A Dash of Insight

Musings

Occasionally we find ourselves with a number of topics which are all important, but do not provide the basis for a full column.  These "musings" are still highly recommended for your consideration.

• James Hamilton at Econbrowser takes a look at the unusual movements in InTrade's prediction market contract for a recession in 2008.  He correctly notes the thin trading, and the recent and temporary price decline.  This is exactly our viewpoint.  These markets may show quick moves when someone sweeps through all of the extant bids or offers, but then other players join.  It is price discovery, and the process is not unlike what we see in the housing market.  The political and economic markets have nothing like the liquidity in the sports markets on their sister site, TradeSports.com.  Prof. Hamilton wisely notes the difference between the NBER definition of a recession and that used to settle the InTrade contract.
• There is another good take on prediction markets by Eddy Elfenbein, who correctly notes that they set odds.  The actual outcome does not mean that the odds were incorrect.
• Scott Rothbort, one of our most valued sources, has established a new web site, TheFinanceProfessor.com.  Scott is a money manager, an adjunct professor at Seton Hall, and a valued colleague on RealMoney.  Most importantly, he shares with us the desire to educate investors, helping them to achieve their goals.  His new site has many educational features and is geared to draw content from readers.  Please check it out and visit regularly as we plan to do.  His blog has also been moved, so we have updated our featured listing.
• Thanks to Bill Rempel for reminding us about his earlier work on comparing home price methodologies.  Thanks also to David Merkel, Tim Plaehn, and VennData for their typically constructive comments in response to the question we raised.  We encourage readers to check out the useful and educational discussion on this topic, and follow the links, starting here.
• Turley Muller at Financial Alchemist has a nice series on Apple Computer, Inc. (AAPL), which we own in both institutional and individual accounts.  After hours traders sent the stock as low as 155 and as high as 170 while we were watching.  We shall see tomorrow.  We sold some very juiced May 170 calls against our positions, expecting to profit from the post-earnings reduction in volatility.
• Abnormal Returns has an excellent article on diversification and the benefit of considering additional asset classes.  We have done this in our TCA-ETF portfolio, but we are always looking for new candidates.  The article is a great source both for ideas and general approach.
• Dr. Brett Steenbarger has a free Webinar session on "Reading the Psychology of the Market."  It is after the market close on Thursday.  We know from our personal experience that any chance to learn from Brett is time well spent.

These are all good sources on important issues, of benefit to investors and traders alike.

More on "The Lost Decade"

There was quite a bit of commentary on yesterday's Wall Street Journal article on The Lost Decade for stocks.

Our view is that readers of this article should give it a careful and critical look, examining the evidence and the conclusions.  We think that many investors will uncritically accept the basic premise, choosing some other asset class at exactly the wrong time -- an expensive decision.

Other Viewpoints

Partly because we feel so strongly about the article, we had a special interest in the reaction of others.  All of the sources below are people that we respect and read regularly.  None of them seem to share our basic concern with the work .  We believe that it was an opinion piece presented as objective research, something that characterizes much of the current mainstream media.  [Thanks to Abnormal Returns for making sure we did not miss anything good!]

David Merkel does not find  this evidence as a good reason either to increase or decrease stock allocations, although he sees more difficulties ahead.

Tim, at The Price of Everything, has similar concerns about current risk.

Gaius Marius cites some other blog commentary, and concludes, "the likely course of aggregate stock prices is significantly lower in real terms."

Bill Rempel has a strong statistical analysis that is well worth reading.  Please check out his own interpretation of the results, but one key statement is the following:

The best that can be said is, in the modern post-WWII era, low-returning decades like the one just past are typically followed by average to above-average decades. What’s to worry?

Bespoke Investment Group provides one of their typically attractive charts and concludes, "While the returns could easily get worse, periods that have been this bad have not lasted longer than 4 years (1937-1941) before they've started to get better."

