September 19, 2012
Posted by Eddy Elfenbein on September 19th, 2012 at 6:20 am

Missed Opportunities Stoke Skepticism in EU Chiefs’ Crisis Fight

Euro-Region Construction Output Fell for Second Month in July

BOE Unanimous on QE Amid Divisions on Need for More Stimulus

BOJ Eases Policy As Japan’s Recovery Prospects Fade

China Stocks Rise First Time in Three Days as Gold Miners Rally

American Real Estate Investors Seek Opportunities in European Debt Crisis

Czech Liquor Ban Hurts Pernod, Ahold as Search Drags On

Oil Drops for Second Day on Saudi Action, FedEx Outlook

An Enigma in the Mortgage Market That Elevates Rates

Yahoo Closes $7.6 Billion Deal With Alibaba Group

Modest Market Return By Ex-Bankrupt Japan Airlines

Inditex Profit Beats Estimates as Revenue Growth Accelerates

Heineken Says Thai Billionaire Supports Its APB Offer

Joshua Brown: The Three Costs of QE3

Roger Nusbaum: Should Anyone Buy MLPs Yielding 19%?

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The Fed Has Been Tightening
Posted by Eddy Elfenbein on September 18th, 2012 at 12:46 pm

If you’re curious about why the Federal Reserve did what it did last week (and it caught me off guard as well), this chart might shed some light. This is the real effective Fed funds rate, meaning it’s the overnight interest rate set by the Federal Reserve adjusted for inflation.

As you can see, the real Fed funds rate has been rising in the past year. Of course, it’s gone from negative numbers to less negative numbers but the effect has been a tightening from the Fed. Interest rates have stayed where they are, but inflation (and this is headline CPI, not core) has trended downward. When rates stay the same and there’s disinflation, that’s an increase in real rates.

Morning News: September 18, 2012
Posted by Eddy Elfenbein on September 18th, 2012 at 6:19 am

Europe Banks Fail to Cut as Draghi Loans Defer Deleverage

ECB’s Coene Says Widening Spreads May Force Spain to Ask for Aid

In Greece, Restlessness Amid a Push for Cuts

Oil Falls To $113, Extends Slide

Defining Bernanke’s New Fed Target

Morgan Stanley Infrastructure Fund Hit By Volcker Rule

Apple Reaches $700 as IPhone 5 Shatters Sales Record

Groupon Falls as Expenses Mount Amid Daily-Deal Fatigue

Lowe’s Pulls $1.8 Billion Bid for Rona

Lenovo Makes First Software Buy to Expand in Cloud Computing

US HOT STOCKS: Office Depot, Tesla, Cliffs Natural Resources, AMN Healthcare

Dole Food Sells Two Businesses To Itochu For $1.7 Billion

Success of Crowdfunding Puts Pressure on Entrepreneurs

Edward Harrison: More On Government Tax Coercion Versus Fiat Money Liberty

Jeff Miller: Weighing the Week Ahead: Higher Hopes for Housing?

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The Missing Risk Premium
Posted by Eddy Elfenbein on September 17th, 2012 at 11:17 am

Imagine if there was a well-established scientific principle that was taught in schools, had won Nobel Prizes and was accepted across-the-board by experts, yet it was completely and totally wrong.

While this may sound far-fetched, this is the basis of Eric Falkenstein’s new book, “The Missing Risk Premium,” and he makes a convincing case.

Instead of science, Falkenstein looks at economics and argues that the “risk premium,” the reward for investors who shoulder risk, does not exist. This isn’t small potatoes he’s taking on. The risk premium stands front and center in the world of financial economics, and Falkenstein shows us that there’s very little empirical evidence it even exists.

We’ve long known that stocks have beaten bonds over the long run. So academics attempted a model to explain this fact. Their model says that the reason why stocks have beaten bonds is due to risk. Of course, they’re just slapping the name “risk” on to something better described as “that which we do not know.” It’s like calling a black hole “Cleveland.”

The model further states that risk can be quantified and the more of it you take, the better you’ll do. So one would expect that stocks with higher risk should do better than stocks with lower risk. But that’s not the case at all. In fact, stocks with the highest risk do the worst, and stocks with the lowest do the best (Falkenstein is a proponent of minimum volatility investing.)

Just because the measurement of risk explains the gap between stocks and bonds, when applied to individual stocks, it says nothing. Falkenstein goes beyond the world of stocks and looks at several areas where there’s no payoff in taking more risk, or the payoff is actually negative.

I think the example of horse racing probably explains this best. Researchers have found that betting on the long-shot has had the worst payoff. My guess is that in any given race, the long-shot will draw interest from bettors who simply want to bet on the long-shot, no matter how good the horse really is. Betting and winning on the favorite may offer a higher payout (losing money somewhat slower), but it’s not as much fun at hitting the rare long shot. This is what probably draws many investors to obviously overpriced risky stocks. They simply want to be in the game, and they’re willing to ignore the numbers. The lottery is the same way.

What caught my attention is that one of the few areas where a risk premium does appear to exist is at the short end of the yield curve. My guess is that what’s happening is that the characteristic of the asset takes on an over-sized image in the mind of investors. As a result, they’ll over pay for a long shot simply because it’s the long shot. Or they’ll overpay for a risk-free asset simply because it’s risk free. This only works at the extreme and going half way won’t get you half the results.

Some of these concepts Falkenstein covered in his first book, Finding Alpha. This book, however, is much shorter and less technical. Regular readers of his blog (Falkenblog) will also surely recognize many of these arguments.

