REAL RETURN STRATEGIES IN PLACE OF BUY AND HOLD STRATEGIES.

WHY MAKE MONEY TODAY WHEN YOU JUST MIGHT MAKE SOME MONEY TOMMORROW?

The Author is a frequent critic of the “buy and hold” investment strategy. The buy and hold strategy involves buying stocks and/or mutual funds and holding them for long periods of times. Although the value of these investments will fluctuate, if you hold them for a relatively long period of time, they will grow in value. This investment approach, like all investment approaches, has both positive and negative aspects. Being polite, the Author will start with the positives of the “Buy and Hold Strategy”.

Positive Aspects of the “Buy and Hold” Strategy:
1. Low Transaction Costs. Since the strategy does not involve frequent purchase and sales of investments, the transaction costs are minimized. But with online brokerage services, transaction costs are usually minimal.
2. Eliminates Investor Propensity to “Buy High, Sell Low”. Many investors, because of lack of confidence or observed human nature, chase performance and buy investments at or near their peak. And they often sell when the price falls, missing the next rally.
3. Broker Convenience. Buy and Hold is simple for brokers to sell and support. The broker manages the client relationship, not the client’s money.
4. When the Markets are Bullish, the Strategy Usually works. Ask anyone who invested into the Secular Bull Markets of 1946 to 1966, or 1982 through 2000.

Negative Aspects of the “Buy and Hold” Strategy:
1. It Fails in a Secular Bear Market. As readers of this website know, the stock markets are in a Secular Bear Market cycle that began in 2000 and may run into the next decade. Secular Market cycles, Bear and Bull, run an average of 18 years. So we could be faced with low or no overall market returns through perhaps 2018.

“Buy and Hold” fails in a Secular Bear Market for two main reasons. First, you are holding a lot of stock in a Bear Market. If you tell a broker, financial planner, or mutual fund sales person that you want to invest for retirement or some other long-term goal, you will usually be advised to invest in stocks. You will be told that “over the long term”, stocks outperform other investors. That is true if your investment period includes a Secular Bull Market. But if you invested in 1966 and pulled out the money in 1982, your stocks under-performed other investments.

2. In a Secular Bear Market you are Often Stuck With the Wrong Stocks. You broker or financial advisor will also tell you that since you are a long-term investor, you should concentrate your holdings in growth stocks. Over time, these stocks will outgrow value stocks. Again, in a Secular Bull Market, growth stocks will out distance value stocks. But not in a Secular Bear Market. The investor gets the worst² (squared). He holds the wrong class of stocks in a period of time when he generally should he limiting his stock exposure.

A TRADITIONAL BUY AND HOLD STRATEGY CREATES A LOSE-LOSE SCENARIO IN THIS SECULAR BEAR MARKET.

If holding growth stocks for the long-term during this Secular Bear Market is a lose-lose proposition, what can you do that works? First, you must resign yourself that earning positive returns will take more work and still produce poorer results than you can earn during a Bull Market. Face the fact you will work harder and earn less. Think of it as your investments and your investing efforts being underemployed.

The proper strategy to employ in a Secular Bear Market is an Absolute, or Real Return Strategy. We want to make money year in and year out. We should find no comfort in the fact that our portfolio only lost 3% when the S&P 500 was down 5%. That is like winning a law suit but going broke paying legal fees.

Remember the lesson from the last post about negative returns and their effect on total returns? Negative returns are killers, especially in a Secular Bear Market. Even if you only squeak out three or four percent a year during the Bear Market, you will be making investment progress. You will be building, albeit more slowly, your wealth platform for the days when the Secular Bull Market is back. And remember, even within long Secular Bear Markets, there will be Cyclical Bull Markets that will provide you with nice returns over a short period of time.

The Author has provided some strategies in prior posts and newsletters. More cash, value stocks, high dividend stocks, and short investments when the markets are in confirmed declines. Gold and commodities may also have their place. In the next couple of posts, we will look at some ideas to move toward absolute return strategies.

FOR RIGHT NOW WE WILL HAVE TO TRUDGE ALONG IN THE RUTS IN THE DESERT OF THE REAL!

WOULD YOU LIKE YOUR RETURNS COMPOUNDED OR AVERAGED?

OH, THE VEXATIONS OF VOLATILITY.

Some readers may have heard a version of the following joke:

Bill Gates walks into a bar. He sits down next to the only other patron in the bar.
The bartender says: “Wow, you’re Bill Gates. You’re worth 40 million dollars!”
The other bar patron, a downtrodden looking fellow, tips his beer to Gates and says sardonically: “I’m worth about 40 bucks. That makes our average net worth 20 billion, 40 dollars.”

So much for averages. Averages can be misleading if there is not a meaningfully large enough sample on which to base the average. But in the finance and investment world, there is a bigger problem with averages. If an “average” return is based upon a series of values that are “vexed by volatility”, the average return is not what your account balance will contain. Highly volatile returns produce, over time, lower returns than less volatile investments.

COMPOUND INTEREST IS MORE INTERESTING.

Compound interest (or a compounded return) is when you earn interest on both the principal and interest you have already earned in the prior compounding periods. Let’s look at example:

You save money in a savings account that pays compound interest annually. You put $100 in the account and forget about it. The account pays 5% interest every year. At the end of the first year you earn $5 interest. So your account has $105.

Year Two. Your account earns 5% interest on $105 and totals $110.25.

Year Three. Your account earns 5% interest on $110.25 and totals $115.76.

And so on. There are formulas and tables for calculating compounded returns, but the concept is straightforward. A compound return is money you earn on the money you already earned.

THREE MUTUAL FUNDS ALL AVERAGING FIVE PERCENT OVER THREE YEARS. COMPOUND OR AVERAGE? VOLATILITY SHOWS ALL, TELLS ALL.

We are looking at three mutual funds that all have a 5% average return over the last three years. Two are our old friends, the Slow and Steady Value Fund and the Afterburner Tech Fund. To this mix we will add the Acme Growth and Income Fund.

Slow and Steady Value Fund. This fund returned 5% in years one, two and three. It averaged 5% and also returned a 5% compounded return. So the $10,000 we invested in the fund in the first year has grown to $11,576.25.

Acme Growth and Income Fund. This fund also had an average return of 5%. However, this fund earned –5 % in year one, 10% in year two, and 10% in year three. Our three year compounded return is $11,495, $81.25 less than the Slow and Steady Fund return. This gives us a compounded return of 4.62%.

After Burner Tech Fund. Like the others, this fund had an average return of 5%. This fund lost 15% in year one, returned 25% in year two and 5% in year three. The three-year total value is $11,156.25, $420 less than the Slow and Steady fund. This gives us a compounded return of 3.8%.

THE FIRST RULE OF INVESTING: NEVER LOSE MONEY.
THE SECOND RULE OF INVESTING: NEVER LOSE MONEY.

As you can see, those negative years are the compounded return killer. Remember, it is the compound returns that you can save or spend. Average return is a less important number. And nothing is more important to compound returns than those first years, the years that build the large pool of money that earns the relatively large compounded returns later in the life of the investment.

Standard retirement investment advice is to invest aggressively when you are young and move to more conservative strategies as you approach retirement. This is great advice if you start investing early in a Secular Bull Market.

But if your early, aggressive years are years battling a long bear market, you will lose your money before you ever have a chance to hit the big returning years. That is why an absolute return investment strategy should replace a “buy and hold” strategy in a Secular Bear Market such as we face. Later, when the Secular Bear gives it up to the Secular Bull, you should have a nice nest egg to put to work. And when the Cyclical Bull Markets squeeze themselves in during the long Secular Bear Market, you must earn what you can while you can.

ABSOLUTE RETURNS MAKE NO ENEMIES IN THE DESERT OF THE REAL!

HAVE YOU FROGGLED TODAY?

HAPPY CYBER MONDAY!

The retail industry calls the Monday after the Thanksgiving “Cyber Monday” because it is the first big day of the online holiday sales season.

The Friday after Thanksgiving is the traditional start to the holiday shopping season. It is often called “Black Friday” because in the holiday shopping Bacchanalian that is the American Christmas run up, it is the period of the year in which many retailers first show a profit.

Cyber Monday refers to the spike in online sales when holiday shoppers return to work on Monday and use their employers’ high-speed Internet connections to shop on-line during working hours. (1) About five percent of holiday sales occur on-line. With the Author, however, about 95% of holiday gifts are bought on-line. But not at work.

It is likely that online sales will increase over time as more people become Internet acclimated and retailers lavish more attention on their online purchasing portals. Which leads, interestingly enough, into the main topic of this post, Google, Inc.

GOOGLE GLOMS ONTO UNUSED FIBER CHANNELS.
A GOOGLENET ON TOP OF THE INTERNET?

The Author has written about Google in two earlier posts. This post will be the last Google post for a while. This post will focus on a Google strategy that should increase its Internet dominance.

Robert Cringely is a technology and Internet writer. In an article for PBS, “Google-Mart”, Cringely writes that Google seeks to effectively “take over the Internet”. (2) They will do it neither through the anti-competitive tactics that Microsoft employs, nor by bribing government officials in the mode of Halliburton and Bechtel. What Google will do is build and operate its own “Internet” alongside much of the existing Internet. They will, in effect, build their own “railroad” on the unused track.

Google is purchasing “dark fiber”, unused optical fiber circuits that can transmit huge amounts of Internet traffic. The nation has a large amount of unused high-speed fiber optic cable. By purchasing access to unused fiber, Google will have the ability to send more data and send it faster. Using the railroad analogy, this dark fiber is the unused segments of track that metaphorically sit alongside the main railroad. The tracks (fiber circuits) are already there. Google only has to rent them; it does not have to build them from scratch. And the rent is cheap.

GOOGLE TRAIN WILL KEEP ‘A ROLLIN’.

Google has also developed prototype data centers that fit in shipping containers. According the Cringely article, these data centers contain the most storage, memory, and processing power that can be stuffed into a shipping container. (3).

