Monday, May 28, 2007

A Bull in the China Shop: The Fundamentals of the Worldwide Share Rally

We're in the midst of the biggest bull market in history. Virtually every asset class has been yielding double-digit percentage gains annually. Here in the United States, the boom is less obvious. In Asia, it is unmistakable and profound. Since this is a blog post, not a book on economic history, I'll try to keep my commentary on this world-changing transformation brief. In particular, we'll go back to the subject of China, which I think will be the defining story of the next century.

Pundits cite numerous reasons for the boom, the foremost of which is a liquidity glut. One explanation for the "easy money" says that as Asian and Middle Eastern nations receive US dollar payments for their trade with the United States, and they have enormous trade surpluses ($1 trillion in China's reserves so far), they are inclined to re-invest that money in dollar-denominated assets to avoid driving up the value of their own currencies. This buying pressure on T-bonds and T-bills leads to decreased interest rates and easier credit for business expansion worldwide.

The general idea is that lower interest rates make borrowing cheap. And who wouldn't borrow at 6% in order to invest in a business with a cashflow over 16%? That's a low-risk return of over 10% annually. Now multiply it times 4 using leverage (40% return), and you have a high-risk hedge fund or private equity fund at your finger-tips.

China alone is growing 10% per year. Many of its businesses are growing earnings 20-30% annually for the past 5 years, as evidenced in the China Stock Directory. Yet the Yuan is pretty stable versus the US dollar, so currency risk is low. Private equity funds can make a killing by arbitraging this type of interest rates to earnings differential. Makes sense that the Chinese government is a pre-IPO investor in Blackstone -- Blackstone gets preferred access to fast-growing Chinese companies, and China gets the know-how to set up a domestic private equity industry.

So there is a fundamental logic to the boom - that's my point anyway. But since this is an investor psychology blog, how can we know when bubbles form on top of booms? In particular, is China in a bubble? Some say that a PE of 42 for China Communications Bank is high, especially when HSBC has a PE of 13. Does a high PE alone mark the top of a bubble? Greenspan used the high PE = bubble logic when he insinuated the US market was irrationally exuberant in December 1996. His timing was way off, but it does have a historical logic.

In my studies of sentiment, tops are usually marked by high optimism. But so are the rallies on the way to the top. If you shorted every period of 2 standard deviations above average optimism over the last 20 years, you'd have zero returns. No matter how pessimistic you are, you have to admit that shorting optimism does not work without other objective criteria to go by.

In April, 5 million new stock brokerage accounts were opened in China. That is 2/3 more than were opened in all of 2006 (per the Economist magazine). That sounds like an investor frenzy. But guess what - they shoud be excited. China has been booming for 20 years, and the tipping point has finally been reached where domestic Chinese investors can chase hot stocks. It's healthy that people are getting involved. Does that mean they will emerge unscathed? No.

When will the psychology of the Chinese bubble become a problem? As I mentioned in a previous blog post, probably not until next year. So far the share prices have been rallying less than two years. While PE's are high in big name stocks, there are still some bargains in China(granted, many with murky accounting).

Even after last year's rally in the US (modest as it was), my stock screens found more cheap small-cap stocks this December than at any time in the past 3 years. And they are up 30+% since then. A rally does not prove a bubble, but it is necessary to one.

So the Asian economic boom is finally being followed by a real stock market boom (China and Vietnam in particular). This is good news, as it means their financial systems are globalizing. The selloff of May 2006 indicated that while some investors were skittish about the huge recent gains, the general trend remains extremely positive. This year is no different from 2006 in terms of economic growth in Asia, except that investors are finally catching on and assets are at or exceeding their fair values worldwide. Yet, they can certainly go further. There will be scary selloffs along the way (probably very steep), but they will be clearing the air for the next rally. Those are my thoughts at the moment. They may change at any time, as flexibility is the paramount virtue in the markets.

Next post we'll look at some recent neurofinance studies.


Monday, May 21, 2007

The Bugs Bunny/Road Runner Investing Hour!

Most of us remember growing up watching cartoons on Saturday morning.

I probably watched too much. It quite literally affected my ability to make sense of the world.

One of my favorites was The Bugs Bunny/Roadrunner Hour that featured the antics of a homicidal supra-genius named Wile E. Coyote who was obsessed with doing harm to a vocab-challenged Road Runner - the Moby Dick to his canine Ahab.

