Trend Analysis

When you do analysis, depending on the data used the results have some degree of objectivity. For example, if you have a population of rats and feed them large quantities of a substance and have another population that has the same diet except for the particular substance, variation between the two populations may be related to the presence or absence of that substance. The more you can eliminate other potential causes of variation, such as genetics and environment, the results increase in value. However, even in a controlled experiment, the potential for some unknown factor to enter the experiment that normally you need to prove the results are repeatable, meaning that someone performing he same analysis halfway around the world would get the same results.

Now when you have analysis performed in an area where variables cannot be controlled the reliability of the results is questionable. For example, you often hear free market advocates talk about how a free market is the best way to promote growth and prosperity. Of course, it is hard to prove this experimentally so they use logic and examples. Now, the United States with something of a free market economy did better than the Soviet Union under communism. This may have been because of the economic systems or any of a million other differences between those two countries. Certainly I have no way of proving the free market economy of the United States was not a significant influence in the outcome, I just can't prove it one way or the other.

Now, consider some of the analysis you hear about financial trends. There are so many different factors influencing most industries that even if you successfully spot a trend, it is impossible to know for certain that there is not some countervailing trend you haven't spotted. Of course, if you can accurately predict that smart phones are taking more and more market share and therefore manufacturers of smart phones and smart phone components should do well, you also have to factor in how much they are losing if they currently manufacture dumb phones and if the phone they come out with is going to be popular or successfully promoted. The i-Phone was a phenomenal success and the Palm Pre and Palm Pixi weren't. I have read many reviews where the Palm products were considered technically better than the Apple phone but one took off with the right amount of hype and growing market share and one didn't.

Of course after the fact you see analysis as to what happened, and sometimes this post mortem seems perfectly logical, however, that is after the fact and somewhat irrelevant to most investors. Consider the events that happened today and the impact they had on the market. First China's announcement concerning the Yuan led to a higher start as this was perceived as another indication that the economic recovery was continuing and that foreign products would become more affordable in China. This trend held the market up for a while and then we had the assault on the banks as first one analyst said that a double dip in the housing market was a certainty and another analyst said that the financial reform bill would be a disaster for the banks. Further, we found out China was holding more gold than previously thought. Each of these factoids and analysis had some impact on the market and by late afternoon, the earlier increases had been erased and the overall market was slightly down. Of course the afternoon sell off may have nothing to do with the negative comments, it could simply be a combination of fund managers taking some profits and others seeing a trend develop, jumping aboard.

In fact, the one thing that is certain is that no trend goes unobserved. Once a sell off becomes clear, selling becomes the thing to do. You can always buy the stock back cheaper after it goes down some. If you are shorting the market, a sell off is a cause for jubilation. In fact, one thing you can count on is that on days with late day drops, there will be a bounce near the close as some traders get out of positions to avoid overnight risk.

Of course that trend analysis has very little real validity.

Victimology

To be honest I didn't have the patience to listen to the President all the way through last night. The things said at events such as that have little to do with what ultimately happens. Now for some reason, it tends to go over well to hear tough talk at times like this. I simply would like to see a solution. This was a horrendous event, and while BP may very well have ignored risks that ended up causing it, they clearly didn't want it to happen. That brings us to the question of competence and/or negligence.

In making decisions we all have to decide the proper line between cost and safety. Certain threats always exist but are so remote that for us to take preventive action would make us, well odd. For example, we all take are exposed to many potential contagious opportunities in a given day. Sometimes we actually get infected. Most of the time we don't. Most of the time the contagions are relatively minor and we recover. Sometimes they are major and sometimes fatal. However, we all hopefully take some preventive actions, such as washing our hands, but if you end up wearing surgical masks and gloves at all times, you are, in the opinion of most people, overreacting.

It should always be remembered that when you look at risk from the point of view of the victim, it always seems much worse than it really was. The victim is a victim and the risk potential has become real. If the victim's chances were only 1 in a million to start, well now it is 100%. So of course when you see a show that interviews victims it seems pretty dire. Of course if you only interviewed non-victims, it would represent reality better but be pretty boring.

Despite all the things we see in the news every day, generally most of us avoid being victims the vast majority of the time. Now, I don't know how much the oil in the gulf is going to hurt the economies of those states. I actually think that the amount of income generated through recovery efforts and victim compensation may well exceed the income lost. Of course in addition there is the environmental damage, but cleaning that up will also create a lot of jobs and income. Will the income go to the people who were the actual victims? I don't know, but as bad as it seems, I would be willing to bet that, from a purely economic point of view, more money will be generated than is being lost. Of course we see habitat destruction and other impacts and it surely is sad but nature has a way of healing itself over time. Getting the spilled oil out of the water is a challenge that can be met once the flow into the gulf can be stopped.

