Happy New Year

Have a very happy, prosperous 2011!

Lien, The Little Book of Currency Trading

I am not a forex trader, nor do I aspire to become one. Nonetheless, I am interested in currencies, so I decided to read Kathy Lien’s The Little Book of Currency Trading: How to Make Big Profits in the World of Forex (Wiley, 2011). This is the sixteenth volume in Wiley’s “little book” series.

Lien covers a lot of ground, from the basics of forex trading to one of her favorite trade setups, from trade management to identifying scams, from having a trading plan and a contingency plan to the top ten mistakes traders make (including, my personal favorite, becoming a demo billionaire). Often she proceeds by way of analogy. For instance, she highlights the difference between a trader and an investor by analyzing the behavior of those New York City taxi cab drivers who pay medallion owners a fixed sum per week for the right to drive a 12-hour night shift: some speed down city streets looking for as many “lower value” fares as possible, others wait patiently at JFK for the few “higher value” fares.

Since readers are always searching for ways to make outsized gains in the markets, I’m going to accommodate today. Well, that’s a gross overstatement. More accurately, I am going to share two practical suggestions that Lien makes on “how to make big profits in the world of forex.”

First, she describes her Double Bollinger Band Method, where the bands are set to one and two standard deviations above and below the 20-period moving average. These double bands, Lien argues, “can be used for identifying whether the currency is in a range or trend, if and when a trend has exhausted, where to find value within the trend, and how to get into a new trend.” (p. 108) I’m not going to steal her thunder. I assume that anyone who is savvy in technical analysis can hypothesize the outline of some of her tactics, if not their details.

Second, she disputes the common claim that traders must maintain at least a 2 to 1 reward to risk ratio. “An overly ideal risk to reward ratio encourages traders to try and take more from the market than is being offered and may encourage scalpers to use excessively tight stops.” (p. 100) Instead, she advocates trading with a negative edge, entering with a double lot and scaling out in two steps. Why adopt a mathematically inferior strategy which needs to be successful at least 60 to 70 percent of the time? Because, she writes, “it is psychologically more palatable, and trading at its core is always more psychological than it is logical.” (p. 103)

The Little Book of Currency Trading emphasizes the practical over the theoretical. Although it’s written for forex traders and investors, much of it is applicable to traders and investors in other markets as well. It’s a quick, lively read; it’s informative and concrete. It may not be a classic, but it’s definitely worth a look.

Digging out, very slowly

The to-do list that started to be checked off before dawn: There are huge sand dunes around my car, except they’re white. And then there’s the area where Delta, the geriatric basset hound, stretches her legs and relieves herself. Not to mention the walkway to the heating oil and propane tanks. I leave the driveway to the professional, who plows when he’s finished his “important” clients. After which, if I don’t shovel, the driveway remains impassable. And it’s a very long driveway. Well, you get the idea.

Unlike many people in my Connecticut town, I didn’t lose power. Which was a godsend, because no electricity also means no heat and no water. Unfortunately the cable connection was down more than it was up, so it was a frustrating day.

The best I can offer you today is a link to a Harvard Business Review blog post by Tony Schwartz from August: "Six Keys to Being Excellent at Anything." It doesn’t break new ground, but it might inspire some New Year’s resolutions.

Santa reading “The Holy Grail of Trading”

In case you didn’t notice, the page is blank.

The happiest of holidays to all my readers.

Durbin, All About Derivatives

All About Derivatives (McGraw-Hill, 2011, a fully revised second edition) is a curious book, and I don’t say that unkindly. It’s just odd that in a book in the “All About” series, touted as “the easy way to get started,” you find such a lengthy discussion of options pricing. But then Michael Durbin is, among other things, a financial technology consultant specializing in high-frequency trading of financial derivatives, and he has helped numerous Wall Street firms develop derivative pricing and trading systems.

The structure of this book is straightforward. After an overview chapter, the author devotes a chapter each to forwards, futures, swaps, options, and credit derivatives. He then looks at using derivatives to manage risk, pricing the various derivatives, hedging a derivatives position, and derivatives and the 2008 financial meltdown. In three appendices he investigates interest, swap conventions, and binominal option pricing.

Even though this book would be a fine introduction to the subject of derivatives, it often goes beyond the elementary. For instance, Durbin points out the subtle pricing differences between warrants and options. Moreover, the book is laced with interesting tidbits. I didn’t know, for example, that Enron issued a series of credit-sensitive notes in 1998 that offered a coupon rate inversely tied to its credit rating.

