Market Selloff and NYSE Trading Collars

Dramatic down days in the market are intriguing for several reasons. First of all because it gives us a glimpse into the psychology of the markets and how interconnected markets from around the world have become. Second of all it gives us a little bit of information about some of the structures of the markets that we usually don't even think about.

For those of you who are reading articles about why the market dropped off today you may have come across the term "trading collars." Check out the rules the NYSE has in place to prevent dramatic declines and dramatic increases in the markets:


These rules are in place to keep the markets orderly. The trading collars were implemented around 3PM this afternoon. No doubt today was a hectic day on Wall St. Today is precisely the kind of day that reminds me why I have no interest in being a trader!

Don't Believe a word David Lereah Says!

I think that one of the most hilarious parts of what I do is reading what David Lereah, the chief economist for the National Association of REALTORs has to say about the housing market. I think its safe to say that he may be a shade biased given his salary is paid by people who rely on a strong real estate market to make their living! Honestly though, would you go to the guy who wrote the book "Why the Real Estate BOOM Will Not Bust" for honest, impartial advice about the real estate market? By the way if you really want the dirt on Mr. Lereah check out the blog dedicated to him here. Or if you don't have that much time on your hands just check out this article bashing Lereah.

I'm not the only one who thinks Mr. Lereah is a ridiculous public figure, just check out what the guys over at Motley Fool had to say:

"There's nothing funnier or more satisfying … than watching the National Association of Realtors (NAR) change its tune these days. The latest news release from this sunny-Jim industry group finally fesses up to its past fiction, but even when it admits the bubble's going to pop, it can't muster the courage to just come out and say it. … the NAR is full of it and will spin the numbers any way it can to keep up the pleasant fiction that all is well. … [T]he cracks began to show in subsequent remarks from NAR 'Chief Economist' David Lereah. The head outfit that ridiculed the idea of a housing bubble for years is now crying for Ben Bernanke to bring it back. … It should have been completely obvious to anyone with a loan calculator and a glance at wage increases that those months of industry bubble denials were just wishful thinking."

Now that hits the nail right on the head. The most sickening part of this whole debacle however is the power that the National Association of Realtors holds over the press. Just take a look at this hilarious chart courtesy of Kevin Depew over at Minyanville. Don't worry about reading the actual words in the articles, just focus on the headlines and the dates.

Anyone who actually follows the data knows that 2006 was a bad year for the real estate market. In fact the 4Q2006 numbers show the largest home price drop in history, 2.7% (y0y). The truth is that we are in the early stages of what looks to be a fairly broad and meaningful fall in the real estate market. Prices are off almost across the board. If you don't believe me check out these reputable sources for more reliable information on the market:

Professor Piggington - Rich Toscano's Great Analysis of the San Diego Market
The Big Picture - Check out the "Housing" Section for in depth analysis of US Housing Market.

Greenspan Predicts a Recession in 2007

Alan Greenspan is retired from his position as the Fed Chairman. Yet, he isn't retired from economic prognostication. Though it was never his real strong point his opinion still holds a lot of weight on the street. This morning he predicted a recession in the US by the end of 2007. Read a quick blurb about it here. Needless to say many people are listening.

Remember, that Greenie's famous "Irrational Exuberance" speach occurred in 1996. Greenie was right in saying valuations looked irrational, after all the P/E ratio of the market then was 24, which surpassed the prior bull market peak of 1966! Unfortunately (or fortunately depending on your POV), the market didn't suffer a major correction for 4 years. I'm not trying to bash Greenie here, just making the point that markets are notoriously hard to predict.

So, don't dump your investment strategy today and move everything to bonds and cash. Manage risks through tactical asset allocation and diversification, not through market timing. I personally try to stay out of the game of predicting the economy or the market. Its not that I don't have an informed opinion, I do. But all of my research suggests that even the most well informed opinions are more often wrong than right.

Condolences to the Tomlinson Family

I was saddened today to hear that San Diego Charger LaDainian Tomlinson lost his father in a car crash near Waco. We all know LT for his exploits on the football field, but the man is a stellar human being and he means so much to everyone who has been able to watch him develop over the years here in San Diego.

I know I speak for a lot of San Diego fans in saying that it is so refreshing to watch a humble, driven athlete reach the pinnacle of the sport. He has been a blessing to the city of San Diego and we all hope that we can help him bring the Super Bowl trophy back to San Diego.

