Archive for December, 2007

  • Inflation’s Impact on the Stock Market
    , December 14th, 2007 at 10:26 am

    So how does inflation affect the market? Well, it’s not good. Inflation is a tax on capital. It’s a way for the government to get your money without asking. In fact, the only thing worse than inflation is deflation.
    I took 80 years of monthly stock market return and ranked them by inflation (lowest to highest). Then I wanted to see the cumulative return as the rate of inflation increased. Here are the results.
    image563.png
    At the far left are the most deflationary months, and the far right are the most inflationary. The blue line shows the after-inflation cumulative return of the market.
    As you can see, deflation has a negative impact on equity prices. The market falls until about the 70th data point which corresponds with an annualized deflation rate of 5.5%. The vast majority of those months were in the 1930s.
    Stocks rise very steadily until it hits a brick wall around data point 660. That corresponds with an inflation rate of 5.1%.

  • CPI Surge
    , December 14th, 2007 at 9:25 am

    The government just reported that consumer inflation surged 0.8% last month. That’s the fastest rate in more than two years. The year-over-year rate is now 4.31%, which is slightly more than where the Fed is. Still, I’m an inflation skeptic. The government’s numbers most certainly understate the rate of inflation, but I’m only concerned if inflation seems to be getting out of hand.
    The core rate was just 0.3% last month. Yes, yes, I know the core rate comes in for a lot of criticism, but I think it’s important to watch. For nearly twelve straight years, the year-over-year core rate has never been greater than 3% or less than 1%. Also, long-term interest rates are still quite low.
    image562.png
    In fact, more Fed rate cuts could be on the way. The rate on short-term Treasury bills are still far below the Fed Funds rate. Yesterday, the T-bill rate closed at 2.78%, the lowest since the August panic. The Fed is about 140 basis points above the market.
    image561.png

  • Bill Miller on Risk
    , December 13th, 2007 at 3:03 pm

    Via B-Ritz:

    You also know that rising stock prices mean lower future rates of return and falling stock prices mean higher rates of return. So I was much happier in the summer of ’02 when you buy everything on sale than I was in the Spring of 2000 when a lot of things were super-expensive.
    My view is that the evidence is overwhelming that most people are too risk averse. And that therefore they should be taking a lot more risk than they feel like is right.
    The problem is that real risk and perceived risk are two different things. And that’s where people get into trouble, because they perceive risk to be high when prices are low, and they perceive risk to be low when prices are high. That’s the psychological problem that most people have.

  • Buy List Update
    , December 13th, 2007 at 12:34 pm

    Good news from Jos. A Bank Clothiers (JOSB). The company just reported earnings of 38 cents a share, which is a big jump from the 30 cents it made in the same quarter a year ago. The Street was looking for earnings of 33 cents a share. Sales rose 10% to $131.3 million.
    This stock has had a bizarre year. For the first half of the year, it charged out of the gate and gave us a quick 57% profit. It then took it all back and we’re now in the red. But I still like JOSB and the numbers look good.
    Late yesterday, Danaher (DHR) reaffirmed its Q4 outlook for EPS of $1.09 to $1.14. Sometimes investors ignore these “reaffirm” stories. I don’t. It’s one thing to say earnings will be good, but it’s nice to see a company follow-up on their forecast, even if it’s just reaffirming. DHR expects 2008 EPS to range between $4.30 to $4.40.

  • Advice from Harry Schultz
    , December 13th, 2007 at 11:52 am

    Peter Brimelow finds some interesting advice from legendary newsletter publisher, Harry Schultz, outside the usual that the world is going to hell:

    Amid the apocalyptic advice, Schultz finds time to dispense some other helpful hints. Avoid fluoride. Cell phones may cause cancer. Sauerkraut makes for a healthier prostate. Use faxes for all financial transactions. Give money to Republican presidential candidate Ron Paul on his Dec. 16 Boston Tea Party anniversary fundathon.

  • Team Spirit
    , December 13th, 2007 at 11:38 am

    A-Rod Signs Record $275 Million Deal With Yankees

    “The real question was, did he really care about being a Yankee or is he just about the money,” Steinbrenner said in a Nov. 14 interview. “It’s apparent he wants to be a Yankee and it’s not about the money.”

