High Frequency Trading explained.

The Finance Professor Blog links to some videos on HFT.  The Paddy Hirsch video is excellent.  Highly recommended.

How fees are destroying pension wealth in the UK

As readers of my blog will know, I frequently rant about fees charged by investment advisors.  In most cases, the people getting ripped off are individual investors.  But in a recent report on the UK pension system, it is revealed that fees paid to City advisors (the City is the UK equivalent of "Wall Street") are so high that in many cases the pension funds are paying all their gains out in fees.  And it's getting worse.

The average equity fund manager makes explicit that they are charging about 1.5% a year of the sum invested for their services, but additional hidden expenses average 0.3% a year and trading costs cut a further 1.4% off an investment. And the situation is getting worse, according to the analysis, which found that charges had increased by 9% in the last decade. The presentation added: "If the trend of diminishing returns and increasing costs continues we could soon expect negative returns on average."

The mind boggles.  There is absolutely no reason why fees should be increasing, furthermore, management fees should not exceed 0.5% for large funds.  The trustees of these pension plans need to start shopping around more.   I'll give them one piece of advice for free.  Try indexing.   It's cheap and it works.

How much has Buffet lost on BofA?

In typical NewsCorp form, a Wall Street Journal headline states that:

"Warren Buffett Is $1.5 Billion Underwater on His Bank of America Stock

Huh?  I said to myself, I didn't think Warren had bought B of A common - his recent deal involved preferred stock and warrants.

Reading a bit further into the article reveals that in fact that author is talking about Warren's position in warrants and not in common stock.  The headline is not only misleading, it's pretty inaccurate as well.  

As a side note, the funny thing though is that the Business Insider Blog presumably didn't read it all the way through when this post first appeared.  The article was rewritten with the apology that "This article originally stated that Buffett had lost money on his investment. We apologize for the error."

Anyhow, back to Warren's warrants.   To state that he is $1.5 Billion underwater is a bit of a stretch.  He bought 700 million warrants at a strike price of $7.14.  The current B of A stock price is currently about $5.00.  So  (7.14-5)*700 million = $1.5 Billion.


But this doesn't mean that he has lost $1.5 Billion on the options.  As my MBA students should know, how much an option changes in value for a $1 change in the underlying stock price is given by the option's delta.  Only if the delta equaled 1 would Warren's warrants have declined by $1.5 Billion.  


Valuing these long term options is pretty tricky, but if we assume a delta of say 0.5 (which is probably reasonably close) then the decline in value of Warren's warrants is about (7.14-5)*700*0.5 = $ 750 Million.  Still a lot of money, but not as much as reported before.


For extra credit - under what circumstances could these warrants have actually increased in value?  Hint (we'd need to see a major increase in one of the other Black Scholes inputs).  For even more extra credit - how would this change have affected his other investment in the preferred stock?

Managing debt is like dieting...

My colleague, Melissa Hart, talks about debt management and bankruptcy. 

IPO outlook

Jay Ritter (my dissertation chair) talks about the IPO outlook.

Economists and their charts

A great article from the Beeb showing the favorite charts of various economists.  In each case the charts show how the euro economy in particular has declined.   Sounds a little dull, but this is a great way to see the Euro crisis in pictures.

LNKD has a forward PE of 300.

Via counterparties: LNKD is trading off 300 times forward earnings.  Either profits have to increase a whole lot or the stock price will have to fall.  I know which one I'd bet on.

Two must read articles on active management and fees.

Articles on active management and fees may sound a little boring, but let's be very clear here: two of the three most reliable ways to increase your retirement wealth involve 1) avoiding actively managed funds and picking index funds, and 2) never paying someone a fixed fee to manage your money.   

Ron at the InvestorCookbooks blog has two great posts on these topics.  First, more compelling evidence on the futility of active management.   And second, the effects of paying a 1% management fee to your financial planner.

And, in case you were wondering, the third way to increase your retirement wealth is to save more.  

Evernote - Inc. Company of the year.

Inc Magazine has just announced that  Evernote is its "Company of the Year".  The article is a great account of the perils of running a startup.

I am a huge fan of Evernote.  For those who don't know, it is a multi-platform app that basically allows you to remember everything.  Check it out.

Is the Administration's mortgage refinancing plan working?

Back in October, the Obama Administration extended the HARP (Home affordable refinance program) to allow homeowners to refinance if even if their mortgages were underwater.   This change had a direct effect on the mortgage market.  Specifically, mortgage securities with high coupons (where the homeowners were paying high interest rates) fell in value.  This was because the market anticipated that a greater number of these homeowners would be able to refinance their loans at lower rates.  Previously they had been unable to do so because their loans exceeded the value of their homes.   I blogged about this back then and it appeared to be a classic case of negative convexity in the MBS market.

Now comes the news that the market has largely recovered.  The amount of expected refinancings will fall far below those initially predicted, apparently in large part due to the decreased credit scores of many homeowners.

(note link to FT website will require you create a free account to view the article).

Why Apple's cheap

Felix has a good analysis of the current relatively low valuation of Apple stock.   The  key problem that Apple faces is the problem that all very large companies face - sustaining a high growth rate becomes much more difficult when you become huge.   Unlike many other large companies, Apple's source of profits changes from one year to the next - which means that the stock is really only as good as its next big product.

Put another way, at some point Apple will stop being a growth stock and become something more boring - like perhaps another past member of the large cap growth club - Microsoft.

Battle for the soul of capitalism

InvestorCookbooks really likes John Bogle's book - Battle for the soul of capitalism.   It's on my reading list.

Pigs will fly?

Investor cookbooks on PIGS.    (European countries that are at the heart of the debt crisis).

A few from around the web

From Counterparties:  Five problems with capitalism.  and Robert Shiller ignores advice from celebrities.

And from Mankiw - "death to pennies".   I hate pennies.   To me it seems utterly bizarre that the USA still uses pennies.

Only 1 in 4 beat the market this year

So says an article posted by Finance Professor.

I fully believe it.  That's why I index.

The winning portfolio?

Apparently a passive portfolio of 50% bonds and 50% stocks wins out in most markets.  

There are probably a few things going on here:  First bonds and stocks provide great diversification.  Second, because the weights are fixed, there is no market timing going on here.  Market timing, as we know is a fast way to loose wealth.  Third, the stock portfolio is indexed.

In otherwords: diversify, don't market time and index.  Simple.

CEO Pay and value added

Tyler Cowen with a nice post on what we know about CEO pay and performance.

Downgrade Rampage

Not a good day for banks...  S&P goes on a "downgrade rampage"

Ratings changes lag the market.

An important aspect of bond ratings is that when they are changed they usually lag the market.  In other words, investors usually price the declining credit quality of the bond into yields before the ratings agencies get around to issuing a new rating.  Case in point:  France.

IGM Forum - what economists think.

