Aaron Hoos’ weekly reading list: ‘Fundamental analysis, monetary policy, and medical ethics’ edition

Aaron Hoos: Weekly reading list

Here’s what I’m reading this week.

  • The limit of fundamental analysis: You. I love investing and I particularly love fundamental analysis. There’s something really fun (perversely so, I realize) about doing your own due diligence on a stock. So the title of this article caught my attention. In the article, Jordan Terry talks about the challenges of performing fundamental analysis and how the analyst’s biases can skew the numbers, and he rightly points out that good fundamental analysis should also force us to consider whether our own point of view is influencing what we see.
  • Monetary policy hindered by demographics. Way back in the day when I was a stockbroker, it was hammered into us at the time that we should be looking forward to the great asset transfer in which baby boomers would pass along their assets (some of it while they were still alive and some of it after they had died) to their children. We were trained to sell around those concepts. So I was fascinated by this article, which reports on how the aging demographic is changing the face of economics in unexpected ways, and I’m particularly interested in the conclusions drawn about how monetary policies need to change to keep up with the massive shifts in demographics.
  • Five days at Memorial: A hospital becomes hell. Normally I write about business and the markets because that’s the kind of stuff I like to think about but I try to read more widely than that because it keeps the old brain juiced up. I stumbled across this article in Salon about the events that occurred at Memorial Hospital in New Orleans during Hurricane Katrina. This article was a tough read — partly because it’s true and partly because it exposes darker truths about ethics (in the medical system and in myself). I want to think that I would do the right thing in that situation but it’s such a complicated situation… and what is the right thing? It’s easy for us to sit comfortably in judgement at things that seem very wrong but gosh, what a crazy scenario. Read this article but be warned that you may ask yourself the same questions I asked… and not like the answers.

Yes, you CAN time the market (just not in the way you want)

You can't time the marketTiming the market is the most ridiculous idea out there. (Well, maybe not the MOST ridiculous idea out there but it’s pretty out there and it’s pretty pervasive so maybe it’s high up on the list).

The thinking behind timing the stock market goes something like this: “Oooh! I want to buy that stock. But the price is too high right now. Maybe I’ll wait until the price goes down.

And then when the price does go down, the thinking changes to: “Ouch! I want to buy that stock. But the price is low and what happens if I buy it and it goes lower?

This is true for real estate, too. A potential homebuyer might say: “Whoa! Houses are too expensive right now. I’m going to wait until home prices come down a bit before I buy.

But when the sellers market becomes a buyers market, the potential homebuyer now says: “Yikes! House prices seem to be declining. What if I buy and the house declines even further in value?

I hear this line of thinking OVER AND OVER AND OVER AND OVER. I heard it when I was a stockbroker and I hear it today in my work with financial and real estate professionals. I’ve tried to talk people out of this thinking but it can’t be done. (And the truth is, sometimes I fall into the trap, too!)

Like some optical illusion, the price of a stock or a property is never perfect right now and investors believe that by waiting, they can buy it at a “better” time.

Unfortunately, there never is a better time. EVERY price point has its advantages and disadvantages. Unfortunately, investors only see the disadvantages to buying now (regardless of price point) and the advantages of buying later (regardless of price point)… and they don’t seem to remember what they said only a few months ago when the price was different.

And waiting for a market bottom or market top is impossible because it takes months of data from indicators (including lagging indicators which come after the event) to prove a market peak or valley.

Timing the market is a fools game because investors and homebuyers are always looking for the perfect price point (even though they often can’t identify what that price point is and, even when they do, they fail to act when the price reaches that point).

Timing the market is ridiculous idea and a fools game… but it’s not impossible. You just have to rethink what you mean when you want to time the market.

Joe Average and Jane Average (Mr. and Ms. Average to you) try to time the market but they fail. There are people who CAN effectively time the market. I’m talking about short term traders. Short term traders (day traders and swing traders in the stock market, and real estate investors such as flippers in the real estate market) can time the market and many of them do pretty well at it.

