Investing

The Fed’s Surprise

Posted by Peter on January 25, 2008
Posted in: Economics, Investing, U.S. Politics. Tagged: .

Early this week, the Federal Reserve Board lowered interest rates at an unexpected time by a surprisingly large amount.
I see three possible explanations, which I think are about equally likely.

  • The Fed has evidence that the economy is slowing more than markets have realized.
  • The Fed has evidence that some big financial institutions have troubles that are endangering the careers of some influential people, and is bailing out those institutions in hopes that those people will use their influence to enhance the job security of the people in charge of the Fed.
  • Bernanke isn’t interested in the kind of publicity he can get by maximizing the total number of rate cuts. He realizes that a steady, predictable series of small rate cuts doesn’t stimulate the economy as well as cutting rates far enough that it isn’t easy to predict that more rate cuts will be needed (for one thing, making further rate cuts predictable creates incentives to postpone borrowing to when rates are lower). If that’s what’s happening, it’s not going to work as well as he would like this time, because the markets think the Fed is following the predictable rate cut strategy that gives them publicity for doing something at the time that the average person is most concerned about recession.

In related news, Singapore has a system which is designed to stabilize the economy rather than to provide politicians with opportunities to claim credit for doing something about the economy.
China is imposing widespread price controls and suffering power shortages which hinder production. If China were like the U.S., I’d say it’s trying to recreate the experience the U.S. had in the early 1970s. But the way Chinese politics work, the central government probably will allow local authorities to use a lot of discretion in enforcing the price controls, so the price controls will probably only produce shortages in a few industries that are dominated by large state-owned firms.

Chinese Stock Bubble

Posted by Peter on October 23, 2007
Posted in: China, Investing. Tagged: , , .

Up to two months ago, I was not too excited by the claims of a bubble in the Chinese stock market. Maybe the stocks that trade only in China were at bubble levels, but the ones that trade in the U.S. or Hong Kong still looked like mostly good investments.
Much has changed since then. On October 17, PetroChina rose 14.5%, more than doubling in about two months. That was a one day gain in market capitalization of almost $60 billion, and a two month gain of $247 billion (doubling the market capitalization). I’ve seen similar but less dramatic rises in smaller Chinese stocks that trade in the U.S., but less on the Hong Kong stock exchange.
By comparison, the largest rises in market capitalization that I’ve been able to find in the technology stock bubble of 1999-2000 were a $50 billion one day rise in Microsoft on December 15, 1999, and a $250 billion rise (doubling) in Cisco which took four months.
I’m not saying that Chinese stocks are clearly overvalued yet, and I’m still holding some stocks in smaller Chinese companies that I don’t feel much urgency about selling. But the unusually strong and long lasting Chinese economic expansion, combined with the unusually frothy action in the stock market, are what I’d expect to be causes and symptoms of a bubble.
Bubbles in the U.S. have peaked when real interest rates rise to higher than normal levels. The Chinese government is keeping real interest rates near zero, and seems to think it can keep nominal interest rates stable and reduce inflation. That would be an unusual accomplishment under most circumstances. When combined with a stock market bubble, I suspect it could only be accomplished with drastic restrictions on economic activity, which would involve instabilities that the Chinese government has been trying to avoid by stabilizing things such as interest rates.
Without a rise in interest rates or drastic restrictions of some sort, it’s hard to see what will stop the rise in Chinese stocks. So I’m guessing we’ll see a bigger bubble than the U.S. has experienced. It’s effects will likely extend well beyond China.

Business Fairy Tales

Posted by Peter on July 25, 2007
Posted in: Investing.