These data centers will be dropped into place, located in secure Internet Hosting facilities, racked up, and attached to the Google dark fiber. So Google will then have a way for trains to run on the less congested tracks that sit next to the regular railroads. And it has a way to switch the trains to and from the regular railroad. So while the trains on the regular tracks travel 30 miles an hour, the trains on the Google track alongside move at 60 mph. But there is still a problem. How do the trains get on and off the Google “track” so they can drop off their freight? This can be done by locating the Google data centers at Network Access Points (NAPs).

Network Access Points are places on the Internet where Internet Service Providers (MSN, AOL, Zianet, Ligtel), the companies that provide users access to the Internet, connect with each other in peering arrangements. Peering arrangements exist between Internet Service providers to provide access directly to their web sites or to other ISPs without going across the Internet. Think of them as shortcuts that reduce congestion and increase speed of transmissions. And staying with the railroad analogy, imagine that these network access points are the railroad yards where trains get off and on to the main tracks to deliver or pickup their freight.

By combining these new Google data centers with the dark fiber, Google can build its own Internet alongside the existing Internet. It will be faster than the existing Internet and will have mammoth amounts of storage next to each NAP. It could host video and become a competitor to cable television. Or sell VoIP (Voice-over Internet Protocol, an equivalent of telephone) services for less than the phone company. Or lots of other services. Or few services. It could just rent its Internet to companies that wanted faster service.

IS GOOGLE A BUY?

The Author does not generally recommend individual stocks. He sometimes suggests ETFs (exchange-traded funds) in sectors that show strong relative strength or inverse funds as alternatives to short positions. The Author does not recommend individual stocks because his style is momentum investing and his stocks often require quick movements in and out. A 12% gain or a 7% loss in a day or two is not uncommon. Because the newsletter is monthly and the posts do not track a recommended portfolio, he cannot get the information out quickly enough to provide real-time guidance. That may change in the future, however.

Additionally, the Author does not buy stocks with the intention of holding them for a long period of time. He buys stocks and holds them until their momentum or other technical attributes change. He is not concerned with whether a company has a great new product coming to market or whether analysts predict strong long-term earnings growth. He buys stocks that are moving up or poised to move-up. He does not concern himself with owning a “piece” of a good company.

But Google may be an exception. Although the Author is primarily a technical analyst, he has done a lot of fundamental stock analysis and may work up Google from that perspective. If he decides to purchase Google for a long-term holding, he will advise his readers and explain his reasons.

As Always,

RUNNING AT FULL THROTTLE THROUGH THE DESERT OF THE REAL!


(1). So much for workplace productivity. But this Cyber Monday phenomenon also demonstrates the lagging rates of high-speed interconnectivity in the US. Europe has a much higher rater of home Internet broadband connectivity. Compared to Europe, more Americans are still using slow-speed dial-up modems for Internet use. According to an article on CNN from June 17, 2005, “Broadband lag could hurt the U.S”, America ranked 4th in the world in broadband access in 2001. But by December 2004, it had dropped to 12th, behind South Korea, Japan, and nine European countries:
http://money.cnn.com/2005/06/16/technology/broadband/
(2). http://www.pbs.org/cringely/pulpit/pulpit20051117.html
(3). See Footnote 2, above.

WHERE THERE IS MOMENTUM, THERE IS MONEY

IF YOU WANT TO HEAR THE MUSIC, YOU MUST JUMP ON THE BANDWAGON.
(JUST JUMP OFF AS SOON AS THEY QUIT PLAYING)

With the stock market in a uptrend, it is time to move the money back into position. Two sectors that appear to be poised for continued gains are the software sector and the formerly battered semiconductor sector. Both of these sectors are tracked as indices, and both of these sectors have ETFs (exchange-traded funds) that are available for purchase.

SOFTWARE SECTOR

This sector is showing short-term strength. This sector trades as an i-share on the AMEX (American Stock Exchange)under the symbol IGV. Its current price is $40.92.

SEMICONDUCTOR SECTOR

This sector also has momentum. It currently trades at $61.77 and its symbol is IGW. It may make sense to wait for a pullback to to $58-59 to purchase.

WHERE THERE IS MOMENTUM, THERE IS MONEY

NOTE: This is reprinted from the August 2005 Newsletter. But it is timely as the the market is in a positive mode.

Studies show that 70 to 80% of a stock’s movement can be attributed to the movement of the overall market and the movement in the particular stock’s sector. Yet most analysts concentrate their efforts on analyzing a stock’s fundamental indicia. And most portfolio strategists just conjure up newer quantitatively derived strategies for portfolio diversification. So most of what you read or hear about a stock from the analysts only influences 20-30% of its movement. How would you like a doctor that could only cure 20% of your ailments or a fire department that would only respond to 30% of fire alarms?

DIVERSIFICATION IS FOR THOSE WHO DON'T KNOW WHAT THEY ARE DOING-WARREN BUFFETT

Diversification is a mantra in the financial services industry. Talk to nearly any broker or financial planner and they will tell you to just buy and hold a basket of stocks, bonds, cash instruments and maybe throw in a few alternative investments like managed futures, REITS (Real Estate Investment Trusts) and foreign equities. Some will do well sometimes, some will do poorly sometimes. But if you hang on long enough, we can guarantee that your investments will regress to the mean.

The author will be the first to say that buying investments based upon their fundamentals or holding a diversified portfolio is better than a poorer strategy, or no strategy at all. But if there were a way to buy the best performing investments at the best times, wouldn’t you like to try it?

Here is one way to do it:

1. When the market is moving forward, you are fully invested in stocks. When the market is reversing course, move to wealth preservation strategies. I am sure some readers are thinking ‘Yeah, right smart guy. How can you tell when the market is going to move up?’ The simple answer is you cannot predict when it will go up or down. But you can employ technical indicators that are trend tracking and trend following. You stay invested until these technical indicators reverse to negative.
2. Within all markets, some sectors will outperform others. Find the best sectors and find the best performing stocks in those sectors.
3. When you find the best stocks in those sectors find the best price points to buy, sell, and plot stop loss points. On this last point, proper implementation of stop loss orders is key to a good strategy. It sounds counterintuitive, but knowing when to cut losses is as important (if not more important) as knowing what to buy. Here is why:
a. If you are buying good stocks in a moving market, you are almost sure to get gains that beat, or at least equal, market-equivalent gains. If you do it well, you will substantially exceed the relevant indices.
b. Despite your best efforts, some of your picks will lose money. That is inevitable. Just keep your losses very small and put your money elsewhere. Being a stock trader is like managing a major league baseball club. The season stretches from April to October. You are bound to lose some games, but consistently win more than you lose and you will keep your job and your club will make the playoffs.
c. Put in stop losses and be mechanical about them. The author usually sets stop loss orders at 7% below the purchase price, or a point on the chart where short-term price support will break down. No exceptions. Also, when you have good gains in a stock, raise the stop-loss price to keep your profits.


EVERY DAY ABOVE SAND IS A GOOD DAY IN THE DESERT OF THE REAL!


IMPORANT DISCLAIMER: This newsletter is offered for informational purposes only. Sources of information provided are believed to be reliable, but are not guaranteed to be complete or without error. Opinions and suggestions are provided with the understanding that readers acting on information contained herein assume all risks involved. The author may or may not buy or sell securities discussed in this newsletter.

HAPPY THANKSGIVING FROM THE DESERT OF THE REAL!

MARKET INDICATORS ARE POSITIVE!

The Author's post of November 10th, "It's Beginning to Look a Lot Like Christmas" has left its presents early. All short positions are off and the Author is taking short-term stock positions. The Author will post more on the Market postition later this weekend. But it looks like the time to throw some money at the market.

The link to the November 10th post is below:
http://desertoftherealecononomicanalysis.blogspot.com/
/11/it-could-be-beginning-to-look-lot-like.html

DRIVE AS IF YOUR INVESTMENT ADVISOR'S LIFE DEPENDED ON IT IN THE DESERT OF THE REAL!

MASH UPS MIGHT NOT BE SMALL POTATOES

GOOGLE AND YAHOO COMBINE MAPS WITH LOCATION INFORMATION.

NEW YEARS EVE REVELERS ASK FOR MASH UP OF FAVORITE BARS AND DWI CHECKPOINTS(i).

About the time the Author learned to fold up a map along the same folds it came with, Yahoo released its Internet Map tool. Who needs maps when an Internet search engine can tell you where to go?

Google and Yahoo maps can give you the directions and a personalized map to a store, a restaurant, a job interview, or a friend’s house. Just hit a link or type in an address. You will get a map to print as well as directions telling you which roads to take and which ways to turn.

Last month Google and Yahoo released program interfaces that allow data about locations to be presented on their maps. The interface, used in a nontechnical sense, is called “Mash Up”. To get an idea of what a Google Mash Up looks like, go to this fellow bloggers' site:

http://googlemapsmania.blogspot.com/

There are already hundreds, probably thousands of Mash Ups. There are many of them linked at the site above. For example, one Mash Up has kosher restaurants plotted on a map of American cities. Another has locations of citings of endangered species.

Combined with Google’s Froggle, it can Mash Up local maps with shopping locations and price information. This is what sends shivers through the corporate boardrooms of big-box retailers.

YOU’RE THE INVESTMENT WRITER. TELL ME WHAT’S IN IT FOR ME, SAYS THE PRACTICAL READER.

If the Author knew what was in it with Mash Ups he would launch the idea himself and stop wasting his time on this Blog. (Smarmy remark.). Per an article in USA Today(ii) , a company called Quova can linkup website viewers or customer locations with a Google Map. One can imagine a million users for mash ups, commercial and non-commercial. Mash ups would be of benefit to people on the move to find traffic backups, restaurants, or where the best fishing is found in Otter Tail County, Minnesota. In real time.

In an earlier post from November 7th, “What Happens when you ‘Google’ Google?”, the Author discussed how Google and mobile technology could tell you where you could get the best price on an Amana Radar Range. You could swipe the bar code for the Radar Range when you are in Mega-Low Appliance Mart and compare that price with the other appliance stores in town. With a Mash Up, the prices and stores would be highlighted on a map.

