How to lose $9 trillion in a bull market - Nov. 29, 2007

Paper gains or no gains at all... between commissions, taxes, and market timing, the average market gain is only 4.3%/year.  Take any information on gains with a grain of salt.

In reality, because investors pumped $1.1 trillion into Nasdaq stock offerings between 1998 and 2000 - just before the worst crash in modern history - the typical dollar invested in the Nasdaq earned only 4.3 percent a year, less than half the historical return.

Source: How to lose $9 trillion in a bull market - Nov. 29, 2007

Why Invest?

We invest for an emotional return that more important even then the financial return. In fact, money is never the goal of investing. It is the means to the end, a currency that buys us emotional states (e.g., feeling safe, feeling proud, feeling free).

Source: Stock Market Psychology Blog: Behavioral finance and beyond

Don't be a Footsie neurotic - Fear and Greed

 The reason why the stock market has been around for so long?  Same reason that any activity involving fear or greed has been - receptors in the brain.  The more they fire, the more you need them to fire to feel at least as good as last time.

Plunging stock prices ignite the same circuits in your brain that respond to the snarl of a lion. Just a flash of the red colour that symbolises a downtick is enough to excite the circuitry in your brain - and to make reflective thinking more difficult.

Merely reading the words "stock market plunges" in this sentence will raise your pulse, quicken your breathing, increase your blood pressure and tense your muscles.

If you needed to make a snap decision about a stock immediately after reading those frightening words, you would involuntarily have been propelled toward selling. Yet, because emotions can often be unconscious, you might well believe that you had made a reasoned decision at the very moment you were in the grip of a primordial fear.

Source: Don't be a Footsie neurotic - Telegraph

I think there will be a lot of Neuro-Economicists in the future.

And the best reason to ditch your Blackberry and become a techno-idiot like Warren Buffett?

Psychologist Paul Andreasen found that investors who received frequent updates on their holdings earned half the returns of those who got no news at all.

Ignorance is bliss.

SSRN-Why We Have Never Used the Black-Scholes-Merton Option Pricing Formula (third version) by Espen Haug, Nassim Taleb

So the option pricing formula everyone is using isn't really Black-Scholes, and all they really did was market a well-known formula that already existed.

Similar to the lightbulb, which Edison didn't invent, or the car, which Ford didn't create, Black-Scholes-Merton have apparently created a mask of illusion that they derived the magic formula for pricing options.

And did they fool the Nobel committee?  How many other Nobel prize winners were actually just good marketers?  The guy who invented the lobotomy?  Prize decisions are irreversible so their medals should be safe.

I wonder if Haug and Taleb have a vendetta against these guys - they sure aren't pulling any punches in this essay.  I'm surprised they didn't put any yo mamma insults in there...

Abstract:
Options traders use a pricing formula which they adapt by fudging and changing the tails and skewness by varying one parameter, the standard deviation of a Gaussian. Such formula is popularly called “Black-Scholes-Merton” owing to an attributed eponymous discovery (though changing the standard deviation parameter is in contradiction with it). However we have historical evidence that 1) Black, Scholes and Merton did not invent any formula, just found an argument to make a well known (and used) formula compatible with the economics establishment, by removing the “risk” parameter through “dynamic hedging”, 2) Option traders use (and evidently have used since 1902) heuristics and tricks more compatible with the previous versions of the formula of Louis Bachelier and Edward O. Thorp (that allow a broad choice of probability distributions) and removed the risk parameter by using put-call parity. The Bachelier-Thorp approach is more robust (among other things) to the high impact rare event. The paper draws on historical trading methods and 19th and early 20th century references ignored by the finance literature. It is time to stop calling the formula by the wrong name.

Source: SSRN-Why We Have Never Used the Black-Scholes-Merton Option Pricing Formula (third version) by Espen Haug, Nassim Taleb

Guts, Long Term Capital Management, and Doubling Down your losses

LTCM was a hedge fund that failed in the late '90s after betting enormous amounts of money and losing to a few 'Black Swans', mainly an event overseas that they couldn't predict (Russian Ruble collapse) along with a loss of liquidity, massive declines in assets, and an increase in their leveraged investments.  Apparently their competition got access to their positions too, which couldn't have helped them.