Book review: Business Fairy Tales by Cecil W. Jackson.
This book provides a better analysis of financial accounting problems than you can find in the news media. But it’s not thoughtful enough for me to recommend it. The author sounds like an academic who has little experience as an investor.
The book provides little perspective on which mistakes did the most harm. I can’t tell whether the author sees any difference in seriousness of Enron’s inconsistent reports to the SEC about when it adopted mark-to-market accounting and the absence of market prices to guide its so-called mark-to-market accounting (it seems obvious to me that the former is trivial and the latter is outrageous, but I wouldn’t have learned that from reading this book).
I’m also disappointed that the book never takes the perspective of the villains to ask why they thought they could get away with bad accounting. Were they all confident that perpetually rising stock prices would ensure that investors would never complain? Could they have have thought they would make enough money before getting caught to profit even if they were punished? In some cases I can guess why the answer might have been yes to one of these, but in most cases I’m as puzzled as I was before reading the book.
The book suggests a number of signals that investors might look for to detect fraud. But none of them are valuable enough to change the way I read financial reports. A few, such as sales growth not meeting expectations or rising inventory / sales ratios, are valuable signs of an overrated company even though they rarely indicate accounting problems. Most of the signals the book recommends involve things like increases in receivables where there’s no obvious way to distinguish routine fluctuations from changes that indicate problems, so I suspect the number of false alarms would make these signals useless.
I suspect that avoiding the stock market during bubbles is a more practical and effective way of avoiding harm from accounting fraud than trying to follow this book’s advice. I’d guess that 10% of investors will learn to avoid bubbles if they try, but I doubt more than 1% will succeed at identifying fraud. If you do try to identify fraud, pay more attention to people such as Jim Chanos who have found ongoing frauds than to books such as this that only do post-mortem analysis.
The book claims that a benefit of Sarbanes-Oxley is that it restored investor confidence in corporate financial statements. This seems misguided. The stock market decline that prompted Sarbanes-Oxley was largely due to mistaken extrapolations of real trends in internet-related profits. Many investors prefer to exaggerate the role played by fraud because it distracts attention from the mistakes they made at the peak of the bubble. It’s unclear whether increased investor confidence is desirable. Accounting fraud is most common at peaks of bubbles because investor confidence makes it temporarily easier to avoid questions about suspicious accounting practices. Stock markets appear to function best with moderate amounts of suspicion among investors to help keep corporate reports honest.

Wisdom of Crowds

Posted by Peter on January 15, 2007
Posted in: Book Reviews, Idea Futures, Investing, Politics. Tagged: .

This book does an excellent job of reporting important evidence showing that group decisions can be wiser than those of any one individual. He makes some good attempts to describe what conditions cause groups to be wiser than individuals, but when he goes beyond reporting academic research, the quality of the book declines. He exaggerates enough to give critics excuses to reject the valuable parts of the book.
He lists four conditions that he claims determine whether groups are wiser than their individual members. I’m uncertain whether the conditions he lists are sufficient. I would have added something explicit about the need to minimize biases. It’s unclear whether that condition follows from his independence condition, partly because he’s a bit vague about whether he uses independence in the strong sense that statisticians do or whether he’s speaking more colloquially.
Sometimes he ignores those conditions and makes unconvincing blanket statements that larger groups will produce wiser decisions.
He makes exaggerated claims for the idea that crowds are wise due to information possessed by lots of average people rather than the influence of a few wise people. For instance, he disputes a Forsythe et al. paper which argues that a small number of “marginal traders” in a market to predict the 1988 presidential vote were responsible for the price accuracy. Surowiecki’s rejection of this argument depends on a claim that “two investors with the same amount of capital have the same influence on market prices”. But that looks false. For example, if the nonmarginal traders make all their trades on the first day and then blindly hold for a year, and the marginal traders trade with each other over that year in response to new information, prices on most days will be determined by the marginal traders.
It’s not designed to be an investment advice book, but if judged solely as a book on investment, I’d say it ranks in the top ten. It does a very good job of explaining both what’s right and what’s wrong with the random walk theory of the stock market.
He does a good job of ridiculing the “cult of the CEO” whereby most of a company’s value is attributed to its CEO (at least in the U.S.). I was surprised by his report that 95% of investors said they would buy stocks based on their opinion of the CEO. They certainly didn’t get that attitude from successful investors (who seem to do that only in rare cases where they are able to talk at length with the CEO). But his claim that “Corporate profit margins did not increase over the course of the 1990s, even as executive compensation was soaring” looks false, as well as being of questionable relevance to his points about executives being overvalued. And I wish he had also applied his argument to beliefs of the form “if we could just elect a good person to lead the nation”.
Chapter 6 does a good job of combining the best ideas from Wright’s book Nonzero and Fukuyama’s Trust (oddly, he doesn’t cite Trust).
He exaggerates reports that the stock market responded accurately to the Challenger explosion before any public reports indicated the cause. He claims “within a half hour of the shuttle blowing up, the stock market knew what company was responsible.” I don’t know where he gets the “half hour” time period. The paper he cites as the source says the market “pinpointed” Thiokol as the culprit “within an hour”, but it exaggerates a bit. If the percent decline in stock price is the best criterion, then the market provided strong evidence within an hour. If the dollar value of the loss of market capitalization is the best criterion, then the evidence was weak after one hour but strong within four hours.
He also claims “Savvy insiders alone did not cause that first-day drop in Thiokol’s price.”, but shows no sign that he could know whether this is true. He seems to base on the absence of reported selling by executives whom the law requires to report such selling, but he appears to overestimate how reliably that law is obeyed, and to ignore a large number of non-executive insiders (e.g. engineers). He does pass on a nice quote which better illustrates our understanding of these issues: “While markets appear to work in practice, we are not sure how they work in theory.”

