Regression to the Mean

A recent Wall Street Journal titled “Rebound of the Losers” from July 6, 2009 described how some specific actively managed mutual funds with large losses recently booked better performance. From the article

Ninety-four diversified U.S.- stock funds that finished 2008 in the bottom 10% of their peers are now performing in the upper 25% of their categories

The article then described their reasons why these specific managers were able to “rebound”. They included:

– purchased shares of better-performing foreign companies (the markets in China and Russia, for example, fell further and later rebounded better as a % than US markets)
– commodity markets improved, so stocks with a commodity footprint like energy benefited
– some managers described their own “guts”

“It’s funny how quickly things can change,” Mr. Soviero says, “but I’m glad I had the level of conviction and stuck with a concentrated strategy.”

– others used terms like “discipline” and said they were looking for companies with a “sustainable advantage”

But the journalist on the article missed the simplest, and most obvious answer –


What this means, in practical terms, is that stocks or sectors that have the largest rise now are likely to fall later, and vice versa. One financial magazine I read had “Chicos”, the clothing store, as the “worst” performer over the last year, and the “best” performer over the prior decade, in back to back pages.

Something to watch for, especially when people describe their recovery in personal terms, rather than ascribing it to typical market “bounce”.

iBonds… You’ll Get Nothing, and Like it (or not)

From time to time I have posted about iBonds as an investments. iBonds are interest securities backed by the US Government that you can purchase online or at a bank (I guess, although I have never tried that). The general attraction to iBonds is that their interest rate goes up as inflation goes up – which provides protection in times of rising prices (hence the “i” in the name – I originally thought it was tied to the “dot com” era). Here is an in-depth analysis that I wrote about iBonds in December, 2008, noting that the government had reduced the total amount that you could buy each year from $30,000 / person to $5000 / person. Note that you can’t LOSE money on iBonds unless the US government defaults, in which case we all have some big problems.

In short – there are 2 components to your iBond return. The FIRST part is the “fixed” interest rate that the US Government offers you. I bonds have been issued for about 10 years, and the “fixed” rate used to be as high as 3.4% / year which dropped as low as 0.0% (yes, that’s zero) but recently were bumped up to a negligible 0.1% rate. What this means is that if you bought an iBond years ago and kept it, that is a better iBond than one that you are buying today since the rate today is near zero. I think that the iBonds that I purchased over a couple year period have a rate near 1%, give or take.

The SECOND part of your iBond return is the variable component. This component takes into account inflation. Thus if prices are going up (you have inflation), then the interest rate that you receive will go up, as well. For the decade or so the iBonds have been in existence, this rate has been positive (meaning rising prices), providing an interest rate of between 1% and 6% or so.

Thus since iBonds have been created, the return that you could have gotten (depending on when you purchased the underlying bond) your return would vary from a fixed component of between 0% and 3% and a variable component of between 1% and 6% meaning that the “real” range of interest is between 1% and 9% overall.

TODAY, however, the new iBond rate has been unveiled… and since we are in a deflationary period (prices are going DOWN), for the first time, the rate of return on iBonds is ZERO (the interest rate can never go negative). The decline in real prices is -2.78% for six months per the government calculations, which means that it annualizes to -5.56%, so no matter when you purchased your iBond your return is ZERO, because even the highest iBond rates were about 3% or so they are all dwarfed by the -5.56% annual rate.

OUCH. It is never good to have an investment with a return of zero, especially when you purchased it explicitly for interest income (and to ensure you didn’t LOSE any money). However, the inflation rate will be adjusted in six months, and if prices are going up then, the interest rate will reset upwards.

I wouldn’t invest in iBonds now if you haven’t already bought some, especially because you are just getting this anemic 0.1% return as a base level. Check again when they announce interest rates for the next six months, which will be on November 1, 2009. I wouldn’t sell what you have, however, because you’d just have to re-invest the money in something else, and savings and checking accounts are generally yielding almost nothing now, as well, along with money markets.

Note – for those of you that don’t get the reference (probably those younger than 21 or so… of course it is from Caddyshack).

Trust Funds and Taxes

As part of running a trust fund or being a beneficiary of a trust fund you need to have some understanding of taxes. As always, if taxes are not your specialty get professional help I am only writing from my own experience.

