Why context matters

Josh Gerstein at Politico recently wrote a piece that compared how similar incidents during both the Bush and Obama administrations have been covered very differently by the press.  The gist of the argument being that Obama has gotten a pass from the mainstream media on these issues.  Gerstein writes:

It’s a sign that the media’s echo chamber can be a funny thing, prone to the vagaries of news judgment, and an illustration that, in politics, context is everything.

Politics aside, the important thing to take away is the fact that context in which a story appears matters a great deal.

To bring this notion around to financial matters, let’s take a look at Wal-Mart (WMT), the nation’s leading retailer.  It is not far-fetched to say that the company was one of the most reviled prior to the onset of the economic crisis.  Not many companies have organizations designed to follow and comment upon their every move.

The funny thing is that chatter about Wal-Mart has declined dramatically in the face of the financial crisis and the resulting economic recession.  As Hank Gilman at Fortune writes:

Let’s go to the numbers. If you did a database search, which my colleague Marilyn Adamo kindly conducted for me, there were some 47 stories in 2006 with the words “evil” within ten words of a “Wal-Mart” mention. So far in 2009: only two.

Gilman notes the many reasons for this decline including changed behavior on the part of Wal-Mart, even worse behavior on the part of Wall Street and “Wal-Mart bashing fatigue.”  He also notes that the value proposition for which Wal-Mart is best known is now an asset in tough economic times. Mark J. Perry at the Carpe Diem blog pulls together a number of threads that amount to what he calls the: “Wal-Mart Economic Stimulus Plan.”

None of this should be read as an endorsement of Wal-Mart as a company or the stock itself.  The fact is that the above news has not been all that positive for the stock.  After outperforming leading up to (and during) the heart of the economic crisis Wal-Mart stock has underperformed notably since then.

To look at it another way, one can see that the era of Wal-Mart bashing was coincident with the stock badly underperforming the S&P 500.  It is impossible to say in which way the causality runs, but it is interesting to note how when Wal-Mart was most reviled it was also a poor holding.

There are any number of examples like this where context affects how a message gets relayed to us by the media.  One need only go back a few years to read how residential real estate was a no-brainer.  Not coincidentally the peak in the housing market was right around the same time.  The fact of matter is that few wanted to read bearish housing stories at the time, and were therefore not written.

This is in no way an endorsement of knee-jerk contrarianism.  Just because the media is covering a story does not mean that is necessarily wrong or out-of-date.  But it is important to be aware of the overall context in which a story is being told.  Stories are one of the major ways in which we humans make sense of our world.  Just don’t get enamored with every story you read.

Disclosure:  No positions in Wal-Mart.


Tuesday links: stock price fragility

Eric Falkenstein, “I would estimate 90% of all alpha is misrepresented.”  (Falkenblog)

Just what is the “implied cost of assuming alpha’s existence“?  (All About Alpha)

Everyone is reading the newly bearish quarterly missive from Jeremy Grantham.  (Market Beat, Credit Writedowns, The Money Game, MarketBeat, Investment Postcards, Fund My Mutual Fund)

An updated look at pullbacks in this market upswing.  (VIX and More)

Transports are signaling economic weakness,  (The Pragmatic Capitalist)

A new ETF, the IQ CPI Inflation Hedged ETF (CPI), targets 2-3% over CPI.  (IndexUniverse)

Don’t get fooled by volume surges in ETFs with easy substitutes.  (Investing with Options)

What is the best way to “buy volatility“?  (Daily Options Report)

“There have been some strange goings on in the world of ETF gold bar holdings of late.”  (FT Alphaville)

Joshua M. Brown, “We are not yet in a frothy enough market to have LBO shops and private equity firms dump their leftovers on us quite so soon.”  (The Reformed Broker)

Gregor Macdonald, “Mostly, American money management remains quite stuck in a bunch of antiquated, regressive viewpoints about the world, most of which are American-centric and offer cheerleading in the place of science, and the hard work involved in understanding these subjects.”  (Gregor Macdonald)

Stock price fragility” measures the relationship between ownership structure and non-fundamental risks.  (SSRN)

Ken Griffin on the need for centralized exchange for derivative products.  (FT)

The August Case-Shiller home price numbers show a modest month over month gain.  (Calculated Risk, Big Picture, Curious Capitalist, Free exchange, Bespoke)

Do home prices need to correct all the way back to pre-bubble levels?  (The Money Game)

The first-time home buyer’s credit was a bad idea.  Why would we extend it?  (Washington Post)

Should the SEC force dark pools to increase trade transparency?  (Marketwatch also DealBook)

Where did all the Wal-Mart (WMT) haters go?  Think recession.  (Fortune)

What is the solution to the fact that our financial skills decline after age 53? (Vanguard Blog)

Investment books to help you think like an investor.  (Contrarian Edge)

The music industry didn’t see the Apple (AAPL) iPod coming.  Is the DVD industry ready for the much-rumored Apple Tablet?  (24/7 Wall St.)

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Monday links: transport weakness

“The hedge fund industry is on the brink of recouping all its investment losses sustained during the credit crunch, placing many funds in a position to earn performance fees.”  (WSJ)

What are we to make of the weakness in Transports?  (Small Fish, Big Odds, VIX and More)

US dollar volatility is returning to normal levels.  (Bespoke)

How is that the bond market is perceived to be “smarter” than the stock market?  (Abnormal Returns)

The case for local currency emerging market bonds being a better way to invest in the emerging markets.  (Kiplinger’s)

Are insider trading cases a big waste of time?  (Forbes, Clusterstock contra Jeff Matthews)

A legal way to profit off insider trading.  (New Rules of Investing)

Estimating the equity risk premium is no easy task.  (CXO Advisory Group)

Carl Icahn is on a bit of cold streak.  (Silicon Alley Insider)

James Surowiecki, “The trouble is that the “market” for banking is so distorted…that it’s hard to know whether big banks are adding value or are simply exploiting their oligopolistic positions.” (New Yorker, The Balance Sheet)

Are the Feds going to soon get more powers to deal with “too big to fail” banks?  (NYTimes)

Is the US Treasury betting on higher inflation?  (The Money Game)

Debating the status of the jobless recovery.  (FT Alphaville)

Is there any evidence that the Fed is manipulating equity prices?  (Credit Writedowns)

Nassim Taleb can’t understand why everyone misinterprets his writings.  (Falkenblog)

What would the Cramer, when he was a hedge fund manager, have said about TheStreet.com (TSCM) stock?  (Wall St. Cheat Sheet, Zero Hedge)

“We have to face facts: the mobile internet has been brought about, and is now owned and controlled by, Apple (AAPL).”  (Ultimi Barbarorum)

StockTwits comes to the iPhone via the brand new Nasdaq Portfolio Manager application.  (StockTwits Blog, Howard Lindzon, TechCrunch, Appolicious, IR Web Report)

Should we just “grow up” and start paying for content on sites like Hulu?  (The Big Money)

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Just who is the smart money?

