Real Men

Too much testosterone can cloud our financial judgment.

Back in June, The Economist discussed a study that proves it. In the experiment, subjects played a simple game in which pairs of players divided and received money from a central pot. One player would propose how to split the pot -- and the other player would decide whether to accept -- for instance, $35 for the splitter and, $5 for the decider. If the decider accepted, both took their cuts. If the decider refused, neither got any money.

An economically rational decider would always accept the offer, no matter how low, because any payoff is more than zero. In practice, something gets in the way, and deciders will sometimes rather take nothing at all than accept an offer considered too low.

Here's where it gets interesting. In this version of the experiment, the players' testosterone levels were checked, and those with higher levels of testosterone were more likely to reject the low-ball offers of money. According to The Economist, "The responders who rejected a low final offer had an average testosterone level more than 50% higher than the average of those who accepted. Five of the seven men with the highest testosterone levels in the study rejected a $5 ultimate offer, but only one of the 19 others made the same decision."

In short, too much testosterone got in the way of their making the most obvious, and profitable, financial decision.

Jeff Mortimer: Lessons From the Trenches

My first big lesson was during the crash of 1987. I remember sitting next to a Quotron, watching tick by tick as clients’ money just melted away. The calls were pouring in. Many clients wanted to bail. But the reality was, it was too late to sell. “Stay put,” we told them. “Don’t panic. This market will rebound. If you panic and sell now, you’ll miss out.” In fact, two years later, the market was back. If you had sat tight, you’d have weathered the storm.

When everyone else is losing their heads, you’ve got to keep yours. And it’s as true in up markets as in down. Remember 2000, when tech-heavy investors insisted there would be no end to the bull run? They refused to rebalance their portfolios. They pushed their bets, and when the bubble popped, those portfolios suffered.

The key is discipline. You’ve got to think like a fiduciary of your own assets. Make your investment plan and stick to it. Be unemotional.

bear and bull cycles

Since 1950, there have been eight declines greater than 20% in the S&P 500. At their worst, the S&P 500 declines since 1950 have twice shrunk the market value of the index by nearly half. The grueling 21-month bear market that began in 1973 cut the index by more than 48% before the beginning of next bull market.

Fortunately, bear markets are only half of the cycle, and a much smaller half at that. The bull phases average over four times the length of the bear phases. And the average gain of 165.7% is a hefty reward for enduring the 33.2% average decline during the bear campaigns.

The Greatest Investment Quotes of All Time

Some of the most profound, insightful thoughts in business aren't that complicated. Heck, a lot of them are clear as day. You might be surprised at how much you can take away from something as simple as a one-line quote.

"I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful."
-- Warren Buffett

"Based on my own personal experience -- both as an investor in recent years and an expert witness in years past -- rarely do more than three or four variables really count. Everything else is noise."
-- Marty Whitman

"Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results."
-- Warren Buffett

"The four most expensive words in the English language are, 'This time it's different.'"
-- Sir John Templeton

"The stock market is filled with individuals who know the price of everything, but the value of nothing."
-- Philip Fisher

Morningstar's Perspective

Some of the strategies in managing Morningstar StockInvestor's Tortoise and Hare portfolios are definitely not in sync with academia or conventional wisdom.

Investors

Francis Chou

Rob Morrison

Blaine Lourd

Blaine Lourd got rich picking stocks. but then he realized that everything he thought he knew about the markets was wrong.

[via brknews]

Three Questions

Before making an investment, I think all investors needs to ask themselves the following three questions.

Morningstar projects a 14% return

Let's cut right to the chase: Our research suggests that SPDRs Trust (SPY), an ETF that tracks the S&P 500 Index, will return 14% annualized over the next three years.

Lest you wonder which hat we pulled that number out of, rest assured that there were no wands or seers involved. And because top-down macro forecasting isn't our bag (what…you were expecting the second coming of Bill Gross?), we kept the focus squarely on the stocks in front of us.

As it turns out, that's a lot of stocks--we cover 2,000 companies, including more than 450 of the S&P 500's constituent holdings. Therefore, we can harness the work that our analysts do in evaluating company fundamentals, such as the presence and durability of competitive advantages each business might boast. That work culminates in a fair value estimate that our analysts place on each stock they cover. We can roll up the fair value estimates that our analysts have placed on the S&P 500's holdings and, voilà!, come up with a fair value estimate for the index as a whole (1,626.80 as of Nov. 7).

But how does that get us to an expected return? We ordinarily expect a stock's price to converge to fair value over a three-year time horizon. Assuming that we compound our fair value estimate at the cost of equity--which is the minimum compensation that we demand for owning a stock--the expected return represents the return that will cause the stock's price to converge to fair value at some point in the future, not to exceed three years.

Seven Traits of Great Investors

Marks Sellers writes there are at least seven traits great investors share that are true sources of advantage. Unfortunately he also believes that they can't be learned once a person reaches adulthood. And "In fact, some of them can't be learned at all; you're either born with them or you aren't."

Value vs. Glamour revisited

As described in our "Value vs. Glamour" studies, value stocks have outperformed growth stocks over the long term. But what about commonly used benchmarks? Over the long term, aren't returns for growth and value indices about the same?

This is a research report by the Brandes Institute.

which investment style?

Morningstar looked at the performance of broad investment styles over time to see if a particular style had done a better job at helping investors meet this goal. A clear pattern emerged.

One style stood out from the pack. Ibbotson Associates has shown that value stocks have outperformed other styles by a wide margin since 1927. And they've done so consistently, beating all other styles in nearly every decade over the past 80 years. But because of active management and fees, stock performance doesn't always translate into fund performance. In this case it does. More than 70% of value funds topped the Dow Jones Wilshire 5000 in the trailing 10- and 15-year periods. That's a much better record than domestic-equity funds in general, and growth and blend funds in particular.

David Swensen

[5/26/09] Consuelo Mack interview with David Swensen

[11/26/07] Wisdom from the World's Second-Best Investor

[10/24/07] Yale University has long been renowned for its prowess in the classroom, but it's certainly no slouch in the investing realm, either. In fact, its giant $22.5 billion endowment notched an impressive 28% gain in its most recent fiscal year ending June 2007. And over the past decade, it returned nearly 18% annually, the best showing of any college endowment in the nation. By contrast, the S&P 500 was up only 7% over that period.

The brain behind it all is longtime Yale endowment chief David Swensen. Swensen's route to investment success at Yale has been unconventional (hence the aptly named title of his most-recent book, Unconventional Success). When Yale appointed him to his post in 1985, most college endowments, including Yale's, stuck to a plain-vanilla mix of stocks and bonds. But Swensen believed Yale's portfolio wasn't diversified enough and eventually built stakes in what are now known as alternative investments--private equity (investments in companies that aren't public), hedge funds, and real assets, such as timber, real estate, and oil--that don't move in step with the stock market or each other. Broadening the portfolio beyond stocks and bonds would moderate volatility, Swensen thought. And by mining less-followed areas, he and his analysts would have a better shot at unearthing undiscovered gems.

That plan of attack couldn't be more different than the one advocated by financial planners.

* * *

IN RECENT YEARS investors have eyed burgeoning Ivy League endowments like high school seniors applying to Harvard and Yale with weak grade point averages, low SAT scores and no extracurricular activities: zero chance of getting in. Can you blame them for being envious? In the year that ended June 2006, Yale notched a 22.9% return for a gain of $3.4 billion. Even more impressive is its consistency. Over the past 10 years, which included the market meltdown of 2000 to 2002, Yale has had annualized gains of 17.2%. Harvard, meanwhile, earned a 16.7% return in fiscal 2006 and boasts a 10-year average of over 15%. Of course, Harvard and Yale have long enjoyed formidable advantages, starting with immense wealth and prestige. Even other institutions, many with endowments in the billions of dollars, have been hard-pressed to keep up, let alone individual investors.

Surprisingly, that may be beginning to change. We've taken a close look at these endowments and at the new investment vehicles now available to the rest of us. Our conclusion: Even average investors can mimic Harvard or Yale in their portfolio, with access to some of the Ivy League's most exclusive and esoteric asset classes. We'll show you how and illustrate our method with a model portfolio.

John D. Rockefeller

John D. Rockefeller is the wealthiest man the world has ever known. On inflation-adjusted terms, Rockefeller's early-20th-century fortune is estimated by Forbes to be more than $300 billion today -- roughly five times the wealth of today's richest man, Carlos Slim.

