Tuesday, December 30, 2008

Where the Next Bubbles Will Come From and How They Will End

One of the biggest problems with our current financial system is the fact that lower interest rates -- or the reasonable expectation of falling future interest rates -- encourages overinvestment. This inevitably leads to speculation and a subsequent asset price bubble. As Kindleberger states in his timeless "Manias, Panics, and Crashes" over trading through speculation will be followed by a "CONVULSION." Oftentimes this is some outside news factor that suddenly makes the boom model untenable.

In the case of the current crisis, the exogenous news factor was the pricking of another asset price bubble: the housing market. When ripples from the housing bust hit the banks of the world, it created a chain reaction. While our banks lost lots of money on their crappy mortgage exposure, their losses were dwarfed in magnitude by those experienced in the subsequent world stock market carnage. Some 30 TRILLION DOLLARS of wealth evaporated in 2008. But how much was made on the way up? Considering the current boom can be traced to the 1970's 30 trillion is just a drop in the bucket.

One lesson must be leaned from the thousands of years humans have used money and trade to lubricate their lives. Markets will have booms. Booms will lead to busts. But when the rate of interest is near zero percent: the urge to lever up will become too great.

Somewhere, sometime in the future, some trader at some bank will figure out that he can borrow from the fed for zero percent and lend for two percent. He will make a huge bonus and all his trader friends will do the same type of trade. The next year many traders will leave this bank and go to other banks and hedge funds. There they will tell tales of their trade, and they will borrow money at zero percent and lend money at two percent. Except when EVERYBODY does this, we will have another credit bubble.

The money lent out at 2% won't just sit in a drawer some where. It will be invested in some asset. If the speed at which money is being lent creates more money that needs to be invested than the supply of existing assets, prices will rise. But we can't use classical economics here. This is because while the supply of assets will certainly increase from bankers hocking IPO's and new bond issues, financial assets are not normal goods.

When a normal good or service rises in price, people consume less of it. When the price of a stock goes up, more people want to buy it. They see others making a killing and want a piece of their own. Likewise, when prices go down people sell more: they don't want to lose even more money. This means that credit bubbles become unstoppable reinforcing "virtuous cycles." These, of course, are followed by horrifying unrelenting market declines (vicious cycles).

Prices will stabilize. Money will be relent at too low interest rates. Money will be borrowed by firms and investors which will push up asset prices. More money will be lent. Some will go to increased demand for borrowed funds by speculators. They want to take advantage of rising prices. More money will be lent...

Monday, December 29, 2008

Oil Making a Bottom

I am in no way long. I'm not going long. This is in no way an endorsement to buy anything in this market. But I am going to call this a bottom in oil and most other commodities for at least 6 months. If i'm right: expect a huge rip off the bottom that is in no way sustainable.
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How the Stock Market Works 2: Some Simple Statistical Arbitrage

So I'm gonna attempt to explain some statistical arbitrage (or stat arb, in the truncated parlance of the street). Depending on your experience level, your reaction to this post should range from "duh" all the way through "well uhh" straight through to the "what the fu..." Its OK, you're gonna make it, I promise. Just stick with it and you will come out a smarter person on the other side.

In finance, there are many assets which seem to be driven by the same process. The fate of a collection of oil companies will rise and fall with the price of oil. A parent company may make record profits only if its partially owned subsidiary company gets a new contract. Or it could be something as simple as company A owns a 20% stake in company B. For whatever reason, there are plenty of examples of how the price of two seemingly different assets are linked together. When an educated investor sees two stocks moving together, he should know that there is an opportunity for profit.

Asset prices that move in concert are known as "cointegrated." Although this term has a technical definition, the intuition is straightforward. If the price of an asset rises, we would expect the price of its cointegrated partners to be rising as well. If prices are not moving together, it is because of some temporary anomaly. Thus an investor can profit by buying one cointegrated asset and selling another.

In particular, suppose we have two related assets- A and B- and we observe A rising and B falling. The arbitrageur can then sell A and buy B. Now he has a "market-neutral" position. Theoretically he does not care what direction the market as a whole takes because he is both long and short.

The investor above is betting only that the spread between the two cointegrated assets will narrow (long and short at the same time is known as a spread) . This will occur if A decreases more than B decreases or if A increases less than B increases.

For example, suppose we're long 100 shares of B and short 100 shares of A. If the market increases, its likely that our two stocks will also increase. We will make profit if the money we make in one side of the spread is more than we're losing on the other. If A rises 2 points and B rises 2.5 points, we will have lost 200 on the short position and made 250 on the long position, netting out to a profit of 50 dollars. Else, if A rose 3 points, we would lose 50 dollars.

It is important to note that a trader can make a spread out of any two assets. You could go long gold and short gasoline for example. But it is the idea of cointegration that makes the above spread so powerful. If two assets are truly related, then the spread will eventually narrow, netting the stat arb a profit.

The risks are twofold. The first is that the spread will increase so much in the short term as to bankrupt the arbitrageur before the relationship returns to normal. This is a very real risk, especially if leverage is involved. The second risk is that the relationship will cease to exist. Perhaps company A dumped its holdings of company B. Maybe company A had a corrupt CEO who embezzled billions and takes the equity to zero overnight. Either way, the fortunes of the two companies could diverge quite strikingly.

On the whole, the cointegration trading described above is useful only for calm and stable markets. But risk profiles can be adjusted for any market. In a benign market, this strategy would seek small but frequent intraday returns. The stat arb would thus make alot of trades to capitalize off of low volatility in the size of the spread itself. In a crazy market like we have now, the number of trades would be cut down dramatically. Spreads have gotten very volatile, and opposing small moves could send one to the poorhouse. Waiting for spreads to widen significantly is the only way to implement this strategy in a high volatility marketplace.
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Saturday, December 27, 2008

What the Data Can't Tell You: Plucking the string of the market

Price-Earnings Ratios as a Predictor of Ten-Ye...Image via Wikipedia
So much time and effort has been placed in the pursuit of analyzing past stock market data sets to mine for statistically significant anomalies. This is a great process for determining what would have made you money in the past, but is lousy for predicting how the strategy will perform when large amounts of money are employed to capture the discovered anomaly. Oftentimes, especially in statistical arbitrage, the presence of one or two more large players can tip a once profitable strategy into a money pit.

The key to arbitrage is being the first or second to find it... and staying small. Scaling up a strategy is hard, but making small amounts of sure money is easy for those patient enough. Perfecting a stable of small but consistently profitable arbitrage strategies is the key to long term income.

A successful arbitrageur should be able to be both statistician and wildcatter. We must pluck the string of whatever market instrument we have assembled and listen to what sound results. We must model the interaction of our strategies with the market as judiciously as we derive the theoretical arbitrage itself. Otherwise, taking a strategy from theory to practice is impractical and useless.

This financial crisis has taught that even the most statistically inclined of us must have a sense of just going with the flow. Make a decision. See what happens. Go from there. Use the tools that have worked before but with new assumptions.
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Friday, December 26, 2008

How the Stock Market Works 1: The Opening Liquidity Premium

There is the most trading volume per second during the first and last thirty minutes than during any other point in the day. This means that if you are a fund manager, or large investor, or whale you want to buy/sell during the opening or closing of the market in order to maximize the amount of your inventory that you can accumulate/liquidate.

For example: assume that during 9:30-10:00am you could sell 5 million shares while depressing the market two dollars. During 10:00-10:30 that 5 million would move the stock 10 points. When do you want to sell it? Exactly: during the open. Since you can buy/sell more off the open, price becomes a non-factor. Moving stocks up or down a few percent is a function of how much size people have to accumulate (buy) or distribute (sell) at any given moment.

Since the open and close represent the greatest opportunity for large shareholders to enter and exit quickly, you will always see large orders towards the opening and close of the market.

The Social Networking Bubble

Bubbles can come in many forms. In the 1600's the dutch pushed the price of tulips to levels that were not justified economically at the time. One could have exchanged several oxen and a wagonload full of a year's worth of food for some moderately desired varieties of the high tulips. Whats more, supply constraints could not explain it.