The Author finds this Mash Up concept very intriguing and it will have some important, as well as a multitude of trivial, uses. That is what the Internet provides and it will be fun, and hopefully profitable, to watch this evolve. But the technology would not appear to be that complicated and simple utilities to create Mash Ups are probably already available. So it might take some imagination to come up with business models for Mash Up business concepts.

Mash Up services might be a service for IT consultants and others to offer to small businesses and organizations. Email the Author and maybe we can kick around some ideas. In fact, a somewhat unusual, but G-rated one, just came to mind. Culled from the Author’s rural roots.

Mash Ups may Find Fertile Soil with Down Home Businesses.

Agricultural seed companies have “show plots”. For non-farmer types, if you have ever driven down a country road and seen the name of a seed company and a number such as “232” on a small sign in front of a farm field, that indicates a show plot. In fact, if it is a cornfield and late in the growing season, some of the ears of corn may be husked back to show how well the ears of corn have developed.

The seed companies put these show plot signs up as marketing tools. People who drive by the show plot can stop and look at the crop to see how well it is doing. By using just a database search of show plots and a Google map, a seed company or seed salesman could quickly do a Mash Up and have maps of show plots available for a township or county. He could post it on the website or print it(iii).

Admittedly, the example above is a (sorry, the Author cannot resist punning it) corny one. But it is a workable one and shows how Mash Ups could be marketing tools for small businesses using only an Access (or other simple) database and a Mash Up utility.

SOMETIMES KNOWING WHERE NOT TO BE IS AS IMPORTANT AS KNOWING WHERE TO BE.

A person who lives a somewhat disreputable lifestyle could mash up their ex-wives, ex-girlfriends, ex-employers, ex-friends and map out all of the places that they should avoid. Such a Mash Up could save Mike Tyson and Russell Crowe a lot of fines and grief. Maybe even some jail time.

THE AUTHOR PROMISES HE WILL NEVER MASH UP HIS READERS AND FIND OUT WHERE ALL OF YOU LIVE IN THE DESERT OF THE REAL!

i. This example is not in good taste and should not be encouraged. Sometimes, however, a “bad” example is the most illustrative example. And it would be doable if you had access to the DWI checkpoint information and the hot clubs in town. A more positive law enforcement use is the mapping of the locations of convicted child molesters in a city. This second example is one that someone is already doing.
ii. http://www.usatoday.com/tech/columnist
/kevinmaney/
2005-08-16-maney-google-mashups_x.htm
iii. The seed companies often track data from show plots and track their locations. But if one wanted to offer a farmer a sell-guided tour of show plots, this would be a simple way to do it. Just put a show-plot Mash Up map in a plastic bag with a promotional item and hand them out to prospects and current customers

HAD WE BUT WORLD ENOUGH, AND TIME. PART DUE

HAD WE BUT WORLD ENOUGH, AND TIME. PART DUE. (i )

In the last post we defined the Intrinsic Value and the Time Value of options. Specifically, we looked at April 2006 Calls for MonopolySoft (MPST), a computer software company. We think that MPST will rise from $25 to $30 per share in late January or early February of 2006 and the value of the Call will also rise.

Below are the Calls we considered:


1. Call with a Strike Price of $23. The premium for this Call is $3. This call is in the money by $2. $25 (stock price) -$23 (strike price)= $2.
2. Call with a Strike Price of $25. The premium for this Call is $1.00. This Call is (at the money because the stock price equals the strike price.
3. Call with Strike Price of $27. The premium for this Call is $.33. This call is out of the money because the strike price is higher than the stock price.

We specifically analyzed the Call with a Strike Price of $23 that is $2 in the money. The premium for this call is $3. Recall that the Intrinsic Value of this Call is $2. ($25 Stock Price - $23 Strike Price = $2.) The Time Value of this Call is $1. ($3 Premium - $2 Intrinsic Value = $1.) This Call represented the best value so we bought a contact at $300. ($3 Call premium * 100 shares per contract).

Calls 2 and 3 have no intrinsic value and consist entirely of time value. Call 2 is at the money. The Strike Price equals the stock price so there is no intrinsic value. The entire $1.00 premium is time value.

Call 3 is out of the money by $2. ($25 Stock Price - $27 Strike Price = ($20).) The entire $.33 premium is time value. Its low value of $.33 reflects that fact that is $2 out of the money.

TIME VALUE IS THE PLAY CLOCK FOR THE INTRINSIC VALUE GAME.

Many things can happen to MPST stock between now and April 16, 2006. Let’s look at some hypothetical activity between now and expiration of our Call.

December 20th - MPST CEO Steve Balderdash announces that the next release of the MonopolySoft Operating System will not allow the Gobble, Inc. search engine to run on the MonopolySoft system. MPST stock rises to $28 per share on this news. Our Call, that has a Strike Price of $23 and a value of $3, rises to $6 (ii). In this case, the intrinsic value of the Call rises to $5. ($28 stock price - $23 strike price = $5.) Further, there is no longer any time value to be allocated to the Call since the intrinsic value of the Call exceeds the premium cost we paid for the Call. ($3 premium -$6 intrinsic value = ($3). Not a bad Christmas Present.

January 15th - Gobble, Inc., the search engine giant, sues MonopolySoft for violations of anti-trust law. MPST stock falls to $20 per share. The Call has lost all of its intrinsic value and is now comprised solely of time value. ($20 Stock Price - $23 Strike Price = ($3) Intrinsic Value.) Since we have no intrinsic value, our Call is now worth $3 of time value. ($3 premium -$0 intrinsic value = $3 time value.) And the value of out Call would also fall in value, since it is now $3 out of the money. But we still have three months to go until expiration, so there can still be good news that will raise the price of MPST.

February 15th. MonopolySoft announces that it will delay release of its 2005 earnings due to “accounting irregularities”. The stock falls to $15 per share and our Call is now $8 out of the money. ($15 Stock Price - $23 Strike Price.) It has no intrinsic value. And we might be starting to worry. We only have two months left and our Call is nearly worthless, as it has fallen to $.15.

But at my back I always hear, Time's winged chariot hurrying near(iii).

With only two months left in the life of the Call, and the Call now $8 out of the money, most would close out the Call and cut their losses. But we have faith in the power of anti-competitive conduct to rally MonopolySoft stock. On April 1st, MonopolySoft releases its earnings and 2005 shows a 40% increase over 2004. Also, on this auspicious day, the Supreme Court dismisses Gobble, Inc.’s lawsuit against MonopolySoft. MPST stock soars to $50 per share. Our Call rises to $25 and we close it with a sale for a $2,200 short-term capital gain. ($25 Call premium value - $3 Call Premium Cost = $23 per share * 100 share per Option Contract).

Saved, just in time. Steve Balderdash can buy another professional sports league and we have pocketed a nice gain. And Internet progress is set back six years. Two out of three ain’t bad.


Thus, though we cannot make our sun stand still, yet we will make him run(iv) in The Desert of the Real!

i. Marvell, Andrew. “To his Coy Mistress”.
ii. This means our Call has a delta of 1. For each dollar in value that the stock rises, the value of the Call rises by $1. See the Author’s post “Options in Operation”, dated November 2nd, where Delta was explained.
iii. Marvell, Andrew.
iv. Marvell, Andrew.

December 2005 Newsletter

The Author will be emailing the December 2005 edition of the Newsletter "Welcome to the Desert of the Real-Real Investment Returns in a Dry Season" later this week.

If you would like to receive a copy of this Newsletter, please email the Author at:

desertoftherealeconomics@hotmail.com

The newsletter will focus on analyzing and comparing Alphas for mutual funds. This Newsletter is a MUST for mutual fund investors.

LINK WRAY
May 2, 1929 - November 5, 2005

The Man That Invented The Power Chord. The Fifth. The Chord that Can Never Fall Silent.

HAD WE BUT WORLD ENOUGH, AND TIME

HAD WE BUT WORLD ENOUGH, AND TIME. ([i])

It is beyond cliché to say, “Time is Money”. But it usually is and that is why the oft-cited aphorism survives. Over the past couple of weeks The Desert of the Real looked at options. We looked at Puts and Calls, the predictions that underlay each option, and some basic option strategies. This post will look at the “time value” component of options and how the limited life of an option affects the value of an option.

THE EXPIRATION CYCLE OF OPTIONS

As we know, options are contracts to buy or sell a specific security at a specific price on or before a specific date. The expiration cycles of options are standardized. The three cycles are:

1. January, April, July and October. (JAJO).
2. February, May, August and November. (FMAN).
3. March, June, September and December. (MJSD).

Options expire on the third Saturday of the month. The last time to execute an option is at close of the Options exchange on the Friday before. After the option expires, the option is worthless. So in addition to considering the type and strike price of the option, we must also consider the time until the option expires.

TIME VALUE AND INTRINSIC VALUE

Options have two types of values: Time Value and Intrinsic Value. We will do a little review on the concept of “in the money”, “at the money” and “out of the money”, and then montage into the concept of time value.

Options can be “in the money”, “at the money”, or “out of the money”. To illustrate, we will use Call examples for the bloatware company MonopolySoft (MPST). MPST is currently trading for $25 per share. We are interested in the April 06 Calls.

We believe that MonopolySoft will rise in price when its 2005 earnings report is issued in late January or early February. We believe that it will rise to $30. So we go to the MonopolySoft options montage in our online brokerage site. There are three April 06 Calls we are considering:

1. Call with a Strike Price of $23. The premium for this Call is $3. This call is in the money by $2. ($25 (stock price) -$23 (strike price)= $2.)
2. Call with a Strike Price of $25. The premium for this Call is $1.00. This Call is at the money because the stock price equals the strike price.
3. Call with Strike Price of $27. The premium for this Call is $.33. This call is out of the money because the strike price is higher than the stock price.

TIME VALUE AND INTRINSIC VALUE CALCULATION

Intrinsic value is the amount that the option is in the money. If it is a Call, it is the amount by which the stock price exceeds the strike price. If it is a Put, it is the amount by which the strike price exceeds the stock price. Stated another way, the intrinsic value is the amount we could make on the option if we exercised it. If we exercised the Call with the $23 Strike Price we could buy MPST at $23, sell it at the market price of $25, and make $2. This $2 profit is the intrinsic value.

