Stocks are on sale - go and buy some..

The FT has a great article talking about two valuation measures - Q and "cape". Q is well known in finance as basically market value to book value. High Q can mean high valuations (although it can get a bit messy as there are other interpretations of this ratio). "Cape" is a "cyclically adjusted price earnings ratio" - but basically a P/E developed by Robert Shiller. Shiller is the guy who said that stocks were overvalued in the late 1990s, and houses were overalued in the 2000s.

Both these ratios point to valuations being below average since the late 1980s. Stocks, by these measures are cheap. Of course, prices could still fall, and even if they are cheap now, they could stay cheap for a long time. But, if you are a long term investor, now would seem like a good time to be buying.

HT: Newmark's door.

Ch 11 and the auto industry

A really nice piece by Joe Stiglitz on why Ch11 is the way to go for the auto industry.

I particularly liked the final paragraph which basically sums it up...

Even if Congress does now give carmakers $15bn as a “stay of execution,” postponing the hard decisions, before the next multi-billon dollar dose of medicine we need to think more carefully about who we are really bailing out and why. This should not end up as just another rescue package for bondholders and shareholders.

I think its pretty obvious that any loan from the Government is just going to delay the inevitable. Furthermore a Car-Czar will have no real power except to pull the financing. Using a medical analogy, this is like a doctor saying that he'll pull the life support plug if the patient doesn't take all the bad tasting medicine. It ain't gonna happen. 6 months from now the big 3 (or 2) will be back, cap in hand, driving their hybrids and begging for more.

On a related note, the Wall Street Journal reviews the Cadillac Escalade Hybrid. To quote the reviewer...

Not in my lifetime has a car company come up with anything as absurd as the 2009 Cadillac Escalade Hybrid, the latest example of hybrid greenwashing

Which reminds me of this "ad" recently posted by Craig Newmark.




Ok, remind me again why we are wanting to bail out these idiots?

HT: Mankiw's Blog

Cheap money

Because of unprecedented demand for safe assets, T Bills are being sold at negative rates. (See this Bloomberg.com article). In effect, people are paying the US government to store money. This can't be good. On the bright side, the loan to the auto industry isn't going to cost much in the short run!

Great videos on the financial markets

A big thanks to the unknown professor for posting a couple of these on his blog. These youtube videos are buy Paddy Hirsch of Marketplace.com. They are simple explanations of various aspects of the current financial crisis and are very watchable. Rather than post them all, I'll just provide the link to the youtube site here

HT: Financial Rounds (Unknown Professor)

Ford to sell volvo

Probably makes sense that Ford is going to sell Volvo - the company could use the cash. It'll be interesting to see who would bid for the unit. Given the market for higher end cars today, I imagine it could be had for a bargain.

and the prize for the dumbest explanation for the current economic crisis goes to...

...the Wall Street Journal editorial page. Daniel Henninger argues (OK, just says) that the reason why we are in this economic mess is because of a bunch of northern atheists who have no morals.

If were thinking: "wasn't it something to do with subprime loans, too much liquidity and a dysfunctional rating system?" then read on...

He starts off with

A nation whose people can't say "Merry Christmas" is a nation capable of ruining its own economy.

And then offers the following explanation...

What really went missing through the subprime mortgage years were the three Rs: responsibility, restraint and remorse. They are the ballast that stabilizes two better-known Rs from the world of free markets: risk and reward.

Responsibility and restraint are moral sentiments. Remorse is a product of conscience. None of these grow on trees. Each must be learned, taught, passed down. And so we come back to the disappearance of "Merry Christmas."

It has been my view that the steady secularizing and insistent effort at dereligioning America has been dangerous. That danger flashed red in the fall into subprime personal behavior by borrowers and bankers, who after all are just people. Northerners and atheists who vilify Southern evangelicals are throwing out nurturers of useful virtue with the bathwater of obnoxious political opinions.

The point for a healthy society of commerce and politics is not that religion saves, but that it keeps most of the players inside the chalk lines. We are erasing the chalk lines.

Feel free: Banish Merry Christmas. Get ready for Mad Max.

Wow. That has to be the stupidest thing I have ever read in the opinion pages of the Wall Street Journal, and frankly, there has been a lot of competition. Of course, now that the Journal is controlled by Rupert Murdoch, we should hardly be surprised that the opinion pages sound like Fox news.

But the tired old argument that the only reason people behave well is because they are religious has been shown time and time again to be completely wrong. For example, see this article in the Times of London.

WSJ on Finance Jobs...

The Wall Street Journal today talks about MBA students who are moving away from traditional finance jobs (which in their world is investment banking) to alternative jobs (corporate finance). The article is not very interesting, but wins the "Duhhhh" prize for most obvious article to write about Finance MBAs.

Notably though, Risk Management is a hot topic.

Must read...by the author of liar's poker

This is a must read piece. It is a little long, but well worth it. It is penned by Michael Lewis, the guy who wrote "Liar's Poker", and frankly it is really excellent. I won't spoil the punch line, but you pretty much know where his story is going once he gets started. Even so, the whole article is still compelling.

There are some great one liners in the piece: I liked this one...

“The single greatest line I ever wrote as an analyst,” says Eisman, “was after Lomas said they were hedged.” He recited the line from memory: “ ‘The Lomas Financial Corp. is a perfectly hedged financial institution: It loses money in every conceivable interest-rate environment.’ I enjoyed writing that sentence more than any sentence I ever wrote.” A few months after he’d delivered that line in his report, Lomas Financial returned to bankruptcy.