Of course, the coyote never succeeded. He got crushed, flattened and blown up every week. But he did teach us a fascinating lesson of cartoon physics that we can apply to markets -- particularly soaring ones.

In every episode, Wile E. Coyote would invariably pursue his elusive quarry off of a cliff. At this point, it became clear to the audience that the coyote was headed for a serious fall. And the more excitable among us were prone to yell things like, "Look out!" at the TV. The coyote; however, was blissfully unaware of his circumstances. In fact, breaking multiple laws of physics, Wile E. Coyote continued to churn his feet, levitating in the same spot, indefinitely free from all harm... until he did one thing; until he looked down.

Upon looking down, the impossibility (even absurdity) of his current status became clear. The coyote would gulp, usually produce a hastily assembled placard featuring the phrase, "Bye bye!" - and fall like an anvil into the void below.

Welcome to the world of investing bubbles. Welcome to Wile E. Coyote Sydrome (TM).

We've seen it before, throughout the late 90s when people were paying 200 P/Es for stocks based on metrics such as "eyeballs" ("eyeballs" is the new "earnings"!). The admonishments of the exasperated spectators (Julian Robertson & Dr. Robert Shiller come to mind), like those of countless children on Saturday morning, were there if you cared to listen -"Look out! You're going to fall!"

The Shanghai Composite has been running off the cliff for quite some time now. (I'm not saying you can't make money there. It's hitting new highs everyday, but if a market up over 200% in 2 years isn't a bubble... what is?) And the warnings coming from land are getting louder. But the coyote never listens. And he doesn't appear to hear Mandarin any better than English. He is far too engrossed in his pursuit to pay any mind anyway. But he'll look down at some point.

In the same way that the tragic coyote defies the laws of physics, investors defy the laws of economics, running on air as the market soars... 5%... 10%... 15%... I can't wait til next week!

But then the warning cries from the cliff break through to the investor's consciousness. And one looks down. (Sell). Then another. (Sell). Then another (Sell) and -- whoosh!-- (SELL! SELL! SELL!) -- the Panic, with its sickening plunge, is on.

And you don't need a sign that says, "Bye bye!" to know it.

Wile E. Coyote Syndrome (TM) at its finest.

So how do you approach this situation? Your wisdom (and high school physics) tells you to run back to land. But it's such a rush dancing off the ledge, and that's where the money is.

For one thing, do not underestimate human greed. Do not overestimate its reciprocal fear either. (Physics also teaches us that every action has an equal and opposite reaction, after all). Be prepared for both. Have cash available to pick the pieces off the ground. Anticipate the sectors to which people will flee. Run around on air for awhile, but take some profits too. Most of all, prepare yourself emotionally for the plunge, because its coming. And no one know when.

The great thing about ol' Wile E. is that when he gets smushed, flattened, and blown up, he bounces back good as new in the next clip.

Investors aren't so lucky. Raise your hand if you bought Intel at 90! (You can't see my hand, it's up.) In fact, many portfolios never bounce back.

So enjoy it while you can. Be prepared for the plunge. And you may want to consider shorting "ACME Gadgets Co." (Their rocket boosters have serious design flaws.)

Sunday, May 13, 2007

"Cutting Winners Short": Of French Fries, Billionaires, and the Chinese B-shares

J. R. Simplot is an American eighth-grade dropout and a self-made multi-billionaire. He made his fortune through saavy investments in potato farming and french fry production. Currently he owns the largest ranch in the United States, the ZX Ranch in southern Oregon. His ranch is larger than the state of Delaware. Despite his tremendous wealth, Simplot is a modest man. He describes his accumulation of wealth to interviewer Eric Schlosser in the book Fast Food Nation:

"Hell, fellow, I'm just an old farmer got some luck," Simplot said, when I asked about the keys to his success. "The only thing I did smart, and just remember this—ninety-nine percent of people would have sold out when they got their first twenty-five or thirty million. I didn't sell out. I just hung on.”

Simplot's key to success was holding on to his winning investments. For most people, when their investments are doing well, they become afraid of giving back their gains. As a result, they do what Wall Streeters call "cutting winners short." Academics call this "the disposition effect."

