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
Wednesday, September 29, 2010
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.
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.
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.
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...
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.
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.
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).
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"
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.
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.
Sunday, September 19, 2010
"Inside Job" - new film coming soon...
A new film "Inside Job", due out Oct 8, 2010 about the financial crash looks like being a must see.
You can check out a few previews here.
You can check out a few previews here.
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.
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.
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.
Stockmapper
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.
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.
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