We could do that and earn the intrinsic value of the Call of $2. But if we did exercise we would still lose $1. Remember, we paid a premium of $3. So if we sell it for $2, we would lose a dollar. It is this $1 difference between the intrinsic value and the premium we paid that is the time value of the Call.

TIME (AT LEAST FOR NOW) IS ON OUR SIDE

The April 06 MPST Calls will expire on April 15th (Hmm, what a coincidence). They must be exercised no later that Friday, April 14th. So if we buy an April 06 Call it has almost 5 months until expiration. A lot can happen in that those five months, and that is to our advantage. There is an aphorism in Options trading that says: “Give yourself enough time to be right”. Many things can go right in the five month life-span of the April 06 Call to cause MPST stock to go up in price. And if MPST goes up in price, our Call will go up in value. And even if MPST slips in price tomorrow, we still have nearly five months for the stock to turn around.

So with nearly five months to go in the April 06 Call, time is on our side. Let’s put a number to the time value of this April 06 MPST $23 Call:

$25 Stock Price - $23 Strike Price = $2 Intrinsic Value.

But since the Premium cost us $3 and the Intrinsic Value is $2, the Call has a Time Value of $1:

$3 Call Premium - $2 Intrinsic Value = $1 Time Value. So the Time Value is the cost, or value of the premium that exceeds its Intrinsic Value.

But what would happen if we have a Call that has no intrinsic value? Like a call that is at the money or out of the money? The entire value of these calls is composed of time value. We will look at this issue and the affect of option values as they approach expiration in tommorrow's post.

And yonder all before us lie[ii] The Desert of the Real.

For fun and for your literary enrichment.

To His Coy Mistress

by Andrew Marvell

Had we but world enough, and time,
This coyness, Lady, were no crime.
We would sit down and think which way
To walk and pass our long love's day.
Thou by the Indian Ganges' side
Shouldst rubies find: I by the tide
Of Humber would complain. I would
Love you ten years before the Flood,
And you should, if you please, refuse
Till the conversion of the Jews.
My vegetable love should grow
Vaster than empires, and more slow;
An hundred years should go to praise
Thine eyes and on thy forehead gaze;
Two hundred to adore each breast;
But thirty thousand to the rest;
An age at least to every part,
And the last age should show your heart;
For, Lady, you deserve this state,
Nor would I love at lower rate.
But at my back I always hear
Time's wingèd chariot hurrying near;
And yonder all before us lie
Deserts of vast eternity.
Thy beauty shall no more be found,
Nor, in thy marble vault, shall sound
My echoing song: then worms shall try
That long preserved virginity,
And your quaint honour turn to dust,
And into ashes all my lust:
The grave's a fine and private place,
But none, I think, do there embrace.

Now therefore, while the youthful hue
Sits on thy skin like morning dew,
And while thy willing soul transpires
At every pore with instant fires,
Now let us sport us while we may,
And now, like amorous birds of prey,
Rather at once our time devour
Than languish in his slow-chapt power.
Let us roll all our strength and all
Our sweetness up into one ball,
And tear our pleasures with rough strife
Thorough the iron gates of life:
Thus, though we cannot make our sun
Stand still, yet we will make him run.


[i] Marvell, Andrew, “To his Coy Mistress”. Some readers may have read this poem in high school or college literature classes. All though some of the phraseology is dated, the message is universal. Yet the Author does not even wear a watch.
[ii] “To his Coy Mistress”.

“WELCOME TO THE DESERT OF THE REAL” IS NOT ALWAYS A GREETING…

“I was just thinking one thing when we drove into that ambush.
Grand Theft Auto: Vice City . . . It was f---ing cool.”- A U.S. Marine in Iraq, quoted by embedded Rolling Stone reporter Evan Wright in his book “In Generation Kill: Devil Dogs, Iceman, Capitan America, and the New Face of American War”.

All nations honor their war heroes. Norway honors the World War II resistance fighters and the French have the Maquis who battled the German occupiers. Russian men and women who turned back the Nazis in the “Great Patriotic war” are national treasures.

Americans too, have a pantheon of war heroes. Conjure up a few American war heroes and you see backwoodsman Alvin York shooting squirrels at 200 yards. Audie Murphy plinking at bottles on his hard scrabble Texas tenant farm. Or the plucky Minuteman loading his musket while he waits for the oncoming Redcoats. Those men are military icons, enshrined in Americana.

Now time shift to today. Army recruiting ads show computer networks and weapons launched by mouse click. Most kids signing up for service have never fired a gun. But most have worked their finger pads raw shooting at electrons at photons on Playstations.

The Marine that is quoted above, and his comrades, may share little with their predecessors from World War I and World War II. They are different, writes Julia Baird of the Australian newspaper “Sydney Morning Herald”. Baird writes:

Each generation produces its own war literature. This batch, from both the recent Iraq War and the Gulf war before it, is different not because of how they end up - usually jaded, depressed and displaced - but how they start the war.

Today's young soldiers are cynical - they know they are being used, and they know this war on terrorism is unlikely to end. They laugh at the "retards" who command them. They are not wide-eyed, seduced by noble aims and determined to save the world from evil, like their forebears in the two world wars who were often reluctant to kill. [i]

American boys flocked to enlist for World War I and World War II. In high spirits, glittering generalities like “Patriotism and Freedom” cut and pasted upon their innocent tongues. Dulce et Decorum Est Pro Patria Mortia.[ii]

The American kids killing and being killed in Iraq are apparently having less jingoistic imagery and drawing more from the barbarous truth of war. The flags and speeches and talking points are for the grieving families and panderers holding political power. These kids walk in already wised up. The Iraqis just happen to be downrange.

HOW LONG WILL IT BE GRAND THEFT AUTO: VICE CITY?

This is not a post about the Iraq war. The Iraq war is just the latest of the serial failures of the human species. Vain, petty, and fundamentally insecure men telling reformatted lies to mask their greed and ambition. “Leaders” who have a pathological need to hear the grateful multitudes proclaim their names and dampen in their ears the whining echoes of their earlier, unresolved failures.

The call to elective war echoes as a horripilating howl down the centuries. And tinny men of megalomanic delusions all do it the same way. Find one of many bogeymen, parade a new fear down the main street of the nation, and inveigh against the rational dissenters as more dangerous than the bogeyman himself.[iii] Betray the sons with an ignoble call to duty for the leaders’ desertion. Ennoble their senseless deaths with parade-ground swagger, marble-writ bravado and ritualized remorse.

NO ONE DIES IN THE DESERT OF THE REAL. THEY GET EXTENDED PLAY CREDITS.

As the Author wrote in the first post on this blog, and in the first footnote to his first newsletter, “The Desert of the Real” is the recognition that the world can be a simulacrum, a hyperreality, an eroding “place” that moves through the following successive phases:

It is the reflection of a profound reality.
It masks and denatures a profound reality.
It masks the absence of a profound reality.
It has no relation to any reality whatsoever: it is its own pure simulacrum.[iv]

Go to Disneyworld and tell yourself you have not been pumped up into hyperreality. Sit down at any of 100 Crackerbarrel restaurants and enjoy a seat in simulacra. Or play Grand Theft Auto: Vice City during your aimless adolescent hours, sign up, and ship out to Iraq.

Jean Baudrillard wrote after the first Gulf War in 1991 that the “Gulf War never happened”. Of course Baudrillard knew that a conflict was fought, people died, and landscapes were destroyed. But in the 24-hour news cycle and infotainment culture where war is branded as “Operation Desert Storm” and given its own logo, the living-room and sports-bar tailored broadcasts are the hyperreality.

The reporters in Saudi Arabia broadcasted the “rockets red glare” of Patriot missiles streaking onward and upward at the Scud missiles. The Patriots illuminated the screen as they missed the warheads but ignited the mostly spent Scud fuel tanks. They had little tactical effect but tremendous propaganda effect. They were spectral across the hyperreality.

Burning Iraqi tanks masked the funeral pyres inside. Nightvision helicopter gunsights, the blurry color of chlorine gas, signed the deaths of thousands with fast streaks and distant flashes.
Grainy, and in a still DOS command-line computer world, this hyperreality masked the molten-metal immolation of men.

The satellite-fed simulacrum of the television war was near universally experienced, while only a relative handful of rough men slaughtered each other along this un-pixilated frontier. And television wars spin off the next generation of video games. Through Windows 95 we came to Windows Millennium. And an X-Box and a Play Station.

Each successive simulacrum has faster graphics but uses more memory. Hardware serves up faster. Software gets smarter. But it still needs the wetware.

WE’RE THE MEATMEN[v]

In the language of geekspeak, humans are wetware, liveware, meatware. The operators of the computers. The tiny serial batteries that power the Matrix. What’s between the chair and the keyboard.

And the young Marine is in the simulacrum of Grand Theft Auto: Vice City as his unit is ambushed in the simulacrum that is the war in Iraq. Blood on the Playstation. Hyperreality poured down broadband. We, the hyperrealising millions, have a 0 or 1 switch. The Marine, in his own little hyperreality, has the unique option to come home as liveware or boxed-up as decaying meatware.

General Sherman, who made the oft-repeated understatement, “War is Hell”, would still recognize war, but wouldn’t recognize the hyperreality of 21st Century Warfare. No draft riots in New York City, no executions of deserters, no excise taxes, no shortages on the home front. Of course there would still be the looters and profiteers of the Home Guard.

In hyperreality, war can only be hell if you burn some sulfurous incense and rotting cadaver candles.

The simulacrum is never what hides the truth-it is the truth that hides the fact that there is none.
So the simulacrum is true. Ecclesiastes.

Rejoice, oh Young Man in thy Youth. Ecclesiastes 11:9 King James Version.

BACK TO THE DESERT OF THE REAL WE ALL KNOW AND LOVE!

