Plan

Intelligent investing requires a plan. Without a plan, you will wander, lost among the fog of ideas and scams.

You need to commit to that plan because long-term wealth requires that commitment, the patience to let an investment compound over time.

That perfect moment

Exiting a stock or the stock market is just one part of trading. The other part is knowing when to get back in.

And in many cases when investors get back in they are under-invested. Much of their portfolio sits in cash waiting for just that perfect moment.

Today, many individual investors are rushing into stocks just as the market is approaching new long-term highs. Where have these investors been?

Chances are very high that their returns are significantly less than what they would have been had they been fully invested throughout.

Turning forecasts into mush

Policy changes can turn all forecasts and statements about the future into mush.

They can ruin valuations, change the way assets are allocated, and reduce investment in needed areas while encouraging investments in the wrong areas. Those in charge of policy have to forecast the future. But they cannot know. They are experimenting, that is all.

As investors, we cannot predict policy changes or their impact. Instead, we have to invest in the right companies for the long term and hope that they'll adapt.

Philip Morris (now Altria and Philip Morris International, I believe) has been a good investment for many in spite of policy changes that have sharply curtailed its expected growth -- though, admittedly, this was a policy change that made sense and probably had to be done.

Calculating your portfolio's delta

Because deltas are nothing but (partial) differentiation operators, and differentiation operators add in the natural way, deltas also add in the natural way. Thus, the delta of a portfolio is the sum of the deltas of the pieces of the portfolio:

\[ \delta_{P}=\sum_{i}w_{i}\delta_{i} \]

Here, $\delta_{p}$ is the delta of the portfolio, $w_{i}$ are the weights of the components of the portfolio, and $\delta_{i}$ are the deltas of the components of the portfolio.

For example, suppose you have a portfolio made up of a stock and call and put options on the stock, as follows:

• 25 percent in the underlying stock.
• 40 percent in call options on the underlying stock, each with a delta of 0.6.
• 35 percent in put options on the underlying stock, each with a delta of -0.3.

Because the delta of a stock is 1, the delta of your portfolio is:

0.25 * 1 + 0.4 * 0.6 + 0.35 * (-0.3)

or

0.385.

In other words, using the implications of the definition of delta, as noted here, your portfolio moves 38.5 percent of the move in the underlying stock.

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Additional material: To understand the essence of delta hedging, read this.

When icons leave

Steve Jobs passes away, and even though Apple hit a lifetime high within a year after his death, Apple is now being derided as a company bereft of innovation. The stock fell below $500 yesterday.

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Jim Skinner leaves McDonald's after 41 years of service in June 2012. McDonald's has one of its worst years in quite in a while in 2012.

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Mark Hurd leaves Hewlett-Packard in 2010. The stock has lost about half of its value since then.

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And it isn't just big companies.

Mellanox was having a banner few quarters until early September 2012. Its stock had risen from about $33 to begin 2012 to $120 by early September. It was not just beating expectations; it was trouncing them. Then, in September, the CFO announced that he was retiring. The stock immediately sank by $10. Since then, the company will have had three iffy quarters, and after yesterday's shellacking to the low 40s at one point, it has been slaughtered.

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Of course, with time, things can -- and do -- turn around.

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Leadership matters. It's more than just who these leaders are. It's obviously what they know. But it's also what they stand for and how they inspire.

Yamada is calling for a generational shift in bonds

The tiny prognosticating titan, the sweet Louise Yamada, is calling for a generational shift in bonds. She says interest rates are bottoming -- thus prices are topping. This means interest rates are going up and bond holders will get punished.

However, she does not think any of this will happen overnight. As with anything dealing with bonds, changes are pretty glacial.

She advocates gradually shortening average bond duration. That's probably right. Anyone who's socking away money in 10-year Treasuries yielding 1.90 percent or so these days is asking for trouble.

And, yes, people have been lamenting about this for years. But when longer-term yields start dipping below the 3.0-3.5 percent rate of long-term inflation, and remaining there for an extended time, then double-bottoming, that's a strong hint that something different is happening.

The little lady is rarely wrong.

We shall see.

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Source: Yahoo! Finance [with video]

Sector earnings for the S&P 500

(Data courtesy of Standard & Poor's)

Generally speaking, stocks follow earnings. For the financials, earnings have been recovering and, not surprisingly, the sector has staged a strong recovery since the mass hysteria of 2008/2009. (Of course, this was after quite a few of them crumpled and the rest were just one Bernanke put expiration date away from purgatory.)

