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Home Investments While Cocooning

admin — Fri, 17 Jul 2009 17:29:10 +0000

People are definitely skittish about the stock market right now. House market predictions are still a bit shaky, with many people losing their homes to foreclosure. Those that are not underwater are digging into their homes, like it was a safety bunker in World War I. Instead of upgrading and trading a home at a time when few homes are selling, many have chosen to take a different route: Maintaining the value of their current homes.

Out With Large Remodeling In With Small Fixes

Contractors are still out of work because many people are putting off those large house remodeling projects. However, companies that specialize in fixing small items like plumbing, roof leaks, drafty windows, and all manner of small home repairs are seeing a jump in business. That’s because people are spending more time in their homes cocooning and want to maintain them in the best condition possible, for when the market finally turns around.

Home Gardens Are Hot

Investing in a few fruit trees and edible landscaping, or a vegetable garden, are very hot trends right now. People have a bit more time to tend a garden and it can be a worthwhile investment in learning how to feed a family on a budget for less. It can also be a great selling point when the market does turn around and people start to trade up.

Greening Their Homes

If you aren’t aware of it, now’s the time to find out about the perks for homeowners in the stimulus package. If you are replacing an old furnace, adding some solar panels, or learning how to conserve water, there are a multitude of savings being offered by utility companies and the Federal government. Investing to green your home can return money in savings in utilities and taxes at the end of the year.

SOME EXAMPLE OPTIONS

admin — Mon, 25 May 2009 18:24:38 +0000

Consider some call and put options on Sun Microsystems (SUNW). The date is 13 June OF and Sun is selling for $16.25. The July options expire on 20 July and the October options expire on 18 October. In the parlance of the profession, these are referred to as the July 15 calls, July 17.50 calls, October 15 calls, and October 17.50 calls, with similar terminology for the puts. These particular options are American style.
Consider the July 15 call. This option permits the holder to buy SUNW at a price of $15 a share any time through 20 July. To obtain this option, one would pay a price of $2.35. Therefore, a writer received $2.35 on 13 June and must be ready to sell SUNW to the buyer for $15 during the period through 20 July. Currently, SUNW trades above $15 a share, but as we shall see in more detail later, the option holder has no reason to exercise the option right now.3 To justify purchase of the call, the buyer must be anticipating that SUNW will increase in price before the option expires. The seller of the call must be anticipating that SUNW will not rise sufficiently in price before the option expires.
Note that the option buyer could purchase a call expiring in July but permitting the purchase of SUNW at a price of $17.50. This price is more than the $15.00 exercise price, but as a result, the option, which sells for $1.00, is considerably cheaper. The cheaper price comes from the fact that the July 17.50 call is less likely to be exercised, because the stock has a higher hurdle to clear. A buyer is not willing to pay as much and a seller is more willing to take less for an option that is less likely to be exercised.
Alternatively, the option buyer could choose to purchase an October call instead of a July call. For any exercise price, however, the October calls would be more expensive than the July calls because they allow a longer period for the stock to make the move that the buyer wants. October options are more likely to be exercised than July options; therefore, a buyer would be willing to pay more and the seller would demand more for the October calls. Suppose the buyer expects the stock price to go down. In that case, he might buy a put. Consider the October 17.50 put, which would cost the buyer $3.20. This option would allow the holder to sell SUNW at a price of $17.50 any time up through 18 October.
He has no reason to exercise the option right now, because it would mean he would be buying the option for $3.20 and selling a stock worth $16.25 for $17.50. In effect, the option holder would part with $19.45 (the cost of the option of $3.20 plus the value of the stock of $16.25) and obtain only $17.50.~
The buyer of a put obviously must be anticipating that the stock will fall before the expiration day.
If he wanted a cheaper option than the October 17.50 put, he could buy the October 15 put, which would cost only $1.85 but would allow him to sell the stock for only $15.00 a share. The October 15 put is less likely to be exercised than the October 17.50, because the stock price must fall below a lower hurdle. Thus, the buyer is not willing to pay as much and the seller is willing to take less.
For either exercise price, purchase of a July put instead of an October put would be much cheaper but would allow less time for the stock to make the downward move necessary for the transaction to be worthwhile. The July put is cheaper than the October put; the buyer is not willing to pay as much and the seller is willing to take less because the option is less likely to be exercised.
In observing these option prices, we have obtained our first taste of some principles involved in pricing options.

