Darwin's Finance » Stock Market Commentary

3 Lessons I Learned from the Greek Riots and Market Panic

Darwin — Sat, 08 May 2010 13:11:27 +0000

The World is a Very Small Place

As the New York Times so eloquently envisioned in the Web of Debt infographic, as Greece goes, so does the rest of Europe due to the incestuous relationships of virtually every large bank. And lest we don’t forget, much of Europe, and the rest of the world for that matter, is still paying the price for the US export of toxic mortgage instruments to their banks. Likewise, US markets suffered yesterday as it became clear that we’re not entirely de-linked back from Europe either. It’s a small world. Who would have thought a year ago that riots in Greece could cause US investors to lose billions in a day? But as Greece found little interest in their bonds, the speculators pounced. It just puts into perspective that markets are complex, nobody has it all figured out and ALWAYS lurking around the corner is another crisis that could very well impact holdings in the US you may have thought were insulated.

Don’t Touch That Trading Account!

Much like many of my friends and family who panicked and sold off all stock investments at the bottom in March 2009, many investors saw the S&P500 down almost 10% in a single day and said, “Get me out of here before it gets worse!”. Within minutes, markets returns to relative normalcy (back to the down ~3% on the day from earlier in the afternoon) and they in essence sold at the bottom – and they were probably buying back in on Friday at a higher price. Personally, I made a volatility trade which had me up over 20% in minutes, but alas, I didn’t sell and it came back to earth within minutes.

Now, many trading experts recommend you put stop-limit orders in place which will automatically trigger stock sales in the event your shares drop to a certain level so you don’t lose more. Well, as a result, investors lost Billions yesterday on what may have actually been an error. As outlined in this CNBC article, since so many traders had order in to trigger if the market dropped say, 5%, even though it just dipped below for a few minutes, millions of trades were executed which probably shouldn’t have been – and then shares rose back to levels above those sales.
All this supports the notion that a) most retail investors probably shouldn’t be “traders” and b) while buy-and-hold failed over long periods in the past decade, at least during shorter periods of crisis and volatility, retail investors are probably best off making more thoughtful, strategic investments, rather than trying to react to daily events.

This Could be the US within Years

Let’s see…Greece is having trouble with unfunded liabilities, runaway debt and constituents that demand they live off the public largess while much of the world recognizes that the current situation as unsustainable. I don’t see how the US is much different. While there are rosy projections that we’ll eventually be decreasing our deficit over the next few years if all goes well, what’s clear even in the most optimistic government models is that in 2030 and beyond we have a runaway situation. We’re seeing states and municipalities struggling to control debt and most of it stems from the overly generous pension and healthcare obligations they’ve made to generations of public-sector workers that is unsustainable. While the private sector has cut jobs, real wages and forced increased employee contributions to benefits for a decade, public workers have pretty much maintained the status quo as if they live in a vacuum. I can’t blame the workers for doing they best they can for their families, but politicians and fiscal oversight decision makers have some tough choices ahead of them. Cut the lavish spending now or face default later due to the generational debt we’ve burdened future generations with. When the time of reckoning comes for the US – we may very well see public workers, school teachers and city employees rioting in Washington.

As far-fetched as it sounds now, are we really that different from the Greeks?

Study: Smart Investors MUCH Better Stock Pickers than Dumb Investors

Darwin — Mon, 21 Dec 2009 13:35:01 +0000

I came across a neat research paper from UCLA and a few others universities seeking to address the topic of whether investors with a high IQ actually exhibit superior investment performance over others. This study strikes at the heart of the notion that stock picking is a random walk and no one investor can reasonably outperform a proxy index over time due to efficient market theory. Based on the conclusions of this study, what efficient markets enthusiasts don’t consider is that not all traders are created equal. It’s a long, painful read, (here) but here are some basic outcomes and interesting points:

The paper starts off with the following ominous, yet so-true statement:

“The behavioral finance literature finds that individual investors, on average, make major investment mistakes. They under-participate in the stock market, grossly under diversify, enter wrong ticker symbols, buy index funds with exorbitant expense ratios, and lose when actively trading in the stock market.”