Volatile earnings trends are more suited to traders than investors. Traders yearn for the volatility of prices. Investors should want a slow and steady rise up and to the right. They should not want to buy and sell. For this to work, they need sectors that do not go through stomach-churning drops every now and then.

Trends such as these are evident in graphs of sector earnings. (Even better are long-term graphs of sector earnings.) Consumer staples, for instance, is one such sector for long-term investors. Others are health care (though this one has too much government meddling) and possibly industrials. Earnings don't yo-yo around. Earnings trend slowly and up and to the right.

Still, a lack of volatility is not the only requirement for long-term investors. They also need growth. Thus, the utility sector is generally not a good choice. And valuations, as always, do matter. Finally, as has been proven time and time again, most analyst estimates are biased toward the optimistic end. Many analysts also miss the macroeconomic picture.

More on the Mean-Variance Portfolio, 1995 to 1999, stocks vs. bonds

More on the 1995-1999 Mean-Variance portfolio, a picture of which was posted earlier, and is reproduced above.

The Mean-Variance Portfolio, stocks vs. bonds, 1995 to 1999, was a fairly ridiculous 90% stocks plus 10% bonds. Compared to today's returns -- and the typical returns in the stock market -- the expected return from this portfolio is absurd: 25%. Risk is absurdly low as well: 5.53%.

The high concentration in stocks in the Mean-Variance portfolio was because (1) stocks performed so exceptionally well during this period;  (2) they did so with relatively low risk; and (3) bonds and stocks were highly correlated.

Stocks averaged returns of 27% a year with risk of just 5.5%. Bonds actually had lower returns, 7.8% a year, and with somewhat higher risk, 6.4%. In addition, adding bonds to stocks added very little -- there was no significant diversification effect: Bonds and stocks were correlated to the tune of 84%.

Stocks did very well during this period because of the internet mania in tech stocks, upgrades to computer systems in anticipation of Year 2000 problems, and the release of liquidity by the Fed in anticipation of a Year 2000 collapse that did not come. Buy on the dip worked then.

Delta Hedging

Consider a portfolio with exactly one share of a stock, value S. How do you protect it from small moves in S? That is, how do you keep the value of your portfolio stable when S changes by a small amount? The answer: You buy insurance. Translated: You take a position (usually, in an option) which moves in the opposite direction of S. Then when S moves one way, the option will offset it with a move in the other way. With the right number of units of the option, your portfolio will now be stable. But what is the right number of units of the option? There's where delta hedging comes in.

In an earlier post, we saw that delta is defined by:

$$\Delta =\frac{\partial f\left(S,\mathrm{...}\right)}{\partial S}$$

Writing this in the form of infinitesimals, we get:

$$\Delta =\frac{\delta f}{\delta S}$$

Transposing the infinitesimal of S with delta:

$$\delta S=\frac{1}{\Delta }\delta f$$

Or, on moving the right-hand-side term to the left:

$$\delta S-\frac{1}{\Delta }\delta f=0$$

In other words, when S changes by a small amount, a number of units of [-1 divided by delta] of f will ensure that your portfolio does not change in value. It is protected. (That's what the 0 means. The change in portfolio value is zero.)

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As an example, suppose you have one share of IBM and you want to delta-hedge it. You are thinking about hedging it with IBM call options each with a delta of 0.5. How many call options do you need? Answer: You need (-1/0.5) or -2. Thus, you need to short 2 call options. Easy, right?

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To summarize: To delta-hedge each share of stock that you hold, you need a position of [-1 divided by delta] units of the option. If the minus sign throws you off, think of the number of units as [1 divided by delta] and set the sign mentally to make the net change equal to 0. Thus, in the IBM example, you need to short the option because you need a negative sign to offset the positive position in the stock.

Bill Gross tells Abby Cohen her 2013 earnings growth rate forecast is "farcical"

The article is also revealing in the arguments made by Gross over the source of recent corporate profit growth:

"Corporate profits have come at the expense of labor. Wages as a percentage of GDP have declined to 54% from 59% in the past 10 years. That trend would have to continue for earnings to keep going up. Also, 30% to 35% of earnings growth in the past five years has come from lower interest expense. Most of you probably would agree that is coming to an end, as well. Corporations have to sell their products to somebody. They can't benefit when that somebody has depressed wages and high leverage. At some point the game begins to change. A forecast of 12%-to-13% earnings growth under such circumstances is not only extreme but almost farcical."

