How are oil prices set?

Crude is a commodity, a raw material like natural gas, corn, wheat, gold, coffee, and cattle used to produce other goods. The costs of extracting oil from its source could vary widely from $5.26 a barrel in the Middle East region to $63.71 for U.S. offshore crude, based on 2004-6 averages from the EIA. Petroleum is bought and sold under exotic names like Nigerian Bonny Light, North Sea Brent Blend, and West Texas Intermediate on a variety of futures markets -- where traders deal for the rights to buy and sell product at a specific price on a future date -- around the world and governed by the rules of a particular country.

"The energy markets are among the largest and most liquid," says Timmer. "The oil market is no different from the stock market in that oil futures are traded on exchanges where buyers meet sellers." For an outsider, however, locating precise figures to explain how crude is currently priced is harder to unearth than a gusher in Central Park.

Generally, there are two ways to trade commodities: either market trading or over-the-counter trading (OTC). Market trading takes place through the New York Mercantile Exchange (NYMEX) and is self-regulated with oversight by the Commodities Futures Trading Commission (CFTC), the government agency charged with regulating the commodities markets. In contrast, OTC trading is conducted without any such regulatory controls.

Only about 25%-35% of all energy trading occurs on the NYMEX,4 which means up to 75% of all oil contracts go unchecked by the federal government. Because OTC trading is unregulated, the exact volume of trades -- not to mention the legality -- is unknown. To compound matters, despite growing activity in the commodities markets, the CFTC has a staff of less than 500, compared to 3,700 for the Securities & Exchange Commission.

Other legal escape routes allow energy trading on so-called "dark markets," exchanges not subject to the transparency and accountability laws governing U.S. exchanges. For example, the "foreign markets loophole" lets investors buy and sell millions of barrels of U.S.-bound oil multiple times overseas before ever reaching American shores, thereby driving up the price with each change of hands.

The standards for trading crude oil and setting prices should be, theoretically, consistent among different international market regulators. However, recent U.S. congressional hearings have introduced terms like "dark markets" and "swaps loopholes" used by some investors to skirt largely toothless government controls. Oil speculators -- typically hedge funds and investment banks -- have come under a spotlight amid allegations of exploiting gaps in the regulatory system.

According to the CFTC, the government agency charged with regulating the commodities markets, the percentage of petrol contracts controlled by speculators has surged to 71% in 2008 from 37% in 2000.

The International Monetary Fund has concluded that speculation has played a significant role in the run-up of oil prices, according to testimony at a June 23 House Energy & Commerce subcommittee. Also at that meeting a Lehman Brothers analysis suggested that more than half of the price of a barrel of oil may be attributed to speculation. Even the Saudis, the world's largest oil producer of 9.7 million barrels a day as of July, contend that supply-and-demand seems to be in balance and that there is no substantive basis for current price levels.5

At this stage, however, no one knows for sure if any improper oil transactions have been executed. In part, that's because American authorities can neither fully police nor gain access to data in most overseas commodities markets.

dividends and growth

In 2003, Rob Arnott -- former editor of the Financial Analysts Journal, a publication of the CFA Institute -- and Clifford Asness, managing principal at AQR Capital Management, looked at dividend yields and subsequent 10-year earnings growth. Their findings? Amazingly, earnings growth increased with dividend payout, right up to the highest payers having the highest next-10-year earnings growth.

a long bear

From 1959 to 1974, the Dow Jones Industrial Average gained precisely 0%. It has gone down as one of the longest and most painful bear markets of recent history.

The Nasdaq is currently in what is shaping up to be an even longer bear market. It's down around 50% from its peak of more than 5,000 in March 2000, and I would argue that it's likely to take another 12 years -- until 2020 -- to reach that level again. That would mean a roughly 20-year period of 0% returns for the index. Like the 15-year bear market from 1959 to 1974, it will go down as one of the biggest bear markets of all time.

But the truth is, there's still money to be made in bear markets.

... the first thing about making money in this bear market is clear: Don't buy and forget. Monitor your existing holdings, sell if your thesis has radically changed, keep cash ready to pounce on new opportunities, and put that money to work on a regular basis. It may seem obvious, but an individual investor would have made far more money by investing throughout the bear market than during the irrational exuberance of the bull.

The Secret of Dividends

Between January 1926 and December 2006, 41% of the S&P 500's total return sprang not from the price appreciation of the stocks in the index but from the dividends its companies paid out.

That's right -- a cool 41%. Annualized, that amounts to 4.4 percentage points. To put it in dollars-and-cents terms, consider this: An investment of $10,000 over that stretch would have grown to $1,013,000 without dividends. With dividends kicked in and reinvested, however, that same sum would have been worth a whopping $24,113,000 by the end of the period.

Talk about the miracle of compound interest!

300 Point Rallies

We're in a very confusing atmosphere. People didn't really know what to make of a 300-point rally in the Dow the other day, but my main message was that 300-point rallies from the Dow don't happen in bull markets. In fact, they never happened in the bull market from October '02 to October '07, but it has happened 6 times in this bear market and happened 12 times in the last bear market. You don't get moves like that in bull markets. As Rich Bernstein has said time and again, "This is the hallmark of a recession and a hallmark of a bear market."

Mauldin not bullish (surprise)

I think we are likely to stay in recession for perhaps the rest of the year and well into 2009 before we start a very slow recovery. It is not time to get bullish on stocks, as I have been writing for the past few months. Earnings are going to continue to come under pressure, and earnings are what drive the stock market over the long term. We could see total S&P 500 as-reported earnings drop below $50. You do the math. Even with a 20 multiple, that does not yield a pretty picture.

I think we are going to test the recent lows and then watch the market go lower as the market gets disappointed in the earnings from the third quarter, and re-test those lows again. We are in for an extended period of Muddle Through, while we wait for the housing market to find a bottom and the credit crisis to abate. Banks and other institutions have written off about $500 billion. There is at least another $500 billion to go. The amount of capital that is going to need to be raised is astronomical, and it is going to be very dilutive to current shareholders.

gurufocus financial data and charts

About two months ago, we informed our users that we have licensed 10-year financial data. The data is now available to all users. Here we like to introduce the features in the new page.

The Accidental Billionaire

About 10 years ago, Forbes Magazine ran an article about an "accidental billionaire" named Franklin Otis Booth Jr.

In the early 1960s, Booth tried to buy a printing company that contracted with The Los Angeles Times. The deal fell through, but he became good friends with the lawyer working on the case.

After discovering they had similar investment philosophies, they partnered up to build a 40-unit condo complex in Pasadena, Calif. -- and managed to double their money in just two years.

Booth decided he wasn't up for pursuing further real estate development, but he did agree to put $1 million into an investment partnership the lawyer put together. Thirty-five years later his stake was worth $1.2 billion.

The cynics and risk-takers among you will undoubtedly chalk Booth's success up to "luck."

Granted, his is a case of being in the right place at the right time, but the actual process that grew his fortune had very little to do with luck.

He didn't dump his money into penny stocks that took off. He didn't get in on the ground floor of Oracle (Nasdaq: ORCL) or IBM (NYSE: IBM). He didn't make smart options trades.

What he did do was hand his $1 million over to that lawyer and a "clever young fellow." They, in turn, made big bets on unexciting businesses with wide moats that were selling at a discount to their fair value. These businesses all had strong brands, outstanding returns on capital, consistent or improving profit margins, and substantial cash profits.

That's all -- big bets on great companies selling at good prices.

Of course, by now I'm sure you know that the lawyer was Charlie Munger and the clever young fellow he teamed up with was none other than Warren Buffett.

* * *

The Accidental Billionaire

yields are high

It's looking gloomy out there. The S&P 500 is down 12% year to date, led by the financial sector, which has lost one-fourth of its valuation.

Amid all the doom and gloom, one silver lining has drawn little attention: Dividend yields are the highest they've been more than a dozen years.

The recent market plunge has increased the S&P 500's dividend yield to 2.2%, its highest level since December 1995. Not even during the aftermath of the tech bubble collapse in the fall of 2002 -- when the S&P 500 traded at a paltry 815 -- did the yield break 2.0%.

But high dividend yields aren't the only reason this is a great time to be in the market -- stocks are also cheaper than trusty bonds.

The 10-year Treasury bond currently yields 4%. The equivalent measure of return for stocks is the earnings yield (earnings divided by price) -- and it currently stands at 5.5% for the S&P 500.

This divergence is unusual -- and a potential boon for investors. According to renowned value investor Arnold Van Den Berg of Century Management, (whose firm returned 13% net of fees vs. 6% for the S&P 500 over the past 10 years):

The usual difference between a bond yield and stock earnings yield is about 1%. For example, if investors can get 6.3% on a guaranteed bond they are willing to accept 1% less, or a 5.3% earnings yield on a stock. The reason for this is that if you have a 5.3% stock earnings yield and it is growing at 7%, it will equal your 6.3% bond yield in about 3 years. Anytime thereafter, the stock earnings yield will increase by 7% per year.