The IGM forum is a group of economists that publish opinion pieces on major policy issues.  It all sounds very academic - but the topics that they address are pretty interesting and very relevant.

For example:

• Buy American requirements in the 2009 stimulus bill did not have a big impact on US manufacturing employment.
• Investors cannot reliably forecast stock prices.
• A 1% increase in the top Federal tax bracket would half cumulative budget shortfalls.

GE's tax return.

Apparently GE's tax return is 57,000 pages long.  The Marginal Revolution blog makes an excellent argument as to why this is not efficient.

The Warning

InvestorCookbooks blog talks about the must see Frontline documentary "The Warning" which looks at how policy makers avoided calls to regulate the derivatives market.  I'll be adding it to my Netflix queue.

Luck or a brilliant value strategy?

Was Bill Miller's 15 year streak at the helm of the Legg Mason Value Trust luck or a skilled implementation of the value strategy (picking cheap stocks)?  

An article in the FT claims that there must have been something to his ability because even though the fund completely tanked in 2007 and hasn't recovered, it did post 15 years of outstanding returns.  

The probability of beating the market 15 years in a row is 0.5 raised to the power of 15 which is about 0.003%.  This is equivalent to about 1 in 33,000.   Obviously he was very very lucky if it wasn't skill.  But I think the FT makes a simple flaw in the analysis.  The fact that we are talking about this guy is because he beat the market for 15 years.  If it wasn't Bill Miller it would have been someone else.  

The point is that we only know he was a 15 year winner after the event.  This is the fundamental problem with active portfolio management - it is easy to pick the winners after the race is over, but impossible beforehand.

Given that Miller's case is so rare, I am inclined to think that he was just a lucky outlier rather than a skilled stock picker.  I have nothing against Mr Miller, I just don't believe that skilled stock pickers exist.  

Without sounding like a broken record, indexing is the only way to go.

Note: with the FT if you want to see the article, you need to register for a free account.  Sorry.

Why are higher education costs rising?

The answer, according to Felix, is pretty obvious really.

First it isn't because of Professor's salaries!  As Felix points out the real culprit causing higher tuition is smaller state subsidies.   Case in point, my own institution has responded to continued cuts in state support by increasing in tuition.

While there is plenty of evidence of some administrative bloat in higher education, I think what we are observing is a move towards a more tuition supported model.

Money Science

My blog feeds are now being syndicated on the moneyscience site.  Check out the site - it has a lot of cool finance related material including blogs, news feeds etc.

B school students don't study as much as engineers

So says a recent study.

OWS at Wharton

An attempt to bring OWS to the cradle of all evil - the Wharton School.  Sounds like it was a pretty entertaining event.

"Everyone dies...you do the math"

An amusing picture... I'll admit, it took me a minute to get it.

How to make trades in an open outcry market

You've seen the videos of traders waving their hands around frantically and somehow ending up buying or selling securities.  Well here is the simple guide to what those hand signals mean.

What to do if you have a bad 401k

InvestorCookbooks talks about how to tell if your 401k isn't good.

Corporate Income Tax

Felix Salmon has a couple of charts showing how much income tax corporations pay.  The amount has been declining pretty steadily over time.

What I found particularly interesting is that firms are not required to report exactly the dollar amount that they paid to the IRS.  Understandably, firms appear reluctant to reveal this number.

Academic Earth

Academic earth is a pretty cool site that contains lots of free lectures about a range of topics, including quite a few finance lectures.

How emotions impact financial decisions..

A webcast from Vanguard featuring Meir Statman (an expert of behavioral finance).  It's a bit long but worth listening to if you have time.

Insider trading on capital hill - mostly harmless...

So says a recent article.   Basically, the practice is harmless in the big picture and is probably not worth worrying about.  

Personally, I take a different view - seeing our elected leaders use their positions to make money off other investors doesn't really create confidence in our democratic process.

Remember that when someone profits from insider trading, someone else is loosing out - in this case the people who voted these leaders into office.

Borrowing Groupon stock costs 100% per year!

I knew it would cost a lot to borrow GRPN to short, but 100% per year?  Wow.

My experience of google adsense...(Blogger related material)

I am involved in a small charity, "the Haiti Tree Project".  We try to raise money to send to a couple of villages in Haiti so that they can plant trees and create a sustainable tree-based agriculture that helps reforest the country (we've planted over 10,000 so far).   As with most small charities, raising money is always the issue and so I thought I'd give google adsense a go.  For the uninitiated, google adsense is a program that will automatically insert ads into your blog.  You get paid when someone clicks on the ads.

I thought that this might be an easy way to make a few hundred dollars for the charity.  But, as my colleague Craig is fond of saying; "there are always tradeoffs".  I soon found that the ads that my blog was getting were either for gold investing or for MBA programs (not the one I teach in).  I didn't feel very comfortable with either of these ads and so I've stopped adsense.   I think I made $4.51 - which will plant a couple of trees!

Anyway, if you've been wondering where the gold ads have been coming from, rest assured that they won't be back.

Gene Fama on volatility

Gene Fama, Chicago Professor and the father of the efficient markets theory,  talks about recent volatility to a group of students.  Well worth reading.

60 minutes on insider trading by congress.

Last night, the CBS news program - 60 minutes -  "exposed" legal insider trading by members of Congress.  Apparently it is entirely legal for members of congress to trade on private information - you can read a nice summary on the InvestorCookbooks blog.

Basically our elected officials on either side of the aisle are trading using information that they gathered in their capacity as lawmakers.  However, this actually isn't really new news.  Several academic finance studies have shown that congressmen and women earn abnormal returns on their stock trades.

This story got me thinking about a blog post that I read on another academic finance blog recently.  The basic gist of that post was that the Occupy Wall Street crowd are misguided in their claims that the system isn't fair.  The blogger's view was that this is much like a child complaining about fairness.

But I think that the blogger was wrong - the issue of fairness is a serious issue.  Whether you support the OWS movement or not, it seems that we should have a system that is a fair and level playing field.  The system should not grant a select few the ability to trade and invest at the majority's expense.  This type of fairness is not about everyone winning, or everyone getting a fair share, but is about a fair game where the rules are the same for everyone.

.

NCSU Jenkins MBA is in the Businessweek Top 30

Great news about our part-time MBA program. 

Most of Groupon's float is being shorted.

Investors could short Groupon on Thursday.  Apparently 100% of the float of GRPN shares is now being shorted.

Even when a stock like GRPN is widely believed to be overvalued, shorting is still a very risky enterprise.  First, the cost of borrowing shares to short is no doubt very high.  At one point it cost 50% per year to borrow shares of Krispy Kreme (another overpriced IPO).   Second, just because you are short, there is no guarantee that you'll make money from your position.  Invariably you need a catalyst - such a missed earnings target or other such news to cause a price correction.  Finally I'd argue that we really don't know anything more about GRPN than we did when it went public and in effect the shorts are just sitting and waiting for the train wreck which may or may not happen.  They may be correct that GRPN is overvalued and they still may end up loosing their shirts.