I recently opened an account statement for one of my brokerage accounts, and I was shocked by the sudden increase in value since the beginning of this year. My first thought? "I've got to sell these stocks to be sure I keep the money." I was first elated by the large gain and then terrified of losing it. My fear inclined me towards selling out.

With world stock markets hitting all-time highs every week, there is a considerable amount of nervousness among long-term investors about the sustainability of the rallies. In China, investors who have been in the market since mid-2005 have 3-4 fold gains. Last week many Chinese B-share stocks were limit up (+10%) each day for 4 days in a row. That kind of gain is terrifying because 1) it makes no fundamental sense and 2) I might lose my enormous paper profits if the market turns down. With Goldman-Sachs analysts on CNBC calling the Chinese market an "overvalued bubble," I have more reason to fear a decline. Yet, as Simplot noted above, truly long-term investors can make an even greater fortune by riding their winners higher, not by selling out too soon.

Whether the Chinese markets will continue their rally is debatable. For psychological reasons, I think the Chinese markets will top in Spring 2008, a few months before the Beijing Olympics. What is most interesting to me now is the tremendous pressure that many long-term investors feel to take profits. Truth be told - if a downturn hits over the next few months, many probably will sell out. There's nothing like short-term declines to prompt long-term investors to "cut winners short."

This photo was taken in 2004 at a Shanghai brokerage (before a muscled bouncer showed me the door). We have had a marketpsych page devoted to Chinese stocks since 2004 here.


Saturday, May 05, 2007

What's Your Ben & Jerry's Investing Moment?

The market has been setting a new record everyday now it seems. The Dow Jones Industrial Average closed on Friday at 13,264.62, a new all time high. And the broader Standard & Poor 500 Index also closed at 1505.62, also a new all time high.

I had a conversation with a friend the other day who is an active investor, and I mentioned that I'm 20% cash. He was surprised.

"You don't need to be 20% in cash!", he explained. "You're not going to need that money for 30 years. You should be more aggressive!"

And he's totally right.

Sort of.

I could certainly stand to me more fully invested. After all, we're talking about a long term investing horizon. And as one who drank the Kool-Aid long ago on the long term safety of equities, I should be able to do so with confidence.

But here's the problem.

One's investing strategy does not exist in a vacuum. It is dependent upon one's Investing Personality. Modern Portfolio Theory does a great job of determining what asset allocation strategy will maximize your returns. But if that investing strategy is not consistent with one's risk preferences, emotional resilience - even attention span, it will succeed in theory, but fail in practice.

Think of it this way: Investing plans are a lot like eating plans. If you want to lose weight, there are any number of diets that will do the job. Barnes and Noble bookshelves are full of them. But what makes a diet right for you, is not whether it "would work" (heck, they pretty much all work). What makes the diet right for you is that it is the plan that you can stick to.

And like proper eating, we're not talking about a short-term, "look good for a wedding" type of situation with our investments. We're talking about following a lifetime plan of prudence and self-discipline. So any long term investment plan doesn't have a built in mechanism for those Ben & Jerry's moments is ultimately doomed to fail. That's why the right plan for me is a sub-optimal investing strategy.

They say that truth lies in paradox. Well here's one for you; I can't be aggressive without a more conservative asset allocation.

When I explained that (emotionally) I needed a decent chunk in cash, my friend assumed it was because I needed to know that at least a part of my portfolio was "risk free". Actually, that doesn't quite hit it.

It's not that the money is "risk free" (i.e., I can't lose it). In fact, the cash position for me gets mentally classified as a loss; I feel like I'm losing money by not having it participate in the rally. No. The reason I need that money in cash is entirely different.

I don't mind risk. In fact, I like being aggressive. But in order to be aggressive (e.g., take some more speculative positions), I need a sense of control. I need to know that if the market gets whacked, I have cash ready to take advantage of it. That way I can cognitively reframe a "bad day" (lost money) into a "good day" (got some bargains). If I couldn't do that, the bad days would overwhelm my portfolio and knock me off course.

For me, losing money only becomes emotionally intolerable when I'm unable to take action, when I can't reclaim some sense of control.

That's my wings/pizza/cheesecake moment. That's when I screw up my plan.

What's your weakness? What are the temptations that push you off your plan? We invite you to check out some of's investor self-assessment tools to determine where you (or your client's) potential vulnerabilities may lie.

In the meantime, eat healthy and enjoy the bull market.