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You guessed it, it is prediction time! Along with the new year, the pundits will come out and make confident, bold predictions about the year to come. They’ll hardly ever revisit last year’s forecast and how wrong it was, but no matter, they will confidently predict this year’s path anyway. Of course, this annual exercise tends to hit the press in January and January is the month that supposedly predicts the stock market for the rest of the year. (Recaps of this topic here and here.) I’m going to pre-empt the February 1st or 2nd headlines right now.

For 2011, the January Barometer was wrong, again. January 2011 was an up month and the rest of the year was down, albeit slightly. That makes the miss three-in a row, 50% on the last decade and only 64% since 1926. No doubt pundits that will choose a time period with more favorable statistics which to cite as evidence (you get 69% by choosing just 1940 onward).

Let’s play a game, shall we? Please post in the comments links to any January Barometer articles you find, so we can chuckle at their ignorance of statistics and logic. I expect them to start appearing in early February.

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And here are the TWO instances of nonsense I’ve already seen:

In this article from CNBC.com, we learn that “Since 1945, a positive January in an election year has never missed in predicting a full-year gain for the Standard & Poor’s 500, going 8-for-8″. Wow, a whole 8 data points, conveniently ignoring pre-1945 data (why?) 8 data points is not statistically significant for, well, anything. But go ahead and peruse the article anyway, it’s laughable. It includes gems like “Whatever the S&P 500 doesn’t provide in absolute return this year, it will likely make up for in predictability”. What the heck does that even mean? I’m floored.

And then we have this little interview on the otherwise good ‘Breakout’ on Yahoo!Finance. At about 2:10 into the interview, the guest disclaims “even with a few errors”, the January Barometer is still “pretty good”. Uh huh.

Please use the comments to share other incidences of magical thinking.

Hedge funds seem to make all the headlines. Rarely do we hear about plain old mutual funds much anymore. ETFs, derivatives and hedge funds are the investments du jour (or perhaps, “du la decennie” or “of the decade”?) There is a tremendous misunderstanding of what “hedge funds” are, how they invest and what to expect from them. The category is as broad and diverse as the “mutual fund” category is.

Regardless, the first step before putting your money anywhere is to understand how likely it is to be subject to fraud or manipulation. In this department, hedge funds do not shine. A recent paper concludes that many hedge funds “intentionally mismark their stock positions.” You see, any fund must report its value to investors periodically. Whether that be monthly or quarterly, all the funds holdings must be valued and summed on a certain date to arrive at the fund’s value. The change in value from period to period is, obviously, the funds performance. The paper’s authors used SEC filings to determine if those positions were being valued properly. They compared each fund reported their holdings value as with public databases of prices.

Say a fund owns stock of Apple and report to the SEC that as of a certain date (usually quarter end), the fund owns 100,000 shares worth $35,157,000. The author’s compared this value of $351.57 per share with the “official” databases used to price securities by investors everywhere. What they found were striking differences between what the funds reported and the values used by everyone else.

Now, there are several reasons why this could be: a stock could be thinly traded. Advisors are legally allowed to used various methods in determining a price when none is readily available or reasonably accurate. So the authors examined only highly liquid, publically traded investments where pricing is well established (you can’t really argue what the final price for a share of AAPL, IBM or XOM is on a certain date).

What the authors found, was that about 7% of the 2.3million positions examined over a decade showed valuation deviations. Consistent with the assumption of intentional manipulation are the following:

• Even highly liquid positions were regularly mispriced
• Price discrepancies were more likely to show a reporting of returns slightly above zero more often than slightly below zero
• Discrepancies went in the direction of return-smoothing (the great attraction of hedge funds is that their returns are more consistent, which is desirably interpretted as returns with less risk)
• Those funds with significant discrepancies were also those more likely to report smooth returns.
• Those funds with lower probability of getting caught (offshore funds and lesser frequency of audits) showed higher discrepancies.

All in all, the data is consistent with what you would expect if the advisors are being less than forthright. As the paper concludes, “our analysis showed that advisors mismark their stock positions in a way that is consistent with a pursuit of their own interests.”

Since the pricing differential is relatively small when measured accross all fund assets (0.22%), that means that the mispricing is probably eggregious at many funds while others are completely innocent of such an offense. The author’s data could be very valuable in identifying manipulators. More importantly, this should be a warning to investors (though no one seems to ever listen to warnings, they just blame others for their misfortune when no one caught it beforehand). Madoff was obviously a fraud, yet no one cared. There were several highly regarded, supposedly sophisticated, institutions which were feeding Madoff. There were plenty of other supposedly sophisticated institutions which couldn’t identify the risks in time. If the experts can’t do proper due diligence, should you trust their advice? Is your advisor able to do proper due diligence? My advice is to be far more wary than trusting when it comes to non-standard investments (things not traded on exchanges).

