Archive for December, 2005

  • The Plunging Price of Risk
    , December 14th, 2005 at 1:07 pm

    There’s a major bear market going on, but most investors don’t see it. It’s not the stock market, but it’s in the stock market. The price of one of the most important commodities has fallen dramatically and it’s having a major impact on your investments. It’s the price of risk. The free market prices risk-taking just like it does everything else—and right now, risk-taking ain’t worth a whole lot.
    First, let me back up and explain what I mean. Risk is a funny concept and it confuses many investors (including some pros). When we talk of risk we mean two things: The chance that something will happen, and the consequences of it happening.
    Let’s assume there are two companies that are similar in every way. Both are expected to earn $1 a share next year. But Company A is expected to earn $1 a share, plus or minus a penny, and Company B is expected to earn $1 a share, plus or minus 10 cents. Which one will have the higher share price? The market will usually give a premium to Company A. Why? Because the market favors certainty—even if the expected payoff it equal. Amos Tversky said that people don’t mind uncertainty so much, but they HATE to lose. As a result, the risk-takers need to be paid.
    We can’t see it, feel it or hear it, but risk is ever-present. Risk can be worth untold billions and it’s traded everyday. You use it in nearly economic decision you make. Looking at Companies A and B, the question arises, “how much of a premium should Company A receive?” Well in today’s market, that premium is low.
    Here’s another good example. Today, you can buy a one-year Treasury bill with a yield of about 4.30%. If you want a 30-year Treasury bond, you’d get a yield of about 4.64%. Not much difference. The risk-taker—the one sacrificing her money for 29 years longer than the non-risk taker—is only being paid 0.34% a year for her efforts.
    If people aren’t paid to take risks, guess what? They don’t take them! The economy has a love/hate relationship with risk-takers. It’s sort of a Prisoner’s Dilemma writ large. Taking risks is what ultimately moves the entire economy along. You can even view the markets as one giant risk-control machine.
    Time risk is just one risk, but there are many, many others. That’s another odd thing about risk. We use one word when we’re really referring to many different things. This is another way in which risk confuses us. James Glassman and Kevin Hassett conflated two different types of risks in their book “Dow 36,000,” which argued that the market was greatly undervalued. (It wasn’t.)
    In addition to time risk, bonds also have default risk. But in this bear market for risk, it seems to be hitting the price for all risks. The low price of default risk can be seen by comparing corporate bond yields with government yields. Corporate bonds aren’t guaranteed, but government bonds are (the government conveniently controls the printing press). The average spread between corporate AAA bonds and a 10-year Treasury is now less than 100 basis points (or 1%). Not too long ago, it was more than twice that. And after 9/11, the price for risk-taking exploded. The spread reached over 260 basis points. The spread for the riskiest bonds, junk bonds, has widened some this year, but it’s still lower than the historical average.
    Then there’s also the VIX (^VIX). The VIX measures the implied volatility of stock prices. This is still risk, but it’s yet another kind. We can determine implied volatility by looking at how much option traders are demanding for risk. Right now, the volatility of the stock market is low. Very low. The current VIX reading is below 11, and it’s close to its lowest readings since the rock-bottom days of the mid-90’s. Back in the bubble days, it was common to see the VIX sail over 40.
    Stock volatility isn’t necessarily tied to other risk prices, like the yield spreads. After all, we had a flat yield curve when the VIX was soaring. But why is everything coming together right now?
    Look at how the major stock industry groups are behaving (I’ve talked about this before). Except for energy, the industry groups are acting very much like each other. They’re just bunching together. Normally, market sectors show some correlation, but nothing this strong.
    In 1999, the beta (a measure of systemic risk) of the S&P 500 Tech Index (^SPLY) was 1.47. In 2000, it was 1.79. This year, it’s 1.06. I don’t think this is a bad thing, and I tend to avoid seeing timing opportunities in this. But it’s a darn curious thing to see. Risk, across the board, is retreating.
    I don’t have an answer, but here are a few thoughts. Perhaps the U.S. markets are exporting risk to the emerging economies in exchange for our ballooning trade deficit. Risk tends to follow opportunity. As our economy has become more stable, we don’t have the need for large risk premiums. So we trade it with economies like China. Markets in Latin American have been particularly strong this year. We need their goods, they need our risk.
    Then there’s the curious issue of gold. Why is it soaring when inflation doesn’t seem to be upon us? Rates are still low and the dollar is rallying. What’s going on? Gold is a weird one for risk purposes. The price of gold is much more volatile than stock prices. That’s not surprising since it’s a popular vehicle for speculators. But gold is also the least risky asset, in terms of the chance of losing its intrinsic value. Perhaps the rally in gold isn’t a bellwether of inflation, but a reckoning for the risk market.

