"Whenever science makes a discovery, the devil grabs it while the angels are debating the best way to use it"
Alan Valentine

The number of e-mails I received during the last several months has been simply astounding to say the least. Most of them are compliments and questions, some of them are ideas and few of them are complaints... I appreciate all of them- so keep them coming :) But today I wanted to address few more of the questions being asked most frequently:

1. Why do I focus my attention on stocks that don't fall under the definition of "sexy" names like AAPL or RIMM?

My answer to this is quite simple. There are literally thousands of stocks out there, and by focusing your attention on the ones that dominate media, message boards and magazine covers- you are likely investing in securities that at best are efficiently priced, and at worst are outright bubbly. And this is not just my opinion- being the research junky I really am- I've read a ton of well known research papers focusing on the impact of affect and media in stock market returns and most of them arrive at the same conclusion- you would do better ignoring the most followed names and instead focusing on the unknown ones... The most recent one was called "Affect in a Behavioral Asset-Pricing Model" by Statman, Fisher and Anginer; you can read the full paper here-

I won't bore you to death but here are some quotes to consider:

"We admire a stock or despise it when we hear its name, whether Google or General Motors, before we think about its price-to-earnings ratio or the growth of its company's sales. Stocks, like houses, cars, watches and most other products exude affect, good or bad, beautiful or ugly, admired or despised..."

"Affect is the specific quality of 'goodness' or 'badness.' It is a feeling that occurs rapidly and automatically, often without consciousness. Investors prefer stocks with positive affect and their preference boosts the prices of stocks with positive affect and depresses their returns...

We study the preferences of investors as reflected in surveys conducted by Fortune magazine during 1983- 2006 and additional surveys we conducted in 2007. We find that the returns of admired stocks, those highly rated by the Fortune respondents, were lower than the returns of despised stocks, those rated low. This is consistent with the hypothesis that stocks with negative affect have high subjective risk and their extra returns compensate for that risk"

The punch line- in pure mathematical terms- returns of companies less "admired" by the market participants have been found to be significantly higher than those of the most "admired" ones. (3.34% a year for portfolios rebalanced every two years (1982-2006)). So why would I focus my attention on AAPL, GOOG and RIMM if I could instead spend my time on CEL, CHNG, NVDA and SYNA!? I'll let the "talking heads" do what they do best- "BS" and instead focus my attention on finding new good " less admired" companies to invest in.

2. You rarely provide a long, company specific research and most of the time you just buy stocks without detailed explanation?

Once again - I've touched on this issue before. The fundamental core of my investing strategy is a belief into the emotion-free process. And by definition, writing a long research report on a specific company implies that on some level you are likely attaching yourself to some kind of opinion, and thus could very well ignore an important piece of information that does not support your initial conclusion. You can disagree with the above statement but I think there is plenty of behavioral finance research out there that supports it.

Once again, I am not participating in a popularity contest but rather trying to outperform the market in both good and bad times. I try to keep an open mind when it comes to specific stocks and instead focus most of my research time on important economic trends that point me to the right sectors and industries. And one thing I can tell you- that before pulling the trigger on any individual stock- I personally read most of the financial information available out there including 10Ks, 10Qs and even some of the analyst research. I do my own fair value calcs and establish entry and exit points, but I also prefer to keep my notes private as it relieves me from an emotional weight of trying to explain what I got wrong if something does not work out. Thus I could easily tell you if I am bullish or bearish at the moment, or which sectors I like but I very rarely state my opinions on individual stocks unless they are part of my portfolio...

P.S. I like technology and healthcare, and now feel more bullish than bearish, and thus one could easily notice that my MSN portfolio is tilted heavily in that direction... :)

Stay safe and cheers, Vad :), skepticalcapitalist@gmail.com

"Life is what we make it, always has been, always will be"
Grandma Moses

Rates are go up before the year is over...

Excerpts from a great speech by one of the only few Fed Presidents ( Dallas' s Fisher) that seems to still get it- Unless inflation is brought under control quickly, US Economy might be in for a very long and rough ride...

