“Financial Services Reform” 1 year later…

   

Back in the fall of 2008 I wrote an article regarding regulatory reform. Back then I stated that we needed to address regulatory reform immediately after the new administration took office because in my opinion, there would not be a better opportunity for some time . While many issues are of paramount importance to our nation, I feel regulatory reform of the financial industry is one of the most important for the future well being of our nation. While healthcare reform is also important as is addressing the status of social security, financial services reform, addresses issues that affect all Americans in one form or another.

 

These loopholes in the regulatory body have been the root causes of not only this particular crisis but just about every financial crisis going back to the Great Depression. This in turn has led to cycles of “boom and bust” and has created an economy dependent on “bubbles” for wealth creation for some and unfortunately, wealth destruction for most.

 

This crisis was particularly severe because it affected the primary asset of most families not only here in our nation but worldwide and that is the housing industry. This crisis was not in the making in 2004 as many would suggest but in the late 1990’s when  the long standing Glass-Steagall act of 1933 was partially repealed by congress. The Gramm Leach Bliley act of 1999 or the “Financial Services Modernization Act” as it was called, took down the barriers that prevented traditional depository banking institutions from participating in the securities and insurance businesses and vice a versa.

 

This allowed banks such as Citibank, Bank of America and Chase to take much higher risks in the business of investment banking and insurance. This was very profitable for many years and great fortunes were created by this legislation. The greates “beneficiaries” of this act were the banks as traditional banking activities are not very profitable and many banks in the 1990s found it difficult to attract private investment capital.

 

What also transpired from this legislation is the loosening of regulations and standards which were enacted after the Great Depression to safeguard banks from insolvency. Capital requirements where relaxed and several loopholes in the law allowed for banks to “hide” investment loses in their balance sheets. Insurance companies could issue securities such as CDSs or “Collateralized Default Swaps” which basically provided what was supposed to be a hedge (insurance) against losses in bonds backed by real estate. This unregulated market grew to about 70 Trillion dollars worldwide and many of these swaps today are just about worthless (think AIG folks).

 

Combine that with the deplorable performance of the rating agencies which issued AAA ratings to paper that was barely investment quality, an SEC that was, and still is,  poorly funded and at times inept at regulating Wall Street (Madoff anyone?) and you have the makings of a crisis every few years on alternating asset classes.

 

I am asked often why I am so bearish on the longer term prospects for the stockmarket and the economy. To be clear, there have been and should continue to be tremendous trading opportunities in equity markets. A Weak dollar and near zero interest rates will benefit larger multinationals and commodities should continue to do very well. In the long run, if reform isn’t addressed, the prospects for sustainable long term economic growth are not very good.

 

The political capital necessary to reform financial services is being spent on reforming healthcare and I am not sure this administration will have enough political capital left to tackle financial services reform once a healthcare bill is passed. As we near the congressional elections of 2010, the ability of the President to negotiate the necessary elements to put forth a real financial services reform package will be greatly dimished.

 

Status quo will make financial services companies very well off again and with the enormous liquidity injected into these firms, stock prices should skyrocket in the near term. The longer term outlook, in my opinion, is a bit more cloudy.  

Gold, Stocks and Bonds All Up

I was commenting today to a subscriber how “crazy” it is to see the market rally in the face of rumors regarding some oil producing nations establishing a trade currency to replace the dollar based on several global currencies and Gold. In the past, such rumors would have sent the market down quite a bit but today, it inspires a stunning rally.  Such are the times we live in when  short term stock market ‘benefits” outweighs the longer term perils of a weak dollar.

 

The stock market as a discounting mechanism prices in an outlook for equities in the time frame of 3 to 6 months. A weaker dollar is going to allow for corporations to post better short term operating results so it is not surprising that stocks have rallied. The Bond market on the other hand is a better indicator of the longer term prospects for the economy. The bond market is telling us that the prospects for the U.S. economy longer term are much less rosy.  As stocks have rallied over the past several months, interest rates have actually declined. Even factoring in governmental manipulation of long term rates via “quantatative easing”, the trend towards safe U.S. Treasury notes, bonds and bills has been on the upswing.

 

So who is right? well they both are. Short term the depressed dollar and extremely accomodative stance by the Fed is the “sweet” spot for equities especially those which derive a large portion of their revenues from overseas. Short term that is good for equities. Bonds prices are signaling that the U.S. economy is headed for a double dip of the recession or  at the very least a weak recovery. With unemployment still rising and consumer spending on the decline, the prospects for a quick recovery in the U.S are not very good which will keep interest rates low for a prolonged period. At least that is what the bond market seems to be saying.

The spike in gold on the other hand is a direct result of inflation fears down the road because of the massive amount of debt that we have accumulated. Gold , and most commodities in general, are usually  assets that investors run to when there is a sense that paper assets are overvalued and risky. The traditional flight to quality trade into U.S. Treasuries is being partially replaced by the flight to Gold trade because investors feel insecure about the dollar.

So how does that relate to trading? Well in my opinion there has never been a better trading market but also a terribly “deceiving” market for “long Term” investors. Again longer term you have to believe that the bond market is a better indicator of the real prospects for the economy and the bond market is telling us to be careful because there is substantial risk of a prolonged downturn.

All About Earnings!

