Tag Archives: equity

The League Of Extraordinarily Lucky Gentlemen

The Wall Street Journal offers investment advice. And it’s not good advice either; or at least, it’s not obviously true that it is. In fact, I very much doubt that it is.

But I’m getting ahead of myself. What’s the article about? The author followed 196 investors since 2007, evaluating how much money they made (and lost) and checking whether they managed to beat the market, as measured by the Wilshire 5000 index. And lo and behold, a “select group” did indeed manage to do so! And these people are willing to give advice to you! The Journal stresses that they outperformed the Wilshire 500 not only during the bull market since 2009, but also during the bear market before. Which is quite a feat:

 “almost without exception, the strategies that have made the most money since March 2009 were big losers in the preceding bear market. For example, the five best advisers over the past five years, among the nearly 200 monitored by the Hulbert Financial Digest, lost an average of 58% during that downturn.”

On a side note: the article just acknowledged that past performance by no means implies future performance, right? Or is the intended takeaway here that past losses by no means guarantee future losses? Which is also true, but it’s hard to make one point without also making the other. Strange as it may seem, the author seems to miss the other side of that particular coin.

Anyway, what about that investment advice? Well, all of these exceptional investors seem to agree on one point, namely that “you should remain at or close to fully invested in your equity portfolios.” Now there are probably good reasons why, depending on your particular situation and available alternatives, you should keep whatever money you can spare right now in equity. So I’m not actually too critical of this. Although I would point out that if you ask a group of people who take “$85 to $299” for their services and tell people to buy stocks for a living, “should I buy some stocks, you think?” they’re probably gonna say, “yes (that’ll be 300 bucks, thank you very much)”.

Other than that, all six advisors seem to be invested in… wait, did you say there’s only six of them who managed to beat the market for that whole period?! Out of 196? Why, that’s… about 2.6%! I’m going out on a limb here, but I assume that that number isn’t statistically significant (-ly different from zero). For the record, I’m of course being polemic here, because I don’t have the data in question; most importantly, I don’t know by how much these lucky few beat the market, which would be what you’d really want to look at to determine whether their exceptional gains were due to chance alone.

But I will say this: I’d take a bet that if I took 196 random stock samples from the Wilshire 5000 right now, 2.6% of them could probably beat the market. Actually, I might go on and compile that list once the semester is over. I’m sure Matlab will be up to the task.

I’ve got another one for you: the initial investors probably weren’t even a random sample of all financial advisors out there. Probably, they’re the ‘good ones’. Which means that even the best of the best don’t have an awesome track record by any means, and what are your chances of drawing an advisor from that pool in the first place, let alone one of the 2.6% that manage to outperform the market? I can’t tell you, but I can tell you that they’re worse than 2.6%.

Oh by the way, it’s a little odd that the article doesn’t mention by how much these guys beat the market. Would it have earned you more than $230? (Not that that’s what you’re really interested in. What you really wanna know is, given that you have to pay a fee, is that fee greater than or equal to your chances of finding an advisor that happens to beat the market, which are smaller than 2.6%, times the amount by which he or she is going to beat the market, which the article doesn’t provide? They’ll need to outperform the market by quite a bit to make that work).

But I digress; I fear that I never got to share the great investment advice, but luckily you can just go and read the article. I do have one last thing that bothers me though: if one of those six really, actually had an awesome secret to making boatloads of money, would they ever tell you? Or even risk that, by observing what happens to your portfolio, you’d ever find out? As soon as the world knew, a) their strategy would probably stop working, and b) nobody would pay them 300 bucks for stock advice anymore! So it’d be in those guys best interest, even if there was a pot of gold at the end of the rainbow, to never, ever, let you get more than a faint glimpse of it.

Which, by the way, also means that anybody who’s letting you in on their big investment secrets is probably either irrational, or lying to your face. Both of which seem somewhat underwhelming traits for a stock broker.