Investors are usually willing to accept a lower yield in stocks, because of the presumption of future growth. Right now, however, investors can get that growth at a better price than bonds -- and with the added bonus of high dividend yields.

Earnings yields like this suggest the market thinks earnings are likely to fall. But I would counter that even if earnings fell, the S&P 500 still would yield almost equal to the Treasury bond rate.

The combination of high dividend and earnings yields relative to bond yields means that this is a great time to buy dividend stocks.

quote of the month

"Wouldn't it be great if we could buy love for $1 million. But the only way to be loved is to be lovable. You always get back more than you give away. If you don't give any, you won't get any. There's nobody I know who commands the love of others who doesn't feel like a success. And I can't imagine people who aren't loved feel very successful." Warren Buffett

-- Warren Buffett Monthly Newsletter Issue #27

what is growth and income exactly?

Generally, a Growth and Income play will have healthy balance sheets, consistent dividend payments, quality products and services and experienced management teams. Usually Growth and Income companies are industry leaders, displaying steady earnings growth.

Companies that continually exhibit stable earnings growth, more than anything else, are ones that should hit the radar screens of Growth & Income investors. After all, companies exhibiting all of the characteristics mentioned earlier should have no problem producing a steady stream of profit growth, right? Analysts will subsequently grow more optimistic about the future earnings potential of the company and adjust their estimates up accordingly.

Growth & income investors get a dual benefit from following earnings estimate revisions. First, positive estimate revisions help investors buy shares in the companies with the best chances to outperform the market. Second, positive estimate revisions provide the easiest means to monitor the health of companies, providing a rather clear signal when the time has come to abandon ship. Companies experiencing upward estimate revisions will generally enjoy positive momentum going forward. Rarely will a stock suffer a significant price decline in the face of improving fundamentals. Add it all up and it’s clear that Growth and Income investors should only buy shares in companies enjoying upward earnings estimate revisions.

[says Zacks]

The bear market is official ... now what?

One of the saving graces to having officially entered a bear market (a >20% drop) in mid-July is that we no longer need to debate whether we're going to get one or not. Based on long-term averages, we may have more to go with this bear both in terms of damage and duration but, as always, we caution investors about full-scale bailing out of the market at this point.

History has shown that typically, once the –20% threshold has been hit, the majority (two-thirds) of the decline is in the past. [The median bear market lost 33.5% and lasted 250 days.] And, of course, timing the bottom is nearly impossible.

The bible talks business sense

Invest systematically: “He who gathers money little by little makes it grow.”—Proverbs 13:11

Pay tax: “Give to Caesar what belongs to Caesar...”—Luke 20:25

Avoid debt:The rich ruleth over the poor, and the borrower is servant to the lender.”—Proverbs 22:7

Save: “The ants are a people not strong, yet they prepare their meat in the summer.”—Proverbs 30:24

Diversify: “Divide your portion to seven, or even to eight, for you don’t know what misfortune may occur on the earth.”— Ecclesiastes 11:2

[from livemint.com via Chirag@investwise]

who's blog?

While googling around, I noticed there's a blog by veryearly1 called Finance and Philosophy Blog. At first I thought this was the blog of veryearly1 of chucks_angels. After all, there is a lot of information pertaining to investing, in particular on Buffett and Munger. And the guy who's writing it is reflective and sounds quite intelligent.

But now, I don't think it's actually THE veryearly1. The guy writing the blog is a software engineer, while VE1 has a financial background and worked at a hedge fund or something. Also I believe VE1 is a now a full-time private investor whereas this guy works for some engineering (or some such) firm. Also it seems that VE1 apparently used to live in Japan. No mention here of that. (It's kind of scary that I seem to know this much about VE1. :$

In any case, the blog is still pretty interesting and thoughtful.

rating CAPS ratings

despite all of the recent market turmoil, five-star stocks outperform the market by 12%, while one-star stocks underperform by roughly 11%. According to this data, investors would do well to look for new ideas among five-star stocks, while potentially unloading one-star stocks.

what is Morningstar good at?

A couple of clear trends emerge from this data. The first is that we're pretty darned good at picking wide-moat stocks--the wide-moats in the Buy at 5 Stars, Sell at 1 Star portfolio have outperformed our wide-moat coverage universe in all trailing periods, and in every calendar year but one. This conclusion is also supported by the performance of our Wide Moat Focus Index (WMW), which consists of the 20 cheapest wide-moat stocks. The Wide Moat Focus Index was off only about 5% in the first half of 2008--compared with a 12% loss for the market--and it has posted returns of about 11% annually over the past five years.

The second trend is that we have not been very good at separating winners from losers among the no-moat companies that we cover. Our performance in this area leaves much to be desired, and (so far) 2008 is the first year in which our no-moat 5-star stocks have outperformed our no-moat stocks as a group. Narrow moats are a toss-up--we have added value over some time frames, but not overall.

We've thought a lot about the causes for this divergent performance, and while it's a complex issue, I think a lot of it boils down to the simple fact that no-moat companies are more difficult to forecast and value. They're more volatile, they often have weaker balance sheets, and they are more frequently affected by tough-to-forecast external factors like commodity prices.

Estate-Planning Pitfalls

H. Susan Jones, a top estate-planning attorney based in the Chicago suburbs, discusses some of the most common pitfalls of estate planning and how to avoid them, as well as some underutilized estate-planning maneuvers.

Investment Decision Checklists

One of Charlie Munger’s most elementary pieces of advice for investors and thinkers is to utilize checklists when ever possible, as a way to improve cognitive ability and minimize errors. In a 2003 speech to UC Santa Barbara Economics, Munger put it thusly:

You don’t have just a hammer. You’ve got all the tools. And you’ve got to have one more trick. You’ve got to use those tools checklist-style, because you’ll miss a lot if you just hope that the right tool is going to pop up unaided whenever you need it. But if you’ve got a full list of tools, and go through them in your mind, checklist-style, you will find a lot of answers that you won’t find any other way.

Gurufocus started a thread discussing investment checklists. We will create a page where users can set up their own checklist, and data in our databases will be used for users to verify each item in the checklist.

This is what they come up with.

First of All
Is this a good business?
Is this a simple business? Is there something that cannot be understood in the business operations, financial instruments?

Business Climate
Is this a cyclical business?
Where is it at the business cycle of the industry?
What are the macro-trends affecting the company?
What is the economic outlook for the companies industry?
What will recession do to the business?

Growth and Competitiveness
Will the company be around in 20 years?
Will (will, not should) earnings and sales and the dividend grow over 5 years?
What's their competitive advantage and moat?
Have sales historically increased annually?
Is the company doing something that is unconventional for their business? Does the company focus on short term profit and forget the long term viability of the business? (sub-prime loans are examples)
Where is the company at in its growth cycle?
Does the company have a moat or durable competitive advantage?

Management
Who are the founders/BOD, what other companies have they been involved in, what are their credentials/biographies?
Are they shareholder oriented?
Are they buying shares lately?

High Quality?
Good return on equity?
Recent Guru buying
What is the downside risk
What is the debt level of the company? Is it increasing or declining?
Is the business predictable? What is the predictability of the business?
Does the business have enough moat to maintain its profitability?

Valuation
What is the earning yield? Is it undervalued?
What is the valuation of the company? What is the margin of safety?
If DCF applies, what is the valuation?
Why is this company undervalued? Is this reason likely to get worse before it gets better?

Level of Confidence
If the share price went down by 50% the day after I bought, would I immediately worry about having made a mistake, or would I buy more shares?
Is this a speculation? What percentage of speculation is there with this idea?
What is the level of confidence we have?

[basically, my checklist boils down to: is it a good company? And is it selling (reasonably) cheap?]

Obama selloff in November?

says Tobin Smith.

If Barack Obama is leading by 10 points over John McCain going into November, I guarantee you that you’re going to have a sell-off purely for locking in capital gains. I mean, Obama said he wants to go to 28%. Don’t fall for the trap that Obama really thinks he’s going to become president of the United States on a platform. Right now, everybody is pimping for John Edwards’ delegates— they need 235 delegates from Edwards. So right now, Obama sounds like he’s a socialist. You have to assume that when that’s done, whenever Obama is the one who’s the leader in the clubhouse—because Edwards hates Hillary Clinton—once he gets the delegates, then you’ll see that rhetoric move back to the middle.

Alternative energy is going to kick ass. The other thing is you’re going to assume that the Fed is going to be at 2% to 2.25%, which means that financials will do well as soon as they make the turn. And the turn is that you will have clarity on Citibank and the real big guys, we’ll have real transparency. We still do not have transparency.

EQUITIES: Is there one rule of thumb regarding investing?

Smith: You have to understand that there’s no free lunch. If you want a bond rate of return, then buy the bond. If you’re looking for superior return, you have to come to grips with the idea that you’re getting paid extra because you’re willing to ride out the bumps in the road. Many times, investors sort of miss that part.Usually, themost powerful psychological ingredient is the fear of not being greedy enough. The other part is that it’s not profitable, nor is it prudent, to always own growth stocks. The thing about an S-curve change that nobody realizes is, if something’s growing rapidly, it’s also getting to satiation rapidly. If it’s slow growth, it’s going to take a long time.