BASIC CHARACTERISTICS OF OPTIONS

admin — Tue, 19 May 2009 18:23:08 +0000

The fixed price at which the option holder can buy or sell the underlying is called the exercise price, strike price, striking price, or strike. The use of this right to buy or sell the underlying is referred to as exercise or exercising the option. Like all derivative contracts, an option has an expiration date, giving rise to the notion of an option’s time to expiration. When the expiration date arrives, an option that is not exercised simply expires. What happens at exercise depends on the whether the option is a call or a put. If the buyer is exercising a call, she pays the exercise price and receives either the underlying or an equivalent cash settlement. On the opposite side of the transaction is the seller, who receives the exercise price from the buyer and delivers the underlying, or alternatively, pays an equivalent cash settlement. If the buyer is exercising a put, she delivers the stock and receives the exercise price or an equivalent cash settlement. The seller, therefore, receives the underlying and must pay the exercise price or the equivalent cash settlement. As noted in the above paragraph, cash settlement is possible. In that case, the option holder exercising a call receives the difference between the market value of the underlying and the exercise price from the seller in cash. If the option holder exercises a put, she receives the difference between the exercise price and the market value of the underlying in cash.There are two primary exercise styles associated with options. One type of option has European-style exercise, which means that the option can be exercised only on its expiration day. In some cases, expiration could occur during that day; in others, exercise can occur only when the option has expired. In either case, such an option is called a European option. The other style of exercise is American-style exercise. Such an option can be exercised on any day through the expiration day and is generally called an American option.
Option contracts specify a designated number of units of the underlying. For exchange-listed, standardized options, the exchange establishes each term, with the exception of the price. The price is negotiated by the two parties. For an over-the-counter option, the two parties decide each of the terms through negotiation.
In an over-the-counter option–one created off of an exchange by any two parties who agree to trade-the buyer is subject to the possibility of the writer defaulting. When the buyer exercises, the writer must either deliver the stock or cash if a call, or pay for the stock or pay cash if a put. If the writer cannot do so for financial reasons, the option holder faces a credit loss. Because the option holder paid the price up front and is not required to do anything else, the seller does not face any credit risk. Thus, although credit risk is bilateral in forward contracts-the long assumes the risk of the short defaulting, and the short assumes the risk of the long defaulting-the credit risk in an option is unilateral. Only the buyer faces credit risk because only the seller can default. As we discuss later, in exchange- listed options, the clearinghouse guarantees payment to the buyer.

Appropriate Strategies

admin — Tue, 12 May 2009 11:04:12 +0000

If you detect the development of a rising wedge, especiauy if the wedge is being confirmed by other indicators, you might take these actions:
Sell at the upper boundaries of the wedge.
Sell on a violation of the lower boundary of the wedge.
Draw the trendlines forward to see the point at which the upper and lower boundaries would meet. If you are selling short because of a rising wedge formation, you might want to use that point as a stop. Cover if the market rises above the level of that point, which usually takes place with an upside run around and above the point of upper and lower hendline convergence.
If you detect the development of a declining wedge, especially if the formation is being confirmed by other indicators, you might take these actions:
Buy at the lower boundaries of the wedge.
Buy when the wedge’s upper trendline is penetrated.
Place protective stops at the convergence of the upper and lower trendlines.

Declining Wedge Formations

admin — Sat, 09 May 2009 11:03:58 +0000

Declining wedge formations have the following characteristics:
The stock market is falling in price.
Trendlines drawn across price highs decline at a constant angle, reflecting uniform selling.
Support trendlines, drawn at price lows, also decline, but a lesser angle than selling trendlines, indicating increasing eagerness on the part of buyers, who are hoping to accumulate stock. Therefore, rising and declining trendlines converge.
Trading volume decreases during the formation, indicating diminishing selling pressure. This is an important condition.
This pattern suggests that although selling pressures remain fairly constant, buying pressures are increasing; buyers are willing to step in at each minor cycle following less in the way of market decline. Tlus pattern, which usually resolves to the upside, carries bullish implication.
Wedge formations tend to be very reliable for short-term and day-trading operations. This is one of my favorite personal charting patterns for day-trading purposes.

