Most pools following the linear scoring method (i.e. you get 10 points if a #10 seed wins), but the key to understanding the game is that the quality of teams are not spread out linearly.

Generally speaking, the better the teams are, the greater the gap between them and the next seed. The teams are really spread out exponentially. If I had to guess, I’d say that the difference between a #12 seed and a #5 seed is probably about the same as the difference between a #3 seed and a #1 seed.

Here’s something what it looks like:

The black line shows how the teams really are while the blue line shows you how points are awarded. (Note: This isn’t drawn to scale. I’m just trying to show you the principle.)

As a result of this mismatch between exponential reality and linear price, there’s an inefficiency to exploit.

I'll show you what I mean.

The tournament expanded to 64 teams in 1985 so we now have 25 years of data. Here's how many Sweet 16 appearances each seed has had over the last 25 years.

Seed................Sweet 16.................Points
#1........................88........................ 88
#2........................64........................ 128
#3........................52 ........................156
#4........................43 ........................172
#5........................36 ........................180
#6........................35........................ 210
#7........................18 ........................126
#8........................9.............................72
#9........................3.............................27
#10......................18..........................180
#11......................11..........................121
#12......................17..........................204
#13......................4............................52
#14......................2............................28
#15......................0............................0
#16......................0............................0

I've also included a point total. As you can see, there's an advantage in picking teams at the optimal spread between quality and points like the #10 and #12 seeds.

The invaluable Abnormal Returns guided us to the Geek’s Guide to NCAA Tournament Pools at Wired. The magazine looked at the bracket picks done by thousands of people at ESPN. They then compared the crowd’s picks with some statistical predictions by two college basketball analysts.

Sure enough, the crowd has responded to incentives. You can see that the crowd has tended to overpick the #10, #11 and #12 seeds (those are the cells in green on Wired's chart). The process is repeated in the later rounds with the #4 and #5 seeds. (Wired notes that the crowd's consensus bracket usually finishes in the 80th percentile.)

This is interesting because the crowd is doing two things. One, they can be overruling what the bracket committee did. Also, they seem to be paying close attention to seeding and acting accordingly.

This behavior illustrates an aspect of why CAPM doesn't work. Historical research has shown that the most volatile stocks aren't the best performers as they should be according to the model. Instead, they're among the worst. This makes sense since people are probably willing to overpay for a long shot of a big payoff, and this leaves the “sure-things” underrepresented.

Selecting the #10 and #12 seeds is a good strategy in the early rounds, but just like momentum investing, it quickly turns against you. After the first two rounds, the most logical way to play the brackets is to select the favorite. Yes, it’s boring but it works—just like value investing.

In the basketball tournament, you can see how unloved the #1 seeds are (note the red cells). The key fact of investing is that the most conservative and ignored stocks are often the best investments.

Last month’s report was noteworthy since it was the first time since 1982 that the seasonally adjusted core rate had a meaningful decline. The core rate has now had its smallest year-over-year increase since 2004. Over the last four months, core inflation is running at just 0.66% annualized.

AFLAC (AFL) is up to another new high today. The shares are now up over 17% for the year. It’s hard to believe this stock was around $10 a share one year ago. I’m also pleased to see SEI Investments (SEIC) break out to a new 52-week high. The stock was upgraded a few days ago and it seems to be responding well. Currently, four of our Buy List stocks are up over 15% this year.

The best news yesterday came from Intel (INTC). Actually, it wasn’t news but a rumor that Intel will pre-announce strong earnings. The company hasn’t said anything and I doubt they will. The next earnings report isn’t due until April 13.

Still, the company is doing well. In January, Intel said that Q1 margins and revenues will above Wall Street’s expectations. The Street currently has Intel’s first-quarter’s earnings pegged at 37 cents a share. That seems about right.

• Many homes are still in foreclosure or under water:
• Although forececlosures last month were still 6% higher than the year ago period, they were 2% less than last month. The 6% is the lowest year-to-year increase since January 2006. The rate of foreclosures are decreasing and the fact that we had a month-to-month decrease in foreclosures suggests that the 50-month stretch of year-to-year increases could be coming to a close.
• The Case-Shiller Housing index has been up for the past six months, suggesting prices are stabilizing
• When a foreclosure happens, people have more money to spend (they are no longer spending on mortgage.
• The housing declines began in 2006. The market top didn’t happen until November, 2007 and the collapse didn’t happen until Lehman collapsed in September, 2008. The market collapse was more a function of the financial collapse and then the “Great Liquidation” (see below) than the housing collapse.