The following comment by Joe Weisenthal via Twitter got us thinking about just who is the “smart money” these days.

With the junk bonds rallying, you don’t hear as much about how “smart” the bond market is, and how it leads stocks.  

The point that Weisenthal is making is that the bond market is only “smarter” when it fits the bear case.  When it fits the bull case, as it does now, the bears are silent.   It is often the case that analysts only cite data that fits their case, i.e. confirmation bias.  The Bloomberg story by Alexis Xydias notes how some strategists are interpreting the performance of corporate bonds.

For the first time in a long while, equities appear inexpensive relative to corporate bonds,” said Kevin Gardiner, the London-based head of investment strategy at Barclays Wealth, which lowered its rating on fixed-income securities to “neutral” this month and recommended owning stocks. “Valuations and the likely news flow over the coming period will inspire people to take more risk.

We are not sure of the exact origin of the myth that the bond market, specifically the corporate bond market, is “smarter” than the stock market.  But one can bet that it has do with the fact that individuals, by and large, are absent from the corporate bond market.  Whereas the stock market seems to be teeming with masses of individual investors.  However to make the leap from the compositional differences of the two markets to make some sort of statistically-based statement on leads (and lags) between the two seems far-fetched.

In today’s capital markets there are vast pools of capital poised to jump on perceived valuation errors. For example, multi-strategy hedge funds have the ability to shift capital from strategy to strategy in pursuit of profits.  Capital arbitrage hedge funds focus solely on generating returns from perceived mis-valuations amidst the capital structure of firms.  One could argue there is a surfeit of capital seeking out just these opportunities.

The introduction of exchange traded funds (ETFs) on a broad range of asset classes, like junk bonds, has helped blur the line between the professional and amateur traders.  Indeed these pools of assets are all now mixed up in the world of ETFs.  Some asset classes, like commodities, were previously the province of only professional traders. However now that individuals and professionals are trading the same instruments it is less clear who is the smart money and who is the dumb money.

There may very well be smart money on Wall Street.  However trying to tease out what they are doing from broad data like the performance of the bond and stock markets is likely wasted effort.


Sunday links: your own time horizon

Jason Zweig, “As an investor, you are free to choose your own time horizon. If other people want to try earning a few fractions of a penny a few thousand times a day, you should wish them well — and refuse to join them.”  (WSJ)

“The wild ride of the last decade or so does not mean that stocks will underperform bonds in the months or years ahead. If only it were that simple.”  (NYTimes)

What role have individual investors had in the run-up in commodity prices?  (The Reformed Broker, Journal of Investing via Infectious Greed)

As money flows into bonds, some of it is finding its way into individual bonds.  (WSJ)

Rydex market timers are “all in” and other  investor sentiment measures at week-end.  (The Technical Take, Trader’s Narrative)

Why should we assume there is a stable relationship between the price of crude oil and the S&P 500?  We shouldn’t.  (Abnormal Returns)

On the use of your equity curve to guide trading decisions.  (CSS Analytics)

The ability to sit through a trade is greatly underappreciated.”  (TraderFeed)

Add Richard Bernstein to the bull camp. (Credit Writedowns)

What are the odds that Bruce Berkowitz can outperform as a bond manager?  (Marketwatch)

Now is a good time for a stock replacement strategy.  (Barron’s)

Who won (collectively) over the past ten years:  Vanguard investors or Fidelity investors?  (Morningstar)

TheStreet.com (TSCM) is a mess.  (Zero Hedge)

Why is Citigroup (C) pulling out all the revenue stops?  (Mish)

Joe Nocera, “Goldman makes its money primarily by taking trading risks, and so long as that is the case, American taxpayers are going to question why they should have to be on the hook if Goldman suddenly runs into serious trouble.”  (NYTimes also Big Picture)

John C. Ogg, “The fate of Fannie and Freddie as far as the common and preferred shares go depends almost entirely upon the political situation in Washington …”  (24/7 Wall St.)

Is the stimulus working?  (Time also Atlantic Business)

Taking a look at the long term effects of substantial federal budget deficits.  (SSRN)

Donald J. Boudreaux, “Insider trading is impossible to police and helpful to markets and investors. Parsing the difference between legal and illegal insider trading is futile—and a disservice to all investors.”  (WSJ)

Do we have the health care plan all backwards?  (NYTimes also EconLog)

Does economics violate the laws of physics?  (Scientific American via Economist’s View)

Howard Lindzon, “There is one bubble that I do not fear…the social web/social leverage bubble.”  (Howard Lindzon)

John Gruber, “Operating systems aren’t mere components like RAM or CPUs; they’re the single most important part of the computing experience.”  (Daring Fireball)

Is blog reading now mainstream?  (A VC)

U-pick-it orchards are a big scam.  (Slate)

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Ratio charts run amok

We recently wrote about the dangers that charts can pose to our pattern-seeking brains.  Charts can be useful tools, efficiently summarizing a great deal of data into a single picture.  Other times the intuition behind the chart itself is flawed.  This is often the case when analysts try to tell a story using the ratio of two price series, when in the fact the two series are not related.

One of the best providers of (free and subscription) charts are the guys at Bespoke Investment Group.  (Who by the way make frequent appearances in our daily linkfests.)  However they may have gone one chart too far in a recent case.  Unfortunately the graph in question is a part of their premium service, but the results were described in a recent Bloomberg article.

In it they plot the ratio of the S&P 500 to the price of crude oil.  From the Bloomberg article:

The benchmark for American equity traded at an average of 21 times oil between 1986 and 1997, Bespoke said in a research note. Should the price of oil remain at its current level, the S&P 500 would have to climb to 1,700 to restore the ratio.