The Portfolio Contribution of Micro Caps

admin — Fri, 01 May 2009 19:20:29 +0000

The simplest way to demonstrate the contribution of micro caps to the asset allocation process is to look at some simple what-if simulations involving micro cap stocks along with other large asset classes. In this instance, the portfolio benefit of micro caps is examined, but the analysis can easily extend to showing the benefit of other asset classes such as international stocks and real estate investment trusts. The examples are designed to be simple and to prove the case that micro caps as an asset class add value in the multiasset portfolio.
In the case of real-life asset allocation situations, consultants and fiduciaries put constraints on the minimum and maximum asset allocation for any given asset class. The specific investment policy and existing nature of the portfolio dictate these constraints. The tax status of a portfolio may have an effect on the amount of income-producing assets that might be targeted for a portfolio. In a taxable portfolio, the allocation may be skewed more heavily toward investments that produce capital gains such as common stocks. In a tax-exempt portfolio, it is likely that the policy guidelines might be more biased toward higher allocations of income-producing assets. Total asset size is also a potential factor when considering allocation targets. Very large institutional portfolios may not be able to effectively use smaller and less liquid asset classes such as micro caps as a part of their overall strategy due to their varying size or liquidity needs.
With the goal of avoiding overly complex math, it is worth examining the potential portfolio contribution of micro caps by constructing a simple set of what-if portfolios using stocks, bonds, and micro caps. These what-if portfolio simulations take simple allocations and add micro caps in varying amounts over differing time periods in an attempt to determine their potential investment contribution to portfolio performance. In this simulation we use the following asset classes. Large stocks are represented by the S&P 500, and bonds are represented by the Lehman Intermediate Government Corporate Bond Index, both of which are very large liquid benchmarks used by institutional investors. Micro cap stocks are represented by the Wilshire Micro Cap Index, an unmanaged index of micro cap stocks that represents the smallest 10 percent of market capitalization in the Wilshire 5000, a broad-based U.S. stock market index. The time period used is the 25 years ended December 31, 2003, which is about as far back as the Wilshire Micro Cap Index extends.
The what-if scenario begins using the classic balanced portfolio that is 60 percent stocks and 40 percent bonds. This case would have provided the investor a return of 7.7 percent, with an annual standard deviation of 13.3 percent before fees and expenses. This is the de facto generic standard balanced portfolio that is used almost universally as the point of departure for institutional portfolio performance measurement. The question is then posed: How would the outcome have differed if the portfolio contained micro cap stocks? For our purposes, we will add micro cap stocks in 5 percent increments to the portfolio while lowering the stock component by a similar amount.
It is remarkable to see that by simply adding the first 5 per-cent allocation of micro caps, the overall return in the portfolio jumps to 8.2 percent while the annual volatility drops modestly to 12.7 percent. Thus, a very modest allocation of micro caps begins to have an immediate and substantial positive impact on the standard balanced portfolio. Moving the allocation of micro caps to 10 percent continues to add benefit as the annual return moves up to 8.7 percent, but more important, the annual standard deviation drops sharply to 11.6 percent, a 100-basis-point decrease in overall portfolio volatility. The volatility of the portfolio continues to decline until micro caps reach 42 percent of the allocation, at which point the volatility begins to rise. Thus, from a purely theoretical point of view, returns increase and volatility declines up to a 42 percent allocation. From a practical point of view, it is unlikely that any institutional investor with responsibilities as a fiduciary would recommend that a client carry an allocation of 42 percent micro cap stocks. However, it is relatively simple to demonstrate in most allocation studies that a 5 percent to 20 per-cent allocation in micro caps can increase overall portfolio return while lowering volatility.