Well it is that time of the year again when Wall street hears from corporate America in regards to how they are performing in these difficult times. Earnings season kicks off on Wednesday with Alcoa set to report earnings for the third quarter of 2009.

 Many analysts are predicting another round of positive earnings especially from the financials who continue to benefit from low borrowing costs and favorable accounting changes which allow for advantageous recognition of losses. Giants such as Goldman Sacks and B of A should come in with strong performance on continued trading gains and favorable market conditions.

 What remains to be seen is how top line revenue comes in and more importantly, how the market will receive overall earnings “meets and beats” on the back of anemic revenue and continued cost cutting. Bottom line if a company is adjusting their costs effectively to provide shareholders with strong earnings isn’t that what it is all about? If a firm is finding a way to make money in this environment it will be hard for the market to punish them too severely. On the other hand, this would be the second quarter of anemic revenues and the market may not be kind to those companies that post much lower top line revenue than last quarter. In an any case, earnings is what it is all about and we will get a good glimpse of the global picture in the coming 3 weeks.

 The fact that the market has found a way to grind higher in the face of poor economic prospects at home is not necessarily a new or unexpected outcome. As the global economy takes a increasing role in overall economic activity, the contributions to corporate profits from overseas now account for nearly 50% of earnings from the S&P 500.

 The current weak dollar policy and zero interest rate stance by the Fed is also a windfall for corporations. The weak dollar provides a “cushion” when repatriating foreign denominated profits and borrowing costs are at all time lows. The Fed seems to be inclined to keep this stance for as long as needed and that has kept a kept a strong bid on the market.

 Obviously the big question is how long can all the stars align in this fashion and at what future costs. For now, most in the administration are willing to do what it takes now and worry about the outcomes later…

Confused About The Economy?

 

There is lot of confusion out there regarding the economy and the our prospects for a quick recovery. Sure there is ample talk of “green shoots” on Wall Street and in the financial media but as we have seen this past week there is good reason to be concerned and some what skeptical of a quick rebound.

 

On Tuesday the Conference Board, an industry group, reported that its index of consumer attitudes fell to 53.1 in September from a revised 54.5 in August. The news surprised Wall Street, which had been expecting the index to rise to 57.0.  This report was surprising because it offered conflicting signals from the prior week;s University of Michigan survey which found consumer sentiment improving.

 

So what is it? are we improving or are we headed for a dreaded “double dip” in the recession. According to Federal Reserve chaiman Ben Bernanke who stated several weeks ago that “from a technical perpective, the recession is very likely over at this point”, but in the same sentence stated “It’s still going to feel like a very weak economy for some time because many people will still find that their job security and their employment status is not what they wish it was”.

 

These statements reflect a growing sentiment amongst economists that the recovery will not be nearly as robust as many on wall street have expected. On Friday, the Labor Department released a jobs number that was substantially weaker than what analysts expected. The consensus figure was for the economy to have shed 175,000 jobs and the number came in at 260,000. Again this calls to question the strentgh of the recovery.

 

Nonetheless, there have been many economic signals that validate the most optimistic scenarios for the economy. Housing for the most seems to have at least stabilized and there is some evidence that government sponsored credit for potential home buyers is helping chop down the inventory of unsold homes that has hampered the housing recovery.

 

 Only time will tell but for the time being, a slow but steady improvement should be in store for 2010.

 

Why Mr Volcker Is Right

 

 

This past thrusday, former Federal Reserve Chairman Paul Volcker testified before the house’s committee on Banking and Financial Services. The testimony called for several changes to existing regulation and amongst the most “radical” is his affirmation that commercial banking should be separated from investment firms. Basically, chaiman Volcker advocates a return to Glass Steagall, the act repealed in 1999 that broke down the barriers between banks, insurers and trading firms.

 

 

Among the other recommendations, chaiman Volcker advises that Americans should not return to “business as usual” and encourages more regulation of financial derivatives, stricter reporting requirement for hedge funds and the moral hazards of the “too big to fail” ongoing policy. 

 

 

In my opinion, Paul Volcker is absolutely on target and his comments raised many eyebrows in the investment community. His testimony was not carried live on CNBC, (surprise anyone?).

 

 

The issue of excessive risk taking by banks and insurance companies is at the heart of this crisis (AIG and CITI?). his assertion that commercial banks should not take on such elevated risks is my opinion a crucial aspect of the regulatory reform we desperately need. Good to hear that there is at least 1 individual close to the President who has not lost his common sense…

Return To Basics For U.S. Consumer

A year after the biggest financial meltdown since the Great Depression rocked the Globe, it seems like  Americans are behaving today much like Americans did then.

 Savings rate are sharply higher today than a year ago and it seems Americans have somewhat changed their views toward investing and financial risk in general. The stock market rally of the past 6 months has been predicated on one major factor. That the consumer will resume their spending ways and that Americans will go back to their pre- crisis views towards risk both of which I believe will not fully recover for some time.

 It is a fact that we as Americans have a remarkable ability to pick up the pieces and roll the dice once again after a set back. This risk taking mentality is  part of what makes our nation the greatest in the world. After all what would happen to ingenuity and industrial progress without risk taking?

