tag:blogger.com,1999:blog-72503953841387087112024-03-13T23:20:15.107-04:00Finance ClippingsA Finance Professor's blog.
I am a Professor of Finance in the Poole College of Management at NC State University.
My website: https://sites.google.com/ncsu.edu/warr
Opinions are my own.Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.comBlogger947125tag:blogger.com,1999:blog-7250395384138708711.post-26060103753433990802022-01-21T12:29:00.004-05:002022-01-21T14:20:57.162-05:00What's going on with inflation?I recently posted an article on the Poole College Thought Leadership page titled: "<a href="https://poole.ncsu.edu/thought-leadership/article/whats-going-on-with-inflation/" target="_blank">What's going on with inflation?"</a>. <div><br /></div><div>This was a pretty general, high level article, so in this post, I wanted to add a few extra resources and details.
</div><div><br /></div><h3 style="text-align: left;">Why doesn't the Fed target inflation at zero percent?</h3><div>2% inflation provides a buffer against deflation (which is generally considered a bad thing). In addition, a low level of inflation can lead provide some inherent flexibility for employers to adjust wage costs in slower economic times. This is achieved by simply not increasing nominal wages, which results in a real wage cut for a worker. See for example, this <a href="http://clevelandfed.org/en/our-research/center-for-inflation-research/inflation-101/why-does-the-fed-care-get-technical.aspx" target="_blank">Cleveland Fed article for more details.</a> Also see <a href="https://www.federalreserve.gov/faqs/economy_14400.htm" target="_blank">https://www.federalreserve.gov/faqs/economy_14400.htm</a> in which the Fed explains its 2% target.</div><div><br /></div><div>In addition, there's <a href="https://www.brookings.edu/research/low-inflation-or-no-inflation-should-the-federal-reserve-pursue-complete-price-stability" target="_blank">evidence</a> that a policy of complete price stability (0% inflation) could lead to a significant decline in GDP and employment.</div><div><br /></div><h3 style="text-align: left;">What other factors might lead to inflation, aside from supply chain issues?</h3><div>It's pretty clear that at the current time, inflation is being driven in large part by supply chain problems. We can look at the price changes of new and used cars to see the impact the global chip shortage on car production. But other factors might also lead to inflation. </div><div><br /></div><div>One possible factor might be stimulus money that was pumped into the economy during the pandemic. This extra cash may result in fewer workers choosing to participate in the labor market. Under classical economic theory, inflation is in part driven by labor market supply.</div><div><br /></div><div>An interesting paper by <a href="https://www.frbsf.org/economic-research/publications/economic-letter/2021/october/is-american-rescue-plan-taking-us-back-to-1960s/" target="_blank">the San Francisco Fed</a> shows that the stimulus money (the American Rescue Plan) did indeed lead to a tightening of the market, but that the overall effect on inflation was fairly small. A more general discussion can also be found in this <a href="https://www.nytimes.com/2021/10/18/business/economy/fed-inflation-stimulus-biden.html" target="_blank">NYT article</a> (maybe paywalled).</div><div> </div><h3 style="text-align: left;">Does everyone's wage increase when inflation increases?</h3><div>The answer is clearly no. There are many individuals who are perhaps on a fixed retirement income (technically not a wage), and also those in professions where wages are sticky. A lot of government positions have fairly sticky wage structures.</div><div><br /></div><div>There is some evidence the service/front line workers have seen wage increases, for example this <a href="https://www.brookings.edu/blog/the-avenue/2021/12/13/with-inflation-surging-big-companies-wage-upticks-arent-nearly-enough" target="_blank">Brookings Institute article</a> shows wage changes at several retailers and restaurants chains. </div><div><br /></div>Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-39855919297458889552021-08-19T16:24:00.006-04:002021-08-19T16:24:53.267-04:00And yet another inflation illusion post...<p>Another inflation illusion post. This time with math.</p><p>Again the issue here is that you can't just increase the discount rate when you are valuing a stock without paying attention to the top line growth rate. </p><p><a href="https://www.barrons.com/articles/tesla-is-cratering-this-is-how-much-interest-rates-hurt-51614973530?mod=article_inline">https://www.barrons.com/articles/tesla-is-cratering-this-is-how-much-interest-rates-hurt-51614973530?mod=article_inline</a></p><p><br /></p>Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-13897366957110736672021-06-02T16:04:00.006-04:002021-06-02T16:04:48.065-04:00Inflation is coming and so is inflation illusion.<p>Inflation illusion is a favorite topic of mine, read prior posts <a href="https://financeclippings.blogspot.com/search/label/inflation%20illusion" target="_blank">here</a>. It's a topic that comes back time and time again, usually whenever there is a hint of inflation. Case in point - this article in Barrons</p><p><a href="https://www.barrons.com/articles/inflation-driven-stock-market-selloff-51622470534?mod=article_inline">https://www.barrons.com/articles/inflation-driven-stock-market-selloff-51622470534?mod=article_inline</a></p><p>The key line: "Both higher yields and inflation itself erode the value of future cash flows, which makes stocks less valuable. "<br /><br />This is basically inflation illusion - the idea that when bond yields increase, the discount rate for stocks should also increase, thus lowering the value of the cash flows generated by the stocks.</p><p><br /></p><p>Here's why this is flawed logic:</p><p>The value of a firm's equity can be given as: Value=FCFE(1+g)/(R-g)</p><p>Where R = the nominal discount rate, FCFE is the free cash flow to equity and g = the nominal growth rate. </p><p>When inflation increases, R will increase. This alone will result in a reduction in the value of the stock. However, inflation will also act upon g, the growth rate. Across the economy we would expect, on average for g to increase by the increase in the inflation rate. The net effect of R-g is that the impact of inflation gets cancelled out.</p><p>Ironically, the article above contains the line:</p>"That noise includes supply-chain constraints, which bring the cost of materials higher, incentivizing companies to raise prices."<div><br /></div><div>Which basically says that the FCFE will increase - because prices are rising and therefore FCFE moves with inflation.</div><div><br /></div><div>To be clear - I am not trying to beat up on a single, short, Barrons article. Instead my point here is to show how common this mistake is.<br /><br /><p><span style="color: #001e20; font-family: Aileron, Arial, sans-serif, Arial, sans-serif; font-size: 16px;"><br /></span></p><p>
