Where the science of investing becomes an art of living
- Name: David M Gordon
- Location: Summerlin, Nevada, United States
A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!
26 September 2010
22 September 2010
The best card trick... ever?
-- David M Gordon / The Deipnosophist
09 September 2010
Always good to laugh, no matter your age
Thank you to Liz Cummings for guiding me to Mary Maxwell's light.
-- David M Gordon / The Deipnosophist
9/11 and the 9-Year War - Stratfor
-- David M Gordon / The Deipnosophist
9/11 and the 9-Year War
By George Friedman
It has now been nine years since al Qaeda attacked the United States. It has been nine years in which the primary focus of the United States has been on the Islamic world. In addition to a massive investment in homeland security, the United States has engaged in two multi-year, multi-divisional wars in Iraq and Afghanistan, inserted forces in other countries in smaller operations and conducted a global covert campaign against al Qaeda and other radical jihadist groups.
In order to understand the last nine years you must understand the first 24 hours of the war — and recall your own feelings in those 24 hours. First, the attack was a shock, its audaciousness frightening. Second, we did not know what was coming next. The attack had destroyed the right to complacent assumptions. Were there other cells standing by in the United States? Did they have capabilities even more substantial than what they showed on Sept. 11? Could they be detected and stopped? Any American not frightened on Sept. 12 was not in touch with reality. Many who are now claiming that the United States overreacted are forgetting their own sense of panic. We are all calm and collected nine years after.
At the root of all of this was a profound lack of understanding of al Qaeda, particularly its capabilities and intentions. Since we did not know what was possible, our only prudent course was to prepare for the worst. That is what the Bush administration did. Nothing symbolized this more than the fear that al Qaeda had acquired nuclear weapons and that they would use them against the United States. The evidence was minimal, but the consequences would be overwhelming. Bush crafted a strategy based on the worst-case scenario.
Bush was the victim of a decade of failure in the intelligence community to understand what al Qaeda was and wasn’t. I am not merely talking about the failure to predict the 9/11 attack. Regardless of assertions afterwards, the intelligence community provided only vague warnings that lacked the kind of specificity that makes for actionable intelligence. To a certain degree, this is understandable. Al Qaeda learned from Soviet, Saudi, Pakistani and American intelligence during the Soviet occupation of Afghanistan and knew how to launch attacks without tipping off the target. The greatest failure of American intelligence was not the lack of a clear warning about 9/11 but the lack, on Sept. 12, of a clear picture of al Qaeda’s global structure, capabilities, weaknesses and intentions. Without such information, implementing U.S. policy was like piloting an airplane with faulty instruments in a snowstorm at night.
The president had to do three things: First, he had to assure the public that he knew what he was doing. Second, he had to do something that appeared decisive. Third, he had to gear up an intelligence and security apparatus to tell him what the threats actually were and what he ought to do. American policy became ready, fire, aim.
In looking back at the past nine years, two conclusions can be drawn: There were no more large-scale attacks on the United States by militant Islamists, and the United States was left with the legacy of responses that took place in the first two years after 9/11. This legacy is no longer useful, if it ever was, to the primary mission of defeating al Qaeda, and it represents an effort that is retrospectively out of proportion to the threat.
If I had been told on Sept.12, 2001, that the attack the day before would be the last major attack for at least nine years, I would not have believed it. In looking at the complexity of the security and execution of the 9/11 attack, I would have assumed that an organization capable of acting once in such a way could act again even more effectively. My assumption was wrong. Al Qaeda did not have the resources to mount other operations, and the U.S. response, in many ways clumsy and misguided and in other ways clever and targeted, disrupted any preparations in which al Qaeda might have been engaged to conduct follow-on attacks.