 There is no doubt that people are again investing. The stock market is up 60% since hitting a 12 year low on March 9th but many financial planners around the nation say that people are returning to basic principles of financial planning that for most, had been put aside for some time. Principles such as maximizing savings and limiting use of credit cards are once again important considerations for many Americans.

 The fact that Americans are saving more and taking less financial risk is in my view, a good thing for the economy. After all, excessive use of very cheap credit and excessive risk taking is the poster child for this financial crisis. 

 The fact that Americans are taking fewer financial risks and using less credit is not so good for the stock market. At least not in the short term as it flies against the very basis of what the Federal Reserve has attempted to do with its loose monetary policy. Even in a market flooded with liquidity, credit is still difficult to secure by everyday Americans and banks do not seem to want to move away from very tight lending standards. If the U.S. economy is 70% consumer based, then it does not take much insight to arrive at the conclusion that without the consumer engaged, the recovery will be tepid at best. Factor in a continued difficult job market and the picture gets even murkier.

 This is the basic thesis of my bearishness towards equity markets today. Not that I believe we should be trading anywhere near the lows of March but, I do not see the rationale behind the market trading at these levels. Sure there are great individual company success stories out there but overall, we are extremely ahead of were we should be even if the rosiest scenario comes to fruition. 

A Year Later…

 

When this crisis began to take form in late 2007, I remember feeling a bit like we do here in South Florida in anticipation of a major hurricane. Indeed some of the same questions we ask ourselves in preparation for a storm such as “how will we protect our loved ones?” and “what will happen to our friends and family?” or questions about how to handle actual preparations for the storm such as “should we ride the storm and stay put or pick up whatever we could and leave town”.

 There is always the media “hype” factor when these storms approach and as anyone who lives in South Florida will tell you, sensationalism abounds and many times after all the media hoopla, the storms actually never comes our way or is nothing more than a strong summer thunderstorm.

 Much in the same manner we found ourselves with that quesy uneasy feeling in our stomachs and the questions I remember asking myself in late 07 went something like this; “Is the media blowing this out of proportion?” or ”will this crisis really come to fruition?” and  ”what if I get out too early and miss a continued rally?…

 It is human nature to wish for good times to last forever and some of the most difficult decisions we make come in times of plenty. Who wants to back away when the getting is good?

 We were warned of this crisis months, even years before it hit. The people in the “know” saw this crisis coming from a mile way…If you think the executives who run our major financial institutions were “blindsided” by this crisis you are just not looking at reality. 

 The true nature of this crisis stems from the fact that we did not address the cause of the last recession. The medicine we took to push us out of the last recession is what eventually drove us to this crisis. The medicine we are now taking in the form of massive stimulus, zero interest rates and reckless spending will also lead us to another crisis down the road unless we are brave enough to tackle the structural issues that led us to this point via financial regulatory reforms. 

In my opinion we have missed a tremendous opportunity to really for once tackle financial reform. The administration certainly had the backing of the American people and the administration had plenty of political capital to tackle the problem.

As of today we still do not know the extent of the toxic assets in the balance sheets of banks. Money allocated by congress to especifically deal with this issue by the previous administration in the form of the TARP to the tune of close to a trillion dollars has gone to basically keep the status quo at banks and mask the real problems at hand. Banks were awarded huge sums of taxpayer money to facilitate their consumer lending programs but in actuality, most banks have not used that capital for such purposes but instead are using it to buy back stock and “shore up” their illiquid balance sheets.

Accounting methods were changed to allow these same banks to not have to recognize toxic asset losses in their quarterly balance sheets. Banks no longer have to write down these assets based on market value and what banks today are less transparent than at any point in recent memory.

I have spoken about the need for stimulus to get us out of the brink of disaster we found ourselves in last October. I believe more needs to be done to directly impact Americans who are struggling to get through this period of crisis but if the real issues that led us to this mess are not addressed, we are just setting ourselves up for another crisis and this time we may not have the same amunition to deal with it.

A year later, next to nothing has been done to correct the mistakes of the past. Changing the status quo will be a difficult challenge.

“IRRATIONAL EXUBERANCE” part 2

 

The recent market action reminds me of the “Irrational Exuberance” of the Greenspan era. This exuberance fueled by extremely low rates for an extended period of time was in part  responsible for the disaster we have experienced over the past 9 months. This recent irrational behavior displayed by the market will not, in my opinion, end well for retail investors. By all accounts the economy is not out of the woods. Jobs are still being lost at an alarming rate and the consumer, although optimistic, does not have the same buying power as before and probably won’t for an extended period of time. 

The positives displayed so far in this recovery have been tremendously overdone by the market, possibly to a larger extent than the down spiral move that led to the March 9^th lows in the S&P 500. The Obama administration initially seemed to be doing a good job of setting realistic expectations for the economy but as of the last 2 months, the administration has adopted a much different approach. When was the last time you heard President Obama make comments that the economy would take time to recover as he did in the early days of his administration? The truth is that right now the administration needs the markets to rally to give the appearance that the “green shoots” are indeed for real. The saying goes that the stockmarket has a short memory but these days it is increasingly looking more like amnesia…

 There is no doubt that the medicine deployed to stimulate the economy is having an effect. How could it not?? The amount of cash pumped into this economy since the inception of this crisis is staggering…Much like a cancer patient who is treated with strong chemotherapy to curtail the growth of a tumor, the U.S. has deployed an all out effort to stop the spread of the financial meltdown. Now this is not to say that this action was unwarranted. In my opinion it was medicine that had to be taken. What concerns me is that there is a tremendous amount of complacency in the market place as to the risks ahead and to the real monetary value of the so called “green shoots” we are presently seeing. There has been some stabilization of the financial system as credit has begun to flow and companies have been able to access the capital markets once again. What many forget to mention is that these improvements are a function of government intervention via the myriad of programs. The market has not discounted that very important fact in this rally and although we are in better shape than the S&P 666 of March 9th, we are no where near a justifiable 1000.