“Unless you think there’s some sort of secular shift in the relationship, oil supplies declining or something, then you would expect the historical relationship to return to normal,” Paul Hickey, an analyst and co-founder of Harrison, New York- based Bespoke, which manages money for wealthy investors and provides financial research to institutions, said in an interview.

Lets leave aside the potentially huge moves this analysis implies for either the stock market or the price of crude oil.  Let’s think more broadly about this ratio.  Below you can find our version of the chart.  The data does not include the entire period Bespoke covers, but you get the general idea.

A quick glance at the chart shows anything but a stable relationship.  Trying to make predictions (short or long term) for either crude oil or stock market seems like a mug’s game.  There is simply too much variability.  For kicks, let’s replace oil with everybody’s other favorite commodity, gold, to see if we get a better result.

Again the variability is such that there is little in this chart that should change the way any one thinks about either the price of gold or the S&P 500.  Back to oil.

We do not know of any economic theory that posits a stable relationship between the price of commodity (oil) and that of equities. Remember that equities are (presumably) priced on the discounted value of their future free cash flows.  (We don’t remember a variable “O” in the dividend discount model.)  The price of oil is driven by the current supply and demand situation.  Given the dynamic nature of the economy why would one expect this ratio to remain relatively stable over decades?

On the contrary there are any number of reasons to believe that this relationship is not stable.  For instance the changing energy intensity of economic production should affect this ratio.  As should the changing sectoral composition of the S&P 500.  To say nothing of the changing dynamics (including technology) of the global oil industry.  Let’s not forget about the role of interest rates either.  In short, there any number of dynamics at play that should work against there being a stable relationship between the price of oil and stocks.

The S&P 500 might soar (or fall) and the price of oil might fall (or soar) but it will not be because the relationship between the two got out of whack.  The underlying dynamics of each market will do that all by themselves.

The fact of the matter is that these type of charts are generated every day.  Before drawing any sort of conclusion you need to ask yourself whether there is any sort of financial or economic intuition behind the posited relationship.  If not, there is nothing to see here, move along.


Friday links: slick sales pitches

Meriwether, in other words, is proof that markets are not efficient, and investors are frequently stupid, and frequently dazzled by slick sales pitches.”  (Ezra Klein also Credit Writedowns, Fund My Mutual Fund earlier Abnormal Returns)

2009 is a rarity with equities, gold and bonds all up double digits.  (Economist)

Two analysts firmly in the stock market is overvalued camp.  (FT Alphaville, The Pragmatic Capitalist)

What recent sector performance tells us about the state of the stock market.  (Afraid to Trade)

The financial sector is back to their historical weighting in the S&P 500.  (Bespoke)

Do a couple of financial IPO filings indicate a “return to risk”?  (Deal Journal, Telegraph)

The return of the Why-P.O.  (The Reformed Broker)

Some of the big banks are still way behind in their loan loss reserves.  (Accrued Interest)

The junk bond rally YTD has been breathtaking.  (WSJ)

Earning estimates, read (AMZN, MSFT) sometimes “fail.”  (Daily Options Report)

Is a buy-and-hold investment strategy the best of a bad lot?  (Abnormal Returns also Crossing Wall Street)

Smita Sandana, “Don’t confuse time frames.”  The long term is made up of a series of short terms.  (Wall St. Cheat Sheet)

“I would argue that as long as people are responsible for making investment decisions whether directly or indirectly, there will always be a huge impact of their aggregate bias on the market.”  (CSS Analytics)

The slew of new mortgage REITs are designed to be lucrative for their managers.  (Morningstar)

Risk in any diverse financial organization cannot be summed up by a third party into a scalar.”  (Falkenblog)

Nassim Taleb is trying to correct misperceptions about the Black Swan.  (CXO Advisory Group)

Why do bankers make so much money?  (Rick Bookstaber also The Big Money)

Skepticism abounds about the effectiveness of proposed pay restrictions.  (WashingtonPost, NYTimes, Clusterstock, Time)

“The overwhelming majority of the working population will never be able to prepare themselves for a period of unemployment lasting more than six months.”  (Felix Salmon)

The UK recession is not over.  (Calculated Risk, EconomPic Data)

“Nothing out there currently exists as a tech platform for RIAs.”  (World Beta)

How Havard economists invest.  (Harvard Crimson via Greg Mankiw)

On the importance of challenging ourselves and learning from our mistakes.  (The Frontal Cortex)

On the ultimate failure of Moneyball.  Does this include the movie as well?  (TNR via Infectious Greed)

Are today’s college graduates unprofessional?  (Inside Higher Ed)

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Buy and hold the best of a bad lot?

We have been writing on the topic of buy-and-hold investing for the past few weeks now.  We have discussed the need for entries AND exits when market timing, how long run returns are a function of many short term returns and the prospects for buy and hold in the next decade.

We recently come across a handful of other posts on the related topics of index and buy-and-hold investing.  We decided to provide some links and excerpts to whet your appetite.  Without further ado some food for thought.

Kent Grealish at IndexUniverse notes the ways in which our brains fool us as investors.  One antidote to that is index and avoiding market timing.  He writes:

Indexing is a strategy that accepts the futility of timing the market—that there is no reliable system for participating in the good markets while avoiding the bad. Instead, indexing addresses one problem that can be controlled: emotional decision-making.

It seems clear to me that the biggest obstacle to successful investing is our own human nature. Indexing may have its faults, but it can still help protect us from our own natural, but misguided, impulses.

Carl Richards at behavior gap asks a relevant question in light of the many interventions by the federal government in the economy in the past year:

So if traditional buy and hold investing is a bet on the concept of free market capitalism, what if the current version is not quite as free as the model assumed it would be?

James Picerno at The Capital Spectator warns us on the many temptations facing an investor trying to invest with a strategic approach.

The point is that investing requires (demands) constant vigilance on the critical issue of maintaining strategic perspective. It’s tempting to cherry pick a few tidbits of the analytical pie in the belief that a few simple rules and/or market metrics will dispense triumph. Too often they lead to something less.

Jason Zweig was interviewed by Christine Benz over at Morningstar.  In the wide ranging discussion Zweig touches on the topic of (strategic) asset allocation and whether there is an alternative.

The problem with this whole “asset allocation is dead” argument is–let’s just assume for the sake of argument that asset allocation is dead–what’s alive?…Asset allocation hasn’t worked in certain years, but nothing else has either. That’s the problem I have with this whole debate, which is it’s easy to say what hasn’t worked well lately, but it doesn’t mean that all the things that never worked have suddenly started to work.

