The Impact of Sidelined Cash in Disequilibrium on the Stock Market

The purpose of this note is to reconcile two contrasting viewpoints on how the amount of cash in our economy impacts future stock prices:

A. Sidelined Cash View: An example of the view that cash held in investor accounts matters is Alexander Green's commentary this week: 'In February . . . the decline in stocks was just about over [because] . . . [t]here was more money available to buy shares than at any time in almost two decades. The $8.85 trillion held in cash, bank deposits and money market funds was equal to 74% of the market value of U.S. companies, the highest ratio since 1990, according to the Federal Reserve. . . . [T]here is still over $8 trillion on the sidelines earning next to nothing in short-term deposits. . . . Expect to see cash coming off the sidelines to accumulate shares of the largest, most liquid firms around the globe.'

B. Equilibrium View: The opposite view, that consideration of market equilibrium reveals the "tautology" of speaking about cash on the sidelines, is voiced by John Hussman in his comment this week: '[A]s a result of more than a trillion dollars of new issuance of Treasury securities with relatively short durations, it is a tautology that there is a mountain of what is mistakenly viewed as “cash on the sidelines” invested in these securities. This mountain of “sideline cash” exists and must continue to exist as long as these additional government securities remain outstanding. It is an error to view outstanding debt securities as if they are “liquidity” poised to “flow back into the stock market.” The faith in that myth may very well spur some speculation in stocks, but it is a belief that is utterly detached from reality. The mountain of outstanding money market securities is the result of government debt issuance that must be held by somebody until those securities are retired. It is not spendable “liquidity” – it is a pile of IOUs printed up as evidence of money that has already been squandered. The analysts and financial news reporters who observe this enormous swamp of short-term money market securities, and talk about “cash on the sidelines” as if it is spendable in aggregate immediately reveal themselves to be unaware of the concept of equilibrium and of the nature of secondary markets (where there must be a buyer for every security sold, and a seller for every security bought).'

Which view is right? Is it useful from a trading or investment timing perspective to think of sidelined cash as waiting to flow back into the stock market? Or, does any particular stock transaction involve a mere transfer of cash from buyer to seller and, therefore, leave the aggregate amount of cash in the economy, sidelined or not, unchanged? Further, what is the long-run impact of the amount of cash in our economy, i.e., the money supply, on stock prices?

The Fed, the Treasury and the Private Sector

Three primary parties feature in our analysis: the Federal Reserve ("Fed"), the U.S. Treasury and the private sector. To illuminate essential points, I intentionally employ a "no frills" simplified model of the creation of cash (or, more generally, a broader measure, M2), bonds and stocks in the economy:

1. Cash Creation and Swap: The Fed creates cash (in the amount of 50 units) and swaps it with the Treasury for a like notional amount of newly issued government bonds.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 50, Bonds = -50

(In each of the skeletal balance sheets here and below, the sections shown in bold indicate a change from the immediately prior stage of the analysis.)

2. Deficit Spending: The government uses the cash to finance expenditures such as national security, infrastructure projects, entitlements and other deficit spending. The private sector ends up holding the cash, received from the government through employment and entitlements.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 0, Bonds = -50
Private Sector: Cash = 50

3. More Bond Issuance: The Treasury issues more bonds, this time to private sector investors instead of to the Fed.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 50, Bonds = -100
Private Sector: Cash = 0, Bonds = 50

4. More Deficit Spending: The government deploys the cash in accordance with its budget, with the private sector again being the recipient of the cash.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 0, Bonds = -100
Private Sector: Cash = 50, Bonds = 50

5. Entrepreneur-Led Growth: Assisted by years of government spending on infrastructure, enterprising individuals form companies and develop new technologies and products for growing consumer markets. Rising stock prices of these entrepreneurial companies represent new wealth creation, seemingly materializing "out of thin air," but actually resulting from the "value-add" through conversion of natural resources, labor, capital and technology into useful products and services.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 0, Bonds = -100
Private Sector: Cash = 50, Bonds = 50, Stocks = 100

6. Business Cycle: As the market's perception of future business prospects shifts, stock prices rise and fall. The corresponding aggregate wealth held by the private sector in stocks fluctuates from a cycle low of, say, 75, to a cycle high of, say, 150. At the nadir of the business cycle, the corresponding cash-to-stocks ratio is 50/75 = 67%, while at the peak this ratio is 50/150 = 33%.

7. Government's Rescue Plan: During the depths of an extended recession (i.e., when stocks = 75), the government implements an economic rescue plan, involving

a. Creation of more money (25) by the Fed;
b. The Fed's use of this money to purchase lower credit assets from banks;
c. Banks' use of the proceeds to purchase new bonds from the Treasury.

This plan strengthens bank balance sheets and provides the government with cash for new deficit spending. (By deliberate design, this model parallels the actions taken by the Fed and Treasury over the past half year in dealing with the current financial crisis.)

Fed: Cash = -75, Bonds = 50, Other Assets = 25
Treasury: Cash = 25, Bonds = -125
Banks: Bonds = 25, Other Assets = -25
Private Sector: Cash = 50, Bonds = 50, Stocks = 75.

8. Still More Deficit Spending: The government deploys its new cash of 25 as part of a stimulus package to jump-start the economy (cf., Obama's approximately $1 trillion fiscal stimulus package, currently being deployed). As before, the cash ends up in the hands of workers and consumers in the private sector.

Fed: Cash = -75, Bonds = 50, Other Assets = 25
Treasury: Cash = 0, Bonds = -125
Banks: Bonds = 25, Other Assets = -25
Private Sector: Cash = 75, Bonds = 50, Stocks = 75.

The result is an increase in the cash-to-stocks ratio to 75/75 = 100%, which is a sign of the gross disequilibrium now inherent in the economy, since the cash-to-stocks ratio is outside of its "normal" range of 33% to 67% shown in Stage 6 of our model.

How Both Views Can Be Right

First, although our model is very simple, it exhibits important monetary, fiscal and economic trends in the U.S. economy:

• The amount of cash in the economy increases over time (from 0 to 75 in our model) as the economy grows and the Fed prints money to provide a currency to accommodate transactions among consumers and producers;
• The amount of government debt increases over time (from 0 to 125 in our model) as the Treasury issues bonds to fund the government's growing budget deficit;
• The value of the stock market rises secularly (from 0 to 100 in our model) as innovation, population growth and economic growth drive aggregate earnings of companies higher;
• Also, stock prices are prone to fluctuations (from 75 to 150 in our model), due to changes in market participants' perceptions of the future business prospects and earnings potential of companies within the economy.
  

This situation is hardly one of steady equilibrium. On the contrary, our economy is a dynamic system, continually evolving from one point of instantaneous and imperfect equilibrium to the next. Population growth, innovation and technological change drive secular increases in the amount of cash, bonds and stocks, and government monetary and fiscal policy alters the money supply, bond issuance and tax revenues in a Keynesian attempt to influence the course of the economy. The result is an economy in perpetual disequilibrium, wherein apparently the only constant aspect is change itself.

Within a framework of disequilibrium, let's now examine the situation at the end of Stage 8 of the scenario presented above. Given the new infusion of cash (from a sudden increase in the money supply), the stock market (along with other assets such as real estate) is arguably likely to rise, consistent with the Sidelined Cash view, as investors chase higher returns by buying stocks with the new portion of their "sidelined cash" (now 75, up from the recent figure of 50 in our model). The idea here is that, when enough newly printed aggregate cash from fiscal stimulus makes its way into consumers' and investors' hands, some combination of more consumption and more investment will (eventually) push asset prices higher. Though ostensibly at variance with the Equilibrium view he espouses, Hussman points out that a probable outcome of current government policy is "a near-doubling of the U.S. price level over the next decade," citing Nobel economist Joseph Stiglitz's characterization of the government's strategy as "trying to recreate the bubble [in a way] [t]hat's not likely to provide a long-run solution . . . [but instead] says let's kick the can down the road a little bit."

To sum up:

• The Sidelined Cash view correctly points out that "cash on the sidelines" can drive stock prices higher; however, by failing to distinguish between aggregate cash in the economy and cash held by individual investors, this view leaves too much room for (mis)interpretation;
• The Equilibrium view is right in pointing out that the aggregate amount of cash in the economy does not change when investors trade stocks with each other; however, this view fails to incorporate the disequilibrating impact of new cash creation by the Fed (and the banking system).

I offer the following combined "sidelined cash in disequilibrium" view as a synthesis of the two views: The private sector of our economy operates, not in equilibrium, but in perpetual disequilibrium, due to the impact of our government's deficit spending using money printed by the Fed and accounted for as borrowing by the Treasury. New cash created by this dynamic process (which drives additional cash creation via fractional reserve banking) enters the economy through fiscal stimulus and becomes the "sidelined" component of aggregate cash that is forever chasing new opportunities and effectively encourages future economic growth.

So, we might say that cash is continually rolling off the printing presses at the Fed as our government's deficit expands and the economy grows. This capacity of our government to print money, constrained at any moment but secularly unlimited, provides a large pool of sidelined cash that can jump-start a recessionary economy and, in practice, has an inflationary impact on stock and other asset prices. The ultimate long-run outcome of our government's deficit spending policy and its influence on the relative strength of the U.S. economy versus that of other countries is debatable but, in my opinion, a correct prognosis will involve both a) interpreting "sidelined cash" to include the capacity of the Fed to print new money and b) recognizing that our economy is always in disequilibrium.

Hey, Baseball Fans: Winning Takes Money

Investing and professional sports have a lot in common--competition, winners and losers, uncertain outcomes, lots of data, and a wide range of opinions among participants, spectators and analysts. During a conversation the other day with a friend, I casually mentioned what I thought to be an accepted truism in the sport--that, just as money is a vitally important determinant in the business world, Major League Baseball teams with higher payroll (hence, better players by presumption) ought to win more often than teams with lower payroll.

To my surprise, my friend, who is a baseball fanatic, retorted that money and winning are not as intimately linked as one might presume, and proceeded to recite from his encyclopedic memory a number of examples of World Series play over the past 10 years--the Arizona Diamondbacks over the New York Yankees in 2001, the Los Angeles Angels over the San Francisco Giants in 2002, and the Florida Marlins over the Yankees in 2003--all cases in which teams with significantly lower payroll took the championship from their more generously compensated opponents. All right, I had to admit, I take "strike one" against my follow-the-money presumption.

After getting off the phone, I did a quick web search to check further. The first study I came across stated that "results from the two years of data [2002 and 2003] indicate that there is no real correlation between a team's salary and its win percentage." In other words, higher salaries do not significantly boost win percentage. Hmm--strike two, I mused. . . .

Wanting to avoid striking out, I resolved to find the data and run numbers myself.

Team Payroll and Win Percentage Data

The USA Today Salaries Database gives MLB payroll figures for all 30 pro baseball teams in both the American and National leagues going back to 1988. The ESPN MLB standings database shows seasonal win percentages from 2002. Combining the data for the seven years from 2002 to 2008, we can generate the scatter plot shown below.



A least-squares analysis of team payroll versus win percentage gives the "best fit" regression line:

Win Percentage = 0.426 + (Team Payroll in $ Millions) x 0.00097,

indicating that approximately each one million dollars of team payroll adds about 1 point out of 1,000 (i.e., 0.001) to the win percentage. The t-statistic for the regression is 6.96, which means that we can state this relationship between payroll and win percentage with an extremely high degree of confidence (in fact, the likelihood of a false positive is less than one in ten billion!).

It is also instructive to look at the data on a team-by-team basis for the same seven-year period from 2002 to 2008. Notice how the New York Yankees and the Boston Red Sox have not only the first and second highest average team payrolls ($181 million and $122 million) but also the first and second highest average win percentages (0.600 and 0.580), respectively. At the other extreme, the three teams with the lowest average win percentages--Kansas City Royals at 0.410, Tampa Bay Rays at 0.423, and Pittsburgh Pirates at 0.431--are among the five Major League teams with the lowest average team payroll (each less than $50 million).



I also provide a table showing the payroll of baseball teams playing in the World Series over the past 20 years (actually from 1988 through 2008, with the exception of 1994 when, as baseball fans will recall, the Series was cancelled due to a player strike), assisted by data from Baseball Almanac. The results reveal that in 14 out of the 20 years, or 70% of the time, the team with the higher team payroll defeated the team with the lower payroll in the World Series. This result is consistent with the strong relationship between team payroll and win percentage shown in the graphs above.



What I conclude is that money does matter in professional baseball. Teams that have higher payroll generally do win more games, both during the regular season and during the World Series. Suffice it to say: the correlation between performance and pay is surely at least as high in baseball (and, in all likelihood, in other profesional sports as well) as it is in the business world. On a related though distinct topic, I would conjecture that, based on the relationship between payroll and win percentages, it is undoubtedly much easier to predict outcomes in Major League Baseball than in the stock market and other financial markets.

A Note on Statistical Analysis

In case anyone is wondering why my conclusion differs so radically from the study I mentioned as being my "strike two," I provide an explanation here. Warning: Only those interested in statistical analysis should continue reading, since the discussion becomes somewhat technical. However, I encourage anyone who at least occasionally spends time looking for patterns in data to read on, since an important lesson in applying the right tools to the job at hand will arise from the detail.

The author of the study I cited chose to analyze that data using a multiple regression, in an effort to determine how each of three variables--starting pitchers' salaries (P), fielders' salaries (F) and closing pitcher's salary (C)--affects a baseball team's win percentage. For example, for 2003, the study produced the following regression result,

Win Percentage = 0.406 + 0.0022 x P + 0.0015 x F + 0.0018 x C,

along with corresponding t-statistics of 1.72, 1.46 and 0.41 for the significance of the regression coefficients corresponding to independent variables P, F and C, respectively. With all t-statistics less than 2.00, the study was unable to discern at the standard minimum of 95% confidence any dependence of win percentage on the three payroll variables.

Interestingly enough, when I perform the analysis using the same 2003 data, but formulating the problem as three separate one-variable single regressions (instead of one comprehensive three-variable multiple regression as employed in the study), I arrive at t-statistics of 2.93 for dependence of win percentage on starting pitchers' salaries, 2.77 for dependence on fielders' salaries, and 1.49 for dependence on closing pitcher's salary--all higher than the t-statistics for the multiple regression given above. Further, if I combine starting pitchers', fielders' and closing pitcher's salaries into a single variable (i.e., P+F+C) and again run a one-variable regression, I find an even higher t-statistic, namely, 3.49.

In other words, by "zooming out" and viewing the data using an effectively lower resolution microscope, we actually find a more robust statistical pattern--this is reminiscent of the proverbial necessity of stepping back from the individual trees in order to view the grander forest. But, you might be wondering, how can this be? How is it possible in a regression to see a pattern at a lower resolution that essentially disappears at a higher resolution?

To understand the mechanism behind this paradoxical statistical behavior, consider a very simple regression example. Suppose we are trying to understand the relationship between a dependent variable, z, and two independent variables, x and y, based on five data points:

Data point 1: x = 1, y = 1 and z = 1
Data point 2: x = 2, y = 2 and z = 2
Data point 3: x = 3, y = 3 and z = 3
Data point 4: x = 4, y = 5 and z = 4
Data point 5: x = 5, y = 4 and z = 4.

Graphically, three plots are relevant:

a) Multiple Regression: Three-dimensional plot of x and y versus z,
b) Single Regression: Two-dimensional plot of x versus z (same as y versus z), and
c) Single Regression: Two-dimensional plot of combined variable, x+y, versus z.



In the multiple regression, the t-statistics are 3.3 for each of x and y. Observe the "dispersion" of data points 4 and 5 in the three-dimensional plot, with each of these points offset in a different direction from the straight line that can be drawn through data points 1, 2 and 3. This dispersion adds extra error to the regression, creating a relatively poor regression fit to the data.

In the single regression of x versus z (or, symetrically, y versus z), four of the five data points are collinear, and only the fifth data point introduces error into the otherwise perfect linear fit. This tighter fit of the data to a straight line yields a t-statistic of 6.9, higher than in the multiple regression case.

Still better yet, if we regress on the combined variable, x+y, we end up with a t-statistic of 17.9, substantially higher than in either of the other cases. By combining x and y into a single variable, we eliminate the oppositely directed "dispersive meandering" of x and y. The combined variable allows the regression analysis to reveal a closer correspondence between the independent variable (x+y) and the dependent variable (z).

Back to Baseball . . . and a Lesson

In an analogous way, the baseball statistics study relying on multiple regression produces a poorer picture of the relationships between variables than does the single regression. Behind the scenes is probably a mechanism akin to the following: Owners and managers of a given baseball team work within budget constraints during any particular season, so that the total amount of money available to pay all players on the team may be viewed effectively as a fixed quantity for that year. If more money is spent paying starting pitchers, then less money is available to hire and pay fielders and closers. Similar to how in the simple example above, x is less than y at data point 4, but y is less than x at data point 5, a particular baseball team may decide to spend less of its budget on starting pitchers than fielders, while another team may decide to flip the allocation the other way around, with less of its budget going to fielders than starting pitchers.

When the salaries of the all pitchers and fielders are combined, a more meaningful variable results against which to regress the win percentages. For this reason, the single regression using the combined salaries produces a higher t-statistic and better fit to the linear regression model.

The basic lesson here is that, when analyzing problems, it helps always to look for simpler relationships, explanations and solutions first, before implementing more sophisticated analytical tools. In working with scientific, financial, economic, sports or any other type of data, we are often warned against fabricating false patterns (artifacts of the analysis) by overfitting data to a model. In a similar vein, our discussion shows how it is also sometimes possible to overlook robust patterns by forcing an overly complicated model onto an intrinsically simpler set of data.

Blind Men and the Elephant: On the Urgency of Asset Price Reflation

You've surely heard of the six blind men and the elephant. If we adapt the traditional story to our current financial and recessionary crisis, the key role-players become:

1. The Fed, who figures that the money supply and interest rates are what matter, and proceeds to lower short-term rates all the way to zero percent, while starting open-market purchases of commercial paper and mortgage securities to reel in credit spreads;
2. The Treasury, who decides that weak banks are the problem, and spends $350 billion of TARP funds recapitalizing banks and financial institutions, and deliberates over details of how to deploy the remaining $350 billion;
3. The FDIC, who feels that confidence in the financial system matters most, and boosts deposit insurance limits to $250,000 to help prevent runs on the banks;
4. Democrats in the House and Senate, who are sure that our problems will go away if the government spends more without worrying so much about the deficit, and quickly assemble a massive $900 billion stimulus package;
5. Republicans, who are certain that only tax cuts matter, and refuse to support the Democrats' proposal; and
   
6. President Obama, who believes that jobs and working together matter most, and pushes to get his stimulus package passed to jump-start creation of the 3 million jobs being forecast by his economic advisers, while reiterating his willingness to compromise for the sake of expediency.

That's six governmental players and six differing viewpoints, each of which may be construed as complementing the others, but together still falling short of definitively identifying the beast they are touching. In the traditional story, the six blind men do not realize that it is an elephant; and in the case of our economy, the elephant that everyone is touching but not seeing is an obvious truth that has gotten lost in the debate.

You see, the publicly spoken solution to our economic crisis--which seems like it ought to go away if only interest rates were lower, if the banks had more capital, if depositors and consumers had more confidence, if the government were to spend more to stimulate demand, if we had lower business and personal taxes, or if we could replace lost jobs--is really missing one essential ingredient. The elephant that everyone is touching but not quite comprehending (or at least not openly acknowledging) is the pressing need for a reflation of assets, home prices in particular.

In what now seems like quaint history, our economic woes began with a "minor" subprime mortgage problem in the middle of 2007. Through an unfortunate combination of regulatory leniency, misplaced incentives, financial irresponsibility and sheer Wall Street greed, a sizable number of underqualified, overleveraged borrowers began to have difficulty paying their mortgages and, as home prices fell, found themselves "upside-down" with negative equity, holding mortgages exceeding the value of their homes. Mortgage problems quickly spread to other highly leveraged borrowers as well, and over the ensuing year and a half have precipitated a downward spiral of plummeting real estate and stock prices, loan defaults and foreclosures, deteriorating bank balance sheets, abnormally tight credit markets, depressed consumer demand, a rising number of layoffs, etc.

Some wisdom may be gleaned by going further back in history to the last time our economy faced a crisis of this magnitude. As described by Irving Fisher in 1933, the basic problem we are experiencing is over-indebtedness, which leads to price deflation, which in turn makes matters only worse:

"[I]n great booms and depressions [the] two dominant factors [are] over-indebtedness to start and deflation following soon after. . . .

"Debt liquidation leads to distress selling and to . . . contraction of deposits and of their velocity . . . [which] causes . . . [a] fall in the level of prices, . . . [a] still greater fall in the net worths of businesses, precipitating bankruptcies and . . . [a] like fall in profits, which . . . leads . . . to . . . [a] reduction in output, in trade and in employment . . . to [p]essimism and loss of confidence, which in turn lead to . . . [h]oarding, . . . [all of which] cause . . . [c]omplicated disturbances in the rates of interest.

"[I]t is always economically possible to stop or prevent such a depression simply by reflating the price level [bold added] up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged."

(Irving Fisher, "The Debt-Deflation Theory of Great Depressions," Econometrica, 1933, pp. 337-357)

Indeed, it is curious that, although we all recognize our over-indebtedness and are suffering through painful dislocations because of it, no policymaker is placing front-and-center the glaring need for asset price reflation.

In addition to the Fed's policy of keeping inflation moderate, which is a long-run strategy to stabilize the rate-of-change of prices, current crisis-oriented policy must target a short-run higher absolute price level, if we are to steer ourselves out of the mess we are in. Essentially, we need to re-create wealth by reflating asset prices, as quickly as possible, up to a high enough level to make our bad debt problem go away. When the relationship between home prices and indebtedness returns to a more manageable level comparable to where it was prior to the onset of our current crisis, we will find that those underwater mortgages are not so underwater anymore, that the banks are no longer on the verge of bankruptcy, that consumer confidence and retail sales are rising again, that companies are no longer laying off workers, and that our economy is finally on the road to recovery.

Two recent news items are relevant here:

• Senator Johnny Isakson has proposed a homebuyer tax credit, approved last night by voice vote in the Senate for amendment to the stimulus package being worked out. The measure "would offer new homebuyers a tax credit of up to $15,000 or 10 percent of the purchase price of a house that could be spread over two years." This tax credit would create increased demand among homebuyers and is fairly direct way of supporting home prices. In my opinion, the legislation should be amended to offer even more stimulus to the housing market and economy, by both a) raising the upper limit on the tax credit to $50,000, and b) allowing the amount of the credit to be carried forward indefinitely and applied to taxes owed until used in full by the taxpayer.
• UCLA economics professor, Roger Farmer, proposes that "just as it sets the fed funds rate to control inflation, the Fed should set a stock market index to control unemployment." Targeting the price level of a stock market index, like the S&P 500 or even a broader index, would give the Fed a more direct handle on influencing performance of our economy. With our wealth as a society linked to the stock market, consumer psychology (which determines demand) is impacted more by a 10% drop in stock prices than by a substantial change in short-term interest rates. The Fed should continue to use all of the existing tools at its disposal--rate cuts, open-market operations and so on--and with an added mechanism for targeting for stock prices, policy objectives would become clearer and more effective, particularly in market environments like the present with standard interest rate easing already pinned to its zero percent lower limit.

I like to think that the actions of policymakers matter more than their words, but, particularly today with our global economy in crisis, vocalizing a credible plan with concrete and realizable objectives can make a difference. If Obama, Geithner, Bernanke or another official in a position of authority would openly acknowledge a policy objective of asset price reflation--the need to raise the prices of homes, other real estate and stocks--then we would at least be looking the elephant directly in the eye. Thereafter, the task of getting our stubborn economic elephant to move in the right direction would become more straightforward.

