August 25, 2009
Cramer in his show is a stock-picker, not a portfolio manager, and Professors Bolster and Trahan therefore had to make assumptions in order to aggregate Cramer’s advice and to make it amenable to analysis. For example, they had to assume when stocks were bought, what the holding periods were, and how the investment money was allocated. They chose assumptions that approximated what an investor might realistically be able to do. So, for their first pass at analysis, they assumed that Cramer (or someone following him) would act on his recommendations using the closing price on the day following the day that the show was broadcast, and that he would hold the stocks until Cramer recommended selling them. They also assumed that the same amount of money (say, $1) is invested in every buy recommendation.
Over the entire period from July 2005 to the end of 2007, Cramer’s advice (on these assumptions) would have produced a cumulative return of 31.75%, or an annualized return of 12.09%, versus a cumulative 18.72% or 7.35% annualized for the S&P 500. Subtracting an assumed transaction cost of 1%, which may or may not be reasonable but should reflect the cost of trading what in many cases are small-capitalization stocks, would have reduced Cramer’s cumulative return to 22.42%, still well ahead of the S&P 500, but slightly behind the Russell 1000 Growth and Value indices, and nearly matching the Russell 2000 Growth index. It was probably the first result that prompted Cramer to say on his show, according to Professor Bolster, that “These two guys from Northeastern got it right.”
That suggests that he hadn’t read the rest of their paper.3
Using a standard methodology from financial economics for “event studies,” they looked for the impact on prices of Cramer’s recommendations. They found that in the first day after he recommended a buy, the price rose, but that this little return was then given up over the remainder of a thirty-day interval. Not quite symmetrically, after he recommended a sell, the price declined over the next day, and then continued to decline over the thirty days following his recommendation. On the whole, these results were statistically significant. So Cramer’s advice does move stock prices by a small amount. One wag in the audience at Professor Bolster’s presentation pointed out that this suggested that an investor should wait a day after Cramer makes his recommendations, and then short both his buys and his sells.
But the event study and the cumulative return analysis did not take risk into account. Did Cramer generate an alpha? That is, after allowing for risk, did his recommendation produce any additional return?
Using the Capital Asset Pricing Model (CAPM) to estimate risk, they found that Cramer’s recommendations had a beta of around 1.2 and an alpha of 0. This means that the extra return that Cramer’s recommendations produced came simply from their having more market risk than the universe of stocks. This helps to explain why his stocks outperformed the S&P 500 during the period of the study, even though, over the thirty days following his recommendations, there was no excess return from his buy recommendations.
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