For options traders who want to delve a little more deeply into pricing models, Durbin offers a gentle account in the text, coupled with a more mathematical description in an appendix. He explains why Black-Scholes cannot be used to determine the value of every type of option. Yes, it was meant to apply to European-style options, and there are other choices for American-style call options. But, he writes, “for American puts, Black-Scholes is simply not a choice. You must use a binomial tree method because an analytical method for pricing an American put option simply does not exist. An analytical solution is one in which you plug factors into a function and get a result. A nonanalytical method is more of a brute-force or trial-and-error approach, which the tree method really is.” It seems that the absence of an analytical solution to pricing American-style puts is an example of a “free boundary” problem. “These things,” Durbin continues, “are hard, like trying to predict precisely where water will flow when poured from a bucket onto a flat surface.” (p. 172)

All About Derivatives is a survey of a world that nearly everybody caught a glimpse of after 2008, but Durbin gives it structure and some mathematical clarity. It is a how-it-works book, not a how-to book. The trader in search of a quick buck will be disappointed. I was not.

Schreiber and Stroik, All About Dividend Investing

What’s all the fuss over dividends? Do they really make that big a difference? In All About Dividend Investing, 2d ed. (McGraw-Hill, 2011) Don Schreiber, Jr. and Gary E. Stroik argue that they make a huge difference. In a classic dividend story they compare the portfolios of twins who were each given $10,000 in 1944 to invest in companies that made up the Dow Jones Industrial Average. The twin who spent his dividends each year had a portfolio worth $767,000 in 2009; he spent more than $370,000 in dividend income from 1944 through 2009.The conscientious twin reinvested his dividends until he retired in 1984 and needed his dividend income to help support his lifestyle. By the end of 2009 his portfolio was worth more than $4.7 million, and since 1984 he had collected more than $1.7 in dividends. So the first twin realized a little over $1 million from his initial gift; the second, about $6.5 million.

Dividend stocks are often recommended in down cycles. In the particular cycle the authors picked (or cherry-picked) $100,000 invested in the DJIA Index in 1966 would have declined to $90,275 by 1981. Had a person reinvested dividends, thereby acquiring more shares as prices were falling, the account would have been worth $186,661 in 1981. And had he taken his dividends in cash, he would have received $64,978 over those years; instead of losing $10,000 he would have netted about $50,000.

In bull markets dividend-paying stocks may underperform the more speculative non-dividend-paying growth stocks (in 1999 the NASDAQ gained 85% while the DJIA advanced only 25%). But with dividends reinvested the return would have increased substantially. An investment of $100,000 in the DJIA in 1982 would have been worth $1,302,760 at the end of 1999; with dividends reinvested, the value would have been $2,056,109.

The authors are writing for the relatively uninformed investor. They offer basic advice on how to screen for stock candidates and how to rank them. They outline alternatives to individual stocks such as folios, ETFs, and mutual funds. They explain simple risk management techniques and write about the current tax treatment of various kinds of dividends.

All About Dividend Investing is a good book for investors who are planning for their retirement needs, although it may not take the place of a financial planner. It offers a model portfolio: 70% dividend payers, 14% tactical choices, 14% noncorrelators, and 2% cash. Within the dividend payers segment the allocation is equally divided into five slices: value, growth, quality, yield, and overall best. But then the reader has to get down to work to find the right stocks to plug into these slices. Otherwise, he can use what he learned to find the right advisor for his needs.

Dion, The Ultimate Guide to Trading ETFs

The Ultimate Guide to Trading ETFs: How to Profit from the Hottest Sectors in the Hottest Markets All the Time by Don Dion and Carolyn Dion (Wiley, 2011) is a workmanlike account of the benefits and pitfalls of investing in ETFs, many of which have been amply documented in the financial press and on blogs. The authors, however, give structure to the tidbits that the investor can pick up from other sources. The result is (contrary to the subtitle) a well-organized, balanced book that should serve the ETF investor well.

Although most investors know the advantages of ETFs over mutual funds, they are undoubtedly less aware of some of their potential disadvantages. The authors begin with the basics: appropriateness, liquidity, and concentration. Consider liquidity, for instance. The authors explain that ETFs have both primary and secondary liquidity. Primary liquidity refers to the liquidity of the fund’s underlying basket of securities whereas secondary liquidity refers to demand for the ETF itself. If either primary or secondary liquidity is lacking or dries up, the ETF “will tend to trade at a noticeable premium or discount” to its NAV. (p. 9)

Domestic, international, and derivative-based ETFs each come with their own sets of complications. International ETFs can become disconnected from their underlying equities because of time-zone differences; futures-based funds can trade at significant premiums to their NAV when position limits are imposed or threatened.