Needed: A Large Drop of Helicopter Money

During the past half year, the concerns of the Fed have shifted from worry about commodity-driven inflation (recall $147 oil in July) to its polar opposite--fear about the onset of deflation (coinciding with oil falling below $40 today). With short-term interest rates now lower than the targeted 1% rate, traditional monetary policy measures have become less potent and the U.S. economy is more susceptible to descending into a "liquidity trap." As mentioned by Ben Bernanke in a 2002 speech, one way out of such a predicament is a "helicopter drop"--effectively dropping money from helicopters to consumers and businesses below in order to thwart deflation, stimulate spending and prevent economic stagnation.

Consumer-Based Crisis

The financial crisis we are facing today first surfaced a year and a half ago as a consumer-based subprime mortgage problem that soon developed into an institutional credit crisis, morphed into a pervasive illiquidity dilemma, and earlier this week was, long after the fact, officially named an economic recession that began 12 months ago! As parallels with the Great Depression of the 1930s and Japan's stagnant economy of the 1990s grow more conspicuous, the gloomy predictions of NYU economist Nouriel Roubini loom larger and closer. We are now one year into a recession that, according to Roubini, will most likely extend at least another year. What began as a seemingly minor problem has expanded into a full-blown, global financial crisis that could very well extend into 2010, becoming the most severe economic downturn in the adult lifetime of anyone alive today--unless, of course, our policymakers take appropriate and sufficiently drastic measures to stabilize the financial system.

Bush, Bernanke and Paulson have tried to fix the problem with a whole series of measures--a moderately sized consumer stimulus package in early 2008, bailouts of financial institutions, successive rate cuts, capital infusions to strengthen bank balance sheets, an increased limit on bank deposit insurance, government backstops on portfolio asset losses, purchases of illiquid assets, etc. So far, nothing has worked as well as anyone would like, and our faltering economy and plunging real estate and stock markets continue week after week to drive each other lower, in a relentless asset deflation spiral that is dragging down even the endowments of elite institutions like Harvard. Come January 20, President-elect Obama (incidentally, a Harvard Law alumnus) and newly appointed Treasury secretary Geithner will replace Bush and Paulson, respectively, and we can only hope that the stimulus package in Obama's vision for the future of our economy will be large enough to usher in real change in a favorable direction.

As for the root cause of our economic problems, the consensus opinion among economists and laymen alike implicates overleverage, basically too much debt and too little savings, particularly among consumers. Everyone agrees that saving more would be prudent for any individual consumer facing an uncertain future, but when aggregate consumption falls our economy unfortunately enters a vicious circle, as reduced consumer demand (from saving more) leads to reduced delivery of goods and services and higher unemployment, which, in turn, reduces demand still further. To halt this vicious circle before it does further collateral damage to our fragile economy, we need to find a practicable way to provide debt relief at the consumer level--as soon as possible. This is where the helicopter money comes in.

Helicopter Money Initiative

As Bernanke pointed out in his speech, even when monetary policy by itself becomes ineffective, there are a number of alternative ways to combine monetary policy with fiscal stimulus to prevent deflation and encourage economic growth, despite being in a near-zero interest rate environment like the one we are experiencing today. These less traditional, more innovative measures are:

A. Broad-based tax cuts,
B. Increased purchases of goods and services by the government,
C. Purchase of private assets via the Treasury, and
D. Increased direct transfer of money from the government to the private sector.

President-elect Obama is already planning to provide tax cuts (measure A above) to at least 95% of Americans and some talk of reducing payroll taxes is also circulating. The large (maybe $1 trillion?) stimulus package (measure B) currently under discussion in Congress will hopefully be ready for signing by inauguration day. Purchase of private assets (measure C) is already underway in the commercial paper and mortgage-backed security markets, but practical limitations (i.e., how to price highly illiquid instruments) have prevented the proposed wide-scale purchase of toxic mortgage assets that was the main objective the initial TARP plan. Consumer stimulus packages (measure D), along the lines of the one implemented in the first half of 2008, work most directly and immediately to maintain GDP growth and, for this reason, deserve further serious consideration.

Because near-term inflation is no longer an issue, policymakers now have the luxury of taking the most aggressive actions possible to turn our economy around. With the financially stressed, heavily indebted American consumer so central to our problems, it makes sense to implement an enhanced version of measure D--this time in much larger size. Just as people suffering in the aftermath of a natural disaster need immediate and basic emergency assistance, prior to tax-related benefits and government spending to rebuild infrastructure, our severely damaged economy needs a very significant injection of helicopter money delivered directly to the overleveraged consumer.

To achieve the quickest and most direct money transfer to the consumer, here's what our government should do:

Beginning during the first half of 2009, write checks to every household filing a tax return, in the amount of, say, $10,000 per dependent (taxpayer, spouse, children, other household members), which is an order of magnitude larger than the consumer stimulus in early 2008.

Offhand, it might appear that this type of seemingly frivolous fiscal policy would be a desperate and highly wasteful use of taxpayer money that could spark a new, undesirable bubble. However, given the precarious state of our economy, such a radical measure stands a greater chance of doing more good than harm and has many benefits:

1. Immediate and Direct Impact: Helicopter money provides an immediate stimulus to consumers and businesses, directly benefiting Main Street (a refreshing change after all the prior rescue plans with trillions of dollars going to Wall Street financial institutions);

2. Reduced Consumer Leverage: Consumers will use some of the money to pay down mortgages, credit card debt, car loans, etc.;

3. Increased Consumption: Consumers will use some of the money to do what consumers do best, i.e., buy products and services, which will immediately boost sales of businesses large and small, preventing further job destruction;

4. Market Support: Some of the money will be invested in the stock and real estate markets, relieving downward pressure on asset prices and helping to create the market bottom that is so badly needed to build consumer and investor confidence and turn our economy around;

5. Global Economic Growth: Reduced consumer leverage, increased consumption and increased investment will all boost the U.S. economy, which in turn will help revive the global economy.

With the U.S. population at about 300 million, this new consumer stimulus package of $10,000 per person would total $3 trillion, which is about four times the $700 billion TARP package but less than half of the approximately $8 trillion in cumulative funds the government has already committed through all of the various measures announced. The net effect of this helicopter money plan would be to shift up to $3 trillion of debt from the consumer to the government. This would reduce leverage at the consumer level and boost aggregate demand to stave off a deflationary spiral.

As Professor Roubini points out in this interview, the basic structural problem we face is a global supply glut cannot immediately be reduced even though demand has fallen. Therefore, at least in the short run, the severity of the current crisis justifies "pulling out all stops" to create the demand necessary to meet existing supply. A large helicopter drop appears to be exactly what is needed to stabilize our economy and sidestep the negative impact that further deterioration in employment and the housing and stock markets will otherwise bring.

Hedging Is Simple, But Market Timing Is Not

What follows is some perspective on the buzz we're hearing about portfolio and fund manager performance in this horrendously painful bear-market year, which most investors would love to forget about--if only they could.

While Miller Missteps (Again) . . .

Recall that around this time in 2005, Bill Miller was being hailed as the most successful fund manager of all time, with his Legg Mason Value Trust Fund outperforming the S&P 500 for a record-breaking 15th straight year. Then, in 2006, Value Trust underperformed for the first time since 1990, returning just 6% versus the S&P 500's double-digit 16%. Last year, in 2007, Miller again underperformed, this time -7% (i.e., a loss) for Value Trust versus a 5% gain for the S&P 500. In 2008, as of last Friday, Nov. 14, Value Trust is down a whopping 50%, versus a 40% decline for the S&P 500, making it quite likely that Miller will underperform once again--for the third straight year.

In his third-quarter commentary published last week (Nov. 12), Miller discusses flaws in the government's delayed ("too late") response to the financial crisis, while also admitting,

"I have made enough mistakes in this market of my own, chief among them was recognizing how disastrous [government] policies being followed were, yet not taking maximum defensive measures [italics mine], believing that the policies would be reversed or at least followed by sensible ones before things got completely out of control."

Miller is alluding here to his failure to implement an appropriate hedging strategy to protect his fund against the precipitous collapse of the market during the past couple of months. With 20/20 hindsight, of course, it is easy to say that he (or anyone long the market) should have either sold their equity holdings, shorted S&P 500 futures, or bought puts to protect the downside.

. . . Hussman Hedges

While most equity fund managers, like Miller, are suffering complete and unforgiving drubbings this year, one fund manager is making news due to his notable outperformance in this year's most disastrous market in decades. John Hussman's Strategic Growth Fund (HSGFX) is running only slightly negative year-to-date through Oct. 31, which sure beats the 40% or larger decline most fund managers are experiencing. Of course, Hussman's stand-alone performance begs the question, what's his secret formula?

Though academic credentials do not necessarily or even typically help one become a better investor, perhaps at least it is no detriment to his performance that Hussman holds a Stanford economics Ph.D. and is a former finance professor at the University of Michigan. His investment strategy, as described on his website and in his fund's prospectus, seems to be a rational approach firmly grounded in interpreting historical data, utilizing "observable evidence" (sounds scientific . . .) in an attempt to distinguish between favorable and unfavorable "market climates" (weather forecasting analogy?), taking into account both "market action" (an allusion to physics or sports?) and valuation (yeah, he has a value-investing approach, similar in some respects to Buffett and Grantham).

To date, Hussman's differentiator has been his hedging. What really distinguishes his investment style from that other fund managers is his ongoing implementation of partial or full hedging of his underlying long-equity portfolio, even though he could potentially become fully invested or even leverage up beyond full exposure if market conditions ever call for it:

"In conditions which the investment manager identifies as involving high risk and low expected return, the Fund's portfolio will be hedged by using stock index futures, options on stock indices or options on individual securities. . . . The Fund will typically be fully invested or leveraged when the investment manager identifies conditions in which stocks have historically been rewarding investments."

In Hussman's framework, although market action remains unfavorable, the market's recent decline has shifted valuation from unfavorable to more favorable, leading him to begin transitioning his portfolio from being fully hedged (underlying stock positions essentially 100% protected by put-call combinations as of a few months ago) to taking on moderate market exposure (now 70% to 80% protected). Currently, Hussman views any near-term market declines as opportunities to strip away a few more layers of protection and increase market exposure, since stocks have become "both undervalued and oversold."

Because Hussman varies the amount of his protection (or exposure) to market moves in accordance with market conditions, he is, in my opinion, attempting at least partially to "time" the market, even though he insists that he is not pursuing "market timing" in the usual sense of the term. In his own words from a recent weekly commentary:

"The Strategic Growth Fund is not a 'market timing' fund. Nor is it a 'bear' fund or a 'market neutral' fund. Strategic Growth is a risk-managed growth fund that is intended to accept exposure to U.S. stocks over the full market cycle, but with smaller periodic losses than a passive buy-and-hold approach. We gradually scale our investment exposure in proportion to the average return/risk profile that stocks have provided under similar conditions (primarily defined by valuation and market action). We make no attempt to track short-term market fluctuations. We leave 'buy signals' and attempts to forecast short-term market direction to other investors, preferring to align our investment positions with the prevailing evidence about the Market Climate."

Hedging Versus Market Timing

To understand the impact of hedging on Hussman's longer-term performance, we can look at his fund's returns, which he conveniently discloses both before and after hedging.

Since its inception in 2000, Hussman's Strategic Growth Fund has carved out a winning track record, as evidenced by the stellar performance chart displayed prominently on Hussman's website. For the eight-year period, while the S&P 500 has lost 1.04% annually, Hussman's unhedged portfolio has gained 6.37% annually, and his Strategic Growth Fund has returned 10.76% annually. These results indicate that Hussman's stock-picking ability (or is it luck?--more on this topic below) has boosted his annual return to some 741 b.p. above the S&P 500, while his hedging has apparently added another 439 b.p. to his annual performance. This is a very solid track record over the past eight years, particularly in light of the two bear markets fund managers have had to endure, both in 2000-2002 and beginning from the last quarter of 2007.

Before jumping to conclusions about Hussman's apparent analytical genius or market clairvoyance in largely avoiding both bear markets, let's take a closer look at the data--his data--posted here on his website for the casual (or better, not so casual) perusal by anyone interested. Taking the 33 quarters of data from the third quarter of 2000 through the third quarter of 2008, we can make a scatter plot of his unhedged and realized fund performance versus the S&P 500, as shown in the chart below.

If Hussman's realized fund performance points (in pink) on the chart seem to sketch out a typical, albeit somewhat noisy, hockey-stick-shaped option payoff diagram, this graphical result should come as no surprise, since, after all, the basic purpose of Hussman's hedging is to protect his portfolio against market declines, while allowing participation in market upside potential.

Let's take our analysis of Hussman's performance a step further. In the chart above, observe that the pink points sit above the blue points on the left half, while the reverse is true--pink below blue--on the right half. To understand this behavior, we need to distinguish between hedging and market timing:

• Hedging: The underlying unhedged position is Hussman's long-equity exposure to his chosen portfolio of stocks. If he were always (i.e., without attempting to time the market) simply to buy put options with at-the-money or slightly out-of-the-money strikes to protect his portfolio against market downside, the puts would show a profit when the market declines but would expire worthless when the market rises. The result would be an insurance-like payoff pattern from the hedge--protection against loss in a declining market, but with a cost relative to the unhedged position particularly evident when the market rises.
• Market Timing: On the other hand, if Hussman were attempting to time the market and successful in doing so, presumably by selectively hedging to protect against downside under risky market conditions but operating without a hedge when prevailing conditions are less risky, the data ought to show not only realized fund performance above the unhedged case (pink above blue in the chart) when the market declines, but also at least an occasional occurrence of this type of outperformance of his fund over the unhedged case when the market rises.

By inspection of the data, we can see that for the 14 quarters when the S&P 500 fell about 2% or more, Hussman's realized fund performance always exceeded the S&P 500, indicating that, to date, he has always succeeded in avoiding any sizable market loss. However, there is also a flipside to this flawless track record in falling markets, namely, in the 13 quarters when the S&P 500 rose about 2% or more, Hussman has never outperformed the market. In fact, the negative correlation between the S&P 500 and Hussmans's hedge (being just the difference between his realized fund return and his unhedged return) is a strikingly large -0.96.

What this all indicates is that Hussman's performance is basically consistent with that of someone who makes a practice of always hedging with put options, regardless of market conditions. By and large, it is not what we should expect to see from a portfolio manager implementing a market timing strategy, even though Hussman does at least occasionally remove some portion of his hedge to reduce cost when he believes that risk is low and the chance of a market rise is high.

Skill Versus Luck

The above classification of Hussman as a hedger and not a market timer is in agreement with the often-stated warning to investors and traders that market timing is difficult, if not impossible, and should be attempted only with extreme caution by anyone with risk aversion. In a Tech Ticker interview last week on the topic of skill versus luck in stock-picking and market timing, Professor Kenneth French (whose name figures prominently alongside Fama's in finance theory) states:

"There this a whole academic literature trying to figure out who won because of luck and who won because they truly had skill. We don't know how to do it. I mean there's a little bit of evidence that we can distinguish luck from skill, but, in essence, it's absolutely futile.

"So, when I have a mediocre M.B.A. student who spent the weekend studying Morningstar and is convinced he knows how to pick the winning fund, what I challenge him with is sort of, 'Geez, you know, it's good that you didn't even need to bother to get a Ph.D. and spend the last 30 years of your life solving this problem. You know, those of us who did that, we don't know how to do it. But, congratulations. That was a really productive weekend!'

". . . To basically try to distinguish skill from luck . . . [is] almost impossible. . . . What I'm saying is, I can't tell . . . one from the other. . . . If I can't tell good from bad, why play the game?"

Surely, coming from an accomplished expert in finance, this type of statement is enough to throw into question anyone's claim of having ability to pick stocks and time the market to achieve excess returns in a consistent fashion.

What this means is that we, the investing public, should not read too much into the performance of successful fund managers, however superb their performance may have been (in Miller's case) or appear to be (in Hussman's case). Both Hussman and Miller have certainly assembled relatively long track records as ostensibly excellent stock-pickers, but, as history has shown, anything is possible. If Miller's 15-year winning streak can suddenly undergo a complete metamorphosis into a 3-year (or longer?) losing streak, and if Hussman's track record is solid but exhibits inherent underperformance in rising markets as consistently as it displays outperformance in falling markets, we can only suspect that unquestionable evidence of skill, as opposed to luck, in investing has become that much harder to find.

Although anyone actively managing a stock portfolio may hate to admit it, Professor French is most likely right--unfortunately, in the world of investing, we will probably never really be able to tell if our own or anyone else's performance stems primarily from luck or, as many may want to believe, from having a discernible edge over other investors who are only almost-as-skilled as ourselves.

The Next Boom Will Come

The global economy is in the doldrums. Collapsing housing prices and ensuing foreclosures have brought both borrowers and lenders to their knees, frozen credit markets, depressed stock prices, softened consumer demand, forced oil, metal (even gold) and other commodity prices lower, and now dragged down the commercial real estate market as well. The Bush and Paulson $700 billion financial rescue plan has morphed from an impracticable illiquid-asset buyback plan to shore up bank balance sheets into an across-the-board equity infusion scheme and sadly, along its porky way, lost focus, impact and credibility. Cynics question what benefit Bernanke's many years of academic study of the Great Depression have brought him, or anyone else, for that matter. Respected business figures (for example, Soros and Dimon) warn of a deepening recession in 2009, possibly even a depression.

Given the dour outlook of economic experts and pervasive pessimism of the investing public, it's hard to be optimistic--but I am. I'm confident that better times and a stronger economy lie ahead of us. Really, a brighter future is all but inevitable. Yes, I repeat, just as day follows night, we will see better times. Let me explain the root of my optimism.

Generally speaking, two basic schools of economic thought have been most influential over the past 75 years--Keynesians (including neo-Keynesians), who advocate fiscal measures such as an increase in government spending to stimulate a sluggish economy, and higher taxes to cool an overheated inflationary economy; and monetarists (led by Friedman's Chicago school), who believe that what's more important is controlling the money supply, primarily through buying and selling government bonds in the open market and raising and lowering the discount rate. Both schools of economic thought unabashedly lay claim to real-world successes of their models--Keynesians take credit for lifting the economy back onto its feet through FDR's New Deal spending following the Great Depression in the 1930s, and monetarists boast of steady and prolonged economic growth in the 1980s (Reagan years) and 1990s--despite the many recessions we have seen, including those in recent decades: 1980 (7 months), 1981-1982 (17 months), 1991-1992 (8 months), 2001-2002 (12 months), and presumably 2008-2009.

While these two mainstream schools of economic thought certainly have their differences, they also share an important commonality--both rely heavily on government intervention to control or at least influence economic growth. President Bush's consumer-targeted economic stimulus package during the early days of the current financial crisis and the new stimulus package that President-elect Obama stressed as a high-priority item in his first press conference a week ago are examples of Keynesian policy in action. The Fed's continual "busy-body" adjustment of the discount rate--Greenspan's lowering of the rate to 1% in 2003 during the last recession precipitated by the dot-com bubble, and raising it back up to the 5% range by the time of his retirement in 2006, and Bernanke's pushing the discount rate all the way back down again to 1% last month, while hinting at more rate cuts to follow--are examples of attempts to steer the economy using monetary policy.

In sharp contrast to these two mainstream schools are those who argue that both the Keynesians and monetarists are wrong-headed. For example, the Austrian school, based on the thinking of Mises and Hayek, explain how government intervention is not the solution. Stating that fiscal and monetary policy fail to produce their intended impact, these economists insist that, instead of smoothing the vagaries of the business cycle, government intervention actually causes the booms and busts, through over-extension and over-contraction of credit at artificial prices via the highly government-regulated fractional-reserve banking system. Quite contrary to active intervention, the Austrian school recommends following a laissez-faire "do nothing" approach, theorizing that this is the only way to cure permanently our economic woes. For a coherent exposition of the Austrian school's position, see Murray Rothbard's 1969 essay, "Economic Depressions: Their Cause and Cure," here.

Which economic school is right? Well, first off, practically speaking, it would be grossly out of character and, in fact, outright political suicide for any president--whether lame-duck Bush, or our country's new icon of hope, "renegade" Obama--to tell us American citizens that, after serious dialog and lengthy reflection, the elected officials and their appointed experts have decided that a "do nothing" policy is best. With home foreclosures at historical highs and rising, and growing worries over burdensome credit card balances, auto loans and other consumer debt, the popular approval ratings of even the most charismatic of political leaders would undoubtedly suffer greatly if all their economic advisory team could come up with is to a "do nothing" strategy for tackling the current economic crisis. No, simply put, Americans are by nature more active doers than thinkers, and doing nothing never has been and probably never will be an acceptable alternative for managing our economy.

So, much to the chagrin of Austrian school economists, we must conclude that government intervention, whether effective or not, will continue when Obama and later presidents take office. Given this inevitability that politicians and their mainstream economic advisers will always be inclined to fiddle with the economy, here's the logic of what to expect:

• If the sketchy long-run track record (performing like a "B" student, with 13 out of the 115 quarters beginning in 1980 showing negative real GDP growth, according to BEA data) of the Keynesians and monetarists is any indication, we should see at least some degree of over-shooting in the future, perhaps this time manifested by a delayed but sudden response of our economy to excessive fiscal stimulus or overly loose monetary policy, resulting in either consumer price inflation or yet another asset bubble. (On the other hand, if by chance (or fluke?) policymakers have learned from the last boom-bust cycle and this time around manage to get the economic fine-tuning exactly right, they will have realized the heroic feat of taming the recalcitrant business cycle, macroeconomic volatility will cease, and we will all live, at least economically, happily ever after. . . . but I would tend to believe other fairy tales before placing undue faith in this one, wouldn't you?)
• If the Austrian school is correct in their critical analysis of the shortcomings of Keynesian and monetary policy, the current credit-driven bust will inevitably be followed by a boom, and the more our government intervenes to try to fix the problem, the higher the crest and deeper the trough we will see during the next boom-bust cycle.

In other words, however we dissect our economic situation, the business cycle remains alive and well. Both empirically and theoretically, we can be sure that economic booms and busts will continue. Admittedly, the precise timing is anyone's guess but, following the current, painful de-leveraging and retrenchment of credit in our financial system, at some point in the future, credit creation will again be in vogue, creating over-expansion of credit in some asset class, and soon enough spilling over into other asset classes. Yes, however unlikely it may now appear to be (case in point: was anyone predicting a collapse in oil prices to today's $58 per barrel when it soared above $140 as recently as July?), one day we will experience yet another bubble. Seeing how the collective memory of market participants tends to be selective and short, I wouldn't be surprised if such a rebound happens earlier and quicker than any respected market commentator would now dare to predict.

Suffice it to say, for anyone distraught by the current bust, please have patience: the next boom will com--maybe even sooner than you or anyone now thinks.

Older Bulls Wiser than Younger Bears? Maybe

Old bulls versus younger bears. This could be entirely coincidental. Has anyone noticed that bullish sentiment seems correlated with age?

Bullish and Buying

The most prominent U.S. stock market bull to surface in recent days is highly respected Mr. Buffett, who was born in 1930 and grew up during the Great Depression years. If as a child he was too young to comprehend the hard times and economic turmoil of the era, we can at least presume that, in his early adult years as a student of Ben Graham, Buffett absorbed the first-hand lessons garnered by his teacher, who had lost everything during the stock market crash of 1929, which apparently was the life-changing event that led Graham to formulate his well-known value-investing methodology. Quoting from Buffett's op-ed piece in the New York Times:

Warren Buffett (age 78): October 16, 2008. "Buy American. I am."
"The financial world is a mess, both in the United States and abroad. So . . . I’ve been buying American stocks. . . . I previously owned nothing but United States government bonds. If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities."

