Dogs, Bulls, and Bears Oh My!

Reminiscences of a Stock Operator

The book Reminiscences of a Stock Operator is written about events that occured approximately hundred years ago, but the lessons still ring true today. Mr. Livingston is the basis of the book and details how he earned a fortune through the stock market. It wasn’t easy at times, as Livingston would say he paid tuition and lost everything he had. I wouldn’t recommend speculating the same way today, some of the manipulation would be impossible, but by reading Reminiscences of a Stock Operator you might be able to avoid paying some tuition.

Livingston got his start as a boy reading the ticker in bucket shops and posting the numbers on the quotation board, where people could speculate before you could just log in into Fidelity and trade. Livingston had an ability to recognize patterns in numbers as they scrolled across. He began to notice what trends indicated the next action on individual stocks would be, and thought he could earn a few dollars with a small line to trade on. Before Livingston began to speculate on his beliefs he started to track his predictions and keep record of his hits and misses. After realizing the potential earnings he could of made Livingston began to trade with real money. He began to accumulate a fortune, the bucket shops didn’t want his business as it was costing them money and eventually Livingston ran out of places to speculate.

This led Livingston to New York to trade on the exchange. In New York, he quickly realized the system perfected in bucket shops wouldn’t work on the exchange. In the bucket shops one can sell at the price on the quotation board in an instant, while in the market you need a buyer to purchase your shares. By the time a broker would process the transaction on the stock market, Livingston would lose the advantage which was his ability to recognize patterns he learned  in the bucket shops. This created the need for Livingston to return to the bucket shops. He headed west to Saint Louis, a location where his reputation was not known, to trade in bucket shops again. While in Saint Louis, Livingston quickly made some money before he was recognized and banned from the bucket shops there.

Livingston highlighted the importance of recognizing the general trends of the market and testing out theories. One of Livingston theories is identify the general direction of the market and place your bets in that direction. When speculating concern isn’t about bull or bear exactly just that your on the right side of the movement. Livingston noted the news often exaggerated the current direction of the market and warning signs of the reversing market are ignored. Livingston determined the market by finding the line of least resistance and following that line. If he bought one thousand shares and the market went up, confirming the bull market he would buy another round of shares and continue as the market increased. Livingston sold before the market reached the pinnacle, which he was able to determine by a decreasing rise in the price between rounds, an indication to start selling. If he bet wrong to begin with and lost Livingston would sell his line, it doesn’t make sense to chase your losses. Livingston made his first million dollars by identifying the general trends of the market and being right. He shorted stocks in a bear market and kept shorting as other investors bet on a rally when general conditions didn’t indicate it was time for a bull market. The financial situation eventually gets so bad that the banks do not have enough cash to loan individuals requesting loans. This limited the public ability to buy securities worsening the bear market, increasing Livingston’s gains. Livingston made a killing during the early years of the exchange and lost it a few times to but left us with a few lessons.

Discipline is also an important characteristic for a trader to have or obtain. It is impossible to be right every time, when one has a proven plan to make money in the market, one sticks to the plan despite occasional losses. Decisions in the market must be based on facts and strategy. Changing your bets on speculation, tips, or favors you owe will cost one money. If you don’t have facts to place your bets in the market or unsure of the direction of the market, you do not need to be active in the market. Livingston also informs the reader that nowhere does history repeat itself more often or uniformly than in the stock market. While no one can predict the exact future, previous trends can help us make an educated guess upon what will happen. One can’t say exactly that you will be a millionaire if you invest five hundred dollars a month in well ran mutual funds and exchange traded funds from college until retirement but it is pretty certain.

The most important lesson from the entire book is “A man may beat a horse race, but no man can beat horse racing”. Now one may be wondering what in the hell does horse racing have to do with the stock market. One may be the most talented evaluator of horses alive and still won’t be able to predict half of the races because of circumstances. A horse got injured during the race, the unknown track conditions favor one horse over the other, the horse could be ill, another horse given performance enhancing drugs, got a bad gate pick etc. the list goes on and on. The stock market is the same way, history provides evidence to try and make educated guesses, but that's all it is, a guess. You may be able to pick the right horse a few times but it is impossible to beat horse racing.

Another lesson Livingston teaches is that as he says every dog will have its day. Now you're probably saying another animal reference, but stick with me. Trade conditions and prospects should cause stocks in a group to react alike. Success should be shared by all yet not to the same degree.  Livingston uses the example of steel companies in the book. If C.D. Steel and X.Y. Steel both go up, it is reasonable to assume even the dog like A.B. Steel will go up to. A dog is referencing BCG matrix of a company with low market share and growth. The subject of the stories may change but the information and lessons remain the same. Think of Livingston the next time you hear one say they beat the stock market and the horse race story.

