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Converting a Divergence into a Trend Trade

admin — Sun, 06 Dec 2009 11:29:39 +0000

Divergence trades represent a clear chart pattern of slowing price direction. At the same time they are countertrend trades and have a higher degree of risk. Before the October 1987 stock plunge, there were numerous divergence signals in the S&P, both long-term and short-term, and many traders posted losses trying to sell what might have been the top of the market. Most gave up before the decline. If, in fact, the greatest opportunities come when the divergence is strong, that is, the decline in the momentum peaks is large. then the best results will come from entering a short position, then holding that short when a long trend turns to a short one. By entering the trend trade early (and exiting the old long position), a divergence can become a large profit rather than a small one.

The economic way of thinking about government

admin — Thu, 03 Dec 2009 11:21:16 +0000

Given its monopoly power over the legitimate use of force, people have a tendency to believe that the government, particularly a democratic representative government, can solve all types of problems. Further, if things do not go well, people tend to think that it is be- cause the “wrong” people won the last election. Public-choice analysis suggests that the problem is more fundamental: there is sometimes a conflict between winning elections and following sound policies. For some types of activities, there is reason to believe that the political action that will help get one elected will, at the same time, reduce income lev-els and living standards.
Both the market and the political process have shortcomings.
Understanding the strengths and weaknesses of both sectors is important if we are going to improve our current economic institutions. When the government protects property rights, enforces contracts, and provides a stable monetary environment, economic prosperity is more likely to ensue. The basic problem, however, is how a society can obtain the benefits of the protective functions of government and at the same time constrain it to those activities where it is a productive force.

INVESTMENT MANAGEMENT

admin — Fri, 27 Nov 2009 11:20:13 +0000

A basic decision that you and every other investor must make is whether you will manage your investments yourself or hire someone else to do it. At the one extreme, you can open an account with a broker and make all of the buy and sell decisions yourself. At the other extreme, you can invest all of your money in a managed account, such as a wrap account, and make no buy and sell decisions at all.
Often investors partially manage their investments themselves and partially use professional managers. For example, you might divide your money between, say, four different mutual funds. In this case, you have hired four different money managers. However, you decided what types of funds to buy, you chose the particular funds within each type, and you decided how to divide your money between the funds.
It might appear that managing your money by yourself is the cheapest way to go because you save on the management fees. Appearances can be deceiving, however. First of all, you should consider the value of your time. For some, researching investments and making investment decisions is something of a hobby; for many of us, however, it is too time-consuming and this is a powerful incentive to hire professional management. Also, for some strategies, the costs of doing it yourself can exceed those of hiring someone even after considering fees simply because of the higher commissions and other fees that individual investors frequently pay. For example, it might not be a bad idea for some of your investment to be in real estate, but a small investor will find it difficult to directly acquire a sound real estate investment at reasonable cost.
An interesting question regarding professional management concerns the possibility of generating superior returns. It would seem logical to argue that by hiring a professional investor to manage your money, you would earn more, at least on average. Surely the pros make better investment decisions than the amateurs! Surprisingly, this isn’t necessarily true. We will return to this subject in later chapters, but for now, we will simply note that the possibility of a superior return may not be a compelling reason to prefer professional management.

SECURITY SELECTION

admin — Sun, 22 Nov 2009 11:18:45 +0000

Finally, after deciding who will manage your investment, whether you will try to time the market, and the various asset classes you wish to hold, you must decide which specific securities to buy within each class. This is termed security selection.
For example, you might decide that you want 30 percent of your money in small stocks. This is an asset allocation decision. Next, however, you must decide which small stocks to buy. Here again there is an active strategy and a passive strategy. With an active strategy, we try to identify those small stocks that we think will do the best in the future; in other words, we try to pick “winners.” Investigating particular securities within a broad class in an attempt to identify superior performers is often called security analysis.
With a passive security selection strategy, we might just acquire a diverse group of small stocks, perhaps by buying a mutual fund that holds shares in hundreds of small companies.

