How to Speak Fed

The Federal Reserve: seen by some as an economic savior, and by others as an evil force.

Through its direct manipulation of interest rates and other mechanisms, the Federal Reserve determines the overall pace of U.S. economic growth (or decline).



Since investors trend toward euphoria when times are good & panic when times are bad, the Fed’s mandate is to control the economy; for example, to stimulate a weak economy by lowering interest rates, or to slow down an overheated one by raising interest rates. Yes, that's right – the Fed sometimes purposely initiates recessions. This is not conspiracy, but rather a method of controlling human stupidity (or at least cleaning up after it).

In good times wages tend to increase, which in turn increases spending, which increases prices of goods, which increases stock and real estate prices, which induces inflation, which causes wages to increase and so on. When times are good and voters are happy, the government wants it all to continue. If an independent Fed did not exist, human greed and optimism would allow bubbles to grow to stratospheric levels, then come crashing horribly down. The recent crash and burn of the U.S. housing bubble is an example of the Fed's failure to do its job – it let the bubble grow for too long.

Importantly, while the Fed always hints at what it wants to accomplish in the future, it does so in a cryptic manner. So, while the Fed’s intentions may be crystal clear to professionals, they pass by virtually unnoticed to non-professionals – exactly as intended.

Buying reasonably priced stocks of good companies is always a good idea, but it’s an even better idea to buy them when the tide of the economy is moving with you. The purpose of this article is therefore to teach the rules of “Fed speak,” the cryptic voice that shapes the nation’s economy.


Rule #1 - The Fed Understates Everything

The Fed is aware of its huge influence in the market, and takes care not to overstep its boundaries. If the Fed simply said, for example, “we intend to raise interest rates because we think there is a bubble in technology stocks,” the market would likely dive and the Fed would be blamed. For this reason, the Fed avoids stating anything of importance directly. Thus, “this market has a bit of froth,” really means, “this is a bubble of massive proportions.” Asking, “Is there a reason to think that homes are overvalued?” means that homes are terribly overvalued. Whenever the Fed states or suggests an opinion, you can safely magnify it tenfold.


Rule #2 –Recognize Moral Suasion

Moral suasion, also known as “jawboning,” is the name for scolding market participants in order to change behavior. By sending a warning to the market, the Fed hopes that it can delay or even avoid taking a negative course of action.

For example, in 2009 the Bank of Canada (Canada’s equivalent to the Fed) stated, “the recent sharp increase in the value of the Canadian dollar, if it proves persistent, could fully offset recent positive developments in financial conditions, commodity prices, and confidence.” This stern warning (see Rule #1) told market participants that if they keep buying the Canadian dollar, the Bank will take measures to devalue it (to improve exports).

In the long run moral suasion rarely works, but in the short run it can have the desired consequences. Moral suasion also indicates the course of action the Fed will take if moral suasion fails.


Rule #3 – Read the Speeches Verbatim

The introductions and conclusions of Fed speeches are made for public consumption (the media) and generally reflect useless broad opinions (such as, "the economy is improving.")

The subtle nuances with true predictive value are in the carefully chosen text. For this reason, any online news article about a Fed speech will include a link to the Fed’s word-for-word text. This verbatim text is meant for market professionals.

Examples of Fed Speak in Action:

“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"
Alan Greenspan, Chairman of the Federal Reserve Board, 1996 Speech

Translation: Stocks appear to be grossly overvalued (the Internet bubble).
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"It's pretty clear that it's an unsustainable underlying pattern. People are reaching to be able to pay the prices to be able to move into a home."
Alan Greenspan, Chairman of the Federal Reserve Board, 2005 Speech

Translation: There is a housing bubble in the U.S., and it will crash.
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“With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus.”
Bank of Canada, Press Release, Apr 2010

Translation: We will be raising interest rates soon.
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The importance of understanding the Federal Reserve cannot be underestimated. To a large extent, the Fed determines the near-term growth or contraction of business, and therefore the direction of the stock market. In addition, the Fed is a reliable asset bubble "early warning system." Learning to speak Fed can save you a lot of anguish.

