Robert Shiller on Valuations and Inflation Screening for

June 2013
VOLUME XXXV, No. 6
American Association of Individual Investors
Also Inside:
Robert Shiller on
Valuations and Inflation
Screening for Best Ideas
Among Dividend Stocks
Does the AAII Sentiment
Survey Foretell Market
Reversals?
AAII’s Surveys Offer Valuable Insight
on and for Individual Investors
If you haven’t visited AAII.com recently, please take some time today to see what the website offers. Plenty of helpful
resources are available at your fingertips to aid you in the investment process.
Most investors who make their own decisions utilize some
form of online discount brokerage service to buy and sell
securities. AAII conducts an ongoing broker survey where
members tell us what they think about the broker they use.
The Online Discount Broker Survey results are updated
on a weekly basis and aggregated for the year, giving you a
guide to members’ usage of and satisfaction with the most
popular online brokers.
To navigate to the broker survey, click Surveys in the
Home tab. The 2012 year-end results are currently available,
showing a list of the top 10 brokers by number of survey
responses along with their ratings by members on trade price,
speed of execution, reliability and satisfaction (Figure 1).
AAII also conducts two other surveys: the Asset Allocation Survey and the Sentiment Survey. The Sentiment
Survey has long been used by investment professionals and
individual investors alike to gauge the direction of the market. Respondents are asked whether they are bullish, neutral
or bearish on the stock market over the next six months
(Figure 2). The survey’s record as a contrarian indicator is
discussed on page 31 in this issue. The Asset Allocation
Survey polls members on their percentage of holdings in five
asset categories (Figure 3). Historical data for both surveys
Figure 2. Sentiment Survey Results
Figure 3. Asset Allocation Survey Results
Figure 1. Online Discount Broker Survey
Year-End Results
are available back to 1987.
These surveys provide valuable insight on the investment
trends of individual investors. We encourage you participate
in the surveys and make use of the results. Surveys can be
found at www.aaii.com/investor-surveys.
To log into AAII.com, simply type in your 10-digit AAII member
number (from the mailing label on your AAII Journal) for both Login
Name and Password when prompted. 
June 2013
JUNE 2013
Table of Contents
Volume XXXV, Number 6
Feature: Stock Strategies
Using Seasonal and Cyclical Stock Market Patterns ................................ 7
By Jeffrey A. Hirsch
EDITORIAL STAFF
Vice President, Editor: Charles Rotblut, CFA
Managing Editor: Jean Henrich
Production Editor: Andrew Lautner
Editorial Assistant: Fareeha Ali
Presidential terms, the calendar month and a basket of January indicators
give insight into market direction.
Stock Strategies
Valuations, Inflation and Real Returns ............................................. 12
An Interview With Robert Shiller
The Yale economics professor explains why he looks at 10 years of
earnings and the importance of factoring in inflation when valuing assets.
Mutual Funds
Money Funds and the Regulators .................................................. 17
By Mike Krasner
Following the 2008 financial crisis, there has been debate about how much regulatory
change is needed, including whether floating net asset values should be required.
AAII Stock Screens
Lowell Miller’s Best Dividend Screen ............................................... 26
By John Bajkowski
Portfolio manager Lowell Miller says the best dividend stocks combine
growth, reasonable valuations, financial strength and price momentum.
Trading Strategies
Is the AAII Sentiment Survey a Contrarian Indicator? ...................... 31
By Charles Rotblut, CFA
Both optimism and pessimism have had periods where they have
stayed at high levels; low levels of optimism have had the highest correlation with
market reversals.
Retired Investor: Determining When to Switch to the RMD .................................... 35
By Charles Rotblut, CFA
Determining when to change from the 4% withdrawal rule to the RMD depends in
part on your age and the types of retirement accounts you own.
Departments
Editor’s Note .........................................2
AAII Investor Surveys .............................3
Briefly Noted..........................................4
Letters ...................................................6
Member News .....................................22
Chairman: James B. Cloonan, Ph.D.
Vice Chairman: John Markese, Ph.D.
President: John Bajkowski
Senior Financial Analyst: Wayne A. Thorp, CFA
Assistant Financial Analyst: Z. Joe Lan, CFA
EDITORIAL POLICY
It is not the policy of the AAII Journal to
promote any specific investments or techniques
of analysis. The opinions of authors are their
own and not necessarily those of AAII. It is the
editorial opinion of the Journal that no one area of
investment is suitable for all investors and that no
single method of evaluating investment opportunities has proven to be successful all of the time.
AAII is not a registered investment adviser or
a broker/dealer. Readers are advised that articles
are provided solely for informational purposes
and should not be construed as an offer to sell or
the solicitation of an offer to buy securities. The
opinions and analyses included herein are based
on sources believed to be reliable and written in
good faith, but no representation or warranty,
expressed or implied, is made as to their accuracy,
completeness, timeliness, or correctness. Neither
we nor our information providers shall be liable
for any errors or inaccuracies, regardless of
cause, or the lack of timeliness of, or any delay or
interruptions in, the transmission thereof to the
users. All investment information contained herein
should be independently verified.
Past performance is no guarantee of future
results. Investment information provided may
not be appropriate for all investors. Investment
information is provided without consideration of
your financial sophistication, financial situation,
investing time horizon, or risk tolerance. Readers
are urged to consult with their own independent
financial advisers with respect to any investment.
The AAII Journal (ISSN 0192-3315) is published monthly by the American Association of
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© 2013 by the American Association of Individual Investors and its licensors. All Rights Reserved.
Printed in the U.S.A.
Editor’s
Note
I
f I could use a single word to describe a theme of
this month’s issue, it would be correlation.
It is human nature to confuse correlated events with
causal events. Correlated events are ones where there is
a pattern of one event followed by another. Since World
War II, September has been the worst month of the year
to hold stocks. A causal event occurs when one event
causes another. The tornadoes which formed over Moore,
Oklahoma, a day before we went to press caused the sad
deaths of many as well as considerable property damage.
(Our hearts and prayers go out to all those who were affected by May’s storms.) On the other hand, the month
of September does not cause stocks to fall. Though there
are contributing factors, it just so happens that September
tends to be a lousy month for stocks.
Understanding what correlations have held up over time
can help you put returns into context. An adviser, website
or newsletter citing good returns based solely on this year’s
performance so far should be approached with skepticism,
since January gains are typically followed by full-year gains.
At the same time, any market weakness this month should
not be a cause for concern since June is the second-worst
month of the year for the Dow Jones industrial average,
according to Jeff Hirsch of the Stock Trader’s Almanac.
Jeff is an expert on calendar cycles and explains the three
major ones on page 7.
High valuations are also correlated with stock market
reversals, and I think the long-term relationship could
arguably be described as causal. The rationale is simple:
Higher valuations lead to greater expectations, and greater
expectations create more opportunity for disappointment.
It is a cycle that has happened continually over history.
While asset values can stay irrational for an extended period, unusually high valuations are followed by corrections
and bear markets. This does not just apply to stocks either;
we are still recovering from the bursting of last decade’s
housing bubble.
Best-selling author and Yale University Professor Robert
Shiller tracks valuations and investor behavior in reaction
to market cycles. I had the pleasure of being able to meet
with him and discuss both his CAPE (cyclically adjusted
price-earnings) ratio and his S&P/Case-Shiller Home Price
Index. You can see a transcript of our interview on page 12.
If you enjoy the interview, come to our Investor Conference this November. Thanks to the efforts of Connecticut
2
AAII Chapter President Ronnie Braun, Robert will be the
luncheon keynote speaker. More information about the
conference can be found on page 24.
Low reasonable valuations, growing dividends, underlying financial strength and good price momentum are
a combination associated with good future stock price
performance. AAII President John Bajkowski uses Lowell
Miller’s “Single Best Investment” strategy to build a new
stock screen. Though current valuations limit the number
of passing companies, stockpickers would do well to pay
attention to the screen’s criteria. John’s article starts on
page 26.
Many individual and institutional investors view our
weekly Sentiment Survey as a contrarian indicator. The
survey has a reputation for signaling changes in market
direction, particularly when optimism or pessimism reach
extraordinary levels. Is the reputation warranted? I looked
at the data and the answer is generally yes, though there
have been two notable periods when optimism or pessimism stayed at high levels. You can see my analysis of
the data on page 31.
There are two articles in this issue that have nothing
to do with correlation, but I think you will find them to be
of interest. The first is about money market funds. Mike
Krasner explains exactly what a money market fund is and
gives a great overview of the ongoing regulatory efforts
to reform them starting on page 17. It is a must-read for
anyone who owns a money market fund. The second is
my latest Retired Investor column. I discuss the complex
rules governing required minimum distributions (RMDs)
on page 35.
Wishing you prosperity,
Charles
Charles Rotblut, CFA
Editor, AAII Journal
twitter.com/charlesrotblut
AAII Journal
Investor Surveys
AAII Investor Surveys As of May 15, 2013
Sentiment Survey
Historical Averages
Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%
The sentiment survey measures the percentage of individual investors
who are bullish, bearish and neutral on the stock market short term;
individuals are polled on the AAII website; the percentages and averages
are for all members responding.
Bullish Sentiment
40
Spread Between Bullish & Bearish Sentiment
35
40%
30
30%
20%
25
10%
20
0%
-10%
15
-20%
10
-30%
-40%
Apr-12
5
0
38.5%
26.8%
Most Recent Prior Month
Jun-12
Aug-12
Oct-12
Dec-12
Feb-13
Apr-13
Blue line = historical average
23.6%
Last Year
Historical Averages
Asset Allocation Survey
The asset allocation survey measures the percentage holdings of
members in five asset categories. Members are polled monthly on
the AAII website; the percentages and averages are for all members
responding.
Stocks: 60%
Bonds: 16%
Cash: 24%
80
70
18%
Cash
60
4%
32%
Bonds
Stock Funds
50
40
16%
30
Bond Funds
20
30%
Stocks
10
Apr-12
Jun-12
Aug-12
Stocks
Oct-12
Bonds
Dec-12
Feb-13
Apr-13
Cash
Updated results for both surveys are available by going to www.aaii.com/investorsurveys. The Sentiment Survey is updated
every Thursday morning, while the Asset Allocation survey is updated on the first day of every month. Numbers may not add up
to 100% because of rounding.
June 2013
3
Income Is a Challenge for Investors Worldwide
Four in 10 investors worldwide are generating less
income than they hope for, according to Legg Mason.
The firm surveyed more than 3,000 affluent investors
in North America, Europe, Asia and Australia about
their current attitudes toward income investments.
Nearly seven out of 10 respondents described investing for income as being extremely important. Yet,
across the globe investors said gaps exist between the
rates of return they desire and the rates of return they
are actually receiving. The largest gap between desire
and reality was evident in Taiwan (4.0% gap), with the
U.S. ranking sixth (2.6% gap). Low yields and uncertainty over tax law changes were listed as the biggest
challenges for U.S. investors. Notably, concerns about
inflation were the highest in China, Taiwan and Australia.
In terms of what they invest in, the U.S. led all
countries in terms of holding equities (a 39% alloca-
tion). U.S. investors also had the largest percentage of their
equity allocations held in mutual funds (49% allocation). In
terms of fixed income, U.S. investors ranked third worldwide with a 19% allocation, behind Italy and Canada. U.S.
investors relied on bond mutual funds more than investors
in other countries, however, with a 45% allocation of fixed
income to them. U.S. investors were also more likely to
invest domestically than any other country, with just 11%
investing internationally for income.
Less traditional income-producing investments, such as
master limited partnerships (MLPs), real estate investment
trusts (REITs) and currency trading, were much less popular.
Just 10% of U.S. investors said they held these assets. Their
popularity trailed that of real estate, which 16% of U.S.
respondents said they own to generate portfolio income.
Source: Legg Mason Global Income Survey, Global Summary
Report, March 2013.
Pension and Settlement Streams Raise Regulatory Concerns
Concerns about pension and settlement income
streams prompted an investor alert from regulators
last month. The Securities and Exchange Commission
(SEC) and the Financial Industry Regulatory Authority
(FINRA) warned pension holders, individuals receiving
income from lawsuit settlements and investors about
abuses in the marketing of products referred to as
pension loans, pension income programs, mirrored
pensions, factored structured settlements or secondarymarket annuities.
These products are created and sold by factoring
companies, which may refer to themselves as pensionpurchasing companies or structured-settlement companies. The business model is pretty straightforward:
Purchase a stream of income for as little as possible, sell
the stream of income to an investor and pocket both
the difference between the purchase and sale price plus
various transaction fees. Factoring companies will offer
a lump-sum dollar amount to the pension or settlement
recipient that is less than what the current value of all
future payments is worth. The companies may also sell
the income stream without properly disclosing risks
and charging high transaction fees.
Regulators advise those considering selling their
pensions or settlements to question whether the
transaction is actually legal. Federal law may prevent or
4
restrict retirees from “assigning” their pensions. A sale of
a structured settlement may need court approval. Would-be
sellers should also question whether they are receiving a
good price, what the reputation of the purchasing company
is and what the tax consequences are. Also, they should
ask if a life insurance policy will be required and factor
that cost into the actual aftertax proceeds.
Investors considering pension or structured incomestream products should realized that the advertised yields
of 5.75% to 7.75% may not be as attractive as they first
seem. Commissions can be 7% or higher, the securities will
likely not be registered with the SEC, they can be very difficult to sell and your “rights” to the income stream could
face legal challenges. Investors need to specifically inquire
about the financial status of the organization making the
payment and who is sending the check. Some arrangements call for the pensioner to manually send the check
and that person may refuse to do so. As is the case with
any other investment product, look into the reputation of
the company offering the product and find out how the
salesperson is being compensated.
Most importantly, realize that if an investment looks
too good to be true, it probably is.
Source: “Pension or Settlement Income Streams: What You Need
to Know Before Buying or Selling Them,” SEC Investor Bulletin.
AAII Journal
Briefly Noted
Postpone Retirement for Your Health
Retirement leads to poorer health, according to a new study
by Britain’s Institute of Economic Affairs. Author Gabriel
Sahlgren found that retirement has an adverse impact on both
physical and mental health.
Sahlgren bases his research on data from the Survey of
Health, Ageing and Retirement in Europe (SHARE). The data
group covered between 7,000 and 9,000 individuals aged 50 to
70 years old at the time of the first interview. Sahlgren looked
specifically at changes in health over various stages and factored
in the number of years that was spent in retirement.
What he found is that not only does retirement adversely
affect health, the number of years spent in retirement also
impacts health. Specifically, he found that being retired led to:
• A 39% reduction in the likelihood of describing one’s
health as “very good” or “excellent,”
• A 41% increase in the probability of suffering from
clinical depression and
• A 63% increase in the probability of having at least one
diagnosed physical condition.
Doubling the number of years spent in retirement:
• Decreased the likelihood of being in “very good” or
“excellent” health by 11%,
• Increased the probability of suffering from clinical
depression by 17% and
• Increased the probability of having at least one
diagnosed physical condition by 22%.
Commenting on his findings, Sahlgren concluded, “It is
found that whereas the short-term impact of retirement on
health is somewhat uncertain, the longer-term effects are consistently negative and large.” He further stated, “The findings are
in line with research showing that general practitioners note a
drop in various health indicators as a result of early retirement,
despite the fact that their patients often believe that retirement
has positive effects on their health.” Sahlgren does acknowledge,
however, that the type of work was not measured, meaning
there could still be different health effects for those engaged
in manual labor versus those who perform office work.
This new research backs up a study we discussed last year.
University of Zurich researchers estimated a decrease of 1.8
months in lifespan for each year a person retires early. (See “Early
Retirement, Early Death?” in the Briefly Noted section of the
June 2012 AAII Journal.) Though several factors determine when
to retire, we will point out that there is a financial benefit to
waiting: more salaried years and fewer years of relying on savings.
Source: “Work Longer, Live Healthier,” Institute of Economic Affairs, May 2013.
June 2013
Value-oriented money managers discuss their
strategies and philosophies in “The Art of Value
Investing: How the World’s Best Investors Beat the
Market” (John Wiley & Sons, 2013). Authors John
Heins and Whitney Tilson compile snippets of interviews they have conducted with a large number of
mutual fund and hedge fund managers to provide insights on how professionals approach value investing.
The authors describe the book as providing
answers to questions every money manager should
ask before running a portfolio. To their credit, Heins
and Tilson cover a lot of ground in approximately
300 pages. They have managers on record speaking
about analyzing a company’s financials, assessing its
business models, measuring valuation, managing a
diversified portfolio and deciding when to sell. The
voices are as varied as the answers given. Even where
there appears to be consensus, there are answers
from managers who use a different approach from
the others.
The differences of opinion can be good or bad,
depending on what a reader is looking for. This is
not a book that provides a clear-cut approach to
value investing. Rather, it gives voice to a variety of
approaches, with some advice being very specific
and other advice being broad in nature.
John Vento gives a comprehensive overview
of financial planning in “Financial Independence
(Getting to Point X): An Advisor’s Guide to Comprehensive Wealth Management” (John Wiley &
Sons, 2013). His discussion covers a variety of topics,
including budgeting, taxes, investing, insurance and
estate planning.
We have seen several personal finance books and
were initially concerned about a lack of anything
new in this book. Vento does spend a lot of text
explaining the basics in each chapter. What pleasantly
surprised us, however, was the attention he gave to
more complex topics. For instance, in his chapter
about insurance, Vento details what types of losses
and reimbursements are tax-deductible.
We also like the additional level of detail provided by the various tables, charts and highlighted
text. Among them are pie charts for seven asset
allocation models and a table showing how to calculate the amount a family may have to pay toward
college costs after financial aid is provided.