Rockefeller quickly learned that the fastest and easiest way to make money was to sell "real" products that every household needed. When he discovered that crude oil could be refined into kerosene, a high-quality illuminating oil for lamps (automobiles and their need for gasoline would come later), Rockefeller saw the opportunity to help every U.S. family light up its house and jumped into the oil business in 1863.

Sound Investing and Peaceful Sleep

by Ben Stein [via wakywakyisha@chucks_angels]

INVEST FOR THE LONG HAUL If you are a smart long-term investor, do not pay any attention to short-term developments. They are often reported by people whose motivation may be to scare you (screaming about the subprime “crisis”) or to make you giddily greedy (screaming about that one certain stock you should buy to retire rich).

Some articles may scare you into selling, or not buying, at the wrong time, because the worse things are, and the worse the mood of speculators, the better the time to buy. Or some may motivate you to buy in excess — sort of like drinking in excess — at exactly the wrong, “irrationally exuberant” time. The people who write some of these articles often know very little about markets, are way too young to have learned much, have no money to invest anyway or just like to act like big shots with your money.

In the very long run, stock prices plus dividends (in the postwar period) have rewarded patient, long-term, careful accumulation of broad indexes, mutual funds, exchange-traded funds and variable annuities (with a careful eye on fees). They have not rewarded short-term trading. Such trading based on tips seen on television shows — even shows whose hosts are true comic geniuses with bald heads — or read in magazines can be potentially disastrous. The short term is no place for the ordinary investor to trade.

What's the market worth?

According the Morningstar, the Dow is 6.4% undervalued and the S&P 500 is 4.2% undervalued.

P/E expansion and contraction

Vitaliy Katsenelson writes in "Active Value Investing"

...I wanted to see what would happen to the average P/E of each quintile if I bought each quintile in the beginning of the range-bound market (January 1966) and sold it at the end in December 1982...The highest-P/E quintile exhibited a P/E compression of 50.3 percent. The P/E of the average stock dropped from 29.3 in 1966 to 14.6 in 1982. That portfolio generated a total annual return of 8.6 percent. The lowest-P/E quintile to my surprise had a P/E expansion of 34.8 percent. Yes, you read it right. The P/E of the average stock in my lowest-P/E quintile actually went up from 11.8 to 15.8 throughout the range-bound market. That portfolio produced a nice bull market-like total annual return of 14.16 percent...

see also

Tweedy Browne's What Has Worked In Investing (page 23)

According to What Works on Wall Street, low PERs worked well with big stocks, but not with small stocks.

Reminiscences of the 1987 Crash

Fast-forward 20 years later, and here we sit, facing the crash's 20th anniversary. It's no wonder the history books are out and comparisons are being made between today's environment and that of two decades ago. Yes, it's natural to reminisce on anniversaries, but the comparisons between then and now are somewhat eerie. However, a resultant prediction of a pending crash would still be difficult to make, notwithstanding the chart below showing the simple Dow chart patterns for the two periods.



You have probably seen this chart, as it's made its way into many an investment blog and newsletter. What many fail to add, however, is that although the price movement comparison is quite similar, the percentage change for the two periods is not at all similar.

Panic No. 12

David Dreman 10.15.07, 12:00 AM ET

The capital markets have suffered mightily in the mortgage meltdown. Mortgage-backed securities--whether backed by nasty subprime loans, slightly better Alt A ones or even highly rated borrowings, have sunk. Junk bonds, often linked to MBSs, are hard to float. Private equity deals, frenetic not so long ago, are iffy now that high-yield funding is harder and costlier to provide.

That has introduced intense fear to stock- and fixed-income investors worldwide. Despite the Federal Reserve's half-point reduction in mid-September, there's still a lurking suspicion that more bad news lies ahead. What will happen when all those adjustable-rate mortgages reset upward in months to come, plunging more strapped homeowners into default? Are we approaching a financial meltdown that will take everything, including the stock market, into a dizzying drop not seen since the bear market of 2000--02?

Yes, it's bad now and could take many months to unwind, hurting swarms of investors who were suckered into going for sky-high returns of MBSs without examining the ridiculously poor security behind them. Ditto some of the convoluted securities that bundle them called collateralized debt obligations. The mortgage problem also could put a dent into economic growth for a while. But as all good value investors know, dire times bring opportunities. The long-term trend of the stock market is up.

Since coming to Wall Street in the late 1960s, I have been through seven such crises. Somehow, the market survived them and thrived. Look back even further to the period following the end of World War II, and sure enough, you'll find that pattern holding in four more market spills. Beginning with the first postwar panic, resulting from the 1948--49 Berlin blockade, stocks have tumbled only to come roaring back to new highs. The worst market break came in 1973--74, during a nasty recession and the Arab oil embargo. The most recent was the dot-com slide, which began in March 2000 and ended in late 2002. The Nasdaq Composite, heavy with tech names, still has not regained the ground lost in that crash, but the broad indexes have.

During each crisis investors felt confused, uncertain and panicky. They believed nothing in their previous experience could help them cope with the ominous new world they faced. "Sell, sell, sell," their inner worrywarts advised. "Save your capital before it's too late."

This almost always turned out to be a bad move. Selling in a crisis is foolish. Yes, if you had sold the S&P 500, say, a year into the bear market, in March 2001, you would have avoided another 28% decline before it hit bottom. But would you have had the wisdom to get back into stocks a year and a half later? I don't know of anyone advising an exit in March 2001 who also switched to a bullish stance in fall 2002. And if you had sold in March 2001, and stayed out, you would have missed an opportunity. Since then the stock market has returned 46% (including dividends). On average, for each of the dozen crises, the market was up 36% one year after the low point, 44% after two years.

Today's stock market remains solid with good fundamentals and many cheap stocks at hand. The ongoing liquidity crisis must be handled gingerly, of course. Commit your capital slowly as several more shocks must be absorbed before a broad market rally begins.

bad timing

An examination of historical flows to U.S. stock mutual funds and the performance of the U.S. stock market reveals that, on average, individual investors have done a poor job of market timing. In general, they tended to increase their exposure to stocks just prior to a sell-off, and reduce their holdings ahead of a period of stellar appreciation (See the chart above). For example, investors allocated a record $219 billion in net new money to stock mutual funds during the 12-month period ending October 31, 2000, which preceded a decline of 27% for the S&P 500® Index throughout the following year. Another example of poor timing took place soon thereafter. After three straight years of stock market declines, flows turned negative (redemptions exceeded sales) during the 12-month period to February 28, 2003. However, from that point on throughout the next year, the S&P 500 rallied 35%. In other words, most investors were selling out of equity funds prior to a significant rebound and at exactly the time when they would have benefited the most by owning a higher percentage of stocks.

The effect of taxes

According to the brokerage Charles Schwab, an investor who sells a stock with a short-term gain (a stock held less than 366 days) must find a new stock that outperforms the sold stock by 21.2% just to offset the taxes. In contrast, selling a stock with a long-term gain requires that a replacement stock outperform by only 8.1%. Although taxes should never be the primary driver of your investment decisions, if at all possible, hold your winning stocks for at least 366 days -- and preferably much longer!


[9/26/07] The trading secrets of the super-rich.

Twenty Years Ago

Twenty years ago, on October 19, 1987, the day that would soon become known as “Black Monday,” the Dow Jones Industrial Average (DJIA)plunged 508 points––or 22.61%. By any measure, it was the worst single day in U.S. stock market history.

Of course, the markets eventually bounced back, building ever-increasing strength over the 1990s and hitting a fever pitch before the dot-com bubble burst in the spring of 2000. What followed was a disastrous bear market, in which investors experienced three years of consecutive, double-digit losses. At the time, a common joke was to say that your 401(k) had shriveled into a 201(k).

But the numbers help put things into perspective: The DJIA today trades above 13000. On the day of the crash in 1987, the Dow opened at 2246. Just imagine the gains you would have forfeited had you given up on stocks back in 1987.

The stock market is a mighty resilient beast. Remember September 11, 2001? The Dow lost 7.7% when it reopened on September 17. Six months later, it was up 10.47%. The day President Kennedy was shot, the Dow fell nearly 3%. Six months later, it had rebounded by 15.37%. The Cuban missile crisis in 1962…the North Korean invasion of South Korea in 1950…the Japanese attack on Pearl Harbor in 1941. All these incidents brought immediate havoc to the market. And yet the market came back every time.

