Lloyd's Investment Blog

Attractive Relative Value in Chinese "BATJ" vs. U.S.-Based "FANG" Stocks

noreply@blogger.com (Lloyd Sakazaki) — Wed, 03 May 2017 19:24:00 +0000

Consider the basic economic truth that faster GDP growth corresponds to higher revenue and earnings growth for companies, typically leading to higher stock returns over the long run. With this principle in mind, let's take a look at the current market situation involving large-cap Internet stocks.

Due to governmental restrictions limiting access of companies seeking to do business in China, the global Internet economy naturally divides into two geographical regions:

U.S.-based "global" Internet companies doing business everywhere except China: Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Google/Alphabet (GOOG), comprising the four so-called "FANG" stocks, represent the ex-China Internet economy; and
Chinese Internet companies doing business primarily in China: Baidu (BIDU), Alibaba (BABA), Tencent (TCEHY) and JD.com (JD), being the so-called "BAT" stocks plus JD.com, represent the analogous China-centric "BATJ" foursome.

As is reasonably expected in China's developing economy (annual GDP growth = 6% to 7%) which is growing faster than the global economy (annual GDP growth = 3%), the Chinese "BATJ" Internet stocks exhibit both historical and forecast revenue growth rates that are higher than growth rates for their U.S.-based "FANG" counterparts:

Between 2013 and 2015, the "BATJ" companies (revenue growth = 42% to 55%) showed average revenue growth about 20 percentage points higher than the "FANG" companies (revenue growth = 25% to 31%);
For 2016, the average revenue growth figures are comparable;
For 2017 and 2018 (based on analysts' consensus estimates), the "BATJ" companies (revenue growth = 27% to 37%) are again ahead of the "FANG" companies (revenue growth = 21% to 27%), now by 6 to 10 percentage points.

Contrary to expectation based on revenue growth, observe that over the past five years the Chinese "BATJ" stocks have actually underperformed the U.S.-based "FANG" stocks. Between year-end 2012 and yesterday (May 2, 2017),

$100 invested in an equally weighted (25% in each of four stocks) "FANG" portfolio, rebalanced annually, would have grown to $581, while
the same amount of money ($100) similarly invested in the "BATJ" portfolio (with Alibaba and JD.com purchased at the end of 2014 following their IPOs) would have resulted in the lesser sum of $315.

Using analysts' consensus estimates of next year's (calendar year 2018) earnings per share and earnings growth, we can examine current market valuation by considering the PEG ratio (P/E divided by earnings growth rate). The table and graph below show this PEG ratio for both "FANG" and "BATJ" stocks. Observe how the "BATJ" stocks (average PEG = 0.76) are currently trading at a more attractive (less expensive) average PEG ratio than the "FANG" stocks (average PEG = 1.08).

The outperformance of the "FANG" stocks over the past four to five years is reflected in the richness of their PEG ratio relative to the "BATJ" stocks:

(2013-2017YTD return of "FANG")/(2013-2017YTD return of "BATJ") = 581/315 = 1.84
(2018 PEG of "FANG")/(2018 PEG of "BATJ") = 1.08/0.76 = 1.42.

In other words, if the Chinese "BATJ" stocks were to rise 42% relative to the U.S.-based "FANG" stocks, the Chinese and U.S.-based stock porfolios would show comparable valuation ratios. Such a prospective rise of the value of the Chinese portolio would close much of the performance gap between the two portfolios that has accumulated over the past four to five years.

Therefore, a rational investor might expect, assuming all else equal, to see general outperformance of Chinese Internet stocks relative to U.S.-based Internet stocks over the next few years.

(Disclosure: Author currently manages portfolios long BIDU and BABA.)

Net Worth Iso-Percentiles Across Age Brackets: The Wealth and Poverty of Our Nation In Five Pictures

noreply@blogger.com (Lloyd Sakazaki) — Tue, 10 Feb 2015 04:40:00 +0000

The Rich . . .
(the 90th percentile and above, where the top 0.1%, the top 1%, and the top 10% reside)

. . . the Upper Middle . . .
(the 70th to 90th percentile, where college graduates tend to gather)

. . . the Middle . . .
(being the 30th to 70th percentile middle, the "heart of America")

. . . the Lower Middle . . .
(the 10th to 30th percentile, where iso-percentiles continue rising even into the septuagenarian and octogenarian age brackets)

. . . and the Poor
(the 10th percentile and below, including those over-indebted with negative net worth)

Data Source and Methodology: All data are extracted from the Federal Reserve's 2010 Survey of Consumer Finances, with data set last updated September 4, 2014. The Net Worth dollar figures are for households, inflation-adjusted to 2013 dollars. Percentiles are calculated by a) ordering the data by net worth within each age bracket and b) accumulating the statistical weights (included in the data set and associated with the Fed's multiple imputation technique) corresponding to the ordered data points.

Fed's Technical Note: "Missing data in the survey have been imputed five times using a multiple imputation technique. The information is stored in five separate imputation replicates (implicates). Thus, for the 6,492 families interviewed for the survey, there are 32,460 records in the data set. Ten observations were deleted for the public version of the data set for purposes of disclosure avoidance; thus, there are 32,410 records in the public data set for 6,482 families."

The Shape of History: From Predictable West-East Oscillations to Mind-Boggling Singularity (or Nightfall?)

noreply@blogger.com (Lloyd Sakazaki) — Mon, 10 Feb 2014 01:42:00 +0000

(Below is commentary on a history book worth reading: Ian Morris, Why the West Rules—For Now: The Patterns of History and What They Reveal About the Future. New York: Farrar, Straus, Giroux, 2010. The well-written work offers valuable historical and geographical insight, providing indispensable background reading for any investors trying to make sense of global investment opportunities today.)

Ian Morris’s Why the West Rules—For Now is the most engrossing, expansive, evidence-based, single-volume story of humankind written to date. The author’s personable presentation is an interdisciplinary magnum opus of big-history theorizing rooted in essential bean-counting analysis, running from the beginning of observable space-and-time over 13 billion years ago to our present-day global village, and even boldly projecting our (accelerating) development out into the foreseeable future (year 2103). No work better bridges the gap between the humanities and the sciences—the book should be required summer reading for all freshmen entering college.

Morris’s thesis can be expressed in three words: “Maps over chaps.” That is to say, for measuring human “progress” (defined, following Herbert Spencer, as: when the simple becomes more complex), geography (maps) has more explanatory power than biology and sociology (chaps—O.K., the author is British, and “humans and their relationships” hardly has the same snappy ring that “chaps” does). Morris systematically tracks a “morally neutral” social development index (additional detail available) consisting of four components—energy capture, urban population, information processing, and war-making capacity—for both a Western core (SW Asia/Europe/U.S.) and an Eastern core (China/Japan) from 14,000 BCE to the present. His thorough analysis explains how any historical West-East developmental differences are best attributable to geography, not race and culture, and how both long-term lock-in (West always ahead) and short-term accident (change driven by one-off flukes) models fail to explain the (oscillatory) patterns of history. “Each age gets the thought it needs, dictated by the kind of problems that geography and social development force on it. . . . [P]eople accommodate their culture to the needs of social development,” says Morris. (Note: Jared Diamond explained how geographical advantage led to Eurasia’s socioeconomic domination over other continents. Morris uses geography to explain differences in development between the Western and Eastern cores within the Eurasian continent.)

Keeping Score

Archeology reveals how biologically “modern” Homo sapiens walked out of Africa about 60,000 years ago, replacing Neanderthal, Peking Man and other varieties of humankind who had left Africa earlier. Morris’s historical account “keeps score” as leadership oscillates between West and East, impacted by semi-hard ceilings on growth, paradoxical disadvantages of development, and oxymoronic advantages of backwardness:

14,000 BCE to 600 CE: West is ahead of East for almost 15,000 years. Following the receding of the Last Glacial Maximum around 14,000 BCE, humans transition from roaming hunter-gatherers to settled agriculturalists, beginning in the most fertile areas (Hilly Flanks and Mesopotamia, and Yellow-Yangzi river valleys) of the Eurasian continent. Villages become cities, then kingdoms and empires. Megalomaniacal monuments include King Khufu’s 450-foot-high Great Pyramid in Egypt and the First Emperor’s 6,000-strong clay-soldier Terracotta Army (discovered only in 1974) in Chang’an (now Xi’an). During the Axial Age from around 500 BCE, the moral foundation of “Man, as we know him today, came into being” (Karl Jaspers), with Confucian and Daoism (East), Buddhism and Jainism (South Asia), Greek philosophy and Judaism, Christianity and Islam (West). By 1 CE, core population soars: Rome (population 1 million) and Chang’an (pop. 500,000) in the Roman Empire and Han China, respectively;
600 CE to 1750 CE: East moves ahead of West for about 1,000 years. Completion of the Grand Canal during the early 7^th century Sui Dynasty catalyzes growth, continuing into the Tang and Song Dynasties with Empress Wu Zetian in sprawling Chang’an and ironmasters in coal-rich Kaifeng (pop. 1 million each), the Yuan Dynasty with Marco Polo at Kubilai Khan’s court in the 1270s, the 15^th century Ming Dynasty with admiral Zheng He’s 300-vessel Treasure Fleets carrying 28,000 men, and the middle of the Qing Dynasty in the 18^th century. During this time, the Roman Empire crumbles, Western development shifts to peripheral areas with expansion of the Habsburg, Holy Roman, Ottoman and Russian empires, and growth later returns to Italy during the Renaissance with Leonardo da Vinci, followed by Kepler in Germany and Newton in England (*); and
1750 CE to Present: West surges ahead of East for about 250 years. Factors driving the rise of the West are: the relative ease of traversing the Atlantic (the Pacific is broader and more difficult to sail round-trip), closure of the steppe highway by Romanov and Qing gun power (incidentally protecting Europe from disruptive invaders), and the higher economic incentive the West has to go East (appetite whetted by Marco Polo’s tales) than the East has to look West (China stops funding voyages showing little to no economic payoff). The 18^th century Enlightenment is propelled by science and technology (Boulton and Watt’s efficient steam engine) and finance (banking hub in the Netherlands), and growth shifts to northwestern Europe (factories in Britain), followed by the U.S. (industrialization, stock ownership, and consumerism). In the East, the core shifts to Japan (Tokyo is now the world’s largest urban area with 27 million people) before returning most recently to China. The result is our present-day, precarious, China-as-creditor/America-as-debtor arrangement (coined “Chimerica” by historian Ferguson and economist Schularick).

Next comes Morris’s educated guess about what will happen next:

Future: East again catches West. “As surely as geography dictated that the West would rule, it also dictates that the East will catch up, exploiting the advantages of its backwardness until its social development overtakes the West’s.”

“But here we encounter another irony. Rising social development has always changed the meaning of geography, and in the twenty-first century, development will rise so high that geography will cease to mean anything at all. The only thing that will count is the race between a Singularity and Nightfall.” (p. 619)

If the “five horsemen of the apocalypse” (climate change, famine, mass migration, epidemic, and state failure) trample humankind during the next few decades, we will succumb to Isaac Asimov’s terrifying Lagashian Nightfall before reaching Ray Kurzweil’s enthusiastic vision of the Singularity, when human and machine intelligence (are projected to) merge by around 2040. Morris’s extrapolation of his social development numbers shows East surpassing West around 2100; however, ironically, if we are “fortunate enough” to reach the Singularity before Nightfall, the distinction between West and East will no longer matter. By that time, as “machine-enhanced, post-biological creatures,” we will come to realize the irrelevance of the quaint “West vs. East” squabbling that once preoccupied us when we were “mere biological humans” earlier in our evolutionary history!

If Morris’s informed wisdom is right, our future will be even weirder than Thomas Friedman’s “global weirding” (which itself is weirder than global warming). Get used to it. Prepare to see a warping of the shape of history over the next few decades as social and technological change accelerates to infinite speed! (**)

Towards a More Inclusive Theory

But, wait a minute. Is Morris right about our future? What if, instead of experiencing a Singularity, we continue to muddle through at conventional evolutionary speed?

Surely, Morris is a unifier. By analogy, he is archeology and history’s Newton (classical mechanics) or, better yet, a Maxwell (classical electromagnetism), but not yet an Einstein (seeker of a complete unified field theory). Similar to Maxwell, who taught us that light is a combination of electric and magnetic phenomena, Morris provides a way of viewing humanity across the West-East divide. However, extending beyond Eurasia-centric West and East, a more comprehensive theory would need to include at least South and Southeast Asia (with India, Pakistan and Bangladesh, Indonesia and the Philippines), South and Central America (with Brazil and Mexico), and Africa (which by 2100 is projected to have 11 of the top 20 countries by population, including Nigeria, Tanzania, DR Congo, Ethiopia and Uganda in the top 10). In a sense, Morris’s focus on Eurasia is an example of what he elsewhere calls “chainsaw art,” making crude cuts to exhibit gross features, while ignoring finer detailing. Because in science a single exception is sufficient to invalidate a theory, the greater diversity of our world requires a broader scope encompassing the developmental history of all geographical regions, not just Eurasia.

Perhaps a more inclusive theory would shed light on the likelihood of some other region of our world rising to global leadership as we muddle along, “rarely knowing what we are doing,” as Morris says. If it is true that “people—in large groups—are all much the same,” what is to prevent a crowded India, resource-rich Brazil, or quickly expanding Nigeria from one day leading the pack? After all, they too must be as “lazy, greedy and frightened” as Eurasians, also “looking for easier, more profitable, and safer ways to do things,” right? As technology becomes more available and affordable (ever ponder what happens when 3D-printing extends to food?), more rapid oscillations in development and shifts in world leadership could conceivably lie ahead.

Maybe a Singularity (or Nightfall) really is the most probable outcome, but from my humble perspective, claiming that cultural distinctions will be erased through a Singularity appears to be the “lazy” way out of a messy, multi-continental analysis—one that, if done properly, should embrace all of the greater complexity inherent in the colorful history and cultural diversity of humankind.

In Morris’s recounting, both “Albert in 1848 Beijing” and “Zheng in 1431 Tenochtitlan,” of course, were only fictional. How about “Morris in the 2040 Singularity”? Ian Morris was born in Stoke-on-Kent (also called Potteries—think “Wedgwood”), England, in 1960, and as a teenager in 1970s Britain “sat around wearing American jeans, watching American films, and playing American guitars.” In the early 2000s, when Professor Morris was busy at Stanford researching and writing Why the West Rules—For Now, “the China price” became “the three scariest words in U.S. industry,” as made-in-China anything and everything hollowed out American manufacturing. By the time the 2040s come around, will Chimerica prove to be reality or chimera? By 2050, I hope to read Professor Emeritus Morris’s sequel, Why the West-East Divide No Longer Matters—For the Singularity is Here! Or, might it be, Why the East Now Rules—For the Singularity Will be Late in Arriving? Or, maybe even, Why Africa Rules—A Fortuitous 60,000 year Homecoming?

(*) On p. 113 of Why the West Rules—For Now, Morris mentions Leo Tolstoy’s “odd excursus denying free will in history.” He offers a slightly modified quote from the Second Epilogue, Chapter 11, of Tolstoy’s War and Peace that cites the laws of Kepler and Newton. Next, Morris calls Tolstoy’s thinking “high-level nonsense.” In my opinion, Morris is being (uncharacteristically, for his writing is otherwise quite level-headed and gentlemanly) too harsh and judgmental here. As the next and final chapter in the Second Epilogue of War and Peace reveals, Tolstoy is posing two viewpoints for understanding history—an older one based on Ptolemaic-style individual free will (what Morris calls, “great men and bungling idiots”) and a newer one based on Copernican-style universal natural law (science-based). Among these opposing viewpoints, Tolstoy states an intellectual preference for the utility of the universal-law approach over postulating individual free-will-based causes to explain historical events.

Tolstoy mentions an interesting analogy: Just as we do not feel the earth’s motion (we think we are not moving) but must admit it (our motion) to understand the laws of astronomy, we also are not conscious of our dependence on everybody and every thing around us (we think we have free will) but must admit it (our lack of true freedom) in order to understand the laws of history. In other words, as Einstein was so adept at showing us through his Gedanken experiments relating to relativity, one’s frame-of-reference matters, especially when theorizing. Personally, I find more harmony than discord in the philosophy behind Tolstoy’s “odd excursus” and Morris’s own style of analysis.

(**) As if global weirding and the Singularity are already not weird enough, consider philosopher Nick Bostrom’s “simulation argument” which, for our purposes, essentially states: Assuming that a) the human species will most likely not become extinct before reaching “post-human” stage (i.e., we avoid Nightfall), and b) advanced civilizations, including our own, are prone to running simulations of their evolutionary history (and variations thereof), we are forced to conclude that, although we feel that we are “truly real” flesh and bones, we are, like it or not, almost certainly “merely artificial” beings living inside of a more advanced civilization’s simulation. Now, that’s quite a humbling predicament for any free-willed humanist, isn’t it?

On Wealth Accumulation and Inheritance

noreply@blogger.com (Lloyd Sakazaki) — Tue, 13 Apr 2010 04:40:00 +0000

While most of us are busily engrossed in our oh-so-American habit of trying to accumulate unbounded wealth, it is instructive to remind ourselves of the words of philanthropic wisdom penned by Andrew Carnegie more than a century ago:

"[T]he duty of the man of wealth . . . [is] to set an example of modest, unostentatious living, shunning display or extravagance; to provide moderately for the legitimate wants of those dependent upon him; and after doing so to consider all surplus revenues which come to him simply as trust funds which he is called upon to administer . . . to produce the most beneficial results for the community." (Andrew Carnegie, from essay on "Wealth" published in the North American Review, 1889)

A quintessential living example of Carnegie's model philanthropy of 1) living frugally, 2) providing modestly for the material well-being of family members, and 3) giving the remainder back to the community, is Chuck Feeney, the so-called "billionaire who wasn't":

"He was prepared [in 1997] to reveal his secret to the world, that he was not a billionaire, as he was usually referred to in the business pages, and that he had long ago given everything, including his DFS [Duty Free Shoppers] shares and his businesses, to his two philanthropic foundations, the Atlantic Foundation and the Atlantic Trust, based in Bermuda. He was personally worth less than $2 million, a fact known only to a tight circle of family and friends. . . ." (excerpt from Conor O'Clery, The Billionaire Who Wasn't: How Chuck Feeney Secretly Made and Gave Away a Fortune, 2007)

Apparently, at least for Feeney in 1997 at the age of 65, less than $2 million out of his $4 billion fortune is all that he felt necessary to retain to assure his (and his wife's) own personal financial security during the remainder of their lifetime.

Taken together, the above two quotes on philanthropy provide what I consider to be valuable ancillary guidance on inheritance, particularly for any parents deliberating over how much wealth to leave to their children:

a. "Provide moderately for the legitimate wants of those dependent upon [them]": Though Carnegie is not more specific on this point in his "Wealth" essay, it seems fair to interpret "legitimate wants" to range from basic needs to a modest though comfortable lifestyle, and "those dependent on [them]" to refer to children of minor age and any dependents of majority age in need of funds due to illness, unemployment or other significant financial setbacks in life;

b. "Less than $2 million": If a person who made not "just" millions but billions of dollars can feel secure retaining less than $2 million in personal wealth, then we can reasonably infer that anyone outside of this rarified circle of billionaires ought to require no more than $2 million to feel materially content. In other words, we should interpret $2 million as an upper limit on the total amount of accumulated wealth that a single individual or married couple could possibly require to meet personal needs, including whatever earnings and savings they are able to realize through their own efforts prior to considering any inheritance.

