Your Questions About Hedge Funds That Invest In Movies

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Thomas asks…

What is design economy?

Justin answers:

In a globalizing economy based on mass production and commoditization, the business of design is more than ever the path to productivity and profit, not to mention a sense of soul. What elements does this design economy entail? Fast Company magazine provides a look:

Be project-based: Aka the hollywood model, creativity thrives when there’s a finite beginning and end (like movies, and the design and construction of Prospect (image) in Colorado), rather than what becomes a bureaucracy.

Design economy gone wrong
The Wall Street types have found a new “new economy” to hype. According to Andy Kessler, a former hedge fund manager and now techie investment pundit, its The Design Economy:

Perhaps here’s how the world works these days. No need to borrow billions and build big ethylene plants anymore. You invent something here (chip, movie, iPod, medicine, financial instrument), email the design overseas for manufacture in $1-an-hour factories (OK, not financial stuff), and then ship it back for consumption. Sure, this runs up trade deficits, and our precious dollars leave the country, but that’s only half the story. Those dollars come back and invest in the U.S. Most go into long bonds, 10-years and 30-years. That’s why Alan Greenspan left with a puzzled look on his face. Foreign buying is keeping long rates low; the yield curve is flat.

But maybe the stock market has figured out that we’re running out of long bonds. Maybe, just maybe, the surprise is fiscal discipline being voted into office in November and shrinking red ink in D.C. Marginal rate tax cuts and lower rates on dividends and cap gains might actually work and increase revenue. If we run smaller deficits, then there’ll be fewer bonds for foreigners to buy, so they have to buy something else with those dollars and the next big pot of liquidity is — hmm, let me think for a second, oh yeah, on Wall and Broad, the $15 trillion stock market. When bonds are scarce, foreigners are going to have to buy our stocks, or so the stock market might be screaming.

That scenario may be great for the Wall Street speculators looks for the next big score. But it is a disaster for the economy. Yes, those dollars come back and pump up an inflated bond market (higher bond prices = low interest rates) and could pump up an inflated stock market. But, they still represent the selling off of our assets (either IOUs or equities) to foreigners – leading to what Warren Buffett calls the “sharecropper society” (in this case, where we labor to come up with those wonderful designs that make other rich.

John asks…

Does anyone else agree with that McCain advisor who said that America is having a “mental recession”?

I understand that many are unemployed, but the reality is, the economy has continued to move on. I know plenty of people who’re busier than ever. We have record-breaking movies and video games coming out, I see huge traffic and tons of people making commerce and business. I sometimes think the “recession scare” is what caused the restructuring of many businesses and that‘s what caused the unemployments… I mean if we hadn’t scared businesses into thinking the world was gonna end, they may not have layed off so many people.

Do you think this is mainly a mental recession?

Justin answers:

No, I don’t think it’s purely mental.

Officially, the “recession” has ended, and economic growth in the US has resumed – but it’s been very anemic growth, not nearly vigorous enough to generate new jobs for some 14 million Americans who are now officially “unemployed” and other 12-13 million Americans who are either “underemployed” or so discouraged about seeking for jobs that they’ve dropped out of the work force.

So long as these 26-27 million Americans are either jobless, under-employed or “discouraged” workers, the US economy isn’t close to being healthy, even if the recession has officially ended.

A second major problem: Because of the aftermath of the subprime mortgage mess, there are an estimated 4 million American homeowners or more who are at risk of seeing their mortgages foreclosed and their families evicted from their homes within the next year.

So long as these four million families are at risk of homelessness, and so long as their houses stand likely to be thrown onto an already glutted real estate market, further driving down real estate values in many parts of the country, the US economy continues to be pretty sick.

A third big problem: As many liberal economists and not-so-liberal business journalists have noted, and as Robert Reich has documented in his new book “Aftershock,” the distribution of income between the rich and the poor in the United States is more unequal today than it has been at any time over the past 80 years — the most unequal it has been since before the famous 1929 stock market crash.

The problem with a grossly unequal distribution of income, with the vast majority of income in society going to the top 10% to 20% of the population, is that this inequality depresses the buying power of the middle class and grossly pushes down the buying power of the poor. The result is that “effective consumer demand” is often inadequate to match the productive power of the US economy.

And when “effective consumer demand” is too low to purchase all the goods & services that the economy can produce, there’s always a good chance of renewed recession and added job losses, as factories and other businesses with too much capacity shut down production and lay off workers in order to trim their output to what the market can bear.

Another problem with a grossly unequal distribution of income, Robert Reich argues, is that when the rich and the super-rich has even more money on hand than usual, they’re likely to invest it — not in productive activities — but in pure speculation, in “finance” rather than the industrial sector or the service economy.

After all, if the middle class and the poor have too little income to support economic growth in the real world economy, what sense does it make for the rich to invest in increasing the productive capacity of that real world economy?

What profitable investment outlets are there for rich people with extra cash to invest — except in the latest Wall Street instruments for financial speculation?

