Buffet and Black Scholes

Aswath Damodaran (of NYU) takes on Warren Buffet's criticism of academics and their "obsession" with Black Scholes.  I agree with Prof Damodaran on this one.

A couple of reposts from the Finance Professor Blog...

Just working through some of the starred postings in my RSS reader...

The Finance Professor  blog has a nice video of Harry Markowitz talking about portfolio theory and another one featuring Gene Fama Jr talking about asset pricing.

Well worth a view.

Deviations from put call parity have predictive power.

We've been talking about options in class this week and we've covered put call parity.  Put call parity simply states that the call price + the present value of the strike = stock price + put price.  A question that comes up in class is what do deviations from PCP really mean?

A forthcoming article in the JFQA (a top finance journal) finds that deviations from PCP have predictive power.  When calls are relatively expensive compared to puts, the underlying stock outperforms.  Likewise, when puts are relatively expensive compared to calls the underlying stock underperforms.  These results hold the strongest for illiquid stocks that have liquid options.

Inflation linked bonds are back in the spotlight

With global concerns about inflation, the attention turns, predictably, to asset classes that are good inflation hedges.  The FT has a good article on the topic.   Mechanically, inflation linked bonds will provide inflation protection.  But they have a problem - only part of their nominal return comes from inflation - the other part is a real return.  Currently the real return on US inflation linked bonds is basically zero.  If demand for TIPs increases this could go negative (it has in the past).  

Alternatives to TIPs include any real asset.  For example, in the long run, stocks are excellent inflation hedges, although in the short run they often do poorly, in large part because investors don't understand that they are real and not nominal assets.  Commodities are good hedges - but very volatile.  

At the end of the day, trying to bet on inflation is a risky business.

How important is the stock market?

Felix Salmon recently posted an op ed in the New York Times that argues that the US equity markets are becoming less important to the US economy.

The striking number is that in 1997 there were 7,000 publicly traded firms.  Today there are 4,000.  The number of IPOs is way down and the market is increasingly becoming dominated by large cap stocks.  Furthermore, these stocks rarely use the market to raise new equity.  Many small firms that would have listed on the markets are now being funded with private equity.

Felix follows up on his original column and asks what this means for small investors.

Trading on volatility

I was updating some lecture notes on option volatility and was doing a little research on the various VIX (S&P 500 implied volatility) products that are out there these days.  It turns out that there are a whole host of securities (mostly ETNs) that allow an investor to trade various futures positions in the VIX.

Consider the following post on the blog VIX and More.   At the time of writing, you can trade leveraged 5 month VIX futures or if you're wanting to go short volatility you can trade an ETN that takes a short position in 1 month VIX futures.   The graphic at the bottom of the post shows the different products.

A lot of these have fairly small trading volume, so you have to wonder about liquidity.  They also look pretty risky.

Personally though, I'll just stick with my index funds.

Hedge funds searching for ways to short munis

Munis - the name given to municipal bonds - are bonds sold by states and state agencies.   For years munis have been considered safe and boring.  But now, with many states facing severe budget crisis, investors (and in particular hedge funds) are paying close attention to munis.

If you are running a hedge fund, you might sense an opportunity here.  If you believe that the credit worthiness of states will continue to decline, then the price of munis should fall (and at the same time the yield on these bonds will increase).  The obvious strategy then is to go short munis.  The question then is how?

The Financial Times tackles this question.  First it turns out that shorting muni bonds is quite hard as most muni debt is held by buy and hold investors like pension funds who are not interested in lending the bonds out to short sellers.  Second, even though in theory you could buy credit default swaps, the market for muni CDS contracts is pretty thin and as a result there are liquidity issues.  Finally, you could just try and short a muni index, but you won't be able to target a specific state.

For students of finance, this is what we call a "limits to arbitrage" problem.  While in theory the smart money should try and short overpriced bonds, frictions in the market render such a strategy costly or unpractical.   It is important to note however, that this doesn't mean that markets are not efficient, just that they are not perfect.  There is a difference.

The stock market and the super bowl

My colleague, Craig Newmark, just posted a link to a report on an article that claims that there is a link between whether a firm advertises in the Super Bowl and that firm's stock performance immediately after the game.   The authors claim a significant positive relation.

Like Craig, I don't buy it.  I'd like to have a good look at the paper, but the authors don't appear to have it posted in any of the usual places - for example on their websites.  So it is hard to look at their method.  My guess is that the effects are due to mis-measurement, failing to correct for risk and other known factors that affect stock returns, oh and of course luck.  The results would imply a very simple trading rule, which I just don't buy.

There are, however, some cases where a link between sports advertising and stock performance has been found.  For example,  there is the NASCAR effect - where the winning car's sponsor gets a small stock price boost. This effect makes a bit more sense because brands are tied more directly to the outcome of the race, and NASCAR fans are very loyal.  So there may be a real spike in sales of soap powder after a win.

