Naked Capitalism comments on the idea that Mark-to-market accounting contributed to the credit crisis. The argument made is that by marking the money to market they can grow their capital bases which allowed them to use more leverage.
It should be clear to most observers that credit bubbles are created by interest rates below the natural rate. In this case low interest rates drove higher home prices. Obviously this made securitized debt appear less risky than it should have been which kept the equity and mez tranches spectacularly overpriced.
I suppose I should go on to say that mark-to-market still would make sense for things that are actively traded or things that are strongly correlated with things that trade actively. However, the question comes to whether assets that do not trade actively should be marked-to-market?
Most securitized debt does not trade actively by any common-sense way of looking at it. Since they are typically classified as level 3 assets, these securities are actually marked-to-model when there are no market prices. That being said, the problem is too much of a reliance of mark-to-model, not mark-to-market. They couldn't properly value these instruments (ignoring times of declining home prices) and overestimated the fair value of the securities. Mark-to-market was what kept them honest when the securities lost value. I agree with the story that the increase in value due to the securities allowed them to increase their capital base and lend an larger absolute value, but I disagree that mark-to-market was a cause of that.
Friday, February 29, 2008
Update on 1% days
Obviously today opened more than 1% down and the trade woulnd't have been successful. I suppose an update would be to rate the value of the news. If there is important news, the trade shouldn't be taken.
Wednesday, February 20, 2008
1% up or down days at the open
In the past 250 days of trading, there have been 25 days where the market opened up or down by 1% or more. Today and yesterday were two of them and there have been quite a few lately. I have noticed that most of these days, especially lately are a fade (do the opposite, sell when it is higher, buy when it is lower).
To test that strategy, I programmed it in TradeStation to buy when the market is down 1% and sell when the market is up 1% and to enter the position the next minute after it starts to go my way. I used simple position sizing of 1000 shares of SPY with $.007/share commissions each way (what I'm paying now). The cover strategy is simply after 30 minutes to get out of the positions.
Over the past 250 days, excluding interest from not being in the market most of the time, you would have made 7,490 with a profit factor of 3.55(4.35 long, 2.7 short) with 52% profitable (50.00% long, 54.55% short) and the ratio of average profit to average loss would be 3.27 (4.35 long, 2.25 short). In other words, this strategy is right most of the time and the profits are much larger than the losses.
If you wanted to hold positions longer and just sell out some time after holding it thirty minutes when stochastics give an indication to cover, there's a profit factor of 3.68 (3.32 long, 4.91 short), but you are right 68% of the time (71.43% long, 63.64% short) and unfortunately the profit factor decreases to1.73 (1.33 long, 2.8 short). You would be making 11,590 over the entire period which is about 4 grand more for a very simple change.
With the SPY, 1000 shares would require at least probably 35k in margin to be able to trade it and you could get about a 33% return just trading this strategy (not including interest) over the course of a year. A more complex exit strategy could hold longer or start taking profits to reduce the draw down that can occur. Nevertheless, I find it interesting that this strategy (at least for a relatively small amount of money) could be this successful.
To test that strategy, I programmed it in TradeStation to buy when the market is down 1% and sell when the market is up 1% and to enter the position the next minute after it starts to go my way. I used simple position sizing of 1000 shares of SPY with $.007/share commissions each way (what I'm paying now). The cover strategy is simply after 30 minutes to get out of the positions.
Over the past 250 days, excluding interest from not being in the market most of the time, you would have made 7,490 with a profit factor of 3.55(4.35 long, 2.7 short) with 52% profitable (50.00% long, 54.55% short) and the ratio of average profit to average loss would be 3.27 (4.35 long, 2.25 short). In other words, this strategy is right most of the time and the profits are much larger than the losses.
If you wanted to hold positions longer and just sell out some time after holding it thirty minutes when stochastics give an indication to cover, there's a profit factor of 3.68 (3.32 long, 4.91 short), but you are right 68% of the time (71.43% long, 63.64% short) and unfortunately the profit factor decreases to1.73 (1.33 long, 2.8 short). You would be making 11,590 over the entire period which is about 4 grand more for a very simple change.
With the SPY, 1000 shares would require at least probably 35k in margin to be able to trade it and you could get about a 33% return just trading this strategy (not including interest) over the course of a year. A more complex exit strategy could hold longer or start taking profits to reduce the draw down that can occur. Nevertheless, I find it interesting that this strategy (at least for a relatively small amount of money) could be this successful.
