1/21 newsletter

Samuel brain MRI shows that he suffered a stroke during pregnancy. Please pray for him that he will be able to grow out of it. He has shown a lot of progress in the past few weeks.

*** Market
SP500 retreated 1.5% this week. Dow losed all the gain in 2006. However, the mid/small cap seems quite rescilient to the bear. Technically the selloff has been anticipated. Economically, oil price is testing $70 high again amid tension with Iran. It is a short squeeze on oil bear and a good chance for selloff on the stock side. Some fear that persistently high oil price will eventually slow down the global economy.

My portfolio mirrors the mid-cap, resisting to fall. it is now almost 2% ahead of SP500 for January. Doing quite well. I want to mention DNB. This was a longtime Wall Street star, which spinned off Moody's and Cognizant. Last year, it was basically flat to a point I thought it has losed its growth steam. But it finally broke the $65 barrier in 2006 and roared into $70's. Blackrock (BLK), the premier asset management firm, is also doing very well. The diversification to international stocks seem to work well too. The rationale for international stocks is that when dollar begins to fall, you will gain from currency translation on top of superior growth of the emerging markets.

However, the medical instrument firms are not doing good, despite general belief that the industry will be benefited by demographic trend. COO was stopped out, PDCO slipped 40% from its high. BCR is flat (Amy's Zimmer is also down).

*** Comment
Inspired by hedge fund strategies, I began to look into portfolio correlation and optimization. One reason to study correlation is that the 2000 crash seems to be caused by a group of highly correlated stocks. A highly correlated portfolio is not as diversified as you would like it to be. The algorithm indeed reveals the picture of correlation to a certain degree. From 1996-2000, the portfolio correlation was getting higher and higher. And after 2002, portfolio correlation was reduced to a reasonable degree.

I have not quite figured out how to optimize portfolio automatically. But it seems possible manually. It has been shown possible to have two 100% anti-correlated stocks in a growth portfolio. This portfolio has least volatility and maximum Sharpe ratio. Last week I sold SHFL and bought AET thinking I should get some healthcare stocks. It turns out AET is almost 0% correlated to my current portfolio. It then is a good choice for portfolio optimization... Ideally if you can get a group of non- or anti- correlated stocks, your portfolio will be extremely bear-proof. Maybe I can find such combination! Am I dreaming?

Steve

1/14 newsletter

The layoff has finished here. It was done quite cleanly. It was completed before I noticed it in our group. Now the task as an investor/insider is to find out whether the management has done the right cut or not. It seems to me they have done the right thing. Older, therefore more expensive and less productive, employees (>49) were bridged to let go. I heard the package is quite generous. Several younger employees were let go due to the intent to offshore their jobs. They also seem to be less skilled developers.

*** Market
The market is full of optimism because Dow touched 11000, a phsychological level marked the peak of dot com bubble (11500). Even my coworker mentioned it during the lunch. This is a bad sign from contrarian's point of view, that when a street person who is barely in the market, suddenly pays attention, it is an indication of overheated market. We will see if the market can manage to get that heat off a little bit.

My portfolio has done nicely, reaching +23% compared to SP500's 10.3% since 12/2004. The underlying market is still healthy. Companies are handful of (repatriated) cash. We will see what they do with it and maybe give some action in the large-cap sector in 2006.

*** Comment
I want to touch on a tricky issue of value investing with MRK as example. Although MRK was full of bad news in 2005, did you notice that it closed at the same price as beginning of the year? That means it performed in par with Dow in 2005. You would've thought it should close somewhere in the negative territory. How come? This is because the value investors have fully discounted the negative impact of everything you know (Vioxx, pipelines) in the 4th quarter of 2004 when it dropped 40-50%. Therefore, when the bad news actually hit the media in 2005, the public bailed out, the value investors bought in. And they made sure the price they bought was so low ($25-$30) that it could even sustain a small amount of capital gain. And comparing it to other Dow/SP500 companies in 2005, it actually did quite well... Strange, Hummm!

--Steve



--Steve

1/8 newsletter

*** Market
General market has been doing very well in the first week of 2006. Major indexes rose more than 3% to another new high, continuing its bull march, with international funds advancing most. The reason? FED is loosening up its language of further rate increase in light of a potential inversion of yield curve. This cap of short-term rate gave bulls new weapon to march on (although not all stocks participated in it). Enjoy the wonderful January effect.