The implication here is that parents should not feel obligated to bequeath to their children any more than $2 million minus whatever the children are able to accumulate through their own careers, and for children with high earnings power this means no inheritance whatsoever is in order. As Carnegie states, most giving spreads "a spirit of dependence on alms, when what is essential for progress is that they [the recipients] should be inspired to depend on their own exertions." In an even earlier age, Plutarch issued the warning, "he that first gave thee money made thee idle, and is the cause of this base and dishonorable way of living."

My own view is that the best gift that parents can provide their children is making sure that the children learn by the time they reach adulthood how to educate themselves, earn their own living and save for retirement through their own effort and ingenuity, without counting on any inheritance to be forthcoming from parents or the proverbial "rich uncle." Large gifts of money and assets unfortunately subject recipients to the risk of reduced motivation and deflated self-esteem, arguably to a larger extent than providing any real benefit to their material well-being. After children reach adulthood, parents should, while continuing to offer open-minded and big-hearted emotional support, provide for their children (and grandchildren) not much more than a financial safety net, similar in substance to temporary unemployment benefits--all in the spirit of, as Carnegie put it, "helping those who will help themselves."

How Guessing Market Direction Can Be PREDICTABLY Bad for Your Financial Health

noreply@blogger.com (Lloyd Sakazaki) — Wed, 20 Jan 2010 22:17:00 +0000

"The game is called probability guessing. . . . [S]ubjects are shown a series of cards or lights which can have two colors, say green and red . . . appear[ing] . . . with different probabilities but otherwise without a pattern. . . . The task of the subject, after watching for a while, is to predict whether each new member of the sequence will be red or green. . . . Humans usually try to guess the pattern, and in the process we allow ourselves to be outperformed by a rat. . . ." (excerpt from Leonard Mlodinow's The Drunkard's Walk--How Randomness Rules Our Lives, 2008)

In a stock market context, the probability guessing game described above would read like this: In any given year, the stock market either rises (green) or falls (red). If we look over the past six decades, from 1950 through 2009, we find that during the sequential decades (1950s, 1960s, and so on) the S&P 500 Index rose in 8, 6, 7, 9, 8 and 6 out of the 10 years (using data from Yahoo! Finance). In other words, during a "typical" decade annual stock market returns are "green" about 7 or 8 out of the 10 years, and "red" about 2 or 3 out of the 10 years. Based on these historical data, we can infer that the stock market tends to rise during any particular calendar with a probability of about 75%, and fall with a probability of about 25%. As investors, we, of course, would like to try to predict whether this year (or next year, or any future year for that matter) will be green or red.

For us investors, the million-dollar question is: Should an investor attempt to "time" the market, by investing in stocks during years the market is more likely (in the investor's opinion) to rise and staying out of the market during other years when the market is more likely (again, in the investor's opinion) to fall?

Obviously, if the investor truly has enough information, foresight or precognition to know with a high degree of certainty when the market will rise or fall, then market-timing makes perfect sense and will lead to higher returns. However, what happens if the investor only believes that he knows but actually does not, so that for all practical purposes the investor is really faced with the 75% green versus 25% red probabilities described above? Is any harm done by guessing?

Analogous to the general guessing game Mlodinow mentions in his book, let's consider two strategies:

1. Buy-and-Hold Strategy: Since the market rises during 75% of the years, one could just go long the market by buying an exchange-traded fund tracking the S&P 500 Index (or buying individual stocks), without attempting to time the market at all. A buy-and-hold investor can expect to generate positive returns 75% of the years but must also accept the unavoidable "fact" that the market will typically fall 25% of the time. In this "simpleton" strategy, an investor's long-run win percentage (i.e., the percentage of years the investor's portfolio will show positive returns) is expected to be 75%;

2. Market-Timing Strategy: A presumably more "sophisticated" investor will, through some combination of fundamental and technical analysis and application of his general intelligence and market wisdom, come up with a convincing explanation for why the market is more likely to rise (or fall) during any particular year. Believing he can distinguish beforehand (i.e., predict) which years are among the 75% "green" years when the market will rise and, likewise, which years are among the 25% "red" years when the market will fall, such an investor will want to go long 75% of the time and stay out of (or go short) the market 25% of the time.

If the bright and sophisticated market-timing investor has an "edge" over the the naive and unthinking buy-and-hold simpletons, then he will end up being right more than 75% of the time and will show higher long-run returns. At the other extreme, if it turns out that the market-timer only believes he has an edge but actually does not, one would think that his edge would just vanish and there should be no penalty for guessing, right?

Well, you might think that guessing carries no penalty, but that's actually wrong! Quite counter-intuitively, investors should expect lower returns when they guess. Here's why.

Let p be the (stationary) probability that the the market will rise in a given year, i.e., p = 0.75, representing the 75% "green" probability. Supposing that the market-timer's guesses do not give him any significant edge, his overall win percentage is given by a straightforward weighted-probability calculation:

Market-Timer's Win Percentage
= (Portion of time the market-timer goes long) x (Probability that market rises)
+ (Portion of time the market-timer stays out of market) x (Probabiility that market falls)
= p x p + (1 - p) x (1 - p)
= p² + (1 - 2p + p²)
= 2p² - 2p + 1.

On the other hand, the Buy-and-Hold Investor's Win Percentage is just p, as we saw earlier. Consequently, we may write that the expected potential downside of the market-timing strategy versus the buy-and-hold strategy is the difference:

(Buy-and-Hold Investor's Win Percentage) - (Market-Timer's Win Percentage)
= p - (2p² - 2p + 1)
= -2p² + 3p - 1
= 2(p - 0.5)(1 - p),

where the last expression is the factored-form equivalent of the quadratic polynomial in the previous line.

From the factored-form expression, we can easily see that whenever p is in the "physical" range (i.e., consistent with the probabilities indicated by market history for a wide variety of investment time windows) from 0.5 to 1.0, a buy-and-hold investor is expected to outperform any market-timer who is really just guessing without appealing to any special knowledge of market direction. In particular, when p = 0.75 (which is the historical win-percentage for a sequence of annual returns), the Market-Timer's Win Percentage becomes 2(0.75)² - 2(0.75) + 1 = 0.625, or 62.5%, which is 12.5 percentage points worse than the Buy-and-Hold Win Percentage of 75%.

Therefore, to the extent that a market-timer is "only guessing" (and who can really be so certain?) about market direction, he is (presumably unknowingly) effectively "shooting himself in the foot," following a self-destructive path of degrading his expected returns by staying out of the market 25% of the time (by the way, shorting the market 25% of the time would make matters even worse). Despite his seemingly sophisticated ways, this market-timer can actually be expected to underperform the simpleton buy-and-hold investor in the long-run.

Lesson: Don't attempt to "time the market" unless you are absolutely certain that your market-timing strategy actually works, since your expected downside from "believing without knowing" far exceeds your time spent strategizing, not to mention your trading costs and commissions consumed.

Perpetual Income Generation

noreply@blogger.com (Lloyd Sakazaki) — Fri, 04 Sep 2009 20:23:00 +0000

A student who earned a few thousand dollars over the summer working remarked to me yesterday, "I don't know how I'm going to spend the money if I don't use it to travel over the holidays."

At first, this statement seemed quite innocuous, in line with what I have come to expect in our work-and-spend, consumer-oriented society. People earn money working and then, quite predictably, spend the bulk of their earnings soon thereafter, buying all types of consumer goods and services with whatever remains after paying for life's essentials.

Three Personal Financial Management Philosophies

Upon further consideration, I became struck with just how one-sided the student's attitude on what to do with his money is. On the spectrum of personal money management philosophies, he is at the consumerist end of the two extremes:

Consumerist Philosophy: Earn and spend; earn and spend; earn and spend. In short, spend all of today's earnings on consumer items, because another paycheck will always come "tomorrow." Examples of this type of philosophy include people who live paycheck-to-paycheck more by choice than circumstance, the young woman from England who won a multi-million dollar lottery six years ago at the age of 16 and now regrets having spent all of the money so frivolously, and highly successful, high-income celebrities like photographer, Annie Leibovitz, and singer, Michael Jackson, who, despite their millions in earnings, have ended up "awash in debt" due to their personal financial management, or lack thereof.

Wealth Accumulator's Philosophy: What's important is accumulating as much wealth as possible during one's lifetime. Be frugal, even to the point of being miserly. Save as much as possible from one's earnings, prudently invest one's savings, and reinvest as much as possible of one's investment earnings. An example of this type of thinking is self-made billionaire, Warren Buffett, who not only is worth some $40 billion but is rumored to have once stooped down to pick up a penny in an elevator, remarking to those around him, "This is the start of my next billion."

My opinion is that most of us will be best off following neither of the above extremes but, instead, adopting a middle-of-the-road philosophy, which emphasizes neither consumer spending nor wealth accumulation:

Perpetual Income Generation: Use one's "excess" earnings (i.e., whatever is not needed to pay for basic necessities) from work and investments to build an investment portfolio that will reliably generate long-term income to cover all of life's expenses. The focus here is neither on spending all of one's earnings, just because one has money currently available to spend, nor on stockpiling cash without limit, primarily to see how much wealth one can accumulate. Rather, the core of this philosophy is to accumulate enough wealth to reach an ongoing state of financial independence, which means that the income generated from one's investment portfolio should over time be enough to support one's lifestyle without relying on external employment.

Historical Analogies

I'm now reading Jared Diamond's insightful work, Guns, Germs, and Steel, which discusses how and why some societies developed farming and technologies and came to dominate societies that remained hunter-gatherers throughout the millennia since the most recent Ice Age some 13,000 years ago. We can draw a simplistic analogy between hunter-gatherer societies and the consumerist philosophy mentioned above, since both emphasize current consumption without any significant savings component. Similarly, agricultural societies may be compared to the wealth accumulator's philosophy, since any excess harvest can be stored or sold for income, allowing for investment in technology development, which in turn can be used to promote further wealth accumulation.

As Diamond mentions, the recurring pattern throughout history has been that agriculture-based societies have not only developed better technology but have also deployed it to exploit societies having more primitive technology. A striking 19th century example is how, in December 1835, a group of 900 Maoris from New Zealand's North Island sailed 500 miles east to the Chatham Islands and conquered a peaceful society of 2,000 Moriori hunter-gatherers, brutally and indiscriminately killing men, women and children who refused to become their slaves. Apparently, what induced the Maoris to attack the Morioris en masse was news from a seal-hunting ship that visited the Chathams, revealing islands rich in shellfish, eels and berries, with inhabitants who "do not understand how to fight, and have no weapons."

Such are the tragic consequences of the collision of societies. Other well-known examples range from the probable driving of the Neanderthals into extinction by Cro-Magnons some 40,000 years ago, to Cortes's and Pizarro's 16th century conquests of the Aztec and Inca empires, respectively, to the so-called Manifest Destiny of European settlers in the 19th century to expand across North America, decimating native Indian tribes in their path.

I mention these historical analogies because of the perspective they bring to personal financial management. As history shows, societies that have had a "savings" component in their culture have inexorably won an upper hand over societies with more purely consumption-oriented habits. If taken to the extreme, this might seem to indicate that pure wealth accumulation should be, at least from a survival point of view, our preferred personal financial management strategy. Hence, my advice to the student I mentioned at the outset could be to save all of his summer earnings in order to maximize wealth accumulation, but is this really best?

Goal: Perpetual Income

Pure consumers live for the present, much as hunter-gatherer societies have throughout history. On the other hand, pure wealth accumulators emphasize the future, based on a "stockpiling" mentality that always favors acquiring more, no matter how much one already has. Rather than simply consuming or saving, it is, in my judgment, critical to forecast one's future financial needs and reach the right balance between consumption and savings that will best optimize one's overall life satisfaction.

So, my advice to the student is: Instead of focussing on how to spend your earnings, or saving all of it for the future, ask yourself how best to utilize your earnings to begin to create a perpetual income stream that will allow you to gain financial independence and support your future lifestyle. Your focus should be neither on consumption nor on wealth accumulation, but on how best to employ your earnings, consumption, savings and investments to one day to replace your own labor as the primary source of income in your life. (Note: Some people call it "retirement," but for me it's closer to financial "rebirth.")

College and Salary: "With Whom" You Study Matters as Much as "What" You Study

noreply@blogger.com (Lloyd Sakazaki) — Thu, 20 Aug 2009 22:45:00 +0000

The topic of how attending a "good college" relates to getting a "good job" came up in a recent conversation I was having with my high school-aged son, whom I am encouraging to give serious consideration to both what he enjoys doing and what type of lifestyle he wants to have after he graduates from college.

Using the popular U.S. News & World Report ranking of universities and salary data from Payscale.com, we can take a look at the correlation between university attended and resulting mid-career median salary. The table below shows the top 30 U.S. universities and the mid-career median salary of their graduates.

As might be expected, Ivy League schools (Harvard, Princeton, Yale, University of Pennsylvania, Columbia, Dartmouth, Cornell and Brown) figure prominently on the list, along with the well-known science and engineering schools (Caltech, MIT) and the so-called non-Ivy Ivies (Stanford, University of Chicago, Duke, etc.).

The relationship between university attended and salary can be seen in the graph below.

The regression line is:

Mid-Career Median Salary = $121,400 - $900 x (Ranking of University Attended),

giving a decrement of about $9,000 in annual salary for each 10 spots in university ranking. For example, a graduate of a university with a ranking of about 5 might expect to have a mid-career salary of about $9,000 more per year than a graduate of a university with a ranking of about 15. The numbers actually show more scatter and skew than is captured by the linear regression, as evident in the following examples of ranking-university-salary:

4. Caltech, $115,000
5. MIT, $126,000
6. Stanford, $124,000

14. Johns Hopkins, $94,900
15. Cornell, $106,000
16. Brown, $107,000

24. UCLA, $97,000
25. University of Virginia, $97,200
26. USC, $103,000.

The general trend of higher ranking (smaller number) correlated to higher salary (correlation of .63) is clear. While there are, of course, many individual exceptions to the rule, one of the tell-tale indicators for predicting lifetime earnings and net worth is the college one attends.

As I tell my son, the college one attends (i.e., with whom one studies) is just as important as what one studies in college. Choice of a college typically has a lifelong impact on one's social circle, which in turn often influences whom one does business with throughout one's career.

The Impact of Sidelined Cash in Disequilibrium on the Stock Market

noreply@blogger.com (Lloyd Sakazaki) — Sat, 23 May 2009 04:33:00 +0000

The purpose of this note is to reconcile two contrasting viewpoints on how the amount of cash in our economy impacts future stock prices:

A. Sidelined Cash View: An example of the view that cash held in investor accounts matters is Alexander Green's commentary this week: 'In February . . . the decline in stocks was just about over [because] . . . [t]here was more money available to buy shares than at any time in almost two decades. The $8.85 trillion held in cash, bank deposits and money market funds was equal to 74% of the market value of U.S. companies, the highest ratio since 1990, according to the Federal Reserve. . . . [T]here is still over $8 trillion on the sidelines earning next to nothing in short-term deposits. . . . Expect to see cash coming off the sidelines to accumulate shares of the largest, most liquid firms around the globe.'

B. Equilibrium View: The opposite view, that consideration of market equilibrium reveals the "tautology" of speaking about cash on the sidelines, is voiced by John Hussman in his comment this week: '[A]s a result of more than a trillion dollars of new issuance of Treasury securities with relatively short durations, it is a tautology that there is a mountain of what is mistakenly viewed as “cash on the sidelines” invested in these securities. This mountain of “sideline cash” exists and must continue to exist as long as these additional government securities remain outstanding. It is an error to view outstanding debt securities as if they are “liquidity” poised to “flow back into the stock market.” The faith in that myth may very well spur some speculation in stocks, but it is a belief that is utterly detached from reality. The mountain of outstanding money market securities is the result of government debt issuance that must be held by somebody until those securities are retired. It is not spendable “liquidity” – it is a pile of IOUs printed up as evidence of money that has already been squandered. The analysts and financial news reporters who observe this enormous swamp of short-term money market securities, and talk about “cash on the sidelines” as if it is spendable in aggregate immediately reveal themselves to be unaware of the concept of equilibrium and of the nature of secondary markets (where there must be a buyer for every security sold, and a seller for every security bought).'

Which view is right? Is it useful from a trading or investment timing perspective to think of sidelined cash as waiting to flow back into the stock market? Or, does any particular stock transaction involve a mere transfer of cash from buyer to seller and, therefore, leave the aggregate amount of cash in the economy, sidelined or not, unchanged? Further, what is the long-run impact of the amount of cash in our economy, i.e., the money supply, on stock prices?

The Fed, the Treasury and the Private Sector

Three primary parties feature in our analysis: the Federal Reserve ("Fed"), the U.S. Treasury and the private sector. To illuminate essential points, I intentionally employ a "no frills" simplified model of the creation of cash (or, more generally, a broader measure, M2), bonds and stocks in the economy:

1. Cash Creation and Swap: The Fed creates cash (in the amount of 50 units) and swaps it with the Treasury for a like notional amount of newly issued government bonds.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 50, Bonds = -50

(In each of the skeletal balance sheets here and below, the sections shown in bold indicate a change from the immediately prior stage of the analysis.)

2. Deficit Spending: The government uses the cash to finance expenditures such as national security, infrastructure projects, entitlements and other deficit spending. The private sector ends up holding the cash, received from the government through employment and entitlements.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 0, Bonds = -50
Private Sector: Cash = 50

3. More Bond Issuance: The Treasury issues more bonds, this time to private sector investors instead of to the Fed.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 50, Bonds = -100
Private Sector: Cash = 0, Bonds = 50

4. More Deficit Spending: The government deploys the cash in accordance with its budget, with the private sector again being the recipient of the cash.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 0, Bonds = -100
Private Sector: Cash = 50, Bonds = 50

5. Entrepreneur-Led Growth: Assisted by years of government spending on infrastructure, enterprising individuals form companies and develop new technologies and products for growing consumer markets. Rising stock prices of these entrepreneurial companies represent new wealth creation, seemingly materializing "out of thin air," but actually resulting from the "value-add" through conversion of natural resources, labor, capital and technology into useful products and services.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 0, Bonds = -100
Private Sector: Cash = 50, Bonds = 50, Stocks = 100

6. Business Cycle: As the market's perception of future business prospects shifts, stock prices rise and fall. The corresponding aggregate wealth held by the private sector in stocks fluctuates from a cycle low of, say, 75, to a cycle high of, say, 150. At the nadir of the business cycle, the corresponding cash-to-stocks ratio is 50/75 = 67%, while at the peak this ratio is 50/150 = 33%.