We especially like the discussion from Kevin Price at The Float (now added to our list of recommended sites).  He points to a 2004 story from the Financial Times (free subscription required).  This story is much more balanced than the WSJ piece.  One can also see how that advice from 2004 would have worked. [not so well]  While he sees the potential for more multiple compression in large cap stocks, he notes that there was plenty of opportunity during the decade.  He also observed the negative market effect from the CNBC commentary.

This is the closest analysis we saw to anyone who saw the impact of this story on the individual investor, perhaps because Peter's company and ours are in touch with that clientele.  Many bloggers are more attuned to professionals who are expected -- rightly or wrongly -- to be able to spot such issues.

The thoughtful commentary from these sources, and those we cited yesterday, could help an investor to make wise decisions.  Unfortunately, the readership for these articles is much lower than for the WSJ.  A recurring crucial question at "A Dash" is how much work an investor is willing to do to gain the best information.

TCA-ETF Update

Each Thursday we update the sector ratings and current results from our TCA-ETF model.  There has been continued shifting, since money is moving rapidly among sectors.  This is not ideal for any method that includes trend as a component.

Most investors and traders have difficulty with trend-following models in gyrating and declining markets.  It is frustrating to switch around, often taking losses.  Those experienced in such methods understand that the point is to be on the right side of big moves.  There have been some changes since this list was generated (always delayed by a day or so).  Interested readers can get a complete report on the overall system performance from an interesting and unique test.

Musings: A Mini-Linkfest

In our daily reading we come across many articles we think our readers should see.  Sometimes these cover some of our major themes, but we cannot give the coverage they deserve.  Here are some recent ones:

Bob McTeer, one of our featured sites (but ignored by most bloggers) has a special insight about what is going on at the Fed.  In this  post he reminds us that Monday was the 49th anniversary of "The Day the Music Died."  More will be made of it next year, of course.  His article shows something of the human side within the Fed.  Investors would do better to think of the Fed as a group rather than a unitary actor.  The money line in the story is that Buddy had more hits than JS Bach.

Pradeep Bonde, who continues to publish strong work, reminds investors that America works.  He is anticipating our theme about understanding government and why bearish blogs do not "get it."

Chris Perunna makes an important point with a gambling analogy.  Regular readers will know that we think this is fine, since the gambling literature covers investment odds and money management in a scientific way.  His observation is that one needs to avoid focus on recent outcomes and pay attention to process, exactly what we recently wrote.

Talking Biz News helps us stay on top of media and stocks.  The site points out that Charlie Gasparino moves markets.  We agree.  It is probably right to short some S&P futures every time he is about to come on the air.  He seems to be on a mission to disparage any effort to solve problems on the bond insurance business.  Every report quotes anonymous sources about whatever is wrong with the most recent plan or discussions.  Gasparino's early reports on this topic showed a complete ignorance of the role of state insurance commissioners in regulating these companies.  His original viewpoint was that a free market solution was the answer and that "politicians" were interfering.  (We would link to the CNBC segments, but they were not even posted).  Later reports show a more sophisticated understanding that insurance companies do not get to operate without supervision, but he still freely offers his personal opinion in each segment.

The bond insurance question is the biggest one worrying investors since it raises the issue of counter party risk.  Gasparino does not seem to understand why it is in the interest of nearly everyone to solve this problem.  At some point he and his sources will realize that the insurance commissioners, the Fed, the Treasury, and anyone else in government with any authority are going to fight the collapse of the bond insurance market.  Reports by  CNBC's David Faber and Steve Liesman  have provided more balanced coverage.

Musings on Buffett, Mortgage Insurance, and the TAF

Occasionally we encounter important information that is not the basis for a full article, but we wish to highlight for our readers.  We note these topics in our "musings" series.

Warren Buffett and Mortgage Insurance

Since Berkshire Hathaway is in the insurance and reinsurance business, it has been natural for pundits to speculate about Warren Buffett and various financial companies.  Some thought that this might involve buying some existing bond insurance companies.  Most were surprised to learn that the plan was instead for a competing enterprise.