John Rekenthaler at Morningstar echoes our thoughts on the challenges of the re-entry decision when it comes to market timing.  Although there may be times to be shy of the market, he notes:

To echo Mr. Churchill, buy-and-hold is undoubtedly the worst form of investing — except for the alternatives.*

The thrust of these articles is that buy-and-hold is decidedly flawed, but it may makes up for it by allowing investors to make fewer decisions.  That is a good thing, because for most investors decision making is an experience fraught with potential error.  As William Bernstein notes that “..no more than a few percent of the population is qualified to manage their own money.”  If that is truly the case then a buy-and-hold, or “strategic policy with re-balancing” may be a sub-optimal strategy that may turn out to be the best solution for the vast majority of investors.


Thursday links: demand for yield

The demand for yield is blowing new bubbles.  (Clusterstock)

John Meriwether is raising money for yet another hedge fund.  Is the risk culture back?  (Abnormal Returns)

Why do we encourage debt so?  (Atlantic Business)

Jason Zweig, “When people say diversification failed, they’re defining failure in a very strange way. They seem to be saying if, when most assets went down, something didn’t go up, then diversification didn’t work.”  (Morningstar)

Canada, for good reason, has become a target for foreign capital.  (Trader’s Narrative)

What do Apple (AAPL), Visa (V) and Mastercard (MA) have in common?  (World Beta)

Pattern seeking run amok.  How we humans (and investors) see patterns were none exist.  (Abnormal Returns)

How to fix bond ETFs.  (IndexUniverse)

Do gold-denominated hedge funds allow you to have your cake and eat it too?  (Felix Salmon)

Updating the statistics on value-glamour returns around the world.  (SSRN)

Given their Madoff-like returns, just how long did The Galleon Group benefit from insider trading?  (The Pragmatic Capitalist)

“Not all traders feeding off of Galleon’s wind down are making wise moves.”  (Dealbreaker)

What you need to know about dark pools of liquidity.  (Clusterstock)

Don’t put too much stock in the ABC Weekly Consumer Comfort Index.  (Bespoke)

Commodity investors are at the mercy of the futures curve.  (Neil Collins)

Is the CFTC trying to kill domestic futures trading?  (Bloomberg)

“If after years of trying to gain its independence the CBOE is folded back into the CME Group, it would make for one nice happy family — Chicago style.”  (Minyanville)

America’s banks resemble a pyramid, and not in a good way.  (Economist)

Given the state of the US dollar foreign central banks are reluctant to raise their rates before the US does.  (The Money Game)

On the prospects of a job-less recovery:  “The percentage of employee separations labeled permanent is at a recorded high.”  (macroblog)

Financial regulation could become THE political issue of 2010.  (FiveThirtyEight)

Americans are driving again.  (Carpe Diem)

Twitter posts will soon be searchable via Bing or Google.  (NYTimes)

Is Twitter a fad or a true democratic platform? (24/7 Wall St., DailyFinance)

Apparently the Bogleheads know something about retirement planning.  (Aleph Blog)

A bull market in hand sanitizer.  (Infectious Greed)

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Return to a risky normal

Sam Jones in the FT reports that John Meriwether is getting back into the hedge fund business.  Reportedly and not surprisingly the new JM Advisors Management plans to utilize a relative value arbitrage strategy that was the downfall of Meriwether’s two previous hedge fund operations.  From the FT:

The strategy, described by the Nobel Prize-winning economist Myron Scholes as being akin to a giant vacuum cleaner “sucking up nickels from all over the world”, can be highly successful in periods following market dislocations.

Relative value trades profit by betting on unusual pricing relationships between securities, anticipating a return to an historically modelled “normal” state between them.

Michael Corkery at Deal Journal notes that Meriwether’s previous funds relied heavily on leverage to generate returns.  And in the case of Long Term Capital Management, potentially endanger the entire financial system.  Corkery writes:

It’s not clear how much leverage Meriwether and his merry band of investors will be willing to stomach in the latest fund…But in some ways that’s beside the point. The fact that Meriwether – whose name is synonymous with the high-flying hedge fund boom earlier this decade — is back in action says a lot more about investors’ overall appetite for risk. Namely, it’s back.

We have previously noted the many signs of the return of the risk culture. However we are no sure that this is one of them.  The strategy Meriwether employs requires the capital markets act in a more normal (whatever that means) way.  This may say less about risk and more about a belief that the worst of the crisis has past and that the historical relationships between various assets will mean-revert.

It has been shown that even the most simple arbitrage schemes can generate losses and higher than anticipated levels of return volatility.  As Felix Salmon writes:

This is why only the biggest and most liquid companies tend to try their hands at arbitrage: it’s very much a don’t-try-this-at-home strategy. Even if you’re convinced that the trade is risk-free, it really isn’t.

Maybe the twin notions of a “return to risk” and a “return to normal” are not, as we previously thought, antithetical.  Maybe they are simply two sides of the same coin.  One thing the past year has taught is that arbitrage, or in this case relative value arbitrage, is in fact a risky endeavor.  In short, a bet on the convergence of prices is in fact a risky trade.  One need only look at Meriwether’s track record.

Then again maybe this news says less about the state of the global financial markets and more about hedge fund investors.  As Joe Weisenthal at Clusterstock writes:

There really is no way to destroy your reputation in this industry, so long as your failures are spectacular…The craziest part is not that he’s starting a new fund (why not?) but that investors will throw their money at him.

Third time is a charm. Right?

Update: We just noticed two more (incredulous) posts worth a read on the Meriwether news.  Felix Salmon notes that the hedge fund business is in large part an exercise in marketing.  Kid Dynamite wonders how it is that Meriwether is getting another shot at managing money.

Pattern seeking run amok

We human beings are pattern seekers.  We can’t help it.  We see patterns even where none exist.  As Jason Zweig in his book Money & Your Brain (via IndexUniverse) writes:

It’s vital to recognize the basic realities of pattern recognition in your investing brain:

It leaps to conclusions. Two in a row of almost anything—rising or falling stock prices, high or low mutual fund returns—will make you expect a third.
It is unconscious. Even if you think you are fully engaged in some kind of sophisticated analysis, your pattern-seeking machinery may well guide you to a much more instinctive solution.
It is automatic. Whenever you are confronted with anything random, you will search for patterns within it. It’s how your brain is built.
It is uncontrollable. You can’t turn this kind of processing off or make it go away.