Leverage...

Jon Stewart on MF Global, regulation and the effects of leverage.  (via Greg Mankiw's blog).

If there is one repeated lesson from virtually all financial disasters it is that it is not bad bets that are the problem, but the amount of leverage used to make those bets.

Reducing leverage would be the simplest way to prevent future financial disasters.  But, as the case of MF Global shows, even when there were limits to leverage, a well connected ex-regulator could circumvent them.

Reading lists of Vanguard Fund Managers

Vanguard is a mutual fund company known for its devotion to the concept of indexing rather than active management (although they do have some actively managed funds).  It should be no surprise then that "A Random Walk Down Wall Street" is a popular book with Vanguard Fund Managers.   Here is a full list of their favorite finance reads.  This list would be a good starting point for any finance student wanting to broaden his or her knowledge of the subject.

How much do different college majors earn?

From the WSJ - a sortable list by pay, employment and popularity.  As my colleague, Craig Newmark points out, a lot of the highest paid majors contain the word "engineering".

Pension plan day of reckoning is 15 years away...

I've talked about how state pension plans are underfunded in both obvious and not so obvious ways.  The obvious way is that even with their return assumptions, they are often unable to meet their promised obligations.  The not so obvious way is that they use a high rate of return (usually about 8%) to find the present value of what they owe.  Because their obligations are virtually riskless, they should use a much lower rate, which would result in these obligations having a much higher present value.

In this article - Josh Rauh, who has done a lot of work on this topic, predicts that we've got about 15 years to go before this all blows up.

Wall Street doesn't want financially literate investors

An interesting article that argues that the last thing Wall Street wants is investors that know what they are doing.  

What the equity risk premium is not...

Today's Financial Times had an article titled "What the equity risk premium tells us today" authored by Jason Voss of the CFA Institute.  I had high hopes for the article, but unfortunately it makes two fundamental errors.

1. The article defines the equity risk premium as the difference between the earnings yield on stocks and the 10 year treasury yield.  The earnings yield on stocks is the inverse of the P/E ratio.  It is designated as E/P.

ERP = E/P - 10 year ytm

This is incorrect.  The equity risk premium is the amount by which investors expect the return on stocks to exceed the return on riskless bonds.  Roughly computed it would be the expected return on the S&P 500 less the treasury rate.  Edit: The formula as shown above is merely a very rough method of estimating the ERP.  It implicitly assumes stocks pay all excess cash as dividends, grow at a constant rate, don't require external financing, and exist in a world of zero or unchanging inflation.  For all practical purposes, this is a not a realistic method of estimating the ERP.  Far better methods exist.

To compute the equity risk premium one must try to extract the premium implied by the current level of a market index (such as the S&P 500).  I won't do it here because Aswath Damodaran does an excellent job of it each month on his site.  Aswath estimates the current premium to be about 5.20%.   We can also estimate what the realized risk premium is by looking at the past difference between stock returns and bond returns.  Depending on what time frame you look at, this number is about 6%.

So why is this article interested in the difference between E/P and the treasury rate?   Well what is really going on here is that Mr Voss is invoking the long discredited (and I thought dead and buried) "Fed Model".  (Note: despite the name, the Fed Model has nothing to do with the Fed).   The Fed Model argues that the earning yield on stocks should be about equal to the yield to maturity on bonds.  If E/P is greater than the YTM on bonds, then stocks are cheap.  If E/P is less than the ytm on bonds, then stocks are expensive.

This appears to be the argument that is being made in the article.  But let's be really clear here - despite its simplicity, the Fed Model makes no sense whatsoever and this represents the second mistake in the article.  The Fed Model is garbage for at least two reasons:

1. Stocks are real assets, bonds are nominal assets.  When inflation is high the ytm on bonds will be higher, but the E/P ratio for stocks should be unaffected because both the numerator and the denominator are measured in real dollars.  This means that the Fed Model is very easily distorted by inflation.  In fact the reason that it is positive now is precisely because inflation is so low.

2.  E/P is not a valid measure of return.  E/P is merely the accounting earnings over price - a number easily manipulated that doesn't reflect the true cash flow of the firm and certainly does not come close to measuring the return of a stock.

I've posted on the Fed Model before - its a flawed model because it compares apples to oranges.

Groupon IPO

Of relevance to my undergraduate students in BUS 420 - Groupon has just conducted its IPO.   We'll be talking in class about issuing securities to the public next week - so pay attention!

Here are a few links related to Groupon.

Aswath Damodaran has a crack at valuing the stock.  His valuation came in around $14 - somewhat less than the offer price of $20.  He notes that his valuation makes some pretty optimistic assumptions.

The actual IPO of Groupon raised $700M.  This values the overall company at 12.7Bn.   But what is important to note here is that the IPO only sold a fraction of the company's equity (5%).  In essence Groupon is testing the waters with a small sale.  As Jay Ritter of the University of Florida notes - the initial price pop is largely due to the very restricted initial supply of stock.

If the price holds up then I would expect Groupon to follow up the IPO with several much larger secondary equity offerings in the coming months.  Google raised far more money in secondary offerings than in the initial IPO.

Investors also shouldn't read much into the initial price pop for Groupon.  Of 25 recent hot IPOs, 20 tanked later.

Finally what about IPOs in general?  In most countries around the world, IPOs underperform in the long run when compared to similar non-IPO stocks.  For example US IPOs underperform by about 20% after three years.  (See page 15 of this article).


Update: Trading of Groupon has started and the price is up 40%.

Treasury considering floating rates notes.

Very interesting.  Yet another thing to cover in the bond lecture!  Of course higher interest rates mean that the Government's liability would increase (As Campbell Harvey of Duke notes in the article), but this is already the case with TIPS, so I would wonder to what degree investors would actually just substitute these new bonds for TIPS.

(reposted from financeprofessor)

Bank of America - up to no good.

Bank of America apparently just shifted a huge block of Merrill Lynch derivatives to a bank unit funded by federally insured deposits.   In other words, moral hazard reared its ugly head again and B of A took advantage of the Governments deposit insurance program to placate some counter-parties.  Nice work B of A.

In unrelated news, I've transferred all my bill pay stuff from my previously bankrupt bank to the local credit union.  I'll be closing my bank account this week.

Where are new freshman from?

An interesting web site that shows where freshman at major universities are from.  Link should take you to the NCSU page.

Best month in a decade

Turns out this past October was one of the best months for stocks in a decade.   Popular wisdom holds however that October is usually a bad month for investors.   However, I subscribe to Mark Twain's view of stock investing:

"October: This is one of the particularly dangerous months to invest in stocks. Other dangerous months are July, January, September, April, November, May, March, June, December, August and February."

Negative convexity in mortgage bonds

I love it when the real world behaves in just the way that I wrote on the class room white board!