Mayweather V. McGregor

      No, this article isn't about a physical fight, but does contrast theories between living legends of finance, Josef Lakonishok and Eugene Fama. Josef Lakonishok is a professor of finance at University of Illinois, and is a market behaviorist. Market behaviorist believe the market isn't rational. Behaviorist argue that if people were rational the dot-com bubble wouldn't of occurred, as astronomical price to a variety of measures were being paid. Fama believes in the Efficient Market Hypothesis which relies on the assumption investors are rational. Both finance professors have put there money where there mouth is so to say by creating and managing funds. Lakonishok fund is LSV Asset Management with 8 billion under management while Fama has DFA with 34 billion under management. Both sides outdo the market but LSV outperforms DFA in small and large cap funds over both 3 and 5 year periods. Both though believe in value stocks as good long term investments. LSV picks stocks by old fashioned value ratios and ruling out stocks that have been public for less than two years or lack momentum and headed towards bankruptcy.  DFA builds its portfolios by categories such as international and micro-cap, along with ruling out stocks that could be in line for a takeover. They often own similar stocks albeit for different reasons. 

      The LSV Value Equity Fund trades under the ticker LSVEX. Its investment approach is deep value orientated, risk controlled, and qualitative. The majority of the portfolio is constructed of large and mid cap stocks in the United States. The fund typically has low price to earnings ratio compared to that of the market. The fund has a minimum holdings of 75 and an expense ratio of 0.66%. The five year average annual return is 11.91% compared to 10.34% of the Russell 1000 Value index. When comparing LSVEX to SPY the average return from March 2009 to September 2018 is 22.14% and 21.66% respectively.LSVEX beat the market, although slightly, an accomplishment for almost 10 year period. LSVEX has a higher monthly standard deviation of 4.27 compared to SPY's 3.62. SPY also outpaces LSVEX in Sharpe ratio due to having a lower standard deviation. SPY Sharpe ratio which is excess return for risk taken is .003988 compared to LSVEX of .00345498.  LSVEX is able to create a positive alpha of 0.374, signifying an excess return. LSVEX has a beta of .88 since 2009. 

      I would advise investing in LSVEX it has outperformed the market, and provides stable returns through seeking out value stocks similar to what made Warren Buffet famous. I am a believer in the market behaviorists theories. LSVEX also provides alpha over an extended period. Fama and Effiecent Market Hypothesis is sound if the assumptions are true, and still provide good returns when investing in index funds. The Efficient Market Hypothesis relies on the assumption that people are rational, and I've met people and know that there are many exceptions. I'm sure you would agree. 

The Three Factor Model

    When deciding where to place you investments you will always hear buzzwords like diversification and return, but important factors like your or goal for the investment play a big role too. If you are a recent college graduate with 30 years before you will want to retire you will take  a long term approach compared to someone in there upper 50's looking to retire soon. Small Cap stocks offer a greater return on investment than mid and large cap stocks as they have more room to grow but also more risk. Small cap stocks are more volatile but over a 30 year period you experience several market cycles and timing of the market isn't as important. An index fund can diversify this risk while still providing higher return than the market.        

Vanguard Small Cap ETF trades under the ticker VB. Vanguard Small Cap ETF seeks to mimics the investment returns of a small cap index, CSRP U.S. Small Cap index. This diversifies the investment in growth and value. The fund remains fully invested and with low expense to minimize tracking error. VB offers 10 year average annual return of 12.27% with 9.81% return since inception. The top three holdings are WellCare Health Plans, GrubHub, and Veeva Systems with its top ten holdings accounting for less than 3.5% of total investment. The fund has a median market cap of 4.5 billion with a Price to Equity ratio of 19.7. VB has a turnover rate of 14.5% at year end of 2017.

Vanguard Small Cap ETF offers slightly higher average returns than SPY but has a much larger deviation. VB average monthly returns since 2009 is 1.63% compared to 1.44% for SPY, annually the return would be 19.56% and 17.28% respectively. SPY on the other hand has less deviation with a monthly standard deviation of 3.63% compared to that of 4.73% for VB. Vanguard ETF offers slightly higher return than the market as a whole, but has higher fluctuations, which is acceptable for long term investing.  As stated in previous articles the Sharpe Ratio calculates the excess return for the risk taken, since VB has significantly more deviation and therefor risk its Sharpe Ratio is .0034 compared to .0039 for SPY despite better return for VG.