HT: Newmark's Door.

A tour of the NYSE

From the BBC - here is a short video of a broker giving us a tour of the floor of the NYSE. You'll note that it looks pretty quiet - that's because a great deal of the volume now bypasses the floor brokers and is handled electronically.

Still, interesting stuff if you've never seen what a specialist looks like.

Next in line for blame - credit rating agencies

A student of mine told me about this - as we expected, and predicted, credit rating agencies were just in it for the money. Who would have thought?

I wrote earlier that credit rating agencies seem to be run like protection rackets..

from CNBC

In a hearing today before the House Oversight Committee, the credit rating agencies are being portrayed as profit-hungry institutions that would give any deal their blessing for the right price.

Case in point: this instant message exchange between two unidentified Standard & Poor's officials about a mortgage-backed security deal on 4/5/2007:

Official #1: Btw (by the way) that deal is ridiculous.

Official #2: I know right...model def (definitely) does not capture half the risk.

Official #1: We should not be rating it.

Official #2: We rate every deal. It could be structured by cows and we would rate it.

A former executive of Moody's says conflicts of interest got in the way of rating agencies properly valuing mortgage backed securities.

Former Managing Director Jerome Fons, who worked at Moody's until August of 2007, says Moody's was focused on "maxmizing revenues," leading it to make the firm more "issuer friendly."

Stay the course...says Malkiel

Burton Malkiel author of a "Random Walk Down Wall Street", advocates very clearly that we should stay the course. Don't try to market time.

It is very tempting to try to time the market. We all have 20/20 hindsight. It is clear that selling stocks a year ago would have been an excellent strategy. But neither individuals nor investment professionals can consistently time the market.

I agree. Right now is the time to be shoveling money into stocks. They look cheap. Very cheap. (except GM and Ford that is).


HT: Greg Mankiw's Blog

March Madness in September

This "bracket" has been making the rounds. A student sent it to me, and I've also seen it on Greg Mankiw's blog.

Its amusing enough, except that the creator spells Barclays wrong. Call me finicky, but its not like Barclays is some sort of washed up has been, like, er, Leeman Brothers.

An old NYT article and the current situation

From the Freakonomics blog, this article from the New York Times in 1999.

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.

The action, which will begin as a pilot program involving 24 banks in 15 markets -- including the New York metropolitan region -- will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring.

I may be going out on a limb here, but could this have something to do with the current mess?

Quote for the day from Buffet

"You should get greedy when others are fearful and fearful when others are greedy"

Further opinions from economists

For more great insights into the current mess check out Greg Mankiw's blog...

Campbell Harvey's proposal

Campbell Harvey, current editor of the Journal of Finance, has put forward what he calls a "proactive" solution to the current financial crisis. You can read it here. He makes a lot of excellent points. Whether or not our leaders in congress pay any attention to them is another matter.

Essential Reading on the current mess

My colleague Craig Newmark, has put together an excellent listing of articles discussing the current situation. Many are written by some of the brightest and smartest names in economics. This really is a fantastic resource and makes excellent reading.

The first post is here. The second is here .

Zero interest for a limited time

The yield on T Bills actually touched zero percent today.



This is consistent with institutions looking for any place to park money while things sort themselves out. Getting a return is probably a secondary issue. This is generally referred to as a flight to quality.

Graph from finance.yahoo.com. The current quote is here.

HT: My colleague Bart.

Charlotte NC

Charlotte NC (the other big city in NC - I'm in Raleigh) could be an unexpected beneficiary from the financial fall out. We've already heard of Bank of America buying Merrill. Now there is talk of Morgan Stanley trying to hook up with Wachovia.

Both BofA (which used to be North Carolina National Bank - NCNB) and Wachovia are headquartered in Charlotte.

Of course, its very unlikely that Merrill or MS would move the brokerage or investment banking business to the queen city.

Worst crisis since 1930

The (newly designed and very nice looking) Wall Street Journal website has a great article about the current financial problems. This is not a discussion of how we got here, but more specifically of why it is hard to correct the problems. The key is an orderly de-leveraging of financial firms. Firms have to unwind their debt and build up capital. Unfortunately, as they sell assets to reduce positions, the value of these assets decline, worsening their capital position. We're in a sort of death spiral. It is looking more a more likely that more government intervention will be needed to help these firms get out of their debt positions. This obviously brings with it unpleasant questions about who gets bailed out and who doesn't.

What is clear is that going forward, credit will not be as easily available. Particularly to more marginal borrowers, and those who want to borrow at very high leverage rates.

From a personal finance side, I take the view that first you want to remain very well diversified, and second, when the recovery comes, which it will, you want to be in the market. Therefore, I am staying the course.

Buffet was right....

The oracle of Omaha correctly foretells the future, yet again. (He previously predicted the collapse of the tech market).

HT Newmark's Door

Not a happy day for stocks

The market was down today by over 4%, making this the worst trading day in 7 years. It is surprising that it didn't fall further. The bankruptcy of Lehman, the takeover of Merrill and the continuing problems at AIG and WAMU all point to massive weakness in the financial sector. Top it all off with more weak numbers about the economy and surprisingly better news about oil prices (which hurt oil stocks) and you are in for a bad day.

My MBA students manage a real money portfolio and we took big hits on energy stocks - with Constellation Energy and Frontier Oil both down over 15%. Citigroup was also off 15%. On the bright side, consumer non-durables did relatively well - showing their general recession proof qualities. Overall the portfolio was off about 3.7%, which at least wasn't as bad the market overall.