IBM will terminate its defined pension plan in 2008. I guess Merck and other blue chips will follow very soon... One reason that I joined Merck is diminished, too bad. Henry told me this is because of the new accounting rule on pension and stock option. These items historically are off-balance sheet, and now they are required to show up in balance sheet. These areas have been abused by many companies and severely criticized by sensible investors. I think in the future labor market, the employee compensation will be "mark-to-the-market" and compared dollar-to-dollar. Therefore, this is one step further in Greenspan's vision of creating a "very flexible" labor market (Does it sound aweful?). He thinks this is critical to the competitive advantage of this captial economy. The economic structure, in his view, should allow employer to allocate (meaning add and remove) labor dynamically just as the capitalist adjusts positions among different stocks. You can not create a liquid market unless you can compare apple-to-apple (labor) on a mark-to-market basis. Once all the perks are removed, labor will be transferred "easily" between companies ( from employer's point of view first, please).

There has been a debate on the future of dollars if you are a Buffett fan. Buffett and major bankers have bet dollars downfall, but dollar strengthened 14% in 2005. (You need to substract this amount when looking at international funds) They still believe dollar will fall once rate stops increasing because of the extremely weak fiscal discipline of the Administration. We will see if this indeed happens in 2006... (It will affect on how hot money is allocated across the border.)

Steve

1/1 newsletter

*** Market
The year of 2005 has closed with a weak note. In a broader scope, DJIA closes with +0% while SP500 at +5% range. If you are candlestick chartist, DJIA's cross shape close for the year will send you strong alarm that the market is "in doubt". Why is the last week so weak? My view is that on Tuesday, 10-year Treasury yield touched FED discount rate briefly. This signals the so-called inverted yield curve, which historically is a prelude of recession. Although FED has been comforting Wall street this time it will be different, it remains questionable how things will develop. Will long bond drop to give way? Or discount rate has to drop? Or economy can still find its way without the arbitrage opportunity in yield curve? Your answer is as good as everybody else (since this time it will be different).

*** Portfolio
My portfolio returns 18% since 12/2004, which is about +15% YTD. I counted the yield of top Lipper funds, it beats 94% of them. Not bad... From factor model, this coincides with mid-cap sector. (However, both large-cap and small-cap both performed under par) Value did not show advantage over growth. But most outperforming funds have claims on the value camps. Other funds are international funds (which is corelated with mid-cap). Emerging market is very strong as well as everything related to oil. Korea, India, Latin America stood out. Japan also had a late rally toward its 2000 high.

*** Comment
Energy is a widely known story. Your prediction is as good as mine. You also need to understand that in many emerging countries, PetroXYZ is often the large, heavily weighted stock in their indexes, while in SP500, it is only a small sector (10% and has negative correlation to other sectors). Therefore, it is not surprising that these countries are doing very well when oil industry is profitable.

The other factor is that US is pushing to widen the free-trade zone. Flow of globalization is benefiting these emerging markets once again -- until the next currency crisis? Emerging market is historically high return but high volatility. It is not an easy game to play. Particularly you can only buy indexes. It is hard to buy stocks in these countries. As I said, many of these indexes are dominated by a few stocks. You are basically buying these stocks whether you like them or not. I have allocated a few stocks in these areas. We will see how it goes.

The number posted by these markets are mind-boggling. +50% to +100% a year. However, the fact that you do not see these numbers in top Lipper funds tells you something. Either these rating agencies are cheating you. Or those numbers are hard to get. If you check into where these numbers are coming from. It kind of gives you a clue.

These numbers are coming from two sources. One, sector funds or country funds. Two, leveraged play of sector funds. In the first catagory, the firm (such as Morgan Stanley, Fidelity) has a fund for everything you can imagine. And the hot ones will always stand out (right?) in any sorted list you see on the newspaper/website as if they got something right... In the second catagory, the best example is a small firm called ProFund. It has funds in every sector you want to play. And each fund has a basic version and a leveraged version (2x, called ultra-somthing). Therefore, in any sorted listing you see, if the basic fund performs in par, the ultra ones will definitely stand out (since it is ~100% outperforming other funds). Quite tricky, Hum?

I have been reading a lot of material about hedge funds. One concept in hedge fund is particularly useful in these plays. Sharpe Ratio, it measures the return per unit risk. If a fund is leveraged, the SR is the same or worse than the basic one. If a fund is very volatile, its SR is small even its one-year can be very large. It is a good concept, telling you how much risk you are taking in persuing the return. But whether you want to take heed of these numbers (or the firm/newspaper/website is telling you the numbers), that is still your homework...

Steve