Time Machine - 1111 and the US National Debt

INVESTOR PSYCHOLOGY

Recency Bias is the tendency for people to remember recent events more than past events, and to believe that the most recent situation has always been so.  Put another way, people tend to frame their memories based on recent events, and to remember what they want - and likewise, to forget what they want.

I mention all this because it seems like lifetimes ago that the US national debt was not only in control, but people were actually talking about paying it off.  That moment was 11 years, 1 month, and 1 day ago today.

Bill Clinton had just finished his term in the White House, stained by political scandal (ie. the Monika Lewinsky affair).  Many viewed Clinton as a very unpresidential, even embarassing president.  Yet, no one could deny the positive economics of his term.  At the end of the Clinton presidency, the National Debt stood at 5.73 trillion dollars - a relatively small sum for the massive US economy.  After three straight years of budget surpluses, economists were estimating how long it would take to pay off the National Debt completely.

Presidential hopeful Al Gore, for example, outlined an economic plan that would eliminate the National Debt by the year 2012.  When candidate George W. Bush was asked if he had a similar plan, he said that although he agreed with paying off the debt in principal, he would not commit to a specific date.

Soon thereafter, Bush was elected as President.  He immediately began a series of tax cuts for high-income families, which he (and his economic advisors) believed would stimulate the economy so much that the end result would be an overall increase in tax revenues (known as "trickle-down economics."); unfortunately, it didn't work .  Tax revenues declined drastically with each cut.

Bush ran a budget deficit (increasing the national debt) in 7 of his 8 years in office.  In 2003,  he set a record for the largest annual debt increase in US history.  Due to a combination of tax cuts and expensive foreign interventions, by the end of the Bush term the US National Debt had nearly doubled - from $5.73 to $10.69 trillion.

People now talk about the National Debt as if it was meant to be, always was, and always will be.  Many cannot remember the time - not so long ago - when there was talk of the United States of America having no debt at all.

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"I've abandoned free market principles to save the free market system."

George W. Bush, 2008

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Culling the Sheep - again

This week marked the single biggest wave of selling by retail investors ever recorded.

On Monday Aug 8th 2011 alone, Swiss bank UBS recorded retail outflows of 1.3 billion dollars! No wonder the markets crashed.

In The Intelligent Investor’s Mind, I speak about "myopic loss aversion" – the tendency for people with long-term goals (such as retirement) to focus on short-term events, especially the gyrations of the stock market. Myopia literally means “shortsightedness.” Such shortsightedness typically beds with "recency bias" – the tendency to think that the current situation (good or bad) will last forever. This week’s market activity shows just how strongly these cognitive errors can destroy people’s financial well-being: usually their own.

If you doubt the intensity of this week’s retail investor freakout, check out these choice quotes:

"Investing in U.S. Markets is DEAD....DEAD… and it is NOT COMING BACK!!"

"Yeah, it's different all right, as in it is ALL coming down."

"Their plan is to get rid of paper currency and go to digital currency so they can make you a slave."

"666, whatever you'd like to call it is coming."

Yet the market rollercoastered, showing that as much as retail investors were frantically selling, professionals and value investors were swooping in to pick up the spoils. Bloomberg reported that insider buying by S&P 500 company executives reached levels not seen since March 2009.

This week also revealed some great moments in calm and cool leadership. First was Barack Obama’s matter-of-fact speech regarding the S&P debt downgrade, where he basically said (I’m paraphrasing), “I didn’t need a downgrade by S&P to tell me that our government had a dysfunctional moment. We need to fix the way our government works.” The second was from Federal Reserve chairman Ben Bernanke, who said that he would keep interest rates low (which makes it easy for businesses to expand & develop), but other than that, the markets just need to grow up and get on with it. The final moment was an interview with Bank of America’s Jamie Dimon, who demonstrated the sensibility of long-term thinking (see video below). Interestingly, all of these great moments were regarded negatively by the public, who just wanted their leaders to DO SOMETHING!

As usual, the counterintuitive nature of the stock market is at work: those who are fearful of losing their money are losing their money; those who are unafraid of losing their money are making more.

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"There is no comparison between fear and greed. Fear is instant, pervasive and intense. Greed is slower. Fear hits."

Warren Buffett, Aug. 11, 2011

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US Home Prices Drop Again

But is that bad?

In a story on CNBC, Home Prices fall for 8th straight month, David Blitzer, chairman of the Index Committee at S&P Indices, is quoted as saying, "There is very little, if any, good news about housing. Prices continue to weaken, trends in sales and construction are disappointing." When I read the same statement, I thought it was good news. Why the difference?