[roundabout link via Mauldin, who is now appearing in Equities Magazine]

Have financial stocks hit bottom?

Investment strategist Barry Ritholtz wrote in his blog that one reason to doubt that the bottom is in for bank stocks is that The New York Times, The Wall Street Journal and Barron's (the latter two sharing an owner with this newswire) all produced prominent articles on Saturday suggesting the worst was over for financial stocks.

"Can you recall the last time three major media players all picked the bottom in a market or sector on the exact same day -- and were all proven correct?" he asked.

taxing the rich

Washington is teeing up "the rich" for a big tax hike next year, as a way to make them "pay their fair share." Well, the latest IRS data have arrived on who paid what share of income taxes in 2006, and it's going to be hard for the rich to pay any more than they already do. The data show that the 2003 Bush tax cuts caused what may be the biggest increase in tax payments by the rich in American history.

The nearby chart shows that the top 1% of taxpayers, those who earn above $388,806, paid 40% of all income taxes in 2006, the highest share in at least 40 years. The top 10% in income, those earning more than $108,904, paid 71%. Barack Obama says he's going to cut taxes for those at the bottom, but that's also going to be a challenge because Americans with an income below the median paid a record low 2.9% of all income taxes, while the top 50% paid 97.1%.

... If Mr. Obama does succeed in raising tax rates on the rich, we'd also wager that the rich share of tax payments would fall. The last time tax rates were as high as the Senator wants them -- the Carter years -- the rich paid only 19% of all income taxes, half of the 40% share they pay today. Why? Because they either worked less, earned less, or they found ways to shelter income from taxes so it was never reported to the IRS as income.

The way to soak the rich is with low tax rates, and last week's IRS data provide more powerful validation of that proposition.

[via john/chucks_angels]

Zacks Rank is wrong

.. 44% of the time. Which means it's right 56% of the time.

Steve Reitmeister explains (video) how this short-term (1 to 3 months) strategy beats the markets despite being wrong nearly half the time.

The Bear is Back

If any of us needed further confirmation that things are bad out there, we got the signal right before the July 4 holiday -- the markets officially dipped into bear-market territory. The Dow Jones Industrial Average, Nasdaq Composite, and the S&P 500 Index are all down more than 20% from last fall's highs.

A lot of investors have lost a good chunk of their portfolio since those highs. And with a black cloud hanging over the financial sector, home values continuing to plummet, and gas prices resting comfortably above $4/gallon, the economic outlook is murky at best.

No one will deny that seeing the market fall 20% or more is unsettling. But if you're a truly long-term investor, does it really matter?

The market has endured bear markets before -- 33 of them since the Dow Jones Industrial Average was created. Since 1896, then, the market has dropped more than 20% on 33 separate occasions -- and each time, it recovered to reach new highs.

Sure, the length of time it took the market to recover those losses varied, but in most cases, the year or two directly following the end of the bear market saw a considerable jump in average share prices.

[Then again, the times it didn't jump back in a year or two were the ones that really hurt.]

market sentiment hits bottom?

Financial market turmoil has returned with a vengeance, weighing on the dollar and pressuring global stocks to distressing lows. However, an extreme in negative investor sentiment, a break in oil prices and some better-than-expected bank earnings spurred a rally in stocks this week—led by an impressive comeback in financials.

Stresses in the short-term funding markets are elevated once again, but not to the extent seen in mid-March. The Federal Reserve's aggressive rate cuts and lending facilities appear to be working. The latest market riot revolved around worries about the stability of the broader financial system—specifically the fate of government-sponsored entities (GSEs) Fannie Mae (FNM) and Freddie Mac (FRE).

Together, the GSEs own roughly $1.5 trillion in mortgages and guarantee $3.7 trillion. According to BCA Research, a failure would expose $4.3 trillion in mortgage-backed securities (MBSs) to losses, as well as $1.5 trillion in agency debt to potential default. Of course, the government cannot allow this to happen: An emergency weekend meeting July 12–13 of the Federal Reserve and the U.S. Treasury Department resulted in a plan to keep the GSEs in the "current form," assuaging concerns that they will be allowed to fail.

However, in one of the largest bank failures in U.S. history, the FDIC was forced to take over IndyMac Bancorp (IDMC), which was a large player in the Alt-A and subprime mortgage market. Although the majority of IndyMac's deposits are insured, the bank's failure sparked concerns that many other regional banks could potentially see the same fate.

With many financial institutions scheduled to report second-quarter financial results, investors became increasingly concerned that banks would not be able to raise fresh capital to cover losses—particularly because sovereign wealth funds (SWFs) could potentially shy away after seeing their investments during the past year lose value.

This dour outlook on the financial sector, in combination with still-high oil prices, pressured nearly all investor sentiment measures to below the March-low levels and close to the lows seen in the 1998 Long-Term Capital Management crisis (an infamous Fed-orchestrated bailout) and the 2002 tech bubble. Volume and volatility measures have not registered capitulation levels, but the depressed market and economic sentiment set the market up for a significant bounce. Although more banks and thrifts are likely to fail, calamitous failures (like IndyMac) have historically occurred near market lows.

Remember, it's not just fundamentals that drive stocks and markets but the relationship between fundamentals and expectations. At market lows, the expectations bar has usually been set sufficiently low for fundamentals to hurdle them, even if those fundamentals remain weak in absolute terms.

As panic gives way to the reality that the financial system and federal regulatory bodies are well-equipped to deal with this crisis, and/or if oil prices continue their descent, we see the potential for additional sharp rallies like those we witnessed this week. However, we remain skeptical that an enduring rally is in the offing until inflation pressures ease significantly and the U.S. housing market stabilizes.

Bombay near capitulation?

[7/13] Indian ADR's got the hammering of their life at the Nasdaq/NYSE Friday last, slicing 13 per cent off the market cap of Infosys, 7 per cent for ICICI Bank and 4 per cent for HDFC Bank. Banks, Real Estate and Technology stocks should be the key contributors to a possible enmasse selling this Monday, as investors move out in droves towards the EXIT gates.

-Conditions are now set for a mass capitulation beginning July 14, 2008 and getting close to a situation where the Buyer's side will become non-existent.

[via Maverick@investwise]

To the rescue of Fannie and Freddie

The Bush administration hastily arranged the dramatic Sunday evening rescue of Fannie Mae and Freddie Mac after Wall Street executives and foreign central bankers told Washington that any further erosion of confidence could have a cascading effect around the world, officials said on Monday.

Treasury Secretary Henry M. Paulson Jr. and other top officials were warned, after Fannie and Freddie lost nearly half their stock market value on Friday morning, that any more turmoil threatened to reduce the value of trillions of dollars of the companies’ debt and other obligations, which are held by thousands of domestic and foreign banks, pension funds, mutual funds and other investors, government officials said.

The warnings of a potential systemic failure led to the resulting rescue package, and one of the most striking — though unspoken — regulatory shifts in modern times. For decades, Treasury secretaries and Federal Reserve chairmen have insisted that the government did not stand behind the debt of Fannie and Freddie. But the safety net Mr. Paulson announced on Sunday sends the opposite message: that the government is determined not to let either one fail.

The plan calls on Congress to give officials the power to inject billions of dollars into the beleaguered companies through investments and loans. Until the plan is adopted, the Federal Reserve has agreed to let the companies have access to its so-called discount lending window, a move that most regard as a symbolic gesture intended to show the markets that the government stands ready to help the companies if they need cash.

Six in a row

It's clear that the "crisis of confidence" in Fannie Mae (FNM) and Freddie Mac (FRE) was a prime factor in driving the stock market down this week to its sixth weekly loss in a row (Standard & Poor's 500 index).

Losing streaks of this length are rare. In fact, the last run of six down weeks ended at the major market bottom in October 2002. However, I still firmly believe that we're due for a bounce any day now, although the market will probably come back and "test" today's lows later in the summer.

-- Richard Band

Freddie and Fannie in Freefall

The dike might be cracking on the U.S. financial system and U.S. regulators are trying to figure out how to make sure it doesn't burst.

Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), the behemoth caretakers of U.S. home ownership financing, are looking increasingly unstable. Their demise would spell disaster, and the U.S. cannot allow that to happen.

The market went nuts this week as former St. Louis Fed President Albert Poole suggested that Freddie Mac is technically insolvent. What does the market think? As of Friday morning, Fannie and Freddie stock were down 53% and 64%, respectively ... just this week!

IndyMac fails

WASHINGTON (Reuters) - U.S. banking regulators swooped in to seize mortgage lender IndyMac Bancorp Inc on Friday after withdrawals by panicked depositors led to the third-largest banking failure in U.S. history.

California-based IndyMac, which specialized in a type of mortgage that often required minimal documents from borrowers, became the fifth U.S. bank to fail this year as a housing bust and credit crunch strain financial institutions.

The federal takeover of IndyMac capped a tumultuous day for U.S. markets that saw stocks slide on a surging oil price and renewed fears about the stability of the top two home financing providers, Fannie Mae and Freddie Mac.

