than picking individual stocks. In our view, most investment themes can be implemented with ETFs, and their diversification often outweighs the lack of personalization.
Trading the News
Every day we are bombarded with market news, telling us about the stocks that made headlines that day. It is very tempting to invest in these stocks – but you should resist. There are multiple reasons for this.
First, the news change every day, but the markets move slower than that. Investing is a long-term game, which we should approach calmly and with a steady hand. If you had a healthy portfolio yesterday, today's news most likely did not change that. Neither fear nor greed help us make better decisions.
Stock markets are often irrational. That convincing success story told by the news anchor does not necessarily lead to the outsized returns we are craving. Picking winning stocks requires much more insight into the company's fundamentals and macro-economic sentiment than can be conveyed in a 30-second clip.
Further, when a stock just made a big move, the chances are high that it won't do as well the following day. Stock returns are mean-reverting, meaning that over short periods, outsized returns are often followed by below-average periods until returns are in line with long-term trends again.
At Bertram Solutions, we are big proponents of active portfolio management. However, this should not be interpreted as us trading the news or even trying to predict them. Instead, we are looking for the big picture of anticipated market changes spanning a horizon of months and years.
We hope this post provided you a helpful overview of the stock market. Bertram Solutions offers comprehensive wealth management services to retail investors, specialized in quantitative analysis and active management. Please contact us to learn more.