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Subsuming the Efficient Market Hypothesis
By Keith C. Goddard, CFA
March 1, 2011

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Armed with this information, how many investors would demand that their investments be handled differently when the stock market trades at a CAPE of 23.7 (where it sits today), as opposed to when this multiple is in the cheapest or second quartile?

The second cycle is driven by momentum in the asset markets.  The table below tracks the average monthly return when markets start from two distinct starting points – positive momentum or negative momentum. A second table tracks the likelihood of a negative month in each scenario. ”Momentum” is defined by a monthly moving average for each asset class in the study.

Momentum Indicator
Monthly Moving Average

 

Average Subsequent Month Return

     
Pre-Condition               

                           US Stocks
(1872-2009)

International    
(1970-2009)

Emerg. Mkt.
(1989-2009)

   Nat. Resource  
(1989-2009)

  Real Estate
(1972-2009)

Index Above its Moving Average…….       

1.17%

1.32%

1.79%

1.21%

1.14%

Index Below its Moving Average…….         

0.25

-0.07%

0.14%

-0.48%

0.17%

 

 

Frequency of Negative Months

Pre-Condition        

USStocks
(1872-2009)

International
(1970-2009)

Emerg.
Mkt.
(1989-2009)

Nat.
Resource
(1989-2009)

Real
Estate
(1972-2009)

Index Above its Moving Average…….       

35.0%

35.9%

33.3%

41.9%

33.1%

Index Below its Moving Average…….      

46.3%

46.5%

42.4%

60.2%

43.3%

Source: Robert J. Shiller (1872-1925): Standard & Poor’s; Ibbotson; Bloomberg LP (1926-2010) ; MSCI Barra; REIT.com; Deutsche Bank AG; Capital Advisors, Inc.

For my money, I would like at least part of my portfolio to be positioned to dynamically adjust to recent market momentum, since the distribution of likely outcomes is much better in positive-trending markets than in negative-trending markets.

Booms and busts in asset prices are not anomalies resulting from unpredictable spasms of “irrationality.”  Rather, they are fundamental to the way asset markets work.  The mistakes we all make as we feel our way through one structural change after another cause asset prices to overshoot their longer-term values in both directions.  A primary responsibility of professional investors is to exploit these market cycles, rather than try to avoid them, or worse yet, pretend they don’t even exist.


Keith C. Goddard, CFA is president of Capital Advisors, Inc. and co-manager of the Capital Advisors Growth Fund (CIAOX).  As of December 31, 2011, Capital Advisors served as manager and advisor to $847 million in client assets.

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