Knowing that about al Qaeda in 2001 was impossible. Knowing which operations were helpful in the effort to block them was impossible, in the context of what Americans knew in the first years after the war began. Therefore, Washington wound up in the contradictory situation in which American military and covert operations surged while new attacks failed to materialize. This created a massive political problem. Rather than appearing to be the cause for the lack of attacks, U.S. military operations were perceived by many as being unnecessary or actually increasing the threat of attack. Even in hindsight, aligning U.S. actions with the apparent outcome is difficult and controversial. But still we know two things: It has been nine years since Sept. 11, 2001, and the war goes on.
What happened was that an act of terrorism was allowed to redefine U.S. grand strategy. The United States operates with a grand strategy derived from the British strategy in Europe — maintaining the balance of power. For the United Kingdom, maintaining the balance of power in Europe protected any one power from emerging that could unite Europe and build a fleet to invade the United Kingdom or block its access to its empire. British strategy was to help create coalitions to block emerging hegemons such as Spain, France or Germany. Using overt and covert means, the United Kingdom aimed to ensure that no hegemonic power could emerge.
The Americans inherited that grand strategy from the British but elevated it to a global rather than regional level. Having blocked the Soviet Union from hegemony over Europe and Asia, the United States proceeded with a strategy whose goal, like that of the United Kingdom, was to nip potential regional hegemons in the bud. The U.S. war with Iraq in 1990-91 and the war with Serbia/Yugoslavia in 1999 were examples of this strategy. It involved coalition warfare, shifting America’s weight from side to side and using minimal force to disrupt the plans of regional aspirants to gain power. This U.S. strategy also was cloaked in the ideology of global liberalism and human rights.
The key to this strategy was its global nature. The emergence of a hegemonic contender that could challenge the United States globally, as the Soviet Union had done, was the worst-case scenario. Therefore, the containment of emerging powers wherever they might emerge was the centerpiece of American balance-of-power strategy.
The most significant effect of 9/11 was that it knocked the United States off its strategy. Rather than adapting its standing global strategy to better address the counterterrorism issue, the United States became obsessed with a single region, the area between the Mediterranean and the Hindu Kush. Within that region, the United States operated with a balance-of-power strategy. It played off all of the nations in the region against each other. It did the same with ethnic and religious groups throughout the region and particularly within Iraq and Afghanistan, the main theaters of the war. In both cases, the United States sought to take advantage of internal divisions, shifting its support in various directions to create a balance of power. That, in the end, was what the surge strategy was all about.
The American obsession with this region in the wake of 9/11 is understandable. Nine years later, with no clear end in sight, the question is whether this continued focus is strategically rational for the United States. Given the uncertainties of the first few years, obsession and uncertainty are understandable, but as a long-term U.S. strategy — the long war that the U.S. Department of Defense is preparing for — it leaves the rest of the world uncovered.
Consider that the Russians have used the American absorption in this region as a window of opportunity to work to reconstruct their geopolitical position. When Russia went to war with Georgia in 2008, an American ally, the United States did not have the forces with which to make a prudent intervention. Similarly, the Chinese have had a degree of freedom of action they could not have expected to enjoy prior to 9/11. The single most important result of 9/11 was that it shifted the United States from a global stance to a regional one, allowing other powers to take advantage of this focus to create significant potential challenges to the United States.
One can make the case, as I have, that whatever the origin of the Iraq war, remaining in Iraq to contain Iran is necessary. It is difficult to make a similar case for Afghanistan. Its strategic interest to the United States is minimal. The only justification for the war is that al Qaeda launched its attacks on the United States from Afghanistan. But that justification is no longer valid. Al Qaeda can launch attacks from Yemen or other countries. The fact that Afghanistan was the base from which the attacks were launched does not mean that al Qaeda depends on Afghanistan to launch attacks. And given that the apex leadership of al Qaeda has not launched attacks in a while, the question is whether al Qaeda is capable of launching such attacks any longer. In any case, managing al Qaeda today does not require nation building in Afghanistan.