Information received since the Federal Open Market Committee met in January suggests that economic activity has continued to strengthen and that the labor market is stabilizing. Household spending is expanding at a moderate rate but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly. However, investment in nonresidential structures is declining, housing starts have been flat at a depressed level, and employers remain reluctant to add to payrolls. While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve has been purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt; those purchases are nearing completion, and the remaining transactions will be executed by the end of this month. The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.

In light of improved functioning of financial markets, the Federal Reserve has been closing the special liquidity facilities that it created to support markets during the crisis. The only remaining such program, the Term Asset-Backed Securities Loan Facility, is scheduled to close on June 30 for loans backed by new-issue commercial mortgage-backed securities and on March 31 for loans backed by all other types of collateral.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh. Voting against the policy action was Thomas M. Hoenig, who believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to the buildup of financial imbalances and increase risks to longer-run macroeconomic and financial stability.

I haven’t drilled down on the numbers but it looks like Seneca is going for about seven times earnings. Best of all, this is one of those stocks that’s almost completely ignored by Wall Street.

If you have the time, you can listen to a 42-minute presentation Seneca gave to Merrill Lynch’s Consumer Conference yesterday.

Looking at this, I can't help but think it's the Treasury equivalent of the Internet bubble from 10 years ago.

I'm not a bond investor but I won't even think of investing in any bond that had a real return of less than 2%. According to the bend of the current curve, the TIPS yields won't reach 2% for another four years. They won't even turn positive for another two years.

The combined record of the Buy Lists going back to 2006 has made a capital gain of 17.65% which takes out our previous high of 17.46% set on December 24, 2007.

Over that same time, the S&P 500 has lost -8.23%.

At our low point, exactly one year and one day ago, the Buy List had lost 50.36% of its value. Since then, we’re up 101.76%.

That’s just capital gains. If you include dividends, our Buy List is up 22.14% compared with a gain of just 0.39% for the S&P 500.

If add in Dupont (DD), the correlation jumps to 80.5%. (Note this is average daily change, so it assumes you invest equal amounts each day.)

If you add is Disney (DIS), the correlation rises to 85.4%.

Now the extra correlation really is hard to come by. If you add ExxonMobil (XOM), the correlation rises to 88.9%.

Still more?

If we add American Express (AXP) the daily correlations rises to 90.6%.

Verizon (VZ) brings it up to 92.6%.

If you want to go for seven stocks, IBM (IBM) will bring you up to 94%.

Now we’re almost out of room. Wal-Mart (WMT) will bring our eight stock index fund up to a 95% daily correlation with the S&P 500. This is, of course, an equally weighted fund.

If you want the extra 5% so you can be perfectly correlated with the index, just add 492 stocks and value weight them.

Imagine that your stockbroker - or the friend who’s always giving you stock tips - called and told you he had come up with a new investment strategy. Price-to-earnings ratios, debt levels, management, competition, what the company makes, and how well it makes it, all those considerations go out the window. The new strategy is this: Invest in companies with names that are very easy to pronounce.

This would probably not strike you as a great idea. But, if recent research is to be believed, it might just be brilliant.

(HT: Timmay Sykes)

This shows the company’s pre-tax profit (in millions) along with the provision for credit losses. What you see is just how damaging the credit loss provisions have been.

I think it’s interesting that when you combine the two, you can see that NICK’s business appears to be fairly stable. You can also see that the credit loss provisions are declining rapidly. If they get back to the level of 2006 then NICK will be much more profitable.

If the credit loss provisions were to run at the same rate today as they did in 2006, that would be an extra $2 million a quarter in pre-tax profits. Roughly speaking, that’s about 10 cents a share after taxes.

On top of that, there’s an acceleration effect. The better NICK’s business is now, the better it will be in the future. That’s because the more money going to the bottom line means that NICK will have more money to grow its portfolio.

A lot depends on how well the economy improves. If things keep going as they are now, then NICK should earn at $1 a share this year, with the ability to earn as much as $1.20 a share. That’s not bad for a stock going for $7.50 a share.

On the first anniversary of the bull market, E.S. Browning looks at the valuation debate between economists Robert Shiller and Jeremy Siegel. Not surprisingly, Dr. Shiller thinks the stock market is expensive and Dr. Siegel thinks it’s cheap.

Both men have held their positions for quite some time. For the last decade, Shiller has clearly won the debate (while Dr. Siegel has made some sloppy mistakes).