5
Letters
The Journal welcomes letters to the editor. We reserve the right to edit. Letters should be addressed to: Editor, AAII Journal, 625 North
Michigan Avenue, Chicago, Illinois 60611. Be sure to include your name and address. Alternatively, emails may be sent to: [email protected]
and comments can be posted online for all articles. Past AAII Journal articles referenced here can be accessed at AAII.com.
Relying on a Diversified Portfolio
Comments posted to “Should You Maintain an Allocation to Bonds When Current Rates Are Low,” by Craig
Israelsen, in the May 2013 AAII Journal:
The early baby boomers who invested aggressively during the 1980s and 1990s and then survived Y2K began to
focus like a laser beam on a safe, sound and “cushy” retirement at the start of the century. Then, the two worst bear
markets of their adult lives began. Portfolios that remained
heavily concentrated in equities were absolutely devastated.
Retirement goals were delayed and/or devalued.
As a boomer who has studied asset allocation over the
past 14 years, I have developed a sense of peaceful tranquility with respect to a very diversified portfolio similar in
nature to that constructed by the author of this article. The
bottom line is, as one well-known CNBC market madman
has occasionally shouted, “A diversified portfolio is the only
free lunch in the world of investing.”
—Caesark from Missouri
Generally speaking, a diversified portfolio makes sense.
In this particular environment where bonds have had an
unbelievable run due to the artificial stimulus provided by
the Federal Reserve keeping rates at around zero, I can’t
see how it makes sense to own bond funds right now. They
return nothing in yield and have nothing but downside.
—Jay from California
Adjusting Withdrawal by Rate vs. Amount
Comment posted to “Taking Retirement Withdrawals
From a Fund Portfolio,” by Charles Rotblut, CFA, in the
May 2013 AAII Journal:
I thought the rule of thumb was that the amount (not
the rate) of the first-year withdrawal should be adjusted for
inflation so that the withdrawal is always a fixed value in real
terms (4,000 current-year dollars every year into the future).
Also, 4.0% is quite sporty if you plan 40 years of withdrawals, which is not unreasonable for a healthy 65-year-old
couple and future medical capabilities. Closer to 3.0% would
be safer, as would adjusting the amount of withdrawal on a
yearly basis as a function of market performance.
—BRM from Illinois
Charles Rotblut responds:
I will rerun the numbers assuming the initial withdrawal
amount is increased for inflation, instead of withdrawal rate.
The new numbers will be posted as an addendum to the article.
Bond Due Dates When Laddering
Investing in Buffett’s Stock
Comment posted to “Why Buy Bonds If Interest Rates
Will Rise,” by Hildy Richelson and Stan Richelson, in
the May 2013 AAII Journal:
What I don’t understand about this article is that it is
suggesting laddering your bonds with due dates from 15
to 23 years, while elsewhere in the article it talks about
time frames of five to 10 years. I don’t want to lock up my
money for a minimum of 15 years when interest rates may
be going up in the next few years; I will want to cash out
then and invest in higher-yield bonds.
—Jay from California
Comment posted to “Insights on Warren Buffett From His
Friend and Editor,” an interview with Carol Loomis, in
the May 2013 AAII Journal:
Warren Buffett is undoubtedly one of the greatest
investors. That being said, for retired retail investors such
as myself, my outlook on his investments, and my advice
to others in my category: go elsewhere. Buffett stock will
never provide any dividends as long as he is in charge. His
“A” class stock is way beyond my free cash available, and
his “B” class stock’s performance is nothing to write home
about, compared to many other high-quality stocks. Also,
when Buffett retires, there is no guarantee that the performance of Berkshire holdings will continue to appreciate.
—Steve from Pennsylvania
Hildy Richelson responds:
We recommend bonds in the 15- to 23-year range because
6
that is where the yield is. If the Federal Reserve starts to raise
short-term interest rates, our recommendation would probably
change. However, if you want some yield, two- to five-year
maturities just don’t do it! Five-year Treasuries are currently
paying 0.83% taxable, while AA-rated munis are paying 0.99%.
Twenty-year munis with the same rating are paying better than
3% currently, and are federal, state and maybe local tax-free.
AAII Journal
Feature: Stock Strategies
Using Seasonal and Cyclical Stock
Market Patterns
By Jeffrey A. Hirsch
Article Highlights
• The presidential election cycle, the best six months and January’s basket of indicators are the three main calendar patterns.
• Stocks perform best during the final two years of a presidential term, with the highest returns occurring in the fourth year.
• An alternative approach to selling in May is to take a more defensive posture.
“Those who cannot remem-
ber the past are condemned to
repeat it,” proclaimed philosopher
George Santayana. I believe that
“those who study market history
are bound to profit from it.”
There are three main seasonal and
cyclical patterns that have stood the test
of time and consistently provide me
with an edge in managing my portfolios:
the four-year Presidential Election/Stock Market Cycle, the
Best Six Months Switching Strategy and January’s basket of
indicators and trading strategies.
But first, let’s get one thing straight. While I am a strong
proponent of historical and seasonal market patterns, I am
always mindful that history never repeats itself exactly. I have
used history as a guide for navigating current market conditions and anticipating trends with quite a degree of success
over the years. What we try to get Stock Trader’s Almanac
traders and investors to do is not necessarily follow historical
patterns to a “T,” but to keep them in mind so they know
when their radar should perk up.
Politics, Politics, Politics
What happens on Wall Street is inextricably linked to what
transpires in Washington. For five decades, the Stock Trader’s
Almanac has discussed and demonstrated this phenomenon.
The Four-Year Presidential Election/Stock Market Cycle is
the “Old Faithful” of indicators for us.
Presidential elections every four years have a profound
June 2013
impact on the economy and the stock
market. Wars, recessions and bear markets
tend to start or occur in the first half of
the term, with prosperous times and bull
markets in the latter half. This pattern is
most compelling.
As you can see in Figure 1, the third
year in the presidential term has the best
performance, as there have been no Dow
Jones industrial average losses in preelection years since war-torn 1939. While
pre-election years have generally had
greater gains, election-year market performance has weakened, thanks in part recently to the year 2000’s bear market
and undecided election and the year 2008’s financial crisis.
How the Government Manipulates the Economy
to Stay in Power
In an effort to gain reelection, presidents tend to take
care of most of their more painful initiatives in the first half
of their term and “prime the pump” in the second half so
the electorate is most prosperous when they enter the voting booths. The “making of presidents” is accompanied
by an unsubtle manipulation of the economy. Incumbent
administrations are duty-bound by their parties to retain the
reins of power. Incumbent administrations during election
years try to make the economy look good to impress the
electorate and tend to put off unpopular decisions until the
votes are counted.
After the midterm congressional election and the invariable seat loss by his party, the president during the next two
years jiggles fiscal policies to get federal spending, disposable
income and Social Security benefits up and interest rates and
7
Figure 1. DJIA Average Annual Percentage Gain (1833–2012)
midterm year. (A good number of these
midterm bottoms occurred during the
worst six months.)
A 50% Dow Gain From Midterm
Low to Pre-Election High
Source: Stock Trader’s Almanac.
inflation down. By Election Day, he will
have danced his way into the wallets and
hearts of the electorate and, it is hoped,
will have choreographed four more years
in the White House for his party.
Post-Presidential Year Syndrome
Subsequently, the “piper must
be paid,” producing an American
phenomenon that we have coined
the Post-Presidential Year Syndrome.
Victorious candidates rarely succeed in
fulfilling campaign promises of “peace
and prosperity.”
Most bear markets began in such
years—1929, 1937, 1957, 1969, 1973,
1977 and 1981. Our major wars also
began in years following elections—the
Civil War (1861), World War I (1917),
World War II (1941) and the Vietnam
War (1965). Post-election 2001 combined with 2002 for the worst back-toback years since 1973–74. (These were
first and second presidential term years).
We also had 9/11, the war on terror and
8
the build-up to confrontation with Iraq.
Global financial calamity and the
Great Recession sent the second-worst
bear market for the Dow to its ultimate
low in post-election 2009. Less severe
bear markets occurred or were in progress in 1913, 1917, 1921, 1941, 1949,
1953, 1957, 1977 and 1981. Only in 1925,
1989, 1993 and 1997 were Americans
blessed with peace and prosperity in
the post-election year.
Bottom-Picker’s Paradise
Practically all bear markets began and ended in the two years after
presidential elections. Bottoms often
occurred in an air of crisis: the Cuban
Missile Crisis in 1962, tight money in
1966, Cambodia in 1970, Watergate and
Nixon’s resignation in 1974 and threat
of international monetary collapse in
1982. But crisis often creates opportunity in the stock market. In the last 13
quadrennial cycles since 1961, nine of
the 16 bear markets bottomed in the
In the last 13 midterm election years
(second year in the presidential term),
bear markets began or were in progress
nine times; we experienced bull years in
1986, 2006 and 2010 (1994 was flat).
But by the third year (the pre-election
year), the administrations’ focus shift to
“priming the pump.” Policies are enacted
to improve the economic well-being of
the country and its electorate.
From the midterm low to the preelection year high, the Dow has gained
nearly 50% on average since 1914. A
swing of such magnitude is equivalent
to a move from 10,000 to 15,000. The
puniest midterm advance, 14.5% from
the 1946 low, was during the industrial
contraction after World War II. The
next four smallest advances were: 1978
(OPEC–Iran) 21.0%, 1930 (economic
collapse) 23.4%, 1966 (Vietnam) 26.7%
and 2010 (European debt) 32.3%.
It’s also important to note the
concentration of midterm lows: six in
January and four in October, plus four
secondary lows in 1962, 1974, 1978
and 1998. On the flip side, the greatest
concentration of pre-election year highs
has been in December, with nine occurring in the last month of the year and
six on the last trading day of the year.
Best Six Months Strategy
There is no such thing as a perfect
trading strategy, but our Best Six Months
Switching Strategy has an undeniable
track record. The Best Six Months
strategy is basically the flip side of the
old “sell in May and go away” adage.
It comes from an old British saw, “Sell
in May and go away, come back on St.
Leger Day.” Established in 1776, the St.
Leger Stakes is the last flat thoroughbred
horserace of the year and the final leg
of the English Triple Crown.
While the St. Leger Stakes has little
to do with stock market seasonality, it
does coincide with the end of the worst
AAII Journal
Feature: Stock Strategies
months of the year for stocks. Market
seasonality is a reflection of cultural
behavior. In the old days, farming was
the big driver, making August the best
market month—now August is one of
the worst.
This matches the summer vacation
behavior, where traders and investors
prefer the golf course or beach to the
trading floor or computer screen. Institutions’ efforts to beef up their numbers
help drive the market higher in the fourth
quarter, as does holiday shopping and an
influx of year-end bonus money. Then
there’s the New Year, which tends to
bring a positive new-leaf mentality to
forecasts and predictions as well as the
anticipation of strong fourth- and firstquarter earnings.
After that, trading volume tends to
decline throughout the summer. In September, there’s back-to-school, back-towork and end-of-third-quarter portfolio
window dressing that has caused stocks
to sell off, making it the worst month of
the year on average. Though we may be
experiencing some shifts in seasonality,
the record still shows the clear existence
of seasonal trends in the stock market.
Figure 2. DJIA Monthly Annual Percentage Gain (1950–2012)
Source: Stock Trader’s Almanac.
October months lost
1,654.97 points, up 37
times and down 25.
Figure 3 shows the
average change in the
Dow Jones industrial
average for both the
best and worst sixmonth periods.
Figure 3. Average Percentage Change in DJIA
Since 1950
Performance of Best Six Months
Investing in the Dow Jones industrial average (DJIA) between November
1 and April 30 each year and then switching into fixed income for the other six
months has produced reliable returns
with reduced risk since 1950. Exogenous factors and cultural shifts must
be considered, however. Farming made
August the best month from 1900–1951.
In fact, before 1950 the better strategy
appeared to be “buy in May,” the polar
opposite of present day. Compare this
to modern day where August has been
the second-worst month of the year
for the Dow and the S&P 500 index
since 1987.
Figure 2 illustrates that November,
December, January, March and April
are the top months since 1950. Add in
February, and you have an impressive
trading strategy. These six consecutive
months gained 14,654.27 Dow points
in 62 years, up in 48 years and down in
14, while the remaining May through
June 2013
Seasonal Portfolio
Management
Use of the words
“buy” and “sell” has
created some confusion when used
in conjunction with
our Best Six Months
Switching Strategy.
They are often interpreted literally, but
this is not necessarily
the situation. Exactly
what action an individual investor takes
when we issue our official fall buy or spring
sell recommendation
Source: Stock Trader’s Almanac.
depends upon that
individual’s goals and,
most importantly, risk tolerance.
tails simply switching capital between
A more conservative way to execute stocks and cash or bonds. During the
our switching strategy, the in-or-out “best months,” an investor or trader is
approach as we like to refer to it, en- fully invested in stocks or stock index
9
exchange-traded funds (ETFs) and mutual funds. During the “worst months,”
capital would be taken out of stocks and
could be left in cash or used to purchase
a bond ETF or bond mutual fund.
Another approach involves making
adjustments to a portfolio in a more
calculated manner. During the “best
months,” additional risk can be taken
as market gains are expected, but during the “worst months,” risk needs to
be reduced, but not necessarily entirely
eliminated. There have been several
strong “worst months” periods over
the past decade, such as 2003 and 2009.
Taking this approach is similar to the
in-or-out approach; however, instead of
exiting all stock positions, a defensive
posture is taken. Weak or underperforming positions can be closed out,
stop losses can be raised, new buying
can be limited and a hedging plan can
be implemented. Purchasing out-of-themoney index puts, adding bond market
exposure, and/or taking a position
in a bear market fund would mitigate
portfolio losses in the event a mild summer pullback manifests into something
more severe such as a full-blown bear
market. This is the approach that we
use in the Almanac Investor Stock and
ETF Portfolios.
January Jambalaya
The January Effect
The tendency of small-cap stocks to
outperform large-cap stocks in January
is known as the “January effect.”
It has been reported that the January
effect was first identified by economist
and investment banker Sidney Wachtel.
He studied the seasonal movements
in the stock market and is believed to
have coined the term. Wachtel detailed
his research in his 1942 paper, “Certain
Observations on Seasonal Movements
in Stock Prices,” which was published
in the Journal of Business. The theory
and pattern was that U.S. stock prices
outperformed in January and that small
caps outperformed large caps in January. The January effect phenomenon
was originally likely caused by year-end
tax-loss selling of small-cap stocks,
10
driving their stock prices down. These
bargain stocks are often bought back
in January with the help of year-end
bonus payments.
In a typical year, small-cap stocks
stay on the sidelines, while large-cap
stocks are on the field. Then, around
late October, small stocks begin to wake
up and in mid-December they take off.
Anticipated year-end dividends, payouts
and bonuses could be a factor. Other
major moves are quite evident just before
Labor Day—possibly because individual
investors are back from vacations—and
off the low points in late October and
November. Small caps hold the lead
through the beginning of May.
Wall Street’s “Free Lunch”
Investors tend to get rid of their
losers near year-end for tax purposes,
often hammering these stocks down
to bargain levels. Over the years we
have shown in the Stock Trader’s Almanac that New York Stock Exchange
(NYSE) stocks selling at their lows on
December 15 will usually outperform
the market by February 15 in the following year. When there are a huge
number of new lows, stocks down the
most are selected, even though there are
usually good reasons why some stocks
have been battered. We call this the Free
Lunch Strategy.
In response to changing market
conditions, we tweaked the strategy the
last 13 years, adding selections from the
NASDAQ market, the American Stock
Exchange (Amex) and the OTC (overthe-counter) bulletin board, and selling
in mid-January some years. We have
come to the conclusion that the most
prudent course of action is to compile
our list from the stocks making new
lows on Triple-Witching Friday before
Christmas, capitalizing on the Santa
Claus Rally. (The Santa Claus Rally is
the propensity for the S&P 500 to rally
during the last five trading days of December and the first two of January by
an average of 1.5% since 1950.) This
also gives us the weekend to evaluate
the issues in greater depth and weed out
any glaringly problematic stocks.
This Free Lunch Strategy is only
an extremely short-term strategy reserved for the nimblest traders. It has
performed better after market corrections and when there are more new
lows to choose from. The object is to
buy bargain stocks near their 52-week
lows and sell any quick, generous gains,
as these issues can often give up these
bounce-back gains immediately.
January Barometer
January’s predictive prowess has
been a powerful tool for traders and
investors for decades. Back in 1972,
my father, Yale Hirsch, the creator and
founder of the Stock Trader’s Almanac,
devised the January Barometer. Ever
since the passage of the 20th “Lame
Duck” Amendment to the Constitution
in 1933, it has basically been that as the
S&P 500 goes in January, so goes the
market for the year.
The January Barometer has registered only seven major errors since
1950, for an 88.9% accuracy ratio. Of
the seven major errors, Vietnam affected
1966 and 1968. 1982 saw the start of a
major bull market in August. Two January rate cuts and 9/11 affected 2001.
The market in January 2003 was held
down by the anticipation of military
action in Iraq. The second-worst bear
market since 1900 ended in March of
2009, and Federal Reserve intervention
influenced 2010.
As the opening of the New Year,
January is host to many important events,
indicators and recurring market patterns.
U.S. presidents are inaugurated and present State of the Union addresses. New
Congresses convene. Financial analysts
release annual forecasts. Residents of
earth return to work and school en mass
after holiday celebrations. On January’s
second trading day, the results of the
official Santa Claus Rally are known, and
on the fifth trading day, the First Five
Days early warning system sounds off
(when the first five trading days of the
year are up, the full year has ended up
85% of the time over the last 40 years).
However, it is the whole-month gain or
loss of the S&P 500 that triggers our
January Barometer. Beyond the obvious reasons, a positive January is much
AAII Journal
Feature: Stock Strategies
better than a negative one, since every
down January in the S&P 500 since
1938, without exception, has preceded
a new or extended bear market, a 10%
correction, or a flat year.