</p></div>Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-89339846114105167312021-03-24T11:38:00.001-04:002021-03-24T11:38:27.246-04:00The Fed Model is not dead...but really should be.<p>The Fed Model (not endorsed by the Fed) is one of those rules of thumb that investors use to value stocks, that while being intuitively appealing, is fundamentally flawed. Recently, one of my MBA students shared another example of its application (which I'll get to in a moment).</p><p>First - what is the "Fed Model"? Simply put, it argues that there is a relationship between the medium term Treasury yield (or some other interest rate) and the earnings yield or forward earnings yield for some basket of stocks (such as the S&P 500).</p><p>The idea is this: Say the 10-year Treasury is yielding 4%, and the forward earnings yield of the S&P 500 is 4%, then stocks are fairly priced. (Note: the earnings yield is the inverse of the Price - earnings ratio).</p><p>If, due to inflation, the Treasury yield increases to say 5%, the Fed Model suggests that the earnings yield of the S&P 500 must adjust to 5% also. This will result in the PE ratio of the S&P 500 falling from 25 (1/0.04) to 20 (1/0.05). As earnings haven't changed, the price of the S&P 500 must fall from 25 to 20 or 20%. Ouch! You can see why investors who subscribe to the Fed Model get so upset about inflation. In my example, a 1% increase in inflation takes 20% off the stock market.</p><p>But, it turns out that this is entirely flawed logic and suffers from my favorite behavioral finance error - "<a href="http://financeclippings.blogspot.com/search/label/inflation%20illusion" target="_blank">Inflation Illusion</a>". This is because the Fed Model ignores a key fact. When inflation increases, the cash flows from a bond don't change. The bond coupons are fixed. But, the cash flows from stocks DO change. Earnings will, on average, increase at roughly the rate of inflation. The reason is simple - inflation occurs because companies that sell stuff put up prices, which results in higher sales (Sales = Price*Quantity) and are passed down to the bottom line. <i>As an exercise for the reader - make a simple income statement and increase all the costs and revenues by 1% and see what happens to the Net Income.</i></p><p>So when inflation increases, future earnings of the stocks will increase also. The stock price will also adjust up to reflect inflation. The result is that PE ratios and earnings yields stay the same, because both the price and earnings of the stock move in accordance with the higher inflation rate. This means that the PE of the stock market can stay at 25 even if the Treasury yield is at 5%. There's no misvaluation, because there is no fundamental reason why the Earnings yield must track the Treasury yield.</p><p>You may be wondering - why does the stock price increase in the presence of inflation?</p><p>Consider a simple dividend discount model. Inflation is 0%, dividends grow at 2% a year and the discount rate is 5%. Dividend today is $1.</p><p>Price = 1*(1+0.02)/(0.05-0.02)=34</p><p>Now assume 1% inflation. Inflation increases the discount rate to 6% and the growth rate to 3%.</p><p>Price = 1*(1+0.02+<span style="color: red;">0.01</span>)/(0.05+<span style="color: red;">0.01</span>-0.02-<span style="color: red;">0.01</span>) = 34.33</p><p>The price change is: 34.33/34 -1 = 1% (rounded because we didn't compound the growth rates).</p><p>The takeaway: When inflation occurs, all else equal, stock prices rise.</p><p>So on to that article. It's <a href="https://www.cnbc.com/2021/03/12/a-2percent-10-year-yield-could-knock-20percent-off-tech-stocks-ned-davis-research-calculates.html" target="_blank">here on CNBC and is firewalled</a> , but the gist, according to Ned Davis Research, is that if the current 10-Year Treasury goes from 1.6% to 2%, this will result in a decline of as much as 20% in the Nasdaq index. Unfortunately, this is exactly the Fed Model. I've done the calculation, and yes, I get roughly the same number. If you assume the following:</p><p>Nasdaq forward PE = 37, implying an E/P = 2.7%. An increase of 0.4% in the E/P would result in a new Nasdaq forward PE of 32, and a price decline of about 13%. </p><p>Unfortunately this analysis is entirely flawed. It assumes Nasdaq earnings don't adjust with inflation.</p><p>So, to conclude - the Fed Model is still being peddled by Wall Street Firms, even though they may not call it as such. But it's still wrong. For an excellent take down of the model, see Cliff Asness's post at AQR here: <a href="https://www.aqr.com/Insights/Research/Journal-Article/Fight-the-Fed-Model">https://www.aqr.com/Insights/Research/Journal-Article/Fight-the-Fed-Model</a> - full article here: <a href="https://images.aqr.com/-/media/AQR/Documents/Journal-Articles/JPM-Fight-the-Fed-Model.pdf">https://images.aqr.com/-/media/AQR/Documents/Journal-Articles/JPM-Fight-the-Fed-Model.pdf</a></p>Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-30117622292741744072021-03-11T15:08:00.000-05:002021-03-11T15:08:18.285-05:00How does the weather impact HFT?