Also notable is so-called "perma-bear" Grantham, whose switchover into the bullish camp can be considered significant, since he spent the past couple of decades marauding with the bears:

Jeremy Grantham (age 69): October 18, 2008. "Silver Linings and Lessons Learned"
We "have moderately cheap U.S. and global equities for the first time in 20 years. . . . We at GMO [Grantham's investment management company] are already careful buyers. We are reconciled to buying too soon, but we recognize that our fair value estimate of 975 on the S&P 500 is, from historical precedent, likely to overrun on the downside by 20% to 40%, giving a range of 585 to 780 on the s&P as a probable low."

I am not sure how much weight Glickenhaus's opinion carries today in the investor community, but he is said to be the lone voice who boldly spoke out when stocks fell 23% on Black Monday in 1987, confidently calling a market bottom and the start of the next bull market. FOX Business has interviewed Glickenhaus twice during the past few weeks, highlighting the relevance of his experience of having lived through the stock market crash of 1929 and seen how the government's actions (or inaction) impacted the severity of the Great Depression:

Seth Glickenhaus (age 94): October 27, 2008. "On the Verge of a New Bull Market. . . "
"We are making a painful but meaningful low. . . . This is a rare opportunity to buy stocks at substantially below their intrinsic values. . . . We are on the verge of a new bull market beginning within a week or two. . . ."
(Note: On October 15, 2008, on Neil Cavuto's show on FOX Business, Glickenhaus indicated that a new bull market would start "next week." That day, the S&P 500 closed at 908. Today, a week and a half later, the S&P 500 closed at 849, a fresh, new five-and-a-half-year low.)

Bearish and Avoiding Stocks

As might be expected, so-called "Dr. Doom," Marc Faber, sees the U.S. and world mired in a serious recession that will last a few years. However, he also sees potential for a near-term rally within the longer-term bear market:

Marc Faber (age about 60?): October 20, 2008. "Stocks May Rally, Won't Reach Records"
"We're extremely oversold at the present time. The market is in a position to rebound." However, Faber holds only a small equity position: "stocks make up 7 or 8 percent of his holdings, with cash, bonds and gold, his biggest position, accounting for the rest." Also, his opinion on the U.S. economy remains gloomy: "To rebuild economic health in the United States, you need a serious recession that will last several years. The patient that got drunk on credit growth needs to go into rehabilitation. To give him more alcohol, the way the Fed and the Treasury propose to do, is the wrong medicine."

Next, here's the opinion of a firmly committed, unwavering bear, who is calling for a significantly lower bottom:

Gary Shilling (age in 60s): October 22, 2008. "We Haven't Seen the Worst Yet"
"The economy hasn't hit bottom yet. Neither, in all likelihood, have stocks. . . . If you're an equity investor with a long-only portfolio, it's not too late to take some money off the table. Remember 777--not the airliner but the low that the Standard & Poor's 500 hit in 2002. That's 21% beneath where we are today, but if it's breached, then all the stock rise of the last six years will have been but a bear market rally, and the bear market that started in March 2000 will still be with us."

Finally, representative of the diversity of opinion, here's a market commentator who is one of the few courageous enough to state publicly that Buffett is, whether we like it or not, just plain wrong this time around:

Diane Francis (age in 40s): October 27, 2008. "Buffett Is Wrong: Avoid Stocks"
"Far be it from me to contradict one of the world's greatest stock sages and business analysts. But I will. Seems to me that we are in uncharted territory with this panic until the U.S. election is staged on November 4 and until the global community demonstrates that it is going to appoint sheriffs to patrol the global economy and stop the kind of jurisdictional arbitrage that led to the casino-ization of banking. . . . For me, buying and selling should not be an option at least until the U.S. election and probably until January 2009."

Does Age Matter?

Admittedly, based on a sample size of just three opinions from each camp, we have at hand little more than anecdotal evidence and, consequently, cannot draw any conclusion that comes even close to being statistically significant. However, with the bull opinions coming from investors in approximately the 70-to-90 age group, versus the bear opinions from a younger cohort in the 40-to-60 age group, I suspect that investor age might be an indicator of stock market sentiment.

One interpretation is that the older generation, having closer first-hand experience with the crash of 1929 and economic hard times during the 1930s, have a deeper appreciation for today's unprecedented government efforts to stem the current financial crisis before it reaches depression-era proportions. If the bulls end up being correct, we will in a few years' time look back upon today and have to acknowledge that the older seers professed a certain "market wisdom" that the less experienced, younger generation lacked. On the other hand, if the bears win the battle and the actual market bottom turns out to be much lower, I can already almost hear the youthful crowd "writing off" the elderly bulls as having "gone senile," being "out to pasture," or at least being "out of touch" with these ever so "modern" times of ours.

For the sake of global economic stability, I certainly hope the old bulls really are the wiser. However, on days like today, with the market closing at a new low, we have to fear that the younger bears could be right in the short run.

Potential secret weapon to battle our financial crisis: A trillion dollar debt-to-equity swap

While heavily indebted American consumers struggle to make mortgage and credit card payments, a larger shift is underway. News from Tokyo indicates that politicians in Japan, America's "friendly" creditor nation, are beginning to consider investing the country's massive horde of foreign reserves, to "take advantage of the opportunities opening up around the world" during this global financial crisis we are in.

The largest foreign exchange reserves are held by China with $1.9 trillion and Japan with $1.0 trillion, followed by Eurozone countries and Russia, each with about $550 billion. Almost all of these largely U.S. dollar-denominated reserves are invested in conservative fixed-income instruments like U.S. Treasury bonds. However, as noted already in a 2005 article by Andrew Rozonov, who first used the term "sovereign wealth fund," the practical distinction between foreign exchange reserves and their more equity-like sovereign wealth fund counterpart has begun to blur.

In the earlier part of the subprime crisis, we saw high-profile investing of $21 billion by sovereign wealth funds (Singapore, Kuwait and South Korea) into U.S. financial institutions (Citi and Merrill). This week's closing of Mitsubishi UFJ's $9 billion capital infusion into Morgan Stanley is a private sector version of the same type of foreign investment. Given the, not billion, but trillion dollar scale of the foreign exchange reserves that China and Japan have amassed, any decision on their part to swap even a small portion of their fixed-income funds into equity-like investments will have a tremendous impact on the U.S. equity market.

Ponder this: The investments last January by smaller sovereign wealth funds in U.S. financial institutions helped to boost capital, but nevertheless Merrill is now being acquired by Bank of America and Citi's balance sheet is still under pressure. The U.S. government coordinated JPMorgan's acquisition of faltering Bear Stearns in March, but that did not prevent Lehman from going bankrupt in September. After an unprecedented $85 billion government lifeline to AIG last month, AIG needed another $38 billion just last week. Also, despite heightened government intervention in recent weeks--Paulson's $700 billion bank rescue plan signed into law on October 3, coordinated global rate cuts by many G-7 members and other countries last week, and the government's "no objections allowed" infusion of $125 billion capital into JPMorgan, Bank of America, Citi, Wells Fargo, Goldman, Morgan Stanley and other financial institutions announced on Monday--the economic outlook grows bleaker, people worry more about their jobs and retirement and cut back on consumption, and the stock market resumes its downward spiral while real estate prices sag further.

In short, each and every policy measure to date, however unprecedented and seemingly "radical" at implementation, has failed to stem the economic bleeding.

So, where do we turn at this juncture? Well, recall the proverbial "rich uncle," who is perennially forthcoming with money gifts when you are a kid, lends you the extra money you need for a down payment when buying your first house, and provides half the capital you need to start a new business. As our financial crisis runs its course, we Americans as owners of over-leveraged assets in our increasingly distressed U.S. economy really have only one place to go for the capital we so badly need. Because there is not enough capital internally within our national borders, the much-needed equity capital to stabilize our economy and restore confidence of consumers and among financial institutions must come from abroad.

Like it or not, for equity capital rather than just debt, American financial institutions, large corporations and our U.S. equity markets as a whole need to tap into the trillions of dollars of foreign exchange reserves on the books of governments throughout the world, and particularly the trillion dollar balances of each of China and Japan. Back in March, the House held a hearing on the role of foreign government investment in the U.S. economy and financial sector. More along these lines is needed.

My guess is that our equity markets will not find a firm bottom until cross-border government-level deals are struck to convert from debt to equity significant portions of the U.S. dollar-denominated foreign exchange reserves sitting overseas in Asia. How about a trillion dollar swap out of Treasuries and into a broad-based equity index like the S&P 500?

A substantial increase in foreign ownership of the American economy is probably a lot closer than we think.

Irony of Capitalism in Crisis: The rich lose more, but the poor and middle class suffer . . . and we need more government intervention, not less.

With credit tight and real estate and stocks at multi-year lows, who wins and who loses? Certainly, any trader short the market or long put options is making out like a bandit, while anyone long real estate and stocks is experiencing painful net worth erosion.

But, in the midst of the financial turmoil we're in, how's the "average American" faring? For insight, let's first have a look at household balance sheets.

Household Balance Sheets

According to the Fed's triennial Survey on Consumer Finances (using 2004 data--results of the 2007 survey come out in early 2009), assets owned and debt held by 10% or more of all American families, along with the median dollar value of holdings among the specified percentage of families holding the particular asset or debt, are:

Financial assets:

• Checking or other transactional account: 91% of families, $4k
• CDs: 13% of families, $15k
• Savings bonds: 18% of families, $1k
• Stocks: 21% of families, $15k
• Mutual funds and other pooled assets: 15% of families, $40k
• Retirement accounts: 50% of families, $35k
• Life insurance products with cash value: 24% of families, $6k

Nonfinancial assets:

• Car or other vehicle: 86% of families, $14k
• Primary residence: 69% of families, $160k
• Other residential property: 13% of families, $100k
• Business equity: 12% of families, $100k

Debt:

• Mortgage on primary residence: 48% of families, $95k
• Car loan or other installment loan: 46% of families, $12k
• Credit card balance: 46% of families, $2k

Clearly (and this should come as no surprise, particularly in light of the mortgage-related crisis we are in), the most significant asset owned by most American families is our primary residences, against which we carry sizable mortgages.

The Poor, the Middle Class and the Rich

The landscape gets more interesting when we probe one layer deeper, to see who owns what and against how much debt. Taking a look at three distinct groups classified by net worth (again in 2004 dollars), we can list assets and debt commonly held by 40% or more of the households in each group:

The Poor (below 25th percentile): $2k median net worth

Assets:

• 75% have checking accounts with median value $1k
• 70% own car(s) with median value $6k

Debt:

• 48% have car loans or other installment loans with median value $11k
• 40% carry credit card balances with median value $2k

Typical leverage: Debt/assets = 0.8 (estimated based on net worth)

The Middle Class (50th to 75th percentile): $171k median net worth

Assets:

• 98% have checking accounts with median value $6k
• 62% have retirement accounts with median value $34k
• 92% own car(s) with median value $17k
• 93% own their primary residence having median value $159k

Debt:

• 66% carry a mortgage on their home with median value $97k (60% implied loan-to-value)
• 49% have car loans or other installment loans with median value $13k
• 53% carry credit card balances with median value $3k

Typical leverage: Debt/assets = 0.4 (estimated based on net worth)

The Rich (above 90th percentile): $1.43 million median net worth

Assets:

• 100% have checking accounts with median value $43k
• 63% own stocks with median value $110k
• 47% own mutual funds with median value $160k
• 83% have retirement accounts with median value $264k
• 44% own cash value life insurance products with median value $20k
  
• 93% own car(s) with median value $31k
• 97% own their primary residence having median value $450k
• 46% own other residential property with median value $325k
• 41% own business equity with median value $527k

Debt:

• 58% carry a mortgage on their home with median value $186k (40% implied loan-to-value)

Typical leverage: Debt/assets = 0.1 (estimated based on net worth)

On the asset side of the household balance sheet, the picture that emerges is pretty much as expected: the rich own everything that the poor and middle class do, and have more of everything, item by item. The typical middle class household owns a checking account, car, house and retirement account. By comparison, rich households own what their middle class brethren do, plus a long list of investment assets: stocks, mutual funds or hedge funds, insurance annuities, second homes or investment real estate, and private businesses. At the other extreme, the majority of poor households have only a checking account and a car.

The situation flips, however, when we look at the liability side of the balance sheet: although the rich have higher absolute dollar amounts of debt, their debt-to-assets ratio is the smallest among the three groups. Borrowing is most prevalent among the middle class, where two-thirds of the households have mortgages on their homes, half have car loans, and half carry balances on their credit cards, resulting in typical household leverage of about 0.4. Among the poor, slightly fewer than half have car loans and about four out of ten households have credit card debt. However, it is actually the poor who are most overburdened by debt, with a high debt-to-assets ratio of about 0.8. This trend of the "asset-poor" being the most "debt-rich" can easily be seen by looking at the fraction of car owners in each group who have car loans and other installment debt: the poor (48%/70% = 0.7), the middle class (49%/92% = 0.5), the rich (27%/93% = 0.3).

Weathering the Financial Storm

Who fares best: the over-leveraged poor, the debt-laden middle class, or the asset-endowed rich?

As real estate and stock prices fall, here's how each group is affected:

• The poor, who do not typically own real estate, stock or mutual funds, are not immediately affected by falling markets. However, a small yet significant subset (12% in 2004, presumably higher today) of these households in the lowest quartile of net worth are homeowners carrying mortgages and, being the most highly leveraged group, are undoubtedly the most adversely impacted by depressed home prices. Further, having little to no savings, this group is the first to fall behind in loan and credit card payments when job losses escalate as the economic downturn runs its course.
• The middle class comprises the bulk of homeowners with substantial mortgages who are feeling the brunt of the fall of the housing market. These households also have retirement accounts with stock and mutual fund positions that shrink as stock prices slide. In the event of a job loss, most of these families can cover their bills for at least a few months by relying on their savings and, if needed, early withdrawals from their IRAs and 401ks. But, if the downturn lengthens and unemployment rises further, many of these households will unfortunately suffer through home foreclosures and the like.
• The rich experience the fewest financial dislocations, despite the fact that their vast holdings of stocks and real estate are immediately impacted when prices fall, putting downward pressure on the equity in their private businesses as well. Although rich households lose the most money in absolute terms when prices fall, their minimal household leverage (debt-to-assets ratio of just 0.1) makes true financial hardship a foreign concept to most in this group. Because very few of the rich have large mortgages on their homes (and even if they do, they usually have liquid assets they can sell off to reduce leverage), foreclosures among this group will be almost unheard of, however severe the economic downturn becomes.

Policy Implication

The recent chain of events is becoming all too familiar: real estate and stock markets fall, investor sentiment (i.e., among the rich) turns negative, headlines carry news of our ensuing financial crisis, smaller investors (i.e., the middle class) either sell out or hesitate to buy, consumers (all groups) spend less on goods and services, businesses earn less, the economy stalls, layoffs begin, sentiment worsens, and market prices fall further, bringing us full cycle--but at a lower level.

If this downward spiral continues, the over-leveraged poor lose their jobs, cars and homes (through foreclosure if they own them, or eviction if they are renters); the debt-laden middle class exhaust their savings and deplete their dwindling retirement accounts trying to stave off foreclosure of their homes (but many lose their homes anyway); and the asset-endowed rich watch their asset values plunge but keep their homes and still own America. While an extended economic recession is definitely not desirable for any group, note that:

Economic pain and suffering is inversely proportional to wealth: the poor suffer the most, the middle class are next, and the rich, well, they become a little less rich.

The public policy implication should be clear: at this point, whatever can be done to stabilize the markets should be done. President Bush distributed cash to families last year through his fiscal stimulus package, which helped the consumer and temporarily kept the economy afloat. The recent moves of the Fed, FDIC and government--in rescuing Bear Stearns and AIG, saving Fannie Mae and Freddie Mac, coordinating orderly takeovers of WaMu and Wachovia, increasing deposit insurance levels from $100k to $250k, preparing to buy $700 billion of "toxic" mortgage-related assets from the banks, and buying commercial paper in the markets today--have all helped.

But, one problem remains: we're not yet on solid ground.

Australia cut rates this morning by 100 b.p., twice as much as anticipated. Pimco's Bill Gross is right to push the Fed for a similar massive rate cut later this month. A coordinated global rate cut is also in order.

For any advocates of laissez faire capitalism, this "visible hand" of persistent government intervention in the markets must be appalling, particularly following the apparent successes of American-style capitalism over Cold War communism during the past few decades. However, we are now in a "leveraged asset" crisis and the only way to stop the bleeding is do what it takes to stabilize asset prices, and the only entity capable of acting on a large enough scale to make a difference is the government.

From Economics 101, we know that the four factors of production are innovation, labor, physical resources and money. Despite this financial crisis we're in, America and the world still have plenty of entrepreneurial ideas, people willing and able to work, and all the (arguably diminishing) natural resources we always have had. What is lacking is capital, and at this point only the government has deep enough pockets to keep the money flowing.

With the U.S. government stepping in so often in recent months and taking ownership (or warrants) in our prime financial institutions, it may be surprising to many that America is involuntarily slipping through some convoluted "looking glass" into a society with increasing government ownership of businesses, where the state, by default, has become the largest market participant.

Such is the irony of modern capitalism, with more government intervention, not less, being needed to keep the ship above water as the economic tide sloshes all around us--poor, middle class and rich alike.

How to play this crisis--Do nothing?

What should an investor do after a day like Monday, when the Dow, S&P, and Nasdaq all plummeted about 8% following Congress's "no" vote on the $700 billion bailout plan? Some say: "I wouldn't recommend anyone sell after a day like Monday but wouldn't be in a rush to buy stocks either." (See article by Aaron Task and Henry Blodget at Tech Ticker)

So, neither sell (if you own stocks), nor buy (if you have cash to buy). In other words, do nothing.

Does this make sense?

Think about the various market views one might have:

Bullish: If you "know" for sure that the stock market will rise from here, obviously you should be invested 100% in stocks, and presumably you would recommend that others buy stocks too (since "knock-on" effects help to fulfill your prophesy);

Bearish: Similarly, if you "know" the market will fall, you'll want to be sidelined, holding all cash and no stocks, and you would recommend that others (at least anyone you care about) sell out too to avoid additional losses;

Neutral: Or, if you just happen to "know" that the market will trade in a tight band, essentially unchanged, you would tell others that it really doesn't matter what they do, since holding stock in your portfolio or not will land you at the same place as cash if the market doesn't move.

In this context, the recommendation to "do nothing" appears to be an implicit statement that the stock market will trade sideways, meaning that, whether you currently hold stocks or hold cash, making no changes to your portfolio (i.e., neither buying nor selling) will not leave you at any disadvantage relative to someone who takes action and switches strategy.

A glance over at Intrade for a popular prediction about where the stock market is headed shows a 50% chance that at year-end (close of trading in December) the Dow will be at or above 11,000, in the opinion of those willing to wager bets on their views. Seeing that the Dow is now (1:55 p.m., New York time, Tuesday, September 30) at 10,700, the benchmark level of 11,000 on December 31 is essentially unchanged from today.

With the financial media being what it is, this match between Tech Ticker and consensus opinion should be no surprise. . . .

However, I also note that anyone holding cash who chose not to deploy it after yesterday's fall is missing today's rally, which appears to be strengthening as I write. At least so far today, the right decision has been to be 100% long this market. So much for doing nothing . . . unless you are already fully invested.

Will we ever get out of this financial mess we're in?

I look out my office window and see a suburban scene pretty much as usual--a few parked cars, an occasional pedestrian, a tree-lined street, a bird flies by. . . . Yet the headlines say we are in the midst of the worst financial crisis since the Great Depression. Fannie Mae and Freddie Mac are bailed out by the government, Bear Stearns is forced into a government-orchestrated sale to JPMorgan, Lehman goes bankrupt, Merrill is getting bought out by B of A, AIG is fighting to avoid becoming 80% government-owned, Morgan Stanley takes a 10% to 20% investment from Mitsubishi UFJ, WaMu will likely get bought out, Citi is surviving but staggers like a wounded elephant with arrows in its back. . . . And many pundits say we have not yet reached the bottom.

What's the root cause of this financial mess? Some point to the falling housing market, particularly in California and Florida, where millions of homeowners are struggling and many thousands are defaulting on their monthly mortgage payments. Others say it's debt in general, not just mortgages but also car loans, credit cards and the like, i.e., consumer debt as a whole. Yes, it's easy to understand how the debt burden in our consumption-oriented society with a savings rate either slightly negative or close to zero just "had to" catch up with us sooner or later.

There's a thought-provoking video entitled "Money as Debt," pedagogically praiseworthy if not completely accurate in all detail, which explains how money itself can be viewed as a form of debt that is created by our financial system. If you can spare 47 minutes of your day to watch the video, here's the link. The video's thesis is that our modern system of money is intrinsically unsustainable, since money's very existence depends on the continual creation of more and more money (or debt, depending on your perspective) to pay the interest (in addition to principal) owed by all us borrowers who have drawn down loans from banks and other financial institutions. The picture here is that of an ever-increasing pile of debt, an exponentially growing mountain of indebtedness that inevitably leads to the outcome we all fear like the plague--a collapse of our entire monetary system and its consumer-capitalist lifestyle that we just "can't live without." Right . . . try to imagine a world without WaMu, Citi, JPMorgan, Goldman, B of A . . . maybe even no Walmart, Costco, Nordstrom. . . . Pretty hard to visualize, eh?

A friend wrote to me the other day, saying that he has heard that one way to fix the U.S.'s financial problems is to "inflate the dollar." While economic solutions are never as easy to implement as they are to state, I think this view is essentially correct. This morning, as Bernanke and Paulson adamantly urge Congress to float their $700 billion bank rescue plan (that's $2,300 for every American), what we are seeing is an attempt to feed the credit-hungry monster that we have created over the past century. The proposal is to use $700 billion to buy "bad" (illiquid) loans from the many embattled banks, thereby replenishing their books with new (liquid) money that they can, in turn, lend to struggling consumers who are in dire need of more loans to make principal and interest payments on their existing loans--hence, stabilizing the housing market and stemming the breakdown of the financial system before it truly spirals out of control.

And where does this $700 billion come from? Well, that's why Congress is being asked to approve a higher statutory limit on federal debt, to the tune of some $11.3 trillion. With a higher debt ceiling, the government can borrow the $700 billion from investors through the capital markets (i.e., foreign governments and institutions, since that's who buys government bonds these days). The net result will be a "re-leveraging" of our financial system here in the U.S., which will likely, over time, lead to higher interest rates (to persuade foreigners to continue to lend), a need for more borrowing to pay off this principal and interest, the creation of more money. . . . Sound familiar?

From an investment point of view, I believe stock market direction in the short run is anyone's guess, as the dynamics (I first mistyped "dymanics" here, which, come to think of it, better captures the spirit of today's volatile, "manic" market!) of the current situation change from day to day, if not hour to hour. Longer term (i.e., over the next five to ten years), I believe that the equity markets (both stocks and real estate) will stabilize, rebound and even see new highs. Both economically and politically, "the powers that be"--meaning the billionaires who own stock and real estate, the politicians who wish to be re-elected, and the business executives who want to keep their jobs--will do whatever they can to protect their own self-interest and, in so doing, keep confined to its ever-expanding cage that awakening credit monster with a voracious appetite for more and more debt.

Drawing an analogy of our 232-year old U.S. economy to Rome some two thousand years ago:

". . . Essentially it was an aristocracy, in which old and rich families, through ability and privilege, held office for hundreds of years, and gave to Roman policy a tenacious continuity that was the secret of its accomplishments.

"But it had its faults. It was a clumsy confusion of checks and balances in which nearly every command could in time of peace be nullified by an equal and opposite command. . . . What astonishes us is that such a government could last so long (508 to 49 B.C.) and achieve so much. . . . Devotion to the state marked the zenith of the Republic, as unparalleled political corruption marked its fall. Rome remained great as long as she had enemies who forced her to unity, vision and heroism. When she had overcome them all she flourished for a moment and then began to die." (Will Durant, The Story of Civilization: Part III, Caesar and Christ, pp. 34-35)

As the historical record indicates, the expansive Roman Empire (146 B.C. to 192 A.D.) followed the earlier Republic (508 B.C. to 30 B.C.) stage, and the fall of Rome "was not an event but a process spread over 300 years." (Durant, p. 665) In a similar vein, I would venture to say that the U.S. economy and the larger global economy, however fragile they may now appear, most likely will see more prosperous years ahead. Though Wall Street's headline events of these past few months may be eye-popping, our debt-laden system, despite its flaws, will most likely bring lots of volatility (both upside and downside) but will not collapse anytime soon.