Every year I need to review the taxes for each of the trust funds that I run. Here are the elements of determining taxable items:

1. interest income – every brokerage account is attached to a money market account, which bears interest. When you put funds into the trust, it starts out in the money market account and earns interest until you make an investment, and as you earn dividends, the dividends also go into your money market account. You also may opt to NOT invest a portion of the cash that is in your money market fund, because you are waiting or are afraid of the market, so it will also earn interest until you invest it in stock. Generally, your interest income nowadays will be puny because rates are extremely low right now (less than 2%) on short term money market funds and unless you have large balances the amounts are trivial. For tax purposes, unless your money market account invests in tax-exempt (municipal) securities, you will pay taxes on this interest income, generally at the highest taxable rate

2. dividend income – many, but not all, stocks pay dividends. Dividends may be paid out quarterly, semi-annually, annually, or on special occasions. The “dividend yield” takes the current payout plan of the company divided by the stock price, to see what the stock would pay if it is the equivalent of an interest bearing bond or CD. Right now, for example, Procter and Gamble pays out a dividend with a 3% yield. When a stock price plunges, the yield can get very high, but that is a sign that the stock may reduce payouts – for example right now Nokia has a yield of 10%. Dividends are taxable when received, and they generally are eligible for a reduced taxable rate of 15% if they are “qualified” and US based.

3. capital gains and losses – when you buy or sell a stock, you earn capital gains or losses on the difference between the price you paid for the stock and the price you sold it for (including commissions). Thus if you bought a stock at $10 / share and bought 20 shares, and then you sold that stock for $15 / share, you’d have a capital gain of ($15 – $10) * 20 or $100. If your “holding period” of the stock was less than 12 months, it would be a short gain, and if your holding period was greater than 12 months, it would be a long term gain. Generally long term capital gains are eligible for favorable tax treatment. Note that all capital gains and losses are “netted” against each other, and you can roll-forward your losses. For practical purposes this means that the VAST majority of Americans won’t be paying capital gains taxes for years to come, since most of their existing stocks are trading for less than what they paid for it. Even if you want to sell a stock for a gain, it is easy to find something to sell for an equivalent loss to avoid paying taxes.

Portfolio one – $352 in dividends, $32 in interest, and a long-term loss of $590 on a sale of GE stock

Portfolio two – $188 in dividends, $22 in interest, and a short-term loss of $761 on a sale of ICICI (IBN) stock

Portfolio three – $21 in dividends, $11 in interest, and a short-term loss of $550 on a sale of ICICI (IBN) stock


Filing requirements are complicated. For this purpose I am discussing whether or not you need to file a return on a given trust fund.

For 2008, if your “unearned” income (basically interest, dividends and gains / losses on sales) is less than $900, you don’t have to file. Based on the above items, they do not need to file. In prior years, we sold some stocks off for gains that pushed them beyond the filing thresholds and we did need to file.

There is an IRS publication 929 (they go by number) which attempts to explain all of this. I would recommend going to and look for this publication (it is a PDF), download it, and read it. In another post I will explain some of the complexities the best I can.

What I’ve Learned About the Stock Market

Anyone who has a retirement fund or personal investments has an interest in the stock market.  I have an additional interest because I am the fiduciary in charge of trust funds and describe at this site.

When the stock market started cratering in 2008, I didn’t take immediate action, for the most part (I was going to say didn’t do anything “rash” like sell off, but in hindsight of course probably that would have been under the category of “smart”).  I did sell off financials (owned ICICI, an Indian bank, and GE, which is essentially a giant financial conglomerate with a few businesses stuck in there) immediately, and although my exposure to that sector was limited in those funds, those stocks had not done well.

Now I am trying to re-visit the stock market and do some research to consider what to do next.  I am starting out with what I’ve learned from this debacle.  As always, do your own research, this is just my 2 cents based on my experience and body of knowledge.