Despite Shiller’s accuracy, I’m skeptical of his methodology (after all, a person can be right for the wrong reasons). He relies on the market’s P/E Ratio with earnings going back 10 years. That seems too far for me. Plus, I suspect (both I’m not convinced) that earnings multiples need to be higher compared with decades ago. Shiller is very good at getting tons of data, often from many decades ago, but I’m not so sure such long-term comparisons are helpful. The economy and markets are quite different from the 19th century. Stocks are much safer compared with bonds and that difference should be reflected in valuations.

In fact, higher earnings multiples are nothing new for the market provided that you ignore the inflation racked period from 1966 to 1982. Earnings multiples started to rise in the 1950s and reached very elevated levels in the early 1960s. I think people forget that because the market didn’t suffer a severe reckoning until the 1970s (though there were some painful episodes in between).

Once inflation started creeping into the economy, interest rates soared and earnings multiples took a tumble. However, once Paul “Big Paul” Volcker squeezed inflation from the economy, multiples slowly resumed their climb back to JFK levels. The problem with that analysis, of course, is that you’re adjusting for a heck of a lot of data. So has the normal level for P/E Ratios been around 18 or so for the past 50 years with the inflation era as an aberration? Or are there natural 15 to 20 year periods of multiple expansion and compression? I lean toward the first, but I’m far from certain.

Siegal’s research centers around the fact that stocks have returned 7% a year adjusted for inflation. I’ve used that figure myself many times and it’s interesting to see how we’re doing against the long-term trend. In fact, when you adjust the market’s total return against a 7% trend line, it looks suspiciously like a P/E Ratio chart.

The problem with this method is that it assumes past data is an unbroken trend and all subsequent deviations have been corrected by reversions to the mean. That’s where I hold up a red flag. On top of that, the deviations from the long-term trend are very extreme. If the market can be so vastly out-of-whack from where it should be and for so long, then what’s the point? As an investor, I want to know what looks good right now.

My view is that I’m leery of all market forecasts. I tend to be on the bullish side simply because long-term interest rates continue to be low (Moody’s AAA Corporate Bond Index is currently around 5.2%), the market doesn’t expect a major resurgence of inflation anytime soon (the TIPs spread is fairly quiet) and the yield curve continues to be very wide (all of the market’s capital gains have come when the 3-month/10-year Treasury spread is over 65 basis points—the spread is currently at 355 points).

Still, I’m not investing in the entire market. My advice for investors continues to be to focus on high-quality stocks. The market's dislocation has left us some bargains. Some of my favorite stocks include AFLAC (AFL), Nicholas Financial (NICK), Dean Foods (DF) and Reynolds American (RAI).

Actually, I did see it but still didn’t pull the trigger. These are the trades that really annoy me. Here’s what I wrote last June after HD raised guidance:

Last year, HD earned $1.78 a share. In May, the company said that it expects to see EPS fall by 26% and sales to fall by 9%. That translates to full-year earnings of $1.32. Today they said to expect EPS to fall by 20% to 26%. A 20% drop works out to $1.42 which is slightly above Wall Street’s consensus of $1.40.

Make no mistake, this isn’t great news but it’s not awful and all the news until now has been awful. HD’s earnings peaked in 2007 at $2.83 a share so we’re going to see earnings fall in half—so has the stock price.

At its current price, I wouldn’t say Home Depot is a good buy, but it’s not unreasonable to see year-over-year earnings increases within a few quarters. If there’s more good news from HD, it could be a good buy before the end of the year.

The good news did come. HD beat earnings in August, November and a very nice beat a few weeks ago (24 cents per share vs. 17 cents per share), but moron me didn’t step it up.

The shares dipped below $25 in early November and it’s been off to the races ever since. Since November 4, HD is up 28% compared with 9% for the S&P 500. I let that one get away.

Tomorrow is the first anniversary of the bull market. The S&P 500 closed March 9, 2009 at 676.53. That was a Monday. During the day on the previous Friday, March 6, the index got to its spooky intra-day low of 666.79.

The day after tomorrow is the seventh anniversary of the 2003 market low. On March 11, 2003, the S&P 500 closed at 800.73. The intra-day low came the follow day at 788.90.

This month will also market the tenth anniversary of the bull market high of 2000. The S&P 500 reached its closing peak of 1527.46 on March 24. However, the index that everyone was watching back then was the Nasdaq which marked its closing high of 5,048.62 ten years ago this Wednesday.

We’re still than half of where we were.