Thursday, February 14, 2008
Bond Insurers
It looks like there is a proposal to split up the bond insurers. I'm not particularly surprised by this development. If MBIA and Ambak took Buffett's deal, it would effectively have split them up anyway.f Buffett offered to take the Muni portfolio of the three major bond insurers. By taking that portfolio, they would be left with their CDS and CDO positions that would have likely bankrupted the firms. I would much rather prefer these companies to take Buffett's private offer than to be forced to split up. However, if they do not split up voluntarily, it is fairly clear that they will be forced to split up whether it is part of a bankruptcy agreement or outright. Municipalities won't put up with interest rates that high and not being able to borrow money and will complain up the chain of government until it gets done. The new firms holding the Muni insurance might be worth examination of whether to buy. I'm guessing that the other part will declare bankruptcy, there could be a situation where it would be a VERY distressed play. If it isn't liquidated in bankruptcy it would likely be severely undervalued coming out of bankruptcy.
Monday, February 11, 2008
Societe Generale
Societe Generale announced a rights offer today almost 40% below the current share price. The current share price is roughly 77.72 euro and the rights offer guarantees the holder of 4 shares of SocGen the right to buy one share at 47.50 euro. The cost of the rights offer is estimated in the article with a theoretical value of 5.90 euro. Current shareholders should be particularly happy with this offer. If you held 4000 shares of SocGen, you could swap out 1000 for 5900 euro for an immediate net profit of 24,320 euro (excluding commissions and slippage) which would be about 7.8% of the current value of your shares while maintaining the same allocation. I should note that I haven't read the document and there might be limits to the offer so that this arbitrage could not happen exactly. I'm just pointing out the theoretical profit.
If you don't hold any of the shares, there could still be a big opportunity here. Many firms, Bearings, LTCM, Amaranth, to name a few, have been destroyed by large unprofitable trades. However, many of these trades would have been profitable had they been able to hold on to them (or at least not nearly as costly). These firms could have continued to exist if they had weathered the storm and mainained their financing. Their problem is the crisis and the sharks moving their positions against them. SocGen doesn't hold any more of their costly positions and have announced the write-off. The problems are over. The stock might continue to go down further in the short-term, but with it makes real sense to take advantage of this offer. I did a few calculations in an excel sheet and found that if you take advantage of this offer the spread between the yield when taking advantage of this offer and just holding shares outright increases substantially as the stock price increases (never going negative, but that makes sense). Selling at the current price would earn almost 7% on this strategy. That seems to be pretty safe and could be levered for a large return. With a longer term outlook on this company, you could earn a very nice return beyond what you could earn otherwise.
If you don't hold any of the shares, there could still be a big opportunity here. Many firms, Bearings, LTCM, Amaranth, to name a few, have been destroyed by large unprofitable trades. However, many of these trades would have been profitable had they been able to hold on to them (or at least not nearly as costly). These firms could have continued to exist if they had weathered the storm and mainained their financing. Their problem is the crisis and the sharks moving their positions against them. SocGen doesn't hold any more of their costly positions and have announced the write-off. The problems are over. The stock might continue to go down further in the short-term, but with it makes real sense to take advantage of this offer. I did a few calculations in an excel sheet and found that if you take advantage of this offer the spread between the yield when taking advantage of this offer and just holding shares outright increases substantially as the stock price increases (never going negative, but that makes sense). Selling at the current price would earn almost 7% on this strategy. That seems to be pretty safe and could be levered for a large return. With a longer term outlook on this company, you could earn a very nice return beyond what you could earn otherwise.
Friday, February 8, 2008
Dow 100^100
During the 90s there were two books predicting the Dow would go to insane levels of valuation. Dow 36000 and Dow 40000. While there certainly is much to criticize in these books, I was thinking about when inflation would make their dreams come true. The Dow Jones Industrial Average closed at 12650 in the end of January. According to Global Financial Data, the DJIA earnings were 260.86 at the end of January implying a PE of roughly 48.49. I suppose this number isn't exactly fair since the number jumped up in July (a nice signal to get out of the market) when GFD has earnings going from like 800 to like 200 or so. It looks like the data is quarterly and they just have the numbers in the months spots multiple times. So, I'll just use the PE and earnings data from before the ratio goes from 20 to 50 since 20 is closer to the historical average. For that quarter GFD has earnings at 824.65 and with 13409.3 as the number for the DJIA. I'll average those two with the most current numbers so that I don't totally throw off my estimates of the growth rate (giving 542.76 and 13029.65). That gives a PE estimate at 24 that I'll assume could be a long-term number.
