The Investment Scientist

In June of 2007, I wrote my first article on stock market seasonality. There I wrote that there was a rather persistent and robust stock market phenomenon that the market tended to perform well in the winter months than in the summer month. By “persistent” I meant that it lasted for decades in the US market, by “robust” I meant that the phenomenon showed up in other stock markets as well, as can be seen by this chart. 

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I admit this is not exactly an investment piece. However, if you continue to read, it might yet turn out to be your best investment. Study after study has shown that what determines life satisfaction is not money, but relationships you are able to build with other human beings. Come to think of it, our lives are but tapestries of woven human connections. The stronger the connections, the happier and resilient you are. And what better way to strengthen your most important relationships than gifting meaningful songs during this holiday season. You can get a song custom-made for your loved ones on this website:

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I started writing the Investment Scientist newsletter in May of 2007, and I think it would be fun to review my old articles. First of all to see if I was right back then, and if I wasn’t completely right, to see what I would write differently with the benefit of hindsight.

In May, 2007, I wrote three articles. In the first one, “The Unbearable Lightness of Chinese Stocks,” I made the statement that there was a huge bubble in the Chinese equity market and investors should stay away. In fact during that time, many (American) clients wanted me to invest in Chinese stocks, so much so that they said the reason they signed up with me was they thought I would help them do that. At the time I wrote it, the Shanghai Stock Exchange Composite (SSEC) just passed 4000, now it stands at 3412. After 15 years, it is still 15% below the level at the time. I lost a few clients for steering their money away from Chinese stocks, but in retrospect, I am glad that I made the right call. 

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Some of you know that I went back to school in 2019. Specifically, I was accepted into the EMBA program at Oxford University Said Business School. The program was interrupted by the pandemic in April when I still had about a quarter of classes to finish, so I postponed it for a year. Now 2020 is coming to a close and the Dow has recovered all its losses. It’s a good time to reflect on how my studies there changed the way I invest. 

The most important thing I learned is about how central banking works, specifically how money is created. I came to understand that terms like “central bank balance sheet expansion”, “central bank asset purchases”, “quantitative easing” all mean one thing: printing money. I also came to understand that the amount of money the Fed releases into the economy to a large extent really determines asset prices. This understanding helped me make the right call during the stock market panic in March and April. 

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This is the opening story of my book “Physician Wealth Management Made Easy” published nearly three years ago. It was briefly the Amazon Bestseller in the physician category.

Twelve years ago, I got a call from my internist. “Michael, I am afraid I can’t be your doctor any more,” he said, right after hello. It was an odd opening, and his voice sounded strained. Doc Johnson and I had always been on friendly terms. Had I done something wrong to offend him?

“What’s going on, Doc?” I replied. “Is it .. is it my insurance?”

“No, Michael,” he said and took a deep breath. “I’ve been diagnosed with pancreatic cancer. And …” he paused again. “I have only a few months to live.”“Wow, that’s terrible, Doc.” I didn’t quite know how to go on and ask, “OK, but why did you call me? I am no doctor. What can I do about it?” So I just waited on the line.

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nfc-android.jpgNear-Field Communication  (contactless) payment either through your smart phone or through your credit card chip has revolutionized commerce.  Instead of swiping or inserting your credit card, waiting for a printout and signing your name, you can just wave your phone, wait for the beep and go. But just a moment ago, I learned the hard way that this technology is not secure.

I went to Giant to buy a bottle of Diet Coke. I do that because I know soda is a bad habit so I don’t keep it in my refrigerator. When I want to drink Coke, I will drive to the nearby Giant and buy only one.

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Co-founders are fighting so much that nearly half are forced to leave the startup -

There are three major factors that drive the stock market: economic fundamentals, investor sentiment and the Fed. Lately the Fed’s role has become more and more prominent. It’s thus very important to be able to read Fed’s moves correctly. For instance, what does it mean when The Wall Street Journal reports “Fed Weighs Abandoning Pre-Emptive Moves to Curb Inflation.”

Let me show you how I read the Fed’s moves since the onset of the Pandemic …

On March 13th, as the Pandemic was picking up in the US, the Fed announced a $1.5T injection into the market. This prompted my newsletter article  “What Fed’s $1.5T Injection Means For The Market” when I wrote:

There are only three buckets into which this money “water” can go: 1) goods, 2) services and 3) assets. Do you think that over the next few months, we the people will consume more goods and services? Apparently not since we will all be hunkering down in our basements. The only place the new money can go is to purchase assets, meaning stocks, bonds, and real estate.

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1000x-1.jpgIn my last article, I wrote that the Fed’s actions were necessary to backstop the economy from sliding into another Great Depression. Now let’s talk about a few of the negative long-term consequences.

With so much liquidity sloshing around in the economy that is only half-opened, the only outlet is the financial market. That’s why we’ve seen a divergence of the financial market and the real economy. These two will have to converge at some point. When this happens, will we see hyperinflation? That is, the prices of goods and services are rising fast like they do for assets. In its communication, the Fed has signaled to the world that they don’t foresee any inflation in the next two years. If you read between the lines, it appears that the Fed does not see the economy returning to normal in the next two years, and during this time, they may print still more money.

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40397946-close-up-view-of-cash-money-dollars-bills-in-amount.jpg“Since the beginning of March, the Fed’s balance sheet has expanded by just over $3 trillion, with the bulk of it from central bank purchases of Treasuries and agency mortgage-backed securities.” This is a quote from a MarketWatch news piece titled “Fed’s Daly Defends $3 trillion in Asset Purchases …”

After my last newsletter article, you should understand that balance sheet expansion is just an economic jargon of money creation. Today I am going to give you three reasons why the Fed needed to “print” money to prevent a Great Depression scenario.