This begs the question as to whether more intelligent people make more rational, better-performing decisions. While the study’s data set was from trading in Finland and not the US (or which many readers here hail from), Finland is probably actually MORE suitable to a study of this sort for the following reasons:

The Finnish school system is remarkably homogeneous: all education,including university education, is free and the quality of education is uniformly high across the country.
The country is also racially homogeneous and compared to other countries, income is distributed fairly equally.
These factors make it more likely that differences in measured IQ in Finland reflect genuine differences in innate intelligence.

So, Are Smart Investors Better Stock Pickers?

They found that high IQ investors’ stock purchases subsequently outperform low IQ investors’ purchases by “an economically and statistically significant margin” (more on this below), particularly in the near future.
They also found (interestingly) that High IQ investors obtained lower trading costs. i.e. the market orders of smart investors are placed at times when bid-ask spreads temporarily narrow.
The results indicate IQ’s influence on stock-picking skill is particularly strong for returns measured two days later, when the purchases of high IQ investors outperform the purchases of their low IQ peers at an annualized rate of about 11% per year.
However, high IQ investors’ purchases also earn superior and significant returns up to one month in the future.
The benefit tends to dissipate after approximately 1 month.

Interesting Study Observations:

In looking at the data, it’s evident that high IQ traders have larger portfolios (this would tend to make sense that smarter people tend of have more money), but they also conduct more trades. Everything we’d been taught over the years was that smart investors buy and hold, while dummies traded. The data indicates otherwise – both from a standpoint of what smart investors do AND from a performance standpoint.
The final graphs also indicated that high IQ traders not only had better buy executions, but also knew when to sell. Many tenured traders will highlight that knowing when to sell is more than half the battle (not just 50% of the battle).

My Thoughts on Smart vs. Dumb Investors:

I know my trading portfolio has performed marginally better than the S&P 500 each year over the past few years prior to expenses. There is no good proxy to compare with though since I generally trade riskier stocks/ETFs, emerging markets ETFs and I hedge with options (see how stock options work) to protect from rapid downside moves such as what we saw in 2008-2009. With expenses, it’s hit or miss each year. This is encouraging in that if I were trading with a big-time investment portfolio, perhaps I would routinely outperform when trading fees were marginalized due to scale. Conversely, in my situation, it begs the question as to whether the time and effort that go into research and executions are really worth it. I like to think that as I hone my skills over decades of experience it will have a meaningful contribution to my net wealth and benefit my family. But with only 10 years of active trading to draw on (and not knowing my IQ!), perhaps there’s no way for me to draw any meaningful conclusions.

I don’t know what my IQ is. My parents would never tell me. I suspect either they didn’t remember or they didn’t think I’d like what I heard.

Regardless, I’m curious to hear what your thoughts are on the study, whether you can draw any meaningful conclusions from the study and whether it would influence your affinity for trading.

How to Get Your Market Losses Back Now! (Read on)

Darwin — Fri, 02 Oct 2009 03:42:35 +0000

Now, that’s a disingenuous title for an article. But I see it everywhere following the 2008-2009 stock market crash – from prominent money mags at the bookstore to web investing outlets and blogger posts. And it sure is enticing to click through and read on. There’s a simple reason you can’t and won’t easily “get it back”. Investing returns are commensurate with risk! Over long periods of time, stock investors are rewarded with higher returns than bondholders, which reap higher returns than FDIC-protected savings accounts and so on. This is both logical and is also demonstrated historically (excluding when you cherry pick your timeframes like the lazy portfolio articles propagating the web). However, it is naive to think that by simply piling on more risk you’re guaranteed higher returns any time soon – especially after the US equities market has just rallied 50% in 6 months.

If it were that easy to achieve high returns with low risk, don’t you think everyone would be doing it? (Efficient Market Theory basics).