So when US economic distribution becomes as unequal and as tilted in favor of the rich as it is today, it stands to reason that the super-rich will put much of their money into corporate mergers & acquisitions, into “junk bonds,” into speculative hedge fund activity .. And it’s exactly that kind of financial speculation that caused the US economy to blow up in 2007, 2008 and 2009.

A fourth big question: as former IMF economist Simon Johnson points out, in his book “13 Bankers,” the US banking system since the 2008 financial panic has become even more dominated by a few giant institutions that are literally “too big to fail.”

The scope of their economic reach is so big that both Republicans and Democrats will HAVE to bail them out in case of future emergency — which means they know they’re free to engage in continued reckless investment behavior.
Which they’re doing, Simon Johnson warns.

So I think while outright “recession” has been stopped — at least for now — there are 4 big underlying factors that can plunge the US economy back into recession at a moment’s notice.

I think McCain’s former aide is whistling past the graveyard when he tries to ignore these 4 warning signs. Ditto for any Democratic optimists who do the same.

Robert asks…

Ways to use my money to make more money?

I have a job but no expenses, so for now at least I want to make my money work for me. I want to do as little work as possible and get the highest returns possible (duh?) I know there are ways to make money without work so long as you have enough money to start out with (like buying a business and paying someone to manage it for example) so dont say im dreaming and that it cant happen. But I also want to know everything i need to about bonds, stocks, cds, money markets, etc etc. Longest list of ways to get money without doing a LOT of work gets best answer.

Justin answers:

Claude Shannon at MIT once took his engineering class off on a tangent by proving mathematically how to always make money off a stock. What he did was he took an imaginary portfolio and invested 50% of it in a stock then he simply rebalanced it back to 50% whenever there was a price change in the stock, when the value of the stocks constituted more than half the portfolio, he sold stocks, when the cash portion was more than 50% of the portfolio he bought stocks, the end result was buying low, selling high and he proved mathematically that so long as the stock didn’t just disappeared, that strategy would always make money.

Ed Thorp in his book “Beat The Market” described buying stocks and shorting warrants on the stocks so that whether the price of the stock moved up or down, a profit was guaranteed. This is known as arbitrage or hedging. Needless to say he went on to start one of the most successful hedge funds ever. Warrants are like a option to buy except they are issued by the company itself often to make a bond more attractive. Basically, a warrant allows the owner to purchase the stock at a set price before the expiration date hence the warrant tends to trade at a price that’s no greater than the current stock price minus the strike price and premium hence it’s a derivative product whose pricing is related to the stock price by market forces, when the stock goes up, it tends to go up too, when the stock goes down, it goes down but it’s price is significantly lower than the stock.

Warrants and options have more or less the same price movements as the underlying stock but are less expensive hence the price movements are a greater percentage of the investment. This can be used to leverage your investments by buying the warrants or options for a stock rather than the stock itself. It’s sorta like penny stocks except that when it becomes worthless (the stock is below the strike price), it still has speculative value as the stock may yet rise to be above the strike price before the maturity date, penny stocks tend to just disappear when they become worthless.

John Kelly from Bell Labs postulated that the information theories of Claude Shannon could be used in investing and gambling. These are equations dealing with the maximum transmission rate of data over noisy phone lines. He came up with the Kelly Criterion which essentially calculates the maximum percentage of your available capital should be invested given the probability of success/failure and the expected rewards. Basically investing under the criteria gives you a high probability that your assets will grow exponentially, with the maximum growth rate at the criteria itself. Over that limit and you have a high probability of losing it all. This is useful in situations where you can evaluate the probability of success and the net profit expected but is difficult to use beyond the binary outcome form. An analysis of Warren Buffet’s investments shows that all of his investments have been below the Kelly Criterion and often quite close to the limit calculated. Basically the criteria requires you to reserve some money for later rather than risking everything on one gamble.

Ed Thorp and Sheen Kassouf applied the Kelly Criteria and detailed analysis of probabilities to games in Vegas and the racetrack. The profits were used to start a very successful hedge fund company on Wallstreet. You may have heard of a movie inspired by his escapades in Vegas.

In the 80’s, Thorp put a grad student in a motel room in Vegas to place Sports Bets according to analysis that they did on the University Computer. They started with $50,000 and had $123,000 a few short months later but managed to bankrupt the sportsbook at Little Caesars in the process. They ended the project due to the inconvenience of having someone in Vegas and because their efforts on Wallstreet were much more profitable. He published a paper on it in 1991, he concluded that it may be worthwhile if you could place sports bets from outside the state. The main technique involved cross book arbitrage which also meant transferring large sums of cash between casinos by hand. Some people that attempted to continue on the process without them, wound up being robbed while performing one of these transfers.

Thorp has a new book coming out on the Kelly Criterion.

Alex Doulis in his book “Take Your Money and Run” described two strategies, one was to find an index fund with the lowest operating costs and the other was to evaluate stocks by comparing the reciprocal of their Price/Earnings ratio to the prevailing interest rates. The main geist of the book was to save slowly but surely and arrange to be free of taxes.

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