Detractors of the January Barometer refuse to accept the fact that the
indicator exists for only one reason:
the 20th “Lame Duck” Amendment to
the Constitution. Prior to 1934, newly
elected senators and representatives did
not take office until December of the
following year, 13 months later (except
when new presidents were inaugurated).
Since 1934, Congress convenes in the
first week of January and includes those
members newly elected the previous
November. Inauguration Day was also
moved up from March 4 to January 20.
In addition, during January, the president
gives the State of the Union message,
presents the annual budget and sets
national goals and priorities.
These events affect our economy,
Wall Street and much of the world. Add
to that January’s increased cash inflows,
portfolio adjustments and market strategizing and it becomes apparent how
prophetic January can be. Switch these
events to any other month and chances
are the January Barometer would become a memory.
Over the years, there has been much
debate regarding the efficacy of our
January Barometer. Disbelievers in the
January Barometer point to the fact that
we include January’s S&P 500 change in
the full-year results and that this detracts
from the January Barometer’s predicative power for the rest of the year. In
light of this debate, we calculated the
January Barometer results with both the
full-year results and the returns for the
following 11 months (February through
December). You can see these results,
along with the S&P 500’s return for
the Santa Claus Rally and the First Five
Days in Table 1.
The Indicator Trifecta
The lack of a Santa Claus Rally
has often been a preliminary indicator of tough times to come. This was
the case recently in 2000 and 2008. A
June 2013
Table 1. Three Positive Early Indicators for S&P 500 Full-Year
Performance
Highlighted rows are post-election years.
Year
1950
1951
1952
1954
1958
1959
1961
1963
1964
1965
1966
1971
1972
1975
1976
1979
1983
1987
1989
1995
1996
1997
1999
2004
2006
2011
2012
2013
Average
Santa Claus First Five
Rally
Days
1.3
3.1
1.4
1.7
3.5
3.6
1.7
1.7
2.3
0.6
0.1
1.9
1.3
7.2
4.3
3.3
1.2
2.4
0.9
0.2
1.8
0.1
1.3
2.4
0.4
1.1
1.9
2.0
2.0
2.3
0.6
0.5
2.5
0.3
1.2
2.6
1.3
0.7
0.8
0.04
1.4
2.2
4.9
2.8
3.2
6.2
1.2
0.3
0.4
1.0
3.7
1.8
3.4
1.1
1.8
2.2
S&P 500 Index Gain (%)
January
Barometer
February
1.7
6.1
1.6
5.1
4.3
0.4
6.3
4.9
2.7
3.3
0.5
4.0
1.8
12.3
11.8
4.0
3.3
13.2
7.1
2.4
3.3
6.1
4.1
1.7
2.5
2.3
4.2
5.0
1.0
0.6
(3.6)
0.3
(2.1)
(0.02)
2.7
(2.9)
1.0
(0.1)
(1.8)
0.9
2.5
6.0
(1.1)
(3.7)
1.9
3.7
(2.9)
3.6
0.7
0.6
(3.2)
1.2
0.05
3.2
4.1
—
0.5
Last 11
Months
19.7
9.7
10.1
38.0
32.4
8.1
15.8
13.3
10.0
5.6
(13.5)
6.5
13.6
17.2
6.5
8.0
13.5
(9.9)
18.8
30.9
16.5
23.4
14.8
7.1
10.8
(2.2)
8.7
—
12.3
Full
Year
21.8
16.5
11.8
45.0
38.1
8.5
23.1
18.9
13.0
9.1
(13.1)
10.8
15.6
31.5
19.1
12.3
17.3
2.0
27.3
34.1
20.3
31.0
19.5
9.0
13.6
(0.003)
13.4
—
17.4
Source: Stock Trader’s Almanac.
4.0% decline in 2000 foreshadowed the
bursting of the tech bubble and a 2.5%
loss in 2008 preceded the second-worst
bear market in history. There have been
several instances in which a Santa Claus
Rally preceded bad years or markets, so
some caution is in order. This was the
case in 2011, although the market did
manage to recoup most of its losses to
finish the year flat.
The last 40 up First Five Days were
followed by full-year gains 34 times,
an 85.0% accuracy ratio and a 13.6%
average gain for all 40 years. In postpresidential election years, this indicator
has a solid record. Just six of the last
15 post-election-year’s First Five Days
showed gains. Only 1973 was a loser,
coinciding with the start of a major bear
market caused by Vietnam, Watergate
and the Arab Oil Embargo. The other
five post-election years gained 22.8%
on average (1961, 1965, 1989, 1997
and 2009).
It’s incredible just how bullish it has
been when all three indicators are positive. Since 1950, all three indicators have
been positive 27 times and full-year gains
followed 25 times. Losses occurred in
(continued on page 36)
11
Valuations, Inflation and Real Returns
An Interview With Robert Shiller
Article Highlights
• A 10-year history needs to be looked at in order to really get a sense of whether stocks are cheap or expensive.
• Most people, even economists, view returns in nominal terms, rather than factoring in the impact of inflation, which reduces real returns.
• A feedback exists between earnings and the market, where a rise in one can contribute to an increase in the other.
Robert Shiller is the Sterling Professor of
Economics at Yale University. He developed
a cyclically adjusted price-earnings ratio, called
the CAPE ratio. We spoke recently about his
research on stock asset valuations and market
bubbles.
—Charles Rotblut
Charles Rotblut (CR): Can you explain what your CAPE
ratio is and what it measures?
Robert Shiller (RS): The basic idea is that you need
some measure of value relative to fundamentals. You can’t
just look at price per share, which doesn’t tell you how
something is over- or undervalued, but price relative to something. It seems to me that earnings is the natural candidate
to compare price with. But the problem with earnings as it
is used is that people tend to use lagging one-year earnings
or projected earnings for the next year. One year is just too
short of a time period because earnings are volatile and they
jump around. In particular, the business cycle affects earnings. When we are in a recession, earnings tend to be low, for
instance. So, I don’t think we should overreact to short-term
fluctuations in earnings.
CAPE is called cyclically adjusted price-earnings ratio,
and it is cyclically adjusted in the sense that we average the
earnings over a longer interval of time. I have been using
10 years, which seems like a very long time for most finance
people. People tend to think that something that happened
10 years ago is just so long ago that it is irrelevant. But,
the conservative strategy argues that, no, it is not irrelevant
and that companies last a long time. In order to really get a
12
sense of their value, you have to look
at a 10-year history and that is what I
have been doing. I work with a former
student, who is now a Harvard professor,
John Campbell. We found that real price
divided by 10-year average of earnings
does actually help predict the stock market.
The stock market is somewhat predictable, using data
all the way back to 1881. It has held up for a long period
of time. The CAPE ratio does not predict what is going to
happen next year very well. It is for long-term investors. It
predicts what will happen over the next five or 10 years. In
other words, when prices are high relative to 10-year average earnings, then that suggests that prices will come down,
but you don’t know exactly when. You might have to wait
five years or 10 years for them to come down. For patient,
long-term investors, I think it makes sense to follow CAPE
as an indicator of value.
CR: What is the CAPE right now?
RS: It reached 23.3 on May 7, the day that the Dow first
broke 15,000, and that is high. [Figure 1 shows the CAPE over
time from Shiller’s website www.irrationalexuberance.com.]
CR: What should a long-term investor looking at the number
do? Should they hold off on stocks or lighten up on their allocations?
What would you suggest?
RS: You have to compare the alternatives. The problems
now are that the main alternatives are not very good either.
Long-term bond yields are near record lows, short-term
interest rates are just about zero and the Treasury InflationProtected Securities (TIPS) are actually paying a negative yield
AAII Journal
Stock Strategies
CR: If we were in a more normal situation for interest rates and bonds looked more
attractive for investors, should investors put
less in stocks or pull out of stocks until the
ratio goes down? Using the year 2000 as an
example, what should an investor have done
at that point?
RS: In 2000, that’s when my first
edition of “Irrational Exuberance”
(Princeton University Press) came out,
I expressed strong worries about the
stock market. So the smart thing to do
would have been to pull out completely
or almost completely in 2000. In fact,
more aggressive investors may have
shorted the market. Shorting the market
is a more aggressive policy that most
people won’t do.
The question today is whether you
want to short the bond market. And in
a sense, I think you do want to short
it. One thing is to buy a house and get
a mortgage. Mortgage rates are so low
now, so borrowing to buy a house is like
shorting the bond market.
We live in a very unusual financial
world right now. I find it so strange that
the TIPS (Treasury Inflation-Protected
Securities) yield is negative because that
means that long term, 10 years, you
can’t make a riskless return at all in real
(inflation-adjusted) terms. Nothing. Less
than nothing. If you invest your money,
and you want it to be riskless, you are
guaranteed that you will lose money.
Guaranteed. But then it becomes a
problem of preservation. There isn’t
any safe way to store value and make
money. If it is safe, it is losing money. If
it is safe in real terms, it is losing money.
And that’s just the world we live in now.
June 2013
Figure 1. Historical Stock Market Valuations, as Measured by the CAPE
50
20
2000
45
18
1981
40
16
1929
35
14
30
12
1901
25
1966
23.2
Price-Earnings Ratio
20
8
15
6
1921
10
5
0
1860
10
Long-Term Interest Rates
Price-Earnings Ratio (CAPE, P/E10)
out 10 or 15 years, so the alternatives are
not very good. Taking that into account,
the stock market doesn’t look so bad.
I’m thinking that people should have
something in stocks. You have to put
your money somewhere, so although
the CAPE ratio is high, it is not super
high. In the year 2000, it was twice as
high as it is now; I thought that was a
bad signal, and I was right about that. We
aren’t getting such a bad signal now from
CAPE, so I think it is still important to
put something in the market.
4
Long-Term Interest Rates
1880
1900
2
1920
1940
1960
1980
2000
0
2020
Year
Source: IrrationalExuberance.com. Data as of May 5, 2013.
CR: Do you think investors grasp the
concept of real returns and how their investments are faring relative to future changes in
their purchasing power?
RS: It is something that has been
remarked for over a century. People,
even economists, are not good at being
consistent at correcting for inflation.
I say even economists, professors of
economics, would get very upset if
their employer cut their pay in nominal
terms, but not very upset if they don’t
raise it. But that’s not really rational. If
in an inflationary environment your pay
isn’t raised, you really have taken a pay
cut in terms of buying power. But most
people don’t see it that way. They think
in nominal terms rather than real terms,
so it is very hard to correct. It affects
people in strange ways. For example,
one reason people think that housing
has been a great investment is because,
more often in housing than in other
investments, they hear what an asset cost
20 or 30 years ago. Grandma is selling
her house to move to a continuing care
retirement community and someone
points out that we sold her house for
$300,000, but she only paid $30,000 for
it 40 years ago. Wow, that looks really
good. But, they don’t reflect that the
Consumer Price Index rose five-fold
in the last 40 years, and so she got less
than 2% a year real return on that investment. So they have the impression
that housing has been this wonderful
investment, when it really hasn’t.
CR: When you look at inflation, what
do you use as a measure?
RS: I customarily use the CPI (U.S.
Consumer Price Index). But right now
there’s a lot of talk about the chained
CPI [which attempts to account for the
effects of substitution when estimating
price changes] and the Federal Reserve
likes to use the personal consumption
expenditure deflator, and these both give
lower measures of inflation. This is what
is being debated in Congress right now
about redoing the indexing of Social
Security with the chained CPI. They’re
not that different, however. The chained
CPI tends to show an inflation rate of
about 4/10ths of a percent less, so it is
not a huge difference. If you’re trying to
get a general sense of investing, I don’t
think it matters which index you use.
TIPS use the Consumer Price Index,
not the chained Consumer Price Index.
CR: One of the criticisms of the CAPE
that I have heard is that over time accounting
standards have changed, so earnings in the early
20th century are different than earnings now.
RS: They are different. I believe
13
one difference going back to the 19th
century is that companies more often
expensed capital expenditures rather
than depreciating them, so that gives a
volatility and rockiness to their earnings
numbers because it is more sensible to
depreciate expenses. But for the purpose
of using them in CAPE, that particular
change doesn’t matter a whole lot because we average over 10 years anyway.
So, I don’t think that is a big issue. There
may have been differences in the way
they did write-offs, I can’t be sure they
are entirely consistent.
But I have looked at earnings statements of firms from long ago, and from
outward appearances they’re basically the
same. You have your revenue, your sales,
your costs and your taxes—all that was
the same. There is a broader problem
in reading history that when you look at
things from long ago, you have a problem putting yourself in their shoes and
understanding their vocabulary and their
thinking. But I don’t think we should
shy away from trying to read history,
because we only learn from history. A
hundred years ago is still relevant. This
room we are sitting in for this interview
here at Yale is from 1884 and we are
still enjoying it. So I think 100 years
ago is still relevant; that is one of my
philosophical orientations.
CR: Another criticism, particularly from
people who are bullish, is that earnings from
the last 10 years are depressed by the last two
recessions.
RS: We have also had a big boom
too. One could go in and make adjustments. I’m not saying that someone
should rely exclusively on CAPE as a
measure. You can make adjustments.
If you go back to Graham and Dodd
in their 1934 book, “Security Analysis,”
which is a classic that apparently informed the judgments of many successful investors, they mention something
like CAPE. And Benjamin Graham
mentions other value indicators. What
he tells you to do is to sit down and
think about every company, using all
available value measures.
I have a product with Barclays,
which is called the Barclays ETN+
14
Shiller CAPE ETN (CAPE); it is traded
on the New York Stock Exchange. It
invests in U.S. sectors, according to the
CAPE. It invests in low-CAPE sectors.
It is an exchange-traded note, so it
does not look at anything else. I don’t
think that should be the only thing one
invests in. But because it goes into the
low-CAPE sectors, it stands a good
chance of outperforming the overall
stock market. So, as a substitution, it
seems to be sensible.
CR: Can you explain the S&P/CaseShiller Home Price Index, what it measures
and how it is constructed?
RS: I started working with Karl
Case in the 1980s. It is kind of amazing
what is not measured. In Europe, the
governments are spending billions of
dollars to try to measure the health of
troubled countries [Portugal, Ireland,
Italy, Greece and Spain], but they don’t
even measure home prices very well, or
at least they didn’t when we first started
this. People didn’t know. I went back
looking at old newspapers and they
would comment on home prices, but it
would be impressionistic. They would
quote some real estate broker and say,
“Oh I think home prices went up maybe
5% last year,” and that’s all they had.
They didn’t have indexes.
Then they started to get median
home values from the National Association of Realtors. These were the
same people who had earlier published
surveys of impressions by realtors of
home prices. They just looked at median
home prices, and medians are sometimes
unreliable indicators.
We thought we could do a better job.
So we produced the Case-Shiller Home
Price Index, and now it is being run by
Standard & Poor’s and CoreLogic. What
we wanted to do was get the price of an
unchanging home, so it is a repeat-sales
index; it looks at changes in prices of
individual homes. What we discovered
was that when you clear out all of the
noise, home prices are very inertial. They
tend to go in the same direction for
years sometimes. It is different than the
stock market. So, home prices are going
up now and that suggests further price
increases based on our index, although
I’m not so sure about that because of
the economic situation we are in. They
are going up now according to our measure and that suggests, based on history,
they will continue to go up for a while.
CR: Other than viewing it as a sign
of the health of the economy, is there a way
investors can use the index in terms of making investment decisions with their portfolios?
Obviously, a house is a very illiquid asset with
a lot of transaction costs.
RS: Usually investment decisions
are very difficult, and I think people
would benefit from having an investment adviser to help them. I have no
connection with financial advisers, but I
do think people could use the help. Right
now, for example, if you are thinking
of buying a house, the main thing that
comes to my mind is whether you want
to accelerate the purchase. Say you’re
thinking of waiting a year and then
buying a house: I think there might be
reason to think that home prices will be
higher in another year, so you might want
to get in sooner. On the other hand, the
inventory is low now. There isn’t a lot
of choice and selection. So if you rush
into it you may buy a house that you
don’t really like. That probably is more
important than any speculative game.
Living in the wrong neighborhood could
cost you for years and years. So one
thing people are deciding is whether they
should speed up the purchase or not.
Another decision people are making is should I buy or rent? That’s an
interesting question. If you think home
prices are going to go up a lot, then you
might want to buy and take those capital
gains over years. I’m thinking that the
argument that home prices are going
to go up a lot over the next five, 10, 15
years is not very strong. It’s more likely
that the stock market will go up a lot.
People should remember that when buying a house, you’re committing yourself
to maintaining this property and paying
property taxes on it. It’s only a hope
that it will go up in price. And history
suggests that it probably won’t. If it is
like history, it probably won’t go up very
much in real inflation-corrected terms.
AAII Journal
Stock Strategies
So I’m thinking that buying a house is
more of a consumption decision than
an investment decision. You should buy
it if you want it; if you would like living
in a house and you want to settle down
for a long time, then that’s great.
The other thing about our economy
right now is that interest rates are so
low. Coming back to my earlier point,
if you’re deciding to buy now or wait a
year, I kind of wonder if it wouldn’t be
better to do it now, other things being
equal, and if you can find a house that
you like, because you might get a lower
mortgage rate now.
CR: In “Irrational Exuberance,” you
talk about bubbles. Do you think when people
approach a decision, whether it’s to buy a house
or a stock, that they think they are making a
decision based upon maximizing profit when
they are really instead acting more on emotion?
RS: The problem with investing
well is that it takes attention and work.
A lot of people don’t want to do that;
they don’t want to give it the time and
attention. Thinking back to the bubble
in 2003: Home prices were going up fast,
so it looked like a great idea to invest
in houses because you could borrow at
a 6% mortgage rate and home prices
were going up 20% a year. It wasn’t
so much that people were irrational or
stupid; they were looking at the obvious.
