Efficient Markets and the financial crisis

Craig Newmark discusses Robert Shiller's view that the Efficient Market Hypothesis predicts that the financial crisis couldn't happen.

Craig thinks Shiller is wrong, and I agree with Craig.  I'm a little surprised that Prof Shiller would actually make such a statement.    

It's worth remembering that the EMH is actually quite narrow in its predictions.   All the EMH states is that prices should reflect all available public information.  This coupled with frictions in the market, such as the inability to short certain stocks means that a market collapse can occur when there is a great deal of uncertainty about the future.  

The EMH does not imply that markets should function in a nice orderly fashion - only that when markets do get out of whack, investors cannot earn abnormal profits by trading on public information.

Although the EMH is quite narrow, it is also very powerful.  A simple way of thinking about how the EMH applies to the financial crisis is to ask the question: - At each point in time, was there clear information available that would allow an investor to risklessly earn an abnormal profit from trading on a mispriced security?  I think the answer to this question is no.

How many stocks are there anyway?

How many stocks trade on the NYSE and the NASDAQ.   Felix Salmon has some nice graphs that show a significant decline in the number of stocks listed on the exchanges.

Eye balling the charts suggests there are about 1500 on the NYSE and 2500 on NASDAQ - so about 4000 in total.  This isn't actually the number of securities traded on those exchanges though as the total will include ETFs and Closed End Funds.

Worried Retirees

My local paper, the News and Observer, published a letter from a worried retiree of Progress Energy.  For those not following our local news, Progress Energy (NYSE:PGN) is merging with Duke Energy (NYSE:DUK).  PGN is located here in Raleigh and so there are many folks in the area who have worked for the company and are now retirees.

The letter expressed concerns as to how the merger would affect the retirees dividend stream from her PGN stock, which was presumably bought as part of some company employee stock ownership plan.

For students of finance, and in particular corporate finance, see if you can spot the major misconceptions held by the letter writer.  For bonus points, advise the writer as to whether or not she might want to diversify her portfolio.

The link to the letter is here.

The text is here:

The Fortune 500 company was once CP&L, and then it became Progress Energy. Now that the company I loved is going to be Duke Energy, I wonder what is in store for the employees - especially for the retired employees.

When I worked at CP&L, the company valued its employees parallel to safety and the bottom line. This change is a major worry. How will Duke treat CP&L's vested retirement plan? What about dividends paid? Will they be paid at Duke's rate or Progress Energy's rate? Will dividends be increased from time to time as before?

Enhancing our stock value by 6.4 percent may be good news for some, but for us who reinvest dividends, the enhanced value is not exciting - we will be buying fewer shares.

I am in shock and saddened that "my company" is being sold. When I joined CP&L, the personnel representative told me if I worked hard and kept my nose clean, I could retire there. I wonder what he would say now.

The buyout, or merger, whichever it is, may be a sound business transaction, but retired employees, who are nostalgic, feel a great loss of connection and of pride, and we are concerned for our future financial security.

Retired CP&L 1994

Stock Repurchases

Aswath Damodaran ponders the reasons behind the recent increase in stock repurchases.  Required reading for all MBA finance students!

The research - teaching disconnect in MBA education.

An opinion piece today in the Financial Times laments the disconnect between Management research and teaching.   It argues that

What is being taught in management courses is usually not based on solid scientific evidence. Instead, it concerns the generalisation of individual business cases or the lessons from popular management books.

While this may or may not be the case in some management disciplines, it is not the case in Finance.  I usually start off teaching Financial Management (our intro MBA class) by pointing out that we will cover 4 Nobel Prize winning theories.  I'll then draw much more recent research (including some of my own) into lectures.

For example: last week in my Investments class, we were talking about creating portfolios with short positions in foreign securities and I noted that US traded ADRs facilitate shorting in cases where their home countries have short sales bans - a topic of one of my current working papers.

While, there is frequently much hand wringing in the business press about the relevance of some content of MBA education, I think Finance is in pretty good shape.

Stata Resources

This not really a finance post, but as a financial economist, one of my main tools is the statistical software package called STATA.   Stata is one of three programs that most academics in my area use.  The other two are R and SAS.  Anyhow, Stata users might find useful a recent post on the marginal revolution blog about some helpful Stata resources.

I particularly like this one which allows you to visually pick the kind of graph you want to make, and then shows you the code to do it.

Burton Malkiel on random walks and indexing.

We're working on portfolio theory in class this month, and we've talked about index funds a little.

Here is a must watch video interview of Burton Malkiel talking random price movements and the business of actively managed funds.

http://finance.yahoo.com/tech-ticker/article/535789/Burton-Malkiel:-Markets-Arent-100%25-Efficient-But-You-Still-Cant-Beat-Em

Adventures in market reporting

Felix Salmon talks about how journalists try to interpret up and down movements in the market.

He sums it up.

They all basically follow the same rubric: first you say what the market did, then you mention some piece of news which happened that day, and then, depending on how bold you are, you either assert or else you try to back away from the necessary implication that there’s a causal relationship between the two.

50 Cent manipulates stock prices with Twitter.

From the excellent Stephen Colbert.
http://www.colbertnation.com/the-colbert-report-videos/370860/january-12-2011/50-cent-makes-money-on-twitter

Note: some possibly inappropriate language.

Perceptions about inflation

Before you read any further - what do you think the current inflation rate is?

OK now continue...

The Pew Research Center for People and the Press periodically does surveys to test political and economic knowledge.  On a survey done last November, one result really surprised me.

Here are the responses on the inflation question.  The percentage chosen is in the left column.


PEW.18  Do you happen to know if the national inflation rate reported by the government is closer 
to…
   
 14    1% (Correct)
 15    5% 
 15   10%   
 7     20% 
 49   Don’t know/Refused (VOL.)



