Avoiding The Next Nortel

May 4, 2012

The last thing that any investor wants to experience is one of their holdings going bankrupt.  Yet, it happens–Washington Mutual, Lehman Brothers, Refco, WorldCom, Enron, Kodak, and the list goes on.  In fact, during the 20-year period from 1989 to 2008, 21% of of all stocks listed in US stock markets became bankrupt (Phys.org).  But, how can you identify those companies that may be on their way to going under?  That was the topic of a recent study by physicists, from Boston University in Boston, Massachusetts, and Fudan University in Shanghai, China.  Their study attempted to “develop a statistical-analysis-based early warning system to forecast the time of bankruptcy.”   Among their findings:

For all stocks, there is a correlation between volatility and volume. However, the closer a stock is to bankruptcy, the stronger the correlation, since both volatility and volume increase as bankruptcy approaches.

Maybe they’re on to something.  However, here’s a more straightforward approach to identifying danger stocks: avoid declining trends!

It’s easy to get hooked on the story of a company…why the market is making a mistake…how it’s becoming a better value…how it’s about ready to turn around (and some certainly do), but I would suggest that the best approach to avoiding stocks that are on their way to bankruptcy is to simply listen to the chart (or, even better, let your model listen to the chart!).

BTW, the chart above is that of Nortel Networks (currently being liquidated in bankruptcy).

A list of all Dorsey Wright holdings for the trailing 12 months is available upon request.

HT: Abnormal Returns

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Real Wages: Big Mac Edition

May 4, 2012

Global investing is becoming extremely important, as so much dynamic growth is located overseas.  In the last decade, it seems like China has grown tremendously.  In fact, if you listen to Congress, they see China as a threat to take American jobs.  Maybe this article from the Wall Street Journal will surprise you like it did me.  It’s a genius way to look at real wages.

Comparing wages across countries can be difficult, but one economist has come up with a way to track people doing identical jobs to make an identical product all across the world: McDonald’s employees.

Just comparing how much money workers make across countries is too simplistic. A better guide can come from taking a wage rate and dividing it by a good, which allows economists to see how much of that product an hour of work buys — a so-called real wage.

In order to calculate a real wage across countries Orley C. Ashenfelter of Princeton University found an excellent example using McDonald’s employees. In his paper published by the National Bureau of Economic Research, Ashenfelter notes that McDonald’s workers across the globe by design are asked to perform the same tasks to build the same product: a Big Mac. By calculating how many hours of work it takes an employee to earn enough to afford a Big Mac, he can show how wages change across countries.

You’ve got to admit that’s pretty clever.  (But Mr. Ashenfelter has been pretty clever in other areas as well.)  The graphic that goes along with it is the surprise.

McWages

Source: Wall Street Journal

Western Europe, the US, and Canada are all high wage areas.  China is significantly cheaper—but look at Latin America and India.  They are another magnitude lower in wage rates than China.  Usually other factors, including political stability and the rule of law, come into play before a company decides to locate jobs offshore.  This suggests that other low-wage areas could boom if they develop political structures that are conducive to business.  Maybe China will export jobs to India!

“Real wage rates seem to have been remarkably similar across countries before the industrial revolution,” Ashenfelter says. Since then “real wage rates have diverged across countries, with catch up taking place in different countries at different points in time.”

How can any individual investor keep up with all of this information?  No one person is going to be able to synthesize information about so many central banks, political administrations, and legal systems.  But guess what—asset prices do that all the time.  If prices in Mexico or Columbia or India start to rise, maybe the market is expecting some positive changes.  If the price change persists and results in a high degree of relative strength, that becomes notable.

This is just another way of pointing out that money goes where it is treated best.  Global tactical asset allocation using relative strength is one way to track these changes as they occur—and to create the opportunity to profit from them.

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Managing Volatility

May 4, 2012

Articles like this one in Investment News just confuse me.  Apparently the latest trend among pension plan sponsors is to target volatility.  I guess it is a human desire to eliminate volatility, but at the end of the day, you have to pay your pension benefits from your returns.  Not risk-adjusted returns.  Not volatility or standard deviation.  Focusing primarily on volatility is completely missing the boat.  From the article:

“There’s a big shift in terms of how plan sponsors are defining risk,” said Michael Thomas, chief investment officer for the institutional business in the Americas at Russell. “During the last 10 years, our industry has developed an unhealthy obsession with tracking error, but managing tracking error isn’t managing risk.”

He’s right—tracking error is not the same thing as risk.  Nor is volatility the same thing as risk, I might add.  Volatility management is just another unhealthy obsession.  Besides, the source of all of the evil volatility is readily apparent.

So far, most of the target volatility asset allocation strategies focus on equity exposure, which is, “by far, the biggest contributor of [portfolio] volatility,” Russell’s Mr. Thomas said.

Equity exposure = volatility.  To reduce it, just add some Treasury bills or bonds to the portfolio.  Duh.  That seems like a simpler solution if you really are concerned about reducing volatility.

I don’t think that investors are going to be any more successful targeting volatility than they are trying to target returns. We have no idea year to year what returns are going to be, even though we know exactly what they have been historically.  We can’t forecast it or target it–we just put up with whatever returns we get.  I don’t think volatility is going to be any more tractable.

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Sector and Capitalization Performance

May 4, 2012

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s).  Performance updated through 5/3/2012.

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