 As always in these situations, greed and the fear of “being left out” wins out over better judgment. As a result funds have been pouring back into the market via long only mutual fund and 401K buying. Fund managers have to put this cash to work, sometimes against their better judgment, and what you have is a lot of smoke and mirrors. The “free” market in my opinion is still the best mechanism we have to price assets. I highlight “free” because a free market is one supposedly free from manipulation. I am not sure that has been the case lately…

Secular Bears and Cyclical Bulls….

 

There is much talk about whether or not this past 30% rally is indeed indicative of a newly birthed secular bull market or a relief rally, otherwise known as a cyclical bull market, from the extreme lows established March 9^th of this year. To gauge what may lie ahead, market analysts correctly look to the past for guidance.

In my opinion we have entered what is known as a Secular Bear Market, triggered by the historic housing and credit crisis which began late 2007. The 2007 date is point which could be argued as the causes of this crisis date to a much earlier date, but for purposes of market analysis, I believe October of 2007 will stand as the date of the beginning of the new secular bear market trend. What is a secular bear market? It is marked by longer and more meaningful periods of deterioration interspersed by brief and sometimes furious cyclical bull rallies. Generally in a secular bear market, the bull rallies fail to meaningfully cover the long term investments losses of the more prevalent bearish trend. Secular market trends are longer than cyclical trends and can be anywhere from 5 to 25 years. We have had several bearish secular trends since 1900 with the most notable for equity investors being the period of 1966 to 1982. Another example of a secular trend is the period of 1980 to 1999 known as the “The Commodities Depression”, which was marked by extreme drop in the price of precious metals such as gold and platinum as well as many other commodities. The expiring secular bull was ushered in mid 1983 and lasted until 2007. The primary bullish trend was infused with cyclical bears such as the crash of 1987, the dotcom bust of 2000.

I believe it is important to recognize market trends for what they are and not necessarily what we wish they were. Investors can make money in all markets if they are able to invest with a critical eye towards reality. Those who believe we are climbing out of this turmoil into another long term economic expansion are sorely mistaken. Because most retail investment products such as mutual funds are “long only” instruments, the overwhelming majority of money managers will try and sell this recovery as the beginning of another expansion cycle. In my opinion it is not a great time to invest in equities for the “long term” as many pundits are touting today. The reality of the economic crisis we face and the resulting side affects of the remedies we have adopted to combat the downturn (TARP, TALF, etc etc) will have to be dealt with prior to another major expansion. The fact that we are deleveraging at historic rates means that growth will be anemic in for many years to come. More than ever, short term trading strategies such as the strategies we employ at Trading Options for Income and Trading Puts and Calls, will be key to navigating this more difficult investment landscape. 

On a positive note, lest I be categorized as a “doom and gloomer”, I believe this secular bear market will be on the short side in terms of duration. In my opinion, we may be able to reverse course in 5 to 8 years and begin another major, long term period of economic expansion. My reason for believing in the relatively short duration of this secular bear market is that we are finally having to correct some issues that are crucial for long term sustained expansion. Issues such as alternative energy and dependency on foreign oil, health care, education and social security to mention a few, will more than likely be addressed by this current administration. The short term consequences of these actions will not be easy for markets to swallow. In the next several years Americans will more than likely pay substantially higher taxes, deal with high inflation and at the same time have less access to credit, all of which will dampen economic expansion.

Buy and Hold?? more like Buy and Fold…

A recent subscriber asked me for my opinion regarding his overall portfolio of investments. As you all know, I am not in the financial advisory business and so therefore by law I cannot give an opinion as to the make up of the portfolio. What I can talk about is my personal philosophy regarding the markets. 

I have been involved in trading markets for the better part of 25 years in one form or another,  as a broker, branch manager, registered options principal and as a trader/strategist. During the course of my career and due to my actual experience trading markets, I came to the realization that the always touted “Buy and Hold” strategies do not work. Sure you can look at a piece of paper showing a graph of XYZ stock and say “well if I bought here at $1, 15 years from then it would have been worth $20″.  The issue is that the market is not geared for long term investing. A gain achieved from a long term buy and hold strategy is as much a product of luck than anything else. We all can name many supposedly “Blue Chip” companies that were supposed to be “infallible”. Well we know today that no company is infallible… 

Well if long term Buy and Hold strategy is a fallacy then who makes money in the stock market? Traders do. Not all traders, but professional, well trained and talented traders make a lot of money in the stock/options markets. If one agrees with that premise, then it becomes easy to extrapolate that well informed educated short term traders have a better chance at making money in the market. That is the conclusion I came to many years ago. If professional traders are making money, how could I simulate what they do with a limited amount of tradable assets and do it outside of the floor of an exchange. That is when I began dedicating my time to learning as much as I could about options. A fact which takes be back almost 20 years!. I came to the realization that short term options trading was the best way to piggy back upon what professional stock traders were doing.

