Short Treasuries & Thoughts On Previous Posting

They're going to drop harder than Milli Vanilli's career. It's not a matter of if, it's a matter of when. The only caveat is if we experience sustained deflation. I doubt this will happen with helicopter Ben at the helm. This article provides the info.

Also, I was wrong a month ago on two counts.

One, I was wrong that oil would fall to $40. It actually fell below that amount.

Two, I was wrong when I wrote that the market rally above 8,000 would be temporary. It seems to be stable for the time, and based on the huge amount of money flowing into Treasuries, it may actually be undervalued despite the CAPE figures. I wonder if CAPE is wrong; that is, if the supply of capital has so increased in the last few decades that the required return on equity has fallen, thus allowing for stable and higher P/E ratios across the board. In this case, a simple mean reversion comparison over the last century would be inaccurate since it would not account for the possibility of a newly higher average P/E.

Ho ho ho!

Undervaluations ahoy!

A cheery article in the FT in anticipation of a year that will be anything but. Here are some good quotes:

"

The most interesting now lie in the corporate bond market. As Mark Kiesel of the bond fund manager Pimco points out, high quality credit spreads are trading at their widest levels for 75 years, while investors this month have been able to put their money into a diversified basket of investment grade corporate bonds yielding 8 per cent compared with an earnings yield on the S&P 500 of 6 per cent or less.

All across the developed world, corporate bond yields appear to be discounting defaults on a scale that defies common sense.

Equities likewise look cheap in big markets in terms of the Q ratio, which measures share prices relative to the replacement cost of net assets, and price earnings multiples. Yet the market will probably have to cope with some spectacular bankruptcies in 2009 and in a more muted capitalist environment the earnings prospect in the developed world looks unexciting.

So while the market will find a floor, any bounce may be tame. The way to make big money in equities will be to identify those companies that will defy the market’s expectation that they will fail."

Also:

"The tank traps next year could be in the government bond markets. With no borrowing taking place in the private sector, governments are being crowded in. Hence low yields on fixed interest debt. When credit markets return to health, this will be very dangerous territory.

If you still feel gloomy, remember that it could be worse. In December 1974 the dividend yield on the FT All-Share index reached 12.7 per cent. Things may be bad, but I don’t think we are going back there."

I don't understand what 'tank traps' are in a financial sense. Nor do I fully understand the meaning/implication of crowding-in. And why that leads to low yields on fixed interest debt (is he talking about treasuries?) and why this will be 'dangerous.'

Jim Cramer's Advice Worse Than A Coin Toss

Hahahah.

Link Here

A sweaty balding man who probably does a dozen rails before the show runs across a room screaming stock tips at the audience, and plays wacky noises to indicate whether a stock should be bought or sold. And millions of people take him seriously. I've always thought it was hilarious (human stupidity tends to be) and I'm glad to see that my thoughts are vindicated.

Commodity Price Outlook

Commodity prices shall return!

The question is, will they begin a consistent upward trend at the beginning, middle, or end of the recovery (once it starts to take hold)? And further, if one wanted to invest in commodities, what would be the best way? Futures contracts? Specific equity indices which are highly correlated with commodity price movements (such as oil companies)?

A question

Suppose in a flash of economic magic, the entire world's population was elevated to the prosperity and standard of living of the average American citizen. Given the earth's limited natural resources, is this level of consumption sustainable in the long term? If not, what can be done about it? After this economic speed bump we are experiencing, which may last anywhere from 1-3 more years (though possibly less) world economic growth will undoubtedly return to its long-term trend of 4-5% per annum. And eventually most of the world WILL be living like the American consumer of today (while the American consumer of today will have an even greater standard of living).

Mark to Market

In an efficient, rational market where asset prices are set according to their likely future inflows discounted to the present at a realistic discount rate, marking to market is a great idea. Having written that, you probably get the jist of what I'm about to say next.