Cap and trade

I recently posted about Pigovian taxes - i.e. a Carbon tax. One of the advantages to this tax is that it would reduce carbon emissions and the tax revenue could be used to reduce other types of tax - such as payroll tax. In essence, it could be tax neutral.

An alternative to a carbon tax is a cap and trade system. This works fine if you auction a limited number of carbon credits and collect the revenue from the auction and then use the proceeds to reduce the economic burden of the higher energy costs on consumers. But if you just give them away then you achieve nothing. In fact giving too many away basically results in a subsidy to polluting firms who can then sell them at a profit. These firms collect all the excess from the cap and trade system. Case in point: the experience in the EU.

The following quote from the article pretty much sums it up.

One of the largest over-allocation of permits is to Castle Cement, which makes a quarter of all British cement at three works in Lancashire, north Wales and Rutland. The figures show carbon dioxide emissions from the three plants have fallen from 2.3m tonnes in 2005 to 2.1m tonnes in 2007. Yet, under the ETS, the firm has been handed enough permits to produce 2.9m tonnes CO2 for each of the next five years - an annual surplus of 829,000 permits.

A spokesman for Castle Cement said: "Castle Cement will not require all its allocated permits to cover CO2 emissions in 2008 as we continue to reduce our impact on the environment in line with our sustainability strategy.

"Total CO2 emissions from our three works are likely to be less than in 2007 due to further improvements in efficiency, increased use of low-carbon fuels and a weakening demand for cement caused by the general economic downturn. Surplus credits will be traded."

At the current price of £21, the company could sell its surplus permits for £83.5m over the five years.

Prediction markets

Not getting enough of politics on TV, in the news and everywhere else? Well you can play the prediction market as well..here.

You can bet on either McCain or Obama winning the election. Or you can take a hedge position to offset your post election misery. Your choice.

Finance and Econ researchers have written on these markets. Here are a couple of links. 1. 2.

HT: Freakonomics.

UAL share price drop

Thanks to Craig Newmark for this interesting story.

On Monday (sept 8), UAL (United Airlines) stock dropped 75% amid a story that it had filed for bankruptcy. Turns out the story was from 2002. The original story was on the Florida Sun Sentinel's website. It was on the front page because people had clicked on the old story and made it the most popular news story. (This happens on the BBC news site a lot also).

A google search bot found the story, but as it had no date, assigned the date from the masthead of the paper. Then an analyst (who didn't read the story) uploaded it to Bloomberg. Program trading took over and the "news" triggered a massive sell off of the stock.

The SEC is investigating. The question is: Was this an innocent mistake or was their evidence of a deliberate manipulation of the stock?

Pigovian Taxes

Greg Mankiw has an excellent article on why gas taxes should be higher. I'm inclined to agree with him. In fact the majority of economists support the notion of Pigovian taxes on gasoline. These are taxes that are used to correct some externality generated by consumption. In the case of gasoline, the externalities are pollution, congestion, climate change etc.

Mankiw also explains why cap and trade policies are inferior to a simple carbon tax. The primary reason being that the revenue from the carbon tax can be used to offset the tax burden - for example - it can be used to reduce payroll taxes.

Primary opposition for carbon taxes come from politicians - but as Mankiw points out; just because they oppose a carbon tax - doesn't mean that carbon taxes are a bad idea.

Anyhow, it is an excellent read for both economists and non-economists alike.

Hat tip goes to the Freakonomics blog where I saw this posted.

Arca ECN

It's not often that you can see a financial market in action in real time. Check out the Arca ECN. (Be sure to click on the java book version).

For the uninitiated, an ECN is an electronic market that matches buy and sell orders...

Option ARMS

Yet more good stuff from the economist. Option ARMs - adjustable rate mortgages that allow (give the option) of paying less than the interest rate. The difference is then added to the loan balance. In a down market, you end up owing more than you originally borrowed on a house that is worth less than you paid. Oh yes, and these are mainly in CA.

The name option arm is ironic really because these loans are very much like options, where the buyer of the house is betting on house price volatility and hoping that the value of the house ends up in the money. Consider this fact also - in most cases, if the homeowner has been paying below the market interest rate for the loan for 5 years, he/she will have also been paying far below the rental cost of the property. So even in the case of default, where they loose the house, the occupant has still lived in a house at a lower cost than if they rented.

The trouble isn't going to be centered in CA either, my local bank Wachovia is in on the action...

An option-ARM product called Pick-a-Pay (a name that gave fair warning it could lead to trouble) accounts for 45% of consumer lending at Wachovia, a large bank.

CDS - Credit Default Swaps

The Economist has an interesting piece on the role of CDS - credit default swaps. Not surprisingly the cost of insuring debt has gone up...

The five-year CDS spread had more than doubled to 740 basis points (bps), meaning it cost $740,000 to insure $10m of its debt.

Also of interest is the increasing use of the CDS market to speculate on firms. In essence this might provide a means of betting on a firm's declining credit.

finance crossword from FinanceProfessor..

Huge hat tip to financeprofessor for creating a finance crossword. Combining the excitement of finance with the endless fun of crosswords - brilliant. Give it a try.

crossword

Beer and research

Posted on the freakonomics blog - research that shows that the more beer academics drink, the less they get published. Uh oh.

Inside the mind of an investor

Source:digg.com

Why have gas prices fallen?

