Category: Speculation

Like a Cardinal, The Price Action Will Be Red

Like a Cardinal, The Price Action Will Be Red

Posted on by David Merkel
Photo Credit: Jen Goellnitz
Photo Credit: Jen Goellnitz

Okay, let’s roll the promoted stocks scoreboard:

Ticker Date of Article Price @ Article Price @ 1/20/15 Decline Annualized Dead?
GTXO 5/27/2008 2.45 0.011 -99.6% -55.6%
BONZ 10/22/2009 0.35 0.000 -99.9% -72.5%
BONU 10/22/2009 0.89 0.000 -100.0% -82.3%
UTOG 3/30/2011 1.55 0.000 -100.0% -92.0% Dead
OBJE 4/29/2011 116.00 0.069 -99.9% -86.3% Dead
LSTG 10/5/2011 1.12 0.004 -99.7% -82.5%
AERN 10/5/2011 0.0770 0.0000 -100.0% -93.4% Dead
IRYS 3/15/2012 0.261 0.000 -100.0% -100.0% Dead
RCGP 3/22/2012 1.47 0.003 -99.8% -89.5%
STVF 3/28/2012 3.24 0.360 -88.9% -54.2%
CRCL 5/1/2012 2.22 0.004 -99.8% -90.2%
ORYN 5/30/2012 0.93 0.013 -98.6% -80.1%
BRFH 5/30/2012 1.16 0.466 -59.8% -29.2%
LUXR 6/12/2012 1.59 0.002 -99.9% -92.3%
IMSC 7/9/2012 1.5 0.910 -39.3% -17.9%
DIDG 7/18/2012 0.65 0.003 -99.6% -89.1%
GRPH 11/30/2012 0.8715 0.021 -97.6% -82.5%
IMNG 12/4/2012 0.76 0.010 -98.7% -86.9%
ECAU 1/24/2013 1.42 0.000 -100.0% -98.4%
DPHS 6/3/2013 0.59 0.003 -99.5% -96.0%
POLR 6/10/2013 5.75 0.001 -100.0% -99.5%
NORX 6/11/2013 0.91 0.008 -99.1% -94.7%
ARTH 7/11/2013 1.24 0.200 -83.9% -69.7%
NAMG 7/25/2013 0.85 0.013 -98.5% -94.1%
MDDD 12/9/2013 0.79 0.022 -97.2% -95.9%
TGRO 12/30/2013 1.2 0.056 -95.3% -94.5%
VEND 2/4/2014 4.34 0.655 -84.9% -86.1%
HTPG 3/18/2014 0.72 0.008 -98.9% -99.5%
WSTI 6/27/2014 1.35 0.150 -88.9% -97.9%
APPG 8/1/2014 1.52 0.035 -97.7% -100.0%
1/20/2015 Median -99.3% -89.8%

It is truly amazing how predictable the losses are from promoted stocks, and that is why you should never buy them. Today’s loser-in-waiting is Cardinal Resources [CDNL]. ?The promoters purport that this company will provide cheap clean fresh water to the world, and will make a fortune off of that. ?Now let’s look at some facts:

What commends this stock to you? ?Is it:

  • That it has never earned any money?
  • That the firm has had a negative net worth for the last four years?
  • That their auditors doubted on the last 10-K that this company would be a “going concern?”
  • That the company 12 months ago was known as JH Designs, which was in?the “home staging and interior design services business?”
  • That the writers of the promotion got paid $30,000 to write the speculative fiction of the promotion?
  • That affiliated shareholders of CDNL paid another $670,000 to publish speculative fiction about the company to unwitting people in an effort to raise the stock price, so that they can sell their shares?

Here, have a look at part of the disclaimer written in five-point type on the glossy ad they sent me in the mail:

Resources Kingdom Limited was paid by non-affiliate shareholders who fully intend to sell their shares without notice into this Advertisement/market awareness campaign, including selling into increased volume and share price that may result from this Advertisement/market awareness campaign. The non-affiliate shareholders may also purchase shares without notice at any time before, during or after this Advertisement/market awareness campaign. Non-affiliate shareholders acted as advisors to Resources Kingdom Limited in this Advertisement and market awareness campaign, including providing outside research, materials, and information to outside writers to compile written materials as part of this market awareness campaign.

Thus, we know who is sponsoring and profiting from this scam. ?It is existing shareholders who want to sell. ?I can tell you with certainty that you should not buy this, and that if you own it, you should sell it. ?There is one significant party that implicitly agrees with that assessment — the company itself, which issued shares at a price of ten cents per share in 2014, according to the recent 10-Q, if you look at the balance sheet and cash flow statements.

Avoid this company, and avoid all situations where stocks are promoted. ?They are bad news for all investors. ?Good investments never need promotion.

Redacted Version of the December 2014 FOMC Statement

Redacted Version of the December 2014 FOMC Statement

Posted on by David Merkel
Photo Credit: International Monetary Fund
Photo Credit: International Monetary Fund
October 2014 December 2014 Comments
Information received since the Federal Open Market Committee met in September suggests that economic activity is expanding at a moderate pace. Information received since the Federal Open Market Committee met in October suggests that economic activity is expanding at a moderate pace. No change. This is another overestimate by the FOMC.
Labor market conditions improved somewhat further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources is gradually diminishing. Labor market conditions improved further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish. Shades their view of labor use up a little.? More people working some amount of time, but many discouraged workers, part-time workers, lower paid positions, etc.
Household spending is rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow. Household spending is rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow. No change.