  • CACI up on Anteon Buyout
    , December 14th, 2005 at 10:08 am

    General Dynamics (GD) is buying Anteon (ANT), a company very similar to CACI International (CAI). The deal is for a nice premium. CACI is trading about 9% higher this morning.

  • Market Timing Takes Discipline
    , December 14th, 2005 at 9:44 am

    A reader makes a smart point about market timing—it takes discipline.

    The problem is having the fortitude to act with same set of composure when your stocks are down 50%. Many buy and hold people throw in the towel at the darkest hour. Investor psychology is a set of decision theory than many people will not act correctly given the set of circumstances of being down a lot of money. I read a study that view reactions to money in several sets of outcomes and when people lose money it is far more detrimental than when they have won money.

    This is exactly right. Emotions are the enemy of a successful investor. Many people think that a falling market is somehow being mean to them, so something must be done to show their feelings.
    The economists Daniel Kahneman and Amos Tversky helped develop the field of behavioral economics. Kahneman won the Nobel Price a few years ago, although sadly, Tversky died before he could be recognized. The two found that people’s decisions about risk aren’t always entirely rational.
    For example, let’s said you had a choice: You could either accept $1,000, OR you could take a 50-50 shot of winning $2,500. Which would you choose? Most people would take the $1,000 with certainty even though the expected return of the other choice is $1,250. Why is this? Well, people aren’t coldly rational when they’re faced with risk. They tend to hoard what they have, and underappreciate what they could have. It’s an interesting way to think about human behavior.

  • More Deaths Linked to Guidant’s Heart Device
    , December 14th, 2005 at 5:17 am

    From the New York Times:

    The added reports may reflect the fact that doctors and family members, in light of the attention given to the Guidant devices, are increasingly having the units checked for problems after a heart patient’s death. They also suggest that the devices’ possible contributions to earlier deaths may have gone unnoticed because implanted heart units are not routinely examined post-mortem.
    The new data may pose further legal problems for Guidant because the electrical failures, while involving different models, are all related to the company’s use of an insulating material in a way that apparently made it prone to deterioration. The Justice Department, as part of an investigation into Guidant’s handling of safety issues, is looking into its use of that material, called polyimide.
    In a statement, Guidant, which is based in Indianapolis, said that it “regularly communicates information about product performance to various stakeholders including physicians and regulatory bodies.” The company also pointed out that it had recently begun publicly releasing more detailed data about product malfunctions.
    In 2002, Guidant discovered that one of its heart devices was prone to short-circuiting. Company officials declined to respond yesterday to written questions about the steps Guidant took, if any, at that time to determine if other company heart devices had the same flaw.
    Both the F.D.A. and Guidant have told patients with the affected units that they should consult with their doctors to decide whether the risks posed by the device outweighed those posed by replacement surgery. One heart device specialist, Dr. William H. Maisel, who is based in Boston, said yesterday that the new death reports should not necessarily affect those decisions, because most doctors look at a device’s overall failure rate, rather than the percentage of those failures that involve deaths.

    Here’s a timeline detailing Guidant’s annus horrilibus.

  • The Market Today
    , December 13th, 2005 at 5:40 pm

    The Fed’s announcement turned the market around and pushed the S&P 500 into the black. The S&P 500 rose 0.56% and our Buy List climbed just 0.12%. The market has basically pulled even with us for the month. For December, the Buy List is up 1.45% and the S&P 500 is up 1.44%.
    Interestingly, the market’s strength today was almost solely with the big-caps. The S&P Mid-Cap Index (^MID) was up just 0.14%, and the Small-Cap Index (^SML) was up just 0.04%. Although the Nasdaq climbed higher, the index had slightly more decliners than gainers.
    Fair Isaac (FIC) was our weak link today. Of all the stocks on the Buy List, this is one of the stocks that I’m least concerned about. Thor Industries (THO) was our top gainer, and don’t look now but Dell (DELL) peaked above $33 today. The stock saw its shadow and ran away so we’ll get six more weeks of pro-HPQ stories like this and this. I just don’t get the media’s love affair with HPQ. Today, the company said that in the best scenario, its sales will grow by 5% next year.
    Outside our Buy List, Pfizer (PFE) rose 6.5% on the heels of its dividend hike. Cendant (CD) dropped 10% today as it lowered its earnings guidance. I often tell investors not to fall in love with a stock. However, it’s perfectly acceptable to hate them. And so…Cendant, i h8 u.
    The link o’the day: BlogginWallStreet.