In short, if any end is near, it's probably the end of the financial mess we're in, rather than the end of economic growth and the corresponding secular rise of the market.

Q&A: Ask Lloyd a finance or investment question

Questions Answered:

How can I win the stock-picking contest at my school?
*New*

Should we remain renters or buy a house?

Should we sell the farm and pay the tax?

Real Estate and Leverage: How much is best?

Should I buy-and-hold or trade?

How will U.S. stocks perform versus foreign equity markets?

Can sentiment predict market direction?

How can I use the PEG ratio to value stocks?

Is Baidu worthwhile buying now?

Is the Chinese stock market a bubble?

Have you read the new book, An American Hedge Fund?

Which should I use, a full-service or discount broker?

Will Keystone Automotive shareholders approve the $48 buyout by LKQ?

I'm new to investing. Is there a simple place for me to start?

Should I use an investment advisory service?

Are stocks with high price-to-book ratio worth buying?

I'm a kid. What stocks do you recommend I buy? (Momentum and Recovery Picks)

How do I get the money to invest?

Is buying high earnings-to-price (or low PE) stocks a good strategy?

Should a high-net-worth individual take out a mortgage to buy a home?

How can small investors invest in commercial real estate?

Invitation: Submit your questions about investing, the stock market, finance or other money-related matters, and I will try to provide meaningful responses based on my own research and perspectives. Please post your questions to this blog by clicking on the "COMMENTS" link immediately below. Thanks!

How can I win the stock-picking contest at my school?

Reader's Question: I am taking a finance course in college. Our teacher has set up a competition on Virtual Stock Exchange, where students build their own portfolios and the student who has the highest return at the end of the trimester wins. I'm new at this. Which stocks should I buy?

As you set out to pick your stocks for the contest, I suggest keeping in mind two "facts" about the short-run performance of individual stocks:

1) It is almost impossible to predict with any certainty today which particular stocks will rise and which will fall tomorrow, and

2) Stocks that are volatile today tend to remain volatile tomorrow.

Putting these two principles together, I'll show you how to win the stock-picking contest--at least with greater odds than you might otherwise expect.

A Stock-Picking Analogy: Numbers in a Hat

Imagine that you and each of your classmates are presented with two hats holding cards with numbers written on them. The first hat (call it the "low volatility" hat) holds numbers uniformly distributed between -10 and +10. The second hat (call it the "high volatility" hat) holds numbers uniformly distributed between -50 and +50. You may choose one and only one number from just one of the two hats, and the student drawing the highest number wins.

The million dollar question is: Which hat should you pick your number from, the high volatility hat or the low volatility hat?

The expected outcome when picking a number from a hat is just the average of all of the numbers in the hat. In our example, this average is zero, because in each of the hats the positive and negative numbers are uniformly distributed. The situation up until this point mirrors Principle 1 above, which is equivalent to saying that your expected return when selecting either low volatility or high volatility stocks is zero (or close to zero) over a short time horizon (and a trimester is a fairly short period of time, so far as investing goes).

Now, if you and your classmates were actually to draw numbers out of the hats as described, you would find that the winner (i.e., the person who is lucky enough to pick the highest number) will almost always be a student who draws a number from the hat with numbers ranging from -50 to +50, and not the hat with numbers from -10 to +10. The prescription, then, is that, if you wish to win the contest, you should draw a number from the hat with the wider range of numbers, i.e., from the high volatility hat, since the winning number will almost always be drawn from this hat. You might be able to see intuitively why this is so, but for anyone interested in seeing how the probabilities work out, I'll provide a bit more detail.

Probability Analysis

(You may skip this section, but it's an informative application of probability if you are willing to put a little effort into following the math, which really is not very difficult.)

For the idealized case of uniformly distributed numbers in each hat, suppose you draw a number from the (-50,+50) hat, while everyone else in your class picks from the (-10,+10) hat. Three outcomes are possible:

a) If the number you draw is between -50 and -10, you will lose the contest, and this will occur 40% of the time;

b) If your number sits between +10 and +50, you will win, and this outcome also has a 40% chance of occurring;

c) The remaining 20% of the time, your number will be between -10 and +10, and you will typically lose, since the expected value of the highest number drawn by your classmates from the (-10,+10) hat approaches +10 as the number of your classmates drawing from the (-10,+10) hat becomes large, i.e., the best draw from the (-10,+10) hat will typically beat your middling draw from the (-50,+50) hat.

Overall, when you are the only one drawing from the (-50,+50) hat, you have a 40% chance of winning the contest, which is much better than the odds of winning you would have (e.g., 1/30 or about 3.3%, if there are 30 students) if you, along with everyone else, were to "follow the herd" and pick from the (-10,+10) hat.

Now, what happens if some of your classmates also decide to draw from the (-50,+50) hat? Suppose that N students, i.e., you and N-1 others, pick numbers from the (-50,+50) hat. The probability that at least one of these N students (including you) draws a number exceeding +10 is equal to one minus the probability that all of these N students draw numbers between -50 and +10, which is (1 - 0.6^N). Also, since your draw is just one among N from this high volatility hat, we need to divide by N to arrive at your probability of winning the contest. The result is:

P(N) = (1 - 0.6^N)/N

For N = 1, P(1) = 1 - 0.6 = 0.4, which represents the 40% chance you have of winning when you are the only one drawing from the (-50,+50) hat. For larger N, i.e., when some of your classmates also follow the high volatility strategy, your probability of winning declines:

P(2) = (1 - 0.6²)/2 = (1 - 0.36)/2 = 0.32 = 32% chance of winning
P(3) = (1 - 0.6³)/3 = (1 - 0.22)/3 = 0.26 = 26% chance of winning
P(4) = (1 - 0.6⁴)/4 = (1 - 0.13)/4 = 0.22 = 22% chance of winning
P(5) = (1 - 0.6⁵)/5 = (1 - 0.08)/5 = 0.18 = 18% chance of winning
Etc.

In the limit of large N, your probability of winning will fall to 1/N, which is another way of saying that any strategic advantage you have disappears when everyone else learns about and decides to copy your superior strategy (so, keep quiet about how you go about picking your stocks!).

Picking High Volatility Stocks

Based on the above logic, you can generally enhance your chances of winning the stock-picking contest by selecting stocks with the highest volatility possible. You may not be able to determine with certainty whether a particular stock will rise or fall (Principle 1 above); however, because stocks that have recently risen or fallen a large amount are likely in the near future to move a large amount one way or the other (Principle 2 above), you have both greater upside and greater downside when playing the high volatility game. High volatility investing tends to produce large stupendous gains as well as shocking losses.

In following the high volatility strategy, you should realize that the chance you will end up performing the worst in your class equals the chance you will end up being the top performer. However, in stock contests like the one you are participating in, the benefits of winning first place usually far outweigh the drawbacks of being the last place finisher, since kudos and recognition go to winners, while everyone else, no matter how low in ranking, is simply not mentioned at the awards ceremony. Within the context of your stock-picking contest (at least as I am imagining it), you will be better off increasing your odds of "winning big" with risky high volatility stocks than "playing it safe" with more conservative low volatility stocks.

As a practical matter, you are probably wondering how to identify high volatility stocks. One easy way is to go Yahoo! Finance and examine the daily lists of largest percent price gainers and largest percent price losers. (Although I have not used MarketWatch's Virtual Stock Exchange, I have noticed that their website also provides lists of largest percent price gainers and losers.) On any given trading day, there will typically be a handful of stocks that have moved 20% , 30% or more, up or down. In some cases, the large price movement will have been driven by buyout, earnings or new product announcements, so that the large price move will typically not be followed by another large move--avoid these one-time news situations. Instead, focus on the large percent gainers and losers that have moved on no news.

More often than not, the "no news" movers will be stocks of small companies, so-called microcaps or "penny stocks," which are highly volatile, trade in small volume (or at least small dollar volume) and most institutional investors stay away from. Have you ever heard of RXI Pharmaceuticals (RXII), Aristotle Corp. (ARTL), ULURU Inc. (ULU), or I-Many Inc. (IMNY)? Most people probably have not, since they are by no means household names. However, these four stocks were among those that moved more than 20%--two of them up and two of them down--in Friday's trading, on no significant news. Your job will be to do the research and identify stocks whose volatility is likely to remain high, and, if you are lucky, you'll pick stocks that will actually rise (or fall, if you are allowed to go short in your contest).

So, while your classmates are holding Google (GOOG), Apple (AAPL), Microsoft (MSFT) and other such popular stocks in their portfolios, you will be off buying and selling shares of small companies that no one has ever heard of. Due to their high volatility, the stocks of these microcap companies are the venue of daytraders, stock promoters and others "gambling" for a quick profit. As you are engaged in your game with your classmates, the short-term traders will be the ones doing all of the heavy-lifting, causing the stock prices to ramp up and down, allowing you to ride the opportunity for potential profit within the safe harbor of your stock-picking contest.

Best of luck paper-investing or paper-trading, as the case may be. I hope you win the contest!

P.S. Over the weeks ahead, could you please post a comment to let us know how you do in the stock-picking contest compared to your classmates? Thanks.

Important Note: The strategy I outline above for your stock-picking contest is not the strategy I would recommend following when you actually invest your own money in the real world outside of the classroom. Within the confines of an in-school contest, even the worst case outcome of a dismal investment return will probably not drag down your grade (but check with your teacher to make sure before entering your trades), since educational environments generally adhere to a philosophy that "it doesn't matter whether you win or lose; it only matters how you play the game" (yet it is nice to win, and that's why you've asked for my opinion, right?). When you are using real money, the potential downside inherent in trading extremely high volatility stocks, namely, the miserable prospect of losing all or most of your money, is just too damaging financially, psychologically and emotionally, and should be avoided. For a strategy I suggest following in any real-world investing you do in the future, please read a five-part series of articles on long-term investing I have written, accessible through the last part in the series here.

Should we remain renters or buy a house?

Reader's Question: My husband and I are 40 years old, live in Australia, and have no kids. We own a small business and have annual income between $80k and $100k. We live within our means, have no debt, and save about $30k to $50k per year. We do not contribute to superannuation (tax-advantaged retirement plan) because we prefer to manage our investments on our own. Our savings and investments (mostly common stock) are currently worth about $400k. Instead of buying a house, we have chosen to rent, since local real estate prices are very inflated, making renting much cheaper than buying. However, I am wondering if we should invest in real estate so as to diversify and have some place to live further down the line. How do you see renting vs. buying? Do you think we are on the right track to a comfortable retirement in about 15-20 years?

Rent vs. Buy Analysis

As with many financial decisions (e.g., invest in stocks or bonds?, use leverage or not?, continue to hold a stock or sell it now?), much can be said about the choice between renting and buying a house, but we only really find out tomorrow if we truly are making the right decision today. I'll go through an example using the U.S. real estate market, and then return the discussion to a broader perspective.

Back in 2000, just after the stock market had peaked and the dot-com crash was beginning, my family and I arrived in the city we currently live in. At that time, the local residential real estate market was firm with median-priced homes around $400k, and prices were rising at a solid though moderate mid-single digit annual rate. Being new to the area, we initially rented, paying $1,700 per month for an average-size house on a quiet street in a good school district. While renting, I occasionally would run through a quick rent vs. buy analysis, similar to the one I imagine you are now doing. Assuming no mortgage, the pre-tax calculation is simple, at least in principle (income taxes and a mortgage complicate matters but the main variable remains the relative investment performance outlined below):

Renting: As renters, we were paying 12 x $1,700 = $20,400 per year in rent, and the owner was responsible for all property tax, homeowner's insurance and necessary repairs on the house. Since the $20,400 annual rent was about 5% of the estimated $400k price of a comparable house at that time (in the year 2000), we can write:

Annual cost of renting = 5% of price of house.

Buying: If we were to buy a comparable house, we would need to sell $400k worth of investments (mostly stock), foregoing whatever future return we might realize, and use this money to buy the house, which itself would show some rate of price appreciation. The financial burden of 1) paying property tax and insurance (about $4,000 annually on a $400k house) and 2) performing repairs or at least putting money aside into a reserve account for major repairs (e.g., roof replacement or painting) to be performed at some point in the future (estimated at another $4,000 annually), together add up to $8,000 per year. So, in approximate percentage terms, we have:

Annual cost of buying = 2% for property tax, insurance & repairs + (S - R),

where S is the estimated future annual percentage return on investments (mostly stocks) to be sold in order to buy the house, and R is the anticipated future annual percentage price appreciation of the house (real estate).

From an investment point of view, renting should be preferred over buying when the annual cost of renting is less than the annual cost of buying, i.e., when 5% <> R + 3%. In other words, as a rough rule of thumb: If stock market returns exceed house price appreciation by more than 3% (i.e., 300 b.p.) per annum, one can expect be better off renting a house (and owning stock) instead of (selling the stock and) buying a house.

The graph below shows how stock market returns (S&P 500) have compared to house price appreciation (for the Seattle area where I live) for the eight years between 2000 and today.


(click graph to enlarge)

During 2000-2002, when the stock market fell sharply, I expected the sell-off in equities to exert noticeable downward pressure on local real estate prices, but the correlation between the stock and real estate markets was weak. When the stock market turned around in late 2002, initiating an extended five-year bull run, real estate price appreciation accelerated as well. Currently, amidst fallout from the subprime crisis here in the U.S., the housing market seems softer than the stock market, which itself is largely moving sideways as the economy flirts with recession.

In my family's case, after an extended house search, encompassing a few years but focussed on a small neighborhood with very little available inventory, we finally found the right house, liquidated other investments and closed escrow, switching from being renters to homeowners in early 2005. in retrospect, we managed to capture the bulk of the rapid price appreciation our local real estate saw in 2004-2006, and have ended up being on the correct side of the rent-vs.-buy dichotomy for each of the past three years.

Assessing the Future

Like you and everyone else, I wish I had a crystal ball to predict the future. If I could correctly forecast the relative performance of the S&P 500 versus my local real estate market, I would always know whether to be a renter or homeowner. Short of knowing the future, however, I look to "softer," more qualitative factors--such as being partially "hedged" through having exposure to both the stock and real estate markets, the freedom to replant a garden or repaint a room without consulting a landlord, peace of mind from having neither rent nor a mortgage to pay, and so on--for assurance that owning a house and allocating much of the balance of our investment portfolio to the stock market is the right decision, at least for now.

For a comparison to other markets, you might wish to read the Global Property Guide article here covering the state of housing markets around the world, giving both price appreciation and rent figures for many countries. Some highlights, with emphasis on the Pacific Rim (including both Australia and the U.S.), are:

House Price Appreciation (2007, in local currency):

Shanghai 28%
Singapore 28%
Hong Kong 11%
Australia 11%
UK 10%
South Korea 9%
Japan (6 major cities) 8%
New Zealand 7%
Canada 6%
Japan (nationwide) -1%
U.S. (average of indices) -2%.

Rental Yield (gross rent as percent of house price):

Shanghai 7.8%
Sydney 5.9%
London 5.4%
New York 5.0%
Tokyo 4.7%
Hong Kong 4.2%
Singapore 2.8%

Offhand, I would guess that at some point during the next couple of years a few of the hotter real estate markets around the Pacific Rim will see declines similar to what the U.S. (particularly the submarkets like California, Florida and Las Vegas, Nevada, which rose fastest on the way up) is now experiencing. How your neighborhood real estate market in Australia is impacted is really something you, being local, should have a better handle on than I do.

When making your decision, keep in mind that a) the future is hardly ever crystal clear, and b) it is the relative future performance between whatever particular investments you will sell (the "S" above) and the specific house you will buy (the "R"), that will allow you (and only retroactively!) to determine conclusively if you made the correct rent vs. buy decision in prior years.

Overall, seeing that you and your husband are entrepreneurial, hardworking, persistent in your saving habits, self-directed in your investing, and debt-free, I am optimistic that either path, i.e., renting or buying, will lead you to the comfortable retirement you are targeting. Best of luck in the years ahead!

Why Successful Traders Are So Secretive

I set out to explain why successful traders are so secretive, by stepping through a logical argument of how a trader, if he publicizes his trading decisions, will almost certainly sooner rather than later undermine his own success. For many reading this, secrecy among successful traders may be a truism not requiring elaboration. However, for anyone wishing to hear the story, here it is:

Let's call our (hypothetical) young trader Mr. Bright. Assume that Mr. Bright either has an innate and remarkable ability to discern patterns in stock price movement or, alternatively, has developed a sophisticated computer program that can correctly forecast price action. Using his uncanny ability or his financial technology, Mr. Bright buys and sells stocks, typically taking positions for only a few hours, and achieves a highly favorable track record, soon vaulting him to multi-millionaire status.

One sunny morning, driven by apparent altruism camouflaging a layer of megalomania, Mr. Bright wakes up and decides to "share the wealth" with others by publishing his trading decisions via a website, announcing his buy and sell targets for particular stocks, and detailing his actual trades real-time.

Now, the media, always looking for a good story, is quick to pick up on young Mr. Bright's impressive track record and his openness and willingness to educate anyone who will listen. However, the public, including numerous "little guy" investors, who have only painful memories of losing too much money on rumors, hearsay and not-so-sound "advice" from "experts," is more skeptical. At first, only a few people take Mr. Bright and his predictions seriously enough to put their own hard-earned money at risk mimicking his trades. However, the success of the bold early adopters soon attracts a small army of followers, who are eager to partake of the "easy money," free for the taking simply by copying Mr. Bright's trading actions--buying when he buys and selling when he sells.

For quite a few months all is well. Mr. Bright's trades, along with those of his army of copycats, are profitable more often than not. He and his followers are on track to realize a 100% return during the first year. To the surprise of all skeptics, Mr. Bright is consistently putting money into the pockets of every little investor in his army and quickly becoming a popular hero.

By this time, as success tends to generate its own publicity, Mr. Bright and his uncanny forecasting system have caught the attention of professional investors (hedge funds, proprietary trading desks at investment banks and others). Since Mr. Bright makes a habit of publishing his trades real-time, he and his army of followers are an easy target for deeper-pocketed pros.

The strategizing in the pros' minds goes like this: Seeing that the stocks that Mr. Bright and his army buy rise so predictably, why not kick in a few dollars and join them on the way up? Then, instead of waiting for Mr. Bright's typical 10% rise before taking profits, how about front-running Mr. Bright and his army by selling out a little sooner, say at 9% profit, and proceeding to go short in significant size? As the stock starts to fall due to our short, Mr. Bright and his army will have little choice but to cut their profits and join us in selling, thereby pushing the stock down further and faster. As Mr. Bright and his army go into rapid retreat, the corresponding surge in trading volume and collapsing stock price will provide us pros with an opportunity to buy back shares to cover our short for a quick profit. As is easy to see, Mr. Bright and his army, with their well-publicized trades, will inevitably fall right into our trap!

In essence, Mr. Bright's system breaks down when more money is put into play. While the system initially succeeds in predicting price movement and generating profits for Mr. Bright and a small army of followers, the forecasting ability of the system vanishes when deeper-pocketed pros toss more money into the game. The very actions of Mr. Bright and his followers become a significant part of the overall market and, ultimately, the predictability of their behavior becomes a target of the pros.

Ironically, Mr. Bright's uncanny forecasting ability, when publicized to allow everyone free access to his trading decisions, itself becomes a predictable aspect of the market. In other words, the very act of revealing the predictions of a successful trading system predictably undermines its own ability to predict!

Moral of the story: Mr. Bright wasn't so bright after all.

Corollary: The brightest traders keep their systems secret.

Should we sell the farm and pay the tax?

Reader's Question: Next year we will sell our family farm and expect to net in excess of $200,000. Our tax preparer says to pay the tax and invest the rest. Is this correct? If so, where should we invest? My husband and I are both in our 60s and would certainly like more income to help us enjoy this stage of our life.

Since you are selling real estate, you should first determine whether or not your farm qualifies as your principal residence; in accordance with IRS rules, if your farm property is your home, you and your husband might qualify for exclusion of up to $500,000 in profits from your capital gains tax calculation. Here's a Bankrate.com article covering this home-sale tax exemption.

If your farm is not your principal residence, then it will likely be treated as an investment property and you can qualify for a "like-kind" 1031 tax-deferred exchange if you meet the IRS requirements. Again, here's a Bankrate.com article for an overview. You might consider swapping your farm for any of a variety of common types of rental income property (e.g., apartments, small offices, self-storage facilities). Appropriately selected rental properties are capable of offering solid positive cash flow, which can provide the income stream you are seeking. With real estate markets weakening across the country, now seems to be a good time to start looking for properties being offered at attractive prices by motivated sellers.

As your tax preparer suggests, you can alternatively just pay any capital gains tax you might owe upon sale of your farm and roll the after-tax proceeds into other investments of your choice. If you choose to follow this option, I would suggest paying close attention to fees and expenses when reinvesting. Minimizing investment management fees will tend over time to give you higher returns. If you are comfortable choosing individual stocks (including ETFs and REITs, many of which pay substantial dividends) and bonds on your own, you'll save by avoiding having to pay fees to a fund manager. Opening an account at a reputable discount broker can also help reduce transaction costs. If you decide that mutual funds suit your investment style better than buying individual securities directly, I suggest seriously considering only funds with low fees and low portfolio turnover.

In case you have not yet seen it, you might also wish to peruse my earlier comments on wealth generation in a five-part series on long-term investing.

Real Estate and Leverage: How much is best?

Reader's Question: I'm 28 years old. My wife and I both work as electrical engineers in jobs that pay well. Using our savings we have been buying income-producing real estate to replace our employment income and now own 11 units. Is real estate the best vehicle for achieving our goal of becoming financially independent to free up time for activities we consider more meaningful? I have not found other investments that offer such handsome cash yields and permit a similar degree of leverage. Also, regarding leverage, what is the optimal amount of overall leverage for our property portfolio? Is it wise to "lever to the max" with exotic strategies (like wrap notes on properties purchased subject-to), or would we be better off de-leveraging our portfolio so that we don’t need to keep as much cash on hand to cover downside risk associated with leverage? I am struggling with the correct amount of property to purchase given our cash reserves.

In asset allocation and capital structure, the two areas of portfolio management your questions relate to, there are many different investing approaches, each of which has its own merits and unwavering supporters. Rather than try to show in any objective sense that one approach is always superior to the others, I will provide a personal perspective based on my own investing experiences, going broader than your specific inquiry to provide a fuller picture of what has worked for me over the past 25 years. I hope anyone reading this article is able to benefit from what I have to say; however, since even small differences in personal circumstances and preferences can sometimes lead to very different choices and approaches to investing, I encourage you to consider my opinions only as a point of reference, while proceeding to seek out advice from professionals who have the time and expertise to understand your situation thoroughly and work with you more closely to achieve your goals.

Real Estate Investing During the 1980s and 1990s

Since you are targeting a high cash yield and refer to your real estate as "units," I assume that you own apartments (though office buildings, neighborhood retail stores, mixed-use properties, storage facilities, mobile home parks and other real property are also all capable of generating predictable cash flow).

During the early 1980s, I made my first income property investment using a few thousand dollars I had managed to save from my job as a teaching and research assistant while studying for my graduate degree at an East Coast university and living frugally in a shared student house. I invested in apartments in California through a partnership run by an experienced general manager familiar to me through friends and relatives. We were leveraged at about 70% loan-to-value and the property produced good cash flow distributions. With California real estate steadily appreciating, the investment did well throughout the 1980s.