Markets go through periods of terrible inefficiency for indeterminable amounts of time. For example, banks (which rely on positive balance sheet capital to stay solvent) may experience such dramatic, irrational writedowns in the values of their assets (loans for example) that they could potentially be shut down, even though those loans will eventually be paid in full and the primary reason for their dramatic loss of value is irrational fear. In this instance, mark-to-market accounting is a terrible idea and may even cause nasty feedback loops, to the point where what began as an irrational selloff of a financial institution might become rational as other actors lose confidence and stop transacting with the institution. When that happens, the company is doomed, unless uncle Hank steps in with billions of dollars in bailout cash.

[example of S&L bailout and eventual loan repayment]

Short Now

Going out to dinner... brief thought:

1000 point jump in 2 days? With a plethora of bad economic news still on the way? Give me a break. Now is the time to short the market. My instincts tell me it's going down.

Oil at $40?

Yet another predictive story by the FT . National oil companies expect oil to fall to $40/barrel. Personally I don't think they will go that low, although it's certainly a possibility. This prediction reminds me of the summer, when Goldman Sachs predicted $200/barrel oil and OPEC gave even higher forecasts.

Deflation and Stock Market Valuation

Here's an interesting article about the spectre of deflation which bond markets are anticipating (inflation-indexed bonds are priced with the assumption that there will be deflation over the next 5 years).

In 2003, as the article points out, there was a deflation scare which caused the Fed to cut interest rates down to 1% and helped fuel the housing bubble. To paraphrase one banker who posted on an investing forum, "Under normal conditions, you go to work at 9 am and cautiously lend money until 5 pm. In 2003, all the 'good' loans for the day were made by 12 pm. This left everyone 5 hours to have a party and make crappy loans (and huge profits) with really cheap money."

30-year treasuries are now yielding a mere 4.4%. Short sale opportunity anyone? The only problem is proper timing. I KNOW they are overvalued, perhaps drastically so because most investors are afraid. This is irrationality in action. The only question is, WHEN will confidence return to the bond markets (so that yields can rise again and you can make money on a short sale)? And will the return of confidence be gradual or sudden?

Also, I am grappling with the question of whether the stock market is currently 'undervalued' or whether it is now finally returning to fair value after a decade of decadent capital gains. I have seen blog posts and heard people say both. I suppose it depends on the way you compute P/E. This article answers the question rather nicely. As does the graph below, showing cyclical P/E ratios just returning to average after years of overvaluation. Cyclical P/E ratios are computed using the price of the stock over the average of the earnings over the last 10 years.


As the article says however, "The news has to come with the caveat that markets are prone to overshoot and become too cheap after prolonged periods when they have been too expensive. Hence, both these measures are consistent with stocks falling much lower before they find a bottom, even though they are currently fairly priced."

Will the market fall ever further after the recent boom period? If one believes that economies which experience a tremendous amount of unsustainable activity must compensate by enduring periods of slowdown below potential growth to compensate and that these economic booms and busts are reflected in stock prices (translated in technical terms as the negative serial correlation of real stock market returns) , then it looks like we may still have a long way to fall.

Here is a prescient report by Andrew Smithers written in February 2007. His thinking on economics, finance and market valuation is quite pragmatic and many of his predictions have already come true. He writes:

"The average return over the past 10 to 30 years has been over 8%, compared with 6.9% over the past 135 years. Investors in the US stock market must expect very poor returns over the medium-term, such as the next 5 to 10 years."

Check THIS one out:

"The gap between the valuations given by CAPE and q indicate, at first sight, that financials are much more overvalued than nonfinancials. We check, by an alternative approach to cyclical adjustment, the overvaluation indicated by CAPE. This confirms the estimate of overvaluation. On the other hand, our look at the details of net worth data for non-financials leads us to suspect that these have become increasingly overstated in recent years."

He concludes:

"The US stock market is probably overvalued by around 77%, as indicated by CAPE, and thus needs to fall to around 800 on the S&P 500 index to reach fair value."

Keep in mind, this was written BEFORE THE FINANCIAL CRISIS. The S&P 500 as of today is at 873. Which means there is still quite a way down to go, especially if you take overshooting into account.

A Goodwill Bubble

I have always been wary of extreme emotion on a group level. It can be fun and exciting in a harmless context like a sports game, but in the arena of national politics it can be deadly, especially without strong institutions.