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Source: Business Insider

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Wages might be going down because corporations are moving labor costs overseas and technology is replacing many jobs.

If lower interest rates become a thing of the past, bonds will get cauterized and Bill Gross's bond funds will be clobbered. He states later that money have not "yet" vacated his funds.

Corporations are also selling their products overseas and wages there, at least in the developing world, are improving.

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All that said, 12-13% growth does seem pollyannish.

Of preparation and patience in the stock market

"The Tao abides in non-action, yet nothing is left undone." Lao-tzu

In other words, prepare like a maniac before you buy. Pay attention to valuation. Buy only high-quality stocks that can stand the test of time.

Once you have bought, leave your high-quality stocks alone. Don't trade.

Chances are if you trade you'll do yourself more harm than good.

Balance only if things get totally out of whack.

Only once in a generation will you have to pay attention to a mania.

And, again, buy only high-quality stocks that can stand the test of time. Don't buy junk. With the bulk of your assets, don't speculate.

Time

Do not put your long-term investments at risk by investing in companies with weak or varying profits. Stay away from them -- or trade them. These companies are often just one downturn or one bad decision away from disaster. A long-term investment in a weak company must always end badly.

Time hacks away at a weak company's business, slowly but surely sending its share price to zero.

Warren Buffett: Buy American. I Am.

On 16 October 2008, in a New York Times op-ed, Warren Buffett wrote “Buy American. I Am.” This during a spell when the market had endured one of its most horrific moments less than a week before.

Early October 2008 was not the absolute low. March 2009 was the absolute low. But that does not matter. No one has a crystal ball; but gauging sentiment and taking advantage of market panic matters.

In the stock market, courage matters.

Buy when others are scared.

If you buy solid companies at times like these you actually lower your risk not increase it.

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Source: New York Times -- Buy American. I Am.

Credit Suisse's Top Picks in Software for 2013

Picks from the guys at Credit Suisse:

"Oracle is our top pick in large-cap stocks for 2013, followed by VMware, Salesforce.com, and Sap, while our favorite midcap-software stocks include Cornerstone, Proofpoint, NetSuite, Splunk, Jive Software, and Ultimate Software."

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For now, the market is rewarding revenue growth from the smaller software players in cloud computing -- it is allowing them to get away with investing in their businesses. This has meant that valuations are high -- extreme really -- based on traditional metrics, such as those based on earnings.

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Source: Barron's

If the above link gives you limited access, google "A Top Pick in Software for 2013" and click on the Barron's link. If you haven't reached the Barron's article limit for the month (?), you should be able to read the article in its entirety.

Delta

Delta is one of the infamous Greeks of Modern Portfolio Theory.

It is the most straightforward of the Greeks, however, being the partial derivative of an option (future, or whatever) with respect to the underlying (here, stock price):

\[ \delta=\frac{\partial f(S,...)}{\partial S} \]

As a (partial) derivative, delta indicates how much the option moves when the underlying moves.

For instance, an option with a delta of +0.3 moves 30 percent of the underlying in the same direction. If the underlying moves up 20 percent, the option moves up 6 percent; if the underlying moves down 20 percent, the option moves down 6 percent.

Conversely, options with negative deltas move opposite to the direction of the underlying: They move down when the underlying moves up and up when the underlying moves down.

Because of this neat little trick, options with negative deltas form the basis of hedging.

Albert

"Everything should be made as simple as possible, but not simpler." Albert Einstein

(Image courtesy of Wikipedia)

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Simple models of stocks generally lead to wrong conclusions. P/E and PEG models are simple models that often misinform.

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For instance, a cyclical stock has a low P/E just when it is most dangerously valued.

A stock with a declining business has a low P/E because investors expect nothing, not because it is a good buy.

PEGs tell you nothing about the quality of growth or the following year's growth.

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You can -- and should -- simplify; but you cannot simplify so much that your Mona Lisa begins to look like a Betty Boop.

Feel the beat from the tambourine

Released during the heyday of bell-bottoms and disco, one of the greatest songs of all time, so lyrically beautiful, Abba's Dancing Queen...

The Best Online Brokers from Kiplinger's

I wish they would have indicated -- numerically -- what each firm had scored in each category.

That way, each of us could re-rate the firms independently of how they rated them.

