This Week's Random Stock List and a Response to Comment

Here's this week's random stock list with closing prices as of Friday 2/1/08. More about the experiment here.

  1. Dean Foods (DF) $28.42
  2. MoneyGram International, Inc. (MGI) $6.32
  3. Esterline Technologies Corp. (ESL) $47.22
  4. Fuel Systems Solutions, Inc. (FSYS) $13.03
  5. Daktronics, Inc. (DAKT) $20.78
  6. Stantec Inc. (SXC) $33.24
  7. Vestin Realty Mortgage II, Inc. REIT (VRTB) $9.7
  8. CSK Auto Corp. (CAO) $8.98
  9. Commerce Group, Inc. (CGI) $36.25
  10. Epicept Corp. (EPCT) $1.45
Curiousjoe left a comment, making the point that given that there are more small caps than other stocks in the pool from which I'm randomly selecting stocks, my picks will have a small cap bias. If I modify, or do an additional experiment where picks are market cap weighed, I'll have a large cap bias.

No matter what I do, Curiousjoe suggests, since my picks are random, their performance will mirror some market index, whether small cap, large cap, etc.
This makes for an uninteresting experiment, because whatever index the picks mirror, the performance will have to do with business cycles. Let's say the picks mirror a small cap index. The random stocks will do well in periods when small caps do well, and poorly when small caps do poorly, etc.

I agree with the above, but not entirely.

First, it's perfectly fine if the random stocks mirror an index. Indeed, they should. My hypothesis, originally stated, was "Over time stocks as a group tend to go up. You pick enough stocks, and your performance shouldn't be bad." I could have been more clear. This includes stock index performance. In fact, that's what it is.

Second, the experiment isn't about evaluating a random stock picking strategy. That is, I'm not saying "picking stocks randomly will beat the market" or anything of the sort. Most likely, as implied above, results should mirror the performance of market, or some large portion of it. The experiment's purpose is to be "one measure against which gurus and newsletters will be compared." That is, if picking stocks randomly does better than a newsletter people pay for, maybe that newsletter isn't worth it.

But here there may be the objection already mentioned: it will depend on business cycles.

I have two responses to this.

One, so what? Stock gurus and newsletters should account for business cycles in their picks. They pick stocks from all market segments, so why shouldn't I? (If certain newsletters expressly limit themselves to particular market segments I'll make sure not to use that fact against them). [For further research: are paid stock recommendations small cap biased?]

Two, to the extent the first response is inadequate, I've decided to measure the performance of the picks in a few different ways. These are as follows, and I might add more along the way depending on whether I think of something useful:

1. Same dollar amount in each stock when picked. For example, $100 per stock. Taking this week's list, for instance, this would amount to 3.519 shares of Dean Foods and 15.82 shares of MoneyGram. This will most likely have a small cap bias.

2. Dollar amount by market cap. I'd have to set the parameters, but large cap stocks would presumably affect the portfolio's performance more than small caps.

3. Averaging the performance of each stock relative to its starting price. For example, suppose I'll have 3 picks (instead of the 520 per year). Let's say one went up 50%, the other down 35%, and the last finished up 3%. Using this measure, I'll say the random picks' performance was up 6%. What bias here? Does it depend on the business cycle? While most picks will probably be small caps, there will be large and mid caps.

4. Just list how many went up and how many went down. Probably small cap bias.

I'm open to suggestions.


Simply Investing Blog Carnival

Welcome to the January 28, 2008 edition of the Simply Investing Blog Carnival. Of 23 submissions, here are 13 that have been accepted. Enjoy.

Tyler McKinna presents It’s Time To Buy POT! posted at Dividend Money, saying, "Potash Corp. (POT) is a well run and highly profitable fertilizer company that has seen its share price beaten down unjustly given recent market conditions. Investors looking to profit from the huge worldwide demand for fertilizer now have an opportunity to do so at a very attractive price."