Gates and Buffett still top the Forbes 400

A billion dollars just doesn't go as far as it used to. For the first time, it takes more than $1 billion to earn a spot on Forbes magazine's list of the 400 richest Americans. The minimum net worth for inclusion in this year's rankings released Thursday was $1.3 billion, up $300 million from last year.

The new threshold meant 82 of America's billionaires didn't make the cut.

Collectively, the people who made the rankings released Thursday are worth $1.54 trillion, compared with $1.25 trillion last year.

The very top of the list was unchanged: Microsoft Corp. founder Bill Gates led the list for the 14th straight year [actually 13], this time with a net worth estimated at $59 billion. He was followed by Warren Buffett of Berkshire Hathaway Inc. in second place with an estimated $52 billion and casino mogul Sheldon Adelson, No. 3 with an estimated worth of $28 billion.

Larry Ellison of Oracle Corp. maintained his ranking at No. 4, with an estimated net worth of $26 billion.

But the list showed some notable changes.

Joining the top 10 of the country's richest for the first time were Google Inc. founders Sergey Brin and Larry Page, who tied for fifth place. The 34-year-old moguls' wealth has quadrupled since 2004 to an estimated $18.5 billion this year, while their company's stock value has surged 500 percent.

Fortune's foresight

Perfect foresight is impossible in the complicated and dynamic world of investing. Even the best investors typically turn out to be wrong – meaning they don’t beat a risk-free rate of return – on 30-40 per cent of the investments they make. That’s perfectly fine – if your winners on average also go up more than your losers go down, you can build an outstanding record over time.

The fallibility of investment foresight came to mind recently when I revisited a feature article in Fortune magazine that appeared in the summer of 2000 under the ambitious headline “10 Stocks to Last the Decade”. As the table (below) indicates, a portfolio of this august group has tumbled 39 per cent since the article ran, versus a meagre, but positive, 3.5 per cent gain for the broader market as measured by the Russell 3000 index.

... Valuation matters. Guess what the average price/earnings ratio was of the stocks on Fortune’s list. 30x? 40x? Such ratios were for wimps in mid-2000. How about a nice round 100x? As Jeremy Siegel writes in The Future for Investors: “The long-term return on a stock depends not on the actual growth of its earnings, but on the difference between its actual earnings growth and the growth that investors expected.” That’s something to remember every time you buy a stock, especially if you’re betting on “sweeping trends”.

[via brknews]

Chuck Hughes

‘Investing with the trend’ is an important requirement for profitable stock investing for investors with a short term time horizon. Timing is everything. If you are a short term investor ‘Investing with the Trend’ should be your investing mantra. Regardless of which investment strategy you use to buy and sell stocks there is always ‘entry and exit’ timing risk for short term investors.

I like to use moving average ‘cross overs’ to define the short term price trend. For example, my Fail Safe EMA System uses 50-Day (fast) and 100-Day (slow) Exponential Moving Average (EMA) ‘cross overs’ to define a trend. A price up trend exists when a stock’s 50-Day Exponential Moving Average (EMA) line is above the 100-Day Exponential Moving Average line and the stock should be bought. A price down trend exists when the 50-Day EMA is below the 100-Day EMA and a stock should be sold. This is a simple but effective system for buying stocks when they are in a price up trend and selling stocks when they are in a price down trend.

Note: Chuck Hughes placed second in the 2006 World Cup Championship of Stock Trading, first in 2005, third 2003. Don't know how he did in the other years.

Stumbling on Value Investing

One of the Brandes Institute’s goals is to expand the investment community’s understanding of market behavior. As such, we are interested in aspects of behavioral finance.

Using excerpts and examples from Daniel Gilbert’s book, Stumbling on Happiness (New York: Knopf, 2006), this article seeks to illustrate psychological pitfalls that may prevent long-term success for investors. It also includes seven tips designed to limit the influence of potential behavioral shortcomings and help investors make more informed decisions.

in the bank or on the bank?

Is it better to put your money in the bank--or bet on the bank? Investors face this dilemma when weighing the choice between bank certificates of deposit and shares of a given bank's stock. In the discussion below, we explain why the decision boils down to how quickly an investor needs to access the funds. That is, there is no one-size-fits-all solution.

Looking Better?

To a casual observer the stock market seems almost giddy with joy. Ben Bernanke and the Fed stand ready to come in if there is trouble. President Bush is going to help sub prime borrowers which will, in turn, help ease the credit crunch. The stock market responds with a sharp rally on Friday.

But the reality is that there is a lot of fear and worry in market land. Chart 1 shows one manifestation of concern. This is the percentage of bears among market advisors and newsletter writers as reported by Investor's Intelligence. Historically whenever the percentage of bearish advisors moves above 35, it's time to start looking to buy. The percentage did get into the 40's during the 2000-2002 bear market, but during bull markets the current reading is an extreme.

It's such a reliable law. Investors get scared at bottoms and optimistic at tops, so based on this indicator, we are flirting with a bottom.

[via scalenet]

What is risk?

So what is risk? Well, risk should be viewed as the likelihood of permanent loss of capital. Betting at a casino is a good example. And it is in this context that the risk-versus-reward profile should be assessed. When you buy shares in a business for $30 apiece because you have determined through data analysis and your reasoning that the shares have an intrinsic value of $60, but then the stock tanks to $20, you have not taken on risk but mere price volatility. Of course, you should naturally go back and determine that the intrinsic value has not materially changed for the worse. If it hasn't, then your investment has really become less risky, and you should view the price volatility as an opportunity to take advantage of a better bargain.

It's this misunderstanding of risk that causes investors undue stress and results in sloppy buying and selling. Buffett used to say that you should be able to watch your investment decline by 50% and not feel pressured to sell. Mohnish Pabrai told me that a stock's price immediately tends to decline whenever he buys a stock and shoot up when he sells, yet the declines don't bother him, since he doesn't concern himself with price volatility.

5 Ways to Be a Horrible Investor

Are you one of those people frustrated with your inability to beat the stock market? Despite watching CNBC and Jim Cramer religiously, and reading The Wall Street Journal every day, you just can't seem to make it happen. Here are five ways I think that investors shoot themselves in the foot.

1. Do Little Research
   
2. Buy On Tips and Rumors
   
3. Envy
   
4. Low Conviction
   
5. Ignore Value

Uncertain Investing

"Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain. Yet high uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information." Margin of Safety, Seth Klarman.

Dividends Rule

[8/31/07] Famed Wharton finance professor Jeremy Siegel -- you've likely seen him on TV or read his books -- found out something very powerful recently: From 1871-2003, a full 97% of the stock market's return came from reinvested dividends -- only 3% was from capital gains on the original principal!

The case for dividends gets stronger. Dividend stocks have a reputation for safety, but they also have a secret agenda that enriches investors. Rob Arnott, former editor of the Financial Analysts Journal, and Cliff Asness, managing principal at AQR Capital Management uncovered it: Stocks with the highest yields actually show the highest earnings growth over the next decade.

There's more. Ned Davis research found that from 1972 to 2006, S&P 500 stocks not paying a dividend returned 4.1% annually, while dividend payers returned 10.1%!


[6/14/05] says Matthew Emmert, the chief analyst of Motley Fool Income Investor.

Meanwhile, Tom Gardner mentions nothing about dividends.

Quant King

The acknowledged quant king is James Simons, 69, an M.I.T.-trained mathematician with a groundbreaking theory that physicists are using to plumb the mysteries of superstring study and get at the very nature of existence itself. Simons turned his big brain on investing after his math career, founding Renaissance Technologies quant shop. The firm pocketed $1.7 billion in investor fees last year, among the highest in the industry. In return, his clients can reap annual returns of more than 30 percent, according to news reports.

As elegant as the models are, they cannot predict unpredictable events, or human panic, some traders say. Further, some say, too many quant funds are full of myopic brainiacs, overly reliant on their tools.

"Most are idiot savants brought to industrial proportion," Nassim Nicholas Taleb, former quant-jock and bestselling contrarian author, said by phone from Scotland, where he is promoting his new book on improbability, "The Black Swan."

"They are very smart in front of a textbook but not smart enough to understand very elementary things in reality," he said.

Market performance after volatility spikes

[8/23/07] Investors panicked in 1997 during the Asian crisis… but once the fear subsided, stocks shot up something like 20%. Investors then panicked in 1998 (during the Russian bond default/LTCM crisis). Once again, as the fear started to subside, stocks soared. The S&P 500 shot from less than 1,000 to 1,400 in no time.