Case in point: Mortgage bonds have negative convexity over certain ranges of interest rates.  This means that when rates fall the value of the bond falls instead of increases as would be the case for a typical bond.  The reason for this effect is refinancing by the homeowners whose mortgages make up the cash flows of the bond.  As these homeowners refinance, the amount of promised cash flows declines, and so does the value of the bond.   Interest rates matter here because lower interest rates result in more refinancing.

OK, so what is happening today?  Well, there are a lot of homeowners who can't refinance because they have negative equity.  So even though they see interest rates fall, they cannot take advantage of these lower rates, that is, until now.  President Obama's latest initiative to enable these under water homeowners to refinance will result in many mortgage bonds getting paid off early and, as a result, fall in value.

The FT has a great article on this which notes that only the mortgage bonds which had coupon rates that are above the prevailing mortgage interest rates suffered a price decline around the announcement of the plan - exactly as we would expect.

As noted in the article, part of this plan is basically paid for by a wealth transfer from the mortgage bond holders to households.

Lionization of small business

Much is made of how small businesses are the main source of job growth in the economy.  Turns out this is not really true.  Start ups create jobs (and also destroy jobs if the fail), but existing small businesses as a group don't contribute that much to the overall jobs picture.  As usual, my favorite finance blogger, Felix Salmon has the scoop.

Dropbox

Finance Professor raves about Dropbox - a great product and a very successful company that has mastered the freemium model.

I am one of the 4% paying customers - $100 per year to have all (I repeat ALL) my work instantly backed up and accessible anywhere is a great value.  I'm also a huge fan of evernote (another freemium service).

Target date funds

Target date funds are good in theory - but in practice they often fall short.  The investor cookbooks blog has a great analysis.

More on externalities

Greg Mankiw cites a paper talking about taxes on externalities.  (something I blogged about recently).
Taxes on negative externalities are a good thing.

Stock market liquidity and volatility.

Felix Salmon asks "should we be worried about stock market liquidity?".  He cites a Wall Street Journal article that claims that as volatility increases liquidity decreases.   Felix correctly recognizes that this isn't really anything to worry about.  In fact the positive relation between spreads and volatility is very well documented (even in my own work - see table 5).

The question then seems to relate to high frequency trading and whether algorithmic trading is perhaps eating up liquidity.  Recent academic work in this area provides evidence that this is not the case.

Finally Felix notes that a investor who was trying to buy a $250 Million chunk of a $4 Billion company was apparently surprised when his buying pushed up the stock price.  Again, this is to be expected when you are trying to buy a 6%+ stake in a company.

I agree with Felix here - there really doesn't seem to be much of a story - despite what the WSJ thinks.

Capitalists of the world unite

There's been a lot of talk about the Occupy Wall Street movement recently, but today, the Wall Street Journal Sunday edition printed a great article on why capitalists should be mad at Wall Street also.

(The article defines capitalists as anyone who invests money - which would include pretty much anyone with a 401K or retirement plan).

Why should capitalists be mad?  Well it all boils down to fees.  The finance industry is basically a fee based business.  When investment firms make loads of money it is usually because they earned fat fees.  (The other way they make money is by making levered bets).   Most investors are either clueless about the fees that they are paying or they think that higher fees somehow translate into better performance (they don't).   

Time to wake up and pay attention people.  The only reason to pay higher fees is because you want to put someone else's kids in a fancy private school.   As the article states at the end "you can search in vain for the customer's yachts."

The solution is simple - indexing.   

You shouldn't pay more than 0.6%  of your wealth in fees.  This includes mutual fund expense ratios.

State pension funds - more underfunded.

The degree to which state pension funds are underfunded has increased, in part due to lower bond rates.  This is because the present value of the liability faced by a state should be estimated by discounting the promised retirement payments at something close to a risk free rate.  The risk free rate is very low so the present value of these liabilities is high.

Of course states continue to use 8% to present value these liabilities.

Market volatility and drug use.

Apparently Berlusconi (the Italian PM) wants to start drug testing traders.  He thinks cocaine use is causing market volatility.

More on News Corp.

Felix Salmon talks about the latest News Corp scandal which I blogged about yesterday.

Mutual funds without morals.

A must read for anyone who buys actively managed mutual funds.  Ron Elmer explains how mutual funds game the system by merging, closing or changing style to make their bad returns look good.

Yet another reason to index.   You do index don't you????

The Wall Street Journal has been running a circulation scam

I used to subscribe to the Wall Street Journal - it was an excellent newspaper.  Then Rupert Murdoch took it over in 2007.  I now get my financial news at breakfast time from the Financial Times.  I got tired of the pseudo sensationalism that started to dominate the paper.

Murdoch's company, News Corporation, is without a doubt, one of the most crooked, ethically bankrupt companies in existence.  The latest scandal that has emerged is the finding that the Wall Street Journal was buying up copies of its own paper to boost circulation numbers.  Full details are here.  In classic News Corp style, the initial reaction of the company was to deny it, and then, when this didn't work, go ahead and fire someone.

Let's not forget that News Corp is also still embroiled in the phone hacking scandal in the UK in which the "sister" publication of the WSJ, the News of the World, hired hackers to hack and delete phone messages from the cell phone voice mail of a missing girl.  In doing so, the parents thought that their daughter was still alive, because she was accessing her voice mail.  News Corp employees also hacked the phones of the relatives of deceased British soldiers, and also victims of the July 7 London terrorist attacks, as well as numerous phones of celebrities and politicians.  All this occurred with the full knowledge of senior News Corp officials.

Recently Rupert Murdoch has said that the focus by shareholders on the hacking scandal is "disproportionate".

 

It's hard becoming an investment banker.

My Colleague, Craig Newmark,  links to a great post on what it takes to become an investment banker.

Executive Stock Options

Ron Elmer who writes "Investor Cookbooks" has posted a lengthy discussion of why executive stock options are bad, and why, in his opinion, they should be outlawed.

He makes some very good points.  I have a few comments.

First, I fully agree that the big problem with Wall Street firms is that they converted from being partnerships to being publicly traded.  As Ron points out, when they were partnerships, risk management was everyone's business.  The banks became public largely because the existing partners wanted a way to cash out.  They benefited and risk management suffered.

Second, I disagree that options do not align incentives.  The example given assumes that a manager will exercise his options at some future date and convert the gains straight to cash.  The important thing to remember here, is that up to the time when he cashed in his options, his incentives were very much aligned.  In fact, well in the money options are very much like stock.

Third, I agree that options represent a huge unknown in compensation because we really don't have any idea what they will be worth 5 or 10 years.  But I think the issue here is with the quantity of options that are being issued, not the option per-se.  Firms seem to make very large option grants that end up being worth huge amounts in the future.

Finally, Ron alludes to the bigger question of whether US CEOs should make 300 to 400 times what the rank and file worker makes.  This ratio is higher in the US than for most developed countries and I am also pretty sure it is higher now than it was, say 30 years ago.  I don't know what the correct ratio should be, but 400 seems high.  Having said that, I note that movie stars and professional athletes make stupid amounts of money for doing stuff that seems pretty unimportant in the big scheme of things.