That is in part why charts hold such sway with investors and traders alike.  We are not necessarily focusing on technical analysis, per se, but simply visual presentations of data.  As with statistics, with enough effort one can get a chart to say pretty much anything.  However even charts that are produced in good faith can still mislead us.

That is why we as investors and traders need to be constantly on alert to situations where our brains can fool us into thinking we can foresee the future.  There has been a very popular chart (from Doug Short at dshort.com*) floating around the blogosphere during the past year that depicts graphically four (including the most recent) bear markets.   Although it has been reproduced any number of times we present it below for the sake of convenience:

Four Bad Bear Markets

Source: dshort.com

A quick look at the chart shows how one might have instinctively reacted during three distinct phases to the latest bear market.  Prior to October 2008 one would have come away from the chart thinking we were in the midst of a run of the mill bad bear market.  A few months later one could not help coming away from the chart thinking that the 2008-2009 bear market was tracking with 1929 (and the subsequent disastrous results).  Today the chart would seem to indicate that the worst has past and that a bull market is now firmly in place.

Short wisely notes on the site that: “These charts are not intended as a forecast but rather as a way to study the current decline in relation to three familiar bears from history.”  However that does not prevent our primitive brains from doing exactly that.

One blogger Eddy Elfeinbein at Crossing Wall Street thinks we should stop looking at these charts altogether.  Elfeinbein writes:

Starting today, I refuse to look at any more charts that contain five or more squiggly lines, one labeled 2009, another labeled 1929, another 1974, another 1379. Enough!

These charts were kind of fun to look at a few months ago, but seriously, markets don’t trace out precise patterns from decades ago…Once you start toying around with the data, you can make anything fit.

The problem for Eddy and everyone else is that these charts are not going away any time soon.   As we have seen, even if a chart is produced correctly it can still induce us to generate implicit forecasts where none are really warranted.  Unfortunately none of us are immune from this pattern seeking run amok.  It is a part of what makes us human.  However being forewarned is forearmed.  Now when it comes to charts you know what to look out for (or avoid altogether).

*If you have not checked out dshort.com we would recommend a visit.  In addition to the four bears chart he has a number of other interesting charts and articles that are worth a look.


Wednesday links: cash returns

Low returns on cash are pushing investors into riskier assets.  (FT Alphaville)

Is the gold trade getting crowded?  (Rolfe Winkler)

Is the “distressed debt party” already over?  (All About Alpha)

On the use of stock screens:  “The problem is that most investors use these strategies only after a period of significant outperformance only to then suffer disappointing underperformance by doing so.”  (Kirk Report)

Historical comparison graphs “were kind of fun to look at a few months ago, but seriously, markets don’t trace out precise patterns from decades ago.”  (Crossing Wall Street)

How soon we forget.  A sub-20 VIX is quite high if you look at the paste decade or so.  (VIX and More)

Money is flowing back into ultra-short bond mutual funds.  (Morningstar)

“Every day you own an option that’s overpriced relative to the volatility realized in the underlying, you theoretically lose money.”  (Daily Options Report)

Is Warren Buffett at risk of being behind the curve?  (24/7 Wall St.)

On the benefits and drawbacks to using 13F filings instead of direct investing in a  hedge fund.  (World Beta)

“In trading, we see inertia when a position is obviously going against a trader, but the trader does not exit the position until an obvious stop out level is hit..”  (TraderFeed)

More notes from the Value Investing Congress.  (market folly)

How financial news and firm advertising affect subsequent stock returns.  (SSRN, ibid)

The yuan forward market anticipates a reset higher for the Chinese currency.  (The Money Game)

The US dollar, as a reserve currency, has problems, but what is the alternative?  (Daniel Drezner)

The Galleon Group winds down (no bailout required).  (DealBook, DailyFinance)

Paul Volcker is pounding the table on de-risking banks.  Is any one listening?  (NYTimes also Baseline Scenario, Big Picture)

The Hank Paulson-Goldman Sachs (GS) connection stinks.  (Felix Salmon, Economist’s View)

How much weight should we put on predictions of deflation based on current unemployment levels?    (Econbrowser)

Good people don’t get very far in Washington.”  (DJ Market Talk)

“Do lower health care costs mean higher wages?”  (Ezra Klein)

No wonder enrollment in community colleges is jumping.  (Economix also Atlantic Business)

Cash on the balance sheet is both a boon and a bother for the tech giants Microsoft (MSFT), Google (GOOG) and Apple (AAPL).  (Infectious Greed)

A look at the best books on the financial crisis.  (New York)

A roundtable takes a closer look at Andrew Ross Sorkin’s Too Big to Fail.  (The Big Money)

On the challenges of setting a blogging agenda:  “The more you study, the more intellectual hooks you find.  They all seem important.”  (A Dash of Insight)

Turning the tables.  An interview with Damien Hoffman of Wall St. Cheat Sheet.  (Behind the Spread)

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Tuesday links: making market calls

If you’re in the business of making market calls, you’re going to wrong. That’s just how it is. I’m wrong all the time. So is Jim Cramer. It happens. But I won’t tolerate someone trying to run away from their calls. There’s no excuse for that.”  (Crossing Wall Street)

Will investors in Covestor and kaChing’s new investment accounts fare any better than they would have in mutual funds or ETFs?  (Abnormal Returns also Kirk Report)

What time frame is the promising for individual traders?  (CSS Analytics, A Dash of Insight)

“There is now only one problem with the rally in stocks…CNBC and some real shitty money managers are getting off the hook. I hate that more than anything. Some time the guilty just get off.”  (Howard Lindzon)

Should we care if the VIX dips below 20?  (Bespoke, Daily Options Report)

“The real issue here is that the idea of monolithic bond indexes just doesn’t work.”  (IndexUniverse)

More notes from the Value Investing Congress.  (footnoted, Rolfe Winkler, market folly, Deal Journal)

Breaking down how a (non-leveraged) mutual fund returned 121% YTD.  (Morningstar)

What lessons did investors learn from Black Monday?  (Floyd Norris)

“For all the damage from the crisis, the exposure of ordinary folks — Main Streeters — to the financial markets looks to remain at best unchanged and at worst more extensive than when the crisis began.”  (Dealscape)

“Hard and fast rules like this “fill the gap” belief were made to be broken.”  (The Reformed Broker)