<p><span style="color: #495057; font-family: UniversLight, "Open Sans", "Helvetica Neue", Arial, sans-serif; font-size: 15px;">Sometimes I come across an academic research paper that is just so interesting I feel compelled to share it with my MBA students. This is one of those papers.</span></p><p id="yui_3_17_2_1_1615492270681_7227" style="border-radius: 0px !important; box-sizing: border-box; color: #495057; font-family: UniversLight, "Open Sans", "Helvetica Neue", Arial, sans-serif; font-size: 15px; margin-bottom: 1rem; margin-top: 0px;">Here's the basic set up:</p><p id="yui_3_17_2_1_1615492270681_7228" style="border-radius: 0px !important; box-sizing: border-box; color: #495057; font-family: UniversLight, "Open Sans", "Helvetica Neue", Arial, sans-serif; font-size: 15px; margin-bottom: 1rem; margin-top: 0px;">High Frequency Traders (HFT) try to make money out of tiny price deviations between stocks traded in Chicago and New York. Same stock, two trading locations. If you can see the stock move in New York and can get a trade in in Chicago, you can capture a profit before Chicago figures out what's going on.</p><p id="yui_3_17_2_1_1615492270681_7229" style="border-radius: 0px !important; box-sizing: border-box; color: #495057; font-family: UniversLight, "Open Sans", "Helvetica Neue", Arial, sans-serif; font-size: 15px; margin-bottom: 1rem; margin-top: 0px;">There are two ways to do this. </p><p id="yui_3_17_2_1_1615492270681_7230" style="border-radius: 0px !important; box-sizing: border-box; color: #495057; font-family: UniversLight, "Open Sans", "Helvetica Neue", Arial, sans-serif; font-size: 15px; margin-bottom: 1rem; margin-top: 0px;">1. Fiber optic cables. Very fast</p><p id="yui_3_17_2_1_1615492270681_7231" style="border-radius: 0px !important; box-sizing: border-box; color: #495057; font-family: UniversLight, "Open Sans", "Helvetica Neue", Arial, sans-serif; font-size: 15px; margin-bottom: 1rem; margin-top: 0px;">2. Microwaves. A tiny bit faster.</p><p id="yui_3_17_2_1_1615492270681_7232" style="border-radius: 0px !important; box-sizing: border-box; color: #495057; font-family: UniversLight, "Open Sans", "Helvetica Neue", Arial, sans-serif; font-size: 15px; margin-bottom: 1rem; margin-top: 0px;">You also need to know something else about stock trading (and this is an area I did quite a bit of work on in my earlier days) and that is that we can look at the bid-asked spread of a stock and infer from it something called the adverse selection cost of trading the stock. The adverse selection cost measures uncertainty about the true value of the stock. For example, if I tell you I have two cars I am selling - they are identical, except one comes with a warranty the other doesn't - you'll pay more for the warranty car. In effect the reduced price of the other car reflects an uncertainty cost - the uncertainty of how good the car actually is.</p><p id="yui_3_17_2_1_1615492270681_2760" style="border-radius: 0px !important; box-sizing: border-box; color: #495057; font-family: UniversLight, "Open Sans", "Helvetica Neue", Arial, sans-serif; font-size: 15px; margin-bottom: 1rem; margin-top: 0px;">OK so back to stocks - higher adverse selection cost means that there is more uncertainty about the true value of the stock. Its true value could be higher, or lower. High Frequency Traders contribute to this cost as they add risk to the market by being able to exploit mispricing at the expense of other market participants.</p><p id="yui_3_17_2_1_1615492270681_2760" style="border-radius: 0px !important; box-sizing: border-box; color: #495057; font-family: UniversLight, "Open Sans", "Helvetica Neue", Arial, sans-serif; font-size: 15px; margin-bottom: 1rem; margin-top: 0px;">So how does this relate to the weather? Well it turns out that microwaves don't work when it is raining hard or snowing. So away go some of the HFT traders - just for a short while. But during that time, the adverse selection component <span id="yui_3_17_2_1_1615492270681_3710" style="border-radius: 0px !important; box-sizing: border-box; font-weight: bolder;">declines!</span></p><p id="yui_3_17_2_1_1615492270681_2760" style="border-radius: 0px !important; box-sizing: border-box; color: #495057; font-family: UniversLight, "Open Sans", "Helvetica Neue", Arial, sans-serif; font-size: 15px; margin-bottom: 1rem; margin-top: 0px;">It's a testament to the ingenuity of the authors to devise an experiment to capture this effect. And this isn't merely an academic exercise, millions of dollars if not billions are spent in the pursuit of HFT gains.</p><p id="yui_3_17_2_1_1615492270681_2760" style="border-radius: 0px !important; box-sizing: border-box; color: #495057; font-family: UniversLight, "Open Sans", "Helvetica Neue", Arial, sans-serif; font-size: 15px; margin-bottom: 1rem; margin-top: 0px;">The paper is here if you are interested. The intro is well written and quite accessible. <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2848562" id="yui_3_17_2_1_1615492270681_6191" style="border-radius: 0px !important; box-sizing: border-box; color: #990000; text-decoration-line: none;" target="_blank">https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2848562</a>. Not surprisingly, this paper wound up in the very top finance journal.</p>Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-9349435736301353632019-12-18T14:41:00.000-05:002019-12-18T14:41:04.271-05:00Beanie BabiesThere are a lot of similarities between the boom and bust of the Beanie Baby market in the 1990s and booms and busts in financial markets. They are often based on the so-called "greater fool theory" which is essentially "I know that I am a fool for buying this at this price, but I am counting on a greater fool to buy it from me in the future".<br />
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Anyhow, here's a fun article about the Beanie Baby market: <a href="https://www.theguardian.com/lifeandstyle/shortcuts/2019/jun/19/what-beanie-babies-taught-a-generation-about-the-horrors-of-boom-and-bust?" target="_blank">https://www.theguardian.com/lifeandstyle/shortcuts/2019/jun/19/what-beanie-babies-taught-a-generation-about-the-horrors-of-boom-and-bust</a>Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-88670904949380425372019-12-16T13:27:00.000-05:002019-12-16T13:27:05.021-05:00Using satellite data to count cars in parking lotsSome hedge funds are using satellite data to count cars in parking lots of retailers.<br />