I appreciate a book that exposes the underbellies of trading vehicles since too many investors have a decent investing idea (hedge a winter’s supply of heating oil with an ETF, circumvent the short-selling restriction in an IRA by buying short ETFs, increase leverage with the 2X and 3X ETFs, gain exposure to an individual country with an ETF) without truly understanding the product they are using to execute their idea. How closely does it track the underlying? Is it best used for short-term trading or investing?

The authors stress again and again that the investor has to educate himself. For example, “there is a world of difference between … iPath Dow Jones-UBS Platinum Subindex Total Return ETN (PGM), which is based on platinum futures contracts, and ETFS Physical Platinum Shares (PPLT), which is backed by a physical stockpile of platinum. The word ‘platinum’ is the only thing these two funds have in common. The ways they provide exposure to that market are diametrically opposed.” (p. 152)

The book also has useful appendixes. One ranks all U.S.-listed ETFs and ETNs (as of April 30, 2010) on a scale of 1 to 5, a scale which is intended to be a guide to their complexity. A second is a tax guide for ETF investors. Yet another appendix offers sample portfolios for various trader/investor types.

The Ultimate Guide to Trading ETFs is not a revolutionary book. But any ETF investor who is not familiar with all of the material included in it is bound to stumble.

Waltzek, Wealth Building Strategies in Energy, Metals, and Other Markets

I have many vices, but listening to talk radio (Internet or otherwise) is not among them. Reading Chris Waltzek’s Wealth Building Strategies in Energy, Metals, and Other Markets (Wiley, 2010) doesn’t tempt me to change my mind. Waltzek is the host of Goldseek.com Radio, a weekly two-hour broadcast. He has thousands of enthusiastic followers, some of whom have written glowing reviews of this book on Amazon.

Well, it’s certainly different from the run-of-the-mill investment book. Where else can you read about survivalist techniques to ensure against food shortages and rationing, commonplace in times of rampant inflation? If you really want to know, “a home-based safety net can be purchased for less than $5 per week, by simply adding a few canned items and/or a 5 lb. bag of rice to the grocery store shopping cart on each visit.” (p. 79) And then there’s the home garden, which I happen to have but never viewed as a key to survival in the event of runaway inflation. Waltzek even explains how to grow potatoes which, “pound for pound of yield, … requires 75 percent less garden space than does grain or rice.” An interesting statistic, but how many home gardeners grow grain or rice? Perhaps more telling, “Since potato tubers grow underground, unlike tomatoes, corn, and so on, hungry neighbors are far less inclined to borrow a meal without express written permission.” (pp. 79-80) He also recommends replacing credit cards with a cash emergency fund, best kept in a fireproof home safe in the event of a prolonged bank holiday.

It is within this “build the bunker” framework that Waltzek recommends investing in precious metals (especially silver) and energy. “Thanks to Fed monetary gamesmanship the greenback has relinquished 99 percent of its purchasing power since the unconstitutional Federal Reserve seized control of the national money supply.” (p. 47) The United States is following a monetary path similar to Voltaire’s France and risking Voltaire’s doomsday prediction: “Paper money eventually returns to its intrinsic value—zero.”

Waltzek also devotes considerable space to the housing crisis and offers rules of thumb that “every home hunter needs while stalking real estate prey” in 2012. And for those not familiar with Sun Tzu’s The Art of War and the uninspired Sun Tzu’s Art of War for Traders and Investors, Waltzek provides a few summary points.

“Standing on the shoulders of the great philosopher and mathematician, Vilfredo Pareto, as well as Taleb and Mandelbrot,” the author presents his major theoretical contribution: the Pareto-Waltzek Hypothesis. It comes in the form of two rules. First, “although prices typically gyrate in a random manner, eventually all markets enter protracted trends.” (p. 10) And second, “all primary market movements (trends) are the result of at least one fundamental event, the significance of which is rarely recognized at the time.” (p. 13) Punkt.

If you are anti-government and anti-Fed, and if you think it’s essential to prepare for a financial Armageddon, you may like this book. If you really want to learn about commodity investment strategies, much better alternatives are available.

Bogle, Don’t Count on It!

Don’t Count on It!: Reflections on Investment Illusions, Capitalism, “Mutual” Funds, Indexing, Entrepreneurship, Idealism, and Heroes (Wiley, 2011) is an anthology of recent writings and speeches by John C. Bogle, the venerable founder of Vanguard. It is a substantial book, over 600 pages long, and, as its subtitle indicates, covers a range of topics. Here I’m going to confine myself to two. I’ll begin by exploring three principles that underlie Bogle’s well-known case for low cost passive index funds. Then I’ll jump to the lecture he gave to the Risk Management Association in October 2007: “Black Monday and Black Swans.”