"We know from centuries of evidence in countless economies, from ancient Rome to today's Zimbabwe, that running the printing press to pay off today's bills leads to much worse problems later on. The inflation that results from the flood of money into the economy turns out to be far worse than the fiscal pain those countries hoped to avoid

Earlier I mentioned the Fed's dual mandate to manage growth and inflation. In the long run, growth cannot be sustained if markets are undermined by inflation. Stable prices go hand in hand with achieving sustainable economic growth. I have said many, many times that inflation is a sinister beast that, if uncaged, devours savings, erodes consumers' purchasing power, decimates returns on capital, undermines the reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency.

Purging rampant inflation and a debased currency requires administering a harsh medicine. We have been there, and we know the cure that was wrought by the FOMC under Paul Volcker. Even the perception that the Fed is pursuing a cheap-money strategy to accommodate fiscal burdens, should it take root, is a paramount risk to the long-term welfare of the U.S. economy. The Federal Reserve will never let this happen. It is not an option. Ever. Period."

The good news for the long term health of the economy is that Fed Funds probabilities are now starting to slowly point towards an inevitable rate increase- 13% chance of a rate hike in August... I think we might see at least one hike before the year is over- hence financials are once again might not yet be cheap enough...

source: ClevelandFed.org

Want another confirmation of more trouble coming the Financial's way?- Bernanke's speech today- while pretty worthless and non informative on the inflation part, offered new details of what's in store for financials- if you still own lot's of banking shares- watch out- you could be saying "ouch, that hurts..." a lot more...

"Finally, we are taking action in our role as regulators. We have worked with lenders and servicers to encourage appropriate modifications of distressed mortgage loans, and we have proposed new rules to improve disclosure and to ban unfair or deceptive acts and practices in mortgage lending. We are also collaborating with other regulators, both domestically and abroad, to put in place changes that will help make the financial system less vulnerable in the future. Among the changes we expect to see are strengthening of capital and liquidity rules, greater disclosure requirements, an increased emphasis on the measurement and management of firmwide risks, and further steps to increase the transparency and resilience of the financial infrastructure. Our goal is to emerge from this difficult period with a financial system that will be more stable without being less innovative, with a more effective balance between market discipline and regulation."

Stay safe and cheers,
Vad skepticalcapitalist@gmail.com

Continued from Part 1...

Remember, understanding the theoretical principles is just the first step- the most important part is trying to figure out how use it in action. Today I wanted to mention just one of the topics that deals with the question that I get e-mails about most often- how and why should one choose when to sell stocks?

In my opinion- selling strategy could actually be more important than the buying one. Remember, nominal stock prices go up in the long haul- pure and simple, and thus your diversified portfolio is very likely to go up regardless of when and what exactly you buy, if you just leave it alone for long enough period of time.

In my experience, however, the single biggest mistake investors make is selling out too early. Here is my advice and rule of thumb - NEVER sell stocks on the way up- sell them ONLY on the way down. Yes it might sound counterintuitive and make people question my logic, but that might be just the single biggest factor in why some people do better in investing than others.
Why does it work this way? Weren't we all taught that it is a better to set a target price and sell it when the stock reaches it? Before jumping to conclusions simply too quickly -consider these few findings of behavioral finance and try to apply them to the stock market:

1. "Loss aversion"-

humans have been found to strongly prefer avoiding losses to acquiring gains- it means that people, on average, refuse to admit that they made a mistake by buying a particular stock and thus end up sticking to losers when they should have been selling. Social Psychology Fourth Edition, Aronson et al., p. 175: "Once we have committed a lot of time or energy to a cause, it is nearly impossible to convince us that it is unworthy"

2. "Endowment Effect" -

"People place a higher value on a good that they own than on an identical good that they do not own" - by Kahneman, Knetsch, and Thaler (1990