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<a href="https://newsroom.haas.berkeley.edu/how-hedge-funds-use-satellite-images-to-beat-wall-street-and-main-street/">https://newsroom.haas.berkeley.edu/how-hedge-funds-use-satellite-images-to-beat-wall-street-and-main-street/</a><br />
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<br />Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-55423253694740166382019-12-13T13:08:00.000-05:002019-12-13T13:08:16.205-05:00Alphabeticity Bias in 401(k) InvestingIt's interesting how little biases creep into how people make investing choices. For example, the alphabetical order of the 401K choices listed in a plan brochure (or website) can influence the choices that investors make.<br /><br />This is discussed in a recent paper published in the Financial Review (an academic journal that I c0-edit). <br />
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Here's the paper<br />
<a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3295400&mod=article_inline">https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3295400&mod=article_inline</a><br />
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And here's a link to a discussion in the WSJ. <a href="https://www.wsj.com/articles/for-some-401-k-holders-picking-funds-is-as-simple-as-abc-unfortunately-11575861000?shareToken=st5b42cefaa561463394d1c01677966180">https://www.wsj.com/articles/for-some-401-k-holders-picking-funds-is-as-simple-as-abc-unfortunately-11575861000?shareToken=st5b42cefaa561463394d1c01677966180</a><br />
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There are several solutions to this problem.<br />
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<ol>
<li>Don't have so many options on the plan in the first place. If there are just 5 choices, people are more likely to work down the full list.</li>
<li>Group choices in more logical groups. For example, group by "equity" "bonds" "international". And again, don't provide too many choices.</li>
<li>Allow re-sorting of the list.</li>
</ol>
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<br />Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-51598568092191351122019-12-13T10:08:00.002-05:002019-12-13T10:08:48.310-05:00A nice discussion of cash - money in short term accounts<iframe allowfullscreen="true" frameborder="0" height="288" mozallowfullscreen="true" scrolling="no" src="https://video-api.wsj.com/api-video/player/v3/iframe.html?guid=0957DAF4-2D0B-43CD-B332-8151CBE3E8A0" webkitallowfullscreen="true" width="512"></iframe>
Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-3502433703576515502019-09-13T12:30:00.002-04:002019-09-13T12:30:37.573-04:00Austria's 100 year bond.If you create a bond with a 2% coupon in a world where interest rates are 0.9%, you can bet that that bond is going to be very very volatile. <br /><br />Case in point - <a href="https://www.economist.com/graphic-detail/2019/09/12/austrias-100-year-bond-has-delivered-stunning-returns" target="_blank">Austria's 100 year bond that matures in 2117</a>. (note: register for the economist and you can view a few articles for free).<br />
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My quick calculations show that this bond has a duration of about 56. That's pretty high! I'd be interested to know whether investors are buying this a straight bet on interest rates or whether they are using it as part of a portfolio. You wouldn't need much of this bond to tilt the duration of your portfolio higher.<br />
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Here are my excel computations, with the predicted price change using duration alone (which is not terribly accurate in this case). For bonus points - explain why this is the case...<br />
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<br />Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-18899934459750052822019-06-10T10:43:00.003-04:002019-06-10T10:45:04.578-04:00Why stocks are good hedges for inflation.I was quoted yesterday in the Wall Street Journal on why stocks are good hedges for inflation.<br />
Article is here: <a href="https://www.wsj.com/articles/which-is-the-better-inflation-hedge-stocks-or-gold-11560132361?mod=searchresults&page=1&pos=8">https://www.wsj.com/articles/which-is-the-better-inflation-hedge-stocks-or-gold-11560132361?mod=searchresults&page=1&pos=8</a><br />
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Quoting from the article:<br />
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The reason stocks are a decent inflation hedge is because corporate earnings grow faster when inflation is higher, and grow more slowly when inflation is lower, according to Richard Warr, a finance professor at North Carolina State University. Consider the growth rate of corporate earnings over all 10-year periods since 1871, according to data compiled by Yale University finance professor (and Nobel laureate) Robert Shiller. The volatility of those growth rates was 21% less on an inflation-adjusted basis than it was on a nominal basis, which Prof. Warr says is a good indication of the extent to which equities are able to hedge inflation.</div>
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To be sure, Prof. Warr adds, higher inflation does reduce the present value of the otherwise higher future earnings. But these two effects should more or less cancel each other out over time.</div>
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Prof. Warr acknowledges that, over shorter periods of a year or two, stocks often suffer when inflation heats up. His research suggests that is because many investors are guilty of what economists refer to as “inflation illusion.” That is, they focus only on the reduction in the present value of future earnings to which inflation leads, while ignoring the tendency for nominal earnings to grow faster when inflation is higher. So when inflation spikes upward, they sell stocks.</div>