Maybe they weren’t thinking through all
of the steps carefully or making historical comparisons, but people back then
were saying, look, when home prices are
going up 20% a year and I can borrow
at 6%, it’s a no-brainer to go in. Some
of them were right about that.
But then there’s the other side of
it: You also had to get out at the right
time. You had years to do that. This was
in 2003 and the peak didn’t come until
2005, so that’s two years later and you
could have still gotten out at a profit for
several more years. Eventually, though,
it catches up with you and home prices
fall. And most people are not going to be
that attentive, that’s the problem. Business success tends to reward people who
like business, who like to think about
it and are willing to spend the time. If
you’re not, then maybe you don’t want
June 2013
to try to time the market. Just invest in
a diversified portfolio.
CR: In your book, “Finance and the Good
Society” (Princeton University Press, 2012),
you made a comparison between bubbles and
mental illnesses.
RS: There’s an analogy that a speculative bubble is like an infectious disease:
The excitement of one spreads to another often by word of mouth, but also
through the news media. There’s also a
comparison to mental illnesses, where
most mental illnesses also occur in mild
form in normal people. For example,
some people are addicted to gambling
and they have ruined their lives—I’d call
that a mental illness. But normal people
can get a little bit addicted to gambling
and that’s not really abnormal, it’s within
normal range, but it can cloud their
thinking when they’re doing something,
like deciding whether they should get in
to a housing bubble. So, decisions aren’t
always made rationally. You’re thinking,
well, the housing bubble is going on
right now, but I have to get out before
it bursts so maybe I shouldn’t get in.
But when you’re actually making the
decision, the little devil inside you says,
“Come on now, live life with gusto. Let’s
do it.” That’s a bit of a gambling spirit
that influences judgment. It’s not clear
that a gambling spirit is a bad thing to
have because it may encourage one to
be entrepreneurial or to take calculated
risks. But it can also have a bad side
where it can bring you into speculative
booms as well.
CR: Any suggestions to investors on how to
avoid this behavior? I’m sure you have seen the
fund flow data where it shows investors buying
into funds when the market is going up and
selling funds when the market is going down.
RS: You have to be aware of human
psychology. It is good to read about psychology. Most people don’t know about
the certain anomalies that psychologists
have discovered about human decisionmaking and they think of themselves
as being more rational than they really
are. Most people underestimate, I think,
just how much they are influenced by
hearsay and by others. It’s hard to think
independently. You have to work at it.
CR: Do you view the markets as being
efficient, or do you think they are more driven
by behavioral errors or herd mentality?
RS: I like to talk about this with my
students and I have a free online course
that anyone can take: Econ 252: Financial Markets (oyc.yale.edu/economics/
econ-252-11). I tell my students that it
is a half-truth. I like to start off with the
good side of efficient markets theory,
which is that markets are harder to beat
than you ever thought. It always seems
so easy, but it turns out that there are
a lot of other very smart people you’re
competing against who are trading in
markets. You have to recognize that skill
and professionalism does confer an advantage—again why I think people need
financial advisers. But then the dark side
of efficient markets is that the theory
doesn’t recognize that there are bubbles
and that there is craziness in markets and
that it does take some kind of common
sense to stay out of these and that there
is something to be gained to be aware
of speculative bubbles.
CR: Do you think analysts or investors
have a hard time judging whether an asset is
fully priced or overpriced?
RS: It is very hard. One problem is
that there are so many different ways to
look at any one investment. It’s like the
blind men and the elephant fable. Each
blind man touched a different part of
the elephant, and imagined that what
he touched was something totally different. It’s the same way with stocks. It
is also possible for people to play tricks
on you. It’s easy to lie with statistics by
quoting statistics in a biased way, even
though all the statistics are accurate.
People confuse themselves by looking
at statistics and they get overconfident.
Overconfidence is an important
thing that has been documented by
psychologists. Most people think they’re
above average, when in fact only half
the people are above average. In order to
really succeed well in investing, you have
to do better than just be above average.
It’s not just raw talent, you have to put
work into it and be consistent. That is, if
15
Figure 2. S&P 500: Price Movement and Real Earnings
450
2500
350
300
1500
250
Price
200
1000
150
Real S&P Composite Earnings
Real S&P 500 Stock Price Index
400
2000
100
500
50
Earnings
0
1870
1890
1910
1930
1950
1970
1990
0
2010
Year
Source: IrrationalExuberance.com. Data as of May 5, 2013.
news comes in while you’re on vacation,
you drop your vacation. That’s one of
the costs of good investing.
CR: What do you think drives stocks
higher? In “Irrational Exuberance,” you
talk about how people think it has to do with
earnings or economic growth, but you say there
is not an exact correlation.
RS: Well, when you talk about
aggregate earnings, they are driven by
irrational exuberance as well. It is driven
by people’s spending on the products
that companies make. I show a plot of
corporate earnings through history and
a plot of stock prices and they do seem
to match up somewhat [see Figure 2].
When earnings are growing, stock prices
go up. So you might think that earnings
are really driving the market, and in some
sense they are. But in another sense, it
is feeding back because the market is
driving earnings. When the market goes
up, people spend more because they
feel richer and are more optimistic, so
earnings go up. So it is feedback both
ways between stock prices and earnings.
It is not that earnings are just driving
things; they’re not exogenous. It’s part
of a feedback between stock prices and
earnings.
CR: When they’re analyzing the market,
should investors look at a variety of indicators
and piece together a story versus try to decide
on one data point?
RS: It depends on your interests.
But I think it’s reasonable for most
people to conclude that they are not
going to put enough time into this, especially to try to figure out the large-cap
stocks that everyone is trading in because
there are professional analysts following
them and there are a lot of smart people
you’re competing against. So I think it’s
quite reasonable for someone to delegate
authority by either getting an adviser who
does it for them or simply diversifying
broadly. The very simple way to diversify
broadly is to invest in a market index.
But those who are interested in thinking
about investing can get somewhat of an
edge. It’s not a huge edge, not as big as
you might wish, but it is enough to be
worthwhile if you enjoy doing this kind
of thing. 
Robert Shiller is the Sterling Professor of Economics at Yale University. He will give a keynote address at AAII’s Investor
Conference this fall in Orlando, Florida; go to www.aaii.com/conference for details. Find out more about Shiller at www.aaii.
com/authors/robert-shiller. Charles Rotblut, CFA, is a vice president at AAII and editor of the AAII Journal. Find out more about
Charles at www.aaii.com/authors/charles-rotblut and follow him on Twitter at twitter.com/charlesrotblut.
16
AAII Journal
Mutual Funds
Money Funds and the Regulators
By Mike Krasner
Article Highlights
• Money market funds are not bank products and there is a risk that shareholders could lose money.
• The demise of the Reserve Primary Fund in 2008 led to regulatory changes in 2010.
• Debate about whether additional changes are needed, including floating net asset values, is ongoing.
It is highly likely that as
a member of AAII you have
savings or retirement money
tucked away in a money market mutual fund (MMF), or
indeed maybe more than one.
The Investment Company Institute (ICI), the trade association that speaks for the mutual fund industry, cited in
its 2013 “Fact Book,” year-end 2011 data attributed to The
IRA Investor Database showing that traditional IRA investors
allocated 13.9% of their portfolios to money market funds
while in their 30s and 13.9% when in their 60s. Overall, ICI
stated that retirement account assets in money market funds
totaled $379 billion in 2012.
Money fund investors are all given a fund prospectus
that spells out the fund’s objective and what types of securities it is allowed to buy or specific security types it is not
allowed to hold in its portfolio. The prospectus also covers
the benchmark index used to measure investor returns, how
the fund allocates its expenses, how to invest in the fund,
and other pertinent information.
The prospectus and each accompanying marketing piece
issued by a fund provider include some bullet points in bold
type intended to make it as clear as humanly possible that
a money market fund is an investment product and is not
a bank product. Fund providers note in bold letters that a
money market fund is not covered by bank insurance. Such
communications also include an unambiguous, strong warning
that there is a risk that you can lose money by investing in
June 2013
a money market fund. In fact, each
fund offering typically includes language that is similar to this: “While
the fund’s portfolios seek to maintain
a stable net asset value of $1.00 per
share, it is possible to lose money
investing in the fund.”
Plus, money market funds are subject to regulation by
the Securities and Exchange Commission under its Rule 2a-7
to the Investment Company Act of 1940.
These very clear pronouncements and current oversight
apparently are not clear enough for a cadre of regulators,
mostly on the banking side, or money fund critics who are
provided soapboxes by media outlets. They seemingly will
not be satisfied until every penny of the $2.6 trillion recently
held in U.S. money market fund portfolios is redirected into
federally insured bank accounts or the funds themselves are
radically restructured. The suggested restructuring would
morph money market funds into products equivalent to
extremely short-term bond funds. Such a change would likely
drive investors into alternative products that, in many cases,
are beyond the reach of regulators and provide much less
transparency than do money market funds.
Before we discuss the possible next steps affecting
money funds and you as a money fund investor, let’s pause
for a refresher about how and why they came into being.
A Brief History of Money Market Funds
Bruce R. Bent and a partner launched the first-ever
17
money fund, called The Reserve Fund,
in October 1971 with the goal of permitting any investor, large or small, to
earn money market rates on their cash
holdings. Bent often described his fund
as being a “sleep-at-night” stable-value
product. The fund was conservatively
invested in short-term instruments that
were deemed to be extremely safe. It
was billed simply: “a dollar in, a dollar
out with some interest,” though no
guarantees were issued.
Over time, other companies introduced their own money funds, and
checking privileges were added. In the
super-inflationary period of the late
1970s and early 1980s, even banks created their own funds to stem deposit
outflows to retail-oriented money funds,
which resulted from mandated limits on
allowed interest-rate payouts for banks’
savings products.
Taxable money market funds, which
consist of government funds and prime
funds, came first. They were later joined
by tax-exempt money market funds.
Government funds principally invest in
“U.S. Treasury obligations and other financial instruments issued or guaranteed
by the U.S. government, its agencies or
instrumentalities,” according to the ICI.
Prime funds, the ICI noted, “invest in a
wider variety of high-quality, short-term
money market instruments, including
Treasury and government obligations,
certificates of deposit, repurchase agreements, commercial paper and other
money market securities.”
Tax-exempt or tax-free money
market funds likewise seek to maintain
a stable net asset value of $1 and invest
in municipal money market securities.
“The dividends of these funds are not
taxed by the federal government, nor
in some cases are they taxed by states
and municipalities,” stated ICI.
Total assets of U.S. money market
funds reached $1 trillion in August 1997
and smashed through the $2 trillion barrier in November 2001, iMoneyNet data
recorded. The funds’ virtually unblemished success, the simplicity of keeping
track of $1-per-share pricing and higher
returns than offered by competing bank
products, continued to attract investors
18
seeking safe havens during periods of
market turbulence or to set aside cash
intended for future purposes, first primarily retail then later predominately
institutional investors.
Tranquility in money-fund land was
disturbed by the financial crisis of 2008
and the blowup of securities packaged
with subprime mortgages issued in the
U.S. This crisis led to European banks
refusing to lend to one another, and the
U.S. commercial paper and repurchase
agreement (“repo”) markets seizing up.
[Editor’s note: The International Capital
Market Association defines a repo as an
agreement where “one party sells an
asset (usually fixed-income securities)
to another party at one price at the
start of the transaction and commits to
repurchase the asset from the second
party at a different price at a future
date or (in the case of an open repo)
on demand.”]
Tranquility disappeared when the
first-ever money fund, which by then
had been renamed as the Reserve
Primary Fund, ran aground in midSeptember 2008. Bent’s fund was caught
holding large amounts of top-rated but
suddenly worthless securities issued
by Lehman Brothers when that firm
unexpectedly filed for bankruptcy and
was not included in a government rescue
plan. The Reserve Fund thus became
the first retail fund to “break the buck,”
meaning its price fell below $1 per share.
The fund ceased operations immediately
and its shareholders ultimately received
about $0.98 on each dollar invested. The
fund’s demise prompted a thorough
review of money fund structures and
operations by the industry itself and
by the SEC, which in January 2010 announced changes to Rule 2a-7.
“The SEC’s new rules are intended
to increase the resilience of money
market funds to economic stresses and
reduce the risks of runs on the funds
by tightening the maturity and credit
quality standards and imposing new
liquidity requirements,” the agency said.
Post-Financial Crisis Changes
Taxable funds since the phase-in
of the SEC’s amended rules have been
required to hold at least 10% of total
assets in “daily liquid assets” and at
least 30% of assets in “weekly liquid
assets.” Liquidity provisions were added
to meet reasonable requests by investors
to cash in some or all shares. Basically,
daily liquid assets are subject to a onebusiness-day demand feature and feature
cash or U.S. Treasury securities, while
the fund’s so-called weekly liquidity
bucket consists of similar securities
with remaining maturities of 60 days
or fewer, or that mature or are subject
to a demand feature within five business days.
All money market funds are now
subject to periodic stress testing. They
are also allowed to suspend redemptions
if maintaining the “amortized-cost”
$1.00 share price is believed to be problematic. Other rule changes include limitation to a 60-day maximum weightedaverage maturity for all securities being
held in portfolios (it was previously set
at 90 days); institution of a new metric,
the 120-day weighted-average life based
on final maturity dates; and fresh curbs
on investments in repos.
The SEC also required fund companies to supply the agency with detailed
portfolio information and market-based
value for each fund at the end of every
month. Funds were additionally required
to show investors, through monthly
website postings, details about the securities in each fund’s portfolio. Such
postings are supposed to appear within
five business days after a month ends,
enabling investors to better compare
one fund’s makeup to another’s. Furthermore, the 2010 money market fund
amendments also gave fund families
until October 31, 2011, to be able to
process transactions at a variable price
other than $1 per share.
Proposed Additional Changes
The SEC chairman at the time,
Mary Schapiro, made it known that while
she was head of the regulatory body,
she personally would continue to press
for variable net asset values (NAVs) to
supplant the long-established constant
AAII Journal
Mutual Funds
net asset value pricing for all funds. Her
reasoning was that investors would be
shown that pricing of the securities
held in money fund portfolios fluctuates each day due to market forces. She
feared that the share price of $1.00 was
being misinterpreted by many as being
a “bank-like” guarantee.
In August 2012, the SEC held up
a planned discussion of mandating a
floating net asset value for money funds
and other suggested further changes to
Rule 2a-7. This occurred after three of
the five members requested a staff study
about the funds’ ability to withstand
financial upsets in Europe, the downgrading of U.S. government debt by a
major rating agency and other market
developments since the 2010 amendments were adopted. That report was
issued on November 30, 2012.
In the meantime, Schapiro had
taken her arguments for further moneyfund regulation to the Financial Stability
Oversight Council (FSOC), a body created by the Dodd-Frank Act on which
she served due to her SEC position.
Five of the 10 voting members of the
FSOC regulate banks or depository-type
institutions. Then-Treasury Secretary
Timothy Geithner and Schapiro pushed
through a package of several alternative structural reforms “to address the
risks posed by money market funds”
on November 13, 2012.
The FSOC continues to study assigning the systemic-risk label to money
market funds and other so-called nonbanks operating in the “shadow-banking
system.” The council first called for
replacing the stable net asset value,
based on amortized-cost accounting
and/or penny rounding (see the box
on this page for explanation), with a
floating net asset value, which would
not always be at $1 based on market
values of securities held in a portfolio,
a concept that the SEC had rejected
several times previously after study.
SEC rules currently state that fund
managers must “periodically ‘shadow
price’ the amortized-cost net asset
value of the fund’s portfolio against
the mark-to-market net asset value of
the portfolio. If there is a difference of
more than one-half of 1% (or $0.005
per share), the fund’s board of directors
must consider promptly what action, if
any, should be taken, including whether
the fund should discontinue the use of
the amortized-cost method of valuation
and re-price the securities of the fund
below (or above) $1.00 per share, an
event colloquially known as ‘breaking
the buck.’”
Other ideas advanced by the FSOC
for public comment included creating
NAV buffers and delaying redemptions
of the full amount of cash put in by
investors of troubled funds for up to
30 days. The FSOC made clear it would
send its final recommendations to the
SEC for action, if it has not acted on
its own.
Commissioner Troy Paredes, while
appearing at the iMoneyNet Money
Market Expo (MMX) on March 12,
2013, declared that “It’s paramount that
money-fund reform be decided within
the commission.” New SEC Chairman
Mary Jo White, who officially assumed
her role on April 10, 2013, stated at her
Senate confirmation hearing that she
believed securities regulators should
set the future course for regulation of
money funds, as they are investment
products. SEC Commissioner Daniel
Gallagher has been quoted as indicating that money-fund reform should be
taken up by the commission within the
next two months, or by mid-June 2013.
The SEC, for its part, has focused
in the past on ways to discourage some
investors from fleeing funds rumored
to be in trouble. If some investors
pulled out of perceived troubled money
market funds, other slower-acting investors would be left to bear the costs of
winding down an ill-fated fund.
“Fundamentally, we have to ask,
‘What are we solving for?,’ which explains the need to focus on data analysis,
on the economics, and on the costs and
benefits of any proposed reforms,”
Paredes told the Money Market Expo
audience in March. “If you think that
what really happened was a massive run
from risk, getting rid of the buck doesn’t
solve the problem because a run-fromrisk isn’t addressed by a floating NAV,”
an apparent allusion to the failure of
floating-NAV French money market
funds at the height of the 2008 crisis.
“If regulation solves the wrong problem
and drives investors into less-regulated
products, we will have damaged an enormously effective investment product,
incurred substantial costs and created
rather than mitigated risk in the financial
system,” Paredes added.