Let’s take a look at what it would take to “get it back” from the 2008-2009 market crash:

Consider an investor who was 100% US stocks at the peak and now they’re looking at a steaming pile of dung in their 401K account. They want to “get it back”. Looking at where SPY, the S&P500 ETF (see this list of all developed and emerging market ETFs) was at the peak in 2007 at around 160 and where it closed today at around 103, in order to get it back, you’d need to return to 160 PLUS make up for inflation adjusted time loss (i.e. over a two year period, you shouldn’t consider getting back to even the old value, but value plus inflation). Let’s be kind and say inflation averaged 2.5% per year. This roughly matches the current dividend yield of the S&P500, so they roughly offset each otherm (I knew someone would comment that those dividends are going to help bridge the divide – but at these yields, it would be generous to say they even match inflation; we’ll call it even).

Let’s say you’re giving yourself a year to “get it back” quickly which the title implies. That would mean SPY would need to be at 160 in a year which implies a return of another 55% on equities following one of the most spectacular rallies in stocks of the century. Fat chance. Don’t get me wrong, I’m virtually 100% equities in my long time horizon retirement portfolios. I do hope stocks continue their ascent. But I’m pragmatic enough to understand that with these higher expected returns comes increased volatility and no guarantees of steady positive returns.

Some of these articles purport to “spice up” your portfolio with even higher alpha instruments like Tech ETFs and emerging markets – and the really dangerous ones entice you to consider double and triple ETFs. Long term, an equity-heavy portfolio including international stocks is great (not the leveraged stuff over time!).

But what about the 58-year old reading that article?

They just lost $500,000 in their 401K and have to consider either:

a) not retiring next year as they’d planned for years

b) not funding their kids’ college tuition which they were expecting

c) “Getting it back”.

Would it be prudent for someone with a 1 year time horizon to be heeding the call to MORE risk now in an attempt to “get it back”? Double down?

To avoid any confusion, I am a proponent of stock investing. I own equities – plenty of them. My time horizon is multiple decades, not the next couple years. For my short-horizon traditional trading account, I employ a different approach with hedges, options, income instruments and more (see my recent portfolio trading update). However, I do caution against making any assumptions on where equities are going to be in the next year – especially if I’m going to need to withdraw that money for living expenses.

What are your thoughts? Is it responsible journalism to entice readers to “get it back quick”?

How Stupidity on Wall Street Violated the Most Basic Laws of Physics

Darwin — Wed, 30 Sep 2009 02:48:31 +0000

As a physical sciences and astrophysics buff, I was struck by the irony in some of man’s greatest and most enigmatic physical laws in contrast to some of the dumbest behavior imaginable by Wall street, politicians and main street for that matter. I couldn’t help but compare some of the most famous physical laws we’ve come to know and love to what we’ve seen transpire in recent years in the investment and banking world. You’ll surely recognize some of these venerable laws and theorems and surely the people rooted in the midst of frenzied wheeling and dealing on Wall Street and in the mortgage industry should have known that what they were doing was unsustainable, but in retrospect, there’s a tinge of irony in these laws in comparison to how things played out:

1 – The Law of Gravity

What comes up must come down

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Housing Market anyone? For years, the best and brightest minds in the world (physicists and math whizzes from the likes of MIT in fact) developed complex securitization models and derivatives products which quite foolishly assumed that US home prices would continue to appreciate at 6-8% per year when over 100 years of history dictates that home prices appreciate roughly in line with inflation – currently running at 2-3% per year. Already way above the trend due to a secular bull trend with no actual change to fundamentals, these instruments of mass destruction brought the financial industry and the global economy to its knees during a reversion to the mean – during the fall back to earth.

2 – Conservation of Energy

Energy can neither be created nor destroyed

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Somehow, Wall Street and the frenzied home buying public created value out of nothing. No down-payment loans and a blind eye to income verification turned home prices loose. There was real estate flip speculation whereby someone with literally no income and no assets could purchase a condo in Miami for $400K and flip it for $460K the same week. This went on for years, until the music stopped playing. You can’t continue to extract value (cash-out refis and flips) from an asset in which it doesn’t exist.

3 – The third law of thermodynamics

It is impossible to create a thermodynamic process which is perfectly efficient.