A Stock with a Strange Price History

Posted by Peter on September 4, 2006
Posted in: Investing.

While browsing through charts of various stocks, I came across a company (Manchester Inc., symbol MNCS) with a chart that’s unusual enough that I had to check around to reassure myself that my primary source for stock market prices wasn’t playing tricks on me.
It has a history of unusually steady increases with few signs of the randomness that I normally see in stock prices. If you had bought at the closing price any day this year and held for ten trading days, it would have closed higher than your purchase price (your average gain would have been over 3 percent), and it was almost as predictable the prior year.
A paragraph in the middle of this Forbes story explains why its market value looks strange.
The only guess I have as to what might cause this is an unusual form of manipulation where the manipulators produce this phenomenon until traders who buy purely on price trends provide enough liquidity for the manipulators to cash out. But even that is pretty implausible – if that’s what’s happening, why wouldn’t they create a bit more day to day randomness to disguise it a bit? And how could they afford to risk as large an investment as I suspect that would take on an approach which seems different enough from anything tried before that it ought to be hard to predict whether it will work?

How to Weight Holdings in Stock Funds

Posted by Peter on June 17, 2006
Posted in: Investing. Tagged: .

For those investors who (unlike me) can’t afford to do fundamental analysis on a large number of companies (and if you can’t afford to analyze thousands of companies, you’re probably using a questionable method to select which ones to analyze), there’s a new class of ETFs which sounds like fixes some of the worst problems with typical stock funds.
Most people invest in funds that are based on a capitalization weighted index, which means that any time there’s a bubble affecting some of the stocks in the index, the fund is buying those stocks at the peak. The more popular those funds are, the easier it is to create bubbles in the stocks they buy.
There’s a new ETF (symbol PRF) that weights its holdings on dividends instead, which will sell stocks that are affected by bubbles (except in the unusual case where the company increases its dividend in step with the bubble).
The Political Calculations blog mentions similar strategies which appear to work about as well (the dividend weighting selects against small immature companies, and it ought to be possible to avoid that).
Weighting on revenues sounds like it works well, although it overweights retailers and underweights successful pharmaceutical companies and oil producers that find cheap sources of oil.
Weighting on the number of employees should work (although that underweights companies that outsource).
I’m somewhat partial to weighting on book value, but instead of the standard book value, I’d use tangible book value plus an estimate of amortized R&D expenses.
Shorting the 5 or 10 companies with the largest market capitalizations would probably be a good way to invest a modest portion of a portfolio in a way that would reduce risk and improve returns.
These strategies do have the potential to underperform if they becomes as popular as buying and holding S&P 500 funds was around 2000, but it will take some time to become that trendy, and even if it does there will probably still be funds using unpopular versions of fundamental weighting that will remain good investments.

When Genius Failed

Posted by Peter on April 12, 2006
Posted in: Book Reviews, Investing. Tagged: , .

Book Review: When Genius Failed : The Rise and Fall of Long-Term Capital Management by Roger Lowenstein
This is a very readable and mostly convincing account of the rise and fall of Long-Term Capital Management. It makes it clear to me how the fairly common problem of success breeding overconfidence led LTCM to make unreasonable gambles, and why other financial institutions that risked their money by dealing with LTCM failed to require it to exercise a normal degree of caution.
The book occasionally engages in some minor exaggerations that suggest the author is a journalist rather than an expert in finance, but mostly the book appears a good deal more accurate and informed than I expect from a reporter. It is written so that both experts and laymen will enjoy it.
One passage stands out as unusually remarkable. “The traders hadn’t seen a move like that – ever. True, it had happened in 1987 and again in 1992. But Long-Term’s models didn’t go back that far.” This is really peculiar mistake. The people involved appeared to have enough experience to realize the need to backtest their models better than that. I’m disappointed that the book fails to analyze how this misjudgment was possible.
Also, the author spends a bit too much analysis on LTCM’s overconfidence in their models, when his reporting suggests that a good deal of the problem was due to trading that wasn’t supported by any model.