[i] http://www.smh.com.au/news/opinion/
thrill-of-the-kill-the-other-tragedy-in-iraq/
2005/11/16/1132016860340.html
[ii] Owen, Wilfred, Dulce Et Decorum Est. (1917).
[iii]"Of course the people don't want war. But after all, it's the leaders of the country who determine the policy, and it's always a simple matter to drag the people along whether it's a democracy, a fascist dictatorship, or a parliament, or a communist dictatorship. Voice or no voice, the people can always be brought to the bidding of the leaders. That is easy. All you have to do is tell them they are being attacked, and denounce the pacifists for lack of patriotism, and exposing the country to greater danger." Nazi leader Hermann Goring.
[iv] Baudrillard, Jean, “Simulacra and Simulacrum”, p. 6 (1981).
[v] The Meatmen were a punk rock band from the 1980s and early 1990s. One of their better CDs was “We’re the Meatmen …and You Suck!”

THE MORTGAGE TAX DEDUCTION. EIGHT GOOD REASONS TO KILL IT NOW.

FIRST, LET’S KILL ALL THE REAL ESTATE DEVELOPERS. (Not serious. Just a literary trope.)

The Bush administration’s tax commission recently released a series of tax proposals. The Author’s post of Wednesday, October 12th, “Tax Panel Says Popular Breaks Should Be Cut”, agreed with the proposal to limit the mortgage tax deduction. But today the Author goes further. He proposes that this savings distorting pig be sent to slaughter[i]. There are plenty of good reasons. Here goes:

1. The mortgage interest tax deduction (subsidy) raises the price of houses. In an efficient market like the housing market, subsidies such as the mortgage interest deduction give borrowers more money to buy homes than they would otherwise have. Rational sellers know that the purchasers are subsidized and can pay more for homes. So they raise the sales price and the buyer pays that increased price.
2. The mortgage interest tax subsidy penalizes fixed-income and low-income homeowners. The government subsidized house prices in number 1, above, raise house prices and the attendant property taxes. These tax increases may be difficult for low-income and fixed-income owners to pay.
3. High house prices and high mortgage payments decrease the American savings rate. The American rate of savings reached zero % in June of 2005. That’s zero with a 0. Lower debt service payments would free up money otherwise profligate Americans could save for retirement, their children’s education, a rainy day.
4. The mortgage interest tax subsidy shifts the tax burden from homeowners to renters. Homeowner’s lifestyles are subsidized by the tax code. Renters help to make up the lost revenue.
5. The mortgage interest subsidy increases energy consumption. Since home purchase loans are subsidized, people can buy larger homes than they could otherwise afford. Larger homes mean greater energy expenditures and greater energy usage. More money for big oil, if you are inclined to bash that industry.
6. The home mortgage interest subsidy contributes to the shrinkage of farmland and open space. Again, since the demand for homes and home sizes is subsidized, more land is used for housing and less is left for farming and open space.
7. The home mortgage interest subsidy contributes to traffic congestion and attendant pollution. Once more, subsidized demand for homes encourages more homebuilding and relocation from cities, to suburbs, to exurbs. This artificially subsidized growth increases congestion and auto emissions as people drive further to work and shopping
8. Finally, the home mortgage interest subsidy was eliminated in Great Britain in the late 1980s and 1990s by the monetarist Thatcher government. And guess what? Housing prices at first fell, but then regained their price support and home prices in Great Britain have increased 300 percent since the late 1980s.[ii]

The Author acknowledges that the elimination of the tax will cause short-term disruption. But it if it phased in over a period of years, like in Great Britain, the long-term benefit will be positive.

YOUR MONEY ALWAYS GOES FURTHER IN THE DESERT OF THE REAL!

[i] Remember that the Author is a vegetarian, so this is just a literary device. Not a call to waste a porcine.
[ii] http://money.cnn.com/2005/11/18/commentary
/mortgagetax_fortune/index.htm?cnn=yes

JUST TWO THINGS

If you overesteem great men, people become powerless.

If you overvalue possessions, people begin to steal.


Tao Te Ching by Lao-tzu (abt.551-479 BCE)

RECORD DEFICITS, PART TROIS

THE CAPITAL ACCOUNT. BECAUSE THAT’S WHERE THE MONEY IS.


Both companies and countries have assets. A company’s assets are its machines, its materials to be used in production, its office equipment, unsold product, its accounts receivables (money owed to it by other businesses) all kinds of things it uses in conducting its operation. A country can be thought of in the same way. Its assets are the businesses within its borders, its government buildings, the cash, gold and other deposits it holds in its central bank, and the debts it is owed by other counties or organizations.

In economics, finance, and investment analysis, we often refer to capital. Capital is used in many different contexts and has many shades of meaning. Below are a couple of good definitions that will work in the context of analyzing a nation’s Capital Account:

1. Monetary Capital: Money used (or to be used) for investment purposes
2.Real or Invested Capital: Capital goods (machines and production- & distribution infrastructure) needed for the production of goods and services. [i]

When the US (usually through its citizens) sells assets to foreigners, it has a capital inflow and a credit in the Capital Account. When the US (usually through its citizens) buys a foreign asset, it has a capital outflow and a debit in the Capital Account. And a surplus (credit) in the Capital Account will offset a deficit (debit) in the Current Account. So a trade deficit can be offset by Capital Surplus. And that is what is occurring with the US Balance of Payments situation.

There are three general categories of capital assets in the Capital Account:

A. Direct Foreign Investment. If Honda or BMW builds an auto plant in the United States, this is a direct foreign investment in the US. Similarly, if Ford builds a plant in Argentina, it is a direct US foreign investment in Argentina. One thing to note is that these direct foreign investments result in control of the investment remaining in the hands of the investing company.
B. Portfolio Investment. These are assets such as stocks, bonds, options, and the like. Foreigners can buy and hold them in a manner similar to that in which an American investor would hold such an investment. Conversely, Americans can buy foreign bonds, foreign stocks, and American Depository Receipts (ADRs), an investment generally comparable to owning stock of a foreign company.[ii]
C. Other Investments. These are shorter tem instruments like currency, cash deposits, and trade credits. Banks, corporations, and other large organizations buy and sell such investments in the international market.

The Capital Account is what keeps American Balance of Payments in equilibrium. Foreign governments and investors are huge purchasers of American stocks and corporate bonds. And they are gorging on US government debt, buying huge percentages of US Treasury Securities issued or available.

BACK TO THE BALANCE SHEET.

The last post looked at the Current Account for a hypothetical “Year”. In that Year, the US had a trade deficit of .25 Billion Dollars. The Current Account is reprinted from yesterday’s post and set out below. The Capital Account will follow.

CURRENT ACCOUNT.

Credit/Debit

Imports. 200 billion dollars

1. Merchandise 100 billion dollars
2. Services 50 billion dollars
3. Factor income 50 billion dollars

B. Exports 175 billion dollars

1. Merchandise 50 billion dollars
2. Services 75 billion dollars
3. Factor Income 25 billion dollars

Current Account Surplus/Deficit: Imports 200 billion dollars
Exports 175 billion dollars

-25 billion dollars, or a 25 billion
dollar debit (deficit).


CAPITAL ACCOUNT.
Credit Debit

C. Direct Investment 8 Billion - 1 Billion
D. Portfolio Investment 30 Billion - 16 Billion
E. Other Investment 15 Billion - 11 Billion

Balance On Capital Account 25 Billion (53 Billion credit- 28 Billion Debit)

So the Balance of Payments books equal out.[iii] In effect, the US Trade Deficit, as we have often discussed in this forum, is offset by foreign investment in the US.

HOW LONG CAN THE CAPITAL ACCOUNT CARRY THE MASSIVE TRADE DEFICITS, OR ATTENTION WALMART SHOPPERS-CASH ONLY. NO CREDIT CARDS.

This is the question that has occupied economists and analysts for a number of years. Attention to this question increases as each month seems to reveal an increasing trade deficit and more Treasury Securities being purchased by foreign investors and foreign central banks. The risk, as readers should know, is that international bondholders will become insecure in their Treasury holdings and start selling them off to diversify their holdings. Such a bond sell off will raise US interest rates and, if large enough, trigger a cascade failure in the American economy as consumption drops, the cost of debt service rises, and businesses and consumers default on their obligations.

The foregoing scenario would not be a bad result in the long-term as the US imports would shrink, a cheaper Dollar would spur exports, asset prices would fall, and interest rates would plunge as the good old mean reversion mechanisms of capitalism work out the situation. But it would be a kick in the teeth for many an American.

In any event, your always intrepid and engaging Author is set to read a couple of books over the next few weeks on the possibility that the US Capital Account surplus will continue to grow and offset the increasing trade deficits. And of course the Author is always reading and researching economic, financial, science, and political material for this weblog. That is the price one pays to toil in misdirected obscurity.

THERE CAN BE NO CASCADE FAILURES IN THE DESERT OF THE REAL!

[i] http://faculty.washington.edu/krumme/gloss/c.html
[ii] ADRS are held by an American Bank and represent shares of a foreign corporation. The shares of the foreign company are actually held by the American Bank. The ADR gives the ADR holder a right to the shares held by the bank.
[iii] For simplicity’s sake, we have ignored statistical discrepancies in the calculation and the Official Reserve Account. Statistical discrepancies arise because these balance of payment figures are estimates, not actual totals. The Official Reserve Account is an account held by the central bank, the Federal Reserve System here in the US. These accounts hold gold, foreign exchange credits and can borrow from foreign banks. These accounts are used if there must be payments made on actual balance-of-payment deficits.

RECORD TRADE DEFICITS, PART DEUX

INTERNATIONAL BALANCE OF PAYMENT ACCOUNTING IN TROIS EASY LESSONS

In the last post we introduced Lemon County Lead Sleds, a custom “chopper” motorcycle shop. Please recall that they had fallen on lean times last year and had sales of 1 million and expenses of 1.2 million. So they had a .2 million-dollar loss. The last post discussed two common strategies for Lemon County to absorb the loss:

Dip into their retained earnings (savings) to pay their suppliers and cover the .2 million deficit; or
Borrow the money to cover the loss. We discussed two ways to borrow the money to cover the loss.
Go to the bank or other lender and borrow .2 million dollars to pay the supplier.
Take delivery of the suppliers’ material on credit and pay for the materials as an accounts receivable. In other words, Lemon County would make the supplier its “Lender”.

