The Investment Scientist

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From the peak, Nasdaq is down about 24% and the S&P 500 is down about 14%. I am sure when you read your investment statement, you will feel queasy and wonder if you should stay invested. I think this is a good time to review my wardrobe theory of investment. Here is what I wrote in December 2018:

Treat your investment portfolio the same way you would treat your wardrobe…

For simplicity’s sake, let’s say you acquire your entire wardrobe from Neiman Marcus. If Neiman Marcus had an across-the-board 50%-off sale, would you throw up your hands in despair and say, “Darn it, my entire wardrobe just lost half of its value. I better sell it all at the flea market or I will lose everything?”

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When something seems too good to be true, it is often not true. But there is one exception in the financial world: I bonds. 

I bonds are federal government bonds sold to individual investors that pay a very high-interest rate that is linked to inflation. For instance, the current rate is 7.12%. On the first business day of May, the Treasury Department will announce a new rate that will be close to 10%. Some expected it to be 9.62%. Nowhere in the world can one get this high of an interest rate, guaranteed by none other than the US government.

So what is the catch?

Well, there is no catch, but there are some limitations.

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The US inflation numbers for March just came out – it’s 8.5%, another 40-year high. I am afraid that, with the Ukraine War still raging, inflation will get worse before it gets better.

Shortly after the Russian Invasion of Ukraine, the West adopted the “Nuclear Option” of economic sanctions – expelling Russia from the SWIFT system. SWIFT is the payment system that undergirds international trades. Now that  Russia is no longer part of this, it can not sell its energy and agricultural products to the world market. 

How Would That Affect Global Commodity Prices?
Russia is one of the top three exporters of the following commodities: oil and gas, wheat, maize, sunflower seeds, sunflower oil, and fertilizers. On average it accounts for about 15% of world supplies. When these supplies are pulled out of the global market, the price of these commodities will skyrocket as they already have. Since these are basic commodities, and many products use them as inputs. The price shock is going to filter through downstream products as well. 

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In the face of rising uncertainties and the prospect of persistent inflation, today I investigated the historical performance of stocks and gold relative to inflation. Here is what I found:

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Over the last few days, I have begun to sense that a number of my clients are worried since the S&P 500 has dropped 13% and Nasdaq, about 20%. 

I would like to argue, if you are going to worry about something, please worry about the inflation rate, which just went up to 7.9% in February even before Russia’s invasion of Ukraine. 

Why is inflation so much more damaging?
You could have kept your money in a safe, and yet you still lost 7.9% to inflation in one year. If this level of inflation keeps going for ten years, you will lose 79% of the value of your money. That’s basically a wipeout.

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Last Thursday when the news reported that Russia had just launched an invasion of Ukraine, the market opened down nearly 800 points. A client called to ask if we should move to safety, but I was able to persuade him to stay put. I did that without knowing that the stock market would end the day slightly positive, followed by the BEST rally since 2020 on Friday. Such is the unpredictable nature of the stock market. Today I am gonna show you, missing the best days of the market can be extremely costly

Below is research from JP Morgan that I found on the internet. You can see that between 1995 and 2014, the annual return of the S&P 500 is 9.85% if invested through the whole duration. But missing just the 10 best days would drop the annual return to only 6.1%. Missing the 20 best days would drop the annual return to 3.62%. Missing the best 30 days would further drop the annual return to only 1.49%. 

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Yesterday in a client progress meeting, the client asked me a question: “What do you think of crypto?” I usually get this question either when cryptos are rallying or crashing. As you may know, over the last three months, most cryptos have lost 50% of their value. In fact, I more or less alluded to this in my earlier newsletter. I wrote that in a Fed tightening cycle, the vanguard market will fall first. Decades ago, the vanguard market used to be the emerging market, now it’s the crypto market.

So what do I think of crypto? I have asked myself the same question, read a lot of books and white papers about it, and even took a full-length MIT class on crypto taught by Gary Gansler, who is now the SEC chairman. I have a good understanding of the technical aspect of cryptos, but I still can’t figure out the economic rationale of their existence and their sky-high valuations.

