As Dave Barry would say, it sounds like a great name for a band. But really it's the name for what the International Monetary Fund says is going to kill this stock market. It ain't earnings, it ain't P/E ratios, it ain't declining margins -- it's haircut contagion. To wit:
"The IMF is particularly concerned about a phenomenon it dubs "haircut contagion".
A fall in value in assets in a hedge fund provokes a margin call, forcing the fund to sell assets to bring leverage back to its initial level. However, the lender now imposes a higher margin, or "haircut", as the assets are now riskier. This in turn forces further borrowing and further sales." (The Australian, 9/25/08)
Can you believe the IMF thinks hedge-fund managers will ratchet their leverage back up to previous levels? If the managers would just listen to the market and accept lower returns, we'd be OK. But the IMF rightly recognizes that hedge funds aren't structured to adapt to lower returns. They've promised big returns so they can get paid big. Lots of hedge funds will lose money if they have to accept lower returns. Then they're gone.
So the IMF apparently believes that hedge funds are inextricably linked to leverage. They have to have leverage, no matter what it costs. They can't trade lower leverage for lower costs. One more comment from the same article, then we'll tell you how we found it:
"The IMF believes there were $US300 billion in leverage loans planned in the second half of this year, although the market for them has now collapsed. "In the near term, financial institutions are exposed to potential syndication risks, with unsold bridge commitments contributing to an overhang in the market."
We found this article on http:/hf-implode.com. It's the best financial-news aggregator we've come across. It's the first website we check every day once we decide to get down to serious business. Highly, highly recommended.
Monday, September 24, 2007
Thursday, September 20, 2007
I'll Sell My Gold Stocks to You
Last week the bonds were peaking and getting ready to revert to the mean. This week it’s the gold stocks.
Coming into today, Gold/Silver (XAU) was exactly two standard deviations above its 90-day mean price. And those standard deviations are quite large. With an implied volatility of 38, the options market sets the three-month expected trading range for the index at nearly 66 points. That’s 11 points per standard deviation, placing XAU among the most volatile sector indexes.
We like to buy into sectors when they’re two standard deviations below their means, then sell those sectors once they’ve risen to two standard deviations above their means. Here’s why: A full 96% of all price points are expected to fall within two standard deviations of the mean, up or down.
The key is obtaining a worthwhile standard deviation. We believe the standard deviation estimates delivered by the options market – in the form of implied volatility – are the best you can find.
Back to the XAU. The index bottomed during the day back on August 16, reaching a low of around 120. We even called a couple of our preferred customers to let them know XAU had fallen to two standard deviations below its 90-day mean. (These guys already knew, just like they already know now that it’s time to sell. But they appreciated the calls.)
Here’s part of our post on this blog on August 19:
“XAU touched Zone 1 during intraday trading Thursday and then rallied. We suspect you’ll get another chance to buy in the lower 120s before this is over. The index is still in Zone 2, so it’s already a good buy. Buy some now, save some cash for buying some more later.”
A month later, and the index is up 50 points. Yesterday, XAU sold off at the end of the day after a real nice rally. That’s an indication the speculators are getting ready to bail. We wouldn’t be surprised to see the same thing happen today. But we love the liquidity because it allows us to sell on the offer.
So we’ll reduce our risk by taking all our profits now, with the index up more than 40% since we jumped in. Nice trade.
In fact, we’ll buy some puts here. Just as we did it on the way up, we’ll buy some puts here while saving about half the money we want to invest in the position for buying more puts if the index continues to rise.
Coming into today, Gold/Silver (XAU) was exactly two standard deviations above its 90-day mean price. And those standard deviations are quite large. With an implied volatility of 38, the options market sets the three-month expected trading range for the index at nearly 66 points. That’s 11 points per standard deviation, placing XAU among the most volatile sector indexes.
We like to buy into sectors when they’re two standard deviations below their means, then sell those sectors once they’ve risen to two standard deviations above their means. Here’s why: A full 96% of all price points are expected to fall within two standard deviations of the mean, up or down.
The key is obtaining a worthwhile standard deviation. We believe the standard deviation estimates delivered by the options market – in the form of implied volatility – are the best you can find.
Back to the XAU. The index bottomed during the day back on August 16, reaching a low of around 120. We even called a couple of our preferred customers to let them know XAU had fallen to two standard deviations below its 90-day mean. (These guys already knew, just like they already know now that it’s time to sell. But they appreciated the calls.)
Here’s part of our post on this blog on August 19:
“XAU touched Zone 1 during intraday trading Thursday and then rallied. We suspect you’ll get another chance to buy in the lower 120s before this is over. The index is still in Zone 2, so it’s already a good buy. Buy some now, save some cash for buying some more later.”
A month later, and the index is up 50 points. Yesterday, XAU sold off at the end of the day after a real nice rally. That’s an indication the speculators are getting ready to bail. We wouldn’t be surprised to see the same thing happen today. But we love the liquidity because it allows us to sell on the offer.
So we’ll reduce our risk by taking all our profits now, with the index up more than 40% since we jumped in. Nice trade.
In fact, we’ll buy some puts here. Just as we did it on the way up, we’ll buy some puts here while saving about half the money we want to invest in the position for buying more puts if the index continues to rise.
Wednesday, September 19, 2007
Two Sides of the Same Coin
Sub-prime mortgage sellers and hedge funds are inextricably linked. In fact, we think they're two sides of the same coin. Hence, we expect most hedge funds to follow the sub-prime sellers right on out the door.
Here's why. Both were new products, with no regulation. Once investors find out how toxic these products are, no one wants to touch them. It's happened to sub-prime sellers, and it's beginning to happen to hedge funds.
Case in point: Absolute Capital. Supposedly, the founder of the company quit because of a pay dispute within the firm. We don't believe it. Most of the guy's funds are impossible to value because of there is no secondary market for the investment vehicles they hold. Many investors want to withdraw their funds now that the guy is leaving. How convenient: Now he doesn't have to face the slow pain of watching his vehicles waste away to nothing. He can just claim the funds failed because investors withdrew their funds.
Now it's time to screw the customer. First, Absolute Capital has decided you can't take your money out now. Second, they're going to divide some funds up and re-issue two different types of stock. Apparently, one type of stock in will contain performing assets, while the other type of stock will contain the non-performing assets (sub-prime related stuff).
So instead of devaluing their portfolios by half, they're going to split each portfolio into a fund that has half the worth of the original fund and a fund that is worthless.
Man, that really sucks. But hedge-fund investors have signed away their rights like nobody's business. As long as the market rises, no problem. When the market falls, though, it's time to invoke those protective clauses their lawyers slipped in. Just like many sub-prime loan owners ignored the risk they were taking because they wanted in on the deal, so too did hedge-fund investors sign away their rights to the fund manager.
There will be no claims that people didn't read the paperwork, which is what most sub-prime investors are telling anyone who asks. Hedge-fund investors are supposed to be smarter than others, because they have a net worth of more than $1 million. So they can't say they didn't understand the contract, though I'm sure many will try.
But eventually, just like with sub-prime loans, the public will learn what a bad deal they signed into. And people won't want to do it again. At least for another few years, until they invent some new products that are ahead of all regulation.
We'll end with this: Marc Faber, a guy we really like, says the market could fall 30% before it bottoms. That's down to 10,000 on the Dow, and down to around 1,000 on the S&P 500 (SPX). If that happens, people are going to hate hedge funds as much as they hate sub-prime sellers.
Here's why. Both were new products, with no regulation. Once investors find out how toxic these products are, no one wants to touch them. It's happened to sub-prime sellers, and it's beginning to happen to hedge funds.
Case in point: Absolute Capital. Supposedly, the founder of the company quit because of a pay dispute within the firm. We don't believe it. Most of the guy's funds are impossible to value because of there is no secondary market for the investment vehicles they hold. Many investors want to withdraw their funds now that the guy is leaving. How convenient: Now he doesn't have to face the slow pain of watching his vehicles waste away to nothing. He can just claim the funds failed because investors withdrew their funds.
Now it's time to screw the customer. First, Absolute Capital has decided you can't take your money out now. Second, they're going to divide some funds up and re-issue two different types of stock. Apparently, one type of stock in will contain performing assets, while the other type of stock will contain the non-performing assets (sub-prime related stuff).
So instead of devaluing their portfolios by half, they're going to split each portfolio into a fund that has half the worth of the original fund and a fund that is worthless.
Man, that really sucks. But hedge-fund investors have signed away their rights like nobody's business. As long as the market rises, no problem. When the market falls, though, it's time to invoke those protective clauses their lawyers slipped in. Just like many sub-prime loan owners ignored the risk they were taking because they wanted in on the deal, so too did hedge-fund investors sign away their rights to the fund manager.
There will be no claims that people didn't read the paperwork, which is what most sub-prime investors are telling anyone who asks. Hedge-fund investors are supposed to be smarter than others, because they have a net worth of more than $1 million. So they can't say they didn't understand the contract, though I'm sure many will try.
But eventually, just like with sub-prime loans, the public will learn what a bad deal they signed into. And people won't want to do it again. At least for another few years, until they invent some new products that are ahead of all regulation.
We'll end with this: Marc Faber, a guy we really like, says the market could fall 30% before it bottoms. That's down to 10,000 on the Dow, and down to around 1,000 on the S&P 500 (SPX). If that happens, people are going to hate hedge funds as much as they hate sub-prime sellers.
Sunday, September 16, 2007
Greenspan: The Perfect Patsy
Can you believe this guy? Wouldn't say anything but mumbles when he was employed by The People, but now that he has to make his own money he's full of opinions. Devoted to the ideal of the Virtue of Selfishness, now he can't believe where the selfishness has gotten us -- in debt up to our arseholes. Can't believe that lenders would take his free money and sell The People a pipe dream. Never heard of such a thing, didn't know it existed. Knows nothing of the "Observed Price" phenomenon Shiller wrote about 15 years ago. And the politicians -- don't get him started on what he's learned about those guys!
Overall, the perfect patsy for the hedge-fund era.
Now he's trying vainly to salvage his legacy by blaming the politicians. Why does this whole thing have a Sammy-the-Bull turns-on-John-Gotti feel to it? Disavowing his bosses now that he's joined the publicity-protection program (PPP). Here's what got me stirred up today:
To keep inflation under 2 percent, ``the Fed, given my scenario, would have to constrain monetary expansion so drastically that it could temporarily drive up interest rates into the double-digit range not seen since the days of Paul Volcker,'' Greenspan wrote. (Bloomberg)
Now, what if Greeny has said to The People four years ago: "Hey, we're gonna let the big boys borrow for a year at 1%, but it might result in 10% inflation in a few years. That OK with you guys?" The only thing we've ever asked of the Fed chairman is to watch out for inflation. Greeny always said he supported the strong dollar, and a year after he's gone it's at all-time lows. And poised to fall further.
Anyway, part and parcel to his flood-us-with-cash philosophy was his hands-off approach to the sorry state of government statistics. Everyone knows that official government inflation figures don't track today's true household expenditures. Unfortunately, I'm not in a position to develop appropriate figures to release to the People. Greeny was.
He should have waited until he got his Medal of Freedom before publishing his Bad, Bad Bush book.
Overall, the perfect patsy for the hedge-fund era.