This is mostly rambling and there are victims from the oil spill (remember 11 died) and there will be others. However, if you can't fish, but get compensated, I'm not sure that makes you a victim.

 

 

Looking for Risk

There is the old saying that only two things in life are certain, death and taxes. Actually some people manage to avoid the second quite well so maybe there is only one thing actually certain. Everything else has a degree of risk. Somehow humanity has struggled along and in fact I think it is safe to say that most people are better off than their ancestors were. All of this was accompanied by risk.

In today's economy we are recovering from a significant risk event, triggered by the sub-prime mortgage situation. Now when you look at that situation many of these mortgages were clearly not justifiable except in a scenario where prices climbed forever. Once prices stabilized and started to fall, as they had to eventually, the sub-prime people were doomed. Further, that collapse had all sorts of repercussions as the instruments designed to mitigate risk started to pay off and the companies that had to pay couldn't.

Now had the issuers of the subprime mortgages not been able to package and sell them raising money to issue more that they packaged and sold, etc. etc., the subprime mess would have been contained. Of course for a certain period of time this activity led to increased economic activity in construction, furnishings, appliances, well just about everything as houses were built, sold and provisioned.

But what was probably the most interesting part of the whole crisis for many investors, was that a few people made extraordinary amounts of money. Now you can make money in a good market, sort of the old fashioned way, relatively slowly and over time. However in a collapse you can make a whole lot of money in a very short time. This is quite appealing to many who now are constantly looking for the next big collapse so they can short it.

Now, identifying this risk is not very rewarding unless you can convince everyone else the risk is real and maybe even cause a panic. The European debt crisis looked ripe and did cause a decline but without actual defaults it didn't attain the level required to really cash in. If you trade instruments that require defaults by Greece, Spain, Portugal, they go up and down in value until the actual default happens. Those looking to really cash in will hold hoping that like a lottery ticket they become the next big winner, and the next legendary trader.

Mostly this won't happen since those types of panics are relatively rare and those who hold these instruments will probably hold them too long since cashing them in before the default seems like throwing away the golden goose.

Liquidity

Liquidity in the marketplace is a justification you hear about a number of behaviors that might not otherwise be justifiable. For example, someone buys a stock hoping or thinking it will go up, and then that stock is borrowed by a short seller who sells it trying to drive it down, it is OK because it adds liquidity to the market. Of course then there are the high frequency traders who have computers make trades that net very small profits individually but because of the volume they make a lot of money. This has nothing to do with investing since most of the action is computer driven based on pre programmed scenarios. However, they add liquidity to the market.

What exactly is the value of this liquidity? Well, it is nice to know that if you want to buy or sell just about any stock, your order can be executed any instantly when the limit you place is reached. However, is that really that important? Generally you would think publicly traded stocks would reach price points in a marketplace without the need for additional liquidity.

Recently we have seen France and Germany come out against short selling. I have discussed short selling before and no matter how I look at it, it seems designed to provide Wall Street insiders a way to gamble and manipulate the market. Now, it is a simple math problem. Increase the number of shares you can sell without increasing the total number of shares will correspondingly increase supply and unless demand already exceeded supply it will drive a price down, exactly what a short seller desires. Now yes, at some point the short seller will cover his short and that will create a sort of artificial demand, but why is this practice anything other than manipulation? Some short sellers have argued that they help to expose weak companies. Maybe they do, but what they then accomplish is to drive these companies down, below where a "normal" market would price them. In the scenario where the short sellers smell blood in the water as the price drops, real investors sell (often losing money) and analysts and lenders lose confidence in the company, often over something that without the short sellers wouldn't even have caused a ripple in the stock price. They love to exploit every possible way to drive prices down and some have become influential enough to be the cause of a dip.

And it leads to greater liquidity?

Did someone hear the Euro Drop?

A few months ago, all you heard about was how weak the dollar was and how Government borrowing was causing all Americans to lose wealth. Now it's the Euro's turn as they have weakness in many of the poorer nations. So while the US Economy slowly recovers and the Asian story remains unchanged, the fear that the Europeans will derail the whole thing has given us a correction.

The real question you have to consider is whether the recovery is going to be derailed. Ultimately, the value of a company is based on its profitability. Now past profitability has little relevance, so what you consider is the ability of a company to continue to be profitable and hopefully that it will increase its profitability.

Currently, most American companies are profitable and while many are still cautious, they see profitability continuing as long as the recovery continues, even at a tepid rate. So take a company like AT&T which has solid earnings, is expected to have earnings increase and is trading at about 12 times earnings and also pays a significant dividend. You can get almost 7% holding that stock. Yet it has fallen from its high of over $28 to around $24. In fact with the drop in value, it is closer to 10 times earnings than 12. Is it expected that the cell phone market is about to dry up? Not by anyone I know. The only factor that seems somewhat negative for AT&T (as well as Verizon and others) is that consumers are not as willing to sign multi-year contracts in exchange for a big phone discount.