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Since the inflation illusion is irrational, it is difficult to predict whether investors will be guilty of it the next time inflation heats up. But Prof. Warr says that if they do and their selling causes the stock market to drop, investors should treat it as a buying opportunity."</div>
</blockquote>
<br />Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-15962048546427949082019-01-17T13:53:00.001-05:002019-01-17T13:53:18.310-05:00Bogle and the genius of indexing.Jack Bogle passed away this week and the investing world lost one of the most important figures in modern history. Bogle's contribution to investing is simple but of profound importance. He showed that an index fund, run entirely passively, could outperform most actively managed funds in the long run. <br />
<br />
I've long been a very strong proponent of indexing. I've posted heavily on the topic <a href="https://financeclippings.blogspot.com/search/label/index%20funds" target="_blank">here</a> in this blog, but a quick recap of why indexing is so brilliant is probably in order.<br />
<br />
In any given year (ignoring costs), about 50% of all active equity managers will beat the market, while 50% or so will trail the market. This has to be the case. It cannot be the case that the majority of equity managers beat the market, because the market is largely actively managed. Simply put - there has to be winners and losers. <br />
<br />In reality however, more than 50% of active managers trail the market because of trading costs and fees. These costs can easily be 1-3% or more per year, enough to cause a significant drag on performance. Bogle realized that if you just bought "the market" and didn't trade and didn't spend money on active management, you could reduce the total costs to a nearly trivial amount, less that 1/10 of a percent. The simple outcome of this strategy is that the "indexed" fund will beat more than 50% of all active funds in a given year, and in the long run will beat most active funds.<br />
<br />
You might be thinking, surely 1 or 2 percent isn't that much? Well, consider an investor with a million dollars: 1% is $10,000 per year every year. This is a significant performance drag.<br />
<br />
Or consider if you take $1,000 and compound for 40 years at 8% you'll end up with about $21,724. But if you compound only at 7%, just 1% less per year, your original $1,000 will only grow to $14,974. The 8% investment is worth 45% more than the 7% investment. <br />
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This is why, in the long run, indexing always wins. It's why I personally am 97% indexed and why I strongly advocate it for all investors (including pension funds).<br />
<br />
And this is Bogle's legacy. He's enabled many ordinary investors to be much wealthier than they would have bee had they stuck with active managers.<br />
<br />
As Mark Hulbert <a href="https://www.marketwatch.com/story/jack-bogle-mutual-fund-industry-agitator-got-the-last-laugh-2019-01-16" target="_blank">says</a>:<br />
<blockquote class="tr_bq">
"... he bet his entire career and his mutual-fund firm on the notion that the vast majority of active fund managers would be unable to beat a simple index fund. And there was hardly a single calendar year since 1976, when he created the Vanguard 500 Index Fund in which he was wrong."</blockquote>
<br />Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-76282180060600238642018-10-31T13:56:00.002-04:002018-10-31T13:56:44.749-04:00IBM to buy Redhat.An interesting deal. IBM has a strong presence in this area, and of course Redhat is a Raleigh based company. Details of the deal are here: <a href="https://www.marketplace.org/2018/10/29/business/ibm-bets-34-billion-cloud-computing-red-hat-purchase">https://www.marketplace.org/2018/10/29/business/ibm-bets-34-billion-cloud-computing-red-hat-purchase</a>.<br />
<br />A back of the envelope analysis suggests that there's about $7bn in merger gains.<br />
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<br />Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-59592438970204842342018-10-31T13:52:00.002-04:002018-10-31T13:52:55.473-04:00GE cuts dividendsDividend cuts are quite rare and even rarer for a stallwart stock like GE. But yesterday, GE cut it's dividend to a penny a share.<br />
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<a href="https://www.cnbc.com/2018/10/30/general-electric-earnings-q3-2018.html">https://www.cnbc.com/2018/10/30/general-electric-earnings-q3-2018.html</a><br />
<br />
There wasn't much of a price reaction, the stock had been on a downward trend, but the dividend cut certainly didn't help.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEit5YLKDTS2WAsjN4gBTkoDSfbiXGceftdZGT-BmtdB9BOaBwTd__9v5QBJ31eaXUldm22BBJR1wQFQfHhoP15Wxt0aKW0AbuTqGAj7Ve51xQXaRhL9Q02rk2cq0OFcShWLYNV8H_zjnFmM/s1600/Screen+Shot+2018-10-31+at+1.48.51+PM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="482" data-original-width="660" height="291" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEit5YLKDTS2WAsjN4gBTkoDSfbiXGceftdZGT-BmtdB9BOaBwTd__9v5QBJ31eaXUldm22BBJR1wQFQfHhoP15Wxt0aKW0AbuTqGAj7Ve51xQXaRhL9Q02rk2cq0OFcShWLYNV8H_zjnFmM/s400/Screen+Shot+2018-10-31+at+1.48.51+PM.png" width="400" /></a></div>
<br />
A dividend cut signaled that GE is struggling, but I don't think that was news to anyone. Even an analyst upgrade didn't help the stock price.<br />
<a href="https://www.barrons.com/articles/ge-has-problems-but-analyst-sees-upside-for-the-stock-1540998708">https://www.barrons.com/articles/ge-has-problems-but-analyst-sees-upside-for-the-stock-1540998708</a><br />
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A lower dividend payout means that the company can retain more cash and invest in growth, but as basic finance theory would state, dividend policy should be largely irrelevant in firm value.<br />
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<br />Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-4258811801945502282018-01-11T09:27:00.004-05:002018-01-11T09:27:50.851-05:00Do pro-diversity policies lead to greater corporate innovation?That's the question that we (myself, Roger Mayer of NC State and Jing Zhao at Portland State) recently studied in a paper that's forthcoming in the finance journal: Financial Management.<br />