I'll split the difference of 36k and 40k (38k) and use that a future price target. Since PE=P/E, That leaves 24 on the left side and 38000 in the denominator. The earnings value I want to use is 542.76*(1+r)^n where r is the rate of growth for earnings and n is number of years to achieve 38k in the Dow (what I want to solve for). GFD has the June 2005 earnings number at 571 which would give a 44% increase in earnings to June and a similar negative decrease to use January's number. It would probably be more appropriate to run a Monte Carlo simulation using all of the data and put together a complicated model (since I am at a library with limited user rights I can't do that right now). Another long-term estimate would look at the average growth rate over the paste twenty years (the 1976 number is 95.81) which gives a number of about 9% growth a year. This number includes inflation (which is important) so you could consider the real number at about 5 or 6% a year depending on your estimate of inflation.
Plugging in the numbers and solving for n (ln 2.912/ln 1.09) gives 12.42 years. This would seem like a few number of years. I agree. This number is incredibly sensitive to the PE ratio or the growth rate. A one point change in the PE ratio would change n by (-1/24)/(ln 1.09) or roughly 6 months (granted the effect changes as you change the start date and decreasing the PE means lengthesns the time it takes to reach 36k). However, a one point change in the growth rate has an even larger effect, -ln(2.912)*(1/1.09)/(ln 1.09)^2 or (-132.3/100) or decreasing by 1.3 years for each percentage point increase in the growth rate. Certainly there are huge uncertainties with this analysis and calibrating the proper numbers. If actual earnings growth is comes in at 6% (3% inflation, 3% real GDP growth) with a long-term PE of 15 (not historically uncommon), then it might take (4.5+3.9) or 8.4 longer than originally planned at almost 21 years.
The Dow may reach 36000 (or 38000 or more) with a sound valuation over the next 10-20 years by pretty reasonable assumptions and 20-30 years from when the author's book was published. However, this does not imply anything about what the Dow will do tomorrow, next month, or next year (or even the next five years). It is a simple estimation that anyone who has taken high school math and introductory finance could figure out. I suppose the author's main flaw was not looking at a longer-trend of earnings growth and PE ratios. Saying the Dow will go to whatever 20 years from now doesn't save you from a Standard deviation that's twice as large as the yearly expected return if you're retiring in five years.
Furthermore, when the earnings growth for the Dow is a number as low as 6% or 9%, inflation will destroy half of the increase in value. If you only looked at real earnings, real Dow Prices, and the real PE, it would be unlikely to see real Dow going to 36000 by the end of the 21st century and it is mathematical impossibility with positive inflation for it to double in value when the nominal Dow doubles in value. For the average long-term investor, country and sector analysis combined with tactical rotation can provide much stronger returns in an inflationary environment.
I'll split the difference of 36k and 40k (38k) and use that a future price target. Since PE=P/E, That leaves 24 on the left side and 38000 in the denominator. The earnings value I want to use is 542.76*(1+r)^n where r is the rate of growth for earnings and n is number of years to achieve 38k in the Dow (what I want to solve for). GFD has the June 2005 earnings number at 571 which would give a 44% increase in earnings to June and a similar negative decrease to use January's number. It would probably be more appropriate to run a Monte Carlo simulation using all of the data and put together a complicated model (since I am at a library with limited user rights I can't do that right now). Another long-term estimate would look at the average growth rate over the paste twenty years (the 1976 number is 95.81) which gives a number of about 9% growth a year. This number includes inflation (which is important) so you could consider the real number at about 5 or 6% a year depending on your estimate of inflation.