3. "Disposition Effect"-

"Investors are unwilling to recognize losses (which they would be forced to do if they sold assets which had fallen in value), but are more willing to recognize gains". "Shefrin and Statman (1985) predicted "that because people dislike incurring losses much more than they enjoy making gains, and people are willing to gamble in the domain of losses, investors qill hold onto stocks that have lost value (relative to the reference point of thir purchase) and will be eager to sell stocks that have risen in value. They called this the disposition effect."Montier (2002) pages 23-24

4. "Post-purchase rationalization" -

"...common phenomenon after people have invested a lot of time, money, or effort in something to convince themselves that it must have been worth it. Many decisions are made emotionally, and so are often rationalized retrospectively in an attempt to justify the choice"

Now, these are just a few of the well researched human biases that affect investor's behavior when they make investment decisions - but all of them point us to the same conclusion- investors on average sell winners too early and hold on to their losers for too long... And if on average people make the same mistake over and over again- the smartest thing you could and should do- is take advantage of it and do just the opposite, hence my selling rules...

Anyway hopefully that helps to answer some of the questions, for now stay safe and please feel free to e-mail with any questions at skepticalcapitalist@gmail.com

"The essence of success is that it is never necessary to think of a new idea oneself. It is far better to wait until somebody else does it, and then to copy him in every detail, except his mistakes." Aubrey Menen

Becoming a successful "intelligent investor" is not something one should expect to achieve in a very short period of time... Too many of the very smart, well educated and successful people out there believe that picking stocks is just as easy as running their own business or that one can create a mathematical model that will tell them exactly what the stock is worth. Unfortunately, it's not quite that easy. As we all know, most of the professional managers out there fail to beat the market year after year, and number of those who have been able to do so consistently is so limited that you probably know them most of them by name.

Just think about again- every year hundreds of newly minted MBAs leave Top business schools around the world and join the asset management industry in their quest to become the next Warren Buffet or George Soros. Most of them are more intelligent and driven than an average person out there- but still the vast majority fails measurably... I personally always wondered why does this happen and how could I possibly avoid their mistakes? Finding an answer to this question is not an easy, but as with everything else, I have my own skeptical opinion...

After one of the many rereads of my favorite books about investing psychology "Reminiscences of a Stock Operator" by Edwin Lefevre, I realized that a large portion of this question might have already been answered almost a 100 years ago -

"... The desire for constant action irrespective of underlying conditions is responsible for many losses on Wall Street even among the professionals, who feel that they must take home some money every day, as though they were working for regular wages..."

Too many of us approach investing just like we would anything else-with great passion and determination to make it work- we plunge wholeheartedly into the "mysterious world" of stocks, spend countless hours reading about "magic, bullet proof formulas", listen and watch to Bloomberg and CNBC and dream about the next "Berkshire size" investing opportunity out there. But unfortunately, there lies our biggest flaw- we become so devoted to our new passion- that we let emotions drive our decisions, we let our affection for a particular stock to overrule the common sense and we deviate from what at first seemed to be our well thought out, "iron clad" strategy.

As if our human nature wasn't enough, the continuous and never stopping media flow of new tips, "important" information and "expert" opinions lead us to sell winning stocks when we should be sitting tight or force us to "fall in love" with a money losing stock and ride it all the way down to zero. And this emotional urge is frequently so difficult to resist that many finally give up, pull whatever is left out of the market, put it in the money market or some other cash equivalent account, where inflation slowly takes care of whatever is left...We've seen it happen over and over again and it is very unlikely to stop anytime soon.

That's' precisely why I think learning the behavioral/psychological side of financial world is as or may be even more important than the traditional quantitative one. And I am not talking about the technical analysis (TA) driven world of "self fulfilling prophecies", I am talking about good-old boring fundamental ones- like herding, group-think, loss aversion, mental accounting etc... The list is simply too long and obviously can't be covered in serious detail within one article- if you want to learn more on your own- the good place to start would be Wikipedia...

Continued in Part 2...