IndyMac will reopen fully on Monday as IndyMac Federal Bank under Federal Deposit Insurance Corp supervision, but tensions ran high as customers at a branch at its Los Angeles-area headquarters read a notice in the window saying it was closed.

upgraded broker ratings

I'm sure a lot you have experienced the pleasure of waking up and finding that a covering broker upgraded their rating on one of your stocks.

I'm also guessing that you probably experienced the opposite, and found that one of the brokers downgraded your stock.

While nobody can perfectly guard against downgrades (or forecast all upgrades), it's important to know how the market reacts. Therefore, you can stay in your upgraded winners (or buy if you're on the fence) and consider getting out if a downgrade comes your way.

When I'm screening for new stocks, I like to look for companies that have recently seen a broker rating upgrade. Tests have proven that stocks with broker rating upgrades outperform those that don't get upgraded and really outperform those that get downgraded.

-- Kevin Matras, Zacks.com

Reinvigorating the PEG ratio

Marc Gerstein ran a series of backtests to examine different strategies using the PEG ratio.

Even the gurus are down

If you haven't been having a great time in the market since last spring, you may take some consolation by seeing how many 'fund managers of the year' and other top-notch investors have been faring over the recent past. Even Warren Buffett is now in negative territory for both the 6 and 12-month periods just ended.

[via g66k]

Sir John Templeton

Sir John Templeton, a Tennessee-born investor and philanthropist who amassed a fortune in global stocks and gave away hundreds of millions of dollars to foster understanding in what he called "spiritual realities," died on Tuesday in Nassau, the Bahamas, where he had lived for decades. He was 95.

His death, at Doctors Hospital in Nassau, was caused by pneumonia, said Don Lehr, a spokesman for the Templeton Foundation.

The foundation awards the Templeton Prize, one of the world's richest, and sponsors conferences and studies reflecting the founder's passionate interest in "progress in religion" and "research or discoveries" on the nebulous borders of science and religion.

In a career that spanned seven decades, Sir John dazzled Wall Street, organized some of the most successful mutual funds of his time, led investors into foreign markets, established charities that now give away $70 million a year, wrote books on finance and spirituality and promoted a search for answers to what he called the "Big Questions" — realms of science, faith, God and the purpose of humanity.

Along the way, he became one of the world's richest men, gave up American citizenship, moved to the Bahamas, was knighted by the Queen of England and bestowed much of his fortune on spiritual thinkers and innovators: Mother Teresa, Billy Graham, Aleksandr Solzhenitsyn, the physicist Freeman Dyson, the philosopher Charles Taylor and a pantheon of Christians, Jews, Muslims, Buddhists and Hindus.

* * *

Templeton's 16 Rules to Investment Success

Neglected stocks

Last week, Mark Hulbert reported on a new study in The New York Times that found that from 1962 to 2003, stocks that could go at least a day without trading any shares -- like Brazil Fast Food -- outperformed stocks that traded every day by more than 8 percentage points annually. And that was the case even though the "neglected stock portfolio," as researchers Athanasios Bolmatis and Evangelos Sekeris called it, contains "a disproportionate number of stocks that underperform the market by a dramatic margin."

Good To Great

Jim Collins, already established as one of the most influential management consultants, further established his credibility with the wildly popular Good to Great: Why Some Companies Make the Leap...and Others Don’t, originally published in 2001. The book went on to be one of the bestsellers in the genre, and it is now widely regarded as a modern classic of management theory.

Collins takes up a daunting challenge in the book: identifying and evaluating the factors and variables that allow a small fraction of companies to make the transition from merely good to truly great. ‘Great,’ an admittedly subjective term, is operationally defined according to a number of metrics, including, specifically, financial performance that exceeded the market average by several orders of magnitude over a sustained period of time. Using these criteria, Collins and his research team exhaustively catalogued the business literature, identifying a handful of companies that fulfilled their predetermined criteria for greatness. Then, the defining characteristics that differentiated these ‘great’ firms from their competitors were quantified and analyzed.

[via gfs1354@chucks_angels]

price anchoring

Price anchoring is a mental mistake that can be very costly to your long-term returns.

As soon as your intuition seizes on a number -- any number -- it becomes stuck, as if it had been coated in glue. That's why real estate agents will usually show you the most expensive house on the market first, so the others will seem cheap by comparison -- and why mutual fund companies nearly always launch new funds at $10.00 per share, enticing new investors with a "cheap" price at the beginning.

Share prices are complicated things -- they account for not only the underlying quality of the company, but also public opinion, assumed earnings growth, and investor enthusiasm.

Anchoring to a price means you'll ignore the more important trait -- value.

financial stocks are cheap

says Richard Pzena.

In brief, the subprime mortgage and liquidity crisis has sent investors into panic mode about financial stocks, driving their prices far below their underlying value. Major firms with strong franchises have fallen precipitously, despite their historical records.

A bubble not unlike that seen with internet stocks in the late 1990s seems to have formed, with energy, commodities, and industrial cyclicals being bid up with little regard to earnings. Indeed, the spread in valuations between commodity and financial stocks is wider than at any time in the past 55 years, and financials represent one of the most compelling investment opportunities we have ever seen.

bubblin' crude

June 13 (Bloomberg) -- The rally that drove oil to a record $139.12 a barrel last week surpassed the gains in Internet stocks that preceded the dot-com crash in 2000.

Crude rose 697 percent since trading at $17.45 a barrel on the New York Mercantile Exchange in November 2001, and reached 28 record highs this year. The last time a similar pattern was seen in equities was eight years ago, when Internet-related stocks sent the Nasdaq Composite Index up 640 percent to its highest level ever, according to data compiled by Bloomberg and Bespoke Investment Group LLC.

The Nasdaq tumbled 78 percent from its March 2000 peak, erasing about $6 trillion of market value, as investors concluded that prices weren't supported by profits at companies such as Broadcom Corp. and Amazon.com Inc.

Billionaire investor George Soros and Stephen Schork, president of Schork Group Inc., say oil is ready to tumble because prices aren't justified by supply and demand.

"There's nothing different between this mania, the dot-com mania, the real estate mania, the Dow Jones mania of the 1920s, the South Sea bubble and the Dutch tulip-bulb mania," said Schork, whose Villanova, Pennsylvania-based firm advises the Organization of Petroleum Exporting Countries, Wall Street firms and oil companies on the outlook for energy prices. "History repeats itself over and over and over again."

A Warning from the Royal Bank of Scotland

The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks.

"A very nasty period is soon to be upon us - be prepared," said Bob Janjuah, the bank's credit strategist.

A report by the bank's research team warns that the S&P 500 index of Wall Street equities is likely to fall by more than 300 points to around 1050 by September as "all the chickens come home to roost" from the excesses of the global boom, with contagion spreading across Europe and emerging markets.

Such a slide on world bourses would amount to one of the worst bear markets over the last century.

[via chucks_angels]

Why John Montgomery invests

[Austin Edwards] remembers when John Montgomery, founder, CEO, and fund manager of Bridgeway Funds, came to Fool HQ to give us some insight into why -- not how -- he runs his funds.

Granted, I would've loved to learn more about how he invests. His Bridgeway Aggressive Investors 1 Fund (BRAGX) has returned a jaw-dropping 19.1% annualized since he started it in 1994, and currently owns market superstars Intuitive Surgical (Nasdaq: ISRG), Mosaic (NYSE: MOS), and Potash (NYSE: POT).

Nonetheless, it was refreshing to see that Montgomery has never lost sight of why he's investing. See, Bridgeway donates a whopping 50% of its after-tax profits to charities -- most notably to foundations dedicated to stopping genocide in Africa.

Bill Miller Deja Vu?

In 1991, financial markets opened the New Year with significant weakness, weighed down by a lingering recession in the U.S. housing market, soaring oil prices and fallout from war in the Middle East. Markets were also contending with a major crisis in the financial sector that arose from junk bond investments in the savings & loan industry.

Sound familiar? It should, as we face similar challenges today -- only this time, the turmoil in the financial industry stems from the subprime lending collapse.

Reflecting on his [poor] recent performance, Bill Miller noted that 2007 was "the first time since 1990 the Value Trust has lagged the S&P 500 in two consecutive calendar years. Perhaps, not surprisingly, that was also a time of panic due to a housing market recession, soaring oil prices, plus huges losses in the banking and financial sector. We took advantage of lower prices back in the 90s, which ushered in a pretty good period of excess returns.

-- from Legg Mason's empower Magazine, Spring 2008

Consuelo Mack

Consuelo Mack has a TV show called WealthTrack that only now I found out about from a link at gurufocus.

Listening to her show, she sounds like the spiritual successor to Rukeyser (without the bad puns). And in fact, she's actually a real successor to Rukeyser having hosted Rukeyser's Wall Street in its final months.

The latest show (6/6/08) features Bruce Berkowitz.

