EFF: This is a market efficiency question. If firms facing extreme financial difficulty are properly priced to take account of the risks they face, there is no reason to avoid them, unless you don't like the risks.
KRF: Whenever you think about a proposition like this, you should ask yourself, "What do you know that the market doesn't?" Does the market know the firms are facing extreme difficulty? If so, your best bet is that the price is right. This does not mean that the price is always right, or even that the market always incorporates all publicly available information. Sure the price of a distressed firm may be too high, but it is equally likely it is too low. To decide how the market has erred in a specific case, you have to know more than the market or you need a better model than the market. Although most investors seem to think they have the expertise to beat the market, an enormous amount of empirical evidence says this is a very high bar.
EFF/KRF: Active management is always a zero sum game, before fees, expenses, and trading costs, regardless of market conditions. If there are active winners, they win at the expense of active losers. And active management is always a negative sum game after costs. This is an algebraic condition, not a hypothesis. We call it equilibrium accounting.
Moreover, our research on individual mutual funds says that it's impossible to identify true winners on a reliable basis, even if one ignores the costs that active funds impose on investors. Funds that seem to be winners, based on past returns, were probably lucky rather than smart. After costs, that is in terms of returns to investors, there is no game to play; there is no evidence of managers with enough information to cover costs, other than on a purely chance basis. And there is no evidence that this depends on market conditions. If you are interested, see our paper Mutual Fund Performance.
In short, passive management and passive investing always make sense.
EFF: This is a market timing question, and there is no evidence that anyone can predict markets or the duration of market episodes. Unfortunately, the same is true for business cycles. The average length of contractions during the post WW II period is about a year. But since there are so few observations on contractions, this historical evidence is not much of a guide.
KRF: This question has several interpretations. Perhaps the simplest is, "How long will prices continue to fall?" Since we are never certain what stock prices will do next, we cannot be sure they have stopped falling, but there is no reason to expect the market to go down over the next year, month, or even day. In fact, the historical evidence suggests that, rather than being negative, expected stock returns are unusually high in recessions to compensate investors for the additional risk they bear during these turbulent periods.
The question can also be interpreted as, "Gosh, we've lost a lot of money in the market. When will we get it back?" There is bad news and slightly better news here. First the bad news. Much of the drop in prices is permanent and reflects the reduction in profits firms have suffered and will continue to suffer as a result of the recession. This reduction is real and will have a permanent impact on firm values and security prices.
The good news -- if you want to call it that -- is that part of the price drop is probably temporary. Just as bond prices must fall when interest rates go up, if some combination of greater uncertainty about economic conditions and an increase in aggregate risk aversion increases expected stock returns, stock prices must fall to accommodate the higher expected returns. And this part of the losses is temporary; we expect to recover the price drop through higher future returns. Of course, the increase in expected returns we are talking about is not free. Any increase in expected stock returns is likely attributable to an increase in market risk and possibly an increase in risk aversion.
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