David Merkel writes a typically first-rate analysis of this decision, looking at various aspects of the problem.  His analysis is difficult to summarize, so we urge anyone interested in credit markets to give the entire article a careful reading.

Update on the TAF

We have written a series of articles on the Fed's new TAF approach to relieving pressure in the credit markets.  We gave the Fed a "B-" because of the size of the auctions, and the resulting rate.  Recent events lead us to be a bit more optimistic.

As we suspected, the Fed was testing the waters.  Since the early auctions worked well, there will be more of them as needed.  These are not permanent additions to liquidity, but an alternative to the discount window.

The demise of the Master Enhanced Liquidity Fund (M-LEC) has as much to do with the success of the TAF as the lack of interest in the M-LEC.  Some financial institutions were hoping to establish a separate fund to hold questionable mortgage securities.  They believe that payouts will probably exceed current market expectations.  It is better to hold these securities, collect payments, and sell at a more propitious time.  The TAF has helped in doing this, as have recent cash infusions for major financial companies.

Sometimes market observers see events as negative when they are really signals of progress.

The Key Market Question and Pre-Holiday Musings

Occasionally we take up a series of topics where we have a comment, but not a full-length article.  As we head into the holiday period (including some travel and lighter posting) there are some topics that deserve special mention.

The Key Market Question

Is the US economy about to enter a recession?  If so, how bad will it be?  How much is already reflected in earnings?

The market has voted, taking down financial stocks, retail stocks, and cyclical stocks.  For many, including Doug Kass (who points to plenty of current evidence) and Barry Ritholtz (who once again questions economic forecasts), the verdict has already been delivered.

To Dick Green, CEO of the highly-respected Briefing.com, the evidence is not so clear.  Like us, he views economists as the most expert source of recession forecasts.  Read his article to understand how he sees the data.

Regular readers know that we are more optimistic on the economy than the market suggests.  The biggest source of outsize gains comes from figuring out when the market is over-reacting.

Having said this, we follow the discipline of market signals in a portion of our trading -- that governed by our TCA-ETF model, which shows zero sector buys out of 44 choices, and recommends a short on all indices.  Our positions are duly hedged.

Intelligent observers, including those who all have great track records, can look at the same evidence and disagree about the conclusions.  This is such a time.

Great Advice on Reading

Any serious investor should be willing to read.  This means not just the online news and commentary, but serious books on investing approach, style, and methods.  While we are behind on our own reading list (taking something along on our travels) we are delighted to see this helpful list of suggestions from links at Abnormal Returns.

Great Advice for Individual Investors

Barry Ritholtz describes a conversation with a familiar ring.  Someone learns that you manage money and that you have had some success.  The person really wants to hit some big score.  Most individual investors do not carefully analyze the most powerful things they can do to get started.

No one should invest without first reading Barry's advice.

New ETF's -- Shorting China

Bill Luby at VIX and More highlights a new ETF that allows anyone to sell short the Chinese market.  Is it a coincidence that this development occurred just as our system sold our position in FXI?  Hmm.

Core Inflation

Karl Smith writes about core inflation, well before the recent Fed decisions to forecast the headline number.  We really like Karl's work.  (We admit the reasons.  He is a very smart guy, doing what we used to do, in a good program.  His analysis is strong and balanced.)  If you want to understand what the Fed is doing, read Karl.  The Fed may be reporting headline inflation, but they expect the two series to converge.  There will come a time when core inflation is higher than the headline number.

Happy Thanksgiving to our readers and to those who cannot be with their families, especially those serving our country.

Some Vacation!

Any investment manager knows the problem.  It is important to take some time away.  Those who study vacations say that one must really disengage and the first week is barely enough to start the process.  A Chicago hotel provides a service where they take your Blackberry as you check in!  For many, that is a painful process of withdrawal.