Some notable (to me) past shows include

Chris Davis (1/18/08)

Jean-Marie Eveillard (12/28/07)

Dan Fuss (12/14/07)

Whitney Tilson (12/7/07)

Robert Hagstom, Steve Leuthold (10/19/07)

Bill Gross, Jean-Marie Eveillard (10/14/07)

Ron Muhlenkamp (9/21/07)

Jason Zweig and Whitney Tilson (9/7/07)

Ben Stein and Jason Zweig (7/6/07)

David Winters and Rob Arnott (5/25/07)

Keith Trauner (3/16/07)

Ben Stein, David Winters (2/23/07)

is this the bottom?

With stocks down sharply from their bull market peaks, Forbes compiled a group of four prominent analysts and asked them to share their viewpoints on whether the markets had truly reached bottom. Here's what those experts had to say:

"Stocks are down, expectations are down, valuations are down, fear is up and the money supply growth has already started to take off along with the Fed cuts. Those are all positives for the market. The significant volume of selling, or panic selling, over the last few months is commensurate with a bottom."

-- Stuart T. Freeman, A.G. Edwards

"We're in a transitional area, but the trend looks like we're at or near the bottom. We're probably going to move up from here, but the question is how quickly."

-- Holly Gustafson, Legg Mason

"We should see a sustainable upturn from here."

-- Joseph Kalinowski, Thomson Financial/IBES

"In March a bottom occurred."

-- Daniel Peris, Argus Research

Will the experts' predictions prove correct? I wouldn't bet on it.

You see, those quotes were taken from early May. May 2001, that is.

After an extended bull rally, the S&P 500 dropped sharply in late 2000, characterized by sudden price swings and sharp volatility. In the spring of 2001, the market temporarily rebounded, and Forbes' experts all agreed: This was the bottom.

They were wrong.

Over the next four months, the S&P 500 fell 24%. It rebounded briefly, then dropped another 30%.

They weren't just wrong -- they were spectacularly wrong.

Soros on oil

Soaring oil prices are increasingly the result of speculation, financier George Soros said in an interview published Monday.

The billionaire investor said the money pouring into the oil market increasingly had the look of a bubble, but that it would not burst until both the United States and Britain were knocked into a recession.

"Speculation ... is increasingly affecting the price," Soros was quoted as saying by The Daily Telegraph. "The price has this parabolic shape that is characteristic of bubbles."

But the cost of oil — which briefly reached new record highs of more than US$135 a barrel in trading Thursday — was unlikely to fall dramatically until the U.S. and Britain economies began contracting, the paper quoted Soros as saying.

Ken Fisher is bullish

I'm getting a lot of hate e-mail these days. This onslaught is not entirely a bad thing. It reassures me that my bet against the crowd is a wise one. I'm bullish and have been steadily since the July 8, 2002 issue. In my Jan. 28 column I reiterated the upbeat outlook and reminded you that the fourth year of a presidency only rarely delivers losses to stockholders. Now, with stocks globally (as measured by the Morgan Stanley All-Country World Index) down 8.6% so far this year, people are telling me I'm an idiot. Someone posted to FORBES Web site, "Hi Ken. It's been an absolute pleasure watching you vie for the 2008 Henry Blodget Award. Keep up the good work!"

Gloat for now, but please note that 2008 isn't over. I still think the year will end in the plus column. And I'm never happier than when I'm alone.

My critics call me a perma-bull. They forget I called the last three full-fledged bear markets right here in FORBES--reasonably well and better than most--and mostly alone (June 15, 1987; Nov. 27, 1989; Feb. 19, 2001). I know I may be wrong now. But I see what's happened since Jan. 1 as just a major correction, very comparable to 1998, with a few things flip-flopped, as described in my Feb. 25 column.

On Mar. 13 Goldman Sachs demoted market strategist Abby Cohen for having been bullish too long. That day marked the bottom of the back half of what I think is a double-bottom whose first bottom was in January. I see Goldman's move as bullish. That once famous market timer Joe Granville materialized out of nowhere saying that we are beginning a bad bear market. I'd bet against Joe any time. Gloomy people are saying that we are in the midst of the worst financial crisis since the 1930s. They said the same thing in 1998. Bullish!

You can't find a time in the 20th century when, less than five months into a real global bear market, people were talking bear market and recession in any visible numbers. But they always talk disaster during corrections. Check out "Russian Financial Crisis" on Wikipedia. The second sentence says 1998 was a "global recession … which started with the Asian financial crisis in July 1997." Wrong. There wasn't a global recession then. There isn't one now.

An old saw says, "You should be fearful when others are greedy and greedy when others are fearful." Clearly folks are fearful now. So you should be greedy. Another saw: "Buy when there is blood on the streets." There's plenty of blood, or at least depression, on Wall Street. So keep buying.

[via investwise 5/13/08]

Memorial Day

According to Martin Zweig's Winning on Wall Street, the day before Memorial Day (and holidays in general) is supposed to be bullish, "the odds of the market rising on the day before a holiday was about seven out of eight." However if the market is down on that day, then one should short the market for the day after the holiday.

So this means we should expect the market to go down further on Tuesday.

Of course, the mere fact that we know this affects the pattern. The book uses data thru 1985 and was published in 1986. Since then, the tendencies may not as strong.

[6/3/08] The market finished positive on May 27. In other words, wrong again.

How has van den Berg done it?

Although he is not quoted as frequently as master value investor Warren Buffett, value investor Arnold van den Berg's long-term investment returns at Century Management are nearly as impressive.

Since its 1974 inception, the firm has delivered more than 16% annual returns to investors before fees, and nearly 15% annual returns after fees. As Century points out, that means the firm would have doubled your money every 4.8 years.

How has van den Berg done it? Mostly by concentrating on buying stocks that are out of favor with other investors. At a presentation he gave in 2006 (which was transcribed in an excellent issue of Outstanding Investor Digest), he described four psychological states investors experience that he takes advantage of in order to earn those outsized returns.

• Apathy: The stock price has gone nowhere for a number of years, and people are just tired of it.
  
• Disgust: The stock has done nothing; earnings and sales might be down. People might have lost money holding on to it and can't bear to own it any more.
  
• Fear and panic: The bad news hits, the company runs into trouble, and the price drops off a cliff. Sell! Sell!
  
• Anger: Nothing's gone right while holding it, lost a lot of money, it will never turn around! Just dump this piece of garbage!

Those conditions, especially the last two, lead investors to "buy high, sell low." It's from those same people that Van den Berg buys his stocks. "People, acting as a herd," he said, "do some very foolish things because of emotions that block out reason and intelligence. ... So don't let your emotions dominate."

a penny costs more than a penny

WASHINGTON (AP) -- Further evidence that times are tough: It now costs more than a penny to make a penny. And the cost of a nickel is more than 7½ cents.

Surging prices for copper, zinc and nickel have some in Congress trying to bring back the steel-made pennies of World War II and maybe using steel for nickels, as well.

Market Cycle Math

During bull markets, a vibrant, peaceful combination of P/E expansion (a staple of bull markets, a great source of return) and earnings growth brings outsize returns to jubilant investors. Prolonged bull markets start with below- and end with above-average P/Es.

P/Es are some of the most mean-reverting creatures, and range-bound markets act as clean-up guys: they rid us of the mess (i.e., deflate high P/Es) caused by bull markets, taking them down towards and actually below the mean. P/E compression wipes out most if not all earnings growth, resulting in zero (or nearly) price appreciation plus dividends.

Bear markets are range-bound markets' cousins; they share half of their DNA: high starting valuations. However, where in cowardly lion markets economic growth helps to soften the blow caused by P/E compression, during secular bear markets the economy is not there to help. Economic blues (runaway inflation, severe deflation, subpar or negative economic or earnings growth) add oil to the fire (started by high valuations) and bring devastating returns to investors.

A true secular bear market has not really taken place in the US, but one has occurred across the pond in Japan. The market decline caused by the Great Depression, though referred to as the greatest decline in US stocks in the 20th century, only lasted three years and thus doesn't really fit the traditional "secular" requirement of lasting more than five years. Japan's Nikkei 225 suffered through a true secular bear market: stock prices declined over 80 percent from their 1989-1991 highs until they bottomed in 2003 (the market seems to be coming back now). For more than a decade the country struggled with deflation caused by its banking system coming to a near halt on the heels of a collapsing real estate market and the bad loans that came with it. Of course, all this took place on the heels of a huge bull market, and thus very high valuations.

Sell in May?

Numerous studies show that since World War II, as much as 99% of stock market returns have been generated between November 1 and May 1. Good friend and fishing buddy David Kotok of Cumberland Advisors sums it up nicely:

"According to the Ned Davis (NDR) database, starting in 1950, $10,000 invested in the S&P 500 Index every May 1st and then liquidated every October 31st would only be worth $10,026 today. That's right: had you stayed out of the stock market from November through April and only been in the market from May through October, you would have had no change during the last 57 years. 21 of those years would have been negative; 36 were positive. Thi s happened during the same period that stock prices were rising about 75% of the time and markets made extended upward moves.