7. Government's Rescue Plan: During the depths of an extended recession (i.e., when stocks = 75), the government implements an economic rescue plan, involving

a. Creation of more money (25) by the Fed;
b. The Fed's use of this money to purchase lower credit assets from banks;
c. Banks' use of the proceeds to purchase new bonds from the Treasury.

This plan strengthens bank balance sheets and provides the government with cash for new deficit spending. (By deliberate design, this model parallels the actions taken by the Fed and Treasury over the past half year in dealing with the current financial crisis.)

Fed: Cash = -75, Bonds = 50, Other Assets = 25
Treasury: Cash = 25, Bonds = -125
Banks: Bonds = 25, Other Assets = -25
Private Sector: Cash = 50, Bonds = 50, Stocks = 75.

8. Still More Deficit Spending: The government deploys its new cash of 25 as part of a stimulus package to jump-start the economy (cf., Obama's approximately $1 trillion fiscal stimulus package, currently being deployed). As before, the cash ends up in the hands of workers and consumers in the private sector.

Fed: Cash = -75, Bonds = 50, Other Assets = 25
Treasury: Cash = 0, Bonds = -125
Banks: Bonds = 25, Other Assets = -25
Private Sector: Cash = 75, Bonds = 50, Stocks = 75.

The result is an increase in the cash-to-stocks ratio to 75/75 = 100%, which is a sign of the gross disequilibrium now inherent in the economy, since the cash-to-stocks ratio is outside of its "normal" range of 33% to 67% shown in Stage 6 of our model.

How Both Views Can Be Right

First, although our model is very simple, it exhibits important monetary, fiscal and economic trends in the U.S. economy:

The amount of cash in the economy increases over time (from 0 to 75 in our model) as the economy grows and the Fed prints money to provide a currency to accommodate transactions among consumers and producers;
The amount of government debt increases over time (from 0 to 125 in our model) as the Treasury issues bonds to fund the government's growing budget deficit;
The value of the stock market rises secularly (from 0 to 100 in our model) as innovation, population growth and economic growth drive aggregate earnings of companies higher;
Also, stock prices are prone to fluctuations (from 75 to 150 in our model), due to changes in market participants' perceptions of the future business prospects and earnings potential of companies within the economy.

This situation is hardly one of steady equilibrium. On the contrary, our economy is a dynamic system, continually evolving from one point of instantaneous and imperfect equilibrium to the next. Population growth, innovation and technological change drive secular increases in the amount of cash, bonds and stocks, and government monetary and fiscal policy alters the money supply, bond issuance and tax revenues in a Keynesian attempt to influence the course of the economy. The result is an economy in perpetual disequilibrium, wherein apparently the only constant aspect is change itself.

Within a framework of disequilibrium, let's now examine the situation at the end of Stage 8 of the scenario presented above. Given the new infusion of cash (from a sudden increase in the money supply), the stock market (along with other assets such as real estate) is arguably likely to rise, consistent with the Sidelined Cash view, as investors chase higher returns by buying stocks with the new portion of their "sidelined cash" (now 75, up from the recent figure of 50 in our model). The idea here is that, when enough newly printed aggregate cash from fiscal stimulus makes its way into consumers' and investors' hands, some combination of more consumption and more investment will (eventually) push asset prices higher. Though ostensibly at variance with the Equilibrium view he espouses, Hussman points out that a probable outcome of current government policy is "a near-doubling of the U.S. price level over the next decade," citing Nobel economist Joseph Stiglitz's characterization of the government's strategy as "trying to recreate the bubble [in a way] [t]hat's not likely to provide a long-run solution . . . [but instead] says let's kick the can down the road a little bit."

To sum up:

The Sidelined Cash view correctly points out that "cash on the sidelines" can drive stock prices higher; however, by failing to distinguish between aggregate cash in the economy and cash held by individual investors, this view leaves too much room for (mis)interpretation;
The Equilibrium view is right in pointing out that the aggregate amount of cash in the economy does not change when investors trade stocks with each other; however, this view fails to incorporate the disequilibrating impact of new cash creation by the Fed (and the banking system).

I offer the following combined "sidelined cash in disequilibrium" view as a synthesis of the two views: The private sector of our economy operates, not in equilibrium, but in perpetual disequilibrium, due to the impact of our government's deficit spending using money printed by the Fed and accounted for as borrowing by the Treasury. New cash created by this dynamic process (which drives additional cash creation via fractional reserve banking) enters the economy through fiscal stimulus and becomes the "sidelined" component of aggregate cash that is forever chasing new opportunities and effectively encourages future economic growth.

So, we might say that cash is continually rolling off the printing presses at the Fed as our government's deficit expands and the economy grows. This capacity of our government to print money, constrained at any moment but secularly unlimited, provides a large pool of sidelined cash that can jump-start a recessionary economy and, in practice, has an inflationary impact on stock and other asset prices. The ultimate long-run outcome of our government's deficit spending policy and its influence on the relative strength of the U.S. economy versus that of other countries is debatable but, in my opinion, a correct prognosis will involve both a) interpreting "sidelined cash" to include the capacity of the Fed to print new money and b) recognizing that our economy is always in disequilibrium.

Hey, Baseball Fans: Winning Takes Money

noreply@blogger.com (Lloyd Sakazaki) — Sun, 29 Mar 2009 01:06:00 +0000

Investing and professional sports have a lot in common--competition, winners and losers, uncertain outcomes, lots of data, and a wide range of opinions among participants, spectators and analysts. During a conversation the other day with a friend, I casually mentioned what I thought to be an accepted truism in the sport--that, just as money is a vitally important determinant in the business world, Major League Baseball teams with higher payroll (hence, better players by presumption) ought to win more often than teams with lower payroll.

To my surprise, my friend, who is a baseball fanatic, retorted that money and winning are not as intimately linked as one might presume, and proceeded to recite from his encyclopedic memory a number of examples of World Series play over the past 10 years--the Arizona Diamondbacks over the New York Yankees in 2001, the Los Angeles Angels over the San Francisco Giants in 2002, and the Florida Marlins over the Yankees in 2003--all cases in which teams with significantly lower payroll took the championship from their more generously compensated opponents. All right, I had to admit, I take "strike one" against my follow-the-money presumption.

After getting off the phone, I did a quick web search to check further. The first study I came across stated that "results from the two years of data [2002 and 2003] indicate that there is no real correlation between a team's salary and its win percentage." In other words, higher salaries do not significantly boost win percentage. Hmm--strike two, I mused. . . .

Wanting to avoid striking out, I resolved to find the data and run numbers myself.

Team Payroll and Win Percentage Data

The USA Today Salaries Database gives MLB payroll figures for all 30 pro baseball teams in both the American and National leagues going back to 1988. The ESPN MLB standings database shows seasonal win percentages from 2002. Combining the data for the seven years from 2002 to 2008, we can generate the scatter plot shown below.

A least-squares analysis of team payroll versus win percentage gives the "best fit" regression line:

Win Percentage = 0.426 + (Team Payroll in $ Millions) x 0.00097,

indicating that approximately each one million dollars of team payroll adds about 1 point out of 1,000 (i.e., 0.001) to the win percentage. The t-statistic for the regression is 6.96, which means that we can state this relationship between payroll and win percentage with an extremely high degree of confidence (in fact, the likelihood of a false positive is less than one in ten billion!).

It is also instructive to look at the data on a team-by-team basis for the same seven-year period from 2002 to 2008. Notice how the New York Yankees and the Boston Red Sox have not only the first and second highest average team payrolls ($181 million and $122 million) but also the first and second highest average win percentages (0.600 and 0.580), respectively. At the other extreme, the three teams with the lowest average win percentages--Kansas City Royals at 0.410, Tampa Bay Rays at 0.423, and Pittsburgh Pirates at 0.431--are among the five Major League teams with the lowest average team payroll (each less than $50 million).

I also provide a table showing the payroll of baseball teams playing in the World Series over the past 20 years (actually from 1988 through 2008, with the exception of 1994 when, as baseball fans will recall, the Series was cancelled due to a player strike), assisted by data from Baseball Almanac. The results reveal that in 14 out of the 20 years, or 70% of the time, the team with the higher team payroll defeated the team with the lower payroll in the World Series. This result is consistent with the strong relationship between team payroll and win percentage shown in the graphs above.

What I conclude is that money does matter in professional baseball. Teams that have higher payroll generally do win more games, both during the regular season and during the World Series. Suffice it to say: the correlation between performance and pay is surely at least as high in baseball (and, in all likelihood, in other profesional sports as well) as it is in the business world. On a related though distinct topic, I would conjecture that, based on the relationship between payroll and win percentages, it is undoubtedly much easier to predict outcomes in Major League Baseball than in the stock market and other financial markets.

A Note on Statistical Analysis

In case anyone is wondering why my conclusion differs so radically from the study I mentioned as being my "strike two," I provide an explanation here. Warning: Only those interested in statistical analysis should continue reading, since the discussion becomes somewhat technical. However, I encourage anyone who at least occasionally spends time looking for patterns in data to read on, since an important lesson in applying the right tools to the job at hand will arise from the detail.

The author of the study I cited chose to analyze that data using a multiple regression, in an effort to determine how each of three variables--starting pitchers' salaries (P), fielders' salaries (F) and closing pitcher's salary (C)--affects a baseball team's win percentage. For example, for 2003, the study produced the following regression result,

Win Percentage = 0.406 + 0.0022 x P + 0.0015 x F + 0.0018 x C,

along with corresponding t-statistics of 1.72, 1.46 and 0.41 for the significance of the regression coefficients corresponding to independent variables P, F and C, respectively. With all t-statistics less than 2.00, the study was unable to discern at the standard minimum of 95% confidence any dependence of win percentage on the three payroll variables.

Interestingly enough, when I perform the analysis using the same 2003 data, but formulating the problem as three separate one-variable single regressions (instead of one comprehensive three-variable multiple regression as employed in the study), I arrive at t-statistics of 2.93 for dependence of win percentage on starting pitchers' salaries, 2.77 for dependence on fielders' salaries, and 1.49 for dependence on closing pitcher's salary--all higher than the t-statistics for the multiple regression given above. Further, if I combine starting pitchers', fielders' and closing pitcher's salaries into a single variable (i.e., P+F+C) and again run a one-variable regression, I find an even higher t-statistic, namely, 3.49.

In other words, by "zooming out" and viewing the data using an effectively lower resolution microscope, we actually find a more robust statistical pattern--this is reminiscent of the proverbial necessity of stepping back from the individual trees in order to view the grander forest. But, you might be wondering, how can this be? How is it possible in a regression to see a pattern at a lower resolution that essentially disappears at a higher resolution?

To understand the mechanism behind this paradoxical statistical behavior, consider a very simple regression example. Suppose we are trying to understand the relationship between a dependent variable, z, and two independent variables, x and y, based on five data points:

Data point 1: x = 1, y = 1 and z = 1
Data point 2: x = 2, y = 2 and z = 2
Data point 3: x = 3, y = 3 and z = 3
Data point 4: x = 4, y = 5 and z = 4
Data point 5: x = 5, y = 4 and z = 4.

Graphically, three plots are relevant:

a) Multiple Regression: Three-dimensional plot of x and y versus z,
b) Single Regression: Two-dimensional plot of x versus z (same as y versus z), and
c) Single Regression: Two-dimensional plot of combined variable, x+y, versus z.

In the multiple regression, the t-statistics are 3.3 for each of x and y. Observe the "dispersion" of data points 4 and 5 in the three-dimensional plot, with each of these points offset in a different direction from the straight line that can be drawn through data points 1, 2 and 3. This dispersion adds extra error to the regression, creating a relatively poor regression fit to the data.

In the single regression of x versus z (or, symetrically, y versus z), four of the five data points are collinear, and only the fifth data point introduces error into the otherwise perfect linear fit. This tighter fit of the data to a straight line yields a t-statistic of 6.9, higher than in the multiple regression case.

Still better yet, if we regress on the combined variable, x+y, we end up with a t-statistic of 17.9, substantially higher than in either of the other cases. By combining x and y into a single variable, we eliminate the oppositely directed "dispersive meandering" of x and y. The combined variable allows the regression analysis to reveal a closer correspondence between the independent variable (x+y) and the dependent variable (z).

Back to Baseball . . . and a Lesson

In an analogous way, the baseball statistics study relying on multiple regression produces a poorer picture of the relationships between variables than does the single regression. Behind the scenes is probably a mechanism akin to the following: Owners and managers of a given baseball team work within budget constraints during any particular season, so that the total amount of money available to pay all players on the team may be viewed effectively as a fixed quantity for that year. If more money is spent paying starting pitchers, then less money is available to hire and pay fielders and closers. Similar to how in the simple example above, x is less than y at data point 4, but y is less than x at data point 5, a particular baseball team may decide to spend less of its budget on starting pitchers than fielders, while another team may decide to flip the allocation the other way around, with less of its budget going to fielders than starting pitchers.

When the salaries of the all pitchers and fielders are combined, a more meaningful variable results against which to regress the win percentages. For this reason, the single regression using the combined salaries produces a higher t-statistic and better fit to the linear regression model.

The basic lesson here is that, when analyzing problems, it helps always to look for simpler relationships, explanations and solutions first, before implementing more sophisticated analytical tools. In working with scientific, financial, economic, sports or any other type of data, we are often warned against fabricating false patterns (artifacts of the analysis) by overfitting data to a model. In a similar vein, our discussion shows how it is also sometimes possible to overlook robust patterns by forcing an overly complicated model onto an intrinsically simpler set of data.

Blind Men and the Elephant: On the Urgency of Asset Price Reflation

noreply@blogger.com (Lloyd Sakazaki) — Fri, 06 Feb 2009 00:45:00 +0000

You've surely heard of the six blind men and the elephant. If we adapt the traditional story to our current financial and recessionary crisis, the key role-players become:

The Fed, who figures that the money supply and interest rates are what matter, and proceeds to lower short-term rates all the way to zero percent, while starting open-market purchases of commercial paper and mortgage securities to reel in credit spreads;
The Treasury, who decides that weak banks are the problem, and spends $350 billion of TARP funds recapitalizing banks and financial institutions, and deliberates over details of how to deploy the remaining $350 billion;
The FDIC, who feels that confidence in the financial system matters most, and boosts deposit insurance limits to $250,000 to help prevent runs on the banks;
Democrats in the House and Senate, who are sure that our problems will go away if the government spends more without worrying so much about the deficit, and quickly assemble a massive $900 billion stimulus package;
Republicans, who are certain that only tax cuts matter, and refuse to support the Democrats' proposal; and
President Obama, who believes that jobs and working together matter most, and pushes to get his stimulus package passed to jump-start creation of the 3 million jobs being forecast by his economic advisers, while reiterating his willingness to compromise for the sake of expediency.

That's six governmental players and six differing viewpoints, each of which may be construed as complementing the others, but together still falling short of definitively identifying the beast they are touching. In the traditional story, the six blind men do not realize that it is an elephant; and in the case of our economy, the elephant that everyone is touching but not seeing is an obvious truth that has gotten lost in the debate.

You see, the publicly spoken solution to our economic crisis--which seems like it ought to go away if only interest rates were lower, if the banks had more capital, if depositors and consumers had more confidence, if the government were to spend more to stimulate demand, if we had lower business and personal taxes, or if we could replace lost jobs--is really missing one essential ingredient. The elephant that everyone is touching but not quite comprehending (or at least not openly acknowledging) is the pressing need for a reflation of assets, home prices in particular.

In what now seems like quaint history, our economic woes began with a "minor" subprime mortgage problem in the middle of 2007. Through an unfortunate combination of regulatory leniency, misplaced incentives, financial irresponsibility and sheer Wall Street greed, a sizable number of underqualified, overleveraged borrowers began to have difficulty paying their mortgages and, as home prices fell, found themselves "upside-down" with negative equity, holding mortgages exceeding the value of their homes. Mortgage problems quickly spread to other highly leveraged borrowers as well, and over the ensuing year and a half have precipitated a downward spiral of plummeting real estate and stock prices, loan defaults and foreclosures, deteriorating bank balance sheets, abnormally tight credit markets, depressed consumer demand, a rising number of layoffs, etc.

Some wisdom may be gleaned by going further back in history to the last time our economy faced a crisis of this magnitude. As described by Irving Fisher in 1933, the basic problem we are experiencing is over-indebtedness, which leads to price deflation, which in turn makes matters only worse:

"[I]n great booms and depressions [the] two dominant factors [are] over-indebtedness to start and deflation following soon after. . . .

"Debt liquidation leads to distress selling and to . . . contraction of deposits and of their velocity . . . [which] causes . . . [a] fall in the level of prices, . . . [a] still greater fall in the net worths of businesses, precipitating bankruptcies and . . . [a] like fall in profits, which . . . leads . . . to . . . [a] reduction in output, in trade and in employment . . . to [p]essimism and loss of confidence, which in turn lead to . . . [h]oarding, . . . [all of which] cause . . . [c]omplicated disturbances in the rates of interest.

"[I]t is always economically possible to stop or prevent such a depression simply by reflating the price level [bold added] up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged."

(Irving Fisher, "The Debt-Deflation Theory of Great Depressions," Econometrica, 1933, pp. 337-357)

Indeed, it is curious that, although we all recognize our over-indebtedness and are suffering through painful dislocations because of it, no policymaker is placing front-and-center the glaring need for asset price reflation.

In addition to the Fed's policy of keeping inflation moderate, which is a long-run strategy to stabilize the rate-of-change of prices, current crisis-oriented policy must target a short-run higher absolute price level, if we are to steer ourselves out of the mess we are in. Essentially, we need to re-create wealth by reflating asset prices, as quickly as possible, up to a high enough level to make our bad debt problem go away. When the relationship between home prices and indebtedness returns to a more manageable level comparable to where it was prior to the onset of our current crisis, we will find that those underwater mortgages are not so underwater anymore, that the banks are no longer on the verge of bankruptcy, that consumer confidence and retail sales are rising again, that companies are no longer laying off workers, and that our economy is finally on the road to recovery.

Two recent news items are relevant here:

Senator Johnny Isakson has proposed a homebuyer tax credit, approved last night by voice vote in the Senate for amendment to the stimulus package being worked out. The measure "would offer new homebuyers a tax credit of up to $15,000 or 10 percent of the purchase price of a house that could be spread over two years." This tax credit would create increased demand among homebuyers and is fairly direct way of supporting home prices. In my opinion, the legislation should be amended to offer even more stimulus to the housing market and economy, by both a) raising the upper limit on the tax credit to $50,000, and b) allowing the amount of the credit to be carried forward indefinitely and applied to taxes owed until used in full by the taxpayer.
UCLA economics professor, Roger Farmer, proposes that "just as it sets the fed funds rate to control inflation, the Fed should set a stock market index to control unemployment." Targeting the price level of a stock market index, like the S&P 500 or even a broader index, would give the Fed a more direct handle on influencing performance of our economy. With our wealth as a society linked to the stock market, consumer psychology (which determines demand) is impacted more by a 10% drop in stock prices than by a substantial change in short-term interest rates. The Fed should continue to use all of the existing tools at its disposal--rate cuts, open-market operations and so on--and with an added mechanism for targeting for stock prices, policy objectives would become clearer and more effective, particularly in market environments like the present with standard interest rate easing already pinned to its zero percent lower limit.