Following graduation in 1985, I took a high-paying job on Wall Street and continued to invest my (now more substantial) savings into other apartment buildings in Southern California. With occupancy above 95%, rents rising at above 5% per year, and limited available land for new development, rental properties continued to appreciate. I recall at the end of 1990 receiving an unsolicited offer for a 16-unit property of ours at a price of $1.15 million (or $72,000 per unit, a very attractive price at that time), which on paper produced a total return-on-equity of 150% in less than three years!

But good times, of course, don't last forever. The U.S. recession beginning in late 1990 hit Southern California hard. Real estate prices softened and buyers evaporated. Realtors and investors caught in the fallout coined the phrase "Stay alive till '95," expressing their confidence that the market would recover by the middle of the decade. Recovery, however, was slower than expected, and significant market strength did not return until around 2000, a full decade following the 1990 peak.

During the market nadir in the mid-1990s, the vacancy rate in one of our buildings rose to 15% and we had to reduce rents by about 10% and offer move-in specials to attract new tenants. In the worst year of operations, cash flow became negative by about 1% of property value (which would have been worse if we had been leveraged more highly).

After what in retrospect was a long roller-coaster ride, partially buffered by not being over-leveraged, we ended up selling the properties, mostly during the market runup from 2000 to 2005. During my total 10- to 15-year holding period, I achieved acceptable but unimpressive, single-digit compounded annnualized returns. This muted, bond-like, long-run performance of an equity investment is largely a reflection of the extended market slump during the mid-1990s, but perhaps the more important outcome from this experience is that we survived and even managed to make a little money during a period when a number of more highly leveraged investors and developers faced foreclosure and bankruptcy.

Lessons from the Last Time Around

With attention to leverage and cash flow, a few observations may be helpful:

Cyclicality: Despite a strong secular tendency to rise indefinitely, real estate markets also exhibit significant cyclical behavior. On a timing clock, with 12 o'clock at the market's top and 6 o'clock at the bottom, I would pair up the following times and dates:

9 o'clock: Market rises in late 1980s
12 o'clock: Market peaks at end of 1990
3 o'clock: Market falls during early 1990s
6 o'clock: Market bottoms around 1995
9 o'clock: Market recovers in late 1990s

Though it may still be too early to judge conclusively, I suspect that we will likely look back at 2005 or 2006 as defining another 12 o'clock real estate market peak.

Leverage and Cash Flow: Leverage slices both ways, producing quick double-digit returns on the way up (as during the middle and late 1980s) and often even quicker negative double-digit returns on the way down (as from 1990 to 1995). As a general principle, I believe it prudent never to leverage a property beyond the zero-cash-flow breakeven point between positive and negative operating cash flow (after debt service and a reserve charge for major repairs, but before depreciation and amortization). A conservative rule of thumb for determining appropriate leverage is to apply a stress test by bumping the economic vacancy rate up to two or three times its normal level (e.g., 5% vacancy becomes 10% to 15% vacancy) and making sure that the property still has either sufficient positive cash flow or adequate cash in the bank to cover this worst-case scenario for a full year of stressed operation.

Total Investment Return: While prudent cash flow management and avoidance of over-leverage (of which a wrap note can be a tell-tale sign) are important for survival during times of protracted rental market weakness, investment returns are often more impacted by property price appreciation than cash flow. Particularly for investment horizons of 10 years or shorter, market timing tends to matter. Admittedly, buy and sell decisions are difficult to get exactly right and each time around is different from the previous times, but I believe that it is possible to cultivate a type of "wisdom" about the markets by observing the macro and local economic forces and their influence on prices over many cycles, thereby developing a slight edge over less diligent players.

Don't Forget About Alternative Markets

Between 2000 and 2005, while I was selling my units in California, I seriously looked for replacement properties in the Washington state area where I now live. My target was a 15% return-on-equity over a pro forma five-year investment horizon, consistent with an 8% cap rate, at 70% loan-to-value, 7% debt service (principal and interest), a 10% cash-on-cash return, and 3% annual property price appreciation, fully accounting for property management fees during the holding period and brokerage fees upon sale. During my property search, I made a handful of offers but was unable to close on a desirable investment property at my price target.

What drove my direct investment target was an investment alternative: indirectly investing in real estate by buying shares of publicly listed REITs. At that time, which was in the wake of the dot-com bubble when office vacancy rates had risen to 20% in high-tech centers, shares of office REITs were trading at depressed price levels consistent with my 8% cap rate and 10% cash-on-cash return target. I viewed office REITs as more attractively priced and having more upside pootential than apartment, retail and other REITs, and proceeded to roll my sales proceeds from the California apartments into shares of Equity Office Properties and Trizec. As good fortune would have it, these two office REITs ended up getting bought out at premium prices in late 2006 and early 2007 by large private-equity buyout funds, providing me with returns that well exceeded my original total return target.

The message here is that, before concluding that direct ownership of income-producing real estate is the best way to meet your investment objectives, I would encourage you to give serious consideration to at least the REIT market and, more generally, the overall stock market. Since the middle of last year, with the subprime crisis feeding recession fears, REITs have taken a fall and are again beginning to look relatively attractive. In my opinion, HRPT Properties (NYSE: HRP), an office REIT with class A and class B properties in both major and more minor cities, is worth considering, since it is now trading at just 65% of book value (equivalent to a "see through" 9% to 10% cap rate with a 14% to 15% cash-on-cash return) and offers an 11% dividend which looks stable. This or other REITs or other dividend-paying stocks may also provide you with the sense of financial independence you are seeking through direct ownership of real estate.

Although I currently own no real estate other than my own residence, I expect again to buy investment properties when an attractive opportunity presents itself. My guess is that the U.S. real estate market as a whole is now at about 3 o'clock on the timing model mentioned above, and could have another year or two to go before reaching the 6 o'clock bottom. The Seattle market where I am is still performing stronger than most other markets, which leads me to believe that I could have even a longer wait if I keep my local focus. On the other hand, I'm sure that there must be a few markets in other states (including your area?) where great deals may be found even this year.

When a Job Can Be More Than Just a Job

Your desire to generate investment income to give you financial freedom to pursue other activities you believe will be more fulfilling than continuing to work at your job as an engineer is a common goal of many people in our 21st-century society dominated by large corporations driven by efficiency and profit objectives. For better or worse, within a few years on the job, most of us Americans come to view our occupations primarily in financial terms, i.e., exchange of our labor for money, while disregarding less tangible benefits such as constructive participation in an endeavor for the good of society, contributing to the smooth operation of our economy, making widgets that we all need and use, helping others by applying our individual talents, etc.

Given the focus of so many Americans on becoming financially independent and retiring early, I was surprised recently to run across an interesting statistic indicating the extent to which America has become less aristocratic over the past century. In 1929, 70% of the income of the top 0.01% (or 1 out of 10,000) earners came from investment income derived from ownership of income-producing assets such as real estate, stock and bonds. By contrast, in 1998, again among the top 0.01% of earners, just 20% of income came from income-producing assets, while the remaining 80% came from wages and entrepreneurial income. (From Piketty and Saez, "Income Inequality in the United States, 1913-1998," as cited in Rajan and Zingales, Saving Capitalism from the Capitalists, 2003, p. 92)

I find it intriguing and even inspiring that the bulk of the income of top earners comes from business endeavors that these top earners are actively involved in as wage earners and entrepreneurs. What this indicates is that today in America, even moreso than a few generations ago, tremendous opportunities exist for anyone clever enough, bright enough and enterprising enough to apply their talents constructively to provide products and services in high demand. In other words, we should view our labor not just as a simple exchange of our time for money but also, at a higher level, as a contribution to the advancement and betterment of society with potential for phenomenally high compensation for the highest achievers. I'm not sure how you are planning to spend your time if or when you do one day leave your current job, but here's a suggestion: how about aspiring to rise to the level of those one-in-ten-thousand hardworking wage earners and entrepreneurs who are making a difference in our world? Generous financial and personal rewards are apparently available for those who succeed.

Certainly, investing to achieve self-sustaining personal lifetime income is a worthy goal to have. But, let's not stop there. Anyone focussed and fortunate enough to get that far should, I feel, both for one's personal satisfaction and for the good of society, actively proceed to find ways to share one's expertise and continue contributing to improving the lives of everyone.

Should I buy-and-hold or trade?

Reader's Question: How does a buy-and-hold strategy compare to a trading strategy for ETFs [and stocks in general]?

Your question pertains specifically to exchange-traded funds (ETFs); however, because the buy-and-hold versus trade decision is basically the same for individual stocks, I will answer within the general context of equity-style investing.

Investing vs. Trading

The primary difference between a buy-and-hold approach to investing and a trading strategy is one's time horizon. To some extent, the distinction is relative: a day-trader considers any holding period longer than a day or two to be investing, whereas a buy-and-hold investor might consider any portfolio with turnover exceeding just 10% or 20% per annum to be trading. For concreteness, however, let's define "investing" as holding any position for a year or longer, in line with the cut-off for tax purposes between long-term and short-term capital gains. Within this definition, managers running portfolios with turnover exceeding 100% per year will be deemed to be "trading."

Rationally speaking, the decision to invest or trade should be based on your assessment of two quantities:

"Pick-Up" in Expected Return: How much pick-up in return do you expect to gain by trading, i.e., by switching from one asset to another, such as selling one stock to buy another?

"Frictional" Costs of Trading: What are the frictional costs including broker's commissions, bid-offer spread, tax impact of trading, and additional administrative time required to keep your records in order and account for trades?

Whenever expected pick-up exceeds frictional costs, it makes sense to trade out of one asset and into another that promises the higher return.

If markets are efficient, with perfect and instantaneous information flow among all participants, no pick-up in expected return should be available from switching out of one asset and into another; instead, frictional costs will only drag down returns. On the other hand, if it is possible to use available information to one's advantage to outsmart others, then trading can be a highly profitable business.

Prominent Winners and Losers

A glance at popular lists of the rich and famous shows that at least a few people have been amazingly successful trading the markets. Here are some well-known traders on the Forbes list of the 400 wealthiest Americans:

George Soros (age 77): #33 on list, $8.8 billion net worth. Bachelor’s, London School of Economics. Founded Quantum Fund with Jim Rogers. With Stanley Druckenmiller, "broke" British pound in 1992, made $1 billion profit. Lost hundreds of millions with ill-timed investments in former Soviet Union 1996.

Steven Cohen (51): #47, $6.8 billion. Bachelor’s, Wharton, U. Penn. Founded hedge fund SAC Capital 1992 with $25 million in assets. Today manages $14 billion. Charges 3% of assets, 35% of profits; has returned an average of 34% net of fees each year since 1992.

James Simons (69): #57, $5.5 billion. Math Ph.D., UC Berkeley. Founded Renaissance Technologies 1982. Quantitative hedge fund uses complex computer models to analyze and trade securities. Fees as high as 5% of assets, 44% of profits. A $2.5 million investment in his funds in 1990 would be worth $1 billion today (for a 42% annualized return). Hires Ph.D.s over M.B.A.s. $25 billion institutional fund RIEF so far performing below expectations.

Stanley Druckenmiller (54): #91, $3.5 billion. Bachelor’s, Bowdoin College. Orchestrated billion-dollar raid on the British pound in 1992 with timely short position. Believed to help generate string of 30% returns for Soros' Quantum Fund. Duquesne Capital Management, runs No Margin Fund.

Bruce Kovner (62): #91, $3.5 billion. Bachelor’s, Harvard. Started trading soybeans; turned $3,000 he borrowed on his credit card into $45,000. Forgot to hedge, lost half the profits. Founded Caxton Associates 1983. Caxton Global Investments hedge fund has returned 25% annually net of fees. Assets: $15 billion.

Paul Tudor Jones II (53): #105, $3.3 billion. Economics, Bachelor’s, Univ. of Virginia. Early success trading cotton on Wall Street. Founded Tudor Investment Corp. hedge fund 1980. Predicted 1987 stock market crash, returned 125% net of fees that year. Assets now $20 billion. Estimated average annual returns 24%; down this year amid summer's violent market turmoil.

Kenneth Griffin (38): #117, $3.0 billion. Bachelor’s, Harvard. Started investing as undergrad, managing $1 million of family's, friend's money by senior year. Founded Citadel Investment Group 1990 with Frank Meyer's money. His hedge funds said to have averaged 20% net of fees annually. Assets under management exceed $16 billion.

David Shaw (56): #165, $2.5 billion. Ph.D., Stanford. Investment geek uses complex algorithms to capitalize on tiny anomalies in the stock market. Former professor of computer science at Columbia U. Launched hedge fund D.E. Shaw & Co. Assets have swelled from $28 million to $34 billion in 20 years (or 43% annual compounded asset accumulation).

David Tepper (49): #239, $2.0 billion. M.B.A., Carnegie Mellon. Ran junk bond desk at Goldman Sachs. Started hedge fund Appaloosa Management in 1992. Fund up 150% in 2003; believed to have averaged 30% returns net of fees since inception. Manages $7 billion.

Louis Bacon (51): #286, $1.7 billion. Literature, Bachelor’s, Middlebury College. Founded Moore Capital in 1989; returned 86% in first year on savvy bet that Gulf war would drive up oil prices. Assets under management: $13 billion. Last year returned 16.7% after fees (25% of profits, 3% of assets).

Daniel Och (46): #317, $1.5 billion. Bachelor’s, Wharton, Univ. of Penn. Took job in arbitrage at Goldman Sachs 1982; worked with Eddie Lampert , billionaire Richard Perry. Left to found Och-Ziff hedge fund with $100 million initial investment from Ziff brothers. Consistent returns: 16.5% a year after fees. Manages $29.1 billion.

Israel Englander (59): #317, $1.5 billion. Bachelor’s, NYU. Founded investment outfit Jamie Securities 1980s; firm collapsed. Created Millennium Partners 1990; fund said to have returned 17% net of fees. Assets under management $11.5 billion. Employees created 100 legal shell companies in order to market time mutual funds.

The persistent 15% t0 40% or higher annual returns these traders show is evidence that it is possible to realize consistent profits trading the market.

Lest we become too carried away with these success stories, we should also keep in mind that there have been many equally prominent "blow-ups" of risk-taking traders, including: Victor Niederhoffer, one of Soros's former colleagues, whose funds failed twice, in 1997 and again this year; John Meriwether's Long-Term Capital Management, the multi-billion dollar hedge fund run by ex-Salmon traders and even a couple of economics Nobel prize winners, which collapsed in 1997; and Amaranth Advisors, which spectacularly lost $6 billion in one week on natural gas futures in September 2006. This year's subprime crisis is another example of how businesses, investments and trading strategies that have been profitable for many years can suddenly turn sour. Then, too, think about all the unlucky traders who lose money so quickly that we never get a chance even to hear about them!

Base Strategy: Buy-and-Hold

The only certain way to know whether you yourself have the ability become a successful trader is to commit both significant time and capital to trying. Unfortunately, most people have neither the time nor capital to spend finding out. Also, for those who seriously begin trading but fail, the costs can be very high, both financailly and emotionally.

In my opinion, instead of launching off and haphazardly trying your luck at trading, it makes sense at least initially to pursue a buy-and-hold strategy to exploit certain advantages it offers:

1. Long-Term Returns Favor Equities: The nature of capitalism as we know it in the U.S. and in most parts of the world is that laws and regulations are skewed to promote economic growth, corporate profits, and wealth generation for stockholders. In this environment, risk-taking buy-and-hold equity holders more often than not end up with higher returns than bondholders and cash-rich non-risk-takers. Therefore, it makes sense to allocate as much of your portfolio as you can to equities, reserving for cash and bonds only what you need for emergency living expenses (e.g., six months' income in case you lose your job) or predictable future expenses (e.g., a college fund for children). While it is very difficult to predict whether equities will outperform bonds and cash in any given year, over periods of 10 or 20 years or longer, equities have generally outperformed.

2. Cost Efficiency: Compared to trading, buy-and-hold investing controls costs by keeping broker's commissions and other frictional costs to a minimum. Though not as evident as a trading commission, the bid-offer spread is a cost that can often be larger than commissions. To give an extreme example, a micro-cap "penny" stock with a $0.06-$0.08 bid-offer (you can buy at $0.08 and sell at $0.06 in an unchanged market) actually has round-trip execution costs of an enormous 25% of one's initial investment! At the other end of the spectrum are exchange-traded funds, the most liquid of which is the S&P Depositary Receipts (AMEX: SPY) with round-trip bid-offer costs of just 0.007% (or less than 1 b.p.). More typically, moderately liquid mid-cap individual stocks have bid-offer spreads of about 0.50% (50 b.p.).

3. Tax Efficiency: Keeping portfolio turnover to a minimum through buy-and-hold investing is also more efficient from a tax point of view. First of all, the long-term capital gains tax rate of 15% that applies to positions held for more than a year is substantially lower than the ordinary income tax rate running as high as 28% that applies to short-term capital gains on positions held for a year or less. For certain types of trading accounts, the IRS offers a favorable 60%/40% split between long-term and short-term capital gains tax treatment, which produces an effective tax rate of 20.2% (of course, higher than the 15% pure long-term gains rate). Also, since taxes on gains are due only when securities are eventually sold, capital gains tax can be deferred indefinitely into the future through extending buy-and-hold positions without selling for many years.

While it may seem simplistic, a buy-and-hold approach to investing, characterized by continuously holding a very high percentage of equities with only very infrequent though carefully considered buy-sell decisions, can, in my opinion, give small retail investors a slight "edge" over other investors and traders based on the efficiencies cited above.

Numerical Comparison

To gauge the impact of frictional costs on returns, let's compare two portfolios over a 10-year period in a market that returns 10% annually:

Buy-and-Hold: Assume no turnover. At 10% annual appreciationn, $100 grows to $259 after 10 years. After payment of 15% long-term capital gains tax on the $159 gain at the end of year 10, the net portfolio value becomes $235, for an annualized after-tax return of 8.94%.

Trading: Assume 200% annual turnover, or the equivalent of two round-trip trades per year at a cost of 0.50% per round-trip. Trading costs as stated and annual taxes of 28% on short-term gains reduce the 10% annual market appreciation to (10% - 2 x 0.50%) x (1 - 0.28), or 6.48%. At this after-tax growth rate, an original $100 investment becomes $187 after 10 years.

Assuming that trading produces no pick-up in return, the frictional trading costs and additional tax lead to an inferior after-tax annual return 246 b.p. lower (8.94% vs. 6.48%) than the return available through buy-and-hold investing. On a pre-cost, pre-tax breakeven basis, the trading strategy will need to outperform the buy-and-hold alternative by a full 342 b.p. annually in order for trading to beat the buy-and-hold alternative.

As a rough rule of thumb, then, you should engage in trading only if you honestly believe that your buy-sell decisions give you at least a three or four percentage point advantage annually (and more if your turnover exceeds 200% per year) above the buy-and-hold alternative.

Self-Assessment: What's My Trading "Edge"?

Expressed another way, the buy-and-hold versus trading decision really boils down to having an "edge" large enough to overcome the costs of trading. What in particular about you, your personality, your abilities, and your current situation gives you a competitive advantage over others in the market? Based on the information you can easily get your hands on, digest and analyze, do you have an edge over professionals who devote themselves full-time and make careers out of trading the market?

While a genius-level of business and financial acumen may not be strictly necessary for wealth-building, I would contend that your odds of becoming a successful investor or trader will be greatly enhanced if you know what your edge is. If you plan to trade ETFs or large-cap stocks over a short-term time horizon, keep in mind that you'll be competing with Wall Street traders and hedge funds who usually have access to more up-to-the-minute newswires, customer flow information, and analytical tools than you do. Your odds of success may be slightly better in small-cap and penny stocks, asset classes that more sophisticated investors often avoid due to limited liquidity and trade size (Tim Sykes, whose claim to fame is trading his way from $12,415 to $1.65 million in just four years, day-trades small-cap stocks and is attempting to teach us all how it can be done again).

Over the years I have looked at many fundamental, technical and sentiment-based possibilities for constructing a system for beating the market, always searching for a methodology to ensure at least a 70% winning trade percentage. From one (perhaps too naive and hopeful?) point of view, given how readily availability price, volume, earnings and other quantifiable time series are, it seems that trading ought to be a "science" amenable to analysis and predictability. Unfortunately, from what I have seen so far, analytical trading rules do not appear to produce excess returns in any consistent and reliable way. Also, to date, I have yet to meet anyone who has a trading system that runs without human intervention and produces consistent excess returns. From what I can tell, trading is more like a game involving both luck and skill than a predictive science.

To Trade or Not To Trade?

Whether to engage in buy-and-hold investing or to pursue a short- or middle-term trading strategy, then, really depends on your own abilities and risk preferences. For the vast majority of people, I suspect that a buy-and-hold strategy will bear larger and more fruit than an active trading strategy. In my own case, I currently follow a buy-and-hold approach, targeting no more than 10% annual turnover to keep trading costs and taxes at a minimum.

Concurrently, I continue my search for a Holy Grail of sorts that is capable of producing winning trades at least 70% of the time (which I view as equivalent to a low-C grade, i.e., barely passing). The day I convince myself that I have a working system that meets this 70% threshold, I will begin to trade, putting real money at risk.

By the way, to anyone reading this: If you or someone you know has a trading system that produces consistent and reliable above-market returns, and don't mind sharing a little information about it, please leave a comment. We would all love to hear about it.

How will U.S. stocks perform versus foreign equity markets?

Reader's Question: Do you think the U.S. stock market will provide at least 10% to 20% returns over the next one to two years? Also, how about foreign equity markets?

I am bullish on equities over the long term and think it very possible that the U.S. stock market will see returns around the level you indicate. Negative factors--softness in residential real estate, sub-prime debt problems, possibility of recession, record high oil prices, weakening dollar--have potential to derail the current bull market and will continue to worry investors. Nevertheless, despite the short-term negatives, equity markets tend to exhibit a secular rise on the back of economic growth--and this long-term trend, with solid footing in our world's market economy and capitalism, is unlikely to subside anytime soon.

Think Global

Rather than focussing solely on U.S. equities, I would encourage you to think and invest globally, if you aren't already doing so. The pie chart below shows how the U.S. accounts for about 27% of the world's economy as measured by nominal GDP. This means that almost three-quarters of the world's economic output (i.e., the overwhelming majority of the pie) is generated outside of the U.S. Certainly, the U.S. remains the world's largest economy by a wide margin; however, rapid economic growth rates elsewhere provide a reason to look beyond U.S. borders.



Economic Growth Matters

The world's three largest economies--U.S., Japan and Germany--all have real GDP growth rates in the neighborhood of 2% to 3% annually. That's very sluggish when compared to high growth rates in many other countries among the world's largest 15 economies. Most notably, China continues to show robust 10% to 11% growth, India around 9% or 10%, Russia around 7%, and South Korea and Mexico about 4% to 5% growth. Since GDP growth in the underlying economy drives corporate revenue and earnings growth, which in turn determines stock price performance, it behooves us to focus in on high-growth countries.

As investors, we want growth, but we also want to make sure that we are not paying too much for the growth we get. A good way to gauge the cheapness or richness of entire stock markets is to look at the P/E ratios of representative ETFs. Barclays iShares manages country-specific ETFs that can serve as proxies for most of the largest economies. For example, one of their most popular ETFs is the FTSE/Xinhua China 25 Index (NYSE: FXI), which invests in H-shares of 25 large companies listed in Hong Kong and doing business in China. This China ETF has a market capitalizaion-weighted P/E ratio of 31, as of the end of September.

It is helpful to plot P/E ratio against GDP growth to develop an intuitive feel for how cheap or expensive the various stock markets are. In the graph below, I have drawn lines sloping upward from the origin for the four countries with the most attractive (i.e., lowest) ratios of P/E (for proxy ETFs) to GDP growth rate (for the corresponding countries). This composite ratio is a type of "PEG ratio" that measures P/E relative to growth, allowing for a quick comparison of low-P/E, low-growth and high-P/E, high-growth investment alternatives.



