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.
___

"He is a masochist who wants to lose."
Sigmund Freud, in regard to compulsive gamblers

How to Speak Fed

The Federal Reserve: seen by some as an economic savior, and by others as an evil force.

Through its direct manipulation of interest rates and other mechanisms, the Federal Reserve determines the overall pace of U.S. economic growth (or decline).



Since investors trend toward euphoria when times are good & panic when times are bad, the Fed’s mandate is to control the economy; for example, to stimulate a weak economy by lowering interest rates, or to slow down an overheated one by raising interest rates. Yes, that's right – the Fed sometimes purposely initiates recessions. This is not conspiracy, but rather a method of controlling human stupidity (or at least cleaning up after it).

In good times wages tend to increase, which in turn increases spending, which increases prices of goods, which increases stock and real estate prices, which induces inflation, which causes wages to increase and so on. When times are good and voters are happy, the government wants it all to continue. If an independent Fed did not exist, human greed and optimism would allow bubbles to grow to stratospheric levels, then come crashing horribly down. The recent crash and burn of the U.S. housing bubble is an example of the Fed's failure to do its job – it let the bubble grow for too long.

Importantly, while the Fed always hints at what it wants to accomplish in the future, it does so in a cryptic manner. So, while the Fed’s intentions may be crystal clear to professionals, they pass by virtually unnoticed to non-professionals – exactly as intended.

Buying reasonably priced stocks of good companies is always a good idea, but it’s an even better idea to buy them when the tide of the economy is moving with you. The purpose of this article is therefore to teach the rules of “Fed speak,” the cryptic voice that shapes the nation’s economy.


Rule #1 - The Fed Understates Everything

The Fed is aware of its huge influence in the market, and takes care not to overstep its boundaries. If the Fed simply said, for example, “we intend to raise interest rates because we think there is a bubble in technology stocks,” the market would likely dive and the Fed would be blamed. For this reason, the Fed avoids stating anything of importance directly. Thus, “this market has a bit of froth,” really means, “this is a bubble of massive proportions.” Asking, “Is there a reason to think that homes are overvalued?” means that homes are terribly overvalued. Whenever the Fed states or suggests an opinion, you can safely magnify it tenfold.


Rule #2 –Recognize Moral Suasion

Moral suasion, also known as “jawboning,” is the name for scolding market participants in order to change behavior. By sending a warning to the market, the Fed hopes that it can delay or even avoid taking a negative course of action.

For example, in 2009 the Bank of Canada (Canada’s equivalent to the Fed) stated, “the recent sharp increase in the value of the Canadian dollar, if it proves persistent, could fully offset recent positive developments in financial conditions, commodity prices, and confidence.” This stern warning (see Rule #1) told market participants that if they keep buying the Canadian dollar, the Bank will take measures to devalue it (to improve exports).

In the long run moral suasion rarely works, but in the short run it can have the desired consequences. Moral suasion also indicates the course of action the Fed will take if moral suasion fails.


Rule #3 – Read the Speeches Verbatim

The introductions and conclusions of Fed speeches are made for public consumption (the media) and generally reflect useless broad opinions (such as, "the economy is improving.")

The subtle nuances with true predictive value are in the carefully chosen text. For this reason, any online news article about a Fed speech will include a link to the Fed’s word-for-word text. This verbatim text is meant for market professionals.

Examples of Fed Speak in Action:

“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"
Alan Greenspan, Chairman of the Federal Reserve Board, 1996 Speech

Translation: Stocks appear to be grossly overvalued (the Internet bubble).
_

"It's pretty clear that it's an unsustainable underlying pattern. People are reaching to be able to pay the prices to be able to move into a home."
Alan Greenspan, Chairman of the Federal Reserve Board, 2005 Speech

Translation: There is a housing bubble in the U.S., and it will crash.
_

“With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus.”
Bank of Canada, Press Release, Apr 2010

Translation: We will be raising interest rates soon.
_

The importance of understanding the Federal Reserve cannot be underestimated. To a large extent, the Fed determines the near-term growth or contraction of business, and therefore the direction of the stock market. In addition, the Fed is a reliable asset bubble "early warning system." Learning to speak Fed can save you a lot of anguish.

____

“Augmenting concerns about the Federal Reserve is the perception that we are a secretive organization, operating behind closed doors, not always in the interests of the nation as a whole. This is regrettable, and we continuously strive to alter this misperception.”