I like to think that the actions of policymakers matter more than their words, but, particularly today with our global economy in crisis, vocalizing a credible plan with concrete and realizable objectives can make a difference. If Obama, Geithner, Bernanke or another official in a position of authority would openly acknowledge a policy objective of asset price reflation--the need to raise the prices of homes, other real estate and stocks--then we would at least be looking the elephant directly in the eye. Thereafter, the task of getting our stubborn economic elephant to move in the right direction would become more straightforward.

Needed: A Large Drop of Helicopter Money

noreply@blogger.com (Lloyd Sakazaki) — Sat, 06 Dec 2008 05:35:00 +0000

During the past half year, the concerns of the Fed have shifted from worry about commodity-driven inflation (recall $147 oil in July) to its polar opposite--fear about the onset of deflation (coinciding with oil falling below $40 today). With short-term interest rates now lower than the targeted 1% rate, traditional monetary policy measures have become less potent and the U.S. economy is more susceptible to descending into a "liquidity trap." As mentioned by Ben Bernanke in a 2002 speech, one way out of such a predicament is a "helicopter drop"--effectively dropping money from helicopters to consumers and businesses below in order to thwart deflation, stimulate spending and prevent economic stagnation.

Consumer-Based Crisis

The financial crisis we are facing today first surfaced a year and a half ago as a consumer-based subprime mortgage problem that soon developed into an institutional credit crisis, morphed into a pervasive illiquidity dilemma, and earlier this week was, long after the fact, officially named an economic recession that began 12 months ago! As parallels with the Great Depression of the 1930s and Japan's stagnant economy of the 1990s grow more conspicuous, the gloomy predictions of NYU economist Nouriel Roubini loom larger and closer. We are now one year into a recession that, according to Roubini, will most likely extend at least another year. What began as a seemingly minor problem has expanded into a full-blown, global financial crisis that could very well extend into 2010, becoming the most severe economic downturn in the adult lifetime of anyone alive today--unless, of course, our policymakers take appropriate and sufficiently drastic measures to stabilize the financial system.

Bush, Bernanke and Paulson have tried to fix the problem with a whole series of measures--a moderately sized consumer stimulus package in early 2008, bailouts of financial institutions, successive rate cuts, capital infusions to strengthen bank balance sheets, an increased limit on bank deposit insurance, government backstops on portfolio asset losses, purchases of illiquid assets, etc. So far, nothing has worked as well as anyone would like, and our faltering economy and plunging real estate and stock markets continue week after week to drive each other lower, in a relentless asset deflation spiral that is dragging down even the endowments of elite institutions like Harvard. Come January 20, President-elect Obama (incidentally, a Harvard Law alumnus) and newly appointed Treasury secretary Geithner will replace Bush and Paulson, respectively, and we can only hope that the stimulus package in Obama's vision for the future of our economy will be large enough to usher in real change in a favorable direction.

As for the root cause of our economic problems, the consensus opinion among economists and laymen alike implicates overleverage, basically too much debt and too little savings, particularly among consumers. Everyone agrees that saving more would be prudent for any individual consumer facing an uncertain future, but when aggregate consumption falls our economy unfortunately enters a vicious circle, as reduced consumer demand (from saving more) leads to reduced delivery of goods and services and higher unemployment, which, in turn, reduces demand still further. To halt this vicious circle before it does further collateral damage to our fragile economy, we need to find a practicable way to provide debt relief at the consumer level--as soon as possible. This is where the helicopter money comes in.

Helicopter Money Initiative

As Bernanke pointed out in his speech, even when monetary policy by itself becomes ineffective, there are a number of alternative ways to combine monetary policy with fiscal stimulus to prevent deflation and encourage economic growth, despite being in a near-zero interest rate environment like the one we are experiencing today. These less traditional, more innovative measures are:

A. Broad-based tax cuts,
B. Increased purchases of goods and services by the government,
C. Purchase of private assets via the Treasury, and
D. Increased direct transfer of money from the government to the private sector.

President-elect Obama is already planning to provide tax cuts (measure A above) to at least 95% of Americans and some talk of reducing payroll taxes is also circulating. The large (maybe $1 trillion?) stimulus package (measure B) currently under discussion in Congress will hopefully be ready for signing by inauguration day. Purchase of private assets (measure C) is already underway in the commercial paper and mortgage-backed security markets, but practical limitations (i.e., how to price highly illiquid instruments) have prevented the proposed wide-scale purchase of toxic mortgage assets that was the main objective the initial TARP plan. Consumer stimulus packages (measure D), along the lines of the one implemented in the first half of 2008, work most directly and immediately to maintain GDP growth and, for this reason, deserve further serious consideration.

Because near-term inflation is no longer an issue, policymakers now have the luxury of taking the most aggressive actions possible to turn our economy around. With the financially stressed, heavily indebted American consumer so central to our problems, it makes sense to implement an enhanced version of measure D--this time in much larger size. Just as people suffering in the aftermath of a natural disaster need immediate and basic emergency assistance, prior to tax-related benefits and government spending to rebuild infrastructure, our severely damaged economy needs a very significant injection of helicopter money delivered directly to the overleveraged consumer.

To achieve the quickest and most direct money transfer to the consumer, here's what our government should do:

Beginning during the first half of 2009, write checks to every household filing a tax return, in the amount of, say, $10,000 per dependent (taxpayer, spouse, children, other household members), which is an order of magnitude larger than the consumer stimulus in early 2008.

Offhand, it might appear that this type of seemingly frivolous fiscal policy would be a desperate and highly wasteful use of taxpayer money that could spark a new, undesirable bubble. However, given the precarious state of our economy, such a radical measure stands a greater chance of doing more good than harm and has many benefits:

1. Immediate and Direct Impact: Helicopter money provides an immediate stimulus to consumers and businesses, directly benefiting Main Street (a refreshing change after all the prior rescue plans with trillions of dollars going to Wall Street financial institutions);

2. Reduced Consumer Leverage: Consumers will use some of the money to pay down mortgages, credit card debt, car loans, etc.;

3. Increased Consumption: Consumers will use some of the money to do what consumers do best, i.e., buy products and services, which will immediately boost sales of businesses large and small, preventing further job destruction;

4. Market Support: Some of the money will be invested in the stock and real estate markets, relieving downward pressure on asset prices and helping to create the market bottom that is so badly needed to build consumer and investor confidence and turn our economy around;

5. Global Economic Growth: Reduced consumer leverage, increased consumption and increased investment will all boost the U.S. economy, which in turn will help revive the global economy.

With the U.S. population at about 300 million, this new consumer stimulus package of $10,000 per person would total $3 trillion, which is about four times the $700 billion TARP package but less than half of the approximately $8 trillion in cumulative funds the government has already committed through all of the various measures announced. The net effect of this helicopter money plan would be to shift up to $3 trillion of debt from the consumer to the government. This would reduce leverage at the consumer level and boost aggregate demand to stave off a deflationary spiral.

As Professor Roubini points out in this interview, the basic structural problem we face is a global supply glut cannot immediately be reduced even though demand has fallen. Therefore, at least in the short run, the severity of the current crisis justifies "pulling out all stops" to create the demand necessary to meet existing supply. A large helicopter drop appears to be exactly what is needed to stabilize our economy and sidestep the negative impact that further deterioration in employment and the housing and stock markets will otherwise bring.

Hedging Is Simple, But Market Timing Is Not

noreply@blogger.com (Lloyd Sakazaki) — Mon, 17 Nov 2008 20:44:00 +0000

What follows is some perspective on the buzz we're hearing about portfolio and fund manager performance in this horrendously painful bear-market year, which most investors would love to forget about--if only they could.

While Miller Missteps (Again) . . .

Recall that around this time in 2005, Bill Miller was being hailed as the most successful fund manager of all time, with his Legg Mason Value Trust Fund outperforming the S&P 500 for a record-breaking 15th straight year. Then, in 2006, Value Trust underperformed for the first time since 1990, returning just 6% versus the S&P 500's double-digit 16%. Last year, in 2007, Miller again underperformed, this time -7% (i.e., a loss) for Value Trust versus a 5% gain for the S&P 500. In 2008, as of last Friday, Nov. 14, Value Trust is down a whopping 50%, versus a 40% decline for the S&P 500, making it quite likely that Miller will underperform once again--for the third straight year.

In his third-quarter commentary published last week (Nov. 12), Miller discusses flaws in the government's delayed ("too late") response to the financial crisis, while also admitting,

"I have made enough mistakes in this market of my own, chief among them was recognizing how disastrous [government] policies being followed were, yet not taking maximum defensive measures [italics mine], believing that the policies would be reversed or at least followed by sensible ones before things got completely out of control."

Miller is alluding here to his failure to implement an appropriate hedging strategy to protect his fund against the precipitous collapse of the market during the past couple of months. With 20/20 hindsight, of course, it is easy to say that he (or anyone long the market) should have either sold their equity holdings, shorted S&P 500 futures, or bought puts to protect the downside.

. . . Hussman Hedges

While most equity fund managers, like Miller, are suffering complete and unforgiving drubbings this year, one fund manager is making news due to his notable outperformance in this year's most disastrous market in decades. John Hussman's Strategic Growth Fund (HSGFX) is running only slightly negative year-to-date through Oct. 31, which sure beats the 40% or larger decline most fund managers are experiencing. Of course, Hussman's stand-alone performance begs the question, what's his secret formula?

Though academic credentials do not necessarily or even typically help one become a better investor, perhaps at least it is no detriment to his performance that Hussman holds a Stanford economics Ph.D. and is a former finance professor at the University of Michigan. His investment strategy, as described on his website and in his fund's prospectus, seems to be a rational approach firmly grounded in interpreting historical data, utilizing "observable evidence" (sounds scientific . . .) in an attempt to distinguish between favorable and unfavorable "market climates" (weather forecasting analogy?), taking into account both "market action" (an allusion to physics or sports?) and valuation (yeah, he has a value-investing approach, similar in some respects to Buffett and Grantham).

To date, Hussman's differentiator has been his hedging. What really distinguishes his investment style from that other fund managers is his ongoing implementation of partial or full hedging of his underlying long-equity portfolio, even though he could potentially become fully invested or even leverage up beyond full exposure if market conditions ever call for it:

"In conditions which the investment manager identifies as involving high risk and low expected return, the Fund's portfolio will be hedged by using stock index futures, options on stock indices or options on individual securities. . . . The Fund will typically be fully invested or leveraged when the investment manager identifies conditions in which stocks have historically been rewarding investments."

In Hussman's framework, although market action remains unfavorable, the market's recent decline has shifted valuation from unfavorable to more favorable, leading him to begin transitioning his portfolio from being fully hedged (underlying stock positions essentially 100% protected by put-call combinations as of a few months ago) to taking on moderate market exposure (now 70% to 80% protected). Currently, Hussman views any near-term market declines as opportunities to strip away a few more layers of protection and increase market exposure, since stocks have become "both undervalued and oversold."

Because Hussman varies the amount of his protection (or exposure) to market moves in accordance with market conditions, he is, in my opinion, attempting at least partially to "time" the market, even though he insists that he is not pursuing "market timing" in the usual sense of the term. In his own words from a recent weekly commentary:

"The Strategic Growth Fund is not a 'market timing' fund. Nor is it a 'bear' fund or a 'market neutral' fund. Strategic Growth is a risk-managed growth fund that is intended to accept exposure to U.S. stocks over the full market cycle, but with smaller periodic losses than a passive buy-and-hold approach. We gradually scale our investment exposure in proportion to the average return/risk profile that stocks have provided under similar conditions (primarily defined by valuation and market action). We make no attempt to track short-term market fluctuations. We leave 'buy signals' and attempts to forecast short-term market direction to other investors, preferring to align our investment positions with the prevailing evidence about the Market Climate."

Hedging Versus Market Timing

To understand the impact of hedging on Hussman's longer-term performance, we can look at his fund's returns, which he conveniently discloses both before and after hedging.

Since its inception in 2000, Hussman's Strategic Growth Fund has carved out a winning track record, as evidenced by the stellar performance chart displayed prominently on Hussman's website. For the eight-year period, while the S&P 500 has lost 1.04% annually, Hussman's unhedged portfolio has gained 6.37% annually, and his Strategic Growth Fund has returned 10.76% annually. These results indicate that Hussman's stock-picking ability (or is it luck?--more on this topic below) has boosted his annual return to some 741 b.p. above the S&P 500, while his hedging has apparently added another 439 b.p. to his annual performance. This is a very solid track record over the past eight years, particularly in light of the two bear markets fund managers have had to endure, both in 2000-2002 and beginning from the last quarter of 2007.

Before jumping to conclusions about Hussman's apparent analytical genius or market clairvoyance in largely avoiding both bear markets, let's take a closer look at the data--his data--posted here on his website for the casual (or better, not so casual) perusal by anyone interested. Taking the 33 quarters of data from the third quarter of 2000 through the third quarter of 2008, we can make a scatter plot of his unhedged and realized fund performance versus the S&P 500, as shown in the chart below.

If Hussman's realized fund performance points (in pink) on the chart seem to sketch out a typical, albeit somewhat noisy, hockey-stick-shaped option payoff diagram, this graphical result should come as no surprise, since, after all, the basic purpose of Hussman's hedging is to protect his portfolio against market declines, while allowing participation in market upside potential.

Let's take our analysis of Hussman's performance a step further. In the chart above, observe that the pink points sit above the blue points on the left half, while the reverse is true--pink below blue--on the right half. To understand this behavior, we need to distinguish between hedging and market timing:

Hedging: The underlying unhedged position is Hussman's long-equity exposure to his chosen portfolio of stocks. If he were always (i.e., without attempting to time the market) simply to buy put options with at-the-money or slightly out-of-the-money strikes to protect his portfolio against market downside, the puts would show a profit when the market declines but would expire worthless when the market rises. The result would be an insurance-like payoff pattern from the hedge--protection against loss in a declining market, but with a cost relative to the unhedged position particularly evident when the market rises.
Market Timing: On the other hand, if Hussman were attempting to time the market and successful in doing so, presumably by selectively hedging to protect against downside under risky market conditions but operating without a hedge when prevailing conditions are less risky, the data ought to show not only realized fund performance above the unhedged case (pink above blue in the chart) when the market declines, but also at least an occasional occurrence of this type of outperformance of his fund over the unhedged case when the market rises.

By inspection of the data, we can see that for the 14 quarters when the S&P 500 fell about 2% or more, Hussman's realized fund performance always exceeded the S&P 500, indicating that, to date, he has always succeeded in avoiding any sizable market loss. However, there is also a flipside to this flawless track record in falling markets, namely, in the 13 quarters when the S&P 500 rose about 2% or more, Hussman has never outperformed the market. In fact, the negative correlation between the S&P 500 and Hussmans's hedge (being just the difference between his realized fund return and his unhedged return) is a strikingly large -0.96.

What this all indicates is that Hussman's performance is basically consistent with that of someone who makes a practice of always hedging with put options, regardless of market conditions. By and large, it is not what we should expect to see from a portfolio manager implementing a market timing strategy, even though Hussman does at least occasionally remove some portion of his hedge to reduce cost when he believes that risk is low and the chance of a market rise is high.

Skill Versus Luck

The above classification of Hussman as a hedger and not a market timer is in agreement with the often-stated warning to investors and traders that market timing is difficult, if not impossible, and should be attempted only with extreme caution by anyone with risk aversion. In a Tech Ticker interview last week on the topic of skill versus luck in stock-picking and market timing, Professor Kenneth French (whose name figures prominently alongside Fama's in finance theory) states:

"There this a whole academic literature trying to figure out who won because of luck and who won because they truly had skill. We don't know how to do it. I mean there's a little bit of evidence that we can distinguish luck from skill, but, in essence, it's absolutely futile.

"So, when I have a mediocre M.B.A. student who spent the weekend studying Morningstar and is convinced he knows how to pick the winning fund, what I challenge him with is sort of, 'Geez, you know, it's good that you didn't even need to bother to get a Ph.D. and spend the last 30 years of your life solving this problem. You know, those of us who did that, we don't know how to do it. But, congratulations. That was a really productive weekend!'

". . . To basically try to distinguish skill from luck . . . [is] almost impossible. . . . What I'm saying is, I can't tell . . . one from the other. . . . If I can't tell good from bad, why play the game?"

Surely, coming from an accomplished expert in finance, this type of statement is enough to throw into question anyone's claim of having ability to pick stocks and time the market to achieve excess returns in a consistent fashion.

What this means is that we, the investing public, should not read too much into the performance of successful fund managers, however superb their performance may have been (in Miller's case) or appear to be (in Hussman's case). Both Hussman and Miller have certainly assembled relatively long track records as ostensibly excellent stock-pickers, but, as history has shown, anything is possible. If Miller's 15-year winning streak can suddenly undergo a complete metamorphosis into a 3-year (or longer?) losing streak, and if Hussman's track record is solid but exhibits inherent underperformance in rising markets as consistently as it displays outperformance in falling markets, we can only suspect that unquestionable evidence of skill, as opposed to luck, in investing has become that much harder to find.

Although anyone actively managing a stock portfolio may hate to admit it, Professor French is most likely right--unfortunately, in the world of investing, we will probably never really be able to tell if our own or anyone else's performance stems primarily from luck or, as many may want to believe, from having a discernible edge over other investors who are only almost-as-skilled as ourselves.

The Next Boom Will Come

noreply@blogger.com (Lloyd Sakazaki) — Fri, 14 Nov 2008 18:28:00 +0000

The global economy is in the doldrums. Collapsing housing prices and ensuing foreclosures have brought both borrowers and lenders to their knees, frozen credit markets, depressed stock prices, softened consumer demand, forced oil, metal (even gold) and other commodity prices lower, and now dragged down the commercial real estate market as well. The Bush and Paulson $700 billion financial rescue plan has morphed from an impracticable illiquid-asset buyback plan to shore up bank balance sheets into an across-the-board equity infusion scheme and sadly, along its porky way, lost focus, impact and credibility. Cynics question what benefit Bernanke's many years of academic study of the Great Depression have brought him, or anyone else, for that matter. Respected business figures (for example, Soros and Dimon) warn of a deepening recession in 2009, possibly even a depression.

Given the dour outlook of economic experts and pervasive pessimism of the investing public, it's hard to be optimistic--but I am. I'm confident that better times and a stronger economy lie ahead of us. Really, a brighter future is all but inevitable. Yes, I repeat, just as day follows night, we will see better times. Let me explain the root of my optimism.

Generally speaking, two basic schools of economic thought have been most influential over the past 75 years--Keynesians (including neo-Keynesians), who advocate fiscal measures such as an increase in government spending to stimulate a sluggish economy, and higher taxes to cool an overheated inflationary economy; and monetarists (led by Friedman's Chicago school), who believe that what's more important is controlling the money supply, primarily through buying and selling government bonds in the open market and raising and lowering the discount rate. Both schools of economic thought unabashedly lay claim to real-world successes of their models--Keynesians take credit for lifting the economy back onto its feet through FDR's New Deal spending following the Great Depression in the 1930s, and monetarists boast of steady and prolonged economic growth in the 1980s (Reagan years) and 1990s--despite the many recessions we have seen, including those in recent decades: 1980 (7 months), 1981-1982 (17 months), 1991-1992 (8 months), 2001-2002 (12 months), and presumably 2008-2009.

