1 Throughout the text I use the term “Wall Street” to refer only to the banks and investment banks and some of the hedge funds that were instrumental in causing the financial crisis, and not the majority of money managers, analysts, mutual funds, and scores of other parts of the financial industry that had nothing to do with the debacle and were, along with their clients, hurt by it.
2 Amazingly, an almost identical scheme was pulled off on a much larger scale in the 1996–2000 Internet bubble.
3 We will discuss cognitive heuristics in chapter 3.
4 An earnings discount model takes the analyst’s estimate of future earnings for a company well into the future (often thirty years or more) and applies a discount rate to each year’s earnings composed of the current price of long-term government bonds, then 5.9 percent, and then adds a 9.1 percent risk factor (which the author believed was quite conservative, given the staggering growth projected in markets which were in a very early stage of development and for which almost no attention was paid to future competition or a multitude of other factors that could limit growth over time).
5 As expected, the strength of the experts’ affective reactions was found to strongly influence the inverse relation toward the hazardous items being judged. In a second study, these same toxicologists were asked to make a “quick intuitive rating” for each of thirty chemical items (e.g., benzene, aspirin, secondhand cigarette smoke, dioxin in food) on an Affect scale (bad–good). Next, they were asked to judge the degree of risk associated with a very small exposure to the chemical, defined as an exposure that is less than 1/100 of the exposure level that would begin to cause concern for a regulatory agency. Rationally, because exposure was so low, one might expect these risk judgments to be uniformly low and unvarying, resulting in little or no correlation with the ratings of Affect. Instead, there was a strong correlation across chemicals between Affect and judged risk of a very small exposure. When the Affect rating was strongly negative, judged risk of a very small exposure was high; when Affect was positive, judged risk was small. Almost every respondent (ninety-five out of ninety-seven) answered in this manner.
6 This will be an important point to remember for chapter 7.
7 Approximately + or – 25 percent to 35 percent range above or below fundamental value, as noted previously.
8 Tversky served on the board of the Dreman Foundation.
9 Writer’s gripe: if it is not a United Express flight to a Colorado ski resort, which almost seems to be congenitally late.
10 The base rate’s trampling the case rate is also found with other important cognitive heuristics, as we shall see shortly.
11 Mortgage agencies raised their securities quality ratings enormously over where they should have been; this was an important cause of the financial crisis.
12 Also known as the Markowitz-Sharpe-Lintner-Mossin theory.
13 MPT looks to optimize return for a given level of risk. CAPM states that the only way to receive higher returns is to take higher risk; lower risk will result in lower returns.
14 The late Paul Samuelson, a Nobel laureate, contributed one of the most important papers to this subject: “Proof That Properly Anticipated Prices Fluctuate Randomly,” Industrial Management Review (Spring 1945).
15 The initial work by Bachelier showed that similar movements of commodity prices were thought to be random, as were the particles in Brownian motion. The research did not show that stock prices themselves were random.
16 There are hundreds of such indicators. Price volume statistics measure whether stocks are moving up or down on increasing volume. A stock rising on increasing volume is considered bullish, and a stock going down is bearish. Nikolai D. Kondratieff was a brilliant Russian economist who is known for the Kondratieff wave, major self-correcting economic cycles that the European economies seemed to go through approximately every fifty years. After holding a major position under Lenin after the Russian Revolution, he disappeared into the Soviet Gulag system and was never heard from again.
17 A significant number of academics still believe in, or at least still stay employed, teaching these subjects.
18 Horses and cavalry were then unknown in the Americas.
19 Beta is calculated using regression analysis. Nonmathematically, think of beta as a number signifying the relative volatility of a stock compared with the broad market.
20 Later called the weak form of EMH.
21 As of 2011, he is the Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business.
22 In 1992, Professor Fama himself “discovered” that contrarian strategies actually worked, after dismissing them for twenty years because of claimed methodological errors. They were then considered an “anomaly.”
23 In fact, numerous research studies, including some on contrarian strategies, were dismissed for one methodological cause or another—yet after they were redone, correcting for the methodological criticisms, the findings remained valid.
24 The Russell 2000 Index is the most widely followed small-company index.
25 For a definition and details, please see text below.
26 Shorting S&P 500 futures had the same effect on a portfolio as selling stocks directly and was believed to be much easier to do. If a money manager decided to lower his equity exposure by 10 percent, he could short the S&P futures 10 percent and get the same result.
27 Another term for index arbitrage.
28 The studies were flawed because the time periods were too short and did not cover characteristics of behavior in different market cycles.