The common and widely available tulips exploded in value as well. They were traded by the lower classes and even had options written on them for forward delivery. If the 17th century dutch had google back then, I would be willing to bet more than a few guilders that the search term "tulip" would garner a result like the one above in google trends.

I am frightened that we're in a social networking
bubble. Some of the corpses are already floating to the surface. myspace has faltered, something i don't have a compelling explanation for at the moment.

since microsoft's historic investment, much focus has shifted to facebook. One only has to glance at the charts below to see the danger that a pricking of the social networking bubble could bring.

Anecdotal evidence points to a different story for your average social networker now has the easiest time in history finding new friends and exchanging ideas. The philosophy that has inflated the bubble was always very compelling .

But relying on a network that thrives on people adding their own media content is bound to garner more than one was bargaining for. Just look at the successive waves of negative responses that the facebook management fields after each update to its mainpage.

One thing is clear. At current search levels, if facebook were to go public, I am buying.

Wednesday, December 24, 2008


not that i'm predicting the end of the world but i feel the need to comment on the absolute VACUUM of market commentary predicting a huge decline next year. i haven't seen anyone say that they think there's another 50% decline in the market next year. where are the crack pots? everyone on cnbc is non directional or at least vague as shiiiii.

ever being the contrarian, shouldn't the market gravitate towards the thing everybody fears but no one will say? i see so much "this one will be different than before" on the upside and even now during a decline. japan has been f%$#ed for years. the great depression lasted for 10+. there were several recessions referred to as depressions in the 1800's. the most notable being after the western blizzard of 1857, initiated by the huge gold discoveries in 1849 onward, which created a HUGE MOTHER F%$#ING CREDIT BUBBLE. it just all sounds so familiar.

the governments of the world discovered a huge new pile of gold in the form of export-saving economies financing import-spending economies. asia financed america's spending binge by loaning us all the cash we just sent over through intermediaries like wal-mart and target. this gigantic ponzi scheme touched off a gigantic credit bubble that sent house prices (and the price of everything else) soaring.

now we're in the pricking of the bubble phase. where did people like this get off saying that we would have a large recovery in six months. now this is the mantra of every commentator out there. i have since realized that mine was based more on a hope and a song than rational thought, and have thusly revised my M.O.

I now realize that we are on the cusp of something great. obama refered to it as the arc of history... right now it is more like a pin head. On the downside is the great financial "demon" of deflation. this would destroy our current world economy, but would rebalance them for the long term better. short term interests (the current world order) do not want this to happen, and will fight tooth and nail to maintain inflation. they very well might, but they will systematically devalue the dollar to do so.

on the upside is another huge credit fueled bubble like the ones we've seen in the past. then the inevitable bust and a further retesting of our trajectory on the needle point of history.

historic volatility has certainly increased. build a bunker.

Tuesday, December 23, 2008

Sorry for the Absence

First of all I would like to allay fears that my buy the dips mentality has put me asunder. I mean, it would have, had I continued to follow a V-shaped recovery hypothesis that failed to materialize. As the crisis unfolded, it became clear that we were at the beginning of a prolonged period of economic change. As such, some serious revamping of my strategies was in order.

My personal trading has gone from directional to completely market neutral. I am no longer trying to make money on the market going in a particular direction. The market is sh#! and may remain so for much longer than expected. Thus arbitrage strategies (and the sure but small profit) take precedence over killing it on one side of the market.

I would not abandon the buy on the dips philosophy entirely. As this website points out, the traditional public sentiment indicator seems to be alive and well. This states that when the public is rushing to one particular side of the market, a smart trader had best be taking the opposite side of their trade. This chart shows that one could have used the google search traffic for the term "stock market" to time each major bottom we have experienced since Feb 2007. Pretty amazing to see it in action.

Sorry again for the disappearing act. My goal is to continue to provide quality content at a more reasonable pace. Keep it posted. Happy Holidays. Here's to a better 2009 for everyone!

Tuesday, October 14, 2008

All Systems Go for Sustained Government Intervention

Today the US government added yet another weapon in their crash fighting arsenal: outright stock purchases. The US Treasury is prepared to deploy some 250 billion dollars to buy direct stakes in US financial firms. The results were predictable: with shorts running for the hills and investors seduced by avarice buying on the open, short term money dumped shares bought during yesterday's long orgy.

The government has remained ready and willing to do anything to prop up financial markets. They have temporarily guaranteed bank loans in response to similar actions in europe. With Treasury long bond prices still above par, the government still possesses an infinite supply of monetary bullets to fire at the evolving bear market.

Friday, October 10, 2008

The End of "The End"

This day marks the end of this current crisis. We might trade lower from here, or even sideways for the the short term. However, at some point in the next 6 months we will rally much higher.

The stage is set for a lot of unwinding and reshuffling of banks balance sheets. funds will fail and strong ones will consolidate. Just like after a forest fire, young saplings will take the place of large trees felled by the firestorm. All of this will happen in the market, but it will take time.

In the meantime the governments of the world have proven their resolve to act in unison to alleviate monetary pressure. There may be a meeting of the G8 (or G21) soon. Multilateral action will avert any currency crises that could arise from huge US government intervention in debt and equity markets.

Such willingness to rate cut out of trouble may set the stage for further longer term inflation, as the contemporary wave of inflation (that started in 1897 ) looks set to continue for at least a few more years hence.

As commercial paper rates come back into line with treasuries, investment firms will be able to conduct their primary business of financing and arranging transactions and the whole world economy can start anew the great ponzi scheme of growth that we currently rely on.

Thursday, October 9, 2008

It's Over

Ok, I'm willing to admit i was premature in thinking this market would bounce today. But losing a few percent isn't bad when the whole world is crumbling. Keeping the stop tights allowed me to survive this week; all the while betting on a bottom.

I'm going to continue trying to pick a bottom in this market, because one of my central market principles is that nothing can move in the same direction forever. On the microscopic intraday time level, stocks reverse themselves all the time. There will be a day when this market bounces 1000 points. It might not be tomorrow, but it will be soon. I will keep the stops tight until that day.

I will know it is time to buy when the cadence of the last few days abates itself. Sellers won every battle this week, so when they appear to back away I'll test if there are any buyers. If it is truly a reversal to the upside, a simple buy the dips and accumulate strategy will do just fine. Otherwise I will keep the stops tight, so I live to fight another day.

Keep the stops tight.

Wednesday, October 8, 2008

Forensic Examination of the Market

A view of the overall market might convince one that the end of the world is nigh. However, a closer examination of the market that composes this index tells a different story.

We can see that the oil services have gotten killed in the same pattern as the market (which is an AVERAGE of other stock prices, including oil service stocks)

Rio Tinto, one of the worlds largest mining firms, has lost 60% of its value. Arcelor-Mittal (MT) has lost 70%. US Steel is down 75%. This is all since the end of June.

What we are experiencing is a huge popping of a liquidity fueled commodity bubble. Remember the Chinese Liquidity Mechanism? Thats been happening in every asian country in to some degree. So since 2003 there has been a mechanism for creating a ton of money and reinvesting it both in the US and emerging markets. Since commodities are priced in dollars, they have represented an easy way to reinvest accumulated dollar reserves held in foreign banking systems. Now that the largest mechanism for financing this huge ponzi scheme -- the investment banks -- are rotting six feet under, the whole money flow system is under pressure. That has meant less money creation in emerging markets and falling demand for raw materials as Americans buy less shit.

All this has combined with our banking crisis and election cycle to make everyone jittery as fuck. Take a look at some banks. They have gone NO WHERE in the same time frame:

The MASSIVE (combined market cap of greater than $400 billion) domestic banks haven't done anything in the last 5 months except rattle about. Granted they have made huge moves, they just represent the uncertainty that has gripped the market in 2008.

Of course, if you were long some foreign bank ADR's, all bets are off:




Long story short: our banks our fine. They have huge net interest margin from rate cuts and tons of high yielding commercial paper to buy. They have a 700 billion dollar buyer for their toxic mortgage products.