The Investor presents Being fearfully greedy: Why I buy in bear markets posted at Monevator.com, saying, "Rather than whimpering in a bear market, if you're well-positioned you should be whooping with joy that you’ve got an unlooked for chance to buy the same shares you were buying last month for 10%, 20%, or even 50% less than you expected to pay."

The Dividend Guy presents The Dividend Guy Investment Process Part 6: Fundamental Analysis - Revenue and EPS posted at The Dividend Guy Blog, a post in a series of posts describing his overall investment approach.

LIVING OFF DIVIDENDS presents Global Markets Crash: All Non-Correlated Markets Converge In A Downturn posted at LIVING OFF DIVIDENDS, explaining why global markets converge during a down cycle in the economy."

Michael Bass
presents Dave Ramsey, Peter Schiff, and decline of U.S. Economy. posted at Debt Prison, saying, "There are two distinct differences in their perspectives concerning our U.S. Economy and monetary policy that I find puzzling."

Raag Vamdatt presents Goal Based Investing :: RaagVamdatt.com :: Financial Planning demystified posted at RaagVamdatt.com - Financial Planning demystified, about defining major investment goals to be a more disciplined investor.

Jed Norwood presents Forex Trading Tips | Investment Without Emotion posted at Forex Strategy Secrets, saying, "Investing in the Forex Market can be a smart move, but it requires discipline and consistency. This article helps you understand what needs to be kept out of your trading."

Chris presents Two Recession-Proof Investment Picks for 2008 posted at Martial Development, a clever take on investing.

Robert Phillips presents The Law of 250 posted at CYBERCA$HOLOGY, talks about marketing your website using insights from Joe Girard's book How to Sell Anything to Anybody.

KCLau presents Why Financial Planner will be the Hottest Job in 2008 posted at KCLau's Money Tips, saying, "An article on why financial planning will be a hot job this year. Also the introduction of financial planning into various domains in life, eg. education"

Investing Angel presents Tips For Shorting Stocks posted at Stock Tips, saying, "In today's unstable market, many people are considering shorting stocks. This might be because they believe the market is going to get worse, so they want to bet against the market or they just wish to hedge their bets."

Dave presents Ballooning Inflation - Vox posted at Cheapo Groovo, a short post on energy and food inflation.

That concludes this edition. Submit your blog article to the next edition of Simply Investing Blog Carnival using our carnival submission form. Past posts and future hosts can be found on our blog carnival index page.


Why (Financial) Stocks Should Head Lower

It looks like there will be trouble in the Credit Default Swap market.

Credit Default Swaps are used to transfer credit exposure of fixed income instruments, such as mortgages and bonds, between parties, to spread risk. It works in the following way. One party buys protection on a debt instrument from another party, the seller, who guarantees the credit worthiness of the debt instrument. If the instrument, let's say a corporate bond, defaults in its interest payments, for example if the company that issued the bond goes out of business, the seller of the credit default swap is supposed to reimburse the buyer. Basically, Credit Default Swaps are insurance on fixed income securities that holders buy to limit their risk. We can call Credit Default Swap sellers insurers.

The combined value of all Credit Default Swaps is somewhere around $450 trillion, but this includes lots of reselling. That is, the same default swaps have been sold multiple times. The actual value of the Credit Default swap market is in the range of $27 to $90 trillion. For perspective, note that the size of the US economy was around $12 trillion, as of July, 2007.

So what's the problem, and what does it have to do with stocks?

In the Credit Default Swap market, it's really difficult to determine who owns what. As defaults rise, and Standard & Poors estimates the default rate will go up to 3.4% by the fourth quarter of this year (up from the current 2.6%), and it turns out that some sellers cannot reimburse the buyers, a panic may ensue. The market may freeze up because no one really knows who holds what.

Why would swap sellers be unable to reimburse buyers if buyers' bonds default? Because some (maybe most) sellers have sold much more insurance than they have in assets. Imagine a seller with $500 million in assets selling $5 billion worth of insurance. Should those bonds default, the seller can't possibly pay for all of them. It will go out of business, leaving the buyer in a bind.

