S & P earnings...Fama and French comment

This issue keeps coming back like a bad penny. The issue of how S&P computes earnings ratios. My last post on it was here.

Fama and French have weighed in and argued that they use the method used by S&P, which in "normal" circumstances probably makes sense. But I disagree with them on this comment...

It is easy to see the logic if you imagine merging all of the firms into one giant conglomerate. The new firm's earnings and market equity are just the sum of the individual firms' earnings and market equity.

The S&P 500 is not a giant conglomerate. If a massive firm goes bankrupt and posts massive losses that outweigh it's market value, those losses are not absorbed by the other firms in the index as in a conglomerate. Once the firm has zero value, that's it. The losses are then absorbed by the creditors.

LTCM - an insider's view

From financeprofessor - here is a video of an ex LTCM insider talking to Zvi Bodie's MIT class. This really is required viewing for any MBA finance student.

Excellent stuff.

Indexing wins, again.

From Greg Mankiw... Indexing wins again.

Whether you should be in large cap stocks or not is based on your risk tolerance and overall asset allocation. But what is clear, time and time again, is that you should not pay anyone to actively manage your large cap portfolio. Just index, or buy and hold.

Market timing

If you are questioning why some people managed to get out of the market before the big drop, the answer is given, succinctly as usual, by Fama and French: They got lucky.

Taleb - your 15 minutes is up

Finance Professor posts a couple of links about Nassim Taleb (the black swan dude) that criticize some of Taleb's recent prognostications. Although Finance Professor likes Taleb, I think Taleb has had his 15 minutes of fame. We get it! Returns have fat tails. This isn't new information. What was new was that Taleb had the notion to write a book on it. Anyhow, his rants on academic economists are childish and frankly tiresome.

Ratings agencies become more irrelevant...

At least that is the view in this article here which argues that Moody's downgrades don't really matter.

Jeremy Siegel responds...(on S&P's P/E ratios)

Jeremy Siegel recently caused a lot of fuss by arguing that S&P mis-reports earnings in the 500 index. I posted a comment on his idea here. Then S&P responded. At the time I agreed with Siegel and I disagreed with S&P (I still do).

Finally Siegel himself has re-entered the fray and confirms what I thought he was saying. Furthermore, he has enlisted Robert Schiller who also supports his arguments.

No doubt, S&P will still argue that Siegel's arguments are without merit, but I think that this issue is closed. Not value-weighting historical earnings of companies that loose huge amounts of money causes the stated earnings of the S&P 500 to be too low. The argument made by S&P that the index is just like a multi-division company is just plain stupid.

Why active managers underperform..

A nice post on Portfolio.com on why active managers underperform. Click through to the underlying article also.

The basic idea: Only about 1/5 of stocks are actually significant winners. Most don't do too much. A completely passive approach to picking stocks uses an equal weighted method and will put at least some money in the unknown "winners". But most active managers don't equally weight, and weight more heavily in their "expected" winners. As they (the active managers) don't actually have any stock picking skill, there is a good chance that there overweighting is in stocks that will underperform (i.e. they overweight in the 4/5 that don't do too much).

This relates to my recent post on the re-jiggering of the Dow and S&P 500. More I think about it, it seems that rather than index funds, folks should invest in randomly generated "buy and hold" funds. Which of course, are not available in most retirement plans.

Conflicts of interest. A case study....

A commenter on this blog provided this link on the seekingalpha site. Very well worth reading. The basic idea can be summarized in this quote from the article...

Ah, good old circular conflicts of interest. To summarize: i) Merrill, which is probably not too happy with having loaned Kimco $707 million on its credit facility, underwrites a $720million (including a 15% overallotment) stock offering for which it gets $20 million, ii) Merrill's analyst changes the stock from a Sell to a Buy, causing it to pop 30% in one day, and allegedly allowing participants in the offering to sell their shares at a 30% gain in a day, a mindblowing annualized return, iii) Kimco uses the proceeds to repay Merrill's credit facility, cleaning out any credit risk exposure Merrill might have with respect to Kimco's underperforming properties and operations.

It makes my head hurt. I'd say that this kind of stuff gives Wall Street a bad name, but I think it's too late.

How Dow Jones and SP mess things up

A student of mine sent me this link in which it is argued that changing the composition of the Dow (or SP 500), causes these indices to underperform a fixed basket of stocks.

The components of both indices change when a stock drops out and is replaced by a new stock and the new addition is invariably some hot growth stock that has seen a rapid run up (i.e. MSFT, GOOG, Yahoo etc) and the stock that is dropped out (particularly in the Dow) is a value stock. So, in effect, the indices buy growth stocks when their values are high.

Indexing is great because it reduces the cost of active management. But as this article shows, there is still the active management of the index creator that can mess things up for you.

MM homemade leverage and hedge funds

Students of corporate finance should remember learning about homemade leverage and the Modigliani and Miller theory of capital structure irrelevance. In a nut shell (absent taxes and bankruptcy costs), leverage doesn't matter. This is because an investor can lever up or de-lever a position to attain his or her own desired level of leverage.

Hedge funds make bets on securities and also lever up. On Portfolio.com there is a nice posting talking about why hedge fund managers shouldn't use leverage, and why hedge fund investors should choose the level of leverage that they desire.

It's a nice example of an application of capital structure irrelevance.

Searching for value

The Economist has a stab at trying to determine if the market is cheap yet. The conclusion, cheaper yes, dirt cheap - perhaps not.

The Federal Debt and Retirement Planning.

Last night, Frontline on PBS aired "Ten Trillion and Counting" , a documentary on the national debt. The picture isn't pretty. The debt had already ballooned under the previous administration due to a couple of wars and the Medicaid part D prescription drug benefit. Currently, bailout and stimulus payments are increasing the debt further. But the real problem is entitlements - Social Security, Medicaid and Medicare. Under current growth projections, these programs will consume most of the federal budget within just a few years.

The problem is two fold. First, our legislators have continued to expand these programs, because the programs are popular (and the legislators want to be popular as well). Second, the ratio of workers to beneficiaries continues to fall. Fewer people are paying in to the system relative to those drawing out of the system.

This is not really my area of expertise, but it seems that there are two solutions: Raise taxes or cut benefits.

In my personal retirement planning both of these will impact me (and most people) directly. First, higher taxes in the future means that I have uncertainty as to the value of my retirement portfolio which is made of pre-tax dollars. When I retire, I will have to pay taxes on these funds, and higher future tax rates will hurt my wealth. Second, part of my retirement will be funded by social security. It seems clear that the growth of these benefits will have to be curtailed, and when these benefits are paid will have to be delayed.

These two possibilities suggest that 1) it might make sense to put cash in a Roth IRA where the taxes are paid up front. This will reduce the "tax risk". 2) Lower benefits means that I will either need to put more away, or expect a lower standard of living when I retire.

Another question is whether the traditional retirement portfolio of mostly stocks is prudent. Zvi Bodie (one of the authors of the leading MBA investments text) argues that we have it all wrong in asset allocation for retirement. Rather than buying stocks, we should buy TIPs (Treasury Inflation Protected Securities). I'll write a blog post on his ideas in the near future.

In the meantime, it seems pretty unambiguous that we need to save more.