But let me state a more radical thesis: The threat of terrorism cannot become the singular focus of the United States. Let me push it further: The United States cannot subordinate its grand strategy to simply fighting terrorism even if there will be occasional terrorist attacks on the United States. Three thousand people died in the 9/11 attack. That is a tragedy, but in a nation of over 300 million, 3,000 deaths cannot be permitted to define the totality of national strategy. Certainly, resources must be devoted to combating the threat and, to the extent possible, disrupting it. But it must also be recognized that terrorism cannot always be blocked, that terrorist attacks will occur and that the world’s only global power cannot be captive to this single threat.
The initial response was understandable and necessary. The United States must continue its intelligence gathering and covert operations against militant Islamists throughout the world. The intelligence failures of the 1990s must not be repeated. But waging a multi-divisional war in Afghanistan makes no strategic sense. The balance-of-power strategy must be used. Pakistan will intervene and discover the Russians and Iranians. The great game will continue. As for Iran, regional counters must be supported at limited cost to the United States. The United States should not be patrolling the far reaches of the region. It should be supporting a balance of power among the native powers of the region.
The United States is a global power and, as such, it must have a global view. It has interests and challenges beyond this region and certainly beyond Afghanistan. The issue there is not whether the United States can or can’t win, however that is defined. The issue is whether it is worth the effort considering what is going on in the rest of the world. Gen. David Petraeus cast the war in terms of whether the United States can win it. That’s reasonable; he’s the commander. But American strategy has to ask another question: What does the United States lose elsewhere while it focuses on the future of Kandahar?
The 9/11 attack shocked the United States and made counterterrorism the centerpiece of American foreign policy. That is too narrow a basis on which to base U.S. foreign policy. It is certainly an important strand of that policy, and it must be addressed, but it should be addressed through the regional balance of power. It is the good fortune of the United States that the Islamic world is torn by internal rivalries.
This is not dismissing the threat of terror. It is recognizing that the United States has done well in suppressing it over the past nine years but at a cost in other regions, a cost that can’t be sustained indefinitely and a cost that could well result in challenges more threatening than a rising Islamist militancy. The United States must now settle into a long-term strategy of managing terrorism as best as it can while not neglecting the rest of its interests.
After nine years, the issue is not what to do in Afghanistan but how the global power can return to managing all of its global interests, along with the war on al Qaeda.
9/11 and the 9-Year War is republished with permission of STRATFOR.
05 September 2010
How Indices Work -- Excellent primer from David Blitzer
David Blitzer is a managing director and the chairman of the S&P Index Committee with overall responsibility for security selection for S&P’s indices and index analysis and management. Dr. Blitzer is the author of Outpacing the Pros: Using Indices to Beat Wall Street’s Savviest Money Managers (McGraw-Hill, 2001) and What’s the Economy Trying to Tell You? Everyone’s Guide to Understanding and Profiting from the Economy (McGraw-Hill, 1997)
Q: Let's start by talking about how the S&P 500 is composed.
A: It is 500 companies. We occasionally get phone calls, believe it or not, about how many stocks in the S&P 500. It's overseen and maintained by a committee of nine people, all of whom work for Standard & Poor's and McGraw Hill, our parent company.
We have a series of published guidelines and requirements for a company to be added to the Index. It has to be a US company worth at least $3.5 billion dollars, trade with adequate liquidity, have at least half the stock available in public float.
We look at what sector or industry it belongs to, to keep the balance of sectors in the Index very close to the balance in the market. And last, but certainly not least, it has to have made money. It has to have four quarters of positive earning using generally accepted accounting principles (GAAP) net income.
Over the years that has proven to be surprisingly important to the whole process.
What happens when someone reads that the S&P is up 10 points or down 10 points. How is that calculated?
The Index is what we call a value-weighted index, or sometimes called market-cap or market capitalization-weighted index. You take the market value of each company in the Index, and you add it all together, and you will get a number that is probably about $9 trillion right now.
Well, $9 trillion is sort of a big number to report every 15 seconds. In fact, by the time you get to the end of the number you've used your 15 seconds.