 
Inflation has continued to run below the Committee’s longer-run objective. Market-based measures of inflation compensation have declined somewhat; survey-based measures of longer-term inflation expectations have remained stable. Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices. Market-based measures of inflation compensation have declined somewhat further; survey-based measures of longer-term inflation expectations have remained stable. Shades their forward view of inflation down.? TIPS are showing slightly lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.07%, down 0.28% from September.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. No change. Any time they mention the ?statutory mandate,? it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators and inflation moving toward levels the Committee judges consistent with its dual mandate. The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators moving toward levels the Committee judges consistent with its dual mandate. They are no longer certain that inflation will rise to the levels that they want.
The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced. Although inflation in the near term will likely be held down by lower energy prices and other factors, the Committee judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year. The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced. The Committee expects inflation to rise gradually toward 2 percent as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate. The Committee continues to monitor inflation developments closely. CPI is at 1.3% now, yoy.? They shade up their view down on inflation?s amount and persistence.
The Committee judges that there has been a substantial improvement in the outlook for the labor market since the inception of its current asset purchase program. Sentence removed.
Moreover, the Committee continues to see sufficient underlying strength in the broader economy to support ongoing progress toward maximum employment in a context of price stability. Accordingly, the Committee decided to conclude its asset purchase program this month. Sentence removed.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Moves this sentence lower in the document.
This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions. Moves this sentence lower in the document.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. Highly accommodative monetary policy is gone ? but a super-low Fed funds rate remains.? Policy normalizes, sort of, but no real change.
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. In other words, we?re on hold until something goes ?Boo!?
The Committee anticipates, based on its current assessment, that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program this month, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored. No real change.
However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated. However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated. Tells us what we already knew.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions. Sentences moved from higher in the document.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. No change.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run. No change.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Loretta J. Mester; Charles I. Plosser; Jerome H. Powell; and Daniel K. Tarullo. Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo.

 
Voting against the action was Voting against the action were Richard W. Fisher, who believed that, while the Committee should be patient in beginning to normalize monetary policy, improvement in the U.S. economic performance since October has moved forward, further than the majority of the Committee envisions, the date when it will likely be appropriate to increase the federal funds rate; Fisher thinks the economy is healthy enough to take some rate hikes.
Narayana Kocherlakota, who believed that, in light of continued sluggishness in the inflation outlook and the recent slide in market-based measures of longer-term inflation expectations, the Committee should commit to keeping the current target range for the federal funds rate at least until the one-to-two-year ahead inflation outlook has returned to 2 percent and should continue the asset purchase program at its current level. Narayana Kocherlakota, who believed that the Committee’s decision, in the context of ongoing low inflation and falling market-based measures of longer-term inflation expectations, created undue downside risk to the credibility of the 2 percent inflation target;

 

 

 Kocherlakota wants to create another bubble, along with the rest of the doves.
and Charles I. Plosser, who believed that the statement should not stress the importance of the passage of time as a key element of its forward guidance and, given the improvement in economic conditions, should not emphasize the consistency of the current forward guidance with previous statements. Plosser wants to say that a shift has happened, when no shift really has happened in policy.? He also thinks they should avoid the idea that the Fed is waiting to do something, suggesting that tightening could come sooner.

 

Comments

  • Pretty much a nothing-burger. Few significant changes, if any.? The only interesting thing is that they have given up on inflation getting anywhere near 2% for now.
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.? Wage growth is weak also.
  • Equities flat and long bonds rise. Commodity prices are flat.? The FOMC says that any future change to policy is contingent on almost everything.
  • Don?t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The FOMC chops some ?dead wood? out of its statement. Brief communication is clear communication.? If a sentence doesn?t change often, remove it.
  • In the past I have said, ?When [holding down longer-term rates on the highest-quality debt] doesn?t work, what will they do? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.? The Fed is playing with forces bigger than themselves, and it isn?t dawning on them yet.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain?t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
Have Your Cake, Eat It Too, And End Up With Only Crumbs

Have Your Cake, Eat It Too, And End Up With Only Crumbs

Posted on by David Merkel
Photo Credit: brett jordan
Photo Credit: brett jordan

Beware when the geniuses show up in finance. “I can make your money work harder!” some may say, and the simple-minded say, “Make the money sweat, man! ?We have retirements to fund, and precious little time to do it!”

Those that have read me for a while will know that I am an advocate for simplicity, and against debt. ?Why? ?The two are related because some of us tend toward overconfidence. ?We often overestimate the good the complexity will bring, while underestimating the illiquidity that it will impose on finances. ?We overestimate the value of the goods or assets that we buy, particularly if funded by debt that has no obligation to make any payments in the short run, but a vague possibility of immediate repayment.

The topic of the evening is margin loans, and is prompted by Josh Brown’s article here. ?Margin loans are a means of borrowing against securities in a brokerage account. ?Margin debt can either be for the purpose of buying more securities, or “non-purpose lending,” where the proceeds of the loan are used to buy assets outside of brokerage accounts, or goods,?or?services. ?Josh’s article was about non-purpose lending; this article is applicable to all margin borrowing.

Margin loans seem less burdensome than other types of borrowing because:

  • Interest rates are sometimes low.
  • They are easy to get, if you have liquid securities.
  • They are a quick way of?getting cash.
  • There is almost never any scheduled principal repayment or maturity date for the loan.
  • Interest either quietly accrues, or is paid periodically.
  • You don’t have to liquidate securities to get the cash you think you need.
  • There is no taxable event, at least not immediately.
  • Better than second-lien or unsecured debt in most ways.