Alan Greenspan, Federal Reserve Board Chairman, 1996

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.
____

“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.
____

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.

Greek Debt Bailout – What Happens Now?

The Greek (actually Euro) debt crisis has been, at least temporarily, averted via a $1 trillion rescue package that could really be looked at as a “render predatory traders useless” package. Now what? Is the EU set to recover? Is everything just fine?

Despite these efforts, much of the world including the U.K., Canada, Israel, Dubai, Korea, China etc. (see: World Housing Bubble) are set to stagnate and/or enter recession within the next 18 months. In these countries, economic recovery has been more about new housing bubbles and consumer credit growth than real recovery.

Although the U.S. was the instigator of the worldwide collapse, it is now in the best position to move forward (no one said life is fair). The U.S. has inexpensive housing, low interest rates, a devalued dollar, moderately valued stocks, citizens with reduced debt, and increased productivity - all of which give the U.S. economy plenty of upside potential.

Under normal circumstances, a multinational recession would not bode well for U.S. stocks and I would say, “sell.” However, the current situation is more complicated than that. American stocks today are priced at levels that reflect modest post-recessionary income and a definite lack of euphoria. Even if world markets slow down, it is already priced into U.S. stocks at this level.

Secondly, you may have noticed that although world markets are global and affect each other, it is mostly the U.S. market that affects the rest of the world – and not the other way around. Even when a powerhouse like China experiences market drops, for example, the effect on the U.S. market is negligible. I suspect that when world markets decline it will bring down the American market only temporarily, until everyone realizes that U.S. growth is sustainable domestically at a level that supports and even exceeds today’s stock prices.

In short, most Commonwealth, EU, Arab and Asian countries have, at this point, little or no room on the upside, but plenty of room on the downside. Conversely, U.S. stocks that grandmothers around the world are still afraid to buy are the best investment opportunities around.

Many high-quality U.S. stocks, including members of the Dow 30, remain at single digit or low-double digit P/E levels, even on modest sales. If prices drop from here and you are a long-term investor, I recommend going against the grain and buying more, since any dip below today’s reasonable prices is a blessing. If you are afraid of volatility in your portfolio (there is sure to be plenty), ignore all this advice and stay away from the cheap-stocks party.

PS - The International cheap stocks party should begin sometime next year.

Statistics (at time of writing)
Dow Jones Industrial Average: 10,785
Hang Seng: 20,320
FTSE 100: 5,385

____

"These high prices [in the Dow] were the cause of great jubilation on Wall Street, but I found them depressing. I was happier with a good 300-point drop that created some bargains."
Peter Lynch, Beating the Street
____

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.

Two Stocks I Like - BioPharmaceutical

When it comes to stocks, I’m of the Peter Lynch School, which says that you shouldn't purchase a stock unless you can, a) rationalize your purchase in few sentences, and b) draw what the company does with a crayon. These companies fit the bill.

I have no idea whether these stocks will go up or down in the next 6 hours, days, or weeks, and don’t know anyone who does. My intention is to hold them (I own both) until at least the peak of the next market cycle, or until the company proves to be something other than what I thought (for example, the dreaded words, “accounting irregularities.”)

Note that both of these companies are relatively unknown and relatively low-priced, which puts them squarely in the "speculative" category.

____






CRTX – Cornerstone Therapeutics Inc.

To quote from the 2004 10-K report (honesty at its finest): “We were incorporated in Delaware on July 14, 2000. Since our inception, we have incurred significant losses each year. As of December 31, 2004, we had an accumulated deficit of $58.5 million. We expect to incur significant and growing losses for the foreseeable future…we expect our operating losses to continue to increase over the next several years as we continue to fund our development programs and prepare for potential commercial launch of our product candidates. We do not expect to achieve profitability in the foreseeable future; and we cannot assure you that we will achieve profitability at all.”

In those heady days of rising housing markets and consumer glee, Cornerstone (formerly Critical Therapeutics) was trading at about $70 per share, despite having no earnings whatsoever. That was then. Fast-forward to 2010, and Cornerstone touts rapidly increasing sales at great margins and with no long-term debt; yet, its share price is only 1/10th what it was as a purely speculative play in 2005.