Here’s why some people can time the market but most people fail at it:

  • Information volume and prioritization: Successful market timers do it effectively because they receive a barrage of information and they filter out what they don’t need. Compare this to Mr. and Ms. Average who glean tidbits from headlines or from the half-wits around the watercooler at break time and act on each piece of limited info that they get, as if the latest piece of information is the most correct.
  • Entries AND exits: Successful market timers consider both entry and exit positions before they buy. To a successful market timer, an “expensive” stock is still cheap if the price goes up and a “cheap” stock is still expensive if the price ends up going down. The same goes for those in real estate. It doesn’t really matter what the entry point is… it’s how much you can sell it for afterward when you are ready to sell. Compare this to Mr. and Ms. Average who likely intend to hold their stocks for decades and who will have to live in their house. They are making entry-only decisions and forgetting that there are other (hard-to-measure) aspects to owning these assets.
  • Mindset: Successful market timers view the (financial or real estate) markets as their “business”. They make money from it. Therefore, they make decisions from a business perspective. The Average family, on the other hand, is looking at buying stocks for their retirement portfolio or their next home and they are trying to weigh their decisions on a much more personal level, which makes the stakes seem higher.
  • Buying a range instead of a single price point: Successful market timers don’t look to one specific price point as THE bottom or THE top. Rather, they expect to buy a range, buying through the bottom and selling through the top and fully realizing that they might miss a few points here or there but overall they are hitting it at the right time. Mr. and Ms. Average, though, see every single low price point as a question (“is this the bottom or will it get worse?”) and every single high price point as the top (“is this the top or will it continue to climb?”). In a way, they are making a technical trading decision without any technical information.

Don’t bother trying. You cannot time the market… at least, not in the way that you want to time the market.

 

Image credit: 2020VG

My 7 favorite economic indicators

Economic indicators are tools used by investors and economists and governments and business owners to forecast how the economy is likely to change so they can plan accordingly.

I’ve always followed a couple of economic indicators but I recently picked up a book called The Wall Street Journal Guide To The 50 Economic Indicators That Really Matter by Simon Constable and Robert E. Wright because I wanted to find more to follow. It’s a great book and if you are ever interested in following economic indicators, you’ll find some in there!

Obviously, I can’t follow all 50 but reading the list helped me add to and change the list of economic indicators I’m following.

So here are my 7 favorite economic indicators:

CONSUMER CONFIDENCE INDICATOR

Uses surveys of households to measure how consumers feel about the economy. Although I find surveys to be generally unreliable, the consumer confidence indicator still offers a glimpse into the mind of the consumer, which is a pretty good starting point in any economic study.

HOME SALES

Okay, I’m cheating a little by using two economic indicators here instead of one – existing home sales and new home sales (see the press release on this page) – but I like to pay attention to both numbers.

FEDERAL FUNDS RATE

Banks lend each other money and the interest rate they charge each other is set by the Feds (sort-of; I’m simplifying a bit here). This interest rate is a frequently reported number (you’ll hear it on the news a lot) and it determines how much interest banks eventually charge its customers. Feds have traditionally used this number to help speed up or slow down the economy so the Federal Funds rate is a good measure of how the Feds see the economy and what they’re doing about it.

WEEKLY LEADING INDEX

I love this aggregate indicator that measures money supply, industrial price indexes, housing activity, jobs and labor indicators, and prices in the capital markets. Although you’ll need a membership to access some of the information, you can get a good synopsis of the Weekly Leading Index in their news center.

METAL INVENTORIES AND PRICING

Good economies require infrastructure and infrastructure requires metals (mostly copper but other stuff too). Based on the laws of supply and demand, remember that smaller inventories will drive prices higher and bigger inventories will usually drive prices lower. So tracking the inventories and prices of various metals is a great way to see whether economies are building infrastructure or not.