1.  Watch the level of debt, and the timing of debt – for many years there was an absence of a risk premium, which meant that newly emerging (risky) companies could raise debt very cheaply, such as only a couple of points above the treasury rate.  Today, it is unlikely that these types of companies can raise any money AT ALL, and if they did it would be at a rate perhaps 10 percentage points above Treasuries (i.e. if Treasuries are at 4%, they would pay 14% for financing).  Companies are moving into bankruptcy rather than try to refinance at these rates – companies like Charter Communications, for example.  Even if bankruptcy is avoided (or deferred) the company would have to be highly profitable to earn enough to cover that level of interest payments – and most companies can’t profit when their cost of capital is that high.  I won’t even comment on the 33-1 leverage used by investment banks because we all know how that turned out

2. Guessing the actions of the US Government is important – during the cold war, “Kremlinologists” attempted to divine what was occurring at the top levels of the Soviet government, since it had a direct bearing on our policies.  For example, the Feds let Lehman die and saved AIG, although in both cases their equity value evaporated to the point that a 100% equity loss and a 98% equity loss were a toss-up either way.  The subtle way in which by saving AIG they benefited Goldman Sachs (since AIG was a major counter-party to Goldman Sachs) would be something worth understanding, for example.  The Feds also didn’t bail out Fannie Mae and Freddie Mac preferred shares, which caused whole ranks of smaller institutions to fail.  In general, if you are investing in an industry that looks likely to need government help, you should get out now, because whether or not you have a few equity crumbs or go to zero is a Hobson’s choice you don’t want to face

3. Correlation between asset classes is higher than you expect – Basically unless you were 100% in gold or treasuries you were likely hurt badly in this market.  Foreign stocks, US stocks, many debt instruments, preferred stocks, real estates and most commodities (excluding gold) all dived together.  One of the “core” beliefs of “modern portfolio theory” is that if you spread your investments across classes with lower correlation to one another, you will do better over time.  Modern portfolio theory basically didn’t save anyone in the time frame we are talking about here

4. Liquidity can evaporate, and if you depend on liquid markets, you are in trouble – Not only did the risk premium (see #1 above) go up quickly, liquidity in the market evaporated, meaning that if you counted on liquid markets, you were in big trouble.  Illiquid markets mean that you can’t “roll over” debt and if you do have to sell, you will receive a distressed price for those assets (a big loss, in real terms).  One of the first items to fail were the “auctions” in the municipal area which were a sign of bad tidings to come

5. Real estate is no bulwark – For individuals, there was often an assumption that real estate is a “safe” investment, but real estate values have proven to be anything but.  Real estate losses for individuals were semi-spared because the government has set a very low rate for mortgages and nationalized Fannie and Freddie – without that floor mortgages would be illiquid and subject to #1 and #4 below.  Now, however, the mortgage market is basically subject to government fiat – see #2 above.  If the government decides that condominiums are too risky and pulls back on guaranteeing mortgages on half built condominiums, those investments will fail.  For real estate companies that specialize in building new homes, those stocks are basically dead, since demand won’t catch up with supply for years.  The government is definitely working to prop up the home market, with tax incentives for the new buyer (and likely no more talk about not making home interest deductible)

6. Complexity is dangerous – Another early warning sign was the fact that Citicorp and others had to bring in “off balance sheet” entities onto their balance sheet when liquidity failed (see #4 above).  Those companies were incredibly complex, and their financial statements were incomprehensible even to me, a financial professional.  These counter-parties, off balance sheet entities, and WAY too much leverage made a toxic stew.  In general, companies that have a very complex “story” will likely have a harder road to travel when trying to show their value to the equity community, since people have been burned by what they don’t understand

7. Dividends provide little shelter – over time a significant portion of the total “return” from stocks is driven by dividends paid to stockholders.  Many companies paid dividends at a steadily growing rate for decades, and constantly re-emphasized the importance of dividends to their strategy (giving investors confidence that these dividends would continue in the future).  However, virtually everyone gave up on their dividends, from the financial companies that are sliding to the edge of oblivion to GE (who really is a financial company anyways) to many other industrial companies.  There are exceptions to the rule (companies that are not facing dire straits) but the fact is that strong companies can pay dividends and weak companies cannot, so betting on a dividend independent of the underlying financial structure is a fools errand.  The dividend is nice to have (and starting from a solid one is better), but counting on it in the future has proved to be devastating

8. For the most part, no one (who talks) knows anything – yes you can point to the occasional seer who cried doom and certainly many, many smart and rich (and tight lipped people) made tons of money shorting the entire market all the way down, but for the most part the conventional wisdom was completely and utterly wrong.  There are people or firms that understand the market well and can profit in down times, but you aren’t getting their thoughts from Jim Cramer on CNBC or in the WSJ or Barron’s or anywhere else, much less the popular magazines like Time, Money or your local paper columnist.  Look at how their stock ratings performed, and generally it was terrible.  A lot of this is institutional bias because those magazines and paper can’t just tell you to short everything and get out of the market because those same companies buy advertising and those sorts of negative messages frankly sound un-American when explained out loud.