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The answer is YES. We found that firms that promote diversity have more new products, more patents and more influential patents.<br />
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You can read the paper here: <a href="http://onlinelibrary.wiley.com/doi/10.1111/fima.12205/full">http://onlinelibrary.wiley.com/doi/10.1111/fima.12205/full</a><br />
<br />
Here's the summary on the NC State news page. <a href="https://news.ncsu.edu/2018/01/diversity-boosts-innovation-2018/">https://news.ncsu.edu/2018/01/diversity-boosts-innovation-2018/</a><br />
<br />
And here's a nice write up on WUNC radio's website, together with some additional links that talk about the benefit of diversity in teams. <a href="http://wunc.org/post/study-diverse-companies-are-more-innovative">http://wunc.org/post/study-diverse-companies-are-more-innovative</a>Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-77072417523824016772017-09-13T14:13:00.000-04:002017-09-13T14:17:26.473-04:00Bitcoin is a fraud says JPM boss<a href="https://www.theguardian.com/technology/2017/sep/13/bitcoin-fraud-jp-morgan-cryptocurrency-drug-dealers">https://www.theguardian.com/technology/2017/sep/13/bitcoin-fraud-jp-morgan-cryptocurrency-drug-dealers</a><br />
<br />
It should be remembered however, that this is coming from the CEO of the company that received a $12bn government bailout. <a href="https://dealbook.nytimes.com/2008/03/18/jpmorgans-12-billion-bailout/">https://dealbook.nytimes.com/2008/03/18/jpmorgans-12-billion-bailout/</a><br />
<br />
The problem with Bitcoin, as I see it, is that it is a commodity and not a currency. It's largely like gold, except that gold has some use outside of being a means of speculation.<br />
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While I wouldn't be surprised if Bitcoin remains marginalized, what is more important is the role that blockchain technology will play in finance in the future. Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-76851808660010603752017-08-01T14:00:00.001-04:002017-08-01T14:00:22.418-04:00The stupidest thing you can do with your money.In a recent episode, the Freakanomics podcast talks about why you should index. It's a great show - check it out: <a href="http://freakonomics.com/podcast/stupidest-money/">http://freakonomics.com/podcast/stupidest-money/</a><br />
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<br />
Interestingly, Anthony Scaramucci is interviewed as being an advocate of active management (he's the guy who ended up being fired by Trump after 10 days). Scaramucci's arguments for active management don't really make any sense - they are based on the idea that financial advisors and active management are the same thing. They are not. A good financial advisor who understands indexing is well worth the fees. Such an advisor can help in tax planning, retirement, college savings etc and provide real value to clients without ever selling an actively managed product.Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-14882782271913358082017-07-20T14:30:00.000-04:002017-07-20T14:30:03.086-04:00Why 8.5% is delusionalI am quoted today in an article on Bloomberg.com about the Connecticut pension fund return assumptions. The article is here: <a href="https://www.bloomberg.com/news/articles/2017-07-20/connecticut-sinks-deeper-in-debt-as-pension-returns-lag-target">https://www.bloomberg.com/news/articles/2017-07-20/connecticut-sinks-deeper-in-debt-as-pension-returns-lag-target</a><br />
<br />
So why is an 8.5% return assumption delusional?<br />
<br />
It's pretty simply really. Assume that your fund is 50% bonds, 50% stocks. Currently 10-year Treasuries are yielding about 2.3%. Let's round that up to say 3% to be generous. Assume an equity risk premium of 5%, and equities will return about 8%. So our hypothetical pension fund is going to earn:<br />
<br />
50% bonds + 50% equities = 0.5*3 + 0.5*8 = 5.5%<br />
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Even with a tweaking the bonds to 4%, and using a risk premium of say 6%, you are looking at:<br />
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0.5*4 + 0.5*10 = 7%<br />
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I think 7% is still pretty optimistic, but if we use today's numbers, 8.5% implies stock returns of:<br />
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8.5 = 0.5*3 + 0.5*X<br />
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Solve for X, ... go ahead, I'll wait.<br />
<br />
X = 14%. <br />
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So stocks would need to return 14% on average, implying an 11% equity risk premium. That's why it's easy to say that 8.5% or even 8% is delusional. <br />
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But just labelling something delusional doesn't really help anyone, and I appreciate this. Unfortunately to ensure a pension fund is fully funded, and meets a realistic return goal, either contributions have to increase, or payouts have to decrease. Both are hard choices and there's no easy fix. Just setting a high return merely kicks the can down the road.<br />
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<br />Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-68765838073752969902017-07-15T10:15:00.000-04:002017-07-15T10:15:28.021-04:00Will fee cutting hurt the pension fund?In an article yesterday in the News and Observer (<a href="http://www.newsobserver.com/news/business/article161425553.html">http://www.newsobserver.com/news/business/article161425553.html</a>), David Ranii explores whether fee cutting by the pension fund might hurt future returns.<br />
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It's a good article, I was interviewed for it, and I recommend that you read it. I would, however, like to add a small comment/clarification with regard to my comments within the article.<br />