Observe how the ETFs of India (NYSE: INP) and China (NYSE: FXI) offer the most attractive PEG ratios, indicating that even though their respective stock markets are currently trading at relatively high P/Es of 23 (estimated) and 31, respectively, the double-digit (or near-double-digit) growth of their underlying economies appears to support their high-P/E valuations. The ETFs of Mexico (NYSE: EWW) and South Korea (NYSE: EWY) also show attractive PEG ratios.



Prospects for Growth and Profit

Although it is extremely difficult to predict which stock markets will rise the most over the next year or two, or whether the recent strength of global equity markets (particularly China and India) will continue in the near-term, I offer two suggestions:

1. Invest Globally: As a baseline when investing in equities, weight countries in approximate proportion to their contribution to world GDP. ETFs provide a means for taking on exposure to foreign equities while keeping costs and management fees low. Buying ADRs (U.S.-listed shares of foreign companies) is another way to go for those who enjoy (as I do) investing in individual companies. While U.S. equities may comprise the largest single-country contribution, all of the non-U.S. countries together should, in my opinion, add up to more than half of your overall portfolio.

2. Over-weight High-Growth Countries: Given their high GDP growth, China, India, Russia, South Korea and Mexico are good places to search for equity investments. Investors willing to take a long-term view and ride out the higher volatility of these markets stand to benefit from the tailwind that higher GDP growth provides.

Reporting this week of Mukesh Ambani and Carlos Slim's rapid ascent to the #1 and #2 positions in world wealth ranking (both appear to have edged out Bill Gates) is a sign of India and Mexico's strong economic growth and soaring stock market fortunes (as well as evidence of how concentrated wealth is among the super-rich in these countries of relatively low per-capita GDP). Also, Warren Buffett's investment in POSCO (NYSE: PKX) and other South Korean stocks is indicative of the potential upside this Asian market offers.

(Disclosure: The author does not currently have positions in any of the ETFs or stocks mentioned in this article but is overweight in non-U.S. equities from high-growth countries.)

Can sentiment predict market direction?

Question: Is investor sentiment a useful indicator of market direction? If possible, I would like to trade on sentiment to make money.

Blogger Sentiment

Popular measures of investor sentment are reported in Barron's each week. For brief background reading, try the Investopedia article entitled "Investors Intelligence Sentiment Index." The article cites an academic study published in 2000 by Ken Fisher and Meir Statman that concluded: "We found the relationship between the sentiment of newsletter writers as measured by the Investors Intelligence survey and future S&P 500 returns to be negative but not statistically significant." As is the case with most (if not all?) fundamental and technical indicators, the prospect of using a simple sentiment index to trade and consistently realize excess profits does not look very encouraging.

However, instead of giving up so easily, let's have a look at a newer sentiment index that is being tracked by Ticker Sense, a financial blog of Birinyi Associates, run by former Salomon executive Laszlo Birinyi. Beginning in July of 2006, Ticker Sense has been reporting at the start of each trading week market sentiment figures resulting from a poll sent out to participating bloggers the prior Thursday. Bloggers state whether they are bullish, bearish or neutral on the S&P 500 for the upcoming 30 days. The chart below shows this sentiment data for the past 12 months.



We can develop a qualitative feel for how useful this type of sentiment data might be in a trading context by plotting the S&P 500 index alongside the weekly difference between the bull and bear sentiment percentages. The chart below shows that for the past couple of months blogger sentiment has correlated favorably with the directional movement of the S&P 500 index--the market moves down with negative bull-bear sentiment in early August, up with positive bull-bear sentiment from about mid-August through the market's recent highs in early October, and down on slightly negative sentiment last week. Hey, this is beginning to look promising. . . .



"Batting Average" Test

One barometer for gauging how helpful blogger sentiment can be in predicting market direction is to perform a "batting average" calculation. A baseball player's batting average is a number between zero and 1.000 (or zero and 1000, if we ignore the decimal point), indicating the ratio of hits to at-bats during a season. For example, during 2004 when Seattle Mariners all-star player Ichiro set a new all-time major league baseball record with 262 hits, his batting average in his 704 season at-bats was 262/704 = 0.372.

In an analogous fashion, we can define a sentiment "batting average" as being the time-average of the relevant (bull, bear or neutral) sentiment percentages corresponding to the actual up, down and flat market outcomes observed during all of the trials in a specified testing period:

Sentiment "Batting Average" = Sum(X_i)/N,

where

X_i = bullish (bearish, neutral) sentiment percentage at time i-1 if market return ends up in bullish (bearish, neutral) range at time i,

and i runs from 1 to N, inclusive, where N is the number of trials in the testing period.

(Note: Since the Ticker Sense sentiment poll is updated at a weekly frequency, for our analysis we pair each week's sentiment data with only the following week's market movement. In effect, sentiment predictions are "refreshed" each week, even though bloggers participating in the poll are asked for their opinion about the next 30 days.)

Here's a numerical example: If a particular week's sentiment poll gives bull-bear-neutral sentiment percentages of 50-30-20 and the market ends up falling into the bearish range the week after the poll is taken, this particular trial contributes an X-value of 0.300 to the average. Obviously, the highest batting average is attained when the actual market movement always matches the strongest prevailing sentiment (or highest percentage) among the three possible sentiment "states" (bull, bear and neutral).

Two extreme cases help to clarify the meaning of our sentiment "batting average": If all bloggers participating in the poll had complete clairvoyance, the sentiment percentages would always be 100-0-0 (bullish), 0-100-0 (bearish) or 0-0-100 (neutral), and each trial would always contribute an X-value of 1.000, resulting in a perfect time-average of 1.000. At the other extreme, if the bloggers were always completely split without any predominating opinion, the sentiment percentages would be 33-33-33 (rounded), and each trial would always contribute an X-value of 0.333, regardless of whether the market rises, falls or remains flat. Importantly, this batting average of 0.333 is also the expected outcome when collective opinion, whether skewed or split, is no better than a random guess at determining market direction.

In order to apply our batting-average methodology to the blogger sentiment data, we also need to define what we mean by bullish, bearish and neutral outcomes, and ideally these three "states" should be equally likely, so that no particular outcome is favored over the others. To take into account the possibility of "trending" regimes, rather than referencing static return ranges I use a 26-week moving window ending just prior to each weekly trial:

"Bullish": Above 67th percentile return of immediately prior 26 weeks

"Neutral": Between 33rd and 67th percentile return of immediately prior 26 weeks

"Bearish": Below 33rd percentile return of immediately prior 26 weeks

Though there is some variation from week to week, for the S&P 500 over the past year the 26-week moving averages of the 33rd and 67th percentile weekly returns have hovered around -0.3% and 1.2%, respectively, giving sentiment ranges approximately as follows:

"Bullish": Weekly return above 1.2%

"Neutral": Weekly return between -0.3% and 1.2%

"Bearish": Weekly return below -0.3%

The graph below shows the week-by-week contributions to the overall average. For example, for the week ending October 5, bullish sentiment (from the poll sent out Thursday of the prior week) was 50% and the market traded up, thereby contributing an X-value of 0.500. Note, however, that the overall average from the past one year is the smaller figure of 0.319, which is slightly worse than the 0.333 expected in the case of random guessing. In other words, the batting-average calculation suggests that blogger sentiment will probably not be very useful in predicting market direction.



Simulated Trading Test

Another way to visualize the sentiment data is to look at scatterplots of the bull-bear sentiment difference (at time i-1) versus S&P 500 returns for the following week (at time i). I divide the past year into two 26-week periods to enable us to run two simulated trading tests on the sentiment data.

For the first 26-week period, from October 2006 through April 2007, there is a somewhat negative correlation between sentiment and returns, suggesting that sentiment could be slightly contra-indicative of market direction.



However, over the next 26-week period, from April 2007 through October 2007, the correlation is essentially zero, indicating no apparent relationship between sentiment and subsequent returns.



We can trade on the sentiment data by using the weekly bull-bear sentiment differences to weight one-week trades on the S&P 500 index (or futures), going long when the difference is positive (net bullish) and going short when it is negative (net bearish). Trade size equals the absolute value of the bull-bear sentiment difference, so that we take larger trading positions when sentiment is more extremely bullish or bearish. The graph below shows the simulated outcome of such trading over our two 26-week periods. The initial 26-week trading period produces a loss, while the later 26-week trading period begins in negative territory but goes slightly positive from early August to early October when sentiment, as mentioned above, matches market direction.



Is There Hope?

Overall, with the batting-average test failing to show all-star-like performance above the 0.333 expected value of random guessing, and the trading test producing what appears to be little more than a random walk, it is difficult to place any confidence in blogger sentiment as a useful predictor of market direction.

But, perhaps we should not overlook how traders, investors and bloggers (myself included) all learn as we go, thereby opening up the possibility that the blogger sentiment index could be an example of a self-improving dynamic system engaged in an adaptive learning process. The most recent two months certainly show promise, and sentiment data from last Thursday's poll (bull-bear-neutral: 50-33-17), with bloggers turning bullish following last week's 4% sell-off, again matches the S&P 500's interim performance so far this week (up from Friday's 1501 close)--though, of course, it is too early to tell how the remainder of the week will turn out.

What, then, should we believe: the negative overall read from the past year, or the more promising performance of sentiment over the past few months? Rather than allowing our hopes to rise too high, I suggest keeping in mind a market truism: if there really is any predictive power in a well-publicized indicator, opportunistic traders will soon exploit this information, thereby squelching any excess returns that might have been available. Maybe, then, the trick is to be quick--exploit the winning "streak" before it vanishes! Good luck trading!

How can I use the PEG ratio to value stocks?

Reader's Question: I have a started to pay attention to PEG ratios. Can you please explain how to calculate the PEG ratio for a stock? Can you show how Apple's (Nasdaq: AAPL) PEG is 1.6, as you indicated in an earlier post? How can PEG be used to value stocks? What is a good source for finding estimated five-year growth rates?

Calculation of PEG

The PEG ratio is a straightforward way to combine two fundamental aspects of stock analysis for the purpose of gauging how cheap or rich a stock is trading:

Earnings: Traditional value-oriented analysis looks at price ratios, the most common of which is the price-to-earnings, P/E, or "PE ratio." At a given level of earnings (E), a lower price (P) results in a lower PE ratio, providing investors with a "cheaper" investment.

Growth: Extension of PE ratio analysis to include growth can be accomplished by simply dividing the PE ratio by the earnings growth rate (G), which gives (P/E)/(100 x G), or the "PEG ratio." The factor of 100 is included to convert the growth rate from a percentage to a number of percentage points (e.g., 15% = 0.15, becomes 0.15 x 100 = 15). Since PE ratios are typically around 15 to 20, and growth rates are often in the 10% to 15% range, the PEG ratio is often numerically around 1 or 2 (note that the S&P 500 has a PEG ratio of 1.64, according to data from the Yahoo! Finance Stock Screener). As with PE ratio, a lower PEG ratio generally indicates a "cheaper" stock.

To run through an example for Apple (Nasdaq: AAPL): In the earlier post that you refer to, from back in early September, when Apple was priced at $144 per share, the trailing 12 months (July 2006 to June 2007) of reported earnings were $3.55, the one-year forward (to Sep-2008) consensus earnings estimate was about $4.40, and the consensus earnings growth estimate for the upcoming five years was 22.5%. At that time, I calculated the PEG ratio for Apple as follows:

PEG = {$144/[($3.55 + $4.40)/2]}/(100 x 0.225) = 1.6 (as of close on 04-Sep-2007),

where I use the average of the trailing 12 months (ttm) and one-year forward earnings to generate a proxy for "current" earnings on an annualized basis.

Today, with Apple trading 21% higher at $174 per share and the one-year forward consensus earnings estimate having been raised to $4.58 through revisions reported by the 27 analysts covering the company, the PEG ratio calculates to:

PEG = {$174/[($3.55 + $4.58)/2]}/(100 x 0.225) = 1.9 (as of close on 18-Oct-2007).

The higher PEG, caused by the rise in the stock price, reflects Apple's richer valuation, versus a month and a half ago. Surely, we would be measurably wealthier today if we had bought Apple in early September at $144 (corresponding to the lower PEG of 1.6) and held our shares through today's close of $174 (corresponding to the higher PEG of 1.9).

PEG and Returns

Now, if succeeding at investing were as simple as buying low-PE or low-PEG stocks and selling out at higher PE and PEG ratios, it would seemingly be easy to make money. Generally, what we, as investors, really want to do is maximize our return-on-investment. In other words, while PE and PEG are convenient price ratios that help to describe a stock, ultimately we are more concerned with the compounded annual return, R, in the formula:

(Price at 5-Year Horizon) = (Price Today) x (1 + R)⁵,

where we select a five-year investment horizon to match up with the standard five-year term used in earnings growth estimates provided by Wall Street analysts.

It is instructive to understand how PE, growth rate and PEG all relate to return-on-investment. By definition of the PE ratio (i.e., PE = P/E), we can write:

(Price at 5-Year Horizon) = PE₅ x E₅ = PE₅ x E₀ x (1 + G)⁵,

applying, in the second equality, the definition of earnings growth from today to the end of year five. Setting the right-hand sides of the above equations equal to one another and rearranging, we can write:

(1 + R)⁵ = (PE₅/PE₀) x (1 + G)⁵,

recognizing that (Price Today)/E₀ = P₀/E₀ = PE₀.

Although analysts report estimated five-year earnings growth rates (G), the terminal PE ratio at the end of the five-year investment horizon (PE₅) is not a commonly reported figure. Since the purpose of this discussion is to look at five-year returns, I am going to assume for the scope of our calculations that the terminal PE ratio equals the analyst consensus five-year earnings growth rate (multitplied by a factor of 100). To see why this is a reasonable assumption to make, let's again look at numbers for Apple: since G = 22.5%, we are assuming that PE₅ = 100 x G = 22.5. Today, Apple's PE ratio based on current earnings is about 43. We are essentially assuming that over the next five years, as the company's iPod and iPhone product lines mature and both revenue and earnings growth decelerate, Apple's relatively high current PE ratio of 43 will fall to a terminal five-year value of 22.5, which is about half of where it is today.

Our terminal PE assmption allows us to rewrite our return equation as:

(1 + R)⁵ = (100 x G/PE₀) x (1 + G)⁵ = (1/PEG) x (1 + G)⁵,

which tells us that return, R, is high when the PEG ratio is low and the earnings growth rate (G) is high. In other words, in order to maximize our investment return, we are concerned not only with low PEG--we will also want to pay close attention to companies that have high earnings growth rates.

While our last result is conceptually appealing, it turns out that PE and PEG ratios are more readily available in online databases than the growth rate, G. Consequently, for convenience we use the definition of PEG to rewrite the return equation as:

(1 + R)⁵ = (1/PEG) x [1 + PE₀/(100 x PEG)]⁵,

or, solving explicitly for the return-on-investment:

R = [1 + PE₀/(100 x PEG)]/PEG^0.2 - 1.

To help visualize what this equation means, I provide the graph below, showing contours of constant PE. Observe that calculated returns are higher for lower values of PEG. Also, for a given level of PEG, a higher PE ratio (implicitly indicating a higher earnings growth rate) produces higher returns.



We can also take a look at contours of constant return, as indicated in the plot of PEG ratio versus current PE ratio below.



Back to our example for Apple: If we had bought the stock in early September at $144, when the current PE ratio was 36 and the PEG was 1.6, our pro forma five-year annualized return would be 11.4%. The same calculation today with Apple's share price at $174, current PE ratio of 43, and PEG ratio of 1.9 gives a pro forma return of 7.7%. Since the stock price has risen 21%, while our assumptions about future earnings growth remain unchanged, anyone buying the stock today should, of course, reasonably expect to earn a lower return, compared to having bought Apple shares when they were cheaper in early September.

Application to Dow Component Stocks

To build our intuition about the relationship of return to PE and PEG ratios, it is helpful to look at actual market data for familiar stocks, such as the 30 components of the Dow Jones Industrial Average. The scatterplot below shows the PE and PEG ratios for each of the Dow 30 component stocks. JP Morgan Chase (NYSE: JPM) has the lowest PE ratio, at 9.5, while McDonald's (NYSE: MCD) has the highest PE ratio, at 25.6. AIG (NYSE: AIG) has the lowest PEG ratio, at 0.78, while Pfizer (NYSE: PFE) has the highest PEG ratio, at 2.74.



Using our expression for return, R, we can proceed to calculate the pro forma five-year returns based on the PE and PEG data, again assuming that the terminal PE at the five-year horizon equals the five-year earnings growth rate as projected by the analyst consensus estimate. Results are plotted below.



Notice that there is a very strong correlation between low PEG and high pro forma return. AIG, trading at a low PEG of 0.78 (PE = 9.9, G = 12.7%) produces the highest pro forma return, a very respectable annualized rate of 18%. At the other end of the spectrum is Pfizer, with a PEG of 2.74 (PE = 10.3, G = 3.8%) that leads to a strongly negative pro forma return of -15%. It is the measly estimated growth rate of 3.8%, coupled with the assumption that the terminal PE equals this growth rate (indeed, a PE ratio of 3.8 is awfully low!) that produces the substantial loss on a pro forma basis.



Cautionary Remarks

As with most (maybe even all) analytical frameworks for valuing stocks, the formulation presented above has its shortcomings. The pro forma returns are calculated by relying on two key underlying assumptions to make the otherwise formidable problem tractable:

Consensus Earnings Growth Estimates: Analysts periodically revise their earnings and earnings growth estimates, based on new information about a company's business plans, the competitive landscape, industry pressures, and the overall economic outlook. Five-year growth estimates, though the "best available" at any point in time, can and do vary considerably from quarter to quarter and year to year.

Terminal PE Ratio: While our assumption that the terminal PE ratio at the five-year horizon equals the five-year earnings growth rate may be a reasonable one that allows for a "ballpark" comparison of pro forma returns for investment in many different stocks across diverse industries, it simply is not possible to determine PE ratios so far forward in time with any degree of confidence and accurary.

Consequently, we cannot and should not expect the calculated pro forma returns to end up closely predicting the actual returns that will materialize over the next five years. The financial world is complex and continually changing and, with this change, our assumptions themselves need to shift as the months and years go by. Think of stock forecasting models as being like "the man who is always 100% confident, except that his opinion changes from day to day." You see, on any particular day it is possible to peer five years into the future; but you must realize too that our predictions today about future years will generally be very different from our predictions next month about these same future years.

Nevertheless, the PE and PEG ratios, while having limited predictive power, do remain useful tools for assessing the cheapness or richness of stocks--at least in the current market environment, and at least relative to other stocks in the same or similar industries. For an analysis of potential returns offered by leading U.S. and Chinese Internet stocks, applying techniques explained in this article, please see my recent post highlighting prospects for Baidu (Nasdaq: BIDU) and Google (Nasdaq: GOOG).

Data Source

A comprehensive source for stock data is Yahoo! Finance. The Key Statistics page for any listed stock includes the trailing 12-month PE, forward 1-year PE, and PEG ratio. From these PE and PEG ratios, we can obtain the five-year earnings growth rate, G, by working through the definition, PEG = (P/E)/(100 x G). The consensus five-year earnings growth estimates, G, are given on the Analyst Estimates page for any listed stock, along with PE and PEG ratios.

(Disclosure: Among the stocks mentioned in this article, the author holds or manages long positions in Baidu and Google.)

Is Baidu worthwhile buying now?

Reader's Question: Baidu (Nasdaq: BIDU) set an all-time record high of $359 (intra-day) on Thursday, before plummeting 14% on news of an analyst's reduced revenue forecast. Despite the sharp price swing, the stock closed on Friday at $323, essentially unchanged for the week. Is the stock now a buy? What do you think about future prospects?

First of all, regarding the JP Morgan analyst's 2007Q3 revenue cut from $67.9 million to $65.7 million (that's just 3%), I tend to agree in principle with Jim Cramer's comment that it "means nothing to me"--since it's the company's underlying business that drives the stock price in the long run, not what analysts say or write, and, in any event, the analyst, Dick Wei, maintains his overweight rating on Baidu (Nasdaq: BIDU) with a price target of $400. I also think there's a lot of truth in Cramer's remark that "the stock is going to $500,"--however, I do not know if it will take months or years to get there and, if Baidu's recent trading pattern is any indication, the ride from here to $500 is likely to be a very volatile one.

Revenue Growth Matters

Although cash flow, earnings and the prospect of future dividends are what determine whether a particular stock will rise or fall in the long run, the key driver of growth is top-line revenue, without which there can be no bottom-line profit. As is very clear from the graph below, between 2004 and 2006, Google (Nasdaq: GOOG) overtook Yahoo (Nasdaq: YHOO), Amazon (Nasdaq: AMZN) and eBay (Nasdaq: EBAY) in revenue generation, catapulting the global search leader into first position among Internet companies. Analogously, as if in a Chinese sequel to Google's success story, during 2007 and 2008, Baidu is expected to sprint past the current Chinese Intenet revenue leaders, Sina (Nasdaq: SINA), Sohu (Nasdaq: SOHU) and Netease (Nasdaq: NTES).



Among these U.S.- and China-based Internet companies, only Google and Baidu still show annual growth rates exceeding 50%. For 2007, Google's revenue is expected to expand to 58% above its 2006 level, while Baidu's revenue is forecast to surge 108%. For 2008, while consensus estimates show Google's growth slowing to 37%, Baidu's growth is projected at 78%. The message here is that China, being a younger Internet market with still only about 10% of its 1.3 billion population online, exhibits higher growth. A careful look at the graph below also reveals that revenue growth for the other Chinese Internet companies--Sina, Sohu and Netease--is generally expected to accelerate going into 2008, presumably boosted by the positive impact of the upcoming Beijing Summer Olympics on online ad spending by corporate customers.



Pro Forma Returns

Clearly, Baidu is growing the fastest among the Internet leaders. However, with its stock price having tripled from its 2006 close of $113, it is now trading around a PE of 145 based on expected 2007 earnings, which most people consider nosebleed territory. Before jumping to conclusions based on PE ratio alone, however, let's see how the expected investment return from holding Baidu over the next few years compares to that for the other companies.

Using analyst consensus EPS figures for 2007 and 2008, along with the consensus five-year earnings growth forecasts, we can project where earnings are expected to be five years from now for each company. Letting the five-year growth rate also serve as a proxy for the terminal PE ratio at the five-year horizon (consistent with PEG = 1), we can then calculate a terminal stock price for each company, from which we can derive the pro forma return figures shown in the table below.



Notice that, largely due to their higher expected growth rates, Google and Baidu show the highest pro forma returns, each being a little above 30% per annum. Even if it turns out that the terminal PE ratios end up being just half of what we have assumed, the five-year returns for Google and Baidu will be around 15% per annum, which is still a very respectable long-run rate of return.



Baidu Is Still a Buy

Compared to where we were a year ago--when Baidu was trading around $85 on 2006 EPS of $1.08 and revenue of $105 million--the stock trades at a much richer price today. During the past 12 months, Baidu's stock price has almost quadrupled (to $323 at Friday's close), while expected 2007 EPS at $2.22 is a little more than double the level a year ago, as is expected 2007 revenue at $225 million. No longer can we say that Baidu is cheap; however, it does not look outrageously expensive either.

Today Baidu's market cap is about $11 billion, still just 5.5% of Google's $200 billion, and still inside of the ratio (8.8%) of number of Baidu (3.25 billion) to number Google (37.1 billion) worldwide searches, as reported by ComScore for the month of August If Baidu's market cap quadruples over the next decade, it will approximately reach the level where Yahoo ($38 billion), Amazon ($38 billion) and eBay ($54 billion) presently are--which seems very possible based on the potential size of the Chinese Internet market. Also, as another general indicator of rational valuation, note that Baidu is about four or five times the size of Sina ($3 billion), Sohu ($1.7 billion) and Netease ($2.3 billion), which is in line with the multiple of Google's market cap to that of Yahoo, Amazon and eBay.