One of the most eye-raising aspects of the book is where Falkenstein discusses the many small losses that individual investors suffer between the stock gains they see reported on CNBC, and the returns they get. Investors are constantly dinged by things like bad timing, transactional costs, bid-ask spreads and taxes. Once you throw in variables like survivorship bias, Falkenstein says that the historical databases we have return bare little resemblance to what made its way towards investors’ pockets. This topic alone could serve as a useful book.

Falkenstein does say, and I’m inclined to agree, that a risk premium exists between stocks and bonds exists but only for the highly-efficient investor. My guess is that the equity risk premium is probably between 1% and 2% which is far less than what’s accepted by many economists.

Falkstein’s meta-thesis is that investors aren’t greedy; they’re envious. In other words, they don’t simply want the most they can get. They want more than their neighbors. Once you adopt this frame of reference, it undermines the idea that greater wealth can be purchased with greater risk.

My only criticism of The Missing Risk Premium is that this is a self-published book, and the editing is somewhat sloppy. Also, some language explaining difficult concepts is unnecessarily convoluted. Still, the argument presented is strong and clear and will hopefully convince the world that better returns aren’t paid for with pain.

The Stock Market Opens With Week With a Sluggish Start
Posted by Eddy Elfenbein on September 17th, 2012 at 9:37 am

The stock market looks to open flat to lower this morning. Stocks, of course, have had a good run since Ben Bernanke’s move last week. Over the last four trading sessions, the Dow has added 339 points.

The bond market is, once again, not pleased with Spain. After some squabbling among finance ministers, yields on the 10-year Spanish bond rose to its highest level in four months.

Bloomberg picks up this cutting quote from Joachim Fels, the chief economist at Morgan Stanley in London: “Experience suggests that just as day gives way to night, improvement gives way to policy complacency, which is then followed by renewed crisis.” That pretty much sums it up.

The major economic report this morning showed that the Empire State Manufacturing Index fell to its lowest point in three-and-a-half years. As the name suggests, this covers economic activity in the State of New York. The one bright spot in the report is that the outlook for the future improved greatly since August.

For reasons not immediately clear, Occupy Wall Street has pledged to disrupt the morning commute for many Wall Streeters. Today is the movement’s one year anniversary.

Morning News: September 17, 2012
Posted by Eddy Elfenbein on September 17th, 2012 at 6:19 am

European Squabbling on Euro Crisis Solution May Test Rally

Draghi Euro Humbles Thought Leaders Seeing End of Union

Indian Rates Held Steady Despite “Big Bang” Reforms

German Banks’ Funding Boost Drives Global Loan Rebound

Istanbul Aims to Outshine Dubai With $2.6 Billion Bank Center

U.S. to File W.T.O. Case Against China Over Cars

The Crude World of Middle East Oil

Stocks, More Than Housing, Seen As Initial QE3 Winners

Probe Focuses On JPMorgan’s Monitoring Of Suspect Transactions

Buffett Style Fashions Berkshire’s Foreign Deals

Hennes & Mauritz Sales Miss Estimates After August Heatwave

Billionaire Arnault’s LVMH Amasses EU4 Billion in Belgium

1 Year On, Occupy Is In Disarray; Spirit Lives On

Howard Lindzon: What does a Market TOP Look Like…Not [Friday]!

Phil Pearlman: Shrinkologicals: Who Is Really Panicking?

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The Market’s P/E Ratio Is Lower Now Than It Was Most of the Time from 1991 to 2010
Posted by Eddy Elfenbein on September 16th, 2012 at 8:17 am

One of the paradoxes of this market is that stocks have climbed higher even as earnings estimates have come down. Consider that the S&P 500’s earnings multiple is up nearly 30% since the market’s low nearly one year ago.

I think part of the reason for the increased valuation is that the economic uncertainty has started to fade. The Federal Reserve’s move last week probably helped clear up some of that uncertainty.

What’s interesting is that despite the higher valuations, the S&P 500’s Price/Earnings Ratio is still lower now that it was at any point from March 1995 to October 2008. And except for some brief periods, the market’s P/E Ratio is currently lower than it was during the vast majority of the time from 1991 to 2010.

Fed Admits Up Until Now U.S. Has Just Been Coasting Off Money From ‘Avatar’
Posted by Eddy Elfenbein on September 15th, 2012 at 12:13 pm

‘We Spent It All’ Reveals Bernanke

From The Onion:

WASHINGTON—Addressing the nation’s finances at a major economic conference Friday, Federal Reserve chairman Ben Bernanke acknowledged that for the past three years the United States has been scraping by on the revenue generated by the 2009 sci-fi blockbuster Avatar. “By circulating $2.8 billion through the economy in gross box-office receipts alone, the cash from Avatar has been the only thing keeping America’s head above water,” said a solemn-faced Bernanke, adding that when money from the theatrical release ran dry, DVD sales had been able to pick up just enough slack to keep the United States solvent for another year. “We had hoped the Avatar money would see us through the end of 2012, but at this point we’ve blown through all the revenue from toys, clothing, video games, and book tie-ins, and it appears we are now headed over the fiscal cliff.” With a sequel not expected until 2015, Bernanke called for an emergency rerelease of the film “in IMAX 3-D with bonus scenes” in order to prevent the United States from defaulting on overseas loans.

Seagull Steals Camera
Posted by Eddy Elfenbein on September 15th, 2012 at 6:34 am

UnitedHealth to Go in the Dow
Posted by Eddy Elfenbein on September 14th, 2012 at 12:05 pm

The keepers of the Dow just announced that UnitedHealth Group ($UNH) will take the place of Kraft Foods ($KFT) in the Dow Jones Industrial Average. These changes aren’t made very often.

What’s interesting to note is that Kraft has mostly been a market performer but UNH has not. The Dow is going in a different direction and this will increase the volatility of the index.