Since LTCM had an almost unlimited bankroll, they could easily put their funds 'all in' and scare off any competition.  They could move markets, and even create new ones.  Manipulation?  Definately possible.

However, they couldn't win if there was no market left, and the loss of liquidity and value of the Ruble killed their Russian bets and ultimately the fund.  Being large meant that they could not easily exit their positions without major losses.  The very fact that they were selling some of their smaller positions caused the value to decrease.  Plus their competition could snipe them as they went down.

This article talks about the Kelly criterion, which is really a way of position sizing your bets based on a given expectation of positive value, while keeping some money left in your bankroll.  Perhaps LTCM used this type of formula in their quant-based system, along with some time-decay math?

It didn't work for them, because "the market can stay irrational longer than you can stay solvent."

The cold hard fact is that all progressive betting systems are nothing more than modified versions of the Martingale system. In the Martingale, you risk one unit, and if you win you keep risking one unit. If you lose, you double your bet, and if you lose again you re-double and keep re-doubling until you finally do win. Then you go back to risking one unit.

As any fool can plainly see, the Martingale can’t miss, so long as you win one more bet before you die you’re going to be a winner.

Well, yeah, if you lose12 bets in a row you’d have to risk $409,600 to win $100, but how often is that going to happen?

As it turns out, plenty.

Source: Debunking the Kelly Criterion - Sports betting picks, sports betting 'how-to' material, sports betting books, audio tapes, research material, sports betting computer programs on disks, gambling info, football, basketball, baseball picks, gambling money management, team stats, 'Professional Gambler' newsletter, tools for serious gamblers

One of the guys I used to work with bet on ProLine.  His sports gambling habit one year paid off to the tune of $27,000 in just a couple of tickets.  He went out and bought a brand new truck.

Less than a year later he hit a Black Swan - not literally, but he had the truck stolen from a parking lot near work.  Along with his golf clubs.

Do you think he went out and bet $60k on Proline tickets?  Could have, he was a pretty big gambler... but I doubt it.

At least he didn't somehow manage to borrow $7,950,000 against the truck like LTCM did.

If he did, I think the bank would have been willing to loan him another $60k to get their money back.

Ritual dating from 1919 sets price of gold - washingtonpost.com

How is the price of gold determined?

In addition to Barclays and Deutsche Bank, the other banks who take part in the fixing are HSBC Bank, Societe Generale and Bank of Nova Scotia's bullion division, Scotia Mocatta.

Ritual dating from 1919 sets price of gold - washingtonpost.com

Fear and Greed - The Risk of a U.S. Hard Landing and Implications for the Global Economy and Financial Markets

 This speech from NOURIEL ROUBINI, Stern School of Business, New York University on September 13th is the best summary of the current capital market mess and its implications for the world that I have seen.  If you're an optimist or realist, I would suggest not reading this as it could get you down.  If you're a pessimist don't read it either - it will just make you worse.

So we have created essentially in part a little bit of a monster. Of course we all know the benefits of financial globalization and securitization and all those things, I am not saying that I am against them. But you've created a financial system in which if you take out mortgages, the mortgage originator does not care: he or she maximizes volume and [gets higher] income. Then the bank originates the stuff and packages it in MBSs and then they get the fee and they shove it to the investment banks. And the investment banks tranch it in all the different tranches of CDO and then shove it to their final investors and the rating agencies give their blessings. You would think that the final investor is the one who has to provide the market discipline but after four stages you do not even know what it is, and after CDOs you have CDOs of CDOs, and CDOs of CDOs of CDOs
(Laughter.)

and then how you price this stuff. Of course there is an element of greed. At some point people were searching for yields or they should have known better, so I cannot just blame the rating agencies. But you have a whole system in which essentially people were making income not from bearing the credit risk but essentially transferring it somewhere else and getting the fees, and in most of the financial system that is how it gets its profit these days, so there is a fundamental kind of problem. On top of that the regulators [were] asleep at the wheel and let this stuff occur without any kind of constraint.