Money market funds, meantime,
continue to be the object of some media
scorn. A March 29, 2013, commentary
by MarketWatch columnist Rex Nutting
claimed that money market funds are
riskier than ever.
“Money market funds, thought to
be one of the safest investments, are
actually some of the most dangerous.
Stable NAV Accounting Methods
Current money market fund regulation, SEC Rule 2a7(a)(2) of the Investment Company Act of 1940, defines
the amortized-cost method as “the method of calculating
an investment company’s net asset value [per share] whereby
portfolio securities are valued at the fund’s acquisition cost
as adjusted for amortization of premium or accretion of
June 2013
discount rather than at their value based on current market factors.” Rule 2a-7(a)(20) defines the penny-rounding
method of pricing as the method of computing a fund’s
price per share “for purposes of distribution, redemption
and repurchase whereby the current net asset value per
share is rounded to the nearest one percent.”
19
Figure 1. Taxable Retail Fund Asset Flows, 8/31/08 to 4/30/13
$1,100
Millions
$900
$700
$500
$300
8/
1
10 / 200
/1 8
/
12 200
/1 8
/2
2/ 008
1/
2
4/ 009
1/
2
6/ 009
1/
2
8/ 009
1
10 / 200
/1 9
/
12 200
/1 9
/2
2/ 009
1/
2
4/ 010
1/
2
6/ 010
1/
2
8/ 010
1/
10 201
/1 0
/
12 201
/1 0
/2
2/ 010
1/
2
4/ 011
1/
20
6/ 11
1/
2
8/ 011
1
10 / 201
/1 1
/
12 201
/1 1
/2
2/ 011
1/
2
4/ 012
1/
2
6/ 012
1/
20
8/ 12
1
10 / 201
/1 2
/
12 201
/1 2
/2
2/ 012
1/
2
4/ 013
1/
20
13
$100
Source: iMoneyNet
Pri me Reta i l
Ta xa bl e Reta i l (Al l )
Government Reta i l
Figure 2. Tax-Free Retail Fund Asset Flows, 8/31/08 to 4/30/13
$325
Millions
$275
$225
$175
$125
8/
1/
10 20 0
/1 8
12 /2 00
/1 8
/2
2/ 008
1/
2
4/ 0 09
1/
2
6/ 0 09
1/
20
8/ 09
1/
10 20 0
/1 9
/
12 2 00
/1 9
/2
2/ 009
1/
2
4/ 0 10
1/
2
6/ 0 10
1/
2
8/ 0 10
1/
10 20 1
/1 0
/
12 2 01
/1 0
/2
2/ 010
1/
2
4/ 0 11
1/
2
6/ 0 11
1/
20
8/ 11
1
10 /20 1
/1 1
/
12 2 01
/1 1
/2
2/ 011
1/
2
4/ 0 12
1/
20
6/ 12
1/
2
8/ 0 12
1/
10 20 1
/1 2
/
12 2 01
/1 2
/2
2/ 012
1/
2
4/ 0 13
1/
20
13
$75
Source: iMoneyNet
Ta x-Free Na ona l Reta i l
They are still vulnerable to the same
kind of bank run that nearly pushed the
global economy over the brink in 2008,
and there’s no plan by the industry or
by its regulators to fix that vulnerability,” Nutting wrote. “Current U.S. law
prohibits the kind of federal guarantee
that, in 2008, stopped the bank run
before it could bring down the financial
system. The next run on these shadowy
bank-like institutions could be fatal.”
Federated Investors, which runs the
third-largest U.S. money market fund
complex by assets, was quick to provide
a rebuttal to Nutting’s piece, noting that
60 million investors as well as corporations and state and local governments
understand the disclaimers cited earlier
that money funds are investments and
are not akin to banks. Money funds,
Federated stated, unlike banks and other
20
Ta x-Free Reta i l
financial-services companies, did not
need “to get rid of any toxic assets in
the aftermath of Lehman’s bankruptcy,
AIG’s rescue or other bailouts. Money
fund portfolios were sound, but the
global liquidity crisis prevented the funds
from selling assets. The industry pleaded
for liquidity in the system, not insurance
for fund companies, it claimed.
The Federated response also faulted
the MarketWatch columnist for ignoring the 2010 SEC reforms. The company argued that those reforms have
proven to be effective in bolstering
longstanding rules, while helping carry
the funds through the Greek debt crisis,
downgraded U.S. government debt, and
debate over the U.S. budget and debtceiling impasse, covering all redemption
requests as assets declined 10% during
the summer 2011 events.
“Most recently, in January of this
year [2013] money-fund industry leaders
took additional steps and began publicly
reporting the daily net asset [market]
value of money market funds [also called
the variable, ‘shadow’ or floating net
asset value]—another initiative Mr. Nutting fails to mention. The bottom line
is that money funds are well-regulated
and the system, particularly in light
of the 2010 amendments, is running
smoothly,” Federated declared.
Brian Reid, chief economist at the
ICI, while presenting at the Money
Market Expo in March, pointed out
differences between banks and money
funds. “Banks have modest amounts of
capital, heavy leverage, no explicit liquidity requirements, long-dated, illiquid,
nonmarketable loans, with significant
credit risk and almost no transparency
about their assets and liabilities.” They
are vulnerable to runs by depositors, he
added. Money funds, by contrast “are
not leveraged, have requirements to
maintain mandated levels of liquidity
and hold short-dated liquid, high-quality,
marketable securities with minimal
credit risk. They publish their portfolios
monthly, and they are not guaranteed
by the U.S. government.”
Funds are also able to routinely accommodate asset outflows because the
short-dated securities they hold “trade
in liquid and diverse markets. That type
of volatility in a bank’s balance sheet
would cripple it,” he commented.
iMoneyNet portfolio holdings data
demonstrates that prime retail funds
are being operated even more conservatively than before the Reserve Fund’s
collapse in September 2008. Holdings of
U.S. Treasury and “other U.S.” government-backed securities have increased
to a combined 17% of total assets as
of April 9, 2013, up from a combined
9% on September 2, 2008. Holdings of
commercial paper have been reduced,
which is mainly due to reduced supply.
The SEC’s Paredes, answering
questions at the iMoneyNet event,
stated his belief that prime institutional
funds, which sustained large outflows
immediately after the Reserve Fund
went down as investors sought safety
AAII Journal
Mutual Funds
in Treasury money market funds,
Table 1. Highest-Yielding Retail Money Funds
should be the focus of “reform
approaches” rather than retail,
7-Day
Compound
Assets
Phone
Treasury and tax-free money
Government Retail Money Funds
Yield (%)*
($ Mil)
Number
funds.
Figures 1 and 2 show that
1. Selected Daily Govt Fund/Cl D
0.14
21.6
(800) 243-1575
prime and government retail fund
2. Direxion US Govt MMF/Cl A
0.09
20.0
(800) 851-0511
assets and tax-free retail fund as3. First Amer Govt Oblig/Cl A
0.02
252.0
(800) 677-3863
sets tracked by iMoneyNet have
3. Lord Abbett US Govt & Govt SE MMF/A 0.02
547.1
(888) 522-2388
dipped since August 2008, but
Government Average
0.01
the declines could be considered
Prime Retail Money Funds
modest due to the prolonged
near-zero interest-rate environ1. Invesco MMF/Investor Class
0.09
168.5
(800) 659-1005
ment. The Federal Open Market
2. Meeder MMF/Retail
0.08
68.1
(800) 325-3539
Committee has held its federal
3. Schwab Cash Reserves
0.06
35,904.6
(800) 435-4000
funds target rate at between zero
4. Capital Assets Fund/Preferred MMP
0.05
1.8
(800) 730-1313
and 0.25% since December 2008.
4. Delaware Cash Reserve/Class A
0.05
222.2
(800) 362-7500
Nancy Prior, president of
4. PNC Money Market Fund/Cl A
0.05
265.6
(800) 622-3863
Money Markets at Fidelity InvestPrime Average
0.01
ments, the largest money-fund
Tax-Free National Retail Money Funds
complex with assets exceeding
$415 billion, in an address at
1. Invesco Tax-Exempt Cash Fund/Inv
0.20
8.5
(800) 659-1005
Money Market Expo, noted that
2. Alpine Municipal MMF/Inv
0.08
214.0
(888) 785-5578
“more than 450 banks have failed
3. Vanguard Tax-Exempt MMF
0.05
17,108.1
(800) 662-7447
since the financial crisis began.”
4. PNC Tax-Exempt MMF/Cl A
0.02
41.7
(800) 622-3863
Prior argued that the 2010 SEC
4. Western Asset T-F Reserves/Cl N
0.02
59.5
(800) 331-1792
amendments “have made money
Tax-Free National Average
0.02
market mutual funds more resilient. Further action is simply not
*Highest compounded (effective) rate of return to shareholders reported to Money
Fund Report for the past seven days for period ended May 7, 2013.
warranted.”
Source: iMoneyNet Inc., an Informa Financial company,Westborough, Mass. 01581;
She further observed, “A
www.imoneynet.com.
floating NAV is not the answer.
It would impose burdensome tax,
accounting and recordkeeping
requirements for investors. Moreover, the FSOC and SEC have identified as than ever before. Many firms that did
there is no evidence to suggest it would a concern, these types of funds should not operate money market funds as a
prevent outflows in a crisis. It won’t re- be excluded from any additional reform core business have been weeded out of
duce risk in the system. Our customers measures,” she declared.
the industry due to low rates and the
have told us, loudly and clearly, that they
As that event in Orlando wrapped expenses associated with complying
have little or no interest in a product with up, a consensus seemed to emerge that with the regulatory requirements added
a floating NAV or one that continually that would be the most likely avenue for in 2010, making their continued fund
limits access to their funds.”
the SEC to explore as it regroups under operations uneconomical.Table 1 shows
Prior urged regulators, as they press new leadership, with the FSOC watching the highest-yielding retail money market
ahead, to narrowly focus on solving closely as events proceed.
funds as of May 7, 2013.
problems related to the ability of money
The issue facing the industry and
market mutual funds to “sustain large,
investors
who rely on money funds is:
Conclusion
abrupt redemptions in times of severe
Will regulators harm or kill a product
market stress. Because Treasury, governThe SEC has taken steps supported that is admittedly not risk-free, in the
ment, municipal and retail prime money by the industry to make funds “safer,” interest of attempting to eliminate all
market mutual funds do not pose the with evidence showing that fund port- risk? As Commissioner Paredes asked,
liquidity, credit and redemption risks that folios are being run more conservatively “What are we solving for?” 
Mike Krasner is managing editor at iMoneyNet, which provides information on money market funds to institutions. Find out
more at www.aaii.com/authors/mike-krasner.
June 2013
21
Member News
American Association of Individual Investors® Spring 2013, Number XXVIII
Model Portfolio Combines Mutual Funds, ETFs
AAII members trying to decide
whether to invest in mutual funds or
exchange-traded funds (ETFs) can now
look to the Model Fund Portfolio for
guidance. This portfolio has been revised to take advantage of the strengths
of both, by combining mutual funds
and ETFs.
As AAII Founder and Chairman
James Cloonan explained, ETFs offer the advantages of generally lower
expenses, the ability to both get updated
pricing information and buy and sell
shares any time the market is open and
the ability to tax-manage them according to individual requirements. What
ETFs cannot do, however, is exploit the
significant inefficiencies that currently
exist.
Actively managed mutual funds,
which are not tied to an index, can
exploit these inefficiencies. Mutual
funds add value when the investment
approach used provides a post-expense
return advantage or reduces risk for the
portfolio.
In both cases, prudent fund selection
is required, and this is what the Model
Fund Portfolio does. Five ETFs targeting asset classes best suited to indexing
are held to lower the expense ratios
paid. Four mutual funds with good
long-term performance and that follow
unique actively managed strategies are
also held. This combination allows the
portfolio to take the advantage of both
worlds, rather than dogmatically adhering to an ETF-only or mutual fund-only
strategy.
The Model Fund Portfolio is updated
quarterly, with new commentaries
appearing in the March, May, August
22
and November issues
of the AAII Journal.
Performance figures
are updated monthly,
typically on the 15th
of each calendar
month. A complimentary monthly
email with the results
is available and AAII
members can subscribe to the email
at www.aaii.com/
email. (On this page,
you can also sign
up for other helpful
AAII newsletters,
including the weekly
Investor Update and
the monthly Stock
Screens Update.)
If you prefer to
build and manage your own fund
portfolio, AAII has
information and
guides that can assist
you, as explained below.
Mutual Fund Resources
Every February, we publish an annual
Guide to the Top Mutual Funds. This
year’s guide covered 733 funds in the
printed magazine and 1,560 funds on
AAII.com. The guide is very comprehensive, providing 10 years of return
data, performance for the current bull
market and last bear market, yield,
expense ratio, risk information and tax
efficiency.
Funds are grouped by category. This
year we added new target date fund
categories. We also expanded our sector
listings to include new categories for
funds investing in consumer discretionary, consumer staples, industrials,
natural resources/commodities and
global real estate stocks. To make comparisons easier, we publish averages for
each category and bold those funds that
rank the best among their peers for each
characteristic (e.g., three-year return).
If you prefer instead just to see the
best funds, each March we tell you.
This popular AAII Journal article identifies the funds in each category that
realized the highest five-year returns.
Member News 2013
We further explain the trends behind
the good performance, so you can judge
whether the performance advantage is
sustainable.
Our Investor Classroom can also help
you better manage a fund portfolio. We
offer useful lessons on what exactly a
mutual fund is, how to assess a fund’s
risk, what to look for in fund statements and how to buy and sell fund
shares. You can find these lessons and
other useful information at www.aaii.
com/classroom.
ETF Resources
In addition to our mutual fund guide,
we also publish an annual guide to the
top exchange-traded funds. Last year’s
guide covered 450 ETFs in the print
version of the AAII Journal and 1,475
funds on AAII.com. We provided
return data on all U.S. exchange-listed
ETFs, including performance, yield, net
asset value, expense and tax efficiency.
Whenever possible, we use the same
categories as our mutual fund guide
to make comparisons. Also like the
mutual fund guide, those ETFs that
rank best among
their peers are
highlighted with
bold type.
The best-performing ETFs
are highlighted
in the September
AAII Journal. We
highlight those
funds with the
best three-year
performance by
category. We also
explain the factors
behind the strong
performance so
you can judge
whether the good
returns are sustainable. Updates to
the ETF Guide
and the Top ETFs
will be published
in the August 2013
and the September
2013 AAII Journal,
respectively.
Additional Guides
The Mutual Fund Guide and the ETF Guide are just two of the guides available to you as an AAII member. On the AAII
Guides page (www.aaii.com/guides), you can also find helpful information on taxes, investment websites and discount brokers.
You can also read Jim Cloonan’s Lifetime Investment Strategy, which provides important guidelines for successful portfolio management.
AAII Financial Summary
Annually, AAII publishes its year-end balance sheet for members and life members interested in the finances of the association. Prior years’ balance sheets can be found online in the Member News sections of past AAII Journals.
American Association of Individual Investors
Balance Sheet: December 31, 2012
Assets
Current Assets ........................... $728,406
Investments .............................. 6,583,842
Net Fixed Assets............................ 10,508
Liabilities and Fund Balance
Accounts Payable ................................. $285,530
Deferred Membership Revenue .......... 4,241,933
Deferred Life Membership Revenue.. 12,768,061
Fund Balance ....................................(9,972,768)
Total Assets............................ $7,322,756
Total Liabilities and Fund Balance.. $7,322,746
Note: Deferred membership revenue is recognized periodically as income over the membership period. Deferred life membership is
recognized periodically as income over a 25-year period. This accrual method of accounting reflects the Association’s long-term obligation
to its members.
23
AAII Investor Conference 2013:
Keynote Speakers This Fall in Orlando
This November, AAII will be hosting our Investor Conference in Orlando, Florida, and we are pleased to announce that we’ve
arranged for two well-respected and prominent investment professionals to provide their view of the markets to our members.
James
O’Shaughnessy
CEO, CIO, O’Shaughnessy
Asset Management
Author, “What Works
on Wall Street” and
“Predicting the Markets of
Tomorrow”
Opening Session
Luncheon Session
The AAII Conference Keynote
Opening Session will feature
James O’Shaughnessy. He will
discuss stock investing while using
history and data as a guide to
explain to attendees the key characteristics of investments that do
and don’t lead to better returns.
Jim is the chairman, CEO and
CIO of O’Shaughnessy Asset
Management (OSAM).
Recognized as one of America’s
leading financial experts and a
pioneer in quantitative equity
analysis, he has been called a
“world beater” and a “statistical
guru” by Barron’s. In February
2009, Forbes.com included Jim in
a series on “Legendary Investors,”
along with Benjamin Graham,
Warren Buffett and Peter Lynch.
The Keynote Luncheon Session will feature Dr. Robert
Shiller, Yale economics professor
and renowned investor. Shiller is
one of the most far-seeing economists of our time. He will discuss
whether stocks are attractive
or expensive at current levels.
Using historical data and relative
valuations, conference attendees
will see how stocks are valued
now and where investors should
look for future opportunities.
Shiller is known around the
world for his brilliant forecasts
of financial bubbles and his
penetrating insights into market
dynamics. His presentation is a
“must see” for anyone who has
money in the markets.
Dr. Robert Shiller
Yale Economics Professor;
Financial Columnist;
Co-developer, Case-Shiller
Home Price Indices
Author, “Irrational
Exuberance” and “Finance
and the Good Society”
The 2013 AAII Investor Conference is being held at the Loews Royal Pacific Resort in Orlando, Florida, from Friday, November 15 to Sunday, November 17, 2013. The event features over 25 educational presentations and 30 investor workshops.