"But, logic, like whiskey, loses its beneficial effect when taken in too large quantities"
Edward John Moreton

Time for another economic update in graphs- today's it's focused primarily on financials- once again I think things are not "all clear" yet as many assume- I'll let the graphs do the talking though...

Let's start with an introduction- banking sector's health seems to be quite different depending on the state. The list should not surprise anyone- right column is heavy on states where housing prices are collapsing- but there are also few states that don't quite come to mind when one is thinking about the housing crisis like Virginia, Maryland and New Hampshire...

Source: FDIC

Net Interest Margin in smaller banks (<1B in assets) is contracting rapidly despite the fact that yield curve now is very beneficial for banks, which again supports my hypothesis that a number of smaller regional banks are having trouble attracting lower cost deposits and that many might collapse later this year...

Source: FDIC

Reserve coverage ratio has been declining since 2005 and now stands at only 120%- this might mean higher loan loss provisions in the next few quarters.

Source: FDIC

Now here is the punch line- I think all the pundits claiming that the Financials are "dirt cheap" are pretty much basing their case on the assumption that since the commercial loans (CRE and C&I) side of the business has held up so far, it won't deteriorate in the future- I think this logic is flawed, what's more it could be outright dangerous- because CRE and C&I loans are by definition much larger in size; and thus outlook for a smaller bank that has high commercial real estate exposure on the asset side and does not have real diversified funding base on the liability side (like DDAs (checking accounts) or other lower cost sources) could change literally overnight...

I think the graph above is an indicator that regardless of all the noise in the media- we aren't yet close to the bottom of the credit cycle in financials- closer to start than to finish...

Expect the commercial side to look similar to the residential side before it's over...

In my opinion, we could very well see the volume of bank failures explode in the next few quarters- (so far only 4 this year)... They are likely to be concentrated in smaller regional banks that have heavy exposure to CRE and C&I loans and no diversified deposit base. Larger banks are also likely going to write off a lot more commercial loans and thus real earnings probably won't improve much until 2009, which in turn means there are still a bunch of good shorts in the financial sector...

Stay safe, Vad skepticalcapitalist@gmail.com

"History is the sum total of the things that could have been avoided"
Konrad Adenauer

Rate hike chatter is getting louder every day... Futures are now pricing in a 25% probability of a rate hike in June and almost a 50% chance of a hike in August. What's more now even a 50BP hike is a possibility. One interesting thing about Bernanke's Fed so far has been the fact that futures have a been a solid predictor of their actions...

source: ClevelandFed

source: ClevelandFed

Now what does that all mean for the markets? I think that the severe declines of the last week are the answer. But as usual in any market there will be winner sectors and losers. Below are some excerpts from a research paper that studied the impact of Fed's actions on various sectors called "Sector Rotation and Monetary Conditions" by C. Mitchell Conover; Gerald R. Jensen; Robert R. Johnson and Jeffrey M. Mercer

"We focus on the efficacy of a particular timing-decision variable advocated in prior studies, that being a simple gauge of the stance of Federal Reserve monetary policy. In particular, our objective is to determine whether there are potential benefits associated with using monetary conditions to guide a sector rotation strategy. Our results show that, in general, using announced Fed policy changes as indicators of when to shift a portfolio to a more aggressive or defensive posture, would have allowed investors to significantly enhance portfolio performance. Specifically, performance is enhanced by shifting into cyclical stocks following Fed changes that signal a more expansive monetary policy, while the appropriate response to a signal of a more restrictive Fed policy is a shift into defensive stocks."...

... "One of our more interesting and potentially useful findings relates to the rotation portfolio's performance during expansive relative to restrictive monetary periods. As indicated, the rotation portfolio assumes a defensive posture during restrictive monetary periods, and it is during these periods that the most prominent improvement in portfolio performance is observed. During restrictive monetary periods, the rotation portfolio returns approximately twice the benchmark return, yet the rotation portfolio has considerably less risk. This result suggests that the primary benefit associated with using monetary conditions to guide an investment strategy is that the strategy can be used to improve the disappointing performance associated with bear markets"

Below is the table of results of their findings slightly modified by me... The punch line is that resources sector actually on average does quite well? A bit surprising, but math is math...Another clear cut message- Technology does not do well during restrictive cycles- I will have to think hard about being so wide open in the IT field...On the other side just as expected- financials have not done too well when rates went up, neither did discretionary consumer goods...