Now, this could impact the profitability somewhat, but remember the company already has a huge subscription base among consumer and corporate customers and it reported that the I Phone is making inroads with business users.

So, the how do you account for the drop in the stock price? I mean, while admittedly there should be a premium for taking common stock risk versus buying a treasury bond, T gives you almost double the 10 year rate, doesn't tie up your money and has essentially no negative indicators of any substance. In fact by my rather simple calculations, the company is simply undervalued by the market by 15%.

Oddly, this is approximately about the percentage decline in the Euro vs. the Dollar over the last few months. So let's think about what this might mean. Suppose you think in Euros. AT&T was selling at 20 Euros a share when it was at $28 and the exchange rate was at 1.4 dollars per euro. 20 Euros will only get you $24 at an exchange rate of 1.2. So if you simply think of T in Euro terms, the price hasn't changed much at all.

Risk is its own reward

It is always interesting how the perceptions of the world economy change so much faster than the world economy actually changes. Take the so called European debt crisis. Greece and the others have been borrowing to pay for the high level of benefits they gave their citizens to win elections. Certainly, anyone with a calculator could have figured out that they couldn't keep this up forever, unless of course some new source of wealth suddenly appeared like a Goddess of Gold stepping out of a clam shell.

The risk was there, but all of a sudden the perception of that risk became widespread. Now, there are reasons for this, not the least of which being that some people can make a lot of money as the perception of risk goes up. Now, there are some scenarios where the European Union would abandon its weak sisters and let them default, but these scenarios are really quite unlikely considering the impact such an action would have on their economy. Europeans are nothing if not pragmatic and while here in the United States, certain of our officials listened to political ideologues who said "Let a big bank fail" and then suffered the consequences, as did most of us, they will use the current crisis to get the population to accept the need for some austerity and reduction in social programs, improving the future bottom lines.

Now, it would be rather cynical, perhaps justifiably so, to say that we have a certain percentage of our population who value being rich above all else. These people have always existed and they are mentioned quite unfavorably in the bible. However, much like drug lords or people who made their money during prohibition, they feel that having a lot of money will ultimately justify their methods. For example, we know a few people got very rich as the subprime mortgage industry collapsed. There is actually nothing wrong with that, but what would be wrong would be manipulating things to make an event happen that could have been avoided. Certainly, as the subprime mess developed, some actions could have transpired to mitigate it. Of course the existence of the subprime mess is directly attributable to the same mentality of profit above all else.

Now, it certainly is not my intent to say that becoming rich is a bad thing. Bill Gates became very rich because he had the foresight to create a software company at the perfect time. Quite a few others also got rich that way. What is questionable is when you are placing bets while rigging the game. Goldman Sachs created instruments that were destined to fail, and it was likely they knew they would, at least partly fail. It is likely they didn't know that the subprime collapse would be as widespread as it became, because they probably didn't think the Government would let a company like Lehman fail starting the domino effect.

The Europeans are too pragmatic to follow that example.

Paying it back

Greece, Spain, Portugal, and quite a few other countries have been spending more than they have been taking in, especially since the recession started. To make up the difference they have to borrow, and all things being equal, you can’t borrow unless you are going to pay back the debt. Now, one of the phenomena’s of the modern world is the fact that many countries, including the United States, run a permanent deficit. This means that year after year, they have to borrow to make up the difference. Of course, as the debt grows the interest on the debt grows, thereby increasing the deficit even more.
Now, when you look at any enterprise that spends more than it takes in, you have to consider the reason. It is fairly acceptable to borrow a large amount now to pay for an unusual purchase that you will pay back over a future period, say a mortgage on a house. Of course, the loan is that case is secured and the risk to the lender is based on the underlying asset value. If, on the other hand you have to borrow every month just to buy groceries, you would need a dramatic shift in your fortunes to pay that back.
So what are these countries borrowing money for? Well unfortunately, much of the borrowing is going to fund current accounts, the day to day expenses of the government. Now, how are they going to pay it back? Well, the only way to pay it back is to run a surplus, not a deficit. Now, sometimes you can grow your way into a surplus, meaning that if the economy starts to boom, the tax revenues will start to increase, and if you don’t increase spending eventually the taxes collected will exceed the expenses. Now, when you set up programs that guarantee spending growth, you need more growth in your tax receipts.
Now, to some extent, certain countries are going through a particularly bad spell due to demographics. The number of baby boomers in the population is going to create demands on resources that are not sufficient to cover the demand. It might be reasonable, to run a deficit until this reverses itself, as long as the underlying math shows that it will reverse itself in the future.