But, what does a margin loan say about the borrower?

  • He?needs money now
  • He?doesn’t want to liquidate assets
  • He wants lending terms that are easy in the short run
  • He doesn’t have a lot of liquidity at present.

So what’s the risk??If the ratio of the value of assets in the portfolio versus accrued loan value falls enough, the broker will ask the borrower to either:

  • Pay back some of the loan, or
  • Liquidate some of the assets in the portfolio.

And, if the borrower can’t do that, the broker will liquidate portfolio assets for them to restore the safety of the account for the broker who made the loan.

Now, it’s one thing when there isn’t much margin debt, because the margin debt won’t influence the likelihood or severity of a crisis. ?But when there is a lot of margin debt, that’s a problem. ?As I like to say, markets abhor free riders. ?When there is a lot of liquid/short-dated liabilities financing long-dated assets, it is an unstable situation, inviting, nay, daring the crisis to come. ?And come it will, like a?heat seeking missile.

Before the margin desks must act, some account holders will manage their own risk, bite the bullet, and sell into a falling market, exacerbating the action. ?But when the margin desks act, because asset values have fallen enough, they will mercilessly sell out positions, and force the prices of the assets that they sell lower, lower, lower.

A surfeit of margin debt can turn a low severity crisis into a high severity crisis, both individually and corporately, the same way too much debt applied to housing created the crisis in the housing markets.

I would again encourage you to read Josh’s excellent piece, which includes gems like:

Skeptics from the independent side of the wealth management industry would ask, rhetorically, whether or not most of these loans would be made with such frequency if the advisors themselves were not sharing in the fees. The answer is that, no, of course they wouldn’t.

He is correct that the incentives are perverse for the advisors who receive compensation for encouraging their clients to borrow and take huge risks in the process. ?It’s another reason not to take out those loans.

Remember, Wall Street wants easy profits from margin lending. ?They don’t care if they encourage you to take too much risk, just as they didn’t care if you borrowed too much to buy housing.

The Free Advice that Embraces Humility

Just say no to margin debt. ?Live smaller; enjoy the security of the unlevered life, and be ready for the day when the mass liquidation of margin accounts will offer up the bargains of a lifetime.

If you have margin loans out now, start planning to reduce them (before you have to). ?You’ve had a nice bull market, don’t spoil it by staying levered until the bear market comes to make you return your?assets to their rightful owners.

Wisdom is almost always on the side of humility, so simplify your life and finances while conditions favor doing so. ?If you must borrow, do it in a way where you won’t run much risk of losing control of your finances.

And after all that… enjoy your sleep, even amid crises.

Should Jim Cramer Sell TheStreet or Quit CNBC?

Should Jim Cramer Sell TheStreet or Quit CNBC?

Posted on by David Merkel
Photo Credit: Penn State
Photo Credit: Penn State

Like my friend Josh Brown does, I often don’t know where I will end when I start writing… I know I have something to say, given my own time writing for RealMoney.com, and now having publicly written on financial matters for over eleven years, with?thanks to Jim Cramer, who gave me my start.

Recently, a 9% holder of TheStreet sent a letter to Jim, asking him to either sell off TheStreet in an auction or leave CNBC and rebuild the value of TheStreet. ?The Stock rose roughly 7% on the news. ?Personally, I don’t think it should have budged. ?Here’s why:

1)?What is a perpetual money-loser worth? ?TheStreet hasn’t earned significant money since 2007.

2) What is TheStreet worth in an auction? ?The complainant says:

Despite these improvements TST trades at an enterprise value to 2015 estimated revenues of 1.3. This compares to BC Partners Limited?s acquisition of Mergermarket Group at three times revenue. Morningstar Inc. (?MORN? ? $65.97) trades at 3.4 times 2015 consensus revenue estimate. Allegedly, BoardEx competitor Relationship Science recently raised capital at a $300 million valuation compared with its purported $5 million revenue for 2013.

TheStreet is not comparable to these in my opinion. ?I’ll use Morningstar as my example: it is a comprehensive site offering a wide amount of data about investments, and relatively light on opinions. ?Where it speaks, it is authoritative, and it has a relatively sticky following, making their revenues more valuable than that of TheStreet. ?Let’s be real… would you buy TheStreet at the same enterprise value to sales ratio as Morningstar?

3) Selling investment opinions is a very competitive business, with low barriers to entry. ?If a party is any good at marketing it, and wants to sell a newsletter, there are a lot of people who will buy, as noted later by the complainant:

We estimate that 41,500 customers pay roughly $350 per annum ($14.5 million in totum) for your newsletters. This is nothing to scoff at but a fraction of the 400,000 to 500,000 subscribers enjoyed, by (we believe) The Motley Fool Stock Advisor and Stansberry & Associates Investment Research ? two wildly more profitable competitors which charge similar prices. (We estimate that each of these competitors yield $25 to $45 million of pre-tax earnings for their private owners.) Given the strength of your brand, it both amazes and frustrates that subscriptions to your products are so paltry. Were you to de-couple from CNBC (where you are understandably prohibited from promoting PLUS) I would hope, nay expect, that subscriptions of PLUS would treble.