Now he's trying vainly to salvage his legacy by blaming the politicians. Why does this whole thing have a Sammy-the-Bull turns-on-John-Gotti feel to it? Disavowing his bosses now that he's joined the publicity-protection program (PPP). Here's what got me stirred up today:
To keep inflation under 2 percent, ``the Fed, given my scenario, would have to constrain monetary expansion so drastically that it could temporarily drive up interest rates into the double-digit range not seen since the days of Paul Volcker,'' Greenspan wrote. (Bloomberg)
Now, what if Greeny has said to The People four years ago: "Hey, we're gonna let the big boys borrow for a year at 1%, but it might result in 10% inflation in a few years. That OK with you guys?" The only thing we've ever asked of the Fed chairman is to watch out for inflation. Greeny always said he supported the strong dollar, and a year after he's gone it's at all-time lows. And poised to fall further.
Anyway, part and parcel to his flood-us-with-cash philosophy was his hands-off approach to the sorry state of government statistics. Everyone knows that official government inflation figures don't track today's true household expenditures. Unfortunately, I'm not in a position to develop appropriate figures to release to the People. Greeny was.
He should have waited until he got his Medal of Freedom before publishing his Bad, Bad Bush book.
Tuesday, September 11, 2007
Coast-to-Coast for Bonds
Bond ETFs and yield indexes appear to have completed another coast-to-coast move. In just three months, bonds ETFs have gone from more than three standard deviations oversold on a 90-day basis to more than three standard deviations overbought on a 90-day basis.
Yield indexes, which move opposite of bond prices, have gone from more than three standard deviations overbought on a 90-day basis to more than three standard deviations oversold on a 90-day basis.
(Actually, yields indexes usually move further from their means than do bond ETFs. We don't know why, because both long-term yields and long-term bonds trade with a pretty solid implied volatility of 9.)
Right now, long-term yield indexes are more than 150% oversold over both 90-days and 10-days. Long-term bond ETFs have moved to around 100% overbought over both 90-days and 10-days. These are extremes, and it is highly probable that these issues will begin to revert toward their respective means sometime soon.
Three months ago, the market was heavily overbought because bonds had slumped and yields had risen. Broker/Dealer (XBD) was more than three standard deviations above its mean price over both 90-days and 10-days. Here's what we wrote on June 4:
"10-Yr. Interest Rate (TNX) and 5-Yr. Interest Rate (FVX) each are more than 130% overbought over 90 days. (As a result, so is Eurotop 100 (EUR).) 20-Yr. Bond Fund (TLT), now deep in Zone 1, confirms the rate-index strength. Our experience is that there isn't long to go at this level. And there's so much trading liquidity out there. In three months or so, the bonds will be near Zone 6 and yields will be weak."
Of course, you know what happened from there. Two weeks later we were buying puts on the market and the financials. Wish you'd been there with us, it was fun.
Now it's different. Broker/Dealer (XBD) enters today at more than two standard deviations below its 90-day mean price, one of the weakest sector indexes on the planet. (Another really weak index is Retail (MVR), more than three standard deviations below its 90-day mean price.)
Bonds and yields are getting ready to revert to their means, and so are the financials. And the retails, too. We call that a fourth quarter rally. It should set up a wonderful opportunity to get short again in December. Next time, the rout will really be on.
Yield indexes, which move opposite of bond prices, have gone from more than three standard deviations overbought on a 90-day basis to more than three standard deviations oversold on a 90-day basis.
(Actually, yields indexes usually move further from their means than do bond ETFs. We don't know why, because both long-term yields and long-term bonds trade with a pretty solid implied volatility of 9.)
Right now, long-term yield indexes are more than 150% oversold over both 90-days and 10-days. Long-term bond ETFs have moved to around 100% overbought over both 90-days and 10-days. These are extremes, and it is highly probable that these issues will begin to revert toward their respective means sometime soon.
Three months ago, the market was heavily overbought because bonds had slumped and yields had risen. Broker/Dealer (XBD) was more than three standard deviations above its mean price over both 90-days and 10-days. Here's what we wrote on June 4:
"10-Yr. Interest Rate (TNX) and 5-Yr. Interest Rate (FVX) each are more than 130% overbought over 90 days. (As a result, so is Eurotop 100 (EUR).) 20-Yr. Bond Fund (TLT), now deep in Zone 1, confirms the rate-index strength. Our experience is that there isn't long to go at this level. And there's so much trading liquidity out there. In three months or so, the bonds will be near Zone 6 and yields will be weak."
Of course, you know what happened from there. Two weeks later we were buying puts on the market and the financials. Wish you'd been there with us, it was fun.
Now it's different. Broker/Dealer (XBD) enters today at more than two standard deviations below its 90-day mean price, one of the weakest sector indexes on the planet. (Another really weak index is Retail (MVR), more than three standard deviations below its 90-day mean price.)
Bonds and yields are getting ready to revert to their means, and so are the financials. And the retails, too. We call that a fourth quarter rally. It should set up a wonderful opportunity to get short again in December. Next time, the rout will really be on.
Saturday, September 8, 2007
5 Stages of Real Estage Grief
Lifted this from the comments in the LA Land blog of the LA Times. Thanks to Charles Wilson:
The Five Stages of Real Estate Grief
DENIAL: "Don't listen to those doom and gloomers. They're nothing but a bunch of jealous renters. Probably Democrats."
BARGAINING: "Okay, maybe things got a little out of hand. If I take a 15% haircut, is that fair?"
ANGER: "You traitors in the liberal media are driving down prices and killing the American Dream! And dammit, stop laughing at me!"
SADNESS: "I'll be ruined, I'll tell you! Ruined! Everything I've worked for will be gone! Just kill me now!"
ACCEPTANCE: "Honey, who knew that we'd be so happy in a trailer?"
The Five Stages of Real Estate Grief
DENIAL: "Don't listen to those doom and gloomers. They're nothing but a bunch of jealous renters. Probably Democrats."
BARGAINING: "Okay, maybe things got a little out of hand. If I take a 15% haircut, is that fair?"
ANGER: "You traitors in the liberal media are driving down prices and killing the American Dream! And dammit, stop laughing at me!"
SADNESS: "I'll be ruined, I'll tell you! Ruined! Everything I've worked for will be gone! Just kill me now!"
ACCEPTANCE: "Honey, who knew that we'd be so happy in a trailer?"
Thursday, September 6, 2007
Deadly Diversion
Another day in the bond market like yesterday, and the Fed will cut rates on Friday. Short-term interest rates and long-term interest rates are moving in opposite directions. When that happens, it's bad news.
We're tracking the divergence through yield indexes that trade at the CBOE. Yields move in the opposite direction to bonds. Right now, the three long-term yield indexes we follow -- 5-Year (FVX), 10-Year (TNX) & 30-Year (TYX) -- are more than three standard deviations below their respective 90-day mean prices. They're more than two standard deviations below their 10-day mean values.
But the short-term yield index -- 13-Week (IRX) -- is only one standard deviation below its 90-day mean. On a 10-day basis, IRX has been around three standard deviations above its mean price for the past couple days. Banks will not lend to each other over the short term, hence the divergence.
If the black-box hedge funds couldn't deal with CDOs, they'll never be able to withstand this incredible divergence for long.
We thought it was laughable that the Fed said it will look to "anecdotal" evidence of tight credit in the future. LIBOR rates are at seven-year highs, and that's what most scalable loans use as a reset touchstone.
So, either the Fed acts soon, or the stock market takes a serious hit. If they're smart, the Fed will try to help this thing settle down slowly by instituting a series of rate cuts. We think they are smart, they just needed to be reminded of it by the market.
We're tracking the divergence through yield indexes that trade at the CBOE. Yields move in the opposite direction to bonds. Right now, the three long-term yield indexes we follow -- 5-Year (FVX), 10-Year (TNX) & 30-Year (TYX) -- are more than three standard deviations below their respective 90-day mean prices. They're more than two standard deviations below their 10-day mean values.
But the short-term yield index -- 13-Week (IRX) -- is only one standard deviation below its 90-day mean. On a 10-day basis, IRX has been around three standard deviations above its mean price for the past couple days. Banks will not lend to each other over the short term, hence the divergence.
If the black-box hedge funds couldn't deal with CDOs, they'll never be able to withstand this incredible divergence for long.
We thought it was laughable that the Fed said it will look to "anecdotal" evidence of tight credit in the future. LIBOR rates are at seven-year highs, and that's what most scalable loans use as a reset touchstone.
So, either the Fed acts soon, or the stock market takes a serious hit. If they're smart, the Fed will try to help this thing settle down slowly by instituting a series of rate cuts. We think they are smart, they just needed to be reminded of it by the market.
Monday, September 3, 2007
The Barry Bonds Defense
Apparently Barry Bonds and Angelo Mazillo have the same spin doctor. Those close to Bonds are supposed to have told the press that he took steroids to keep up with home-run slugger Mark McGwire, who Bonds believed was using illegal enhancement substances. Now Mazillo is telling the LATimes:
"Most of the large bank lenders, as well as Countrywide, were limited, slow, reluctant followers behind the lenders who most aggressively relaxed underwriting guidelines," the company said in a written response to a question from The Times.
In other words, the McGwire's of the lending world were offering juiced-up packages, so Countrywide (CFC) was forced to as well. The company says that banks wouldn't loan them money if they didn't sell the juiced-up stuff along with the prime stuff.
A childish response, we know. Angelo, if you saw the other kids jumping off a bridge, would you do it too? Society isn't going to buy it.
But there are similarities between the regulating authorities, the ones we trusted to keep the games safe. In baseball, the commissioner's office had dismissed steroid abuse with a wink-and-a-nod for years. It was good for the game when home-run records were being trashed. Now we know why. The commissioner's lax policies allowed dishonesty to flourish.
Same in the housing markets. The Fed was asleep on the job, both in regulating mortgage sellers and in calculating the rate of inflation without properly considering housing appreciation. The lack of regulation allowed the market to flourish, and the lack of assessment in regards to housing prices led them to keep rates too low too long.
In both instances, the regulatory authorities appear to have been co-opted by the people who own the franchises. Who would trust either of them now?
"Most of the large bank lenders, as well as Countrywide, were limited, slow, reluctant followers behind the lenders who most aggressively relaxed underwriting guidelines," the company said in a written response to a question from The Times.
In other words, the McGwire's of the lending world were offering juiced-up packages, so Countrywide (CFC) was forced to as well. The company says that banks wouldn't loan them money if they didn't sell the juiced-up stuff along with the prime stuff.
A childish response, we know. Angelo, if you saw the other kids jumping off a bridge, would you do it too? Society isn't going to buy it.
But there are similarities between the regulating authorities, the ones we trusted to keep the games safe. In baseball, the commissioner's office had dismissed steroid abuse with a wink-and-a-nod for years. It was good for the game when home-run records were being trashed. Now we know why. The commissioner's lax policies allowed dishonesty to flourish.
Same in the housing markets. The Fed was asleep on the job, both in regulating mortgage sellers and in calculating the rate of inflation without properly considering housing appreciation. The lack of regulation allowed the market to flourish, and the lack of assessment in regards to housing prices led them to keep rates too low too long.
In both instances, the regulatory authorities appear to have been co-opted by the people who own the franchises. Who would trust either of them now?
"Observed Price Movements:" Buying High and Selling Low
I got into an on-line argument the yesterday with a guy who said the Case/Shiller numbers and the OFEO numbers were inconsistent, so you should ignore both. I couldn't believe the guy, an investment manager, could even compare pencil-pushing government figures with data from a brilliant Ivy League professor acknowledged to be at the top of his profession. I think Shiller is great, and I take every opportunity to read anything he produces.
For a quality article on how the government's inflation figures would look if Case/Shiller replaced rent-equivalency in the calculations, see http://www.iaconoresearch.com/. As usual, the government's numbers suck. Interestingly, the article shows that inflation was running at about 10% with Case/Shiller included, but that now it's dropped to negative if you include the Case/Shiller figures. A much more informative statistic than the one the government offers.