The member attendee fee is $345. Attendees receive full access to all presentations, the keynote luncheon, the welcome reception, a Forbes panel discussion, the Smart Investor Exhibit Hall and complimentary continental breakfasts.
To learn more about this special AAII event, please visit www.aaii.com/conference.
Supplemental Benefit: The AAII
Discover Bank Program
AAII is partnered with Discover
Bank to give you access to certificates
of deposit (CDs), IRA CDs, money
market accounts and online savings accounts earning preferred members-only
rates that are higher than the nationally
advertised rates on comparable Discover accounts.
Though you may know the company
for its credit products, Discover has
actually been in the banking business
24
since 1911—and today, it’s emerging
as one of the nation’s leading direct
banks. As an AAII member saving with
Discover, you’ll benefit from:
• Rates that have consistently exceeded the national average1
• No minimum opening deposit
requirement
• Easy and convenient online account management
• 24/7 customer service, both online
and by phone
• Accounts insured up to FDIC limits, currently $250,000
Visit https://aaii.discoverbank.com or
call Discover at (800) 347-7513 to learn
more about these products and the preferred members-only rates you’ll earn.
1
Based on top 50 U.S. banks by deposit
provided by Informa Research Services Inc. as of
5/1/2013.
Member News 2013
Academic Awards: Fostering Investment
Education and Research
Six papers won awards for investment
research from AAII in 2012. The awards
are presented as part of AAII’s ongoing effort to encourage education and
research in the area of investments and
are given for papers that provide insight
into investing.
The awards are made in conjunction
with the meetings of major finance associations around the country. The best
academic paper in investments presented
at these meetings is selected by a committee of investment research experts.
AAII awards the writers of winning
papers $1,000, and papers are selected
based on the quality and thoroughness
of research and on the contribution to
shaping effective investment decisions.
Since the program began in 1983, over
150 awards have been presented. The
award-winning papers and recipients for
2012 include:
“Can Large Pension Funds Beat the
Market? Asset Allocation, Market Timing, Security Selection, and the Limits of
Liquidity,” by Aleksandar Andonov and
Rob Bauer of Maastricht University, and
“Unknown Unknowns: Vol-of-Vol and
the Cross Section of Stock Returns,” by
Sjoerd Van Bekkum and Guido Baltussen of Erasmus University Rotterdam,
both awarded by the Eastern Finance
Association.
“Understanding the Term Structure of
Credit Default Swap Spreads,” by Bing
Han of the University of Texas at Austin
and Yi Zhou of Florida State University,
awarded by the Midwest Finance
Association.
“The Impact of Leveraged and Inverse
ETFs on Underlying Stock Returns,” by
Qing Bai, Shaun Bond and Brian Hatch
of the University of Cincinnati, awarded
by the Southwestern Finance Association.
“Public Versus Private and Focused
Versus Conglomerate Mutual Fund
Companies,” by Fan Chen, Gary C.
Sanger and Myron Slovin, awarded by
the Southern Finance Association.
“A New Asset Pricing Model Based
on the Zero-Beta CAPM: Theory and
Evidence,” by Wei Liu, James Kolari
and Jianhua Huang of Texas A&M
University, awarded by the Financial
Management Association.
These papers are technical; however,
the AAII Journal does publish the findings of papers that are of particular interest to individual investors. If you would
like a copy of a paper, you can contact
Fareeha Ali at (800) 428-2244 or
[email protected].
Supplemental Benefits
AAII offers several supplemental
benefits to members. These include
discounts on financial publications,
an insured money market deposit
program from Discover Bank and an
affinity credit card program provided
by Capital One.
We view these programs as
supplemental benefits and do
not want to lose sight of our main
purpose. However, many of these
programs are helpful to a significant
number of our members; in some
cases, they provide AAII with additional income. For example, with the
Discover money market program,
AAII receives 0.05% per year on the
outstanding deposits. These funds
help us to support our investment
research grants and to educate
individual investors.
Future supplemental benefits will
also be offered as opportunities,
and not as recommendations. Only
you can decide what is best for you.
AAII.com Privacy Policy
Our goal at AAII is to offer you the
best investor education in a simple and
secure manner over the Internet. We
gather member information in order to
provide an investor-friendly service.
We request your email address as
part of the registration process for
AAII.com. We use this information to
contact our members and guest users
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To improve our website, we regularly
track usage through log analysis to
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The information we collect through
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user and remains confidential. This
information is used to determine
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clicks and the length of time a member
spends on a page. We keep track of this
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AAII.com uses cookies to remember
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disturbance. Our site is set to keep you
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that during a single browser session you
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AAII does maintain a subscriber list
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screened companies that offer personal
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receive these offers, please let us know
by contacting AAII Member Services at
(800) 428-2244.
25
Lowell Miller’s Best Dividend Screen
By John Bajkowski
Article Highlights
• High dividend-paying stocks with increasing dividends offer rising income streams and higher price valuations.
• “Best stocks” have above market yields, dividend growth, financial strength and a reasonable valuation.
• Miller also considers price momentum and the quality of management.
A low interest rate environ-
ment has helped to fuel a run-up
in the prices of dividend-paying
stocks.
Equity-income investing is once again
fashionable, but some investment advisers
have always preached the long-term benefits
of investing in dividend-paying stocks. Lowell Miller is known for his disciplined, dividend-focused investment strategies. He founded Miller/Howard Investments
Inc. (www.mhinvest.com) in 1984 and manages a number of
portfolios constructed of financially strong firms with the
ability to pay and consistently raise dividends.
The Philosophy
Lowell Miller lays out his strategy in his book “The Single
Best Investment: Creating Wealth with Dividend Growth”
(Print Project, second edition, 2006). We first featured a
screen based upon his approach in a June 2009 AAII Journal
First Cut article titled “High Quality + High Yield + High
Growth Stocks.” At the time, Miller argued that high-dividendyielding stocks have performed extremely well after past bear
markets, especially bear markets induced by a recession—a
prediction that proved to be very accurate. With the run-up
in dividend-paying stocks, it is important to have a system in
place to keep your emotions in check and have an analytical
framework to select and manage your portfolio. In this article,
we provide a more detailed examination of the investment
approach presented by Lowell Miller in his book.
Miller argues that too many investors have a hodgepodge
of holdings that lack any overall strategy or philosophy behind
26
their investment decisions. In the information
age, it is too easy to come across investment
ideas that turn individuals into traders reacting
to the continuous market noise. Individual
investors will have a tough time succeeding if
they trade a lot and select 10 different stocks
for 10 different reasons. Miller feels that
individuals should stop “playing the market”
and instead become investors. Like Warren
Buffett, we should consider our stock investment as a partnership interest in a real and ongoing business. The ownership
perspective frees investors from trying to guess the next hot
sector or investment style, provided they invest in financially
sound companies with reasonable long-term growth prospects.
A long-term perspective does not free a portfolio from
the market up and down swings, but confidence in one’s
approach provides a vision and understanding of why the
market is down and its ability to rebound. An investor must
stick with a plan. Successfully jumping from strategy to
strategy is very difficult to do. If you are comfortable with
your approach, you will be able to maintain a cool head, not
panic and not let emotions take over your decision making.
Cars don’t crash, the driver behind the wheel crashes. A good
investment strategy must acknowledge the human operator
and protect the investor from himself. The marketplace is
unpredictable, often forcing investors into emotional decisions.
Miller advocates that investors establish a strategy that
relies on common sense, with reasonable, achievable goals.
Of course the strategy should be supported by evidence that
the approach works over the long run. Investors should also
avoid swinging for the fences: Investors will not succeed
over the long term if they try to get higher returns than the
market normally allows for a given level of risk. While it is
AAII Journal
AAII Stock Screens
important to spread your risk among
a number of investments, you should
not lose control of your portfolio by
investing in too many stocks.
Dividend Income
An advantage that a stock dividend
has over interest income from a bond
is the potential for the stock dividend
payout to increase over time. Bonds do
not offer growth of income, which is
why they are called fixed-income investments. A fixed-income investment may
not be able to overcome the loss of
purchasing power due to inflation. Miller
equates investing in dividend-paying
stocks to building a structure out of
bricks in which the bricks themselves
make more bricks. Equity income offers long-term growth of principal and
income. A good stock investment must
overcome inflation and justify its risks.
Miller reminds investors that investments such as stocks do not have
the same rate of return each year. To
compare investments, you must also
consider the volatility of the return and
seek out the highest level of return for
a given level of risk. The stock dividend
payment helps to smooth out the return
over time, and you do not need to hit
a home run every time to build wealth.
An investment with a 10% annual return
will grow 600% in 20 years. Investors
just need to find a business with reliable
growth willing to share its profit with
its owners. A long-term viewpoint is
important, as an obsession with monthly
and even quarterly returns may “gum
up the gears.”
Stock dividends make it easier to
hold onto investments through price
fluctuations of individuals stocks and
the market as a whole. The compounding principal of equity income success
remains in play whatever the market
is doing. Income-producing securities
are priced based upon the amount of
income they produce. If the income
output of a security increases, its price
will rise. Miller looks for high-dividendpaying stocks with increasing dividends
because investors will get the rising
stream of income and the higher income
June 2013
level should eventually result in higher
price valuations as well. Of course this
assumes relatively normal price-earnings
ratios and interest rates.
Miller points out that dividends tell
the truth. A meaningful dividend and a
growing dividend payment are signals
that the company has the wherewithal to
pay its dividend. With a rising dividend,
investors have some evidence that they
are partnering with a real company that
is doing well enough to pay and increase
its dividend on a regular basis. Dividends
are paid from earnings once a company
is mature and stable enough in its life
cycle to distribute excess cash. There
may be a number of ways a company can
make its earnings look good during its
quarterly release, but dividends don’t lie.
They are an acid test of a firm’s finances.
Dividends have a signaling attribute
of the state of the firm’s business to
investors. Boards of directors never want
to cut the dividend, and they will only
raise the payout after considering the
business strength and capital needs of
the firm. Miller highlights a 2004 study
published in the Journal of Finance by
Adam Koch and Amy Sun that revealed
investors buy dividend growth stocks to
confirm the quality of reported earnings.
Miller acknowledges that dividend
strategies fall out favor at times, but he
reminds us that investors will continue
to be rewarded with the income portion of the approach until the market
comes around to appreciating these
stocks again. Long term, Miller feels
that you should see the stock price rise
by an equal percentage to the dividend
increase for stocks trading with aboveaverage dividend yields. If you purchase
stocks with low current dividend yields,
the market is looking at other factors to
value the stocks.
The 12 Rules
Miller seeks out high-quality stocks
trading with high current dividend yields
that offer high growth of dividends. He
refers to a company with these qualities
as a Single Best Investment (SBI) stock.
Miller lays out 12 rules to follow in buying and holding a Single Best Investment
stock and cautions that investors need to
be somewhat adaptable rather than rigid
when following the rules. However, for
all but the most sophisticated investors,
the rules should be treated as rules and
not guidelines. Under normal market
conditions, if a stock does not meet one
of the 12 rules, there should be another
stock that manages to meet all of the
requirements. Miller cautions investors
not to try to be too clever or a hero.
1) The company must be
financially strong.
High-quality stocks have superior
financial strength: low debt, strong cash
flow and good overall creditworthiness.
While some debt is good, too much
debt puts the company at risk during
a slowdown. Dividend payments are
optional, but interest obligations from
debt must be paid. Failure to do so will
result in default if the lender is not willing to restructure debt obligations. A
temporary sales slowdown may leave a
company scrambling to conserve cash
by cutting marketing, research and development, employee salaries and even
dividends. These types of moves may
help a company stay solvent at the cost
of future growth. It’s far better to have
financial flexibility to buy assets at firesale prices during economic downturns.
A high need to borrow may also force a
company to take on debt when interest
rates are high.
While companies with very stable
and predictable cash flow may be able
to take on higher levels of debt, Miller
indicates that investors should avoid
companies that have a debt-to-capital
ratio greater than 50%. Capital is the
long-term source of funding for the
firm and consists of the sum of longterm debt and owner’s equity (book
value). Debt to capital is calculated by
dividing long-term debt by capital. Half
debt and half equity results in a ratio of
50%. The higher the ratio, the greater
the proportion of debt.
We used AAII’s fundamental
screening and stock database program
Stock Investor Pro to construct a screen
that follows the Miller Single Best Investment strategy laid out in his book.
27
The program’s dataset covered 7,452
companies as of May 10, 2013. Just
over 5,000 companies had a debt-tocapital ratio less than or equal to 50%,
eliminating around 2,500 companies
from consideration.
Beyond the level of debt carried on
the company’s books, investors should
also examine the ability to pay interest
obligations from the company’s cash
flow. The times interest earned figure,
sometimes referred to as the interest
coverage ratio, is a traditional measure
of a company’s ability to meet its interest
payments. A custom calculation within
Stock Investor Pro looks at earnings before
interest, depreciation and taxes divided
by the income expense. It indicates if a
company is able to generate pre-dividend
earnings to pay interest on its debt. The
larger and more stable the ratio, the
lower the risk of the company defaulting.
Miller looks for a coverage ratio of at
least 3 to 1. Just over 5,000 companies
in the Stock Investor Pro universe have a
times interest earned ratio of 3 or better.
Adding this filter to the debt-to-capital
filter left us with 3,792 passing stocks.
Miller looks for overall cash flow to
be strong for his Single Best Investment
candidates. Strong cash flow provides
financial flexibility for companies in
good times and bad. It allows firms
to expand, run marketing campaigns,
develop new products, etc. Miller wants
cash flow to be strong enough to fund
the dividend and the investment need
to keep the company growing. We created a custom field in Stock Investor Pro
that took the cash flow from operations
and subtracted capital expenditures
and divided the total by the number of
shares outstanding to create a per share
figure. We then required that this cash
flow per share figure be greater than
the indicated dividend. Around 3,500
firms passed this filter independently.
Adding the filter to our Miller SBI
screen reduced the cumulative number
of passing companies to 1,817.
As a final quality check, we excluded
stocks that were not listed on the New
York, American or NASDAQ stock
exchanges. This reduced the cumulative
number of passing companies to 1,517.
28
2) The company must offer a
relatively high current yield.
Miller requires that the dividend
yield (indicated annual dividend divided
by stock price) be high enough at the
time of investment to be meaningful,
even if high dividend growth is anticipated. The goal is to locate stocks with
high current yields and high expected
growth. It is important for the yield to
be high enough to be a “compounding
machine.” High-yielding stocks attract
income-seeking investors who will put
pressure on management and the board
of directors to continue paying an attractive dividend.
Miller compares the current stock
yield to the market yield (S&P 500 index)
and requires that the yield be at least
1.5 times the market. Two times the
market yield is even better. Screening
for a dividend yield relative to a market
benchmark automatically adjusts the
filter to the market valuation levels. Barron’s publishes a number of valuation
ratios for the popular market indexes
and averages every week in its Market
Lab section. The current yield of the
S&P 500 is 2.1% ($35.02 dividend ÷
1667.47 index value). The yield is down
from 2.4% one year ago, even as the
dividend for the index has increased by
12.2%. Our Miller SBI screen is looking for companies with a dividend yield
of 3.1% or higher (2.1% ª 1.5). Only
1,025 stocks out of a universe of 7,452
companies trade with a yield of 3.1%
or greater. Adding the requirement to
our financial strength filters reduces the
number of passing companies to 172.
3) The yield must be expected to
grow substantially in the future.
Miller looks for a combination of
high quality, high current yield and high
dividend growth. These are firms with
the financial strength and willingness to
raise dividends. Just screening for high
yield may leave investors with high current yield, but little prospect of future
dividend growth. The dividend growth
rate should be at least as high as inflation.
Examining the past pattern and records
of dividend increases should help to gain
an understanding of dividend growth
patterns. Miller looks for expected dividend growth of 5% or greater to assure
growth in excess of inflation. Stock Investor
Pro does not have consensus dividend
growth estimates. Our Miller screen
required a compound annual growth
rate of 5% or greater over the past
three years. Around 1,000 stocks in the
database had a historical growth rate of
5% or higher, and adding this requirement to our Miller SBI screen reduced
the number of passing companies to 62.
Miller notes that investors should not
just mindlessly extrapolate the historical
growth rate into the future, but it helps
to provide a feel for the dividend growth
policy of the firm.
Dividends are paid from earnings,
so many investors look at the dividend
payout ratio to measure the flexibility
of the firm to continue paying and increase its dividend payout. The payout
ratio is the annual dividend divided by
annual earnings per share. The lower the
ratio, the more secure the dividend and
the greater the chance for a dividend
increase. The acceptable payout ratio
varies by industry, with companies in
more stable industries often having
higher payout ratios. Our Miller SBI
screen looks for utilities with a payout
ratio of 85% or lower and for all other
firms to have a payout ratio of 60%
or below. Around 3,400 firms met this
filter. Adding the requirement to our
Miller SBI screen reduced the number
of passing companies to 29.
4) The company should offer at
least moderate consistent historical
and prospective earnings growth.
Miller looks for stocks in which
earnings are expanding on a steady
uptrend. Dividends are paid from the
income stream, so earnings must also
be expected to expand. The earnings
growth does not need to be humongous,
but it should be at least as strong as
the dividend growth you are expecting.
Annual earnings growth that is consistent and in the 5% to 10% range is
required. Our Miller screen looks for
companies with an expected compound
annual growth rate in earnings of 5%
or greater over the next three to five
AAII Journal
AAII Stock Screens
years. We also added simple filters that
required positive expected earnings per
share for the current and next fiscal year.
About 2,000 stocks possess these characteristics. Adding the positive earnings
requirements along with the minimum
expected long-term earnings growth rate
of 5% reduced the number of passing
companies to 10.
5) Management must be excellent.