Gas prices have fallen and oil prices are well below their recent peek - which raises the question: Why? Some might say it was supply and demand with the higher price reducing demand, thus resulting in a lower equilibrium price. Others offer a different explanation...prayer.

Perhaps this will lead to a new area of theological economics.

Confessions of a risk manager

Great article on the Economist website giving the views of a risk manager at a major bank at what went wrong in the credit crunch.

We had not fully appreciated that 20% of a very large number (of AAA bonds) can inflict far greater losses than 80% of a small number (of sub investment grade bonds).

italics added by me

Although he doesn't blame the traders, he does say that the risk managers were frequently ignored or overruled, or were under pressure to approve deals. And not surprisingly, the most pressure was on the highest returning deals....

Worthless Money

Ever wondered what a bank note from Zimbabwe looks like?

Check it out

Note the expiration date !

Save for your retirement

Everyone should save for their retirement. Here's a nice story from India.

As a side, the story notes that coins in India are smuggled to Bangladesh to be melted down into razor blades. The metal content of the coin exceeds the face value of the currency. In the US we're getting close to that point with the 1 cent.

Inflation and stock prices

Stocks should be a good hedge against inflation - they are claims on real cash flows. Bonds on the other hand should do terribly when inflation increases - they are claims on nominal cash flows that cannot adjust. In reality though, stocks do pretty poorly when inflation increases. This article in the Economist offers an explanation - that earnings decline during periods of inflation.

An alternative explanation, and a better one I think, is that investors don't understand how to value stocks in the presence of inflation. They discount real cash flows using nominal rates and they fail to realize that the reduction in earnings due to higher interest costs is merely illusory. In essence, investors suffer from money or inflation illusion. My 2002 Journal of Financial and Quantitative Analysis paper with Jay Ritter discusses this, and several others (here here and here) provide further evidence.

Some thoughts about oil prices

An article in Fortune says that it is unlikely that higher oil prices are due to futures trading. There are two basic reasons for this. First, these futures traders are not building inventories of oil, in fact oil inventories are down. Second, for every futures contract, there has to be a long and a short. If the longs are paying too much - the shorts should stand to make a killing. As usual, congress is blaming speculators for high oil prices and proposing legislation to reign in these "speculators". A similar article is in the Economist




On a related note, Newmark's door has an article about how the onion market is more volatile than the oil market, perhaps because there is not a futures market for onions. This finding is supported by my own work that shows that Single Stock Futures reduce volatility in the spot market for stocks. In fact most evidence shows that futures markets have a stabilizing effect on the underlying spot asset.

Finally, on NPR this weekend I heard a story about people trying to trade in their SUVs for more fuel efficient vehicles. In the story, one person brought a 2007 Escalade to a CarMax dealership. The truck was a year old, and cost over $70K. The owner was making $1400 a month payments on it. The CarMax buyer offered him about $30K for it. Here's what I don't get. You buy a 70 grand SUV a year ago when gas prices are $3 a gallon, but when gas prices hit $4 a gallon, you can't afford to run it? What's more, the owner said he would have sold it for $40,000 to the dealer - basically taking a $30,000 loss to save the pain of an extra $1 per gallon of gas. In behavioral finance this is called "mental accounting".

Finance Salaries

From Craig Newmark. An article saying that many Harvard grads go into finance because that's where the $$ are.

http://newmarksdoor.typepad.com/mainblog/2008/07/dept-of-no-surp.html


The article discusses whether we are seeing a "finance bubble" - I doubt it, but I am sure that finance jobs are not going to be quite as plentiful and high paying in the near term.

Sometimes the simple ideas are the good ones..

This is a little off topic, not really finance. But a couple of Duke Management profs have published a piece in Science that says folks suffer from mpg illusion. Basically, they argue that we focus on trying to get higher and higher mpg, when the biggest savings are for those people who drive vehicles that get really bad mileage.

The story is here...
News and Observer article here

The basic idea is this. If you drive some big ugly truck that gets 10 mpg, you'll use 1,000 gallons a year to go 10,000 miles. Now if you trade to a truck that gets 15 mpg you'll use 666 gallons. A savings of 333 gallons a year.

Now consider someone who is getting 25 mpg and they trade up to a hybrid that gets say 35. Their gas savings go from 400 gallons to 285 gallons. A savings of about only 115 gallons a year.

The point then is that the biggest savings come from fairly small improvements on poor mpg vehicles.

The idea is so obvious of course it is brilliant and what is really great is that these guys got it published in Science.

Google stock screener

Google has a new stock screener. What is cute about it is that you can see the distribution of the values you are screening on graphically. For example you can see the distribution of market values. Very nice.

Google stock screener

You can also screen by sectors etc. What would be nice is if you could screen by index membership as well.

Finance sayings.

Stephen Dubner at the freakonomics blog has a bleg out for finance sayings.

One of my faves is

The market can stay irrational longer than you can stay solvent. - Keynes

Salaries for college grads

If you are graduating or have just graduated, then this is going to help much - but if it's still interesting.
Salaries for college grads for 2008

HT: Newmark's door.

As Craig Newmark points out - Econ grads earn more on average than finance grads. Food for thought. My limited experience has been that Econ majors taking my classes have always been among my best students. So I suspect that there is a selection bias - on average better quality students become Econ majors.

Bad news in the charts

My colleague Don sent me this picture. As all chartists know, you should sell when you see the black swan indicator.