We had a few more panics… September 11, 2001, of course, but the S&P 500 rallied nearly 20% very quickly – and this was during a bear market! Late 2002-early 2003, as the U.S. invaded Iraq. Once again, as the uncertainty/panic subsided, stocks soared… The S&P 500 ran from 800 to 1,100.

We're in another panic now. But the fear is subsiding…

The Volatility Index (the VIX) is my measure of fear. Some call it the Fear Gauge. On Friday, it closed at 30. On Monday, it closed at 26. Today, it's around 23.

Now I can't guarantee that fear can't jump once again. As you can see from the chart, the Fear Gauge often has more than one spike to "scary" levels.

But if you ask me, I think we're closer to a near-term bottom than a top. I can be completely wrong, of course… The Crash of '87 set a record on the Fear Gauge, and we didn't get a whole lot of advance warning. Just days before the '87 Crash – the worst one-day drop in Wall Street history – the Fear Gauge was right in line with its average for the previous 12 months.

Instead of betting on a decline from here, this is what I see: Based on valuation, stocks are as cheap as they've been in a dozen years. The Fed is about to start cutting interest rates. And if you believe that you've got to be a contrarian to make money, the contrary thing is to believe in stocks when most people don't… and that's now.

[8/20/07] At its recent peak, the Volatility Index (VIX) was up 90% from 50 trading days earlier. Since 1990, there have been only six other periods of such intense short-term volatility. Each time, the S&P 500 was higher one, three and six months later.

How good is Jim Cramer?

[3/15/09] Cramer vs. Stewart

[3/12/09] The Daily Show vs. Jim Cramer

[2/8/09] Cramer's recommendations underperform the market by most measures. From May to December of last year, for example, the market lost about 30%. Heeding Cramer's Buys and Sells would have added another five percentage points to that loss, according to our latest tally.

To his credit, Cramer's Sells "made money" by outperforming the market on the downside by as much as five percentage points (depending on the holding period and benchmark). His Buys, however, lost up to 10 percentage points more than the market.

Our research reveals that the stocks Cramer picks as Buys have been rising versus the market for several days in advance of his show, while his Sells have been falling. This doesn't prove there is a leak in the tight security surrounding CNBC's show. It could merely mean that Cramer and his staff are heavy-footed in their research. Or it could mean that his stocks are primarily momentum plays. That is the network's explanation. "Jim likes to recommend 'what is working'," said CNBC communications vice president Brian Steel in a written response Friday. "So it is no surprise there would be movement in these stocks prior to Jim mentioning them."

In any event, these pre-show moves are the probable cause of Cramer's underperformance. As the stocks revert to the market's trend in the weeks after the show, Cramer's followers get hurt.

[10/31/08] Like him or hate him, Jim Cramer gets people's attention. And whether he gets his picks right or wrong, he's done at least one thing that deserves the highest praise. Every night on Cramer's Mad Money program, you'll hear about how Cramer owns some of the stocks he talks about in his charitable trust. He owns a mixed bag of stocks, some up and some down. But regardless of how those picks have done, Cramer deserves the most credit for making the donation to charity in the first place.

[5/14/08] While looking through AOL videos, I happened to put in a search for Jim Cramer and came up with Wizetrade vs. Jim Cramer which is a technical analysis of Jim Cramer's picks of the day (hint: sort by most recent)

[3/7/08] Tracking the performance of Jim Cramer’s Jan 2007 stock picks

[2/27/08] Five mistakes amateurs make

[8/20/07] Does it pay to short Cramer?

[8/9/07] Cramer flips out [via tairbear00@chucks_angels]

[5/31/07] Who does Jim Cramer think he is?

[3/16/07] Is Jim Cramer a rule breaker?

[2/15/07] Track Cramer's top picks at TopStockGuru

[1/15/07] Jim Cramer is a Rule Breaker

[12/5/06] Jim Cramer's 10 Lessons From Success: Some Buy and Sell Rules (excerpted from Jim Cramer's Mad Money: Watch TV, Get Rich)

1. Follow The Street's Lead
   
2. How to be Contrarian
   
3. Wall Street's Often Wrong
   
4. Don't turn your nose up
   
5. Be Politically Savvy
   
6. Learn momentum's rhythm
   
7. The Best Way to Use tips
   
8. A selling formula
   
9. Look out for downturns
   
10. Beware multiple contraction

Jim Cramer's 10 rules from New Mistakes, New Rules: Ten Lessons From My Bad Calls (excerpted from Jim Cramer's Mad Money: Watch TV, Get Rich)

1. Ride the business cycle
   
2. Know the markets
   
3. Do the right homework
   
4. LatAm's always a trade
   
5. Admit it when it's too hard

Bonus: Hold Your Own Lightning Round

[8/3/07] Cramer's Soundboard!

[12/2/06] Booyah Breakdown: Cramerisms

[11/16/06] Buffett watches "Cramer" [from rrlbva@chucks_angels]

[10/23/06] Kiplinger's Personal Finance magazine profiles Cramer

[8/28/06] A review of 'Confessions of a Street Addict'

[8/11/06] Is the market mad?

[5/5/06] CramerWatch.org announces the re-launch of the first, and only, free website that evaluates the stock picks and recommendations of Wall Street guru Jim Cramer, star of MSNBC’s nightly 'Mad Money with Jim Cramer.'

The goal of CramerWatch.org is to impartially review if Cramer is good for investors. The website collects each of Mr. Cramer’s “lightning round” recommendations and tracks the performance of each stock recommendation. The performance of the stock is also compared to the performance of the overall market over 30 days.

The recommendation is also compared to the recommendations of Leonard ‘The Wonder Monkey’ CramerWatch.org’s resident stock picker. Leonard recommends buying or selling stocks that appear on Mr. Cramer’s lightening round by simply flipping a coin. CramerWatch.org shows that randomly buying or selling those picks will actually make the investor more money than following all of Mr. Cramer’s recommendations.

* * *

[4/21/06] Mark Skousen predicts the demise of Jim Cramer

[4/5/06] Cramer vs. the benchmarks

[1/19/06] Munnariz reiterates

[1/13/06] TMFBreakerRick's take on Cramer

[12/21/05] This guy has been unimpressed by Cramer's Actions Alert Plus. His beef seems to be that the portfolio doesn't own several stocks that he says to buy on his show. In particular: GOOG, WFMI, AMGN, DNA. I think a reason might be that Cramer is unable to buy stocks for 7 days after he mentions it on his show (or something like that). That likely handcuffs the Actions Alert portfolio to no end. He does say though the show is worth listening to for free and that Cramer has made him money in the past.

[10/24/05] Cramer makes the cover of BusinessWeek

[10/17/05] Krakower was offering Cramer something all the money in the world can't buy. She would make Jim Cramer a rock star.

[9/1/05] CNBC's Raging Bull

[8/8/05] San Francisco Chronicle story (Cramer replied on 8/1 that he has already sold some of those picks that have gone nowhere - he doesn't buy and hold, he buys and homework]

[8/1/05] My answer is he's real good at entertainment. But how good is he at picking stocks?

According to this study, he's right about 50% of the time. (That statistic alone is not necessarily bad. If you let your winners run and cut your losses, you can come out far ahead. I still don't know the actual performance of Cramer's portfolio.)

Here's an earlier New York Post article.

Links:

Mad Money Recaps [3/25/07]

Mad Money (from wikipedia)

Mad Money Recaps

Jim Cramer Mad Money Forum

BOO-YAH BOY AUDIT! [9/15/05]

RealMoney Radio

New York Metro archive

Mad Money Machine, a blog by Paul Douglas Boyer [3/29/06]

---

[4/19/05] Jim Cramer's 25 Rules for Investing

[9/5/05] Cramer School

Calculating mutual fund cost basis

[9/24/07] Changes to the law back in 2003 made an already great strategy—holding investments for the long term—a better deal than ever. To recap, realized gains on stocks, bonds and mutual funds held over one year are taxed at the long-term capital gains rate of 15%.1 Short-term gains (on investments held one year or less) are still subject to ordinary income tax, which ranges up to 35%.

Whether short-term or long-term, the gain on your investment is the sale price minus your cost basis, or what you paid. It sounds simple, but calculating your cost basis can be more complex than you might think—and if you calculate it incorrectly, you may overstate your gain and pay more tax than necessary. The accounting method you use to report your cost basis can have a big impact on your tax bill, as well.


[8/18/07] The IRS allows you to use one of four methods when calculating your mutual fund's basis. You'll need to think about this decision before you actually sell anything. Your choice will affect how you treat sales in the future.