  • American Investors: We Suck
    , December 13th, 2005 at 3:19 pm

    A survey finds that most investors are completely clueless about investing:

    More than 80 percent of U.S. investors flunked a basic investor survival skills test, showing their limited ability to translate their savings into a comfortable retirement nest egg, according to a survey released on Tuesday by investor protection organizations.
    The Securities Investor Protection Corp. (SIPC) and Investor Protection Trust (IPT) said most investors failed a test of key knowledge and behavior, such as correctly defining a prospectus and checking financial planners’ backgrounds.
    “This survey is a yardstick that shows us how investor education in the U.S. needs to measure up if it is going to be helpful to investors,” said IPT Chief Executive Don Blandin in a statement.
    The organizations said only 17 percent of investor respondents were able to correctly answer six of eight knowledge questions and three out of four behavior questions.
    Women were more likely than men to fail the investor test by a margin of 91 percent to 77 percent.
    The SIPC said one of the most concerning results was that fewer than 10 percent of investors surveyed understood that no agency or organization insures them against losing money as a result of financial portfolio fraud.
    “We obviously have our work cut out for us,” said SIPC President Stephen Harbeck in a statement.

    Here’s the survey.

  • Fed Raise Rates
    , December 13th, 2005 at 2:10 pm

    The Fed just raised rates for the 13th straight time. The Fed funds rate is now 4.25%.
    Here’s the Fed’s statement:

    The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 4-1/4 percent.
    Despite elevated energy prices and hurricane-related disruptions, the expansion in economic activity appears solid. Core inflation has stayed relatively low in recent months and longer-term inflation expectations remain contained. Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures.
    The Committee judges that some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.
    Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Roger W. Ferguson, Jr.; Richard W. Fisher; Donald L. Kohn; Michael H. Moskow; Mark W. Olson; Anthony M. Santomero; and Gary H. Stern.
    In a related action, the Board of Governors unanimously approved a 25-basis point increase in the discount rate to 5-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.

    Glad that’s all cleared up.

  • Fair Isaac Lower on Downgrade
    , December 13th, 2005 at 12:55 pm

    Fair Isaac (FIC) is trading lower today on a downgrade from JMP Securities.

    JMP Securities analyst Kevane Wong reduced his rating to a “Market Underperform” from a “Market Perform,” and called for a $43 price target within the next 12 months.
    “We believe the company is beginning to encounter increased competition in account management and a tougher operating environment for scoring,” Wong said in a report. “We understand that four credit-card issuers are expected to shift from Fair Isaac’s Triad account management system to Experian’s Probe system in the first part of 2006.
    Last month, Stephens analyst Brad Elchler said he believes rivals such as Experian, Equifax and TransUnion have focused on Fair Isaac’s business. He downgraded the company to an “Equal Weight” from an “Overweight,” and lowered his 12-month stock target to $53 from $49.
    Shares of Fair Isaac fell $2.23, or 4.8 percent, to $44.28 in midday trading on the New York Stock Exchange, and earlier changed hands as low as $43.22. The stock is still up about 21 percent so far this year.

  • Spot the Phony
    , December 13th, 2005 at 12:17 pm

    Two Swiss grad students are conducting a test to see if people can tell the difference between a real stock chart and a randomly generated one. I gave it a shot and hit three-for-three (Boo-Yah).
    That got me thinking. I wonder if people could tell the difference between a computer-generated concept for a reality TV show and an actual real reality TV show. Hmmm.
    (Via The Stalwart and Marginal Revolution.)

  • Lehman’s Earnings
    , December 13th, 2005 at 10:48 am

    Lehman Brothers (LEH) reported earnings today, and once again demolished Wall Street’s estimates. Fans of Lehman know that this is a quarterly habit for the firm. All told, Lehman raked in $2.76 a share, 14 cents more than estimates and 80 cents more than last year. This has been a terrific year for Wall Street.
    As phenomenal as those numbers are, Lehman has done this before. Last quarter, the company beat earnings by 57 cents a share, and in March Lehman beat earnings by 71 cents a share. If there’s a Google of Wall Street, Lehman is it.
    I still think of the company as a “little” firm on Wall Street, but its market cap is over $30 billion. And as amazing as Lehman’s performance has been, the stock has slightly underperformed the Amex’s Broker/Dealer Index (^XBD) over the long term. Just about every stock in that sector has been a market beater. Shares of Lehman still trade for less than 12 times this year’s earnings estimate (and we’ve seen how accurate those are), plus there’s a little dividend to boot.
    So how come I don’t love the stock? It pains me to say this, but I just don’t see the stock going much higher next year. Lehman is still primarily a bond shop. The company has done a very good job of diversifying over the past few years (Neuberger Berman was a great buy), but bonds are still the heart and soul of the company. With the yield curve so flat, I’m skeptical that the earnings surprises will keep coming.
    Half of the firm’s profits come from fixed-income trading which was up 22% over last year, but down 14% from last quarter. That may be a minor blip for Wall Street, but in Lehman’s case it’s too big a risk to ignore. I want to believe in the stock, but for now I’m content with being a spectator not an owner.