Source: Transcript of IMF Seminar -- The Risk of a U.S. Hard Landing and Implications for the Global Economy and Financial Markets

And then he goes into speaking about a possible hard landing in the US Economy, and whether the world will be affected.

The final thing I want to just briefly just speak about is this question of will the world decouple from the U.S. or not.

A little bit less than briefly, this is the longest paragraph in the speech.

The first victim of a hard-landing in the US economy?  China? Who would benefit the most from a hard landing in the US economy?  Russia?  Other parties affected?  Emerging markets due to risk aversion.  Commodity-rich countries.  Anyone and everyone, though not on the scale of the US.  The bigger they are....

The question and answer session has even more tidbits of information.

MS. SANTOS: That was quite a disturbing lecture. I am Barbara Santos, retired from the World Bank. Let me ask you, professor, if you were in Mr. Greenspan's shoes a year ago or 18 months ago, what measures would you have taken to avoid this terrible scenario?

Mr. Roubini speaks about the last few years of "laissez-faire" regulation, and summarizes the current financial woes in the simplest manner possible.

So essentially you have the element that private markets want to make money, they are greedy, and you have to have good, sound public policy and there were failures of the credit ratings of the financial institutions and the regulators. So that was an element of the problem.

The other element of the problem is right now: I think there is going to be a renewed debate about this issue of how you deal with asset bubbles.

He suggests that the Fed should have popped the bubble long ago, but that it is the belief of Greenspan, Kohn, and Bernake that you should let the market do it's thing in good times, and only be there to provide a cushion in bad times.  (The cushion being the US taxpayer eventually.)

The Canadian finance minister's view on bubbles seems to contradict our neighbours to the south.  BCE, one of Canada's largest taxpayers, decided to go the Income Trust route and save $800 million a year.  Last October, the minister promptly and efficiently put a pin into the Income Trust bubble, calling it "a growing trend towards corporate tax avoidance" that would hurt Canada.  However, he left REITs alone, and the housing bubble has kept growing since, with the best year ever for Toronto markets.  The average house price is almost $400k. By contrast, homes in the US are expected to decline in price by 10%-20% between the peak of 2007 to the low of 2009. 

His comments on 'Chindia'—China giving us all the cheap goods and India all the cheap services really make sense when it comes to inflation control on goods and services, while increasing the prices of assets and commodities.  By outsourcing inflation to China & India, it causes the CPI number to go down.

What happens when the Fed intervenes in a bubble?  It breaks, but when a bubble breaks it can sometimes form many smaller bubbles.

MR. ROUBINI: It could be the next housing crisis or maybe the next bubble. Some people say the Fed created first the tech bubble and then the housing bubble, and if they now ease they are going to create another bubble, even if we are running out of asset markets in to create bubbles.

(Laughter.)

For a while people thought it was private equity; now that has reached its peak and so on. But we can find other things.

There is already a post-mortem being done by the Financial Stability Forum (FSF) on the financial situation that came to a head in August, and the patient isn't even dead yet.  They recommend a quick adoption of the Basel II capital guidelines, a set of requirements for managing risk to a portfolio of instruments.  This report won't come out until next Spring at the earliest, so don't expect any fast solutions to the problem, and don't expect the US to spend more CAPEX on adopting Basel II.

According to Mr. Roubini, "(t)here will be changes. After LTCM I remember—in 1998 I was in the U.S. Treasury and the White House—there were lots of proposals and then when calm came back and nothing was done, and 10 years later we are still discussing whether we should regulate hedge funds or not, directly or indirectly, and I am not saying that we should. But changes in financial regulation, even when there are big crises, occur only slowly, incrementally at the margin."