While these two mainstream schools of economic thought certainly have their differences, they also share an important commonality--both rely heavily on government intervention to control or at least influence economic growth. President Bush's consumer-targeted economic stimulus package during the early days of the current financial crisis and the new stimulus package that President-elect Obama stressed as a high-priority item in his first press conference a week ago are examples of Keynesian policy in action. The Fed's continual "busy-body" adjustment of the discount rate--Greenspan's lowering of the rate to 1% in 2003 during the last recession precipitated by the dot-com bubble, and raising it back up to the 5% range by the time of his retirement in 2006, and Bernanke's pushing the discount rate all the way back down again to 1% last month, while hinting at more rate cuts to follow--are examples of attempts to steer the economy using monetary policy.

In sharp contrast to these two mainstream schools are those who argue that both the Keynesians and monetarists are wrong-headed. For example, the Austrian school, based on the thinking of Mises and Hayek, explain how government intervention is not the solution. Stating that fiscal and monetary policy fail to produce their intended impact, these economists insist that, instead of smoothing the vagaries of the business cycle, government intervention actually causes the booms and busts, through over-extension and over-contraction of credit at artificial prices via the highly government-regulated fractional-reserve banking system. Quite contrary to active intervention, the Austrian school recommends following a laissez-faire "do nothing" approach, theorizing that this is the only way to cure permanently our economic woes. For a coherent exposition of the Austrian school's position, see Murray Rothbard's 1969 essay, "Economic Depressions: Their Cause and Cure," here.

Which economic school is right? Well, first off, practically speaking, it would be grossly out of character and, in fact, outright political suicide for any president--whether lame-duck Bush, or our country's new icon of hope, "renegade" Obama--to tell us American citizens that, after serious dialog and lengthy reflection, the elected officials and their appointed experts have decided that a "do nothing" policy is best. With home foreclosures at historical highs and rising, and growing worries over burdensome credit card balances, auto loans and other consumer debt, the popular approval ratings of even the most charismatic of political leaders would undoubtedly suffer greatly if all their economic advisory team could come up with is to a "do nothing" strategy for tackling the current economic crisis. No, simply put, Americans are by nature more active doers than thinkers, and doing nothing never has been and probably never will be an acceptable alternative for managing our economy.

So, much to the chagrin of Austrian school economists, we must conclude that government intervention, whether effective or not, will continue when Obama and later presidents take office. Given this inevitability that politicians and their mainstream economic advisers will always be inclined to fiddle with the economy, here's the logic of what to expect:

If the sketchy long-run track record (performing like a "B" student, with 13 out of the 115 quarters beginning in 1980 showing negative real GDP growth, according to BEA data) of the Keynesians and monetarists is any indication, we should see at least some degree of over-shooting in the future, perhaps this time manifested by a delayed but sudden response of our economy to excessive fiscal stimulus or overly loose monetary policy, resulting in either consumer price inflation or yet another asset bubble. (On the other hand, if by chance (or fluke?) policymakers have learned from the last boom-bust cycle and this time around manage to get the economic fine-tuning exactly right, they will have realized the heroic feat of taming the recalcitrant business cycle, macroeconomic volatility will cease, and we will all live, at least economically, happily ever after. . . . but I would tend to believe other fairy tales before placing undue faith in this one, wouldn't you?)
If the Austrian school is correct in their critical analysis of the shortcomings of Keynesian and monetary policy, the current credit-driven bust will inevitably be followed by a boom, and the more our government intervenes to try to fix the problem, the higher the crest and deeper the trough we will see during the next boom-bust cycle.

In other words, however we dissect our economic situation, the business cycle remains alive and well. Both empirically and theoretically, we can be sure that economic booms and busts will continue. Admittedly, the precise timing is anyone's guess but, following the current, painful de-leveraging and retrenchment of credit in our financial system, at some point in the future, credit creation will again be in vogue, creating over-expansion of credit in some asset class, and soon enough spilling over into other asset classes. Yes, however unlikely it may now appear to be (case in point: was anyone predicting a collapse in oil prices to today's $58 per barrel when it soared above $140 as recently as July?), one day we will experience yet another bubble. Seeing how the collective memory of market participants tends to be selective and short, I wouldn't be surprised if such a rebound happens earlier and quicker than any respected market commentator would now dare to predict.

Suffice it to say, for anyone distraught by the current bust, please have patience: the next boom will come--maybe even sooner than you or anyone now thinks.

Older Bulls Wiser than Younger Bears? Maybe

noreply@blogger.com (Lloyd Sakazaki) — Tue, 28 Oct 2008 05:02:00 +0000

Old bulls versus younger bears. This could be entirely coincidental. Has anyone noticed that bullish sentiment seems correlated with age?

Bullish and Buying

The most prominent U.S. stock market bull to surface in recent days is highly respected Mr. Buffett, who was born in 1930 and grew up during the Great Depression years. If as a child he was too young to comprehend the hard times and economic turmoil of the era, we can at least presume that, in his early adult years as a student of Ben Graham, Buffett absorbed the first-hand lessons garnered by his teacher, who had lost everything during the stock market crash of 1929, which apparently was the life-changing event that led Graham to formulate his well-known value-investing methodology. Quoting from Buffett's op-ed piece in the New York Times:

Warren Buffett (age 78): October 16, 2008. "Buy American. I am."
"The financial world is a mess, both in the United States and abroad. So . . . I’ve been buying American stocks. . . . I previously owned nothing but United States government bonds. If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities."

Also notable is so-called "perma-bear" Grantham, whose switchover into the bullish camp can be considered significant, since he spent the past couple of decades marauding with the bears:

Jeremy Grantham (age 69): October 18, 2008. "Silver Linings and Lessons Learned"
We "have moderately cheap U.S. and global equities for the first time in 20 years. . . . We at GMO [Grantham's investment management company] are already careful buyers. We are reconciled to buying too soon, but we recognize that our fair value estimate of 975 on the S&P 500 is, from historical precedent, likely to overrun on the downside by 20% to 40%, giving a range of 585 to 780 on the s&P as a probable low."

I am not sure how much weight Glickenhaus's opinion carries today in the investor community, but he is said to be the lone voice who boldly spoke out when stocks fell 23% on Black Monday in 1987, confidently calling a market bottom and the start of the next bull market. FOX Business has interviewed Glickenhaus twice during the past few weeks, highlighting the relevance of his experience of having lived through the stock market crash of 1929 and seen how the government's actions (or inaction) impacted the severity of the Great Depression:

Seth Glickenhaus (age 94): October 27, 2008. "On the Verge of a New Bull Market. . . "
"We are making a painful but meaningful low. . . . This is a rare opportunity to buy stocks at substantially below their intrinsic values. . . . We are on the verge of a new bull market beginning within a week or two. . . ."
(Note: On October 15, 2008, on Neil Cavuto's show on FOX Business, Glickenhaus indicated that a new bull market would start "next week." That day, the S&P 500 closed at 908. Today, a week and a half later, the S&P 500 closed at 849, a fresh, new five-and-a-half-year low.)

Bearish and Avoiding Stocks

As might be expected, so-called "Dr. Doom," Marc Faber, sees the U.S. and world mired in a serious recession that will last a few years. However, he also sees potential for a near-term rally within the longer-term bear market:

Marc Faber (age about 60?): October 20, 2008. "Stocks May Rally, Won't Reach Records"
"We're extremely oversold at the present time. The market is in a position to rebound." However, Faber holds only a small equity position: "stocks make up 7 or 8 percent of his holdings, with cash, bonds and gold, his biggest position, accounting for the rest." Also, his opinion on the U.S. economy remains gloomy: "To rebuild economic health in the United States, you need a serious recession that will last several years. The patient that got drunk on credit growth needs to go into rehabilitation. To give him more alcohol, the way the Fed and the Treasury propose to do, is the wrong medicine."

Next, here's the opinion of a firmly committed, unwavering bear, who is calling for a significantly lower bottom:

Gary Shilling (age in 60s): October 22, 2008. "We Haven't Seen the Worst Yet"
"The economy hasn't hit bottom yet. Neither, in all likelihood, have stocks. . . . If you're an equity investor with a long-only portfolio, it's not too late to take some money off the table. Remember 777--not the airliner but the low that the Standard & Poor's 500 hit in 2002. That's 21% beneath where we are today, but if it's breached, then all the stock rise of the last six years will have been but a bear market rally, and the bear market that started in March 2000 will still be with us."

Finally, representative of the diversity of opinion, here's a market commentator who is one of the few courageous enough to state publicly that Buffett is, whether we like it or not, just plain wrong this time around:

Diane Francis (age in 40s): October 27, 2008. "Buffett Is Wrong: Avoid Stocks"
"Far be it from me to contradict one of the world's greatest stock sages and business analysts. But I will. Seems to me that we are in uncharted territory with this panic until the U.S. election is staged on November 4 and until the global community demonstrates that it is going to appoint sheriffs to patrol the global economy and stop the kind of jurisdictional arbitrage that led to the casino-ization of banking. . . . For me, buying and selling should not be an option at least until the U.S. election and probably until January 2009."

Does Age Matter?

Admittedly, based on a sample size of just three opinions from each camp, we have at hand little more than anecdotal evidence and, consequently, cannot draw any conclusion that comes even close to being statistically significant. However, with the bull opinions coming from investors in approximately the 70-to-90 age group, versus the bear opinions from a younger cohort in the 40-to-60 age group, I suspect that investor age might be an indicator of stock market sentiment.

One interpretation is that the older generation, having closer first-hand experience with the crash of 1929 and economic hard times during the 1930s, have a deeper appreciation for today's unprecedented government efforts to stem the current financial crisis before it reaches depression-era proportions. If the bulls end up being correct, we will in a few years' time look back upon today and have to acknowledge that the older seers professed a certain "market wisdom" that the less experienced, younger generation lacked. On the other hand, if the bears win the battle and the actual market bottom turns out to be much lower, I can already almost hear the youthful crowd "writing off" the elderly bulls as having "gone senile," being "out to pasture," or at least being "out of touch" with these ever so "modern" times of ours.

For the sake of global economic stability, I certainly hope the old bulls really are the wiser. However, on days like today, with the market closing at a new low, we have to fear that the younger bears could be right in the short run.

Potential secret weapon to battle our financial crisis: A trillion dollar debt-to-equity swap

noreply@blogger.com (Lloyd Sakazaki) — Thu, 16 Oct 2008 19:25:00 +0000

While heavily indebted American consumers struggle to make mortgage and credit card payments, a larger shift is underway. News from Tokyo indicates that politicians in Japan, America's "friendly" creditor nation, are beginning to consider investing the country's massive horde of foreign reserves, to "take advantage of the opportunities opening up around the world" during this global financial crisis we are in.

The largest foreign exchange reserves are held by China with $1.9 trillion and Japan with $1.0 trillion, followed by Eurozone countries and Russia, each with about $550 billion. Almost all of these largely U.S. dollar-denominated reserves are invested in conservative fixed-income instruments like U.S. Treasury bonds. However, as noted already in a 2005 article by Andrew Rozonov, who first used the term "sovereign wealth fund," the practical distinction between foreign exchange reserves and their more equity-like sovereign wealth fund counterpart has begun to blur.

In the earlier part of the subprime crisis, we saw high-profile investing of $21 billion by sovereign wealth funds (Singapore, Kuwait and South Korea) into U.S. financial institutions (Citi and Merrill). This week's closing of Mitsubishi UFJ's $9 billion capital infusion into Morgan Stanley is a private sector version of the same type of foreign investment. Given the, not billion, but trillion dollar scale of the foreign exchange reserves that China and Japan have amassed, any decision on their part to swap even a small portion of their fixed-income funds into equity-like investments will have a tremendous impact on the U.S. equity market.

Ponder this: The investments last January by smaller sovereign wealth funds in U.S. financial institutions helped to boost capital, but nevertheless Merrill is now being acquired by Bank of America and Citi's balance sheet is still under pressure. The U.S. government coordinated JPMorgan's acquisition of faltering Bear Stearns in March, but that did not prevent Lehman from going bankrupt in September. After an unprecedented $85 billion government lifeline to AIG last month, AIG needed another $38 billion just last week. Also, despite heightened government intervention in recent weeks--Paulson's $700 billion bank rescue plan signed into law on October 3, coordinated global rate cuts by many G-7 members and other countries last week, and the government's "no objections allowed" infusion of $125 billion capital into JPMorgan, Bank of America, Citi, Wells Fargo, Goldman, Morgan Stanley and other financial institutions announced on Monday--the economic outlook grows bleaker, people worry more about their jobs and retirement and cut back on consumption, and the stock market resumes its downward spiral while real estate prices sag further.

In short, each and every policy measure to date, however unprecedented and seemingly "radical" at implementation, has failed to stem the economic bleeding.

So, where do we turn at this juncture? Well, recall the proverbial "rich uncle," who is perennially forthcoming with money gifts when you are a kid, lends you the extra money you need for a down payment when buying your first house, and provides half the capital you need to start a new business. As our financial crisis runs its course, we Americans as owners of over-leveraged assets in our increasingly distressed U.S. economy really have only one place to go for the capital we so badly need. Because there is not enough capital internally within our national borders, the much-needed equity capital to stabilize our economy and restore confidence of consumers and among financial institutions must come from abroad.

Like it or not, for equity capital rather than just debt, American financial institutions, large corporations and our U.S. equity markets as a whole need to tap into the trillions of dollars of foreign exchange reserves on the books of governments throughout the world, and particularly the trillion dollar balances of each of China and Japan. Back in March, the House held a hearing on the role of foreign government investment in the U.S. economy and financial sector. More along these lines is needed.

My guess is that our equity markets will not find a firm bottom until cross-border government-level deals are struck to convert from debt to equity significant portions of the U.S. dollar-denominated foreign exchange reserves sitting overseas in Asia. How about a trillion dollar swap out of Treasuries and into a broad-based equity index like the S&P 500?

A substantial increase in foreign ownership of the American economy is probably a lot closer than we think.

Irony of Capitalism in Crisis: The rich lose more, but the poor and middle class suffer . . . and we need more government intervention, not less.

noreply@blogger.com (Lloyd Sakazaki) — Tue, 07 Oct 2008 19:35:00 +0000

With credit tight and real estate and stocks at multi-year lows, who wins and who loses? Certainly, any trader short the market or long put options is making out like a bandit, while anyone long real estate and stocks is experiencing painful net worth erosion.

But, in the midst of the financial turmoil we're in, how's the "average American" faring? For insight, let's first have a look at household balance sheets.

Household Balance Sheets

According to the Fed's triennial Survey on Consumer Finances (using 2004 data--results of the 2007 survey come out in early 2009), assets owned and debt held by 10% or more of all American families, along with the median dollar value of holdings among the specified percentage of families holding the particular asset or debt, are:

Financial assets:

Checking or other transactional account: 91% of families, $4k
CDs: 13% of families, $15k
Savings bonds: 18% of families, $1k
Stocks: 21% of families, $15k
Mutual funds and other pooled assets: 15% of families, $40k
Retirement accounts: 50% of families, $35k
Life insurance products with cash value: 24% of families, $6k

Nonfinancial assets:

Car or other vehicle: 86% of families, $14k
Primary residence: 69% of families, $160k
Other residential property: 13% of families, $100k
Business equity: 12% of families, $100k

Debt:

Mortgage on primary residence: 48% of families, $95k
Car loan or other installment loan: 46% of families, $12k
Credit card balance: 46% of families, $2k

Clearly (and this should come as no surprise, particularly in light of the mortgage-related crisis we are in), the most significant asset owned by most American families is our primary residences, against which we carry sizable mortgages.

The Poor, the Middle Class and the Rich

The landscape gets more interesting when we probe one layer deeper, to see who owns what and against how much debt. Taking a look at three distinct groups classified by net worth (again in 2004 dollars), we can list assets and debt commonly held by 40% or more of the households in each group:

The Poor (below 25th percentile): $2k median net worth

Assets:

75% have checking accounts with median value $1k
70% own car(s) with median value $6k

Debt:

48% have car loans or other installment loans with median value $11k
40% carry credit card balances with median value $2k

Typical leverage: Debt/assets = 0.8 (estimated based on net worth)

The Middle Class (50th to 75th percentile): $171k median net worth

Assets:

98% have checking accounts with median value $6k
62% have retirement accounts with median value $34k
92% own car(s) with median value $17k
93% own their primary residence having median value $159k

Debt:

66% carry a mortgage on their home with median value $97k (60% implied loan-to-value)
49% have car loans or other installment loans with median value $13k
53% carry credit card balances with median value $3k

Typical leverage: Debt/assets = 0.4 (estimated based on net worth)

The Rich (above 90th percentile): $1.43 million median net worth

Assets:

100% have checking accounts with median value $43k
63% own stocks with median value $110k
47% own mutual funds with median value $160k
83% have retirement accounts with median value $264k
44% own cash value life insurance products with median value $20k
93% own car(s) with median value $31k
97% own their primary residence having median value $450k
46% own other residential property with median value $325k
41% own business equity with median value $527k

Debt:

58% carry a mortgage on their home with median value $186k (40% implied loan-to-value)

Typical leverage: Debt/assets = 0.1 (estimated based on net worth)

On the asset side of the household balance sheet, the picture that emerges is pretty much as expected: the rich own everything that the poor and middle class do, and have more of everything, item by item. The typical middle class household owns a checking account, car, house and retirement account. By comparison, rich households own what their middle class brethren do, plus a long list of investment assets: stocks, mutual funds or hedge funds, insurance annuities, second homes or investment real estate, and private businesses. At the other extreme, the majority of poor households have only a checking account and a car.

The situation flips, however, when we look at the liability side of the balance sheet: although the rich have higher absolute dollar amounts of debt, their debt-to-assets ratio is the smallest among the three groups. Borrowing is most prevalent among the middle class, where two-thirds of the households have mortgages on their homes, half have car loans, and half carry balances on their credit cards, resulting in typical household leverage of about 0.4. Among the poor, slightly fewer than half have car loans and about four out of ten households have credit card debt. However, it is actually the poor who are most overburdened by debt, with a high debt-to-assets ratio of about 0.8. This trend of the "asset-poor" being the most "debt-rich" can easily be seen by looking at the fraction of car owners in each group who have car loans and other installment debt: the poor (48%/70% = 0.7), the middle class (49%/92% = 0.5), the rich (27%/93% = 0.3).

Weathering the Financial Storm

Who fares best: the over-leveraged poor, the debt-laden middle class, or the asset-endowed rich?