A commodity bust led to a bust in emerging markets. In a country like China or India, natural resources make up a much larger portion of their economy. Their banks lend to raw material firms. Prices just collapsed. Loans will go bad. Banks will go bust.

The S&P's look bad because its made up of raw materials firms and banks. Don't panic, make money when the world returns to normal. Just don't lose it all now.

My Bailout

Having been shredded by the ~11am back and forth, I became bound and determined to be in NTRS when it began its inevitable rise back upward. If it were going to go down after I bought it, it would have just collapsed like on the moves that caught me earlier. But this one was different in that the buyers stayed pat on every down move, and the XLF's and regional banks were ticking up too.

Buying on the rebound happened fast, with a sub minute move from 62 to below 60. Within ten minutes the stock was up two points to its highs. Sold too soon on both trades.

Structural vs Fundamental Causation: A Look at Hedge Fund Redemptions

Depending on what sources you use, hedge funds face redemptions of 10-20% of their assets under management from disgruntled investors. When an investor redeems their capital from a hedge fund, unless the fund has excess cash it must sell some of its positions. If the market is depressed to begin with, and a herd of investors rush for redemptions all at once then we can see how the market could turn ugly quickly (e.g. the last 2 days).

This provides an excellent opportunity to contrast two different classes of causation in the market: structural vs fundamental. Everyone is familiar with a fundamental reason to make an investment decision. An investor could buy a company because their earnings look good. The return on investment might be higher with one company vs another. The economy could be expanding or contracting. These are all fundamental qualities.

Structural causation comes from things like the massive hedge fund redemptions: they are causes of a not necessarily fundamental basis. They may be caused by fundamentals; a rash of redemptions was caused by a fundamentally crappy market. But structural causes often appear disconnected from fundamental reality. The government has intervened in unprecedented scale and scope; net interest margins will be improved by coordinated worldwide rate cuts. But there are some firms that still need to sell things to raise cash. Until they are able to get the cash they need in loans or by selling inventory, the crash will continue.

Mid-day Report: Don't Feel So Bad, Traders are Getting Annihilated Too

I make my living exploiting statistical linkages between stocks on a microscopic level. Because I am so short term and exploit spreads, I make money on 85% of the days that I trade. That being said, these last two days have been complete garbage. Correlations that I have used profitably for months were demolished today. Any semblance of order was replaced by an inexorable pressure to the downside.

The moral of this story is to stay on the sidelines or if you do trade stay as small as possible. That is not to say that there isn't any opportunity in this market. Buy and hold investors are getting amazing prices. But if your strategy is X and the market wants Y then you've got to take a chill pill for awhile and relax. Either get some new strategies or sit back and watch until yours work again. IT IS EXTREMELY EASY TO LOSE EVERYTHING IN A MARKET LIKE THIS. Be careful, and live to buy another day.

Justice in the World?

Looks like they finally got around to busting those crazy trades I was blogging about on the 19th of september. Is this all really designed to protect the investor? How did the SEC/FINRA decide that 9:37 (where the chart really starts) was the proper cutoff time to bust trades? Do the people who bought at 57 feel protected when they just saw it trade for >100?

It all seems rather arbitrary, because it is...


Tuesday, October 7, 2008

The Ineffectiveness of a Short Sale Ban: Russell 2000 Anecdotal Evidence

This chart is the IWM exchange traded fund (ETF) which tracks the Russell 2000 stock index. Note the large spike up to ~$78. That was September 19th, which some of you might remember as the day the SEC out lawed short selling a list of mostly financial services stocks. It doesn't take a computer program to see the nearly 30% decline that has occurred since the ban.

Like I have said before: no short sellers leaders to less buyers on the downside and less sellers on the upside. What we have experienced here is the market in the absence of shorting, and it is the stupidest wild whipsaw ride I have ever experienced as a trader. The SEC should seriously consider letting the ban expire this Thursday; perhaps then markets will start to behave again and prices will actually mean something for a change.


There's Lots of Blood Everywhere

If you have ever waited for one of those dare to be great moments, the next few days will be it. If a 20% decline in the sp500's constitutes "blood in the streets," then this is a good time to buy. There might be some despondent selling off the open, but if we don't bounce HARD tomorrow we're in for some serious trouble.

The VIX is at 53.68. Here is a disclaimer. I think the spyders have to bounce some time tomorrow or we're doomed. That being said, I have never been trading when the VIX is >50.

Stay alive to fight another day. This market is for long term buyers and traders.

Sunday, October 5, 2008

The Binary Volatility Regime

There is a lot of empirical evidence that suggests there exists two different states of the market: high volatility and low volatility. A corollary of this binary model is that volatility "shocks," defined as sudden large changes in volatility, are persistent; when a shock occurs that increases volatility quickly, it will stay elevated for a macroscopic (multiday) period of time. 

I agree with this model; but it is made more perceptive by adding on a level of complexity. What if there are four states to the market: high volatility & bull market; high volatility & bear market; low volatility & bull market; low volatility & bear market. This assumes that the market is either bull or bear at any point in time. Under this model, we use august 2007 as the transition from a bull to a bear market.

Right now we are in a high volatility & bear market model. This means huge moves up or down; but the market will maintain a proclivity to crash and reverse. It will be hard to make money long or short, but not impossible. Remember my previous post and buy on huge declines for a short but sure return.

The question reduces to where do we go from here? 


Saturday, October 4, 2008

Sector Trading: A Primer

One of my favorite setups is to watch an entire group of competing stocks. If there is a leader, you can watch the leader and trade the laggers to make a quick scalp. This makes money because of the existence of statistical arbitrageurs who keep a sector in line. 

Take the agricultural chemicals, for example: POT, MOS, AGU, TRA, CF, MON. Using a statistical technique known as a minimum spanning tree, we can establish POT as the "leader." AGU is the closest lagger behind POT. 

So in the beginning of the day, if POT is ripping you can buy a little AGU and have a positive expected value of your return; as long as POT keeps going you can book profit in AGU. The same works on the downside.

Do your own research; look at some good charts to verify what i'm saying. use some stats packages to establish a theoretical price for POT given AGU. the best approach is a combination of the two. 


Friday, October 3, 2008

Staring Into the Abyss

I know its getting pretty hard to be forced to be a long only trader during a huge market decline, but there is still hope in buying low and selling high. As I've come to find out over many years of trading, when a stock goes down a lot it almost always overshoots. By that I mean that the stock will always go down more in the short term than it ends at the end of the day. Take the case of State Street (STT) as pictured below:
After the bill passed, the market took a huge shit. STT and all the other financials got sold like there was no tomorrow. While I still have no idea why we sold off, it is a fundamental property of the market that when a stock experiences a huge decline it will inevitably overshoot and correct itself to some degree.

Here we see STT doing just that. This killing allowed for 4 possible quick buy points. The first came after the initial 4 point decline from 52 that occurred in five minutes. Any time a stock moves down with such velocity the chances are good for at least some reversal. Buying on the bid meant you could have flipped your stock for a point profit several minutes later. The second buying opportunity occurred when down velocity picked up on the drop from 50 to 47. Within twenty minutes the stock had made the rebound back to 50. The third chance occurred after STT broke though its old lows at 47 and crashed to 42. This was the hardest to catch, because how would you know when it would stop? You will notice, however, that the decline was an almost unbroken string of red bars downwards. If you had bought after the stock stopped falling and began a rally, you could have caught several points from 42-44. The final buy occurred when the stock dipped back below 44 in one minute. Ten minutes later you have a point profit.

While it can be very difficult to make money buying dips in a bear market, hopefully this example can show you where to find short term buying opportunities even in bad markets.

Thursday, October 2, 2008

The Dollar Remains Strong

The Euro is 1.38. Pound is 1.76. The Dollar is as strong as it has been in a long time. The rest of the world is still keeping shortest t-bill rates low (at <1%). All this reflects a confidence in our government as the truly risk free products that make us the reserve currency of the world.