But it got us to thinking about one of Robert Shiller's best books, Market Volatility ('89). So we checked in on the chapter called The Behavior of Buyers in Boom and Pre-Boom Markets. In 1988, the authors sent about 20-page questionnaires to 500 people in four cities. Two of the cities, Anahiem and San Francisco, had booming real-estate markets at the time. One city, Boston, was starting to fall after it's boom. And the other town, Milwaukee, was neither boom nor bust.
Here's one of the main questions the authors wanted to answer:
1) "What causes sudden and often dramatic and sustained price movements? Although questionnaire survey methods can never provide a definitive answer to such a question, they can provide information that helps us begin to understand the process: What are home buyers thinking about, and what sources of information are used to decide how much to pay for a house? How motivated are they by investment considerations, and how do they assess investment potential? Is destabilizing speculation affecting house prices?"
Sounds like what we just went through, doesn't it? Remember, this was written almost 20 years ago. I'll check this week to see if they've done an updated study. Just check out the authors' conclusions. and see if those don't fit this time around, too. It should influence your opinion about where we're headed.
"First, virtually every buyer in our California cities and the vast majority of buyers in Boston and Milwaukee believe that prices will rise...The average annual increase for buyers in California was in the 15% range, while for Milwaukee and Boston, the figure was roughly half as high... Even in Boston, 77.8% reported that it was a good time to buy because prices were likely to rise in the future. For Milwaukee the figure was 84.8%, while it was well over 90% in both California cities."
Again, sounds like our situation. In California, prices took a turn for the worse the next couple years after this article. Now, over the 15 years since, I bet we've reached those expected returns (not compounded). For now. It took an amazing run the last few years to get there, and now we're due to give some back. Back then, they didn't have the loan-quality problems we're facing now. Here's more:
"Since most people expressed a strong investment motive, one would assume significant knowledge of underlying market fundamentals. The efficient markets hypothesis assumes that asset buyers make rational decisions based on all available information and based on a consistent model of underlying market forces...The survey reveals little knowledge of, or agreement about, the underlying causes of price movements. Rather than citing any concrete evidence, people retreat into cliches and images."
"In all four cities, interest rate changes are cited as a major factor...It is hard to understand how price changes in all four cities can be driven by interest rates."
"Second in overall frequency were general comments about the local economy, such as 'strong local economy' or 'growing regional economy'...The response to questions in this section leave the strong impression that people look to observed price movements to form their expectations and then look around for a logic to explain and reinforce their beliefs...Irrelevant stories that make a vivid impression tend to be cited."
"Among the most popular cliches were 'The region is a good place to live' and 'There is not enough land.' Neither of these is news and neither could explain the sudden boom...Very few people mentioned these cliches in Milwaukee."
You can expect Shiller's conclusion to hold when the housing market starts to retreat. When home prices start to fall, the "observed price movements" will cause more selling. Most people buy high, and sell low. Once this phenomenon starts spreading to the housing market, you'll see that we have a serious problem on our hands. We've done the buy high, there's only sell low left.
For a quality article on how the government's inflation figures would look if Case/Shiller replaced rent-equivalency in the calculations, see http://www.iaconoresearch.com/. As usual, the government's numbers suck. Interestingly, the article shows that inflation was running at about 10% with Case/Shiller included, but that now it's dropped to negative if you include the Case/Shiller figures. A much more informative statistic than the one the government offers.
But it got us to thinking about one of Robert Shiller's best books, Market Volatility ('89). So we checked in on the chapter called The Behavior of Buyers in Boom and Pre-Boom Markets. In 1988, the authors sent about 20-page questionnaires to 500 people in four cities. Two of the cities, Anahiem and San Francisco, had booming real-estate markets at the time. One city, Boston, was starting to fall after it's boom. And the other town, Milwaukee, was neither boom nor bust.
Here's one of the main questions the authors wanted to answer:
1) "What causes sudden and often dramatic and sustained price movements? Although questionnaire survey methods can never provide a definitive answer to such a question, they can provide information that helps us begin to understand the process: What are home buyers thinking about, and what sources of information are used to decide how much to pay for a house? How motivated are they by investment considerations, and how do they assess investment potential? Is destabilizing speculation affecting house prices?"
Sounds like what we just went through, doesn't it? Remember, this was written almost 20 years ago. I'll check this week to see if they've done an updated study. Just check out the authors' conclusions. and see if those don't fit this time around, too. It should influence your opinion about where we're headed.
"First, virtually every buyer in our California cities and the vast majority of buyers in Boston and Milwaukee believe that prices will rise...The average annual increase for buyers in California was in the 15% range, while for Milwaukee and Boston, the figure was roughly half as high... Even in Boston, 77.8% reported that it was a good time to buy because prices were likely to rise in the future. For Milwaukee the figure was 84.8%, while it was well over 90% in both California cities."
Again, sounds like our situation. In California, prices took a turn for the worse the next couple years after this article. Now, over the 15 years since, I bet we've reached those expected returns (not compounded). For now. It took an amazing run the last few years to get there, and now we're due to give some back. Back then, they didn't have the loan-quality problems we're facing now. Here's more:
"Since most people expressed a strong investment motive, one would assume significant knowledge of underlying market fundamentals. The efficient markets hypothesis assumes that asset buyers make rational decisions based on all available information and based on a consistent model of underlying market forces...The survey reveals little knowledge of, or agreement about, the underlying causes of price movements. Rather than citing any concrete evidence, people retreat into cliches and images."
"In all four cities, interest rate changes are cited as a major factor...It is hard to understand how price changes in all four cities can be driven by interest rates."
"Second in overall frequency were general comments about the local economy, such as 'strong local economy' or 'growing regional economy'...The response to questions in this section leave the strong impression that people look to observed price movements to form their expectations and then look around for a logic to explain and reinforce their beliefs...Irrelevant stories that make a vivid impression tend to be cited."
"Among the most popular cliches were 'The region is a good place to live' and 'There is not enough land.' Neither of these is news and neither could explain the sudden boom...Very few people mentioned these cliches in Milwaukee."
You can expect Shiller's conclusion to hold when the housing market starts to retreat. When home prices start to fall, the "observed price movements" will cause more selling. Most people buy high, and sell low. Once this phenomenon starts spreading to the housing market, you'll see that we have a serious problem on our hands. We've done the buy high, there's only sell low left.
Genie Is Out of the Bottle
Haven't you wondered how the market could keep going up for four straight years, with barely a correction? No, you haven't. I understand, you've just been riding it. No concern about risk. Heck, you wouldn't even recognize stock-market risk if you saw it walking down the street.
I'm here to tell you that the risk genie has been let out of its bottle. Risk is back in the market, and at some point fairly soon it's going to be realized. You better start preparing now.
By lowering the Fed funds rate to 1%, the Fed allowed the risk in the stock market to be bottled up. Low rates let you borrow money to invest in long-term debt, which provides the collateral to let you sell short-term debt. You make the difference between the long-term debt you buy and the short-term debt you sell. Arbitrage allows you to deny the effects of risk for a period of time. When the arbitrages unwind, look out below.
Here's an example. The muni-bond market has been crushed. Funny, you'd think that investors would be running to those low-risk, no-tax funds as risk has increased. But it turns out that many funds were buying long-term munis so they could sell short-term collateralized debt obligations (CDOs). Now these funds can't sell short-term debt, so they don't need (and can't afford) the long-term debt. Down go munis.
Muni-bond sellers are telling you that munis are a bargain now. Some muni yields are higher than treasury yields. Muni-bond sellers are telling you that the market is somehow wrong. Who do you believe, the muni pushers or the market? The market is telling you to watch out. States and municipalities issued a record number of munis last year, 25% above the previous year's rate. In areas where foreclosures are highest, municipalities are cutting back on services left and right. You don't get paid enough by munis to take the risk of default. Stay away from munis at least until you start hearing about muni-bond defaults coming out of California.
Munis deserved to plunge, because the riskless arbitrage play that was responsible for at least part of their increased values no longer exists. That's a fundamental change to the value of those entities. Now you have to evaluate the securities based upon their own merits. And them merits are looking worse and worse each day.
Same thing is going to happen to stocks. The funds tell you it's a liquidity situation -- if we had more money (or could borrow more money), we'd support these prices. Money's gone. There is no more. So they're selling the things in their portfolio that have value right now. We see it differently. Risk is now seeping back into their portfolios, so they no longer are able to leverage their positions to the hilt. Banks see the risk, and they won't lend them the money.
As risk seeps back into the market, it will cause a repricing of assets going forward. And they won't be pricing these assets higher. Time to shake hands with the genie.
I'm here to tell you that the risk genie has been let out of its bottle. Risk is back in the market, and at some point fairly soon it's going to be realized. You better start preparing now.
By lowering the Fed funds rate to 1%, the Fed allowed the risk in the stock market to be bottled up. Low rates let you borrow money to invest in long-term debt, which provides the collateral to let you sell short-term debt. You make the difference between the long-term debt you buy and the short-term debt you sell. Arbitrage allows you to deny the effects of risk for a period of time. When the arbitrages unwind, look out below.
Here's an example. The muni-bond market has been crushed. Funny, you'd think that investors would be running to those low-risk, no-tax funds as risk has increased. But it turns out that many funds were buying long-term munis so they could sell short-term collateralized debt obligations (CDOs). Now these funds can't sell short-term debt, so they don't need (and can't afford) the long-term debt. Down go munis.
Muni-bond sellers are telling you that munis are a bargain now. Some muni yields are higher than treasury yields. Muni-bond sellers are telling you that the market is somehow wrong. Who do you believe, the muni pushers or the market? The market is telling you to watch out. States and municipalities issued a record number of munis last year, 25% above the previous year's rate. In areas where foreclosures are highest, municipalities are cutting back on services left and right. You don't get paid enough by munis to take the risk of default. Stay away from munis at least until you start hearing about muni-bond defaults coming out of California.
Munis deserved to plunge, because the riskless arbitrage play that was responsible for at least part of their increased values no longer exists. That's a fundamental change to the value of those entities. Now you have to evaluate the securities based upon their own merits. And them merits are looking worse and worse each day.
Same thing is going to happen to stocks. The funds tell you it's a liquidity situation -- if we had more money (or could borrow more money), we'd support these prices. Money's gone. There is no more. So they're selling the things in their portfolio that have value right now. We see it differently. Risk is now seeping back into their portfolios, so they no longer are able to leverage their positions to the hilt. Banks see the risk, and they won't lend them the money.
As risk seeps back into the market, it will cause a repricing of assets going forward. And they won't be pricing these assets higher. Time to shake hands with the genie.
Friday, August 31, 2007
Love That Late News
You gotta love the news that comes out late Friday or early Saturday on Labor Day weekend. Always something interesting. Usually something being swept under the rug.
How about Citigroup (C) quietly absorbing ACC Capital Holdings, one of the largest sub-prime lenders over the past few years, on Friday. How are we ever going to find out what really went on in that place? How is anyone going to be held accountable for making these loans to unqualified recipients? The old owner of the company is US ambassador to the Netherlands, so you know he's got some Carlyle connections. Poof! It's all gone, except the servicing agreements. Now all the fees these fools agreed to pay will accrue to C, which effectively put the company in business anyway. And the legal risk has disappeared. Arms-length my ass.