ARUOBA-DIEBOLD-SCOTTI BUSINESS CONDITIONS INDEX

The Philadelphia branch of the Federal Reserve publishes some great data on the economy, including the ADS Business Conditions Index. This aggregate indicator pulls together a lot of really useful economic information on unemployment, industrial production, personal income, sales, and GDP growth.

MISERY INDEX

The Misery Index is one of my favorite aggregate indicators. And it’s so simple, too; just add the inflation rate to the unemployment rate. And voila! You have two depressing numbers combined together in one.

… AND THE RUNNERS-UP

There is also a ton of great economic indicators here:

Financial apocalypse or bonanza? A rant against the newsmedia

It was the best of times, it was the worst of times… or, at least that’s the case according to the newsmedia.

There’s a problem with the economy and it is NOT the Eurocrisis. It is the newsmedia.

Newsmedia companies need to sell more papers and get more eyeballs on their websites. So they are incentivized to spin the news to generate those sales and clicks.

To do that, reporters are forced to break open their thesauruses (thesauri?) and find ways to talk about the market in thrilling, reader-magnetizing ways. Then they file their story, send it off to an editor who is also incentivized to get more readers and viewers, and the story gets published.

To generate some “read-it-now” urgency, reporters use power verbs to describe market movement. So falling prices become plunges and dives and rising prices become surges and skyrockets.

Unfortunately, a regular stock market movement that no one might care about suddenly gains a boom/bust quality that whipsaws investors between financial apocalypse and bonanza.

This contributes negatively to the market because this alarmist writing creates volatility: Inexperienced investors (there are A LOT of inexperience investors) see that the market is “plunging” so they sell stock; or, they see that the market is “skyrocketing” so they buy stock. Thus, a story about a normal market movement, which has been juiced up by an eager reporter, creates a self-fulfilling prophecy

There are no winners in this scenario. The newsmedia has done a disservice to the public and the vast majority of investors buy at the wrong time because inexperienced investors are reactive investors who lose money by buying when prices are high and selling when prices are low.

Of course this issue has gone on for a long time but I’ve noticed it even more lately as widespread economic challenges around the world provide fodder for an eager-to-get-their-story-in-print reporter.

It concerns me because a Greek exit from the Euro will be difficult for Greece and will definitely be a blip in Europe’s economic reality. But from a global perspective, many people (in the economic powerhouses of North America, Russia, East Asia, and Central Asia) wouldn’t even notice Greece’s exit if we weren’t inundated with news about it over and over and over again. The same will be true when other countries exit the Euro.

How can I say that Greek’s exit won’t affect the rest of the world? Well here’s a quick example (there is more to it than this but I’m simplifying)… What would happen to the world economy if a hole opened up and swallowed Switzerland without any notice? Well, aside from needing to find a new source for Swiss cheese and secretive bankers, not a heck of a lot would happen. The world would go on. A little sadder, a little less chocolate and accurate time-pieces, but the world would go on. Well guess what: Switzerland has twice the nominal GDP as Greece (or another measure: 50% more GDP by population). Greece’s GDP is .004% of the world’s GDP and Greece isn’t falling into a hole. They’re just going through tough times. Those delicious gyros would still be made, and tourism won’t diminish either. (Disclaimer: GDP of course isn’t a complete measure of economic impact but I needed a quick familiar number to show you).

But because the newsmedia splashes Greece’s economic problems all over the news, inexperienced investors react negatively because it sounds bad. And when inexperienced investors react negatively, the markets drop. And when the markets drop, newsmedia writes stuff like “plunge” and “dive” and “crumble”.

This is not helpful to anyone.

What’s the solution? I’m not exactly sure; I’m still all frothed up from writing this rant. But I think the solution (which won’t ever become reality) goes something like this:

  1. Investors need to become more educated to understand the stock market. They need to know that a Greek exit will only affect them if they get jittery by it.
  2. Newsmedia need to have some accountability in how they report the markets. Viewer-generating (alarmist) headlines sell papers but hurt the market. This won’t happen because a headline like “Markets have a normal day” and “Greece’s exit doesn’t impact the rest of the world” don’t sell newspapers.

