8 arata markets

8/12/2019 8 Arata Markets

1/11

2013 Risk and Profit ConferenceBreakout Session Presenters

8. Investing 101 and Why Economists Drive Dodge Darts

Joe Arata Joe Arata teaches courses, provides information and conducts research oncommodity futures, options on futures and off exchange derivatives.Currently he is working on an analysis of futures market price valuation andmarket information; analyzing profit due to underlying asset price changesas opposed to profit due to option mispricing; and decomposing optionmispricing into volatility and formula error.

Abstract/SummaryEconomic financial theory is based in part on the theories that include theEfficient Market Hypothesis, Random Walk theory and other that aremanifestly false and incorrect.


2/11

nves ngWhy Economist Drive

Dodge DartsJoseph O. Arata Ph.D.

Department of Agricultural Economics

Kansas State University

o ge ar 2

Heres the Plan

Saving - Investing

Stocks

nanc a a os

3

Saving VS Investing

Saving - Postpones spending Has safety precautions

Investing Longer term capital Exchanges money for something with the

u ure expec a on o rece v ng a pro

Has risk factors

4

Saving VS Investing

Places to Invest

Bonds

Mutual Funds

Retirement Plans

Real Estate

Stocks

5 6


3/11

What Economists Believe

Efficient Markets Hypothesis

Micro Economics Theory

7

Efficient Markets HypothesisTextbook Version

Security prices accurately reflectavailable information, and res ond

rapidly to new information as soon as itbecomes available

Richard Brealey & Stewart Myers,,

8


nves ors, as a group, can o no e erthan the market, because collectively theyare e mar e . os nves ors ra emarket because they are burdened by

comm ss ons an un expenses. Jonathan Clements, the Wall Streetourna ,

June 17, 2007

9


80-90% of price volatility is the result of thinternal dynamics of speculators watchingother speculators: EMH idea of investors focusing solely

upon expected risk/return is wrong:

Instead,Prices are determined by speculation on

immediate behavior of other speculators,rather than rational calculation

10

Market Realities

Professional managers: choose portfolios thatare c ose o e enc mar ey are eva ua e

against benchmark

Select stocks that other managers select, Again to avoid falling behind and looking bad

Add stocks that have recently done well, and ,

To look good to investors who are getting end ofyear reports on portfolio holdings

11

Market Realities

Individual investors do not do this

Self-defeating (irrational?) behavior as well

follow the advice of financial gurus, Fail to diversify,

Actively trade stocks and churn their portfolios,

thereby increasing their tax liabilities (Shleifer2000 p. 10)

Undermines both EMH and possible gains from marketinefficiency

Also partly explains market inefficiency

As does behavior of money managers12


4/11

pple StockA le

500

510

480

490

460

470

440

450

3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3

137/29/1

7/30/1

7/31/1

8/1/1

8/2/1

8/3/1

8/4/1

8/5/1

8/6/1

8/7/1

8/8/1

8/9/1

8/10/1

8/11/1

8/12/1

8/13/1

8/14/1

8/15/1

8/16/1

8/17/1

8/18/1

8/19/1

pple Stock

700

750

pp e

600

650

450

500

350

400

14

300

8/17/12

8/31/12

9/14/12

9/28/12

10/12/12

10/26/12

11/9/12

11/23/12

12/7/12

12/21/12

1/4/13

1/18/13

2/1/13

2/15/13

3/1/13

3/15/13

3/29/13

4/12/13

4/26/13

5/10/13

5/24/13

6/7/13

6/21/13

7/5/13

7/19/13

8/2/13

8/16/13

o as o as a c ewan50

45

40

30

35

25

12

12

12

12

12

12

12

12

12

12

12

12

13

13

13

13

13

13

13

13

13

13

13

13

13

13

13

13

13

15

7/20/

8/3/

8/17/

8/31/

9/14/

9/28/

10/12/

10/26/

11/9/

11/23/

12/7/

12/21/

1/4/

1/18/

2/1/

2/15/

3/1/

3/15/

3/29/

4/12/

4/26/

5/10/

5/24/

6/7/

6/21/

7/5/

7/19/

8/2/

8/16/

eere -86

85

83

84

82

81

167/16/13

7/17/13

7/18/13

7/19/13

7/20/13

7/21/13

7/22/13

7/23/13

7/24/13

7/25/13

7/26/13

7/27/13

7/28/13

7/29/13

7/30/13

7/31/13

8/1/13

8/2/13

8/3/13

8/4/13

8/5/13

8/6/13

8/7/13

8/8/13

8/9/13

8/10/13

8/11/13

8/12/13

8/13/13

8/14/13

8/15/13

8 / 1 6 / 1 3

onsan o- yngen a90110

85105

80100

70

75

90

95

6585

12

12

12

12

12

12

12

12

12

12

12

12

13

13

13

13

13

13

13

13

13

13

13

13

13

13

13

13

13

17

7/20/

8/3/

8/17/

8/31/

9/14/

9/28/

10/12/

10/26/

11/9/

11/23/

12/7/

12/21/

1/4/

1/18/

2/1/

2/15/

3/1/

3/15/

3/29/

4/12/

4/26/

5/10/

5/24/

6/7/

6/21/

7/5/

7/19/

8/2/

8/16/

The Richest People

1. Carlos Slim Helu 2. William Gates. manc o r ega . arren u e

5. Larry Ellison 6-7. C&D Koch-. - .10. Bernard Arnault 11. Christy Walton12. Stefan Persson 13. Michael Bloomber14. Jim Walton 15. Sheldon Adelson16. Alice Walton 17. Bobson Walton18. Karl Albrecht 19. Jeff Bezos20. Larry Page 21. Sergey Brin

