Monday, November 29, 2010

Thursday, November 18, 2010


The GM IPO seems to have gone fairly well.   Notably, the Government will need to sell the rest of its shares at about $53 to break even from the bailout.  The price of GM today is about $35.

Tuesday, November 16, 2010

PIG spreads

A graph showing the yield spreads of the government bonds of 3 PIGs (Portugal, Ireland and Greece).
It's not pretty.  But it shows a fundamental premise of finance.  Ex-ante, you should get compensated for risk.

Source: The Economist

GM times the market

It's looking like GM's IPO is going to be pretty successful.  Whether by luck or skill, GM has managed to time the market pretty well.  Stock prices are at their highest for quite a while and GM just reported some healthy profits.

Of course we'll have to see whether GM shares turn out to be a good buy in the long run.

Fama talking about efficient markets and the impact of regulation Fama thinks that capital requirements aren't high enough for big banks.  He's absolutely correct of course.

Monday, November 15, 2010

Personal Finance on a Napkin (or three)

NY Times presents some personal finance tips written on napkins.  Brilliant.

HT: FinanceProfessor

Technology and teaching.

The Economist magazine argues that MBA programs should use more technology in their teaching.  As Professor who teaches in an MBA program, I hear this a lot.

I'm not at all averse to technology - I'm a bit of a geek really.  I run linux as my primary O/S and I think cloud storage (dropbox, evernote) is the greatest thing since sliced bread.  But I also think that you should use the simplest technology that gets the job done.  My primary teaching tool is a large white board and a lot of colored markers.  I'll use powerpoint to put up talking points, excel to show examples, and of course the web to grab data.  But beyond that, what is there?

The use of hardware technology seems very overplayed.  Do Ipads, kindles and Ipod touches really help?   Are smart boards, where you can manipulate the items on the screen really worthwhile?  For that matter, is excel 2007 so much better than excel XP?

I think that all these technologies are cute toys, but if I'm teaching target date immunization, they would just get in the way.  Of course I might just be a luddite.

I welcome comments on this topic.  But please, don't suggest that I use Second Life.

Sunday, November 14, 2010

Wednesday, November 10, 2010

Is gold at a record high? Actually, no.

A nice take down in the NYT about the current gold frenzy.   Gold isn't at a record high after you adjust for inflation.   And as the author of the article says "you should always adjust for inflation".

Personally, I think there is a gold bubble forming.  I predict prices below $1000 in a year.

Monday, November 8, 2010

Opportunistic Capital Structure

Aswath Damodaran has an interesting post on whether firms have an optimal capital structure or are more opportunistic and sell whatever security seems cheap at the time.

The idea of an optimal capital structure is often formally called the trade off theory.  The theory states that firms have an optimal capital structure that is based on the trade off of the costs and benefits of debt.  Debt is cheap (tax deductible) but too much increases the risk (and expected costs) of bankruptcy.  Therefore firms pick an optimal combination of both.  Recent work however, shows that there is evidence that firms often time security markets when they issue equity (I've published a couple of papers on this topic).  This theory has come to be known as the market timing theory of capital structure.

Damodaran suggests that perhaps firms have an optimal target and use market timing to take advantage of mispricing opportunities around this target.  This is actually the topic of a working paper of mine (with Bill Elliott of UTEP, Ozde Oztekin of KU and Anjo Ko√ęter Kant of VU University).   In this paper we argue that firms adjust faster or slower to their targets depending on whether market timing makes it advantageous to do so.  In effect we overlay market timing on top of the trade off model of capital structure.  The paper is currently being revised as it is working its way through the review process at a journal so I don't have a current version to post, but when we get through the review process I'll post a more detailed discussion.

Damodaran on Taleb

Aswath Damodaran is a Prof of Finance at NYU.  He's well known for his book on equity valuation, which is excellent.  He also maintains a blog, which unfortunately he doesn't update that often, but when he does, he posts some gems.   For example, here is his take on Nassim Taleb's rant about the Nobel prize committee.

As readers will remember, I've posted on Taleb before.

Aswath also posts on QE2 with the memorable title "QE2 or Titanic"

Duke's Cam Harvey on QE2

Duke Finance Prof, Campbell Harvey, talks about quantitative easing (the Fed's plan to buy government bonds to lower rates).  Suffice to say, he doesn't think it will work.

Link from Newmark's door.

Thursday, November 4, 2010

The Fed's QE plan in plain English

There's plenty of talk about the Fed's plan for quantitative easing.  If you're having trouble understanding the details, then follow this link for a plain English version.

HT: Felix Salmon

What discount rate should the California teacher's fund use?

From my colleague, Craig Newmark:

The Cal teacher's retirement fund is set to vote on whether to reduce their assumed discount rate from 8% to 7.5%.  I've blogged on this a couple of times before (here and here).

Reducing the rate will have the effect of increasing the reported present value of the liability faced by the State of California.  In reality the liability remains unchanged - the fund owes what it owes.  In fact, because this liability is guaranteed - it must be paid - the correct discount rate is probably much nearer the risk free rate of interest which is about 4%.

Tuesday, November 2, 2010

What role commodities?

Ken French talks about the role of commodities in a portfolio.  He makes a brilliant but sometimes overlooked point:

The claims that, going forward, commodity funds (i) will have the same Sharpe ratio as the stock market, (ii) will be negatively correlated with the returns on stocks and bonds, and (iii) will be a good hedge against inflation can't all be true. Who would want the other side of this trade? 

Friday, October 29, 2010

What do Finance Professors talk about at conferences?

Here are a few links to a series of posts by FinanceProfessor which provide nice little summaries of some papers that he found interesting at the recent Financial Management Association conference in New York.   They provide a nice insight into some of the current research topics and also go some way to answering the question "so what do Finance academics do research on?"

First list here, part 2 here, part 3, part 4 and part 5

Good stuff.

Tuesday, October 26, 2010


I was in NYC for the Financial Management Association's annual meetings last week and I snapped this pic of the Nasdaq marketsite on Times Square.   Keepin' it classy NASDAQ!

TIPs selling off negative yields

So the big news in the world of TIPS (inflation protected bonds) is that they are selling off a negative yield.  To be clear, this is the real return, not the nominal return on these instruments.  The view is that investors are willing to accept a negative real return in exchange for at least some inflation protection.
My colleague, Steve Allen expands upon this...