Apparently investors in Galleon Group hedge funds don’t want their money with an accused inside trader.  (WSJ, Dealbreaker, Clusterstock)

Where is the line between insider trading and just good old fashioned information?  (NYTimes)

A blunt tool, a windfall profits tax, is being wielded against bonus-paying banks.  (Big Picture, Economist)

“By failing to withdraw its support of an overtly strong dollar when one was no longer desirable (quite the contrary), the US Treasury has done America and the rest of the world a disservice.”  (Macro Man)

A slew of currency pairs are at or near parity with the US dollar.  (The Money Game)

Brazil puts the kibbosh on financial inflows with a 2% tax.  (WSJ, FT Alphaville)

China still has a bunch of stimulus in the pipeline.  (The Pragmatic Capitalist)

The commercial real estate decline has a ways to go.  (EconomPic Data, Calculated Risk)

A nice primer on relative strength rotation models.  (Market Rewind)

Apple (AAPL) reports blow out earnings.  Is the stock now overvalued? (Bespoke, ROI)

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The song remains the same

Alternatives to mutual funds continue to flood the marketplace.  ETFs have grown into an industry unto itself with some $700 billion in assets under management.  Now on a more micro-scale, services that intersect between the worlds of social media and the investment industry are bidding to take more market share from the mutual fund industry.

You can now include kaChing in that bid to take market share.  (Covestor Investment Management had earlier launched a similar offering.)  At the kaChing blog it is clear that the mutual fund industry is the target:

Compare the kaChing service to its closest alternative, Mutual Funds.  Mutual Funds provide no transparency into their behavior, so the only basis on which you can choose a fund is its past returns.  But we all know that past returns are not indicative of future returns.  You’ll see that disclaimer on the bottom of every investment site webpage (including ours).  Why then do people rely on Morningstar ratings (which are almost solely based on past returns) to choose their mutual fund?  Because there is no alternative!  That is until now.

A great deal of attention being heaped upon kaChing including the New York Times, GigaOM, Technologizer and the New Rules of Investing. This service provides investors with some beneifts including performance measurement, transparency and disclosure.  The question is whether these benefits will accrue to investors and will they have better luck with these modular investment accounts than they have had with open-end mutual funds?

The problem lies not with the incumbent investment management industry, but rather with investors themselves.  None of this should be read as a defense of the mutual fund or ETF industries.  There are plenty of problems there.  However, investors as a whole have shown themselves to be their own worst enemy when it comes to fund investing.

Steve Hsu at the Information Processing blog has an interesting anecdote from a discussion with noted investment author William Bernstein.  In which Bernstein outlines the abilities a successful investor needs to have.  After some admittedly rough math they came to the conclusion that only 1 in 1000 people have the requisite skill set to be competent investors.

The evidence is pretty clear that investors have the tendency to chase the hot hand in investment performance to the detriment of portfolio returns.  In a research paper Friesen and Sapp* estimate that investors experienced dollar-weighted returns some 1.50% lower than time-weighted returns in open-end mutual funds.  In short, the (poor) timing decisions of investors have cost them real money  mutual funds.

The story isn’t any better with ETFs.  John Bogle writing at IndexUniverse shows that in the vast majority of ETF categories investor returns have lagged fund returns.  Over the five year period covered ETF investors traded themselves out of some 4.5% returns per year.  Bogle writes:

So we have evidence—strong evidence—that exchange-traded funds, because of the timing that goes on in them, are not acting in the best interest of investors. Or, that investors are not acting in their own best interests, which may be a better way to put it.

Jared Woodard at Condor Options recently had a piece up expressing his frustrations with investors who to their own detriment flit from one hot strategy to another.  An extended excerpt:

Investors are notorious for chasing performance. If a mutual fund or advisor or trading strategy has done well recently, chances are much greater that traders will commit money to that strategy or product, often independently of the long term performance, general suitability, or distinguishing features of the strategy or product.  I’ve seen the same behavior among the audience for our paid newsletters: after a winning month, new subscribers are more likely to rush in, and if we have a flat or down month, interest from new readers drops. This is exactly the kind of backwards thinking that dooms most investors to underperform even basic market benchmarks: most investors would literally be better off allocating every cent to a plain vanilla index fund, rather than jumping around from one strategy to the next like insects in the lighting section of a hardware store.

This evidence, both quantitative and anecdotal, should give one pause before embarking on any new active investment program.  The Covestor and kaChing investment programs are interesting especially in their ability to harvest new talent using the power of social media.  However as a whole we are skeptical whether investors as a whole will truly benefit.

Investors will likely flock to those managers who have experienced outsized returns.  The subsequent returns, for any number of reasons, will likely mean-revert.  It is therefore unlikely that the any of that any alpha these managers might deliver will actually accrue to the vast majority of investors.

Is this a problem with these new investment accounts?  No, it is simply a function of human nature.  Now if they could somehow fix that problem, then we would really have something.  For now, it is business as usual.  Some managers and investors will do well for themselves.  However for the majority of investors the song remains the same.

*Friesen, Geoffrey C. and Sapp, Travis, “Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability.” Journal of Banking and Finance, Vol. 31, pp. 2796-2816, 2007. Available at SSRN: http://ssrn.com/abstract=957728

Monday links: competence and confidence

With the insider trading cat out of the bag, former colleagues are turning on Galleon Group head Raj Rajaratnam.  (WSJ, Clusterstock)

Are there more hedge fund-related insider trading cases on tap?  (FT Alphaville, 24/7 Wall St.)