<br />
While I strongly support attempts by the pension fund to reduce fees, this has to be done in a sensible manner. When high cost equity managers are liquidated, the proceeds should be put into an equivalent low cost index fund. What the pension fund has been doing is to put these proceeds into cash and fixed income. In the article, I am quoted as noting that this action will likely result in lower returns for the pension fund going forward. <br />
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The article incorrectly portrays me as in conflict with critics of the pension fund's strategy. This is inaccurate. I fully agree that cutting fees by firing equity managers and then putting the proceeds into cash is a bad idea. This will hurt future returns.<br />
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<br />Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-87448371540174158092017-06-14T11:39:00.000-04:002017-06-14T11:39:02.674-04:00Folwell reduces fees by $50mSome good news from the Treasurer's office. Apparently our new Treasurer has reduced fees by $50 million so far. He reports that he's on track to hit $200 million by the end of his first term.<br />
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<a href="http://www.newsobserver.com/news/business/article155868344.html">http://www.newsobserver.com/news/business/article155868344.html</a><br />
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This is great news. I am sure we will be digging into the numbers when the annual report comes out, but for now, this is a great start. Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-38157428464391545652017-01-25T16:20:00.001-05:002017-01-25T16:20:20.199-05:00Dow hits 20,000What does this mean?<br />
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Ummm. Not much.<br />
<br />
<a href="https://www.bloomberg.com/news/articles/2017-01-25/-time-to-get-out-as-dow-milestone-a-call-for-caution-pros-say">https://www.bloomberg.com/news/articles/2017-01-25/-time-to-get-out-as-dow-milestone-a-call-for-caution-pros-say</a><br />
<br />
Some will say that you need to get out once a milestone is met. Trouble is - when do you get back in? Oh - that's right - before the market goes back up.<br />
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Of course, 20,000 is no <a href="https://en.wikipedia.org/wiki/Dow_36,000" target="_blank">36,000</a>. We're still waiting for that one.Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-45629596058525920052017-01-03T17:38:00.002-05:002017-01-03T17:38:44.078-05:00What's the best way to protect against inflation?I was recently interviewed by Mark Hulbert for this article in Barrons:<br />
<a href="http://www.barrons.com/articles/whats-the-best-way-to-protect-against-inflation-1482943455">http://www.barrons.com/articles/whats-the-best-way-to-protect-against-inflation-1482943455</a><br />
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<br />Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-31594929791538980502016-10-26T06:00:00.000-04:002016-10-26T06:00:14.019-04:00Nevada only pays $13 Million to run its $35 Billion pension fund!A recent article in the <a href="http://www.wsj.com/articles/what-does-nevadas-35-billion-fund-manager-do-all-day-nothing-1476887420" target="_blank">Wall Street Journal </a>is getting some attention - as it reports that Nevada only pays $13 million to run its $35 billion Pension Fund. To put this in perspective; North Carolina pays 12 times as much, even after you take account of the size differences in the plan.<br />
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So how does Nevada keep costs so low? The answer is simple: the plan is indexed.<br />
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Not only are the costs super low, the performance is pretty good. Ron Elmer <a href="http://investorcookbooks.blogspot.com/2016/10/nevada-does-not-gamble-with-their.html" target="_blank">runs the numbers </a>and finds that over 10 years, Nevada's plan earned 6.2% while NC earned 5.5%. A difference of 0.7%. <br />
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Together with a few others (<a href="http://investorcookbooks.blogspot.com/2013/02/wall-street-fees-explode-in-north.html" target="_blank">Ron Elmer,</a> <a href="http://meditationonmoneymanagement.blogspot.com/2016/08/north-carolinas-public-pension-is.html" target="_blank">Andy Silton</a> and <a href="http://www.charlotteobserver.com/news/business/banking/article9101813.html" target="_blank">SEANC</a>), I've been <a href="http://financeclippings.blogspot.com/search/label/north%20carolina" target="_blank">advocating</a> indexing for the NC Pension Fund for quite a while now and we've struggled to see any meaningful change. But now we're now in a position to elect a new state Treasurer.<br />
<br />
Recently - WRAL's "On the record" interviewed both candidates - you can see the video here.<br />
<a href="http://www.wral.com/candidates-for-state-treasurer-go-on-the-record-/16005623/" target="_blank">http://www.wral.com/candidates-for-state-treasurer-go-on-the-record-/16005623/</a><br />
(start at the 18 minute point).<br />
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Of the two candidates, I think that Dale Follwell understands the problems and has a realistic approach, so I'll be voting for him.<br />
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Just as a point of clarification (this came up in the video) - there is a huge difference between the funding of the plan and the performance of the plan.<br />
<ul>
<li>A plan's funding level is based on how much money is put into the plan - basically - has the state honored its obligation to fund the plan?</li>
<li>A plan's performance is based on the investment choices that the plan makes. Poor investment choices (and high fees) result in lower performance and can negative impact the funding level. These choices are largely controlled by the Treasurer.</li>
</ul>
