Saturday, April 28, 2007

On Technical Analysis or TA

One of the books recommended on this blog has this interesting story about technical analysis or TA. A professor ask a class of students to play a game. They are all given each a pencil, paper and a coin. They are to draw a stock chart with stock price at $1 starting from Day 1. Every toss of a coin represents how the stock will do for that day, and if it lands on head, the stock price goes up 3%, if it lands on tail, the stock price goes down 3%. And from there, they can plot the stock charts for 100 days (i.e. 100 tosses).

Guess what the resulting charts look like?

They look exactly like actual stock charts with famous patterns like head and shoulders (btw this is not a shampoo brand hor, this is a technical signal in stock charts), double tops, double bottoms, flag formation, cup formation etc.

Why is this so?

According to the professor, in the short run (short run means anything less than 10 yrs hor) stock prices move on positive and negative news, and news flow as such are random, like tossing a coin. Hence by looking at how the stock has moved in the past cannot help you predict what it will do in the future. On every new day, the stock has 50% chance of going up and 50% chance of going down, (like tossing a coin), depending on whether good or bad news will come out on that day. So how can you try to determine which way it will go by seeing what coin toss you have done in the past 10 or 20 days?

Then why is there all those studies about technical analysis, head and shoulders, double tops etc? To give them the benefit of the doubt. I think these things work a bit. They probably work 52% of the time and fail you 48% of the time. Btw these are quite good statistics bcos if you go casino it becomes more like 80:20, meaning 80% chance you will lose.

The main reasons why TA work are probably:

1) self fulfilling prophecy: people think that they work and then strive to make it happen, eg when you see a double bottom, you and 10,000 other TAcians buy the stock, of course it goes up.

2) human/investment crowd psychology does not change: this is the basis for TA as explained by TA textbooks, support and resistance levels are formed bcos investor crowd psychology dictates these levels until the next driver pushes the stocks to another paradigm.

But having said that, we must understand that stock markets are complex systems and hence TA can only help you win 52% of the time. There are times that TA can drive the stock prices, and there are times other information like macro outlook, earnings announcement, sentiments etc drive the stocks.

TA is only marginally useful in predicting short run stock peformance and not useful at all in predicting long term stock performance. On the other hand, value investing has zero use in predicting short run stock performance but gives you a little bit of an edge in predicting long term stock performance (probably 54% or so). The good thing about value investing is if you have done work homework, even if you are wrong, you will not lose your shirt.

See also Securitizing Taxis

Monday, April 23, 2007

Balance Sheet and Asset Allocation of a Singaporean Family

Before we go into the asset allocation , let’s take a look at the balance sheet of the Singaporean family. BTW I made all the no.s up and it is not based on any official statistics and no scientific/accounting methodology has been used to come up with the no.s. So please take them with a bucket of salt ok?

Anyways here it is:

Balance sheet of a typical Singaporean family
Cash & CPF $25,000
Stocks $25,000
Car $45,000
Other assets $5,000
HDB $400,000

Mortgage $350,000
Car Loan $50,000

Shareholders Equity $100,000

Thanks to the real estate recovery in the last 1 year, the typical household now sees some positive equity (as compared to past 10yrs of negative equity for a lot of Singaporean households)

So if we take a look at just the asset part we come to realize that a typical asset allocation/portfolio mix of a Singaporean family is about as interesting as watching a big snake poo-poo. i.e. not interesting at all lah! Anyway, in percentage terms, this would be

5% cash
5% stocks
10% in totally worthless depreciable assets like 1 x Automobile, 2 x Plasma TV and 32,000 credit card points exchangeable for 1 x 60GB white silly looking music player which is also worthless. (btw all these are under Other assets).
80% real estate (HDB flat)

If we apply what we have learnt about Modern Portfolio Theory, diversification and Markowitz, the Singaporean household is really quite undiversified and the fortunes of the household is basically determine by how much this little red dot is worth in the eyes of the world.

Fortunately our Government (with a capital G one, don’t pray pray) realizes this (maybe 10 yrs ago) and has planned to make the little red dot the favourite spot for foreigners to come and work and/or invest in our real estate. In concrete terms, 2 important policies made it all successful.
1) The 2 x Integrated Resort (IR) projects
2) The decision to grow our population from 4mn to 6mn pple
And as they say, the rest is history.

So what does it mean for the Singaporean family that is trying to push its asset allocation closer to the efficient frontier? Well if you believe in the almighty of our beloved Government, you can buy more real estate, hopefully somewhere overlooking Marina Bay and Sentosa. If your bet is right, forget about efficient frontier and the rest of the crap, you can start writing your own blog about how you made it and how this blog sucks.