B of A needs a new PR firm

Chief Exec of Bank of America states that "we have the right to make a profit" in charging a $5 debit card fee.  Sure you do B of A.  Your customers also have the right to change to another bank (or credit union).

Given the press that the Occupy Wall Street crowd has been getting recently, this probably wasn't the right time to say this.  B of A really needs to find a new PR outfit.

Damadoran on the current low risk free rate.

Aswath Damadoran has put together an excellent post on the current low risk free rate and the effect that it has on valuation.  His main point is that the risk free rate must be considered with the current expected risk premium.  When these are combined the result is relatively low valuations.   He also touches on another point which I'd like to emphasize.   In an equity valuation model we normally think of the risk free rate as only affecting the discount rate - so a lower risk free rate should result in a lower discount rate and thus a higher valuation.  But - and this is very important - the risk free rate also tells us a lot about the growth rate of the cash flows.  A low risk free rate implies low real growth and also low inflation.  Thus it will also reduce the level of future cash flows.  Failure to account for the two edges of the risk free sword is an example of inflation illusion.

Dilbert on MBAs

All I can say is that I have a Finance PhD and an MBA and I'm not making any money in the market either.

Externalities in energy production

OK - today a slightly non-finance post.

There has been much hand wringing recently over the Solyndra Solar scandal in which it is alleged that the solar company received government support without proper controls.  Solyndra filed chapter 11 and is now being investigated by the FBI.

In the same way that I don't think subsidies for agriculture make sense, I don't think that subsidies for certain industries make sense either.  The government shouldn't subsidize solar power.  But it also shouldn't subsidize fossil fuels either.  Turns out that fossil fuel subsidies are a lot larger than the solar subsidies.  A whole lot larger.  This of course, doesn't get Solyndra, its management or the government off the hook in the current scandal.

(graphic from the Environmental Law Institute )


But the Solyndra case is a distraction to the bigger issue.  Even ignoring federal subsidies of fossil fuels, these industries are able to provide low cost energy because they impose negative externalities on other parties.  These externalities are primarily airborne pollution which have a very significant effect on the economy overall.   A recent paper published in the American Economic Review (the very top journal in Economics) finds that the magnitude and costs of these externalities are huge.  If the article is a bit dense, Paul Krugman gives a nice summary of the article.

The solution is to impose a Pigovian Tax - a tax on carbon.  A carbon tax works by raising the cost of carbon fuels towards a point that more accurately reflects their true cost (externalities included).  The key element of such a tax is that it is revenue neutral.  This means that all proceeds are rebated back to tax payers.  The most obvious way of doing this would be to reduce payroll taxes.  Greg Mankiw, the noted Harvard economist, who will admit to being on the opposite side of many debates to Paul Krugman, is a huge fan of a Pigou Tax.

With such a tax in place, and the removal of federal fossil fuel subsidies, the playing field would then be fully leveled for alternative fuels to compete based purely on their merits.

Price risk in the junk bond market

In one of my classes we've been talking about price risk and reinvestment risk for bonds.  These occur when market rates move from the initial YTM that an investor purchased the bond off of.  A great example is the current junk bond market where yields have risen very high and resulted in prices falling dramatically.  As a result year to date returns on these bonds are now negative.

Article here, HT Felix Salmon

Why do firms break up?

Aswath Damodaran has put together a really fantastic post on why firms break up or spin off divisions.  This is well worth a read.

Berkshire Hathaway to buy back shares

This story is a few days old, but Berkshire Hathaway is planning to start a share buyback.  This is pretty big news in that the company has never distributed cash to shareholders before.  Warren Buffet claims that the stock is significantly undervalued.  If this is so, then the buy back probably makes sense.  The evidence on buy backs is a little mixed, but in general there it supports the view that firms that do buy backs usually do so when their stock is undervalued.  We know this from two observations.  First buyback announcements are usually greeted with a positive stock price reaction, and second, valuation models show that firms that commence buybacks are, on average, undervalued compared to other firms.

Goodbye Wachovia

Here in Raleigh NC, the Wachovia building has long dominated the downtown skyline.  Not anymore.  It's now the Wells Fargo building.   My local newspaper has a nice set of pictures showing the transformation.

Robert Shiller on Stock Valuations

From Greg Mankiw: Robert Shiller thinks stocks aren't that cheap.

Pension fund returns

My colleague, Craig Newmark, links to an article on why Public Pension Plans can't be expected to earn returns of greater than 8% in the future.

The article argues that because the real risk free rate of interest is very low - close to zero, the expected return on pension assets should be reduced also.  I agree, but I would also point out that a non-trivial part of the historic return earned by pension funds comes in the form of inflation.  A far more sensible approach would be to  create pension plan return expectations in real, not nominal terms.

I've posted on this topic before.  Aside from over optimistic return assumptions, the other problem of state pension plans is that they discount their liabilities at the same return that they use for their assets.  Pension plan liabilities are virtually risk free and should be discounted at a much lower rate.  The net result of doing this would be to increase the value today of those liabilities and most likely reveal that most pension plans are horribly underfunded.

Dairy subsidies

A new proposal for dairy industry basically makes dairy producers pay premiums in good times in order to get a bailout in bad times - basically this an insurance policy.  The proposal would be voluntary.

I have some concerns...
First, I don't really understand why the government needs to insure farmers.  Why can't they buy private insurance?
Second, and probably the explanation for the first point - I bet this program will loose money.
Third, as someone who doesn't consume dairy products, I fail to see why dairy is so important to our nation.  I
think beer subsidies would be a much better idea.
And finally, this quote cracked me up:

Some farmers objected to the federal government limiting how much milk they could produce, saying the answer to problems facing the dairy industry was less government interference, not more.

I completely agree - but if you want less government interference you also have to take less handouts.

HT: Vegan blog

Is high frequency trading causing market volatility?

No - according to the founder of a HFT trading shop.  He makes a valid point - that a large amount of the movement in prices is from close to open - in other words after the market closes and before it opens the next day.

The HP 12c is 30 years old.

Most finance students use newish calculators like the HP BAii, but the granddaddy of them all, the HP 12c turns 30 this month.  

The 12c is a quirky calculator, but as the Financial Times says this morning: "By slapping the old HP 12c down on the table, you’re saying: ‘I’m a complex thinker, I can handle detail and I mean business”.

Apparently the 12c and the BAii are the only calculators permitted on the CFA exams.

Markets are down and the 10 year bond rate is at 1.77%

Not good (unless you want to refinance your mortgage).

The Greek default

My colleague, Steve Allen has an excellent discussion of the impending Greek default.  Bottom line.  It isn't going to be pretty.  Everyone will get hurt.  Why - well it turns out that everyone is involved in some way.  JP Morgan tried to explain it with Lego figures. Click here for an explanation.

