self-directed investors

More On Internet Stock Manipulations; SEC v. Lebed (2000), revisited

Capital Markets, Investors, Issuers, Law , , ,


I was reminded recently of the story of Jonathan Lebed, a 14 year old kid from New Jersey who was investigated by the SEC for stock manipulation using the internet back in 2000.  This case was a big deal at the time, garnishing a segment on 60 Minutes and some interesting discussions in the financial and legal press.

Even though he was underage, with the help of his parents, Lebed had managed to open an account at one or two of the discount brokerage firms. He was apparently trading his accounts in low price stocks when the SEC came knocking on his parents’ door. 

It seems that in the course of trading Lebed liked to post positive comments about what he was buying on various websites, bulletin boards and chat rooms where people who might be interested in purchasing these stocks would see them.  This was in 2000 when the chat rooms were not sophisticated and the web reached a fraction of the people it reaches today. 

Lebed would buy a low priced stock and then say something nice about the company in a message that he posted in a chat room. Using multiple e-mail addresses he might get that same, positive message posted in 200 chat rooms.  Some of the people who saw his posts would re-post them again. 

Lebed knew that his simple postings would create significant interest in these shares and that the price would move up.  He commented that posting the messages with key words in all capital letters would actually get even better responses. 

Bringing a lot of attention to a more obscure, low priced stock can, indeed, lift the price. The SEC called it an intentional market manipulation.  Lebed said that he was only doing what the research analysts at the big firms did, publish their opinions about companies whose share price they wanted to go up. 

Lebed did all this out in the open. Several of his classmates and school teachers followed his leads and invested with him. They were willing to take a chance of doubling their money if the share price of one of these companies went from $.30 to $.60. 

Many of these investing neophytes did understand the positive effect that Lebed’s postings and his quasi investor relations campaigns had on these stocks.  They wanted to buy before he posted and get out as the buyers reacting to his posts pushed up the price.  

Lebed was not the only person or group at that time that was using the internet to enhance the price of shares of small public companies.  But he demonstrated that in the year 2000 the power of the internet to sell investments directly to investors was underrated.  In the almost 20 years since, the use of the internet to sell almost anything, including investments, has become much more powerful and pervasive. 

In the regulated financial markets the dissemination of information is encouraged, but it is also controlled.  Regulations require that information be accurate and complete. Public companies are required to report specific information about their business, to present that information in a specific manner and to release that information on a regulated schedule. 

For a licensed stock broker or investment advisor every e-mail, tweet, posting, comment and utterance about any investment is subject to the scrutiny of his/her employer and by regulators. The SEC depends on the market professionals and market participants to play by the rules. There are significant penalties for non-compliance. 

But Lebed was not a market professional. He was an outlier. He was an independent investor, not a licensed participant in the marketplace.  In the end the SEC let Lebed keep most of the money that he made from his trading as long as he promised to stop.  

At the time, no one really questioned the SEC’s jurisdiction over Lebed or what he was doing. Lebed was a US citizen, operating out of New Jersey. His posts were about US companies whose shares traded in the US markets. Many of his posts were made through a US based internet company (Yahoo Finance). 

In the ensuing 20 years, social media and on line platforms, publications and unregulated “experts” have demonstrated that they can easily sell investments directly on line to millions of investors.  Moreover they have demonstrated that they can disseminate information about public companies and new issues without regard to the truth of the information.  And they can do so without regard for regulations or national borders.

In the “direct to investors” investment world, social media “followers” has replaced “assets under management” as a measure of how many investors’ dollars a person can bring to an investment or new offering.  And you can buy people who have a lot of followers.

If I wanted to hype a stock, either a new issue or one that is already trading, I can make a financial arrangement with any number of independent “experts” who have a lot of social media “followers”.  Some may write articles for financial publications, some write books and blogs and many can be found going from conference to conference and podcast to podcast. 

Any financial “expert” can purchase the right to give the keynote speech at a conference and purchase any number of other speaking slots and sponsorships as well.   Anyone can buy interviews on financial websites, blogs and podcasts or pay for the right to create and distribute positive content on these sites.   

If you look at the numbers you can get an idea of how this works.  I can hire a financial “expert” to tout any stock that I wish. The “expert” will send his/her followers a series of e-mails, appear at a series of conferences and write a series of articles about that company. An expert with 1 million followers might reach 2 million other investors who see re-prints and references to it.

If only 10,000 investors of those followers invest an average of $1000 a new issuer can raise $10,000,000. That much new money coming into a thin trading market can often raise the trading price of the shares of a smaller company.  

There is no limit to the number of experts I can hire or the size of the e-mail lists I purchase for their use to augment their own list of followers.  If I hire multiple experts to hype the same stock, other experts who have not been paid may mention the company independently.  And before you say that this type of scheme using paid experts to hype the stock may be questionable under US law, who said that US law applied?   

If you solicit investors in the US for a new issue the offering is subject to US law.  That would require full and fair disclosure to investors in the US and provide for government penalties for non-disclosure.  But what if you donot make the necessary disclosures and you only solicit investors in other countries? 