HT: Mike (one of my students)

Tuesday, October 19, 2010

Twitter predicting the stock market? I doubt it.

A recent paper by some computer science folks at Indiana finds that the mood on twitter can predict movements in the Dow Jones Industrial Average.  The paper argues that this is evidence against the efficient markets hypothesis (EMH).

Lets take a look at a few potential criticisms that I have of the paper.
1. The paper argues that
"First, numerous studies show that stock market prices do not follow a random walk and can indeed to some degree be predicted ... thereby calling into question EMH’s basic assumptions"
Out of the papers that are cited to support this, only one (#8) is actually published in a journal that I have heard of and that paper is referring to thinly trading stocks.  Journal quality matters and it matters a whole lot when we are looking at such a fundamental theory as the EMH.  If the authors had cited numerous studies from leading finance journals, then they would have been on solid ground.  The fact that they didn't speaks very loudly.  This is either shoddy authorship, or the work of someone who just doesn't understand the subject.  The evidence for the EMH is very, very strong. 

2. The paper claims that there is evidence of online chatter predicting other things.
"Recent research suggests that news may be unpredictable but that very early indicators can be extracted from online social media (blogs, Twitter feeds, etc) to predict changes in various economic and commercial indicators. This may conceivably also be the case for the stock market. For example, [11] shows how online chat activity predicts book sales. [12] uses assessments of blog sentiment to predict movie sales."
Again, the authors demonstrate their complete lack of understanding of the EMH hypothesis.   There is no surprise that online buzz is related to movie sales.  The EMH states that you cannot use publicly available information to earn a profit above the risk adjusted rate of return.   It doesn't say you can't predict how well a movie would do.

3. There is a long list of things that are supposed to predict the market, that include: super bowl winners, hemlines and sunspots.  In all cases, these are confusing correlation with causation.

4. The paper doesn't do an out of sample test.  Any trading rule that is found to be revealed in past data must be then tested in new data.

5. The paper ignores trading costs.  What are the potential returns that could be earned by trading on this information?  What are the costs of implementing the strategy?

6. The results could be driven by a few events.   For example, because the markets are not open on weekends and if bad news originated on the weekend and then was twittered (tweated?) over the weekend, it would appear that you could predict returns.  However, because the markets are closed, there is no way that the bad news could be impounded in to prices.  Thus the illusion of predictably would be created.  There is evidence that in 2008 a lot of bad news happened on the weekends.

7.  Finally, let's just assume for a minute that these authors had found a way to reliably predict the Dow 30 using publicly available information, and could do so and make a profit.  By publishing this information, they basically rule out any chance of making massive profits from their research.   

Unfortunately, this paper is on the verge of going viral.  A google search of "can twitter predict the stock market" yields 348,000 hits.  However, a search of "can justin bieber predict the stock market" yields 968,000 hits.  No doubt, it will be picked up and written about in numerous news outlets (see my earlier post on how well journalists understand finance).

Thursday, October 14, 2010

State pension fund return assumptions...part deux.

recently posted about the return assumptions used by state pension funds.  Most seem to use around 8% which seemed a bit high.  In order to back out the expected return on equities that an 8% overall return implies, you have to make an assumption about the asset allocation of the fund.   My colleague, Doug Pearce kindly provided Federal Flow of Funds data which shows the actual composition of state pension funds (in aggregate).  This data is here.  The state fund data is item L119.  I took the liberty of putting the data in the graph below.  (Note the 2010 data is for the second quarter).

We can see that on average, states had about 70% of their allocation in stocks.   Going back to my original analysis, if we assume an 8% expected return on the portfolio and 3.9% risk free rate, we can solve for the expected return on the equity part.

8% = R(TBond)*wbond + R(Equity)*wequity

8% = 3.9*0.3 + R(Equity)*0.7
Solve for the R(Equity) = (8 - 3.9*0.3)/0.7 = 9.75%

An assumption of a 10% return for equities seems more reasonable and roughly in line with the back of the envelope calculation I did last week.   But it doesn't end there.

Another colleague, Robert Clark (who does research in this area) suggested I take a look at the work of Joshua Rauh.   Josh Rauh is a Professor at Northwestern who has written several excellent papers on the whole topic of state pension funds.   In particular, his piece (with Robert Novy-Marx) in the Journal of Economic Perspectives is very readable and highly recommended.   I've linked here to a version on his website.

Novy-Marx and Rauh paint a grim picture of state pensions.  First, they point out that an asset allocation that is 70% equities is far too risky.   Remember that we are talking about an 8% expected return here.   The big word is "expected".   In finance, an expected return means that on average we might expect to earn 8%, but we also expect a wide range of other possibilities.   For large stocks in the US this range could easily be +/- 20% for 2/3 of the time.   Of course, it is argued by many that in the long run, stocks should earn their expected return even if there are short term ups and downs in the market.  But Novy-Marx and Rauh argue that the duration (average maturity) of pension fund liabilities is about 15 years.   Considering that we are in year 11 of a flat market, this means that many funds need the next 4 years to be pretty spectacular to make that 8% average.

Second, and perhaps even more disturbing, is that state pension funds use their assumed expected return to present value the liabilities of the fund.   This makes no sense as the liabilities are virtually risk free to the extent that the state has promised to pay them and is unlikely to renege.  This is more than a mere accounting artifact, as by using a too high discount rate, states are, in effect, undervaluing their pension liabilities.  They are making what they owe look much smaller.

Novy-Marx and Rauh attempt to quantify how much state pension funds are underfunded just based on the use of the wrong discount rate.  The results are quite shocking.  They estimate that the liabilities of state funds to be about $5.17 trillion as of the end of 2008 compared to the $1.94 trillion in actual assets. Thus there is a funding shortfall of $3.23 trillion.  This equates to a short fall of about $161,500 per plan participant.

Finally, the authors point out that just because personal retirement accounts might hold a high level of equities doesn't mean that state pension funds should do the same.  A state pension fund has to meet the clearly defined annuity obligations to its participants.   A personal retirement account (like a 401-k) is really just a means on transferring wealth through time.  Although it is worth noting that Zvi Bodie strongly advocates very heavy allocations to risk free securities in personal pension portfolios also.

The conclusion?  States, and taxpayers are in trouble.  No doubt we'll keep kicking this massive debt down the road, but it isn't going to go away.

Footnote to North Carolina residents - our state pension fund is in better shape than most.  For one, they only use a 7.25% return assumption.