• Average cost (single category): Most people (and brokerages) use this method. You add up all of your purchases of the security, including reinvested dividends and capital gains, and divide by the total number of shares you own. To determine whether your gains/losses are short-term or long-term, you assume the oldest shares are sold first. Once you use this method to calculate the cost basis of shares you've sold, you must continue to use this method for the rest of the shares you sell in the future.
  
• Average cost (double category): This is similar to the above method, but first you sort your shares into two categories: those in which your gains and losses are short-term and those in which you have a long-term gain or loss. Then you add up the purchases in each category and divide by the number of shares in each category.
  
• Specific-share identification: This method is a little trickier, but it can also save you money. You specifically tell the brokerage which shares you want to sell and use the cost basis of those specific shares. For example, you may have bought shares of XYZ company five years ago when prices were higher--let's say $15 per share. Then later you bought more shares when the price was lower--say $5 per share. If you specifically tell your brokerage firm to sell the shares that you purchased at $15 and you sell them at $16, you only have to pay tax on the $1 per share of capital gain. If you specified the shares with a $5 cost basis, you'd owe tax on $11 per share.
  
• FIFO (first-in, first-out): If you don't specify a method for calculating your basis, the IRS will assume you're using FIFO. This method assumes that when you sell some of your shares, they are the first shares you bought. If those shares have a lower cost basis, you'll end up owing more in capital gains tax (and vice versa).

When calculating cost basis on stocks, the average cost basis may not be used.

Fed cuts discount rate

Before the commencement of trading, the Federal Reserve announced a cut in the discount rate, the rate at which banks borrow directly from the Fed, by 50 basis points to 5.75% and eased terms, but left the official target for the fed funds rate at 5.25%. In its statement, the Federal Open Market Committee said, "Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward," emphasizing that "downside risks to growth have increased appreciably."

The FOMC is "prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets." The Committee said the move will remain in place "until the Federal Reserve determines that market liquidity has improved materially." Treasury yields have fallen in recent days, with the biggest drop coming at the short end of the curve, while the yield on the 3-month T-bill has plunged over a full-percentage point as investors seek safety from the storm. Treasury prices are mixed following the Fed's move, with prices rising on the short end of the curve, but are lower on the middle and long end as the rise in stocks and the reduction in the discount rate calm jittery nerves.

[Charles Schwab Morning Market View]

Just A Correction?

We hear each day the idle prattle of Wall Street “Buy Side” investors, discussing whether the recent decline in stock prices is just a correction in a healthy market, or whether this is the start of a bear market. Not surprisingly, to a man these ‘experts’ seem to unanimously agree that this is just a correction, and that a bottom is close at hand, not to mention the John Chambers quote that “this is the strongest global economy I’ve ever seen.” In our view, these guys need to have lunch with the Housing Market economists who have been saying the same thing over the last 18 months -- still no bottom there either!

In our view, the ‘pundits’ arguing that this is just a ‘correction’ are absolutely kidding themselves as there is an overwhelming argument to be made that prices are headed much lower, and within relatively short order. The mistake being made is a complete lack of understanding of the opaque nature of the credit derivatives market.

Simplicity

Mohnish Pabrai has compounded money at 29% annually for eight years in his investment partnership. He recently stated in an interview with the Motley Fool that “Usually two to three variables control most of the outcome. The rest is noise. If you can handicap how those key variables are approximately likely to play out, then you have a basis to do something.” This is such a simple idea but investors do not apply it in their endeavors. Every company has key variables and as Mohnish so eloquently put it “If I find myself reaching for Excel, it is a very strong sign to take a pass.” If one cannot figure out the key variables, look at a different company, do not stray outside one’s circle of competence.

“There are an infinite number of facts that you can learn about a company, but there are usually two or three very important variables that make the company succeed or fail. A lot of Wall Street gets so bogged down in the minutiae and details that it misses these two or three big things that make or break the investment. Part of what worked for me over the years is being able to distinguish what matters from what doesn’t. That’s one of Buffett’s great gifts. He focuses on the critical issues involved in analyzing. I don’t pretend to be able to do it like he does but it’s one of the most important things you can do.” – Wallace Weitz

[9/20/07] From a CIA report, "Once an experienced analyst has the minimum information necessary to make an informed judgment, obtaining additional information generally does not improve the accuracy of his or her estimates. Additional information does, however, lead the analyst to become more confident in the judgment, to the point of overconfidence. [via wreck_of_m_deare@chucks_angels]

even gold doesn't glitter

Given the volatility of stocks and bonds, many investors assume that gold is a smarter investment. If you also want to become a goldbug, you have several options. You might invest in gold stocks or gold mutual funds, but these can be rather volatile, too. You might buy into gold accounts at bullion banks, which require large minimum investments, or gold certificates and pool accounts, which don't. Gold coins or bars might be tempting, but you'll need a safe place to store them.

David Kathman of Morningstar.com has noted that "Returns aren't the point when you're investing in gold; diversification is ... A small amount of gold alongside your stocks can be a stabilizer." But all does not glitter in the world of gold. In his seminal book "Stocks for the Long Run" (McGraw-Hill, $30), University of Pennsylvania finance professor Jeremy Siegel reveals what a dollar invested in various things would have grown to from 1802 to 2001 (yes, nearly 200 years!): stocks, $599,605; bonds, $952; bills, $304; and gold, 98 cents. (Amounts have been adjusted for inflation.)

So, through many wars and economic times even more troubling than those we face today, gold hasn't proven to be a great long-term investment. True, it has zoomed up in recent years to nearly $700 per troy ounce, but that's a level it approached back in the late '70s and early '80s, and it spent most of the intervening years in the $300s and $400s.

In Fortune magazine, David Rynecki noted: "Gold investors are notoriously bad forecasters. From 1985 to 1987, for example, a collapse in the dollar boosted gold 76 percent and had many metalheads predicting an extended rally. Instead the price fell 15 percent the very next year." He adds: "Even bullish gold pros caution the average investor to put no more than 5 percent of a total portfolio into gold-related holdings and say it's safest to invest through funds."

the more research,

Should you spend countless hours researching a stock before buying it, or just a few hours? The common wisdom is that the more time you spend on research, the better your investment results will be. But is this correct?

Not according to studies on the subject. At least two I have seen came to the conclusion that anything more than a cursory review of a company’s prospects is a waste of time. One study looked at whether more information was useful to experienced horse racing gamblers. The researchers first gave the gamblers a few items of relevant information (age of horse, pedigree, jockey, etc) and asked them to predict which horse would win the race.

They then gave out dozens more items of information about the race
and asked the experts to predict again, based on the additional information they had received. The conclusion was that the first few items of information given to them were useful but further information had no effect on the accuracy of their predictions. The gamblers were far more confident about their predictions after receiving more information, but this didn’t translate into accuracy.

Another study showed that sell-side stock analysts, who spend 50-80 hours a week on research and presumably have loads of information at their fingertips, are no better than a monkey with a dart at predicting a company’s five-year earnings growth rate. In fact, they are actually worse than a monkey with a dart because they tend to project the recent past into the distant future, rather than assuming growth will revert to the mean. If the analysts’ projections were simply random, the results may have been closer to reality.

[via pohick2@chucks_angels]

Bogle on rebalancing

We’ve just done a study for the NYTimes on rebalancing, so the subject is fresh in my mind. Fact: a 48%S&P 500, 16% small cap, 16% international, and 20% bond index, over the past 20 years, earned a 9.49% annual return without rebalancing and a 9.71% return if rebalanced annually. That’s worth describing as “noise,” and suggests that formulaic rebalancing with precision is not necessary.

We also did an earlier study of all 25-year periods beginning in 1826 (!), using a 50/50 US stock/bond portfolio, and found that annual rebalancing won in 52% of the 179 periods. Also, it seems to me, noise. Interestingly, failing to rebalance never cost more than about 50 basis points, but when that failure added return, the gains were often in the 200-300 basis point range; i.e., doing nothing has lost small but it has won big. (I’m asking my good right arm, Kevin, to send the detailed data to you.)

My personal conclusion. Rebalancing is a personal choice, not a choice that statistics can validate. There’s certainly nothing the matter with doing it (although I don’t do it myself), but also no reason to slavishly worry about small changes in the equity ratio. Maybe, for example, if your 50% equity position grew to, say, 55% or 60%.

In candor, I should add that I see no circumstance under which rebalancing through an adviser charging 1% could possibly add value.