Why, according to Bogle, is it preferable to invest in broad index funds rather than actively manage a portfolio? First, “the past is not prologue” (p. xxiii) or, put another way, “historic stock market returns have absolutely nothing in common with actuarial tables.” Bogle continues, quoting Keynes: “’It is dangerous to apply to the future inductive arguments based on past experience [that’s the bad news] unless one can distinguish the broad reasons for what it was’ [that’s the good news]. For there are just two broad reasons that explain equity returns . . . (1) economics and (2) emotions.” (p. 7) The math here is blissfully elementary. Add earnings growth and dividend yield to get investment return. Calculate the percentage increase in the P/E ratio to get the speculative return. Add investment return and speculative return to get total return. “In the short run,” Bogle writes, “speculative return drives the market. In the long run, investment return is all that matters.” (p. 66)

Second, actual investor returns and theoretical market returns are miles apart. About 98 percent of the theoretical return of $212,000 on a $1,000 investment 50 years ago would have gone up in smoke as a result of inflation, intermediation costs, and taxes (and here Bogle assumes a hit of only 2% for taxes). We end up not with $212,000 but a mere $4,300.

Third, we should respect the power of reversion to the mean: “reversion to the mean is the rule, not only for stock sectors, for individual equity funds, and for investment strategies that mix asset classes, it is also the rule for the returns provided by the stock market itself.” (p. 65) A chart showing the investment real return of $1 versus the market real return (1900-2009) nicely illustrates this point.

Now on to Bogle’s lecture given on the twentieth anniversary of Black Monday (October 19, 1987). In this lecture Bogle reviewed the literature on risk and uncertainty: Popper, Knight, Mandelbrot, Keynes, and Minsky. Elaborating on Minsky’s prediction that the financial economy would come to overwhelm the productive economy, Bogle said: “When investors—individual and institutional alike—engage in far more trading—inevitably with one another—than is necessary for market efficiency and ample liquidity, they become, collectively, their own worst enemies. While the owners of business enjoy the dividend yields and earnings growth that our capitalistic system creates, those who play in the financial markets capture those investment gains only after the costs of financial intermediation are deducted. Thus, while investing in American business is a winner’s game, beating the stock market—for all of us as a group—is a zero-sum game before those costs are deducted. After intermediation costs are deducted, beating the market becomes, by definition, a loser’s game.” (pp. 177-78)

In this lecture he also pointed to the staggering growth of the financial sector. Financials accounted for only about 5 percent of the earnings of the S&P 500 25 years ago; in 2007 that figure was 27%. Adding in the likes of GE Capital and the auto-financing arms of GM and Ford, he figured that financial earnings probably exceeded one-third of S&P 500 annual earnings. This growth was spurred by the explosion in intermediation costs and the boom in complex financial instruments.

By October 2007 banks were beginning to cut the values of their mortgage-backed portfolios, a clear sign that systemic risks were rising. But how, Bogle asked, “can it be that risk premiums on stocks are at less than one-half the historic average?” He quoted Alan Greenspan, who said in 2005: “History has not dealt kindly with the aftermath of protracted periods of low risk premiums.” (pp. 182-83) Indeed.

Don’t Count on It! is a wise book. As most traders and investors remain convinced that they can beat the market, it’s always sobering to hear a compelling voice from the other side.

Rotblut, Better Good Than Lucky

It seems that Lefty Gomez, who played for the Yankees in the 1930s, gets credit for having said “I’d rather be lucky than good.” Charles Rotblut turns this around in his book title: Better Good Than Lucky: How Savvy Investors Create Fortune with the Risk-Reward Ratio (W&A Publishing, 2010). His central tenet is that being a successful investor is about making good decisions, not about being lucky.

In this slight book Rotblut introduces the beginning investor (as well as the investor who is trying to rejigger his portfolio in a more thoughtful way) to the rationale for value investing and to some of its basic principles.

“One reason,” he writes, “why stock prices rose too much in the 1920s and the 1990s—as well as other periods—was that forecasts were given more weight than valuations.” (p. 9) Analyst forecasts usually have about as much predictive value as the divination that comes from reading entrails. “Placing an emphasis on valuation provides a margin of safety against making mistakes.” (p. 10)

Rotblut takes the reader through the fundamentals of corporate analysis: business models, the balance sheet, income statement, and cash flow statement. He then cuts to the chase and offers what he considers the two most profitable measures of valuation (price-to-book and price-to-earnings) and “a sanity check to ensure you are not overpaying for a stock” (discounted cash flow).