 The truth is that not until online trading began to explode in the late 90’s that it became possible to even attempt to go up against the pro’s and have a chance at winning. As technology exploded and information became readily accessible to all via the internet, the playing field also began to narrow. Today as you all know, many independent traders make substantial money trading alongside the pro’s from outside the exchanges.    

Like every trader before me, I took many losses and many lessons were learned the “hard way”. These tough lessons taught me to value risk management techniques that have enabled me to continue trading for all these years. hedging strategies, and capital allocation discipline is key to surviving as a trader. 

Because of my professional trading activity, I am a big believer in maintaining the overwhelming majority of my assets in semi- liquid short term guaranteed instruments like FDIC insured CDs and T-Bills. Many who hear that find it hard to believe that an options strategist/trader would keep such high percentages of his investable assets in cash equivalents. Obviously these days with interest rates at these extremely depressed levels it is not an attractive proposition but not too long ago a 4% to 5% or higher coupon was not impossible to achieve in these types of instruments. Long term, the average return on these instruments is very comparable to the long term average return on equity investments! 

The portion dedicated to options trading I view as my “business”. That capital is dedicated to risk taking and is where I really look for extraordinary returns. As a matter of fact, I have made the argument to many investors with “diversified portfolios” invested for the long haul that my overall risk profile is lower than theirs! Less of my capital is at risk at any one time and the relatively small portion that is dedicated to trading is traded aggressively in options. I don’t go through steep ups and downs in the value of my overall assets (a big reason why long term investing doesn’t work) and I generally can sleep better at night. 

Many arguments can be made for and against my philosophy (and believe me they have been made! ) but this recent debacle in the markets has once again reinforced my faith in that what I am doing is the best course of action for me and my family. I speak to many folks who were close to retirement last year. I say “were” because many will not be able to retire as planned. With 401Ks chopped in half and property values crushed, many are facing several more working years than they anticipated as recently as a few years ago….

Implied Volatility 101

 

The most misunderstood component of options pricing is implied volatility. Successful options traders understand that implied volatility is the key “ingredient” to making proper trading decisions when buying and selling options and options spreads. Volatility in regards to options is measured two fold. The first and most easily understood is called Historical or Statistical volatility. Statistical volatility simply is the volatility of a financial instrument based on historical returns. Statistical (historical) volatility as the name implies, refers to past actual data.

Implied volatility on the other hand refers to a future expectation of price fluctuation. The higher the implied volatility the more one could expect the stock or underlying instrument to move in either direction. Conversely, the lower implied volatility references a more stagnant underlying instrument. This implied volatility is an extremely important component of options pricing and its effect on an options price is what makes an option either “cheap” or “expensive”.  Rising implied volatility makes options more expensive and conversely decreasing levels of implied volatility makes options less expensive.

Of all the inputs that go into pricing models such as the Black-Scholes options pricing model, implied volatility is the only variable component. The other components of the pricing model are exercise (strike) price, the riskless rate of return, time until expiration, and the price of the underlying. Implied volatility (variable) is determined by the market maker and is based on the public’s expectations of upcoming events that may change the ultimate value of the options contract. Market makers who are charged with making a market for these instruments increase and decrease implied volatility to increase or decrease the price of the option. The other components mentioned above are all factual and are not based on subjective interpretation.

Because of what I just mentioned above, sharp traders realize that money can be made in strategies that exploit the expected moves (or lack of  movement) in implied volatility. There are many strategies that can accomplish this but the general rule of thumb is that if your expectation is for decrease in implied volatility, then being a seller of an options contract would behoove you . Conversely the opposite would apply; being “Long Vega” or buying volatility would benefit the trader who believes implied volatility is set to rise.

3.4% Increase In Durable Orders

 

The market was caught by surprise again today as orders for durable goods rose for the first time in 6 months. The 3.4% increase beat analysts expectations of a 2.5% decline and offers a break from 6 months of deteriorating economic news.

On Monday, the market was surprised by an 5% increase in existing home sales and on Tuesday, the government reported a rise in home prices after 10 consecutive months of declines. This follows earlier reports that consumer prices were thought to be stabilizing and that retails sales also seem to have fallen much less than expected in the month of February.

These recent numbers are not exactly “good” readings on the economy but they do signal that the economy may have begun to feel the impact of the massive deployment of capital in the form of stimulus, bank bailout measures and loosening credit. Although economists agree the recession is still not contained, the better than expected news was received as a catalyst lifting the markets over 20% from the recently set lows.

Despite the apparent break in the onslaught of bad news, most economists agree we are not out of the woods by any means. Manufacturing activity is still in for some rough months of steep declines as job cuts and reduced capital spending work its way through the economy.

This recent bullishness has place the broad market in a precariously dangerous short term oversold condition and we are very likely to see some retracement of the recent rally. If anything this would be a healthy sign for the market and should be followed by broader buying if critical levels are held.