[via roberts1001 @ chucks_angels]

Grantham sees opportunity

Jeremy Grantham says he's spotted the third great investing opportunity of his career. The first was small caps in the 1970s. The second was real estate, Treasury Inflation-Protected Securities, and value stocks during the tech bubble in 2000. Before you get too excited, I should make clear that the main opportunity today, in Grantham's view, is getting out of the way and watching the markets plummet in what he calls a slow-motion train wreck. Grantham made this call in a report published July 25--a day before the Dow got 300 points sliced off the top (talk about instant gratification!).

Grantham calls this new opportunity "anti-risk." He says the opportunity lies more in bonds than stocks. "The ideal way of playing this third great opportunity is perhaps to create a basket of a dozen or more different anti-risk bets, for to speak the truth, none of us can know how this unprecedented risk bubble with its new levels of leverage and new instruments will precisely deflate. Some components, like subprime and junk bonds, may go early, and some equity risk spreads may go later."

I asked Grantham what else individual investors could do to make some anti-risk bets of their own. The wagers he's making for clients are too complicated for individuals, but he did offer a few ideas in addition to buying TIPS.

• Hold a lot of cash so that you'll have plenty of dry powder to take advantage of cheaper markets in years to come.

• Regular bonds are not too bad to own. (This means core high-quality bonds, such as corporate or Treasury bonds.)

• Short the Russell 2000 and go long on the S&P 500.

The final notion reflects Grantham's view that low-quality small caps will be terrible after many years of outperformance and high-quality large caps will fare well after years of lagging. The S&P 500 isn't a perfect proxy for GMO's definition of high quality, but it's close. Grantham notes that 80% of the companies they consider high quality are in the United States. "If the economy weakens substantially, these stocks will be pure gold," he said.

Percentage Retracements

In almost all uptrends and downtrends after a particular market move, prices retrace a portion of the previous trend before continuing the move in the original direction. Studies show these countertrend moves tend to fall into predictable percentage parameters.

The application best know in this phenomenon is the 50% retracement. For instance, a market is trending higher traveling from the 100 level to the 200 level. Most often, the subsequent reaction retraces half of the previous movement, to about 150, then regains its momentum and moves upward. This market tendency happens frequently and in all degrees of trend, such as, major and secondary. It also occurs in all trading systems including day trading, swing trading and options trading.

There are also minimum and maximum percentage parameters, one-third and two-third retracements, which are useful. Divide the trend into thirds, and site the minimum retracement as approximately 33% and the maximum as 66%. So when the corrections in the market retraces at least a third of its movement, the trader can compute a 33-50% area as a general frame for buying opportunities.



The 66% parameter becomes a critical area in the event the retracement enters that area. For the trend to be maintained, the correction must not go beyond the two-thirds mark. However, this 66% area becomes a relatively low risk buying area in an uptrend and selling area in a downtrend. Retracement beyound 66%, two-thirds, strongly indicates a trend reversal instead of just a retracement.

[via investwise]

America gives it away

According to a recent report from the Giving USA Foundation, in 2006, Americans donated $295 billion to charities -- a slight but impressive increase over 2005, which saw more than its share of (hopefully) once-in-a-lifetime disasters. (Back out the natural-disaster donations, and 2006 giving was up 3.2%.) Giving USA stats show that the United States ranks first worldwide in philanthropy, at 1.7% of GDP. (The United Kingdom is No. 2, at 0.73%.)

US Equity Returns: What To Expect

Does one's entry level into the market, i.e. the valuation of the market at the time of investing, make a significant difference to subsequent investment returns?

In an attempt to cast light on this issue, an interesting multi-year comparison of the price-earnings (PE) ratios of the S&P 500 Index (as a measure of stock valuations) and the forward real returns was done by my colleagues at Plexus Asset Management. The study covered the period from 1871 to 2006 and used the S&P 500 Composite Index (and its predecessors). In essence, a total real return index and coinciding ten-year forward real returns were calculated, and used together with PEs based on rolling ten-year earnings.

In the first analysis the PEs and the ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals) (Diagram A.1). The cheapest quintile had an average PE of 8,5 with an average ten-year forward real return of 11,0% p.a., whereas the most expensive quintile had an average PE of 21,6 with an average ten-year forward real return of only 3,2% p.a.

The study was then repeated with the PEs divided in smaller groups, i.e. deciles or 10% intervals (see Diagrams A.2 and A.3). This analysis strongly confirms the downward trend of the average ten-year forward real returns from the cheapest grouping (PEs of less than six) to the most expensive grouping (PEs of more than 21). The second study also shows that any investment at PEs of less than 12 always had positive ten-year real returns, while investments at PE ratios of 12 and higher experienced negative real returns at some stage.

A third observation from this analysis is, interestingly, that the ten-year forward real returns of investments made at PEs between 12 and 17 had the biggest spread between minimum and maximum returns and were therefore more volatile and less predictable.

Based on the above research findings, with the S&P 500 Index's current PE of 18.4 and dividend yield of 1.8%, investors should be aware of the fact that the market is by historical standards not in cheap territory, arguing for luke-warm returns. Although the research results offer no guidance as to when and at what level the current bull market will run out of steam, they do indicate that it would be irrational to bank on above-average returns from these valuation levels. As a matter of fact, investors should expect higher volatility and even the possibility of some negative returns.

Is the party over?

It may surprise you to learn that a slowdown in the growth rate of corporate earnings doesn’t necessarily mean the party’s over for stocks. Not only are earnings slowdowns natural at this time in the economic cycle, but history has shown the market actually has performed best during such periods.

That’s because the stock market looks ahead. Once investors believe the Fed is done raising rates, price/earnings (P/E) ratios tend to expand—unless they are already unrealistically high, which they’re not now.

That positive story, combined with low core inflation, could yet provide the fuel for another leg up in the market. In such late-cycle rallies, history also suggests that growth and large-cap stocks tend to be market stars.

Morningstar looks at China

Visiting China in 2007 is a bit like visiting Silicon Valley in 1999 at the height of the dot-com era. Things are happening at light speed, and the economy is white hot here, but caution is certainly warranted. The economy has grown at a 10%-13% rate for several years in a row, and on a purchasing power parity basis (excuse the economist-speak), the Chinese economy now has a GDP of about $10 trillion, trailing only the EU and the U.S. at roughly $13 trillion each. (After adjusting for currency effects, the actual value is much lower, but that's another story.) The bottom line is that like it or not, you cannot be a student of the modern world economy without taking time to study China. It is simply too large a force to be ignored.

Jean-Marie Eveillard is back

Jean-Marie Eveillard is back at First Eagle Fund. He just wrote his first shareholder letter reiterating his views on value investing.

First, a reminder: for more than twenty-five years, we have been in the business of establishing “intrinsic” values for securities which catch—on a preliminary basis—our attention. In a nutshell, we try to figure out what a somewhat knowledgeable buyer (“somewhat”, because we’re on the outside, looking in), expecting a reasonable long-term return, would be willing to pay —in cash—for the entire business. That number is the intrinsic value. If the market price of the security is at some discount to the intrinsic value, then we might be interested. The appropriate size of the discount is a function of how well we think we understand the business and of how much we like the business. The better we understand and like it, the smaller the required discount. As for the sale of securities, it takes place whenever we realize that our intrinsic value was overstated, in other words, when our analysis was flawed. We also sell when the price of the security moves up to the intrinsic value, though we make exceptions—not without trepidation—when we believe the odds are good that the business will continue to create value over the years.

This investment approach—the value approach—is not a recipe, a formula, a black box. But I believe it is a sound approach. As Seth Klarman, a successful value investor, has said, a long-term orientation is the biggest edge a value investor can have. Or, as Benjamin Graham put it, short-term the market is a voting machine, long-term it’s a weighing machine. In other words, we’re not interested in the psychology of the market. We’re interested in the realities of a business. We play bridge, not poker, the difference being that there is much less luck associated with bridge than there is with poker.

Two Surprises are better than one

A new study suggests investors who use earnings surprises the right way can double the market's average return of 10 percent a year. That's a profitpalooza: Invest $10,000 for two decades, and it's the difference between $383,000 and $67,000.

The finding is based on an oddity that researchers have written about since the 1960s, called post-earnings announcement drift, or PEAD. Simply put, stocks don't fully "price in" good earnings news immediately after it's released. They tend to jump right away, and then gradually drift higher for up to a year. PEAD has done more than perhaps any other financial phenomenon to blow holes in the notion that markets are perfectly efficient.