The Galleon case emphasizes the ongoing need for hedge fund due diligence.  (Breakingviews)

The return on leveraged ETFs is so path dependent it is hard to say much about their returns.  (Daily Options Report)

A list of “strategies in a box” or actively managed ETFs.  (VIX and More)

The basic premise of most corporate bond indexes is flawed. There has to be a better way.”  (IndexUniverse)

A boom in Asian sovereign bond issuance.  (FT Alphaville)

Country risk is down across the board YTD, with one notable exception, Japan.  (Bespoke)

Everyone is bearish on the US dollar, but valuation models differ on its underlying value.  (WSJ)

Gold can now be used as collateral at the CME.  (Bloomberg)

CME Group (CME) is in talks to buy the Chicago Board Options Exchange.  (Crain’s Chicago Business, DealBook)

Happy 22nd anniversary, Black Monday.  (Crossing Wall Street)

Another example why shorting is more difficult than going long.  (The Money Game)

Some notes from the Great Investors’ Best Ideas symposium.  (Distressed Debt Investing)

“It’s tempting to thinking otherwise, but the future is always unclear.”  (Capital Spectator)

PIMCO wants to get into the active equity business.  (Pensions & Investments)

Investment site kaChing now allows investors to piggyback on the trades of “genius investors.”  (NYTimes also New Rules of Investing, Technologizer earlier Abnormal Returns)

Noted author William Bernstein estimates only 1 in 1000 people are “competent investors.”  (Information Processing via Alea)

Julian Robertson likes gold stocks better than gold.  (market folly)

The banks are risking a populist backlash with their compensation plans.  (Free exchange)

Dr. Copper is not all that impressed with the economy to-date.  (The Money Game)

Just what is the Treasury market saying about inflation?  (EconomPic Data)

The typical excuse for paying traders enormous amounts of money is that if you don’t, they will leave for somewhere else…But after the crisis, the options for someone hoping to leave a major investment bank must have declined.”  (Baseline Scenario)

Thinking of opening a restaurant?  Take a deep breath and just walk away.  (Ezra Klein also Abnormal Returns)

The media and blog aggregators are at odds.  Why are sports blog aggregators get a pass?  (The Big Money)

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Good food isn’t enough

Why do so many restaurants fail?

Is it because of the quality of the food, or something else altogether?  Given that most people get into the restaurant business because they love food it should be surprising that is simply bad food. Ezra Klein at the Washington Post links to a piece that notes an estimated 60% fail rate for restaurants in the first three years.  (Which frankly seems low.) The fact of the matter is that restaurants fail for any number of reasons, not least of which is not having a fully realized plan (and vision).

What does this have to do with investing?  Everything.

Unlike the restaurant business investors have the ability to be perfectly average with not much time or effort.  The twin concepts of index investing and simple asset allocation techniques allow an investor to broadly match the performance of the capital markets.  This “average” performance will generally outperform the majority of investors.  Frankly not many investors take advantage of this default option.

Where investors get into trouble is when they attempt to generate above normal, i.e. abnormal returns.  To achieve this requires a plan and the dedication to stick to the plan.  Running a portfolio is not all dissimilar to running a business (or restaurant).  It requires a diverse set of skills and a desire to achieve something beyond the ordinary.  By definition, not everyone can achieve this goal.

There is a well worn cliche in the trading business is that 90% of traders wash out in their attempt to become successful.  (Again likely a low estimate).  Unfortunately a desire to succeed is not enough.  That desire has be paired with a realistic plan for success, the vision to achieve it and the dedication to follow through on the plan.

For aspiring restaurateurs and investors alike the path to success is not an easy one.  Make sure you have a realistic plan in place to before you start burning through your hard earned capital.

Sunday links: blog stars

How ETFs went from sideshow to the main stage.  (Barron’s)

The ways you can fight mutual fund “fee blindness.” (WSJ)

What stock do people feel is the best stock to hold for the next five years?  (market folly)

Michael Mauboussin, “My sense is that at least some of the appetite for bond funds represents less a love of bonds than a distaste for stocks.”  (Morningstar)

What commodities have yet to run?  (The Reformed Broker)

The state of investor sentiment at week end.  (Trader’s Narrative, The Technical Take)

What does it take to be a successful market timer?  (World Beta earlier Abnormal Returns)

A better way to structure hedge fund fees.  (Breakingviews)

Discretionary trading need not be reactive trading.”  (TraderFeed)

The golden age of insider trading yields a big fish.  (Deal Journal, Matthew Goldstein)

Expert networks, hedge funds and the rise of insider trading.  (DailyFinance also The Daily Beast)

Washington set the stage for this year’s Wall Street bonus bonanza.  (NYTimes, Clusterstock, Zero Beta)

Goldman should announce that it’s taking itself private and becoming a partnership again.”  (The Stash)

Who is going to win in this era of cheap money and “state capture”?  (Baseline Scenario)

“..the deal Citi cut with Oxy struck strongly suggests that Phibro’s performance was in large measure the result of amped up leverage that no one outside Citi was able or willing to provide.”  (naked capitalism)

The worldwide recession appears to have ended, with surveys showing manufacturing activity is on the rise nearly everywhere.”  (NYTimes)

Real output grew significantly this quarter. Will employment follow?”  (Econbrowser also Calculated Risk)

Bruce Wassterstein was a complicated man.  (Epicurean Dealmaker)

Four places Google (GOOG) could put its money, but shouldn’t.  (GigaOM also Dealscape)

An extended interview with Howard Lindzon.  (Trading for the Masses)

Blog stars are real people, not companies.”  (A VC)

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Friday links: cognitive biases

Dow 10,000 gives you a great opportunity to re-evaluate your portfolio.  (Felix Salmon)

It’s a bull market now matter how you slice it.  (Bespoke)

The US Dollar is lower against nearly every currency except the Chinese renminbi.  (NYTimes)

The final words on the “smart guys ruined Wall Street” thesis.  (Dealscape, FT Alphaville)

Grains have not participated in the “rally in everything.”  (FT Alphaville)

Cognitive bias is the sole reason I do not watch the news during the trading day.”  (Anne Marie’s Trading Blog)

Mark Carhart is getting back into the hedge fund business.  (Reuters)

Goldman Sachs being proud of their performance this year is like the Harlem Globetrotters bragging that they went undefeated. It’s not really a normal competition.”  (NPR)

Is Goldman Sachs (GS) more hedge fund than bank?  (Rolfe Winkler also Felix Salmon)

The only foolproof way to change Wall Street is from the bottom up.  (HarvardBusiness via Zero Beta)

10 year TIPS-implied inflation is around 1.75%.  (Carpe Diem also The Technical Take)

Looking at the causes of the oil bubble and what it means for the price of oil post-crisis.  (The Stash)

Signs that the recession is over.  (Calculated Risk, Bespoke)

Hedge funds have garnered some clout on The Hill.  (DealBook)

Why isn’t there more political unrest at this point in the economic cycle?  (naked capitalism, Baseline Scenario)

High unemployment and rising gasoline prices are pushing California to the “breaking point.”  (Gregor Macdonald)

Despite being blamed for many of our economic ills, business schools are thriving.  (Economist)

