Smith, Who Stole the American Dream?

If you cheered Elizabeth Warren at the DNC, you’ll love Hedrick Smith’s latest book, Who Stole the American Dream? (Random House, 2012). If you’re an Ayn Rand devotee, you’ll probably hate it. If, however, you’re one of the 99%--Democrat or Republican, liberal or conservative, you owe it to yourself to read Smith’s plea to restore middle-class prosperity and power. Hedrick Smith, for those too young to remember, was a New York Times reporter who wrote a brilliant 1976 book, The Russians, and who shared a Pulitzer for the Times’s Pentagon Papers series.

Smith analyzes the U.S. slide from “one large American family with shared prosperity and shared political and economic power” in the decades following World War II to “a sharply divided country—divided by power, money, and ideology,” a “house divided against itself” which, as Lincoln famously warned, “cannot stand.”

Slowly but inexorably, beginning as Smith tells the tale with a 1971 memorandum written by future Supreme Court justice Lewis Powell, the country embraced a “pro-business power shift in politics and a new corporate mind-set” and abandoned the middle class. Worker salaries stagnated, CEO pay skyrocketed. Business lobbyists dramatically outspent lobbyists for labor, nearly 60 to 1 from 1998 through 2010.

The first “bend in the path of American history” came not during a Republican administration but in the late 1970s when Democrats controlled both Congress and the White House—that is, during the Carter administration. Congress embraced deregulation. They passed an omnibus tax bill that contained the 401(k) provision, intended at the time as a tax break for corporate executives at Xerox and Kodak but soon enough expanded to apply to the rank-and-file, to replace lifetime company pensions with do-it-yourself retirement savings plans. And, balking at Carter’s tax bill that closed loopholes for the wealthy and for corporations and that cut taxes for lower-income families, Congress passed a bill that cut the maximum capital gains tax rate from 49 to 28 percent, cut the top corporate tax rate from 48 to 46 percent, and included generous write-offs for small businesses. “Although the size of the tax cuts was relatively small, it marked a watershed in Washington’s tax and economic policies. Instead of following the traditional pattern of using the tax system to redistribute income from the affluent and from corporations to the less well-off, the 1978 tax bill charted the opposite course, a course that would be pursued by Ronald Reagan and George W. Bush.”

The New Economy undid the equality and prosperity of the postwar period. No longer would Americans at all income levels move up together. “The dynamics of the New Economy disrupted the virtuous circle of growth, the economy of middle-class power, and the Great Compression, where the destinies of management and labor had been linked.” By 2011 the OECD ranked the U.S. thirty-first—fourth from the bottom—among its thirty-four member countries in ratio of incomes.

How can average Americans counteract the influence of money in politics, what Joseph Stiglitz called government “of the 1%, by the 1%, for the 1%”? Smith contends that “millions of average Americans will have to become directly involved once again in citizen action—making their presence felt, taking to the streets, just as millions did in the 1960s and 1970s—to restore the vital link between Washington and the people.” Occupy Wall Street was an inchoate first step, “but for significant long-term impact, either Occupy will need to mature or some new movement will need to emerge with broader participation, better organization, more clearly articulated goals, and specific policy targets.”

A movement of the 99% would, of mathematical necessity, cut across party lines. It would connect people to government instead of alienating them from it; it would give them power in place of their current powerlessness. It would bring the political power game out of the shadows into the broad daylight. And it might just restore, and even strengthen, the middle class. Smith’s book is a call to action. The choice for Americans, in the words of Louis D. Brandeis, is stark: “We may have democracy, or we may have wealth concentrated in the hands of a few, but we can’t have both.”

Cohen, The Insider Edge

Guy Cohen, the author of several books on options and CEO of FlagTrader.com, has developed a new indicator—OVI (Options Volatility Indicator)—for stock traders. The indicator is proprietary, so naturally The Insider Edge: How to Follow the Insiders for Windfall Profits (Wiley, 2012) is in large part a marketing tool. There are, however, two upsides for those who are cheap. First, readers who go to the website linked to the book can view Cohen’s top twelve OVI charts for free. Second, even though mighty few readers will have the extensive data base necessary to reverse engineer the indicator, the principle behind the indicator is relatively straightforward. Imaginative traders may be able to figure out ways to implement it, in what would have to be a dumbed-down form, with readily available data. Of course, those who are truly enchanted can sign up for Cohen’s subscription services. They seem to be reasonably priced, although I can’t pass judgment on their value.