Cornerstone’s specialty is respiratory ailment medications. Although Cornerstone is engaged in research, it is more interested in acquisitions. That is, CRTX finds established products that are poorly marketed, and re-launches them for a quick earnings boost. It also acquires late-stage development products that it can push for FDA approval and bring to market. Once products have been acquired or approved, Cornerstone uses a highly focused sales force of 113 agents to market these products.

The only thing I don’t like about Cornerstone is that, like many growing companies, is has been regularly increasing its number of outstanding shares (essentially printing money) for acquisitions. Having said that, when it does issue shares the purpose is to acquire product rights for added revenues – a good sign.

CRTX Statistics (at time of writing):
$6.77 per share
P/E of 8.8
No long-term debt
Gross margin 76.6%

____





SKBI – Skystar Bio Pharmaceutical

Skystar is a Chinese pharmaceutical company (incorporated in Nevada) that primarily engages in medicines, vaccines and related health care for animals, both personal (pets) and commercial (livestock and poultry).

In one of those ridiculous transitions that can only happen in the world of speculative stocks, Skystar was incorporated in 1998 as “Hollywood Entertainment Network,” which was an independent film company. In 2000, riding the wave of the technology boom, it changed it’s name to “Cyber Group Network Corp” and became a security hardware and software developer. Several paragraphs of 10-K report later, and Skystar is now a bio pharmaceutical company. Normally I wouldn’t invest a dime with a change-your-line-of-business-a-thousand-times company, except for one important factor: Skystar is now legitimate.

In 2009, Skystar had over 33.8 million in revenue at 51% gross margin. Skystar manufactures a long list of products, including medications, microorganisms, feed additives and vaccines, while employing over 200 people. It has research and development facilities in China. And it has solid, growing earnings.

I suspect that Skystar's shaded past has a lot to do with its low stock price.

China's stock market is firmly in bubble territory and volatile of late, so expect this share price to move around a lot.

SKBI Statistics (at time of writing):
$9.75 per share
P/E of 7.17
No long-term debt
Gross Margin 51.09%

_____


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.

Goldman Sachs - Buy or Sell?

GS has taken a beating recently, both with the public flogging its members have taken from Congress as well as its stock price. Just how much is Goldman’s image damaged? Is it the same company it was? For my opinion, I refer you to the MS Outlook note I scheduled for myself next week:

"Buy more Goldman Sachs if share price has stabilized."

Goldman is a company of sharks, whose ambition is to make money no matter what the circumstances: usually, this is one of their selling points. Goldman taking bets against its own large clients is similar to college girls flashing their breasts during spring break: shocking, but not surprising.

In a large financial institution it’s common for one arm to take a position opposite to another, sometimes without either side knowing. For example, in one bank I know, the brokerage arm was recommending natural gas stocks to clients, as well as taking long positions in its own portfolio. The trading arm of the same firm was shorting natural gas futures. Traders for large firms are given significant independence.

Salespeople at brokerages generally have to go with the recommendations of their analysts, even if the salespeople themselves think the investments are garbage. As strange as this may sound, it is a necessity. Investing is an art, not a science, and it is highly unlikely that all brokers at a firm would agree whether a stock is a “buy” or a “sell.” For obvious reasons, a firm can’t have one broker advising clients to buy a stock while the broker at the next desk is advising them to sell it. In addition, if a broker sells something they personally recommend (but analysts of the firm don’t), they can be sued if that investment turns sour. For all these reasons, brokers must sell whatever their company’s “squawk box” is touting. Yet, when investigators find evidence of a broker selling stock that they personally hate, it’s presented in the media as “proof” that the company is corrupt.

Goldman is the same company that it was two weeks ago, only a) it could owe a large fine and face criminal charges, and b) its stock price is 27% lower. Unless Goldman is fined 20 billion dollars (the approx. market capitalization it has lost since 2 weeks ago) its stock is now a bargain.

Goldman Sachs is no angel, and never has been. It is still a company of sharks, intent on making money. It is still the firm that every broker wants to work for. And its P/E ratio is 6.1.

Goldman is a buy.



Price (at time of writing): $145.20

____

“As a public company, Goldman Sachs will have the financial strength and strategic flexibility to continue to serve our clients effectively as well as to respond thoughtfully to the business and competitive environment over the long term.”
Henry (Hank) Paulson, former U.S. Treasury Secretary, during his time as Goldman Sachs CEO, June 1998.
____

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.