As real estate and stock prices fall, here's how each group is affected:

The poor, who do not typically own real estate, stock or mutual funds, are not immediately affected by falling markets. However, a small yet significant subset (12% in 2004, presumably higher today) of these households in the lowest quartile of net worth are homeowners carrying mortgages and, being the most highly leveraged group, are undoubtedly the most adversely impacted by depressed home prices. Further, having little to no savings, this group is the first to fall behind in loan and credit card payments when job losses escalate as the economic downturn runs its course.
The middle class comprises the bulk of homeowners with substantial mortgages who are feeling the brunt of the fall of the housing market. These households also have retirement accounts with stock and mutual fund positions that shrink as stock prices slide. In the event of a job loss, most of these families can cover their bills for at least a few months by relying on their savings and, if needed, early withdrawals from their IRAs and 401ks. But, if the downturn lengthens and unemployment rises further, many of these households will unfortunately suffer through home foreclosures and the like.
The rich experience the fewest financial dislocations, despite the fact that their vast holdings of stocks and real estate are immediately impacted when prices fall, putting downward pressure on the equity in their private businesses as well. Although rich households lose the most money in absolute terms when prices fall, their minimal household leverage (debt-to-assets ratio of just 0.1) makes true financial hardship a foreign concept to most in this group. Because very few of the rich have large mortgages on their homes (and even if they do, they usually have liquid assets they can sell off to reduce leverage), foreclosures among this group will be almost unheard of, however severe the economic downturn becomes.

Policy Implication

The recent chain of events is becoming all too familiar: real estate and stock markets fall, investor sentiment (i.e., among the rich) turns negative, headlines carry news of our ensuing financial crisis, smaller investors (i.e., the middle class) either sell out or hesitate to buy, consumers (all groups) spend less on goods and services, businesses earn less, the economy stalls, layoffs begin, sentiment worsens, and market prices fall further, bringing us full cycle--but at a lower level.

If this downward spiral continues, the over-leveraged poor lose their jobs, cars and homes (through foreclosure if they own them, or eviction if they are renters); the debt-laden middle class exhaust their savings and deplete their dwindling retirement accounts trying to stave off foreclosure of their homes (but many lose their homes anyway); and the asset-endowed rich watch their asset values plunge but keep their homes and still own America. While an extended economic recession is definitely not desirable for any group, note that:

Economic pain and suffering is inversely proportional to wealth: the poor suffer the most, the middle class are next, and the rich, well, they become a little less rich.

The public policy implication should be clear: at this point, whatever can be done to stabilize the markets should be done. President Bush distributed cash to families last year through his fiscal stimulus package, which helped the consumer and temporarily kept the economy afloat. The recent moves of the Fed, FDIC and government--in rescuing Bear Stearns and AIG, saving Fannie Mae and Freddie Mac, coordinating orderly takeovers of WaMu and Wachovia, increasing deposit insurance levels from $100k to $250k, preparing to buy $700 billion of "toxic" mortgage-related assets from the banks, and buying commercial paper in the markets today--have all helped.

But, one problem remains: we're not yet on solid ground.

Australia cut rates this morning by 100 b.p., twice as much as anticipated. Pimco's Bill Gross is right to push the Fed for a similar massive rate cut later this month. A coordinated global rate cut is also in order.

For any advocates of laissez faire capitalism, this "visible hand" of persistent government intervention in the markets must be appalling, particularly following the apparent successes of American-style capitalism over Cold War communism during the past few decades. However, we are now in a "leveraged asset" crisis and the only way to stop the bleeding is do what it takes to stabilize asset prices, and the only entity capable of acting on a large enough scale to make a difference is the government.

From Economics 101, we know that the four factors of production are innovation, labor, physical resources and money. Despite this financial crisis we're in, America and the world still have plenty of entrepreneurial ideas, people willing and able to work, and all the (arguably diminishing) natural resources we always have had. What is lacking is capital, and at this point only the government has deep enough pockets to keep the money flowing.

With the U.S. government stepping in so often in recent months and taking ownership (or warrants) in our prime financial institutions, it may be surprising to many that America is involuntarily slipping through some convoluted "looking glass" into a society with increasing government ownership of businesses, where the state, by default, has become the largest market participant.

Such is the irony of modern capitalism, with more government intervention, not less, being needed to keep the ship above water as the economic tide sloshes all around us--poor, middle class and rich alike.

How to play this crisis--Do nothing?

noreply@blogger.com (Lloyd Sakazaki) — Tue, 30 Sep 2008 17:56:00 +0000

What should an investor do after a day like Monday, when the Dow, S&P, and Nasdaq all plummeted about 8% following Congress's "no" vote on the $700 billion bailout plan? Some say: "I wouldn't recommend anyone sell after a day like Monday but wouldn't be in a rush to buy stocks either." (See article by Aaron Task and Henry Blodget at Tech Ticker)

So, neither sell (if you own stocks), nor buy (if you have cash to buy). In other words, do nothing.

Does this make sense?

Think about the various market views one might have:

Bullish: If you "know" for sure that the stock market will rise from here, obviously you should be invested 100% in stocks, and presumably you would recommend that others buy stocks too (since "knock-on" effects help to fulfill your prophesy);

Bearish: Similarly, if you "know" the market will fall, you'll want to be sidelined, holding all cash and no stocks, and you would recommend that others (at least anyone you care about) sell out too to avoid additional losses;

Neutral: Or, if you just happen to "know" that the market will trade in a tight band, essentially unchanged, you would tell others that it really doesn't matter what they do, since holding stock in your portfolio or not will land you at the same place as cash if the market doesn't move.

In this context, the recommendation to "do nothing" appears to be an implicit statement that the stock market will trade sideways, meaning that, whether you currently hold stocks or hold cash, making no changes to your portfolio (i.e., neither buying nor selling) will not leave you at any disadvantage relative to someone who takes action and switches strategy.

A glance over at Intrade for a popular prediction about where the stock market is headed shows a 50% chance that at year-end (close of trading in December) the Dow will be at or above 11,000, in the opinion of those willing to wager bets on their views. Seeing that the Dow is now (1:55 p.m., New York time, Tuesday, September 30) at 10,700, the benchmark level of 11,000 on December 31 is essentially unchanged from today.

With the financial media being what it is, this match between Tech Ticker and consensus opinion should be no surprise. . . .

However, I also note that anyone holding cash who chose not to deploy it after yesterday's fall is missing today's rally, which appears to be strengthening as I write. At least so far today, the right decision has been to be 100% long this market. So much for doing nothing . . . unless you are already fully invested.

Will we ever get out of this financial mess we're in?

noreply@blogger.com (Lloyd Sakazaki) — Tue, 23 Sep 2008 18:47:00 +0000

I look out my office window and see a suburban scene pretty much as usual--a few parked cars, an occasional pedestrian, a tree-lined street, a bird flies by. . . . Yet the headlines say we are in the midst of the worst financial crisis since the Great Depression. Fannie Mae and Freddie Mac are bailed out by the government, Bear Stearns is forced into a government-orchestrated sale to JPMorgan, Lehman goes bankrupt, Merrill is getting bought out by B of A, AIG is fighting to avoid becoming 80% government-owned, Morgan Stanley takes a 10% to 20% investment from Mitsubishi UFJ, WaMu will likely get bought out, Citi is surviving but staggers like a wounded elephant with arrows in its back. . . . And many pundits say we have not yet reached the bottom.

What's the root cause of this financial mess? Some point to the falling housing market, particularly in California and Florida, where millions of homeowners are struggling and many thousands are defaulting on their monthly mortgage payments. Others say it's debt in general, not just mortgages but also car loans, credit cards and the like, i.e., consumer debt as a whole. Yes, it's easy to understand how the debt burden in our consumption-oriented society with a savings rate either slightly negative or close to zero just "had to" catch up with us sooner or later.

There's a thought-provoking video entitled "Money as Debt," pedagogically praiseworthy if not completely accurate in all detail, which explains how money itself can be viewed as a form of debt that is created by our financial system. If you can spare 47 minutes of your day to watch the video, here's the link. The video's thesis is that our modern system of money is intrinsically unsustainable, since money's very existence depends on the continual creation of more and more money (or debt, depending on your perspective) to pay the interest (in addition to principal) owed by all us borrowers who have drawn down loans from banks and other financial institutions. The picture here is that of an ever-increasing pile of debt, an exponentially growing mountain of indebtedness that inevitably leads to the outcome we all fear like the plague--a collapse of our entire monetary system and its consumer-capitalist lifestyle that we just "can't live without." Right . . . try to imagine a world without WaMu, Citi, JPMorgan, Goldman, B of A . . . maybe even no Walmart, Costco, Nordstrom. . . . Pretty hard to visualize, eh?

A friend wrote to me the other day, saying that he has heard that one way to fix the U.S.'s financial problems is to "inflate the dollar." While economic solutions are never as easy to implement as they are to state, I think this view is essentially correct. This morning, as Bernanke and Paulson adamantly urge Congress to float their $700 billion bank rescue plan (that's $2,300 for every American), what we are seeing is an attempt to feed the credit-hungry monster that we have created over the past century. The proposal is to use $700 billion to buy "bad" (illiquid) loans from the many embattled banks, thereby replenishing their books with new (liquid) money that they can, in turn, lend to struggling consumers who are in dire need of more loans to make principal and interest payments on their existing loans--hence, stabilizing the housing market and stemming the breakdown of the financial system before it truly spirals out of control.

And where does this $700 billion come from? Well, that's why Congress is being asked to approve a higher statutory limit on federal debt, to the tune of some $11.3 trillion. With a higher debt ceiling, the government can borrow the $700 billion from investors through the capital markets (i.e., foreign governments and institutions, since that's who buys government bonds these days). The net result will be a "re-leveraging" of our financial system here in the U.S., which will likely, over time, lead to higher interest rates (to persuade foreigners to continue to lend), a need for more borrowing to pay off this principal and interest, the creation of more money. . . . Sound familiar?

From an investment point of view, I believe stock market direction in the short run is anyone's guess, as the dynamics (I first mistyped "dymanics" here, which, come to think of it, better captures the spirit of today's volatile, "manic" market!) of the current situation change from day to day, if not hour to hour. Longer term (i.e., over the next five to ten years), I believe that the equity markets (both stocks and real estate) will stabilize, rebound and even see new highs. Both economically and politically, "the powers that be"--meaning the billionaires who own stock and real estate, the politicians who wish to be re-elected, and the business executives who want to keep their jobs--will do whatever they can to protect their own self-interest and, in so doing, keep confined to its ever-expanding cage that awakening credit monster with a voracious appetite for more and more debt.

Drawing an analogy of our 232-year old U.S. economy to Rome some two thousand years ago:

". . . Essentially it was an aristocracy, in which old and rich families, through ability and privilege, held office for hundreds of years, and gave to Roman policy a tenacious continuity that was the secret of its accomplishments.

"But it had its faults. It was a clumsy confusion of checks and balances in which nearly every command could in time of peace be nullified by an equal and opposite command. . . . What astonishes us is that such a government could last so long (508 to 49 B.C.) and achieve so much. . . . Devotion to the state marked the zenith of the Republic, as unparalleled political corruption marked its fall. Rome remained great as long as she had enemies who forced her to unity, vision and heroism. When she had overcome them all she flourished for a moment and then began to die." (Will Durant, The Story of Civilization: Part III, Caesar and Christ, pp. 34-35)

As the historical record indicates, the expansive Roman Empire (146 B.C. to 192 A.D.) followed the earlier Republic (508 B.C. to 30 B.C.) stage, and the fall of Rome "was not an event but a process spread over 300 years." (Durant, p. 665) In a similar vein, I would venture to say that the U.S. economy and the larger global economy, however fragile they may now appear, most likely will see more prosperous years ahead. Though Wall Street's headline events of these past few months may be eye-popping, our debt-laden system, despite its flaws, will most likely bring lots of volatility (both upside and downside) but will not collapse anytime soon.

In short, if any end is near, it's probably the end of the financial mess we're in, rather than the end of economic growth and the corresponding secular rise of the market.

Q&A: Ask Lloyd a finance or investment question

noreply@blogger.com (Lloyd Sakazaki) — Sat, 31 May 2008 22:03:00 +0000

Questions Answered:

How can I win the stock-picking contest at my school?
*New*

Should we remain renters or buy a house?

Should we sell the farm and pay the tax?

Real Estate and Leverage: How much is best?

Should I buy-and-hold or trade?

How will U.S. stocks perform versus foreign equity markets?

Can sentiment predict market direction?

How can I use the PEG ratio to value stocks?

Is Baidu worthwhile buying now?

Is the Chinese stock market a bubble?

Have you read the new book, An American Hedge Fund?

Which should I use, a full-service or discount broker?

Will Keystone Automotive shareholders approve the $48 buyout by LKQ?

I'm new to investing. Is there a simple place for me to start?

Should I use an investment advisory service?

Are stocks with high price-to-book ratio worth buying?

I'm a kid. What stocks do you recommend I buy? (Momentum and Recovery Picks)

How do I get the money to invest?

Is buying high earnings-to-price (or low PE) stocks a good strategy?

Should a high-net-worth individual take out a mortgage to buy a home?

How can small investors invest in commercial real estate?

Invitation: Submit your questions about investing, the stock market, finance or other money-related matters, and I will try to provide meaningful responses based on my own research and perspectives. Please post your questions to this blog by clicking on the "COMMENTS" link immediately below. Thanks!

How can I win the stock-picking contest at my school?

noreply@blogger.com (Lloyd Sakazaki) — Sat, 31 May 2008 21:56:00 +0000

Reader's Question: I am taking a finance course in college. Our teacher has set up a competition on Virtual Stock Exchange, where students build their own portfolios and the student who has the highest return at the end of the trimester wins. I'm new at this. Which stocks should I buy?

As you set out to pick your stocks for the contest, I suggest keeping in mind two "facts" about the short-run performance of individual stocks:

1) It is almost impossible to predict with any certainty today which particular stocks will rise and which will fall tomorrow, and

2) Stocks that are volatile today tend to remain volatile tomorrow.

Putting these two principles together, I'll show you how to win the stock-picking contest--at least with greater odds than you might otherwise expect.

A Stock-Picking Analogy: Numbers in a Hat

Imagine that you and each of your classmates are presented with two hats holding cards with numbers written on them. The first hat (call it the "low volatility" hat) holds numbers uniformly distributed between -10 and +10. The second hat (call it the "high volatility" hat) holds numbers uniformly distributed between -50 and +50. You may choose one and only one number from just one of the two hats, and the student drawing the highest number wins.

The million dollar question is: Which hat should you pick your number from, the high volatility hat or the low volatility hat?

The expected outcome when picking a number from a hat is just the average of all of the numbers in the hat. In our example, this average is zero, because in each of the hats the positive and negative numbers are uniformly distributed. The situation up until this point mirrors Principle 1 above, which is equivalent to saying that your expected return when selecting either low volatility or high volatility stocks is zero (or close to zero) over a short time horizon (and a trimester is a fairly short period of time, so far as investing goes).

Now, if you and your classmates were actually to draw numbers out of the hats as described, you would find that the winner (i.e., the person who is lucky enough to pick the highest number) will almost always be a student who draws a number from the hat with numbers ranging from -50 to +50, and not the hat with numbers from -10 to +10. The prescription, then, is that, if you wish to win the contest, you should draw a number from the hat with the wider range of numbers, i.e., from the high volatility hat, since the winning number will almost always be drawn from this hat. You might be able to see intuitively why this is so, but for anyone interested in seeing how the probabilities work out, I'll provide a bit more detail.

Probability Analysis

(You may skip this section, but it's an informative application of probability if you are willing to put a little effort into following the math, which really is not very difficult.)

For the idealized case of uniformly distributed numbers in each hat, suppose you draw a number from the (-50,+50) hat, while everyone else in your class picks from the (-10,+10) hat. Three outcomes are possible:

a) If the number you draw is between -50 and -10, you will lose the contest, and this will occur 40% of the time;

b) If your number sits between +10 and +50, you will win, and this outcome also has a 40% chance of occurring;

c) The remaining 20% of the time, your number will be between -10 and +10, and you will typically lose, since the expected value of the highest number drawn by your classmates from the (-10,+10) hat approaches +10 as the number of your classmates drawing from the (-10,+10) hat becomes large, i.e., the best draw from the (-10,+10) hat will typically beat your middling draw from the (-50,+50) hat.

Overall, when you are the only one drawing from the (-50,+50) hat, you have a 40% chance of winning the contest, which is much better than the odds of winning you would have (e.g., 1/30 or about 3.3%, if there are 30 students) if you, along with everyone else, were to "follow the herd" and pick from the (-10,+10) hat.

Now, what happens if some of your classmates also decide to draw from the (-50,+50) hat? Suppose that N students, i.e., you and N-1 others, pick numbers from the (-50,+50) hat. The probability that at least one of these N students (including you) draws a number exceeding +10 is equal to one minus the probability that all of these N students draw numbers between -50 and +10, which is (1 - 0.6^N). Also, since your draw is just one among N from this high volatility hat, we need to divide by N to arrive at your probability of winning the contest. The result is:

P(N) = (1 - 0.6^N)/N

For N = 1, P(1) = 1 - 0.6 = 0.4, which represents the 40% chance you have of winning when you are the only one drawing from the (-50,+50) hat. For larger N, i.e., when some of your classmates also follow the high volatility strategy, your probability of winning declines:

P(2) = (1 - 0.6²)/2 = (1 - 0.36)/2 = 0.32 = 32% chance of winning
P(3) = (1 - 0.6³)/3 = (1 - 0.22)/3 = 0.26 = 26% chance of winning
P(4) = (1 - 0.6⁴)/4 = (1 - 0.13)/4 = 0.22 = 22% chance of winning
P(5) = (1 - 0.6⁵)/5 = (1 - 0.08)/5 = 0.18 = 18% chance of winning
Etc.

In the limit of large N, your probability of winning will fall to 1/N, which is another way of saying that any strategic advantage you have disappears when everyone else learns about and decides to copy your superior strategy (so, keep quiet about how you go about picking your stocks!).

Picking High Volatility Stocks

Based on the above logic, you can generally enhance your chances of winning the stock-picking contest by selecting stocks with the highest volatility possible. You may not be able to determine with certainty whether a particular stock will rise or fall (Principle 1 above); however, because stocks that have recently risen or fallen a large amount are likely in the near future to move a large amount one way or the other (Principle 2 above), you have both greater upside and greater downside when playing the high volatility game. High volatility investing tends to produce large stupendous gains as well as shocking losses.

In following the high volatility strategy, you should realize that the chance you will end up performing the worst in your class equals the chance you will end up being the top performer. However, in stock contests like the one you are participating in, the benefits of winning first place usually far outweigh the drawbacks of being the last place finisher, since kudos and recognition go to winners, while everyone else, no matter how low in ranking, is simply not mentioned at the awards ceremony. Within the context of your stock-picking contest (at least as I am imagining it), you will be better off increasing your odds of "winning big" with risky high volatility stocks than "playing it safe" with more conservative low volatility stocks.