The Capital Asset Pricing Model (CAPM) was developed to calculate whether an investment provides abnormal returns and redefined beating the market. If a fund manager invests in a stock twice as risky as the market and provides returns of only 1.5 times of the market, yeas he provided higher returns than the market but actually has negative abnormal returns and lost to the market as he should have twice the returns for twice the risk. Beta is the measure of systematic risk and cannot be avoided by diversification. Fama and French later published a paper "Beta is Dead" that showed a better model was needed. The model they constructed was the Three Factor Model that uses three factors hence the name. The market factor, the small stock effect, and value stock effect can all be used in the equation to better calculate Alpha, the abnormal return. When running the individual regression for each factor for VB the beta for market is 1.20, SMB is 1.16, and HML is .61 all with significant t-stats above 1.96. When running the regression for all three  together the betas were 1.067, 0.604, and .086 respectively all significant. The average alpha for VD since 2009 until present using the individual regression for the three factor model is -0.35 and with using a regression for all three factors at once an alpha of -.05 which is not economically significant. This return slightly lower than the market can be explained by the management fee Vanguard charges. I recommend that an investor holds both Vanguard Small Cap ETF and SPY. Both offer returns that are close to the market but not abnormal unfortunately, and have insignificant differences between there alphas and Sharpe ratio.

Goldman Sachs or Blackstone

         The Goldman Sachs Group is a global investment bank, that provides financial services to clients such as corporations, individuals, government entities, and financial institutions. Goldman Sachs is headquartered in Manhattan and was founded in 1869. Former Goldman Sachs employees have held important positions in governments across the world such as United States Secretary of the Treasury, President of the European Central Bank, Governor of the Bank of Canada and Bank of England, the World Bank, and other large financial institutions. Two employees of Goldman Sachs was able to convince the bank to take a short position during the subprime crisis, profiting 4 billion by the collapse of the housing market. In September of 2008 Goldman Sachs agreed to be a traditional bank holding company which made it eligible to receive funds from 10 billion from the U.S. Treasury as an investment under the Troubled Asset Relief Program or TARP. In 2009 the investment was repaid to the U.S. Treasury at 23% interest.  Investment banking accounts for approximately 21% of current revenue, Goldman Sachs is one of the largest merger and acquisition firms, known for avoiding hostile takeovers. The largest sector of Goldman Sachs is Institutional Client Services which account for 37% of revenue. The Blackstone Group is a multinational private equity firm,  the largest alternative asset management firm, and provides financial services. Alternative assets include tangible assets such as wine, art, and coins. Blackstone was founded by two former employees of Lehman Brothers in 1985. In 2007 BX went public with an IPO value of 4 billion. Blackstone has four business units; private equity with over 100 billion assets under management, real estate which is the largest private equity firm in the world with 115 billion assets under management, Hedge fund Solutions, and  Credit where it leverages alternative asset management.

Goldman Sachs trades under the ticker GS and Blackstone under BX. Goldman Sachs has an average monthly return of 1.29% which is 15.5% annual compared to Blackstone's 1.94% and 23.3%  respectively. The standard deviation of the of Blackstone 0.0655 is slightly higher than Goldman Sachs at 0.0623. Blackstone appears as the superior investment based on these two factors. To estimate beta of the two stocks we will use SPY, an exchange traded index fund that mimics the S&P 500. As expected based on standard deviation Blackstone has a slightly higher beta at 1.43 compared to Goldman Sachs 1.30. When constructing a portfolio you can mix GS and BX to achieve a beta of 1.5, riskier than the market. In order to achieve this portfolio you would need to short Blackstone 121% of your investment in capital in order to allocate 221% in Goldman Sachs. The theory works but due to having to have capital to cover margin it is not feasible due to  accomplish. This portfolio would provide a return of 0.5% a month, 6% annually, less than SPY, GS, and BX. To construct a portfolio to get a return of 0.9% monthly, you will need to short 61% of your investment in Blackstone and use the proceeds to allocate 161% of your portfolio in Goldman Sachs with a beta of 1.4.

When using the CAPM model to build a portfolio the model assumes a one period world where investors only plan one period ahead. Using this model we can calculate the abnormal returns of two money managers by calculating beta by rolling regression. The alpha is calculated by taking the realized return minus the required return. The average alpha for Goldman Sachs is -.0128 meaning its return is less than the required for the beta or risk. The average alpha for Blackstone .0057 indicating abnormal returns above required. The Sharpe ratio which also indicates excess return for risk taken shows Blackstone as a better investment than Goldman Sachs as the ratios are .296 and .207 respectively. Treynor's measure calculates excess return using beta instead of standard deviation but comes to the same conclusion of .099 for GS and .0169 for BX. The information ratio is used by dividing the average alpha by the standard deviation of alpha. The information ratio also indicates Blackstone with a ratio of .175 and Goldman Sachs ratio of -.317. Based off of the above analysis I recommend Blackstone Group over Goldman Sachs as they offer a greater excess return in all ratios analyzed.