Link to the paper

Exhibit A: The Range (S&P500 index)

As the nice guidelines point out, the market was “stuck in a range”. Nothing particularly special about this, investors are simply waffling, waiting for more data to see where the world is headed. TA looks for ”breakouts” from the range.

Exhibit B: The Breakout

When the line of “support” is broken, it is considered a “breakout”. A “downside breakout” to be more precise. This supposedly indicates the market is breaking down, sell now and protect capital. Once support around 1220 on the S&P was “broken”, chart watchers issued orders to head for the lifeboats.

And it worked! For a few days. It does appear that a lot of selling was triggered which actually helped push the market lower into the first few days of October. A bit self-fullfilling, don’t you think? But it didn’t last long.

Exhibit C: The Bear Trap

The market promptly reversed and climbed instead- almost in a sprint- right back to the top of the range. Were the chart readers wrong? Of course not! The sell signal was quickly labeled a “Bear Trap” in hindsight that only the amateurs stepped in. Sort of like when the fortune teller asks if one of your parents was “sick”? Well, yeah, Dad died from cancer/heart disease/old age. Fortune teller: you must be careful because you will inherit many of your father’s genes/traits. You: I was adopted. Fortune teller: I meant your biological father [then changing the subject] I see someone whose name starts with ’M'…

So the market rallied. Up 10%, in fact, between the sell signal and the top of the range. When the S&P “broke out” of the range on the upside, they yelled “buy”. This rally has promptly faded to back below the line. I saw at least one “sell” get issued today.

TA fans like to say this is art as much as science. I like to say that drawing lines on top of other lines is art- the kind you find in coloring books. To be fair, if enough people listen to the same witch doctor, there *might* be some small effect. Certainly not an effect repeatable and believable enough for me to put any capital behind- Except to know that when a major threshhold is broken, causing TA to issue a sell for example, AND valuations are high AND fundamentals are bad, the TA trend may help reinforce what ought to happen anyway (“may help” because it might not- just like in this case). That wave of selling by the witch doctor congregation is certainly not going to help anything. This says nothing for the other 85+% of the time and its only a reinforcement, not a cause in and of itself.

One more thing is clear from the way TA works, illustrated perfectly above: did you notice that TA buys after the price rises and sells after the price falls. Isn’t the object of investing to buy low and sell high? Seems backwards to me.

The WSJ had an interesting article about Chinese (and Russian) “economic espionage”. Let me share a few passages from that piece, as they speak for themselves (emphasis is mine except for the article headline):

“China Singled Out for Cyberspying: U.S. Intelligence Report Labels Chinese ‘Most Active’ in  Economic Espionage; Russia Also Named
The U.S. government accused the Chinese of being the world’s “most active and  persistent” perpetrators of economic spying”

…

” ‘The nations of China and Russia, through their intelligence services and  through their corporations, are attacking our research and development,’ said  U.S. counterespionage chief Robert Bryant.”

…

“The U.S. is a prime target of economic espionage by countries like China and  Russia that seek to build up their domestic industries with stolen technology  and intellectual property from more advanced U.S. firms, officials say.”

…

Thursday’s report was unusual because it called out China and Russia by name  as the top perpetrators of economic espionage, which is something U.S. officials  have been reluctant to do for fear of harming diplomatic relations.

“When you hide these things, nobody does anything about them,”

…

Economic espionage is condoned by both China and Russia and is part of each  country’s national economic development policy, the official said. The Chinese government is believed to have been behind a number of recent  high-profile cyber attacks, including multiple hacks of Google Inc. and the EMC  Corp.’s RSA unit

The U.S. intelligence agencies do not steal industrial secrets for our businesses. To me, this is still more evidence that the trade relationship with China is anything but “free” trade on a level playing field. What say you?

(*I try to credit any sources for things posted here; many things, like this, are sourced from friends via email or Facebook and no source is available. That is unfortunate, but not much we can do about it.)

After a day marked by a brawl among Italian lawmakers, debating cutbacks in the country’s pension system, Italian Prime Minister Silvia Berlusconi took time out from the Brussels summit to call into a popular television show shortly after midnight, criticizing the European Central Bank and dismissing reports he plans to call for early elections.

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And in another, even sadder, sign of the times, Hallmark has ID theft cards too:

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