For anyone already long or interested in buying in at today's levels, I would suggest taking a long-term view, not letting the wild day-to-day gyrations of this particularly volatile stock in a volatile market sector ravage your emotions. Potential upside factors to pay attention to are: incremental growth of Baidu's current 58% Chinese market share (versus Google's 23%), in a leader-grab-more manner, mirroring Google's success in the U.S. market; the possibility that Baidu's deployment in Japan begins to show meaningful revenue; future search enhancements following establishment of new research centers in Shanghai and Tokyo. We should also keep in mind, however, the risk that Google, through its partnership with Sina, could begin to wrest market share away from Baidu.

All in all, I think that Baidu today is still a buy, but with the stock price up some 300% in 12 months, versus year-on-year revenue and profit growth of a "mere" 100%, I cannot be as bullish as I was a year ago. That said, I do see potential for another 300% rise, which would vault Baidu to around $1,300 per share, though this is likely to take another five or ten years. So, unless you like being disappointed, I wouldn't start looking for anything north of $1,000 per share until the Olympics following Beijing, i.e., five years from now in 2012, when the Summer Olympics are in London. Bear in mind, too, that if the Shanghai stock market is a bubble which bursts over the next year, we are likely to have trouble even reaching Wei's target of $400, let alone Cramer's bogey of $500. Let's hope that a year from now we won't find ourselves looking back and reluctantly having to admit that Warren Buffett's recent sale of PetroChina (NYSE: PTR) was prescient--for, at least in the short run, it appears the market is still headed higher.

(Disclosure: Among the stocks mentioned in this article, the author either owns or manages long positions in Baidu, Google, eBay and Netease.)

Is the Chinese stock market a bubble?

Reader's Question: What causes asset price bubbles? Have Chinese stocks reached bubble levels? Can you share your perspective on the potential for a Chinese stock market crash?

The Logic of Asset Bubbles

Given the commonly accepted conclusion (with 20/20 hindsight, of course!) that the Japanese stock and real estate markets around 1990, dot-com stocks in the year 2000, and current U.S. housing market (now beginning to deflate) are all notable examples of asset price bubbles, and that at least some people are smart enough to learn from the past, it would seem logically to follow that either:

1) All market players ought to be wiser now and should behave more rationally (i.e., "arbitraging away" bubbles by selling overly rich assets and buying whatever is cheaper), so that future bubbles caused by psychological polarization and excessive asset buying do not have a chance to form, or

2) Even if not all market players have learned their lesson, at least the more alert and perceptive investors among us ought to have learned from prior bubbles and should now know when to buy and sell to profit from any bubble currently underway.

If #1 above is true, then the Chinese stock market is not a bubble, since investors are collectively "smarter" now and behave as a group to "nip any bubble in the bud," so that it never forms. Alternatively, if #2 above is true, then there's an opportunity for at least those who have learned from the past (that's both you and I, right?) to become a little richer. . . .

Before getting too carried away with theory, however, let's see if we can learn anything by looking at some actual Chinese market data.

Shanghai Premium

From the vantage point of a U.S.-based investor, the most readily accessible Chinese stocks are those that are listed on U.S. stock exchanges. Some of these companies are listed only in the U.S., like China's dominant search provider Baidu (Nasdaq: BIDU), even though their businesses are inherently Chinese. Others are listed in both the U.S. and Hong Kong, like oil giant PetroChina (NYSE: PTR), whose domestic IPO in Shanghai has been approved but not yet launched (incidentally, PetroChina is also a stock which Warren Buffett has been (for better or worse?) incrementally divesting of late). Still a smaller group of companies is triple-listed: in the U.S. as ADRs (or ADSs), in Hong Kong and also in Shanghai.

Because current Chinese government policy severely restricts both investment by domestic Chinese in markets outside of mainland China and investment by non-Chinese investors in the domestic Chinese market, the Shanghai stock market is effectively isolated from the Hong Kong and U.S. markets. Consequently, domestic pricing in Shanghai is driven by a different set of supply-demand curves, while U.S. and Hong Kong prices for a particular stock move more or less in tandem, after translation through the foreign exchange rate and ratio of shares per ADS.

Historically, the Shanghai market has traded at a premium to Hong Kong and the U.S., indicating a higher level of overall demand by domestic Chinese investors for the same stocks. This "Shanghai premium" is most evident if we focus on the handful of triple-listed stocks:

Yanzhou Coal Mining (NYSE: YZC, $101.70; Hong Kong: 1171.hk, HKD 15.32; Shanghai: 600188.ss, CNY 22.92), 50 shares per ADS

China Petroleum & Chemical Corp., "Sinopec" (NYSE: SNP, $126.81; Hong Kong: 0386.hk, HKD 9.77; Shanghai: 600028.ss, CNY 18.94), 100 shares per ADS

Huaneng Power International (NYSE: HNP, $52.48; Hong Kong: 0902.hk, HKD 9.90; Shanghai: 600011.ss, CNY 17.42), 40 shares per ADS

Guangshen Railway (NYSE: GSH, $42.30; Hong Kong: 0525.hk, HKD 6.40; Shanghai: 601333.ss, CNY 9.93), 50 shares per ADS

China Life Insurance (NYSE: LFC, $95.97; Hong Kong: 2628.hk, HKD 48.35; Shanghai: 601628.ss, CNY 62.41), 15 shares per ADS

Aluminum Corp. of China, "Chalco" (NYSE: ACH, $76.85; Hong Kong: 2600.hk, HKD 23.10; Shanghai: 601600.ss, CNY 47.75), 25 shares per ADS

(Prices shown above are closing prices on October 5, 2007 for New York and Hong Kong, and September 28, 2007 for Shanghai due to holidays last week. Exchange rates: 7.76 HKD/USD, 7.51 CNY/USD.)

The graph below shows in percentage terms how the Shanghai premium for these stocks has varied over time, beginning with Yangzhou Coal Mining in 1999 and joined by the other companies as they later became triple-listed, the most recent being Chalco with its Shanghai listing in the middle of this year. Notice how the Shanghai premium contracted from the 200%-400% range in 1999-2000 to zero, on this scale, at the end of 2005. Then, beginning in 2006, the premium resurfaced, gradually building in conjunction with the outperformance of the Shanghai market, to the 50%-100% range where it sits today.



Taking a broad-brushed approach to highlight general trends, we can see from the graph below that over the past eight years the New York-listed, per-ADS share values of these companies have consistently marched higher, with some price acceleration over the past year or two. There is, of course, plenty of variation among the particular stocks, but the basic trend is as stated--up.



Examination of the Shanghai-listed per-share values of the stocks, on the other hand, presents a different picture, as shown below. From 1999 through 2005, these stocks in the Shanghai market traded sideways, followed by a quick ascent beginning in 2006. The flatness of Shanghai prices while New York and Hong Kong prices steadily rose during 1999 to 2005 corresponds to the falloff in the Shanghai premium during this time period. The relative outperformance of the Shanghai market from 2006 coincides with the reappearance of the premium over the past two years.



Which Market Is Right?

Now, with two strikingly different indications of value--the higher one in Shanghai and the lesser one in Hong Kong and the U.S.--being the source of the Shanghai premium, it would seem that both markets can't be right. Either the Chinese on the mainland are, relatively speaking, paying too much for these stocks, or investors outside of China are not yet paying enough. A common explanation of the situation, based on pent-up domestic Chinese demand chasing too little domestic supply of shares, attributes the valuation "error" to the restricted Chinese investor, suggesting that Shanghai pricing is more overvalued than Hong Kong and U.S. pricing is undervalued.

Over the years ahead, as the Chinese government fully opens the gates and allows unrestricted two-way capital flow in and out of China's stock market, the Shanghai premium must vanish, since it will then presumably be possible for traders to arbitrage small pricing differences between markets. In the meantime, there is an opportunity, albeit risky, for investors outside of China to go long Hong Kong- and New York-listed shares, based on the expectation of continued upward price pressure through increasing demand from mainland Chinese investors for cheaper offshore shares as Chinese financial policy liberalizes.

How to Play the Bubble, If There Is One

To resume our bubble discussion: If the Chinese market is not a bubble (scenario #1 above) and the future GDP and earnings growth implied by current price levels actually does materialize, then anyone long needn't worry so much, since the market is behaving rationally and Chinese stock prices should not collapse, despite their recent run-up. On the other hand, if the Chinese market is a bubble (scenario #2), then, although it is extremely difficult to know when the bubble will burst, investors in Hong Kong- and New York-listed shares can find some degree of comfort in the upward price pressure from the Shanghai premium. In this regard, the New York-listed ADS shares of Chalco and Sinopec, with Shanghai premiums currently around 100%, offer a larger "cushion of safety" than the other four companies, all of which are trading at significantly smaller, though still very sizeable, Shanghai premiums.

(Disclosure: Among the stocks mentioned in this article, the author has been and remains long at the time of this writing shares in the following companies: Baidu, Chalco and Sinopec.)

Have you read the new book, An American Hedge Fund?

Question: What do you think of Tim Sykes' newly released book, An American Hedge Fund?

Below is a review I wrote up earlier in the year. Read the book for insight into the hedge fund business, from the point of view of an outsider looking in. It's a captivating story about wealth-building and a young day-trader's tenacity and entrepreneurial spirit.

A Modern Odyssey: Young Day-Trader Turns Hedge Fund Entrepreneur

Timothy Sykes’ An American Hedge Fund is the candid autobiography of a young, spectacularly successful day-trader, chronicling his rapid ascent from $12 thousand in Bar Mitzvah gifts in 1998 to $2.75 million in hedge fund assets at the end of 2005—and his equally dramatic, ego-deflating slide over the next 15 months, halfway down the financial mountain he single-handedly built.

Mainly, as told from the perspective of a “little guy” newcomer struggling to gain a toehold in the exclusive New York-centric hedge fund scene, this captivating book is a personal finance story, offering a vicarious educational experience for aspiring traders and budding entrepreneurs. From our front-row seat, eyes glued to Tim’s triplet of high-tech trading screens, we follow him on the way up as he nimbly advances from trading publicity plays to overnight gap-ups to short-selling microcaps, and on the way down when he diversifies away from his trading niche through a venture capital investment that unfortunately turns sour. During the Internet craze of the late 1990s, dot-com crash in 2000, post-9/11 market volatility and subsequent bull market, we see play-by-play examples of intraday trades that work for a while but, sooner or later, stop being profitable. In spite of (or perhaps because of) his strikingly high trading volume (annual turnover rate of 200 times fund size!), Tim shows remarkable adaptability, uncannily discovering new market opportunities whenever old ones fade away.

Parallels exist between self-appointed hero, Tim Sykes, and well-known “giants” of finance. As Tim’s story unfolds, we find him engaged in: trading baseball cards and reselling lost tennis balls, reminiscent of Warren Buffett’s many childhood business ventures; playing high school tennis with a fervor akin to Victor Niederhoffer’s in pro squash, and experiencing a similar reversal of fortune (though thankfully not as shattering as Niederhoffer’s); switching from the long side to the short side of trades, with the agility of George Soros; and suffering through investor withdrawals precipitated by unexpected fund losses, though fortuitously without the crippling leverage that ultimately led to the demise of colossal hedge fund, Long-Term Capital.

Similarities with the world’s wealthy and famous aside, however, the true richness of An American Hedge Fund lies in Tim’s honest, inspirational and, at times, entertaining portrayal of his personal aspirations, struggles, triumphs, defeats, admission of mistakes and, ultimately, wholehearted tenacity—something the underdog in all of us can easily relate to. Despite misfortune—elbow pain stymies his pro tennis dreams, spotty high school grades preclude him from admission into Ivy League colleges, size requirements prevent deep-pocketed institutions from investing in his small hedge fund, and straying into venture capital brings heavy losses—Tim always finds a way to pick himself up and move on.

Having battled the microcap market with the fortitude and intensity Odysseus displayed fighting the Trojans, Tim, still a youthful 20-something, now enters the next leg of his life quest, this time in the public spotlight as financial media celebrity and up-and-coming author. Are these latest developments a temporary distraction, or the beginning of a longer-term wandering like Odysseus’s circuitous, decade-long journey home from battle across the Aegean Sea? Whatever Tim’s future may bring, following his formative years of nearly incessant buying and selling of stocks, I find it hard to fathom how he could be content for long without trading.

Which should I use, a full-service or discount broker?

Reader's Question: I trade commodities through a full-service broker, paying commissions of $73 for each option trade I make. I am considering switching to a discount broker for lower commissions but have read that discount stock brokers can end up costing an investor more through "hidden costs" coming from time delays in trade execution, worse pricing when filling orders, etc. Which is the better alternative: full-service or discount?

Trading Cost Comparison

First, from a trading efficiency point of view, we need to examine whether the higher commissions full-service brokers charge are worth any improved trade execution they offer. For the sake of this discussion, I assume that considerations relating to the choice between full-service or discount brokers generally apply to both commodities and stock trading. The information I share comes from the stock arena.

In the way of background, you may wish to browse an SEC article summarizing the methods available to a broker for execution of a customer's trade: a) direct to stock exchange; b) through a market maker, with the broker earning payment for order flow; c) to an electronic communications network (ECN) for automatic processing, particularly for limit orders; and d) internalization of the trade on the brokerage firm's own account. Discount brokers often route trades through third-party market makers and get paid a "rebate" for order flow, which allows them to offer lower commissions. Full-service brokers usually route trades more directly to the stock exchange, which can result in better execution. Let's see how the two compare.

An academic paper published in 2005 reports on an empirical study conducted in 1999 involving 64 actual (32 buy and 32 sell) trade executions of 100 shares each of NYSE- and Nasdaq-listed stocks through six different brokerages, two from each of three categories: full-service voice-order brokers charging commissions averaging $47, brand-name online brokers with $23 average commissions, and deep-discount online brokers with $7.50 commissions. The authors found that "for NYSE listed stocks online brokers disproportionately route orders to regional and third-party exchanges offering fewer price improvements, compared to traditional brokers." However, for trading involving a 50/50 mix of NYSE- and Nasdaq-listed stocks, "we find no statistically significant difference among the three types of brokers on price improvements." Consequently, "Our empirical study found that online brokers offer lower quality trade execution [by about $0.01-$0.02 per share on NYSE trades], but that the higher commission costs of full-service brokers are not [emphasis mine] offset by these quality differences."

The bottom line is that you can generally execute "retail" size, small trades more efficiently using online discount brokers, since what you save through lower commissions will typically more than offset what you lose through the marginally worse trade execution the discount brokers tend to provide. However, if a full-service broker has a more direct connection to the commodities or stock exchange and can achieve better fills by, say, a penny or two on an underlying price of $50 to $100--that's one part in 5,000--then when notional trade size exceeds about $250,000, we reach a breakeven between paying commissions of $20 to a discount broker or $70 to a full-service broker.

Suggestion: You can do your own "experiment" by opening up accounts at both a full-service and a discount broker, splitting your trades in half, and proceeding to give equally sized, simultaneous and identical orders to both brokers. This will allow you to check which alternative really offers you more efficient overall trade execution, taking both commissions and fill pricing into account. If you do proceed with the experiment, I and many other readers I'm sure would be curious to find out what you discover; so, please post your findings as a blog comment below.

What's a Broker Relationship Worth to You?

Beyond strict, easily measurable economic cost, another consideration is that, if you have developed a good relationship with a full-service broker and believe you are significantly benefiting from the trading and investment advice and market information the broker provides, then you might not want to switch.

Here's some anecdotal evidence that may help: A few years ago a friend of mine told me that, despite drastically reduced commissions available through Internet-based discount brokers, he sticks with his traditional full-service broker since he "enjoys" being awaken at five in the morning by phone calls from his broker with breaking news about the stocks he owns. He insists that on at least a few occasions timely information from his broker directly impacted his buy-sell decisions and actually allowed him to make "many thousands of dollars" in profit, far outweighing the "mere hundreds of dollars" he paid in full-service commissions each time he traded.

Personally, I'm at the other end of the spectrum. I like to rely on my own ability to follow and interpret the news and do my own analysis. As such, I favor using reputable online discount brokers (at commissions of about $10 per trade) and can live very happily without any word-of-mouth investment tips, information and advice from brokers. At the same time, however, I do realize that there are some successful and sophisticated investors who prefer the full-service alternative, if for no other reason than they choose not to spend their time watching the markets so closely. Perhaps it's more of a lifestyle choice than anything else.

Will Keystone Automotive shareholders approve the $48 buyout by LKQ?

Reader's Question: In July, LKQ Corp. (Nasdaq: LKQX) offered $48.00 per share for Keystone Automotive (Nasdaq: KEYS) in an all-cash deal. Keystone is currently trading around $47.65. The merger is contingent upon approval by Keystone shareholders on October 10. Do you feel that the deal will go through? I am a Keystone shareholder and have voted "no."

Deal Background

For the benefit of any who have not been following the details of this deal, here's a chronology according to the September 5th proxy statement for the merger: Our story begins in December 2006 when Joseph Holsten, CEO of LKQ Corp. (Nasdaq: LKQX), phones Richard Keister, CEO of Keystone Automotive (Nasdaq: KEYS), to arrange a meeting. At dinner on January 18, Mr. Holsten broaches his interest in pursuing an acquisition, which leads to a meeting involving these two CEOs and the chairmen of their respective boards on March 2, when Keystone's shares are at $32.00. Since both companies are active in the replacement auto parts market--Keystone as a leading distributor of aftermarket collision auto parts and LKQ as a provider of replacement parts including recycled parts from salvaged cars--the merger is expected to produce abundant synergies, creating new efficiencies and marketing opportunities for the combined enterprise.

LKQ's initial price indication is $37 to $39 per share, half in cash and half in LKQ shares, which Keystone directors, now having engaged JPMorgan as advisor, formally reject on May 3, when Keystone's shares close at $37.57. Supported by JPMorgan's opinion that Keystone would be undervalued in the low-$40s, the Keystone team states (posturing?) that Keystone is "not for sale" and, even if it were, LKQ's indication of value is "significantly less than the intrinsic value of Keystone."

On May 7, LKQ raises its offer to $45 all-cash. The following day, the Keystone team discusses the situation and concludes that, besides LKQ, "no other automotive aftermarket supplier or other strategic industry participant would likely have an interest in acquiring Keystone due to, among other things, the differences in their business models with that of Keystone." Thereafter, JPMorgan turns to private-equity buyers, and a short list of six interested parties is whittled down to one potential buyer who offers $46 to $48 per share on June 15, contingent on arranging financing for the purchase.

On June 19, LKQ again raises its offer, now to $47, based on 60% cash and 40% stock, which Keystone counters with $49 all-cash. Over the ensuing month, Keystone decides to reject the private-equity buyer's offer, reasoning that LKQ is further ahead in the due diligence process and would be more likely to close given the financing commitment LKQ has already obtained from its bankers. Further negotiation between Keystone and LKQ leads to agreement, and Keystone's board approves the $48 all-cash deal on July 16, when Keystone's share price closes pre-announcement at $43.61.

The day of the merger announcement, July 17, Keystone's shares close at $46.80, up just 7%, while LKQ's shares jump 15% from $25.38 to $29.09. During the next two months through the close of trading this past week, LKQ's shares rise another 21% to $34.44, while Keystone's share price crawls up barely 2% to $47.67, just shy of the $48 all-cash buyout price. In short, while acquiror LKQ's shareholders have enjoyed an impressive 36% gain since the deal was publicly announced in mid-July, acquiree Keystone's shareholders have seen a much smaller 9% gain (see graph). With acquiror's shares having risen more than acquiree's, which is just the reverse of typical acquiror-acquiree share price action following merger announcements, something seems amiss. This unusual price behavior leads me to suspect that further surprises could follow.



How Should Keystone Shareholders Vote?

Apparently, the market is assigning kudos to acquiror LKQ in this deal, who manages, if the deal goes through at $48 as planned, to buy Keystone "on the cheap" and benefit from the resulting synergies between the two companies' businesses. Keystone shareholders, with their upside capped at $48 per share, certainly appear to be getting the short end of the stick. Indeed, there are some (viz., 4% shareholder Rockhampton Management and an analyst) who have already spoken out, insisting that the Keystone board failed to represent the best interests of the shareholders in negotiating and accepting the deal. However, rather than go down the path of discussing who's right or wrong, let's focus on the question at hand: Will the shareholders approve the $48 buyout deal on October 10?

As I see it, there are four possible outcomes:

1. New buyer enters bidding: By the terms of the merger deal, Keystone may terminate the agreement by paying LKQ $30 million plus expenses up to $1.4 million, which amounts to about $1.90 per share based on 16.6 million shares outstanding. This implies that any new buyer would need to offer at least $50 per share to enter the bidding at this stage. Similar to what occurred in the Blackstone Group's buyout of Equity Office Properties in February, it is possible that a qualified and serious second bidder surfaces over the next few weeks prior to October 10, forcing LKQ to raise its offer to above $50 per share to stay in the running. If a bidding war develops, the buyout price could run as high as $60 per share or more, in a combination of shares of the acquiror and cash. Possible bidders include auto parts distributors and retailers, recyclers and steel companies, and private-equity firms. The same private-equity buyer who bid earlier in the process could re-enter the bidding, and I have to believe that, however respectable JPMorgan's banking contacts are in the auto-related and private-equity sectors, there could very well be other potential buyers who, for whatever reason, are only now considering the situation seriously.

2. LKQ pre-emptively raises offer: If LKQ begins to sense that the Keystone shareholders could reject the deal in the October 10 vote, LKQ may wish pre-emptively to raise its offer to $50 per share or a bit higher to "sweeten" the deal to make sure that it gets approved. In my opinion, based on the attractive synergies the merger promises, LKQ will be better off in the long run following through with the deal, even if at a slightly higher price, than shortsightedly tolerating a rejection by Keystone shareholders and walking away with a $30 million consolation prize in hand.

3. No new offer and shareholders reject $48 buyout: If fewer than half of the Keystone shares are voted in favor of the deal, the $30 million termination payment will kick in, resulting in a one-time loss to Keystone of about $1.90 per share. That's, of course, an undesirable outcome; however, through deal disapproval, there's also a potential positive: Keystone's share price could actually rise a few dollars, based on the market's realization that the $48 buyout price was too cheap to begin with. Meanwhile, LKQ's share price would almost certainly fall, giving up part of the 36% gain from its pre-announcement price level, since the synergies of the merger would no longer be available. At this point, the stage would be set for a brand new round of buyout talks, this time with all parties having a better understanding of the value of Keystone, the synergies of an LKQ-Keystone combination, the market's consensus view of the situation, etc.--and I believe that all of this information, now public, should work to the advantage of Keystone shareholders.

4. No new offer and shareholders approve $48 buyout: In my opinion, a simple "yes" vote to approve the deal as it now stands would lead to the worst possible economic outcome for Keystone shareholders, since the share price is capped at the $48 buyout price. Each of the alternative scenarios above provides a means for Keystone shareholders to realize higher value for their shares.

Basically, the market has "spoken" through the unusual acquiror-acquiree price behavior of LKQ and Keystone shares following the July 17 deal announcement, revealing very clearly that Keystone is worth more than $48 per share, even though there remains some skepticism regarding a mechanism for Keystone shareholders to realize this value--hence, Keystone's share price still sits marginally below $48 per share. The market seems to be telling us that, despite factors in Keystone's business such as the Ford patent litigation risk and the question of whether State Farm will re-commence authorization of aftermarket parts, fundamentally the alternative auto parts market is a viable growth opportunity for LKQ, Keystone and other companies in their business niche.