Mostly Economics Blog

Just a quick mention of the Mostly Economics Blog. Plenty of good stuff over there on current market and economic conditions..
http://mostlyeconomics.wordpress.com/

Bernanke's Bubble Lab

Great article in the WSJ a few days back. This article talks about recent research (in particular by Harrison Hong of Princeton) that looks at why bubbles form.

To summarize...
1. Bubbles occur when investors disagree about the significance of some event. The internet being the obvious one. It's hard to bet on prices going down (limits to arbitrage etc), so the optimists dominate and prices shoot up.

2. Bubbles are then identified by intense trading.

3. Bubbles continue even when "smart" investors know that prices are too high - as individually they cannot attack the bubble. Only when they act simultaneously can their actions have an effect.

The conclusion is that it might be in the best interest of the Fed to contain bubbles rather than let them run their course.

Robert Shiller in his book "Irrational Exuberance" talks about bubbles also. He focuses on the feedback loop between the media and market participants. Bubbles make news and are great for exchanges (lots of trading) so plenty of people have an incentive to keep them going. Bubbles also falsely give the impression to investors that they have stock picking skill when in reality they are just riding the bubble with everyone else. The skill is not in buying the stock, but knowing when to sell.

On a related note - an interesting article on the freakononmics blog here talks about how we tend to think we are above average (drivers, stock pickers etc) which relates us back to a recent post on stock trading and speeding....

Its summer...and oil prices keep on rising.

So it was pointed out to me that I haven't updated the blog of late. This is a major faux pas in blogging apparently. Actually, its summer. As they say in academia - the top 3 things about being a professor are June July and August. In my case, its just July and August as I am teaching a summer MBA course.

I read a piece recently about Exxon and it's strategy for managing it's franchises. Basically, Exxon HQ knows exactly what each one is charging and varies the wholesale cost to them based on what the local market can stand. From the point of the franchisee this isn't that great, as in times of high gas prices you are still only making pennies per gallon. The full article is here.... The basic tone of course is that big bad Exxon is sticking it to all of us. Well guess what... they are. Its called capitalism.

Exxon is acting entirely rationally in a shareholder wealth maximizing manner. We may not like it, but that's the way it is. Get over it, or don't buy Exxon gas - but buy Exxon stock.

But, since we are on the issue of so-called wind fall profits here are a few other firms/industries that need to be examined.

1. Apple computer - why can't I have an iphone for $99? You know they are making a boatload on those puppies. Loads of demand and carefully controlled supply helps maintain a high price and a nice margin. Hmmm, maybe congress should sue them to make more. (see here for a related article)


2. Farmers - food prices are up. Corn prices are at records because of global demand and ethanol production. Those guys are enjoying some great "windfall" profits.

Slightly off topic ... wine and music

As an academic, I spend a good deal of my time doing research. Usually on very exciting topics related to finance. But when I read articles like this I wonder whether I am in the wrong field.

Apparently some researchers in Scotland have found that different types of wine taste better when different music is played. It appears to be a very scientific study, a key finding was that:

The researchers said cabernet sauvignon was most affected by "powerful and heavy" music, and chardonnay by "zingy and refreshing" sounds.

I'm planning to do a follow on piece on beer and rock music. I'll post the results when I have completed the tests.

Word problems for Hedge Fund Managers

This is fun. Word problems for hedge fund managers - see how many you get right.
http://www.mcsweeneys.net/2008/5/7woodiwiss.html

Hat tip: My colleague Don.

Triple A Failure

Newmark's door has a great link to a piece by Roger Lowenstein on the role of bond rating agencies in the credit crisis.

It really is a must read article. In it, the finger is pointed at the bond raters - Moodys, S&P and Fitch for being too close to the banks issuing the mortgage backed debt.

Although this is a bigger question, I do sometimes wonder exactly what value bond rating agencies provide. Their business model seems to be not entirely dissimilar from that of running a protection racket. Consider the evidence:
1. You have to pay for the service. If you don't pay, you may not get as good a rating.
2. They will help you structure the product to get a better rating, but you may have to pay more.
3. The amount you can sell the bond for depends on the rating.
4. Bond rating changes usually lag changes in credit quality and thus have little predictive power.

Diane Rehm show on gas prices

I was riding in my car today and I was listening to Diane Rehm on NPR. Her show was about gas tax holidays as are being proposed by McCain and Clinton.

You can hear it here.

There was a fair amount of discussion from the panel about how a gas tax holiday was a bad idea - it encourages consumption, it reduces tax revenue for road building (and thus has an offsetting fiscal effect) etc.

Then Diane asked about the windfall tax that has been proposed. At this point Mark Cooper (director of research for the Consumer Federation of America) said something truly amazing. To paraphrase: he said that the oil companies don't really do anything with the excess profits - they just buy back stock or pay dividends. Then he said, and I quote "If you look at it from an economic point of view, taxing it away is not inefficient because they are not doing anything efficient with it"

What???? So the government should be able to step in and tax excess profits? This has to be one of the daftest things I have heard in a while. Those profits which are paid out as dividends are being used efficiently. Firms that do not have good investment projects are to be commended for paying out surplus cash to shareholders. Shareholders can then invest in other firms which need cash and have more productive growth opportunities.

It is one thing to make a policy decision to legislate a wealth transfer from one sector of the economy to another, but it makes no sense to argue that the government should tax more because it can put the money to a more efficient use.

Financial Rounds

Just a quick "Hi" to the readers of the excellent blog financialrounds.blogspot.com. Unknown prof said some nice things about me and my blog here

Lure of City money too strong for young

Sometimes you just have to shake your head and wonder...this article in the Guardian quotes the Bank of England Governor and states that:

The governor of the Bank of England issued a stern rebuke to the City today, saying that too many of Britain's most talented young people are being lured into financial careers by the huge bonuses on offer.