Everyone uses mental models in their daily life - whether they are aware of it or not. A mental model is a way of thinking, usually learned from the culture one grows up in, but often changed by education. A clear example is that in the West, most people believe that the mind/soul and body are separate. University educated individuals tend to use the scientific method to discover things, rather than logic or meditation.

Fictional character Sherlock Holmes famously uses “deductive reasoning” to solve crimes. Deductive reasoning is eliminating anything that must be false in order to find the last remaining item, which must be the truth. It is said that Sherlock Holme's author, Sir Arthur Conan Doyle, learned this technique from his university medical professor, who used it to diagnose patients.

Warren Buffett’s business partner, Charlie Munger, commonly uses “inversion.” Inversion is looking at every problem from the opposite direction from the normal one: for example, instead of asking, “How can we improve customer service?” Munger might ask, “How can we have terrible customer service?” The opposite of that answer is the way to have great customer service.

In Iraq, US soldiers and politicians often become annoyed because the Iraqis do not think of the relationship between cause-and-effect the same way we do. That is, they view the relationship between cause and effect as weak. If Iraqis take a day off to play cricket instead of building a new water pipeline, they don’t necessarily see the connection to having no clean water later that month. This difference in thinking is so frustrating for American troops that there is a whole series of military intelligence "lessons learned" documents devoted to it.

Now to examine David Blitzer’s comment: "There is very little, if any, good news about housing. Prices continue to weaken, trends in sales and construction are disappointing." Under normal circumstances, this statement would be perfectly logical. In a normal economic cycle, all these things indicate a weakening economy. David is inferring that low sales, low construction, and falling prices are bad – the traditional economist’s view. But is it truly bad? Or is David using a “fossilized mental model” – one that is not relevant for the situation?

The US had a housing bubble: that means there were unrealistic prices, oversupply, and sales to people who were not qualified. The remedy for a housing recovery is therefore lower prices, no new construction (until excess inventory is gone), and low new home sales (since foreclosures will be sold first). In other words, today's statistical weakness is exactly what the housing market needs to recover. At this point, strength in any of these numbers would be negative.

The banks can only release foreclosures onto the market at the same rate as the market is ready to absorb them. Since the banks control the flow of this inventory, new home sales and price stats are meaningless: any increase in market strength will be met by the release of foreclosures to match.

Prices are low enough that when the housing market does return, it will do so with a roar. Just like the bubble on the upside, the longer US housing numbers stay weak the more sudden and dramatic the recovery will seem.

Several months ago, I wrote that it was a good time to buy US real estate. Since then, in most cities home prices have fallen by about 3%. I do not apologize for this imperfection.

No one knows exactly when the market will recover, yet one thing is certain – buying quality real estate at a time of low interest rates and low prices will never prove to be a bad investment. Don’t try to catch the exact bottom.

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"Don't try to buy at the bottom and sell at the top. This can't be done - except by liars."

Bernard Baruch

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The US Federal Budget (and my 10th Grade teacher)

No, John Maynard Keynes was not my 10th Grade teacher. But it was in Grade 10, from my history teacher, that I learned about famous economist John Maynard Keynes.

It was Keynes who first proposed that markets move in cycles - in repeating booms and busts - and that the best way to lessen the impact of these booms and busts is to implement countermeasures.

Prior to Keynes, governments taxed less and spent more during good times (when they could afford to do so), and taxed more and spent less during bad times (when they couldn't). It all seemed very straightforward. After the Great Crash of 1929, for example, the US government cut back on myriads of projects and social services in order to save money.

Keynes argued that such seemingly sensible measures only worsen recessions. Instead, he argued that in bad economic times we need to cut taxes, cut interest rates, and increase government spending in order to “stimulate” the economy back to life. Then, in boom times, we need to increase taxes and curtail spending (since the economy is sustaining itself), and pay back that debt.

My 10th grade teacher pointed out that Keynes was foolish and that his ideas would never, ever work. The problem was not with Keynes' theory, but rather that his plan ignored human psychology and the reality of politics.

In bad economic times, people enjoy having their taxes reduced and interest rates cut, even though this leads to the large government deficits that these same people become angry about (rather like being pleased to receive expensive presents from your wife, then complaining that she spends too much).

As the economy improves, it gets even harder for the government to implement Keynes’ ideas. Despite being angry about large government deficits (“debt for our children!”) people are nonetheless unwilling to pay more in taxes to reduce it.