Random walks.

Finance academics often view stock prices as being "random walks" in that the price change at any given time is basically random.  If it wasn't, then you'd be able to predict where the price was going and make a killing trading stocks.  But random walks also occur in other areas of life.  For example, in professional basketball, a recent research paper shows that the scoring pattern can be characterized as a random walk.  

I finally feel vindicated, as in all my 20+ years living in the USA I have never seen the point of professional basketball.  With games frequently scoring in the high double digits, but the winning margin only being a few points, it always seems that the final outcome is really just down to luck.  Turns out this is not so far from the truth.

Raleigh

Sorry, I got that wrong - the best city in America, according to Businessweek.

As a resident of Raleigh for the past 9 years, I have to agree.  It gets a bit warm in the summer, but other than that, this is a nice place to live.

(Also posted by Craig)

Jack Bogle, diversification and idiots.

Finance Professor blog posts a video of Jack Bogle (the father of indexing) talking about indexing.

Jack is responding to Mark Cuban's recent claim that "diversification is for idiots".  I am sure Mark is a talented entrepreneur but being a entrepreneur requires taking undiversified risks.  Investing for your retirement is completely different - diversification is essential.  If Cuban doesn't realize this then he is the idiot here.

Moral Hazard in Investment Management.

Via Craig: The overlooked failure in pension markets

Moral hazard occurs in pension markets because investment advisers have the incentive to maximize fees, but don't really get rewarded for performance.

Consider a simple example:

You have $100,000 with an adviser.  The annual management fee is 1%.  The annual dollar fee paid is therefore $1,000.  If the adviser works hard and earns you say an extra 2% return, his fee will increase to: 100,000*(1.02)*(0.01) = $1,020.

Alternatively, the adviser could recommend an "new" investment for your portfolio that charges a 1.5% fee.  Total fees in this case would be $1,500.

Given how hard it is to beat the market and earn an abnormal return, the adviser's best bet is to try and push his clients into higher fee products.

I've said it before and I'll say it again.  There are really only two things you can control in saving for retirement.  One is the amount of money you put in your account.  The other is the fees you pay to invest that money.  Your goal is to maximize the first and minimize the second.

Two more articles on correlation

Via Felix: Correlations are at dysfunctional levels
Via Craig: The guide to picking stocks when everything is correlated

People just don't understand inflation.

A recent article on Yahoo Finance talks about "Hedging 7 Big Retirement Risks"

The article is OK overall, but demonstrates a serious misunderstanding of the effect of inflation on stock prices (something that I am particularly interested in).  The offending paragraph states that:

To guard against inflation, you can invest in inflation-protected securities or other investments that will gain value as overall prices climb. For instance, stocks in your portfolio aimed at growth rather than income will provide a hedge against inflation, says Michael Reese, Certified Financial Planner and founder of Centennial Wealth Advisory based in Traverse City, Mich

 It is incorrect that growth stocks (low dividend paying high P/E stocks) will be a better inflation hedge than dividend paying stocks.   The value of both stocks derives from the present value of the cash flows generated by the underlying business.   Growth stocks reinvest this cash flow, income stocks tend to pay it out.  Either way, on average, the cash flow will grow at the rate inflation.  Thus the expected return on both types of stock is directly correlated to the expected inflation in the economy.  They are both "real" assets and should provide a hedge against inflation.

Rogue Trader at UBS

UBS is likely to post a loss this quarter because a Rogue Trader lost $2bn.  Ouch.

If you haven't seen it, the movie "Rogue Trader" about the Barings trader Nick Leeson is worth watching.

Merrill Lynch and Lehman buyouts, 3 years later.

New York Times discusses how a couple of marriages from the financial crisis are working out.

High fees aren't just a problem for small investors

There are two things individual investors can control: how much money they put in their retirement portfolio and the fees that they pay.  They should maximize the first and minimize the second.

High fees will destroy your wealth.  But individual investors aren't the only ones who can end up paying too much for investment services.  Consider the case of the Libyan Investment Authority.   You'd think that these guys would be able to get a pretty good beak on the fees paid.   Not so as the FT reports. In some cases the fees paid were approaching 10% of the fund's asset value.

So remember, it doesn't matter whether you are just an ordinary investor or a crazy dictator of an oil rich nation, you need to watch out how much you are paying in fees.

Correlations are up again

A year ago I posted about correlations between major asset classes and stocks being higher than they had been in the past.  In reality what was going on was that the portion of the stock's risk that is due to the market was higher relative to the portion of a stock's risk due to firm specific factors.   For my MBA students, this should all be familiar as we've just covered the single index model in class.  Anyhow, apparently we're back to high correlations again as this article in the FT reports. Movement of big US shares harks back to Black Monday

Is social security a ponzi scheme?

Rick Perry recently stated that social security is a ponzi scheme.  Marginal revolution has a good analysis starting with Paul Samuelson who once said that social security was a ponzi scheme that worked.

Finance Theater

This post is mostly for folks living in and around Raleigh - the Burning Coal Company is putting on the play "Enron" by Lucy Prebble.  The play has been well received in London and New York.  The play will run from September 8-25 at the Murphey School in Raleigh.   Check out their website for details.

I plan on going. As the Artistic Director of the theater company told me, the play is "Music, Dance and Derivatives".  Sounds like a fun night out.

The birth of the index fund

From Marginal Revolution - a great article about the birth of the index fund.  The full article is hidden behind the WSJ's paywall but the MR summary is good.

A triple A subprime mortgage bond.

Felix Salmon discusses a new triple A subprime bond.  He's not impressed and neither am I - I would have thought Standard and Poor's would have learned at least something from the ratings debacle of a couple of years back.

Recent active fund manager's performance.

The InvestorCookBooks blog posts some interesting statistics on recent fund manager performance - conclusion:   you're probably better off indexing.  But you knew that already, right?

A great analysis of the BRK - BAC deal

Aswath Damodaran - NYU expert on valuation - provides a really great analysis of the Berkshire Hathaway - Bank of America deal that I blogged on yesterday.   Aswath values the options at around $3 billion which means that Buffet got the preferred stock for only $2 billion.  At that price the yield is around 15%!   My own back of the envelope calculations came in around $8-9 billion for the deal - so basically, BAC shareholders just handed Buffet a nice gift of around $3 to $4 billion dollars.

Aswath concludes that this probably wasn't a good deal for BAC and I'm inclined to agree with his analysis - paying about $4 billion for the Buffet seal of approval seems pretty high.

Advertising on my blog.

I was recently approached about putting an ad on my blog -  a first for me as a blogger!  But such a request presents a bit of a dilemma.  I maintain this blog primarily as a teaching tool - it allows me to collect and relay stuff that I think would be interesting for my students.  However, I sometimes update the blog during the day when I am at work and I think it would therefore be inappropriate for me to keep the proceeds of any ads.