Earnings in the Financial Sector

Although the U.S. economic recovery is still trying to gain momentum, some of the U.S. banks are bigger and earning near their record levels. J.P. Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley earned $76 billion in 2013. According to the Wall Street Journal, “That is $6 billion shy of the collective all time high achieved in 2006, a year U.S. housing prices peaked amid a torrid economic expansion”.

The strength in the financial sector is reflected in their stock prices. The Financial Select Sector SPDR, which is an exchange-traded-fund that tracks the financial sector, is at its highest level since before the financial crisis in 2008-2009.

Ticker: XLF

Ticker: XLF

Banks must continue their strong performance in order sustain their increase in share price. According to the Wall Street Journal, “Now that their stocks have run up so sharply, banks will have to perform well to keep share prices buoyant”. If they fail to meet expectations, they will likely watch their stock prices spiral downward. Thus, banks might undertake risky-decision making or other methods to juice earnings.

During the financial crisis, there were some high profile acquisitions by large U.S. banks that significantly increased market concentration. The consolidation involved stronger banks acquiring weak or failing financial institutions. According to the Wall Street Journal, “Wells Fargo, a West Coast institution that became a national presence after its 2008 purchase of Wachovia Corp., posted the highest annual net income in its 161-year history last year. Bank of America, which gained heft on Wall Street when it bought securities firm Merrill Lynch & Co. in 2009, had its best year since 2007, as revenue increased in all five of its major business units”. In the short run, acquiring failing institutions such as Merrill Lynch and Wachovia (that had massive amounts of subprime, toxic debt soon to default) depressed earnings. However, these acquisitions are clearly proving beneficial in the long run. With the losses already being absorbed, the banks can now enjoy the benefits of economies of scale and increased market share. The banking industry is more concentrated than before the financial crisis. High market concentration and massive barriers to entry in the banking industry creates questionable conduct in which banks are enjoying substantial earnings.

Another reason for near-record earnings is that the healthier U.S. economy is encouraging banks to hold fewer reserves to protect themselves against the possibility of borrowers defaulting. According to the Wall Street Journal, “J.P. Morgan, Bank of America, Citigroup and Wells Fargo freed up $15 billion in loan-loss reserves during 2013, including $3.7 billion in the fourth quarter. That money goes directly to the bottom line, boosting profits. The releases made up 16% of these banks’ pretax income for that final quarter”. The problem with this is that it means earnings are artificially inflated. In other words, this gain is unsustainable and does not reflect earnings from selling a good or service that is a part of ongoing business. When this unsustainable source of earnings disappears, banks will feel an incredible amount of pressure to find another way to juice earnings (or stock prices will likely fall).

The decision of these large U.S. banks to hold less loan-loss reserves is extremely controversial. According to the Wall Street Journal, “Some investors aren’t pleased that big banks continue to rely so heavily on improving credit conditions to pump profits. Regulators have warned the moves may be too aggressive, and that they are unsustainable. The reserves have added to aggregate earnings in every quarter for nearly four years”. Not only is the reduction in loan-loss reserves artificially inflating profits and creating increased expectations for future earnings, it makes me question quality in bank earnings.

The weakness in bank earnings is reflected in their return on equity (ROE), which relates the earnings of the firm to Owners’ Equity. An underlying assumption is that the earnings of the firm belong to the firm’s owners, which makes ROE a closely watched investment-performance ratio for stockholders. According to the Wall Street Journal, “Return on equity has been a problem for banks since the crisis, as regulators cracked down on risky, but potentially profitable, businesses and required financial firms to raise equity to make their capital structures safer”. Regulation is requiring that banks hold more capital rather than put that capital to work. In order to improve ROE, you cannot just increase sales. Rather you must increase the efficiency by which sales are generated. As the economy improves, investors are going to want ROE to improve and this is being made hard by strict financial regulation. This has promoted banks to reduce compensation, cut their workforce, and shed certain lines of business. Although financial regulation is designed to create financial stability, it is creating huge challenges for banks (reflected by a low ROE).