In the United States, any proposed tax changes are complicated by the remarkable fact that low-income earners have been led to believe that rich people need lower taxes, but that they personally don’t need them! Yes, only in America, prefabricated home owners and squirrel hunters can actually be seen protesting against higher taxes for the rich, even if that results in higher taxes for themselves.

The US budget promises to be a Frankenstein-like creation. The US Democratic Party hits walls of opposition because they propose ideas that only economists can appreciate. The US Republican Party is politically successful because they propose simple and intuitive economic ideas, no matter how unworkable those ideas may be.

Like John Maynard Keynes, Barack Obama expects people to be as logical and practical as he is – except that they aren’t. Even my tenth grade teacher knew that.

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"The avoidance of taxes is the only intellectual pursuit that still carries any reward."

John Maynard Keynes

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For an example of the class divide in America see:


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The FDIC - Combating Stupidity Since 2011

Those who understand behavioral finance know that sometimes you have to protect people from orchestrating their own financial doom: in The Intelligent Investor’s Mind, I devote a section of every chapter to it. Financial quants and investment professionals (who should know better) are no exception. In fact, great genius is required to create a truly phenomenal financial disaster.

On March 29th, the Federal Deposit Insurance Corporation approved new rules for mortgages – essentially “anti-greed, anti-laziness” rules - that align the interests of homeowners, bankers and investors.

Under the new rules, banks will not be able to repackage and sell a mortgage (ex. Mortgage bonds, CDOs), unless the borrower puts down a 20% or greater down payment. If the borrower puts down less than 20%, the bank will be forced to keep some of the risk on its own books - known in the industry as “keeping skin in the game.”

Effectively, these new rules force banks to care about the quality of the loans they receive from mortgage brokers, and care how those loans perform. Prior to this, a mortgage broker could underwrite a loan from someone they knew couldn’t pay, sell it to a banker who didn’t care if the owner couldn’t pay, and in turn sell it to an investor who didn’t bother (or didn’t have the skill) to check to see if the owner couldn’t pay.

The National Association of Mortgage Brokers will undoubtedly hate the new rules. They are already fuming about the Federal Reserve’s new “Truth in Lending” regulations in general. Despite pushback, however, the matter will be put to vote this week and is expected to pass.

The days of dreamers with bad credit and no cash, walking into a mortgage broker's office, getting approved, then sitting on their new sofas & waiting for riches through equity appreciation are truly over - even if the market comes back.

People will always find new and ingenious ways to ruin themselves financially. Even so, it’s nice to see the old gaps being closed.

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"If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring."

George Soros
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Pessimism is Wonderful

At dinner parties, coffee shops, classrooms and churches, the common voice of America is focused on the same two topics: recession & unemployment.

I have personally never seen a collective outlook so hopeless and dejected, where being positive about anything is seen as foolish. In short, the opportunity to invest in stocks continues to be wonderful.

I have written ad nauseum about the fact that times of great pessimism are the best times to buy stocks. But, since people find this so counter intuitive, here is the reason expressed in simple numbers…

Stock prices are determined by two major factors – company earnings and popularity. Times of pessimism tend to follow some great crisis that hurts company earnings and creates walls of worry.

Worry causes people to pay less for what earnings companies have, as reflected in a low price-to-earnings (P/E) ratio. During times of prosperity, the average P/E ratio of the market might be over 20. During times of deep pessimism, the average P/E of the market might be in the single digits. For the patient investor, the effects of company earnings and market P/E over the course of the business cycle is profound.

Say, for example, that during a recession, manufacturer General Electric's earnings are $1.00 per share at a P/E of 15, giving it a stock price of $15.00. After a few years, as the economy improves, GE’s income returns to $2.00 per share (the same level as before the recession, assuming that the company doesn't grow at all). At the same time, newly optimistic citizens begin buying stocks again, and stock prices rise to an average P/E of 20. This means that GE will now be priced at $2 x 20 or $40. Since one business cycle takes from between 3-7 years, in seven years or less you could make a return of 267% (from $15.00 to $40). The stock market rewards patience well.

At present, company earnings are low, P/E ratios are low, and negativity is high - the perfect formula for value investing.
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“The most common cause of low prices is pessimism - sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.”

Warren Buffett
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Disclosure

Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.
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Choosing the Right Broker

INVESTOR PSYCHOLOGY

Investment books typically say that you can choose the right broker by checking their background, pedigree, past performance and investing style: the best brokers will have a track record of success.