Miller considers a long record of
success as one measure of good management. A record of expanding during
an economic or industry slowdown is
a good sign. Ownership of shares by
management is another good sign. Share
ownership reflecting one-year’s worth
of salary is a reasonable requirement.
Miller examines how well management has been able to absorb and integrate acquisitions. Miller recommends
identifying management with integrity by
examining if public statements turn out
to true. “A funny odor in the basement
might well be the first hint of corpses
buried there.” These are primarily qualitative measures that should be reflected
in good quantitative results.
6) Give weight to the valuation
measures.
It is natural to seek out bargains
when selecting stocks, but investors
should remember the old maxim that
“quality is always a bargain.” Even Warren Buffett is quoted as saying that it is
far better to buy a wonderful company
at a fair price than a fair company at
a wonderful price. However, Miller
acknowledges that many studies have
shown that stocks that are priced lower
based on traditional valuation measures
outperform more expensive stocks in
the long run. Many investors overpay
for high expected growth and underpay
for assets.
Miller highlights the use of priceto-sales ratios, price-earnings ratios
and price-to-book-value ratios in his
book. When a stock trades with a low
price-to-sales ratio, the multiple likely
reflects investor pessimism about the
company’s ability to maintain or improve
its profit margins. A low price-to-sales
June 2013
ratio is attractive, especially if you notice
an improving trend in profit margins.
Miller references James O’Shaughnessy’s
(“What Works on Wall Street: A Guide
to the Best-Performing Investment
Strategies of All Time,” McGraw-Hill,
fourth edition, 2011) research on desired
price-to-sales ratios and notes that seeking stocks with price-to-sales ratios of
1.5 or lower is a good start. If desired,
you can refine the rule to consider
the norm for the industry. Our Miller
SBI screen looks for companies with
a price-to-sales ratio of 1.5 or lower.
Around 3,000 stocks passed this filter
independently.
Much research also supports the
benefit of seeking stocks with low priceearnings ratios. It provides a quick measure of how expensive or cheap a given
stock is priced currently. Higher-growth
stocks deserve to trade with higher priceearnings multiples, but other factors
such as interest rates also impact the
earnings multiple. Lower market interest
rates can support higher price-earnings
ratios. Miller recommends stocks with a
price-earnings ratio less than the market
price-earnings ratio. The S&P 500 has a
price-earnings ratio of 19.3 currently, so
our Miller SBI screen looks for stocks
with a price-earnings ratio of 19.3 or
lower. Around 2,200 stocks have priceearnings ratio of 19.3 or lower.
Book value is a very rough measure
of the accounting value of a company. It
represents the accounting value of firm
assets less all liabilities. Comparing the
price of a stock to its book value per
share highlights how closely the market
value of the company is trading to its
accounting value. Unfortunately, many
company intangibles will not show up
on the company’s books, so book value
will often understate the true economic
value of the firm. Nevertheless, stocks
with low prices to book values have
historically outperformed the market.
The lower the ratio, the better. Miller
prefers to compare the company’s value
to the market level. The S&P 500 index
is currently trading with a price-to-bookvalue ratio of 2.5. Just over 4,000 stocks
have price-to-book-value ratios of 2.5
or lower.
All three of our valuation filters
reduced the number of passing companies from 10 to 5.
7) Consider the “story.”
In many ways, Miller feels the
story or belief behind the company is
as important as the valuation of the
stock. An undervalued stock has some
proposed story or expectation, and the
investor needs to believe the story will
come true when they buy the stock. The
story must be about the future of the
stock, the market or even the economy.
It might be a simple story that projects
a rebound in earnings over the next few
years and a stock’s return to its normal
valuation level. A tailwind of favorable
industry growth is good. Optimally,
there is a “growth kicker” built on a
base of reliable earnings and cash flow.
Miller believes that “in the end investors
make their buying decision more or less
holistically, looking at the whole picture
of a company, the whole story.”
8) Use charts to help your buying.
While technical analysis can be
complex and difficult to interpret, there
is a great deal of support in the use
of relative strength to highlight stocks
on the upswing. Miller indicates that
underperformance followed by notably
rising relative price strength is a positive
sign. A high-volume selling climax may
point to stock ready for an upturn. Miller
states that technicals are not too useful
for selling, but can help investors select
among their candidates and trim some
positions. Our Miller screen simply looks
for stocks that have outperformed the
S&P 500 index over the last 52 weeks.
About 2,600 stocks have had stronger
price performance than the S&P 500,
and the filter reduced the number of
passing companies to four.
9) Picture the future.
Miller is trying to build a long-term
compounding machine by investing in
businesses with long-term prospects.
When performing their qualitative analysis, investors should ask if the company
provides items that are a necessity of
life: Will the goods produced by the
29
Table 1. High Quality + High Yield + High Growth Single Best Investment Stocks
Company (Ticker)
Meredith Corp. (MDP)
Siemens AG “ADR” (SI)
Sunoco Logistics (SXL)
Raytheon Co. (RTN)
Div Yield
LT Debt
7-Yr
to
Payout
Current Avg Capital Ratio
(%)
(%)
(%)
(%)
3.8
3.7
3.6
3.4
2.7
2.8
6.7
2.7
26.8
35.7
22.2
36.3
57.8
49.1
46.0
35.2
Annual Growth Rate
Past (3 Yrs) Expct
Div
EPS
EPS
(%)
(%)
(%)
P/E
Ratio
(X)
Current
Rel
Price
Strgth
(5/10)
Index
($)
(S&P=0)
Industry
16.8 43.9
23.3 24.2
10.5 25.2
17.3 4.6
16.1
14.3
15.0
11.0
42.7
106.7
63.4
64.3
Printing & Publishing
Electronic Instr & Cont
Oil Well Servs & Equip
Aerospace & Defense
15.0
64.8
12.0
6.2
26.6
1.3
37.7
2.0
Source: AAII’s Stock Investor Pro, Thomson Reuters and I/B/E/S. Data as of 5/10/2013.
company be required years from now?
Are profit margins improving? How has
the company responded to competition
in the past? Is it a dominant market
player and is the size of the market for
its goods or services growing?
10) Hold with equanimity.
Miller feels that successful investing
requires a long-term perspective of an
investor. We should focus on the unfolding story of the company, its industry
and the marketplace. Investors should
stop playing the market and focusing
too much on quarterly reports. Avoid
checking prices too often. We should do
everything possible to keep from “holding anxiety.” The ownership perspective
is a long-term perspective. Emotions and
unnecessary decisions are the undoing
of most investors.
11) Sell when the dividend is in
jeopardy, when the dividend has
not been increased in the past 12
months without an excuse or when
the story has changed.
Dividends are the key to the Single
Best Investment strategy, so investors
need to be alert to the state of the
dividend. Stocks should be sold if the
dividend is in jeopardy. A rise in the
payout ratio may highlight a risk to the
dividend payment. In many ways, the
reverse of the factors used to select
SBI stocks are concerns: Declining
cash flow, growing levels of debt and
earnings declines are issues that should
be explored. A change in the company
dividend policy may signal a change in
the payout philosophy of the firm. Unless there is a reasonable excuse, failure
to raise the dividend annually is a red
flag. A company that has increased its
dividend annually and suddenly stops
doing so should be sold, unless there
are clear and articulated mitigating circumstances. SBI stocks are purchased
for their financial strength, high current
dividend and high dividend growth;
once the story changes, the stock
should be sold.
12) Diversify among as many
stocks as qualify for Single Best
Investment.
Miller states that if your account is
large enough, you should hold around 30
stocks, with equal dollar investments in
each holding. If you hold fewer stocks,
it is better to focus on the more conservative stocks of the universe. The
high-income stocks of the Single Best
Investment universe should be able to
produce long-term income and growth
of capital.
Conclusion
Only four securities passed our
interpretation of the Miller Single
Best Investment strategy, and they are
shown in Table 1 ranked by current
dividend yield. The influx of money into
dividend-paying stocks has lowered the
yield of most stocks and pushed up the
stocks’ prices. Our screen focused on
the quantitative elements of the strategy,
the first step in the process. Miller lays
out a helpful framework in building and
managing an equity-income portfolio.
The next step would be to examine the
qualitative factors of the company, its
management and the industry.
Individual investors have the advantage of time on their side. Investing
in dividend-paying stocks with growing
dividends represents a great way for
investors to harness the power of time
and the compound growth of dividend
reinvestment. Miller even quotes Baron
Rothschild when emphasizing the benefit of reinvesting dividends: “I don’t
know what the Seven Wonders of the
World are, but I do know the eighth:
compound interest.” 
John Bajkowski is president of AAII. Find out more at www.aaii.com/authors/john-bajkowski.
30
AAII Journal
Trading Strategies
Is the AAII Sentiment Survey a
Contrarian Indicator?
By Charles Rotblut, CFA
Article Highlights
• The majority of the weekly sentiment readings fall into typical ranges that have been formed since the survey started in 1987.
• Low levels of optimism have historically been more correlated with market reversals than high levels of optimism.
• Both bullish sentiment and bearish sentiment have had periods where they stayed at high levels for an extended period of time.
Each week, we ask
AAII members a simple
question: Do they feel the direction of the stock market
over the next six months will
be up (bullish), no change
(neutral) or down (bearish)?
We refer to this question as
the AAII Sentiment Survey. Since we started polling our
members in 1987, our survey has provided insight into the
moods of individual investors.
The survey has been become a widely followed measure.
Its results are circulated by various organizations and media
outlets, including Barron’s and Bloomberg. I have heard
directly from, and indirectly of, many market strategists, investment newsletter writers and other financial professionals
who follow the survey.
Can the results signal future market direction? In an update to my colleague Wayne Thorp’s 2004 article, “Investor
Sentiment as a Contrarian Indicator” (Computerized Investing,
September 2004), I look at the data and give perspective. The
key to remember when reviewing the data is that a variety of
indicators and criteria should be considered before making
a tactical change in asset allocation.
(www.aaii.com/sentimentsurvey)
on AAII.com and voting. The survey is open to all members, though
a weekly email is sent to a rotating
group of members reminding them
to participate. Results of the survey
are automatically tabulated by our
database and published online early
each Thursday morning. Prior to
the year 2000, members responded by physically mailing
a postcard back to the AAII offices. Response rates vary,
though we would consider fewer than 100 votes to be low
and more than 350 votes to be high. We do not track longterm response rates, though during the first four months of
2013, an average of 315 members took the survey each week.
The typical AAII member is a male in his mid-60s with
a bachelor’s or graduate degree. AAII members tend to be
affluent with a median portfolio size in excess of $1 million.
The typical member describes himself as having a moderate
level of investment knowledge and engaging primarily in fundamental analysis. This said, AAII has in excess of 160,000
members and simply due to the sheer size of our membership,
there are wide variances in wealth, investment knowledge
and investing styles. We also have many women members.
This mix makes the AAII Sentiment Survey unique in that it
conveys the attitudes of active, hands-on individual investors.
Background of the AAII Sentiment Survey
The AAII Sentiment Survey is conducted each week from
Thursday 12:01 a.m. until Wednesday at 11:59 p.m. AAII
members participate by visiting the Sentiment Survey page
June 2013
Historical Sentiment Readings
Bullish sentiment has averaged 38.8% over the life of
the survey. Neutral sentiment has averaged 30.5% and bear-
31
to pessimistic. These
swings reflect attitudes
toward the direction
Bullish
Neutral Bearish
of the stock market,
(%)
(%)
(%)
the strength or weakAverage
38.8
30.5
30.6
ness of the economy,
Maximum
75.0
62.0
70.3
the quality of earnings
Minimum
12.0
7.7
6.0
and other macro factors
impacting individual
+3 Standard Deviation
70.3
56.8
60.9
investors’ short-term
+2 Standard Deviation
59.8
48.1
50.8
outlook for stock prices.
+1 Standard Deviation
49.3
39.3
40.7
For example, during
2003 and 2004, AAII
–1 Standard Deviation
28.3
21.8
20.5
members stayed mostly
–2 Standard Deviation
17.8
13.0
10.5
bullish, a reflection of
–3 Standard Deviation
7.3
4.3
0.4
the rebound in stock
Numbers are rounded.
prices and expansion
of the U.S. economy.
Conversely, during the
ish sentiment has averaged 30.6% over bear market period of November 2007
the life of the survey. (We round the through February 2009, AAII members
bullish and bearish sentiment averages largely stayed pessimistic about the
to 39.0% and 30.5% when reporting the market’s direction.
The survey’s results can be described
weekly results.) These numbers equate
to approximately four out of 10 AAII as a pendulum that, at times, stays on
members expecting stock prices to rise one side or the other for prolonged
and three out of 10 expecting prices to periods. Both bullish and bearish sentifall over the next six months on a typi- ments have, at times, stayed above their
cal week. This bullish slant aligns with respective historical averages for several
history. The S&P 500 index was at 315 weeks or months. At other times, the
when the survey was first conducted; on sentiment pendulum has stayed close to
May 2, 2013, the index stood at 1,583. center, with individual investors’ moods
It is important to note that these staying largely within their historical
numbers are averages. Over time, the averages.
Given these characteristics, it is
results for all three choices have swung
up and down. Within these swings, useful to apply statistical analysis to the
however, trends have emerged, al- historical results. In addition to tracklowing us to identify what is a typical ing the weekly readings, we maintain
reading, what is an unusual reading and ongoing readings of standard deviawhat is an extraordinary reading. The tions. Standard deviation calculates the
extraordinary readings have had some distance from the average (or mean) a
correlations with market reversals, as I particular data point is. It is best described as an arc with elongated tails
will soon explain.
A spreadsheet tracking the weekly on the left and right side. The majority
readings can be downloaded from the of the readings fall near the midpoint
AAII Sentiment Survey webpage. This of the arc. Unusual readings occur in
spreadsheet lists the weekly results dating the lower left and right areas of the
back to July 1987 and continues to be arc, areas known as +1 and –1 standard
updated every Thursday on AAII.com. deviation. Extraordinary readings are
those that are more than two standard
deviations away from the historical
What Counts as a
average.
A tiny fraction of readings are
Normal Reading?
on the outer edges of the tails; these
Over time, the moods of indi- readings are three standard deviations
vidual investors swing from optimistic away from the average. If the weekly
Table 1. Historical AAII Sentiment Readings
32
results were to match up perfectly with
statistical theory, we would see 68.2% of
all readings within the midpoint of the
arc, 27.2% qualifying as being unusual,
4.2% considered to be extraordinary
and just 0.3% being extreme (more than
three standard deviations away from
average. Reality often does not fall into
clearly defined buckets, but the statistical ranges help to convey the rarity of
readings that are two or three standard
deviations away from average.
Table 1 shows the historical average,
lowest and highest readings for the Sentiment Survey, along with the percentages
at one, two and three standard deviations
away from the average for each choice.
As previously stated, bullish sentiment
has averaged 38.8% over the life of the
survey. It has a standard deviation of
10.5%. This means readings between
28.3% and 49.3% are within the normal
range over the historical results. Bullish sentiment is not considered to be
extraordinarily high until it surpasses
59.8%. It is not considered to be extraordinarily low until it falls below 17.8%.
The record high for optimism is 75.0%,
set on January 6, 2000. The record low
is 12.0%, set on November 16, 1990.
Neutral sentiment has averaged
30.5% over the life of the survey. It
has a standard deviation of 8.8%, with
typical readings ranging between 21.8%
and 39.3% (numbers are rounded). The
record high for neutral sentiment is
62.0%, set on June 3, 1988. The record
low is 7.7%, set on October 9, 2008.
Bearish sentiment has averaged
30.6% over the life of the survey. It
has a standard deviation of 10.1%,
with typical readings ranging between
20.5% and 40.7%. Bearish sentiment
is not considered to be extraordinary
high until it surpasses 50.8%. It is not
considered to be extraordinarily low until
it falls below 10.5%. The record high
for bearish sentiment is 70.3%, set on
March 5, 2009. The record low is 6.0%,
set on August 21, 1987.
Sentiment as a
Contrarian Indicator
As you can see, the moods of in-
AAII Journal
Trading Strategies
dividual investors are subject to swings
and, at times, they reach extreme levels.
Most of the time, the readings from our
survey provide insight into the moods
of individual investors, but are well
within their typical historical ranges.
Extraordinary readings are more interesting, however, since investor sentiment
is considered to be a contrary signal.
Market watchers tend to look at high (or
low) levels of optimism or pessimism
as a sign that sentiment has swung too
far in one direction.
In order to determine whether
there is a correlation between the AAII
Sentiment Survey and the direction of
the market, I looked at instances when
bullish sentiment or bearish sentiment
was one or more standard deviations
away from the average. I then calculated
the performance of the S&P 500 for
the following 26-week (six-month) and
52-week (12-month) periods. The data
for conducting this analysis is available
on the Sentiment Survey spreadsheet,
which not only lists the survey’s results,
but also tracks weekly price data for the
S&P 500 index.
Table 2 shows the data. The returns
for the S&P 500 reflect price changes
over six- and 12-month periods. The
numbers exclude any management fees,
transaction costs or other expenses an
investor may have incurred by making
trading decisions based on the results.
Each reading above or below one
standard deviation from the historical
average was treated as a separate signal.
This resulted in some overlap. For instance, there were four extraordinarily
high bullish readings recorded between
November 27, 2003, and December
26, 2003. Each reading was treated as
a separate six- and 12-month period.
The purpose of the analysis was to see
what happened to the market following
a high or low sentiment reading, not to
optimize a trading strategy based on the
survey’s results.