(I wonder if leaders who enjoy extremely strong support can more easily be hated, and if leaders who merely experience moderate support equivalently experience moderate dislike, in the same way that a high technology stock will gain or lose 40% in a week and a utility company might only fluctuate by 5%.)

I believe that we are currently experiencing a 'bubble' of political goodwill with the election of Obama. Surely he might turn out to be a good (or even great) president, but it is rare that such enthusiasm and adoration from the crowd persists over a long stretch of time. At some point, even the most beloved politicians make one misstep too many and lose their political base. And even if the politican is able to inspire the country (a la FDR) his actual policies may do more harm than good as in FDR's case who attempted to pump-prime the economy in classical Keynesian style by paying men to bury money and then paying them once again to dig it up. As I understand it, unproductive procyclical fiscal policy and a lack of business confidence were two major reasons for the perpetuation of the Great Depression. Undoubtedly fiscal policy only works well when it is conducted productively.

(Note to self: investigate this question some more. What are the quantitative differences between productive and unproductive fiscal policy? What specific policies count as productive or unproductive? Did it really perpetuate the Great Depression? Learn more about the Great Depression's causes. There is so much to learn!)

I digress. I tentatively predict that Obama will enter the White House with a large amount of support, but at some point will slip up and experience a temporary or more likely, permanent decrease in goodwill. Barring assassination, this seems to be the life cycle of most politicians. The less history a politician has, the fewer hard binary choices he's made, the fewer groups he's pissed off, the more people like him. Obama seems to be intelligent and practical; I doubt he would make the recession worse in 2009 by instituting contractionary fiscal policy in the form of much higher taxes or trade restrictions. But if he does, the economic effects could be devastating and his political life cycle would be that much shorter.

Annoying Cliches

I see these all too often when I read business/political news. They are especially prevalent in online forum discussions and political speeches. They betray a lack of rhetorical skill that may also imply a broader lack of creativity and intellect.

"Shore up the economy"

"Quick study"

"Chickens come home to roost."

"Boots on the ground" - in reference to Iraq/Afghanistan usually

"That's an X, if I've ever seen one."

More to be added.

Good Articles

http://blogs.wsj.com/economics/2008/10/29/many-homeowners-think-theyre-immune-to-price-declines/

http://online.wsj.com/article/SB122533157015082889.html

Investing Attitude

The general attitude among many asset managers right now is:

There are opportunities right now, but let's hold off, because there may be more among the future.

Mohammed El-Arian:

The focus on investing now is that you want to focus on the opportunities that have tremendous mean reversion potential, since some asset classes may not mean revert for quite a long time. The system has quite literally broken down. The burden of proof is higher than simply looking at a company's P/E ratio and saying 'this looks low historically, let's buy it.'

He predicts there will be some more institutional failures within the next couple months.

Countervailing Factors to a Deep Recession

Barron's wrote an article (due to be published tomorrow) proclaiming that the recession everybody is anticipating won't be as bad as many in the media think.

Here is the article.

Update this post after reading/thinking about it.

• The main gist of the article is that decreased oil prices will lead to a spur in consumer spending. The question to ask is: Of the average consumer, what percentage of their consumption is devoted to gas/electric bills/goods whose prices fluctuate heavily due to energy costs? How much MORE money would the average consumer spend on goods, ceterus paribus, given its fall since July from ~$147/barrel to new lows of below $70/barrel?
• The author posits that oil at $80/barrel would induce $170 billion in energy savings over 6 months if it held at that level. Assuming half is spent in Q4 2008 and the other half in Q1 2009, the boost to annual spending would be 3.5% in each period. However the author notes that much of this boost would be counteracted by decreased home values and possible decreased stock prices. Overall, GDP will increase slightly according to the author.
  
• Here are his official reasons for hope:

1. Starting in the current quarter, consumer spending (70% of GDP) is likely to post gains, bolstered by lower energy prices.
2. Inventory-to-sales ratios are low. Retailers won't be stuck with a glut of unsold inventory (which would further drag down growth) and may even choose to rebuild inventory next year if the economy grows sufficiently.
3. Capital spending was subdued during the recent expansion, leaving no need to work off excess industrial capacity.
   
4. Net exports will increase growth very slightly.

Here is another article in Barron's with the 'con' point of view.