    In other news: Goldman chief’s pay set to hit $70m.

  • The Back-Dating Bubble Bursts
    , December 12th, 2007 at 1:12 pm

    Larry Ribstein of Ideoblog deserves some sort of blog award. Early on, he correctly called the back-dating brouhaha of 2006 what is was, a media-driven pseudo scandal. Now here we are in 2007 and the scandal bubble has burst.
    The one big fish the authorities got was Greg Reyes, the former head of Brocade. In August he was convicted of conspiracy and fraud. Ribstein said that Reyes was “trying to maximize shareholder value by recruiting the best people, not line his pockets, and where it’s unlikely any misstatements hurt investors.”
    Now it looks like they’re going to lose this case as well. Andrew Ross Sorkin reports in today’s NYT:

    A principal witness in the stock-options backdating trial that ended in a conviction of Gregory L. Reyes, the chief executive of Brocade Communications Systems Inc., has told associates her testimony may have been untrue, according to court documents.
    In affidavits, friends and associates of the witness, Elizabeth Moore, a Brocade employee who testified that Mr. Reyes deceived the company, said she had privately retracted her testimony.

    For uncovering the back-dating scandal, The Wall Street Journal won a Pulitzer Prize.

  • If the Market Is So Darn Efficient, Then Why Is this Blog Free? Wait, Don’t Answer That!
    , December 12th, 2007 at 11:57 am

    Megan McArdle, my favorite libertarian blogstress, has some thoughts about Michael Lewis’ Portfolio article and Efficient Market Hypothesis (see also here and here). Megan is a great blogger and I read her every day.
    I don’t want to get too deep in the weeds on this topic but I’m an EMH skeptic and I want to explain why. My main beef with it is that EMH suffers from theoretical overreach.
    OK class, let’s remember our scientific method. A theory is a logical explanation for natural phenomena. Well, EMH explains a whole lot, but there are still some holes. The wholes aren’t big, mind you, but they’re definitely there and can’t be ignored.
    Maybe some day, someone will come along with a better explanation for the market and those holes. I hope that day comes soon, but until then, EMH is the best we got.
    To me, the most significant hole is that value stocks have consistently outperformed the market and they’ve done it with less volatility. The data here is unambiguous. It goes back 80 years and it’s clear as a bell. Again, we’re not talking about a huge difference, but it’s there. There are others (Yahoo at $25?), but that’s the cleanest.
    Let me be clear: I think the market is very efficient, but the market can be consistently beaten. It’s not luck. It’s just very, very, very, very hard.
    As a practical matter, there’s a lot to be said for index funds. From my experience of investor behavior, more people ought to own them.
    It’s interesting that EMH defenders always say that the market can’t be beaten. They rarely defend the other half—the market can’t beat you. What can I say? I know people who have done a great amount of empirical research on this front and their results are, sadly, quite compelling.
    One final note: Please feel free to ignore the fact that this is a discussion of efficient markets taking place on free blog sites.
    Update: Megan has more today:

    I am being assailed by people pointing out that Berkshire Hathaway has done spectacularly, and therefore this EMH stuff is a bunch of hooey. I could point out that if you’d had a million guys flipping coins repeatedly for a year, at least one of them would have come up with a massive streak of heads. Even if you paid him $1mm for each heads flip, this would not actually be attributable to his awesome coin-flipping skill. Indeed, you’d have at least one cluster of guys who’d done well…perhaps fellows who’d gone to Harvard together, or people who’d all studied “Value Coin Flipping” under a master. There would be other outliers, and other groups of people who’d studied “Fundamentalist Coin Flipping” or “The Vincenzi Flipping Technique” who would not have done well. But no one would be looking to them for advice, so you would never have heard of them, and it would seem like a minor miracle that this guy, this technique had just produced such amazingly outsized returns.

    If superior performance were solely due to luck, wouldn’t we see more “successful” coin-flippers attribute their returns to arbitrary sounding strategies? You know, investing by astrology, the weather or charts patterns. Hey, if it’s all luck so the strategy shouldn’t matter.
    But that’s not what we see. If you go down the list of people who have amassed great long-term track records, each one credits Graham and Dodd style value investing. There’s Peter Lynch. There was Bill Ruane who met Buffett decades ago at a Graham conference. There are the guys who Leucadia National who have done even better than Berkshire. They espouse the exact same philosophy. The guys at Danaher. The Tisch brothers. Eddie Lampert. The list goes on and on.
    As far as I know, no technical analyst is on the Forbes 400 but there are lots of value investors.