Any analysis of a potential market
signal should include an analysis of market performance itself. This is why Table
2 also shows the average performance
of the S&P 500 from July 24, 1987,
through May 2, 2013. During this period
June 2013
Table 2. Performance of Sentiment Survey as a Contrarian Indicator
Number
of
Observations
2
44
167
212
16
7.4
(0.7)
0.8
6.9
14.0
7.4
0.3
2.9
6.2
17.7
0
48
34
80
100
Bearish > +3 S.D. From Mean
3
Bearish > +2 S.D. From Mean
50
Bearish > +1 S.D. From Mean
162
Bearish < –1 S.D. From Mean
211
Bearish < –2 S.D. From Mean
9
All
1,319
25.8
2.8
4.7
3.8
(5.5)
4.0
23.0
5.3
6.0
4.5
(1.7)
4.7
100
60
71
26
67
2
44
167
206
16
3.6
(2.0)
2.4
12.9
20.7
3.6
3.6
6.3
14.3
21.7
50
48
31
84
100
Bearish > +3 S.D. From Mean
3
Bearish > +2 S.D. From Mean
50
Bearish > +1 S.D. From Mean
152
Bearish < –1 S.D. From Mean
211
Bearish < –2 S.D. From Mean
9
All
1,293
35.0
3.1
7.1
7.7
(4.3)
8.4
25.6
14.3
11.8
9.9
4.8
10.2
100
60
74
24
44
Sentiment Level
Median
S&P 500
Change
(%)
% of
Periods
Correctly
Contrarian
(%)
Average
S&P 500
Change
(%)
6-Month Performance
Bullish > +3 S.D. From Mean
Bullish > +2 S.D. From Mean
Bullish > +1 S.D. From Mean
Bullish < –1 S.D. From Mean
Bullish < –2 S.D. From Mean
12-Month Performance
Bullish > +3 S.D. From Mean
Bullish > +2 S.D. From Mean
Bullish > +1 S.D. From Mean
Bullish < –1 S.D. From Mean
Bullish < –2 S.D. From Mean
Based on data from July 24, 1987, to May 2, 2013. Numbers are rounded.
there were 1,319 complete six-month
periods with average and median gains
of 4.0% and 4.7% for the S&P 500. The
S&P 500 appreciated during 71.1% of
these six-month periods and declined
during 28.7% of them. There were also
1,293 12-month periods, during which
the S&P 500 had average and median
gains of 8.4% and 10.2%, respectively.
The large-cap index rose during 77.7%
of all 12-month periods and declined
during 22.3% of them. (Any period
with a change equal to or greater than
+0.1% or –0.1% was counted as an up
or down period.)
Bullish Sentiment
Neither unusual nor extraordinarily
high levels of optimism are highly correlated with declining stock prices when
the entire survey’s history is considered.
The 44 periods with bullish sentiment
readings more than two standard deviations above average were followed by
a six-month fall in the S&P 500 only
48% of the time. The average six-month
decline was 0.7%.
Bullish sentiment twice exceeded
three standard deviations from its historical mean. The S&P 500 was higher
33
Table 3. Six-Month Returns Excluding Long Bull and Bear Periods
Average
Number
S&P 500
of
6-Mo Change
Observations
(%)
Median
S&P 500
6-Mo Change
(%)
% of
Periods
w/Trend
Reversal
Excluding 2003–2004 Bull Market
Bullish > +2 S.D. From Mean
All
25
1,214
(5.0)
3.7
(6.0)
4.5
68
26
1,247
14.2
5.0
15.0
5.1
96
Excluding 2007–2009 Bear Market
Bearish > +2 S.D. From Mean
All
Numbers are rounded.
six months after both readings and
higher 12 months later after one of the
readings. Both the average and median
S&P 500 index six-month gains were
7.4%. Both the average and median S&P
500 index 12-month gains were 3.6%.
Conclusions should not be drawn from
these extreme readings since the sample
size is so small.
The failure of high optimism as
a contrarian indicator can directly be
linked to 2003 and 2004. During this
period of economic expansion and
rising home prices, the S&P 500 rose
from 880 on January 2, 2003, to 1,213
on December 30, 2004. As shown in
Table 3, when the 19 periods of extraordinary optimism during this period
are excluded, the S&P 500 declined by
an average of 5% during the six-month
period following a bullish sentiment
reading of more than two standard deviations above the mean. Furthermore,
the S&P 500 subsequently declined 68%
of the time.
Extraordinarily low levels of optimism have worked better as a contrarian
signal. Bullish sentiment has been below
two standard deviations of its historical
mean 16 times during the survey’s history. The average and median six-month
gains for the S&P 500 following these
low readings were 14.0% and 17.7%,
respectively. The average and median
12-month gains were 20.7% and 21.7%,
respectively. The S&P 500 large-cap
index rose every time after our survey
indicated an extraordinarily low level
of optimism.
34
Bearish Sentiment
Extraordinarily high levels of pessimism have a mixed record of being
correlated with higher stock prices. On a
six-month basis, the S&P 500 rose 60%
of the time following a bearish sentiment reading more than two standard
deviations above the historical mean.
The average and median gains were 2.8%
and 5.3%, respectively. On a 12-month
basis, the S&P 500 rose 60% of the
time, with an average gain of 3.1% and
a median gain of 14.3%. The average
increases in prices are well below the
typical increases realized throughout the
entire history of the survey, though the
median increases are greater than the
typical gains.
Bearish sentiment exceeded three
standard deviations above its historical
average on three occasions. Each of
these occurrences was followed by large
market gains. The average and median
six-month gains were 25.8% and 23.0%,
respectively. The average and median
12-month gains were 35.0% and 25.6%,
respectively. Boosting these numbers is
the record high bearish reading of 70.3%
set on March 5, 2009, literally days before
the bear market ended. The S&P 500
went on to rebound by 39.5% over the
next six months and 56.9% over the
next 12 months.
Like bullish sentiment, bearish sentiment had a period where high readings
were repeatedly recorded. During the
bear market period of November 2007
through February 2009, pessimism was
more than two standard deviations above
its historical mean 24 times. Excluding
this period increases the correlation between extraordinary pessimism and sixmonth market gains to 96%, as shown
in Table 3. The S&P 500’s six-month
gain averaged 14.2%, with a median rise
of 15.0% The index’s 12-month gain
was an average 19.9%, with a median
rise of 22.2%.
Low levels of pessimism also have
a mixed correlation with future poor
market performance. Bearish sentiment
has been more than two standard deviations below its historical mean on nine
occasions. These readings have been
followed by six-month declines 67% of
the time and 12-month declines 44%
of the time. The average and median
six month declines are 5.5% and 1.7%,
respectively. The S&P 500 has declined
by an average 4.3% during the 12-month
period following an extraordinarily low
bearish sentiment reading, but gained
4.8% when the median change is measured instead.
Sentiment’s Role as a
Market Indicator
When our Sentiment Survey was
started in 1987, there was little data on
the moods of individual investors. Since
that time, our survey has developed a
following for both its insights and as its
role as a potentially contrarian indicator
for market direction. As the data shows,
extraordinarily low levels of optimism
have consistently preceded larger-thanaverage six- and 12-month gains in the
S&P 500.
Sentiment is not a flawless contrarian indicator, however. Though
unusual, bullish and bearish sentiment
readings above or below one standard
deviation from their historical average
have a mixed record of signaling market
direction. Extraordinarily high bullish
sentiment and extraordinarily low bearish sentiment (two standard deviations
away from the average) have generally
worked well, with the exception of two
notable periods.
It will be many years before we know
(continued on page 36)
AAII Journal
Retired Investor
Retired Investor
A series devoted to the issues that face investors in retirement.
Determining When to Switch to the RMD
The decision as to how much to withdraw from a retirement portfolio is complicated not only by longevity risk,
but also by tax issues. The commonly cited 4% withdrawal
rate can be trumped by the Internal Revenue Service’s (IRS)
required minimum distribution (RMD) rules for retirement
plan accounts. Determining which withdrawal rate to use
requires an understanding of the RMD rules and a calculator.
The Required Minimum Distribution
An RMD is the annual minimum amount a retirement
plan account owner must withdraw beginning in the year he
reaches 70½. An individual can delay the RMD if he retires
after age 70½. However, if an individual holds an individual
retirement account (IRA) or owns 5% or more of the business sponsoring the retirement plan, an RMD must be taken
starting the year the individual turns 70½.
Most, but not all, retirement accounts are subject to the
RMD rule. RMDs must be taken from traditional IRAs and
IRA-based plans such as SEPs, SARSEPs, and SIMPLE
IRAs. Also subject to the RMD are all employer-sponsored
retirement plans, including profit-sharing plans, 401(k) plans,
403(b) plans and 457(b) plans. Funds held in a Roth IRA are
not subject to RMDs as long as the account holder is alive,
but funds held in a Roth 401(k) account are subject to RMDs.
If you have questions about whether a specific retirement
account is subject to required minimum distributions, contact
a tax professional.
If the RMD is taken from a tax-deferred account, the
distribution is taxable in the year it was taken. If the full
RMD is not taken, the amount not withdrawn is subject to
a 50% tax.
Calculating the RMD
The required minimum distribution changes every year
based on an account holder’s age. It is calculated by dividing
the account balance at the end of the immediately preceding
calendar year by a distribution period. The distribution period
is published by the IRS in its Uniform Lifetime Table. A
retiree who is 70½ and has a spouse not more than 10 years
younger will have a distribution period of 27.4. Assuming
his traditional IRA account balance was $100,000 at the end
of last year, his RMD will be $3,649.63 ($100,000 ÷ 27.4 =
June 2013
$3,649.63). This is the equivalent of 3.65% of his IRA balance.
A required minimum distribution must be calculated
separately for every retirement account a retiree owns that
is covered under the RMD rules. If more than one IRA is
owned, the cumulative RMD can be taken from one retirement account. The same rule applies to individuals owning
more than one 403(b) contract. RMDs from other types of
retirement plans, such as 401(k) and 457(b) plans have to be
taken separately from each account.
The IRS publishes two tables with distribution periods.
The Uniform Lifetime Table is for unmarried retirees, retirees whose spouses are not more than 10 years younger or
those whose spouses are not the sole beneficiaries of their
IRAs. The Joint Life and Last Survivor Expectancy table is
for retirees whose spouses are more than 10 years younger
and are the sole beneficiaries of their IRAs. These tables are
published on the IRS website.
Choosing a Distribution Rate
The 4% withdrawal rate is designed to be adjusted each
year for inflation. A retiree starts by withdrawing 4% out
of his entire retirement savings, regardless of the type of
account those savings are held in, during the first year of
retirement. Each year, the amount withdrawn is increased
by the rate of inflation. Adhering to this strategy results in
high likelihood of not running out of money before death,
assuming a diversified portfolio is used. Early in retirement,
following the 4% withdrawal rate will allow for a larger dollar
amount to be withdrawn than if a rate based on the RMD
is followed. The 4% rule is intended to encompass savings
in all retirement accounts, including Roth IRAs.
As the retiree ages, the amounts withdrawn under the 4%
withdrawal rate scenario change. Though the dollar amount
withdrawn is increased by the prevailing rate of inflation, the
increases may not be large enough to meet RMD amounts
during a low to moderate inflationary environment. Using
the withdrawal rates published in my article “Taking Retirement Withdrawals From a Fund Portfolio” (May 2013 AAII
Journal), I found that the RMD became larger than the 4%
adjusted withdrawal rate 11 years into retirement, assuming
the person retired at age 65.
In a real-life scenario, the point at which the RMD becomes larger than the 4% withdrawal rate depends on many
factors, including when a person retired, the rate of inflation
35
and the type of accounts held. The proportion of savings
held in a Roth IRA can be a significant factor in making the
determination, since they are not subject to the RMD rules.
The presence of an annuity adds another layer of complexity. Non-qualified annuities are exempt from the RMD
rules, but an annuity held within an IRA is not. (Specific
rules apply to annuities, and questions about them should
be directed to a tax professional.) Plus, to the extent an
annuity provides enough income, less than 4% may need
to be withdrawn from other retirement accounts to meet
living expenses. Pensions and Social Security benefits may
also allow a retiree to lower his actual withdrawal rate below
4%. Conversely, some retirees may have no choice but to
withdraw more than 4% to meet living expenses, even though
that increases the risk of running out of money late in life.
Since so many factors can influence how much should
be withdrawn from retirement savings, the decision as to
whether to switch to basing the withdrawal amount on the
RMD is one that needs to be revisited every year. Due to
the complexity of RMD rules, there is not an easy way to
determine the optimal withdrawal rate. One rule of thumb
is that the more money that is held in accounts not subject
to RMDs (such as Roth IRAs), the later in life a retiree will
be forced to base their withdrawal amount on RMDs.
The IRS publishes a helpful list of answers to frequently
asked questions about RMDs (www.irs.gov/Retirement-Plans/
Retirement-Plans-FAQs-regarding-Required-MinimumDistributions). On this webpage, you will find links to the
distribution tables and worksheets for calculating your RMD.
—Charles Rotblut, CFA, Editor, AAII Journal
Feature: Stock Strategies
(continued from page 11)
1966 (Vietnam) and just barely in 2011
(U.S. debt ceiling and European debt).
Excluding January’s performance, the
last 11 months of these years were up
24 times. The market’s crash in 1987 is
the additional blemish on the record.
Eleven-month average gains are impressive at 12.3%.
In 2013, the S&P posted its 17th
best January gain of all time, complet-
ing the indicator trifecta. The January
Barometer, Santa Claus Rally and First
Five Days indicators were all positive this
year—increasing the odds, but not guaranteeing, positive returns for 2013. 
Jeffrey A. Hirsch is chief market strategist at the Magnet Æ Fund and editor-in-chief of the Stock Trader’s Almanac. His latest
book is the “The Little Book of Stock Market Cycles” (John Wiley & Sons, 2012). Find out more at www.aaii.com/authors/jeffreyhirsch.
Trading Strategies
(continued from page 34)
whether the periods of 2003–2004 and
November 2007–February 2009 were
mere blemishes on the survey’s record as
a contrarian indicator or a sign that both
optimism and pessimism can remain at
high levels for an extended period of
time. I tend to think the latter will be
the case, given long-term market history.
The failure of sentiment to work
perfectly highlights two important
points. Though correlations between
sentiment levels and market direction
have appeared in the past, the AAII
Sentiment Survey does not predict future
market direction. Overly optimistic and
pessimistic investor attitudes are characteristics of market tops and bottoms,
but they do not cause stock prices to
change direction. Rather, it is changes
in expectations of future earnings and
economic and valuation trends that
move stock prices. The timing of such
changes has proven to be difficult to
predict with accuracy.
This leads to my second concluding
point: Never rely on a single indicator
when forecasting market direction.
Rather, consider a variety of factors—including prevailing valuations, economic
data, Federal Reserve policy, government
policies and other prevailing macro
trends—and allow for a large margin
of error in your forecast. As the saying
attributed to John Maynard Keynes goes,
the market can stay irrational longer than
you can stay solvent. 
Charles Rotblut, CFA, is a vice president at AAII and editor of the AAII Journal. Find out more about Charles at www.aaii.com/
authors/charles-rotblut and follow him on Twitter at twitter.com/charlesrotblut.
36
AAII Journal
Investment Education = A Positive Return
Here at AAII we know that investment education provides a positive
return! It’s an idea that over the years has served AAII well and it’s a belief
that most of our members share.
Meet the Best & Brightest at
the AAII Investor Conference.
KEYNOTE SPEAKERS
But sometimes it is helpful to go beyond the AAII Journal and take the
time to sit with like-minded folks to learn in-person from one another.
That’s why we offer the AAII Investor Conference. It’s a biennial meeting
of the best and brightest and you are invited to attend.
Conference Attendees Will Learn:
• New income investing approaches for a low-yield environment
• Winning stock selection methods (several approaches will be
presented)
• Ways to make your retirement nest egg last longer
• How to build an asset allocation designed to meet your needs
• Valuable insights into the economy and coming economic
cycles
• Plus insightful ways to select and invest in today’s best mutual
funds and ETFs
“Smart Investing: Seeking Reward
While Reducing Risk”
“Outlook 2014: Is it Time to Buy
or Bail?”
—Charles Rotblut
—Sam Stovall
“Key Ingredients for Successful
Retirement Portfolios”
“An ETF Investor’s Guide to Emerging
Markets”
—Christine Benz
—Ben Johnson
“How to Get the Highest Returns With
the Least Effort”
“Finding a Stock Winner: First Step
Screening”
—Sheldon Jacobs
—Joe Lan
“The Outlook for the U.S. and Global
Economy, and the Financial Markets”
“ETFs & Investment Strategies to
Match Investment Objectives”
—Tony Crescenzi
—Neil Leeson
“Managing Your Money During
Retirement”
“Determining a Stock’s True Worth”
“Income Investing in Volatile Markets”
James O’Shaugnessy
CEO, CIO
O’Shaugnessy Asset
Management
Maria Crawford Scott
Jason Zweig
Former Editor,
AAII Journal
Columnist, The Wall
Street Journal
Date & Place:
This year’s topics and speakers include:
—Maria Crawford Scott
Robert Shiller
Economics Professor,
S&P/Case-Shiller
Home Price Indices
Friday, November 15 –
Sunday November 17, 2013
Loews Royal Pacific
Resort, Orlando, Florida
You’ll receive:
• 25 investing seminars
• Keynote luncheon and
panel discussions
• 30+ workshops
• Continental breakfasts
• Welcome reception
• $345 AAII Member Rate
($295 for accompanying guest)
—Wayne A. Thorp
Social Functions:
“What’s Working Now on Wall Street”
Beyond providing an exceptional
roster of speakers and workshops,
AAII offers the following FREE
social functions to all conference
attendees:
• AAII Welcome Reception
Complimentary drinks and
hors d’oeuvres
• Saturday Luncheon with
Keynote Speaker
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—Mark Hulbert
—Richard Lehmann
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The July AAII Journal will contain a special update from Chairman James Cloonan about the
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