As a practical matter, you are probably wondering how to identify high volatility stocks. One easy way is to go Yahoo! Finance and examine the daily lists of largest percent price gainers and largest percent price losers. (Although I have not used MarketWatch's Virtual Stock Exchange, I have noticed that their website also provides lists of largest percent price gainers and losers.) On any given trading day, there will typically be a handful of stocks that have moved 20% , 30% or more, up or down. In some cases, the large price movement will have been driven by buyout, earnings or new product announcements, so that the large price move will typically not be followed by another large move--avoid these one-time news situations. Instead, focus on the large percent gainers and losers that have moved on no news.

More often than not, the "no news" movers will be stocks of small companies, so-called microcaps or "penny stocks," which are highly volatile, trade in small volume (or at least small dollar volume) and most institutional investors stay away from. Have you ever heard of RXI Pharmaceuticals (RXII), Aristotle Corp. (ARTL), ULURU Inc. (ULU), or I-Many Inc. (IMNY)? Most people probably have not, since they are by no means household names. However, these four stocks were among those that moved more than 20%--two of them up and two of them down--in Friday's trading, on no significant news. Your job will be to do the research and identify stocks whose volatility is likely to remain high, and, if you are lucky, you'll pick stocks that will actually rise (or fall, if you are allowed to go short in your contest).

So, while your classmates are holding Google (GOOG), Apple (AAPL), Microsoft (MSFT) and other such popular stocks in their portfolios, you will be off buying and selling shares of small companies that no one has ever heard of. Due to their high volatility, the stocks of these microcap companies are the venue of daytraders, stock promoters and others "gambling" for a quick profit. As you are engaged in your game with your classmates, the short-term traders will be the ones doing all of the heavy-lifting, causing the stock prices to ramp up and down, allowing you to ride the opportunity for potential profit within the safe harbor of your stock-picking contest.

Best of luck paper-investing or paper-trading, as the case may be. I hope you win the contest!

P.S. Over the weeks ahead, could you please post a comment to let us know how you do in the stock-picking contest compared to your classmates? Thanks.

Important Note: The strategy I outline above for your stock-picking contest is not the strategy I would recommend following when you actually invest your own money in the real world outside of the classroom. Within the confines of an in-school contest, even the worst case outcome of a dismal investment return will probably not drag down your grade (but check with your teacher to make sure before entering your trades), since educational environments generally adhere to a philosophy that "it doesn't matter whether you win or lose; it only matters how you play the game" (yet it is nice to win, and that's why you've asked for my opinion, right?). When you are using real money, the potential downside inherent in trading extremely high volatility stocks, namely, the miserable prospect of losing all or most of your money, is just too damaging financially, psychologically and emotionally, and should be avoided. For a strategy I suggest following in any real-world investing you do in the future, please read a five-part series of articles on long-term investing I have written, accessible through the last part in the series here.

Should we remain renters or buy a house?

noreply@blogger.com (Lloyd Sakazaki) — Thu, 29 May 2008 04:50:00 +0000

Reader's Question: My husband and I are 40 years old, live in Australia, and have no kids. We own a small business and have annual income between $80k and $100k. We live within our means, have no debt, and save about $30k to $50k per year. We do not contribute to superannuation (tax-advantaged retirement plan) because we prefer to manage our investments on our own. Our savings and investments (mostly common stock) are currently worth about $400k. Instead of buying a house, we have chosen to rent, since local real estate prices are very inflated, making renting much cheaper than buying. However, I am wondering if we should invest in real estate so as to diversify and have some place to live further down the line. How do you see renting vs. buying? Do you think we are on the right track to a comfortable retirement in about 15-20 years?

Rent vs. Buy Analysis

As with many financial decisions (e.g., invest in stocks or bonds?, use leverage or not?, continue to hold a stock or sell it now?), much can be said about the choice between renting and buying a house, but we only really find out tomorrow if we truly are making the right decision today. I'll go through an example using the U.S. real estate market, and then return the discussion to a broader perspective.

Back in 2000, just after the stock market had peaked and the dot-com crash was beginning, my family and I arrived in the city we currently live in. At that time, the local residential real estate market was firm with median-priced homes around $400k, and prices were rising at a solid though moderate mid-single digit annual rate. Being new to the area, we initially rented, paying $1,700 per month for an average-size house on a quiet street in a good school district. While renting, I occasionally would run through a quick rent vs. buy analysis, similar to the one I imagine you are now doing. Assuming no mortgage, the pre-tax calculation is simple, at least in principle (income taxes and a mortgage complicate matters but the main variable remains the relative investment performance outlined below):

Renting: As renters, we were paying 12 x $1,700 = $20,400 per year in rent, and the owner was responsible for all property tax, homeowner's insurance and necessary repairs on the house. Since the $20,400 annual rent was about 5% of the estimated $400k price of a comparable house at that time (in the year 2000), we can write:

Annual cost of renting = 5% of price of house.

Buying: If we were to buy a comparable house, we would need to sell $400k worth of investments (mostly stock), foregoing whatever future return we might realize, and use this money to buy the house, which itself would show some rate of price appreciation. The financial burden of 1) paying property tax and insurance (about $4,000 annually on a $400k house) and 2) performing repairs or at least putting money aside into a reserve account for major repairs (e.g., roof replacement or painting) to be performed at some point in the future (estimated at another $4,000 annually), together add up to $8,000 per year. So, in approximate percentage terms, we have:

Annual cost of buying = 2% for property tax, insurance & repairs + (S - R),

where S is the estimated future annual percentage return on investments (mostly stocks) to be sold in order to buy the house, and R is the anticipated future annual percentage price appreciation of the house (real estate).

From an investment point of view, renting should be preferred over buying when the annual cost of renting is less than the annual cost of buying, i.e., when 5% <> R + 3%. In other words, as a rough rule of thumb: If stock market returns exceed house price appreciation by more than 3% (i.e., 300 b.p.) per annum, one can expect be better off renting a house (and owning stock) instead of (selling the stock and) buying a house.

The graph below shows how stock market returns (S&P 500) have compared to house price appreciation (for the Seattle area where I live) for the eight years between 2000 and today.

(click graph to enlarge)

During 2000-2002, when the stock market fell sharply, I expected the sell-off in equities to exert noticeable downward pressure on local real estate prices, but the correlation between the stock and real estate markets was weak. When the stock market turned around in late 2002, initiating an extended five-year bull run, real estate price appreciation accelerated as well. Currently, amidst fallout from the subprime crisis here in the U.S., the housing market seems softer than the stock market, which itself is largely moving sideways as the economy flirts with recession.

In my family's case, after an extended house search, encompassing a few years but focussed on a small neighborhood with very little available inventory, we finally found the right house, liquidated other investments and closed escrow, switching from being renters to homeowners in early 2005. in retrospect, we managed to capture the bulk of the rapid price appreciation our local real estate saw in 2004-2006, and have ended up being on the correct side of the rent-vs.-buy dichotomy for each of the past three years.

Assessing the Future

Like you and everyone else, I wish I had a crystal ball to predict the future. If I could correctly forecast the relative performance of the S&P 500 versus my local real estate market, I would always know whether to be a renter or homeowner. Short of knowing the future, however, I look to "softer," more qualitative factors--such as being partially "hedged" through having exposure to both the stock and real estate markets, the freedom to replant a garden or repaint a room without consulting a landlord, peace of mind from having neither rent nor a mortgage to pay, and so on--for assurance that owning a house and allocating much of the balance of our investment portfolio to the stock market is the right decision, at least for now.

For a comparison to other markets, you might wish to read the Global Property Guide article here covering the state of housing markets around the world, giving both price appreciation and rent figures for many countries. Some highlights, with emphasis on the Pacific Rim (including both Australia and the U.S.), are:

House Price Appreciation (2007, in local currency):

Shanghai 28%
Singapore 28%
Hong Kong 11%
Australia 11%
UK 10%
South Korea 9%
Japan (6 major cities) 8%
New Zealand 7%
Canada 6%
Japan (nationwide) -1%
U.S. (average of indices) -2%.

Rental Yield (gross rent as percent of house price):

Shanghai 7.8%
Sydney 5.9%
London 5.4%
New York 5.0%
Tokyo 4.7%
Hong Kong 4.2%
Singapore 2.8%

Offhand, I would guess that at some point during the next couple of years a few of the hotter real estate markets around the Pacific Rim will see declines similar to what the U.S. (particularly the submarkets like California, Florida and Las Vegas, Nevada, which rose fastest on the way up) is now experiencing. How your neighborhood real estate market in Australia is impacted is really something you, being local, should have a better handle on than I do.

When making your decision, keep in mind that a) the future is hardly ever crystal clear, and b) it is the relative future performance between whatever particular investments you will sell (the "S" above) and the specific house you will buy (the "R"), that will allow you (and only retroactively!) to determine conclusively if you made the correct rent vs. buy decision in prior years.

Overall, seeing that you and your husband are entrepreneurial, hardworking, persistent in your saving habits, self-directed in your investing, and debt-free, I am optimistic that either path, i.e., renting or buying, will lead you to the comfortable retirement you are targeting. Best of luck in the years ahead!

Why Successful Traders Are So Secretive

noreply@blogger.com (Lloyd Sakazaki) — Thu, 15 May 2008 00:35:00 +0000

I set out to explain why successful traders are so secretive, by stepping through a logical argument of how a trader, if he publicizes his trading decisions, will almost certainly sooner rather than later undermine his own success. For many reading this, secrecy among successful traders may be a truism not requiring elaboration. However, for anyone wishing to hear the story, here it is:

Let's call our (hypothetical) young trader Mr. Bright. Assume that Mr. Bright either has an innate and remarkable ability to discern patterns in stock price movement or, alternatively, has developed a sophisticated computer program that can correctly forecast price action. Using his uncanny ability or his financial technology, Mr. Bright buys and sells stocks, typically taking positions for only a few hours, and achieves a highly favorable track record, soon vaulting him to multi-millionaire status.

One sunny morning, driven by apparent altruism camouflaging a layer of megalomania, Mr. Bright wakes up and decides to "share the wealth" with others by publishing his trading decisions via a website, announcing his buy and sell targets for particular stocks, and detailing his actual trades real-time.

Now, the media, always looking for a good story, is quick to pick up on young Mr. Bright's impressive track record and his openness and willingness to educate anyone who will listen. However, the public, including numerous "little guy" investors, who have only painful memories of losing too much money on rumors, hearsay and not-so-sound "advice" from "experts," is more skeptical. At first, only a few people take Mr. Bright and his predictions seriously enough to put their own hard-earned money at risk mimicking his trades. However, the success of the bold early adopters soon attracts a small army of followers, who are eager to partake of the "easy money," free for the taking simply by copying Mr. Bright's trading actions--buying when he buys and selling when he sells.

For quite a few months all is well. Mr. Bright's trades, along with those of his army of copycats, are profitable more often than not. He and his followers are on track to realize a 100% return during the first year. To the surprise of all skeptics, Mr. Bright is consistently putting money into the pockets of every little investor in his army and quickly becoming a popular hero.

By this time, as success tends to generate its own publicity, Mr. Bright and his uncanny forecasting system have caught the attention of professional investors (hedge funds, proprietary trading desks at investment banks and others). Since Mr. Bright makes a habit of publishing his trades real-time, he and his army of followers are an easy target for deeper-pocketed pros.

The strategizing in the pros' minds goes like this: Seeing that the stocks that Mr. Bright and his army buy rise so predictably, why not kick in a few dollars and join them on the way up? Then, instead of waiting for Mr. Bright's typical 10% rise before taking profits, how about front-running Mr. Bright and his army by selling out a little sooner, say at 9% profit, and proceeding to go short in significant size? As the stock starts to fall due to our short, Mr. Bright and his army will have little choice but to cut their profits and join us in selling, thereby pushing the stock down further and faster. As Mr. Bright and his army go into rapid retreat, the corresponding surge in trading volume and collapsing stock price will provide us pros with an opportunity to buy back shares to cover our short for a quick profit. As is easy to see, Mr. Bright and his army, with their well-publicized trades, will inevitably fall right into our trap!

In essence, Mr. Bright's system breaks down when more money is put into play. While the system initially succeeds in predicting price movement and generating profits for Mr. Bright and a small army of followers, the forecasting ability of the system vanishes when deeper-pocketed pros toss more money into the game. The very actions of Mr. Bright and his followers become a significant part of the overall market and, ultimately, the predictability of their behavior becomes a target of the pros.

Ironically, Mr. Bright's uncanny forecasting ability, when publicized to allow everyone free access to his trading decisions, itself becomes a predictable aspect of the market. In other words, the very act of revealing the predictions of a successful trading system predictably undermines its own ability to predict!

Moral of the story: Mr. Bright wasn't so bright after all.

Corollary: The brightest traders keep their systems secret.

Should we sell the farm and pay the tax?

noreply@blogger.com (Lloyd Sakazaki) — Thu, 01 May 2008 03:16:00 +0000

Reader's Question: Next year we will sell our family farm and expect to net in excess of $200,000. Our tax preparer says to pay the tax and invest the rest. Is this correct? If so, where should we invest? My husband and I are both in our 60s and would certainly like more income to help us enjoy this stage of our life.

Since you are selling real estate, you should first determine whether or not your farm qualifies as your principal residence; in accordance with IRS rules, if your farm property is your home, you and your husband might qualify for exclusion of up to $500,000 in profits from your capital gains tax calculation. Here's a Bankrate.com article covering this home-sale tax exemption.

If your farm is not your principal residence, then it will likely be treated as an investment property and you can qualify for a "like-kind" 1031 tax-deferred exchange if you meet the IRS requirements. Again, here's a Bankrate.com article for an overview. You might consider swapping your farm for any of a variety of common types of rental income property (e.g., apartments, small offices, self-storage facilities). Appropriately selected rental properties are capable of offering solid positive cash flow, which can provide the income stream you are seeking. With real estate markets weakening across the country, now seems to be a good time to start looking for properties being offered at attractive prices by motivated sellers.

As your tax preparer suggests, you can alternatively just pay any capital gains tax you might owe upon sale of your farm and roll the after-tax proceeds into other investments of your choice. If you choose to follow this option, I would suggest paying close attention to fees and expenses when reinvesting. Minimizing investment management fees will tend over time to give you higher returns. If you are comfortable choosing individual stocks (including ETFs and REITs, many of which pay substantial dividends) and bonds on your own, you'll save by avoiding having to pay fees to a fund manager. Opening an account at a reputable discount broker can also help reduce transaction costs. If you decide that mutual funds suit your investment style better than buying individual securities directly, I suggest seriously considering only funds with low fees and low portfolio turnover.

In case you have not yet seen it, you might also wish to peruse my earlier comments on wealth generation in a five-part series on long-term investing.

Real Estate and Leverage: How much is best?

noreply@blogger.com (Lloyd Sakazaki) — Wed, 09 Jan 2008 00:20:00 +0000

Reader's Question: I'm 28 years old. My wife and I both work as electrical engineers in jobs that pay well. Using our savings we have been buying income-producing real estate to replace our employment income and now own 11 units. Is real estate the best vehicle for achieving our goal of becoming financially independent to free up time for activities we consider more meaningful? I have not found other investments that offer such handsome cash yields and permit a similar degree of leverage. Also, regarding leverage, what is the optimal amount of overall leverage for our property portfolio? Is it wise to "lever to the max" with exotic strategies (like wrap notes on properties purchased subject-to), or would we be better off de-leveraging our portfolio so that we don’t need to keep as much cash on hand to cover downside risk associated with leverage? I am struggling with the correct amount of property to purchase given our cash reserves.

In asset allocation and capital structure, the two areas of portfolio management your questions relate to, there are many different investing approaches, each of which has its own merits and unwavering supporters. Rather than try to show in any objective sense that one approach is always superior to the others, I will provide a personal perspective based on my own investing experiences, going broader than your specific inquiry to provide a fuller picture of what has worked for me over the past 25 years. I hope anyone reading this article is able to benefit from what I have to say; however, since even small differences in personal circumstances and preferences can sometimes lead to very different choices and approaches to investing, I encourage you to consider my opinions only as a point of reference, while proceeding to seek out advice from professionals who have the time and expertise to understand your situation thoroughly and work with you more closely to achieve your goals.

Real Estate Investing During the 1980s and 1990s

Since you are targeting a high cash yield and refer to your real estate as "units," I assume that you own apartments (though office buildings, neighborhood retail stores, mixed-use properties, storage facilities, mobile home parks and other real property are also all capable of generating predictable cash flow).

During the early 1980s, I made my first income property investment using a few thousand dollars I had managed to save from my job as a teaching and research assistant while studying for my graduate degree at an East Coast university and living frugally in a shared student house. I invested in apartments in California through a partnership run by an experienced general manager familiar to me through friends and relatives. We were leveraged at about 70% loan-to-value and the property produced good cash flow distributions. With California real estate steadily appreciating, the investment did well throughout the 1980s.

Following graduation in 1985, I took a high-paying job on Wall Street and continued to invest my (now more substantial) savings into other apartment buildings in Southern California. With occupancy above 95%, rents rising at above 5% per year, and limited available land for new development, rental properties continued to appreciate. I recall at the end of 1990 receiving an unsolicited offer for a 16-unit property of ours at a price of $1.15 million (or $72,000 per unit, a very attractive price at that time), which on paper produced a total return-on-equity of 150% in less than three years!

But good times, of course, don't last forever. The U.S. recession beginning in late 1990 hit Southern California hard. Real estate prices softened and buyers evaporated. Realtors and investors caught in the fallout coined the phrase "Stay alive till '95," expressing their confidence that the market would recover by the middle of the decade. Recovery, however, was slower than expected, and significant market strength did not return until around 2000, a full decade following the 1990 peak.

During the market nadir in the mid-1990s, the vacancy rate in one of our buildings rose to 15% and we had to reduce rents by about 10% and offer move-in specials to attract new tenants. In the worst year of operations, cash flow became negative by about 1% of property value (which would have been worse if we had been leveraged more highly).

After what in retrospect was a long roller-coaster ride, partially buffered by not being over-leveraged, we ended up selling the properties, mostly during the market runup from 2000 to 2005. During my total 10- to 15-year holding period, I achieved acceptable but unimpressive, single-digit compounded annnualized returns. This muted, bond-like, long-run performance of an equity investment is largely a reflection of the extended market slump during the mid-1990s, but perhaps the more important outcome from this experience is that we survived and even managed to make a little money during a period when a number of more highly leveraged investors and developers faced foreclosure and bankruptcy.

Lessons from the Last Time Around

With attention to leverage and cash flow, a few observations may be helpful:

Cyclicality: Despite a strong secular tendency to rise indefinitely, real estate markets also exhibit significant cyclical behavior. On a timing clock, with 12 o'clock at the market's top and 6 o'clock at the bottom, I would pair up the following times and dates:

9 o'clock: Market rises in late 1980s
12 o'clock: Market peaks at end of 1990
3 o'clock: Market falls during early 1990s
6 o'clock: Market bottoms around 1995
9 o'clock: Market recovers in late 1990s

Though it may still be too early to judge conclusively, I suspect that we will likely look back at 2005 or 2006 as defining another 12 o'clock real estate market peak.