While I can never really get away, my occasional trips to major bridge championships usually have a therapeutic effect.  As an amateur player, one cannot hope to compete with the top professionals without total concentration.  I managed a fourth-place finish in one of the two events I entered, playing only four of the thirteen days of the tournament.  Some of my business associates and clients from the world of high-level bridge won the top events and had several others had high finishes.  Many well-known people in the investment world choose this form of "relaxation."  The experience is difficult to describe to non-players, but there is a reason that many top investors, corporate leaders, and options traders find this a fascinating form of competition.

When traveling, I always follow the market and read extensively.  I am fortunate to have a talented team to implement our models and trading strategies.  Since I do not try to write as well when vacationing, there is always some catching up.

This time there is a lot to do!

Musings for July 19, 2007

At "A Dash" we try to do longer analytical pieces on subjects where we hope to add some value.  Sometimes we have some thoughts, but not a full-scale article.  There are good ideas from top bloggers where we have made a note of the topic.

In "Musings" we reveal our thinking and writing agenda.  The reactions are first thoughts and comments are always invited.

Bespoke Investment Group takes up a question on the minds of all-- whether private equity activity has peaked.  They have a nice chart with an indicator showing a decline.  Our contacts in the investment banking community confirm that August is always a quiet month.  We confidently predict a further decline into August.  This will, no doubt, be interpreted by some as the "end of private equity."

The question is how traders should deal with this likely phenomenon.  Comments welcome on both the seasonal effect and how to trade it.  This situation is similar to the one posed in David Merkel's excellent discussion of how to balance one's fundamental position with technical considerations.

Calculated Risk analyzes Fed Chair Bernanke's testimony on the popular notion of the home as an ATM machine.  They are skeptical.  Our own view is that the Fed and Bernanke have done a pretty good job with both data and policy.  Are we the only ones going back a year to the "soft landing is impossible" forecasts (getting the prize for the most expensive investment research of 2006) and comparing this to what has happened?  Most pundits enjoy having open season on the Fed.  The questions during his testimony show that members of Congress, while acting polite, also enjoy this posturing for the cameras.  We believe that investors consistently underestimate the resources and ability of the Fed and forget that they hold the policy reins.  Listening to Bernanke is important.

CXO Advisory has a nice analysis of how the Fed should respond to energy price spikes.  It is supportive of our prior observations that the Fed cannot control energy prices through any policy means, but must control expectations.  It is worth reading carefully.

The Daily Options Report has suggestions about how to play earnings using options.  We are thinking about this, since we generally use our own volatility estimates and then increase them when there is a critical earnings report, so we are often on the other side.  We do this selectively, but it is an interesting topic for professional fund managers and traders who use options.

Econocator has some nice pieces on the Chinese economy and data.  Their summary is supported by today's CNBC interview by Erin Burnett and Mark Haines featuring the CEO of Genko Shipping -- buying more ships to deal with Chinese demand.  They make money even if the ships are empty on the return run.  Also worth noting is Bernanke's testimony on the need for China to have an "independent monetary policy."  He argued that Congress should not invoke trade sanctions against China for currency manipulation, but that the Chinese should review this as a matter of their own interest.

Dr. Brett looks at opening gaps and finds no sustainable edge in buying.  Going back to our days at the CBOE, traders view it as routine to fade an opening gap move.  The question was not "Did you sell?" but rather "How much did you sell?"  It continues to be viewed as automatic by these professional traders.

Abnormal Returns has a very thoughtful article, drawing upon diverse sources, examining the effect of specific concerns versus an overall perspective.  This is exactly what we were trying to highlight in our lessons from Blackjack.

There is so much to muse about and so little time....

Musings 6/27/07

Our thoughts on interesting observations, where we cannot do a full analysis.

Great call by Scott Rothbort.  His volatility spike observation last night gave his readers a good entry point for the market.  If you do not have his blog on your RSS reader (as we do) it is time to add it.