We divide it by a scaling factor called the divisor, and that gives you the value of the Index, 1,142 or whatever it happens to be. When you say the index is up, you take the value of all those companies – some go up, some go down at any given moment – the ones that went up outweigh the ones that went down, and after you scale it to a number that’s easy to handle, you come out with say 10 points, and maybe the Index has moved from 1,140 to 1,150.
You say that the companies are market weighted. What would be the biggest company in the Index right now, the most important company today?
The biggest one is most likely Exxon Mobile which is a giant US or global oil company.
So you have a company like Exxon at the top of the list, and they are up 3% in a day, and then you have one at the bottom of the list not nearly as important, and they are down 3%. So you've got two members, one’s up, one’s down, but they are not of equal importance to the index as a whole?
That's right. Let's assume the other 498 stocks didn't move, just to make it simple. Exxon mobile goes up 3%, and the number 500th company goes down 3%. The Index overall will be up, because Exxon Mobil's weight in the Index is going to be much larger. Its weight is probably 3, 3.5, or maybe 4%. The one at the bottom we’re talking about is a very small fraction of a percentage point.
You mentioned the S&P is the most widely followed the Index, but probably not the best known. The best known would probably still be the Dow Jones. Can we talk a little bit about how the Dow Jones differs from the S&P 500?
There are two big ways. The obvious one is the Dow has 30 stocks. We have 500. Quantity is not the answer, but with 500 stocks one gets much broader coverage of the overall market. And you know, you cover more, you're more likely to include stocks that either went way up, or way down, or did something else somewhat unusual.
The other way is the calculation. The Dow uses the same calculation method that they started using in 1896 when they did this on the back of an envelope, probably with a pencil and paper. They take the prices of the 30 stocks – not the value, but just the price – and they add up the number, and then they divide by a scale factor which gets them to their number.
So you can have two companies in the Dow, one may be worth 10 times the other one, but a one point rise in either company will have the exact same impact on the Index.
The other thing about the Dow, just because the way the arithmetic works out, is the number they divide by turns out to be very small. It's actually a little less than 1/5. So a one point move in the Dow by a stock, any stock, will be a five point move in that Index.
Or maybe more to the point, if 10 of the Dow stocks do nothing, and the other 20 each go up say two points, those 40 points are going to echo into a 200 point move in the Dow Jones. And a 200 point move in almost any Index is going to hit the news wires in a big way, and get people probably more excited than they really should be.
The Dow is equally weighted, unlike the S&P which is weighted by the actual market value of the company. Let's suppose a stock in the Dow has a price of $150, and another one with a price of $15, and you have a two dollar movement in each of those, does that two dollars have a different impact on the Dow overall?
Yes. If the $150 stock went to $152 which is a tiny little fraction of a percentage, and the other stock at $15 went to $17, this is a big move in percentage terms. Those two moves have the exact same impact on the Dow. Two points on the stock would be about 10 points in the Dow.
So you're getting movements that just depend on whether a stock is priced at $15 or $150, which really has nothing to do with the underlying value of the company.
Whereas in the S&P 500, it’s how much the value of the company has moved that determines the impact on the Index, and that's one of the reasons why we believe that market weighting gives you a much better door to understanding what's going on in the stock market. A big reason to follow indices is to understand what's happening in the stock market overall.
Some of the media coverage you hear occasionally says that we should buy a company, because it might be added to the Index. So could we talk a little bit about the underlying thinking to that?
Look at the S&P 500 and the amount of money that’s managed to track the Index, in exchange trade of funds, Index funds, pension funds, and other institutions whose investment strategy is to replicate the Index.
If a stock is added to the Index or taken off it, do they have to replicate that change?
That's right. They have a commitment to replicate the Index. The totality of that money is something well over a trillion dollars. If you go through the arithmetic of what that means, then for any stock in the Index, about 10% of the outstanding shares are going to be held by this collection of Index replicators.
So if we add a stock to the Index, and let's assume for a moment it's not in any other Index we run at the present time, over a period of a week between when we announce it is going in and when it actually goes in (because we make announcements five trading days in advance), about 10% of the stock is going to get bought up.