"Consider the results of the reverse strategy. Buy the S&P 500 Index on November 1st and sell all your stocks on May 1st. The outcome is dramatically different. Your original $10,000 would now be worth $372,890 as of April 30th closing prices in 2008. Out of the 58 periods you would have had positive results in 45 of them and negative results in only 13 years."

*** 4/30/12

I'm perfectly willing to believe that there is a seasonal component to stocks' price appreciation that is inconsistent with efficient markets, but these data aren't enough to judge the efficacy of a seasonal switching strategy. In that regard, NDR's methodology suffers from several shortcomings: For one, it assumes that when the money isn't invested in stocks, it earns no return whatsoever instead of being invested in Treasury bills. Furthermore, their data do not account for dividends, a critical component of stock returns. Finally, there is no benchmark data corresponding to a straightforward "buy and hold" strategy.

In order to address these issues, I performed my own calculations, using data series from Ibbotson Associates (a unit of Morningstar) that begin in 1926.

There are two key observations here:

The "sell in May" strategy soundly beat the converse strategy, with a margin of outperformance that exceeds 3 percentage points on an annualized basis.

However, "Sell in May" underperformed buy-and-hold; in fact, the outperformance of buy-and-hold is understated because the returns in the table assume no transaction costs and no tax impact.

The Value Imperative

Dr. John Price (creator of ValueSoft and the Conscious Investor) has written a series of articles for gurufocus called the Value Imperative.

Here are the links to the articles:

Part 1: Setting The Scene
Part 2: Replacement Theory and Tobin's q theory
Part 3: Charting and Technical Analysis
Part 4: The Investment Methods of Benjamin Graham
Part 5: Intrinsic Value and Discount Cash Flow Methods
Part 6: Intrinsic Value and Dividend Discount Methods

What the Sydney Harbour Bridge Taught Me

He also has a number of informative articles at Sherlock Investing.

Buffett and Gates on FBN

Liz Klaman of Fox Business News interviews Warren Buffett and Bill Gates:

Buffett discusses the future of Berkshire Hathaway

Bill Gates discusses the failed Microsoft-Yahoo deal

Buffett and Gates discuss the energy industry and alternative energy

Buffett and Gates discuss the American economy

Buffett and Gates discuss their contrasting deal making methods

Emerging Markets are still going strong

Although industrialized economies in the U.S., Europe, and Japan are all likely to see slow growth in the next couple of years, emerging markets are still going strong.

Country   GDP Growth --  2008 GDP      2009 GDP
          Past 12 Months Growth Est.   Growth Est.
United States  2.5%          1.1%          1.7% 
Germany        1.8%          1.7%          1.6% 
Japan          2.0%          1.3%          1.5% 
China         10.6%          9.6%          9.0% 
India          8.4%          7.8%          7.2% 
Brazil         6.2%          4.6%          4.0% 
Russia         8.0%          7.1%          6.2%

By one simple measure -- the P/E ratio -- emerging-market countries have quite reasonable stock market valuations. And in some cases, they look downright cheap.

Country  Trailing P/E  Estimated
                       Forward P/E 
United States  19.2      14.8 
Germany        12.4      11.9 
Japan          16.6      15.6 
China          19.5      16.2 
India          22.0      20.9 
Brazil         16.2      13.2 
Russia         10.4      11.6

2008 Berkshire Hathaway annual meeting

There's a bunch of links regarding the Berkshire Hathaway annual meeting this year, thanks to brknews and chuck_angels and others. There's so many that, instead of cramming them in at WBIARD, I decided to list them here instead.

Warren Buffett to draw biggest crowd ever

The Buffett Madness has begun (Liz Klaman)

CNBC Live Blog Archive

Liveblogging the Berkshire Hathaway annual meeting (Justin Fox)

Joe Ruff's updates

Justin Fuller's blog

Peter Boodell's notes

iluvbabyb's notes

Liz Klaman blog

Buffett says Berkshire won't get indecent results

Buffett advice: Buy smart...and low

CNBC Video Gallery

LIVE BLOG ARCHIVE: Warren Buffett News Conference


Buffett explains his purchase of Berkshire

Adam Smith's Money World transcript 5/15/98 [via pohick2]

Earnings Estimates

A recent eye-opening study by Patrick Cusatis and J. Randall Woolridge of Pennsylvania State University looked at 20 years' worth of published earnings estimates made by Wall Street industry analysts. What they found was startling.

Cusatis and Woolridge found that Wall Street analysts -- supposedly among the smartest, most well-informed prognosticators -- consistently overestimated the future earnings growth rates of the companies they cover. By a lot. I mean by a whole lot.

* * *

also

Sequoia Fund reopens

The Sequoia Fund, after experiencing selling by investors, is reopening its doors May 1 to new investors for the first time since 1982.

The $3.5 billion value fund is celebrated for outperforming the broader market during much of its 38-year history. For years, it was run by legendary stock picker William Ruane, who followed the same approach as Benjamin Graham and Warren Buffett.

In recent years, however, Sequoia has a mixed performance record, lagging the Standard & Poor's 500-stock index in three of the past five calendar years.

Selling by investors caused assets to fall to a level lower than it was a decade ago, the funds' managers wrote in a report for the quarter ending March 31. If that were to continue at that rate, it could "cause us to have to sell stocks that we didn't want to," said co-manager Robert Goldfarb, 63 years old, in a telephone interview Wednesday.

Since its inception in 1970, Sequoia has returned more than three times that of the S&P 500. An investor who put $1,000 into the fund at inception would today have a little more than $200,000, compared to about $63,000 in an S&P 500 fund, according to Morningstar Inc.

Peter Bernstein doesn't like what he sees

Peter Bernstein has witnessed just about every financial crisis of the past century.

As a boy, he watched his father, a money manager, navigate the Depression. As a financial manager, consultant and financial historian, he personally dealt with the recession of 1958, the bear markets of the 1970s, the 1987 crash, the savings-and-loan crisis of the late 1980s and the 2000-2002 bear market that followed the tech-stock bubble.

One of Peter Bernstein's worries: 'If China goes into a recession, God knows.' Today's trouble, the 89-year-old Mr. Bernstein says, is worse than he has seen since the Depression and threatens to roil markets into 2009 and beyond -- longer than many people expect.

[via iluvbabyb]

Writing Put Options

At Morningstar, we are currently developing a methodology that can be used to combine fundamental research with options investing. One strategy that we think can be used relatively safely is writing put options on wide-moat companies with low or medium fair value uncertainty ratings. In other words, we wish to write put options on companies that, in our opinion, have durable competitive advantages whose fair values lie within a tightly bounded range. Using this strategy, we can generate annualized double-digit returns if the options expire worthless. Or in case the stock gets put to us, we'd end up owning stakes in wonderful businesses at attractive prices--we think it's a win-win situation.

What Goes Up

Just because a stock has risen for 10 years in a row, that doesn't at all mean that it will keep doing so. It may very well fall a little (or a lot) in the coming years.

The 10 Greatest CEOs Of All Time

For good reason, we've become cynical about CEOs. There seem to be no heroes left standing, no one to emulate or believe in. There's an increasingly gloomy sense that we should simply throw up our hands and give up on corporate leadership.

I disagree. Having spent years studying what separates great companies from mediocre ones, I can say unequivocally: There are role models to learn from--albeit not the ones you might expect. It's what inspired me to go back to my research and assemble my list of the ten greatest CEOs of all time.

[via brknews]

The Death of the American Billionaire

For the past decade, Forbes' billionaires list has been as American as apple pie. Gates and Buffett have vied for the top spot, typically followed by the likes of Paul Allen, Dell (Nasdaq: DELL) founder Michael Dell, Oracle (Nasdaq: ORCL) founder Larry Ellison, and Las Vegas Sands (NYSE: LVS) chairman Sheldon Adelson.

But in recent years, the upper echelons have been invaded by international businessmen who are growing their fortunes at an astonishing clip. In the past five years, Slim has increased his net worth eight-fold, thanks to the stellar performance of Latin American telecoms like America Movil (NYSE: AMX). With a fortune currently worth $60 billion, Slim has surpassed Gates and is nipping at Buffett's heels.

Meanwhile, a trio of Indian businessmen lurks behind Gates, poised to leapfrog into the top three slots. Over the past two years, shares of Luxembourg-based steelmaker ArcelorMittal (NYSE: MT) have doubled, helping CEO and 11% shareholder Lakshmi Mittal add $21 billion to his net worth.

As impressive as that feat may be, Mittal is hardly the greatest gainer of the past 24 months. That distinction belongs to Anil Ambani, who has increased his fortune from $5.7 billion to $42 billion in just two years through his ownership stake in India's Reliance Communications and Reliance Power. Anil clocks in as the sixth-richest person in the world, just behind his estranged brother, Mukesh Ambani.

The tremendous performance of international stocks has led to a seismic shift in the composition of Forbes' list. As recently as two years ago, 12 of the 25 richest people in the world were Americans. Now only four are.

What actually happens in your brain when you invest?