29 According to EMH, futures cannot fall below the cash price for the same expiration date. For details, see page 114.
30 See the following example.
31 This assumes using the closing prices of both the S&P 500 index and the S&P 500 futures. The spread varied throughout the day. The profit is calculated after commissions are included. There were also quite a number of other ways to capture the greater part of the spread.
32 Such options did not exist, and LTCM had to construct and sell customized derivatives to make the transactions.
33 Obviously the mathematicians worked for LTCM. With high leverage and poor liquidity, the odds of a disaster of this sort were conservatively millions of times smaller.
34 Mortgage bonds backed by pools of mortgages, with different credit ratings. The top credit ratings, AAA, AA, and A, are theoretically the most secure and receive their money first in the event of defaults. They also receive lower interest rates. The lower the quality, the higher the risk and the higher the interest rate. These are Standard & Poor’s rating scale. The other rating agencies have almost identical scales with minutely different letters—e.g., Moody’s uses Aaa instead of AAA.
35 Companies, including banks, that originate mortgages and then sell them to investment banks to make into mortgage-backed securities, which they sell off at handsome profits to hedge funds and a large number of different financial institutions.
36 To review the standard techniques, please go back to chapter 2.
37 By coincidence, two of the three components have been used in my contrarian strategies for over thirty years.
38 One has to marvel at the manner in which the statistics on superior manager performances were set up.
39 Except for a sample of only 52 of 904 splits, or less than 6 percent, which the authors say support their case.
40 The belief that investors cannot consistently beat the market, that markets respond to new information quickly and accurately, and that experienced and knowledgeable investors keep prices where they should be.
41 Change undermines their basic approach. EMH and other such economic axioms allow them to proceed in the manner they know best. They are, after all, trained far more thoroughly in statistical method than in behavioral finance.
42 Eugene Fama, 1998 review mentioned previously (see page 140).
43 Several studies used different averages and time periods.
44 I was one of the experts for six years. Over that period, I used the contrarian strategies we will look at, and my portfolios outperformed the market in five of the six years I participated, from 1987 to 1992, with a combined gain of 156 percent versus 120 percent for the market.
45 Now a subsidiary of Citigroup.
46 To measure this effect, we analyzed a subset of the stocks in Figure 8-1 that eliminated all companies that reported earnings in the plus or minus 10-cent range to prevent large percentage errors in this group from distorting the study. The problem is that many of the fastest-growing small companies report earnings of 30 to 50 cents a share annually, which could translate into 7.5 to 12.5 cents quarterly. Large companies in this range were also eliminated. Even with this ultraconservative method, the average forecast error was 20.5 percent on average, more than quadruple the size that market pros believe could set off a major price reaction.
47 The original study by Eric Lufkin covered the 1973–1996 period. Lufkin used a government industry classification system that was discontinued in the late 1990s. The industry taxonomy developed by Standard and Poor’s (S&P) and Morgan Stanley Capital International (MSCI), called Global Industry Classification Standard (GICS), classifies industries more accurately for financial use. Historical data under the GICS system are available starting in the mid-1990s. However, Lufkin’s results showed even higher industry forecast errors over that period, indicating that industry forecast errors over a thirty-eight-year period were large.
48 Agency theory describes a relationship in which one party, called the principal, delegates work to another, called the agent. The theory states that different parties involved in a given situation with the same given goal will have different motivations and that these different motivations can be manifested in divergent ways. The behavior of Jack Grubman, Henry Blodget, and other analysts we viewed earlier during the Internet bubble was another aspect of agency theory.
49 Now a subsidiary of UBS.
50 Now a part of Wachovia Securities.
51 Kahneman also noted that it took eight more years after that discussion to complete the project.
52 For information on where to find price-earnings, price-to-book-value, and price-to-cash-flow ratios and dividend yields of companies, please turn to page 320 in chapter 12.
53 The market return appears at the bottom of each chart.
54 The event triggers in Figure 9-8 are added together and the signs are removed. The same is done for reinforcing events.
55 Five-year periods were calculated for each three consecutive three-month periods since the commencement of the study and then averaged. There were 132 different periods in the study.
56 As well as similar outperformances by price-to-cash-flow and price-to-book-value groups, which are not shown.
57 In addition to one academic study in Financial Analysts Journal in collaboration with Mike Berry.
58 I had the privilege of knowing and briefly working with Basu in the mid-1980s before his premature death shortly thereafter. We worked on the original concept of industry-relative contrarian strategies used in this book. Before he died, he ran off a test that indicated we were on the right track.
59 A word of caution on performance figures. All are simply averages of performance of the favored stock and contrarian metric results in down quarters throughout the study. Contrarian stocks will not outperform in every down quarter, nor will growth strategies underperform in every one. The same is true for all the charts in this chapter.