Nanotech Breakthrough, Stock Price Reaction

Posted by Peter on March 29, 2006
Posted in: Investing, Molecular Assemblers (Advanced Nanotech).

Paul W.K. Rothemund’s cover article on DNA origami in the March 16 issue of Nature appears to represent an order of magnitude increase in the complexity of objects that can self-assemble to roughly atomic precision (whether it’s really atomic precision depends in part on the purposes you’re using it for – every atom is put in a predictable bond connecting it to neighbors, but there’s enough flexibility in the system that the distances between distant atoms generally aren’t what would be considered atomically precise).
It was interesting watching the delayed reaction in the stock price of Nanoscience Technologies Inc. (symbol NANS), which holds possibly relevant patents. Even though I’m a NANS stockholder, have been following the work in the field carefully, and was masochistic enough to read important parts of the relevant patents produced by Ned Seeman several years ago, I have little confidence in my ability to determine whether the Seeman patents cover Rothemund’s design. (If the patents were worded as broadly as many aggressive patents are these days, the answer would probably be yes, but they’re worded fairly responsibly to cover Seeman’s inventions fairly specifically. It’s clear that Seeman’s inventions at least had an important influence on Rothemund’s design.)
It’s pretty rare for a stock price to take days to start reacting to news, but this was an unusual case. Someone reading the Nature article would think the probability of the technique being covered by patents owned by a publicly traded company to be too small to justify a nontrivial search. Hardly anyone was following the company (which I think is a one-person company). I put in bids on the 20th and 21st for some of the stock at prices that were cautious enough not to signal that I was reacting to potentially important news, and picked up a modest number of shares from people who seemed to not know the news or think it irrelevant. Then late on the 21st some heavy buying started. Now it looks like there’s massive uncertainty about what the news means.

Oil Futures

Posted by Peter on January 17, 2006
Posted in: Economics, Investing.

Arnold Kling writes some interesting comments about the uses of oil futures markets.

I recall reading that the President of Exxon was forecasting oil prices much lower than the futures markets and thinking that if he believes his own forecast, then he should put his company up for sale.

I think there’s a genuine inconsistency between Exxon’s talk and its actions, but selling the company isn’t the optimum response. We don’t know that Exxon’s stock price currently reflects the prices forecast by the futures market (I decided 6 months ago that energy-related companies were underpriced relative to the futures market and sold my last 2009 futures contract while keeping a large position in energy-related companies) or that the market for large oil companies is liquid enough for Exxon to be sold at a good price. It makes more sense for Exxon to hedge larger fractions of its production by selling more futures contracts.
Maybe the long-date futures markets are illiquid enough that prices would approach what Exxon’s president thinks they should be, in which case Exxon would make slightly more money than under its current policies (assuming the resulting prices are right, which Exxon ought to assume is the best available guess). Or maybe the markets have enough liquidity that Exxon would hedge a large fraction of its production at prices near $60/barrel, which would help Exxon dramatically if Exxon’s president is right, and forgo big profits if he’s wrong. It’s fairly clear the market doesn’t have the liquidity to keep long-dated futures prices over $60/barrel if Exxon tries to make big hedges overnight, but if Exxon were fairly patient about building up the hedge positions, I don’t think we can know what would happen without performing the experiment. There are lots of people out there who think that betting against Exxon would be a good deal. Their confidence in their beliefs remains untested.

The government has all sorts of subsidies for alternative energy. However, the most efficient subsidy would be to buy oil futures contracts. If we must have an energy policy, it should consist solely of strategic futures market purchases.

Buying oil futures contracts would be the least wasteful way to subsidize the solar energy market, where there are many designs that are close to providing competitive mass-produced products. But financial markets are pouring enough money into that market that there’s little reason to think government subsidies are valuable.
Buying oil futures won’t provide the kind of subsidy that, say, fusion advocates would want. If markets are inadequately funding fusion research and government is benevolent enough to do better (a suspicious pair of assumptions, but without assumptions of that nature the popular demand for a government energy policy is a mistake), then oil futures markets won’t solve the problem because the problem is something like markets having inadequate information to target the right research or patents not providing inventors with the optimum fraction of the social benefits of their inventions.