The Popularity Question Revisited
Who's fooling whom

by Chris Rugaber (TMF

Alexandria, VA (May 20, 1999) -- Longtime readers of this feature and our message boards know that concern about the Foolish Four's popularity is one of the hoariest old questions raised about this approach. Believers in the Efficient Market Theory, and those with faith in the Wisdom of Wall Street, are simply convinced that there's no way an easy and effective approach like the Foolish Four can continue to work once it becomes well known.

For example, Grant McQueen and Steven Thorley argue in their recent article, "Mining Fool's Gold," that "Market participants are not fools. Even the starched shirt and suspenders gang on Wall Street have agile intellects and sharp pencils." As a result, they believe, the very popularity of the strategy will eliminate this market inefficiency (the low prices that result from overreaction to short-term bad news). The increased demand for those very stocks will cause the prices to rise quickly, and there goes the bargain.

Perhaps. McQueen and Thorley, and others such as Kiplinger's Magazine, which raised a similar criticism, have conflated two issues here. The first is whether so many people are buying the High Yield Dow stocks at the same time (through Unit Investment Trusts or as part of Beating the Dow or Foolish Four strategies) that their prices are being artificially inflated on the first trading day of January.

The second is whether some "agile intellects" are front-running all us dumb Fools and exacerbating the problem. If you were a short-term trader and noticed that the high-yield Dow stocks rose each year at the beginning of the year, you might be tempted to buy the stocks that you think will be on that list a few days in advance, then sell right after the beginning of the year when the prices rise.

As evidence for their theory that the Foolish Four is being front run, McQueen and Thorley present a chart of the "cumulative excess returns" (returns above the total market return) of the Foolish Four stocks from 1994-1997. Beginning 15 days before the first trading day of the year and ending 15 days afterwards, their chart does demonstrate that a significant jump in the share prices of the Foolish Four stocks occurred on the first trading day of each year, with "weak" evidence of increased buying "five or six days" beforehand. They conclude that "Somebody has been fooling the Fools."

Yet prices are always moving up or down for some reason or another. The authors do not compare their chart to the movement of prices in any other period (such as right after an earnings release), nor do they present data from anything longer than their 30-day window, or anything else that would provide context. Let's look at some data on our own to see if theirs is conclusive.

In the charts below are the combined trading volumes and closing share prices for the Foolish Four stocks in the week prior to the first trading day in 1998 and 1999. In other words, for each day, I combined the trading volumes for all Foolish Four stocks in both years and combined their share prices as well. The period represented below is the eight trading days from December 22nd through January 5th of 1998 and 1999.

Looking at these two charts, it's clear that increases in trading volumes and share prices are taking place, though whether this is a result of normal market activity, Foolish Four (and other high yield strategy) investors making their purchases over several days, or "front runners" is obviously impossible to tell.

It probably doesn't matter, though, since if we look at a wider time period we can get a more contextual sense of the fluctuations in trading volumes and prices. Looking at a three-month period from mid-October to mid-January, here are the same variables (combined trading volumes and share prices for the Foolish Four stocks between October 15 and January 15th in both the 1997-98 and 1998-99 periods):

Obviously, when even three months of context are added, we get a clearer picture of what's going on. Certainly there are jumps in trading volume and share prices for the Foolish Four stocks in the late December-early January periods in 1998 and 1999, especially when compared to drops that occurred around the holidays, which make the following upswings appear larger. (In fact, the holiday slump is the most obvious thing about both of these charts. In this larger context, the price and volume rise that follows it simply looks like a return to normality.) But when looking at three months of activity, it's clear that these fluctuations are not really that unusual or out of sync with the normal ups and downs of the market.

This doesn't even take into account the fact that these changes in price and share volumes may be a result of other factors. Many companies report earnings or issue earnings warnings around the end of the year, as both Caterpillar (NYSE: CAT) and 3M (NYSE: MMM) did in December 1998, for example. And of course there are other comparisons that could be made: what did the trading volumes and share prices of Foolish Four stocks look like in, say, late December 1991 through early January 1992, before most people had even heard of Dow Investing?

Make no mistake, there clearly is some price increase in Foolish Four shares on the first trading day of the year, perhaps due to UITs, which are required to buy on that day. As Fools investing on our own, we can avoid that by simply buying earlier than the first trading day of the year -- as we did with our real-money Foolish Four portfolio this year -- or later. This year, prices for the Foolish Four stocks returned to almost pre-January levels by January 15th.

While there's little evidence for the front-running that McQueen and Thorley allege, what I find distasteful about that whole line of argument is the idea that clever investors aren't following the Foolish Four, they're "fooling the Fools" and front-running it. Hey, if that's what floats your boat, go right ahead, buy the Foolish Four stocks in mid-December or whenever and sell them on the second trading day of January. You might even make a few percent, before taxes and commissions.

It's hardly a long-term market-beating strategy, however. Given the recent performance of the Foolish Four, I'll stick with our strategy and leave allegedly clever moves, like front-running the Foolish Four, to others.

Would you work for a bunch of Fools?

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Today's Stock Lists | 1999 Dow Returns

05/20/99 Close
Stock  Change   Last
CAT  +  15/16  58.94
JPM  +   9/16  139.31
MMM  +   1/16  89.44
IP   +  13/16  54.81
                Day   Month    Year   History
       FOOL-4   +0.90%  -0.96%  27.70%  29.60%
        DJIA     -0.19%   0.72%  18.74%  18.27%
        S&P 500  -0.40%   0.27%   9.23%   9.50%
        NASDAQ   -1.36%  -0.02%  15.94%  17.53%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     58.94    36.81%
 12/24/98    9 JP Morgan    105.51    139.31    32.04%
 12/24/98   22 Int'l Paper   43.55     54.81    25.86%
 12/24/98   14 3M            73.57     89.44    21.57%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1414.50   $380.50
 12/24/98    9 JP Morgan    949.62   1253.81   $304.19
 12/24/98   22 Int'l Paper  958.12   1205.88   $247.76
 12/24/98   14 3M          1030.00   1252.13   $222.13

              Dividends Received      $29.45
                             Cash     $28.26
                            TOTAL   $5184.02