You see, to understand how powerful the US government money creation can be, consider the following series of statements. Our government debt is currency that can be traded for dollars. When we issue debt and someone buys it, this has the same benefits as printing money. Actually its even better than printing money because there is a complex multiplier effect.

Lets take a look at the transaction taking place: US government sells bond; investor buys bond and marks as an asset on its balance sheet; government gets dollars from investor and marks liability on its balance sheet. Since federal government debt is regarded as "risk free", that means the government's balance sheet is effectively infinite. So now the government has cash to spend and the investor has assets to hold or use as collateral for loans (which would increase the money supply even further).

Our government debt is regarded as a cash equivalent because they can be sold so easily after purchase or used to get a cash loan with which to buy other dollar denominated products. So when our government sells debt, the money borrowed becomes multiplied several times over because our debt is so liquid. if the government takes the borrowed cash and then loans it as a bailout to dying banks, then the money becomes levered even further.

Some people have wondered how the hell inflation wouldn't go crazy with all this money creation, but that is where our highly liquid capital markets come in. Foreigners face a choice of what to do with all the dollars we give them: invest them in our markets or sell them, ruin your cheap currencies, reverse the trade balance that gave u the dollars, and fuck yourself royally. which would you choose? They all invest in our markets and as long as we sell enough shit into them to mop up liquidity we're all good. sometimes they lead to asset price bubbles, and everyone loves them on the way up. Such is the economy.

Senate Passes Bailout Bill: Sends It Back to House

I see a couple of scenarios playing out here which are combinations of some simple random variables.

List of Var's

+Market's Move In Between Votes

Possible Outcomes:

- We rip up into the new vote
- We trade sideways into new vote
- We die into new vote

*Note Vix has hovered ~40 in last three days, hence the expectation of volatility.

+House Re-vote on Bailout

Possible Outcomes:
sub outcomes of Failure:
=>Eventual Passage
=>Bouncing Back and Forth

+Market Response to ANY US Legislature Event (vote, significant comments, etc)

Possible Outcomes:

-Knee Jerk Up
-Knee Jerk Down

Secondary Outcomes (endemic to knee jerk event reactions):

-Reversal of reaction
-Continuation or maintenance of reaction

-Scenario 1: Rip Into New Vote + House Package Passes => Knee Jerk Up + 50% Reversal
-Scenario 2: Rip Into New Vote + House Package Doesn't Pass => Knee Jerk Down + Continuation
+Sub Scenario 2a: Bailout Eventually Passes: Bottoming or Crashing into Passing Vote => final bottom and upward after
+Sub Scenario 2b: Bailout Bounces: Severe market decline, fed printing money, lowering rates doing everything it can to avoid depression
-Scenario 3: Sideways into New Vote + House Package Passes => Knee Jerk Up + Continuation
-Scenario 4: Sideways into New Vote + House Package Doesn't Pass => Knee Jerk Down + Continuation
+Sub Scenario 4a: Bailout Eventually Passes: Bottoming or Crashing into Passing Vote => final bottom and upward after
+Sub Scenario 4b: Bailout Bounces: Severe market decline, closed markets, fed printing money, loweringrates doing everything it can to avoid depression
-Scenario 5: Crash Into Vote + House Package Passes => Knee Jerk Up + Monster Continuation
-Scenario 6: Crash Into Vote + + House Package Doesn't Pass => End of Time, Interest rates cut to zero

Wednesday, October 1, 2008

Not Out of the Woods Yet, but Certainly Near Town

The VIX has retreated from historic highs back into the "less jittery": <40's. Pretty frightening stuff for everyone I assume.

Some of us enjoy good times when the volatility spikes and the markets jerk from up 300 to down, and so try not to be levered to one side more than the other. I have become a structural bull since bernanke showed his willingness to support credit markets, but we may go down more or at least not go up much while the fed pumps several more injections into money markets. After a lot of liquidity is forced in, the banks will return slowly to their chief pursuit of borrowing short/lending long. This is when the bulls will eat good again

In the mean time don't be greedy and try to be a trader if you are a trader. no one ever went poor taking profits. buy on fast dips, sell on fast rips if its not illegal (short selling ban extended!).

Ron Paul: Buying bad debt is the wrong solution

Two days after the House rejected the $700 billion bailout bill, the Senate is set to vote on the rescue plan for financial institutions.Ron Paul continues to be stuck in the gold standard. He attacks the patient for taking its medicine and then offers no substitute relief of market suffering.

read more | digg story

The Market Is Beautiful

The market has completely reversed the bounce we experienced last week, overshooting on both the upside and the downside. Ending just about right where it started, showing the futility of such short sighted government manipulation of markets.

We're actually lower than before the ban... if we don't start holding some levels on the upside tomorrow, could start getting uglier before it gets better. Keep them stops tight.

Tuesday, September 30, 2008


More federal reserve act...

Section 15. Government Deposits

1. Federal Reserve Banks as Depositaries and Fiscal Agents of United States

The moneys held in the general fund of the Treasury, except the five per centum fund for the redemption of outstanding national-bank notes may, upon the direction of the Secretary of the Treasury, be deposited in Federal reserve banks, which banks, when required by the Secretary of the Treasury, shall act as fiscal agents of the United States; and the revenues of the Government or any part thereof may be deposited in such banks, and disbursements may be made by checks drawn against such deposits. [12 USC 391. As amended by the act of March 18, 1968 (82 Stat. 50). Also, in effect amended by Act of May 29, 1920 (41 Stat. 654).

The Finer Points of the Federal Reserve Act

Federal Reserve Act

Section 2a. Monetary Policy Objectives

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

[12 USC 225a. As added by act of November 16, 1977 (91 Stat. 1387) and amended by acts of October 27, 1978 (92 Stat. 1897); Aug. 23, 1988 (102 Stat. 1375); and Dec. 27, 2000 (114 Stat. 3028).]

Section 10A. Emergency Advances to Groups of Member Banks *

1. Authority of Reserve Banks to Make Advances

Upon receiving the consent of not less than five members of the Board of Governors of the Federal Reserve System, any Federal reserve bank may make advances, in such amount as the board of directors of such Federal reserve bank may determine, to groups of five or more member banks within its district, a majority of them independently owned and controlled, upon their time or demand promissory notes, provided the bank or banks which receive the proceeds of such advances as herein provided have no adequate amounts of eligible and acceptable assets available to enable such bank or banks to obtain sufficient credit accommodations from the Federal reserve bank through rediscounts or advances other than as provided in section 10(b). The liability of the individual banks in each group must be limited to such proportion of the total amount advanced to such group as the deposit liability of the respective banks bears to the aggregate deposit liability of all banks in such group, but such advances may be made to a lesser number of such member banks if the aggregate amount of their deposit liability constitutes at least 10 per centum of the entire deposit liability of the member banks within such district. Such banks shall be authorized to distribute the proceeds of such loans to such of their number and in such amount as they may agree upon, but before so doing they shall require such recipient banks to deposit with a suitable trustee, representing the entire group, their individual notes made in favor of the group protected by such collateral security as may be agreed upon. Any Federal reserve bank making such advance shall charge interest or discount thereon at a rate not less than 1 per centum above its discount rate in effect at the time of making such advance. No such note upon which advances are made by a Federal reserve bank under this section shall be eligible under section 16 of this Act as collateral security for Federal reserve notes.

[12 USC 347a. As added by act of Feb. 27, 1932 (47 Stat. 56).]

Section 16. Note Issues

1. Issuance of Federal Reserve Notes; Nature of Obligation; Where Redeemable

Federal reserve notes, to be issued at the discretion of the Board of Governors of the Federal Reserve System for the purpose of making advances to Federal reserve banks through the Federal reserve agents as hereinafter set forth and for no other purpose, are hereby authorized. The said notes shall be obligations of the United States and shall be receivable by all national and member banks and Federal reserve banks and for all taxes, customs, and other public dues. They shall be redeemed in lawful money on demand at the Treasury Department of the United States, in the city of Washington, District of Columbia, or at any Federal Reserve bank.