9. Timing IS important, as is re-investment risk – I resisted timing in favor of “buy and hold” for years but then I moved into selling stocks when I thought that they had peaked on the upside, or they had huge down side risk (financials).  Buy and hold really hasn’t done anything for anyone in the last decade or so except rack up huge losses.  That doesn’t mean that I have a better strategy, but it is a fact that the central issue is timing.  Tied to timing is re-investment risk – which basically hits you in that even though you sell at a gain, you have to re-invest in something else that has increased in price (due to strong correlation) and you don’t mitigate your risk that much by selling one overvalued stock for a gain and trading it for a new one.

10. If it seems too good to be true, it probably is – I am not a seer but I think that all these people piling into municipal bonds for the tax benefits and historically low default rates are in for a rude awakening when bad things start happening to the states.  I know that there are many ways to bail out a state including the Federal government but it just seems like the municipal financing is going to fall apart and I don’t want to be holding the bag.  This applies to “free lunches” everywhere…

Now with all these “lessons”, what is a forward looking investor to do?  The stock prices are down, and this could be an historic time to “buy in” to the market, rather than sitting on the sidelines licking your wounds.  I am trying to figure that one out now, but thought it made sense to take stock of what, if anything, I learned so far.

Cross posted at LITGM and Chicago Boyz

My “Lost” Purchase

Virtually all of us have been touched to some extent by the decline in stock prices and asset devaluations (houses). I recently was talking to someone and they mentioned this thought experiment:

What if you had spent all the money that was lost in the recent market declines instead of watching it fall in value?

I was walking through River North last weekend when my personal answer sat on the curb right in front of me – a brand new Nissan GTR, valet parked by a high-end restaurant and club. Sure it has a sticker price above $70,000, but it is about the fastest thing on the road and has a great control layout and is a Nissan, to boot (so it likely won’t end up being a rolling pile of junk after a few years).


Of course, this is now fantasy-land, since reality binds me to the GTR’s all-too-practical sibling, a 1999 Nissan Altima, nearing a decade in service but still reliable and practical for the almost no driving I do in the city.

Not that I am encouraging this type of thinking (spend it now because it is falling in value), because it is critical for everyone to keep a long term perspective and to plan for the future. These market losses are discouraging but this is life and we need to keep marching ahead and learn from our failures. It is likely that high government spending and large deficits will mean that relying on social security, always a bad plan, will become even less viable, since all the other spending will crowd out this benefit.

But it is a fun thought experiment, especially when it is sitting on the curb, right in front of you…

Cross posted at LITGM

Negative Net Worth


The Chicago Tribune business section has a series where readers write in with their financial issues and the columnists seek professional help and recommendations and publish the results. This column is titled “Law Degree on Her Side” and shows the plight of a woman under 30 who is a lawyer but is struggling under a mound of student debt and is considering bankruptcy.


A big element in our economy’s struggle is the fact that the analysts and “experts” were focused on the income statement and not the balance sheet. An income statement view focuses on profits, or the difference between earnings (in her case, salaries) and expenses (rent, living expenses, etc…) and what remains each year. Companies often report earnings EBITA which stands for “Earnings Before Interest, Taxes and (depreciation) and Amortization”. In this model, you become a lawyer because you can make a lot of money (top line revenue) and use it to support the rest of your living expenses.

However, this “income statement” model ignores the debt needed to finance education and expenses related to education. This debt keeps piling up and is a negative item on your balance sheet, which is the long term debt that you owe others, along with the annual interest that you need to pay to service this debt. In an analogy to the stock market, it is the debt payments, along with the fact that companies can’t come up with the cash to pay off principal (or roll-over debt) that is causing the liquidation of companies like Circuit City, Linens & Things, Mervyns, and soon to be many others.