It has to happen. This is a very large buyback program. To give you some frame of reference, a corporation running a buyback program buying back its own stock will buy back a half percent to 1% of the outstanding shares in a quarter of a year, 13 weeks.
So these replicators are doing 10% in a week versus 1% in 13 weeks. The stock goes up. Typically it will gain 5, 6 or 7% over a week maybe two-week period. It will gradually give that back over the next three to six months, so this is not a permanent all-time rise, although it is very exciting. If you knew in advance what we were going to do, and we play this very, very close to the vest for obvious reasons, and you traded options, it would be even more exciting, but it would probably be trading on inside information unless it was just a lucky guess.
That's the case when you add a stock to the Index, just buying pressure from institutions and ETFs forces the price up short-term. Does the same apply when you take a stock off the Index that the price gets pressed down?
It does, but it’s much harder to calculate. The data are much thinner for a couple reasons.
First of all, something like two thirds of the exits from the Index are caused by M&A activity. So the stock that's coming out and being acquired in a merger, the price is predetermined by the terms of that merger.
And has already been pushed up?
It's already had its run up at the very beginning of the transaction process. There are other cases where when we take it out because it has fallen on very, very hard times. It clearly no longer makes any sense in the Index, and the selling happened months ago, not right now.
So while there probably is a short-term decline in a stock when it comes out, it’s much, much harder to measure and gauge. There are much less data. There are a lot of special circumstances that would be very hard to disentangle.
If someone is online and they see that you've just announced that you are adding a stock to the Index, should they rush to their broker to buy it?
First of all, we make our announcements at 5:15 PM Eastern time so the markets are officially closed. These days you can trade anything, anytime, anywhere, but the markets are very thin when it comes to 5:30, 6:00, or 6:30 in the evening. So it would be a little bit dicey to do that. But more so, this is a short-term play, and if you are into fast and furious short-term trading, you place your bets and take your chances.
If you're a long-term investor, and if you look at the long-term history of the US stock market and indeed of most developed stock markets, they have sideways periods. They have sustained periods where they don't seem to advance, and we are unfortunately in one, though hopefully coming to the end of one.
But over the long haul, markets do very well. As a long-term investor, the strategy to replicate an Index turns out to be very successful, in large part because it’s incredibly cheap.
I want to talk about some of the sectors in the S&P, where they've been in the past, and where they are today. Let’s start with the financial sector. What's the average importance over time for the financial sector in the US stock market?
The average importance has probably grown over the long term over the last three or four decades. Currently it's in the high teens. At its peak it was probably 20 to 25%, in roughly 2007. Clearly it came down very sharply with the financial crisis, as a huge number of large banks cut their dividends and a couple of very large public companies literally disappeared.
But what surprises many people is that the past decade, from the market bottom in 2002 to the peak in 2007, while financials are very important, they weren't incredibly dominant. It was not a financial repeat of the Tech boom. It was a broad-based improvement in the market over those five or six years.
Talking about the Tech boom, where did the Tech sector peak in terms of its importance in the US stock market?
The Tech sector was almost a once in history event. If you go back to about 1994 when it started, technology was around 8% of the Index. At its peak it was probably a third, 30 to 35% of the Index.
Today it's down to 15 or 16%. It's been moving up lately, and doing somewhat better. Probably in the long-term it will have a strong position. I'm not sure it will get back to the one-third level though.
One of the debates when it comes to investing is value versus growth. Those tend to be the two alternative approaches. What does your track record show in terms of the investor experience using a value approach versus a growth approach over the long term?
Over the long term, value tends to outperform, not year-by-year by any means, but over the long sweep of time. Value builds and maintains what appears to be a sustainable lead on a totally long-term basis. Value stocks tend to have higher dividends and are more likely to have dividends than growth stocks, and that's a big part of their long-term benefit.
But really the only time that growth seemed to suddenly surge ahead briefly was at the very end of the 1990s. At the peak of the technology boom, growth stocks were heavily dominating technology and appeared to be unstoppable. We know as a result of what happened shortly after the beginning of 2000, they were stoppable.