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“Augmenting concerns about the Federal Reserve is the perception that we are a secretive organization, operating behind closed doors, not always in the interests of the nation as a whole. This is regrettable, and we continuously strive to alter this misperception.”

Alan Greenspan, Federal Reserve Board Chairman, 1996

The Canadian Housing Bubble: CREA to the Rescue

In response to a series of headlines suggesting that real estate is overpriced, visibly annoyed members of the Canadian Real Estate Association issued a statement today denying any possibility of a housing bubble, with scores of statistics and beautiful charts to support their claim.

In this article, The Frost Report reviews the CREA's rebuttal (and why they should be ashamed of themselves).

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CREA: “Canada’s solid mortgage market trends, conservative lending practices, and prudent borrowing by home buyers means that Canada will avoid a U.S.-style housing price correction.”

The Frost Report: Canada's conservative lending practices are a myth. In the heat of 2006 Canadian banks were, just like their American counterparts, doing loans without even confirming the borrower’s income. As long as the client’s credit bureau reported the name of the company they claimed to work for, this was considered enough evidence. In addition, although the Canadian Mortgage and Housing Corporation has strict guidelines regarding credit scores and income levels required for approval, a CMHC representative recently told me that they had been making exceptions to the rules "left right and center."
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CREA: The “vast majority” of Canadians have mortgages they can afford.

The Frost Report: Canadians can afford them today because of record low interest rates, which is exactly what caused the bubble to re-expand. For several months now the Bank of Canada has been warning consumers that interest rates will be increasing, and expressing concern about their personal debt levels. From June until Nov 2009, many if not most new mortgages were variable rate; this worried the Bank of Canada as well as the Big 5 banks. As a result, laws were passed stating that all buyers must qualify for a fixed rate even if they intend to take a lower (for the moment) variable rate mortgage.
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CREA: “Over the past 12 months, most new mortgages (64 per cent) have amortization periods of 25 years or less. This is an increase compared to 54 per cent one year ago.”

The Frost Report: The insinuation here is that since people are choosing 25-year mortgages (with higher payments) instead of longer-amortization mortgages, they must have money to spare. In fact, the opposite is true. In the past year home prices have become so high that the majority of home purchases have been from existing homeowners - either selling and repurchasing, or doing equity take-outs to purchase second properties. First time homebuyers are seldom able to afford 25-year amortizations. The decline in longer mortgages means that first time homebuyers are abandoning the market.
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CREA: Twenty five per cent of mortgage holders recently increased their home equity via lump sum payments against the principal and/or by increasing their mortgage payments above their scheduled payment.

The Frost Report: It is not these homeowners, but the 75% of homeowners that do not or cannot make extra payments that is concerning. The CREA's comment ignores that fact that if even a small percentage of homeowners fall behind on their payments it will bring down the entire market. In the United States in Q3 2007, subprime adjustable rate mortgages made up only 6.8% of the market, yet accounted for 43% of foreclosures.
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CREA: Most mortgage holders (77 per cent) have a home equity position of at least 25 per cent.

The Frost Report: This is because until 2006, 25% was the minimum requirement to purchase a home in Canada. At that point, the minimum down payment was changed to 0% in order to boost the housing market. Presumably because of the risks, CHMC pulled the plug on zero down payment mortgages in 2008. The minimum is now 5%.
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CREA: Housing prices will not drop. Instead, personal incomes will rise to match home prices.

The Frost Report: I feel vomit in my mouth right now.
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It's hard to imagine a more biased source of information about real estate than an organization whose purpose is to represent “more than 96,000 real estate Brokers/agents and salespeople working through more than 100 real estate Boards and Associations.” Still, the CREA could do the morally upright thing and at least present the potential downside risks. Due to the CREA's press release, hundreds of dreamy-eyed homebuyers will once again enter the market, oblivious of the dangers.

For more examples of CREA spin-doctoring, see Spin City.

For the full text of the CREA statement from which this article was based, see: Relax: It's Just Another Housing Market Cycle.

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“There is no evidence of a housing ‘bubble’ in the United States and housing demand should stay strong for years to come.”

