Tuesday, November 29, 2011

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"

Tuesday, November 22, 2011

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.

Monday, November 21, 2011

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.

Thursday, November 17, 2011

"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.

Tuesday, November 15, 2011

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.

Monday, November 14, 2011

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.


Friday, November 11, 2011

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.


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.

Thursday, November 10, 2011

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.

Wednesday, November 9, 2011

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.  

Monday, November 7, 2011

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.

Friday, November 4, 2011

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%.