The largest bubble mentioned in Mr. Roubini's speech?  "Credit derivatives 10 years ago were zero, today they are a notional value of $26 trillion".  That's $26,000,000,000,000.00 in US dollars. 

Even with a systemic breakdown in these instruments, he doesn't see a Great Depression or anything of that sort.

More on Nouriel Roubini on his home page at NYU, his Wikipedia entry, his blog on Global EconoMonitor.

Notes from Alan Greenspan's 2008 Forecast @ The Learning Annex

Notes from Alan Greenspan's 2008 Forecast @ The Learning Annex

I recently attended the Wealth Expo organized by The Learning Annex. Bill Zanker has signed Trump on to a 3-year deal, and he was the headliner of the show along with Tony Robbins and Alan Greenspan.

Alan Greenspan came on the satellite feed shortly after 8am on Sunday morning. It was an interview-style presentation, with NBC's Michael Corbett leading with the questions. Some of the ones that stood out for me. Based on my notes, the wording could be slightly modified ** means more than slightly. I tried to recap the message Greenspan was trying to convey, though there could be a bit of misinterpretation based on my memory.

MC - Who was your favourite president to work with?
AG - Gerald Ford, he will be missed greatly by me.

Reagan was great as well, and his policy advisors complemented the policy of the Fed.

MC - *Why is there a housing crisis?*
AG - In 2003, lower rates in Japan caused problems with deflation. The US does not want this to happen here. The housing bubble and condo bubbles are coming to an end. Long term rates ultimately affect the market. Housing bubbles are due to decreases in short term interest rates.

The difference between this bubble and many in the past is that the real estate bubble is the same everywhere. There needs to be a global solution to the problem.

The core reason why the bubble happened is due to consequences of the end of the Cold War, the rise of Market Capitalism, and production growth inflation.

There was an obvious amount of liquidity permeating the markets, and the low rate was creating problems, with a 5% growth in money supply year over year.

MC - How long will the softening of the real estate market continue?
AG - New homebuilders need smaller inventories. Vacant homes cause many problems for builders, including vandalism and exposure to inclement weather. Builders are creating fire sales to move inventory.

How low will prices fall before consolidating? We haven't even started.

(AG cellphone rings off camera. A warning from the Plunge Protection Team? )

If liquidation is fast, there is a possibility of prices flattening out in spring. (AG pauses, somehow I think he believes it is worse than that)

MC - With regards to the dollar decline & economy, why did the USD weaken?
AG - It was not necessarily a weakening of the US dollar as it was an increase in demand for the Canadian dollar. The last several years have gradually seen an improvement of the value of the Canadian dollar compared to the USD. The main reason is the huge demand for commodities in China and emerging markets. Spot exchange rates fluctuate with interest rates, and are cyclical. There is currently a major inflation concern. However, the weakening USD has no real economic consequences for Americans. (Huh?)

A large share of the US national income goes to the finance sector. Savings and capital investments are key spending trends. The US wastes almost no savings. (Wha?!?) China wastes much more.

New York is exporting finance to other markets, including deals in Canada, and Europeans are investing in the United States.

MC - What will be the effect of a new president on the economy?
AG - With the extent that globalization is taking over individual economies, the economic policies of the president and government are mainly relevant to internal problems and not the world economy. The cost of medicare will double in 25 years. With the current demographic trends, society cannot afford Medicare. There appears to be a 50% shortfall in the medicare system. The usual role of the president in foreign affairs has also changed.

MC - Should we invest rather than let our government handle our retirement?
AG - It is essential. The amount of retirement income must be increasingly private. With current social security funding, it is expected that supplements will be 40% less income than pre-retirement. Medicare is declining as the demographic population grows older. With economics and politics, there doesn't appear to be a solution to the medicare problem.

In 25 years, the US will still be a world economy leader. The world depends on the US. We are by far the current leader. The US must continue opening new markets, and maintain these open markets. It must avoid protectionism at all costs, as it erodes the systems and standards of a country. Medicare and protectionism are 2 major problems now and in the next 25 years.