These are common strategies for companies to adjust their sales and purchase among themselves in their day-to-day relationships. From here, we will jump right on the Current Account.

CURRENT ACCOUNTS, CAPITAL ACCOUNTS AND A DEFINITION

First, the definition. Post 1 and Post 2 up to this point were included to lay the groundwork for trade deficit and balance of payment analysis. The example of Lemon County Lead Sleds was used to put out general concepts from the business world that serve as good analogies for the rest of Part Deux, and what looks like Part Trois. The Author doubts he can cram it all into this post. And he hopes there will not be a Part Quatre, as the Author cannot count any further in French.

International balance of payments is the record of international transactions in a defined period of time made in the form of double-entry accounting. Debits, credits, that stuff. And a lot of this is estimated, not finally and officially tracked.

Current Account. Most of what we read and hear about is the trade deficit or surplus. Did the US import more than it exported (the case since at least 1982), or did it export more than it imported? Trade deficit or surplus is “booked” in the Current Account. The Current Account is made up of three[i] categories:

1. Merchandise. Trains, planes, automobiles and gummi feet. The US consistently runs merchandise trade deficits while its key trading partners like Germany, Japan and China run merchandise trade surpluses in relation to the US.
2. Services. This includes things like accounting, engineering, consulting services, as well as tourist expenditures. The US has generally maintained trade service surpluses.
3. Factor income. This category includes things like dividend and interest received on foreign investments. And on the other side of the ledger, dividends and interest that the US must pay to foreign investments.

AN EXAMPLE

In a hypothetical “Year”, the Current Account of the US looked like this:


CREDIT/DEBIT
Imports. 200 billion dollars

1. Merchandise 100 billion dollars
2. Services 50 billion dollars
3. Factor income 50 billion dollars

B. Exports 175 billion dollars

1. Merchandise 50 billion dollars
2. Services 75 billion dollars
3. Factor Income 25 billion dollars

Current Account Surplus/Deficit: Imports 200 billion dollars
Exports 175 billion dollars

-25 billion dollars, or a 25 billion
dollar debit (deficit).

The US then had a 25 billion dollar deficit in its Current Account in this Year. This, on its face, looks bad. But remember that the US has run a Current Account deficit since at least 1982, has not gone “bankrupt”, and in fact has the highest “credit rating” in the world. So what is going on? That is where the Capital Account comes in.

POST TROIS

In the next post, we will discuss the Capital Account and how trade deficits may be “offset” by the financial strength of the US economy. And in later posts, we will take a look at how long the US can sustain huge trade deficits. And what investors will need to consider in an environment of huge trade deficits.

Bienvenue au désert du vrai!

[i] There is a fourth category called “Unilateral Transfers”. This category will not be included for sake of simplicity. It includes foreign aid, reparations, gifts and the like. It is a small category. American foreign aid is miniscule as a budgetary component, comprising less than ½ of one-percent of its federal budget.

US RECORDS RECORD TRADE GAP OF 66.1 BILLION NI SEPTEMBER 2005

MECHANICS OF INTERNATIONAL BALANCE-OF-PAYMENTS, OR WHY INTERNATIONAL ECONOMISTS ARE SEEN BY EVEN THEIR PET HAMSTERS AS BORING INDIVIDUALS

The US Commerce Department recently reported that the US Trade Gap widened to a record 66.1 billion dollars in September.[i] The gap for the previous month was 59.3 billion. The previous record was $60.4 set in February of 2005.

Imports of goods and services for September totaled 171.3 billion. US exports of goods and services were 105.2 billion. The trade gap deficit figure is the most commonly cited figure. But let us take a more global view and look at how international balance-of-payments matters are handled and how the US finances these almost perpetual trade deficits.

Just as the books of a business or an organization must be reconciled, international balance-of-payments must be reconciled between nations. Let’s use an example of business and how it relates to it customers and creditors and then we will use that example to explain international matters. This post will probably be a two-parter, so let’s lay out Part I today.

Lemon County Lead Sleds makes customized “chopper” motorcycles using Hogsome-Darlington engines. Lemon County had a few good years but has recently fallen on hard times. Sales have fallen and the cost of the parts to build the motorcycles have risen. In 2004, it sold 1 million dollars worth of motorcycles and towing services. However, the cost of parts for the Lemons was 1.2 million. (We will forget all about rent, labor, everything else.) Lemon will have to make up this .2 million dollar shortfall somehow. It has two basic choices.

YOU CAN'T LOSE MONEY FOR EVER-UNLESS YOU HAVE A FEMA CONTRACT

One way for Lemon to make up the .2 million dollar deficit is to dip into its bank account and pay the suppliers from earnings it has retained from its better days. This is a common way for a business to take care of a shortfall. Just as individuals dip into their savings to pay bills, businesses do the same thing.

Another way for Lemon to make up for the shortfall is to borrow the money to cover the .2 million dollar shortfall. Lemon might go to the bank and borrow the .2 million dollars. It the bank thought it that Lemon had good potential to turn profits in the future, it would likely loan Lemon the money. But there is another way for Lemon to borrow the money it needs. Ask its suppliers to provide the engines and other components on credit.

JUST GIVE US A LITTLE MORE TIME TO PAY THE BILL

It is common practice among businesses to provide goods and services on credit. When a business allows another organization to buy its products on credit, it is in effect loaning the purchaser the money to buy the goods and relies upon the promise of the buyer to pay for the goods in the future. The seller will recognize the debt from the buyer in its accounts receivable, and will often require payment in 30, 60, 90 days, or in some other time frame. Many businesses will charge the buyer interest on the debt if they take too long to pay the bill.

This is a fairly common commercial arrangement between companies. Let’s assume that Lemon buys all of its motorcycle frames from one company, Fark Frame. Fark Frame is the only motorcycle company to make its frames out of lead. And let’s further assume that Fark Frames has no other customer for its lead frames. If it loses Lemon County Lead Sleds, Fark Frame is out of business. If Lemon County needs to buy frames on credit to stay in business, Fark will have two choices. Go out of business or loan money (extend credit) to Lemon County to buy Fark Frames.

And if Lemon expects to stay in business iit must finance its loss, or deficit, in some fashion. Many readers can see that the relationship between Fark Frames and Lemon County looks a little but like the relationship between the US and China.

See you tomorrow and we will up the stakes and up the deficits.

WE ONLY SHIP PREPAID OR C.O.D IN THE DESERT OF THE REAL!

[i] http://www.bea.gov/bea/newsrel/tradnewsrelease.htm

IT COULD BE BEGINNING TO LOOK A LOT LIKE CHRISTMAS

IT COULD BE BEGINNING TO LOOK A LOT LIKE CHRISTMAS (OR YOUR OTHER FAVORITE WINTER SOLSTICE CLONED HOLIDAY)[i]

DATA SUPPORT OLD ADAGE “SELL IN MAY AND GO AWAY”.

Many readers are familiar with the old stock market adage “Sell in May and go away.” One source of this adage is that the big market players and traders spend the summer at Newport Beach or the Hamptons and do not move much money around until they return after Labor Day. These summer sideways markets are then followed by third quarter earnings warnings issues in September that further depress stock, and then the actual earnings reports in October.

Staying with this seasonal theme, we move through November, which is historically a little better month than September and October. In December we often have a little Santa Claus rally and move into the New Year with the January Effect. (Dude and dudettes, can the Author prattle off the stock market clichés, or what?) But all of this sounds little folksy and anecdotal for real financial and investment people.

IN GOD WE TRUST. ALL OTHERS BRING DATA.[ii]

Dorsey Wright and Associates recently compared Dow Jones Industrial Average (DJIA) returns for the six-month periods of the months of May though October with the returns from November through April[iii]. They basically split the year in half and tested one six-month period against the other period for DJIA performance. The study goes back to 1950 and includes 55-1/2 years of data, through October 31, 2005. The results are amazing.

The months of May-October produced a –0.05% compound return. If you had invested the hypothetical $10,000 in May of 1950, you would now have $9,728, or a loss of $272. Sell in May worked pretty well.

However, if you had invested only in the months of November through April, you would have had a compounded annual return of 7.38 %, or a total return of $4, 931%. The hypothetical $10,000 would now be worth $493,802. Working only November through April. Not a bad work schedule.

ONLY 21% OF NOVEMBER-APRIL PERIODS NEGATIVE

Only 12 of the 56 November-May returns were negative and only in 1969 and 1973 were period down by more than 10%. The last negative November-May period was 2000, with a negative return of –2.2%.

A 55-1/2 year period is a very representative sample. This period covers two Secular Bull markets (1950-1966, 1982-2000), a complete Secular Bear market (1966-1982) and the current Secular Bear Market.

In an upcoming post, the Author will talk about a couple of sector plays that may provide some good returns in the next few months and offer an opportunity to make a November-April play work to an investor’s advantage.

IMPORANT DISCLAIMER: This post is offered for informational purposes only. Sources of information provided are believed to be reliable, but are not guaranteed to be complete or without error. Opinions and suggestions are provided with the understanding that readers acting on information contained herein assume all risks involved. The Author may or may not buy or sell securities discussed in this post.

IT IS ALWAYS SOME HOLIDAY SOMEWHERE IN THE DESERT OF THE REAL!



[i] The Author wishes to be inclusive and include Chanukah, Kwanzaa, Boxing Day and any other festive December Day in the celebration of stock market gains. And we must also remember that major religions co-opted the pagan solstice holidays into their rituals and holidays, so many Western holidays double as pagan ritual days. So its all fun
[ii] This is an oldie but a goodie from the Author’s healthcare law and healthcare IT days. Healthcare cost containment was all the rage in the mid-to-late 1990s. If you had data that could demonstrate your cost-saving ability, you would find a receptive audience.
[iii] The Author does not know if these return calculations include dividends.

HEY OLD MAN, GET BACK TO WORK-REDUX

Happy Valentines Day, Everyone! While the Author is still in more of a Thinking than Concluding Mode, He is Resposting some Prior Posts. The Post Below is From November 8th, 2005.