Leverage and Cash Flow: Leverage slices both ways, producing quick double-digit returns on the way up (as during the middle and late 1980s) and often even quicker negative double-digit returns on the way down (as from 1990 to 1995). As a general principle, I believe it prudent never to leverage a property beyond the zero-cash-flow breakeven point between positive and negative operating cash flow (after debt service and a reserve charge for major repairs, but before depreciation and amortization). A conservative rule of thumb for determining appropriate leverage is to apply a stress test by bumping the economic vacancy rate up to two or three times its normal level (e.g., 5% vacancy becomes 10% to 15% vacancy) and making sure that the property still has either sufficient positive cash flow or adequate cash in the bank to cover this worst-case scenario for a full year of stressed operation.

Total Investment Return: While prudent cash flow management and avoidance of over-leverage (of which a wrap note can be a tell-tale sign) are important for survival during times of protracted rental market weakness, investment returns are often more impacted by property price appreciation than cash flow. Particularly for investment horizons of 10 years or shorter, market timing tends to matter. Admittedly, buy and sell decisions are difficult to get exactly right and each time around is different from the previous times, but I believe that it is possible to cultivate a type of "wisdom" about the markets by observing the macro and local economic forces and their influence on prices over many cycles, thereby developing a slight edge over less diligent players.

Don't Forget About Alternative Markets

Between 2000 and 2005, while I was selling my units in California, I seriously looked for replacement properties in the Washington state area where I now live. My target was a 15% return-on-equity over a pro forma five-year investment horizon, consistent with an 8% cap rate, at 70% loan-to-value, 7% debt service (principal and interest), a 10% cash-on-cash return, and 3% annual property price appreciation, fully accounting for property management fees during the holding period and brokerage fees upon sale. During my property search, I made a handful of offers but was unable to close on a desirable investment property at my price target.

What drove my direct investment target was an investment alternative: indirectly investing in real estate by buying shares of publicly listed REITs. At that time, which was in the wake of the dot-com bubble when office vacancy rates had risen to 20% in high-tech centers, shares of office REITs were trading at depressed price levels consistent with my 8% cap rate and 10% cash-on-cash return target. I viewed office REITs as more attractively priced and having more upside pootential than apartment, retail and other REITs, and proceeded to roll my sales proceeds from the California apartments into shares of Equity Office Properties and Trizec. As good fortune would have it, these two office REITs ended up getting bought out at premium prices in late 2006 and early 2007 by large private-equity buyout funds, providing me with returns that well exceeded my original total return target.

The message here is that, before concluding that direct ownership of income-producing real estate is the best way to meet your investment objectives, I would encourage you to give serious consideration to at least the REIT market and, more generally, the overall stock market. Since the middle of last year, with the subprime crisis feeding recession fears, REITs have taken a fall and are again beginning to look relatively attractive. In my opinion, HRPT Properties (NYSE: HRP), an office REIT with class A and class B properties in both major and more minor cities, is worth considering, since it is now trading at just 65% of book value (equivalent to a "see through" 9% to 10% cap rate with a 14% to 15% cash-on-cash return) and offers an 11% dividend which looks stable. This or other REITs or other dividend-paying stocks may also provide you with the sense of financial independence you are seeking through direct ownership of real estate.

Although I currently own no real estate other than my own residence, I expect again to buy investment properties when an attractive opportunity presents itself. My guess is that the U.S. real estate market as a whole is now at about 3 o'clock on the timing model mentioned above, and could have another year or two to go before reaching the 6 o'clock bottom. The Seattle market where I am is still performing stronger than most other markets, which leads me to believe that I could have even a longer wait if I keep my local focus. On the other hand, I'm sure that there must be a few markets in other states (including your area?) where great deals may be found even this year.

When a Job Can Be More Than Just a Job

Your desire to generate investment income to give you financial freedom to pursue other activities you believe will be more fulfilling than continuing to work at your job as an engineer is a common goal of many people in our 21st-century society dominated by large corporations driven by efficiency and profit objectives. For better or worse, within a few years on the job, most of us Americans come to view our occupations primarily in financial terms, i.e., exchange of our labor for money, while disregarding less tangible benefits such as constructive participation in an endeavor for the good of society, contributing to the smooth operation of our economy, making widgets that we all need and use, helping others by applying our individual talents, etc.

Given the focus of so many Americans on becoming financially independent and retiring early, I was surprised recently to run across an interesting statistic indicating the extent to which America has become less aristocratic over the past century. In 1929, 70% of the income of the top 0.01% (or 1 out of 10,000) earners came from investment income derived from ownership of income-producing assets such as real estate, stock and bonds. By contrast, in 1998, again among the top 0.01% of earners, just 20% of income came from income-producing assets, while the remaining 80% came from wages and entrepreneurial income. (From Piketty and Saez, "Income Inequality in the United States, 1913-1998," as cited in Rajan and Zingales, Saving Capitalism from the Capitalists, 2003, p. 92)

I find it intriguing and even inspiring that the bulk of the income of top earners comes from business endeavors that these top earners are actively involved in as wage earners and entrepreneurs. What this indicates is that today in America, even moreso than a few generations ago, tremendous opportunities exist for anyone clever enough, bright enough and enterprising enough to apply their talents constructively to provide products and services in high demand. In other words, we should view our labor not just as a simple exchange of our time for money but also, at a higher level, as a contribution to the advancement and betterment of society with potential for phenomenally high compensation for the highest achievers. I'm not sure how you are planning to spend your time if or when you do one day leave your current job, but here's a suggestion: how about aspiring to rise to the level of those one-in-ten-thousand hardworking wage earners and entrepreneurs who are making a difference in our world? Generous financial and personal rewards are apparently available for those who succeed.

Certainly, investing to achieve self-sustaining personal lifetime income is a worthy goal to have. But, let's not stop there. Anyone focussed and fortunate enough to get that far should, I feel, both for one's personal satisfaction and for the good of society, actively proceed to find ways to share one's expertise and continue contributing to improving the lives of everyone.

Should I buy-and-hold or trade?

noreply@blogger.com (Lloyd Sakazaki) — Tue, 13 Nov 2007 05:40:00 +0000

Reader's Question: How does a buy-and-hold strategy compare to a trading strategy for ETFs [and stocks in general]?

Your question pertains specifically to exchange-traded funds (ETFs); however, because the buy-and-hold versus trade decision is basically the same for individual stocks, I will answer within the general context of equity-style investing.

Investing vs. Trading

The primary difference between a buy-and-hold approach to investing and a trading strategy is one's time horizon. To some extent, the distinction is relative: a day-trader considers any holding period longer than a day or two to be investing, whereas a buy-and-hold investor might consider any portfolio with turnover exceeding just 10% or 20% per annum to be trading. For concreteness, however, let's define "investing" as holding any position for a year or longer, in line with the cut-off for tax purposes between long-term and short-term capital gains. Within this definition, managers running portfolios with turnover exceeding 100% per year will be deemed to be "trading."

Rationally speaking, the decision to invest or trade should be based on your assessment of two quantities:

"Pick-Up" in Expected Return: How much pick-up in return do you expect to gain by trading, i.e., by switching from one asset to another, such as selling one stock to buy another?

"Frictional" Costs of Trading: What are the frictional costs including broker's commissions, bid-offer spread, tax impact of trading, and additional administrative time required to keep your records in order and account for trades?

Whenever expected pick-up exceeds frictional costs, it makes sense to trade out of one asset and into another that promises the higher return.

If markets are efficient, with perfect and instantaneous information flow among all participants, no pick-up in expected return should be available from switching out of one asset and into another; instead, frictional costs will only drag down returns. On the other hand, if it is possible to use available information to one's advantage to outsmart others, then trading can be a highly profitable business.

Prominent Winners and Losers

A glance at popular lists of the rich and famous shows that at least a few people have been amazingly successful trading the markets. Here are some well-known traders on the Forbes list of the 400 wealthiest Americans:

George Soros (age 77): #33 on list, $8.8 billion net worth. Bachelor’s, London School of Economics. Founded Quantum Fund with Jim Rogers. With Stanley Druckenmiller, "broke" British pound in 1992, made $1 billion profit. Lost hundreds of millions with ill-timed investments in former Soviet Union 1996.

Steven Cohen (51): #47, $6.8 billion. Bachelor’s, Wharton, U. Penn. Founded hedge fund SAC Capital 1992 with $25 million in assets. Today manages $14 billion. Charges 3% of assets, 35% of profits; has returned an average of 34% net of fees each year since 1992.

James Simons (69): #57, $5.5 billion. Math Ph.D., UC Berkeley. Founded Renaissance Technologies 1982. Quantitative hedge fund uses complex computer models to analyze and trade securities. Fees as high as 5% of assets, 44% of profits. A $2.5 million investment in his funds in 1990 would be worth $1 billion today (for a 42% annualized return). Hires Ph.D.s over M.B.A.s. $25 billion institutional fund RIEF so far performing below expectations.

Stanley Druckenmiller (54): #91, $3.5 billion. Bachelor’s, Bowdoin College. Orchestrated billion-dollar raid on the British pound in 1992 with timely short position. Believed to help generate string of 30% returns for Soros' Quantum Fund. Duquesne Capital Management, runs No Margin Fund.

Bruce Kovner (62): #91, $3.5 billion. Bachelor’s, Harvard. Started trading soybeans; turned $3,000 he borrowed on his credit card into $45,000. Forgot to hedge, lost half the profits. Founded Caxton Associates 1983. Caxton Global Investments hedge fund has returned 25% annually net of fees. Assets: $15 billion.

Paul Tudor Jones II (53): #105, $3.3 billion. Economics, Bachelor’s, Univ. of Virginia. Early success trading cotton on Wall Street. Founded Tudor Investment Corp. hedge fund 1980. Predicted 1987 stock market crash, returned 125% net of fees that year. Assets now $20 billion. Estimated average annual returns 24%; down this year amid summer's violent market turmoil.

Kenneth Griffin (38): #117, $3.0 billion. Bachelor’s, Harvard. Started investing as undergrad, managing $1 million of family's, friend's money by senior year. Founded Citadel Investment Group 1990 with Frank Meyer's money. His hedge funds said to have averaged 20% net of fees annually. Assets under management exceed $16 billion.

David Shaw (56): #165, $2.5 billion. Ph.D., Stanford. Investment geek uses complex algorithms to capitalize on tiny anomalies in the stock market. Former professor of computer science at Columbia U. Launched hedge fund D.E. Shaw & Co. Assets have swelled from $28 million to $34 billion in 20 years (or 43% annual compounded asset accumulation).

David Tepper (49): #239, $2.0 billion. M.B.A., Carnegie Mellon. Ran junk bond desk at Goldman Sachs. Started hedge fund Appaloosa Management in 1992. Fund up 150% in 2003; believed to have averaged 30% returns net of fees since inception. Manages $7 billion.

Louis Bacon (51): #286, $1.7 billion. Literature, Bachelor’s, Middlebury College. Founded Moore Capital in 1989; returned 86% in first year on savvy bet that Gulf war would drive up oil prices. Assets under management: $13 billion. Last year returned 16.7% after fees (25% of profits, 3% of assets).

Daniel Och (46): #317, $1.5 billion. Bachelor’s, Wharton, Univ. of Penn. Took job in arbitrage at Goldman Sachs 1982; worked with Eddie Lampert , billionaire Richard Perry. Left to found Och-Ziff hedge fund with $100 million initial investment from Ziff brothers. Consistent returns: 16.5% a year after fees. Manages $29.1 billion.

Israel Englander (59): #317, $1.5 billion. Bachelor’s, NYU. Founded investment outfit Jamie Securities 1980s; firm collapsed. Created Millennium Partners 1990; fund said to have returned 17% net of fees. Assets under management $11.5 billion. Employees created 100 legal shell companies in order to market time mutual funds.

The persistent 15% t0 40% or higher annual returns these traders show is evidence that it is possible to realize consistent profits trading the market.

Lest we become too carried away with these success stories, we should also keep in mind that there have been many equally prominent "blow-ups" of risk-taking traders, including: Victor Niederhoffer, one of Soros's former colleagues, whose funds failed twice, in 1997 and again this year; John Meriwether's Long-Term Capital Management, the multi-billion dollar hedge fund run by ex-Salmon traders and even a couple of economics Nobel prize winners, which collapsed in 1997; and Amaranth Advisors, which spectacularly lost $6 billion in one week on natural gas futures in September 2006. This year's subprime crisis is another example of how businesses, investments and trading strategies that have been profitable for many years can suddenly turn sour. Then, too, think about all the unlucky traders who lose money so quickly that we never get a chance even to hear about them!

Base Strategy: Buy-and-Hold

The only certain way to know whether you yourself have the ability become a successful trader is to commit both significant time and capital to trying. Unfortunately, most people have neither the time nor capital to spend finding out. Also, for those who seriously begin trading but fail, the costs can be very high, both financailly and emotionally.

In my opinion, instead of launching off and haphazardly trying your luck at trading, it makes sense at least initially to pursue a buy-and-hold strategy to exploit certain advantages it offers:

1. Long-Term Returns Favor Equities: The nature of capitalism as we know it in the U.S. and in most parts of the world is that laws and regulations are skewed to promote economic growth, corporate profits, and wealth generation for stockholders. In this environment, risk-taking buy-and-hold equity holders more often than not end up with higher returns than bondholders and cash-rich non-risk-takers. Therefore, it makes sense to allocate as much of your portfolio as you can to equities, reserving for cash and bonds only what you need for emergency living expenses (e.g., six months' income in case you lose your job) or predictable future expenses (e.g., a college fund for children). While it is very difficult to predict whether equities will outperform bonds and cash in any given year, over periods of 10 or 20 years or longer, equities have generally outperformed.

2. Cost Efficiency: Compared to trading, buy-and-hold investing controls costs by keeping broker's commissions and other frictional costs to a minimum. Though not as evident as a trading commission, the bid-offer spread is a cost that can often be larger than commissions. To give an extreme example, a micro-cap "penny" stock with a $0.06-$0.08 bid-offer (you can buy at $0.08 and sell at $0.06 in an unchanged market) actually has round-trip execution costs of an enormous 25% of one's initial investment! At the other end of the spectrum are exchange-traded funds, the most liquid of which is the S&P Depositary Receipts (AMEX: SPY) with round-trip bid-offer costs of just 0.007% (or less than 1 b.p.). More typically, moderately liquid mid-cap individual stocks have bid-offer spreads of about 0.50% (50 b.p.).

3. Tax Efficiency: Keeping portfolio turnover to a minimum through buy-and-hold investing is also more efficient from a tax point of view. First of all, the long-term capital gains tax rate of 15% that applies to positions held for more than a year is substantially lower than the ordinary income tax rate running as high as 28% that applies to short-term capital gains on positions held for a year or less. For certain types of trading accounts, the IRS offers a favorable 60%/40% split between long-term and short-term capital gains tax treatment, which produces an effective tax rate of 20.2% (of course, higher than the 15% pure long-term gains rate). Also, since taxes on gains are due only when securities are eventually sold, capital gains tax can be deferred indefinitely into the future through extending buy-and-hold positions without selling for many years.

While it may seem simplistic, a buy-and-hold approach to investing, characterized by continuously holding a very high percentage of equities with only very infrequent though carefully considered buy-sell decisions, can, in my opinion, give small retail investors a slight "edge" over other investors and traders based on the efficiencies cited above.

Numerical Comparison

To gauge the impact of frictional costs on returns, let's compare two portfolios over a 10-year period in a market that returns 10% annually:

Buy-and-Hold: Assume no turnover. At 10% annual appreciationn, $100 grows to $259 after 10 years. After payment of 15% long-term capital gains tax on the $159 gain at the end of year 10, the net portfolio value becomes $235, for an annualized after-tax return of 8.94%.

Trading: Assume 200% annual turnover, or the equivalent of two round-trip trades per year at a cost of 0.50% per round-trip. Trading costs as stated and annual taxes of 28% on short-term gains reduce the 10% annual market appreciation to (10% - 2 x 0.50%) x (1 - 0.28), or 6.48%. At this after-tax growth rate, an original $100 investment becomes $187 after 10 years.

Assuming that trading produces no pick-up in return, the frictional trading costs and additional tax lead to an inferior after-tax annual return 246 b.p. lower (8.94% vs. 6.48%) than the return available through buy-and-hold investing. On a pre-cost, pre-tax breakeven basis, the trading strategy will need to outperform the buy-and-hold alternative by a full 342 b.p. annually in order for trading to beat the buy-and-hold alternative.

As a rough rule of thumb, then, you should engage in trading only if you honestly believe that your buy-sell decisions give you at least a three or four percentage point advantage annually (and more if your turnover exceeds 200% per year) above the buy-and-hold alternative.

Self-Assessment: What's My Trading "Edge"?

Expressed another way, the buy-and-hold versus trading decision really boils down to having an "edge" large enough to overcome the costs of trading. What in particular about you, your personality, your abilities, and your current situation gives you a competitive advantage over others in the market? Based on the information you can easily get your hands on, digest and analyze, do you have an edge over professionals who devote themselves full-time and make careers out of trading the market?

While a genius-level of business and financial acumen may not be strictly necessary for wealth-building, I would contend that your odds of becoming a successful investor or trader will be greatly enhanced if you know what your edge is. If you plan to trade ETFs or large-cap stocks over a short-term time horizon, keep in mind that you'll be competing with Wall Street traders and hedge funds who usually have access to more up-to-the-minute newswires, customer flow information, and analytical tools than you do. Your odds of success may be slightly better in small-cap and penny stocks, asset classes that more sophisticated investors often avoid due to limited liquidity and trade size (Tim Sykes, whose claim to fame is trading his way from $12,415 to $1.65 million in just four years, day-trades small-cap stocks and is attempting to teach us all how it can be done again).

Over the years I have looked at many fundamental, technical and sentiment-based possibilities for constructing a system for beating the market, always searching for a methodology to ensure at least a 70% winning trade percentage. From one (perhaps too naive and hopeful?) point of view, given how readily availability price, volume, earnings and other quantifiable time series are, it seems that trading ought to be a "science" amenable to analysis and predictability. Unfortunately, from what I have seen so far, analytical trading rules do not appear to produce excess returns in any consistent and reliable way. Also, to date, I have yet to meet anyone who has a trading system that runs without human intervention and produces consistent excess returns. From what I can tell, trading is more like a game involving both luck and skill than a predictive science.

To Trade or Not To Trade?

Whether to engage in buy-and-hold investing or to pursue a short- or middle-term trading strategy, then, really depends on your own abilities and risk preferences. For the vast majority of people, I suspect that a buy-and-hold strategy will bear larger and more fruit than an active trading strategy. In my own case, I currently follow a buy-and-hold approach, targeting no more than 10% annual turnover to keep trading costs and taxes at a minimum.

Concurrently, I continue my search for a Holy Grail of sorts that is capable of producing winning trades at least 70% of the time (which I view as equivalent to a low-C grade, i.e., barely passing). The day I convince myself that I have a working system that meets this 70% threshold, I will begin to trade, putting real money at risk.

By the way, to anyone reading this: If you or someone you know has a trading system that produces consistent and reliable above-market returns, and don't mind sharing a little information about it, please leave a comment. We would all love to hear about it.