The capital markets are regulated country to country.  Each country has its own rules which apply to financial transactions involving its citizens and issuers.  Each has rules governing transactions executed on the exchanges domiciled in their country. The laws of the country where the issuer is domiciled, the exchange is located and where the investors reside may all apply to a single transaction.  An overriding question with the direct to investor market is which country has jurisdiction and over what actions and activities.

If an article about a company’s share price or prospects from a European website gets republished or re-distributed in the US is the author subject to US law? What if the author knew the information in the article was false; do US investors have any recourse?  Does it matter if the author got a royalty for the re-print?

Would the answer be different if the false information originated with just one shareholder who bought a large block of shares cheap and now wants to pump up the price?  Does it matter if that person is in a country other than where the shares trade or the articles originate? 

I recall that when the Lebed case was discussed a lot of people thought that the internet would change and globalize the capital markets. It clearly has.  

I think that there is still a lot of discussion that needs to be had and a lot of questions that need to be asked and answered.  In the meantime, it should be obvious that the current international regulatory scheme does not overlap as well as it could.   

The current and expanding global reach of social media create opportunities and but also highlights problems.  The flow of capital and information continue to globalize. At the same time I am certain that it would is a lot easier today for a 14 year old to manage a single successful, global stock manipulation.    

The Purely Passive Permanent Portfolio

Capital Markets, Economics, Investors ,

My nephew recently asked me to recommend a good book on investing for someone who was just starting to make contributions to his retirement plan.  Somewhat reflexively, I recommended Prof. Malkiel’s “A Random Walk Down Wall Street” as a good place to start.

I first read “Random Walk” in the 1980s and it was an eye-opener for me at the time. I was and continue to be a dyed in the wool Graham and Dodd fundamentalist. I had met and followed quite a few research analysts when I worked on Wall Street. Their opinions were coveted by institutional investors. The brokerage firms were justifiably proud if one of their analysts was named to the annual “All-American” institutional research team.

The random walk theory was not original to Prof. Malkiel. He popularized it in layman’s terms. He used a coin flip to create a trading pattern for a fictional stock and then attempted to have an analyst apply technical analysis to the resulting chart.  When the technician told him to buy the fictional stock he concluded that analysts could not accurately predict the future price of a stock, so why bother?

In Malkiel’s view, simple asset allocation with periodic rebalancing will outperform the overall stock market. The standard allocation, 60% stocks and 40% bonds will never increase as much in a bull market as stocks alone, but the bonds will buffer loses in a bad market.  Many people believe that this type of allocation is fine for investors over the long term.

Asset allocation requires the construction of a portfolio with non-correlated assets. The stock portion of the portfolio must be selected carefully or the entire purpose of the allocation will be defeated.  Prof. Malkiel currently shills for one of the large robo-advisors that does not perform asset allocation very well.

Correlation is a tricky concept. The idea is to purchase investments that are affected differently by shifts in macro-economic conditions.  A truly diverse stock portfolio should have stocks from at least 15 non-correlated sectors.  You cannot create a truly diverse portfolio by investing in large cap, small cap and emerging market funds or ETFs. The stocks in these funds are correlated to each other in too many ways.  Capitalization does not define a sector for allocation purposes.

If you buy an index fund or ETF such as the Standard and Poor’s 500 you get the average market return in good years and in bad years. If the market happens decline for the 3 years just before you need your money, such as the 3 years before you retire, your portfolio may be worth the same as it was worth ten years earlier. You may have earned nothing during the last 10 years that you were working.  That is ten years in which you could have easily doubled your portfolio’s value if you were 100% invested in income producing investments.

Many people want a portfolio that will give them “higher than average market returns with lower than average market risks.”  It clearly is something that can be accomplished but it takes work to get there.

You can beat any index or sector fund by identifying the “dogs” that are in it. Some of the stocks in an S&P 500 fund are not expected to do all that well in the next 12-24 months. Certainly if you constructed a portfolio of the 250 stocks most likely to do well and leave out the dogs, you should beat that index every year.

Eliminating the dogs requires analysis. Fundamental analysis works and is still the primary way in which most professional investors make their investment decisions.

The “problem” is that a lot of people do not think that anyone can actually analyze individual stocks and pick the winners over the losers. That, of course, is not true.

There are a great many securities analysts and portfolio managers out there who are more than competent. The problem is that the best investment advisors are mixed in with a lot of advisors who are more adept at sales than analysis.

Rather than take the time and put in the effort to understand investing well enough to choose a good advisor, people have fallen back on the idea that they can buy a few index ETFs, rebalance periodically and all will be well. That is the investment philosophy behind robo-advisors. It is an investment philosophy I call “cheap and stupid.”

This brings us to Harry Browne.  Browne developed what he called the “permanent portfolio” back in the early 1970s.  He introduced it to the world in a well received 1987 book called “Why the Best-Laid Investment Plans Usually Go Wrong”.