Book value, the theoretical value of a company’s net assets or equity, is according to many studies the best valuation measure of a stock’s performance because “no quality company should sell for a price equivalent to or less than its theoretical liquidation value.” (p. 123) But the P/E multiple should not be ignored, since a high P/E increases the possibility of downside risk whereas a low P/E increases the potential for upside reward. DCF, a mathematical model that calculates the current worth of a company’s future cash flows and that is most often invoked to calculate a stock’s price target, should be used not “to determine a stock’s worth, but whether a stock is undervalued or overvalued relative to its projected future cash flows.” (p. 166) As rules of thumb Rotblut recommends looking for stocks trading at a P/B multiple of 2.0 or lower, a P/E of 12 or lower, and a discount of 10% or more to their DCF-calculated value.

Better Good Than Lucky is an entry-level book. In addition to its discussion of value investing it explains where to get investment advice, how to apply modern portfolio theory, and how to own stocks and still sleep at night. Rotblut, by the way, makes one recommendation that should be followed by everyone, quite independent of investment style: keeping an investing journal, writing down the reasons you bought each stock as well as the factors that would cause you to sell it.

Investors who want a meaty book would be better served with John Price’s The Conscious Investor. But for those who want a quick and easy introduction to value investing, Rotblut’s Better Good Than Lucky is an excellent choice.

Statman, What Investors Really Want

Meir Statman’s What Investors Really Want: Discover What Drives Investor Behavior and Make Smarter Financial Decisions (McGraw-Hill, 2011) is a book that every investor should read. Statman is an academic, but he writes like a best-selling author. He uses the findings of behavioral finance, in which he himself has done extensive research, to expose the mistakes we make and to offer advice that ranges from the “ka-ching” practical to the rabbinical.

For those who are acquainted with the mainstays of behavioral finance literature, let me assure you that there’s a lot of new material in this book. Even where Statman covers familiar ground, he does it in such a winning way that he often unlocks something that was hitherto unknown, or repressed.

He uses the World’s Work, a magazine published a century ago, as well as Internet ads to illustrate his points. He retells stories about such characters as the notoriously stingy Russell Sage; he writes about herding from China to Finland, from librarians to institutional investors. He explores the rationalization that allows investors to find it easier to sell losers in December than in November: “What is framed as a loss in November is framed as a gain, in the form of a tax deduction, in the following December.” (pp. 142-43)

Statman also ventures into world of values because ultimately, he argues, “investments are about life beyond money.” He explores socially responsible investing, our demand for fairness, and our investments in our children and families.

All in all, this is a rich book—and a book that might make you richer in a multitude of ways.

Standard & Poor’s 500 Guide, 2011 Edition

This is a very big paperback—8 ½” x 11”, more than 1000 pages, and weighing in at about 4.5 lbs. With so much information available online, why would anyone need this book? I can think of several compelling reasons.

First, a personal preference: I enjoy flipping through pages, making serendipitous discoveries. I don’t have the same kind of experience online since I normally am looking for something specific, not just seeing what comes my way.

Second, the two pages devoted to each company in the S&P 500 are jam-packed with data, including ten years of company financials (per share data, income statement analysis, and balance sheet and other financial data), five years of revenue and earnings per share, and the five most recent dividend payments. The summary of the company’s business is also more analytical than the run-of-the-mill online fare.

Third, and taking up almost half of the space allocated to each company, is proprietary S&P information, ranging from analysts’ reports to the famous five-star system of investment recommendations. The analysts’ reports, I should note, are not especially timely; some date back to July and the most recent are from October. The book seems to have gone to press in late October; most of the closing prices are from October 22.

Other data include S&P’s qualitative risk assessment, its quantitative evaluation, and each company’s relative strength rank. There is also a price chart from June 2007 through October 2010 overlaid with S&P proprietary metrics.

For the reader who cannot live without stock screens, the book provides lists of companies with five consecutive years of earnings increases, stocks with A+ rankings, rapid growth stocks, and fast-rising dividends.

The book is somewhat unwieldy to handle (it’s definitely best read on a desk, which I personally find awkward), but this is a small price to pay for the amount of information available.

Marr & Reynard, Investing in Emerging Markets

British financial journalists Julian Marr and Cherry Reynard take the reader around the world in 246 pages. Investing in Emerging Markets: The BRIC Economies and Beyond (Wiley, 2010) is an engaging book, well researched and well written. For Americans, it is also refreshing to have a British perspective because so much of the research on emerging markets is done in London. I follow the economy of one country (which fluctuates between emerging and submerging) fairly closely and am constantly being referred in its press to “the analysts in London.”