Without a doubt, there are economic struggles, and the people of Greece (and similarly struggling countries in the Eurozone) will face hardship. But I believe many of those struggles would be considerably less if inexperienced investors weren’t bombarded with alarmist news. The markets are self-fulfilling and they are heavily influenced by information that is motivated to make the markets seem worse.

Financial theory: View the Yale course on YouTube

Okay, some of you will look at this blog post and nominate it as the boringest blog post of the year. But not me! I love this stuff! Here are 26 Financial Theory (ECON251) classes from Yale, along with a “table of contents” from each video.

FINANCIAL THEORY

ECON251 Financial Theory with John Geanakoplos
Download the course material for this course at Yale’s Open Course site.

Lecture 1: Why Finance?
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Course Introduction
10:16 – Chapter 2. Collateral in the Standard Theory
17:54 – Chapter 3. Leverage in Housing Prices
33:47 – Chapter 4. Examples of Finance
46:13 – Chapter 5. Why Study Finance?
50:13 – Chapter 6. Logistics
58:22 – Chapter 7. A Experiment of the Financial Market

Lecture 2: Utilities Endowments and Equilibrium
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Introduction
07:04 – Chapter 2. Why Model?
13:30 – Chapter 3. History of Markets
24:41 – Chapter 4. Supply and Demand and General Equilibrium
37:59 – Chapter 5. Marginal Utility
45:20 – Chapter 6. Endowments and Equilibrium

Lecture 3: Computer equilibrium
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Introduction
02:48 – Chapter 2. Welfare and Utility in Free Markets
16:52 – Chapter 3. Equilibrium amidst Consumption and Endowments
32:43 – Chapter 4. Anticipation of Prices
52:53 – Chapter 5. Log Utilities and Computer Models of Equilibrium

Lecture 4: Efficiency, Assets and Time
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Is the Free Market Good? A Mathematical Perspective
11:20 – Chapter 2. The Pareto Efficiency and Equilibrium
38:42 – Chapter 3. Fundamental Theorem of Economics
46:27 – Chapter 4. Shortcomings of the Fundamental Theorem
52:39 – Chapter 5. History of Mathematical Economics
01:00:21 – Chapter 6. Elements of Financial Models

Lecture 5: Present Value and the Real Rate of Interest
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Implications of General Equilibrium
03:08 – Chapter 2. Interest Rates and Stock Prices
22:06 – Chapter 3. Defining Financial Equilibrium
33:41 – Chapter 4. Inflation and Arbitrage
43:35 – Chapter 5. Present Value Prices
57:44 – Chapter 6. Real and Nominal Interest Rates

Lecture 6: Irving Fisher’s Impatience Theory of Interest
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. From Financial to General Equilbrium
06:44 – Chapter 2. Applying the Principle of No Arbitrage
23:50 – Chapter 3. The Fundamental Theorem of Asset Pricing
39:25 – Chapter 4. Effects of Technology in Fisher Economy
51:31 – Chapter 5. The Impatience Theory of Interest
01:06:48 – Chapter 6. Conclusion

Lecture 7: Shakespeare’s Merchant of Venice and Collateral, Present Value and the Vocabulary of Finance
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Introduction
01:23 – Chapter 2. Contracts in Merchant of Venice
20:23 – Chapter 3. The Doubling Rule
36:07 – Chapter 4. Coupon Bonds, Annuities, and Perpetuities
54:24 – Chapter 5. Mortgage
59:15 – Chapter 6. Applications of Financial Instruments

Lecture 8: How a Long-Lived Institution Figures an Annual Budget. Yield
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Yale’s Budget Set
03:37 – Chapter 2. Analysis of Yale’s Expenditures and Endowment
31:51 – Chapter 3. Yield to Maturity and Internal Rate of Return
51:52 – Chapter 4. Assessing Performance of Coupon Bond