How about Bozo the President's performance on Friday? (Seinfeld says you never have to say Bozo the Clown, everyone knows what Bozo does. Not anymore, now that we have Bozo the President.) "If you've been cheating somebody, we're going to find you," he said to all the sub-prime mortgage brokers out there, "and hold you to account." Back at the sub-prime shops, they could barely hear Bozo talking over the sound of the shredding machines.
That press conference was a joke. He looked like a fish out of water, talking about real economics. Explaining how mortgages work, like he's an expert. Looking sternly into the camera to emphasize his points. The biggest laugh was saying he would make loans available to sub-prime buyers with good credit. You know who those people are? The speculators and the flippers. I actually thought for a moment that I saw the strings attached to his arms, head and legs, the ones his handlers use to play him like a marionette.
How about Citigroup (C) quietly absorbing ACC Capital Holdings, one of the largest sub-prime lenders over the past few years, on Friday. How are we ever going to find out what really went on in that place? How is anyone going to be held accountable for making these loans to unqualified recipients? The old owner of the company is US ambassador to the Netherlands, so you know he's got some Carlyle connections. Poof! It's all gone, except the servicing agreements. Now all the fees these fools agreed to pay will accrue to C, which effectively put the company in business anyway. And the legal risk has disappeared. Arms-length my ass.
How about Bozo the President's performance on Friday? (Seinfeld says you never have to say Bozo the Clown, everyone knows what Bozo does. Not anymore, now that we have Bozo the President.) "If you've been cheating somebody, we're going to find you," he said to all the sub-prime mortgage brokers out there, "and hold you to account." Back at the sub-prime shops, they could barely hear Bozo talking over the sound of the shredding machines.
That press conference was a joke. He looked like a fish out of water, talking about real economics. Explaining how mortgages work, like he's an expert. Looking sternly into the camera to emphasize his points. The biggest laugh was saying he would make loans available to sub-prime buyers with good credit. You know who those people are? The speculators and the flippers. I actually thought for a moment that I saw the strings attached to his arms, head and legs, the ones his handlers use to play him like a marionette.
Tuesday, August 28, 2007
Options Tuesday: Buy/Write Bonanza
The credit crisis has produced some amazing possibilities to take some hedged risk. We're talking about buying some of the headline losers, with the hope they'll be slightly higher at January expiration. That's 144 days, a little less than five months. It's a couple months longer than we like to hold buy/writes, but we'd like to give the market some extra time to recover - especially these headline issues.
The possible returns are quite attractive. First let's look at Countrywide Credit (CFC), the poster boy for this decline. Will it survive? The stock closed at 19.91 on Tuesday. with an option implied volatility (IV) of 70. Right now the stock is 97% below it's 90-day mean and 41% below its 10-day mean. In other words, it's at the bottom of an expected distribution that's simply massive. Lots of risk has been wrung out here.
Say you buy CFC and sell the Jan 22 1/2 call (CFCAX) at 2.20, today's closing bid. You'd make 13.7% on your money if the stock closes at the same price (19.91) on January expiration day (static return). If the stock is above 22.5 at expiration, you'll clear 32.4% (called return). And you experience no loss if the stock is above 17.71 at expiration-day close (downside protection).
To take more risk, sell the Jan 25 call (CFCAE) at today's closing bid of 1.50. Now you're looking at 9.3% static return, but you're called return has risen to 41.2% . Your downside protection is only to 18.41. We like the stats on the 22 1/2 trade better, but it's your money and your risk decision.
Next let's look at the two weakest home builders, Beazer Homes (BZH) and Lennar (LEN). Both are around 80% below their 90-day mean prices, and both are around 60% below their 10-day mean prices. One difference: LEN carries an IV of 53 -- quite elevated -- but BZH options trade at an incredible IV of 114. (Yes, it's possible to go above 100% expected volatility because IV estimates are lognormal.) So even though the two issues are about the same on the Implied Risk scale, one has twice the expected volatility of the other. Clearly, the market doubts whether BZH can survive this crises.
Here's how the possible profits look. Buy LEN at today's close of 27.33 and sell the Jan 30 call (LENAF) at today's closing bid of 2.65. That's 29% static return and 57.5% called return. Not bad, but it requires the stock to gain about 10% by January expiration. You're protected down to 24.68.
If you buy BZH at today's close of 8.88 and sell the Jan 10 call (BZHAB) for today's closing bid of 2.05, you can make about the same amount as the LEN trade on about half the percentage move in the stock. Static return is 32.9% and the called return comes to 49.3%. You've got protection down to 6.83, which represents almost 25% of the value of the stock.
Here's one more set of possible trades from the Implied Risk Buy/Write List, which looks for possible buy/writes from among the weakest stocks in our 2,000-issue database. The bond ratings services have been crushed, probably because they fear lawsuits. Oh yeah, we almost forgot, they'll also be missing all that income from rating sub-prime bonds.
Fist, let's check out McGraw-Hill (MHP). The owners of Standard & Poor's appear to be diverse enough to weather this storm. At 35, the stock's IV is high but not incredible. Buy the stock at today's close of 49.23 and sell the Jan 55 call (MHPAK) for today's closing bid of 2.25. Your static return comes to 13.2%, while your called return maxes out at 44.4%. Downside protection is 4.5%. Not a bad deal.
Then there's Moody's (MCO), which is more dependant on its ratings services than MHP. The stock closed at 44.83 on Tuesday. Buy the stock at the closing price and sell the Jan 50 call (MCOAJ) for Tuesday's closing bid of 3.30. Your static return is 20.6% and your called return is 52.2%. Downside protection is 7.3%. MCO has an IV of 49, significantly higher than MHP's IV of 35. Take more risk, make more money if you're right.
We like all these trades. We prefer using this strategy on stocks that are lower priced, under the theory that these companies aren't going out of business. That's the big question with BZH. The home builders offer the largest gains, but the ratings services probably have a better chance of giving you their max gains. CFC has some big backers, and should profit from any rate cuts.
The possible returns are quite attractive. First let's look at Countrywide Credit (CFC), the poster boy for this decline. Will it survive? The stock closed at 19.91 on Tuesday. with an option implied volatility (IV) of 70. Right now the stock is 97% below it's 90-day mean and 41% below its 10-day mean. In other words, it's at the bottom of an expected distribution that's simply massive. Lots of risk has been wrung out here.
Say you buy CFC and sell the Jan 22 1/2 call (CFCAX) at 2.20, today's closing bid. You'd make 13.7% on your money if the stock closes at the same price (19.91) on January expiration day (static return). If the stock is above 22.5 at expiration, you'll clear 32.4% (called return). And you experience no loss if the stock is above 17.71 at expiration-day close (downside protection).
To take more risk, sell the Jan 25 call (CFCAE) at today's closing bid of 1.50. Now you're looking at 9.3% static return, but you're called return has risen to 41.2% . Your downside protection is only to 18.41. We like the stats on the 22 1/2 trade better, but it's your money and your risk decision.
Next let's look at the two weakest home builders, Beazer Homes (BZH) and Lennar (LEN). Both are around 80% below their 90-day mean prices, and both are around 60% below their 10-day mean prices. One difference: LEN carries an IV of 53 -- quite elevated -- but BZH options trade at an incredible IV of 114. (Yes, it's possible to go above 100% expected volatility because IV estimates are lognormal.) So even though the two issues are about the same on the Implied Risk scale, one has twice the expected volatility of the other. Clearly, the market doubts whether BZH can survive this crises.
Here's how the possible profits look. Buy LEN at today's close of 27.33 and sell the Jan 30 call (LENAF) at today's closing bid of 2.65. That's 29% static return and 57.5% called return. Not bad, but it requires the stock to gain about 10% by January expiration. You're protected down to 24.68.
If you buy BZH at today's close of 8.88 and sell the Jan 10 call (BZHAB) for today's closing bid of 2.05, you can make about the same amount as the LEN trade on about half the percentage move in the stock. Static return is 32.9% and the called return comes to 49.3%. You've got protection down to 6.83, which represents almost 25% of the value of the stock.
Here's one more set of possible trades from the Implied Risk Buy/Write List, which looks for possible buy/writes from among the weakest stocks in our 2,000-issue database. The bond ratings services have been crushed, probably because they fear lawsuits. Oh yeah, we almost forgot, they'll also be missing all that income from rating sub-prime bonds.
Fist, let's check out McGraw-Hill (MHP). The owners of Standard & Poor's appear to be diverse enough to weather this storm. At 35, the stock's IV is high but not incredible. Buy the stock at today's close of 49.23 and sell the Jan 55 call (MHPAK) for today's closing bid of 2.25. Your static return comes to 13.2%, while your called return maxes out at 44.4%. Downside protection is 4.5%. Not a bad deal.
Then there's Moody's (MCO), which is more dependant on its ratings services than MHP. The stock closed at 44.83 on Tuesday. Buy the stock at the closing price and sell the Jan 50 call (MCOAJ) for Tuesday's closing bid of 3.30. Your static return is 20.6% and your called return is 52.2%. Downside protection is 7.3%. MCO has an IV of 49, significantly higher than MHP's IV of 35. Take more risk, make more money if you're right.
We like all these trades. We prefer using this strategy on stocks that are lower priced, under the theory that these companies aren't going out of business. That's the big question with BZH. The home builders offer the largest gains, but the ratings services probably have a better chance of giving you their max gains. CFC has some big backers, and should profit from any rate cuts.
Pep Rally in the Gym this Friday
Look for a big rally on Friday, after Bernanke practically tells the market he's going to cut rates on Sept. 18. That should bring long-term debt vehicles and short-term debt vehicles back in line with each other again. Here's why it'll happen:
There's lots of worry over short-term debt right now. That's reflected by the 13-Week Interest Rate (IRX) index, the shortest term yield vehicle we can get implied volatility (IV) from. On a 10-day basis, IRX is 144% -- let's say four standard deviations -- above its mean. It's even worse than that, though, because IRX IV has soared to the unheard-of level of 44. So short-term yields are rising crazily, meaning short-term bonds are falling.
The longest term yield vehicle we follow -- 30-Yr. Interest Rate (TYX) -- is going the other way. On a 10-day basis, TYX is 79% below its mean. TYX is about the same on a 90-day basis, more than two standard deviations below it mean. So long-term yields are heading down, which means long-term bonds are rising.
Those short-term yields are out-of-whack. Nothing you can trade, because the point movements are so slight due to single-digit IVs. But these are serious spreads that are going to attract the Fed's attention.
The Fed's goal will be to preserve the value in the short-term paper that investment banks are holding. Once we get past the next two or three months, this asset-backed paper will have expired. And it isn't coming back for a while. That's why the longer term bonds are stronger. The Fed will deal with replacing that short-term debt next next year. First things first.
With the downgrades today from Merrill Lynch, this could be a nice upside trading opportunity for the broker/dealers. Broker/Dealer (XBD), after a tepid rally, is slightly better than two standard deviations below its mean on a 90-day basis. The index will rocket back up above 90-day neutral if the Fed says it will cut. We'll short the index again in Zone 6.
There's lots of worry over short-term debt right now. That's reflected by the 13-Week Interest Rate (IRX) index, the shortest term yield vehicle we can get implied volatility (IV) from. On a 10-day basis, IRX is 144% -- let's say four standard deviations -- above its mean. It's even worse than that, though, because IRX IV has soared to the unheard-of level of 44. So short-term yields are rising crazily, meaning short-term bonds are falling.
The longest term yield vehicle we follow -- 30-Yr. Interest Rate (TYX) -- is going the other way. On a 10-day basis, TYX is 79% below its mean. TYX is about the same on a 90-day basis, more than two standard deviations below it mean. So long-term yields are heading down, which means long-term bonds are rising.