The OVI is an oscillator that moves between -1 and +1 in accordance with the buying and selling of stock options at multiple but not all strikes and some but not all expirations. “[N]ot all of the options for one stock are going to be relevant to the sentiment of investors toward the stock in question, so the art is to know which options are relevant for each stock. This is part of the secret sauce.” (p. 59) The oscillator has three components: option volume, open interest, and implied volatility. It is “closely correlated with medium-term trending price-action as it tends to be roughly in line with the major trend of the markets. The OVI is especially useful in sideways markets where it can often indicate the most probable direction of the breakout.” (p. 64) It is, Cohen claims, a leading indicator.

The OVI is best used with “the most important chart patterns in the stock market: flags and channel breakouts.” (p. 109) Cohen discusses these patterns at some length, explaining among other things how to avoid market manipulation by placing entry orders “away from the herd of amateurs.” (p. 133)

Cohen offers the reader a trading plan, complete with stops and profit targets, that incorporates chart patterns and his OVI indicator. In the final analysis, however, he is selling his software services. I wish him well.

Morris, Fly Fishing the Stock Market

I learned more about fly fishing than trading in this book. I don’t mean this as a criticism of Stephen Morris’s Fly Fishing the Stock Market: How to Search for, Catch, and Net the Market’s Best Trades (Wiley, 2012). After all, I went fishing only once in my life—a fish story best left untold, and I’ve been involved with the financial markets and literature about the markets for many years. Moreover, unlike most metaphors that fail after a chapter or two, the fly fishing metaphor is rich enough to go the distance. And it requires a lot of fleshing out for those of us who are unfamiliar with the intricacies of fly fishing.

Dr. Stephen Morris, a practicing orthodontist in Idaho, is not only an avid fly fisherman but one of the top performing traders of Alexander Elder’s SpikeTrade Group. Morris readily acknowledges Elder as his mentor, so it is not surprising to find the impulse system and the force index in Morris’s “tackle box.” But Morris has developed his own catch and release trading system, which includes the weathervane, the weather station, matching the hatch radar screen, the strike indicator, and the drag system. On his web site, www.flyfishingstocks.com, he sells TradeStation programming for this system.

Fortunately Morris describes his indicators in sufficient detail that anyone with even a modicum of programming skills should be able to reproduce them for use on his own trading platform. The weathervane, for instance, combines the weekly VIX and S&P 500 along with an eight-week EMA for the VIX. In a separate panel is Martin Pring’s market seasons indicator—the weekly S&P 500 MACD. This weathervane chart provides buy and sell signals. (I’m not divulging the rules here, but they’re pretty simple.) For shorter-term forecasts (daily, intraday, hourly) he uses the VXX and SPY, going down as low as ten-minute charts.

Morris illustrates his ideas with ample color bar charts printed on heavier than usual stock.

Fly Fishing the Stock Market is a relatively elementary book, but it is certainly not a primer. It describes a complete trading system with specific strategies matched to particular patterns and market conditions—entries, exits, and trade management. The trader who is looking to make sense out of chart patterns and to keep his trading rules simple is offered an excellent model here.

Chan, The Value Investors

Ronald W. Chan introduces an interesting cast of characters, many of whom may not be familiar to readers. In The Value Investors: Lessons from the World’s Top Fund Managers (Wiley, 2012) we meet Walter Schloss, Irving Kahn, Thomas Kahn, William Browne, Jean-Marie Eveillard, Francisco García Paramés, Anthony Nutt, Mark Mobius, Teng Ngiek Lian, Shuhei Abe, V-Nee Yeh, and Cheah Cheng Hye.

Irving Kahn, age 106, has the distinction of being the oldest living active investment professional. Both he and Walter Schloss, who died this year at the age of 95, were students and later employees of Benjamin Graham, so they have impressive value investing pedigrees. Their first jobs were with Wall Street firms; eventually they founded their own highly successful businesses.

I mention the job history of these two men because I was struck by how relatively late in life (of course, not by Kahn standards) many of the value fund managers interviewed in this book found their true calling. Mark Mobius, for instance, of the Templeton Emerging Markets Group fame, started his career as a business consultant (to be more precise, a consulting research coordinator) in Tokyo, studying consumer behavior in the region, and later founded his own research-oriented business consulting firm. Cheah Cheng Hye, co-founder of Value Partners, the largest asset management company in Asia, worked in journalism for eighteen years before he entered the financial world as a stock analyst.

Other future value fund managers started off in finance but faced a different kind of hurdle. They were hired by firms who were devoted to growth investing. They felt uncomfortable in their jobs, though not necessarily understanding why. It took them some time to realize that they were, for whatever psychological/intellectual reasons, at heart and in mind value investors.