MICRO CAPS IN THE PORTFOLIO ASSET ALLOCATION

admin — Tue, 28 Apr 2009 19:19:39 +0000

The notion of asset allocation has increased in complexity and scope over the past decade. In the beginning it was stocks versus bonds and how much of each was appropriate for a given investor. Over time, many other asset classes were introduced. Oftentimes these other asset classes were recognized because they started out in the portfolios of a narrow group of institutional investors. As the diversification benefit of these asset classes became more widely known, they moved into a larger number of investors’ portfolios. Over time, indexes were created to track the performance of these new asset classes, and the investments became available to an ever larger number of smaller investors.
Real estate is a good example of this asset class evolution. When originally introduced to institutional investors, only the largest and most progressive used real estate in their portfolios. As real estate’s low correlation to stocks and bonds became better known, the asset class found its way into a larger number of institutional portfolios. Over time, no self-respecting fiduciary would have a diversified portfolio if it did not include real estate. The emergence of the real estate investment trust (REIT) asset class over the past 20 years has made it possible for smaller investors to enjoy the benefits of owning an interest in a diversified portfolio of real estate. Now even the smallest retail investors can include a REIT mutual fund among their holdings and have the positive diversification of real estate. In many ways, the emergence of the micro cap asset class will allow smaller investors to benefit from the diversification of venture capital through the inclusion of micro cap investments in their portfolios just as the emergence of REITs as an asset class has allowed a similar diversification into real estate. The largest and most sophisticated institutional investors have allocated a portion of their portfolios to venture capital. A study done by Uniplan Consulting found that as of December 31, 2003, pension plans in the $1 billion to $10 billion range had allocated on average 7 percent of their assets to venture capital. This was down from 11 percent as of December 31, 1999, which was likely the peak of venture capital investing among these institutions, and that peak largely coincided with the peak in technology and Internet investing.

Finance Basics, part 8

admin — Sat, 25 Apr 2009 19:09:17 +0000

It is difficult to see how a company with nothing, promising to do nothing, could be worth $22.9 million. In Spring 2000 it was a tough job explaining market efficiency, let alone rationality. This leads to point number eight. The equity market may be broadly efficient, but that does not mean equity prices are accurate signals of the fundamentals in the economy. This is what is meant by allocational and productive efficiency.

Ideally, high profits in any sector of the economy indicate high consumer demand and the need for firms to produce more. This is the heart of a free-enterprise, competitive economy with the equity market at the heart of this process. High profits end up being capitalized into equity prices, with prices increasing above book value, so that high market-to-book ratios indicate that new investment and production are needed. But what of the Internet bubble? The signals given in the late 1990s were that Internet companies, like E-Toys were really valuable; consequently, broadband communication companies, like WorldCom, were valuable and so, too, the equipment makers, such as Cisco and Lucent. The extremely high valuation on these technology stocks provided the signal to the real economy to expand production in those areas.

Unfortunately, those valuations were not the result of high profits: Consumers had not indicated they were demanding or willing to pay large amounts of money for broadband connections and Internet services. The stock market valuations were not based on financial projections, but a “new age of investing,” and it turns out that those signals were hopelessly wrong. We now have a glut of production in most technology areas and large numbers of bankruptcies. In terms of the signal that the equity market gives to managers, we have to remember that it is a very noisy signal. Unlike the fixed income market, it doesn’t always pay to listen to the equity market.

Point number nine is another corollary of potential equity market deviations from fundamentals, which is that executive stock options are not the panacea that finance people have been claiming in terms of executive compensation. The basic assumption justifying executive stock option grants is that they motivate managers to act like stockholders, and further that managers can, by their actions, influence the value of the firm.

In the late 1990s, during the bubble in Internet and technology stocks, it was quite clear that it wasn’t the actions of the managers that were influencing stock prices. The economic fundamentals of these sectors were overwhelmed by the stock market bubble in prices. As a result, managers at many of the Internet and technology companies were actively exaggerating and fermenting the bubble in their stock prices. For many Internet startups, the first senior appointment was not in finance or marketing, but in public relations, to keep a stream of information coming to the market to hype the stock price.

Clearly, there has to be a realignment of the value of executive stock options as a compensation tool. We can’t just allow firms to award executive stock options and not include their cost in the financial statements. For many firms this practice vastly understates the true cost of their operations and distorts both the labor market and the stock market. Further, the practice of lowering the exercise price when the stock price goes down, so that the executive is guaranteed to exercise sooner or later, removes any coincidence of interests with stockholders, who have no such opportunities.

Finally, point number ten is that corporate financial policy isn’t as important as corporate investment policy. Whatever the firm is doing in terms of its financing – in terms of its debt-equity ratio and of its dividend policy – is of relatively minor importance compared to the fundamentals of actually producing profitable products. This is the classic proposition that earned Professors Franco Modigliani and Merton Miller the Nobel Prize. I would guess that the performance of Enron and the use of special-purpose vehicles has brought home to people that financial chicanery can transfer value, sometimes huge amounts of value, from one group to another, but it does not create value.