Therefore I plan to donate all proceeds to charity.  I am involved in a small charity called The Haiti Tree Project.  We have a website www.thehaititreeproject.org and a facebook page .  The charity provides small grants to a couple of villages in Haiti so that they can raise trees in tree nurserys.  To date we have several thousand trees growing.  The trees are primarily fruit (mango) and hardwoods.  When the trees are big enough, the villagers can take them and plant them on their own land.  Ultimately the trees provide a source of sustainable agriculture that will provide an income for the villagers while reversing some of the effects of deforestation.

If you want to know more about the charity, go ahead and check out the pages above and feel free to contact me.  

Berkshire Hathaway buys BAC Preferred Stock and Warrants for $5bn.

Bank of America has been in trouble of late because of ongoing subprime losses.  The Bank needed a significant cash boost.  Warren Buffet has just provided that boost in the form of $5 billion of cash.   The deal is pretty straightforward (full details are here).

CHARLOTTE, N.C., Aug 25, 2011 (BUSINESS WIRE) --Bank of America Corporation announced today that it reached an agreement to sell 50,000 shares of Cumulative Perpetual Preferred Stock with a liquidation value of $100,000 per share to Berkshire Hathaway, Inc. in a private offering. The preferred stock has a dividend of 6 percent per annum, payable in equal quarterly installments, and is redeemable by the company at any time at a 5 percent premium.
In conjunction with this agreement, Berkshire Hathaway will also receive warrants to purchase 700,000,000 shares of Bank of America common stock at an exercise price of $7.142857 per share. The warrants may be exercised in whole or in part at any time, and from time to time, during the 10-year period following the closing date of the transaction. The aggregate purchase price to be received by Bank of America for the preferred stock and warrants is $5 billion in cash.

So basically BAC issued preferred stock that pays a $300 Million dividend and together with 700 million calls with a strike of $7.14.

You don't have to be a financial rocket scientist to realize that this is a good deal, but I'll leave it as an exercise for my students to try to figure out what this deal is really worth.

Why P/E ratios are a poor predictor of market performance.

The Lex Column in the Financial Times today talks about why raw aggregate P/E ratios are poor predictors of stock performance.  Good stuff.  But the final part of the article caught my eye.

Likewise, history shows there to be no predictive power for stocks when comparing equity yields with bond yields. Why should there be? Dividends are risky and rise with inflation; coupons are risk free and do not. It is like buying apples because pears are cheap. There are good reasons why equities are due a bounce – flaky valuation metrics are not among them.

This is basically a take down of the so-called Fed Model (not endorsed by the Fed) that argues that comparing bond yields to earnings yields reveals information about the level of the stock market.  I posted on this a few days ago here.  With bond yields low and earnings yields high, numerous "experts" are claiming this is a signal that the market is undervalued.   They are wrong.  It is a signal that bond yields are low and earnings yields are high.  That is all.

NOVA: "Mind over Money"

I caught a re-run of the PBS NOVA documentary "Mind over Money" last night.   The documentary explores the role of behavioral finance in market bubbles and collapses.  For those wondering: Behavioral finance is the study of how human psychology affects financial decision making.  It is generally at odds with a lot of the predictions of the Efficient Market Hypothesis which states that prices reflect all available information and markets as a whole are rational.  Whether markets are efficient or not is of great importance to investors and policy makers.

Back to the video - this is a MUST SEE for any student of finance.  My current MBA students take note!

Here is the preview.

Watch the full episode. See more NOVA.

The video is well done and features interviews with those who are proponents of behavioral finance - notably Richard Thaler and Robert Shiller, and those that oppose it - Eugene Fama, John Cochrane and Gary Becker.

The experimental evidence for behavioral finance is very strong, but the link between what people do in a lab environment and what markets do as a whole is much weaker.  Consider, for example, the housing bubble: Behavioral proponents will claim that a housing bubble occurred because of various irrational behaviors.  For example people pay too much attention to recent events and see how prices rising and then extrapolate these increases.  In addition, people observe how others are making money in housing, and they feel remorse if they don't buy also.  Finally when prices do go up, people feel that their original decision to buy is being confirmed and that they were correct.  This creates a self feeding cycle until finally the bubble bursts.

But an efficient market proponent would offer a different story - low interest rates, easy credit and limited downside for buying a house you can't afford creates an incentive to buy.   In effect people who buy houses with close to 100% financing on teaser rates are really just buying a call option on the value of the house.  If it goes up then they make money, but if it falls they just walk away.  The rational thing to do for many people  is to take the gamble.

Regardless of where you fall in the efficient markets vs behavioral finance debate, the insights of behavioral finance at the individual level are really important and can protect people from their own irrationality.

A blog about my blog.

A marketing firm that has been working with the Poole College of Management wrote a little piece about my blog.  

I'll be sure to tag this one as "shameless self promotion"

Gold rally overdone?

Apparently some say so.  Presumably they are the ones who just sold.

Earthquake!

The east coast earthquake is all over the interwebs.  But this tweet from "Zerohedge" caught my eye:

S&P upgrades earthquake from 5.8 to 6.0




Brilliant.

SPY and GLD correlations and volatility.

Apparently the value of the GLD ETF (an Exchange Traded Fund that holds gold) has exceeded the value of the SPY ETF (which holds stocks from the S&P 500).  All this gold is held in bank vaults in London (which in light of recent riots may not be that sensible).  The total amount of gold held by the fund in these vaults is about 41. 5 million ounces, which is about 1300 tons.  That seems like a lot of gold.

In the article, a hedge fund manager was quoted as saying that
“Gold has become something of a near-perfect hedge for financial assets such as stocks,”
This got me thinking - I wonder what the correlation between GLD and SPY is?

Here are the daily correlations.  Note that GLD has been trading since 2004.
2004-2011: 0.0506
2008-2011: 0.0108
2010: 0.1961
2011: -0.2655

First of all we can see that over the long run, there has only been a weak correlation between GLD and SPY.  In 2010 however this correlation became positive and quite strongly so.   But for the first half of 2011 we can see a strong negative correlation.  While not a "near perfect" hedge, it certainly looks like GLD is moving against stocks.  The problem of course is predicting how long this movement will continue and at what point in time (if ever) the old pattern of a small positive correlation will reassert itself.

Looking at daily annualized standard deviations, (assuming 250 trading days) we see that GLD is a little less volatile that SPY.

2004-2011
SPY Std Dev:  22.6%
GLD Std Dev: 21.0%

2011
SPY Std Dev. 20.00%
GLD Std Dev. 15.24%

Surprisingly SPY is not as volatile as you might think - perhaps a classic case of investors anchoring their beliefs too much on recent market gyrations.

While I don't make prognostications, it does seem likely that a large amount of the demand for GLD may be coming from people moving money out of stocks.  If this is the case, then if and when the stock market starts to rebound, we should see a pretty rapid fall in the price of gold.

