Saturday, March 28, 2009

Stock Surges Are Usually Unexpected – How To Make Sure You Won't Miss Out

Historical market data explains why many investors, including myself, missed on the recent surge in stock prices

Since my last post the markets have astonishingly recovered over 20%. A couple of press releases by Citi and Bank of America were enough to send the financial sector sky rocketing with these two banking giants doubling their stock prices.

After witnessing such extreme movements up in stock prices I often try to review my thought and decision making process, or to put it in simpler terms, try to figure out why on earth I wasn't a part of the party?

Two weeks ago it seemed like the biggest retail banks in the US may well be on their way to nationalization. The state of the economy seemed poorer than ever and no hope was in sight. The S&P500 stood at 676 and there were no indications something is about to change.
Still, it is the nature of the markets to be cyclical and what goes down usually comes up. Even in these difficult days we've seen the markets go up by as much as 10% a day only to come crushing down again.

It can be quite frustrating to have your predictions and instincts be proved right on the market while you didn't actually have enough confidence to carry them out. Still, short term trading, whether it is performed on an hourly, daily, monthly or even longer time periods is very risky.
Catching the market at its very low is an impossible mission. No one is able to constantly identify the turning point in the markets while strangely enough many think they can. The legendary Warren Buffet had recently reinvested significantly into the market saying he is almost certain we've got a way to go before the markets turn but he is experienced enough to know that he can't time the market.

A look at the data

As readers of The Personal Financier are surely aware by know psychology plays many tricks on investors.

The human mind is not very good in handling large amounts of data over a historical period. We cannot conclude with success from market data we've heard or read through over a period of time.

Just imagine how many times you've heard of price shifts of a certain stock over a week's period, for example. Most of the time you'll be more than certain that stock's price has risen considerably while it actually didn't gain as much as you'd expect. The reason is we more attuned to positive news on stock than negative and we naturally remember and cling to up movements in prices rather than down movements.

The same phenomenon exists in long term trading. Raw data proves there are only a handful of days in which stocks actually gain or lose significantly. These, therefore, cannot be timed and identified in advance.

There were approximately 4,559 trading days between January 1st 1990 and February 2nd 2008. Only 51 of these days yielded a price change of over 5% in the Nasdaq, and a mere 8 days in the S&P. Maybe 5% is too much to ask for? If we suffice with 3% the numbers change to 238 days for the Nasdaq's and 59 days for the S&P.

What are our chances of catching such days? Very basic statistics quickly determines we have a 1.1% chance of catching a 5% price shift and 5.2% chance of catching a 3% price shift in the Nasdaq. The S&P's statistics are even "worse" 0.2% chance of a 5% price shift and 1.3% chance of a 3% price shift.

The long tail or 80/20 principle work here as well. The numbers are a little different but the principle remains. The majority of days will end in price shifts of fewer than 1% or 1%-3%. That is the long tail of trading days or the "80%".

Smart investing

In order to really capitalize on short term market gains, as the one we had only recently witnessed one must be constantly present in the market. Adjusting portfolio exposure to stock and other financial instruments slowly and gradually is the right way to work.
Sure, you'll experience the short term losses as well but the working assumption is that on average the gain is higher than the loss.

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Saturday, March 14, 2009

Learning the financial language will save you money

Proficiency in "Financialish" equals money and empowerment

According to one urban legend the score in tennis matches was meant to confuse the common bystander, safely maintaining it within the confines of aristocracy. Other explanations include a clock face used in medieval French for scoring the game moving a quarter each time and the different gun calibers of English naval ships (15-pound guns on main deck, 30 pound guns on middle deck and 40 pound lower gun deck).

I've also encountered a similar explanation as to the reason why the French language holds so many "redundant" vowels. According to this myth the French royalty added a bunch of complicated phonetic rules the French writing to make it harder for the commoners to develop reading and writing skills.

It doesn't really matter whether the aforementioned is true or false. The point of these arguments, as we all know, is that knowledge is power.

Proficiency in the financial language is directly translated to money saved or earned

Language is a form of skill and knowledge which empowers the ones proficient in it.
The current crisis, for example, has everything to do with ignorance or lack of proficiency in the more complicated aspects of the financial world. Complicated derivatives and structured products drove the world crazy, making regulatory financial reporting such as financial reports completely useless for investors.

Warren buffet had identified the problem with derivatives as early as 2002: "I view derivatives as time bombs, both for the parties that deal in them and the economic system… derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts… ".

We don't have to as far as derivatives in order to demonstrate the importance of proficiency in the financial lingo. Many of us are completely puzzled with even the most basic conversation with our banker. The terminology is perplexing and no one really likes to admit one doesn't understand.