What???? You'd think that the boss of the Bank of England would have some basic notion of supply and demand in labor (or labour) markets.

What is the world equity risk premium?

John Campbell of Harvard has a nice paper published in a Canadian Econ Journal that estimates the equity risk premium. His conclusion: the world (and US) equity premium is around 4% currently.

The article isn't free, but if you are have access to a university library you can probably download it for free.

Given a 30 year bond rate of about 4.3%, this implies a long term return to stocks in the US of 8.3%. Why does this matter??? Well if you are assuming a 40 year investment horizon (someone who is, say 25 now) and you contribute $1,000 a month, 8.3% return will give you about $3.8M in your portfolio at age 65. But if you were using 11% (the long run historical return on equities) you would be expecting $8.6M. Given that most people are not saving enough, a lower return on stocks is not going to help.

Living Yield Curve

A student of mine (thanks Craig) sent me this link. Its for a living yield curve. Basically it shows the shape of the yield curve throughout history (or recent history anyway). Very cool.

Living Yield Curve

How good are analysts?

The Investor Insight website has an interesting study that shows that analyst earnings forecasts basically lag the actual forecasts.

This chart is particularly interesting:



Basically it shows that analysts change their earnings forecasts after the market has started deviating from the trend.

As a side note, the weekly newsletter from John Maudlin (from this site) is excellent.

Test your technical trading skills...

I'm not much of a fan of technical analysis, I think it is pretty much the finance equivalent of reading tea leaves. However, a lot of folks are. The freakonomics blog has a great link to a site where you can test your technical analysis chops.

The site is http://www.inspectd.com/. You get shown a historical stock chart and you have to decide whether to buy or sell. Then the outcome is revealed and you can see how you did.

I did terribly. But then again, I'm an indexer.

Stock market explanations

Stephen Dubner speculates why journalists feel compelled to concoct reasons for why the market went up.

I may be wrong, but it strikes me that the articles that appear in nearly every newspaper every day that describe a particular day’s stock-market movements are pretty much worthless.

For example:

Consider, for instance, this A.P. headline and news brief that appeared on Yahoo! News at about 2:30 p.m. yesterday:

“Stocks Surge to Start Q2″

Wall Street began the second quarter with a big rally Tuesday as investors rushed back into stocks amid optimism that the worst of the credit crisis has passed and that the economy is faring better than expected.

Steven suggests an alternative:

“Stocks Surge, Reasons Unknown; May Be Nothing More Than the Random Fluctuation of a Complex System”

How to make millions out of the Bear Sterns collapse

OK, don't tell everyone. Google has introduced a new feature that allows you to send emails back in time.
https://mail.google.com/mail/help/customtime/index.html

So here's what you do... send yourself an email on this date telling you to short sell Bear Sterns. March 12 would be a good date. Make the short and sit back and watch your fortune grow.

Thanks to my buddy Kevin for suggesting this brilliant trade...

What went wrong?

The Economist talks about "What went wrong" - basically a combination of leverage and perpetual optimism that financial assets could only go up.

Cramer...Cramer....Cramer

Cramer on CNN about his Bear Sterns comments. He's a bit more coherent this time, and as usual the interviewer gives him an easy pass.

Link here

But I still don't get it. He claims he was talking about someone having deposits at Bear Sterns. Since when was Bear Sterns a depository bank?

And in a related post, apparently Fox News Business Channel is playing off the Cramer gaff as a promotion tool.

They (Fox Business news) claims to be a "credible network". Personally I'll stick with the Colbert Report.

Executive compensation schemes

There is no doubt that you have to be smart to be a CEO. In fact, according to the WSJ, you have to be a math wiz just to understand a CEO's bonus compensation.

For example, for Adobe the bonus formula is:

"Target Bonus x Unit Multiplier x Individual Results."

But then comes the definition of unit multiplier. Adobe says it is:

Derived from aggregating the target bonus of all participants in the Executive Bonus Plan multiplied by the funding level determined under the funding matrix, and allocating a portion of the funding level to each business or functional unit of Adobe based on that unit's relative contribution to Adobe's success, and then dividing the allocated funding level by the aggregate target bonuses of participants working within each such unit.

(source WSJ)

Before this era of "transparency" I bet bonuses were just decided in a smoke filled room. Now that companies are expected to reveal their methods, they are opting to make the method as opaque as possible.

Bear Sterns worse than LTCM?

The Telegraph (UK paper) has an article arguing that the Bear collapse is worse than the LTCM failure.

The implosion of Bear Stearns is more dangerous.
A host of other banks, broker dealers, and hedge funds have played the same game, deploying massive leverage at the top of the credit bubble to eke out extra yield. Dozens of them are saddled with the same toxic debt - sub-prime property, credit cards, auto loans, and mountains of unsold paper from the merger boom.

Primarily because the rest of the economy is in bad shape and the risk on the damage spreading is much greater. We'll have to wait and see.

Delta hedging on AMEX

FinanceProfessor.com has a nice piece on a proposed rule change to allow delta hedging to be used to compute the appropriate stock hedges for option positions on AMEX.

Link Here

The rule change states:

All options contracts listed and traded on the Exchange are subject to position and exercise limits as set forth in Amex Rules 904 and 905. Position limits restrict the number of options contracts that an investor, or a group of investors acting in concert, may own or control in one particular option class or the security or securities that underlie that option class.