Those short-term yields are out-of-whack. Nothing you can trade, because the point movements are so slight due to single-digit IVs. But these are serious spreads that are going to attract the Fed's attention.
The Fed's goal will be to preserve the value in the short-term paper that investment banks are holding. Once we get past the next two or three months, this asset-backed paper will have expired. And it isn't coming back for a while. That's why the longer term bonds are stronger. The Fed will deal with replacing that short-term debt next next year. First things first.
With the downgrades today from Merrill Lynch, this could be a nice upside trading opportunity for the broker/dealers. Broker/Dealer (XBD), after a tepid rally, is slightly better than two standard deviations below its mean on a 90-day basis. The index will rocket back up above 90-day neutral if the Fed says it will cut. We'll short the index again in Zone 6.
Sunday, August 26, 2007
Implied Risk and Three of Our Favorite Books
Implied Risk data works -- helps people make more money and lose less -- because the theories surrounding the Normal Curve are perfect for investors who like to buy issues low and sell them high.
The best book on risk and the stock market is Against the Gods: The Remarkable Story of Risk ('96), by Peter Bernstein. The author traces the development of probability theory, which is based on the Normal Curve, to the observation of everyday life occurrences. Now probability theory has developed to the point that it's fair to say most of science is based on, or incorporates, some form of probability theory. The first reason Implied Risk data works is because it's based on the Normal Curve and probability theory.
Probability theory was introduced to the stock market by Harry Markowitz, who defined the concepts that William Sharpe turned into a risk measurement called "beta." (Both won a Nobel Prize for their efforts.) Beta measures an issue's risk relative to that of a constant, such as the historical volatility of the S&P 500 (SPX) or the rate of return from a three-month Treasury bill. In the absence of a market to provide true risk estimates, these relative risk estimates were a vast improvement on no risk estimates at all.
The listed options market debuted in 1973, first with calls only. Puts were added in 1974, paving the way for the theoretical option pricing model developed by Fischer Black and Myron Scholes in 1976. The Black/Scholes model introduced the world to the idea of option implied volatility, or the expected volatility of the underlying issue as implied by the price of the option. The key to this approach was the creation of the listed options market before Black and Scholes wrote their paper. Implied volatility is a product of the forward-looking listed options market, while beta is a product of the backward-looking calculator. That's the second reason Implied Risk data works:
Option implied volatility is produced in the marketplace by stock owners expressing risk concerns about the issues they own.
Another reason Implied Risk data works originated in Beat the Dealer ('66), a book about blackjack and card counting by Edward Thorp. He demonstrated how a seemingly random game could become predictable based upon immediately prior events (observations). The goal of card counting is to determine when the odds turn in your favor. Example: If a high number of face cards have appeared, you can accept new cards more readily because the chances of busting have dropped. Same with stock prices: If the stock has moved to the bottom of the market's estimated range for that issue, the chances of the stock dropping much further are minimal -- as long as you've chosen a fundamentally worthy issue. That's the third reason the Implied Risk data works: The imposition of a scale, along with rules attendant to the scale, permits the data to display an opinion concerning the expectations for further movement.
The key here again is the use of a scale, combined with the observation and analysis of immediately prior events. In blackjack, the scale is 52 cards X #of decks and the observations are which cards have appeared this time around the shoe. In stocks, the scale is three standard deviations from the current mean price and the observations are the stock's current price in relation to that current mean price.
Thorpe demonstrated that the imposition of a scale coupled with observations of events from the immediate past can increase the odds of certain actions occurring, turning a seemingly random game into one that can be somewhat predictable. Another work that continues the thought, The Winner's Curse ('92) by University of Chicago finance professor Richard Thaler, elucidates why opportunities -- he calls them anomalies -- should be expected to occur at either end of the Normal Curve. The anomaly with which we’re most concerned is called reversion to the mean.
Thaler and his colleagues in the burgeoning field of behavioral finance cite the prevalence of financial anomalies as proof that the theory of the fully rational investor is full of holes. One colleague, Yale economics professor Robert Shiller, has demonstrated statistically that markets "overreact" to events, an anomaly Shiller traces to behavioral factors. (Shiller coined the phrase "irrational exuberance" for Federal Reserve Chairman Alan Greeenspan.) Indeed, issues move to three standard deviations away from their 90-day means with greater frequency than the Normal Curve expects. But since Implied Risk data attempts to identify anomalies as interesting trading opportunities, the more the merrier.
One portion of Thaler's book examines the data supporting the conclusion that the phenomenon of reversion to the mean affects the stock market. "Indeed, stock prices do appear to be somewhat predictable," Thaler writes. "In particular, if one takes a long-term perspective (three-seven years) or examines individual securities that have experienced extreme price movements, then stock returns display significant negative serial correlation, in other words, prices are mean reverting." Implied Risk customers believe that stock price movements are mean-reverting over periods as short as three months, and they further believe that the options market provides a very reliable estimate of standard deviation from the mean. Maybe one day Thaler will study Implied Risk customers. Until then, that's the fourth reason Implied Risk data works: Reversion to mean is a fact of life among listed issues.
If reversion to the mean can be measured on a long-term basis of more than 100 years, we should be able to measure it on a shorter term basis such as three months. And if mean reversion works for the overall market, it must work for individual issues. Implied Risk data takes the theory of mean reversion and combines it with option market assumptions to produce useable information about the direction stocks will take in the immediate future.
The ultimate reason Implied Risk data works is because it's built upon sound theoretical assumptions. Two of the assumptions cited -- standard deviation as scale, and reversion to the mean as likely -- spring from the first assumption, that Normal Curve and probability theory apply to the stock market. The final assumption, market volatility as expressed through the options market, is what allows those other three theoretical assumptions to be fully realized.
The best book on risk and the stock market is Against the Gods: The Remarkable Story of Risk ('96), by Peter Bernstein. The author traces the development of probability theory, which is based on the Normal Curve, to the observation of everyday life occurrences. Now probability theory has developed to the point that it's fair to say most of science is based on, or incorporates, some form of probability theory. The first reason Implied Risk data works is because it's based on the Normal Curve and probability theory.
Probability theory was introduced to the stock market by Harry Markowitz, who defined the concepts that William Sharpe turned into a risk measurement called "beta." (Both won a Nobel Prize for their efforts.) Beta measures an issue's risk relative to that of a constant, such as the historical volatility of the S&P 500 (SPX) or the rate of return from a three-month Treasury bill. In the absence of a market to provide true risk estimates, these relative risk estimates were a vast improvement on no risk estimates at all.
The listed options market debuted in 1973, first with calls only. Puts were added in 1974, paving the way for the theoretical option pricing model developed by Fischer Black and Myron Scholes in 1976. The Black/Scholes model introduced the world to the idea of option implied volatility, or the expected volatility of the underlying issue as implied by the price of the option. The key to this approach was the creation of the listed options market before Black and Scholes wrote their paper. Implied volatility is a product of the forward-looking listed options market, while beta is a product of the backward-looking calculator. That's the second reason Implied Risk data works:
Option implied volatility is produced in the marketplace by stock owners expressing risk concerns about the issues they own.
Another reason Implied Risk data works originated in Beat the Dealer ('66), a book about blackjack and card counting by Edward Thorp. He demonstrated how a seemingly random game could become predictable based upon immediately prior events (observations). The goal of card counting is to determine when the odds turn in your favor. Example: If a high number of face cards have appeared, you can accept new cards more readily because the chances of busting have dropped. Same with stock prices: If the stock has moved to the bottom of the market's estimated range for that issue, the chances of the stock dropping much further are minimal -- as long as you've chosen a fundamentally worthy issue. That's the third reason the Implied Risk data works: The imposition of a scale, along with rules attendant to the scale, permits the data to display an opinion concerning the expectations for further movement.
The key here again is the use of a scale, combined with the observation and analysis of immediately prior events. In blackjack, the scale is 52 cards X #of decks and the observations are which cards have appeared this time around the shoe. In stocks, the scale is three standard deviations from the current mean price and the observations are the stock's current price in relation to that current mean price.
Thorpe demonstrated that the imposition of a scale coupled with observations of events from the immediate past can increase the odds of certain actions occurring, turning a seemingly random game into one that can be somewhat predictable. Another work that continues the thought, The Winner's Curse ('92) by University of Chicago finance professor Richard Thaler, elucidates why opportunities -- he calls them anomalies -- should be expected to occur at either end of the Normal Curve. The anomaly with which we’re most concerned is called reversion to the mean.
Thaler and his colleagues in the burgeoning field of behavioral finance cite the prevalence of financial anomalies as proof that the theory of the fully rational investor is full of holes. One colleague, Yale economics professor Robert Shiller, has demonstrated statistically that markets "overreact" to events, an anomaly Shiller traces to behavioral factors. (Shiller coined the phrase "irrational exuberance" for Federal Reserve Chairman Alan Greeenspan.) Indeed, issues move to three standard deviations away from their 90-day means with greater frequency than the Normal Curve expects. But since Implied Risk data attempts to identify anomalies as interesting trading opportunities, the more the merrier.
One portion of Thaler's book examines the data supporting the conclusion that the phenomenon of reversion to the mean affects the stock market. "Indeed, stock prices do appear to be somewhat predictable," Thaler writes. "In particular, if one takes a long-term perspective (three-seven years) or examines individual securities that have experienced extreme price movements, then stock returns display significant negative serial correlation, in other words, prices are mean reverting." Implied Risk customers believe that stock price movements are mean-reverting over periods as short as three months, and they further believe that the options market provides a very reliable estimate of standard deviation from the mean. Maybe one day Thaler will study Implied Risk customers. Until then, that's the fourth reason Implied Risk data works: Reversion to mean is a fact of life among listed issues.
If reversion to the mean can be measured on a long-term basis of more than 100 years, we should be able to measure it on a shorter term basis such as three months. And if mean reversion works for the overall market, it must work for individual issues. Implied Risk data takes the theory of mean reversion and combines it with option market assumptions to produce useable information about the direction stocks will take in the immediate future.
The ultimate reason Implied Risk data works is because it's built upon sound theoretical assumptions. Two of the assumptions cited -- standard deviation as scale, and reversion to the mean as likely -- spring from the first assumption, that Normal Curve and probability theory apply to the stock market. The final assumption, market volatility as expressed through the options market, is what allows those other three theoretical assumptions to be fully realized.
Friday, August 24, 2007
From the Archives: The Missing Link --Sector Analysis
This week in From the Archives we present Chapter 4 in the Yates Guide to Options Investing (1994): The Missing Link -- Sector Analysis, written by Jim Yates.
When most investors think about portfolio management, they see a two-part problem. First, there's the market itself. Second, there are individual stocks. Portfolio managers know that there's a "missing link" between these two subjects. The missing ingredient is called sector analysis.
A sector is defined as "a distinguishable subdivision." From a stock-market point of view, a sector is a group of stocks in the same general industry. Because economic conditions increasingly affect entire industries, sector analysis has become an important part of portfolio management.
Sector analysis isn't an easy task. The job is similar to that of a portfolio manager in that stock selection is an important consideration. Determining the appropriate sector designation for a stock is not always simple because a company may have operations in several different industries. In addition, a decision must be made as to how many distinguishable subdivisions there are in the market. Finally, there's the problem of comparing the performance of sectors. Wile all of the above is going on, it must be remembered that the purpose is to remain objective in the analysis.
The Zone system of stock market analysis is particularly suited to sector evaluation because it allows the objective measurement of the relative movement of often widely varying groups of stocks.
