The Investment Scientist

Let me first define the term “small cap value premium.” It’s an observation (and indeed historical fact up until about five years ago) that small cap value stocks outperform large cap growth stocks in a rather consistent manner. 

In academia, there are two theories attempting to explain it: 1) risk-based and 2) behavior-based.

The risk-based theory was pioneered by Nobel winner Eugene Fama, who argued that small cap value stocks are inherently riskier than large cap growth stocks, thus they deserve higher returns to compensate for higher risks. 

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My long-term readers will remember that since I started writing investment missives, I have always advocated small-cap value investing. That is, holding a broadly diversified portfolio but with a weighting tilt towards small-cap value stocks. 

Up until 2014, the historical evidence is overwhelming. Literally, since there have been stock market data, looking at rolling ten-year periods (see chart below,) there have been only two ten-year periods when small-cap value stocks under-performed large-cap growth stocks, ending in 1998 and 1999 respectively. These ten-year periods corresponded to the dot-com tech-stock bubble in the US.

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I wrote this article in 2007. It’s every bit as valid today as 14 years ago.

I am an amateur pilot. I remember vividly an episode that happened during my training a few years ago. That was a very windy day. Up to that point, I had only experience flying in calm weather. As soon as my Cessna took off, I immediately felt the difference. My plane was tugged and pulled in all directions by crosswinds. I felt like I was losing control of the plane, and fear swelled up from the bottom of my spine to the top of my head. I sat stiffen in the pilot seat and my sweaty palms grabbed tightly at the control handles like a sinking person grabbing onto a straw.

My trainer sensed my tenseness and she asked: “Are you OK?”. Not willing to acknowledge my fear, I asked her instead: “Is it more dangerous to fly in turbulent weather like this?” The trainer smiled and said: “It is not more dangerous to fly in turbulent weather. The plan was built to withstand any turbulence. But occasionally, an amateur pilot would lose his cool and do something stupid. That’s the real danger.

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I promised to continue the GameStop story so here I am. Let me first explain why the broader market dropped about 3% to 4% while the GME frenzy was going on. Remember in the last article, Melvin, a name I will use to denote all the hedge funds that shorted GME, needed about $1.3 billion when GME prices rose from $20 to $30. When GME prices shot up to $420, Melvin needed $55 billion to meet the margin call. Where would they get the money? Well,  they could sell other stocks they hold.  This mass liquidation led to a small drop in the market. Should long-term investors worry? The answer is no, since a liquidity shock like this has no lasting effect. But the saga does reveal a flaw in the system that we weren’t aware of before. More about that later. 

Now in this pitched battle between the retail traders centered around Wall Street Bets and the hedge funds, I am afraid this will end badly for the retail traders. Yes, a few of them may benefit handsomely, turning $50k into $20mm as some of the stories go, but the majority of them who joined the battle when prices crossed $200, $300, and $400 may lose everything. In the end, prices will come back down to the stock’s fundamental value which is likely in the single or low double digits. After all, Melvin was not stupid.

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Before I tell the story, let’s get a few concepts clear.

Short Sell (short) means selling shares you don’t actually own. Instead, you borrow them from the brokerage to sell, but you have to buy them back at some point in the future, hopefully at a lower price, to pay back the brokerage shares you owe. To guarantee that you have the money to buy back shares you owe at all times, the brokerage requires you to have a maintenance margin of 130% of the value of the shorted shares to keep the position open. If you fall under the margin requirement, you will get a margin call to post additional money. Should you fail that, the brokerage will close your positions. This is done by buying shorted shares in the market using your money in the margin account. This forced action can cause a short squeeze. I will give you the definition with an actual example of GameStop (GME).

Just two weeks ago, GME was being traded at around $20. Some big hedge funds like Melvin Capital (Melvin), thought it should be worth only $5, so they began to short the stock. At one point, the short interest ratio, the number of shorted shares relative to the number of outstanding shares, was 140%. Since GME has about 70 million shares outstanding, Melvin shorted nearly 100 million shares of GME. Apparently, a portion of those shares was borrowed and sold twice.

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In July of 2007, I attended a special send-off party for then Fed vice-chair Larry Meyer. As part of the program, we all listened to him spill his thoughts about the economy at the time. You can read my note titled “Larry Meyer: Diminishing Risks …” here.

He essentially saw the risk of a recession diminishing. When asked when he thought the next recession would be, his answer was “not within in the next two years.”

Shortly after his talk, the subprime mortgage company, Countrywide Financial, collapsed. Seven months later, Bear Stearns collapsed, followed in a few months by Lehman Brothers. By the end of 2008, we were already in the depths of the worst recession since the Great Depression. Larry Meyer surely did not see that coming!

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

Twitter: @mzhuang

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