[12 USC 411. As amended by act of Jan. 30, 1934 (48 Stat. 337). For redemption of Federal reserve notes whose bank of issue cannot be identified, see act of June 13, 1933.]

Call it a Comeback

Today was easy. Take it down low on the open after yesterday's bad news. Bleed anybody dry who had the balls to hold through yesterday's debacle. Then rip it in their faces right after they sold at the bottom. Classic example of the most people doing the worst thing at the least opportune time.

Monday, September 29, 2008


In a point that I cannot emphasize enough, the federal reserve has the ability to print money and effectively raise funds ad infinitum (until the whole system falls apart, but thats not going to be now). That means that this vote today was simply a formality; the great and powerful bernanke chose to let the treasury and the congress look like they could handle the bailout (with his blessing, of course). But when our politicians dropped the ball, the US central bank let everyone know who was really in charge.

The fed wields blunt instruments, but they are hugely powerful. As the dollar is the world reserve currency, the fed can create money out of thin air in a way people only dreamed of under the gold standard (GS). They can pump prime the lending markets until the rapture because nervous investors have driven treasury bill yields to historic lows.

Everywhere Dead Bodies

Bombs exploded everywhere. Naz down 9.14%, sp500 down 8.79%, dow down 777. financials took the worst hit, as was to be expected when the ground drops out from under a sector. xlf down 13.18%, some individuals down much more. my boy ntrs down close to 20%.

no one was safe. pot down 15 pts, agu 10, mos 12. oil streaked down 11%. The terror stalked from sector to sector. goog down 11%. bidu 11%. end of world.

the grim grizzly bear reaper slit the bull's throat and paraded its corpse around wall street. then it strangled all the sheep with lengths of entrail.

while the US congress was the catalyst for today's decline (vote ended 13:42:00, take a look at ze chart), the fact of the matter is that declines like this are largely endogenous events with exogenous triggers. The congress rejecting the senate bill was outside the market, in the political environment of an election year. That catalyst found a vulnerable market; punch drunk, bleeding, and reeling with the failure of wachovia.

The Strategy Surreal

If anyone was watching both the vote on C-SPAN and the SPY's today, you could have made a fortune. The second that the nea's surpassed the yea's the SPY's dropped 3.5 points without stopping. While the market was pretty wild, this unexpected trade was the big winner of the day.

Saturday, September 27, 2008

The European Liquidity Mechansim

In the preceding article, we looked at how china's currency manipulation was leading to money creation on a massive scale. Today we will contrast the european method for dealing with the dollars we throw at them.

China is not the only net exporter in the world; it is just the most extreme example. Germany, for instance, maintains large trade surpluses with many nations. Since germany is the largest economy in europe, this means that on a net basis the european union (EU) is one of the largest net exporters to america.

Like china, this means that there is a constant stream of dollars heading into the euro currency zone. Unlike china, there is much less currency manipulation. The european central bank (ECB) does not make it an everyday policy to keep their currency cheap by printing euros and using them to buy dollars like china does with the yuan. This means that the euro has increased against the dollar for most of the past 7 years.

That isn't to say that every dollar sent across the pond is sold for euro's: far from it. As one of the largest markets in the world, the so called "eurodollar" market refers to dollar deposits held by european banks. A great deal of these dollars make their way back to our domestic capital markets in the form of investments in stocks, bonds, and toxic collateralized mortgage obligations (CMO's) like the ones in today's current crisis. That is one of the reasons a US housing bust caused so much pain abroad, both europe and asia were heavily invested in US debt.

Nevertheless, until the US reverses its trade deficit with the EU or the ECB begins a china-esque policy of currency manipulation, the euro will resume its long rise against the dollar.

Friday, September 26, 2008

The Chinese Liquidity Mechanism

In terms of how much liquidity a foreign country injects into the world financial system, countries can be classified using two characteristics: their current account balance and the level to which they manipulate their currency. In trade, a country may either be a net exporter or a net importer. Most countries fall into the exporter category. None more so than China, which maintains a growing trade surplus with the US. As for currency, a more continuous scale can be used: active manipulators on one end and completely unregulated currencies on the other with shades of gray in between. China falls at the extreme end of the manipulation spectrum; they actively manipulate their currency to remain cheap against other currencies like the dollar. China's intention is to remain competitive in export markets by keeping export prices low in terms of dollars. That way more of you will go to target or wal-mart and send your levered cash to chinese exporting firms.

The american consumer sends a constant and growing flow of dollars to firms in china. when the dollars reach the chinese banking system, the domestic banks sell their dollars deposited by the exporters in exchange for yuan on the open market. If unchecked, this exerts a marginal downward pressure on the value of the dollar and a corresponding upward pressure on the value of the yuan. This increases the export price of chinese goods in dollars and makes them more expensive for you to buy at retailers state-side.

The chinese central government wants to avoid such an outcome. They counteract the effect of the domestic banks' currency conversions by entering offsetting positions in the market: printing new yuan and selling them for dollars on the open market. This exerts a marginal upward pressure on the dollar, making both the yuan cheaper and chinese export goods to america. This keeps americans buying cheap chinese shit.

This amounts to money creation on a massive scale. Chinese export firms are awash in yuan that they converted from the dollar profits on exports. Chinese banks get yuan deposits and make domestic loans to chinese firms in yuan. The government prints yuan in order to sell them for dollars. This has the effect of injecting yuan into the world markets, but since the majority of yuan are employed in china, the printing presses increase domestic chinese liquidity even further. The dollars that the central government acquires are then reinvested in dollar denominated assets like US government debt, US corporate debt, US agency debt, oil, gold, corn, soybeans... you get the idea.

Since china actively manipulates its currency, it injects far more liquidity into the world system than a country that allows their currency to appreciate as the result of a prolonged trade surplus. This liquidity has decreased worldwide interest rates, increased the ability of banks to lend in the form of mortgages, car loans, credit card loans and so forth and contributed to the preceding boom we had from 2003-2007.

Thursday, September 25, 2008

A Brief History of Time Part 1: The Beginning of Floating Exchange Rates

Our history begins in 1968 during the Tet Offensive. The rising US government expenditures for the Vietnam war was placing strain on the international monetary system, which at the time was based off of the Gold Standard (hereinafter referred to as GS) and the Bretton Woods Agreement. Under the GS and Bretton Woods, national currencies were either convertible at a fixed rate into gold, or "pegged" to the US dollar. A pegged currency would be actively manipulated by the government to maintain the exchange rate to within +/- 1% of parity with the dollar. The dollar, while still based off its convertibility into gold, became the default reserve currency of the world.

The benefit of the GS was that it was self-correcting. If a country maintained a current account deficit, gold would flow out of the country to those with surpluses. This would contract the domestic money supply, decreasing lending, and pushing the country into recession. This led to a decline in domestic consumption thereby reducing the deficit. An add on effect came from the resulting devaluation in the deficit currency, which made their goods more competitive and helped reverse the current account deficit. Likewise if a country experienced prolonged surpluses, its money supply would increase, leading to increased inflation and a strengthening currency as international money would flow into the surplus currency to take advantage of rising asset prices. This led to a decline in export competitiveness and a reduction in the surplus.

The downsides all stemmed from the fact that it was ultimately the supply of gold which determined the money supply. Unlike today's system, money could not be created at will. Keeping the supply of gold constant, an economic boom would cause demand to outstrip the money supply. The prolonged boom after the end of WWII created what was known as a dollar shortage, because convertibility ensured that the supply of dollars was constrained by the relatively constant supply of gold.

Back to vietnam: by 1968 there began to be widespread concern that increased levels of US military spending was creating a currency crisis and a run on US gold reserves. The US had been maintaining a current account deficit for several years, and as dollars were flowing out to pay for the war, so was gold. Since other major world currencies were pegged to the dollar, the decline in gold reserves began to jeopardize the stability of the fixed exchange rates. As we mentioned earlier, under the GS, a deficit creates negative pressure on the currency of the net importing nation. Normally this would adjust itself naturally by the self-correction mechanism: the dollar should decline and other currencies rise against it. But we were under the Bretton Woods pegging system, which meant that other governments had to spend large amounts of money to maintain the lower exchange rate in the face of a gold run in the US.