If you believe in Markowitz and diversification, then it’s better to think of how to diversify the portfolio from real estate. Alas, this is not easy bcos RE will probably make up a huge chunk of your asset portfolio and you can only either save a lot more money to invest in stocks or other asset classes, or sell your property and downgrade. I admit both are not very realistic lah. But it’s important to keep this in mind though. And when you have the means to diversify, you should do it.

See also Efficient Market Hypothesis

Thursday, April 19, 2007

Asset Allocation

As a seasoned value investor (for those who have been following this blog, hopefully you have become one), asset allocation is a must-know.

Remember we talked about portfolio theory, Markowitz, efficient frontier and the kind of crap. Umm well, actually not that crappy, got win Nobel Prize one, don't pray pray ok. For those blur, read this post. Now in order to earn a return that is on the efficient frontier, meaning the portfolio is so efficient whatever you put in goes straight into your bank account x 10% and then gets immediate giroed to pay your credit card bills.

No, to earn a return on the efficient frontier means that this return can be earned with the least risk possible. Say if you target 10% return, but your portfolio risk is 25% while the risk of a portfolio on the efficient frontier is only 15%, then you loogie big time, bcos your portfolio is not efficient at all and you should really go put some oil on your money to make it run smoothly or something.

So how do we make our portfolio efficient? The answer lies in asset allocation. Asset allocation simply means determining how much to put in different asset classes such that the risk and return will be optimal, i.e. the portfolio is on the efficient frontier.

Back in the good old days when we have only 3 asset classes, the classic answer is 50% stocks, 40% bonds and 10% cash or some similar variation, say 60% stocks, 30% bonds and 10% cash etc. But today, we have 10,000 asset classes, so things are not so simple anymore. An efficient portfolio probably looks like this

40% stocks
10% bonds
10% hedge funds
10% real estate
5% private equity/venture capital
5% commodities
5% gold
5% cash

For a more scientific asset allocation, go google for Havard Endowment’s asset allocation, and you can see how the pros do it. If you want to be better then on top of the above mentioned asset classes, maybe you should consider adding

1% art and antique
1% wine and coke bottles
1% watches and diamond rings
1% krisflyer miles
1% adopted chinese brilliant kids
1% securitized future cashflow from this blog

Ok that’s just for fun hor, don’t follow blindly. The point that is being illustrated here is that current wisdom advocates finding more asset classes that are uncorrelated and then putting some portion of your portfolio in them. (This post has more info). The truth is for the retail investor, finding exposure to asset classes other than equities, bonds and real estate is actually not that easy. Most hedge funds and private equity funds will not accept retail money. But I always believe that when there is a will, there is a way. If you think you really want a well diversified portfolio then you will find ways to do it. Next post of a typical asset allocation for a Singaporean household, watch this space!

See also Efficient Market Hypothesis

Friday, April 06, 2007

Forward PER

PER may be a simple concept but its application can actually be quite complicated. For those who need some refresher course on the PER, it is the Price Earnings Ratio of a stock. It tries to determine the cheapness of the stock by dividing the stock price by its earnings per share (or EPS). For more info, read this post.

Now the issue here, which have never really been discussed in detail in this blog all thanks to this blogger who conveniently left it out, is which EPS should we use to calculate PER? Is it the latest historical EPS announced by the co.? Or what?

The answer is the expected EPS in 1 yr's time (not announced by the co. yet, i.e. it is not in the annual report). The resultant PER is also called the forward PER. The reason is very simple. The stock market always look forward, not backward. It is the culmulation of the expectations of all the players in the market. Hence when using the expected EPS of the stock in 1 yr's time to calculated PER, we roughly get a good sense of the market's expectation of the value of the stock.

BTW, this expected EPS (also called the consensus EPS) is usually the average of all the sell-side analysts EPS estimates for the next year and this no. can be easily pulled off bloomberg or other financial information providers. Now of course you may argue, sell-side is good-for-nothing and their estimates are usually wrong. Then naturally you can do your own homework and come out with your own expected EPS in 1 yr's time and use that to calculate the stock's forward PER. Well that won't be too hard right?

Also, you may ask why 1 yr? Why not 2 yr or 10 yr? Well actually you can use any year you want, if you can forecast correctly the EPS of the stock in 10 yr's time. You should use that. For some business, you can, and you should. But when you are looking at a stock for the first time, it would be easier to get the consensus EPS estimate and get a rough sense of the stock's forward PER. As a rough gauge, I would consider anything less than PER 18x as cheap and I would not buy any stocks that is trading at more than PER 18x.

See also Price to book ratio