Author Archive
How to Set Effective Stops?
Posted on: June 24, 2007
The title is a question posted to me, the following is my answer.
I don’t use stops, there is not any evidence that there are effective stops. (By evidence I mean rigorous and peer reviewed academic research.) To protect against downside risks, I use an “ex ante stop”. OK, this is a term I make up on the fly. What I mean is that I only invest in stocks with P/B less than 1.3 where P is the market value of the stock and B is the book or accounting value of the stock. Presumably, the market value of a stock can not fall below its book value in equilibrium. (It does not work that way all the times, but it works most of the time.) By investing in these type of stocks, I limit my potential losses to less than 25%. Comparatively, S&P 500 stocks have an average P/B of 4.7, which means the average stock price needs to fall over 75% before reaching the average book value. Nasdaq stocks have an even higher average P/B of 8.6. In summary, investing in low P/B stocks is a much more effect way (with a mountain of academic research to back up) to limit downside risks.
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Stock Market Seasonality
Posted on: June 16, 2007
Does the stock market have seasonality? Well, if you have abode by the old investment adage “buy in November and sell in May”, you would have done quite well (if you don’t count taxes and transactions costs). This is because stock gains in November through April have typically been stronger than May through October for reasons yet unknown to mankind.
The Stock Trader’s Almanac has demonstrated this by tracking what would happen to a $10,000 investment in the stocks that make up the Dow Jones industrial average. Over 56 years, this money invested in the Dow stocks in the “best six months” and then switched to fixed income in the “worst six months” grew to $544,323. But if the money invested in the Dow in the “worst six” and then switched to fixed income in the “best six” would result in a loss of $272.
Stock market seasonality is not a unique American phenomenon. A scholar at Erasmus University Rotterdam by the name of Wessel Marquering did a rigorous study of the seasonality effect of 5 major stock markets in the US, UK, Germany, Netherlands and Belgium. He found that the stocks perform better in “winter” season than in “summer” season in all 5 markets (see chart).
How can investors benefit from the seasonality effect? The short answer is “Not much.” Surely one can follow the strategy to “buy in November and sell in May”. This strategy sounds tempting in theory, but jumping in and out of stocks forces the investor to pay transaction costs and short term capital gain taxes. These costs would be more than make up for whatever benefits the strategy might bring about. Using the example referenced above at the Stock Trader’s Almanac, the total capital gain taxes adds up to about $159,000, which is much more that the $272 saved! Further more, I haven’t accounted for the transaction costs yet. Unfortunately, most investors would trade stocks and funds without much regards to the transaction and tax consequences.
Although the seasonality effect can not be exploited directly, the awareness of which could make the investors mentally prepared for the more volatile summer season. My suggestion to you is: stay put, and prepare for a bumpy ride.
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The title is a question posted to me. The following is my answer.
The most important thing to look for in a broker is not the explicit commission rate it charges, but the quality of its execution. In the Celent’s execution ranking, there is a $0.3 per share difference between the best execution and the worst execution. If you buy 1000 shares of stocks, that adds up to $300 difference. My own company, MZ Capital, uses Fidelity. It ranked #2 in the chart. I wonder where would Zecco.com be in the chart? One way a zero commission broker can make money is to channel your trades to a particular market maker instead of finding you the best execution. It is possible Zecco.com is doing that. If that’s the case, then Zecco.com would save you a nickel upfront, but would cost you a bundle in the execution.
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An Overdue Correction
Posted on: June 5, 2007
Yesterday morning, I read the news about the overnight 8.6% drop in Shanghai Stock Exchange Composite Index (SSEC). As I just finished the reading, I got a call from a client of mine who just returned from a trip to Shanghai. Here is what she told me. While she was in Shanghai, her brother, who was (and mostly likely still is) knee-deep in the stock market, told her to dump all her stock investments in the US and move her money to Chinese stocks instead. She was very tempted. Then she got on the flight back to the US, took a long sleep, and got a call from her brother. In addition to making sure she is safe and sound, he also told her that he had just lost 50% of his money in the stock market correction. What a difference 24 hours can make!
Just 20 days ago, I wrote “The unbearable lightness of Chinese stocks“. The article was to make a case that there is a bubble in the Chinese stock market. Chinese investors had the blind faith that the government would not let the market fall leading up to the 2008 Olympics, which will be in Beijing. By then the bubble would be so big, the repercussion of its bursting would be in the same magnitude of the Great Depression. Shortly after I wrote that, 10 days to be exact, Alan Greenspan came out with the same warning. (See the BBC report here.) Apparently, some Chinese officials took heed of Greenspan’s warning and the “stamp” tax for stock transactions was promptly raised to 0.3% from 0.1%, ostensibly to stamp out stock flipping. The action also sent a signal to the market that the government would not necessarily support stock prices leading up to the Olympics. In a country where government intention is still paramount, that signal took the wind out of the sail of the stock market, at least for the moment.