Our sector analysis divides the market into 20 industry groups. These groups were chosen because we wanted to keep the list to a manageable number, and 20 seemed the logical choice. Each stock in our database is assigned to one of the 20 groups on the basis of its major business activity. The 20 sectors are:
-- Aerospace -- Autos -- Building --Chemical --Consumer
-- Data Processing --Drugs --Electronics --Food --Insurance/Finance
--Integrated Oils --Leisure --Machinery --Metals --Miscellaneous (Conglomerates)
--Non-Integrated Oils --Oil Service --Retail Trade --Transportation --Utilities
The ranking score for each sector is determined by averaging the 90-day Implied Risk readings for all the issues in the group. The Implied Risk reading for each stock represents the percentage deviation of the price of the stock from its 90-day trend, relative to what is expected given the stock's option implied volatility.
A stock with an Implied Risk reading of -100 is at the top of its Implied Risk trading range. When stocks are grouped together as they are in this analysis, there's a dampening effect to the average Implied Risk score. This dampening is called the "portfolio effect," and is due to the fact that stocks in a portfolio -- even those is similar industries -- rarely move at exactly the same time. We adjust for the portfolio effect by reducing the group range from +60 to -60.
We rank the 20 groups, with the group nearest the top of its Implied Risk trading range ranked first. We also list the Implied Risk score for each sector over the past week, month and three months. The objective isn't only to determine the strongest sector in the market, but also to determine the probability of future advances. The recent sector scores are intended to provide trend perspective that allows us to identify groups that are making significant moves relative to the rest of the universe.
The sector score range of +60 to -60 means there are six 20-point divisions, which we call Zones. An industry group with an Implied Risk reading above -40 as reached Zone 6. To get to Zone 1, a group needs to compile an Implied Risk reading below +40. The expectation of occurrences in each Zone is the same as for individual issues. We expect each sector to visit each Zone annually, and we expect them to be in Zone 3 or Zone 4 about two-thirds of the time.
The purpose of this type of analysis is to fill in that gap between market-risk analysis and stock-risk analysis. We believe that market risk represents about 50% of the total risk involved in trading stocks. Stock risk represents another 25% of your total risk. That leaves 25% of the total risk for the sector analysis. Proper sector analysis, we believe, can improve both stock-market analysis and and individual-issue analysis.
In the case of the general market, a close study of the sector can often explain otherwise inexplicable market activity. A rising market may be led by the Integrated Oils, for example. That sends a different message than an advance led by Insurance & Finance. Individual stocks analysis also can be enhanced using sector analysis. For instance, a stock that reaches either extreme (Zone 1 or Zone 6) while its sector is at the opposite end of the spectrum could be experiencing an important fundamental change. The stock that resists sector weakness may signal future strength.
This latter factor is similar to a condition technicians often refer to as relative strength. But this kind of relative strength is different, because it relates individual stock movement to the sector rather than to the overall market. Because sector analysis enhances our understanding of both the overall market and of specific stocks, it deserves the title Missing Link.
This system allows us to measure movement relative to expectations. For instance, technology stocks may experience a larger percentage move than other issues, but that greater movement potential is anticipated and incorporated into the volatility estimates for individual issues in the sector. When we adjust the movement for volatility expectations, we're left with a uniform analysis that permits direct comparison of wildly disparate sectors and issues.
When most investors think about portfolio management, they see a two-part problem. First, there's the market itself. Second, there are individual stocks. Portfolio managers know that there's a "missing link" between these two subjects. The missing ingredient is called sector analysis.
A sector is defined as "a distinguishable subdivision." From a stock-market point of view, a sector is a group of stocks in the same general industry. Because economic conditions increasingly affect entire industries, sector analysis has become an important part of portfolio management.
Sector analysis isn't an easy task. The job is similar to that of a portfolio manager in that stock selection is an important consideration. Determining the appropriate sector designation for a stock is not always simple because a company may have operations in several different industries. In addition, a decision must be made as to how many distinguishable subdivisions there are in the market. Finally, there's the problem of comparing the performance of sectors. Wile all of the above is going on, it must be remembered that the purpose is to remain objective in the analysis.
The Zone system of stock market analysis is particularly suited to sector evaluation because it allows the objective measurement of the relative movement of often widely varying groups of stocks.
Our sector analysis divides the market into 20 industry groups. These groups were chosen because we wanted to keep the list to a manageable number, and 20 seemed the logical choice. Each stock in our database is assigned to one of the 20 groups on the basis of its major business activity. The 20 sectors are:
-- Aerospace -- Autos -- Building --Chemical --Consumer
-- Data Processing --Drugs --Electronics --Food --Insurance/Finance
--Integrated Oils --Leisure --Machinery --Metals --Miscellaneous (Conglomerates)
--Non-Integrated Oils --Oil Service --Retail Trade --Transportation --Utilities
The ranking score for each sector is determined by averaging the 90-day Implied Risk readings for all the issues in the group. The Implied Risk reading for each stock represents the percentage deviation of the price of the stock from its 90-day trend, relative to what is expected given the stock's option implied volatility.
A stock with an Implied Risk reading of -100 is at the top of its Implied Risk trading range. When stocks are grouped together as they are in this analysis, there's a dampening effect to the average Implied Risk score. This dampening is called the "portfolio effect," and is due to the fact that stocks in a portfolio -- even those is similar industries -- rarely move at exactly the same time. We adjust for the portfolio effect by reducing the group range from +60 to -60.
We rank the 20 groups, with the group nearest the top of its Implied Risk trading range ranked first. We also list the Implied Risk score for each sector over the past week, month and three months. The objective isn't only to determine the strongest sector in the market, but also to determine the probability of future advances. The recent sector scores are intended to provide trend perspective that allows us to identify groups that are making significant moves relative to the rest of the universe.
The sector score range of +60 to -60 means there are six 20-point divisions, which we call Zones. An industry group with an Implied Risk reading above -40 as reached Zone 6. To get to Zone 1, a group needs to compile an Implied Risk reading below +40. The expectation of occurrences in each Zone is the same as for individual issues. We expect each sector to visit each Zone annually, and we expect them to be in Zone 3 or Zone 4 about two-thirds of the time.
The purpose of this type of analysis is to fill in that gap between market-risk analysis and stock-risk analysis. We believe that market risk represents about 50% of the total risk involved in trading stocks. Stock risk represents another 25% of your total risk. That leaves 25% of the total risk for the sector analysis. Proper sector analysis, we believe, can improve both stock-market analysis and and individual-issue analysis.
In the case of the general market, a close study of the sector can often explain otherwise inexplicable market activity. A rising market may be led by the Integrated Oils, for example. That sends a different message than an advance led by Insurance & Finance. Individual stocks analysis also can be enhanced using sector analysis. For instance, a stock that reaches either extreme (Zone 1 or Zone 6) while its sector is at the opposite end of the spectrum could be experiencing an important fundamental change. The stock that resists sector weakness may signal future strength.
This latter factor is similar to a condition technicians often refer to as relative strength. But this kind of relative strength is different, because it relates individual stock movement to the sector rather than to the overall market. Because sector analysis enhances our understanding of both the overall market and of specific stocks, it deserves the title Missing Link.
This system allows us to measure movement relative to expectations. For instance, technology stocks may experience a larger percentage move than other issues, but that greater movement potential is anticipated and incorporated into the volatility estimates for individual issues in the sector. When we adjust the movement for volatility expectations, we're left with a uniform analysis that permits direct comparison of wildly disparate sectors and issues.
Tuesday, August 21, 2007
America, You're Stupid
Our leaders think you're too stupid to stop sticking your hand in the fire. Sen. Chris Dodd (D-Conn.), chairman of the Senate banking committee, is pushing the Fed to tighten what he terms predatory lending standards. Can you tell he's running for President? First of all, he needs to make up any kind -- something, please -- of standards for all the hedge funds in his home state. We bet he attacks that problem after the hedge funds are gone, too.
But back to the predatory lending. The predators have gone out of business, long before any standard tightening could occur. Seems they ate some bad prey. Now you can't get any type of mortgage that isn't Fannie backed. A question: Does Dodd consider jumbo-loan sellers predatory? Jumbo loaners must have been sharing lunch with the sub-primers, because they're shut down for the moment, too. The market can take care of it -- if you'll let it.
These guys are just protecting their cronies now, giving them a window to get out. (That's what you should be doing too, if you're an investor rather than a trader.) The folks who bought the sub-prime condos, they're not very book smart. But word gets out on the street. With all these people going belly up on their sub-prime loans, the flow of customers for these products would have declined significantly if they would just let the market do its business. Then the people who offer the sub-prime loans would have to adjust -- which means provide more favorable terms to their potential customers -- or they would be out of business. The whole reason this fiasco happened is because these products were new to the consumer. Now that most buyers understand the toxicity -- you can believe the sellers understood it -- of the products, they would have disappeared on their own.
As it stands now, the Fed has decimated the mortgage loan market. House prices are incredibly inflated, and their are no bids. This is the point in time where you want to make mortgages available to practically anyone, just to get the bids going. The tightening of lending standards will only exacerbate the base problem, the lack of home sales. The Fed is giving the money to banks, who are not giving it to the people in the form of eased lending standards. On the contrary, the banks are using the available loans to shore up their own financial positions. Where did all the money go? By the time it's all said and done, most of the profits made by corporate America over the past four years are going to have been spent -- poof! -- on buying their own shares back. Tightening standards only protects the banks at this point in time, not the consumer. The Fed has already failed the consumer.
Essentially, the risk that was inherent in these sub-prime products was bundled up and sold. Now that the risk has come due, nobody wants to own it. So now the risk is back out in the market. This bundling and selling of risk, in the form of these CDOs, was what propped the market up for the past four years. They're the reason we haven't visited Zone 1 on the DYR Phase Chart since March '03. Now the risk has been let out of the bottle and back into the market. CDOs don't exist anymore. Once the ones that have already been sold expire this year, nobody will buy them again for a long time. Hey there risk, it's good to see you again. Where you been?
But back to the predatory lending. The predators have gone out of business, long before any standard tightening could occur. Seems they ate some bad prey. Now you can't get any type of mortgage that isn't Fannie backed. A question: Does Dodd consider jumbo-loan sellers predatory? Jumbo loaners must have been sharing lunch with the sub-primers, because they're shut down for the moment, too. The market can take care of it -- if you'll let it.
These guys are just protecting their cronies now, giving them a window to get out. (That's what you should be doing too, if you're an investor rather than a trader.) The folks who bought the sub-prime condos, they're not very book smart. But word gets out on the street. With all these people going belly up on their sub-prime loans, the flow of customers for these products would have declined significantly if they would just let the market do its business. Then the people who offer the sub-prime loans would have to adjust -- which means provide more favorable terms to their potential customers -- or they would be out of business. The whole reason this fiasco happened is because these products were new to the consumer. Now that most buyers understand the toxicity -- you can believe the sellers understood it -- of the products, they would have disappeared on their own.
As it stands now, the Fed has decimated the mortgage loan market. House prices are incredibly inflated, and their are no bids. This is the point in time where you want to make mortgages available to practically anyone, just to get the bids going. The tightening of lending standards will only exacerbate the base problem, the lack of home sales. The Fed is giving the money to banks, who are not giving it to the people in the form of eased lending standards. On the contrary, the banks are using the available loans to shore up their own financial positions. Where did all the money go? By the time it's all said and done, most of the profits made by corporate America over the past four years are going to have been spent -- poof! -- on buying their own shares back. Tightening standards only protects the banks at this point in time, not the consumer. The Fed has already failed the consumer.