Stock valuation Haiku

P Es are lower

Time to buy say the experts

high risk premium

Do repurchases destroy value?

An op ed piece in today's Financial Times claims that share repurchases destroy value because they are often done at market peaks.  In other words firms are paying too much when they repurchase stock.

Unfortunately, the article is a little sloppy in that it only looks at aggregate data and then only considers a very short time period.  More importantly though, I think that the article draws the wrong conclusion.

When we look at the the academic evidence on share repurchases we find support for firms timing their repurchases for periods when the firm's stock is low relative to the stock's fundamental value.   For example, a paper by Ikenberry, Lakonishok and Vermaelen in 1995 finds that value stocks in particular seem to do very well after repurchases - consistent with managers timing the repurchase when stock prices are low.  The opposite result is usually found for share issuances  - these usually occur when the firm's stock value is high and subsequent returns are low.  Both of these are manifestations of the "Market Timing" theory of capital structure - something that I've done a bit of research on.   In general there is pretty strong evidence that managers time stock issuances and share repurchases to benefit long term shareholders.

I'm also a little concerned about the idea that a share repurchase could destroy value.  First of all, firms are awash with cash - cash that is just sitting in corporate coffers - and share repurchases are an efficient way of getting that cash back to the shareholders.  Second, even if the firm buys back shares when the prices are high, this doesn't destroy value per se.  All it does is transfers wealth from the shareholders not participating in the buy back to those who are participating.

So while it might be the case that share repurchases may not have been optimally timed in the past 2-3 years, the larger evidence doesn't support the article's contention.

The article does make an interesting point however, that managers may be tempted to boost EPS by buying back shares.  They would do this because they are compensated on the level of EPS.   Surprisingly, many managerial compensation contracts are often pretty vague and may not preclude manipulation of EPS via repurchases thus opening the door for such window dressing.  However, if you buy stock in a company that uses such a poor performance metric to compensate the managers, then you probably deserve what you get!

For more on this topic - you can see an earlier post here and Damodaran's excellent post on the valuation effects of buybacks.

Introducing another finance blogger.

Ron Elmer, author of "Investor Cookbooks" has started a blog.  Ron has an extensive background in investment management, so his blog should make for some good reading.

Welcome to the world of blogging Ron!

So HPQ, how is the PC spin off decision working out?

Ooops.  Sorry for asking.

Ratings Agency Rotten To Core With Conflicts, Corruption, And Greed

A former Moody's employee has revealed what we've suspected for years - in their current form, ratings agencies are corrupt beyond redemption.  They should be abolished.

Google search trends and market panic

What do Google search trends say about the stock market?   Not that much apparently.

The madness of Wall Street

Great article on market gyrations.

Using Twitter to beat the market

About a year ago I blogged about a study that claimed to show that the mood on Twitter can predict stock market moves.   Well, it turns out that someone has started a hedge fund using this approach.

I was very skeptical about the original study and I remain skeptical about whether a hedge fund can make money in the long term using this method.   So far they have been going for a month and beaten the market.  As they say "one swallow does not a summer make"

HT: One of my MBA students - Damian.

Guest post on the current market volatility.

In a first for my blog, here is a guest post by Ron Elmer.  Ron talks about the current market volatility.

Over the past few weeks I’ve had numerous friends express concern about the economy and financial markets and have asked for my thoughts.  My thoughts follow…

The way I look at it, everyone has to make a choice between two possibilities and plan accordingly:

(1) Anarchy will reign - stockpile guns, ammo, barbwire around your farm and bomb shelter etc.

(2) We'll get through this like we have for 200 years - rebalance your portfolio and buy stocks when they are down.

I can respect folks who choose either of these options, but anything in between is pointless.

Being 100% cash won't work in either scenario. If the financial system collapses, they won't be able to get their cash out of whatever bank it is in.  Even if they could get it, cash will be worthless during true anarchy. Not many folks would sell their last loaf of bread for any amount of gold either.  

In 2008 we truly were standing at the edge of anarchy - that was scary.  That was the scariest time in our economic history... Oh wait, maybe World War I was scarier, and WWII. Oh yeah, 9/11 when stock market was closed for a week - now that was scary!  Don’t forget the turmoil caused by the Korean and Vietnam wars.  Then there were the race riots in the 60-70s. Can you imagine riots? I can't but it was going on when we were kids. Assassination of JFK, Reagan shot, Nixon's Watergate, Clinton's Lewinskigate. How about nuclear missiles a couple hundred miles off the shores of Florida? Now that must have been really scary.

I'm forgetting a dozen catastrophes I'm sure. Yet, the stock market averaged about +10% annualized return throughout all this. To be sure, the stock market is never up in a straight line.  What is beautiful is the crookedness of the returns. Each and every instance I listed above was a BUYING opportunity.  

Folks that are 100% liquid now may well look like geniuses.  Greece could default and implode the entire European Union. Moody's could agree with S&P and downgrade the US credit rating a meaningless notch. Politicians might shut down the federal government, again (yeah, that's right, it's happened before and in our lifetime too).

But, even if those "liquid" folks are right and the market dives another -20%, they'll never have the foresight or fortitude to buy back in at the bottom when everything looks it's worst. Thus, they can be right ONCE and cost themselves a ton of money when the market snaps back. The folks that are liquid now, are likely liquid because they sold out before the bottom in the market in March 2009.  They likely watched the Dow fall from 14,000 to 8,000 and finally decided to sell all their stock funds. They realized they were geniuses as the Dow continued it's descent to 6,500. But, in the end they would have been better off doing nothing as the Dow is now back up to 11,000 (even after the recent decline) and MUCH higher than where they likely sold. Better yet, instead if selling at 8,000 they would have done well to BUY at 8,000 even while that was not the bottom and the market fell further.

That is another great point; one does not have to pick the exact bottom in the stock market to make a lot of money. The folks that bought stocks at Dow 8000 surely felt more pain as they watched it continue to fall to 6500. But, with the Dow currently at 11,000 they certainly are happier now than the folks that sold at 8000.

We should almost be grateful for each of these "opportunities" that the "sky is falling" alarmists provide us.

Embrace the volatility. The easiest way to do that? Own a mixture of stock and bond index funds and....

Buy monthly with your paycheck and rebalance annually on your birthday.

Buy and rebalance, buy and rebalance - year after year after year.  Over the course of a lifetime, you will have bought low and sold high over and over and over again.  Rebalancing is easy to do in “normal” years. In fact, it’s almost unnecessary most of the time.  When rebalancing is crucial is in times like these – when you have to buy when everyone else is selling.  But, history has shown time and time again, the time to buy is when everyone else is selling.

Rebalance annually and mechanically, don't "think" about it.  Turn off CNBC. Be oblivious. Be happy. Be wealthy.

Ron  

P.S. You can find more information in one of my 4 books on Amazon at the link below.

www.InvestorCookbooks.com