Wednesday, October 13, 2010

Taleb "sue the nobel prize committee"

The author of "Black Swan", Nassim Taleb, says that investors should sue the Nobel Prize committee for legitimizing the work of Markowitz, Miller and Sharpe.  Taleb made his name by arguing that standard portfolio theory understates the likelihood of severe events.  He's clearly got a flair for garnering publicity, but I really think his 15 minutes are up.

I've posted on Talib before.

In other news, Taleb is planning to sue the estate of the Wright Brothers for losses incurred because of airplane crashes.

Tuesday, October 12, 2010

An ancient tale with no empirical support.

Fama and French answer the question:
"Some researchers argue that a market timing strategy based on buy/sell signals generated by a 50- or 200-day moving average offers a more appealing combination of risk and return than a buy-and-hold approach. What is your view?"

Economic Misconceptions

The marginal revolution blog has an interesting post about students' misconceptions about economic theory.  The comments following are also pretty interesting.

Wednesday, October 6, 2010

So what happened to that TARP money?

My colleague, Steve Allen, blogs that the $700bn paid out for TARP has mostly been paid back.  It looks like we won't see much of the $300 bn paid to Fannie and Freddie though.  

We're also waiting to see how much the GM IPO will raise.  Recent reports indicate that it might not go as well as had been hoped...

Nobel Prize Predictions has a prediction market for who will win the Nobel prize in economics.  Notably the top two are Richard Thaler and Robert Shiller who are both behavioral economists.  

The ipredict market is basically a betting market where you can buy a contract on Thaler for about 33 cents which will pay a $1 if Thaler wins.

I won't even get into the issue of the efficiency of the market that is predicting a win by an opponent of efficient markets.

Tuesday, October 5, 2010

Investing in Gold

From time to time I get asked by students whether people should invest in gold.   The obvious attraction is that it has seen huge price appreciation.  The huge negative is that it is very risky.   Here's a nice article the briefly summarizes some of the arguments for and against gold.

Link via Greg Mankiw's blog.

Monday, October 4, 2010

The AP doesn't know what a value weighted index is.

I've pretty much come to the conclusion that most journalists who write about finance don't really know much about finance.  That's because they have degrees in journalism, so they know lots about ... (I'll figure that bit out later).

Anyhow, consider this gem from the AP.

As soon as the total value of the company's shares edges above Exxon's, Apple will take over the top spot in the Standard and Poor's 500, the market index used by most professional money managers.
That means that billions of dollars invested in funds that track the index will have to shift their holdings to reflect Apple's new weighting. Exxon, meanwhile, may see its share price fall from the same effect. That slide could be accelerated by hedge funds and technical traders who make bets based on the rebalancing of major indexes and would be primed to short the shares of Exxon.

This is, of course, completely and utterly untrue.  The S&P 500 is a value weighted index.  If you hold the stocks in it, their weights in your portfolio will adjust at exactly the same rate as the weights in the index.  That's the beauty of a value weighted approach.

Note to finance students.  Don't believe all that you read on the interwebs.

Note to would be finance journalists:  Take some finance classes.

HT: Felix.

Wednesday, September 29, 2010

What should investors do now?

Reader Mike sent me the following link to a really fantastic series of presentations on the Dimensional Fund Advisors (DFA) website.  These presentations explore the role of the media in investing, and the implications of efficient markets on investment decisions.  They also look at the effect of recessions on stock prices.  All highly recommended.

DFA is an investment company that bases its recommendations heavily on the findings of academic finance.   Frequent readers will note that I often post stuff from the Fama-French blog.  The Fama French blog is housed on the DFA website as Fama and French are both board members of DFA.

There's also a bunch of other good stuff on the DFA website.  I'll probably post bits here and there.

HT: Mike McCartney

Stock pickers claim macro forces are why they can't make money....

An MBA 523 student sent me this link to an article in the WSJ.  It's a great article that argues that correlations between stocks have been increasing, and that a larger proportion of overall stock returns are due to macro economic (or market) factors.

The article mentions a few interesting statistics.  First, the average correlation between stocks in the S&P 500 between 2000 - 2006 was 27%.  At the height of the financial crisis it reached 80% but more recently it has dropped to 66%.  The argument is made that stocks are moving lock step with the market and thus stock pickers trading off firm characteristics can't make a buck.  Second, between 1995 and 2007 about 50% of growth funds beat the Russell 1000 growth index.   But last year only 24% of funds beat the index.

I think a few things are going on here.

First, firm specific risk hasn't gone away.  It's just that market risk is making up a larger component of the firm's total risk.  As my students know (we talked about this last night), as correlations go up, the number of stocks that are needed to create a diversified portfolio increases.   Therefore I imagine that many stock pickers are finding themselves less diversified and, ironically, more exposed to firm level risks.

Second, it is quite possible that markets are becoming more efficient.  The advent of hedge funds and high speed trading, is making it increasingly hard to make a living as a stock picker.

Third, as is noted in the article, making investment bets on macro factors is incredibly difficult.  While stock picking involves making a lot of little bets in many stocks, macro bets usually involve making just a hand full of large bets.  The potential for loosing a lot of money is huge.

It never ceases to amaze me how ordinary people think that they can accurately make these large macro bets.  I read in the money pages of our local Sunday paper about some individual who was asking an "expert" about investing in international stocks.  The individual thought domestic stocks weren't going to do too well over the next few years.

How on earth does he know this?   Would this individual bet on where a hurricane still forming in Atlantic is going to make landfall a week or too later?   No, he'd say that he's not an expert on meteorology and not that even the experts can't predict this.  Yet he'll make a long term macro bet against U.S. stocks.

All of this just reinforces my belief in indexing.   You can't consistently beat the market by trading on your stock picks or your beliefs about macro factors.  At best, all you will do is loose money to fees, but more likely, you'll do something really stupid.

Tuesday, September 28, 2010

Dow 38,820. Really?

The editor in chief of the "Stock Trader's Almanac" is forecasting the Dow Jones Industrial Average at 38,820 by 2025.   He's claiming that there will be an eight year boom starting in 2017.

Given that the Dow is at 10,800 today, this implies an annual return of (38820/10800)^(1/15) -1 = 8.9% annually.   The Dow doesn't include dividends so adding in a 2% dividend yield would bring us to 10% per year.  So here we have a news story about a guy who is predicting that markets will perform at their long term average.  Genius.