Problems With P/E Ratios

admin — Mon, 16 Nov 2009 11:26:14 +0000

So, what went wrong in the Cadbury Schweppes valuation? There are basically two possible explanations. The first explanation is that the stock market valuations—either of CSG or KO, or both—are just plain wrong. In this case, it makes little sense to use the methods of comparables. But this scenario is unlikely. If the market values were systematically wrong, you could presumably easily get rich if you purchased undervalued firms. If it is not obvious, the nest series of posts will explain why getting rich is not easy—and which is why only about half of all investors beat the market—so we will assume that misvaluation is not the principal reason. The second explanation is that your assumption that the two firms were basically alike is incorrect. This is the more likely cause. There is a long litany of reasons why comparables are not really comparable, and why the technique failed you in valuing Cadbury Schweppes. Here is an outline of possible problems, on which the remainder of this series of posts focuses:
Problems in Selecting Comparable Firms Comparing businesses is almost always problematic. Every firm is a unique combination of many different projects. Cadbury Schweppes owns Dr. Pepper, 7-Up, A&W Root Beer, Canada Dry, Hawaiian Punch, Snapple, Mott’s Apple products, Clamato juice, plus some confectionary brands. This may not be comparable to Coca Cola, which owns Coca Cola Bottling, Minute Maid, Odwalla, and some other drink companies. Each of these businesses has its own profitability and each may deserve its own P/E ratio.
Even for the main business, as any soda connoisseur knows, Pepsi Cola and Coca Cola are not perfect substitutes. Different consumer tastes may cause different growth rates, especially in different countries.

Maybe as a British firm, Cadbury Schweppes uses altogether different accounting methods.
Maybe Cadbury Schweppes has just had an unusual year, or a year in which it plowed most of its cash into advertising, thereby causing unusually lower earnings for now and much higher earnings in the future.
If you did not use earnings from the most recent four quarters, but instead forecast earnings over the next four quarters, maybe the numbers would then be more comparable.

ASSET ALLOCATION

admin — Mon, 16 Nov 2009 11:17:29 +0000

Another fundamental decision that must be made concerns the distribution of your investment across different types of assets. Different asset types—small stocks, large stocks, bonds—have very different risk and return characteristics. In formulating your investment strategy, you must decide what percentage of your money will be placed in each of these broad categories. This decision is called asset allocation.An important asset allocation decision for many investors is how much to invest in common stocks and how much to invest in bonds. There are some basic rules of thumb for this decision, one of the simplest being to split the portfolio into 60 percent stocks and 40 percent bonds. This popular 60-40 mix is generally a reasonable allocation strategy, but you should read the article in the nearby Investment Updates box before you finally decide.

MARKET TIMING

admin — Thu, 12 Nov 2009 11:16:36 +0000

A second basic investment decision you must make is whether you will try to buy and sell in anticipation of the future direction of the overall market. For example, you might move money into the stock market when you thought it was going to rise, and move money out when you thought it was going to fall. This activity is called market timing. Some investors very actively move money around to try to time short-term market movements; others are less active but still try to time longer-term movements. A fully passive strategy is one in which no attempt is made to time the market.
Market timing certainly seems like a reasonable thing to do; after all, why leave money in an investment if you expect it to decrease in value? You might be surprised that a common recommendation is that investors not try to time the market. As we discuss in more detail in a later series of posts, the reason is that successful market timing is, to put it mildly, very difficult. To outperform a completely passive strategy, you must be able to very accurately predict the future; if you make even a small number of bad calls, you will likely never catch up.

TAXES

admin — Mon, 09 Nov 2009 11:24:12 +0000

Different types of investments are taxed very differently. When we talk about the return on an investment, what is really relevant is the after-tax return. As a result, taxes are a vital consideration. Higher tax bracket investors will naturally seek investment strategies with favorable tax treatments while lower tax bracket (or tax-exempt) investors will focus more on pretax returns.
In addition, the way in which an investment is held can affect its tax status. For example, individuals are generally allowed to open Individual Retirement Accounts (IRAs). The returns on an IRA are not taxed until they are withdrawn, so an IRA can grow for decades with no tax payments required. Thus any investments held in an IRA become tax-deferred.