Lecture 9: Yield Curve Arbitrage
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Defining Yield
09:07 – Chapter 2. Assessing Market Interest Rate from Treasury Bonds
35:46 – Chapter 3. Zero Coupon Bonds and the Principle of Duality
50:31 – Chapter 4. Forward Interest Rate
01:10:05 – Chapter 5. Calculating Prices in the Future and Conclusio

Lecture 10: Dynamic Present Value
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Dynamic Present Values
08:49 – Chapter 2. Marking to Market
39:53 – Chapter 3. Mortgages and Backward Induction
50:42 – Chapter 4. Remaining Balances and Amortization
54:52 – Chapter 5. Weaknesses in the U.S. Social Security System

Lecture 11: Social Security
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Introduction
03:53 – Chapter 2. The Development of the U.S. Social Security System
19:16 – Chapter 3. Economic Imbalances in Social Security
38:48 – Chapter 4. Root Causes of Income Transfer in Social Security
01:05:21 – Chapter 5. Privatization of U.S. Social Securit

Lecture 12: Overlapping Generations Models of the Economy
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Introduction to the Overlapping Generation Model
12:59 – Chapter 2. Financial and General Equilibrium in Social Security
26:37 – Chapter 3. Present Value Analysis of Social Security
59:24 – Chapter 4. Real Rate of Interest and Social Securit

Lecture 13: Demography and Asset Pricing: Will the Stock Market Decline when the Baby Boomers Retire?
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Stationarity and Equilibrium in the Overlapping Generations Model
16:38 – Chapter 2. Evaluating Tobin’s Thoughts on Social Security
35:07 – Chapter 3. Birth Rates and Stock Market Levels
01:02:30 – Chapter 4. Philosophical and Statistical Framework of Uncertainty

Lecture 14: Quantifying Uncertainty and Risk
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Expectation, Variance, and Covariance
19:06 – Chapter 2. Diversification and Risk Exposure
33:54 – Chapter 3. Conditional Expectation
53:39 – Chapter 4. Uncertainty in Interest Rates

Lecture 15: Uncertainty and the Rational Expectations Hypothesis
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. The Rational Expectations Hypothesis
12:18 – Chapter 2. Dependence on Prices in a Certain World
24:42 – Chapter 3. Implications of Uncertain Discount Rates and Hyperbolic Discounting
46:53 – Chapter 4. Uncertainties of Default

Lecture 16: Backward Induction and Optimal Stopping Times
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Calculating Default Probabilities
14:58 – Chapter 2. Relationship Between Defaults and Forward Rates
28:09 – Chapter 3. Zermelo, Chess, and Backward Induction
36:48 – Chapter 4. Optimal Stopping Games and Backward Induction
01:06:47 – Chapter 5. The Optimal Marriage Problem

Lecture 17: Callable Bonds and the Mortgage Prepayment Option
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Introduction to Callable Bonds and Mortgage Options
12:14 – Chapter 2. Assessing Option Value via Backward Induction
42:44 – Chapter 3. Fixed Rate Amortizing Mortgage
57:51 – Chapter 4. How Banks Set Mortgage Rates for Prepayers

Lecture 18: Modeling Mortgage Prepayments and Valuing Mortgages
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Review of Mortgages
03:20 – Chapter 2. Complications of Refinancing Mortgages
19:26 – Chapter 3. Non-contingent Forecasts of Mortgage Value
28:40 – Chapter 4. The Modern Behavior Rationalizing Model of Mortgage Value
54:07 – Chapter 5. Risk in Mortgages and Hedging