LT, our thoughts and prayers are with you in this difficult time. My condolences to you and your family.

An ETF Primer

For those of you who stay up to date on the financial markets I'm sure you have watched with wonder as ETF's have gone from obscure investment product to a position of relative prominence in the industry. For those of you not in the know perhaps a quick brush-up is in order.

An ETF, or an Exchange Traded Fund, has the following features:

1. ETF's are listed on an exchange and thus trade like a stock (High Liquidity)
   
2. When you buy one ETF you get access to a basket of securities (Diversification)
3. An ETF typically tracks an index or an intellidex, and as such it is not actively managed (well at least not yet . . .).
4. ETF's are tax efficient and have very low fees.

While this is by no means an exhaustive list of the traits of ETF's it should be enough for many of you to realize how advantageous these instruments can be for the average investor. In fact many of the top pro's (like Yale's David Swenson) in the industry are now recommending ETF portfolios to the average investor.

For years mutual funds were the standard way to get diversification in a portfolio. When you buy a mutual fund you pay a front end load to get in and then an annual management fee around every single year. The idea is you pay a smart money manager to manage your investments, benefit from being diversified and hopefully get better returns as a result.

One problem; mutual fund returns after expenses underperform the market. In all my reading I have yet to find an economics article in a peer-reviewed journal that has been able to convince me that mutual fund managers are able to "Add Alpha."

The solution: if you can lower your fees, create more tax efficiency and access markets that were previously inaccessible to the average investor, and do all of this using ETF's, it seems like a no-brainer. Unfortunately that isn't the end of the story.

ETF's have trading costs and can suffer from tracking error. They are not great for every investor. They are perhaps best for lump sum investors with a buy and hold philosophy rather than for those making systematic contributions or who actively trade.

I suggest you brush up on the basics using the following resources and we'll pick this up again next week. Feel free to fire off any comments/questions.

• Read the good news about taxes and the balanced view on taxes.

• Read about how well ETF's do at tracking their indexes.

• Read about how ETFs give access to new markets.

Three Great Graphs

I felt that these three great graphs were important to share. Thanks to the guys over at "The Big Picture" for the great information.

1) The first graph relates to historical P/E ratios. In light of recent trends this graph makes the market as a whole look fairly cheap in spite of the strong bull market of the past 4 years.
2) The second graph goes a long way towards explaining why the market still looks cheap. Basically corporate earnings growth has been strong since 2Q2002. The most interesting part of this graph however is the reversal in earnings about half way through the 4Q2006 earnings season. Basically what started as another huge earnings quarter was deflated back down under 10%. While growth hasn't screeched to a halt just yet, the last wave of earnings results left much to be desired.



3) The third graph relates to NYSE Member Firm Margin levels. Basically it tracks how much money is being borrowed to purchase securities. It is useful as a way to track the level of confidence of investors and it is a fairly good barometer of when a market may be overheating. The interesting note here is that margin debt is hitting levels not hit since 1999-2000, but because of strong earnings growth and low P/E 's there may be a lot of room to grow here. It will be interesting to see how high margin levels will get before we see some sort of correction in the market.

Hedging My Bets

Two days ago I blogged about the proposed changes to the hedge fund industry. I wrote that I felt the SEC was overstepping its bounds with the proposed rule. Some might have wondered how this relates back to this random walk that we are on.

In the beginning of Malkiel's "A Random Walk Down Wall Street" which will henceforth be called "The Book", he gives a brief history of bubbles. One particular bubble, that of the growth stocks of the 1960's, was marked by incredibly high valuation of new issues. Many of these stocks had no current earnings but still saw a run up in their share price post-issue (does this remind anyone of the late 90's?). Some may question what exactly the SEC was doing then to protect investors? Well they were doing all they could! These IPO's were sold by prospectus, many of which -- due to SEC regulation -- contained in big bold type:

WARNING: THIS COMPANY HAS NO ASSETS OR EARNINGS AND WILL BE UNABLE TO PAY DIVIDENDS IN THE FORESEEABLE FUTURE. THE SHARES ARE HIGHLY RISKY.