Essentially, the risk that was inherent in these sub-prime products was bundled up and sold. Now that the risk has come due, nobody wants to own it. So now the risk is back out in the market. This bundling and selling of risk, in the form of these CDOs, was what propped the market up for the past four years. They're the reason we haven't visited Zone 1 on the DYR Phase Chart since March '03. Now the risk has been let out of the bottle and back into the market. CDOs don't exist anymore. Once the ones that have already been sold expire this year, nobody will buy them again for a long time. Hey there risk, it's good to see you again. Where you been?
Sunday, August 19, 2007
Zone 2
The DYR Phase Chart has fallen to +24 in Zone 2. Most of the broad-based indexes have eased back up into Zone 3. The financials are leading the bounce. Bank indexes are among the strongest in the market now, over both 10 and 90 days. Broker/Dealer (XBD) has climbed up to the middle of Zone 2, and it's one of the leaders over the short term. Maybe this bounce will take the market back to 90-day neutral, but we suspect there's at least another leg down before the market stages a comeback. There's very little blood in the water. We're still looking for Zone 1.
The unwinding of the Japan carry-trade has taken Japan (JPN) to the deepest depths of Zone 1. This looks like a buying opportunity here, especially if we see more weakness in the index this week. As a result of the unwinding, short-term rates have gone ballistic. 13-week Interest Rate (IRX) is 93% overbought over 90 days and 185% overbought over 10 days. Those numbers have been reached even with a whopping implied volatility (IV) of 40, about twice the index's average. Longer term bond indexes have reached Zone 5, indicating there's a ways to go. The market probably won't find a true bottom until the bonds have found their true top.
The DYR Sector Rankings show the uniformity of this decline. When you can't sell what you want, you sell what you can. Three-fourths of the 20 DYR Sectors are in Zone 2. The other five sectors are less than 1/2-standard deviation stronger than the rest. There are no DYR Sectors above 90-day neutral, and none are in Zone 1. The group we're liking now is the oils. Last time the oil service stocks dipped down into Zone 2, they nearly doubled within six months. If money pours out of the financials, we'd expect a large chunk of it to end up in the oils (and maybe the techs).
Here's another sector we like: Defense. The defense indexes (DFI, DFX) didn't get hit as hard as most, and they're rebounding nicely now. They carry some of the lowest IVs among indexes and ETFs we follow. That means they carry less risk on a relative basis. Like consumer staples and drugs, the preferred type of issue for those abandoning riskier positions. Plus, we don't see a quick withdrawal of our forces from Iraq coming soon. The place is an absolute mess.
Finally, Gold/Silver (XAU) touched Zone 1 during intraday trading Thursday and then rallied. We suspect you'll get another chance to buy in the lower 120's before this is over. The index is still in Zone 2, so it's already a good buy. Buy some now, save some cash for buying more later.
The unwinding of the Japan carry-trade has taken Japan (JPN) to the deepest depths of Zone 1. This looks like a buying opportunity here, especially if we see more weakness in the index this week. As a result of the unwinding, short-term rates have gone ballistic. 13-week Interest Rate (IRX) is 93% overbought over 90 days and 185% overbought over 10 days. Those numbers have been reached even with a whopping implied volatility (IV) of 40, about twice the index's average. Longer term bond indexes have reached Zone 5, indicating there's a ways to go. The market probably won't find a true bottom until the bonds have found their true top.
The DYR Sector Rankings show the uniformity of this decline. When you can't sell what you want, you sell what you can. Three-fourths of the 20 DYR Sectors are in Zone 2. The other five sectors are less than 1/2-standard deviation stronger than the rest. There are no DYR Sectors above 90-day neutral, and none are in Zone 1. The group we're liking now is the oils. Last time the oil service stocks dipped down into Zone 2, they nearly doubled within six months. If money pours out of the financials, we'd expect a large chunk of it to end up in the oils (and maybe the techs).
Here's another sector we like: Defense. The defense indexes (DFI, DFX) didn't get hit as hard as most, and they're rebounding nicely now. They carry some of the lowest IVs among indexes and ETFs we follow. That means they carry less risk on a relative basis. Like consumer staples and drugs, the preferred type of issue for those abandoning riskier positions. Plus, we don't see a quick withdrawal of our forces from Iraq coming soon. The place is an absolute mess.
Finally, Gold/Silver (XAU) touched Zone 1 during intraday trading Thursday and then rallied. We suspect you'll get another chance to buy in the lower 120's before this is over. The index is still in Zone 2, so it's already a good buy. Buy some now, save some cash for buying more later.
Friday, August 17, 2007
From the Archives: The Missing Line --Sector Analysis
This week in From the Archives we present Chapter 4 in the Yates Guide to Options Investing (1994): The Missing Link -- Sector Analysis, written by Jim Yates.
When most investors think about portfolio management, they see a two-part problem. First, there's the market itself. Second, there are individual stocks. Portfolio managers know that there's a "missing link" between these two subjects. The missing ingredient is called sector analysis.
A sector is defined as "a distinguishable subdivision." From a stock-market point of view, a sector is a group of stocks in the same general industry. Because economic conditions increasingly affect entire industries, sector analysis has become an important part of portfolio management.
Sector analysis isn't an easy task. The job is similar to that of a portfolio manager in that stock selection is an important consideration. Determining the appropriate sector designation for a stock is not always simple because a company may have operations in several different industries. In addition, a decision must be made as to how many distinguishable subdivisions there are in the market. Finally, there's the problem of comparing the performance of sectors. Wile all of the above is going on, it must be remembered that the purpose is to remain objective in the analysis.
The Zone system of stock market analysis is particularly suited to sector evaluation because it allows the objective measurement of the relative movement of often widely varying groups of stocks.
Our sector analysis divides the market into 20 industry groups. These groups were chosen because we wanted to keep the list to a manageable number, and 20 seemed the logical choice. Each stock in our database is assigned to one of the 20 groups on the basis of its major business activity. The 20 sectors are:
-- Aerospace -- Autos -- Building --Chemical --Consumer
-- Data Processing --Drugs --Electronics --Food --Insurance/Finance
--Integrated Oils --Leisure --Machinery --Metals --Miscellaneous (Conglomerates)
--Non-Integrated Oils --Oil Service --Retail Trade --Transportation --Utilities
The ranking score for each sector is determined by averaging the 90-day Implied Risk readings for all the issues in the group. The Implied Risk reading for each stock represents the percentage deviation of the price of the stock from its 90-day trend, relative to what is expected given the stock's option implied volatility.
A stock with an Implied Risk reading of -100 is at the top of its Implied Risk trading range. When stocks are grouped together as they are in this analysis, there's a dampening effect to the average Implied Risk score. This dampening is called the "portfolio effect," and is due to the fact that stocks in a portfolio -- even those is similar industries -- rarely move at exactly the same time. We adjust for the portfolio effect by reducing the group range from +60 to -60.
We rank the 20 groups, with the group nearest the top of its Implied Risk trading range ranked first. We also list the Implied Risk score for each sector over the past week, month and three months. The objective isn't only to determine the strongest sector in the market, but also to determine the probability of future advances. The recent sector scores are intended to provide trend perspective that allows us to identify groups that are making significant moves relative to the rest of the universe.
The sector score range of +60 to -60 means there are six 20-point divisions, which we call Zones. An industry group with an Implied Risk reading above -40 as reached Zone 6. To get to Zone 1, a group needs to compile an Implied Risk reading below +40. The expectation of occurrences in each Zone is the same as for individual issues. We expect each sector to visit each Zone annually, and we expect them to be in Zone 3 or Zone 4 about two-thirds of the time.
The purpose of this type of analysis is to fill in that gap between market-risk analysis and stock-risk analysis. We believe that market risk represents about 50% of the total risk involved in trading stocks. Stock risk represents another 25% of your total risk. That leaves 25% of the total risk for the sector analysis. Proper sector analysis, we believe, can improve both stock-market analysis and and individual-issue analysis.
In the case of the general market, a close study of the sector can often explain otherwise inexplicable market activity. A rising market may be led by the Integrated Oils, for example. That sends a different message than an advance led by Insurance & Finance. Individual stocks analysis also can be enhanced using sector analysis. For instance, a stock that reaches either extreme (Zone 1 or Zone 6) while its sector is at the opposite end of the spectrum could be experiencing an important fundamental change. The stock that resists sector weakness may signal future strength.
This latter factor is similar to a condition technicians often refer to as relative strength. But this kind of relative strength is different, because it relates individual stock movement to the sector rather than to the overall market. Because sector analysis enhances our understanding of both the overall market and of specific stocks, it deserves the title Missing Link.
This system allows us to measure movement relative to expectations. For instance, technology stocks may experience a larger percentage move than other issues, but that greater movement potential is anticipated and incorporated into the volatility estimates for individual issues in the sector. When we adjust the movement for volatility expectations, we're left with a uniform analysis that permits direct comparison of wildly disparate sectors and issues.
When most investors think about portfolio management, they see a two-part problem. First, there's the market itself. Second, there are individual stocks. Portfolio managers know that there's a "missing link" between these two subjects. The missing ingredient is called sector analysis.
A sector is defined as "a distinguishable subdivision." From a stock-market point of view, a sector is a group of stocks in the same general industry. Because economic conditions increasingly affect entire industries, sector analysis has become an important part of portfolio management.
Sector analysis isn't an easy task. The job is similar to that of a portfolio manager in that stock selection is an important consideration. Determining the appropriate sector designation for a stock is not always simple because a company may have operations in several different industries. In addition, a decision must be made as to how many distinguishable subdivisions there are in the market. Finally, there's the problem of comparing the performance of sectors. Wile all of the above is going on, it must be remembered that the purpose is to remain objective in the analysis.
The Zone system of stock market analysis is particularly suited to sector evaluation because it allows the objective measurement of the relative movement of often widely varying groups of stocks.
Our sector analysis divides the market into 20 industry groups. These groups were chosen because we wanted to keep the list to a manageable number, and 20 seemed the logical choice. Each stock in our database is assigned to one of the 20 groups on the basis of its major business activity. The 20 sectors are:
-- Aerospace -- Autos -- Building --Chemical --Consumer
-- Data Processing --Drugs --Electronics --Food --Insurance/Finance
--Integrated Oils --Leisure --Machinery --Metals --Miscellaneous (Conglomerates)
--Non-Integrated Oils --Oil Service --Retail Trade --Transportation --Utilities
The ranking score for each sector is determined by averaging the 90-day Implied Risk readings for all the issues in the group. The Implied Risk reading for each stock represents the percentage deviation of the price of the stock from its 90-day trend, relative to what is expected given the stock's option implied volatility.
A stock with an Implied Risk reading of -100 is at the top of its Implied Risk trading range. When stocks are grouped together as they are in this analysis, there's a dampening effect to the average Implied Risk score. This dampening is called the "portfolio effect," and is due to the fact that stocks in a portfolio -- even those is similar industries -- rarely move at exactly the same time. We adjust for the portfolio effect by reducing the group range from +60 to -60.
We rank the 20 groups, with the group nearest the top of its Implied Risk trading range ranked first. We also list the Implied Risk score for each sector over the past week, month and three months. The objective isn't only to determine the strongest sector in the market, but also to determine the probability of future advances. The recent sector scores are intended to provide trend perspective that allows us to identify groups that are making significant moves relative to the rest of the universe.
The sector score range of +60 to -60 means there are six 20-point divisions, which we call Zones. An industry group with an Implied Risk reading above -40 as reached Zone 6. To get to Zone 1, a group needs to compile an Implied Risk reading below +40. The expectation of occurrences in each Zone is the same as for individual issues. We expect each sector to visit each Zone annually, and we expect them to be in Zone 3 or Zone 4 about two-thirds of the time.