I don’t like market newsletters generally, but I know there are a lot of people who would rather pay for opinions than money management services. ?I often get requests to start a newsletter, but I don’t respect the concept. ?My detailed ideas are for my clients; that’s the business that I am in.

Jim’s newsletter has been out for a long time. ?Of those that buy newsletters, most would be familiar with Cramer, and know that the newsletter?exists. ?Even if Cramer came back to TheStreet full-time, I doubt it would get that much more in subscriptions.

4) Also, auctioning off a Cramer-less TheStreet would likely flop. ?There would be few if any buyers for?a such a company that had lost its main writer.

5) Then there is the complainant’s appeal to Cramer as to his legacy:

You are 59. When you lie upon your deathbed, how will you reflect upon on your legacy? Once a $70 stock, TST is now $2.20. You have done well, but how has the common shareholder done?

I have a little insight here. ?A little less than twelve years ago, I was invited by my Merrill coverage to come to an institutional investor conference where Cramer would be the unscripted keynote speaker. ?It was a great talk, and?at the end of it, as Cramer left, I figured out where I likely needed to be if I wanted a word with him. ?Sure enough, he came my way, and I identified myself to him as the guy who had been writing to him on bonds for the past four years. ?He remembered me and greeted me warmly. ?I told him that I was going to work at a hedge fund. ?He?congratulated me, and said that it was where all the smart guys were going. ?And then he said something to the effect of:

I wish I were still running a hedge fund. ?I really loved that.

And at that point, the crowd caught up, and that was the end of my time with him. ?But when I got home that night, I sent him an e-mail telling him that life is too short, do what you love. ?Go back to the hedge fund and write more occasionally for the rest of us. ?His reply was brief as usual, and if my memory is any good it was something like:

Can’t do that. ?Gotta get the price of theStreet.com over the IPO price.

Even at the time, that made me blink. ?Make the stock rise by more than a factor of 10? ?That would be Herculean at minimum.

But, that gives you an insight into Cramer’s mind at one point. ?He’s already thought along those lines. ?He’s no dummy. ?He knows how difficult it would be — and he has pursued that effort for a number of years. ?My sense is that he has given up, or maybe something close to that. ?The price of TheStreet has been remarkably stable for the past five years, despite all efforts made…

6) But does Cramer have no legacy from TheStreet? ?I would argue he does. ?He enriched the investment writing world in two ways: he created a bunch of young savvy journalists that occupy many places in the broader investment journalism world, and he encouraged a lot of clever investors to write for him.

We are all better off as a result of both of these, even if the benefits never went to shareholders. ?It’s a tough business, and even the best enterprises have a hard time making money at it.

7) Perhaps the complainant needs to be reminded of one of Marty Whitman’s principles on value investing: “Something off the top.” ?Control of a company is a valuable thing, and one of the reasons is that a closely-held company does not merely pay the controlling owner dividends, they often receive something off the top. ?That is true of Cramer here, with a salary of $3.5 million/year. ?Why should he relinquish that? ?In his mind, he may think that he has tried to turn it around for years to no avail. ?If the company is not likely to ever get back to a significantly higher price, why should he knock himself out on a hopeless mission that he has already tried?

8?) So, with that, let the complainant contact his fellow shareholders and ask for help. ?I’m not sure they will agree with the prescription, though they might like to see some actions taken. ?Personally, I can’t get excited about it; I would be inclined to pass, and quietly sell my shares into the current strength generated by the complainant.

Full disclosure: no positions in any companies mentioned here, and as they used to say at TheStreet, I am?writing about a microcap stock, so they would typically not allow articles on it without a big warning, if at all. ?To make it plain: don’t buy any TST shares as a result of what I wrote here. ?Thanks.

The Butterfly Machine

The Butterfly Machine

Posted on by David Merkel
Photo Credit: whologwhy || Danger: Butterfly at work!
Photo Credit: whologwhy || Danger: Butterfly at work!

There’s a phenomenon called the Butterfly Effect. ?One common quotation is “It has been said that something as small as the flutter of a butterfly’s wing can ultimately cause a typhoon halfway around the world.”

Today I am here to tell you that for that to be true, the entire world would have to be engineered to allow the butterfly to do that. ?The original insight regarding how small changes to complex systems occurred as a result of changing a parameter by a little less than one ten-thousandth. ?Well, the force of a butterfly and that of a large storm are different by a much larger margin, and the distances around the world contain many effects that dampen any action — even if the wind travels predominantly one direction for a time, there are often moments where it reverses. ?For the butterfly flapping its wings to accomplish so much, the system/machine would have to be perfectly designed to amplify the force and transmit it across very long distances without interruption.

I have three analogies for this: the first one is arrays of dominoes. ?Many of us have seen large arrays of dominoes set up for a show, and it only takes a tiny effort of knocking down the first one to knock down the rest. ?There is a big effect from a small initial?action. ?The only way that can happen, though, is if people spend a lot of time setting up an unstable system to amplify the initial action. ?For anyone that has ever set up arrays of dominoes, you know that you have to leave out dominoes regularly while you are building, because accidents will happen, and you don’t want the whole system to fall as a result. ?At the end, you come back and fill in the missing pieces before showtime.

The second example is a forest fire. ?Dry conditions and the buildup of lower level brush allow for a large fire to take place after some small action like a badly tended campfire, a cigarette, or a lightning strike starts the blaze. ?In this case, it can be human inaction (not creating firebreaks), or action (fighting fires allows the dry brush to build up) that helps encourage the accidentally started fire to be a huge one, not merely a big one.