In this lawyer’s case, her balance sheet is “negative” meaning that she is insolvent or has a negative net worth. She has a tiny amount of assets (a bit of retirement savings, some cash on hand, and maybe equity in a car or something) which is all she can show to offset a mountain of debt.

I don’t have exact statistics but I would venture that most Americans have a negative net worth nowadays. By this I mean that the value of their debts exceeds the value of their assets. I also run a site called “trust funds for kids” and I often tell my nephews and nieces that even the relatively small amounts that we put aside ($10,000 or so), as long as they don’t accrue debt, will make them better off than most Americans who have worked their entire lives, since they will have a positive net worth. Obviously some of this is tongue-in-cheek since you need a steady stream of income to pay minimal living expenses but there is much fundamental truth in that analysis in that if you pile up debt you will never accrue enough assets to offset this debt. And if you have a negative net worth, you can never stop working (retire) unless you have a guaranteed string of income high enough to offset your living expenses, interest costs and principal repayments.

These debts cost money to finance, and this cost is in the interest rate. The woman in this article is drowning because $200k of debt will mean that interest payments of $14k ($200,000 * 7% or so) would be needed just to service the debt, without putting ANY sort of dent in the principal. Likely the principal is going to be due over a certain amount of years – let’s say 20 years – so she needs to pay $10,000 / year in principal plus $14,000 in interest (the interest will go down in future years as the principal is paid down) on the current balance. If her income is below certain thresholds (her income, at $75,000, is for now) then she can receive a tax deduction of $2500 based on the interest component (see IRS publication 970). Thus (using this relatively simplistic analysis) of her $75,000 / year salary, $24,000 (or almost 1/3) would go for debt principal and repayment (the tax deduction would likely offset this for about $1500 in cash, depending on her tax bracket).


One very unfortunate difference between companies and this student is that companies can eliminate debt through bankruptcy (if they are cash flow positive on an EBITA base and can obtain interim financing), but the student debt can NEVER be discharged. I remember when I was studying for my CPA exam (20+ years ago, so maybe it isn’t an exact quote) that they had a section on bankruptcy and they mentioned that the discharge of student loans through bankruptcy was eliminated because

Doctors, who require mounds of debt to pay for medical school as well as finance living expenses while they are interns and only modestly paid, used to accept the diploma with one hand and declare bankruptcy with the other. Tiring of this tactic, the schools lobbied and changed the laws so that student loan could not be discharged through bankruptcy

Thus taking up student debt is serious indeed; unlike your house (which you can walk away from or short-sell to the bank) or auto, you can NEVER discharge this debt, and have to either pay it off or have this debt hanging over your head for the rest of your life (essentially meaning that you can’t accumulate any assets).

If you read the article, not only did the woman take on student debt, she also took a vacation and put it on her credit cards, which have a much higher interest rate (maybe 20% or so) and need to be paid off before she can make a serious dent in the student loans, unless she wants to declare bankruptcy. And even if she does declare bankruptcy, given her level of income, it is likely that the court will make her repay at least some of these obligations.


When you incur tens of thousands of dollars in debt to get your degree (or $200,000, in this unfortunate case) you need to ensure that your degree will pay enough to not only support you going forward (and your family, if you intend to have one) but also to pay off the student loan debt and interest accrued on that debt.

In the case of this woman, she has a law degree. However, one item that wasn’t advice in this article is that she has to leverage this degree to make a lot more money. She needs to work for a firm with high billing rates and she needs to put in a lot of hours. Traditionally law firm employees had to bill 2,000 hours / year – note that this is BILLABLE work so everything that isn’t billable has to go into the rest of the week (or weekend) after you are done with a full days’ work, including what shred of a social life you’d like to have.

Given all the taxes and costs of living in Chicago (remember that the sales tax is over 10%, property taxes are high, and Federal and state tax rates are going up) if she increases her income to pay down debt effectively almost 50% of every dollar is going to be taken away from her between social security and taxes of all stripes. So she needs to increase her income by $50,000 to come up with the extra $25,000 which would allow her to pay down this debt sooner.

My uncle (now deceased) was a man who fought for the little guy. He was a lawyer with his own firm and he represented the poor and often did death penalty cases for the state (as a defender). He summed it up to me that

You can either represent poor innocent people or rich guilty people

I suggest that she find some major companies with problems and burn up a lot of billable hours helping them. Her $75,000 / year job will never pay enough.