Of course really what he is doing is trying to sell copies of the almanac.

In the story linked above there is a mention of Glassman and Hassett who wrote a book predicting that the Dow would hit 36,000 in 2005.  The book called Dow 36,000 was a best seller, but is was based on completely dopey analysis.  They argued that because stocks seemed to beat bonds in the long run, the risk premium on stocks should be very low.  Therefore, assuming a low risk premium, you could basically get a very high valuation.  It turns out stocks don't always beat bonds in the long run (consider the past 10 years or so).  Furthermore, stocks are more risky than bonds - just look at the standard deviations.  Finally stocks have the more insidious (and much more subtle) problem that we have uncertainty as to what their expected return really is.

Multi tasking, interruptions and team building.

A little non-finance, but it is related to study and work habits.

Clifford Nass, Stanford Professor, explains why team building doesn't work and why multi tasking is bad.

The multi tasking bit is especially relevant.  Answer this question.  When you are supposed to be working, are you receiving text messages, emails, facebook updates etc?   Are any of these things so important that you HAVE to read them immediately?

I realized that I have my email set to check for new messages pretty frequently.  I also get a little popup notification on the screen.  But this is crazy - I've configured my computer to interrupt me when I am presumably doing something useful.

As for the part on team building.  I've only been on team building exercises twice and I thought it was a complete and utter waste of time.  I now feel vindicated.

Monday, September 27, 2010

Wall Street II...

I haven't seen Wall Street II.  I'm sure it won't be as good as the original, but I'll probably catch it on Netflix.   In the meantime, in case anyone didn't know, the fictitious firm that is skewered in the movie is, of course, really Goldman Sachs...

And while we are on the topic of movies, I caught the second half of "Capitalism - A love story" on the tele last night.  This is Michael Moore's 2009 rant against the capitalist system.  While I enjoyed "Bowling for Columbine" I have to say that this film is terrible - pure unfocused drivel.  The only entertaining spot was when Moore tried to put crime scene tape around the NYSE.

However, to say that Michael Moore has never directed a good video around Wall Street would be incorrect.  Tom Morello is fantastic...

Is this a "stock picker's market"?

Of course it isn't. It never is, but TV pundits, analysts and other "experts" are apparently saying it is. Let's let Fama and French dispatch this one with their usual brevity.

Tuesday, September 21, 2010

Cree is expanding

I don't usually blog about specific company news, but Durham based Cree is expanding and building a production facility here in the RTP.

I'm a big fan of Cree products. We recently remodeled our kitchen and installed Cree LED can lights as the primary lighting. The LED cans look like very pleasant incandescent light, yet they use virtually no power, generate virtually no heat and last pretty much forever. Sure, they are more expensive that traditional lights, but worth it. Plus, it's always nice to buy local!

Side note: Cree was founded by a team of scientists from NCSU.

The value of education...

Thankfully, getting your degree still has value, and the more advanced degree, the more value.

Of course, this analysis doesn't look at the costs of getting a degree (financial and otherwise) or the non-financial benefits.

Monday, September 20, 2010

How bloggers dissect a chart

Felix Salmon recently posted the following chart on his blog...

The chart, created by someone at the Bank of England, basically claimed that you could outperform using a simple monthly momentum strategy. I didn't buy it when I saw it. First of all, the valid comparison is a buy and hold strategy which isn't shown in the chart. I posted the comment regarding this, (as did many other commentators).
"Without seeing what a simple buy and hold line would look like, this graph is pretty meaningless. For most of the time period (before SPDRS) trading costs would kill you in the momentum strategy."

Felix then posted a new chart showing the buy and hold line.

Sure enough, it doesn't look like there is much there.

Then finally, the death knell to the whole thing..

It turns out that the original momentum chart used the average monthly prices. Something pointed out by another commenter. What this means is that, momentum "might" work a bit, providing you have the benefit of hindsight.

So the blogosphere puts to rest an embarrassing error by the Bank of England's "Executive Director of Financial Stability"

Pension fund return assumptions.

Pension funds have to make assumptions about the returns that they expect over long horizons. These assumptions then form the basis for how much money the fund should invest. If the fund is run by a state, these assumptions then directly impact the state budget.

Pension funds are pretty much free to come up with whatever expected return they choose. Of course this is a decision of monumental importance. Set it too low and you have to raise taxes or cut current expenditures in other areas of state government. Set it too high and you end up with an unfunded liability.

An MBA 523 student of mine forwarded me this article from the WSJ.

The article reports that most states are using an 8% expected return and then goes on to suggest that this might be too high.

I think it is too high. Lets look at some basic numbers..

Assume that a pension fund is 50% in T Bonds and 50% in Equities.

The yield on a 30 year T Bond is about 3.9%.

We can solve for the expected return on the equity portfolio using a little portfolio math...

8% = R(TBond)*0.5 + R(Equity)*0.5
8% = 3.9*0.5 + R(Equity)*0.5
Solve for the R(Equity) = (8 - 3.9*0.5)/0.5 = 12.1

Based on my assumptions these plans are working on an expected return on equities of about 12.1%. Given a risk free rate of 3.9%, this implies an equity premium of:

(1+0.121)/(1.039) - 1 = 7.9%

The historic equity premium has been 6%. To assume near 8% is purely delusional.

However, it could be that I have my portfolio weights wrong. So lets assume a more modest equity premium of 5%. This implies an equity return of 1.05*1.039 - 1 = 9.1%

We can now solve for the portfolio weights.

8 = wRF*3.9 + (1-wRF)*9.1

Doing a little algebra, we can solve for wRF which is the weight in the risk free bond (in this case the T Bond).

We find that wRF = 21%. This implies an equity holding of 79%.

Again, for a public pension fund this seems far too high.

What can we conclude...
1. State governments are just kicking this problem down the road. Eventually taxes will have to go up to fund these plans, and/or benefits will be cut to retirees.

2. If you are in one these plans, you should be funding a 401-K or other plan as a supplement.

Finally: What return assumption are you using for your plan? Over optimistic investors end up living with their kids in their retirement.

Thursday, September 16, 2010

Ragu Rajan on the the cause of the financial crisis and Paul Krugman

Ragu Rajan is a very well respected finance professor at the University of Chicago. He recently wrote a book called "Fault Lines" which details his views on what caused the financial crisis.