Such advice seldom works. It assumes that making money is the client’s primary reason for choosing a broker. It also assumes that the investor actually wants to make money, which is not necessarily the case.

Investing is more about psychology than anything else. Therefore, choosing the right broker is mostly about psychology as well.

The descriptions here are written tongue-in-cheek, but describe real investors and real brokers. Recognizing which one of these reflects you most gives you a powerful advantage.


TYPES OF BROKERS

The Punching Bag – The punching bag broker is essentially a displacement target, whose main purpose is to serve as an outlet for frustration. For instance, a Japanese businessman who is surrounded by superiors may get scolded regularly, yet has no one with which to do the same. The broker, in this instance, would serve as the person against whom the powerless individual could vent his frustrations. Those looking for a punching bag broker should pick either a meek broker who is used to it, or a strong broker who won’t care. A punching bag broker can be an important source of stress relief through Freudian displacement (taking out your aggression against a socially acceptable target), and can lead to greater success in other areas of life, such as work and marriage.

The Thrill Provider – The thrill seeking client does not wish to invest in index funds or other practical investment vehicles, but rather wishes to be part of the exciting world of mergers and acquisitions, penny stocks and new issues. It is not so important whether the stocks go up or down, so long as risk and danger is omnipresent. A broker that specializes in thrill providing is usually a frequent trader, and will cost the client more in trading commissions and taxes. Selecting a thrill seeking broker is an excellent alternative to more harmful options like gambling, drugs, or marital infidelity.

The Loser – The hypochondriac investor should seek a broker with a mediocre record. This way, a client can tell his friends how much money he lost, how horrible it is etc. and get as much attention and sympathy (“injustice collecting”) as required. The loser broker is also good for those who are afraid that success will bring undue pressure to their lives, and so who just avoid being successful altogether. Note that those who use a loser broker are not investing to win, but rather are investing to intentionally fail; therefore, it is important to choose a broker who is not particularly successful. A moneymaking broker will not meet the required psychological needs.

The Arm Candy – Arm candy refers to a broker at one of the world’s top investment firms, whose membership requires a high initial investment amount or referral by an existing member. The purpose of the arm candy broker is primarily snob appeal. For example, a client can say, “My broker at Goldman Sachs told me…” and know that dropping the name “Goldman Sachs” implies a certain elite status and cache that a local boutique would not. Investment returns are not as important as having the account itself.

The Team Player – The team player relationship – perhaps the most healthy of all client-broker relationships - is when client and broker work together to create winning strategies. Good calls are held, and bad calls are dropped before they become overly bad. The client calls the broker just often enough to maintain a regular presence, but not often enough to annoy. With a team player broker, one will actually be working with a broker in a partnership, and so investing prowess and a match of styles is important. Team player relationships tend to break down into co-dependency.

The Discount (Online) Broker – Discount brokerages give no investment advice at all, so winning or losing is completely due to individual investment decisions (assuming the investor does not ask friends, lovers etc., in which case that person becomes the substitute broker). Those who use discount brokers love the intellectual challenge of investing, and tend to believe that they are superior to most other investors. During the early and middle stages of market cycles this idea of superiority may have a grain of truth to it, but is definitely not true during bull markets, when uneducated investors open accounts in droves. Discount brokerage users also tend to believe that their strategies are “secret,” even when they are buying small amounts of stock in large corporations that trade millions of shares a day. Since they are working alone, discount brokerage users must be keenly aware of their own psychological shortcomings (hint: if you make a mistake once, it is a mistake. If you make the same mistake several times, it is not a mistake).

The broker descriptions above are, of course, not exhaustive, and several types may be blended together. Nevertheless, knowing your own motivations – and making sure these motivations are healthy – is useful knowledge. By eliminating those motivations that are most unhealthy, investment success can be improved exponentially.
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"He is a masochist who wants to lose."
Sigmund Freud, in regard to compulsive gamblers

What's Wrong with It?

"What’s wrong with it?” is a question that first-time investors (and some seasoned ones) have a tendency to ask when a stock goes down.

The full question is, “I just bought the stock last week, and now it’s going down! What’s wrong with it?” The actual problem may be the company, it may be the market, or (most likely) may be the question itself.

When a stock drops, the first thing to consider is what the general market is doing. If the market is rising and your stock is dropping, it is likely that something is indeed wrong with the company, especially if the selling continues for more than a few days. On the other hand, if the whole market is dropping and yours is dropping along with it, there is nothing necessarily wrong with the stock you purchased. But, a decision is necessary. And you have to ask yourself a couple of questions before making that decision.