The low real return on inflation linked bonds.

Jeremy Siegel discusses the near zero (and in some cases negative) real return on TIPs and what this means for investors. (source: Financial Times)

First, a bit of background:

• Siegel is a Wharton Professor who is famous (in the finance world) for his book "Stocks for the long run".  Siegel is a strong believer in stocks being excellent long run inflation hedges.  
• TIPs are inflation linked bonds that earn a real return plus the rate of inflation.  The inflation return is certain - the uncertain part is the real return that you earn.

OK, back to the article.  Siegel argues that the low real return on TIPs is due to the low level of economic growth.  This makes sense because it is broadly the case that the real rate of interest should roughly equate to the real growth rate.  He argues that as the economy improves, real growth will increase and so will the yield on TIPs.  Of course, as any student of bond math knows, an increase in rates will result in a drop in the price of the bond.   Siegel argues that the drop in the price of TIPs is all but inevitable as the economy improves.  His solution is to sell TIPs and buy stocks.

His argument has merits, but moving from TIPs to equities will substantially increase the risk of a portfolio.  So while you might dodge an as yet uncertain rate increase on TIPs, you'll expose yourself to much greater market risk.  Furthermore, other fixed income securities would come off worse than TIPs as they would be negatively impacted by both real rate increases and inflation rate increases.

Should the US issue 100 year bonds?

There's been some talk in the press about whether the US Treasury should issue 100 year bonds.  The idea is that by issuing long term bonds, the government would be able to lock in the current low interest rates.   The fundamental premise seems a little silly really.  First of all, the idea of locking in long term rates assumes that rates will, on average be higher than they are currently.   If this is so, then why would anyone buy these bonds off a low rate.   Put another way, to make this argument you have to assume that the Treasury has better rate forecasting ability than the market.

Another argument for these bonds is that there is demand for them from various institutional investors.  So why would investors demand long term bonds?   The most obvious reason is that long term bonds tend to have high duration.  This means that their prices are more sensitive to interest rate movements than shorter duration bonds.  Counter-intuitively, these long duration bonds are actually very useful for managing interest rate risk - particularly when used in immunization strategies.

So this all sounds good, but it turns out the the Federal Government already issues a longer duration bond than a 100 year bond.  The duration of a 100 year 4% coupon bond selling off a yield of 4% is actually about 25 years.   However, 30 year STRIPS, which are zero coupon bonds, have a duration of 30 years.  Therefore the duration argument doesn't really seem to make much sense.  The only small advantage to 100 year bonds is that they have higher convexity than the STRIPS.

You can check these numbers using the Bond function on wolfram alpha.

Bottom line, I don't think that 100 year bonds have much of an advantage over currently available bonds.

The case for ignoring the stock market

A great article by Carl Richards in the NYT about why you should ignore the day to day ups and downs of the market.   Well worth a read.  In the article Carl also links to some of his earlier articles which further expand on the idea that following the daily gyrations of the market is a bad idea for most investors.

Carl also likes to draw cute little diagrams on napkins that convey investing wisdom.  For example...

Brilliant stuff.   

Carl is of course correct in my opinion.  There is no reason why a normal person should pay any attention to the market.   If you've created a well diversified retirement portfolio, then you don't need to tweak it every week - and you absolutely don't need to alter the allocations because of some short term market movements.  

Most people who trade regularly and attempt to time the market are delusional about their own abilities.   They suffer from the "illusion of control".  Just because you can trade in and out of stuff doesn't mean that you actually have any real control over the outcomes.  All it really means is that you want to waste away your wealth on fees and commissions.

Having said all this, if you enjoy trading stocks, then by all means treat it like a hobby.  Put aside some money that you are willing to loose and trade to your hearts content.  But don't trade your retirement portfolio.

HT: Felix Salmon

Is your index fund broken?

Here's an article from SmartMoney about the latest research in alternative index methodologies.

The basic idea is that it is possible to build a market beating index using a method other than market cap weighting.

Of course this is absolutely true.  We know that there are always going to be some portfolios that beat a passive index.  The key questions are 1) will they do this over the long run, and 2) what additional risks are they taking on?

For example, in the article it is noted that the equal weighted index beats the cap weighted index.  This is no surprise.  The equal weighted index will have far more weight in small stocks.  Small stocks tend to be riskier than large stocks, so a portfolio of more small stocks should be expected to outperform a market cap weighted index.

Also as pointed out in the article, the fundamentals weighted index is really a value stock index.   While I am sure that this index is doing well right now, I'd bet that it would have done terribly in the 1990s when growth stocks were in the limelight.

At the end of the day though, you have to ask yourself: "if cap weighted indexes are so bad, why is it that they beat active managers at least 50% of the time?"   These alternative index methods are just active portfolio management in disguise.