My last example is markets. ?We have infrequently?seen volatile markets where the destruction?is huge. ?A person?with a modest knowledge of statistics will say something like, “We have just witnessed a 15-standard deviation event!” ?Trouble is, the economic world is more volatile than a normal distribution because of one complicating factor: people. ?Every now and then, we engineer crises that are astounding, where the beginning of the?disaster seems disproportionate to the end.

There are many actors that take there places on stage for the biggest economic disasters. ?Here is a partial list:

  • People need to pursue speculation-based and/or debt-based prosperity, and do it as a group. ?Collectively, they need to take action such that the prices of the assets that they pursue rise significantly above the equilibrium levels that ordinary cash flow could prudently finance.
  • Lenders have to be willing to make loans on inflated values, and ignore older limits on borrowing versus likely income.
  • Regulators have to turn a blind eye to the weakened lending processes, which isn’t hard to do, because who dares oppose a boom?? Politicians will?play a role, and label prudent regulations as “business killers.”
  • Central bankers have to act like hyperactive forest rangers, providing liquidity for the most trivial of financial crises, thus allowing the dry tinder of bad debts to build up as bankers use cheap funding to make loans they never dreamed that they could.
  • It helps if you have parties interested in perpetuating the situation, suggesting that the momentum is unstoppable, and that many people are fools to be passing up the “free money.” ?Don’t you know that “Everybody ought to be rich?” [DM: then who will deliver the pizza? ?Are you really rich if you can’t get a pizza delivered?] ?These parties can be salesmen, journalists, authors, etc. whipping up a frenzy of speculation. ?They also help marginalize as?”cranks” the wise critics who point out that the folly eventually will have to end.

Promises, promises. ?And all too good to be true, but it all looks reasonable in the short run, so the game continues. ?The speculation can take many forms: houses, speculative companies like dot-coms or railroads, even stocks themselves on sufficient margin debt. ?And, dare I say it, it can even apply to old age security schemes, but we haven’t seen the endgame for that one yet.

At the end, the disaster appears out of nowhere. ?The weak link in the chain breaks — vendor financing, repo financing, a run on bank deposits, margin loans, subprime loans — that which was relied on for financing becomes recognized as a short-term?obligation that must be met, and financing terms change dramatically, leading the entire system to recognize that many assets are overpriced, and many borrowers are inverted.

Congratulations, folks, we created a black swan. ?A very different event appears than what many were counting on, and a bad?self-reinforcing cycle ensues. ?And, the proximate cause is unclear, though the causes were many in society pursuing an asset boom, and borrowing and speculating as if there is no tomorrow. ?Every individual action might be justifiable, but the actions as a group lead to a crisis.

In closing, though I see some bad lending reappearing, and a variety of assets at modestly speculative prices, there is no obvious crisis facing us in the short-run, unless it stems from a foreign problem like Chinese banks. ?That said, the pension promises made to those older in most developed countries are not sustainable. ?That one will approach slowly, but it will eventually bite, and when it does, many will say, “No one could have predicted this disaster!”

Mantra: Interest Rates Have to Rise, Interest Rates Have to…

Mantra: Interest Rates Have to Rise, Interest Rates Have to…

Posted on by David Merkel
Photo Credit: Beto Vilaboim || No, you are not crazy -- it *is* hopeless
Photo Credit: Beto Vilaboim || No, you are not crazy — it *is* hopeless

I thought of structuring this post like a fictional story, but I couldn’t figure out how to make it good enough for publication. ?Well, truth is often stranger than fiction, so have a look at this Bloomberg article pointing at a 37% loss in the?ProShares UltraShort 20+ Year Treasury (TBT).

A few points to start with: shorting is hard. ?Leveraged shorting is harder. ?I think I have reasonable expertise in much though not all of investing, and I put most shorts in the “too hard pile.”

That said, I have taken issue with the “interest rates can only go up” trade for 8-9 years now. ?It is not a major theme of mine, but I remember a disagreement that I had with Cramer over it back when I was writing for RealMoney. ?(I would point to it now, but almost all content at RealMoney prior to 2008 is lost.)

Many bright investors (usually not professional bond investors) have taken up the?”interest rates can only go up” view because of the loose monetary policy that we have experienced, and thanks to Milton Friedman, we know that “Inflation is always and everywhere a monetary phenomenon,” or something like that.

Friedman may or may not be right, but when banks do not turn the proceeds of?deposits into loans, inflation doesn’t do much. ?As it is, monetary velocity is low, with no signs of imminent pickup.

At least take time to read the views of those who are long a lot of long Treasuries, and have been that way for a long time — Gary Shilling and Hoisington Management. ?Current economic policies are not encouraging growth, and that is true over most of the world. ?We have too much debt, and the necessary deleveraging inhibits growth.

Think of this a different way: we have a lot of people thinking that they will retire over the next 10-30 years. ?To the extent that you can live with the long-run volatility, I accept the idea that you can earn 6-8%/year in stocks over that period, so long as there isn’t war on your home soil, or a massive increase in socialism.

But what if you are running a defined-benefit plan, investing to back long-dated insurance products, or just saying that you need some degree of nominal certainty for?some of your assets. ?The answer would be debt claims against institutions that you know will be around to pay 10-30 years from now.

In an era of change, how many institutions are you almost certain will be here 10-30 years from now? ?Personally, I would be comfortable with most government, industrial and utility bonds rated single-A or better. ?I would also be comfortable with some municipal and financial company bonds with similar ratings.