Value investing is in many ways an intellectual no-brainer. It’s smart bargain shopping. You buy a lot of pasta at 50% off because the supermarket messed up its inventory but avoid the strawberries that are on sale because they’re half rotten. Simple enough. On the other hand, value investing is extraordinarily difficult emotionally. You buy a stock that you think is undervalued only to see it become even more undervalued (and that’s if your analysis is correct). You may buy more if you’re self-confident, but you have no external validation. The market is telling you that you got it wrong. And, yes, the market is often right.

The value investors that Chan profiles, all of whom have handily beat their benchmarks, are not a particularly stressed lot. In fact, many of them explain what investing techniques they use (in some cases merely diversification) to be able to sleep soundly at night and avoid stress. I suspect, however, that the real explanation lies not so much in methodology as in personality. It takes a special kind of person to take the inevitable lumps (such as not participating in the dot-com boom) as well as to enjoy the long-term, often slow-grind upside of being a talented value investor.

Chan’s book is a good read. Value investors may make some new international friends. Struggling individual investors may find a style that resonates. And frustrated, antsy twenty somethings may come to realize that life doesn’t end at thirty.

Fisher, Wall Street Women

As a graduate student in anthropology at Columbia, Melissa S. Fisher decided to focus her research on a perhaps unlikely group—the first generation of women to establish themselves as Wall Street professionals. Wall Street Women (Duke University Press, 2012) is a reworking of her dissertation.

The women Fisher studied arrived on the Street in the 1960s, a time when female college grads were often being hired as secretaries and the glass ceiling was a skyscraper away. Women were by and large relegated to the role of support staff; about the most they could hope for, if they were mathematically trained, was to assist in converting the stock exchange’s punch cards to computer data. “Computer programming was, at the time, viewed as a female occupation. Women’s ‘natural’ feminine traits—being patient, detail-minded—were understood to make them ideal computer programmers.” (p. 37)

Almost all of the women who eventually moved up the corporate ladder started off as back-office researchers. (By the way, so did Muriel Siebert.) They were paid significantly less than their male counterparts, and they were not invited to participate in formal training programs. To learn their craft they were largely dependent on the willingness of male mentors. Outside of their firms, however, the women had a support network and an alternate training ground: the Financial Women’s Association of New York City, founded in 1956.

As time passed and Wall Street firms opened their doors to more women and minorities, the original group of women became more visible and successful, although of course none of them broke the ultimate glass ceiling. Nor did the women who followed them. We have only to think of the prominent women who were once considered potential CEO material, only to be summarily fired—Zoe Cruz, Erin Callan, Sally Krawcheck. Ina Drew is a different story, but nonetheless yet another blow to women’s aspirations.

Fisher’s book is not an account of Wall Street careers per se. The women share their often diverse feelings about feminism, politics, affirmative action, and the younger generation of women on the Street. Moreover, Fisher gives theoretical context to their careers by invoking such concepts as corporate neoliberalism and state-market feminism.

Fisher is torn when it comes to gender stereotypes. For instance, she admits that commonly accepted images of women—for instance, that they are risk averse—actually worked to the advantage of this initial cohort of women. When women stepped out of their traditional roles and opted to work in risk-oriented positions, “Wall Street treated them as the ‘anti-mothers’ of the professional-managerial class.” They “threatened the gendered order of firms as well as men’s agency and power.” (p. 98)

If there had been no financial crisis, Fisher would probably have unequivocally defended these “anti-mothers.” But times have changed. There are calls for a “feminization” of markets and for a more “caring” and “softer” capitalism. “Motherly women” have been “touted as the potential rescuers of the global economy.” “The biological system is being directly linked and mapped onto the financial system in strikingly gendered ways.” (p. 172)

Fisher embraces this vision of the future feminization of financial capitalism. I have my doubts, and worries. But then I guess I’m just a skeptical anti-mother.

Brady, Income Investing

I’ve read more than my fair share of books on bonds and have always ended up feeling—well, stupid. Somehow I never seemed to grasp the fundamental structure of bonds. I understood the periphery but not the core. I am happy to report that my stupid days are now behind me, at least on the bond front. Jason Brady’s Income Investing: An Intelligent Approach to Profiting from Bonds, Stocks, and Money Markets (McGraw-Hill, 2012) made all the difference. (And not because it has the word “intelligent” in its subtitle.)

I suspect that Brady might be surprised at my eureka moment. He has, after all, written a practical book for investors who are reaching for yield (something that, as he explains, might be a chimera), not a guide for the perplexed. Nevertheless, when he described bonds in terms of options everything fell into place for me. Bingo!

Brady suggests that we “think about investment in fixed income as selling an option.” (p. 102) Bonds have an asymmetric payout profile, so “both in purchasing a bond and in selling an option the investor takes a small risk of a larger loss in order to receive some small payment.” (p. 106) Not exactly the clichéd picking up nickels in front of a steamroller, but certainly more dangerous than many bondholders have been led to believe.