We do not forsee a retest of the recently set lows until the late spring early summer period and we believe this recent low will mark another intermediate bottom for the markets.

Is Suspending Mark To Market A Good Idea?

 

There has been much debate all over the web as to the benefits and pitfalls of Mark to Market accounting rules. Many are of the opinion that MTM is the only way to get an accurate price for any asset. These folks also argue that without MTM you would have much less transparency of institutions balance sheets. Very valid points.

On the other hand there are those who feel MTM rules have been a catalyst to this financial crisis. By allowing banks and other financial institutions to mark so called level 3 assets to whatever they felt was fair market value. This has had the effect of inflating banks balance sheets and distorting earnings thereby inflating stock prices and CEO bonuses…Valid points as well…

Here is my take on this. The issues that have lead us down this path over the past several years are in part a glitch in the accounting model used by banks. Now before anyone goes off on me for believing the crisis is the fault of some accounting rule, hear me out.

MTM rules gave rise to three levels of assets, which we all have heard of by now:

Level 1 assets are assets that are liquid and where market prices are readily available such as the stock of a company like microsoft.

Level 2 assets are assets with limited liquidity but not so thin that a fair market value cannot be obtained by using what the FSAB (federal standards accounting board) calls “observable inputs”.

Level 3 assets are assets that are deemed impossible to value because of absolute lack of liquididty and a market in general.

Prior to November of 2007, banks were able to mark assets to whatever model they felt appropriate and justifiable to regulators as “fair market value”. Here is where the seeds of this crisis were sown. Banks became extremely aggressive in growing their level three assets exposure. Securitization of mortgage backed securities exploded and everything sent to wall street was packaged into a bond and found a market somewhere around the world. Banks used these “marks to fantasy” to inflate balance sheets which thereby inflated equity prices which helped pay these CEO’s the outrageous pay packages we are so familiar with today.

In November of 2007 the FSAB issued the now also famous rule 157 which stated that institutions must use current prices and market conditions to mark level 3 assets. That is a huge change of winds. Banks now where caught off guard with tremendous amounts of these illiquid level 3 assets that now had to be marked to more market relevant levels. This one change in the accounting rules started the bursting of the housing bubble. Now by no means do I believe the housing crisis was caused by MTM. The cause was compounded by MTM. Over leverage, lax regulatory environments and over building all helped create the mess we are in today.

The question one must ask is what can be done to correct this? Well I believe there are some remedies. One is to suspend mark to market rules for a period and allow a more functional market to develop. Another is to allow banks to amortize these losses over several years instead of taking the losses immediately. Another is to restrict how much a bank can keep of these level 3 assets in the books. I believe that an answer may lie in a combination of several of these options. What I do know is that something must be done to address this loophole now.

Where Do We Go From Here?

 

Many traders and investors alike are shell shocked these days as the broad markets make slow methodical moves to the downside. The fact that the recent stunning headlines regarding GDP and the defacto nationalization of Citi etc have not caused outright panic is in itself reason to worry. Many traders will tell you that this slow and orderly downdraft is actually much more dangerous than a “washout” session or series of sessions marked by heavy selling, high volume and spiking volatility. This recent breach of the technical lows set in November actually sets us back in the recovery of the markets because we are again in the phase of establishing another short term bottom. When the support level is finally established, it will be followed by several tests before the market can trend meaningfully higher.

With that being said, it is very conceivable that we will see a very brisk short term bear market rally in the next few trading sessions. Short term, the market is substantially oversold and even though I am of the opinion that we will be heading lower over the next few months, I believe a short term rally is in the cards.

As I mentioned, longer term we are bearish on the markets.The stock market is dealing with several issues that have been compounded by ineffective actions in the handling of this crisis. At the moment, the root causes of this crisis are still unresolved

1    The deteriorating value of residential real estate and mounting foreclosures. 

2    The amount of illiquid “toxic” assets in institutions balance sheets.

3    The unwinding of the estimated 70 trillion dollar credit default swap market (ie AIG)

The resulting effect of the inability of the government to address these issues effectively is a tremendous drop in business and consumer confidence. Confidence in the fact the consumer will be employed next month or confidence needed to take the risk and expand a business or for banks to make more loans. The effect of this lack of confidence is devastating to the economy and the stock markets. Capitalism is based on the risk taking ability of individuals. Without the confidence needed  for consumers and businesses to take risk, capitalism is stiffled and the void has to be filled by government as we see happening at the moment.

The trading opportunities generated by this instability will make many traders very wealthy while those who continue to believe in the fallacy of “buy and hold” will continue to pay dearly for years to come.

To Nationalize Or Not…

 

Nationalization of our nations banking institutions seems to be making headlines again this week. I mean again, because these headlines where already made several months ago when the Bush administration effectively nationalized Fannie Mae and Freddie Mac and stated flatly that they would not allow institutions that were “too large to fail” to go under. Does anyone really believe that the government does not already have a say in how the banks that took TARP money operate? It is silly not to believe that for all practical purposes, nationalization of some banks has already happened. Here is why I do not believe this will happen.

 First of all it would not happen because the government knows that the headlines generated by the general nationalization of banks would send the broad markets into a freefall. That would add tremendous stress to an already fragile global system. Why would the Obama administration and the democrats in Congress risk being the party that nationalized banks when they can continue to pump money into these institutions to keep them viable? This is how I believe this will play out.