Parting Words From A Hedge Fund Manager

This made me laugh.

Here is the full letter.

Whether his views are right or wrong, he is at least honest. Then again, he can afford to be. There is definitely something to be said for actually enjoying life rather than trying to egotistically inflate one's self-image through money, women, achievements, etc. If those occur coincidentally with the enjoyment, so be it. But when they become the purpose in and of themselves... a hollowness sets in. At least, that has been my experience.

Research This

http://www.youtube.com/watch?v=-NSk_ZeAH_I


Interesting speech by Noam Chomsky.

Research:

- What is the history of R&D funding in the US? Is most of the private sector's progress driven by public sector research, as Chomsky posits? I know that productivity is the key driver of economic growth, and productivity is in turn largely driven by scientific research and advancement. Thus, this is a crucial issue to consider when deciding on how big a role the state should play in the economy.

- Another thought I had while watching the speech. What is the relationship between a nation's increased economic wealth and its level of ethics/values/morality? Is morality an economic luxury?

- Learn about Chomsky's propaganda model. Read the manufacture of consent.

The Fallacy of 'Wages Haven't Risen'

If you read the newspaper at all or listen to political speeches, one pseudo-statistic is quoted with such high frequency that you may need to wear ear muffs before your brain starts to bleed. It goes something like this:

"Over the past 8 years, the average American worker has not had any wage increases. Combined with the soaring cost of health care, most people now feel that they are worse off than they were 8 years ago."

Now hold on a second. Let's assume that most health care is employer provided. Employer provided health care is a sort of economic appendix; it arose in the Great Depression when FDR put wage caps on what companies could pay their employees. To get around these wage caps, companies paid their employees in non-direct ways, such as healthcare/dental care, retirement packages, paid vacations and so on. Thus, if you want to really find out what a given worker 'makes' in his job, the rational way to do so would be to look at not just his wage, but also the benefits he receives.

According to NCHC.org,

"By several measures, health care spending continues to rise at the fastest rate in our history.

In 2007, total national health expenditures were expected to rise 6.9 percent — two times the rate of inflation.¹ Total spending was $2.3 TRILLION in 2007, or $7600 per person. Total health care spending represented 16 percent of the gross domestic product (GDP).

U.S. health care spending is expected to increase at similar levels for the next decade reaching $4.2 TRILLION in 2016, or 20 percent of GDP.

In 2007, employer health insurance premiums increased by 6.1 percent - two times the rate of inflation. The annual premium for an employer health plan covering a family of four averaged nearly $12,100. The annual premium for single coverage averaged over $4,400.^"

My hypothesis (I haven't done any econometric analysis or read any rigorous papers on the topic) is that wages HAVE risen; the rise just hasn't been reflected in dollars per hour. Wages have risen in the sense that employers are now paying more and more for their workers to access a higher quality of health care. I'd like to see if I'm right about this, and if so, what the magnitude of the effect is.

Mr. Market's Gone Schizo

Benjamin Graham must be chuckling in his grave. Believers in semi-strong and strong efficient markets must be rationalizing away. We have witnessed some of the largest inter and intra-day pricing movements in history, violent waves on the surface of the economic ocean, yet as is often the case with short term price movements, the prices (perceptions of the fundamentals set on the margin by fearful/greedy investors) and the fundamentals (the actual reality of the economy) are completely out of proportion. Problems can emerge when the perception of reality affects reality itself, when irrational price change behavior starts to influence economic decision making, but that is a different topic for a different post.

The core issue of this financial crisis is housing prices. The structure of assets that many financial institutions have on their books can be thought of as a huge bet that housing prices in the US would continue to rise or, if they fell, the fall would be shallow at worst. This has obviously not been the case. Witness the Case-Shiller index data on housing prices:

http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/0,0,0,0,0,0,0,0,0,1,1,0,0,0,0,0.html

The most recent data available is for July 2008; using a CPI-esque methodology to measure home prices, the index assigns a value of 100.0 to prices on January 2000. Prior to January 2000, prices slowly rose through the years through a combination of inflation and perhaps a bit of real appreciation as the US economy (and hence the assets within the economy) gained in value. However, it would take a retardedly high amount of economic growth coupled with inflation to justify the extreme price movements we witnessed over the last half decade. Consider...