Researchers from the fields of neuroscience, economics, and psychology — neuroeconomists — have been discovering the role that biology plays in financial decision-making and identifying why our brains can sometimes unwittingly stop us from making sound investment decisions.

Primal Emotions
Exploration into how the brain works and the emotional impact of investment decisions shows that if you’ve ever felt nervous when watching the price of an investment fall, you may have been receiving a message released by your amygdala, the part of your brain that initiates feelings of fear. The amygdala gives off adrenaline, which triggers our most primitive and protective response, preparing us for “fight or flight.” So while we typically no longer rely on our amygdala’s warning signals for our physical survival, it is still responsible for causing a sense of anxiety to arise when there is an expectation of a financial loss as well as when the market actually shifts.

Also, when faced with the prospect of achieving a positive outcome, certain neurons in the brain release dopamine, a neurotransmitter that regulates feelings of pleasure. The mere anticipation of making money on an investment could cause your brain to release this chemical — even more than when you truly realize the return on your assets.

Staying Centered
Neuroeconomists have found that the prefrontal cortex can help counter the amygdala’s impact and guide our thoughts and behavior as investors. The prefrontal cortex is the area of the brain responsible for evaluating the consequences of your actions: it is where people rationally weigh pros and cons. In effect, the prefrontal cortex can help you control impulsive messages sent from your amygdala by enabling you to concentrate, analyze concepts, and draw logical conclusions.

Smart Investing
To increase your chances of success as an investor, it may help to be aware of how primal emotions might influence the decisions we make and the actions we take regarding money. Understanding these instincts can enable your prefrontal cortex to form thoughtful judgments based on established investment strategies such as pursuing long-term goals and maintaining an appropriate asset allocation. As a result, we may be able to make more informed decisions—instead of allowing our primal emotions to guide our actions in a constantly changing market.

Source: Jason Zweig, Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich, 2007.

[from T. Rowe Price Investor, March 2008]

Morningstar's New Fair Value Uncertainty Rating

At Morningstar, we try to look at the future in a probabilistic way. Practically, that means we spend a lot of time thinking about the range of possible outcomes for the companies that we cover, even though the fair values we publish are, of necessity, point estimates. For example, we use scenario analysis and other tools to estimate a variety of fair values given different combinations of plausible future events.

To better reflect this aspect of our research process, we're replacing our business risk rating with a fair value uncertainty rating. Going forward, we'll rate every stock we cover as having low, medium, high, very high, or extreme uncertainty. In assigning the rating, we'll be asking ourselves, "How tightly can we bound the fair value of this company? With what level of confidence can we estimate its future cash flows?" If you have a background in statistics, you'll recognize that what we'll be doing is estimating the size of a confidence interval for the values of the companies we analyze.

Commodities: boom or bubble?

With commodity prices already at record highs, many people are predicting the resources boom is a bubble ready to burst spectacularly. The commodity sector is notoriously cyclical, and the time to buy is at the bottom of the cycle. We are surely closer to the top of the cycle than the bottom, traditionally seen as the time to sell.

But there are plenty of counterarguments, most of which focus on the insatiable Chinese growth story.

Investing like a girl

So how exactly do women invest? Check out these characteristics of female investors that distinguish them from their male counterparts.

Women spend more time researching their investment choices than men do. This prevents them from chasing "hot" tips and trading on whims -- behavior that tends to weaken men's portfolios.

Men trade 45% more often than women do, and although men are more confident investors, they tend to be overconfident. By trading more often -- and without enough research -- men reduce their net returns. But by trading less often, women get better returns and also save on transaction costs and capital gains taxes.

A study by the University of California at Davis found that women's portfolios gained 1.4% more than men's portfolios did. What's more, single women did even better than single men, with 2.3% greater gains.

Women tend to look at more than just numbers when deciding whether to invest in a company. They invest in companies they feel good about ethically and personally. And companies with good products, good services, and ethics tend to have better long-term prospects -- and face fewer lawsuits.

Bear Markets

The average bear market since 1940 lasted 386 calendar days (about 13 months) with an average peak-to-trough decline of roughly 30%. According to Bespoke Investment Group, historically, an average 74% of the bear market was complete (in terms of the number of days the bear market lasted) by the time the market hit official bear territory of –20%. In fact, three of the 11 bear markets (1948–1949, 1956–1957 and 2002) ended within 13 days of crossing the –20% threshold while just one hit –20% when the bear market was less than half over (1946–1947).

Getting back to breakeven was a longer path, but the range was wide around the average 1,177 days (3.2 years) it took the market to get back to its old highs. It took the least amount of time after the 1966 bear market and the longest after the most recent 2000–2002 bear market. And remember, the percentage increase on the way back up beats the percentage drop on the way down. After a 30% drop, a return to breakeven represents a 43% move higher. Panicking out at the bottom of bear markets means a lot of missed opportunity on the way back up.

[3/27/08] Beginning on March 6, the Dow lost 515 points over three days, followed by a 417 point surge the next day, then dropped 200 points a few days later, before soaring 420 points two days after that, only to lose nearly 300 points the next day, before jumping over 230 points the day after that!

If your head is spinning and you are wondering what to do now, you are not alone. Those two big 400+ point up days are often seen near market bottoms. In fact, 4 of the best 10 days from 1988-2007 came in the second half of 2002 as the 2000-2002 bear market was reaching its bottom. [via etrade]

Bears Stearns bought for $2

Dow member JPMorgan (JPM $40 1) has acquired the fifth largest US investment bank Bear Stearns (BSC $4) for a dramatically low price of $2.00 per share, or about $236 million. According to the Wall Street Journal, Bear Stearns had a stock market value of $3.5 billion on Friday and was worth $20 billion in January 2007. The fire-sale price of the deal is related to the massive decrease in BSC's client confidence, which prompted a liquidity scare, forcing the brokerage firm to make a decision to sell the firm at any price or face bankruptcy. The Federal Reserve will also assume management of $30 billion of BSC's debt to help JPM finance the deal. A spokesman for China's CITIC Securities said it was unclear regarding the current situation between BSC and JPM and, as well as the prospects of its original proposed $1 billion investment in the struggling brokerage house.

[3/24/08] JPMorgan Chase (JPM $46 1) is reportedly in talks to raise its offer to buy Bear Stearns (BSC $6) from $2 per share to $10 per share in an effort to win over angry Bear Stearns shareholders, according to the New York Times. People familiar with the matter said the Federal Reserve, which must approve any new deal, has thus far balked at the latest price, in part because a sweetened offer may give critics ammunition to argue Bear's shareholders are being rescued. As a result, the Times said efforts to secure a renegotiated agreement could be delayed or collapse. BSC is up sharply. Neither of the parties involved commented.

Buffett overtakes Gates

Warren Buffett is the richest man on the planet.

Riding the surging price of Berkshire Hathaway (nyse: BRK - news - people ) stock, America's most beloved investor has seen his fortune swell to an estimated $62 billion, up $10 billion from a year ago. That massive pile of scratch puts him ahead of Microsoft co-founder Bill Gates, who was the richest man in the world for 13 straight years.

Gates is now worth $58 billion and is ranked third in the world. He is up $2 billion from a year ago, but would have been perhaps as rich--or richer--than Buffett had Microsoft not made an unsolicited bid for Yahoo! at the beginning of February.

Microsoft shares fell 15% between Jan. 31, the day before the company announced its bid for the search engine giant, and Feb. 11, the day we locked in stock prices for the 2008 World's Billionaires list. More than half of Gates' fortune is held outside of Microsoft shares.

Mexican telecom tycoon Carlos Slim Helú is the world's second-richest man, with an estimated net worth of $60 billion. His fortune has risen $11 billion since last March.

Despite Buffett's meteoric rise, his days as the World's Richest Man are almost certainly numbered. He had long promised to give away his fortune posthumously. But in the summer of 2006 he irrevocably earmarked the majority of his Berkshire shares to charity, most going to the Bill & Melinda Gates Foundation.

January barometer

Does the weak start to the year portend a down year for the market in 2008? The so-called “January Barometer,” which posits that as January goes, so goes the year, would suggest that it does.

First recognized by Yale Hirsch in 1972, the January Barometer appears to be an especially good predictor when the market is up in January. In the 58 years since 1950, the S&P 500 has been up in January 37 times. Of those years, the S&P has been up for the year 34 times, or more than 90% of the time.

On the downside, the correlation is not as strong, but the market direction in January is still predictive of the direction of full-year results more often than not. In the 21 years since 1950 that the S&P 500 has been down in January, it has finished the full year down 12 times, or a little more than half the time.

When the market is very weak in January, as it was this year, the odds rise that the year itself will also be down. Following the 10 worst Januarys since 1950, the S&P 500 was down for the year seven times. Those are higher odds of a down year than we like to see.

On the other hand, in those same 10 worst Januarys, the S&P 500 was down an average of 5.5% for the month, but only down an average of 5.8% for the full year. So, most of the damage for the year was done in the first month, and from there, the market was about flat for the rest of the year.