If followed, and this has been followed by many institutional bond investors, this would result in falling long-term yields, particularly now when economic growth is weak globally.

Now, rates have fallen a great deal over 2014. ?Can they fall further from here? ?Yes, they can. ?Is it likely? ?I don’t know; they have fallen a lot faster than I would have expected.

I would encourage that you watch bank lending, and to a lesser extent, inflation reports. ?The time will come to end the high quality long bond trade, but at present, who knows? ?Honor the momentum for now.

Full Disclosure: Long TLT for my fixed income clients and me (it’s a moderate?part of a diversified portfolio with a market-like duration)

Volatility Can Be Risk, At Rare Times

Volatility Can Be Risk, At Rare Times

Posted on by David Merkel
Photo Credit: Matt Cavanagh
Photo Credit: Matt Cavanagh

There is a saying in the markets that volatility is not risk. In general this is true, and helps to explain why measures like beta and standard deviation of returns do not measure risk, and are not priced by the market. After all, risk is the probability of losing money, and the severity thereof.

It’s not all that different from the way that insurance underwriters think of risk, or any rational businessman for that matter. But just to keep things interesting, I’d like to give you one place where volatility is risk.

When overall economic conditions are serene, many people draw the conclusion that it will stay that way for a long time. That’s a mistake, but that’s human nature. As a result, those concluding that economic conditions will remain serene for a long time decide to take advantage of the situation and borrow money.

When volatility is low, typically credit spreads are low. Why not take advantage of cheap capital? Well, I would simply argue that interest rates are for a time, and if you don’t overdo it, paying interest can be managed. But what happens if you have to refinance the principal of the loan at an inopportune time?

When volatility and interest spreads are low for you, they are low for a lot of other people also. Debt builds up not just for you, but for society as a whole. This can have the impact of pushing up prices of the assets purchased using debt. In some cases, the rising asset prices can attract momentum buyers who also borrow money in order to own the rising assets.

This game can continue until the economic yield of the assets is less than the yield on the debt used to finance the assets. Asset bubbles reach their breaking point when people have to feed cash to the asset beyond the ordinary financing cost in order to hold onto it.

In a situation like this, volatility becomes risk. Too many people have entered into too many fixed commitments and paid too much for a group of assets. This is one reason why debt crises seem to appear out of the blue. The group of assets with too much debt looks like they are in good shape if one views it through the rearview mirror. The loan-to-value ratios on recent loans based on current asset values look healthy.

But with little volatility in some subsegment of the overly levered assets, all of a sudden a small group of the assets gets their solvency called into question. Because of the increasing level of cash flows necessary to service the debt relative to the economic yield on the assets, it doesn’t take much fluctuation to make the most marginal borrowers question whether they can hold onto the assets.

Using an example from the recent financial crisis, you might recall how many economists, Fed governors, etc. commented on how subprime lending was a trivial part of the market, was well-contained, and did not need to be worried about. Indeed, if subprime mortgages were the only weak financing in the market, it would’ve been self-contained. But many people borrowed too much chasing inflated values of residential housing. ?As asset values fell, more and more people?lost willingness to pay for the depreciating assets.

We’ve had other situations like this in our markets. Here are some examples:

  • Commercial mortgage loans went through a similar set of issues in the late 80s.
  • Lending to lesser developed countries went through similar set of issues in the early 80s.
  • The collateralized debt obligation markets seem to have their little panics every now and then. (late 90s, early 2000s, mid 2000s, late 2000s)
  • During the dot-com bubble, too much trade finance was extended to marginal companies that were burning cash rapidly.
  • The roaring 20s were that way in part due to increased debt finance for corporations and individuals.

At the peak some say, “Nobody rings a bell.” This is true. But think of the market peak as being like the place where the avalanche happened 10 minutes before it happened. What set off the avalanche? Was it the little kid at the bottom of the valley who decided to yodel? Maybe, but the result was disproportionate to the final cause. The far more amazing thing was the development of the snow into the configuration that could allow for the avalanche.

This is the way things are in a heavily indebted financial system. At its end, it is unstable, and at its initial unwinding the proximate cause of trouble seems incapable of doing much harm. But to give you another analogy ask yourself this: what is more amazing, the kid who knocks over the first domino, or the team of people spending all day lining up the huge field of dominoes? It is the latter, and so it is amazing to watch large groups of people engaging in synchronized speculation not realizing that they are heading for a significant disaster.

As for today, I don’t see the same debt buildup has we had growing from 2003 to 2007. The exceptions maybe student loans, parts of the energy sector, parts of the financial sector, and governments. That doesn’t mean that there is a debt crisis forming, but it does mean we should keep our eyes open.

Book Review: The Little Book of Market Wizards

Book Review: The Little Book of Market Wizards

Posted on by David Merkel

9781118858691_MF5.inddOver time, I have reviewed a decent number of “Little Books.” ?I have a theory as to why I like some of them, and not others. ?I like the ones that take a relatively narrow concept and summarize it. ?An example of that would be Mark Mobius’ book on emerging markets, or Vitaliy Katsenelson’s book on sideways markets.

But when a concept is broad and not friendly to summary, a “little book” is not so useful. ?As examples, John Mauldin’s book on Bulls?Eye ?Investing went too many directions, and Scaramucci on Hedge Funds could not adequately summarize or describe a large topic.