As one example, this is just happened with Merrill Lynch (MER) recently. Of the $11.5 billion in bad debt that the investment bank wrote down in its last quarterly report, around $3 billion was credit default swaps Merrill Lynch bought from ACA Capital (which was AAA-rated, but sold $60 billion in insurance while its assets were only $500 million!). So, Merrill Lynch wasted its money buying insurance because it was left unprotected. Lehman Brothers (LEH) and Canadian Imperial Bank of Commerce (CM) have experienced a similar problem. All indications point to it happening again with other buyers of Credit Default Swaps. The upshot is that the Credit Default Swap market could dry up, for why should buyers pay for something that could be essentially worthless? Keep in mind that the Credit Default Swap market is a lot bigger than sub-prime mortgages.

Another thing to note is that in addition to being buyers of Credit Default Swaps, banks and hedge funds are also sellers. That is, they are also insurers. No one but them knows how much they have sold. Default rates, until recently, have been at historic lows. It's entirely possible that banks could have sold much more insurance than they have in assets.

Bill Gross of PIMCO has said not too long ago that the typical default rate during recessions is 1.25%. This is around $250 billion dollars. (Note that S&P's figure, mentioned above, is much higher.) Insurers will be driven into bankruptcy and/or buyers of Credit Default Swaps will be left unprotected, also possibly driven into bankruptcy. Either way, someone will lose a lot of money, and this could trigger a chain of defaults that might not stop until the over leverage (e.g. what ACA Capital did) is worked out of the system. There will be lots of fear, and stocks should head lower.

Of course, no one really knows what stocks will do. Another large Fed rate cut could send stocks much higher (this would be an excellent time to buy an inverse ETF, in my opinion) or it could spook investors into selling everything, potentially making some bargains in unrelated industries, like my favorite, tobacco.

Just an example of how near term market activity can be premature/irrational: UBS had reported huge sub-prime related losses before the market opened at the end of October, 2007. If I had enough money and was brave enough, I would have shorted it. The next day, when the market opened, I was surprised to see that the stock was going up. The explanation was that with its losses revealed, all the bank's problems were behind it. How fortunate, I thought then, that I didn't short it. UBS was trading in the low to mid $50s then. As of last market close, it was $41.62, about 20% lower.

If the markets go up in the near term, it will be on unfounded optimism. I am firmly convinced, as I was last October, that the debt crisis is far from over. Nothing has been resolved with the sub-prime mortgages. Home prices are still falling around the country, and are just now starting to fall in NY. The inventory of new homes is large enough to have home prices fall some more. As collateralized debt obligation holders find that their sub-prime mortgages continue to default, and as the recession progresses and corporations begin defaulting on their bonds, the Credit Default Swap market, which is over leveraged, will have problems of its own. I'm not a near term trader, nor do I make buy and sell recommendations (or at least I try not to) but I would ask you to consider selling during market rallies, or at least not buying during them, until hope is finally squashed and the market is less volatile.

Random Stock Experiment List 2

Last week I started my random stock picking experiment, to see how random stock picking compares in performance to that of professionals, my hypothesis being that it will do better than the majority.

Here are this week's 10 random stocks with their closing prices on 1/25/08.

  1. Microsoft Corp. (MSFT) $32.94
  2. Endurance Specialty Holdings Ltd. (ENH) $38.61
  3. AZZ Inc. (AZZ) $33.25
  4. Alaska Communications Systems Group Inc. (ALSK) $12.73
  5. AMIS Holdings Inc. (AMIS) $7.71
  6. OPNET Technologies, Inc. (OPNT) $8.6
  7. Royal Gold, Inc. (RGLD) $30.23
  8. Aircastle Ltd. (AYR) $22.5
  9. Valassis Communications, Inc. (VCI) $
  10. Hercules Technology Growth Capital, Inc. (HTGC) $10.72
I mentioned last week that I would use Stockalicious to track the stocks. I've decided against this, however, as half the time the widget wasn't loading. A few days ago, it prevented this blog from loading. I'll be looking for something better.