Be sure enough banks and financial institutions are quick to exploit on this tendency. A less known fact is that most of the bankers we meet in banks are really marketing personnel "in disguise". It's very simple really. The bank's goal is to sell financial products (loans, credit etc.) in high prices (interest). In order to be smart consumers we must first understand what this guy in a suit is talking about before we are able to be more confident in our negotiations.

It's really not that hard. Much like any other technical terminology the financial language may seem, at first, to be complex and full of subtleties and innuendos. At its higher level this is definitely the case but as with other things in life you can get a good comprehension of about 80% of the subject matter with 20% of the required investment (read this post on the 80%/20% rule). Just be confident enough and you'll be surprised of the results.

When one is proficient in a language one is confident. Suddenly bankers will start mumbling around you and will be turning much more to their manager when suddenly explanations and deviations from the standard pitch are required. This is literally worth money.

Where to start? Or is there a dictionary?

My idea for this post sprang to mind when Oxford university press were kind enough to send me a copy of "The Finish Rich Dictionary" by David Bach, an author of many other personal finance guidebooks.

While I'm less fond of the ever-promising title I did actually find the idea behind the book to be quite helpful. Much like any other language we need a "Finance to English" dictionary which will help in learning Financilsih.

David Bach has cleverly constructed this dictionary 1001 financial words "you need to know" are alphabetically organized and explained. The book is intertwined with helpful personal finance essays which discuss the issues at the very core of our personal finances including: Credit card problems, compound interest, the workings of the Federal Reserve, insurance, buying a home, money mistakes, financial plans, retirement, financial advisors and others.

The book also includes good references to other helpful resources and a interest rate risk calculator to complete the package.

I do feel the added value of this book should be articulated carefully since lack of financial resources is not something the internet is characterized by. This book is helpful as a glossary of words, combined under one roof, which maps the very basics of the financial language. If you don't know where to start this book may very well start you off in the right direction in an easy manner.

The interest offers much more diverse and deep knowledge resources of several kinds I highly recommend to anyone, no matter how proficient in the financial world:

  • Wikipedia is without a doubt one of the best knowledge resources available to us, free of charge. Most of the entries are very comprehensive and well articulated. I often turn to Wikipedia first to find out more on a certain subject matter.
  • Another helpful online dictionary is Investopedia which is centered around finance and investments.
  • Finance blogs are great resources for financial knowledge. Blogs, such as my modest Personal Financier, aim at expanding financial literacy and discussion and are home to many good articles and advice. My link section has many helpful blogs listed. Some of my favorites include The Digerati Life, The Financial Blogger, The Simple Dollar and other more I apologize for not being able to list here.
  • MSN money, Yahoo! Finance, NY Times (Your money section) and many other offer invaluable knowledge on personal finance. The problem is usually where to start from.

Whether you prefer a book to the internet or vice versa don't neglect your financial education. It's worth money.

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Saturday, March 7, 2009

The Japanese Banking Crisis of the 1990's: Are We Facing a Similar Stagnation?

What can we learn from the 1990's Japanese banking crisis and the long slump in the Japanese stock market? Are we facing a similar scenario?

Price levels in stock markets worldwide are increasingly becoming attractive with each day brining yet another slump. The time of the long term investors has come. Still, a relentless doubt lingers on – Does this crisis represent an unorthodox change in the economy? Have the markets set into a recession which might take more than the usual 1-3 years to recover from?

The readers of The Personal Financier are familiar with my favorite example I often use when demonstrating why long term investing in stock is not risk free, as the odds suggest. That example is of the Japanese market which hasn't really recovered from the banking crisis it had experienced in the end of the 80's and early 90's.

The Japanese stock market, represented by the NIKKEI225 index has slumped from a level of almost 40,000 points in 1990 to 7,000 in 2003, a level which the Japanese market is currently revisiting in this crisis. The market hasn't shown any real recovery and has touched the 18,000 points level briefly in 2007.

The Japanese stock market is the stuff of nightmares for all long term investors and demonstrates the significance of geographical diversification.

The big question is: are we witnessing the Japanese banking crisis all over again in the US and western economies? Will the market slump for decades before showing signs of recovery?

The intuitive answer would be: no. No crisis is like another. Still, as I'm constantly considering buying into these levels of stock prices I thought a comparison of the two will prove interesting.

The Japanese Banking Crisis of the 1990's: Sources and Lessons

In January 2000 the IMF (International Monetary Fund) published a paper titled "The Japanese Banking Crisis of the 1990's: Sources and Lessons" which examined the characteristics of the crisis. Hopefully this paper would be able to shed some light onto our current situation.