P.S. STD- stands for Standard Deviation...

I think my MSN Portfolio needs a serious rebalancing...
skepticalcapitalist@gmail.com

"Money never starts an idea. It is always the idea that starts the money"
Owen Laughlin

Many people have been asking me about the screeners I use to pick my stocks. Unfortunately, the precise detailed methodology and criterias would likely take several very long pages and would be very boring. I use a combination of multiple screeners when doing my research and constructing the actual portfolio. Plus the decision to buy is only the start and the decision to sell is actuall more important- in my mind it is also more difficult...

Instead I am actually presenting the results of another monthly screen that actually covers most of the basic factors I covered in my MSN Strategy Lab Articles. Please consider this screen as one more educational presentation and not a recommendation to buy or sell any securities in any shape, size or form. Due your own due diligence and read this disclaimer to understand all the potential conflicts...

Stay safe - Vad @ skepticalcapitalist@gmail.com

P.S. NEITHER Vad Yazvinski NOR skepticalcapitalist.com are investment advisors, hence this we DO NOT endorse or recommend any securities or other investments. All information on this Site, as well as reference materials or links to other sites, has been compiled from publicly available sources believed to be reliable and are for general informational purposes only.

Continued from Part 1

In addition to that Fed is now facing another trade-off- trying to protect as many banks as possible from the insolvency and buying them some more time with lower rates, and at the same time trying to contain the increasingly unstable inflation expectations from spiraling completely out of control.

11. In my opinion, achieving both objectives is at this point virtually impossible and thus Fed could either:

• Own up to its mistakes, raise interest rates swiftly, bankrupt many of the smaller and mid size banks, but kill the inflation genie and deflate the commodities bubble. In the process this will send the entire global economy into a deep but relatively short lasting recession - shape "V" as the media would say...:)

• Keep talking "big game" but not take any "real actions". Force banks to raise more capital by diluting existing shareholders and cutting dividends whether they eventually need it or not. Keep rates low and pump more liquidity in, until commodities or some other bubble, once again blows out of proportion. But inflation in this scenario is very likely going to enter the next stage of a usual cycle -with workers demanding higher wages in turn moving prices even higher etc... Eventually Fed will be forced to raise rates higher than in scenario 1 and thus will inevitably send the economy into a more severe recession- shape "W" as the media would say. (Inflating the housing issues away should allow for the headline GDP to contracts only slightly in the first leg of the cycle).

12. Neither one of the options is pretty at this point, but in my opinion while the first one is clearly the more logical, it is also very politically challenging- with election season in full swing- rates will be tough to raise without a republican "blood bath"... So Fed is going with the option two -which in turn means that because regulators are now going into a severely brutal "raise more capital at all costs" mode, even the healthy bank's shareholders are now bracing for more dilution.

13. Thus my decision to buy into financial sector last week even in a small way was not a correct one and I am reversing it. It also means that S&P and DOW could very well retest/ move past the January lows in the nearest future and thus adding a few more shorts and more defensive play like utilities might not be such a bad idea.

On the positive side, however- the corporate health outside the financial and consumer discretionary sectors still looks ok and income tax withholdings as released by the US Treasury http://www.fms.treas.gov/dts/ have actually picked up in the last few weeks of May and in early June. The most recent data in my interpretation is consistent with a GDP growth of at least equal to or may be even slightly higher than that in Q1 2008...

After playing with the data I have also found what seems to be an interesting correlation between the four weeks lagged S&P 500 index and growth in withholdings- it is by no means bullet proof, but certainly seems to point to a limited short term S&P downside (2-3%) with the next move up of roughly 5-6%.