One friend says to another, “I plan to retire on a beach someday”.
“Wow,” replies her friend, “You must have saved a lot of money for retirement.”
“No, I don’t have anything saved. That is why I will have to retire on a beach”.[i]

Another version of this “joke” goes, “My retirement plan is to work until I die.”

For some others, the retirement plan is the lottery or the Trifecta.

Thinking about investments, finance and economics often brings one into contact with some unpleasant facts. After all, economics is the study of the allocation of scarce resources. But the Author has never backed away from unpleasantries. In fact, he is often described as “unpleasant”.

But the following facts are really unpleasant:

Few Americans are saving enough to fund their retirement.
Social Security will not be able to fund the “obligation” to the Baby Boom generation without major adjustments or reduced benefits.
Corporate pensions are frequently under funded and many companies will default upon their pension payments to retirees.

As unpleasant as these sound, there is at one “solution” and one “workaround”.

Few Americans are Saving Enough. Retirement planning was formerly a “three-legged stool”. One’s retirement was funded by a combination of personal savings, a company pension, and Social Security. Many companies no longer offer “defined benefit” pensions and these traditional pensions have been replaced with 401(k) plans. These plans are effective alternatives to pensions, but require the act of “saving”, foregoing current consumption for future security. An act that Americans are often loathe to do.

There is a solution to the inadequate savings problem. And this is the only one of the three unpleasantries that has a solution. “Bite the Bullet”, “Pony Up”, “Insert your own John Wayne type aphorism here” and save more for retirement. As my former Minnesota neighbors would say, “End ‘uh’ Story”!

Social Security. Social Security has been called, and still is, the “Third Rail” of politics. Like the third rail on an electrically powered commuter train, touch it and you die. Witness Bush’s Social Security proposal fiasco of earlier this year. The Author will not jump in with some proffered solutions for Social Security. But suffice it to say that demographic factors will force change and those changes will mean reduced benefits. Whether those reduced benefits take the form of lower benefits, means testing based upon income, later eligibility age, or a combination of all three, benefits will be reduced.

The solution above, “save more for retirement”, is a solution for reduced Social Security benefits. And there is a “work around”[ii]. Keep working. When Social Security was enacted, the life expectancy of an American worker was 67 years old. It did not take an actuarial genius to know that the program would have it easy for the first few years. But if we look at the nature of work performed at that time, it was physical and demanding. People’s bodies were often “worn out” long before 65. The changing nature of work now leaves most people health and able to continue to keep working well into their 70s.

Additionally, evidence is showing that many people are currently working past 65 and will continue to work as long as they find it satisfying (or economically necessary.)

Corporate Pensions. For many workers, corporate pensions are not an issue. Few companies offer them anymore. And within the past three years, nearly 600 pensions have defaulted, throwing their obligations on an under funded federal agency called the Pension Benefit Guaranty Corporation. (PBGC). These under funded pensions will require shoring up from the earnings of the companies, lowering the value of the company’s stock. In the worst-case scenarios, they will fall upon the “guarantor of last resort”, the US taxpayer.

YOU ARE THE RETIREMENT FUNDER OF FIRST AND LAST RESORT

The Author believes that there will generally be two types of retirees in the next few decades. And their retirement status will NOT be determined by the amount of income they earned during their working lives. Their retirements will be determined by how they PLANNED and SAVED during their working lives. Let’s look at these two types of retirees:

Frankie and Flora Ford. These are the folks that live well within their means, research how much they will need to fund the retirement they desire, and work diligently to save and invest enough to fund that retirement plan. They review their plan yearly and make adjustments as required.
Lenny and Leona Lexus. They live in the best neighborhood they can afford, drive the best car they can lease, and live like there is no tomorrow. Their “tomorrows” will reflect that earlier lifestyle.

WHY IS THE BEST SOLUTION THE HARDEST ONE?

This post has been on the dour side. But it was meant to be. Saving for retirement is the only guaranteed solution to live the kind of retirement you would like. And lower returns in the next decade or so will make the job of saving and investing even harder. But what is the alternative?

Politics aside, the US government lacks the fiscal ability to fund the Baby Boom generation retirement as generously as it has funded the retirement of prior generations. [iii] It might not sound fair to those of who have “paid in all their lives”, but fireside notions of fairness and equity cannot change the demographics and the failure of past government to address this problem. It is the situation the Baby Boom generation will face in retirement. YOYOMF.

LIVE LONG AND PROSPEROUSLY IN THE DESERT OF THE REAL!

[i] This is a paraphrase of a “Bizzaro” comic.
[ii] No pun intended.
[iii] But after the Baby Boom generation is in the ground, the demographics will look a little better. The Baby Boom generation, in benefit funding terms, has been described as the “snake swallowing the pig”. Once the Social Security system digests the “pig” (baby boom generation), the “snake’s” body will return to normal size and the ratio between retirees and workers will come back into line.

WHAT HAPPENS WHEN YOU “GOOGLE” GOOGLE?

WHAT HAPPENS WHEN YOU “GOOGLE” GOOGLE[i]

What has Wal-Mart scared and Microsoft peddling hard to try to catch up? Answer, “Google”, the search engine giant. But it is not the search engine that has Wal-Mart scared. It is the potential for Google to provide shoppers with immediate, real-time information about better prices on merchandise at a neighboring store. Here is how is may work, according to a New York Times article from November 6, 2005, “Just Googling It is Striking Fear into Companies”[ii]

Ibrahim is out shopping for a TV set. Ibrahim is a careful and studious shopper. If Ibrahim had gone out shopping in 1995, here is what he may have done:

1995-Ibrahim goes to the library and reads Consumer Reports and some electronics magazines. He determines that the best TC, given his needs and budget, is the Sashimi 36” rear projection TV. He pulls all of the consumer electronics store ads from the Sunday paper, finds the best price, and buys the set at “Big Tent TV”. The Internet is up and running in 1995, but there is little information on the Internet in 1995 that Ibrahim could not find elsewhere.

2005-Ibrahim needs to upgrade the TV. He researches the TV models on line and determines that the Samsan 48” Plasma TV is the best deal. He goes on Priceline.com and other online retailers. The Samsan TV is a new model, however, and he finds that web discounters do not yet have the TV. So he goes to the websites of electronic retailers in his area and finds the best price. He finds the best price at “Big Box Mart” and buys it there.

2010- Ibrahim is happy with his TV but sees the complete box set DVD set of “Girls Gone Wild-The Lake Minnetonka Years” in “Big Zip Code Entertainment Café. He is out shopping for a video for his brother’s bachelor party. He sees that it is 24 euros. He pulls out his cell phone and swipes the DVD’s barcode. He then enters “GoogleCompare” and sees that Pete the Perennial Sophomore has the same DVD on sale at 19.95 euros. Wackamart has the video for 22.95 euros, and that he can get in online from Terazadon for 19.95 euros. Ibrahim has heard off the Pete the Perennial Sophomore store but has never been there. He Google maps it and gets directions from his current location.

DISRUPTING WALMART AT THE SHELF LEVEL

The scenario for 2010 is what has Wal-Mart concerned. And it should have other retailers concerned. The pieces of the technology are already coming into place for this instant pricing scenario. Cell phones will contain a bar code reader that will upload the product data. Neighboring retailers will post their prices on their websites. Google compare will run a search using geographic parameters Ibrahim has preset and search nearby store websites. Google currently has a map and directions utility and that utility could locate and map the directions to the selected store.

And you can imagine how all of this might go further. Some stores might have a policy that they will meet or beat any other price. So Big Zip Code Entertainment Café might lower its price to match Pete’s. Or Big Zip Code could limit such discounts to frequent shoppers. Or people in affluent zip codes. It could search the volume of Ibrahim’s purchases to determine if he buys enough from the Big Zip Code to offer the discount. Some stores could allow Ibrahim to send his credit card information ahead to reserve an item while he is enroute to the store.

DISRUPTING THE RETAIL CONCEPT ITSELF

Some readers have heard the concept “disruptive technology”. A disruptive technology is one that puts it predecessor out of business. A common example would be the internal combustion engine that ended the horse and buggy. Or the telephone that took out the telegraph industry. Or the telegraph that ended the Pony Express.

In many retail markets, it is price that ultimately drives higher sales volume and ultimately competitive success. Wal-Mart is an extremely efficient organization that reduces costs and gains market share through lower costs and greater sales volume. It is a good economic success, but it has itself been a disruptive force. It has bulldozed the main streets of many American small towns. It has shifted production to China and lower cost countries through its large buying requirements. And it is able to restrain wage costs.

But economic efficiency is an inexorable thing. Unless constrained by political action, the efficiencies Wal-Mart amasses will drive sales volume its way.

Google and these point-of-purchase shopping functionalities may be one way for the market to turn back against Wal-Mart.

DISRUPTION IS INNOVATION IN THE DESERT OF THE REAL!

[i] No, the deadpan literalist comic Stephen Wright did not say this first. The Author, in researching this post, “Googled”, or used the search engine Google to search the term “google”. His results, on a fast connection, provided 759,000,000 [hits] for google. (0.12 seconds).
[ii] www.nytimes.com, subscription probably required. But subscription is free.

THE ECONOMICS OF US ARMY ENLISTMENT

THE DEAD END DRAFT?

Recently released Pentagon figures reveal what many analysts have long known-many military recruits come from rural, poor and disadvantaged backgrounds. According to an article in the Washington Post, “Youths in Rural US are Drawn to Military[i], nearly two-thirds of 2004 Army recruits came from counties in which the median household income is below the US median household income. Simply put, these youth, facing more limited economic prospects in their poor rural counties, are observed to join the military to improve their economic prospects.

ARE RURAL LIMITS INSURMOUNTABLE, OR JUST SELF-IMPOSED

The Author generally believes that there are often several options to escape limited financial or personal opportunities. But it would be naïve to suggest that there is not a strong link between limited financial opportunities and military enlistment.