The authors begin with a sophisticated introduction to the emerging markets, asking such questions as whether globalization and decoupling can possibly occur simultaneously. They analyze the notion of a commodities supercycle (noting in a different context that “in investment, certainty is the rarest commodity of all”). (p. 80) They weigh the benefits and risks of sovereign wealth funds.

Moving on to the BRIC economies, the authors brush aside ideas designed to rationalize grouping the four economies together that “cross the line from the simplified to the simplistic.” Their view is more dynamic. “Suffice to say that the quartet are the flagships of the three main emerging markets regions of Asia, Emerging Europe and Latin America and their importance to global trade over the coming decades is hard to overstate—not least in the way they interact with each other.” (p. 83)

The bulk of the book focuses on individual emerging market economies, including those better described as the “emerged” emerging markets (Hong Kong, Singapore, South Korea, and Taiwan), with a very brief look at the frontier markets. The general format for the more developed economies is a brief economic history followed by a section making the investment case for the country. Sometimes the investment case is weak. Take Argentina, for instance, which “provides a salutary lesson in how not to manage an economy.” (p. 194)

The authors draw insights from a number of emerging markets experts, many of whom highlight the dangers of investing in emerging markets. Throughout the book the authors raise “the spectre of possibilities such as water shortages in China [and] advances in technology derailing demand for certain commodities.” They also quote the risk list of a CIO (abbreviated here): “What happens when interest rates start to rise? … How is the ‘Axis of overspending’ going to finance their projected deficits? Is China the savior of the global economy or its Achilles’ heel?” (p. 222)

Investing in Emerging Markets is a thoughtful, balanced book which offers an overview of regional and country-specific economies. Naturally, anyone thinking about investing in an individual country should seek out far more information than the authors can provide here. Their summaries are but stepping off points. At least they are solid; readers have been given the wherewithal to avoid both slippery slopes and quicksand.

Kiev, Hedge Fund Masters, a second look

I wrote briefly about this book last year but decided to return to it. Ari Kiev, who died just over a year ago, was best known in the trading world as an author and as a coach to traders at Steve Cohen’s SAC Capital Advisors in the early 1990s. Hedge Fund Masters addresses the kinds of traders he coached.

I took notes on Kiev's book when I first read it, and I’m going to select four self-therapeutic passages from them for this post. I suspect that most of my notes are quotations, but I don’t think it’s important to check their accuracy, though I will provide page references.

* * *

By establishing a vision, you have promised to achieve something. The promise means you are giving yourself permission to begin to act in the realm of the impossible, to create all kinds of openings. In that one promise, you begin to abandon self-doubt and the need for approval. This way of being in the world lets loose huge reserves of energy and creates enormous possibilities. Yet none of this can happen until you take the first step forward in pursuit of a goal with no guarantee of outcome. (p. 218)

Living in the gap makes you vulnerable. Once you’re out there, on the cutting edge, you’ll suffer breakdowns as well as breakthroughs. Although it will not always be comfortable, living in the gap between where you are and where you want to be will make your days far more interesting and action packed than if you traded with the intention of avoiding pain and discomfort. (p. 229)

It is useful to note when an activity becomes tedious, dull, and routine and leads to withdrawal and avoidance. This is the time to consider whether you are facing obstacles and are retreating behind your survival needs or whether these feelings signify that you have reached your goal and now need to raise the stakes. (p. 236)

The development of mastery is, in a sense, an existential and experiential methodology, directed at what is and what can be. You invent your own future through commitment to a goal, identifying what is necessary to produce specific results, and learning how to handle the unknown. (p. 247)

McGuire, Hard Money

As the number of books on investing in gold continues to proliferate, Shayne McGuire’s Hard Money: Taking Gold to a Higher Investment Level (Wiley, 2010) stands out in several ways. Most importantly, the author methodically builds a case for gold by analyzing five drivers of potential price appreciation. They are: the increasing likelihood of fiscal crises in major economies of the world, the return of inflation, a small allocation shift into gold by institutional funds, the rise of China, and gold’s potential return to being the dominant financial asset in the global monetary system.

In the second part of the book McGuire describes in some detail the kinds of elements that might be included in a precious metals portfolio as a subset of an overall portfolio—stocks, ETFs, physical metals. He explains how to buy coins, including rare coins. All in all, a good practical guide for the investor.

Here are a couple of points that struck me as worth sharing.