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<br />Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-32228702428538947542016-10-03T13:10:00.000-04:002016-10-03T13:10:07.757-04:00You can't consistently beat the market. Just ask Harvard.Harvard University has been lamenting a substantial loss in the value of their endowment. Apparently about $2 Billion. See:<a href="http://www.chronicle.com/article/What-a-2-Billion-Loss-Really/237965">http://www.chronicle.com/article/What-a-2-Billion-Loss-Really/237965</a><br />
<br />
Harvard has chased all sorts of exotic strategies, including private equity and hedge funds and yet - to quote the above article:<br />
<span style="background-color: white; color: #333333; font-family: Heuristica, 'Times New Roman', Times, serif; font-size: 18px; font-variant-ligatures: normal; orphans: 2; widows: 2;"><br /></span>
<blockquote class="tr_bq">
<i><span style="background-color: white; color: #333333; font-family: Heuristica, 'Times New Roman', Times, serif; font-size: 18px; font-variant-ligatures: normal; orphans: 2; widows: 2;">"...if Harvard had passively invested in a standard mix of 60 percent stocks and 40 percent bonds, it would have gotten a higher rate of return — 8.9 percent over the past five years, versus 5.9 percent with its active in-house management, according to</span><a href="https://www.bostonglobe.com/business/2016/09/22/harvard-endowment-investment-return-drops-percent/e6Jj6GYxhpLOnpVH6kPI3L/story.html." style="background-color: white; box-sizing: border-box; color: #007aad; font-family: Heuristica, 'Times New Roman', Times, serif; font-size: 18px; font-variant-ligatures: normal; orphans: 2; text-decoration: none; widows: 2;"> The Boston Globe.</a>"</i></blockquote>
<br />
What's worse, is that Harvard was paying its money managers millions to come up with these strategies. While Harvard is clearly one of the premier academic institutions in the world, this status does not give it the ability to beat the market. Other institutions (I'm looking at you NC Pension Fund) would do well to learn from this.Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0tag:blogger.com,1999:blog-7250395384138708711.post-56179161122634696582016-09-12T18:00:00.000-04:002016-09-12T18:00:33.921-04:00Money Monster - a reviewI just watched "<a href="https://www.youtube.com/watch?v=qr_nGAbFkmk" target="_blank">Money Monster</a>". It's a thriller staring George Clooney and Julia Roberts that's basically a mashup of <a href="http://www.cnbc.com/mad-money/" target="_blank">Jim Cramer</a> meets the<a href="https://en.wikipedia.org/wiki/2010_Flash_Crash" target="_blank"> flash crash</a> meets (fill in your evil corporation here).<br />
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The movie is OK, if you don't know much about finance. However, if you do happen to know a little bit about how markets actually work, you'll be cringing all the way through. <br />
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The basic plot: Clooney is a TV star (a la Cramer) who runs a stock picking show. Roberts is his producer. At some point Clooney had recommended a stock (in an evil corporation called IBIS) and said it was as safe as a savings account (<a href="http://financeclippings.blogspot.com/2008/03/cramer-master-of-double-meaning.html" target="_blank">sound familiar?</a>). Some guy looses his savings in this stock and comes to the studio and takes Clooney hostage. Drama ensues until there is a showdown with the evil corp CEO who admits defrauding the stockholders. The hapless investor gets shot by the the police, and Clooney suffers a bad bout of <a href="https://en.wikipedia.org/wiki/Stockholm_syndrome" target="_blank">Stockholm Syndrome</a>.<br />
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Here's what drove me crazy.<br />
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Apparently the evil CEO had manipulated his stock price (no explanation of how) so that it crashed and lost $800 million of investors money. He then took this money and bribed a South African union to strike at a mine in South Africa. With the strike underway, he ploughed his $800 million into this mining stock. His brilliant plan was to call off the strike and cash in when the stock went up in price.<br />
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What is so stupid about this, is how on earth the CEO was able to extract the $800 million due to the decline of IBIS corp's stock? All I can think of was that he must have shorted the stock and then announced some very bad news. But such an action would have been such a blatant case of insider trading that the Feds would have been all over it. And anyway, there was no mention of the CEO saying anything. In the movie the price crash is a mystery to the media and to folks at IBIS.<br />
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In reality, the writers of the movie clearly don't understand what happens when a stock price falls. They seem to think that the reduction in value must have wound up in someone's pocket. And of course, who else but an evil CEO. To make a movie about finance and not understand the basic premise of the stock market really boggles the mind.<br />
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What's even more confusing was that IBIS corp apparently hires its own "quants" to run HFT trading strategies on its own stock. Why? Are they buying on IBIS corp's account? Is this some sort of repurchase program? I just don't get it. But the kicker is that the HFT guys hardly trade at all on the day of the IBIS corp stock crash. To quote the movie: "it has someones fingers all over it".<br />
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One more stupid thing:<br />
They send a producer to the SEC to find out what is going on. He comes back with a piece of paper that says that the volume was down 80% on the crash day. Umm, you don't need to go to the SEC to find that stuff out. Try yahoo finance instead.<br />
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So unless you really like Clooney and Roberts, give this one a miss. Watch "the big short" instead.<br />
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<br />Richhttp://www.blogger.com/profile/16883355600904464858noreply@blogger.com0