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Yesterday, when I had a lunch meeting with the chief scientist at Fannie Mae, our conversation quickly turned to inflation.

My view of that is more pessimistic than the Fed and most mainline economists. Somehow, these economists seem to have forgotten a basic economic tenet – the rational expectation theory. This theory, to put it in layman’s terms, basically says that on aggregate, what people expect to happen will happen. That’s why Fed officials have long been extremely careful about what they say that could change people’s expectations. 

Today’s Fed under Jerome Powell has been much less careful. Here are the three acts of the current Fed that have crushed the expectation that inflation will stay low and stable. 

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I had a blessed 2021! Here are the highlights.

1) Finished all my Oxford courses.

2) Produced a Showstopper improvised musical show for my Oxford classmates at Oxford.

3) Visited the Balkans, especially “the Bridge over Drina.” Learned about its fascinating and tortured history.

4) Took my kids to many Western European cities/towns.

5) Continued my hip hop adventure with Doug. Now I can more or less rap freestyle!

6) Started learning German. With help of a fantastic teacher Kat, I can now speak broken German.

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In my last newsletter article, I explained what tapering means and how that would affect the market. At the end of the article, I opined that the Fed’s leisurely pace of turning off the money spigot may not be enough to turn the tide of inflation.

It now appears the Fed agrees with me. The latest announcement from the Fed has dropped the word “transitory”, signaling its recognition that inflation is here to stay. Not only that, but the Fed’s taper timetable has been expedited. The original plan was $15B less money “printed” every month, with July being the month that money printing will come to an end. The new timetable is to end money printing by March. After that, the Fed plans to raise interest rates three times.

The Fed is the banker for banks. When the Fed raises interest rates, banks have less incentive to lend out money since they could easily make a profit by just parking their money with the Fed. This is the traditional way of reducing the amount of money in circulation. 

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Recently, Fed Chairman Powell signaled that the Central bank will begin the process of “tapering”, and in fact may speed up the process given the recent inflation reports. What does that mean? How would that affect investors?

A little bit of background
Since the onset of the pandemic, the Fed has engaged in “unlimited” quantitative easing, a euphemism for money creation. The money base has ballooned from about $4T to $7T. (T here means trillions.) In other words, about $3T worth of new money was created. As of right now, this process has not stopped. Every month, another $120B is being created. (B here means billions.) 

Where did all that money go?
This torrent of money is rushing into all manners of markets: stocks, bonds, commodities, real estate, crypto, labor and even our daily groceries, making all prices go up, though to differing degrees and extents. As investors, we all benefit from the Fed’s action, however, as consumers, we will suffer, if we are not already.

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Yesterday, a young tech worker from the West Coast signed up for my 2nd opinion review. He just had a very successful exit from an IPO, and is now sitting on $20mm worth of company stock, much of it capital gains. Morgan Stanley is pushing strongly for him to put his money into a QOF, and he wanted my view on that. 

I happened to have just written a paper on this topic for a Oxford Private Equity class assignment, so I have done some pretty in-depth research. Mindful that most people don’t have the patience to read a long essay like that, I will summarize my findings as succinctly as possible here. 

What is a Qualified Opportunity Zone (QOZ)?A QOZ is an economically depressed area that can’t attract investments on its own. The Tax Cut and Jobs Act of 2017 established this designation and certain tax benefits for investments into these areas.

What is a Qualified Opportunity Fund (QOF)?A QOZ is a private investment vehicle (in the form of a partnership or LLC) that invests in QOZs.

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I gained a lot from my Oxford experience. Some of the gains are for me personally, some of the gains are for my business, and yet others can help me better serve my clients. I would count the latter as my clients’ gains.