And

Over the past several years, the Exchange as well as the other self-regulatory organizations ("SROs") have increased in absolute terms the size of the options position and exercise limits as well as the size and scope of available exemptions for "hedged" positions. /6/ The exemptions for hedged positions generally require a one-to-one hedge (i.e., one stock option contract must be hedged by the number of shares covered by the options contract, typically 100 shares). In practice, however, many firms do not hedge their options positions in this way. Rather, these firms engage in what is known as "delta hedging," which varies the number of shares of the underlying security used to hedge an options position based upon the relative sensitivity of the value of the option contract to a change in the price of the underlying security. /7/ The Amex believes that delta hedging is widely accepted for net capital and risk management purposes.

Why is this interesting?

Well, as students of mine should know, once we have covered Black Scholes, the appropriate hedge for an option is not 1 share of stock per option, but depends on the delta of the option - that is the sensitivity of the option to the change in the stock price. A 1 for 1 hedge is really only applicable for very in the money options. For most options, the delta is less than 1, and thus a smaller hedge is required. Remember that over hedging is not a good thing.

Cramer: master of the double meaning

So the Bear Stearns collapse has been all over the news. But a slightly amusing side line is the Jim Cramer angle. Cramer as you probably know has a stock show on cable called "Mad Money". Its sort of like Wall Street Week meets Emeril but with more of the "Bammm!" and less of the analysis. Needless to say he is pretty popular. I think both Cramer and Emeril are very overrated.

So last week (March 11) Jim Cramer states that Bear is fine - no need to pull your money out....http://www.youtube.com/watch?v=gUkbdjetlY8. At that point the price was at about $60. Then by Friday the stock had collapsed to basically $2.

By this week, he's catching some heat for his comments. See the video here on financeprofessor's blog.
http://financeprofessorblog.blogspot.com/2008/03/more-news-on-jim-cramer.html

Ahhhh, but does Jim fess up and admit his mistake? Nooooo!!!

In a brilliant use of double meaning, he states that when he was asked "should I pull my money out of Bear?" his answer was referring to whether someone should remove their money from Bear's investment products, not Bear's stock. This is despite the fact that he posted a chart of Bear's stock on the screen.

Given that he had about 3 days to contact this answer I think he did pretty well. This must also mark the first time (on 3/11) that he gave advice about investing in an investment bank's investment products and not the bank itself.

Great stuff Jim. But perhaps you should consider a career in cooking.

Thanks to FinanceProfessor for the original link

The cost of active trading.

Finance Professor has a great link up here which talks about a new study by Ken French that argues that investors collectively spend $100bn trying to beat the market (and collectively failing). The original article is from Mark Hulbert's column on the NYTimes.

This is great stuff and pretty profound really. Fans on indexing should rejoice and can act smug in front of day traders!!! Of course active investors will argue that it doesn't apply to them - for an example see here.

For those of us who buy in to the idea of indexing, this study is not really a surprise, although I have to admit the dollar amount is pretty big!

Black Scholes - the root of all evil?

Last week, one of my MBA students handed me a copy of "Conde Naste Portfolio" which featured an article about the Black Scholes option pricing model. The article is also online and FinanceProfessor has a link to it here.

The article is pretty poor (although the magazine is very glossy!) First of all, it basically rehashes all the material in the PBS Nova TV special from a few years ago which looked at Black Scholes and the collapse of Long Term Capital Management. The Black Scholes Model was blamed for all the ills of the world back then. To make the topic more current, the author of the piece cites a Nicholas Taleb who has basically made a living trashing Black Scholes. People listen to this guy because back in 1987 he correctly bet that the market would crash. By his own admission, he hasn't been able to repeat that feat since - hmmmm. Anyhow, he has this to say about Black and Scholes:

"This is what I'm saying to Merton and Scholes," "You guys are just parasites. You're not bringing anything useful to the market. You are lecturing birds on how to fly. You're watching them fly. And then you're taking credit for it."

He also thinks that they should have the Nobel revoked.

I'm sorry Mr Taleb, but you are so far off base here, your comments barely dignify a response. The Black Scholes model is a model, and just that. It assumes that the risk input that you use is a reasonable estimation of the future risk of the security. If the security does something drastically different to what it has done in the past, then the model will misprice it. Garbage in, garbage out. If you use the model and don't recognize this, then you'll likely get burned.

Mr Taleb, don't go shooting the messengers (or in this case trashing the authors) of the model in such an unprofessional manner.

IBM buys back stock - if EPS goes up - should the price?

IBM is in the news because they are planning to buy back a lot of stock $15bn or so. The stock went up on the news. But why? Well buybacks, especially big ones can signal that the firm has a lot of cash or is going to get a lot more cash - thus will be making loads in the future. Buy backs are also good news for firms with cash sitting around. That money is better off in the hands of shareholders rather than being used for some dubious project.

But the reason why the stock price shouldn't go up is due to an increase in earnings. EPS will rise after a buyback purely because shares outstanding (the denominator in the EPS) went down. But net income (the numerator) is unchanged. I suspect that there are a lot of analysts who fix upon a valuation multiple - say 20X earnings, and apply that multiple to any EPS number that comes along. Thus by their reckoning, IBM's price should go up because the EPS went up. This is completely wrong, and frankly pretty stupid.

Link here

People just don't get compound interest.