Malkiel goes on to write:

"But just as the warnings on packs of cigarettes do not prevent many people from smoking, so the warning that this investment may be dangerous to your wealth cannot block a speculator from forking over his money if he is hell-bent on doing so. The SEC can warn a fool but it cannot prevent him from parting with his money."

I couldn't have said it better myself! Speculators will always find a way to lose money in poor investments, but their actions shouldn't lead the SEC to curtail the investment options of the rest of the responsible investing public.

The Billion Dollar Grin

Hedge funds are not new to the investment world. But, the sheer volume of assets under management for the industry as a whole -- $1.225t at the end of 2006-- indicate that hedge funds aren't going anywhere fast. Perhaps even more astonishing than the explosive growth of AUM are the paydays of those hedge fund managers whose performance hasn't lagged with the size of their funds. Most notable are perhaps Eddie Lampert at ESL Invesments, the first to manager to earn over $1b in a single year and James Simons, who commanded a whopping $1.5b in 2005. Couple these salaries with the nearly $6.5 billion that Connecticut based hedge fund Amaranth Advisors LLC lost on a single bet on natural gas futures and you've got yourself quite a story.

Such news is bound to draw more attention to the industry, so it is no wonder some eyebrows have raised over at the SEC. In his quest to protect unsophisticated investors, SEC commissioner Roel Campos has proposed a new rule that would dramatically change who would be able to invest in hedge funds. When the law on accredited investors was adopted back in1982 an investor was 'accredited' if he/she had $1m of net worth or $200K of disposable income in two of the last 3 years. In 1982 that excluded all but 2% of US households. Today, due to inflation and other factors almost 9% of US households qualify. Clearly the SEC thinks that a change is needed, but is it really? Consider this from Richard Rahn, a director and board member of several economic policy organizations:

"Financial regulation is most often justified by arguing it is needed to protect all participants from those who would engage in fraud or theft, and to protect unsophisticated investors from losing money in investments they do not understand. The U.S. Securities and Exchange Commission (SEC) has just proposed that the amount of liquid net worth an individual must have before investing in hedge funds and other so-called risky investments be raised to as much as $2.5 million. People meeting a net liquid worth requirement are considered "accredited investors."

The new SEC proposal and other proposals for increased regulation raise a number of important questions, such as: Are hedge funds riskier than stocks and bonds that everyone is allowed to invest in? Is a liquid net worth requirement an appropriate measure of one's ability to evaluate an investment opportunity? Is it fair to the nonwealthy to only allow people who already have a large amount of money to invest in certain things that may provide higher rates of return? Why is liquid net wealth as opposed to total wealth an appropriate measure, particularly now that almost all real estate, and many other non-liquid assets, can easily be securitized?"

None of these questions have easy answers. The SEC's mission statement is "to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation." While it is surely important to protect investors from fraud, it seems equally important to recognize the freedom of investors to choose their own investments. In my view increasing the universe of investment choices is a good thing. It should be left up to investors to analyze the risks.

Let Us Begin Our Random Walk

Before I begin I would like to thank Johnny Chan for creative inspiration, Mike Alfred for all of the invigorating intellectual discourse and of course Burton Malkiel for his seminal investment treatise "A Random Walk Down Wall Street." Before I sat down to start this blog I took the time to go back and re-re-read Malkiel's book (yes, for the third time). What I found was exactly what I had remembered; a concise, pragmatic, disciplined approach to building wealth. I will use Malkiel's thoughts as a jumping off point to ignite discussion and analyze the wealth building impact of his suggestions.

So what is a Random Walk? Malkiel's describes it as follows:

"A random walk is one in which future steps or directions cannot be predicted on the basis of past actions. When the term is applied to the stock market, it means that short-run changes in stock prices cannot be predicted."

A simple notion with profound implications for the world of investing as we know it. To be sure Burton Malkiel wasn't the first to make the connection between a random walk in the world of mathematics and physics to the world of finance. From physics we know that for something to be a random walk it essentially must fulfill the following three requirements:

1) There is a starting point.
2) The distance from one point in the path to the next is constant.
3) The direction from one point in the path to the next is random.

Thus we begin. This shall be the starting point of our Random Walk to Wealth. Our goal is to apply Malkiel's pragmatic approach to the world of personal finance today. The next step in our random walk is just that; random. Yet, with a little bit of luck, each step on our random walk will be a step in the direction of increased financial clarity, understanding and ultimately wealth.