Roger Nussbaum highlights a new CBOE  benchmark, probably leading to a tradable index.  Selling naked puts was a factor in the 1987 crash, as I wrote on RealMoney (subscription required and worth it for active traders) today.  There is a good return if the trade is done in appropriate size, but those doing the trade--institutions, market makers, and even individual investors-- got very overconfident in 1987.  Non-professionals should be very careful in determining appropriate size on this one.  More on this topic at CXO Advisory.

Muckdog captures the Fed preview in his typical fashion.  Since he objects to "level headed" we shall just say it always seems to reflect what an intelligent observer might parse from a lot of information.  His presentation is stylishly superior to ours (sometimes criticized as pedantic) and includes useful search optimization terms that we lack.  Check out his post to verify his superior presentation.

Dr. Brett looks at the problem of "chasing" stocks that you like, where you missed the entry.  We suspect that many face this problem right now, and he provides some useful guidelines.  We have discussed this in the past with some stocks that make gap moves after decline, especially Apple Computer, Inc. (AAPL).

Meanwhile, we all await what the Fed says about inflation and the economy.

Musings 6-18-07

Some thoughts that may never become a full post.  Nonetheless, they are all worth reader consideration.

Thinking about risk.  VIX and more gives us a list of great books focused on risk.  This is an important starting point for any investor.  The list includes several that we have studied, some on the shelf but not yet read, and some new ideas for our wish list.

Barry Ritholtz hits the main elements of cognitive bias. This is another theme that any investor must understand.  It's so, so difficult to apply in practice.

David Merkel has a great piece on private equity.  (Any serious investor should take a couple of weekend hours to explore his stock ideas.  He has built a content-rich website in record time.)  Our own piece on private equity has been much delayed, and he hits some of our themes.

The Fly on the Wall sees something coming from Vista and makes some stock picks.  (Full disclosure:  we own MSFT, INTC, and some others in the space.)

David Merkel (again) on how mortgage funds need to adjust.  You have to understand this to interpret moves in the ten-year note, a key market factor.

No correlation between the market and approval ratings, according to Mark Hulbert.  This is going to need some further study.

Journalists are a contrarian indicator on stocks. (Thanks to Paul Kedrosky for citing).  Readers should also check out the long-term record of Ken Fisher at CXO Advisory.

Dr. Brett Steenbarger helps traders and investors alike in the "Trade Like a Scientist Series."  We are citing the final segment, but follow the links to read the first.  Everyone should understand these principles.

Bill Rempel has random disbelief!  This is a story we wish we had written -- just the right touch of humor and insight.  Here's one to add.  Today we read a pundit predicting a recession in 2008-09 based upon housing decline.  Let's stretch out that time frame......

It is often useful to see how the US is perceived across the pond.  Citywire takes a look at actual US economic strength versus data, and provides a perspective on revisions.

Musings for June 11, 2007

Regular readers of "A Dash" know that our topics usually develop an entire theme.  There is a problem.  The list of provocative ideas grows faster than our time to analyze.  In many cases we see something quite interesting, an idea with special merit, which goes on our agenda for future research.  The problem is that we will never have the time to revisit these ideas. To keep our thinking fresh and to solicit help from readers, we are initiating a new series:   Musings.   A "Musing" post might be a reaction, a hypothesis, or a partially formed opinion.  It is generally not a conclusion.  In "Musings" we are going to venture into some gray areas, expecting and hoping for challenges and discussion. Let us see where the idea takes us ----

June 11, 2007 Musings

On weekends I check out news from various sources, helped in my review of online materials by two columns on RealMoney (theStreet.com's paid site for active traders, and worth the fee) --

Barry Ritholtz's "Linkfest" and Paul Kedrosky's Weekend Reading.  Frequently these columns are later moved to public access. Here are some thoughts on the links from the weekend.