There are other “Little Books” that I have read that did not even get a review… probably about 10% of the books I read in entire never get the review written because they were so bad, or just hard to decide what the book was. ?(What do you want to be if you grow up dear? 😉 )

Sorry, too much intro. ?For those at Amazon, there are useful links at my blog.

Jack Schwager is generally a good writer, and expert at talking with clever investors in order to break down the main points of how they invest (without giving away the store). ?In this “Little Book” he goes a different direction, and looks for commonalities among various clever investors, with each chapter covering a different?topic.

My view is that most clever investors fall into one of a bunch of categories, much of which boils down to time horizon for the preferred investment. ?Going down the continuum: day trader, swing trader, longer-term trader, momentum-oriented growth investor, growth investor, growth-at-a-reasonable-price investor, and value investor. ?After that, you might differentiate between those that go for relative vs absolute returns.

As such, the book posits a bunch of topics that apply to different groups of clever investors. ?I think it would have been better to have segmented the book by classes of investors, because then you could have a coherent set of commonalities for each main investor type.

As it is, the book relies heavily on anecdotes, which isn’t entirely a bad thing; nothing motivates a topic like a story. ?But if you were reading this to try to develop your own philosophy of managing money in order to fit your own personality, you might have a hard time doing it with this book. ?I think you would be better off reading one of Schwager’s longer books, and reading about each clever investor separately. ?At least then you get to see the full package for an investor, and how the different aspects of investing in a given style work together.

Quibbles

Already expressed.

Summary

If you just want a taste of what a wide variety of different investors do to be effective, this could be the book for you. ?For most other people, get one of Schwager’s longer books, and read about the different investors as individual chapters. ?If you still want to buy it, you can buy it here:?The Little Book of Market Wizards: Lessons from the Greatest Traders.

Full disclosure:?I?received a?copy from the author’s PR flack.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

The Tip Culture in Amateur Investing

The Tip Culture in Amateur Investing

Posted on by David Merkel

2132090594_78f91a417c_o A reader wrote to me and said:

I’m sure a lot of people have already told you but I want to tell you anyway: Your blog is awesome! I came across The Aleph Blog a couple of months ago and I?m very impressed with your content. I particularly like that 4-part article on Using Investment Advice. I am in the financial industry myself and it makes me wish I came up with the kind of ideas that you have on your blog. Awesome stuff!

Keep up the good work,

Many thanks to the reader, and if you want to read that series, it is located here. ?But when I considered what he wrote to me, it made me think, “Why do we have to tell people how to think about investment advice?”

Then it hit me: because people are looking for easy tips to execute. ?After all, when I wrote the 4-piece series, I had?listening to Jim Cramer in mind. ?The ?tip culture? of inexperienced investors don?t want to learn the ideas behind investing, but just want someone to say, ?Buy this.?? There is little if any guarantee that the same pundit?will ever update his opinion.

We see this on the web, in magazines, newsletters, newspapers, etc. ?On rare occasion, I will print one out, and add it to my “delayed research stack” which means I will look at it in 1-3 months. ?I just did my quarterly clean-out a few days ago — anything I add to the stack now will wait until November.INTC

But why read articles like, “Ten Undervalued Large Cap Stocks with Growth Potential,” “Nine Stocks to Buy and Hold Forever,” “Eight Stocks that are Taking Off, Don’t Miss Out,” “Seven Hidden Gens Among Small Caps,” “Six Stocks for Income and Growth,” “Five Energy Stocks that are Poised to Surge,” Four Titanic Stocks that Every Investor Should Own,” “Three Turnaround Stocks with Potential for Large Capital Gains,” “Two Stocks with Breakthrough Technologies,” and “The One Stock that You Should Own for the Next Decade.”

Now, I made those titles up, though the last one was based off a Smart Money article on Intel in late 1999 which came very close to top-ticking ?the market. ?As you can see, Intel still hasn’t made it back to the tech bubble peak.

As I Googled phrases like, “Ten Best Stocks,” it was fascinating to see the range of pitches employed:

  • Appeals to Buffett (that never gets old)
  • Best stocks for this year
  • Favorite stocks of an author, manager or publication
  • With high dividends
  • With a low price
  • In emerging markets
  • That won’t lose money
  • That our patented investment screener spat out
  • For the rest of your life
  • Etc.

I know that I could get a lot more readers with list articles that tout stocks. ?I don’t do it because most of the articles that you read like that are bogus. ?[I also don’t want the inevitable scad of complaints that come with the territory.) ?So why do such articles?draw readers?

People would rather have false certainty than live in the reality that choosing good investments is difficult. ?Even very good investors hit rough patches where they do not outperform. ?Also, people aren’t comfortable with uncertain horizons for realizing value in investments — article tout holding forever, ten years, one year, but rarely 3-5 years or a market cycle.

The truth is, you can’t tell when a stock will perform, but when it does perform, the results will be lumpy. ?The performance of a stock is rarely smooth. ?During times when the success or failure of a stock idea is realized, the moves are often violent.

Now remember, those who write such articles are looking for media revenue — such articles are sensational, and pander to the desire for easy money. ?But where are the articles telling you to sell ten stocks now? ?(Yes, I know there are some, but they are not so common.) ?Or, where are follow up pieces indicating how well prior picks have done, and whether one should sell, hold, or buy more now?

My main point is this: good amateur investing is like having a part-time job. ?A part-time job, well, takes time. ?Weigh that against other priorities in your life — family, friends, church, public service, fun, etc. ?You may not want a part-time job, and so you can index your investments, or outsource them to a trusted advisor, who hopefully digs up his own ideas, and does not have a consensus, index-like portfolio (If he does, why not index?)