We saw a massive increase in the number of hedge fund, mutual fund and ETF offerings, many of which had complex expense ratios and tracking errors – only to see many of them fail. You can never get a perfect index match without tracking error and fees/commissions and most actively managed mutual funds can’t beat their index – but you can get pretty darn close in low-fee Vanguard mutual funds or various ETFs.

4 – Theory of Relativity

Transformation between a moving object and an observer in another frame of reference

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Classical relativity involves a transformation between a moving object and an observer in another inertial frame of reference.
To main street, the Wall Street bonuses seemed outrageous, unwarranted, unsustainable and flat-out insulting. To those in the ivory tower, it was get while the gettin’s good and do what everyone else is doing. If any one firm didn’t jump on the mortgage securitization bandwagon, their earnings wouldn’t look as good as their peers, and hence, the house of cards was constructed.

5 – The Grand Unified Theory

This is the holy grail of physics, if you will – trying to reconcile and consolidate all major theories like Einstein’s theory of relativity with the fundamental forces of physics.

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The Quants - The whizzes on Wall Street thought they had it all figured out – they found the coveted holy grail. They would take on massive leverage, take inordinate risks on securitized debt and then hedge it with credit default swaps. This was thought to be the perfect investment model – high alpha returns with fully hedged risk. With the potential bankruptcy of AIG (which was involved in Hundreds of Billions in credit default swaps), many of the largest investment banks and sovereign wealth funds would have realized tremendous losses – but they were spared by a US taxpayer bailout. How convenient? AIG made good on payments to the likes of Goldman Sachs which is approaching $200 per share again. Meanwhile, our generation is passing on generational debt the likes of which the world has never seen.

Do any Ironic Parallels Come to Mind After Reading?

Corporate Pension Plan Shortfall – The Next Crisis?

Price to Earnings Ratios Gone Wild – A Measure for Investors to Follow?

Darwin — Sun, 27 Sep 2009 16:27:36 +0000

I came across this visual and thought it was worth sharing. With data from Robert Shiller’s Irrational Exuberance, this BusinessWeek chart highlights the massive secular trends that span years at a time where Price to Earnings ratios of the companies that comprise the S&P500 rarely actually stay around the mean of 16.3, but they do tend to cross back and forth and stay on one side or the other over long spans. In taking a look at just the past few decades, it matches up with the benefits of investing heavily in stocks starting in the early 80s and lightening up around 2000 (the Internet bubble and the euphoric buying that occurred does look rather ridiculous in retrospect in this context).

When looking at retirement portfolios over long periods of time, perhaps worth using this Price to Earnings ratio and mean of 16.3 as an additional data point in determining your allocation to US stocks? This is contrary to the premise of just setting it and forgetting it, but for people looking to rebalance and revisit their allocations annually or so, perhaps this is worth considering.

Corporate Pension Plan Shortfall – The Next Crisis?

Darwin — Thu, 27 Aug 2009 03:43:16 +0000

US Corporations are walking a thin line with Pension Plan Shortfalls that may well translate into the next global crisis. Now that the mortgage crisis is behind us (that is, until the next wave of defaults hit due to more interest rate resets and the reconfigured mortgages that fail anyway – and commercial mortgages to boot), US corporations have racked up pension liabilities that in many cases, well exceed any reasonable chance of being met under the current circumstances and assumptions. To cap it off, there is legislation mandating that corporations hit 100% funding of their pension liabilities by 2011, up from 90% as of last year. While 10% may not sound like much, for US large cap firms, it’s the equivalent of Billions of dollars they need to come up with, possibly in a lump sum while plans falling below 80 percent funding may face added limits on actions that would further drain assets, such as some lump-sum payments.

Corporations have behaved much like the US Federal government and local municipalities. When times were good, put aside the bare minimum and make rosy assumptions that the good times will last forever (i.e. pension fund returns will continue to appreciate 10% or more per year into infinity). Then, when the Black Swan event occurred (but was it?), ask for a bailout. Not only do companies now face decreasing revenues and massive severance payouts, but the assumptions they used in their pension modeling has turned out to be, well, a bit overly optimistic. While stocks have rebounded 50% from their low, they are still well off their highs, when corporate pension funds were already underfunded to begin with! Now the problem has been compounded. While corporations are not explicitly asking for a bailout at this time, what they are asking for is a delay to the implementation of this “draconian” pension requirement – the one that’s been on the books for years.