MC - Who was the most interesting world leader you have met?
AG - Zhu Rongji - the retired premier of China. Quoting Deng Xiaoping, he said he practiced "Socialism with Chinese influences" which in my opinion was wrong. He practiced some of the purest forms of capitalism possible, even more so than in the US.

Rongji and Gorbachev were perhaps the two most significant economic personalities of the last 30 years.

MC - Social Security and Medicare - are they in trouble?
AG - Medicare has a huge shortfall. If there are no tax increases, there will be half the benefits that should be available.

Social Security is cash defined and not increasing. The 2% gap in funding could be closed and there are 5 to 10 proposals out to fix this. There are absolutely no suggestions for Medicare, and both Democrats and Republicans appear to be avoiding the issue altogether.

MC - With all of the stock market scandals, do we have policy changes to implement?
AG - We already have Sarbanes Oxley. Scandals and fraud, however, are human nature. Legislation will target individuals and individual situations, however there is no hope of keeping up with scandals or fraud.

MC - Is real estate one of the best investments?
AG - Over the long run, yes. There will be a testing period for real estate immediately ahead. It is difficult to get investment right now. In the short term, it is a bad investment. I am not sure how long this current market will last.

MC - In 2008, what do we have to look forward to?
AG - Buy my book to find out.


Later on in the evening, Donald Trump came on. I will try and recap his speech later, but these points really stuck out:

Trump's opinion is that we're in a recession. He thinks that could be a good thing for real estate investors, as it allows them to go in and offer money to the banks for discounted foreclosure mortgages.

The best investments are outside of the United States. Trump has 2000 acres of oceanfront in Aberdeen, Scotland. His friends keep calling him asking about investing there.

The banks are out of business - use Other Peoples Money (OPM) for real estate deals.

Green buildings are too costly and technology is not there yet to implement properly.

Banks are gone.

The residential market has dried up, and commercial will follow shortly. If you are being foreclosed due to an exploding mortgage, negotiate with your lenders, or sue the pants off them for improper financing.

Never give up. Always get even.

Microsoft Show How Banks Can Differentiate with Technology at BAI Retail Delivery Conference & Expo

How about a 99% growth rate in your employee base in 5 years?

PressPass: How committed is Microsoft to the banking industry?

Issel: We’re very committed to serving this industry. In the past five years, Microsoft has grown from six to 600 people supporting the financial services business.

Microsoft Show How Banks Can Differentiate with Technology at BAI Retail Delivery Conference & Expo

Marketocracy Funds Masters 100 Fund (MOFQX): Stock Quote & Company Information

A fund for the masses...

Marketocracy Funds Masters 100 Fund (MOFQX): Stock Quote & Company Information

The Fed - Housing & Monetary Transmission Mechanism

Huge document with some interesting items to note with the housing market, including lots of charts around international housing prices, the effects of Fed rates on real estate,

Page 28 has a mortgage delinquency rate chart that is slightly scary... 14% subprime defaults?  Worse than  September, 2001 @ 10%?

Another fact to note - fixed-rate prime is now less than variable rate prime for the first time since mid 2002.

The last few paragraphs contain the best Fed nuggets though...

One objection to an easing of monetary policy following the collapse of an asset bubble is that it might lead market participants to believe that the central bank will always act to prop up asset prices, a belief that can make a bubble more likely. The central bank can mitigate such an interpretation, however, if it publicly emphasizes that its monetary policy is not directed at stabilizing any particular asset price but is rather
focused on achieving price stability and maximum sustainable employment. Making sure that a house-price collapse does not do serious harm to the aggregate economy in no way eliminates sharp declines in house prices and so does not provide insurance against such declines. The same reasoning holds true for stock prices. Indeed, we have seen substantial declines in housing and other asset prices in many countries even when monetary policy has been eased substantially.

http://www.federalreserve.gov/Pubs/feds/2007/200740/200740pap.pdf

E-Trade Shave & A Haircut...

