Comment by nostrademons | Hacker News Reader

Comment by nostrademons | Hacker News Reader

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I worked for a financial software startup from 05-07, and in my spare time there, wrote one of those programs that scans the whole market for stocks with low P/Es and consistent earnings.

I found that nearly everything was fairly valued. When a stock had a low P/E, it was nearly always for a reason, like it being a homebuilder or financial or having a shaky economic position. No way was I going to invest in those. When I did invest in one that looked like it didn't fit in those categories, they missed earnings the next quarter, reported a loss, and haven't gotten back to profitability yet. Again, the market was smarter than me.

The trick to making money in the stock market seems to be to invest when the big boys are constrained not to. They realize that they should be putting money in, but can't, for whatever reason. The best example is if they're a mutual fund and their clients are all pulling their money out. Doesn't matter how many bargains are out there, they still have to sell to honor redemptions.

As I tell one of my hedge-fund-employee friends, "You're only as smart as your dumbest creditor."

An almost risk-free way to money in the stock market is to put most of your money in fixed income while apportioning a small % in long dated options.

Eg. you think Morgan Stanley is dirt cheap at current levels ($10) and you are willing to invest $100,000 in them.

Action 1: You bought $100,000 worth of MS shares at $10 each

Action 2: You bought $90,000 in bonds that yields 11%. You bought $10,000 worth of Jan 2010 MS 5 call options at $7 each.

Scenario 1: MS gets nationalized or goes bankrupt Action 1: You would have lost almost all of your $100,000 investment. Action 2: If you hold out until your bond mature, you'll get back your $100,000 principal after 1 year. Your options is worthless.

Scenario 2: MS goes up to $30 Action 1: Your investment is now worth $300,000 Action 2: You get $100,000 from your bonds and your $7 options is now worth $18. So your investment is worth $125,000.

So Action 1 is very volatile and risky. Your profit range from -100% to 200%.

Action 2 allows you to sleep soundly at night, even during current market conditions. Your profit range from 0% to 25%. Hey not bad at all. In the worst case, you'll have at least preserved your capital.

Assuming both scenarios are equally likely:

   Option 1 Average ROI = 50%
   Option 1 Average ROI = 12.5%

High risk premium. A good time to take risks?.. if you can afford it.

Not for MS.

The probability of MS getting nationalized or going bankrupt is 90%. So it's 0.9 * 0 + 0.1 * 3 = 0.3 = -70%.

Whoops.

Probably not 0 is it?

Scenario 3: The bond issuer defaults because of the sub-prime crisis, and MS is nationalised.

Woopsie daisies.

Haha. Yeah. That's why i inserted the word 'almost' before 'risk-free'

Another constraint on institutional investors is short-term profitability: they need to report annually, to compete for customers; whereas an individual is free to invest for the long-term.

We're in an unusual time period. People (especially the big funds) are right now being driven by incentives other than maximizing expectation, which is creating an oversupply of stock and pushing down prices.

Fear is, for the moment, outweighing greed.

"I found that nearly everything was fairly valued"

Does this still hold in light of the stock market crash this last week?

I haven't run the numbers. I don't work at the financial software startup anymore, so I don't have (easy) access to the data. However, a few spot checks of stocks that were too expensive in 2006 indicated that some were getting very reasonably priced.

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