Since the tax hike, SSEC has corrected close to 20%. This is well overdue. As a matter of fact, the sooner the air is taken out of the bubble, the better. A prolonged correction of another 20% might bring some balance to the market and some sense to the investors. Should the market recover lost ground within one or two months, that would be a bad sign. We might have to steel ourself for an eventual 70% to 80% crash!
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On a recent air trip to China, I found myself sitting next to a Japanese. As our conversation turned to real estate, I opined that the Japanese real estate market had finally turned the corner after 16 years of falling prices, and it might be a good time to buy. He immediately disagreed with and went on to give me a litany of reasons why the Japanese real estate prices would keep on falling. His reasons include that no Japanese nowadays would think that the real estate prices will ever go up again.
In 1991 when the Japanese market was at its peak, banks were lending to home buyers without any down payments, people were taking out interest only loans, and everybody was expecting the real estate prices, already the most pricey in the world, to keep on rising. Does that sound familiar? Was it like what we saw two years ago in some hot markets in the US?
The excess in their real estate market took the Japanese 16 years to unwind. During this time, their real estate prices fell by an average of 60%. Counting inflation, real values have fallen by more than 80%.
Could the US real estate market experience a long recession like what had happened in Japan? I can’t give a definite answer. However, judging by how relatively optimistic people are with real estate, I believe there is still a long way to go before the market turns around. I think when I don’t see real estate investors around me, when I don’t see people talking about real estates as the best investment, better yet, when I see people in the US speak like the Japanese I met on the trip, I can then reasonably conclude the bottom has been reached.
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The title is a question posted to me by email, and the following is my answer.
In 2003, for a very short period of time, I achieved that type of return.
That was when Sarbane-Oxley Act went into implementation w.r.t. insider trading reporting. Before the implementation, company insiders (CEO, COO, CFO etc) had two month time to report their inside trades, and by paper; after the implementation, they had to report within two days electronically. At that time, I created a program to query the SEC insider trade database. As a result, I was able to follow the insider purchases as soon as they were reported. One or two weeks later, when the insider purchase news hit the wire (Dow Jones or Wall Street Journal), the stock prices would jump and I would exit with a tidy profit. At one point, I was making 30% monthly returns. In less than 6 months however, websites were popping up left and right offering real-time insider trading information, and my strategy became obsolete.
The point I want to make is: if there is a way to make 10% monthly return, it won’t last very long if there is no barrier of entry. That’s why in my current investment management practice, I do something others can not easily mimic.
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On May 13th, the Shanghai Stock Exchange Composite Index (SSEC) for the first time crossed the 4000 level. In just this February, when the index crossed the 3000 level for the first time, it promptly dropped 9%, causing a worldwide correction in stock prices. Who would have thought, in the short 3 months that followed, it would have crossed another milestone.
Indeed the whole country of China is swept into stock investment hysteria. By the end of April, there were 96 million brokerage accounts in the country, three times the number there were last April. New brokerage accounts are opened at the rate of 1 million every 3 days. If you get into a taxi in Beijing or Shanghai, you will likely get a free lecture on stock investment along with the ride; street vendors will offer you free stock tips as you shop and even grandmas and grandpas can’t resist dabbling in and out of stocks with their life savings. (The picture below is a grandpa before a screen of stock prices. The coloring convention is the opposite of the US. Red means profits and green means losses.)
Miracle stories abound as well. There are the usual overnight success stories of somebody (names published in newspaper) who made over a million dollar in one day. There are even stories of chronically sick patients who recovered after winning big in the market.
These anecdotal stories of mania are worrisome enough, they are further corroborated by the unsustainable high average P/E ratio of over 50 in the Chinese stock market.
That’s why I see dark clouds gathering even while many people still see green. Stock market crashes of significant magnitude (> 40%) are never caused by economic problems alone, they are usually preceded by a period of unbridled optimism. The optimism in China now is at a hysterical level and it is unlikely to abate leading up to the 2008 Olympics. What I am afraid will happen is that after the 2008 Olympics or shortly before that, smart money will exit the market. A massive exit could trigger a run in the Chinese market that would spread globally.
What can we in the US do about it? First, don’t panic. The ship that is the US financial system is very solid and resilient, storms (even one coming out of China) will shake it but will not sink it. Second, it would be prudent to raise the cash level of your investment leading up to the Olympics. In case you don’t know, the opening ceremony will be on 8/8/2008, still 445 days away. Third, it is wise to invest in defensive stocks.
As a matter of fact, it is always wise to invest passively.
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