And to finish off- here is one more opinion- I think that behind the all the "doom and gloom" noise out there, it is important to clear any disillusions and fears. In my opinion, 10 years from now- all major US indices will be trading at higher nominal prices than they are trading today, period. I am willing to make this bet with pretty much anyone-but I also doubt there will be many takers though as it is pretty much bound to happen for two main reasons:

1. In the world of "fiat" money inflation is not going away and thus while real stock prices might be higher or lower, nominal prices are simply destined to go up!

2. US Economy is still the most vibrant, flexible and productive one in the world and thus it will find a way to reinvent itself and will surely grow in the real terms again at some point :)

So with that in mind, I think that assuming one could weather some serious volatility in the next 12-24 months or so- pulling all the money out of stocks and reinvesting them in cash or money market funds is very likely to be the most counterproductive thing a passive investor could do. However, protecting the principal investment should be the most important goal of any investment manager and thus hedging with short positions is as usual a very prudent decision...

Stay safe out there, skepticalcapitalist@gmail.com

"Be not angry that you cannot make others as you wish them to be, since you cannot make yourself as you wish to be"
Thomas à Kempis

I guess I will never stop being amused by the investment related media headlines out there... One day we hear a story about the "major bubble" in oil, another day "about oil prices going to $250". Same divergence with interest rates, investment banks or for that matter with anything else that is a "soup du jour" of the moment- I guess it is an almost bullet-proof strategy- throw a bunch of things on the wall, make lots of extreme statements and then see what sticks, and at the end declare that you were right.

Recently, forecasting shapes of what seems to be an inevitable eventual recession has become a very popular topic of conversations. Here some of own views and opinions on the subject. I will try to describe them in the "media-like terms" hoping it won't be too boring ...

Some believe that the US Economy is in for a V-shaped recession- a quick and painless slump followed by a fast recovery; others think we might see a W- shaped one with one quick dip followed by a short recovery and then followed by another larger dip with an eventually inevitable upward move. And the last group, ("Elliot Wave" crowd) thinks that we are destined to live in the L- shaped world - with the US Economy entering a decade long Japan-like period of stagflation for the years to come...

I'll start by eliminating the third scenario outright- in my opinion the repeat of Japanese scenario here in the US is pretty much impossible, because we are 1.Nation of spenders, not savers 2.Are as far from the deflation as one could be- "have you seen the inflation numbers lately?"

On the other hand, I believe that the first two shapes of economic downturn are still very much possible- and the end result could very well depend on the next move of the Washington wizard called Ben Bernanke. So below is a hypothetical scenario planning exercise to make sure that my portfolio is ready for the eventual outcome whatever it might be.

Let's now introduce some core factual statements:

1. US Economy is going through a period of highest inflation in more than a decade- all the talk about core, non-core inflation is irrelevant at this point- you can only call high energy and food prices non-core and temporary if they indeed lasted for only a short period of time ...

2. Inflation is always a direct of excess monetary liquidity. High commodity prices are merely a symptom and thus are not likely to be cured until the excess liquidity is drained...

3. Healthy financial sector is a fundamental requirement for any well functioning growing economy- without normal access to credit- the economic system as we know it cannot function...

4. Banks are very unlikely to start lending in a normal fashion again until they become confident that the value of their collateral is no longer eroding.

5. Financial sector especially the investment banks are facing significantly more restrictive regulatory environment and lower leverage

6. It is very rare, however, when you see a combination of persistently high overall inflation and accelerating deflation of the core collateral in the financial sector (real estate) -simultaneously.

7. The longer the current restrictive credit situation drags on, the more likely it is going to spill over to new areas- Fed has to force the banks to start lending again

8. FDIC is now going to virtually force banks to raise more capital whether they need it or not in the short term- expect more capital dilution and dividend cuts...

9. Thus one stakeholder in the financial sector is going to suffer more than the others- shareholders