In this article he rebuffs many of the criticisms levied against his analysis by Paul Krugman. (Krugman won the Nobel prize for economics in 2008).

Rajan argues that the financial crisis can be attributed to a range of factors coming together to create almost a perfect storm. Not least of which was the encouragement of subprime lending by Fannie and Freddie.

Overall, this is a great read.

Cash for clunkers...

Reposted from my colleague, Steve Allen's blog.

Cash for clunkers was a dud.

That is unless you were one of the folks who actually traded in a clunker. In that case you got a nice chunk of cash off a car you were probably going to buy anyway.

From the U.S. tax payers: You're welcome.

Wednesday, September 15, 2010

Flash Crash

Fama and French opine on whether high frequency trading caused the flash crash of May 6, 2010.


From Craig Newmark's blog, Newmark's door, here is a really nice stock market heat map that can be be sorted. Lots of fun to play with, although if you are an indexed like me, it has limited practical use!

Tuesday, September 7, 2010

11 years of a flat market

I was putting together a few numbers for my investments class and in my lecture notes I came across the often quoted figure of 10% as the long term return for large stocks. This figure is based on a very long time period that includes many bull and bear markets. However, the past 11 years have been pretty much flat as far as price growth goes (I'm ignoring dividends). Take a look at this sobering graph which I grabbed from google finance.

In April 1999, the Dow was at about 10,000 which is roughly where it is today.

Thursday, September 2, 2010

GM IPO road show to start after the Nov election...

Surprise, surprise, the GM IPO roadshow will commence after the Nov election. A road show is when the investment bankers try to basically pre-sell the IPO to institutional clients. It is an important process that enables the bank to gauge demand for the offering and also provides information for pricing.

Friday, August 27, 2010

Just how low will credit ratings agencies go?

Credit ratings agencies are a protection racket. Issuers have to get a rating and at the same time, they have to pay the rating agency for it. If they don't pay then their rating will suffer, and this will cost the issuer.

Now the ratings agencies are worried about potential liability if they are wrong about their ratings. So they have added clauses to their ratings contracts requiring that the debt issuer indemnify them if they are sued. The self evident blog presents a couple of examples of this.

It would be one thing if the issuers had a choice about whether or not they could get a rating, but they don't. They have to participate in the protection racket. But now the local thugs are wanting the victims to pay their court costs as well.

There is a better way. One in which ratings are paid for by the bond buyer and where ratings firms don't have monopolies and are liable for their mistakes. Essentially a free market for ratings.

Perpetual Bonds

A nice piece today from one of my favorite Finance bloggers, Felix Salmon. Felix talks about perpetual TIPs and whether the government should issue them. Perpetual TIPs would be inflation linked bonds that never mature. Sort of like inflation linked preferred stock. The example given is for a bond paying an annual coupon of $120 in a world of 2% inflation and 2% real return.

The nominal return (from the Fisher equation) would be (1.02)(1.02)-1 = 4.04%

We could value the perp TIP in two ways.
First treat it like a growing perpetuity (that grows at the rate of inflation):

Price = cpn(1+i)/(R-i)
where i=inflation, and R=nominal rate. In this case the price would be:
6000 = 120(1.02)/(0.0404-0.02)

Alternatively we could value it in real terms and ignore inflation because inflation affects both the growth rate of the cash flow and appears in the nominal discount rate:

Price = cpn/r
where r = real rate of interest.
6000 = 120/0.02 = 6000.

The problem with a perp TIP though is that the duration (sensitivity to interest rate movements would be quite high. A 100 b.p. increase in the real rate would cause you to loose 1/3 of the value of the TIPs.

From a retirement point of view, I think Duration matched TIPS portfolios make more sense. This is an idea promoted by Zvi Bodie and apparently implemented at Boston U. With those I could buy a portfolio of TIPs that would be immune to interest changes provided I held them for the correct holding period.

Monday, August 23, 2010

Is there really a mutual fund outflow?

Felix Salmon gets to the bottom of the Mutual Fund outflow statistics which caused quite an uproar today. There was even a story on Public Radio's marketplace tonight about the $33 bn that apparently has been pulled from equity funds.

The truth, as Felix nicely points out is that while there has been an outflow from domestic equities, the overall flow into world wide equities as a whole is still positive.

Overall, mutual fund flows are pretty much flat this year.

Small Investors Flee Stock Market

Small investors are pulling money out of stock mutual funds and parking it in bonds.

Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year, according to the Investment Company Institute,

As Warren Buffet once said, "be greedy when others are fearful" (or something like that).

HT: Craig Newmark.

Friday, August 13, 2010

More on the negative TIPs yield

The self evident blog argues that the negative TIPs yield is a rational response to the volatility in the "traditional" inflation hedge markets such as gold and real estate. In other words, investors are accepting no real return in return for stability, something which can't be found anywhere else.

The great one liner...

In short, the negative TIPS yield is a rational reaction to the lunatic casino that has infested essentially every market in the world.

Wednesday, August 11, 2010

Uh Oh. Negative real TIPs yields...

Felix Salmon talks today about negative real TIPs yields.

What does this mean? Well basically investors are happy to park money in TIPs just to keep pace with inflation. They are not actually earning a real return.
Why would investors do this? Perhaps there aren't any better places to put cash right now.

So overall this probably isn't the greatest news...

Wednesday, August 4, 2010

Money Illusion and a new blog added

With the fall semester rapidly approaching, it's time to get back into blogging.

The Finance Professor blog posted a link on Money Illusion from the Psy-Fi blog. The Psy-Fi blog is new to me, but looks pretty interesting - with a focus on behavioral finance.

Money Illusion, as I've discussed before, is the act of failing to incorporate inflation into financial decisions. Research (including some of my own) has shown that money illusion affects stock prices and house prices. Despite the phenomenon being well documented, new cases of money illusion are always cropping up.

Wednesday, June 9, 2010

Fama on regulation and the financial markets

Gene Fama - the person credited for developing the efficient markets theory - talks about whether or not markets are still efficient and whether the efficient markets theory still works.

His main points:
1. Of course markets are still efficient.
2. Even professionals cannot time the market. (In other words - buy index funds)
3. Although he prefers less regulation, the concept of banks being too big to fail is a problem. TBTF occurs because the government cannot let a huge bank fail because of the risk to the financial system. In essence the government unwillingly gives a guarantee to the bank. His solution, which is one I have also mentioned before, is to increase capital requirements. He wants huge capital requirements - 40% or more. In this case government regulation is needed to combat this TBTF problem.