I came across this book when I started teaching Law and Economics in the early 1990s.  Much of the literature around Law and Economics at the time came out of the University of Chicago and had a very libertarian bias.  Browne was a Libertarian and later became the Libertarian Party candidate for President.

Browne’s book described the virtues of a diversified portfolio whose composition would stay constant year in and year out — permanent, in other words, except for annual rebalancing. Browne’s idea of diversification into non-correlated assets was different from what you might think and very different from the diversified portfolio that you will get with any robo-advisor.

Browne’s portfolio divided your funds into only four asset classes. The portfolio was equally divided between aggressive growth stocks, which do well in times of prosperity; gold which does well in times of inflation; long-term Treasury bonds which increase in price during times of deflation and Treasury bills which do well in times of tight money/recession.

Browne was a “gold bug”. He recommended that you hold the gold portion of the portfolio in bullion or gold coins. This was fairly common advice at the time.

At the time the book came out, Browne reported that the portfolio had produced an annual return equal to 12% over the preceding 17 years. Much of that return was due to the doubling and re-doubling of the price of gold. Gold was still pegged at $35 per ounce when the portfolio began.  The latter half of the 1970s was a period of high inflation which helped the price of gold to move up.

Browne’s permanent portfolio continued to do quite well in its original form until his death in 2006. A number of books and articles have been written about it and several people have modified it with funds and ETFs.

There is a mutual fund called the Permanent Portfolio fund (NYSE: PRPFX) which uses a modified permanent portfolio including real estate and Swiss Francs. The fund holds about $3 billion in assets. If you are really determined to be a passive investor and appreciate that those robo-advisors are a scam you might take a look at this fund.  You will discover that it has done quite well since 2006, when Browne died, until the present.

As always, I do not know anyone at this fund and no one has offered to compensate me in any way for recommending it.

Browne’s permanent portfolio has apparently produced positive results continually since 1970 through the present. It can do so because growth and recession, inflation and deflation are opposites and assets that perform well in each cycle are non-correlated by definition.

Will Browne’s permanent portfolio continue to do well, year in and year out?  It should. It represents asset allocation and diversification in its purest form.

 

 

 

 

 

 

 

 

 

Investing by yourself– Do you know what you are doing?

Capital Markets, Investors , , , ,

I always shudder when someone tells me that they are managing a few million dollars of their own money through a discount brokerage firm. Do they actually know what they are doing?

I randomly asked a few friends who have been investing on their own for years. How do you select the stocks that you buy and how do you know when to sell, I asked? The answers are not what you should expect.

No one professes to have a crystal ball. At the same time, few actually look at the financial information that companies file with the SEC. Professional investors all over the world use fundamental securities analysis to compare balance sheets between companies they are considering for investment. Self-directed investors rarely tell me that they even know how. It seems that a great many of the investment decisions that they make are emotional rather than rational.

More than one has told me that they get tips from a pundit on TV or a newsletter that they have come to respect. And how did they earn your respect, I ask? By being right more than wrong is the best answer I got but even that tells you nothing about the methodology behind the recommendations.

Remarkably, many people do not seem to trust the large wire houses and investment banks and the registered representatives that work for them. People use words like “crooked” and “conflicted” when they refer to these firms. If a research analyst at one of these firms writes a report regardless of quality, many people seem to dismiss them as dishonest.

More than one person told me that they invest in companies that have great new products coming out. You know that we believe that the fact of the new product is factored into the price of the stock as soon as the product is announced, I asked? For the most part, people, even those investing seven-figure accounts of their own money do not know what I am talking about.

The problem becomes more obvious when you ask: how do you know when to sell? Do you set targets or use stop losses? You really don’t think that I got a single affirmative answer, do you?

When I visit my financial adviser during the trading day, he may have half a dozen screens on; a financial news station with a live ticker; specialized screens following specific stocks that his clients own or which he is considering buying. He follows the market and “his” stocks, all day, every day. Is that how you manage your portfolio?

Even if you are well schooled in balance sheet analysis what do you know of the global markets, global economics and global politics. Forty years ago, Proctor and Gamble was a primarily domestic company. Today it operates in so many markets and has suppliers in so many others that its earnings can be affected by things that you cannot imagine, let alone identify and analyze.

As I got older, I came to realize that part of being wise is knowing what it is that you don’t know. It is true in life and especially in investing.

Ending fixed commission rates was a step toward market efficiency. The idea of discount brokerage firms where customers could purchase mutual funds and set up simple portfolios by themselves was likewise efficient.

The step from there to “do it yourself” with all of your money is a big one. Most self-directed investors do not have what it takes to avoid stumbling.

Emotional, irrational and uneducated investors contribute to market inefficiency. Every time that the market crashes more and more self directed investors come away with significant losses. Investing profitably is a lot harder than it looks. It takes time, attention, data and the knowledge of how to use that data.

If you do not think that you could pass one of the mid-term exams that I used to give to my students, hire an investment adviser.