Question One: Has the company changed?

There should be some good reasons why you initially bought the stock. Hopefully, most of these reasons are related to the company behind it. If you bought a stock only because the chart looked good, you’ll likely lose money. If you bought the stock because the company has steady earnings, low debt, great return on equity, reasonable P/E ratio etc., and the chart looked good, you should be just fine. If the reasons you bought the company still apply, strongly consider keeping the stock.

Question Two: What is the state of the economy?

There’s an expression in investing: “Don’t try to catch a falling knife.” If the market begins falling from a peak, and you have reason to believe that the entire market will continue falling for an extended period of time, you should seriously consider selling the stock and buying it back later. No matter how good your stock is, if the entire market is falling, yours will likely fall with it. On the other hand, if you are not 100% sure (I repeat: 100% sure) that the market will be significantly lower a month from now than it is today, keep the stock.

Question Three: What is the state of the industry?

Have their been any rule changes or significant developments that have impaired the moneymaking potential of the business? Have their been any adverse political developments? If there have been changes, find out about them and assess their impact yourself – do not rely on others to do so for you. Emotions tend to run high in such situations, and emotions have no place in investing.

The fact is, stocks of good companies drop all the time. Just because a stock price drops does not necessarily mean that the stock is “bad.” In fact, if the price has dropped significantly, and the company still has all the great qualities that made you buy it in the first place, consider buying more. Many a fortune has been made by purchasing under-priced assets and having the patience to wait.

“What’s wrong with it?” is often just a way of saying; “I’m overwhelmed with the human fear of losing money, and have no confidence in my original decision.” If this applies to you, take a deep breath and re-read this article with your stock in mind. Then make a decision.

If you still feel overwhelmed, sell your stocks and get out of the market, forever. Not everyone was meant to own stocks. To make money in the market, you have to not care about money.
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“I think that if any reader of these chapters is convinced – really convinced – he cannot master the market, a great deal has been accomplished, because the great majority will fail in the market, & it’s worth dollars and cents to them to know it.”

Gerald Loeb, The Battle for Investment Survival

Is Buy-and-Hold Really Dead?

Since the credit crunch began, many a financial professional has suggested that the buy-and-hold approach to investing is dead. You cannot, they say, simply buy a stock and forget about it. You will lose money.

The most powerful argument against buy-and-hold, popularized during the heat of the crisis, is that if you invested your money in U.S. stocks in 1999 and held them until 2009 (a ten year period), you would have made absolutely nothing: your stocks would not have increased in value at all. Many people found this statement shocking. I also found it shocking, but for a different reason. 1999 was the peak of the Internet bubble. 2009 was dead bottom after the housing bubble. So basically, they were saying that if you were stupid enough to buy stocks at the worst possible time, and then stupid enough to sell those stocks at the worst possible time, you’d still come out even. Truly remarkable.

In reality, buy-and-hold has never meant buying a stock and forgetting about it. Buy-and-hold means buying the stock of a great company at a good price, and holding it for as long as it stays a great company at a good price. If the company's competitiveness declines, sell it. If there are serious “accounting irregularities,” sell it. If the company becomes overvalued, sell it. This is buy-and-hold. So, why does the press always suggest that trading is better? Partially it’s because of ego (surely a complex strategy must be more effective than a simple one); but mostly, it’s because of commissions.

If you buy a stock and sell it several years later you may have a large capital gain, and the government may receive tax income, but Wall Street gains almost nothing. Commissions and trading spreads are the way that Wall Street makes money, and buy-and-hold doesn't encourage either.

You may notice that when you open an account at an online brokerage, they always have free seminars about level II quotes, day trading, chart reading, and anything else that encourages people to trade more. They also have special benefits and pricing for “frequent traders.” In contrast, I have never seen an online brokerage offer a value investing or buy-and-hold seminar, ever. And I probably never will.

Trading certainly has its place, especially in choppy markets. And it’s fun. But for those who can’t marry their computer screens or who do not have a degree in economics, buy-and-hold is the great equalizer. Buying stocks of excellent companies at times of great pessimism, and holding them until times of great enthusiasm, is a moneymaking strategy par excellence.
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“Cash combined with courage in a crisis is priceless.”
Warren Buffett

Power of the VIX

In recent days, newscasters been talking a lot about the VIX – commonly known as the “fear index,” and as an important gauge of investor sentiment.