Compound interest is a wonderful thing, but I always suspect that people just don't get how powerful it really is. One prediction of this is that individuals think that credit card debt is easy to pay off, and that there is not that much benefit from starting to save early.

This paper shows that households do in fact behave in this way, and they offer a theory for why.

But perhaps the simplest illustration of the effect of compounding is the following. Consider $10,000 invested for 10, 20, 30, and 40 years at 10%.

10 years: $25,930
20 years: $67,270
30 years: $174,490
40 years: $452,590

The question then is: If someone gives you $10,000 what should you do with it?

Northern Rock and Continental Illinois

Evan Davis of the beeb draws parallels between the Northern Rock bank and Continental Illinois. If your not familiar with the latter - it was the last big bank run in the US.

Link here

Pay day loans

From Newmark's door and interesting piece on pay day loans. These loans are widely viewed as being some sort of evil money grabbing scheme that exploits the poor. The study finds that pay day loan providers really don't make abnormally high returns. The reality is that the pay day loan business is expensive to operate.

A policy implication then, is that by imposing rate limits, the supply of pay day loans will decline.

A better index to describe subprime woes

Evan Davis of the Beeb has a nice blog about finance related stuff. This article talks about an index that measures the performance of the subprime market. The picture is pretty grim. The line basically drops off the bottom of the chart.

link here Evanomics

Recession worries

Unfortunately, if you start talking about it enough it might happen. US consumer confidence has plummeted. We may be entering the inevitable recession.

Link: BBC

More interest in Yahoo.

First it was Rupert Murdoch's newscorp expressing interest in Yahoo and now it is AOL. Frankly, anything must be better than Murdoch getting a hold of it. But its hard to see how AOL can benefit that much in what would become a marriage of two tired internet brands.

Link BBC website

Northern Rock is nationalized

In a surprise move, the British government has nationalized the Northern Rock Building Society (link to FT article). A building society is like a savings and loan, but it is basically a bank now. Northern Rock had grown aggressively through a practice of making loans and funding them in the commercial paper market. With the subprime collapse they got hit on both sides of the balance sheet.

There had been some talk of a buyout by Virgin. But according to the Government, the numbers didn't add up. Apparently the shareholders didn't agree with this. Their shares were trading for 90p (about $2) and will now be worthless.

This is the first nationalization of a bank for 25 years or so. But the Northern Rock was the first British bank in 100 years to suffer a bank run.

Value weighted returns or dollar weighted returns

We normally compute stock returns using a value weighted index, made up of the stocks in the market weighted by their market caps. But fund managers use a different approach (sort of) - they weight their returns by the amount of money that they had invested in the market. So the months when they were more heavily in the market are more important than the returns from the months when they were not as heavily in the market.

So what - well a study has applied this method to the overall stock market and looked at time dollar weighting the returns based on how much money was invested at a particular time. The results are not encouraging. Market participants are bad at timing the market...For example, the performance of the S&P 500 would fall by 1.4% from 10% a year to 8.6% on a market timing basis.

Article here (source Hal Varian's website and the NY Times)

Words of wisdom on technology

Hal Varian - says “technology changes — economic laws do not.”

Yours truly has said more than once - "it doesn't matter whether you are making computer chips or potato chips - finance is finance"

Its nice to see that I am not alone in this...

Hal Varian is a pretty famous academic economist who consults for Google now. He is also well know to most Business PhD students as his microecon text book is standard reading.

Link from the Freakonomics Blog on the NY Times

Fed rate cuts meet resistance

Despite aggressive rate cutting by the Fed, borrowing costs are going up for home buyers and corporations. Credit spreads have widened as continuing concerns about borrower's credit worthiness continue to worry lenders.

Article here

Source: Bloomberg.

Speeding and stock trading

There's a correlation between speeding and trading too often! Both are examples of over confident behavior. Both are pretty stupid - you can loose your life or your wealth.

New York Times piece

The research is forthcoming in the Journal of Finance.

Link from Finance Professor

Freezing loan rates = bad idea

Freezing prices in a free market is never a good idea. Here Richard Thaler argues why Hilary Clinton's idea to freeze interest rates on subprime loans is just bad economics. I'm inclined to agree with him.

For those who are not familiar with Thaler - he is a renowned behavioral economist from U. Chicago.

Thanks to Newmark's door for this link

MSFT to go to YHOO shareholders

Get out the popcorn and pull up a chair. MSFT is rolling up its sleeves - its gonna be a slugfest.

Yup MSFT looks like they are going to mount a proxy fight - basically try to remove the directors of YHOO.

More credit woes

The Economist has an good piece on how weakening balance sheets of banks is hurting their ability to extend credit.

Yahoo to reject MSFT

It took them a week to figure out a plan, but Yahoo is going to reject MSFT's offer.
Yahoo to reject MSFT

Realistically, this is the appropriate thing for them to do. When you know that your bidder has very deep pockets you owe it to your shareholders to try and get the best price possible. I doubt though, that MSFT will sweeten the deal much. Its still a good deal for YHOO shareholders.


Jerry Yang is clearly playing hard to get and trying to get an extra few bucks out of MSFT. Given that he owns over 40 million shares of YHOO, pushing the price up to $40 per share will net him a gain of over $20 since MSFT originally bid. His holdings will have increased by $800 million!

Bankruptcy Scores

FinanceProfessor talks about bankruptcy prediction and Altman's Z score.

link here

What is interesting is that it is Altman himself making the prediction. Great stuff.

FinanceProfessor also lists a couple of nice sites that show you how to implement Altman's method in excel.