You don’t have to follow this blog very closely to know I’m a big fan of Barry Ritholtz and his blog The Big Picture.  Over the weekend he gave the following presentation, Romancing Alpha, Forsaking Beta at the Trustee Leadership Forum for Retirement Security.

It’s a great presentation that shows how our wetware (to borrow a term from Barry) leads to poor investment decisions – particularly when it comes to the mythical creatures of Wall Street: alpha generating hedge funds.  Check it out:

At last!  A compromise between the Efficient Market Hypothesis (EMH) and Behavioral Finance:

Really nasty market sell offs are notoriously hard to predict.  But one factor that can propel a healthy sell off into a nasty sell off is margin debt.  When investors become especially bullish they like to increase the size of their bets by borrowing money from their broker and using the stock they’re buying as collateral.  This has the effect of magnifying the gains and the losses.  When those bets go sour, investors have to raise cash to meet margin requirements (i.e. you have to post a certain level of cash or securities in proportion to what you borrowed) – if they’re already over extended and using borrowed money to buy stocks then they have to sell their stock in order to raise that cash.  This is known as forced selling and it is something you never, ever want to do.

The SEC actually has a nice little summary of how margin works and highlights the following risks:

• You can lose more money than you have invested;
• You may have to deposit additional cash or securities in your account on short notice to cover market losses;
• You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities; and
• Your brokerage firm may sell some or all of your securities without consulting you to pay off the loan it made to you.

A recent NYT article highlights the margin debt “danger zone” at 2.25% of GDP.  According to their research, when that threshold is breached, bad things generally happen – see charts below.

Between high corporate profit margins, the threat of QE being dialed back, and high levels of margin debt – it seems the seeds for a considerable market correction have been sewn.  Buyer beware.

There is a good article in the WSJ about the current investing landscape called Is This the Best Time for Investors? Don’t Bet On It – it is behind their paywall but usually if you google the headline you can get the articles for free.  The whole article is good but my favorite part is the simple thought experiment offered by Rob Arnott regarding the importance of QE:

How important is [quantitative easing] to asset prices? Some say it is the main story. Rob Arnott, chairman of Research Affiliates in Newport Beach, Calif., suggests investors engage in a simple thought experiment to understand.

Imagine, he says, if Mr. Bernanke announced tomorrow that he would end this policy forever. “Ninety-nine people out of a hundred” on Wall Street, Mr. Arnott says with a chuckle, know full well what would happen immediately: clattering falls of both stocks and bonds.

After that last post about famous speculators and their speculations I have to balance things out a bit…

“For as long as I can remember, veteran businessmen and investors – I among them – have been warning about the dangers of irrational stock speculation and hammering away at the theme that stock certificates are deeds of ownership and not betting slips… The professional investor has no choice but to sit by quietly while the mob has its day, until the enthusiasm or panic of the speculators and non-professionals has been spent. He is not impatient, nor is he even in a very great hurry, for he is an investor, not a gambler or a speculator. The seeds of any bust are inherent in any boom that outstrips the pace of whatever solid factors gave it its impetus in the first place. There are no safeguards that can protect the emotional investor from himself.”

– J. Paul Getty

Found via Hussman

Naturally, Hussman’s broader market commentary is equally as thought provoking as the introductory quote above.  He identifies two aspects of QE that are driving the stock market: (1) the pain of zero interest cash and (2) the superstition that QE removes downside risk.

This got me thinking about all the folks out there who feel they are “forced into equities” because they can’t find adequate returns elsewhere.  Yes, thus far the outcome has been quite nice for those “forced” into the stock market but at some point there will be a correction.  And at some further point the Fed is going to take the punch bowl away.  So rather than sulk about cash’s paltry return, why not recognize the option value embedded in cash?  It is essentially a put option on every asset in the world with no expiration.  Yes it won’t feel very valuable when the stock market is setting records but it will when the market changes course.  I would gladly accept a year or two of 0% to slightly negative real returns (cash today) if in a few years time I can safely find double digit annualized returns elsewhere; ESPECIALLY if the only other offer on the table carries such considerable downside risk (i.e. stocks & bonds today).  Today this thinking / approach is as unpopular as it is boring: very.

Let’s end this post with the money shot from Hussman’s commentary (and please keep in mind price ≠ value):

In short, there is no transmission mechanism by which QE has any large and beneficial effect on the value of equities. There has certainly been an effect on price – but this effect is driven by the willingness of investors to abandon their demand for a risk premium that will actually compensate them for the risk they are taking.