But, just how well does the VIX measure investor sentiment? More importantly, what relevance does it have to investors? We explore these things and more...

Part 1 - What is the VIX?

The CBOE Volatility Index, or VIX, is a measure of the short-term expected volatility of the S&P 500 stock index. In simple terms, the VIX measures the likelihood that stocks of America’s largest companies will go up and down in value in the near future. The higher the VIX, the more likely it is that stock prices will fluctuate.

Part 2 - Is the VIX a good measure of investor sentiment or fear?

Mostly yes.

Using volatility to measure fear is one of those idiotic things that result when mathematicians attempt to measure human psychology. They do this by creating a model that is relevant most of the time, and assume that it is relevant all of the time.

The VIX makes the grossly inaccurate assumption, common in investing circles, that “volatility” and “risk” are the same. If you ask an average person what they are afraid of, they will not tell you that they are afraid their stocks will go up and down. What they are afraid of is that their stocks will go down and never come back up; that is, they are afraid of a permanent loss of capital.

Having said all that, investors often forget their beliefs and flip out when stocks temporarily drop in value. For practical purposes then, it can be said that while the VIX doesn’t measure what investors are truly afraid of, it does a reasonable job of measuring what they actually react to.

Part 3 - Does the VIX anticipate the future?

While some claim that the VIX anticipates the future, what it actually measures is today’s expectations of the future: so really, it measures the present. Expectations of the future change daily, and so does the VIX.

Part 4 – Is the VIX useful to options and futures users?

If you trade options or futures, it is vital to know the level of the VIX. Options that are far out-of-the-money increase in value only when the underlying stock gets close to the strike price. If volatility is high, the likelihood that your strike price will be reached is also higher. Thus, volatility tends to increase the price of options and futures.

A perfect example of the importance of the VIX occurred last March with UYG (a U.S. financials exchange traded fund), where I made one of the biggest investing mistakes of my life. U.S. financials had just hit a new low and everyone was talking about the end of capitalism, so I knew that financials would soon be going up. To capitalize on this, I bought UYG call options with a strike price of $40, at a time when the price of UYG was $15. And I waited.


Even as UYG climbed from $15 to $35, my call options hardly increased in value at all. The reason? Although the ETF was growing closer and closer to the strike price, the VIX was declining at the same time. My option prices hardly moved, and didn’t substantially increase in value until they hit the strike price. It is an important lesson to all those who would buy options during a time of market turmoil: be aware that during times of large market fluctuations, you will be paying a premium for your options. I would have been better off buying at-the-money options or UYG itself. It was a lost opportunity of regrettable magnitude.

Part 5 - Can the VIX be used to hedge my portfolio?

For those who run their own portfolios like a hedge fund, the VIX is tradable under the symbol “VIX,” and has a negative correlation to equities of about -.80. Reread that last line in case you missed it. VIX or VIX call options can therefore be bought in anticipation of disaster as an excellent hedging tool.

Conclusion

The VIX is vitally important if you buy options or futures, important if you want to hedge your portfolio, and useful if you want to put a number to how much gray hair you just got by watching CNBC. As a measure of investor psychology and market sentiment, however, the VIX has little predictive value: it mostly measures what just happened.
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Note to Journalists reading this blog: Please do me a favor and stop printing the headline, "VIX jumps as stocks fall." The VIX will always jump as stocks fall, since it is part of the calculation. It's like reporting, "Body falls as man jumps out window."
Thank you.

Socially Responsible Investing

Nice concept. Stupid, but nice.

Socially responsible investing is the art of investing in companies that are morally upright: no arms manufacturers, no tobacco companies, no companies that have questionable labor practices or pollute the environment, nor companies whose employees surf pornography at lunchtime.

The problem with investing in socially responsible companies is that they don’t actually exist. Medium to large companies, no matter what their field of interest, eventually end up with some kind of litigation against them. Human nature says that if you have 500 employees, not all of them will be angels.

Years ago, when I was in the military, I remember the surprise we all felt when we saw the manufacturers of our equipment: “Don’t they make Barbie?” asked one soldier when examining a trademark on his machine gun. “Hey!” said another, “this landmine is the same brand as my cell phone!”

Since the terms “ethical,” “moral,” and “socially responsible” mean different things to different people, the investment choices of your moral mutual fund may not provide you with the peace of mind you were looking for. In the top-ten holdings of your socially responsible mutual fund you will likely find oil & gas companies, pulp & paper manufacturers, mining companies, banks, breweries and property developers. Wal-Mart famously sells semi-automatic rifles but not pornography: which, if either of these do you consider ethical?