18

. .24. LeeShau Kee 25. David Thomson


5/11

People who earned it all

1. Carlos Helu-telecom 2. W. Gates-Microsoft3. A. Orte a-Zara 4.5. L. Ellison-Oracle 6-7.8. L. Ka-shing-stocks 9.

10. 11.12. S. Persson-H&M 13.M. Bloomberg-Bloomberg. . . e son-cas nos

16. 17.- -. . . .

20. L. Page-Google 21. S. Brin-Google22. M. Ambani-oil&gas 23.24. L. Kee-stocks 25.

The Richest Showbiz Women

1. Oprah Winfrey 2 J.K. Rowling

. ar a ewar . e ne on

5. Madonna 6. Mariah Carey

7. Janet Jackson 8. Julia Roberts

9. Jennifer Lopez 10. Jennifer Aniston11. The Olsen Twins 12. Britney Spears

13. Judge Judy 14. Sandra Bullock

15. Cameron Diaz 16. Gisele Bundchen

. .

19. Christina Aguilera 20. Renee Zellweger

What is a Random Walk?Textbook Version

Formal Definition: In simple symmetricrandom walk on a locall finite lattice, theprobabilities of the location jumping to eachone of its immediate nei hbors are the same.The best studied example is of random walkon the d-dimensional inte er lattice(sometimes called the hypercubic lattice) .

21

What is a Walk?

An Intuitive understanding: A series of

randomly decided (e.g., the path a drunk.

Stock market prices evolve according to a.

consistent with the efficient market hypothesis.

22

Random Walk

Individual stocks prices are extremelyvolatile and that volatility is too large to

rationalize with a random walk

23

Definitions of Volatility

. .continuously compounded stock returns.

. .residuals from a factor model for returns.

mp e o a y e vo a y eve awould produce an observed option price.

VIX (fear index) measures the marketsvolatility expectation over the next 30 days


6/11

Why Volatility Increased

Firm-Specific Factors:

The number of stocks on U.S. exchanges hasmore than doubled since 1980, but theaverage s ze o e new y s e rms ssmaller

, ,need a less proven track record (to be listed)

EPS and ROE (levels declining, variability up)

Stock Price Volatility

Discrete jumps often occur when reported.

Institutional investors now react quite swiftl, .

Thus, stock price change distributions have. ,

especially among lightly traded stocks.

,has exceeded what fundamentals dictate.

Volatility v. Return

Stocks with large sensitivities to marketvo a y ave ower average re urns.

Periods of high volatility tend to occur inbear markets, and periods of low volatilityoccur in bull markets.

Return dispersion is countercyclical, but isrelated ositivel to subse uent marketvolatility, and tends to lead unemployment.

Why Care about Volatility?

High Volatility may make a diversifiedpor o o ess vers e .

Arbitrageurs can get it wrong whenvolatility becomes too high.

Abnormal event-related returns arestrongly impacted by volatility.

associated with changes in volatility.

Explanation for Relationship

It is no surprise that high-risk stocks dore a ve y we n up mar e s, u re a ve y

poorly in down markets. However, the negative effects from down

markets often dominate the positive effectsfrom up markets.

This mi ht indicate an inverse relationshibetween risk (historical volatility) + return.

Liquidity

Liquidity is like pornography. Easy toen y w en seen, u s cu o

define. But, CLM defines liquidity as:Ability to buy or sell significant

quantities of a security quickly,

anonymously, and with minimal or no

price impact.

30


7/11

Extreme Volatility Events

Volatility Spikes tend to occur during times ofow or nsu c en qu y:

October 19, 1987 (portfolio insurance)

August (2nd half), 1998 (Russian financialcrisis

September 11, 2001 (WTC / markets

May 6, 2010 (Flash Crash)

Extreme Volatility Episodes

The Great Depression

The Internet Bubble

The Recent Financial Crisis

In 2008: the daily DJIA changes were atleast 1% on 134/253 (53%) of all tradingdays

This compares to a 15.6% avg. (2004-2007)

European Debt Crisis / U.S. TreasuryDowngrade (3rd Quarter 2011)

Micro Economic Theory

Normal micro economic theory: Demand a negative function of price

If price rises Demand falls

Supplyy = +x

$8

$9

Hypothetical Beer Supply

$5

$6

$7

Bottle

$2

$3

$4

Price

/

$0

$1

0 2 4 6 8 10 1

Quantity

Demand

$8

$9

$5

$6

/Bottle

y = 12 -x$2

$3

$4

Price

$0

$1

0 2 4 6 8 10 12

Quantity

Market Realities

With the stock market ,

positive function of price If price of assets (shares, real estate, etc.)