From January 2000 to July 2006, the ENTIRE NATION's houses more than doubled in value on an aggregate basis. The index went from 100.0 on January 2000 to 206.52 in July 2006. That's a bubble if I've ever seen one! Now consider that many of our financial institutions own assets whose value depends largely on housing prices keeping or continuing to rise in value. NOW consider that they levered up these assets to really high amounts. Bear Stearns had a leverage ratio of 33:1. When house prices were increasing and mortgages could be repackaged and sold abroad easily, this meant massive profits for investment bankers and massive amounts of resources in our economy diverted to more housing production. Witness the huge amounts of empty condominiums and "for sale" signs in many of our metropolises Enough about that though, let's look at where we are today and where we may be going.

As of July 2008, the Case-Shiller index has a value of 166.23. Let's be quite generous and assume that the fair market value of these houses on an aggregate basis is 115.0, despite the massive amounts of new home construction (find out how much new construction) which may have sent home prices below 100.0 And let's also assume that housing prices won't overshoot on the downside (as so often happens when a bubble turns into a crash). What does this mean?

Housing prices still need to fall by about 30% from their current levels just to reach fair market value with very generous assumptions. This means that the toxic mortgage assets banks hold on their books will only become more toxic as housing prices continue to fall. Combined with the insane level of leverage banks used to purchase these assets... it's no wonder that Paulson and Bernanke are asking for huge sums of money to recapitalize our financial institutions. Because while bailing these institutions out is deplorable and has huge opportunity costs (think of all the children who could be given health insurance with $700 billion), having our banking system fail would be even worse. Businesses would not be able to expand (or in some credit-hungry industries, operate at all...), people would not be able to take out loans, economic activity as we know it would slow tremendously and a repeat of the 1930s could very easily set in. The natural human reactions of fear, xenophobia, and political upheaval would rear their heads and it would be an ugly situation.

The national media has a rather limited attention span, and I haven't seen too many people who really grasp the 'big picture' of what's really going on in the financial press, the way that home prices have driven this entire crisis. It's euphoria one day and panic the next. If any of the few people who might stumble across this could point me to someone who really 'gets it', please let me know.

Given:

• Consumer confidence is so highly driven by house prices (when peoples' home values go up, they 'feel richer' and spend more)
  
• House prices are downward sticky (people are extremely reluctant to sell their home for less than they bought it)
• The large amount of debt the average American consumer has already accumulated through reckless spending combined with the consequent tightening of credit (insert data here about average consumer's debt)
  
• The fall that still needs to occur in housing prices
• The large decline in consumer spending, which constitutes 70% of our GDP, that will occur as a result of the above
  

We may be in for a long and nasty recession. The problem could be compounded if President Obama (yes, he will be president) over-regulates the economy and raises taxes too much. I think a tax increase is needed and obviously more regulation is needed in the financial sector, especially with regards to accounting transparency, but the temptation exists to go too far in the direction of higher taxes and more regulation, which would only add fuel to the recessionary fire.

On the bright side, this means if you have a lot of cash, there exists a tremendous potential for profit by buying cheap companies which will only become cheaper and undervalued as our economy deteriorates.

The Subprime Meltdown Explained

http://docs.google.com/Present?docid=ddp4zq7n_0cdjsr4fn

Gone for Two Weeks

http://www.ft.com/cms/s/0/81d4ce44-3717-11dd-bc1c-0000779fd2ac.html

Ben Bernanke stated yesterday he might raise rates and the two-year T-note yield jumped by 50 basis points. Wow. We live in an era of tremendous volatility, which probably increases the expected return of all the various asset classes as investors demand more return for taking on more risk, especially when such volatility is seen in the 'risk-free' asset. I can only hope that my future clients are smart enough to stick around for the long run rather than commit the all-too common error of selling when the market is at its bottom and buying at its peak (assuming that it isn't a bubble situation; in that case, the rules go out the window).