The other major issue with socially responsible investing is, of course, the returns. Finding nice companies that stay nice takes a lot of time and effort, and therefore a lot of stock switching (causing high taxation) and high management fees. My $200 socially responsible mutual fund, purchased when I was in high school, has yielded an annual return of about -.02%. The only reason I don’t sell it is because I couldn’t be bothered to pay the transaction fee. And besides, it amuses me to see it there, performing pathetically.

My recommendation is to stop trying to find “clean” companies, and instead choose your vices carefully. If you drive a car, consider purchasing oil stocks. If you wear jewelry, consider a gold or diamond mining company. If you use a computer, consider an electronics manufacturer. If you use fertilizer in your garden, consider a chemical manufacturer.

You are directly supporting these companies anyway – you might as well make money with them.
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“If you pretend to be good, the world takes you very seriously. If you pretend to be bad, it doesn't. Such is the astounding stupidity of optimism.” Oscar Wilde

America Wasn't Ready

This Sunday, the U.S. health care bill was passed after a furious battle.

The center and left were virtually silent this week, giving the limelight to those who believe that Barack Hussein Obama is not working in their best interests, to say the least. In fact, the opposition united in what both looked and sounded like a religious crusade to save America.

“We have to deny the power of the devil and his disciples in our midst,” wrote one blogger. “Pray to the father God to wake up Congress,” pleaded another. References to “rebuke,” “wickedness,” and “righteousness” were everywhere.

Then there was the coming revolution. There were calls for “bloodshed” if the bill was passed, for “revolution in the streets,” and to “impeach the foreign born dictator.” Conservative talk-show host Rush Limbaugh said that Obama’s secret goal is to divide America before destroying it, while house Minority Leader John Boehner likened the bill to "Armageddon." An ad on the Washington Post's website offered free handguns and knives to those who enrol in a self-defense training course, to prepare you "for what's coming."

The conservative right says that their hatred of Obama is politically – not racially – motivated. Casual observation suggests otherwise. One commenter on a national news website called President Obama a “lying sack of Kenyan dog crap.” Another said that he “lies through purple lips.” Yet another said that the “monkey man will get beaten.”

Of course, the health care bill passed and will now become part of American life. Citizens will have health coverage, whether they like it or not.

For investors, the big question is “what to do now?” When propaganda is rampant & emotions high, what can investors expect? At the opening bell this Monday morning, the 22nd of May 2010, two possible scenarios could occur: A) The right will demonstrate its genuine belief that Obama has destroyed their economic future by selling off U.S. stocks like mad, creating one of the largest stock market crashes in history. Or B) nothing dramatic will happen, showing that it was all just crazy talk.

Personally, I’m hoping for “A.” If so, you will find me at my computer, happily buying underpriced stocks of great American companies, while everyone else loses their minds.
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“Reactance – the urge to do the opposite of what someone wants you to do out of a need to resist a perceived attempt to constrain your freedom of choice.” Wikipedia, “List of Cognitive Biases”

That's a Fact, Jack

INVESTOR PSYCHOLOGY

Over time I have received many good pieces of advice about investing, but one of the simplest and best was, “learn to separate opinions from facts.” Whenever there is financial turmoil, emotionality reigns - and emotion is the mortal enemy of logic. Truths becomes distorted. Facts become obscured in the fog of opinion. To be a great investor, you must first filter these facts, and then form your own opinions.

To illustrate how easily opinions and facts can become obscured, I have included a few recent examples from the media…

- “Greek borrowing rates increased by as much as 10-15% as a result of speculation that Greece would default on its debt.” OPINION
- “A market frenzy in recent weeks saw traders make bets worth billions of dollars against the euro and on the chances of Greece not repaying its massive debts. FACT

- “Due to changes in fuel efficiency and the move to hybrid and electric vehicles, demand for oil will drop by as much as 25% in the next 5-10 years. OPINION
- “Most Americans, and an increasing number of Chinese and Indians, drive gasoline-powered vehicles to work every day.” FACT

- “World demand for oil will increase by 900,000 barrels per day this year.” OPINION
- “OPEC believes that world demand for oil will increase by 900,000 barrels per day this year.” FACT