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Investor-Optimism-Fueling-Corporate-Bond-GainsThree days ago, the Fed announced that they will go directly to the corporate bond market to purchase $250 billion worth of investment-grade corporate bonds. A few of my newsletter readers asked me to comment on this, so here I am.

Basically, the Fed buying $250 billion of any securities can be seen as the Fed creating $250 billion of new money and injecting it into the economy. It really doesn’t matter whether these securities are treasury bonds, munis or corporate bonds. Munis are bonds issued by states.

So how does the Fed create new money?
The classical monetary theory posits that paper money must be backed by something valuable. Since 1974, the US dollar has no longer been backed by gold. For a long time (until 2008) it was backed by US treasuries. The Fed has a balance sheet. Let’s say by 2008, the economy needed $3 trillion to function. The Fed would create $3 trillion out of thin air and use the money to buy $3 trillion worth of treasuries. The Fed balance sheet would look like this : on the assets side, it shows $3 trillion of US treasuries, on the liabilities side, $3 trillion issued. Now the money is no longer considered to be out of thin air, since it is backed by treasuries that carry the explicit guarantee of the US federal government.

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Berkeley professor Terry Odean published an interesting paper in the Quarterly Journal of Economics in 2001 about how men and women invest differently. It was an empirical study based on stock transaction data in tens of thousands of accounts over a seven year period provided by a brokerage firm.

These investment accounts were either opened by a man or a woman, and were single or joint accounts. Thus there were four account types. An interesting phenomenon emerged from the study: the more a man is in control of an account, the worse the performance. (See net return vs benchmark.)

Here the benchmark is not any composite index, it is simply the return that resulted from no trades being made throughout the whole year. 

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Tax-Loss-Harvesting-Should-Investors-Believe-the-HypeOver the last few weeks, I have been busy 1) rebalancing – including increasing exposure to the digital platform economy I discussed in my past post, 2) migrating from mutual funds to ETFs because of the latter’s tax benefit, and 3) tax loss harvesting.

Today I am gonna discuss tax loss harvesting. So what exactly is tax loss harvesting? It’s basically realizing a capital loss while maintaining the same exposure. For instance, if in your portfolio, there is a US equity fund with a $30k loss, you can sell the fund to realize the loss and buy a substantially similar US equity fund to take its place. This way you maintain the same exposure but book an accounting loss of $30k. This maneuver is called tax loss harvesting.

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images (3)In my economics class at Oxford, I learned a very important concept: technology by and large manifests diminishing returns to scale.

When economists use the term “technology”, they usually mean the method of production, that is, taking labor and capital as inputs, and outputting something valuable. For instance, there is a method by which I deliver my financial advisory service, economists would call that technology. It’s a catch-all term.

Diminishing returns to scale simply mean the bigger you are, the harder it is to make money at the same rate. Take my little practice as an example. It’s just me and my assistant. It can’t be smaller, but it’s super efficient. If we were a 20 person firm, I can’t imagine how I would manage all these people who all have their different agendas and motivations. The firm may make more money in the absolute term, but on a per head basis, it wouldn’t  be as profitable as my little practice. That’s the essence of diminishing returns to scale.

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The Premium
The small cap value premium is a Nobel Prize-winning discovery about the stock market by Eugene Fama and Kenneth French. (Only Fama was awarded the Nobel Prize in 2013.) The original paper “The Cross-Section of Stock Returns” was published in the Journal of Finance in 1992. Using stock market data from 1963 to 1990, Fama and French found that small cap stocks outperform large cap stocks (small cap premium) and value stocks outperform growth stocks (large cap premium). Collectively, they are referred to as the small cap value premium.

Since the paper was published, many researchers have done out-of-sample studies and they found that this market feature persists in the data from 1928 to 1963, in the data from 1990 to as late as 2010, and even in foreign stock markets. So in academic jargon, this is a very robust feature of the market. (See chart below.)

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3__L3__001.pngToday the Oxford University Business School arranged a webinar in which my  macro-economics professor, Oren Sussman, explained to us the economic impact of the Coronavirus. I will summarize the key takeaways below. 

The capitalist system is characterized by periodic crises. The last one was the 2007 housing crisis. Even without the Coronavirus outbreak, we were on borrowed time. The long expansion since the last crisis was very much fueled by easy money from the Fed and imprudent fiscal policy from the federal government. As a result, the whole economy is overly leveraged (that is to say,  having too much debt.) An economy without too much debt is like a pond of water. A stone thrown at it will create ripples that will eventually dissipate. An economy with too much debt is like a pane of glass. A stone thrown at it can break the whole thing. Prior to the Coronavirus outbreak, our economy was already like a pane of glass. Read the rest of this entry »

240_F_119564777_rEkf9eOoPwdUrMeRlzSKmO6eKokHwbvd.jpgLet me start with my usual disclaimer that I can not predict the market. Like the similar article I wrote four weeks ago, this article is simply an exercise in which I think through possible scenarios for the market. 

When I wrote “Will The Stock Market Give Us a 30% Discount?” the market had already fallen 19%, and I was thinking through the scenarios under which it would fall through 30%. One of the scenarios unfortunately came true: some US states have lost control of the Coronavirus situation, and the market did drop all the way to 36% before recovering to 23% down as it stands now.

Now with Europe finally turning the corner and the rapid spread in the US beginning to decelerate, will the market discount disappear quickly or will there be more shoes to drop that could  cause the market to give us even deeper discounts? Could it hit 40% or more?

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

Twitter: @mzhuang

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