Over the next two weeks I will be in Switzerland, Germany, Italy and France, some of the shining examples of modern welfare states (with lower economic growth and an increasing fiscal drain from an immigrant underclass to boot). During the long plane ride I hope to finish Den of Thieves (a GREAT book so far) and perhaps start on When Genius Failed, a book about the rise and fall of Long-Term Capital Management in 1998.

The Oil Problem

http://www.ft.com/cms/s/0/23928598-36c1-11dd-bc1c-0000779fd2ac.html - Gazprom, Russia's gas monopoly, says oil could reach $250/barrel by 2009.

The story proffered by financial journalists and economic institutions has been one of rising global demand as emerging markets' increased wealth brings greater energy needs; never mind George Soros' testimony to the US Congress that the recent commodity market's price appreciation has been a bubble driven largely by speculation.

At the beginning of 2007 NYMEX crude oil prices were at a relative low of $50/barrel. This was down from a previous high of $75/barrel in mid-2006. Prices have steadily climbed since the beginning of 2007 to today's high of $137/barrel. Over the past year (52 weeks) oil has appreciated by $71.24/barrel, or 108.22%

Has worldwide demand increased by 108.22% in the past year? And will it increase by a further 80% (the amount needed to bring crude oil to $250/barrel, assuming no supply increases)?

The answer, I believe, is a resounding NO. As fast as the global economy is growing, it cannot possibly be growing at such a rate to justify the doubling of crude oil prices in such a short period. While the equilibrium price of oil is probably above the $50 low at the beginning of 2007, and may even be above the $75 high of mid-2006, I highly doubt that the hysterical speculative excesses we are witnessing are a true reflection of the underlying supply/demand situation of oil.

Assuming that this recent runup is a price bubble (which I believe it is), the question then remains: how do you profit from it?

I don't think it's possible to know when the bubble will pop, but it may be possible to know that it is popping through a combination of rapid and continual price depreciation and highly negative and doomsday-esque market sentiment/press coverage. When one is sufficiently sure that the bubble is popping, load up on puts or short positions and ride it all the way (or at least, most of the way) to its completion.

Care is needed, though.. the recent single-day 8% price runup was the result of fear-mongering over potential war in Iran, a Wall Street report saying oil would show further increases, a relative decline in the dollar and the subsequent covering of short positions by traders who thought that oil prices had peaked. See http://www.ft.com/cms/s/0/e34d30e0-366c-11dd-8bb8-0000779fd2ac.html for more information.

Bernanke's statement today warning of increased inflation may be a signal that the Fed may be ready to raise rates. Assuming the Fed follows through, this should alleviate dollar woes and eliminate the dollar's role in the increasing price of oil.

http://www.ft.com/cms/s/0/290efeb4-367d-11dd-8bb8-0000779fd2ac.html

First Post

Hello. This is the first post of Market Movements, a blog I will dedicate to taking a macro view of the financial and real asset markets both for my own education and (presumably, if you are reading this) your interest.

I am a Level 1 candidate in the CFA program (I took the level 1 exam several days ago and won't know if I passed for a couple months, at which point I can call myself a level 2 candidate if I do indeed pass the exam) and a recent graduate of Washington University in St. Louis with a dual degree in economics and finance. Any views expressed on this blog are my own opinions, and are not meant to be taken as investment advice. I take no responsibility for any investing gains or losses you may incur as a result of reading/acting on these blog posts.


In the following blog posts, I will try to focus in on a few key themes that drive much of the price fluctuation in today's asset markets:

• Price bubbles and the psychology underlying them. How do you know when you are in a bubble? How can you predict whether the bubble will last and when/if it will burst? Is it possible to know when the bubble is bursting, and if so, will you have the intestinal fortitude to take a short position to profit from the sudden depreciation in prices? I am extremely interested in the irrational motives behind bubbles and their resultant crashes, and how to manuever through these financial beasts for maximum benefit.
• The fundamental structural forces that will affect future asset class price appreciation. According to the CFA curriculum, asset classes rather than the individual securities within those classes account for 90% of a portfolio's performance. It is therefore obvious that the majority of one's analysis should be directed at analyzing asset groups rather than individual assets.
• How politics and other such extraneous forces affect the markets, taking into account both the direction and the magnitude of their effects.