 The Treasury will administer the “stress tests” to banks prior to buying any of the banks toxic assets. The stress tests are basically an accounting of the banks ability to meet liquidity demands. The institutions that fail the stress test will be taken over by the FDIC as insolvent institutions and the assets and liabilities of these institutions will be sold to healthy, small to mid size regional banks, many who did not participate aggressively in subprime lending.  The US government will be forced to make this happen and will make it very attractive for these institutions which in my estimation, will be the ultimate winners in the outcome of this crisis. The banking landscape in the United States will be transformed irrevocably by this with several now small to mid size banks taking a much bigger chunk of the nations deposits. The end result, several years down the road would be maybe as many as 10 very large institutions instead of the 3 or 4 we have today. Many large under capitalized, and highly leveraged institutions may be forced to shed themselves of businesses in order to keep their banking charters. It is conceivable that institutions such as Goldman Sacks and Morgan Stanley be given a big role in this new universe and I would expect them to be at the head of the list for takeover of some of these failed banks.

 Basically,  judgment day is coming for those institutions that failed to manage their businesses properly by becoming highly leveraged in these mortgage assets. Why should the government (i.e. the taxpayer) award the poor management of these institutions by bailing them out? In the end this approach would mean survival of the fittest and isn’t that what capitalism is all about anyway?

Mr Geithner- Details Please??

 

The main problem with the Obama Administration’s “financial stability plan” is that there little clarity as to how the losses will be divided amongst the two main characters in this financial drama, the taxpayer ie. the U.S. Government and the financial institutions that hold these illiquid mortgage backed assets. In an effort to present a politically appealing plan, the administration has failed to present clear answers to the American people to the following questions:

How much will it cost

How will we pay for it

How will we prevent it from happening again

The answers to these questions are not politically appealing but necessary for a market looking for clear answers. Treasury Secretary Geithner, promised the new plan would be transparent but omitted describing the plan itself! Stock market averages fell yesterday as traders who had started to turn mildly bullish reversed course and hedged their positions to avoid steep losses. The markets hate uncertainty and we got a day full of just that. The time for promises and pledges is well behind us and the markets want to see some real action.  

Geithner promised a stringent “stress test” of banks’ balance sheets; more aid to banks through a new Financial Stability Trust; up to $1 trillion for a public-private partnership to buy banks bad assets; up to $1 trillion to support student, auto, consumer, small business, and commercial-mortgage lending; and a major effort to lower the rates and monthly payments on home mortgages. Again, all of it theoretical and no real detail as to the how’s and why’s. The Obama plan is going to take much more than the already approved $700 billion in TARP funds. The size of the plan is estimated to be in the range of $2 trillion dollars.

The biggest stumbling block in the plan is how to value the illiquid assets. There is a tremendous amount of political pressure on the administration to not overpay the banks for these assets therefore handing the taxpayer a potential liability which will take many years to repay. The truth is that many banks would be crippled if these assets were to be sold at their actual current market value. The taxpayer is irrevocably entangled in this mess. The question of who loses in this fiasco is clear, although not articulated by the administration, it is the U.S. taxpayer.

The far reaching consequences of the this economic crisis involve many countries who hold preferred shares of these intitutions and who would be severely impacted by severe writedowns. The U.S. taxpayer is entitled to a clear and fair assessment of the crisis and we need to hear clear detailed plans as to how we are going to correct the ship.

How Are Options Priced?

A question asked by many novice options traders is: How is an options contract priced? Obviously knowing the value of what you are buying or selling is crucial to a successful trade. The basic model for options pricing today is the Black-Scholes Model developed in 1973 by Fisher Black, Myron Scholes and Robert Merton. The model is widely used today and is regarded as one of the best ways to determine the “fair” price of an options contract.

Generally the premium of an option has two main components: intrinsic value and time value.

 

When the underlying security’s price is higher than the strike price a call option is said to be “in-the-money.” If the underlying security’s price is less than the strike price, a put option is “in-the-money.” Only in-the-money options have intrinsic value, representing the difference between the current price of the underlying security and the option’s exercise price, or strike price. Prior to expiration, any premium in excess of intrinsic value is called time value. Time value is also known as the amount an investor is willing to pay for an option above its intrinsic value, in the hope that at some time prior to expiration its value will increase because of a favorable change in the price of the underlying security. The longer the amount of time for market conditions to work to an investor’s benefit, the greater the time value. There are several other factors that determine options pricing. Some factors are much more important than others and while some are readily known as fact (such as time until expiration), some are theoretical and therefore subject to interpretation (implied volatility).