On July 29, ERISA, a trade group that represents big businesses on benefit issues under the Employee Retirement Income Security Act, petitioned Congress to approve “relief” on these Pension requirements. While I shudder at the notion of US corporations having to make a decision as to whether to chop another 15% of their workforce to meet a pension funding requirement, it also irks me that something that is supposed to be so long term, so strategic, so conservative – a pension plan – that so many corporations got it wrong.

How did we get here? Pension estimates impact earnings. Earnings influence near term share prices. Executives are compensated with performance based bonuses, of which share price appreciation is often a major factor – and with stock options (see How Stock Options Work), which are leveraged to share price appreciation from the grant date. There is a significant incentive to exercise short-term thinking and little incentive to exercise long-term planning in corporate America; kind of like what got us into this mortgage mess. You mean some of the best and brightest quants on Wall Street, the MIT math whizzes, really thought that US home prices would continue to appreciate at 8% per year ad infinitum? Of course they didn’t. Everyone else was pumping mortgage backed securities, so if they didn’t too, they’d be left in the dust. Well, this pension issue is not much different. Given the opportunity to shift payments that could have or should have gone into a pension system years ago and to inflate anticipated returns on pension plans – well, that’s good for the next quarter’s earnings number.

What does this mean for the average investor? Well, near term, it’s tough to say it will have any impact. The trend is your friend and right now the trend is up (see my take on the “Sucker’s Rally” back when we were 35% off the highs, 15% ago). Shares are rocketing up from the realization that we have not and will not, enter the next Great Depression. Bond spreads have tightened, currencies are less volatile and shares are recovering. However, will the Dow hit 15,000 in the midst of a great pension reset which will impact the bottom line of so many large US corporations? If the legislation sticks, out in the 2010/2011 timeframe when this topic becomes more prominent, it may not look so good.

For further reading on Pension plans and to check whether your company is following pension rules, the US Department of Labor put together a quick reference guide entitled Protect Your Pension.

Why were the Risk-Averse so Heavily Invested in Stocks?

Darwin — Thu, 23 Apr 2009 04:27:42 +0000

Is your Nest Egg Safe?

Akin to how our grandparents’ generation is known for their thrift and frugality from living through the Great Depression, our generation may very well be known for a similar sort of risk-aversion…a changed generation of humility and financial conservatism, after seeing the worst financial conditions and stock market deterioration in our lifetime (note: in our lifetime). While I think much of the current panic and fear has been stoked by the media and politicians (what better way to keep eyes glued to the set and pray for our fearless leaders to save us with spending bills than to invoke fear and panic and claims of “the worst crisis since the Great Depression” when there are actually several periods in between with higher unemployment and greater GDP decay and something we haven’t seen yet – inflation), there are a lot of people now that have seen the chaos, lost a lifetime of savings to market risk that they probably shouldn’t have been exposed to, and perhaps will never own stocks to the degree they once did.

Market Risk: Why were the Risk-Averse so Heavily Invested in Stocks?

Inevitably, one has to ask why so many workers near or even past retirement were so beholden to stock market risk. There were many old assumptions about what sort of exposure people should have based on their risk tolerance and time horizon. Old-timers still espouse the view that you should have a mix of stocks and bonds with stocks comprising 100% minus your age and the remainder in bonds. Unfortunately, for a 55 year old approaching retirement, even having 45% in stocks resulted in a loss of 50% on that share and the bond piece fell apart as well if they were in anything besides Treasuries (which makes now an optimal time to Short Treasuries perhaps given their runup of late). With a nest egg of $1 Million, this “by the book” portfolio may now be worth south of $650,000. In the low interest rate environment we’re in now, trying to draw interest on that $650,000 to live on is a heck of a lot tougher than $1Million without depleting your nest egg in the next few years (rule of thumb is to assume 4% on your nest egg to cover annual expenses without depleting your principal…but who knows if that’s too aggressive now too?).

