John Hussman’s comment this week is a must read, on inflation and the Fed.

“The proper model that ought to be in people’s heads is that, yes, the economy will probably slow down, but largely because it’s living on a mountain of debt that’s going to have a hard time growing because of a) stalling home values and b) a massive current account deficit that’s unlikely to expand indefinitely. So sure, the economy will probably continue to slow. If that happens, we can expect to observe higher, not lower, rates of inflation unless credit defaults increase enough to lower monetary velocity and counter the otherwise detrimental upward pressure that slower economic growth generally has on inflation.”

(Emphasis mine).

I agree 100%. So short-term, anyway, it will be inflation because there is not enough pain in the housing market yet to cause a significant level of defaults - and there probably won’t be until next year. I do believe it is likely that the level of defaults and associated damage to the financial system will cause deflation in the end. But that is just an opinion, by no means a foregone conclusion that one should use as the basis of any strategy at this point.

It is probably worth commenting that John is referring to the basic money supply equation, pq=mv. p (General Price Level) q (Quantity of Goods and Services) = m (Money Supply) v (Velocity of Money). In essence, the money volume of the economy (price x quantity) equals the amount of money available times the number of times each dollar is re-used - participates in a transaction - in a year. When credit is tight, money velocity is reduced, which means the left hand side of the equation must shrink accordingly.

We met a friend for an informal financial chat. She has some stock, a condo, a small business and no time. She is financially conservative. She has friends who have had some hair-raising speculation experiences - penny stocks and Florida condos. Here are the references for topics of conversation.

General reading

Reminiscences of a Stock Operator

The thinly disguised biography of Jesse Livermore, a remarkable character who first started speculating in New England bucket shops at the turn of the century. Livermore, who was banned from these shady operations because of his winning ways, soon moved to Wall Street where he made and lost his fortune several times over. What makes this book so valuable are the observations that Lefèvre records about investing, speculating, and the nature of the market itself.

Fooled by Randomness : The Hidden Role of Chance in Life and in the Markets
by Nassim Nicholas Taleb

In this look at financial luck, hedge fund manager Taleb (Dynamic Hedging) addresses the apparently irrational movement of money markets around the world. Using his own investing experience and examples of others’ successes and disappointments, he discusses theories like Monte Carlo math (easy; considered cheating by purists) and the concept of Russian roulette. Taleb tells interesting, well-wrought stories about individual behavior: “While Nero has succeeded beyond his wildest dreams, both personally and intellectually, he is starting to consider himself as having missed a chance somewhere.” While serious investors and mathematics enthusiasts will be intrigued, readers looking for practical investment strategies will be disappointed by this rambling intellectual discourse.

Market timing

Yes, You Can Time the Market!
by Ben Stein, Phil DeMuth

A smart, commonsense guide to investing. Stein and DeMuth’s primary dispute is with the old adage that one can never tell when the market is going to go up or down, something they attempt to disprove with a wealth of charts showing how to buy stocks cheaply over the long term (as in decades). This is no get-rich-quick scheme, merely a case being made to, in essence, treat the Street like many fans treat baseball: work the numbers. In between the sizable chunks of data, Stein and DeMuth drop in bits of advice, e.g., pay more attention to the S&P 500’s trends than frequently slippery P/E ratios; invest in bonds before stocks-they’re more stable; and always, always buy low. Best of all is a three-page cautionary list that should be required reading for anyone even thinking of investing. Some of the better nuggets: “Does the word `synergy’ appear in the prospectus?… Run!”; “Never accept any unsolicited financial advice”; and “Do not invest in a store because you see a lot of customers there at the mall or because you like the coffee or blue jeans or jelly beans. Sales do not equal profits.”

Beating the Dow with Bonds : A High-Return, Low-Risk Strategy for Outperforming the Pros Even When Stocks Go South
by Michael B. O’Higgins, John McCarty

O’Higgins is no Chicken Little–rather, he’s a market contrarian with a proven and profitable track record. If you think the stock market will go up forever, then look elsewhere for advice. But if you believe in gravity, then get this book and read it soon.