 

The most basic and easily understood factor is change in the underlying security price which can increase or decrease the value of an option. These price changes have opposite effects on calls and puts. For instance, as the value of the underlying security rises, a call will generally increase and the value of a put will generally decrease in price. A decrease in the underlying security’s value will generally have the opposite effect. The strike price determines whether or not an option has any intrinsic value. An option’s premium (intrinsic value plus time value) generally increases as the option becomes further in the money, and decreases as the option becomes more deeply out of the money. Another, albeit traditionally less important factor, is the effect of an underlying security’s dividends and the current risk-free interest rate.This affect has a small but measurable effect on option premiums. This reflects the interest that might be paid for margin or received from alternative investments (such as a Treasury bill), and the dividends that would be received by owning the shares outright. The interest rate and dividend affect can have a much more significant impact on options pricing in times of high interest rates  or when dividends, as expressed as a percentage of an stock’s price, is much higher than historical levels. A good example of this at the current moment is General Electric (GE). The stock price of G.E . has dropped significantly over the past few months and stands at about $13.00 in today’s trading. GE’s dividend, expressed as a percentage of the stock price, is a whopping 12%! Obviously that will have a greater impact on the pricing of the option as opposed to when GE was trading at $50.00!

Time until expiration, as discussed in our previous post, affects the time value component of an option’s premium. Generally, as expiration approaches, the levels of an option’s time value, for both, puts and calls, decreases. This effect is most noticeable with at-the-money options.

Implied Volatility is the most subjective and the most difficult factor to quantify, but it can have a significant impact on the value of an option’s premium. Volatility is simply a measure of risk (uncertainty), or variability of price of an option’s underlying security. Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike.

Another factor that impacts the real value of an option is liquidity. If a contract is illiquid, generally the bid and ask spreads are wider. Lack of liquidity might make it difficult if not outright impossible to trade the contract. As you can see, options pricing is much more complex than plugging a few numbers into a formula. Pricing models will only account for the theoretical value of a contract and not the actual market value of an options contract.

 

 

Theta…The Most Important Greek!

 We wrote a piece some time last year regarding “Theta” and its impact on our strategies. I believe it is worth reviewing again as this important piece of the theoretical options pricing model addresses a very important component in Credit strategies such as Iron Condors and Bull Put/Bear Call spreads. 

Theta represents the measure for time decay of an option. Remember, an option price consists of intrinsic value and time premium. Theta measures the decay in time premium as every day passes until expiration. Therefore, we can say that the theta for a long call or put will be negative meaning that the options will lose time value everyday as time passes towards expiration. Conversely, the opposite can be said can be said for the short call and put, as time passes the positive theta will actually add to the value of a position. This is true because when you are long an option, you will lose money in that option every day all else being equal due to the time premium decaying. However, the time decay in a short option will increase your profits.

Theta does not adjust evenly as time goes on. As you can see in the chart below, Theta’s impact on a position’s value increases as time passes. The closer and closer the option is to expiration, the greater the time decay. Theta will accelerate at a higher rate especially when the option has less than 30 days to go. This also makes logical sense since the option has less time to get or stay in a profitable situation. Additionally, an options theta will be highest when the stock is at the money. Since the stock has basically no intrinsic value, the time value component is the majority of the premium and will fluctuate strongly as expiration approaches. The most pronounced time decay occurs in the last weeks and days prior to expiration

 Expiration and time decay are certainties making “net seller” or “credit” spreads our favorite options strategy. Remember, the value of an option is composed of time value and, if the option is in-the-money, it will also carry intrinsic value. By selling an option and holding the short position to expiration, you will only lose money if that option expires in-the-money.

 

Retail Woes Worse Than Expected

Retail sales figures dropped much more than most analysts expected for December, ending one of the worst retail holiday seasons on record. The Commerce Department reported Wednesday that retail sales dropped 2.7 percent last month, more than double the 1.2 percent decline that Wall Street expected and the worst figures since the 1969 season.

The Commerce Department in a separate report released figures on business inventories as well and said businesses cut their inventories by 0.7 percent in November, the largest decline in seven years.

Consumer spending accounts for about two-thirds of total economic activity making the retail weakness a major factor depressing overall economic activity. Many analysts believe the overall economy, as measured by the gross domestic product, plunged at an annual rate of 6 percent in the just-completed fourth quarter after dropping by 0.5 percent in the third quarter.

The results of the report has put pressure on stocks and at mid day the DOW has shed over 230 points to 8215 or a 2.69% decline and the broader S&P 500 is down 28.09 points or 3.22%. Also disturbing to market participants is the elevated volatility as measured by the VIX which has jumped over 15% in early afternoon trading.

Market Week Ahead 01/11/09

The week ahead will surely bring some more sour, but not unexpected economic headlines. The calender will be highlighted by the December retail sales figures due out on Wednesday and The Fed’s Beige book of economic indicators which is also due out on Wednesday afternoon. Both are expected to point to the continuing economic downturn. January Options expire this week and that should keep volatility elevated  maybe even adding a bit of volume to what has been very anemic trading.

 

The markets need to make a stand at these levels and further breakdown may lead to an earlier than expected test of some support levels. With that being said, I felt the trading activity last week did point to a somewhat more resilient market and the bears did not have as easy a time in asserting themselves. The market’s reaction to last week’s unemployment data was orderly and measured whereas just a few months ago, the same data would have sent the markets into a selling frenzy. No matter how one feels about the economic outlook and longer term market prospects, which by the way aren’t very good, the fact remains that this resilience undoubtedly points to a market that is indeed trying to form a base.

 

The markets are also going to keep an ear out for the squabbling that is developing in Washington over the economic stimulus package proposed by President Elect Obama. I suspect the honeymoon may be over before it even begins! Many Republicans and key Democrats have raised opposition to one aspect or another of the proposed measures. What a surprise…