Bottom Fishing

Most finance academics believe in the “efficient market hypothesis,” which teaches that past stock price changes provide absolutely no information for forecasting future price changes. But just how true is this theory in practice? Is bottom-fishing really a viable strategy?

Fortunately, stock price data is readily available for analysis. Schwab’s equity research team has extensively studied the relationship of historical stock price changes to future stock price changes in markets around the world.

For the purposes of this article, we took the 3,000 largest U.S. stocks by market capitalization each month from 1990 to 2007 and divided them into five uniform portfolios, according to their price changes over the prior 12 months. We then measured portfolio returns over subsequent six-, 12- and 24-month holding periods relative to the 3,000-stock-universe average.

Are stocks that have performed poorly over the past year potential bargains? The graph “Give the Deep Divers Time to Resurface” reveals that the answer depends on your time horizon. Let’s focus on Portfolio 5: the 20% of stocks with the weakest past performance, underperforming the average stock by 30% or more over the prior year. Note: On average, Portfolio 5 stocks continued to underperform for the first six months after portfolio formation, but then eventually reversed and outperformed over a longer 24-month holding period.

This pattern suggests that investors tend to initially underreact to whatever caused the poor performance over the previous year, but then eventually overreact—leading to potential market-beating opportunities for bottom-fishing investors with a longer-term focus.

As a quick aside, these results certainly throw some cold water on the efficient market hypothesis. Past price performance trends tend to persist for holding periods up to six months, which suggests that price momentum can be a useful indicator for active traders.

Dow 18,500?

We [Morningstar] think the Dow Jones Industrial Average will rise more than 6,000 points to roughly 18,500 over the next three years.

How We Arrived at That Estimate
The Dow was trading at a very hefty 17% discount to our estimate of its fair value, which stood at around 14,000 as of Feb. 7, 2008. We base that fair value estimate on the fair value estimates that our equity analysts have placed on the Dow's 30 component stocks. The Dow hasn't looked this cheap to us since September 2002 when the index stood at 7,592 (three years later it had risen to 10,569).

When we take the Dow's market price and fair value estimate together with its 9.7% weighted average cost of equity (our analysts assign a percentage cost of equity to every stock they cover, including all of the Dow's components), it translates to a 17% annualized expected return. In other words, this is the return an investor would reap if the prices of the Dow's components converged to our fair value estimates over a three-year holding period (not ad infinitum).

To isolate the Dow's expected price return--which is what directly influences the index's value--we deducted the benchmark's 2.2% dividend yield from the 17% annualized return we derived. When we compound the Dow's closing value on Feb. 7 by this 14.8% annualized price return, we arrive at an 18,510 index value.

Changes in the Dow

Dow Jones announced yesterday that it will be replacing two
stocks in its Dow Jones Industrial Average effective Feb 19.
Altria Group (MO) and Honeywell International (HON) will be
replaced with Bank of America (BAC) and Chevron (CVX).

This is the first change in the average since April 2004. The
move reflects the desire of Dow Jones to increase the
concentration of financial service and energy in its
benchmark. In addition, Altria is spinning off its
international operations next month. [via Zacks.com]

Estate Planning terminology

Lots of you have wills. Many of you also have trusts and powers of attorney. But, in general, when the subject of estate planning comes up, most people's eyes just glaze over. The terminology is confusing and the subject is, well, depressing.

I can't make the subject matter any more palatable, but I can help with the terminology.

-- By Sue Stevens, CFA, CFP, CPA

Taming Financial Clutter

My name is Dayana, and I have a paperwork problem.

Now that that's out of the way, we can all deal with our piles of shame -- the money-related detritus (those gobs of receipts, bank records, investing statements, warranties, and whatnots) we've been stashing in closets, drawers, and basements for (I admit) years.

Based on the number of decluttering books in the "Get Organized" aisle at the bookstore, there's no shortage of advice on controlling the torrent of items that stack up every day. So let's heed the organizational pros and apply their advice to our financial clutter. For this exercise, I'm using the five steps that author Julie Morgenstern outlines in her popular organization book, Organizing From the Inside Out.

Five Sure Things

Each quarter, the Forbes Investors Advisory Institute under President Wallace Forbes hosts a financial round-table discussion to sample the economic and investment outlooks of some of the best and brightest minds on Wall Street.

The most recent discussion was held on Jan. 8 at Forbes headquarters in New York City. Below are the transcribed and edited remarks of Henry Mercer, president of Mercer Capital Advisors.

...

I'm getting older now, so I only invest in sure things. I don't invest in things that only "might" work out. So let me give you five sure things.

Gold is going to $1,000 an ounce probably this year. I forecast that it would go to $800 an ounce last year.

Oil is going to probably $125 a barrel. I forecast that it would go to $80 last year.

The dollar is going down for the reasons that I said because large holders of dollars are going to diversify into other assets and other currencies. And of course, if the dollar is weak, that's an inflationary phenomenon because the United States, having dismantled its manufacturing establishment, is dependent on foreign goods for our survival. This is something people aren't sufficiently worried about.

Cotton is going to be the commodity of choice because the world's standard of living is increasing, and the places where it's increasing fastest are warm, and they don't wear wool; they wear cotton. Cotton is something nobody wants to grow. They want to grow corn instead. So, while the demand for cotton is increasing, the acreage devoted to it is decreasing, and that's all you have to know.

Finally, I think the Chinese are going to revalue the renminbi (yuan) even more than the 7% that they did last year.

As far as stocks are concerned, I think that my investment ideas follow some of my thesis. Our portfolio is very heavily overseas, but we're in the agricultural area with Potash Corporation of Saskatchewan (nyse: POT - news - people ) and a lot of energy stocks--large caps such as Schlumberger (nyse: SLB - news - people ), smaller caps such as National Oilwell Varco (nyse: NOV - news - people ) and Ultra Petroleum (amex: UPL - news - people ). In technology, Qualcomm (nasdaq: QCOM - news - people ). Finally, in adult education we think that a lot of people will be laid off and they'll be trying to improve their skills so we would buy the Apollo Group (nasdaq: APOL - news - people ).

the greatest secret to investment riches

David Gardner reveals the greatest secret to easy riches in the stock market.

Finding good companies and holding those positions tenaciously over time can yield multiples upon multiples of your original investment. That's what great investors do.

The best time to invest

Consider John Templeton, founder of Templeton Growth Fund and widely regarded as one of the best investors of his generation. His advice about getting into the market is simple: "The best time to invest is when you have money. This is because history suggests it is not timing which matters, it is time."