The paper traces the roots of the crisis to accelerated deregulation and deepening of capital markets without an appropriate adjustment in the regulatory framework as well as to weak corporate governance and regulatory forbearance. Sound very familiar doesn't it?

The favoring economic conditions of the late 1980's Japan which included above-trend economic growth and near-zero inflation resulted in a considerably lower risk premium for the country and a marked upward adjustment to growth expectations which in turn boosted asset prices and fueled rapid credit expansion during the period. Still familiar…

Those who forget history are bound to repeat it. The exponential growth in the derivatives market along with a weak, passive and partial regulatory framework played a major part in the current crisis as well. Weak corporate governance as demonstrated in weak risk management and lack of internal controls proved fatal again.

The foresight of the IMF paper is rather remarkable: "The Japanese banking crisis serves as a warning that such a crisis can befall a seemingly robust and relatively sophisticated financial system".

The question regarding the unusual length of the crisis is answered to some extent
According to the IMF's paper weak corporate governance and regulatory forbearance stifled any incentive for meaningful restructuring of banks as well as their corporate borrowers.

Forbearance and restricting of bad loans – The structure of the banking system in Japan is different an important to understand as it contributed to the length of the crisis. Main banks in Japan act as quasi-insider monitor of the borrowing firm and as a mediator when borrowers fall into stress. This is advantageous as the monitoring costs are lower due to scale advantages of information on borrowers. Unfortunately, these main banks were reluctant to admit they had failed in identifying bad loans and began restructuring them, including the unpaid interest in yet another credit given.

By restricting non-viable loans banks actually increased the amount of problematic credit issued in the market. The end is obvious.

Capital Base - To salvage their deteriorating capital base banks issue more subordinated debt in higher returns to institutional investors thus further increasing the exposure to bad loans throughout the market (always suspect high returns). Furthermore, banks looked to tap unrealized capital gains to increase capital base, thus selling their stock and bond holdings and real-estate.

Weak corporate governance – The ownership structure and the board of directors' composition created little in the way of motivation for sound corporate governance. Owners had been dependent on the credit issued by banks and the boards of directors were comprised of former employees which were expected to hand over the board sit to other employees at the end of every term as a sort of bonus for the years worked at the bank.

Bank management was not under pressure to maximize profitability and returns and the absence of the necessary checks and balances meant no incentive for proper restricting or dealing with problems.

Regulatory weakness and forbearance – It is argued that the strategy of the government, postponing in dealing with the problems, actually raised the fiscal cost of the final resolution of the banks.

The authorities did very little in the way of arresting the decline in the conditions of the banking systems up to 1995. Regulators feared public panic in light of the strong measures needed to salvage the banks which grew in light of the lack of insurance on deposits.

Again, the IMF paper is amazingly insightful: "By giving rise to moral hazard problems, regulatory forbearance and "too big to fail" doctrines can lead to "gamble for resurrection" which often weakens financial institutions further".

Interest rates in Japan have been very low over the past decade and the economy is stagnant. Are we facing the same market conditions?

Conclusions for the current crisis

I felt calmer after reading the IMF paper and writing the aforementioned. It seems both crises have similar characteristics from a quick glance but a deeper examination proves the two are also different.

Regulators world-wide, I'd dare say under the leadership of Bernanke, seem of have learned and implemented the lessons in full. Lehman brothers was a mistake but no one could have foresaw it at the time (it was important to let Lehman fall from the moral hazard perspective on things). Government interventions are enormous and central banks are very attentive to the markets.
Furthermore, corporate governance may have played a part in this crisis but it was lack of adequate risk management and greed that were at the root of the current fall, not forbearance, which is somewhat comforting. Greed can be associated with economic cycles and will give way to prudential management every other cycle.

As far as restructuring and bad loans are concerned banks did delay some write-offs but we are also witnessing the biggest losses in the history of the world which surprisingly serve as a comfort.

The big questions of how much more financial waste is buried deep in balance sheets of financial institutions will remain unanswered but hopefully this crisis will be resolved in less than a decade.

Nationalization of banks, including the biggest two, may be very unpopular but it seems there isn't much choice in the matter and in that case earlier is better as the Japanese example illustrates.

The US market has defiantly had a lost decade as all major stock indices are revisiting levels they hadn't seen for 13 years. Still, perhaps this is an opportunity of a life-time. I, myself, am becoming more and more agitated and I do believe I will buy my way back in the markets in the near future. As I promised before I will update on my decision on this blog as it may be an interesting test case for the long-term.

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