The biggest gain undoubtedly came from Professor Sussman’s macroeconomics class. There I learned all the intricacies of macroeconomics, including how monetary policy is conducted. The class helped me understand a language called “Fed speak.” For instance, in March last year, when the entire stock market was in a tailspin, the Fed came out with an announcement of “unlimited” QE. The me without the Oxford education would have not understood what that meant. But alas, after the macroeconomics class, I knew exactly what the Fed was planning to do and understood its implications for the market. Thus in the depth of market despair, I was confidently rebalancing my clients’ money into stocks. Sure enough, the market snapped back quickly and has been rising ever since. 

Back then I wrote a newsletter article where I informed you:

With this much liquidity, an equity market rally is almost certain …

You can read the entire article here, “Fed’s Unlimited Asset Purchases: What That Means for You and Me?

The second biggest gain came from a part of the microeconomic class. I understood micro far better than macro, but I still learned something new from that class. In the past, the consensus had been that firms manifest a decreasing return of scale. That means as firms get bigger, it’s harder for them to make money at the same rate. Thus smaller firms are usually more profitable and often give investors better returns over the longer run. 

However, the latest research has discovered that with the advent of the internet, some big firms achieve the so-called network effect. That is, the bigger they get, the stronger they get and the more money they make. Think of Facebook, Google and Apple. These types of firms achieve the so-called increasing return of scale unheard of before.

This led me to move a substantial chunk of my clients’ money into stocks with the increasing return of scale characteristics. My clients’ portfolios have benefited since. 

The Behavioral Finance class also taught me a lot. It didn’t really teach me anything new, rather it confirmed my belief that our behavior as investors is much more decisive than whatever investments we select. It feels good to get a stamp of approval from Oxford and I’d like to call that the third biggest gain for my clients. 

I have personally benefited from the clarity I gained at Oxford as well. Before I went, I wondered if I should turbo-grow my business to multiple billions of dollars with hundreds even thousands of clients. Now I have the answer. I will keep the business unique, focusing on serving a small number of clients very well. Instead of growing my business, I’d rather grow myself as a person. It is also the best way to grow my clients’ wealth by focusing on them!

Schedule a 2nd opinion financial review, buy my wealth mgmt books on Amazon.

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Last Saturday I completed my executive MBA study at Oxford. The whole thing actually started quite serendipitously. A client of mine who is a physician studied there and he liked it so much that he encouraged me to apply. Today I’d like to share some funny moments on my journey.

As part of the application process, I went to Oxford for an interview. I booked a student dorm room at Sommerville college, and when I checked in, I was mesmerized. The dorm room looked and smelled like it was right out of a Harry Potter movie. The adjacent canteen looked like the Great Hall at Hogwarts, with walls adorned with huge classical paintings of accomplished women alumni. 

That night I was the only resident in the entire building, and it didn’t take long for me to notice that the bathrooms were not marked by sex, and in fact there were no male bathrooms. Later I found out that Sommerville is the first girls’ college at Oxford and Margaret Thatcher herself graduated from there. 

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Last week I completed the Venture Capital class at Oxford, and I have at least two take-aways  I’d like to share with my readers. Today, let’s talk about SPACs since a few of you have asked me if we should invest in those, and before I had not felt qualified to answer the question.

What are SPACs?
The name SPAC is a shorthand for the Special Purpose Acquisition Vehicle. These are companies backed by famous investors/entrepreneurs (sponsors) that raise a sum of money via IPO then search for a private company to buy.

For venture-backed companies that want to go public, this is a great option since they don’t have to go through the IPO process – roadshows, book building, the whole nine yards. All they need to do is to sell to a SPAC. 

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This is an article I wrote fourteen years ago that was inspired by Daniel Kahneman’s Nobel Lecture “Maps of Bounded Rationality.” Here I will repost it without changing one word – I am proud of the evergreen nature of my articles. At the end, I will make a few additional comments in red that include new insights from the last fourteen years. 

Do you know that the top three one-day drops in Dow Jones happened in October? On the 19th of October 1987, Dow Jones fell nearly 23%, making the day the worst day in the US stock market history. It was followed by the 24th and 29th of October 1929, when Dow Jones fell 13.5% and 11.5% respectively, ushering in the Great Depression. These events are commonly remembered as the crash of 29 and the crash of 87.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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