• Mark Hulbert, whom we have cited  favorably in the past, has an article questioning whether the market  is in Bubble,  Part 2.   Mark quotes the usual suspects on this topic and comes up      with a measure that looks at the past ten years of trailing P/E ratios to consider market valuation.  We wish that Mark would explain why interest rates should be completely ignored in making these comparisons.  Those who criticize the Fed Model (or the many variants) as simplistic, dismiss the fact that interest rates were much higher in many of the prior comparison years.  Maybe Mark will get around to looking at this, as we have.
• Another study of past P/E ratios does the same thing.  Sheesh!
• The "Wall Street Journal" is cited as worrying about liquidity driving markets to an unreasonable high.  My main concern here is for the casual reader.  The WSJ online is picking up commentary from many people.  It is not exactly like an "official" WSJ position, (although they did crank out some bearish articles over the last few days).  The liquidity story cites the rise in M3.  This is a current conspiracy theory among bearish pundits.  They believe the government does not want people to know what the money supply is doing.  Fed Chair Bernanke says that this measure tells little more than one gets from M2.  The key problem is that a lot of credit is now driven by foreign central banks, picked up in M3, but not reflective of Fed policy. The consequence of this is open to discussion, but it is not a conspiracy.
• The Fuqua School surveyed CFO's and finds them less enthusiastic about hiring and the economy than they were last quarter.  As an educator, I have great admiration for the Fuqua program and for this sort of survey research.  I also think that readers should actually follow the link and read the data.  The picture is not nearly as gloomy as portrayed by those citing the story.  The current month compares favorably to last year, but is a dip over the prior quarter.  CFO's are not economists, so one should focus on what they say about their own companies, which is generally more favorable than their overall economic views.  It would be nice to see if this indicator had any leading quality.  My impression of CFO opinion, very subjective and drawn from conference calls, is that they are good readers of the WSJ.
• CEO's are cautious on the economy.  This is similar to the CFO's.  The numbers are still quite strong, and show a decline from the first quarter.  This is a bit curious since many other indicators -- employment, ISM, jobless claims, etc. - are now more optimistic.  CEO's are also good readers of the WSJ.
• The GDP may be overstated due to an improper adjustment for offshoring.  This seems to be a valid point, although the measurement of the effect is in question.  It is difficult to believe in too much economic distress given the other economic indicators, but this bears careful watching as economists debate the topic.
• Economists see the housing problem lasting longer.  Everyone knows that this has been a drag on GDP.  The question is not whether the drag persists, but whether it explodes into a major effect on consumption.  So far there is no sign of that, despite the pessimistic projections of some.  Housing prices have actually moved a bit higher.
• Alert for system developers! Here is a nugget of pure gold which I found thanks to Paul's link. The interval of observation is crucial in stock forecasting.  Briefly put, if you are forecasting next week's stock returns, you might want to restrict your inputs to a day or two.  At least try it.  You need to read the study to see the significance of this.  We have always used some short-term inputs in our models, but we are checking to make sure that the neural network/genetic algorithm process is sufficiently flexible to give proper weight to short interval inputs.

And finally, as Mel Brooks said, "It's nice to be the king!"

Ron Rubin was given credit as Treasury Secretary under Clinton for deft intervention in currency markets at critical points. Others can also enhance their impact.

As interest rates reached key technical levels we saw action from two heavyweights.

Morgan Stanley, after an entirely predictable increase in rates by the European Central Bank, issued a "Triple Sell" on Europe for the first time "since the dotcom bust."  This is not an investment banking situation, so maybe someone can comment on whether there are any "Chinese Wall" rules in place. It certainly would be good to know something like this.

Meanwhile, Bill Gross announced that he was now a bear market bond manager. This was a dramatic change in his position, and it had a major impact on both bond and stock markets. Now should we suppose that Mr. Gross hit the TV and the wires with this news as soon as he had the idea, or that he made some appropriate position adjustments first? What would you expect of him if you were one of his investors?

One of my bond-trader friends at the CBOT has told me that he often feels like he is trading directly with Bill Gross. I hope he was not blindsided on this one!

I hope that readers will provide some guidance on the "Musing" concept and implementation.