Note that opinions often provide more specifics than truths, thus obscuring the fact that they are merely opinions (read that sentence two times fast)! Don’t be mislead. Read every news story with a skeptical eye. Think, “How could this article be wrong? Do the facts (if any) support the conclusion? If it seems logical, what could derail it?” Recognize that correlation does not imply causation. Recognize that taking an opinion contrary to the crowd does not necessarily make it right. Then, after reviewing the data, form your own opinion with a blatant disregard for everything you just read – except, of course, the facts.
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"You can't do well in investing unless you think independently. And the truth is, you are neither right nor wrong because people agree with you. You're right because your facts and reasoning are right." Warren Buffett

“Reverse Attribution” – What the News Doesn’t Know

On Jan 21st 2010, President Barack Obama announced that he would limit the amount of “gambling” (i.e. high-risk leveraged trading) that banks would be allowed to do using client money. Traders worried that as a result of this announcement, future bank earnings may not be as high as they’d anticipated, and so stocks dropped. Pretty straightforward, isn’t it? Not really. Investors should be aware that the market is understood via “reverse attribution” (also known as “post hoc ergo propter hoc”). That is, after a market event has occurred, analysts try to determine why it happened and report it as news. In reality, there are limitless reasons for market moves: some simple, some complex, and others masterfully planned.

In 1929, millionaire trader Jesse Livermore sensed a change in the public. After weeks and months of positive news, he sensed that people were getting bored with the “prosperity” story. Livermore knew that a well-known economist, Roger Babson, was going to give a speech the following day, saying that markets were overpriced and due for a crash. Livermore knew that this would be the speech because it was the same speech that Babson had given the previous two years! Recognizing the opportunity, Livermore sold short vast quantities of stock (meaning that he would make a profit if the market declined), and then had his staff of secretaries call every major new agency in the U.S. and alert them to an “important speech” that was about to take place. When the press conference took place, it took place to a packed crowd of eager reporters. The following day, Babson’s dire predictions made front-page headlines, and the market took a frightening dive. This was the beginning of the end for investor confidence in 1929. The infamous” great crash” occurred less than two months later, with many blaming Livermore’s orchestrated press conference as the catalyst that started it.

The market decline that began on Jan 21st 2010 may have been caused by Barack Obama’s pronouncement, as explained in the opening paragraph. Or, it may have been caused by opportunistic traders. For weeks prior, traders had been saying that the market had gone too high and was due for a correction. These traders, upon hearing Obama’s speech -- and seizing the opportunity -- started short-selling bank stocks like mad. The short-selling led to anxiety on the trading floor, causing stocks to drop further. George Soros calls this “reflexivity”: that cause and effect make things that were not previously a reality, a reality. Or, I could be completely wrong, and it could be that a wealthy Arab, for no particular reason whatsoever, decided to sell his bank stocks that day.

A few years ago, a mutual fund manager told me the story of when his mutual fund decided to sell a certain company’s stock. The day they started selling just happened to coincide with an announcement by the same company, saying that they were changing some of their board members. The next days’ headline: “X company stock drops after appointment of new board members: investors not pleased with changes.”

In the book Wall Street Meat, Andy Kessler tells the story of a German banker who decided to have some fun at the bank’s annual Christmas party. The inebriated banker called in a buy order for a massive number of shares in pharmaceutical company Eli Lilly. As the whole party watched the computer monitor in anticipation, the share price ticked higher and higher and higher due to the onslaught from the huge order. When the Dow Jones newswire reported “heavy buying” by a foreign investor, the partygoers screamed with delight. Finally, the New York Stock Exchange halted the buying on rumors that this was a takeover attempt. Disappointed that the fun was over, the partygoers went back to their steins and punchbowls to continue their Christmas celebration. The following morning the large purchase was quietly sold off.

When news agencies simply have no idea why markets are moving, they employ common expressions, most notably “profit taking” (to describe a drop) and “bargain hunting” (to describe a gain). For instance, “the markets went up today on bargain hunting,” is a convenient way to describe an increase in the market on a day with no substantial news. “Profit taking” and “bargain hunting” are your clues that in fact no one has a clue.

On any given day, no one knows exactly why stocks move. Sometimes guesses are (probably) accurate. Sometimes they are dead wrong. Sometimes they cite a single reason when in fact there are several. It’s up to you to dig further than people watching from their sofas. It’s up to you to know that sometimes people manipulate the market for fun or for personal gain, even if it kills grandmother’s retirement plans.

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“Heavy selling out of the Middle East was an old standby. Since no one ever had any clue what the Arabs were doing with their money or why, no story involving Arabs could ever be disputed.” Michael Lewis, Liar’s Poker.