Let’s Examine How We Got Here

Financial Advisors - Many Financial Advisors had their elderly clients invested heavily in equities. I personally know of people in their 60s and even one in their late 80s that are with “brokers” doing active trading for them with a 100% equities portfolio. Now, this criticism could be oversimplified. Other considerations are what other sources of income you have like guaranteed pensions, social security, etc., and if these other sources are adequate to cover your retirement needs, then yes, there is a place for some equities exposure even post retirement. However, we probably all know someone personally or through 1 degree of freedom, that has had to actually postpone their retirement or make major adjustments to their lifestyle, housing, or retirement plans as a result of the recent market downturn. It would be disingenuous to look back and say, “All Financial Advisors should have seen this coming and had their clients pull their funds out of equities last year”. Hindsight’s 20/20. One does have to question the prudence of some of the aggressive portfolios though, for people who don’t have the time to try and recover their 2007 levels of savings. Thousands, perhaps millions, of Americans will not live long enough to see their nest egg back at 2007 levels again.

Keeping up with Inflation – Depending on how you measure inflation, it’s either been rather tame the past decade or two; or it’s been hellish. If you buy a lot of tech gadgets and clothes, inflation’s been great. If you’re spending disposable income on health-related expenses and trying to put a kid through college, inflation’s rather arduous. According to Moody’s chief economist at Economy.com Mark Zandi, data show that over the past 10 years, education costs have risen 5.91% per year, and health-care expenses have risen 4.16% per year, while wages and income have risen only 3.7% during that time. Imagine trying to keep up with close to 6% inflationary increases in college costs on “risk-free assets”. You can’t do it. In order to keep up with inflation, you’ve got to take on some risk/volatility, right? This is going to be a continual struggle for people since nobody’s predicting a slowdown in inflation in these sectors and you can’t even find a 4% CD any more at today’s best CD rates.

Lack of Alternatives - For most Americans, many alternative investments like hedge funds, structured notes and direct real estate rental income was out of their reach. So, what alternatives existed for them? Assuming market risk. For the most part, people would seek out a financial advisor to try and manage their money for them or just leave it parked on autopilot in their 401K/403B/IRA accounts since that’s what they’ve always done…and it had always worked – and stocks were always part of that equation.

“Stocks Always Bounce Back…And Return 9% over the Long Term” – This is what the history books tell us, as well as Peter Lynch and Warren Buffet. And for generations of investors, the buy and hold mantra had held true. By holding stocks and reinvesting dividends over long periods of time, patient investors were rewarded well. What people didn’t plan for was the Black Swan event that nobody thought could happen in today’s market.

What’s the Answer?

The answer to how to best position yourself in the coming years is even more difficult to answer than how we got here. There are some key considerations that investors need to ALWAYS be mindful of moving forward. I can tell you that I will remember the Market Crash of 2008 for a lifetime and as I’m approaching retirement, my portfolio will be “stress-tested” upside down. My other income streams, my hedges, my counterparties, my contingencies and my backup plan will all be fully vetted and validated. After living through this and seeing the pain and regret that has been bestowed on so many good, hard-working people who were simply doing what had always worked, I will have no excuse for being caught off-guard in my sixties. You need to ask yourself the following questions:

Am I diversified? Will my investments move in lock-step downward? Am I hedged at all?
What is my time horizon? When will I need these funds and can I sustain a period of 10 or so years in order to allow for a partial or full recovery?
What is my risk tolerance? Can I sustain a 75% loss in this particular account and still live survive with just minor adjustments? Should I be assuming market risk? Is it even worth it/necessary?
What other sources of GUARANTEED income do I have? Are there pensions, Social Security, other accounts with Treasuries/FDIC insured CDs and Cash?

In order to lessen the path of resistance to a 99% assured comfortable retirement, living a frugal lifestyle coupled with a disciplined approach to saving/investing over the long term is an easy answer. However, such a small enclave of Americans live such a lifestyle that this path to prosperity becomes a bit more complex for the vast majority of us.

What Are Your Thoughts on How You’ll Prevent the Next 2008 and What are Your Preventative Actions?

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