Plugging in the numbers and solving for n (ln 2.912/ln 1.09) gives 12.42 years. This would seem like a few number of years. I agree. This number is incredibly sensitive to the PE ratio or the growth rate. A one point change in the PE ratio would change n by (-1/24)/(ln 1.09) or roughly 6 months (granted the effect changes as you change the start date and decreasing the PE means lengthesns the time it takes to reach 36k). However, a one point change in the growth rate has an even larger effect, -ln(2.912)*(1/1.09)/(ln 1.09)^2 or (-132.3/100) or decreasing by 1.3 years for each percentage point increase in the growth rate. Certainly there are huge uncertainties with this analysis and calibrating the proper numbers. If actual earnings growth is comes in at 6% (3% inflation, 3% real GDP growth) with a long-term PE of 15 (not historically uncommon), then it might take (4.5+3.9) or 8.4 longer than originally planned at almost 21 years.
The Dow may reach 36000 (or 38000 or more) with a sound valuation over the next 10-20 years by pretty reasonable assumptions and 20-30 years from when the author's book was published. However, this does not imply anything about what the Dow will do tomorrow, next month, or next year (or even the next five years). It is a simple estimation that anyone who has taken high school math and introductory finance could figure out. I suppose the author's main flaw was not looking at a longer-trend of earnings growth and PE ratios. Saying the Dow will go to whatever 20 years from now doesn't save you from a Standard deviation that's twice as large as the yearly expected return if you're retiring in five years.
Furthermore, when the earnings growth for the Dow is a number as low as 6% or 9%, inflation will destroy half of the increase in value. If you only looked at real earnings, real Dow Prices, and the real PE, it would be unlikely to see real Dow going to 36000 by the end of the 21st century and it is mathematical impossibility with positive inflation for it to double in value when the nominal Dow doubles in value. For the average long-term investor, country and sector analysis combined with tactical rotation can provide much stronger returns in an inflationary environment.
News from the front
I'm honestly amazed by Hank Paulson. He has been going around to the press since mid-January and has been talking about the risks to the economy. According to the Guardian, Paulson has said, "I still believe that we are going to continue to grow, although at a slower pace for a while, but the risk is very much to the downside and the risks are primarily housing." This would have been something to have said like 8 months ago or maybe a year and a half ago when housing started showing its decline. More than that, though, I'm curious as to how he thinks about risk. He's obviously not thinking about standard deviation, a traditional measure of how risky an asset is. Standard deviation is not biased to one side or another it is a statistical fact (he might have meant that these figures are increasing, but then he should have said risk is increasing). Furthermore, Value at Risk or the size of losses in worst case scenarios could not be what he is thinking of since they are necessarily always concerned with the downside. I guess I use a pretty common-people conception of risk that is different from Paulson's. There's really no one definition of risk, but courtesy of Frank Knight I know that risk is quantifiable. I know that risk is somehow related to the probability of a loss (or downside deviation from the mean) and the size of that loss. But I'm just not sure how risk could ever not be on the downside. I'm pretty sure that he's not talking about risk, but he is talking about where he thinks the economy in general will be going and saying risks are on the downside (repeatedly to the media) for pure rhetorical reasons.
The Economic Stimulus plan passed Congress last night. I'm pretty sure I'm going to receive some money. I'm pretty sure that it's going to be bad for this country. I'm pretty sure I'm still going to cash the check anyway.
Antitrust regulators are also going after the Nymex/CME deal. The Justice Department is opposed to having the financial futures exchanges controlling or owning their own clearing operations. Typically, antitrust regulators are sticking up for the consumers who get fleeced by prices too high. Most futures contracts have notional values in the hundreds of thousands of dollars and a lot of good brokerage firms don't let you open a futures trading account without sufficient experience. These markets have fierce competition and the people who participate in them have ample means to compete with any exchange if they wanted to. There are plenty of markets where they just block trade equities. It is absurd if the market is just defined as the futures exchanges. Any exchange or ECN could compete in this market and any Investment Bank could start their own if the structure were really fleecing them.
Great opinion piece in the WSJ about McCain's VEEP options. I've heard abunch about Mark Sanford from South Carolina (who would be much better for the economy as President than any of the frontrunners) and I'm glad WSJ put him on their short list. I'm just concerned if he might be too principled for McCain. Sanford could at least run in 2012 by himself.
The Economic Stimulus plan passed Congress last night. I'm pretty sure I'm going to receive some money. I'm pretty sure that it's going to be bad for this country. I'm pretty sure I'm still going to cash the check anyway.