Basically 85% of those surveyed either had no remote idea of the inflation rate, or thought it was significantly higher.   That 35% thought it was 10% or higher is amazing.

Here's a graph of the annual inflation rate.  Inflation over 10% is very rare.

VIX for individual stocks

Another one from my colleague Craig Newmark's excellent blog, Newmark's Door.  This time it's on the plans of the CBOE to create stock specific volatility measures.  Basically a VIX for individual stocks.

Sounds cool although it seems a little like a tool in search of an application.   While overall market volatility is quite important because we can't diversify away market risk, individual stock volatility is less important in the context of a diversified portfolio.

Big stocks in the S&P 500

From my colleague, Craig Newmark, 10 stocks account for 1/5 of the S&P 500's market cap. This is actually the reason why the Dow 30 (30 stocks) does a pretty good job of tracking the much broader S&P 500.  Of course, in recent weeks, the Dow hasn't done so well.

Algorithmic trading

Here is a recent article in Wired Magazine about the increased use of algorithmic trading of stocks.

My conclusion: If you were looking for yet another reason to index, this would be it.

Cloud tools for students...

As we start a new semester, here are a few of my favorite online tools for students.  I use all three.

Dropbox
What it is:

• Free online storage that syncs with a folder on the hard drive of your computers.

Benefits: 

• You'll never have to back up again.  If you put all your work in to your dropbox folder on your computer it is automatically and instantly synced with the cloud.   
• If you have dropbox installed on more than one computer, all your work is automatically synced across all your machines.
• You can share folders with others - which makes it a great tool for online collaboration

Evernote

What it is:

• An online storage for pretty much any type of note - whether it be a text note, pdf file, picture from your phone, web clipping, bookmark etc etc.

Benefits:

• Use it for storing all sorts of data.  
• Find what you need with the powerful search function that even looks for text in pictures.
• You can manipulate your notes using a desktop client.

Springpad
What it is:

• Another online organizer like Evernote but a little different.  
• Allows you to organize notes by type - bookmarks, products, to do lists, check lists etc.
• Makes full use of HTML5 - so has a really nice interface.

Benefits:

• You need a "personal assistant" organizer.
• You want to create to-do lists that are organized by project and keep the associated project files in the same location
• You don't care about a desktop client.

I've been an Evernote user for a couple of years, but more recently I've been using Springpad because it's more user friendly for day to day stuff.

Google Reader
What it is:

• A blog reader for organizing and reading blog postings.

Benefits:

• It's simple and lightweight.
• You can access it via your smartphone.
• You can view this blog on it.

Momentum in stock returns

When a stock that has risen in the past continues to rise, we call it momentum.   Momentum is a bit of a problem for the Efficient Market Hypothesis because it implies a profitable trading rule -  "buy recent winners".

Recent academic studies have found support for momentum effects even after controlling for risk, data mining biases and trading costs.   The Economist has a really nice article on the current state of what we know about momentum.  Well worth a read.

Bogle talks about stocks and bonds

Jack Bogle, creator of Vanguard Funds and devout indexer, talks about returns on stocks and bonds and asset allocation.   The video is on the the Finance Professor blog and is a must see video for all my students.

Jack is forecasting a return on stocks of around 6-7%.  That seems pretty reasonable to me.  If you're using 12% to plan your retirement then good luck.  You'll need it.

Dow vs S&P 500

Considering that the Dow contains only 30 stocks and is a bizarre price weighted index, it does a surprisingly good job of tracking the S&P500.  That is unless if you don't consider the past month or so.  Turns out that the Dow has been lagging the S&P 500 by quite a margin.
Felix Salmon has the details

401K Cookbook.

In full disclosure, this is a blatant plug for a friends book, but I highly recommend it to anyone who is trying to figure out what they should do with the funds in their 401K plan.



The 401K Cookbook is just that.  A cookbook.   The basic premise is that if you want to make brownies you don't need to know how sugar and flour chemically bond with water and chocolate to create yummy brownies, all you need to know is what proportions to put in the mixing bowl.  The same logic applies to retirement investing.  You don't need to know about portfolio theory, risk premiums, efficient frontiers, you just need to know where to put your money and be done with it.

The 401K Cookbook starts off with a little test that tries to figure out your true investing age.  If you are more risk averse, your investing age will be higher, if you are less risk averse your age will be lower.  You then turn to the page for your investing age and use the allocations that are presented there.  It's that simple.

Once you've created your portfolio, you just need to come back in a year or two and re-take the test and tweak the weights.  The whole process shouldn't take more than a couple of hours.  But if you want to learn more about the logic behind the asset allocations, you can read the back 1/3 of the book which provides a crash course in retirement investing.

Ron Elmer, the author, has a long experience in money management.  He's also a big advocate of indexing.   He saw a need for a simple, straightforward book that people could use to set up their portfolios.  As one didn't exist in the marketplace, he decided to write and publish it himself.

Ron is working on further versions of the book that deal with specific fund companies such as Vanguard and Fidelity.

Malkiel's recommended asset allocation

Burton Malkiel of "a random walk down wall street" fame has updated his recommended asset allocation.  

Seems a bit heavy in Real Estate and emerging markets.

Source: Mankiw's blog

A new year, a new semester and back to blogging.

I took a little break from blogging, but it's time to get back to it.  

As everyone knows by now the most evil investment bank, Goldman Sachs, has taken a private stake in the most evil internet company, Facebook.  All we need now is to find out that Facebook servers run on BP oil and the trifecta will be complete.

So what is GS doing with its newly acquired chunk of FB?  Apparently GS is peddling stakes in FB to some of its favorite customers.  The Wall Street Journal points out that the solicitations look remarkably like the classic Nigerian investment scam emails!