That said, strategies based solely on PEAD aren't as profitable as they used to be. Earnings surprises these days, for one thing, are smaller than they were decades ago. More pros are scrutinizing larger volumes of information now, and more analysts contribute to estimates. Wall Street has gotten better at figuring out how much companies will earn next quarter. (Or perhaps, companies have gotten better at hinting.) Recent studies show that investors who buy after upside-earnings surprises can expect to beat the market by around three percentage points over the following six months.

Enter Narasimhan Jegadeesh. A finance professor and market researcher, he has consulted for and sold stock-picking models to Morgan Stanley and Deephaven Capital Management, a Minnesota hedge fund. Today he teaches investing at Emory University, occasionally playing point guard in basketball games against his Ph.D. candidates. (Undergrads run too much, he says.) Earlier this year Jegadeesh, along with Joshua Livnat, who teaches accounting at New York University, published a groundbreaking paper in the Financial Analysts Journal.

The study focuses on separating high-quality surprises from lower-quality ones. A soft-drink maker might crush estimates thanks to runaway demand for its energy drink (think Hansen Natural). That's clearly good news. A tire maker may top estimates even while selling fewer tires if it steers customers toward the most expensive ones and cuts jobs (Goodyear). That's okay, but it may not send the stock on a prolonged run.

How, then, can we tell the good earnings surprises from the not-so-good ones? Look at sales. A company that's ringing the register more has better momentum than one that's merely cutting costs. Also, studies show that instances of numbers massaging are higher among companies that miss sales forecasts but beat earnings estimates.

Jegadeesh and Livnat looked at earnings announcements from 1987 to 2003 and assumed stocks were bought a day after the news hit and held for six months. The 20 percent of stocks that had the biggest positive earnings surprises beat the market by three percentage points over six months. The top 20 percent in terms of sales surprises beat by 2.6 percentage points. Zero in on companies that turn up in both groups, according to the findings, and you'll top the market's return by 5.3 percentage points over six months.

Carlos Slim overtakes Bill Gates

The Mexican financial Web site Sentido Comun has reported that 67-year old Mexican telecom tycoon Carlos Slim Helu has overtaken Microsoft founder Bill Gates as the richest person in the world.

The Web site reported that Slim’s wealth had passed Gates following the superior performance of Slim’s telecommunications firm, America Movil. The Web site also stated that Slim’s lead over Gates amounted to billions of dollars.

"The difference between their two fortunes is around nine billion dollars in favor of Slim,” the financial Web site reportedly stated, owing Slim’s gain to a 26.5 percent rise in the shares of America Movil during the second quarter.

In addition to America Movil, Slim, the son of Lebanese immigrants, controls the INBURSA financial group and the Grupo Carso industrial firm.

In April, Forbes magazine pegged Slim’s wealth at $53.1 billion and Gate’s at $56 billion.

Among Slim’s most notable investment decisions is the one he make in 1997 when he bought 3 percent of Apple Computer at $17 a share shortly before the company launched its iMac computer. Twelve months later, Apple’s shares exceeded $100.

© 2007 Associated Press

Diversification

The idea that you need 160 stocks to diversify is simply ludicrous. The chart below shows diversification benefits can largely be achieved with 30-40 stock portfolios. That is to say, you can have a return profile with roughly the same volatility as the overall equity market by holding around 30-40 stocks.

An alternative perspective is provided by showing the percentage of non-market risk that is eliminated as the number of stocks in the portfolio increases. This is shown in the chart below. Holding two stocks eliminates around 42% of the risk of owning just one stock, holding four stocks this is reduced by 68%, by 83% by holding 8 stocks, by 91% by holding 16 stocks, by 96% by holding 32 stocks. This relationship is graphed in the chart below. Holding two stocks eliminates around 42% of the risk of owning just one stock, holding four stocks this is reduced by 68%, by 83% by holding 8 stocks, by 91% by holding 16 stocks, by 96% by holding 32 stocks.

Live off your investments

Someday, your portfolio will earn more than you do.

Sure, that day may be a long way off, especially if you've just started saving for retirement. But little by little, month after month, as you save more, your investments will earn more. As you increasingly benefit from the magic of compound interest, your portfolio value will climb higher and higher. Eventually, you'll see your account balances rise and fall with the market by amounts that represent months of pay. By then, you may wonder why you're still working at all.

Is Large Growth Now Cheap?

[7/18/07] Large caps have underperformed small caps in seven out of the last eight calendar years. [So it's due?...]

[6/28/07] Is This the Moment for Large-Cap Stocks? I'll put that question to Ron Canakaris of Aston/Montag & Caldwell Growth (MCGFX). I know what Canakaris' view will be. He recently wrote to shareholders and told them that "Now's the time!" He argued that after a very long run for small caps, the tide would turn: "The outperformance of large cap value over large cap growth has continued for an unprecedented seven years. As investment returns normalize for these two asset categories, relative returns should favor growth by a substantial margin. As a result of these performance differences, significant valuation gaps have developed. For example, the relative price to earnings multiple of the largest twenty-five companies in the S&P 500 is at one of its lowest points in twenty years and the Russell 1000 Growth's price to sales ratio relative to the Russell 1000 Value's ratio is at its lowest point since 1980. Furthermore, your equity holdings are particularly attractive at this time. As of 12/31/06 your equities were selling at a median price to present value ratio of 76%, or at a 24% discount to our calculated intrinsic value."

[4/2/07 via russ] Sometimes what you're looking for is hidden in plain sight. And if what you're looking for are some long-term conservative investments at good value, that's the case right now.

While everyone else is off hunting emerging-market equities and high-yield bonds, take a look at something really simple and obvious:

Blue chip U.S. equities.

Yep, the companies everyone knows, like Johnson & Johnson (JNJ - Cramer's Take - Stockpickr - Rating), Procter & Gamble (PG - Cramer's Take - Stockpickr - Rating), IBM (IBM - Cramer's Take - Stockpickr - Rating), Intel (INTC - Cramer's Take - Stockpickr - Rating) and Citigroup (C - Cramer's Take - Stockpickr - Rating).

These are the world's biggest, best run, and most respected companies. They're global. They have underperformed the rest of the stock market, here and abroad, for years.

And that means today they are looking like pretty reasonable values -- especially compared to almost everything else

[3/23/07 via russ] After a seven-year run value stocks are pricier than ever. When Jeremy Grantham says that, it's time to think about buying growth stocks instead.

[7/9/06] In the bull market of the late ’90s, large-company growth stocks, and technology stocks in particular, enjoyed one of their most extended and significant periods of superior performance. Since that bubble burst in 2000, however, large-cap growth stocks have been perennial market laggards, trailing small-cap and value-oriented stocks in each of the past five years through 2004.

Several T. Rowe Price portfolio managers believe that stocks of higher-quality, large-cap companies may be poised to outperform. While small-cap stocks have outperformed in recent years, larger companies have generally had better earnings growth, so their relative valuations appear attractive. At the end of March [2005], small-cap stocks on average sold at a modest valuation premium to large-cap stocks, with the median P/E (price-earnings) ratio for large companies at 16.4X operating earnings compared with 16.6X for small-cap companies. Since 1983, small-caps have sold at a median P/E discount to large-caps of about 2%, according to The Leuthold Group, a market research firm. At the end of 1999, small-caps sold at an extreme 40% discount to large-cap stocks.

Large-cap growth stocks are also relatively attractive compared with large-cap value stocks. The Russell 1000 Growth Index has moved below its historic average P/E premium relative to the Russell 1000 Value Index. In addition, Leuthold observes that large-cap growth stocks, with a P/E ratio of 20.0X in March, are 7% below their historical average P/E, while large-cap value stocks (at 11.8X) are 18% above their historical average P/E.

-- T. Rowe Price Report, Spring 2005

[4/13/06] Tom Gardner says value ratios for small caps are flashing a yellow light (but not red yet).

[3/24/06] "The only thing I know for sure is that we're in a dramatically better place than in 1998 because we're getting a lot more earnings per dollar invested. ... In 1999 the largest 50 companie in the S&P 5000 traded at a 168 percent premium to the next 450 companies. Today the top 50 trade at a 5 percent discount to the next 450, and the big companies with strong balance sheets, globally diverse portfolios, high dividend yields and powerful brands are the cheapest. Statistically, it looks like the largest companies are at the lowest relative valuations they've been at in 10 or 15 years." -- Chris Davis, in the March 2006 SmartMoney.