BP's stock price

Felix Salmon has a nice quick discussion of BP and its huge dividend yield.

For my MBA students - this came up in class on Monday night.

Tuesday, June 8, 2010

Who knows more about economics - the right or the left?

According to a recent survey, right wingers (libertarians and republicans) understand basic economics better than left leaning liberals. The differences were really quite dramatic.

As a bleeding heart I'd like to say that I am shocked and sure it can't be true, but truth be told, the findings are not surprising to me. The article is summarized in the Wall Street Journal here, and the full article is here.

The questions asked are as follows - you can do the test yourself...

1. Restrictions on housing development make housing less affordable.

2. Mandatory licensing of professional services increases the prices of those

3. Overall, the standard of living is higher today than it was 30 years ago.

4. Rent control leads to housing shortages.

5. A company with the largest market share is a monopoly.

6. Third-world workers working for American companies overseas are being

7. Free trade leads to unemployment.

8. Minimum wage laws raise unemployment.

The unenlightened (wrong) answers are as follows...


Scott Adams on investing.

Scott Adams (of Dilbert fame) offers some timeless advice on investing. All of it is highly humorous, and most is pretty true.

Monday, June 7, 2010

Incentives of oil companies ....

Oil companies and other firms in the US and the west like to tout their environmental record. But if they are strictly trying to maximize shareholder wealth, they should only protect the environment when it is value creating to do so. It could be value creating because of public perception, law suits, or regulation. Of course the companies will always say that they are doing the right thing because they love nature...

So one way to figure out what they really are thinking is to look at what they are doing when there is no threat of legal or regulatory action and when the local public opinion doesn't matter. Case in point: Nigeria.

Tuesday, May 25, 2010

The MBA Oath

Apparently 300 graduating MBAs from Havard have taken the "MBA Oath" this year and pledged to make a positive impact on society.

While this seems a positive development, it is worth remembering that MBA programs have historically had a bit of an ethics problem. A study done in 2006 reported that 56% of MBA students admitted to cheating.

Financial numeracy and subprime defaults

The Economist reports on a recent study that shows sub-prime mortgage defaults are more common among people with lower financial numeracy - basically folks who can't do the math too well.

You can take the numeracy test as well. It's not very long.

Note to my MBA students - if you didn't score 5/5 then I don't want to know.

How are corporations taxed?

I'm teaching Financial Management to MBAs for the next 5 weeks. Last night we talked a little about corporate tax rates. This graphic shows nicely the taxes paid by some well known corporations.

Germany expanding short sale ban?

Germany is thinking of expanding its short sale ban to include all stocks.

Personally, I don't think short sellers are the problem here.

Thursday, May 20, 2010

What happens if you ban short selling?

Common wisdom is that stock prices should rise. But this doesn't always happen as Felix Salmon notes.

Wednesday, May 19, 2010

Germany cracks down on shorting

Germany bans naked shorting. Rather than go after the root cause of the euro problem - they go after the hedge funds.

On a related note, my co-authors and I are just putting the finishing touches to a paper that shows that short sale restrictions in one country lead to more shorting elsewhere, and cause prices to deviate from fundamentals more often. Perhaps I'll send Merkel a copy.

Are stocks overvalued?

Fortune seems to think so.

I have no crystal ball, but it seems reasonable to assume that stocks are not going to earn returns of 5-6% over long treasuries in the future. Somewhere in the 2-4% range seems more reasonable.

Thursday, May 13, 2010

Friday, May 7, 2010

Bennis and O'Toole - wrong about B Schools then, still wrong now.

Bennis and O'Toole wrote a paper a few years back arguing that Business Schools had lost their way and were too focussed on quant methods and not enough on real world issues. Their article was widely criticized when it was published in the Harvard Business Review (a sort of B-school magazine).

I blogged about this a month or two back here.

Well, like a bad penny, they are back with an article in Businessweek updating us on the progress that has been made towards their vision.

But nothing has changed really, they were wrong 5 years ago and they are still wrong.

A great rebuttal of their argument is to be found here in an article by DeAngelo, DeAngelo and Zimmerman.

Wednesday, May 5, 2010

The psychological bias song

Behavioral finance has documented how psychological biases influence investing decisions. Turns out there are many types of bias. Here's a fun little ditty to help you remember them.

HT Freakonomics

A few interesting posts from the blogosphere

Rolf Winkler talks about last night's frontline documentary on for profit education.
The frontline documentary is well worth a look.

Greg Mankiw posts a graphic of what the federal budget will look like in 2020.
Bottom line, after you take out defense, social security, medicare, medicaid and interest expense you're left with 23% that goes to "other". The clear reality, that perhaps the tea party crowd have not appreciated is that if you want to cut the government debt you need to make cuts in these four areas.

Mankiw also talks about price gouging.
Apparently there has been a water shortage in New England leading to spikes in the prices of bottled water. Politicians are crying foul and accusing vendors of price gouging. Further evidence of how clueless politicians are when it comes to Econ 101.

Finally, Steve Allen talks about how GM paid back its TARP to the government by borrowing money from the government. Ultimately tax payers are likely to take a $30bn hit on GM.

Monday, April 26, 2010

What is better - buying apple stock, or apple products?

A fairly meaningless graphic, but mildly amusing anyway.

My favorite entry in the table....
Apple iPod (Original/Scroll) 5 GB, 10 GB 2001-10-23 $399 $11,914

Instead of buying that new ipod in 2001, you could be sitting on nearly 12K today.

More on credit rating agencies

A great post buy Steve Allen on the ratings agencies.

Wednesday, April 21, 2010

Gold in a portfolio

A common question I get asked is "shouldn't investors buy gold because it is a hedge against inflation". Fama and French provide an excellent answer to this question. Bottom line is, if you are not wearing it then you won't get a fair return.

Semi variance

Fama & French discuss the use of semi variance as a measure of risk.

Friday, March 19, 2010

William Sharpe's IPO

William Sharpe's company "Financial Engines" has gone public. You'll recall that Bill Sharpe is the Nobel prize winning economist who developed the CAPM. Financial Engines is a company that provides asset allocation advice using portfolio optimization tools.

