Saturday, October 25, 2008

The Contrarian Investor

I wish I had written this book. Although it was published in 1979, the topics it covers are still the bleeding edge of investment science today -- behavioral science and the herd effect, value investing, low price-to-earnings, and cash flow.

The only area in which I differ with David Dreman is in technical analysis. He cites a fair amount of academic evidence against technical analysis. I haven't looked at that research, but studies of technical analysis are easily cherrypicked and misinterpreted. The fact that 90%+ of professional Forex traders use technical analysis is evidence enough of its usefulness. However, Dreman points out the ridiculousness of the other extreme, the efficient markets hypothesis, and the truth is that much of technical analysis is of dubious use.

Since much of this stuff is review for me, I skimmed it. He cites plenty of interesting information, including some psychology literature that I'd never heard of such as Gustave LeBon's The Crowd and Irving Jarvis's Victims of Groupthink, and a bunch of studies showing that experiments frequently make mistakes. Other literature was familiar, such as Muzafer Sherif's light experiment (when "confederates" in a study estimate the distance of light from them, the subjects yield to the judgment of the crowd) and Tversky and Kahneman's look at cognitive biases and judgmental heuristics.

Since the book was written in the 70s, the last chapter of the book is devoted to inflation. Conventional wisdom of the time was that inflation made stocks a poor investment. Dreman particularly focuses upon the Modigliani and Cohn position that professional investors just don't understand how inflation impacts equities.

First, investors confuse nominal and real interest rates (real interest = nominal - inflation). Since bonds pay high nominal rates in inflationary times, such as 9 percent in 1979 when inflation was 7 percent, investors look for rates of return from stocks in excess of 9 percent (the excess to adjust for rate) instead of in excess of the real rate of 2 percent. (UPDATE 2009-10-7: This paragraph doesn't make any sense to me right now. Why would investors looking for higher rates of return from stocks lead to them outperforming bonds? Outperformance occurs when an investment is not valued highly enough...)

Second, investors don't account fully for the effects of inflation. Inflation may create inflated profits (under the last-in first-out accounting method) and depreciation is exacerbated, but corporations benefit from being able to pay back their debt on much cheaper terms -- since the debt is relatively fixed and their income is being inflated.

Put together, these two factors make equity investments much better than bonds -- generating something like twice the return over a 10-year period.

Friday, October 24, 2008

Summary of the Equity Bailout; Money Going to Bailouts?

Here is a nice summary of at least one of the bailout plans, the $250 billion preferred stock recapitalization plan, ie the TARP (Troubled Assets Relief Program) Capital Purchase Program. In other news, someone says that a State Street (NYS:STT) banker is getting a nice bonus check this year, courtesy of the US taxpayers.

I'm still not sure how this program is structured exactly, but I hope that this $250 billion comes from the $700 billion. The Wall Street Journal seems to say that ("TARP will also be used by Treasury when it puts new equity into banks").

Friday, October 17, 2008

The Federal Reserve's Holdings of US Treasury Bonds Declines?

When the Federal Reserve wants to manipulate the federal funds rate, it buys and sells US treasuries in open market operations. When it wants to lower the rate and increase the money supply, it buys treasuries. In September 2007, it had $780 billion in these treasuries on its balance sheet. Last July, it had only $478 billion.[1] Such a decline is unprecedented. Since the US economy nearly always grows, the money supply must increase proportionately in order for deflation not to happen. And yet here we see one influence on the money supply cut by nearly 40%. Yet the monetary base has spiked.[2] This is because the Fed sold its treasury bonds to the public in order to make way for more loans. As long as it doesn't sell the bonds to US banks, it won't hurt the US money supply.

The details are in the Fed's current balance sheet. The new loans are listed in the Term Auction facility and the "other assets". I don't feel terribly comfortable analyzing it. On their September 2007 balance sheet other assets is only 40 billion. These other assets may not be quite clear, although I haven't investigated thoroughly. Bloomberg has sued[3] to gain access to the collateral on the loans and that might include more information on these other asset.

The Big Picture, my favorite financial blog, has a nice graphic on this.

Thursday, October 16, 2008

Worldwatch Institute's State of the World 2007

I'm browsing through this book, and it is generally pretty good. It seems to focus on cities, however, and it is not as heavy on the facts and graphics as I sort of expected it to be.

I read the first half more closely, and now I'm more browsing. I was interested to read about eucalyptus as a cash-crop in Timbuktu, which lead me to the Wikipedia page. Apparently the tree is mainly native to Australia, and there's some major concern that it is an invasive species in South Africa.[1] Yet Worldwatch made no mention of that! The plant they mentioned next as helping to revitalize rural Africa, bourgou, seems more solidly ecological, and the National Research Council mentioned it favorably in a book on "Lost Crops of Africa". Apparently it can survive for months under water,[2] making it somewhat unique, and thus can be planted and harvested in areas where nothing could be grown previously.