Some revaluations were enacted in a piecemeal fashion: the German mark was formally appreciated by 9.29% on September 20, 1969. But the manipulation that governments had to engage in as the US balance of payments deteriorated represented a dead weight loss of productive capacity; the money spent could have been productively employed elsewhere. Moreover government budgets experienced strain as the money flowed into manipulating exchange rates. Since governments have always been huge participants in debt markets, the distortions created by increased government borrowing were transferred to the real economy, and crisis ensued. As Vietnam dragged on, non-governmental actors anticipating devaluation placed extreme pressure on the monetary system.

Finally, during the summer of 1971, the Nixon administration formally suspended the convertibility of the dollar into gold. Thus began the rapid advance of the floating exchange rate mechanism. Under this new system, currencies would float freely against one another. Exchange rates would be determined primarily through market forces, with some government intervention during crises. Most importantly, the supply of dollars would not be constrained by the amount of gold in the world, allowing the government to regulate the money supply as needed.

Stay Tuned for Part II, "Exponential Expansion of Reserve Currencies Under Floating Exchange Rates"


Yet Another Way to Screw the Shorts

Short selling is dangerous. Since a stock can only go to zero and can theoretically go to infinity, a short's upside is limited and the downside unlimited. Shorts can also be outlawed by the government, as many of us found out first hand last friday. Now there is yet another reason it sucks to be a short: it is getting harder and harder to borrow stock.

In order to be compliant, a trader who wants to go short must either be a bona fide market maker or meet the requirements as mandated by the SEC. This means that you have to locate and borrow the stock before you can sell it short. Most brokerages have an easy-to-borrow list and charge little to nothing for the ability to short stocks on the list. Some stocks, however, are harder to borrow and thus carry a higher charge for borrowing them.

The stock you or I borrow to short a stock usually comes from a margin account of somebody who is long the stock with your broker. Because he bought it on margin, technically the stock belongs to your broker, who earns a fee or commission for lending it to you to sell short.

Another source for borrowed stock comes from large pension and hedge funds who want to be both long the stock and earn a return from lending the stock out to shorts. Lately these institutional investors have realized that it is not in their best interest to lend stock for shorting. The thinking is if they do not lend stock out, it will be harder to borrow stock for shorting; the awful thing is that they're right.

Anecdotally I have noticed my borrowing costs increasing since last week. I have also read that big pension funds like CalSTRS are reigning in their stock loan operations hard. The managers of CalSTRS said they would no longer lend stock to the "piranhas" that stalk the markets' murky waters.

Everyday it gets harder and harder to be a short.


How the AIG Bail Out Saved the Airlines Too

Something that has not been commented on in the press as much as it should have was the fact that the AIG rescue package did far more than just bail out their financial products division. It also kept the aircraft leasing subsidiary of AIG, International Lease Finance Corporation (ILFC), out of receivership. This stopped ILFC's 900 planes from going into the hands of creditors. If this had been allowed to happen, it would have thrown the major airlines' operations into a tailspin. As ILFC leases lots of their planes to the majors, a bankruptcy would have derailed flights worldwide at a time when flight operators cannot afford to lose any revenue.

Wednesday, September 24, 2008

Nobody is Trading... We Are All Watching the Bureaucrats on CNBC

It was to be expected that the volatility might compress in the days after the nonsense we went through last week. Add to this the fact that everyone was watching the extensive coverage of the House Financial Services Committee's questioning of the powers that be. If a second day of politicians not knowing how the hell the economy works (why are they on the committee?) was too much for you, the decision to keep trading might have seemed like a good idea. But sideways trade to nowhere is only a good thing for the market makers. One might have been better served by drinking beer and laughing at hapless congressman.

What I find amazing (other than the amount of useless campaigning that takes place at such a gravely important meeting) was the genuine lack of understanding of the world that surrounds these representatives and their decisions. These congress folk continue to be astounded at the "complexity" of our financial markets, fail to recognize that we have the only government who's borrowing costs DECLINE during a market bust, and completely miss that the fed and treasury want to buy up cheap debt assets which will provide a massive amount of cash flow. This is essentially the greatest carry trade ever. Our government borrows (currently) at less than 1% and buys debt products yielding anything from 6%-12%. Any bank would kill your grandmother to get this kind of positive carry.

Anyone testifying in front of congress about financial matters requires a heaping helping of diplomacy and almost infinite patience. There is, however, one representative who understands the market better than his peers: Rep. Spencer Bachus. This guy typifies the scumbag I was mentioning in my rant below. The representative from Alabama made an estimated $160,000 in short term options trades last year. Now I am not in any way saying that I know this guy had insider information.... but it is extremely difficult for me to believe that this man did not posses material information before any other scrupulous trader or investor who was not a member of congress would have. I'm not a member of the House Financial Services Committee, are you? And I know for SURE that Ben Bernanke and Hank Paulson have never shown up at my house on a sunday night to brief me on anything, let alone the largest bailout in history.


Tuesday, September 23, 2008

Beware Specialization in Those that "Serve" You: What Are They Specializing In?

Most politicians are scum. More than that, they're some of the scummiest scum that ever crawled out of the pond (specifically one in china that serves as a phosphate factory's drainage). This is a little thought exercise to explain why.

First think about how we as individuals evaluate the "quality" of a politician. We see and hear them on television and read what they say on the internet. We are able to evaluate how well they speak, and possibly how well they write (although almost everything said or written by a politician really comes from a professional writer). We hear them talk about their policies and voting records. We hear them say how much they care about us.

So what are we really evaluating? Any American would acknowledge that being well spoken and presentable are admirable and possibly monetarily valuable qualities to have. But does this solely qualify them for office?

We read what they write, but that is written by someone else so that any information we can get from that is complete bull$hit.

We hear what they say about policies, but those are CHOSEN by a team of pollsters and back office types who are paid huge amounts by the parties to get their candidates elected. Policies are designed to maximize constituency and easily changed from season to season. If it is a presidential election year then policy is ephemeral; candidates changing policies from station to station. So any policy metric is out.

Voting records suffer from survivorship bias. Candidates drag out records during elections and use them to trash their opponents. They also trot out their own records when it is advantageous to do so. But sooner or later the election has to end and someone has to win; and when they do their good voting record keeps on getting mentioned (by them) and the bad records stop getting mentioned (because the other guy lost and is out of money). So people see the winner in office (that must mean he's good, lacking any other real information), and only hear good things because that's what the party money machine pumps out... eventually all you hear is good about the winner. He's a saint he is.

So that leaves the quality most of us are qualified to judge is speaking skill. This is the only uncorrupted information that we receive... BUT IT STILL DOESN'T TELL US JACK!

I can train a bird to talk. I would probably rather vote for him.

So this means that if someone specializes at speaking, is possibly manipulative, has a good sales team behind him with good writers, and doesn't get caught banging an underage guy with the deacon in a coke fueled rectory rumpus he's a f$#king shoe in for senator.

Still following? One more step:

So you meet someone on the street for the first time and have to bet: do they care about themselves or you more? Bingo: Themselves.

Is it easier to take an opportunity if it: hurts your friend or someone you don't know? Obviously the person you don't know.

So then in a country of 300 million I am willing to bet good money that there are at least 600 motivated, well-spoken, possibly manipulative, well-funded people who care more about themselves than anyone else and doesn't have a clue who you are. I'm betting that some of them are running for president.

All politicians have to specialize at is being a good speaker. They find the political and economic machinery already in place from years of the two party system. Plug and Play Politics: Simply Add Speeches! Now in new colors and action genders!

Hence politicians are scum. QED


The Market is Scared S%^#less of the Senate... and I Am Too

Watching the senate finance committee grill Bernanke, Paulson, and Cox today most certainly did not make me all warm and fuzzy inside. First of all, the market has tanked ever since Cox and crew led a pogrom against the shorts and forced everyone to buy it all back last friday. You can't make money off that however, because (sorry to belabor the point) they outlawed shorts in financials!!! I thought they banned shorting to manipulate stocks upward. Great job there guys, turning our market upside down just to put the shorts out of business. Now we have prices that mean f$@# all.