A POOR CHOICE CAN BE ABOUT THE SAME AS NONE

The top 20 counties with the highest recruitment rates are confined to the South, and Midwest, with a concentration in Montana. A county from the Author’s original home state, Indiana, is Benton County at number 11. Benton County is a sparsely populated rural county. Many counties in Indiana have high rates of Army recruitment. Some of these counties appear to be more urban counties with greater economic opportunities, so some of this concentration may be due to cultural or political factors that promote interest in military enlistment. And it has long been noted that the strong military tradition in the South promotes disproportionate enlistment figures.

The all voluntary military has been in place for more than 30 years and military officials believe that this force functions more effectively than a military of young conscripts. But when we look at today’s military demographics and correlate this with casualties incurred, it is an inescapable conclusion that the rural poor are incurring disproportionate casualties.

IN MEMORIAM.

A 19-year old solder from Noble County, Indiana, the Author’s birthplace, was recently killed in Iraq. Below is the poem “Dulce Et Decorum Est” by Wilfred Owen, a World War I solder poet. Wilfred Owen was killed on November 4th 1918, only seven days before the Armistice to end the “War to End all Wars” was signed. The poem is dedicated to this soldier and to the other casualties in Iraq.

Dulce Et Decorum Est

Bent double, like old beggars under sacks,
Knock-kneed, coughing like hags, we cursed through sludge,
Till on the haunting flares we turned our backs
And towards our distant rest began to trudge.
Men marched asleep. Many had lost their boots
But limped on, blood shod. All went lame; all blind;
Drunk with fatigue; deaf even to the hoots
Of gas shells dropping softly behind.

Gas! GAS! Quick, boys!-
An ecstasy of fumbling,Fitting the clumsy helmets just in time;
But someone still was yelling out and stumbling,
And flound'ring like a man in fire or lime . . .
Dim, through the misty panes and thick green light,
As under a green sea, I saw him drowning.

In all my dreams, before my helpless sight,
He plunges at me, guttering, choking, drowning.

If in some smothering dreams you too could pace
Behind the wagon that we flung him in,
And watch the white eyes writhing in his face,
His hanging face, like a devil's sick of sin;
If you could hear, at every jolt, the blood
Come gargling from the froth-corrupted lungs,
Obscene as cancer, bitter as the cud
Of vile, incurable sores on innocent tongues,
-My friend, you would not tell with such high zest
To children ardent for some desperate glory,
The old Lie: Dulce et decorum estPro patria mori.

Dulce et decorum est pro patria mori: How sweet and fitting it is to die for one's country--an old Latin saying very popular on military gravestones.



[i] http://www.washingtonpost.com/wp-dyn/content
/article/2005/11/03/
AR2005110302528.html?sub=AR

ALPHA, BETA AND PICKING BETTER-PERFORMING INVESTMENTS

GREEKS AND GEEKS

Some readers may have heard the term “Beta” in reference to mutual fund performance. Perhaps a few of you have even heard the term “Alpha”. These concepts are key to assessing risk and reward for a particular investment. Ideally, investors who take on more risk should get a greater reward. That is why one expects a small capitalization technology stock to have a higher return than the stock of a large-cap food company. The odds of small tech company generating positive returns are less than that of an established consumer non-durable company generating positive returns. But many investors do not effectively balance the risk/reward equation. This post will help you bring things back into alignment.

TURNING UP THE RISK KNOB WILL NOT AUTOMATICALLY INCREASE THE REWARD

The interplay of risk and reward must be understood by investors. Without this understanding, you are at a substantial disadvantage to the market and your returns will, over the long term, lag the market. In this post we will look at Beta and Alpha. In another post we may take a run at R-squared or standard deviation. For all you squares and deviants out there.

Risk is a concept that could fill many file server discs. Many books have been written just on the concept, history, and quantification of “risk”. A good definition of investment risk is:

“The chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment.”

This definition comes from Investopedia.com. And there are many types of market risk. But for this post we will look at risk that the Author will vaguely define as “market-adjusted risk”. We will consider, using Beta and Alpha, how a particular investment performs considering the quantified risk we are taking owning such investment.

BETA. DID YOU EVER HEAR A BROKER SAY THAT A HIGH BETA IS BETTER THAN A LOW BETA? DON”T LISTEN TO THAT BROKER AGAIN!

Beta is a measure of a stock’s volatility. Volatility is the tendency of an investment to swing in price over a period of time. A stock that goes up and down by 10% is more volatile than a stock that only swings 1 to 2% in the same period. Usually volatility is measured against a benchmark. In the case of Beta, the Beta of an individual stock or mutual fund is compared against the overall volatility of the S & P 500 index. The S & P 500 Index is assigned a Beta of 1. So if you own an S&P 500 Index mutual fund, its Beta should be darn close to 1.

OUR OLD FRIENDS' THE EXAMPLES

Let’s take a look at a couple of examples that are common in mutual fund investing. We will look at two funds, one a “conservative” value oriented mutual fund called the “Slow and Steady Value Stock Mutual Fund”. The other is an aggressive small capitalization tech stock mutual fund called “Afterburner Tech Stock Fund”.

If the Slow and Steady Value Stock Mutual Fund has a beta of .8, that means that the mutual fund is only 80% as volatile as the S&P 500. This fund historically only moves 80% in value in comparison to the S&P 500. So it the S&P was up 5% for the past year, Slow and Steady would be expected to be up 4% (5 * 80% = 4). However, if the S&P was down 7.21%, then Slow and Steady would have only fallen by 5.77%.

Afterburner Tech Stock Fund has a beta of 1.25. This means that this mutual fund is 25% more volatile than the S& P 500. So if the S&P 500 rises by 9%, then Afterburner would be expected to be 11.25%. But if the S&P nosedives by 13.3%, then Afterburner will sink by 16.625%.

Beta has limits, however. Beta tells you the historical volatility of an investment, and is useful for examining expected returns in light of historical results. But to get an idea of whether you are getting more reward than risk, or more risk than reward, we must plug Alpha into the equation.

LESS RISK, MORE REWARD.

Alpha is not too difficult to explain, but it is a little complex to calculate. But to really understand Alpha, readers will need to know how it is calculated. We will start with the definition, in English not Geek:

Alpha is the risk-adjusted return on an investment. Alpha demonstrates whether your investment outperformed or underperformed a risk-related benchmark. If you outperformed the benchmark, then you got more reward for a given amount of risk. If the investment underperformed the benchmark, then you took on extra risk to get less reward. Alpha is measured in percent of over performance or underperformance. (i.e., Alpha of 1, 2, or -.5 or –1)

Let’s do an Alpha calculation to sort all of this out. For this calculation we will use the Slow and Steady Value Mutual Fund. Last year, the Slow and Steady fund returned 10%. And in doing this calculation we will bring in a couple of other financial concepts. You won’t need a calculator, but a beverage of choice may be advisable.

Risk-free rate of return. One of the first things you need to know to calculate Alpha is the risk free rate of return. This is not hard to calculate, however. The risk-free rate of return is the interest rate paid on a US Treasury note. Why the Treasure Note? They are considered risk-free because they are guaranteed by the “Full Faith and Credit” of the US government. So let’s say that a 6-month Treasury note is paying 4%. So the risk-free rate of return is 4%

Let’s follow the analysis and work up the basis for the Alpha equation at each step. Slow and Steady returned 10% last year. The risk-free rate of return was 4%.

10% (Slow and Steady Return- 4% (Risk free rate of return) = 6%. Slow and Steady exceeded the risk-free rate of return by 6%. Whether that is a good or a poor return will require some more analysis, however.

Excess Return. In a good year for the stock market, many stocks and most indices will have a higher return than the risk-free rate of return, the interest paid on a Treasury Note. Slow and Steady had an excess return of 6%. However, the excess return has to be considered in light of a benchmark for similar investments. Slow and Steady is a value stock mutual fund. For a comparison with an index of comparable stocks, we will compare it with the Russell 1000 Value Index[i]. This is an index of large capitalization value stocks. Last year this index returned 7%. So the benchmark excess return for large cap value stocks is:

7% (Large value stock benchmark)-4% (Risk free rate of return) = 3%

Beta and Expected Excess Return. Remember Beta is a volatility measurement. We need it to compare our risks with our returns. The excess risk we would expect for a our large value fund is calculated as follows:

Beta * Excess Return for Benchmark = Expected Risk-Adjusted Return

.8 (Beta for Slow and Steady) * 3% (Excess Return for large value index) = 2.4%

So the expected excess return for Slow and Steady is 2.4%. This is the excess return that the benchmark value fund index generated.

Alpha. Whew. Finally. Remember that Alpha demonstrates whether your investment outperformed or underperformed a risk-related benchmark. In this case, Slow and Steady drop-kicked the benchmark.

6% (Slow and Steady’s Excess Return) – 2.4% (Expected Excess Return) = 3.6% Slow and Steady has an Alpha of 3.6%. This means you got a return of 3.6% above and beyond the return you should have expected given the risk that you took (as measured by Beta) for investing in Slow and Steady. You should send the Fund Manager a Christmas Card and a Chia pet.

Few people actually calculate Alphas. One good source for Alpha calculations is Morningstar, a service for mutual fund investors. Morningstar calculates Alphas for mutual funds. This is a premium service, but it may be available at your local library if your library subscribes to Morningstar. And while we are on the topic of investments, if you live in a medium-sized town or a large city, your library may provide these services free of charge.

Alpha, as a stock measure of risk-adjusted return, is more problematic. An individual stock is more difficult to compare to a broad benchmark. But if you are a mutual fund investor, Alpha is a concept that you need to consider in fund selection and retention. Remember, however, Alpha is an historical calculation, and past performance is not guarantee of future results.

GEEK, BUT NOT GREEK, IS SPOKEN IN THE DESERT OF THE REAL!

IMPORANT DISCLAIMER: This post is offered for informational purposes only. Sources of information provided are believed to be reliable, but are not guaranteed to be complete or without error. Opinions and suggestions are provided with the understanding that readers acting on information contained herein assume all risks involved. The Author may or may not buy or sell securities discussed in this post.

[i] The symbol of the ETF (Exchange-Traded Fund) for this index is IWD. http://finance.yahoo.com/q?s=IWD