After all, Kiplinger's uses weightings that might differ from what you or I deem as important:

"We based our weightings on what our readers consider important: costs, 25%; investment choices and user experience, 20% each; research and tools, and customer service, 15% each; banking services, 5%."

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Kiplinger's rated E*Trade, Fidelity, and Scottrade first, second, and third.

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Source: Kiplinger's

Dividend stocks in IRAs, HSAs, and taxable accounts

If you hold dividend stocks in a traditional IRA, you do not have to pay taxes on your dividends but you do have to pay income taxes when you withdraw your money.

If your income tax rate is higher than your dividend tax rate, the savings that you gain from not paying taxes on your dividends today -- even after letting those tax savings compound -- may not be enough to offset what you lose in income taxes later on.

In such cases, depending on how long you hold the stock in the traditional IRA, and this may sound sacrilegious, but it may be better to hold your dividend stocks in a regular taxable account.

For example, if you had the stock for exactly one year in a traditional IRA, you'd pay (say) 25 percent in income taxes when you take the money out. On the other hand, if you had the same stock in a regular taxable account, you'd pay just (say) 15 percent in dividend taxes.

By contrast, because you avoid paying taxes on your dividends forever, you can hold dividend stocks in Roth IRAs and HSAs with impunity.

The certainty of dividends

Investors prefer the certainty of dividends today versus the hazy promise of share buybacks -- and the uncertainty of higher prices tomorrow.

They may or may not be equivalent but investors do seem to prefer their dividends.

Higher taxes on dividends? Less efficient than share buybacks? So what. Investors don't seem to mind -- or care.

Stocks could rise 10 percent in 2013

The S&P 500 might hit an all-time high.

Market P/E expected to rise.

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Growth sectors expected to outperform.

Defensive sectors expected to underperform.

Technology, industrials, and energy are the best sector bets.

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Source: Barron's

Feasible set and mean-variance portfolio, stocks vs. bonds, 1993 to 2010

Normally, you'd expect a much higher contribution from stocks. Not so between 1993 and 2010.

If you could magically look back and forecast, the optimal portfolio was 97 percent in bonds and just 3 percent in stocks. How's that for Stocks for the Long Run, Mr. Jeremy J. Siegel!

The shape of the curve is also quite strange. Normally you'd expect something like a U-shaped curve rotated 90 percent clockwise and funneling wide to the right. I'll have to check all of this at some point, because I find it hard to believe, but I think it's right.

Human Capital: Education pays

If you have a Master's degree or higher, America is still the land of opportunity. You are essentially fully employed and you earn a decent wage.

If you have a Bachelor's degree, a few of you are looking for a job but you do earn a decent wage.

If you have an Associate's degree or some college, you are a bit less than the median on both counts.

If you have a High School degree or less, you are in big trouble.

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Source: Education pays

Indexing

The concepts behind diversification led to the creation and popularity of indexing.

Indexing helps when investors know nothing about the market -- or don’t care to know.

Managers of index funds make no attempt to understand the market or their stocks.

This reduces costs and, since costs make a big difference in any competitive field, investing being like any other, index funds have a leg up on the average fund.

Experience

Without the lessons of experience, investors never learn who they are, what works, what does not.

They never learn to appreciate that risk matters; that risky investments often flop; that investment success takes time.

Cash reserves and Warren Buffett

“During the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival,” Buffett said in the letter, which accompanied Berkshire’s 2010 annual report. “That’s what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy.”

From Bloomberg, the full article (its focus is on the buyback but the above quote is mentioned in passing): http://goo.gl/AzguA

The moral of this story: Though Buffett kept a huge cash reserve, it never hurts to keep a reasonable cash reserve. When the opportunity presents itself, you'll be ready.

Relative valuation

Relative valuation never tells you if a stock is overvalued. It only tells you if a stock is overvalued relative to its comparison. You can still lose if the comparison is overvalued.

During the Dot Com Bubble, one internet stock may have looked undervalued relative to another; but, in fact, all were overvalued.

Mean-variance portfolio, 1995-1999, stocks vs bonds

Guesses

The difficulty of short-term forecasting arises because history has this uneasy habit of not always repeating in the way that it once did. What may have been correctly ignored before suddenly becomes relevant today; what was relevant in the past suddenly becomes of questionable value today.

Quite hopelessly, no one can reliably predict anything in the short term. Even if someone gets it right once, the market often proves them wrong later. Most investors guess.

And history has often proved those guesses wrong.