The basic concept of the company is really great. They apply hard core portfolio tools to optimize retirement portfolios of individuals. As they say on their website...
There's no such thing as a one-size-fits-all investment strategy. That's why Financial Engines gives you a personalized Retirement Plan designed to fit your situation. We analyze expense ratios, sales loads, asset turnovers, transaction costs, and management styles. To manage risk, we emphasize diversification—a technique that spreads risk over different investment types. We balance all these factors to create a personal investment strategy designed to maximize expected returns at a risk level appropriate for you.

From an academic point of view, it's always great to see what we teach in class being used in the real world.

Thursday, March 11, 2010

A new penny????

Apparently the U.S. Mint has come out with a new penny. Isn't it time we abandoned the penny?

Benefits of higher education...

A nice graphic showing the benefits of higher education, although the income disparity between men and women is troubling.

Best jobs in America

Just in case you were trying to decide what to do with your are the "best" jobs in America. Apparently the ranking takes account of all sorts of factors.

Fond memories - the end of the dot com bubble

It's the 10 year anniversary of the dot com bubble bursting. To put it in perspective, the NASDAQ is currently at 2356 while at the peak (10 years ago) it was at 5132. I'm betting that it will take more than 10 years to get back to that level.

Monday, March 8, 2010

Inflation Illusion

People don't get inflation. Case in point - another blogger cites a recent communication from the AARP (the American Association for Retired Persons). Apparently, this year because inflation was zero, there will be no cost of living increase in Social Security. The AARP is very upset about this...

We’re already months into 2010, and seniors still haven’t seen any relief because of the lack of a cost-of-living adjustment to their Social Security. For the first time in 35 years, the regular payment update they’ve depended on did not occur.

Congress must act quickly. Will you help us flood their offices with letters, demanding that lawmakers make relief a priority?

Presumably, they'd be happier if we had high inflation and they got a larger cost of living increase.

Thursday, March 4, 2010

What's really wrong with Business Schools.

This is a bit old, but it recently came to my attention again and I thought that I would post it for those who haven't seen it.

A few years back, the paper "How Business Schools Lost Their Way" caused a bit of a stir by basically saying that B schools fail because they are too focussed on teaching theory and quant methods and don't teach enough practical stuff. Their summary was
Too focused on “scientific” research, Business schools are hiring professors with limited real-world experience and graduating students who are ill equipped to wrangle with complex, unquantifiable issues—in other words, the stuff of management.

I pretty much completely disagree with their article. Most students in our MBA program have real world experience. Every day they are solving "real business problems" - they don't come to school to solve more "real world problems". The value added of a business education is the analytical tools and methods that will help them understand and solve these types of problems in the future. This means that we have to teach theory. We have to teach quant methods.

As a professor, my job is to create and disseminate knowledge. Most of the stuff I teach is the result of the research of previous finance and economics researchers. You can't teach finance using anecdotes and cute war stories from the real world - although such things can provide nice little breaks in a 3 hour lecture on portfolio theory!

A very well written, and I think entirely on the mark rebuttal to the Bennis and O'Toole paper is by DeAngelo, DeAngelo and Zimmerman. These authors argue that more rigorous training is what is needed in B'schools and furthermore, that counter to the argument by Bennis and O'Toole, "Research competence does not imply teaching incompetence".

Gene Fama "My Life in Finance"

Eugene Fama is widely credited for developing the theory of efficient markets. As far as finance goes, he is one of the preeminent researchers in the field, ever. It is really hard to begin to quantify his contributions. In my own personal work, I am sure that I cite Fama's work more than that of any other single researcher. (Most of Fama's work is coauthored with Ken French).

Fama's papers are interesting, clearly articulated and well written. He tackles complex problems in the most straightforward way.

Fama has published (on his blog and in a journal) a sort of autobiography titled "My life in finance". It details his major research ideas and is really essential reading for any serious student of finance.

Monday, March 1, 2010

Day trading

Day trading is the practice of buying and selling stocks (usually) all within the same trading day. In theory, day traders should not hold stocks over night. The problem with day trading is the transaction costs. Constant buying and selling will eat your returns, and even with low commissions, the bid-ask spread will still erode your wealth.

That said, I have to say I was impressed by this one day trader's set up. I only hope he makes enough to cover his light bill.

Sunday, February 28, 2010

4 investment "lessons" from the WSJ

A column from the WSJ Sunday was reprinted in my local paper - the News and Observer. The title of the column is "Even the smart guys don't always get it right" by Scott Patterson.

Patterson wrote a book called "The Quants: How a New Breed of Math Whiz Conquered Wall Street and Nearly Destroyed It". I haven't read the book, but based on Patterson's column, I don't think I'll waste my time.

Patterson offers four lessons for individual investors from Wall Street "quants". Each one of these "lessons" is basically a lesson for wealth destruction. It is actually quite amazing how one guy could offer so much bad advice in one article. In fact, I don't think he makes a single intelligent suggestion. Anyhow, let me explain why each one of these nuggets of wisdom is pure idiocy.

1. Forget the old lessons - don't index and forget buy and hold. Individuals need to become more active in managing their portfolios.
Study after study has shown that the only element of investing that the individual can reliably control is costs. Therefore individual investors should invest in broad, well diversified index funds. Furthermore numerous studies have shown that "active management" - especially by individuals is a sure fire way of destroying wealth. Trading costs will eat you alive.

2. Active management doesn't mean role the dice more often
No, says the "expert" in the piece, it means looking for trouble and ducking for cover sooner rather than later. Great advice, if you have a crystal ball. Otherwise, you'll just end up trading too much. The problem with ducking for cover sooner is that there is no way you know what is going to happen later until it has happened.

3. Sell a stock at the first sign of trouble
Again, how do you know whether the "trouble" is a bump in the road, or a major meltdown. You don't. But selling at the first sign of trouble guarantees you'll make the right call about 50% of the time. But you'll eat the transaction costs 100% of the time.

4 Invest only in the cheapest stocks
Brilliant! Why didn't I think of that? Oh yes, and use the P/E ratio as your stock selection tool. Nothing will go wrong there.
First of all, cheap stocks are often (in fact nearly always) cheap for a reason. They are low growth and high risk. It is the same reason why some houses are cheap compared to others - they have problems. While there is some evidence of a "value effect" - that is low P/E stocks out perform high P/E stocks in the long run, this strategy only makes sense at the portfolio level, and many debate whether it is really a true anomaly and not just compensation for extra risk.

