13 June 2008 – The Aleph Blog

Book Review: The Wall Street Waltz

Posted on 13 June 200813 June 2008 by David Merkel

I’ve mentioned this before at RealMoney, but in early 2000, I was doing some serious thinking about investing. I decided to e-mail Ken Fisher a question that he had touched on in one of his Forbes pieces. That began an e-mail dialog that forced me to ask hard questions about how I did value investing. Personally, I was surprised how much time he was willing to waste on me, but I had read the three books that he had written up to that time, Super Stocks, 100 Minds that Made the Market, and The Wall Street Waltz. I had a good idea of how he approached investing.

He challenged me to throw away the CFA Syllabus and think independently — to focus on my own competitive advantage. That led me to analyze what had worked and failed in my prior efforts in value investing, and that led to what would become the Eight Rules. I did well in the prior era, but much better after my discussion with Ken Fisher.

One more note before I begin the book review. He told me that if something is known, it is not valuable for investing. I have modified that rule to be, “If something true is relied upon by many investors, it is not valuable for smart investors. If something false is relied upon by many investors, it is valuable for smart investors to bet against that.”

The Wall Street Waltz takes you on a graphic tour of economic and financial history. Using beautiful old charts created by multiple sources, he uses them to describe market action in the past, and what they might imply for the present. The original version, of which I have a copy, was written in 1987. The new edition updates Ken’s comments to 2007.

The charts provide a springboard for Fisher to explain a wide number of concepts:

Why preferred stocks are suboptimal investments. (Chart 31 — learned that first hand a a little kid as I saw my Litton convertible preferred crater.)
How economically linked Canada is to the US (Chart 15)
The value of P/E ratios for the market (Charts 1&2)
Why you shouldn’t panic over bad political/disaster news. (Chart 24)
How inflation is correlated internationally (Chart 49)
Gold preserves purchasing power in the long run, but that is about it. (Chart 57)
Stocks create value in the long run, despite short/intermediate-term fluctuations. (Chart 88)

I could go on. I chose those pages randomly. There is a wealth of knowledge here. I would like to close with a timely page that I targeted, Chart 64 — Unemployment and the 1 Percent Rule. The stock market tends to rally after the unemployment rate rises 1%, though the challenge is timing when to sell, and I don’t know what the rule should be for that. After the last unemployment report, the rate is more than 1% over the recent low. If correct, it is time to be a buyer, though what is true on average is not always true in specific.

Most investors don’t benefit from an understanding of economic history, which gives a broader skill set for analyzing current problems. This book is an aid in gaining understanding of economic history.

Full disclosure: If anyone enters Amazon through my site and buys something, I get a small commission. Your costs are not increased. This is my equivalent of the “tip jar” and so, if you like what I write, and need to buy through Amazon, please enter Amazon through links on my site.

If You Want to Do Well, Study Math, Science, or Business, and Work Hard

Posted on 13 June 200813 June 2008 by David Merkel

I read the coverage of this academic paper with some amusement. Something not mentioned by the reviewers is that the data set came from just one college. Should that then be applicable everywhere? I don’t know.

Also, the idea of correcting for brightness of students strikes me as misguided. Smart students know to apply themselves to majors that will pay off. Also, the concept that high-paying careers require more hours is also misguided. Most of the graduates in lower earning professions can’t work more hours, even if they want to; there is no demand for that.

The paper was written to deal with how one statistically deals with non-responses in surveying. That it deals with education is a happy accident. I would be careful generalizing from this paper. To me, it is another example of advanced research that is highly intelligent, but may lack common sense.

As The Yield Curve Moves

Posted on 13 June 2008 by David Merkel

My, but haven’t we had interesting times in the short end of the yield curve lately. Have a look at this graph:

This covers the period from the final aggressive 75 basis point move by the FOMC, where there were expectations of a 1% fed funds rate by year end 2008, to now, where the rate at year end is between 2.5-3.0%.? Now look at this chart, which summarizes the yield curve moves:

The graphs and numbers tell a story.? My four datapoints represent:

3/17 – The sharpest point in the loosening cycle, prior to going to 2.25%.
4/25 – Anticipation of the end of the loosening cycle.
6/6 – FOMC jawboning that we must support the dollar and fight inflation.
6/12 – Now.

Let’s describe the moves, period by period.? In Period 1, the transition was from maximum FOMC accomodation to the end of the loosening cycle.? What happened?? Investors required more yield to invest for two years versus cash instruments, because they concluded that short rates would not go near record low levels.? The long end of the curve flattened, because inflation expectations were under control.

In period 2, things were quiet.? Three month rates rose to reflect the new consensus that the FOMC was on hold after the 4/30 meeting for the foreseeable future.? The rest of the curve did nothing.

In period 3, members of the FOMC began beating the inflation drum, particularly the hawks, including Plosser, Lacker, Fisher, and Bernanke.? The belly of the curve (twos to fives) rises the most, anticipating tightening moves by the FOMC, leading the long end to flatten, and the short end to steepen.? This implies that inflation will remain under control in the long run, an idea borne out by the TIPS market, where you can buy 20+ year inflation protection at a real yield of 2.3% — a pretty good bargain for investors that must own Treasuries and other high quality debt.

I’ll give the FOMC this.? In the last four trading days, they helped create the biggest move in the 2-year note yield that we have seen in a long time.? They managed to push up 30-year mortgage yields around 35 basis points, close to the move in the 10-year note.

Now, (to the FOMC) is that what you wanted?? Go ahead.? Start tightening monetary policy in August or September.? See what that does to the investment and commercial banks.? See how that affects weakening employment.? Do it during an election year, when politicians in 2009 might say, “Central bank independence hasn’t helped the nation.? Let’s clip the wings of the Fed.”

I see the FOMC tightening, and then abandoning the tightening early, and reverting to a weak policy, accepting more inflation for the sake of growth in the real economy, and leniency to banks that are facing tough market conditions.