  • Greenspan in Today’s WSJ
    , December 12th, 2007 at 7:53 am

    121207ag.jpg
    The Roots of the Mortgage Crisis
    By Alan Greenspan

    After more than a half-century observing numerous price bubbles evolve and deflate, I have reluctantly concluded that bubbles cannot be safely defused by monetary policy or other policy initiatives before the speculative fever breaks on its own. There was clearly little the world’s central banks could do to temper this most recent surge in human euphoria, in some ways reminiscent of the Dutch Tulip craze of the 17th century and South Sea Bubble of the 18th century.
    I do not doubt that a low U.S. federal-funds rate in response to the dot-com crash, and especially the 1% rate set in mid-2003 to counter potential deflation, lowered interest rates on adjustable-rate mortgages (ARMs) and may have contributed to the rise in U.S. home prices. In my judgment, however, the impact on demand for homes financed with ARMs was not major.
    Demand in those days was driven by the expectation of rising prices — the dynamic that fuels most asset-price bubbles. If low adjustable-rate financing had not been available, most of the demand would have been financed with fixed rate, long-term mortgages. In fact, home prices continued to rise for two years subsequent to the peak of ARM originations (seasonally adjusted).
    I and my colleagues at the Fed believed that the potential threat of corrosive deflation in 2003 was real, even though deflation was not thought to be the most likely projection. We will never know whether the temporary 1% federal-funds rate fended off a deflationary crisis, potentially much more daunting than the current one. But I did fret that maintaining rates too low for too long was problematic. The failure of either the growth of the monetary base, or of M2, to exceed 5% while the fed-funds rate was 1% assuaged my concern that we had added inflationary tinder to the economy.

    Notice how we’ll never know if we avoided corrosive deflation, yet Greenspan is confident that low rates weren’t a major factor in the housing bubble. Conveniently, he saved us from the event that never came and couldn’t protect us from the one that did.

  • Electability Update
    , December 12th, 2007 at 7:12 am

    I written about this topic before but one of the things I find fascinating about finance is how you can use markets for two items to create an “implied market” for a third. This idea is at the root of all the complex financial instruments that caused problems for so many hedge funds recently.
    I’ll give you a good example. At InTrade.com, the site where you can trade futures on real world events, you can buy contracts on which candidate will win his or her party’s nomination next year. There’s a separate contract for which candidate will win the presidency.
    Let’s break out some math, shall we?
    If you divide the latter by the former, you get an “electability” contract. For example, according to recent prices, Rudy Giuliani has a 41.5% chance (I’m using the last price) of getting the GOP nomination and an 18.4% of winning the presidency. Soooo…the market believes that if he gets the nomination, he has a 44.34% chance of winning (18.4% divided by 41.5%).
    (The only minor flaw is that could include a candidate winning but not getting the nomination, however, I’m content with dismissing that possibility as beyond remote.)
    What’s interesting is electability in the general election can have little impact on how well a candidate does in the primaries. Some people, myself included, think that Ronald Reagan would have had a better chance of beating Jimmy Carter in 1976 instead of Gerald Ford, even though Ford beat Reagan for the nomination.
    I should add that I don’t place a great deal of faith in these real world futures markets. I simply see them as fun games to enjoy, but not to take too seriously. Also, the markets aren’t very liquid. A minor change could have a big impact on the smaller-priced contracts.
    Having said that, here’s a look at some candidates and the market’s take on their electability (sorry Paulites and Edwards fan, your candidates were too low to get a useful meaure).
    Candidate………To Get Nomination….To Win…………Electability
    Hillary……………………..59.5……………….39.0………………65.55
    Obama……………………33.0……………….17.2………………52.12
    Giuliani……………………41.5……………….18.4………………44.34
    Huckabee………………..18.6…………………7.2………………38.71
    Romney…………………..18.8…………………5.9………………31.38