Antitrust regulators are also going after the Nymex/CME deal. The Justice Department is opposed to having the financial futures exchanges controlling or owning their own clearing operations. Typically, antitrust regulators are sticking up for the consumers who get fleeced by prices too high. Most futures contracts have notional values in the hundreds of thousands of dollars and a lot of good brokerage firms don't let you open a futures trading account without sufficient experience. These markets have fierce competition and the people who participate in them have ample means to compete with any exchange if they wanted to. There are plenty of markets where they just block trade equities. It is absurd if the market is just defined as the futures exchanges. Any exchange or ECN could compete in this market and any Investment Bank could start their own if the structure were really fleecing them.
Great opinion piece in the WSJ about McCain's VEEP options. I've heard abunch about Mark Sanford from South Carolina (who would be much better for the economy as President than any of the frontrunners) and I'm glad WSJ put him on their short list. I'm just concerned if he might be too principled for McCain. Sanford could at least run in 2012 by himself.
Monday, February 4, 2008
2/4/2008
The market mostly went down for the day. Downgrades in financials and weakness in the housing sector lead the decrease in the beginning of the day. Oil was up with railroads, autos, and airlines down. Utilities were up on the down market. Gold was getting crushed in the pre-market and as long as you stayed away from the South African miners, you could have done well shorting the miners. It felt like there was little moving the market later in the day. There was little news or releases (except Factory orders). The trends that developed in the beginning of the day were pretty much the trends that drove the market the rest of the day.
Microsoft May Borrow for First Time to Buy Yahoo
Yahoo May Seek Pact With Google to Fend Off Microsoft
I can't help but think the Microsoft bid for Yahoo is an awful idea. As a disclosure, I was a former long-term shareholder of Microsoft (by gift and I think I only made $3/share). Microsoft makes the vast majority of its profit on software and operating systems. Their web business doesn't generate nearly the revenues that other lines of businesses either can generate or are generating. Not only that, but they are bidding up Yahoo to such a high level, beyond any reasonable valuation, that they will likely lose money on it. Microsoft has an incredibly long time horizon and they might have thought that with the lower interest rates it would be worth it. However, I don't see anywhere for rates to go, but down. They could have waited several more months and probably could have saved a lot of money on the interest on the debt. This deal will only benefit Yahoo shareholders, Microsoft shareholders are getting hosed like Time Warner by AOL.
Fed Says U.S. Banks Are Tightening Lending Standards
I consider this good news for economy in general, but it could lead to short-term slowdown (not that there's anything wrong with that).
Microsoft May Borrow for First Time to Buy Yahoo
Yahoo May Seek Pact With Google to Fend Off Microsoft
I can't help but think the Microsoft bid for Yahoo is an awful idea. As a disclosure, I was a former long-term shareholder of Microsoft (by gift and I think I only made $3/share). Microsoft makes the vast majority of its profit on software and operating systems. Their web business doesn't generate nearly the revenues that other lines of businesses either can generate or are generating. Not only that, but they are bidding up Yahoo to such a high level, beyond any reasonable valuation, that they will likely lose money on it. Microsoft has an incredibly long time horizon and they might have thought that with the lower interest rates it would be worth it. However, I don't see anywhere for rates to go, but down. They could have waited several more months and probably could have saved a lot of money on the interest on the debt. This deal will only benefit Yahoo shareholders, Microsoft shareholders are getting hosed like Time Warner by AOL.
Fed Says U.S. Banks Are Tightening Lending Standards
I consider this good news for economy in general, but it could lead to short-term slowdown (not that there's anything wrong with that).
Friday, February 1, 2008
2/1/2008
The jobs number was in negative territory. Not one of the 80 economists surveyed by Bloomberg predicted it would be that low. You could have made 140 dollars per 100 shares of SPY shorting in the pre-market and covering before the squeeze.
In other news, the ISM index was slightly better than expected. The initial market reaction was bullish, but I suspect that was hampered by thoughts of a smaller rate cut. Gold has been down, railroads up, mortgages are up (Fannie, Freddie, etc), but what is up has been trending lower and only has relative strength because of a strong open. Everything else I'm looking at is kind of mixed.
In other news, the ISM index was slightly better than expected. The initial market reaction was bullish, but I suspect that was hampered by thoughts of a smaller rate cut. Gold has been down, railroads up, mortgages are up (Fannie, Freddie, etc), but what is up has been trending lower and only has relative strength because of a strong open. Everything else I'm looking at is kind of mixed.
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