[3/22/06] It's been seven years since growth stocks had their day in the sun. That's why many market-watchers think the time is ripe for this group of stocks to come back strong. To find a few companies that might offer good opportunities, we asked Morningstar, the Chicago research firm, to find some attractively priced growth companies.

[3/20/06] In the April SmartMoney, Jack Hough reports on James O'Shaughnessy's new book. While many are predicting that large-company stocks should start outperforming again, "O'Shaughnessey is calling for returns of 3 to 5 percent a year, after inflation, for the next 15 years." Shares of small companies, he argues, will do much better with real returns of 8-10%.

[3/20/06] There's an interesting link in this article on Emerging Market ETFs. It's a chart ranking the various asset classes for each of the last 15 years. I note that Large Growth did quite well for six straight years from 1994-1999. Then went on to do quite poorly for the next six years from 2000-2005. Small value did well from 2000-2004, then fell to the middle of the pack in 2005. Emerging growth had the worst or second worst performance in six of the seven years from 1994-2000. But it had the best performance in 1993 and 1999 and has been hot since 2003.

[3/16/06] Jeremy Grantham says "Growth stocks are merely badly overpriced--down from legendary levels--but value stocks, which were only a tiny bit overpriced, are now at least as badly overpriced as growth stocks."

[2/15/06] The current rally has made small caps less attractive from a fundamental valuation perspective, [Steven Leuthold] said. When small caps began to rise, they were 40 percent cheaper than large caps, according to measures like the price-to-earnings ratio. Today, Mr. Leuthold said, they are about 10 percent more expensive.

Worse yet, he said, their earnings momentum has slowed. And this fundamental deterioration has begun to show up in trading patterns. For the first time in six years, fewer than 50 percent of small caps are outperforming the Standard & Poor's 500-stock index, he said.

[2/12/06] Howard Ward believe the cycle is turning for large cap growth stocks. (Of course, the fact that he's the manager of a large cap growth fund may have something to do with it.)

[2/3/06] Schwab is now advising clients to overweight both large- and small-cap growth stocks relative to value stocks.

[1/2/06, Robert Hagstrom in the LMGTX quarterly report] Since the beginning of 2004, the stock market has bifurcated and we have found ourselves temporarily on the wrong side of the divide. I underscored the word ‘‘temporarily’’ because I firmly believe the relative outperformance of value stocks (which overwhelmingly include energy and utility stocks) to growth stocks (which overwhelmingly include consumer discretionary and technology stocks), will soon reverse. Of course, there is no assurance that this will occur.

Value stocks outperforming growth stocks and small-capitalization stocks beating largecapitalization stocks have now entered its sixth consecutive year. It has been an unprecedented period of relative underperformance by large-cap growth companies. We opined in our last commentary the market pendulum would soon begin to shift from defensive stocks to offensive stocks and from smaller-capitalization stocks to larger-capitalization stocks. Although this has occurred in baby steps over the past two quarters, we believe more substantial gains lie ahead for large-cap growth stocks.

... At present, growth stocks and value stocks trade at similar prices and that is very unusual. The reason why growth stocks should trade at higher multiples than value stocks is based on the differential economic returns for the two groups. Typically, growth stocks have higher growth rates, higher profitability and higher returns on capital compared to value stocks. In an efficient market, value stocks should trade at lower price earnings ratios because they achieve economic returns that are below the economic returns earned by growth stocks.

... Since 1978, the price to earnings ratios of value stocks compared to growth stocks has averaged about .65. At the end of the 1990s, the price earnings ratio of value stocks dipped to .32. By the end of 2004, this ratio reached .75—a 134% increase in valuation. Once again, value stock price earnings ratios compared to growth stocks are at a two-decade high.

* * *

[1/2/06, from Wally Weitz in the WVALX semi-annual report] As we have discussed in recent letters, several of the new stocks we have been buying look suspiciously like traditional “growth” stocks—e.g. Wal-Mart. High-quality companies with predictable earnings growth are generally not available at prices we are willing to pay. These stocks may be more affordable today because investors fled “growth” funds after having been burned in the collapse of the tech bubble and moved to “value” funds that had performed better during the bear market. It may also be that investors have sold these “blue chips” to buy commodity companies (especially energy), utilities and real estate stocks.

Grantham, Mayo, Van Otterloo (GMO), a quantitatively oriented investment firm, wrote about this phenomenon in a July, 2005 report. They point out that from January, 2000 through June, 2005, “value” stocks (which they define as the half of all stocks with less than the median price/earnings or price/sales ratios) out-performed “growth” stocks by 138%. According to their study, “value” is now less cheap relative to “growth” than at any other time in the past 27 years. They also found that “high quality” stocks (as measured by stability of earnings and balance sheet strength) were the cheapest relative to lower quality stocks than at any other time during the study.

This study does not prove that these stocks will do well, but it does help to explain why new faces are showing up in our portfolios. Wal-Mart, AIG, Anheuser-Busch, WellPoint, UnitedHealthcare and several other newcomers were selling at discounts to our estimates of their business values, and that is what attracted us.

* * *

[12/8/05] At the Value Investing Congress, held in New York City and attended by more than 400 investors, one major theme was the appeal of large-cap blue-chip stocks. Increasingly, investors appear to be starting to define these as "value" stocks.

[12/5/05] After beating the big boys for five years in a row, the small stock miracle may be ending -- for now (says CNNMoney).

[9/21/05] For the last five years, small-cap value funds have outperformed their larger counterparts. When one asset class outperforms another over an extended period, the result may be an imbalance in your portfolio, suggesting that now may be a good time to evaluate whether your large-cap growth allocation is underweight.

[8/30/05] Small-cap stocks have outperformed large caps ever since the tech bubble burst back in 2000, and for arguably the right reason -- small cap stocks had much lower valuation multiples. But from the bottom-up perspective of Schwab Equity Ratings, small-cap stocks are no longer a bargain.

During the March 2003 market bottom, the proportion of small-cap stocks that were given an A rating by Schwab Equity Ratings was about 34% near an all-time high, suggesting unusual value was still present in the small-cap sector at that time. Over the subsequent year, the small-cap Russell 2000 index outperformed the large-cap S&P 500 index by 26%.

But now large caps represent about 60% of A-rated stocks while the proportion of small caps has fallen to around 14%, near all-time lows. Since 1986, the only two times large caps constituted over 60% of A-rated stocks were September 30, 1994, and May 31, 1998. After each of those dates, the S&P 500 outperformed the Russell 2000 by an average 16% over the subsequent 12 months and 22% over the subsequent 18 months. Our research suggests that now might be a good time to take some profits in small caps and consider rebalancing your stock portfolio toward large-cap stocks. (Greg Forsythe, On Investing Magazine, Summer 2005).

* * *

[8/21/05] When Growth Is a Value: Since February 2002, the large growth issues are off 40 percent while value equities are trading higher by 50 percent. That disparate performance has made growth much cheaper than usual. As Leuthold notes, the multiple on large-cap growth, at 23.5 times, is 5 percent below its historical average, while the multiple on large-cap value, at 11.9 times, is 19 percent above its historical average. Devoted followers of the "buy cheap" doctrine with a sense of history should be looking at large-cap growth. (ref: chucks_angels post)

* * *

[7/22/05] In line with the thought that growth stocks may be due to come back into vogue is an article in the July 2005 SmartMoney entitled "The Sweet Spot".

In the late 1990s -- the days of outsize expectations -- investors bid up growth stocks to outrageous levels, relative to value. The Russell 2000 Growth Index peaked in June 2000 at a p/e ratio of 128; the index's value counterpart warranted a multiple of just 14. These days, though, the growth index carries a p/e of 21, while the value index has a p/e of 17. Same goes for funds, says Lipper analyst Andrew Clark. "Fund P/Es in terms of growth and value are almost on top of each other these days," he says.

"This is the most extreme swing," says Harry Lange, manager of Fidelity Capital Appreciation, who says that his fund has become "increasingly growth," with names such as Dell, Genentech, and Univsion added in the past year. "Growth hasn't been this cheap in 30 years. A lot of these stocks have been beaten down so much, we're looking for pretty big runs -- a 50 percent increase in most cases."

The article goes on to mention some of the growth picks Bill Nygren has been adding to his Oakmark Fund, Wal-Mart, Citigroup, Abbott Laboratories, Harley-Davidson, Home Depot. "He expects them all to not only show strong earnings growth, but also to benefit as investors become more willing to pay up for solid growth propects and send their P/E ratios higher.