The other more subtle point in this article and overall in finance is that the implied rate of return for investments has been decreasing. Anyone who hasn’t been fully invested in gold and treasuries has seen the value of their investments plummet, possibly by as much as 50%. Various articles come and go about how the DOW is now back to 1992 or prior – although this is kind of specious unless you were heavily invested all this time – sadly enough most people bought into the market much nearer its peak, so they took big losses on actual cash put into the market (and didn’t just lose gains from prior years).

If the markets are down 50%, it will likely take YEARS of sustained 15%+ growth, for instance, just to get back to where we were in 2007. Thus while those returns might be prominently featured in advertisements, essentially for the average investor those returns are needed just to get you back to zero, and then you need to make returns BEYOND this in order to increase your asset base.

Why does this matter? Because while the implied return on YOUR investments has declined (is frankly negative) and banks are paying about 1% in interest (BEFORE taxes), a loan at 7% is very pricey. In the old days when people put in 10% / year return in their model, they figured that a 7% loan was cheap money. Now with negative returns or puny returns in the risk-free market, 7% means that your loans are outpacing your gains and that your problems increase every day that you don’t pay off that loan. I won’t even go into the impact of a 20% credit card loan (plus the fact that consumer interest isn’t even deductible).


ANY students who are considering taking out debt to finance their education NEEDS to understand the gravity of the situation:

1) these loans can NEVER be discharged through bankruptcy
2) the interest rate you are paying is likely higher than the return that you will make on your own assets
3) you need to earn enough money to pay off the principal and interest, as soon as possible
4) as you earn more money and try to pay off these loans, high taxes and cost of living eat up the value of each dollar earned so that you essentially have to earn $2 to get $1 to pay towards your obligations
5) you need to live as cheaply as possible and get this done as quickly as possible – in this case the woman worked as an unpaid intern which just let her interest accrue and she took expensive overseas vacations which caused her to add credit card debt
6) based on all of the above items, it likely isn’t worth accruing debt for a degree unless your degree is extremely marketable (law, medicine, finance, engineering) – that doesn’t mean that you can’t follow your passion, but it does mean that you need to pay-as-you-go or find a way to do it through scholarships or at your local community college
7) if you incur debt, you need to make money ASAP and forgo other social options, expenses and fun – else you will never escape the debt trap. You spent all this money for the degree, so now you have to leverage it to the hilt and make as much money as possible

Cross posted at Chicago Boyz


One of the features of the stock market lately is that stocks tend to move in unison.  On a given day when the stock market goes up, it seems like almost every stock is buoyed in price.  On the other hand, if the market has a bad day, then everything seems to do down.

Above is a snapshot of the day’s results from Friday, February 6, 2009. You can see that every single stock in portfolio one and portfolio two increased in value during the day (portfolio three has a subset of the same stocks as portfolio two, so showing it was redundant for the point I was trying to make).

The covariance in the market is far more pronounced than it used to be in the past. This may be linked to the fact that the market is making more large percentage moves on a given day. Per Harper’s magazine February issue:

Number of times in 2008 that the S&P 500 closed up or down 5 percent in a single day: 17
Number of times between 1956 and 2007 it did this: 17

The fact that the stocks tend to move in unison makes selecting individual stocks more difficult. When you are selecting an individual stock, you are generally doing analysis on the performance prospects of that unique company. However, the fact that market moves are pushing all stocks in one direction or another (unfortunately, they have been mostly downward) no matter what the rationale for your stock may be, it is buried by the overall market moves.

Some items logically cause the entire market to move on a GIVEN day – for example, this day the market was up primarily due to the fact that the stimulus package appeared to be resolved. Other factors, like changes in interest rates, can make equities more or less valuable overall because they are often an alternative to debt instruments. As the interest rates rise, debt instruments become more attractive and stocks less attractive, all else being equal. Items like attacks on the US or foreign countries can also cause one-day (or longer) shocks to the market, or increase “systemic risk”.

In any case, covariance is definitely increasing, meaning that more and more of the return on an individual stock is due to what is happening across the entire market and less and less due to the story of a particular company. Nowadays company specific research should mainly focus on the downside risk – companies that have to refinance debt at unfavorable rates, for example, which could cause their value to go to “bagel-land” or zero.