TIPS

Treasury Inflation-Protected Securities (TIPS)

Treasury Inflation-Protected Securities, also known as TIPS, are securities whose principal is tied to the Consumer Price Index. With inflation, the principal increases. With deflation, it decreases. When the security matures, we pay the original or adjusted principal, whichever is greater.
TIPS pay interest every six months, based on a fixed rate applied to the adjusted principal. Specifically, each interest payment is calculated by multiplying the adjusted principal by one-half the interest rate.

Why to sell the condo

Sell Now! : The End of the Housing Bubble
by John R. Talbott

Sell Now! analyses the evidence and offers clear explanations of these perplexing issues. Overly aggressive mortgage lenders have fueled this overheated market by extending too much credit to home buyers and by offering ever-more exotic forms of mortgages. Many home buyers have been caught in a never-ending race to achieve status, often overpaying for homes in the “right” neighborhoods. And people’s pursuit of easy profits has pushed prices to unsustainable levels.

Why to sell stocks

Valuation - Where we are in the stock market cycle. Just a note, when I talk about value changes in the stock market and real estate market, I’m talking about real prices, that is prices adjusted for inflation as against nominal prices, the unadjusted prices.

Schwab strategist sees cash as king ahead of sucker’s rally

Specifically, she recommends investors “underweight” stocks, remain “neutral” on bonds and be “maximum overweight” on cash.
“Keeping some powder dry makes a lot of sense,” the Schwab (NASDAQ: SCHW) strategist said. “There is likely to develop a great buying opportunity at some point this year. We just feel there’s more pain between now and then.

Investment and Speculation

From one of the earliest posts in the blog:

“We often hear the terms “Investment” and “Speculation” used interchangeably and casually. “Speculation” is often used as a derogatory term for activities considered somehow wrong or extreme. But both these words have relatively well-defined meanings. An “Investment” is a transaction which is entered into primarily to yield an ongoing income stream. While in many cases capital gains may also be a hoped-for result, they are secondary. A “Speculation” is a transaction which is entered into for the primary purpose of a capital gain on sale. Income, if it exists at all, is a secondary consideration and often will be negative, a “carrying cost”. So if I buy an apartment building for rental income, believing that the rents will yield a net return on my capital after expenses, then that is an investment. If I buy a house with the intention of “flipping” for a higher price as soon as possible, then that is a speculation. It is important to define the terms because they will be used frequently, but carefully, for their particular meanings.”

Delightful evening! Hope this helps.

The warning label says: Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital.

It is like drinking wine - drinking responsibly is enjoyable and has demonstrated health benefits. Options provide opportunities to control and manage risk or even to speculate (which is why options trading is viewed as risky by many). Options trading can be very useful in addressing the unknown market risks in a retirement portfolio. Like now for instance.

Stocks, commodities hit by risk aversion
Investors dumped stocks, commodities and emerging market assets on Tuesday on worries that economic growth will suffer from higher inflation and interest rates. Equity markets were punished as investors ditched riskier assets in favor of safe-haven government bonds and cash, with Japan’s Nikkei average <.N225> plunging more than 4 percent in its biggest one-day fall in two years. ..Reuters

The market is declining. There is a good chance of a significant decline sometime in the future - Fall 2006, perhaps. Between now and then, there will proabably be a rally of some sort. What to do? So this isn’t a good time to get short in anticipation of a fall decline. But what if the market doesn’t wait for fall for the big decline? Options!

Finacial Reality explains a very cool strategy for addressing the current situation with options. More expensive but less complex, just covering the downside with put options is insurance against a worst-case scenario.

Some options trading strategies

• straddle - An options strategy with which the investor holds a position in both a call and put with the same strike price and expiration date. The strike prices may be the same or different. The fact that there are offsetting puts and calls makes it a straddle.
• out-of-the-money puts - relatively low-cost way to control risk. If there is a big change in the value of the underlying security, the option would be in-the-money and have value, potentially offsetting loses incurred in the underlying security position.

Do the math…

Using NASDAQ-100 Index (NDX) options with September 06 expiration, the cost to implement the straddle strategy with overlapped the strikes with both puts and calls in-the-money (NDX 1526.54) is shown. The example uses puts and calls at different strike prices but both are in-the-money when the options are purchase and expected to be in the money at expiration.