I wonder whether the Keystone shareholders--the largest among them being Artisan Partners (7.6%), T. Rowe Price (6.9%), Wells Fargo (6.1%) and Wasatch Advisors (6.1%)--will collectively make the proper choice on October 10. Fortunately, control now rests in the hands of these shareholders, who, in my opinion, would only be shortchanging themselves by voting for the merger as it is currently priced. If, over the next few weeks, no new buyer surfaces and LKQ does not pre-emptively sweeten the deal to guarantee approval, then I believe Keystone shareholders will do themselves a favor by rejecting the $48 offer.

Potential Upside

While the actual outcome of the vote is difficult to predict, it is very possible that either another buyer surfaces and/or LKQ sweetens its offer on or about October 10, giving Keystone shareholders a more attractive deal to approve, significantly above the current $48 per share offer price. With Keystone's shares trading below $48, it appears that the market is suggesting that no higher bid will come. Though this might end up being the case, I note that market opinion can change very quickly, once the slightest hint of renewed buyout deal activity begins to flicker on traders' screens.

As an investor or speculator, what's the best strategy to follow? If the $48 deal as written closes by scheduled vote on October 10, anyone holding Keystone shares will realize a return of about 70 b.p. (= 48.00/47.67 - 1) over the three-week holding period from today through settlement shortly after October 10. Although 70 b.p. may seem small, it annualizes to a rate of about 12%, which is actually a very respectable worst case return. If any of a number of events lead to an elevated buyout price, a windfall gain of at least a few dollars per share could result, driving returns considerably higher. By the way I see it, there is essentially a "free" call option embedded in Keystone's current below-$48 share price, and the payout of this option could very well surprise on the upside.

(Disclosure: The author presently has no position in any of the companies mentioned in this article.)

I'm new to investing. Is there a simple place for me to start?

Reader's Question: I'm really new to investing. Do you have a simple place I can start or an article you've written that you can point me to?

Early this year, I assembled the main threads of my thinking on investing into a five-part blog series:

1. Passive Wealth Generation: From Zero to a Million Dollars in Five Measured Steps


2. What Investment Return Should We Target?


3. Investing in Equities


4. Why Controlling Fees and Expenses Matters


5. Perseverance in Long-Run Investing

In this series, I outline the basic methodology behind my own approach to investing, explaining why saving, setting realistic targets, buying equities, watching expenses and staying in the game are so critical to long-term success. As an investor, my own objective is to implement a sustainable investment system that works for perpetuity and properly sets the stage for managing whatever wealth remains in my portfolio when my time on our planet expires.

Within the blog articles, I mention a few books that you might find useful, one of which is Jeremy Siegel's Stocks for the Long Run.

In investing, as with most endeavors in life, I believe that focus and determination can carry one a long way. Since global equity markets tend to exhibit strong secularity (i.e., long-run returns are very significantly positive), really, time is on your side if you have sufficient patience and level-headedness to stick with it.

Should I use an investment advisory service?

Reader's Question: Which is a better way to invest--subscribing to a portfolio advisory service or choosing mutual funds on my own?

I look at investing as consisting of three primary decisions:

Buy equities or fixed-income instruments?

Buy individual securities or a highly diversified portfolio?

Use advisors or do it yourself?

Favoring Equities

As I have mentioned in earlier blog entries, I strongly favor holding essentially 100% equities in an investment portfolio. Historically, equities have outperformed bonds, bank deposits and other fixed-income instruments over multi-decade time horizons. Surely, there have been instances, like the post-tech-bubble fallout during 2000-2002, when equities have shown sharply negative returns. However, over the long run, given our wealth-centric, industrial economy driven by political, govenmental and social forces all promoting growth, it is, in my opinion, highly unlikely that equities will underperform bonds and cash for significant time periods. The current softness in the real estate sector may dampen consumer spending and lead to a recession, but I believe that our economy is quite resilient (though always "on the brink," as George Soros puts it) and will in due course provide better returns for businesses, owners of capital and risk-takers than for those who choose the "safer," fixed-income alternative.

Concentrated Portfolio

Owning one stock or mutual fund is not diversified enough and owning more than a few dozen stocks or mutual funds can be cumbersome to manage. I prefer to hold somewhere between 10 and 20 positions in my portfolio. In practice, I have found that if I hold more than this number of positions, I become unable to track closely enough the news and relevant events affecting my securities. Also, with fewer than about 10 positions, it becomes more difficult to tell if portfolio success (or failure) is just good (or bad) luck or actually statistically significant. For those who prefer mutual funds, it is possible to achieve adequate diversification with just a few fund selections, since the funds themselves are usually quite diversified. For reasons I provide below, however, I prefer managing my own concentrated portfolio of individual securities over investing in more highly diversified, fee-taking mutual funds.

Investing On Your Own

The price behavior of stocks is driven by a combination of random and non-random elements, with the predictable (i.e., non-random) factors typically being so weak that management fees, trading commissions, bid-offer spreads and other frictional costs tend to "wash away" the advantage that any sliver of predictability offers. Hence, we often hear how mutual fund and, more recently, hedge fund managers generally underperform market averages, despite their education, experience, talent and high incentive pay. Compared to practitioners of other professions (e.g., medicine, law and accounting), which offer services exhibiting more predictable outcomes and demonstrable benefits for clients, portfolio managers unfortunately find themselves battling market forces beyond their control. Given the intrinsic unpredictability of the financial markets (at least in the short run), it makes little sense to hire "expert" advisors who have no better than a random chance of outperforming the markets, especially after taking into account the management fees they charge.

Subscribing to a stock-picking or investment-timing advisory service will typically leave you no better off than handing over your investable assets to mutual fund managers. Instead, what I would suggest is one of two alternatives: either do your own research and pick your own equities, or invest in exchange-traded funds (ETFs) that replicate the performance of a market index or sector without making an attempt to time the market. The one area of investing that you do have control over is your out-of-pocket advisory fees and expenses, and keeping these at a minimum will likely improve your investment returns in the long run.

Are stocks with high price-to-book ratio worth buying?

Reader's Question: Are stocks with high price-to-book ratio (P/B) such as Boeing (NYSE: BA) and Apple (Nasdaq: AAPL) worth buying? Is P/E always more important than P/B? Is there any benchmark for P/E and P/B ratios by sector and industry?

High P/B ratio is often a sign that a business has rosier future prospects than past performance. Share price is high relative to book value because investors have bid up the share price based on expectations of better earnings and/or cash flow ahead.

The quintessential example of a well-known company with high P/B ratio is Amazon (Nasdaq: AMZN), with book value of $550 million at the end of June 2007 and current market capitalization of $35 billion, giving a strikingly high P/B ratio of 64. By the nature of its capital-intensive (to build warehouses and technology) and loss-leader (to win market share) business model, Amazon recorded huge losses throughout most of its corporate history and only in recent years has begun to generate consistent profits. Even some value-oriented investors, such as Bill Miller who manages the Legg Mason Value Trust, have been holding large positions in Amazon's shares for years, looking beyond high P/B and focussing instead on the future earning potential of the company's Internet retailing business.

Boeing (NYSE: BA) currently trades at a P/B ratio of 13, which is quite high. From 1997 through 2005, Boeing's P/B ratio was in the range from about 2.5 to 5.0, more in line with typical stocks in the S&P 500 index. During 2006, due to new FASB rules on pension accounting, the company showed a $6.4 billion reduction in book equity from $11.1 billion to $4.7 billion, which effectively raised its P/B ratio from 6 under the old rules to 15 as reported at year-end 2006. During the first half of 2007, earnings have boosted book value by over a billion dollars to $5.9 billion, giving the current P/B ratio of 13 at a market capitalization of $78 billion. As more retained earnings flow into book value over the years ahead when the much anticipated, super-fuel-efficient Dreamliner 787 goes into production, Boeing's P/B ratio should gradually revert towards the historical range reported prior to the pension-related accounting change.

Apple (Nasdaq: AAPL) is now trading at a P/B of 9, which is the highest P/B ratio the shares have seen during the company's "second wind," post-Mac era. From its nadir of close to parity in 2001 and 2002, Apple's P/B ratio has "risen from the dead," tracking the launch of the company's spectacularly successful iPod in 2001, increased market share of personal computer sales, and summer 2007 launch of its innovative iPhone. Today, many of Apple's price ratios are similar to Microsoft's (Nasdaq: MSFT):

Price-to-Book: 9.3 for Apple vs. 8.7 for Microsoft
Price-to-Sales: 5.5 for Apple vs. 5.3 for Microsoft
PEG Ratio: 1.6 for Apple vs. 1.4 for Microsoft

However, Apple's P/E ratio of 40 is roughly twice Microsoft's 20, and analysts' 5-year earnings growth estimates for Apple are 24%, versus just 11.5% for Microsoft. The upshot is that investors expect Apple's earnings to grow rapidly over the next few years and are willing to pay up for the stock.

In all of the examples cited above--Amazon, Boeing, Apple, Microsoft--the P/B ratios are considerably higher than the market's average P/B ratio of around 3. Importantly, each of these companies has highly successful products and services--Amazon's dominant presence in online retailing, Boeing's lead in airplane production, Apple's popular consumer electronics, and Microsoft's near-monopoly on PC operating system and productivity software. For these companies, sales and profit growth trends and investor expectations about future earnings have pushed valuations to high multiples of book value, so that forward P/E and PEG ratios are generally more useful indicators of value than P/B. (Note: In the extreme value investing world pioneered by the likes of Benjamin Graham, where the focus is on the liquidation value of assets instead of earnings potential, the situation is reversed, with P/B being a better indicator than P/E.)

For a handy reference to compare P/E and P/B (and other ratios) by sector and industry, see the Yahoo's Industry Browser.

(Disclosure: The author does not currently have a position in any of the stocks mentioned in this article.)

I'm a kid. What stocks do you recommend I buy? (Momentum and Recovery Picks)

Reader's Question: I am a kid who wants to buy stock with the $8,000 I have in the bank. Will you give me some suggestions on what to buy?

First of all, congratulations on being fortunate enough to have a such a sizeable chunk of cash to invest at such a early age! Please do all that you can to learn how to invest it wisely and make it grow. Sustained success in investing your own capital can set you up for a more comfortable and fulfilling life in your many decades of adulthood ahead.

I will assume that you are investing to maximize your total return over at least the next five or ten years before you head off to college, and that your parents are providing you with food, clothing and shelter, so that you really do not have a need to generate much investment income. I think you are right in choosing to deploy virtually all of your investment capital into equities, since, as Wharton finance professor, Jeremy Siegel, is quick to point out, stocks have a robust track record of outperforming bonds and cash over the long haul.

I am going to suggest ten investment ideas and leave it up to you to “drill down” and do more research to decide which particular stocks to buy. Most of my selections are well-known brand names that you undoubtedly have heard of before. All of the names on my list are companies that I expect to grow substantially over the next decade. Half of the stocks (momentum plays) are currently trading at or near their 52-week highs, while the other half (recovery plays) are trading at large discounts to their prior peak prices. While I can not predict with any certainty whether the momentum plays or recovery plays will perform better over the next few years, I do expect that at least a few of the stocks on the list will very handily outperform market averages--your job is to make sure you pick the winners!

Rather than spreading your money thinly across many different stocks, I recommend that you establish a concentrated portfolio with no more than five positions. By owning only a few stocks, you will be more likely to find time between school and play to follow all of the relevant news about your stocks, read quarterly and annual financial reports, and listen to conference calls. Learning enough to develop a feel for what makes companies and products succeed and fail, and what drives stock prices higher and lower, will be a valuable hands-on educational experience that should serve you well throughout your life.

(Click on chart below to enlarge for easier viewing.)



Momentum Plays

Apple (AAPL): After Macintosh computers came the iPod and iTunes and now the iPhone. Apple has even dropped “Computer” from its corporate name to reflect the company’s success across a broader scope of consumer electronics. A visit to your local Apple store should reveal how the company’s attractively designed products are capturing increasing mind share and market share. Under founder Steve Jobs' leadership, this innovative company is still solidly in growth mode.

Google (GOOG): Google continues to thrive as the global leader of Internet search, despite ongoing efforts by Yahoo and others to capture eyeballs and search-related advertising revenue. Triple-digit year-on-year growth has slowed as Google has grown into its current $150 billion market capitalization, but the stock’s PEG ratio of 1.0 at today's price level is attractive. Expect Google to remain the search engine of choice in the U.S. and most countries for the foreseeable future.

Boeing (BA): The 787 Dreamliner is the first commercial airplane to be manufactured “in pieces” by an international consortium of partners, with final stage assembly at the Boeing factory outside of Seattle. As Dreamliner sales continue to ramp up, Boeing should reap the benefits of global collaboration and realize higher efficiency and profits for many years, likely outselling competitor Airbus in the process.

Toyota (TM): As the maker of reliable, high-quality cars and the popular, fuel-efficient, hybrid-engine Prius, Toyota has overtaken Ford (F) and is poised to edge past General Motors (GM) to capture the top spot in the ranking of automakers by number of vehicles sold worldwide. Innovative design, perfection of their just-in-time manufacturing process and the superb maintenance record of their cars will keep Toyota in the lead. At a forward P/E of 12 and a 14% discount from its 52-week high, Toyota’s shares are a relatively attractive buy at current price levels.

Chinese Stocks: China is the world’s most populous country (over 1.3 billion people vs. a U.S. population of 300 million) and has a booming economy expanding at the remarkable clip of 10% per year. A good way to achieve exposure to the Chinese stock market is through an index fund such as the iShares FTSE/Xinhua China 25 Index (FXI). The most heavily weighted companies in this index are mobile phone giant, China Mobile (CHL); oil and gas producer, Petrochina (PTR); and leading life insurer, China Life (LFC). For more adventurous investors, an interesting smaller company with current market capitalization just under $1 billion is Home Inns (HMIN), which currently has about 150 hotel properties under management and is still in the early stages of building out a major chain of economy hotels across China.

Recovery Plays

Yahoo (YHOO): As indicated by its depressed share price, Yahoo has in recent years performed poorly in search, social networking and other areas, behaving like a lumbering dinosaur around more nimble players including Google, MySpace and YouTube. On the other hand, despite its many missteps, Yahoo remains the world’s most trafficked website and the Internet game is still very much Yahoo’s to lose. Similar to how Amazon’s (AMZN) share price came roaring back from a 52-week low of $30 to a recent high of $89 following a series of unexpectedly strong earnings reports, Yahoo certainly has the potential to surprise on the upside over the months ahead.

Starbucks (SBUX): Starbucks’ 12,000 locations may seem like a lot but, if the Seattle area is an indication of the density of coffee shops this popular brand can support, plenty of expansion potential remains both in the U.S. and internationally. The recently announced deal with Hershey (HSY) to produce a Starbucks-branded premium chocolate should add incrementally to growth. Incidentally, speaking of partnering, Starbucks is no longer selling bottles of Jones Soda (JSDA) in their stores; however, this quirky Seattle soda maker may also be a good recovery play on the back of broader distribution of their unusually flavored sodas through big-name retailers including Wal-Mart (WMT), Target (TGT) and Safeway (SWY).

Whole Foods (WFMI): Whole Foods has led the organic food movement for years, contributing profoundly to the growing awareness across America of what a more healthful diet means. More recently, however, Wal-Mart, Safeway and other supermarket chains have jumped aboard the organic foods bandwagon, putting pressure on Whole Foods’ margins and threatening its leading position in organic food sales. Despite new competition, expect growth to continue as Whole Foods builds out more stores, including establishment of a new presence in the U.K. and Europe. More healthful eating is a long-term trend that won’t go away and, with Whole Foods trading at a forward P/E of 24, now may also be a good time to start nibbling on a few shares.

Homebuilders: A glance at headlines and price charts of major homebuilders--D H Horton (DHI), Pulte Homes (PHM), Lennar (LEN), Centex (CTX)--reveals just how much their stock prices have sagged since nationwide home prices and new construction peaked about a year and a half ago. It is important to note, however, that homebuilding is a cyclical industry and the bottom has to be somewhere, perhaps nearby. Patient investors willing to buy homebuilder stocks at today's prices and hold on over the years to come ought to realize substantial profits once the next real estate cycle gets underway.

HRPT Properties (HRP): Following the flurry of private-equity buyouts of REITs over the past year, culminating with Blackstone’s purchase of Equity Office Properties in February, REITs have generally fallen 20% to 30%. One of the office REITs, HRPT Properties, now trades well below book value (P/B = 0.86) and at a forward price-to-FFO ratio of just 8.1. This REIT is the cheapest way that I am aware of to buy real estate in today’s market. HRPT also offers a very attractive 8.5% dividend yield, which trounces current bank CD rates averaging around 5%.

(Disclosure: The author of this article has no current position in any of the stocks mentioned. However, if one of his sons decided to buy any of the stocks on the list, he would not raise a serious objection.)

How do I get the money to invest?

Reader's Question: How do I get the money to invest? I read a book recently by Robert Kiyosaki, who wrote the bestseller, Rich Dad, Poor Dad. He teaches the advantages of borrowing money to invest, such as getting a mortgage loan, rather than using your own money. Bad debt makes you poor, but good debt is leverage that makes you rich, because it allows you to invest sooner. He swears by it. Any thoughts?

As you indicate, there are two basic sources of money for investing--your own money and other people's money (so-called OPM). Your own money can come from sources as diverse as cumulative life savings, your most recent paycheck, and dividends and profits from your own investing. Common examples of OPM, used for both investing and consuming, are credit card debt, car loans, real estate mortgages and loans or investment capital that can come from family, friends and others in partnerships.

Getting Started With Your Own Money

Often in life, what's most important is getting started on the right foot. In the case of investing, this means putting some money aside, however small, and setting up a suitable investment program for yourself.

To extract "seed capital" for investing, the place to start is with your own personal income statement. You need to arrange your personal finances, so that your income from all sources exceeds your total expenditures. Practically speaking, this usually entails a combination of elements such as:

Income Side: Finding a job that pays better, asking your boss for a raise, saving the incremental pay you receive from your next raise, taking a side job to earn extra income, saving any money gifts and cash bonuses you receive, training (or retraining) yourself to work in an occupation that offers a higher salary, etc.;

Expense Side: Moving into a house or apartment that has lower rent, finding a roommate, renting out rooms in your own house, driving a reliable but affordable car, going out to eat less frequently, spending vacations closer to home, looking for sales when shopping, buying necessities and not luxury items, etc.

The point is that you've got to figure out a way to save some money that will serve as the "seed" to start investing. You might think that $100 or $1000 is "small money," particularly if your financial dream is to become a millionaire, multi-millionaire or billionaire. However, for the sake of your own long-term financial health, you must, as early as possible, establish personal habits that are conducive to wealth-building. In my opinion, successful investing really begins with having the discipline to "live within your means," spending less than you earn and thereby continually augmenting your investment capital. Once you are a prudent manager of your own personal money, you can begin to supplement your investment portfolio with other's people's money.

Using Other People's Money

Having access to sources of money other than your own, which typically means borrowing or using OPM to leverage your own capital, can potentially produce higher investment returns. Some authors (like Kiyosaki, as you cite) make a distinction between: "good debt," like a mortgage on rental property, which can be serviced using rent paid by tenants; and "bad debt," like an auto loan, which you might take out on a new car and now have to service with your own money. Others distinguish between good debt on appreciating assets, like real estate and stocks, and bad debt on depreciating assets, like cars and elegant wardrobes. Still another useful point of view is that good debt produces cash flow, while bad debt does not.

To these dichotomies between good and bad, I would add a measure based on lowest cost of capital:

Good debt is necessary borrowing within reasonable risk limits at the lowest available cost of capital, regardless of source, so long as the expected return on your overall investment portfolio exceeds your cost of capital. Bad debt is borrowing that doesn't meet the specified good debt requirements.

Here are some examples to help illustrate:

New Graduate in New Job: You've recently graduated from college and taken a career-oriented job. Your income from work is enough to cover your rent and living expenses, make payments on your student loan, and save a few hundred dollars each month. You are eager to start investing in stocks, have faith in Steve Jobs' leadership, and want to buy Apple (Nasdaq: AAPL), thinking that the stock will continue to rise on the strength of the company's newly released iPhone and upcoming lower-priced model. Your available sources of investment capital are: $2000 in a savings account, a cash advance on your credit card at 18% interest, or a private loan from a friend who says you can pay him back in a year with interest in arrears at 10%.

My suggestion: Continue to save what you can from your paychecks. In a year's time, when you have a few thousand dollars more in savings, reconsider making the proposed investment if you still have the same outlook on Apple's business prospects. Neither the 10% private-party loan nor the 18% credit card loan is attractive, since your investment return could easily fall shy of these levels if Apple's sales or earnings falter or the stock market sags on unencouraging macroeconomic news. Also, you ought to maintain a few months' living expenses in your savings account, as a buffer against unpredictable changes in your job situation. Be patient. During the upcoming year, you might find even better investment opportunities than what you are seeing today.

Homeowner Buying a Car: Suppose you are buying a factory-certified, pre-owned Toyota Prius, since your gas-guzzling minivan has blown an engine gasket and you are in dire need efficient wheels to get around. To pay for the car, you have three choices: sell $15,000 of stock or other investments, borrow on your home equity line at 8% APR, or take out an auto loan at 7% APR. Based on the bad-debt-on-depreciable-asset thinking, you would eliminiate the auto loan from consideration. The bad-debt-if-you-have-to-service-it-yourself thinking would knock out the home equity line choice as well, leaving only the investment liquidation alternative. But you don't really want to sell stock that you currently own, since you feel confident that you can continue to achieve returns higher than 7% on your investments, since you've been averaging 10% over the past seven years, through both down (2000-2002) and up (2003-2006) markets.

My suggestion: Assuming you are comfortable with the additional portfolio leverage and have adequate cash flow to cover the debt service payments, take out the auto loan, since at 7% it is your lowest available cost of capital and is lower than the 10% return you expect on your investments. Think of the auto loan as not a wasteful loan on a depreciable asset but as your most efficient way to borrow funds within the context of your overall portfolio.

Investor Considering Second Mortgage on Investment Property: You have been out looking for investment property and have found a $500,000 apartment building that looks attractive and will, at 75% loan-to-value, provide positive cash flow with an expected 10% total return. Banks will lend only up to 65% loan-to-value ($325,000), and you can take out a second mortgage for the remaining 10% ($50,000). The interest rate on the second loan is 9%. You may alternatively tap your home equity line at 8% interest to come up with the remaining $50,000 needed to buy the apartments.

My suggestion: Even though the home equity line directly involves payments that you will have to make on your house instead of on the apartment investment, it is your lowest available cost of capital. Therefore, go ahead and tap the equity line on your house, and proceed to make a back-to-back loan into your investment property with terms matching your home equity loan. By effectively transferring the financial burden from your house to your investment property in this way, you achieve your lowest cost of capital and optimize your expected investment return on an overall portfolio basis.

Crossing the Finish Line

Investment capital, then, comes from a combination of your own money and other people's money, with the mix depending on your situation. A few key tenets to keep in mind are:

Savings: Anyone who is seriously interested in starting to invest ought to be able to save some money. Even putting aside just $100 a month is enough to begin to accumulate significant capital for investing.

Patience: However eager you may be to begin buying stocks or real estate, realize that market opportunities will change but will not go away. Getting started a year from now with investment amounts and risk levels that suit your own financial situation is better than rushing to get started today with excessive leverage or using other people's money on terms unfavorable to you as borrower.

Risk Management: So much of successful investing is risk control. Of course, we all seek higher returns, but knowing how much and on what terms to borrow is important. Do not borrow at rates that are higher than you can honestly achieve through your investments.

I think it is helpful to view investing as a life-long race in which you lead with your own money and add, as follow-on, other people's money when you can do so prudently. Relying solely on your own money, you may end up growing your net worth more slowly but you'll never go bankrupt and you will finish the race. At the other extreme, relying too much on OPM, you could grow rich quickly, but you also run the risk of losing it all and never crossing the finish line. Ultimately, the art of successful investing involves pursuing the optimal path at each stage, walking the fine line between too conservative and too aggressive.