McGuire argues that gold can be viewed as the “youngest major investment asset class” because “it is only since the early 1970s that it started being broadly perceived as an investment.” Before the collapse of the Bretton Woods monetary system in 1971, gold was money; currencies were “receipts that represented and were exchangeable for hard money.” Therefore it makes no sense to evaluate gold as an investment prior to the 1970s. As McGuire writes, “Evaluating it as an investment over this time period would be like examining the return on investment of a dollar bill: Both moved in lockstep by government decree.” (pp. 68-69) Yes, gold would rise in value in response to an economic shock, often triggered by war. But “even during these periods of financial stress, nobody was investing in gold. People were hiding in and accumulating savings in gold, the way they hide in cash to move away from volatile financial markets and keep savings accounts in dollars today. In the past, investing generally involved taking risks by moving away from gold, which was always seen as money. Today is the opposite. For any fund manager, buying gold today means investing, taking risk.” (p. 69)

Although McGuire contemplates the possibility of $10K gold, he warns the reader of the genuine economic concerns that underlie allegations of gold market manipulation by financial authorities. The problem for financial authorities is that “a gold investment wave can suck resources out of the broader economy,” especially bonds, resulting in a spike in interest rates, “and ultimately deflation and another banking system crisis.” (p. 85) We have only to think back to 1933 and FDR’s confiscation of gold.

One final cautionary note from the author. He writes: “Although there are reasons why a gold boom could endure for some time, I think a gold portfolio is something that I, personally, would not maintain as a permanent portfolio in my overall diversified portfolio of assets. I think of it as a portfolio to be maintained in these extraordinary times….” (p. 145)

Katsenelson, The Little Book of Sideways Markets

Vitaliy N. Katsenelson’s The Little Book of Sideways Markets: How to Make Money in Markets That Go Nowhere (Wiley, 2011) is thoroughly enjoyable, not so much for the message as for the thoughtful and often entertaining way in which it is delivered. It is part of the “Little Book Big Profits” series that began with Joel Greenblatt’s The Little Book That Beats the Market in 2005 (recently updated) and now includes fifteen titles.

Katsenelson’s hypothesis is that we will likely be in a sideways market, personified by the cowardly lion, “whose bursts of occasional bravery lead to stock appreciation but are ultimately overrun by fear that leads to a descent,” until about 2020. (p. 3) His reasoning is that we are experiencing earnings growth but continuing P/E compression: the gains we get from earnings growth are wiped out by a decline in P/E ratios. Even though there can be a lot of cyclical volatility, over the long haul stock prices will stagnate. Until the 12-month trailing P/E falls “significantly below the historical average of 15” (by mid-2010 stocks were trading at more than 19 times 2010 earnings) the sideways market will continue. (p. 27)

If this hypothesis is borne out, buy and hold (never a great idea in any environment) absolutely must be replaced with buy and sell. “A disciplined sell process injects a healthy dose of Darwinism … into the portfolio, weeding out the weakest stocks—the ones that have deteriorated fundamentals or diminished margin of safety—in favor of stronger ones.” (p. 164) That is, once the reasons you bought the stock (valuation, quality, and growth) have disappeared, sell and move on.

Katsenelson takes his reader step by step into the mind of the value investor by relating, in a fictional addendum to Fiddler on the Roof, the story of Tevye’s purchase of Golde, the cow. He also describes his own big-time gambling evening (he was willing to lose a maximum of $40) and that of a half-drunken, rowdy fellow blackjack player to stress the importance of process. He then moves on to the fundamental principles of active value investing.

What differentiates this book from so many others on value investing is that it describes, sometimes through the use of case studies, the thinking of a value investor. Not just his models or his metrics but his assessments. Katsenelson is an empiricist who weighs facts, looks for contraindications, and makes decisions. He makes value investing come alive.

This may be a little book, but it’s packed with insights for both novices and experienced investors. And it is a delight to read.