 

The Citigroup analyst Prashant Bhatia likes giving haircuts..

http://tinyurl.com/yscv89

Posted by: wavesmash at November 12, 2007 1:51 PM

Bill Cara: Cara's Commentary & Community Chat, Mon., Nov. 12, 2007, 7:25am ET

BullRunner, following the Market

On Monday I posted the following: 

"Taking a look at the USDCAD=X pair chart, the USD is heavily oversold and has been on a downward ski slope since mid-September. "

At the time I was looking at the fact that Relative Strength indicated that the USD was weaker than a little girlie man and needed to pump up a bit.

Then I predicted:

Today the USD should recover slightly, and for the rest of this week either pull back some more or reverse dramatically upwards. 

I should have said today the USD should sell off dramatically, and for the rest of the week plummet to record-breaking lows and then reverse dramatically with a market selloff on Friday.

The way things are looking, people are going to cash after the Fed's statements, and all of the bad news companies and the media are pushing out on them are instilling a sense of fear and dread.

It used to be that you had to use PIPs and Forex trading systems to trade the USD.  I went to the bank Monday and Wednesday, and they were ready to trade the currency realtime with me, and I could have made money buying Wednesday morning and selling Friday.  When the currency should move no more than 25 basis points during a day, and it ends up moving 3-4% something is seriously wrong.

MNTA - P&F Charts from StockCharts.com

Here's an ugly chart... what's with not getting FDA approval = stock crushing.

 

 

MNTA

Source: MNTA - P&F Charts from StockCharts.com

Vietnam latest news - Thanh Nien Daily

 

The Vietnam State Securities Commission (SSC) has announced it would help Cambodian officials open the country's first stock exchange by 2009.

Vietnam latest news - Thanh Nien Daily

Contrarian Currency Trade: The Canadian Dollar - Seeking Alpha

Taking a look at the USDCAD=X pair chart, the USD is heavily oversold and has been on a downward ski slope since mid-September. 

http://finance.yahoo.com/charts#chart3:symbol=usdcad=x;range=1y;indicator=volume+rsi+volumema;charttype=line;crosshair=on;logscale=on;source=undefined

Today the USD should recover slightly, and for the rest of this week either pull back some more or reverse dramatically upwards. 

The obvious question is of course how far will the bulls take it? Perhaps $100 crude and 1.10 CAD, but the upside of a potential reversal and resulting long liquidation (and not enough short interest to keep covering as price supportive) makes it worth shorting both. I am short at 1.07 CADZ07 (December 07 futures), and think a move back to parity is likely. I may exit and re-enter intermediately to manage this entry, but its a trade I intend to press when it starts working.

Contrarian Currency Trade: The Canadian Dollar - Seeking Alpha

Looking at TLT, or TLH, supposed proxies for VIX (Volatility Index), we can see that volatility is at numbing highs and have most likely hit a barrier.  This should result in a decrease in volatility, some cooling of the economy-crushing gold and oil prices, and a higher USD.

Let's see if my theory is correct by the end of the week.  Interesting times...  I won't be shorting the CAD anytime soon, but I will be going long USD... since I'm going to New York next week to see Alan Greenspan, Trump & his buddies again.

The Daily, Tuesday, October 30, 2007. Computer and peripherals price indexes

Statscan has some useful info on the price of computers and hardware in Canada....

More prices on all goods should be dropping dramatically, to compensate for the huge gains in the Canadian dollar.  Everything's for sale on eBay and Amazon in USD right now.

In August, the index for commercial computers decreased 1.4% from July to 34.2 (2001=100). The index for consumer computers also declined, down 1.4% to 14.1.

In the case of computer peripherals, monitor prices decreased 1.0% to 50.8, while printer prices fell, down 0.6% to 47.3.

These indexes are available at the Canada level only.

The Daily, Tuesday, October 30, 2007. Computer and peripherals price indexes

Preferred List

 

Financials are beat down... Can they go lower? 

Preferred Shares of the Big Five Canadian Banks^a,b

Preferred List