The purpose of this type of analysis is to fill in that gap between market-risk analysis and stock-risk analysis. We believe that market risk represents about 50% of the total risk involved in trading stocks. Stock risk represents another 25% of your total risk. That leaves 25% of the total risk for the sector analysis. Proper sector analysis, we believe, can improve both stock-market analysis and and individual-issue analysis.
In the case of the general market, a close study of the sector can often explain otherwise inexplicable market activity. A rising market may be led by the Integrated Oils, for example. That sends a different message than an advance led by Insurance & Finance. Individual stocks analysis also can be enhanced using sector analysis. For instance, a stock that reaches either extreme (Zone 1 or Zone 6) while its sector is at the opposite end of the spectrum could be experiencing an important fundamental change. The stock that resists sector weakness may signal future strength.
This latter factor is similar to a condition technicians often refer to as relative strength. But this kind of relative strength is different, because it relates individual stock movement to the sector rather than to the overall market. Because sector analysis enhances our understanding of both the overall market and of specific stocks, it deserves the title Missing Link.
This system allows us to measure movement relative to expectations. For instance, technology stocks may experience a larger percentage move than other issues, but that greater movement potential is anticipated and incorporated into the volatility estimates for individual issues in the sector. When we adjust the movement for volatility expectations, we're left with a uniform analysis that permits direct comparison of wildly disparate sectors and issues.
Shades of '29
The Fed cut the discount rate this morning, but why? How is a 1/2-point reduction in the rate that banks pay for overnight loans going to help? You think it's time to borrow some money and take some risk? Anyone want to buy a second home as speculation?
The government has repeated the mistakes it made back in '29. This time, they didn't break off credit to stock owners -- they did it to home buyers. If you had any idea what was happening in the condo conversion market the past couple years, you could see we were headed for trouble. There are some many headaches with owning a 20-year old apartment, who would want to do it? Resell value sucks, and good luck fixing the aging structure that houses your apartment. You'll never get your co-owners to agree. And it's going to cost you.
Back to the government. They allowed the creation of these sub-prime brokers -- barely at arms' length from the banks that supported them with credit lines to fund their mortgage pools -- and then allowed them to be shut down. They created a market, then closed it to secondary offerings. Now all these people are stuck with homes and condos for which there is no secondary market. Clearly, they should have created a government entity designed to offer support packages to these stupid buyers. Not for them, but for us.
The Fed seems eager to pump money into the market, but that extra cash is going to the sellers, not the buyers. The banks already made their money on these entities; they shouldn't get more. The government should take all this money their giving the banks to lend and set up an agency to lend only to people who will take a property with a sub-prime loan attached and turn it into a property with a prime-rate loan attached. Of course, that means a serious decline in home prices, because the property will be worth less to a prime-rate borrower than s sub-prime borrower. But it would put a floor on losses we're about to realize in the home market.
Too late. The made credit available, then they cut it off. Guess nobody's around still from '29.
The government has repeated the mistakes it made back in '29. This time, they didn't break off credit to stock owners -- they did it to home buyers. If you had any idea what was happening in the condo conversion market the past couple years, you could see we were headed for trouble. There are some many headaches with owning a 20-year old apartment, who would want to do it? Resell value sucks, and good luck fixing the aging structure that houses your apartment. You'll never get your co-owners to agree. And it's going to cost you.
Back to the government. They allowed the creation of these sub-prime brokers -- barely at arms' length from the banks that supported them with credit lines to fund their mortgage pools -- and then allowed them to be shut down. They created a market, then closed it to secondary offerings. Now all these people are stuck with homes and condos for which there is no secondary market. Clearly, they should have created a government entity designed to offer support packages to these stupid buyers. Not for them, but for us.
The Fed seems eager to pump money into the market, but that extra cash is going to the sellers, not the buyers. The banks already made their money on these entities; they shouldn't get more. The government should take all this money their giving the banks to lend and set up an agency to lend only to people who will take a property with a sub-prime loan attached and turn it into a property with a prime-rate loan attached. Of course, that means a serious decline in home prices, because the property will be worth less to a prime-rate borrower than s sub-prime borrower. But it would put a floor on losses we're about to realize in the home market.
Too late. The made credit available, then they cut it off. Guess nobody's around still from '29.
Thursday, August 16, 2007
Told You So
You gotta love the Merrill analyst who took Countrywide (CFC) to a sell from a buy he issued two days earlier. Hopefully the psychological scars he absorbs from becoming an industry laughingstock will last until the end of his days. Can you say boiler room?
We've been harping since May about the bad prospects for the market in August. Here's what we said about the market in May, June and July:
May 7 -- "We'd guess that most of the gains for this year have already been made. The rest of '07 will be about holding those gains."
May 14 --"This rally is bad for the economy. The groups that are strongest -- commodities, cyclicals and defense -- are the ones killing the country. When all is said and done -- we'd say about August -- it'll be bad."
May 21 -- "We'd stay away from the weakest group in our rankings, though. REITs have been crushed, but we suspect there's more to come. In fact, we'd short Housing (HCX) again while it's around 90-day neutral. When we finally do make it back to Zone 1 this year, we think the housing stocks will be the downside leaders. REITs too."
May 29 -- "Hope you made some money the the last couple months. The next couple months should be a time to reduce your positions heading into August."
June 4 -- "Broker/Dealer (XBD) is one of the strongest sectors again. All is well with the market. We'd get out now. Sell in May and go away sounds about right...In three months or so, the bonds will be near Zone 6 and yields will be weak...We don't believe the economy warrants such an impressive run. It's all about liquidity...There is lots of risk in this market. We're looking for a Zone 1 reading in late August or early September, when the market usually has its worst days. Then we'll talk about buying."
June 11 -- "The Fed says it won't lower interest rates, but the market rallies anyway...This market doesn't want to die yet. Wait until August...We expect bonds to be overbought and yields to be oversold by summer's end."
June 18 -- "Stronger bonds had the stock market on a strange rebound last week. It's strange because most indexes and sectors are near Zone 6. There is so much liquidity that pullbacks don't even reach 90-day neutral. Overall, the market's action doesn't match the data. We don't like it."
June 25 -- "We're halfway through the trading year, and we may have seen the market highs for '07...The true repercussions from the housing bubble are starting to be reflected in the financial markets. And the market is coming off a nice Zone 6 reading. It'll be a long summer..We don't see how banks can get out from under the mortgage mess until some losses are taken."
July 2 -- "The Fed didn't clear things up much last week. Looks like they wouldn't mind if the stock market cooled...The sub-prime mortgage fiasco isn't going away. In fact, it'll get worse. Bank and housing indexes have dipped into Zone 2. They should lead the rest of the market down."
July 9 -- "The DYR Phase Chart has bounced back up to -21 in Zone 5...We still think the new trend is down toward 90-day neutral. A sideways market this month, or a quick drop soon, would get us there. Then we'll see what happens in August and September."
July 16 -- "Did good retail numbers really send the Dow Jones Industrial Average (DJIA) up 250 points in one day? But didn't Home Depot (HD) and Sears (SHLD) warn? Looks to us like there's a bunch of people spending a bunch of other people's money on risky stocks...We're just waiting for Broker/Dealer (XBD) to start leading the market south...Consumer (CMR) and Retail (MVR) are among the weaker sector indexes on a 90-day basis. We wouldn't be surprised to see these indexes lead the fall as we get into August and September."
July 23 -- Headline: Time For Puts. "Broker/Dealer (XBD) has broken down...We think the market follows the brokers. That means it's time to buy puts on the market and certain sectors...As far as strategy goes, look at puts on the stronger indexes (SOX, QQQQ), foreign ETFs (XEX, CZH) and financials (XBD, RKH)...time to take profits on Gold/Silver (XAU). The index is in Zone 6, just barely, over both 90-days and 10-days. It's hard to see the dollar falling lower. If the market tanks, golds will fall too."
July 30 -- "There's another one or two standard deviations to fall before we call it a wipeout. Our last Zone 1 reading: March '03."
We've been harping since May about the bad prospects for the market in August. Here's what we said about the market in May, June and July:
May 7 -- "We'd guess that most of the gains for this year have already been made. The rest of '07 will be about holding those gains."
May 14 --"This rally is bad for the economy. The groups that are strongest -- commodities, cyclicals and defense -- are the ones killing the country. When all is said and done -- we'd say about August -- it'll be bad."
May 21 -- "We'd stay away from the weakest group in our rankings, though. REITs have been crushed, but we suspect there's more to come. In fact, we'd short Housing (HCX) again while it's around 90-day neutral. When we finally do make it back to Zone 1 this year, we think the housing stocks will be the downside leaders. REITs too."
May 29 -- "Hope you made some money the the last couple months. The next couple months should be a time to reduce your positions heading into August."
June 4 -- "Broker/Dealer (XBD) is one of the strongest sectors again. All is well with the market. We'd get out now. Sell in May and go away sounds about right...In three months or so, the bonds will be near Zone 6 and yields will be weak...We don't believe the economy warrants such an impressive run. It's all about liquidity...There is lots of risk in this market. We're looking for a Zone 1 reading in late August or early September, when the market usually has its worst days. Then we'll talk about buying."
June 11 -- "The Fed says it won't lower interest rates, but the market rallies anyway...This market doesn't want to die yet. Wait until August...We expect bonds to be overbought and yields to be oversold by summer's end."
June 18 -- "Stronger bonds had the stock market on a strange rebound last week. It's strange because most indexes and sectors are near Zone 6. There is so much liquidity that pullbacks don't even reach 90-day neutral. Overall, the market's action doesn't match the data. We don't like it."
June 25 -- "We're halfway through the trading year, and we may have seen the market highs for '07...The true repercussions from the housing bubble are starting to be reflected in the financial markets. And the market is coming off a nice Zone 6 reading. It'll be a long summer..We don't see how banks can get out from under the mortgage mess until some losses are taken."
July 2 -- "The Fed didn't clear things up much last week. Looks like they wouldn't mind if the stock market cooled...The sub-prime mortgage fiasco isn't going away. In fact, it'll get worse. Bank and housing indexes have dipped into Zone 2. They should lead the rest of the market down."
July 9 -- "The DYR Phase Chart has bounced back up to -21 in Zone 5...We still think the new trend is down toward 90-day neutral. A sideways market this month, or a quick drop soon, would get us there. Then we'll see what happens in August and September."
July 16 -- "Did good retail numbers really send the Dow Jones Industrial Average (DJIA) up 250 points in one day? But didn't Home Depot (HD) and Sears (SHLD) warn? Looks to us like there's a bunch of people spending a bunch of other people's money on risky stocks...We're just waiting for Broker/Dealer (XBD) to start leading the market south...Consumer (CMR) and Retail (MVR) are among the weaker sector indexes on a 90-day basis. We wouldn't be surprised to see these indexes lead the fall as we get into August and September."
July 23 -- Headline: Time For Puts. "Broker/Dealer (XBD) has broken down...We think the market follows the brokers. That means it's time to buy puts on the market and certain sectors...As far as strategy goes, look at puts on the stronger indexes (SOX, QQQQ), foreign ETFs (XEX, CZH) and financials (XBD, RKH)...time to take profits on Gold/Silver (XAU). The index is in Zone 6, just barely, over both 90-days and 10-days. It's hard to see the dollar falling lower. If the market tanks, golds will fall too."
July 30 -- "There's another one or two standard deviations to fall before we call it a wipeout. Our last Zone 1 reading: March '03."
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