Shaffer, Profiting in Economic Storms

So you woke up feeling pretty good this morning? Well, Daniel S. Shaffer is out to ruin your mood. In Profiting in Economic Storms: A Historic Guide to Surviving Depression, Deflation, Hyperinflation, and Market Bubbles (Wiley, 2010) he foresees a deflationary depression coming between 2012 and 2014. He bases his doomsday forecast on cycle theory, invoking both natural cycles (especially sunspot cycles) and investment cycles. But he warns that “your investment strategy should include disruptions by regulators or politicians that purposely disrupt the natural order of the markets.” (p. 156)

Shaffer pads his book with rather pedestrian discussions of trading psychology, the reliability of economic releases, accounting irregularities, modern portfolio theory, fallen civilizations, the history of the U.S. banking system, and famous market manias. Shaffer is a Fed and Bernanke basher who suggests that “the Federal Reserve should not be in existence in its current form by 2013.” (p. 121)

Unfortunately, Shaffer adds nothing substantive to cycle research. He pays homage to Welles Wilder’s Delta Society, Elliott wave theory, Fibonacci sequences, and Terry Laundry’s T Theory and includes a few charts to illustrate their applications. How he himself arrived at a projected 40-year cycle low of about 3,500 on the Dow Jones Industrial Average, probably in 2013, remains something of a mystery. Nor is it clear why “hyperinflation has a high potential of showing up around 2020.” (p. 201)

Investors should always be on their toes. Listening to one self-styled prophet will probably provide little actionable information.

Fisher, Debunkery

Ken Fisher’s Debunkery: Learn It, Do It, and Profit From It—Seeing Through Wall Street’s Money-Killing Myths (Wiley, 2011) is a welcome antidote to the intellectual pap, often laced with arsenic, that is regularly dished up on CNBC and in financial planning books.

The reader need not and should not agree with Fisher on every point. Nor should he merely store away talking points for cocktail parties or potential zings for his financial planner. Instead, this book should set the investor on a course of independent thinking, during which he honors Santayana’s oft-quoted statement that “skepticism is the chastity of the intellect, and it is shameful to surrender it too soon or to the first comer.”

Fisher debunks fifty myths, ranging from “retirees must be conservative” to “when the VIX is high, it’s time to buy,” from “so goes January” to “pray for budget surpluses,” from “stocks love lower taxes” to “consumers are king.” Here I’ll share two of his “debunkeries” as well as his thoughts on the usefulness of history.

Bunk 12: “Stop-losses stop losses!” Wrong, claims Fisher. “It would be more accurate to call them ‘stop-gains.’ In the long term and on average they’re a provable money loser.” (p. 51) The reason that stop-losses don’t work is that stock prices aren’t serially correlated: “What happened yesterday doesn’t have a lick of impact on what happens today or tomorrow.” He continues: “If stock price movements dictated later movements, you could just buy stocks that have gone up a bunch. But you know, instinctively, that doesn’t work. Sometimes a stock that’s up a lot keeps going up, sometimes it goes down, or sometimes it bounces along sideways. You know that. So why don’t people understand that correctly on the downside?” It should be clear that Fisher is no believer in momentum investing. As he writes, “momentum investors don’t do better on average than any other school of investors. In fact, they mostly do worse. Name five legendary ones. Or even one!” (p. 52)

Bunk 19: “Beta measures risk.” No, Fisher contends, “it measures prior risk. … It doesn’t measure anything about the present or future.” (p. 75) Fisher’s argument again hinges on his claim that price action is non-serially correlated “by definition.” And if price can say nothing about the future that’s exploitable, how could volatility (which is based solely on price action) be useful, academics be damned? It can’t—at least not in the sense that a low-beta stock implies low risk going forward and a high-beta stock implies high risk. But if used in a contrarian way in specific circumstances beta can be a profitable guide. In V-shaped recoveries “those categories that hold up better than the market during the beginning of a bear that then fall the most in back of a bear market (making them high-beta) bounce most in the early stage of the new bull.” Put another way, “Those categories with the best returns after the bottom had the biggest beta at the bottom. They had more volatility to the bottom and more volatility than the market in the new bull! But the way our brains work, we tend to think: When it’s down, it’s ‘volatile,’ but when it’s up, it’s ‘good’!” (p. 77)

Although Fisher readily accepts the notion that past performance is no guarantee of future results and, as we have seen, rails against those who seek patterns in past price action (or volatility) to shed light on future price action (or volatility), he nonetheless believes that history is the “investors’ lab.” Investing, he writes, is not a craft; becoming a master craftsman does not give you an edge. Instead, investors should model themselves on scientists. “In science, you develop a hypothesis, test, confirm, and retest—continuously. It’s a non-stop query session. While investors don’t have a traditional lab like biologists or chemists, they do have history.” (p. 135) By history he means the kind of stuff that happens in the real world and that is easily researched, such as whether gold is a safe haven and whether high unemployment is a stock killer. In this sense, “history is one important tool for shaping forward-looking expectations” (p. 136) and improving the probabilities of profitable investing results.

Debunkery may not be a core library holding, but it’s a fast, often provocative read.

Keeping a trade alive

Perhaps we can all learn something from, or at least be inspired by, this amazing play.