Yes, I had help with this. I retrieved the Quotes for Chains for the NASDAQ 100 Index (Symbol NDX) and selected Expiration Sep 06. As of today, calls less than 1526.54 are in-the-money. Puts greater than 1526.54 are in-the-money. The positions were chosen to be in the expected range for the NASDAQ through September.

At expiration, the calls or the puts are expected to be in-the-money so I should get money back. The difference between the strike prices is 100 points (1575-1475). So long as the the NASDAQ is in this range, I get $10,000 back (100 units x 100 points).

Straddles can be purchased with a put and call at the same strike
price. However, it may cost more as only one - the put or the call,
will be in the money at expiration.

The cost of the out-of-the-money puts as protection against a sudden
significant decline (NASDAQ 1450 or below.) Puts less than 1526.54 are
out-of-the-money.

It gets a lot more complicated than this, but this scenario is an interesting demonstration.

There is good news and bad news. If options are out of the the money at the expiration date, that premium is lost. If the options were a hedge or risk control, that may have been a small price to pay for a good night’s sleep. If this was a big gamble, well… yes, all the money is gone.

More than 90% of all options expire out of the money, so the option writers make money. Occasionally, the option writers are wrong and they lose a lot of money. But if used appropriately, opions can be a very useful investing tool.

Learn more…

• Options Trading Tips for Success - requires three key elements - bargain-hunting instinct with the ability to identify undervalued and overvalued options, sound and well-designed game plan that provides consistent action over time and that works in all market conditions and discipline to follow the game plan.
• OptionsXpress Educate - links to educational information about investing in general and specificly about trading options
• Options Basics Tutorial - An introduction to the world of options, covering everything from primary concepts to how options work and why you might use them.

Stanford MS&E242S: Investment Science - Everything you need to know for retirement investment management, is included in this summer program from the Stanford Center for Professional Development.

Emphasis is on a cash flow approach. Topics include deterministic cash flow analysis (time value of money, present value, internal rate of return, taxes, inflation), fixed income securities, duration and bond portfolio immunization, term structure of interest rates (spot rates, discount factors, forward rates), Fisher-Weill duration and immunization, capital budgeting, dynamic optimization problems, investments under uncertainty, mean-variance portfolio theory, capital asset pricing, and basic options theory. Goal is to create a link between engineering analysis and business decision making.

Prereqs: Calculus, probability, and optimization. Students should be well versed in multivariable differential and integral calculus, including Lagrange multipliers and the theory of constrained optimization. Students should also know probability with a single and multiple random variables. Familiarity with Excel is helpful.

Text: Investment Science by David. G. Luenberger (Oxford Press, 1998)

http://www.stanford.edu/class/msande242s/

Paul Merriman’s site, FundAdvice.com, has an excellent paper on the consequences of drawdown for retirees. He points out that withdrawals during the drawdown period sap the ability of the portfolio to recover in a subsequent rally.

“When you’re accumulating money, what matters (at least mathematically) is how much you wind up with eventually. If you get to your goal, it doesn’t matter much how you got there. If your portfolio lost 45 percent the first year and then enjoyed an unending run of 14 percent annual gains (this is too good to be true in real life, but it makes the point well), you could be happy. In 16 years, you would nearly quadruple your money.

But here’s something that might surprise you : That very same hypothetical scenario – a serious loss followed by unending 14 percent gains, could spell disaster for a retiree. Those returns seem very favorable. But in a $1 million portfolio from which $60,000 is taken the first year and the withdrawal is raised by 3.5 percent every year, those returns would leave an investor broke after 16 years.”

Paul interprets this to mean that a retiree should switch into bonds to reduce risk of drawdown and accept lower returns. The problem with this strategy (apart from the lower returns) is inflation. Not only will inflation drive up rates and reduce the value of bonds, but it will reduce the purchasing power of the portfolio and can be just as serious, albeit more insidious, as a stock market decline. I interpret this to mean a broader set of asset classes must be used, for example including commodities to offset inflation, as well as market timing to at least avoid serious declines.