Finally the article says "in general be more vigilant". This is about as useful as telling a basketball player to "try to be taller".

Overall, this article is the stupidest thing I have read all week.

Friday, February 26, 2010

The "sensationalist Wall Street Journal"

Felix Salmon delivers a take down of the Wall Street Journal. His argument is that since Murdoch took over, the paper has become increasingly sensationalist and less objective.

I used to be a subscriber to the Journal. Even though I frequently disagreed with a lot of what was written on the editorial page, I found the rest of the paper to be pretty even handed. I don't think that this is the case now. I also don't subscribe anymore.

HT: Felix Salmon

How the credit card industry works

The Daily Show's take down of the credit card industry. Not entirely safe for work.

The Daily Show With Jon StewartMon - Thurs 11p / 10c
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Political HumorVancouverage 2010

Why you should consider TIPs

for a retirement portfolio.

For my MBA students - The Bodie quoted in your article wrote your text book.

Wednesday, February 10, 2010

A few great videos

Videos from Paddy Hirsch from - they're mostly pretty straightforward, but worth watching.

Ratings conflicts...

How the banks are still making money...

Interest rates and economic stimulus...

Hostile takeovers...

There are many other worthwhile videos on the marketplace channel on youtube.

You can also check out the marketplace website...

Tuesday, February 9, 2010

Interest expense and taxes

We know from basic corporate finance that firms can deduct interest expense from their taxes. I didn't realize that if you have enough debt, you could actually have a negative tax rate.

Hard to believe, but the Government will actually pay you to lever up.

Greece uses swaps to hide borrowing

An interesting article on how Greece used swaps to, in effect, hide borrowing....

Friday, January 29, 2010

Where would the best invest?

The BBC asks where the "best" finance brains would invest. Quite interesting.

The article does note that last year the recommendation was to go to cash which turned out not to be a such a brilliant move.

I'll stick with index funds and TIPS.

Wednesday, January 27, 2010

How Buffet values mergers

Warren Buffet is the largest shareholder of Kraft and he's not happy that Kraft is buying the UK chocolate manufacturer, Cadbury. He thinks Kraft is paying too much.

A couple of bloggers have posted his comments and tried to analyze them. As usual with Buffet, he doesn't do rocket science. Well worth a read.

Check the links here, here.

Monday, January 25, 2010

The quants...

A new book on how quant traders contributed to the 2007 meltdown. Might be worth a read...

What is a good hedge against inflation?

TIPs are good. But there is the uncertainty about the real rate.

Fama and French discuss the pros and cons.

So how is the first time home buyer's credit working out?

Not that good. As soon as it expired, sales plunged, just as most predicted, all the credit served to do was borrow demand from the future.

Expected inflation

It is possible to estimate expected inflation by looking at the spread between TIPS and T Bonds. Here is a link that presents the data in a pretty clear way.

HT: Craig Newmark

Friday, January 22, 2010


I don't watch CNBC, and I don't really understand why any professional money manager would watch it either. This quote sums it up.:

“Isn’t it funny when you walk into a investment firm, and you see all of the financial advisors watching CNBC — that gives me the same feeling of confidence I would have if I walked into the Mayo-clinic or Sloan Kettering and all the medical (staff) were watching General Hospital…”

-Senior portfolio manager, UBS

HT: Felix Salmon's blog

Thursday, January 21, 2010

Winners and loosers in banking

New banking regulations are in the mix. Pres Obama has been talking about limiting the activities of banks - in essence going back to the Glass-Steagel days when banks weren't allowed to get into investment banking. As usual the market has reacted predictably - regional bank stocks are doing well and big bank stocks are doing not so well. This graph captures the two beautifully.

Saturday, January 16, 2010

Is high inflation around the corner?

Probably not. We talked about the spread between TIPS and Long Government bonds in class this week and in particular how this spread is only about 250 basis points. This spread represents the market's expectation of inflation embedded in bond prices.

Greg Mankiw makes the same point in his article tomorrow (Sunday) in the New York Times. You can read it here.

Friday, January 15, 2010

Bank Tax

In class this week we talked a bit about a bank tax to prevent banks getting too big to fail. Greg Mankiw (a Havard economist) weighs in the on the debate. He agrees with the idea of the tax.

Thursday, January 14, 2010


If you're thinking of donating to help the Haiti earthquake here is a nice site that evaluates charities...

Tuesday, January 5, 2010

Bernanke: poor regulation was to blame...

Ben Bernanke at the AEA meetings in Atlanta blamed the financial crisis on weak regulatory oversight, and not low interest rates.

I don't know that weak regulations were the root of the problem alone - bad regulations and policies played a big role also.

Low interest rates also certainly helped keep the bubble going.

Mint's best financial graphics of 2009's picks of their best financial graphics for 2009. Some of these are quite good.

Best performing stocks of the decade has nice profiles of the best performing stocks of the decade here. MED, a maker low carb diets returned 9244% apparently over the 2000-2009 period. Of course this is only useful information if you happen to own a time machine...

Monday, January 4, 2010

Should lecture notes be open source?

This article appeared a couple of weeks ago and Greg Mankiw linked to it.

The basic question is whether lecture notes should be available to anyone with an internet connection. Some big players are already well established, notably MIT's open courseware.

My 2 cents - I don't think that I am ready to embrace it quite yet....too many unresolved issues such as intellectual property ownership and whether the materials can be redistributed in a different form and by whom.

The lost decade

A great link showing how, as far as stocks are concerned, we gained pretty much nothing over the past decade. The last graph on PE ratios is worth a look if you don't read the whole article.

Spring semester is almost upon us...

Blogging has been light for the past few weeks because of the holidays. But now that the spring semester is almost here, its time to get back to it.

Right now in Atlanta the American Finance Association is having its annual meeting. I'm not attending this year, but the meetings have gotten a fair amount of media attention because they also include the American Economics Association.

The Wall Street Journal discusses why the meetings are held in early January, frequently in a location that is cold. Turns out, economists are cheap. However, economists do have a sense of humor. Well at least they have a "humor session". HT: Greg Maknkiw

Finally, my colleague, Craig Newmark posts a link in which a journalist asks "why do we still pay attention to economists?" In Craig's usual style he makes short order of the journalist, but I think the best come back comes from a commenter who says "I'm pretty amazed, given the past 30 years or so, that anyone is still paying attention to journalists."