Finance Basics, part 7

admin — Thu, 23 Apr 2009 19:08:12 +0000

Point number seven is that even though the equity markets are efficient, that doesn’t mean they’re also rational. We have to understand that there is an enormous amount of noise in the equity market, and share prices are affected by many more factors than bond prices. It is very difficult to pick stocks consistently to beat the market, but that doesn’t mean that those equity prices are set rationally. It is a conundrum that although it is well known that in an efficient market, asset prices fluctuate randomly, this can also happen in an inefficient market: Randomness per se or, alternatively, the difficulty of beating the market, doesn’t in and of itself prove market efficiency.

The basic problem is that sometimes we get bubbles in the stock market. Some academics will go though amazing contortions, rather than face the obvious truth that security prices are set by individuals operating in capital markets and that individuals both individually and collectively sometimes make mistakes, huge mistakes. The central problem is that it is incredibly difficult to form a correct valuation of the equity market. Unlike the bond market, where prices always revert to the bond’s principal value at maturity, there is no “anchor” for equity market values. As a result, equity values can drift off from fundamentals for a long period of time without any certainty of a short-term reversion to their “true” values. So even though the prices are still set in an “efficient” market, and it is difficult to make money, it is not necessarily true that the prices reflect the underlying fundamentals.

To some extent the foregoing remarks are time-dependent and reflect the run-up in the Internet and technology stocks in the late 1990s and their subsequent collapse. With hindsight it is clear that prices were considerably in excess of fundamentals and that the equity market wasn’t rational. However, it was still extremely difficult to take advantage of these opportunities in terms of making money by speculating against the market. Why this is the case has been one of the most controversial topics in finance for the last hundred plus years. This is partly because we have had bubbles in stock markets going back to the Amsterdam tulip mania and the South Seas Company bubble in England in 1720, where famously Sir Isaac Newton lost his fortune and declared, “I can calculate the motions of the heavenly bodies, but not the madness of people.”

Classically trained economists tend to believe that speculation offsets bubbles, so that they can’t exist. If prices get above the fundamentals, then shrewd speculators step in and sell to reap huge profits when prices revert to their fundamental values. If this were true, we would have expected to see professionals selling at the top of the stock market bubble. However, it turns out that this was not the case. Those who should know the most about the value of their companies, the companies themselves, repurchased a record amount of stock in 2000 right at the top of the market!

In 1936 John Maynard Keynes pointed out that professional investors do not speculate in the manner described in classical economics. As he argued:

They [professional investors] are concerned, not with what an investment is really worth to a man who buys it “for keeps,” but with what the market will value it at, under the influence of mass psychology, three months or a year hence.

Keynes himself was a very successful speculator, as well as the most brilliant economist of the 20th century, and was under no illusions as to how financial markets worked. However, even he would have wondered at some of the implications of the Internet bubble. Michael Lewis, the author of Liar’s Poker, pointed out that an Internet company, NetJ.com, had filed statements with the Securities and Exchange Commission with the confession, “The company is not currently engaged in any substantial activity and has no plans to engage in any such activity in the foreseeable future.” The company had $127,631 in accumulated losses and so little money on hand that the directors would have had to chip in themselves to pay any filing costs to raise capital. The only snag was NetJ.com had a market capitalization of $22.9 million!

Finance Basics, part 6

admin — Mon, 20 Apr 2009 19:06:52 +0000

Point number six is essentially the same as point number one, that equity markets are efficient in the sense that it is incredibly difficult to make money in the stock market by following simple trading strategies using publicly available information. Financial research has demonstrated many times that simple rules do not deliver superior returns, especially once the transactions costs of constant trading are taken into account. Some rules appear to have some merit and work for a while, and then they stop working and deliver stunning losses. For example, in the late 1990s momentum trading was all the rage, as the stock market was in a long-run bull market. However, none of the momentum rules picked up the peak of the market and stung many investors as the market turned into a three-year bear.

I tend to believe that the equity markets, like the bond market, are efficient in the sense that there is no easy money to be made and that prices are set by many reasonably sophisticated investors constantly searching out relevant information. However, does this mean that, like the bond market, there are corollaries in terms of interesting information we can glean from these prices? Here I think that the answers are not so obvious.