Corporate spreads are, for instance, highly correlated to the VIX. “So when volatility spikes during market stress periods like the Asian Financial Crisis, the Enron/WorldCom debacle, or the Global Financial Crisis of 2008/2009, corporate bonds react in a very nonlinear way. To put it another way, bond investors look at the value of their coupon payments when times are good, but look to the value of the assets that they’re going to receive when times are bad. When the overall value of the asset has a chance to move below the strike price because of volatility spikes, the premium on the covered call suddenly becomes a lot less immediate than the claim on the asset itself.” (pp. 113-14)

One point that Brady hammers home is that yield is a terrible measure of return. There is, however, one place where yield can have value—as a downside cushion. “For most fixed-income instruments, the only protection the investor has against loss is the income return of the bond. There are any number of ways to lose money in bonds and not very many ways to get more than yield. But when prices decline for whatever reason, the total return you receive from bonds can still be reasonable if the yield on the bond is high. … The margin of safety in U.S. Treasuries is low.” (pp. 116-17)

Unlike investors in stocks (well, at least during bull markets) corporate bond investors are a gloomy lot, in part because they have sold the upside to stockholders. Bondholders want a low volatility environment; stockholders want stocks to move ever higher.

One way for the income investor to bridge the gap between bonds and stocks is by owning dividend-paying stocks which, when things go reasonably well, provide both income and capital appreciation. Dividend payers, by the way, have a record of outperformance. From January 1992 to June 2011 the DJ Dividend Select Index had a total return of 12.8% whereas the DJ Total Stock Market Index returned 9.8%. The MSCI World High Dividend Yield Index returned 10.7% as opposed to 2.3% for the MSCI World Index. And the MSCI EAFE High Dividend Yield Index returned 11.8%, the MSCI EAFE Index 7.2%. Somewhat counterintuitively, “the outperformance by dividend-paying stocks is not just due to their income properties, but due to the growth of earnings as well.” (p. 152)

Investing in dividend-paying stocks has been something of a fad of late, but the fad may be waning. For a short-term take on rotation out of these stocks, I suggest Bespoke Investment Group’s piece from August 17, "How Rising Rates Make Dividend Stocks Less Attractive."

Brady describes several income-producing vehicles that investors might want to consider. In whatever way investors structure their portfolios, however, they should always exercise due diligence, diversify their holdings, and stay the course.

I’m pretty sure that I’ll be the only slow learner to thank Brady for looking at bonds through the lens of options. Moreover, I apologize to the author for not giving equal time to some of his other ideas. But eureka moments happen rarely these days, and I am very grateful for them.

Wildermuth, Wise Money

Wise Money: Using the Endowment Investment Approach to Minimize Volatility and Increase Control (McGraw-Hill, 2012) by Daniel Wildermuth covers a lot of familiar ground. Think back, for instance, to Meb Faber’s The Ivy Portfolio (2009). But I suppose it’s worth going over this ground again.

Wildermuth, the founder and CEO of Kalos Capital and Kalos Management, describes “how the smart money invests”: in domestic and international equities, real assets, private equity, absolute return funds, and fixed income. His discussion of asset allocation is particularly apt for the high net worth individual, but investors with smaller portfolios can make the appropriate adjustments and still mimic the endowments.

One point that Wildermuth stresses and that, I think, merits some space here is the illiquidity advantage. “Liquid investments usually cost more and are worth more than similar illiquid investments because nearly all investors value liquidity.” But liquidity “introduces volatility, which most investors try to avoid. Nearly any asset that can be bought and sold on a daily basis prices according to current demand. Since demand for liquid investments can change markedly and quickly, prices can as well.”

“Liquidity premiums can only be approximated and vary across time and asset classes. As an example, a real estate holding that transitions from an illiquid structure to a readily tradable stock has historically increased in value a bit more than 10 percent. With stocks, the premium is usually much greater, oftentimes approaching or even exceeding 100 percent.” (p. 38)

Wildermuth claims that “a very common mistake made by most investors is assuming that their entire portfolio must be liquid.” In fact, since most people have investment time horizons closer to decades than months, “a completely liquid portfolio is usually undesirable for most individuals. The reasons are simple. Performance and diversification possibilities are missed, and the flip side of liquidity for investments with strong return possibilities is virtually always volatility.” (p. 41)

The author suggests that “a significant percentage of a portfolio, possibly even up to 40 to 50 percent, may be prudently invested in assets that have limited or unpredictable liquidity.” (p. 50) Investors with, let’s say, a $500,000 portfolio simply don’t need a supersized emergency fund.

For those investors who are unfamiliar with the endowment model Wise Money provides a good introduction—nothing revolutionary but useful nonetheless.