So, avoid tips if you can. ?If you can’t, develop a research discipline, or set them aside like I do, and revisit them when the original reason for buying it is forgotten, and you must evaluate for yourself now. ?The investment that you do not understand why you bought it, you will never know when it is the right time to sell it.

Either learn to evaluate investments on your own, or index your investments, or find a good investment advisor. ?But don’t think that you will do well off of tips.

Avoid Buying Individual Stocks in Distress

Avoid Buying Individual Stocks in Distress

Posted on by David Merkel

There is a temptation, particularly among novice value investors, to throw money at a stock that has fallen hard. ?Bargains are hard to pass up.

It can be worse if you owned the stock prior to the fall, and kept investing as it went down. ?There is the temptation to follow blindly the axiom, “Well, if you liked it before, you must love it now! ?Load the boat!” ?Far better to sit down and talk with a friend who has more skill than you, who does not own the stock, and if he/she has time, ask for his opinion. ?While you are waiting, go out to the web, and listen to the opinions (perhaps triumphal opinions) of those that did not like the stock. ?Particularly take note of:

  • Allegations that the accounting is aggressive, or worse, crooked
  • Claims that the management team has goals different than that of shareholders.
  • Check to see that the balance sheet isn’t weak. ?Compare it to the balance sheets of competitors.
  • Is there too much debt? ?Is there too much debt potentially coming due soon, and too little resources to pay the debt?
  • Is revenue falling dramatically? ?What competitor is benefiting from the firm’s troubles?

But even if you didn’t own the stock, you might be wary of a stock that has fallen hard for a number of reasons, if the fall indicates the company may be in danger of default.

  • It’s likely that the management team that is responsible for the problem is still in charge.
  • Most ordinary management teams are not used to managing a company that is in distress.
  • Suppliers become less likely to extend favorable credit terms to the firm.
  • Rival companies spread rumors that you are going under and try to attract your best customers away.
  • Talented employees look for greener pastures as opportunities dry up. ?It’s no fun to turn from growing a profitable business, to putting out fires.
  • Management will be distracted with staying alive, maybe vulture investors, analysts seeking more data, regulatory requests, lenders seeking assurances, etc.
  • Credit will be harder to get from bonds, loans, etc., and if the firm gets?it, it will be expensive. (Especially if the firm uses?the Financing Methods of Last Resort.)
  • And, management may make things even tougher by having a round of layoffs. ?Less people to do the same work.
  • Not only that, but even if you are right about the stock, there will be a lot of sellers selling as the stock price rises, because they got back to even.

When a company is in distress, everything fights against it. ?All of the normal courtesies are gone, replaced by a haze of suspicion. ?At the time it most needs friends, they vanish. ?Tempting as it may be to buy the stock quickly, it might be worth it to wait and see whether things get worse, and analyze who would like to buy the company to use?some subset of the assets for their?own company.

Now recently I read a classic Journal of Finance article called, “In Search of Distress Risk, by?Campbell, Hilscher, and Szilagyi.” [Download is for wonks only, I will summarize.] ?Distress tends to happen to firms that have negative price momentum, are small, and are classified as value stocks because of the high ratio of net worth to market capitalization. ?As a result, some suggested that the risk premiums that exist for owning small and value stocks must be related to distress. ?But firms under distress tend to do badly, while small and value stocks tend to do well. ?Negative momentum fits, but distress is a small part of that anomaly.

So maybe if you are a value investor or a small cap investor, you might be able to improve your performance by screening out distress situations. ?The simplified variables used in the paper are (and their effect on the probability of distress [page 2910]):

  • Net Income / Total Assets (lower means higher probability of distress)
  • Total Liabilities?/ Total Assets (higher means higher probability of distress)
  • Three month total returns?(lower means higher probability of distress)
  • Realized stock price volatility over the last three months?(higher means higher probability of distress)
  • Market capitalization?(higher means higher probability of distress)
  • Stock price under $15??(yes means higher probability of distress)
  • Cash and near cash as a fraction of total assets (lower means higher probability of distress)
  • Market to Book?(higher means higher probability of distress)

Most of these make intuitive sense. ?The one for market capitalization doesn’t except the the effect of a stock being under $15/share is more closely related to distress.

One thing that might make you change you mind is if a new management team is brought in. ?Every quarter I pull together a list of companies that have fired or replaced their CEO, and I throw them in as competitors against the existing companies in my portfolio. ?[there were about 80 over the last three months] A fresh set of eyes, a fresh mind can change things, but analyse to see whether the new man or team has the right ideas.

SEASTo close with an example: don’t buy Seaworld [SEAS] after the negative surprise of yesterday, at least not yet. ?Analyze for solvency. ?Try to figure out whether the actions management is proposing will actually make things better, or whether the company’s prospects have been permanently reduced.

Don’t try to catch a falling knife. ?Rather, analyze, and if it makes sense when the panic has died down, buy some as a part of a diversified portfolio.

PS — In distress, the real pros look down the capital structure to see whether the preferred stock, junior debt, senior debt, bank loans, or trade claims look attractive. ?That’s beyond the average investor, but in times of distress, those securities trading at a discount may be where the real action is. ?The securities that get hurt but not destroyed will typically control the firm post-bankruptcy.

Full Disclosure: No holdings in any securities mentioned

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