Will there still be Bloomberg boxes on traders’ desks in ten years?  (Silicon Alley Insider also Howard Lindzon)

Are the other big biz magazines, Fortune and Forbes, doomed to the same fate as BusinessWeek?  (The Deal)

The reviews for the most anticipated economics book of the year (oxymoron?), Super Freakonomics, are trickling in.  (Marginal Revolution, Time, EconLog)

“So it’s entirely possible that Windows 7 will be good for both Microsoft (MSFT) and Apple (AAPL).”  (Daring Fireball)

On the dead weight costs of holiday giving.  (Real Time Economics)

Just how much does it cost to endow a professorship?  (Economix)

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Thursday links: fear and frustration

Dow 10,000.  (Bespoke, DJ Market Talk, Curious Capitalist, The Reformed Broker)

The S&P 500 is once again trading 20% over its 200 day moving average.  (Small Fish, Big Odds)

A bearish set-up over the next few days.  (Quantifiable Edges)

Long/short hedge funds are back to their historic equity exposure levels.  (Trader’s Narrative)

Perhaps the most compelling reason of all for investors to fret is that private equity firms are selling shares in companies they control to the public.”  (Slate)

“Because of the fear in the stock markets…all from the illiquid and underinvested, I will remain long, but small.”  (Howard Lindzon)

Money managers are still playing catch-up this year.  (Money & Co.)

Without a plan many investors who exited the stock market last year have yet to re-enter.  Maybe we should blame Cramer?  (Abnormal Returns)

Muni bonds rallied right into a brick wall.  (Accrued Interest)

There is a shortage of junk bonds on Wall Street.  (WSJ)

Don’t try this at home.  “Buying toxic [mortgage] assets is brutal business.”  (Felix Salmon, NY Magazine, ibid)

Eight investing themes from JP Morgan Chase.  (The Pragmatic Capitalist)

Day traders know more about investing than the so-called pros.  (The Money Game)

An interview with Jason Zweig on the practical aspects of behavioral finance.  (Morningstar)

“As for investors, well, we need to learn that uncertainty and ambiguity dog our every step. For it is when we are at our most certain that we are at most risk.”  (The Psy-Fi Blog)

Calvin Trillin was right.  Smart guys did flood Wall Street to catastrophic consequence.  (Baseline Sceenario also Floyd Norris, The Stash, Free exchange, Daring Fireball)

Free money should produce “heroic profits.”  By that standard Goldman Sachs (GS) and JP Morgan Chase (JPM) disappointed.  (Clusterstock)

Goldman Sachs (still) has a PR problem.  (Big Picture)

Outrage is easy. But fixing something is hard. And that’s why all the whining about Wall Street pay is for naught. It takes us nowhere.”  (Deal Journal)

The NYSE is under siege.  “Young, fast-moving rivals are splintering its public marketplace and creating private markets that, their critics say, give big banks and investment funds an edge over ordinary investors.”  (NYTimes)

It is very difficult to find a job at the moment.  (Economist’s View)

This is an example of why fund managers still love to go on CNBC.  (The Disciplined Investor)

Why exactly did Reuters buy Breakingviews?  (FT Alphaville also DealBook)

Just how much is Bill Luby’s blogroll worth?  Hint, more than BusinessWeek.  (VIX and More)

“Not many outsiders understand what a powerful learning mechanism the blogosphere has set in place.”  (Marginal Revolution)

It’s official your bullying boss really is an idiot.  (New Scientist)

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Exits and entries

We have been writing a great deal of late on the challenges of investing in a post-crisis world.  For many investors whatever plan they had prior to the crisis has long since gone out the door.  In retrospect the benefits of a market timing or tactical strategy look pretty good.

However with the attendant media attention on the stock market with the Dow 10,000 we are seeing evidence that a number of small investors missed the opportunity that was the rally of late. As Brett Arends writing at WSJ notes that shouldn’t be altogether surprising:

Millions of ordinary investors, burned by two stock-market crashes in the past decade, are leery of Wall Street. Mutual-fund investors continue to sell their stock funds and buy bond funds in the quest for more stability. And yet the market keeps rising. What should investors do?

At the moment many of them seem content to continue putting their money into “safe” bond funds.  The most recent data show bond funds continue to receive inflows while equity funds even after this rally continue to demonstrate outflows.  As Daisy Maxey at WSJ writes:

Even some bond-fund managers are surprised by investors’ continuing appetite for bonds and are warning that this year’s outsize returns won’t likely continue.

Only now does it seem that some investors are willing to re-enter the stock market albeit in a modest way.  Tomoeh Murakami Tse at the Washington Post writes:

And in interviews over the past two weeks, fund managers and financial advisers said most small investors have only recently begun to talk about getting more aggressive with their beaten-down portfolios.

Maybe we should just blame Jim Cramer for all this.  Henry Blodget at The Money Game re-visits Cramer’s “call of lifetime” in which he told investors back in October 2008 to sell prior to an additional large drop in the market.

Blodget does not take issue with that call, which in retrospect turned out to be correct.  The question is he asks is how many of those investors who took that advice got back into the stock market at any point along the way?  Absent a clear call to get back into the market, the anecdotal evidence indicates few actually did.  As Blodget writes:

Cramer was certainly right about the near-term direction of the market, and, for a while, he saved those who acted on his advice some money.  A year later, however, with the market having recovered all of its losses, Cramer’s call just looks like what most of Cramer’s calls look like: Noise.  And, in our opinion, it stands as yet another clear example of why most investors should avoid market-timing..”

A cynic might note that any one who takes their market calls from some on television gets what they deserve, but that is not altogether fair.  For a long time, buy and hold seemed like the way to go.  However the past decade punctuated by the events of last year demonstrate the psychological toll holding on can have.  The past year was the death knell for many buy-and-holders.  The problem is now that they now have no viable investment plan going forward.

In short, they got out of the game.  As we wrote a couple of days ago when discussing how to invest in a post-crisis world:

All an investor can hope to do is try maintain a flexible approach and stay in the game.  Only those investors who stay in the game will be able to capture some gains along the way.

It is easy to get out of the market.  It feels good especially in hindsight when you see the market continue to tumble.  However it is difficult to get back in especially when all the headline news reeks of a continued economic downturn.  In short, market timing can only be successful if one has a steadfast plan for both exits and entries. As we have seen panic exits from the market can often lead to the new panic of having missed a 60% rally off the lows.