Rent seeking

admin — Fri, 06 Nov 2009 11:15:47 +0000

There are two ways individuals can acquire wealth: production and plunder. When individuals produce goods or services and exchange them for income, they not only enrich themselves but they also enhance the wealth of the society. Sometimes the rules – or lack of rule enforcement- also allow people to get ahead by taking, or plundering, what others have produced. This method not only fails to generate additional income – the gain of one is a loss of another – but it also consumes resources and thereby reduces the wealth of the society.
Rent seeking is the term economists use when they refer to actions taken by individuals and groups seeking to use the political process to take the wealth of others. Perhaps “favor seeking” would be a more descriptive term for this type of activity, which generally involves “investing” resources in lobbying and other activities designed to gain favors from the government. The incentive for individual5 to spend time and effort in rent seeking will be determined by how rewarding it is. Rent seeking will be unattractive when constitutional constraints prevent politicians from taking the property of some and transferring it to others (or forcing some to pay for things desired by others).
When a government fails to allocate the costs of public-sector projects to the primary beneficiaries (through user fees, for example), or when it becomes heavily involved in transfer activities, people will spend more time organizing and lobbying politicians and less time producing goods and services. Resources that would otherwise be used to create wealth and generate income are wasted as people fight over slices of the economic pie- a pie that is smaller than it could be if they were engaged in productive activities instead. When the government grants favors to some people at the expense of others (instead of simply acting as a neutral force protecting property rights and enforcing contracts), counterproductive activities will expand while productive activities will shrink. As a result, the overall income level will fall short of its potential.
There is ample evidence that rent-seeking consumes a substantial amount of resources. Washington, D.C., is full of organizations seeking subsidies and other favors from the federal government. More than 3,000 trade associations have offices in Washington, and they employ nearly 100,000people seeking to alter the actions of Congress. Of course, business and labor organizations are well represented, but so, too, are agricultural interests, health care providers, trial lawyers, senior citizens, export industries, and many others.
As we noted earlier, income transfers have grown substantially during the last several decades. The government now taxes approximately one out of every seven dollars citizens earn, and transfers it to someone else. Rent seeking is the political “fuel” for most of these transfer activities. Interestingly, means-tested transfers, those directed toward the poor, constitute only about one-sixth of all transfers. No income test is applied to the other five- sixths of income transfers. These transfers are generally directed toward groups that are either well organized (like businesses and labor union interests) or easily identifiable (like the elderly and farmers). The people receiving these transfers often have incomes well above the average person.
Within the framework of public-choice analysis, the relatively small portion of income transfers directed toward the poor is not surprising. There is little reason to believe that transfers to the poor will be particularly attractive to vote-seeking politicians. After all, in the United States, the poor are less likely to vote than middle- and upper-income recipients. They are also less likely to be well informed on political issues and candidates. They are not an attractive source of political contributions. Politicians often argue that their proposed policies will help the poor, but there is little reason to believe that this will be a high priority for most of them.
There are three major reasons why government transfer activity will reduce the size of the economic pie. First, income redistribution weakens the link between productive activity and reward. When taxes take a larger share of a person’s income, the reward
from hard work and productive activity is reduced. Second, as public policy redistributes a larger share of income, more resources will flow into wasteful rent-seeking activities. Resources used for lobbying and other rent-seeking activities will not be available to increase the size of the economic pie. Third, higher taxes to finance income redistribution and an expansion in rent-seeking will induce taxpayers to focus less on income- producing activities, and more on actions to protect their income. More accountants, lawyers, and tax-shelter experts will be retained as people seek to limit the amount of their income redistributed to others. Like the resources allocated to rent seeking, re- sources allocated to protecting one’s wealth from the reach of government will also be unavailable for productive activity. Predictably, the incentives created by government redistribution policies will exert a negative impact on the level of economic activity.

Political decision making

admin — Sat, 31 Oct 2009 11:13:11 +0000

Public choice analysis is a branch of economics to the operation of the political process. Public-choice analysis links the theory of individual behavior to political action, analyzes the implications of the theory, and tests them against events in the real world. Over the past fifty years, research in this area has greatly enhanced our understanding of political decision-making.’ Just as economists have used the idea of self-interest to analyze markets, public-choice economists use it to analyze political choices and the operation of government. After all, the same people make decisions in both sectors. If self-interest and the structure of incentives influence market choices, there is good reason to expect that they will also influence choices in a political setting.
The collective decision-making process can be thought of as a complex interaction among voters, legislators, and bureaucrats. Voters elect a legislature, which levies taxes and allocates budgets to various government agencies and bureaus. The bureaucrats in charge of these agencies utilize the funds to supply government services and income transfers. In a representative democracy, voter support determines who is elected to the legislature. A majority vote of the legislature is generally required for the passage of taxes, budget allocations, and regulatory activities. Let’s take a closer look at the incentive structure confronting the three primary political players- voters,legislators, and bureaucrats- and consider how they affect the operation of the political process.