60 The Kenneth French site is http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.
61 For information documenting these findings, please see “Investor Overreaction: Evidence That Its Basis Is Psychological,” David N. Dreman and Eric A. Lufkin, which can be found at www.signallake.com/innovation/DremanLufkin2000.pdf.
62 With dividends reinvested.
63 For a more detailed discussion of how stocks fare against bonds over time, please see chapter 14.
64 The Dreman Market Overreaction Fund.
65 Martin S. Fridson’s book Financial Statement Analysis (New York: Wiley, 2002) provides a brief introduction to corporate accounting and outlines most of the important financial ratios the average investor would require.
66 As a manager, one has a fiduciary obligation to bring one’s clients the best legitimate opportunities available. The client makes the decision on the moral question of whether to own tobacco, alcohol, or defense stocks and so on.
67 Although these charges are reflected in earnings, they do not show in cash flow. Granted, the depreciation must be made up eventually; but it gives breathing space if the company needs it to meet payments in financially difficult years.
68 The offer was raised to $10 to complete the transaction quickly and avoid threatened suits by Bear Stearns stockholders.
69 Dividends are reinvested.
70 Futures contracts on the S&P 500 that are one-fifth as large as the normal S&P futures contract.
71 Circuit breakers determine how much a stock can rise or fall before trading is temporarily stopped. They are also used for S&P 500 and other stock options.
72 The risk premium is not correct, but that doesn’t help you.
73 You can also short double the amount of Treasuries if you want to lose your money more quickly, as some of the younger analysts in my office did several years back when they were convinced that bond prices would drop rapidly.
74 Forbes ranks funds through at least two bear markets to get its bear market rankings. The best funds are the top 5 percent relative to all stock funds, the F’s the bottom 5 percent.
75 For information, contact the Vanguard Group at 1-800-860-8394 or go to www.vanguard.com.
76 For information, contact State Street Global Advisors at 1-866-787-2257 or go to www.spdrs.com.
77 For information, contact iShares at 1-800-474-2737 or go to www.ishares.com.
78 Our firm has a low-P/E ADR international fund that invests precisely in this manner. It has been ranked by Lipper in the 13th percentile since its inception.
79 Naturally, as prices change over time, the weightings of stocks in the portfolio will differ. When stocks are sold, the effort should be made to bring the weightings more into balance with one another.
80 With the exception of some calamitous event such as the current financial crisis or the Great Depression.
81 Both are before taxes, as noted earlier.
82 The average top tax bracket was 62 percent between 1946 and 2010. I used 60 percent to be conservative. I also did not include state and municipal income tax, to bring the top tax bracket down further. Please see note 5 for a more complete breakdown of the tax rate through the entire period.
83 Through the post–World War II period.
84 Fixed-income denotes all interest-bearing securities, including Treasuries, corporate bonds, debentures, and savings accounts.
85 In the past sixty-five years there has been only one period when stock prices did not go up for fifteen years, 1969–1982. Still, even in that disappointing time, total return was 5 percent a year because of dividends. Stocks prices rose more than twelvefold to 2000. The performance of bonds, as we have seen, was pitiful by comparison.
86 Alt A’s are mortgages with only partial documentation about the buyer, as well as other very flexible requirements.
87 Most of the mortgages, secured by the mortgages themselves, were quickly turned into securities and sold as bonds to institutional clients, hedge funds, and scores of other buyers. The process is known as securitization.
88 To be fair, he had come into office only months before the 1987 crash. But he was a strong believer in efficient markets and was likely to have supported the policies that led to the 1987 crash. His statements after the crash support this line of thinking.
89 A collateral debt obligation is a far more leveraged and complex mortgage security backed by a wide range of securitized assets from commercial mortgage-backed securities, credit card debt, non-mortgage bonds, and bank loans to complicated mortgage derivatives. The CDO is originated by a regulated and authorized financial institution.
90 The New York Fed made a $27.1 billion payment and allowed $35 billion of collateral received prior to the transaction to be kept by the syndicate.
91 In a bankruptcy proceeding, the unsecured creditors were likely to receive only a small fraction of this amount years into the future.
92 Not quite correct. In another internal e-mail Blankfein wrote, “We lost money, then made more than we lost because of the shorts”—presumably a fair amount on the underwritings it sold to its clients described in this section.
93 Our gas reserves are enormous and with fracking have increased rapidly in recent years. If we converted our trucking fleets to natural gas, we would significantly reduce our imports of oil while creating thousands of new jobs.