Add to this sour mood the image today of the senate finance committee burned into everybody's retina: seemingly BALKING at the rescue plan set forth by the treasury, fed, and sec. On one side of the desk you have the most powerful banker in the world saying that the market cannot recover unless we enact this 700 billion dollar rescue and on the other you have sen. D0dd stumping. GET YOUR F#$KING CAMPAIGN OFF THE TRADING FLOOR YOU DIRTY CRIMINAL. This guy is an idiot anyway: he's from connecticut, which last time I checked was the center of the hedge fund universe. Who does he think this bailout is for? The public? Main Street? This is welfare for the rich, plain and simple.

The fact is if the senate harpoons this deal we don't know what kind of hell will ensue. Its no wonder this market can't hold a bid into the close. Keep in mind that my earlier optimism is completely dependent on government intervention in the markets. Without them we would have a good ol' fashion credit starved depression. The drop would have been spectacular. It could still happen, you just wouldn't be able to short it.

Suppose you are a tax collector and you have two types of people to make money off of: bulls and bears. Would you, while the bulls are getting killed and not paying any taxes, shoot all of the bears in the head? Why NO, because then you would have no tax revenue. Then you would be smarter than our government.


What is Worse: Short Selling or RIGGING THE MARKET?

Consider the following example of Zion Bank Corp (ZION) last friday. At 9:28 it was trading approximately $50. By 10:00 it had printed $108, $46, and everything in between. HOW IS IT BETTER FOR FINANCIAL STABILITY TO HAVE SOMEONE PAY $100 AND THEN WATCH IT GO TO $50. I'm sure more than a few people got absolutely destroyed because of the short sale moratorium. Even more lucky gamblers were bailed out after doubling and quadrupling down on losses. Luckily I was not one of either group, but even so I realize that the market has fundamentally changed from a free market to a rigged one.

The risk factor of a company's political importance has to be brought to the very core of our new market models. Economic reality is shunned in favor of betting on blatant market manipulation.


Why Banning Short Sales Screws Everyone

1) It leads to steeper declines

While it may seem counterintuitive, the people who are buying the most during market declines are people who sold the stock short and are buying it back to cover their positions. While shorts want stocks to go down, they become net buyers during declines because it represents an easy opportunity to book the profit out of a short position. The presence of these short buyers exerts a marginal pressure upwards on the stock price. Without these buyers (because they outlawed shorts on financials), longs who want to sell find less of a willing market to sell into. This means that there is less buy-side liquidity for any given market decline. Thus long sellers have to push the price down further to attract the same amount of buyers as before the ban.

2) It leads to steeper rises and worse buy prices

Normally when the market is presented with a bid that seems too high any participant can sell to that buyer (be it a long sale or short sale). With shorts banned only someone who is already long the stock can sell to this "too high" bid. This is by necessity a smaller number of people than before the ban. Thus for any given rise in price, there are less sellers attracted now than before the ban. Just as the absence of short buyers led to steeper declines and worse prices for sellers, the lack of short sales means that buyers have to push up the price higher to receive the same amount of stock as before the ban. This means that when you buy a financial during an upswing, you are paying more for it than you would if there were short sellers.

3) It causes dislocated prices

Markets are interconnected more than in any time in history. Computer based statistical arbitrage traders push stocks that have nothing to do with each other economically around as though they were competitors. These trades are based off of identifying and enforcing statistical correlations among large portfolios of stocks. A stat arb trader relies on being able to go both long and short at a moments notice. The ban on short sales has thrown a wrench in their trading systems, which leads to crazy price movements as the programs attempt to adjust to the new world order. This has led to extremely dislocated prices since last week: stocks will move points in seconds, effectively establishing two prices for a stock at once. While this has been a bonanza for traders like me, we must all realize that this severely hurts the systemic health of the system: who is going to want to invest when they get completely screwed (by multiple percent) on their price within a few seconds?


PS: while I am aware that banning shorts causes a certain marginal decrease in selling, as a trader I assume that most short selling is done on the way up and not used to pound stocks into oblivion. The only time a short seller can make a stock go down is if there are already an imbalance of long orders to the sell-side. A short seller who tries to single handedly push down a stock will get his face ripped off. Lets face it, shorts are sometimes the ONLY buyers of stock on the way down. They support the market on declines and regulate its exuberance on rips.

An Altogether Appropriate Admonishment

Some Notes on Determinism vs Probability

There is an irresistible force within each human that compels them to find reason in the randomness around them. This is why people come to read blogs like this one: to glean some truth out of the game of deception that is Wall Street. But how we describe events determines how valuable the lessons we learn from today eventually become.

In trading, ways of describing the world come in two forms; there are those that try to provide discrete causal explanations for a particular market event -- this is known as determinism. These explanations are consistent in logic and view each event as a unique combination of forces. The other form -- probability -- takes a different approach, considering each event as the summation of a number of random variables. These probabilistic explanations are less satisfying on the surface. They make no causal claims about today's event, they merely say that there was "a 60% chance of the market rising today given treasury bond yields and what the nikkei did yesterday." Unlike determinism, the probabilistic mind makes no attempt at causality, he merely counts the past and extrapolates into the future, knowing all the while that relationships are bound to change. The probabilist makes use of causation, but not as a one way street. He knows that when oil goes up there is a good chance airlines are going down. But he does not say that airlines went down BECAUSE of oil.

A determinist and a probabilist will view the same event in different ways. Suppose we flipped a coin fifty times without knowing whether the coin was fair or not. If the results show 30 heads and 20 tails the determinist might conclude that the coin was indeed biased to come up heads. Or he might say that there was an error in the flipping method that we used. He has no way to find out the quality of his theory, as it is generated ad hoc to explain the 30 heads. The probabilist will say that if the coin was fair he knows there is a 4.19% chance of getting 30 heads exactly and moreover, we would only get 30 heads or more about 10.1% of the time (see chart). He will do another statistical test and will most likely conclude that he too thinks the coin to be unfair and biased towards heads.

Risk Affine Market Wisdom Cumulative Binomial Distribution with 50 trials @ p = 0.5

If both parties are not allowed to examine the true state of the coin (as is often the case in the market if we replace "coin" with "company") then the two approaches can produce numerous different explanations and not have any real idea which is true. The determinist could say that since he couldn't examine the coin it could be any of his explanations that led to the bias. The probabilist will tell you that on one hand it could happen even if the coin was far, but on the other an outcome with greater than 30 heads would only happen 10% of the time, but on the other hand...

This example should highlight both the usefulness and the pitfalls of using either approach by itself. The solution comes in the form of a judicious combination of the two philosophies and an iterative approach to model building. One must use both models together while using how the models respond to repeated experiments; each time refining the models to reflect new information.

If we further assume that our two coin commentators can repeat the fifty tosses, they can use their combined knowledge to come up with a better explanation of events. Suppose the coins again show a bias with 30 heads and 20 tails. The determinist will be cock sure about his explanation. The probabilist will say that the odds of that happening twice (if unbiased) are 0.16%. He will calculate that the probability of the 30/20 split is maximized when the probability of each coin toss going heads is about 60%. After two experiments, both approaches conclude that the coin is likely biased.

Determinism also provides a useful tool for the imagination of the probabilist, and visa versa. Combing the cannon of possible causal explanations may lead one to examine a relationship that would have never been considered under either approach alone. Likewise, knowing that market participants follow probabilities intensely could lead to a deterministic explanation if the numbers change rapidly.

Through a combination of these two approaches one can overcome a great deal of the downsides inherent in a single strategy. Take this lesson to heart, and always remember that its never as complicated or as simple as it looks.