You mentioned dividends just a moment ago. Can you point to long-term data in terms of the investor experience focusing on companies that pay dividends compared to those that don't?
Yes. We put together a list a number of years ago which we continue to maintain, and what we nicknamed Dividend Aristocrats. These are companies in the S&P 500 with a record of at least 25 years of increasing their cash payout to investors.
So not only were they paying dividends or maintaining their dividends year-by-year, they were actually increasing their payout. There are not too many of them, and we've lost a lot in the last few years to other issues, but over the long term on a total-return basis, these stocks do very nicely.
Last fall I had a chance to interview Jeremy Siegel at Wharton. In his most recent book, Why the Tried and the True Beats the Bold and the New, one of his suggestions was that new companies get added to the Index after they've had the best period of their run-up, and investors actually are often not served by buying companies after they are added to the Index. What is your perspective on that?
Two things stand out, one particularly regarding Jeremy Siegel and his research.
He did some work a few years back for which we provided a lot of the background data, looking at the companies that were in the S&P 500 in March of 1957. This was when the Index moved from being 90 stocks, as it had been in ancient days, to being 500 stocks as it is now.
He studied how those companies did. His argument was that the original 500 actually outperform some of the ones that went in and out of the Index. There were a lot of particular stories in that period of time. So I'm not sure it's a general result, but it was a fascinating piece of work.
More to the focus of investors today, the S&P 500 is the large-cap stocks at the top of the market. Below that in size is a mid-cap Index of 400 stocks, and below that is a small-cap Index of 600 stocks.
The small-caps tend to be very exciting. There are some wonderful stocks there. There are some less wonderful stocks. They’re a little more volatile, and because they are small they are a little bit riskier typically.
The 500, as Jeremy Siegel suggests, are solid long-term good ideas, but they may have passed some of their high-speed growth.
Sitting in the middle turns out to be the mid-cap Index, and while obviously the past is no indication of the future, over the long haul since the mid-cap Index was created in the early 1990s, it does seem to have this attractive balance between the more rapid growing, more exciting, more dynamic smaller stocks, and the more secure larger stocks. It seems to get the best of both worlds.
For an investor who listens to Professor Siegel and doesn't want to own just the biggest stocks there are, but wants a little more interest and excitement, I would poke around and look at the mid-cap 400 among other things.
That sounds like an interesting idea, and one I think that many people hadn't thought of. Is there a risk that of that the 400 mid-cap companies you'll get the 20 or so that excel, that really become home runs, and then they grow to the point that they move off the mid-cap Index onto the 500? So will investors lose the growth once they've met that threshold and are no longer in the mid-cap Index?
Looking at the three indices, a large proportion of the stocks going to the S&P 500 come out of the mid-cap.
The way we maintain the indices, a stock can only be in one Index of the three at a time. It can't be in multiple indices. A company that outperforms or grows faster than most other companies will move up in size, and if it continues to do so, it will move to the top of the mid-cap and it will become a reasonably good candidate to be moved to the 500.
There's certainly no guarantee. Number one in the mid-cap by size is no more likely than number five, or number 10, or number 15, to be moved into the 500, although clearly the top 50 to 100 are probably more likely than the bottom hundred.
The one aspect that makes it very intriguing is the following.
I mentioned earlier that a stock going in the S&P 500 gets a short-term bump up. So let's say we announced tonight at 5:15 that a stock is going to come out of the mid-cap and go into the 500 after the market closes a week from today, which is the typical time frame.
For this week, which is when it gets a lot of that bump, it is in the mid-cap Index. It is not in the 500. At the end of this week it will get moved into the 500. So if you were sitting on the mid-cap, you got the bump. It goes into the 500, and over the next two, three, or six months it gradually drifts down and gives back what we're calling an “artificial bump.” It's already in the S&P 500, which is another reason why the mid-cap might be an interesting thing to take a look at.