Avoid these investment mistakes

Whether it's the Dutch tulip craze of the 17th century, the dot-com mania of the late 1990s, or the most recent rush into real estate, there's no shortage of examples of investors behaving irrationally.

In the world of traditional economists and finance professors, though, that's not supposed to happen. If investors are rational decision-makers, then emotion-driven bubbles shouldn't be possible. Yet human weaknesses can limit our ability to think clearly. Many studies of investor behavior have shown that investors are too willing to extrapolate recent trends far into the future, too confident in their abilities, and too quick (or not quick enough) to react to new information. These tendencies often lead investors to make decisions that run counter to their own best interests.

... According to several studies, overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade. And all that trading can be hazardous to your wealth, as University of California, Berkeley professors Brad Barber and Terrance Odean put it in their 2000 study of investor trading behavior. The study looked at approximately 66,000 households using a discount broker between 1991 and 1996 and found that individuals who trade frequently (with monthly turnover above 8.8%) earned a net annualized return of 11.4% over that time, while inactive accounts netted 18.5%. Investors who traded most often paid the most in brokerage commissions, taking a huge bite out of returns.

Morningstar performance

[Pat Dorsey writes] As an investor, I have always valued candor very highly when assessing both CEOs and portfolio managers. So, I will be as candid as possible in reviewing the overall performance of our stock picks in 2007: We had a bad year. Our 5-star calls underperformed just about any relevant benchmark, and they also posted poor absolute returns.

Bottom Fishing

Most finance academics believe in the “efficient market hypothesis,” which teaches that past stock price changes provide absolutely no information for forecasting future price changes. But just how true is this theory in practice? Is bottom-fishing really a viable strategy?

Fortunately, stock price data is readily available for analysis. Schwab’s equity research team has extensively studied the relationship of historical stock price changes to future stock price changes in markets around the world.

For the purposes of this article, we took the 3,000 largest U.S. stocks by market capitalization each month from 1990 to 2007 and divided them into five uniform portfolios, according to their price changes over the prior 12 months. We then measured portfolio returns over subsequent six-, 12- and 24-month holding periods relative to the 3,000-stock-universe average.

Are stocks that have performed poorly over the past year potential bargains? The graph “Give the Deep Divers Time to Resurface” reveals that the answer depends on your time horizon. Let’s focus on Portfolio 5: the 20% of stocks with the weakest past performance, underperforming the average stock by 30% or more over the prior year. Note: On average, Portfolio 5 stocks continued to underperform for the first six months after portfolio formation, but then eventually reversed and outperformed over a longer 24-month holding period.

This pattern suggests that investors tend to initially underreact to whatever caused the poor performance over the previous year, but then eventually overreact—leading to potential market-beating opportunities for bottom-fishing investors with a longer-term focus.

As a quick aside, these results certainly throw some cold water on the efficient market hypothesis. Past price performance trends tend to persist for holding periods up to six months, which suggests that price momentum can be a useful indicator for active traders.

Dow 18,500?

We [Morningstar] think the Dow Jones Industrial Average will rise more than 6,000 points to roughly 18,500 over the next three years.

How We Arrived at That Estimate
The Dow was trading at a very hefty 17% discount to our estimate of its fair value, which stood at around 14,000 as of Feb. 7, 2008. We base that fair value estimate on the fair value estimates that our equity analysts have placed on the Dow's 30 component stocks. The Dow hasn't looked this cheap to us since September 2002 when the index stood at 7,592 (three years later it had risen to 10,569).

When we take the Dow's market price and fair value estimate together with its 9.7% weighted average cost of equity (our analysts assign a percentage cost of equity to every stock they cover, including all of the Dow's components), it translates to a 17% annualized expected return. In other words, this is the return an investor would reap if the prices of the Dow's components converged to our fair value estimates over a three-year holding period (not ad infinitum).

To isolate the Dow's expected price return--which is what directly influences the index's value--we deducted the benchmark's 2.2% dividend yield from the 17% annualized return we derived. When we compound the Dow's closing value on Feb. 7 by this 14.8% annualized price return, we arrive at an 18,510 index value.

Changes in the Dow

Dow Jones announced yesterday that it will be replacing two
stocks in its Dow Jones Industrial Average effective Feb 19.
Altria Group (MO) and Honeywell International (HON) will be
replaced with Bank of America (BAC) and Chevron (CVX).

This is the first change in the average since April 2004. The
move reflects the desire of Dow Jones to increase the
concentration of financial service and energy in its
benchmark. In addition, Altria is spinning off its
international operations next month. [via Zacks.com]

Estate Planning terminology

Lots of you have wills. Many of you also have trusts and powers of attorney. But, in general, when the subject of estate planning comes up, most people's eyes just glaze over. The terminology is confusing and the subject is, well, depressing.

I can't make the subject matter any more palatable, but I can help with the terminology.

-- By Sue Stevens, CFA, CFP, CPA

Taming Financial Clutter

My name is Dayana, and I have a paperwork problem.

Now that that's out of the way, we can all deal with our piles of shame -- the money-related detritus (those gobs of receipts, bank records, investing statements, warranties, and whatnots) we've been stashing in closets, drawers, and basements for (I admit) years.

Based on the number of decluttering books in the "Get Organized" aisle at the bookstore, there's no shortage of advice on controlling the torrent of items that stack up every day. So let's heed the organizational pros and apply their advice to our financial clutter. For this exercise, I'm using the five steps that author Julie Morgenstern outlines in her popular organization book, Organizing From the Inside Out.

Five Sure Things

Each quarter, the Forbes Investors Advisory Institute under President Wallace Forbes hosts a financial round-table discussion to sample the economic and investment outlooks of some of the best and brightest minds on Wall Street.

The most recent discussion was held on Jan. 8 at Forbes headquarters in New York City. Below are the transcribed and edited remarks of Henry Mercer, president of Mercer Capital Advisors.

...

I'm getting older now, so I only invest in sure things. I don't invest in things that only "might" work out. So let me give you five sure things.

Gold is going to $1,000 an ounce probably this year. I forecast that it would go to $800 an ounce last year.

Oil is going to probably $125 a barrel. I forecast that it would go to $80 last year.

The dollar is going down for the reasons that I said because large holders of dollars are going to diversify into other assets and other currencies. And of course, if the dollar is weak, that's an inflationary phenomenon because the United States, having dismantled its manufacturing establishment, is dependent on foreign goods for our survival. This is something people aren't sufficiently worried about.

Cotton is going to be the commodity of choice because the world's standard of living is increasing, and the places where it's increasing fastest are warm, and they don't wear wool; they wear cotton. Cotton is something nobody wants to grow. They want to grow corn instead. So, while the demand for cotton is increasing, the acreage devoted to it is decreasing, and that's all you have to know.

Finally, I think the Chinese are going to revalue the renminbi (yuan) even more than the 7% that they did last year.

As far as stocks are concerned, I think that my investment ideas follow some of my thesis. Our portfolio is very heavily overseas, but we're in the agricultural area with Potash Corporation of Saskatchewan (nyse: POT - news - people ) and a lot of energy stocks--large caps such as Schlumberger (nyse: SLB - news - people ), smaller caps such as National Oilwell Varco (nyse: NOV - news - people ) and Ultra Petroleum (amex: UPL - news - people ). In technology, Qualcomm (nasdaq: QCOM - news - people ). Finally, in adult education we think that a lot of people will be laid off and they'll be trying to improve their skills so we would buy the Apollo Group (nasdaq: APOL - news - people ).

the greatest secret to investment riches

David Gardner reveals the greatest secret to easy riches in the stock market.

Finding good companies and holding those positions tenaciously over time can yield multiples upon multiples of your original investment. That's what great investors do.

The best time to invest

Consider John Templeton, founder of Templeton Growth Fund and widely regarded as one of the best investors of his generation. His advice about getting into the market is simple: "The best time to invest is when you have money. This is because history suggests it is not timing which matters, it is time."

Bill Gates and capitalism

Gates highlighted some fundamental problems with capitalism, including how innovation and technological advancement create an ever-growing economic disparity between the bottom third and the rest of the world's population. When businesses earn more profits in regions that are already economically stable, innovation tends to bypass the world's poor.

In what he calls "creative capitalism," Gates hopes to banish some of this disconnect by encouraging a new system of business. This new system would promote economic incentives for global powers to have a bigger presence in areas of the world stricken by disease and poverty, particularly Africa. When doing business there would not present profitable opportunities, using a company's reputation to pull in money is one way to use the marketplace to help the poor.

Get the Most Out of an Annual Report

Some annual reports are pretty, color-filled documents that, although helpful, function more as a marketing and communications tool than anything else. What you really want to dig into is the annual 10-K, the boring (and, at times, long) black-and-white document containing the information that public companies must file with the SEC.

eating your own cooking

According to a study recently published in The Journal of Financial Economics, there is a direct correlation between the amount of money a mutual fund manager has invested in his fund and its performance. No huge surprise there, particularly if you've spent any time reading about the importance of "eating your own cooking."

But wait, it gets better. The study cites that the amount a manager invests in his fund is the most accurate indicator of how well the fund will perform over time.