Monday, September 22, 2008

The Levered Elite

How Government Regulation Robbed Retail Equity Investors of their Right to Borrow and Gave it to the Investment Banks... (who $%^&ed it all up)

After the stock market crash of 1929, the federal government enacted what is known as Regulation T (Reg T), which effectively limited any participants ability to buy stocks on margin (with borrowed money from a broker). Currently you can purchase four times your capital for intraday transactions and two times for interday. Of course, if someone other than your broker handed you a million dollars as a loan for speculation/investment, you could deposit it alongside your personal capital in a brokerage account and still be in compliance with Reg T margin requirements while in effect having much higher leverage. But there isn't anyone lining up to loan you money to speculate. For an investment bank, however, it is a different story...

During normal market conditions, an investment bank usually has loads of people willing to lend it money. Since these lenders are usually investors themselves (not brokers) they are not covered by Reg T and thus the investment bank may use the proceeds of these loans to speculate in equities. As was already mentioned in the moral hazard section of the glossary, this combined with other loose regulation to allow investment banks to buy assets worth 60 to 70 times the value of their capital.

When market conditions turned sour and lenders stopped throwing money at the banks, it was exactly this level of gearing (leverage) that led to such precipitous declines in asset prices. If you buy a stock for cash and it rises 10%, you make 10% on your capital invested. If you're levered up 60 times and the investment rises 10%, you make 600%. The same is true on the downside, however, and being geared up over 50 times means all you need is a 2% move to wipe you out. This is why banks were indiscriminately selling stocks, because they were all levered up way too much to handle anything but rising asset prices across the board. Once intraday traders smelled blood in the water, the forced selling came in earnest as stop after stop was uncovered.

To understand how this epic amount of borrowing was allowed to take place we have to skim the dense surface of a subject known as financial mathematics. This allowed investment banks to calculate a likely amount that they could expect to lose/earn in the event of certain market conditions. This practice is known as the Value-at-Risk (VAR) model. Statisticians make assumptions about a particular asset's distribution of returns in order to predict, for example, how much a bank could lose during a complete market meltdown. Of course if your assumptions turn out to be wrong, your VAR model will be wrong. Why does this matter? Because of the interwoven nature of banking regulation and financial math.

There has been a push since the early nineties to tie how much a bank can borrow to how "risky" its assets are. Lacking any other way of quantifying risk, regulators and practitioners alike have embraced the VAR model. This would all be fine and just if the models actually worked; but they don't. The reason is that the results these mathematical models pump out are HIGHLY DEPENDENT on what data is used to estimate them. The data that banks and regulators used to define risk was from the last thirty years (most of it from the last ten), which was largely a time of uninterrupted credit expansion. The models were thus completely inadequate for predicting what would happen in the event of a liquidity drought. Most models in the literature don't even take into account the idea of liquidity; being a hard to quantify it was simply left out.

If you are looking for someone to blame in this mess, blame the investment banks who hired physicists to run trading desks. I'm not joking. There are entire programs at well respected institutions that make it their business to turn 40 year old engineers into quantitative traders. As a result, people who had never traded a share in their lives were tasked with running billions of dollars. These financial children were given the keys to the family flatbed truck which was then loaded with gold. They were told to drive 200 mph at what they thought was an even bigger pile of money and when they all rolled over at credit crunch curve we act surprised.


Some Notes on Bail Outs, Numbers, and the Long- vs Short-Term

Re: Bail Outs

Last week the Fed organized an $85 billion loan to American International Group (AIG). The loan allows AIG to post collateral against billions in claims from their financial products division. This doomed unit underwrote credit default swaps (CDS's) and other credit derivatives; it has almost single handedly brought down one of the largest insurers in the world. Given the Fed's predilection for stabilization, they had no choice but to extend the loan after the prospects of securing financing through a non-sovereign banking consortium deteriorated yesterday. Letting AIG go into bankruptcy would have been disastrous. To understand why, lets look at how insurers work.

Insurance companies underwrite policies against certain risks occurring. During "good" times, insurers collect premiums, pay out a small percentage of claims, and invest what's left in stocks, bonds and the like. This makes insurers as a group some of the largest investors in the world. AIG is one of the largest of all insurance companies, which means it owns at lot of financial assets.

If AIG had not received the $85 billion loan from the Fed, it would have been forced to start liquidating these assets until it had raised the necessary collateral to cover its derivatives losses. Since the market was already depressed to begin with this easily could have led to an all out rush for the door, with investors selling anything and everything. We saw a shadow of what could have happened last monday and wednesday.

Of course, the Fed is expanding its balance sheet by selling more treasury bills. This would be a problem if foreigners didn't eat our sovereign debt as quickly as the government can print it. But for now it seems the Fed has unlimited scope, especially with the dollar not deteriorating at any real clip Holding short term interest rates firm at 2% (instead of cutting) was perhaps the cause of this dollar strength.

Moreover, investors were so spooked by last wednesday's market action that they drove 3-month treasury bill yields negative. This means that people bid the price of a 3-month T-bill so high that buying it will actually earn you negative interest: YOU PAY THE GOVERNMENT TO LOAN IT MONEY.

The Fed either has the smartest people in the room or the luckiest, and which doesn't matter; I still want to stand next to them. This means that the government, even if yields go positive, is financing this AIG bailout for almost nothing. They are lending to AIG at approximately 12%. This might very well be the best trade in history. That's a positive carry of .12 * $85 billion = $10.2 billion per year. If AIG defaults the government will repossess one of the best property-casualty insurers in the world.

As former fed governor Wayne Angell said last week: "THE FED'S BALANCE SHEET IS INFINITE." This is especially true now that investors don't even demand interest to loan our government money...

Re: Numbers

It always amazes me the double reversals that can take place after numbers. Take the price of oil last wednesday after the 10:35am announcement of inventory data, which traded immediately down reversing an earlier gain, only to reverse again throughout the rest of the day; it was even so bold as to make a new high. The same thing happened last tuesday in the S&P 500 after the Fed rate decision was announced at 2:15pm. The market immediately tanked, only to spend the rest of the day going higher.

It has been my experience that opposing the knee-jerk reactions people have after numbers is the closest thing to a free lunch in this market.

Re: Long- vs Short-Term

Finally I want to stress the importance of planning long term and living short term. Planning long term goals and thinking about where the world is headed are noble pursuits, and it can bring us comfort to feel that we know where we're going. But we must remember
the Keynes quip that "in the long run, we're all dead," in addition to the fact that the short term can bankrupt you well before the long term saves you.
This doesn't mean you should ignore the long term, far from it, only that you should always be aware that in a market like this (especially if you are
using leverage) you must always be containing your short term losses. The moves have been so volatile
that you could be completely right long term, but blow out your equity waiting for it to happen. In this market it is best to dump any position that isn't going your way immediately and wait for a clean move that you nail from the beginning. In a market where there exists so much opportunity, there is no point in sticking to a bad trade and wasting your money.


Our Market is Actively Manipulated by the Government, Relax...

It strikes me that despite the current mood of death and despair that stalks the market, we should all wake up and smell the negative real interest rates! So let's lever-up, get LONG, and quit all this belly-aching about a "credit crisis." The government just bailed out the debt holders which means credit and moral hazard will rain from the sky, eventually. So while prices are getting smashed I will lever up and buy.

The dollar has been rallying to its high against currencies far and wide. This means despite the losses we feel so acutely in this country, foreigners who bought at the lows are still making dough. So blow out the trade gap, and give them all the cash, because our people can print more of it just as fast. Pump it into their banks and strengthen trade ties, they all have to buy our debt not to let their currencies rise. Thus they will lend it right back to us and we will do it all again, and I will multiply my position by ten.

Remember Rothschild: "Buy when there is blood in the streets." I will go further. Wait 'til it runs into the Hudson, the Thames, the Rhine. That's when you will know it is time. But it is when the bounce has started in earnest that you must push your credit furthest and watch asset prices soar higher than the burj dubai.

But when bank profits wax fat and real estate agents are telling YOU to buy this stock and that, this is the time to pull your position back. Cash in and check out, buy some puts if you must-o... because trying to short the top is an easy path to bust-o.