,Buyers hope to buy and sell on a rising

The faster the rate of price increase

demand


8/11

Market Realities

Tendency to move away from equilibriumun amen a va ue , s or c pr ce o

earnings ratios, etc.)

r ce us es a zes an asse mar e Far-from-equilibrium process means verva ua on o popu ar grow s oc s

Undervaluation of unpopular value stocks

Market Realities

Argument that investors eac s ow y o news Under-react and Over-react

Series of good reports leads to expectation

Firm valuation rises, seen as growth stoc rise becomes self-fulfillin bandwa on bu in

Market Realities

Firm cannot sustain above sector/economyper ormance n e n e y

Initial bad news reports ignored as firmrever s o mean

Finally, bear valuations set in; bandwagonse ng growth stock underperforms in medium term

Stocks

Standard & Poors 500: 90 U.S. stocksup o an a er a . ea ersin their industries and among the largestrms ra e on . . ar e s.

Small stocks: Securities traded on theNYSE with market capitalizations in thebottom 10%.

40

Stocks

S&P 500

January 3, 2012 1,258.86

Au ust 13, 2013 1,691.42

, .

January 3, 1977 107.00

41 42


9/11

Major Stock Classes

Large company growth stocks

Small company growth stocks

Small company value stocks

Mid cap growth stocks Mid cap value stocks

Mid Foreign stocks

Developed

merg ng

43

Small company growth stocks

Growth stock generates substantialand sustainable positive cash flow andwhose revenues and earnings are

expected to increase at a faster ratethan the average company within thesame industry

Small stocks: Securities traded on theNYSE with market capitalizations in thebottom 10%.

44

Wrong ETF

Brazil

Chile

ur ey

United States

South Africa

45

Price Earnings Ratio

Ratio of a stocks price to the companiesearning per share

P0/E1

E1 Earnings per share

average shares

46

Price Earnings Ratio

Ratio of a stocks price to the companiesearning per share

P0 / E1

Conventional wisdom,

Riskier stocks have lower P/E

47 48


10/11

Price Earnings Ratios

Problems with the P/E

arn ngs anagemen

Practice of using flexibility in accountingru es o mprove apparen pro a y o rm

Large amount of discretion in managing

2012 P/E Ratios

10.2

8.5

Integrated oil & gas

Aero spac e/defen se

14.9

14.7

13.2

11.8

.

Industrial metals

Telecom services

Computer systems

Health care plans

17.4

17.2

16.5

15.6

Chemical products

Pharmaceuticals

Home improvement

Electric utilities

21.4

21.1

17.5

17.5

Restaurants

Food products

Ass et man agemen t

App lic atio n so ftw are

34.7

32.4

28.0

25.3

Business software

Heavy constructio n

Trucking

Aut o man ufac tur ers

0 10 20 30 40 50

P/E ratio

Financial Statements

www.sec.gov/edgar.shtml

dripinvesting.org/Tools/Tools

51

Financial Ratios: Can the

CURRENT RATIO is the ratio of current assets tocurrent liabilities.

Current assets

',million in current assets and $5 million in currentliabilities, ou et: Current Ratio = $10 million/ $5 million = 2.0

As a general rule, a current ratio of 1.5 or greater normally sufficient to meet near-term operatingneeds.

Financial Ratios: Can theus ness ay s e s

TheACID TEST (QUICK) RATIO, the ratio of

current assets minus inventory to current liabilities,. Current assets - inventory

Current liabilities

The balance sheet of Joe's Bar and Grill shows thatey ave . m on o e r curren asse s n

hamburger buns that are sitting in inventory. You'


TheACID TEST (QUICK) RATIO,

The balance sheet of Joe's Bar and Grill shows tha.hamburger buns that are sitting in inventory. Younow can fi ure out the com an 's uick ratio:

Quick Ratio = (Current Assets - Inventories)urren a es

= $10 mm - $2.5 mm / $5 mm

54


11/11

Financial Ratios: Can the

WORKING CAPITAL is the amount ofcurrent assets less current liabilities.

Current assets - Current liabilities

55


ACCOUNTS RECEIVABLE TO WORKINGCAPITAL shows the riskiness of thecompany's ability to make current payments.

Accounts receivableor ng cap a

INVENTORY TO WORKING CAPITALstates the riskiness in terms of inventory.

InventoryWorking capital

56

Bottom lineInefficiency markets generate opportunities

Fund mana ers cant ursue because of short-term monitoringIndividuals tend to miss by following the crowd

Fund ManagersShort-term horizon forces index following

n v ua sBehavioral herding causes following of fads

Buy high out of favor sectors, low volatility, low PE

Worse performance over short term possibleBetter performance over medium-long term likely

57 58

8 arata markets

Documents