Lecture 19: History of the Mortgage Market: A Personal Narrative
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Fannie Mae, Freddie Mac, and the Mortgage Securities Market
17:01 – Chapter 2. Collateralized Mortgage Obligations
22:44 – Chapter 3. Modeling Prepayment Tendencies at Kidder Peabody
35:40 – Chapter 4. The Rise of Ellington Capital Management and the Role of Hedge Funds
52:52 – Chapter 5. The Leverage Cycle and the Subprime Mortgage Market
01:13:51 – Chapter 6. The Credit Default Swap
01:18:36 – Chapter 7. Conclusion

Lecture 20: Dynamic Hedging
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Fundamentals of Hedging
15:38 – Chapter 2. The Principle of Dynamic Hedging
24:26 – Chapter 3. How Does Hedging Generate Profit?
43:48 – Chapter 4. Maintaining Profits from Dynamic Hedging
54:08 – Chapter 5. Dynamic Hedging in the Bond Market
01:10:30 – Chapter 6. Conclusion

Lecture 21: Dynamic Hedging and Average Life
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Review of Dynamic Hedging
09:15 – Chapter 2. Dynamic Hedging as Marking-to-Market
19:55 – Chapter 3. Dynamic Hedging and Prepayment Models in the Market
30:50 – Chapter 4. Appropriate Hedges against Interest Rate Movements
01:05:15 – Chapter 5. Measuring the Average Life of a Bon

Lecture 22: Risk Aversion and the Capital Asset Pricing Theorem
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Risk Aversion
03:35 – Chapter 2. The Bernoulli Explanation of Risk
12:38 – Chapter 3. Foundations of the Capital Asset Pricing Model
22:15 – Chapter 4. Accounting for Risk in Prices and Asset Holdings in General Equilibrium
54:11 – Chapter 5. Implications of Risk in Hedging
01:09:40 – Chapter 6. Diversification in Equilibrium and Conclusio

Lecture 23: The Mutual Fund Theorem and Covariance Pricing Theorems
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. The Mutual Fund Theorem
03:47 – Chapter 2. Covariance Pricing Theorem and Diversification
25:19 – Chapter 3. Deriving Elements of the Capital Asset Pricing Model
40:25 – Chapter 4. Mutual Fund Theorem in Math and Its Significance
52:36 – Chapter 5. The Sharpe Ratio and Independent Risks
01:04:19 – Chapter 6. Price Dependence on Covariance, Not Variance

Lecture 24: Risk, Return, and Social Security
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Testing the Capital Asset Pricing Model
14:08 – Chapter 2. Evaluation of Fund Management Performance Using CAPM
22:30 – Chapter 3. Reassessing Assets within Social Security
53:04 – Chapter 4. Reconciling Democratic and Republican Views on Social Security
59:32 – Chapter 5. Geanakoplos’s Personal Annuitized Average Wage Securities
01:08:48 – Chapter 6. The Black-Scholes Model

Lecture 25:The Leverage Cycle and the Subprime Mortgage Crisis
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Assumptions on Loans in the Subprime Mortgage Market
18:27 – Chapter 2. Market Weaknesses Revealed in the 2007-2009 Financial Crisis
29:00 – Chapter 3. Collateral and Introduction to the Leverage Cycle
38:53 – Chapter 4. Contrasts between the Leverage Cycle and CAPM
43:36 – Chapter 5. Leverage Cycle Theory in Recent Financial History
01:03:55 – Chapter 6. Negative Implications of the Leverage Cycle
01:14:14 – Chapter 7. Conclusion

Lecture 26: The Leverage Cycle and Crashes
[Click here and the video will open in a new window]
Video contents:
00:00 – Chapter 1. Introduction
02:15 – Chapter 2. Understanding Leverage
13:45 – Chapter 3. Supply and Demand Effects on Interest Rates and Leverage
21:52 – Chapter 4. Impatience and Volatility on Setting Leverage
34:48 – Chapter 5. Bad News, Pessimism, Price Drops, and Leverage Cycle Crashes
48:01 – Chapter 6. Can Leverage Be Monitored?