James F. Smith, Society of Industrial and Office Realtors, 2005
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Increased Risk that Something May Happen in World Markets

World markets fell again today, increasing the likelihood that adverse consequences could result if the drop in equity values continues.

Nervous investors are worried about Greek debt, the Euro, and other things that change regularly, keeping the U.S. economic recovery in jeopardy but increasing news turnover and ratings significantly.

If credit markets continue to tighten, it could result in conditions that may negatively affect the U.S. market, leading to a double-dip recession. Despite this, moderate economic growth is predicted unless something else occurs.

In a statement released today, T.V. personality and part-time economist “Dr. Sinister” said that the S&P 500 could fall to as low as 700 to 500, or could go “even lower.” He did not elaborate on how these numbers were chosen, but his expression appeared very serious so it must be true.
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“…if there were to be a significant tightening of financial conditions and credit availability gets tighter in a big way, there is risk the economy could fall back into recession...”
CNBC, 24 May 2010, http://www.cnbc.com/id/37324540
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"Nearly everyone interested in common stocks wants to be told by someone else what he thinks the market is going to do. The demand being there, it must be supplied."
Benjamin Graham, The Intelligent Investor

Cognitive Dissonance

INVESTOR PSYCHOLOGY




Improve your investing by improving your way of thinking.





"Cognitive dissonance" is the name for anxiety caused by disconcerting thought processes. That is, when people are faced with facts that make them uncomfortable, they tend to ignore these facts, literally to the point of self-denial.

Cognitive dissonance is the reason why a mother won’t accept that her son is dead, even when the police are standing in the doorway telling her. Cognitive dissonance is the reason why a husband with an unfaithful wife will always be the last to know. It is why those in debt do not open their mail. It is why Al Capone thought he was a good person because he donated to charity. And, it is why Americans who wished to buy a home in 2006 (or already had one) insisted that there was no housing bubble, despite all evidence to the contrary.

It is a natural thing for people to seek confirmation of their existing beliefs. Finding facts to prove you are right is both satisfying and comfortable. This is why conservative Republicans watch Fox News, anti-globalization protesters read Noam Chomsky, and why environmental activists seldom read the Oil and Gas Journal. But in order to be a truly effective thinker, one must embrace cognitive dissonance by intentionally seeking disconfirming evidence. For many great thinkers, including investors Charlie Munger and George Soros, the best technique for embracing cognitive dissonance is a simple one known as “Inversion.”

Inversion states that in order to prove that something is true, you should try to prove it false; that is, for any strong belief that you have, regularly search for evidence you might be wrong. If you wish to buy a stock, for example, you would include a search for reasons not to buy it. You would read not just the glowing press releases about the company, but also seek out all negative facts about the company, and judge these facts without emotion. Only after finding no significant reasons not to buy the stock would you actually buy it.

Cognitive dissonance is not easy to overcome. You will be fighting natural human emotion every step of the way. Despite a lifetime of working on it, I have fallen prey at least twice, and will no doubt do so again. But by making a habit of questioning your own judgements and attempting to prove your own beliefs false, you will become a stronger and more reliable investor (and possibly a better person). Soon, you will find that your mental discomfort becomes a source of pride and pleasure, not to mention lucrative.
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“Faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.”
John Kenneth Galbraith

The Financial Reform Bill

THE GOOD, THE BAD, AND THE....WELL, YOU KNOW


Both Democrats and Republicans who voted for the bill say that it is not about "revenge" against Wall Street, but merely about prudent regulation and control. Are they right?

In this article, we review the details of the bill that changes everything.


The Good

No Compensation for Lies – Requires public companies to set policies to take back executive compensation based on inaccurate financial statements (if you have been cooking the books, you have to give back the money).

SEC Registration - Hedge Funds that manage over $100 million will now be required to register with the SEC and disclose financial data. This should lesson the amount of false disclosures and scams, common for hedge funds.

Skin in the Game – Requires companies that create securitized investment products (ex. buying crappy mortgages and selling them to others) to keep at least 5% of them on the books. If the product is awful, the company selling them will suffer too, even if just a little.

Consumer Protections – Various excellent amendments for consumers. For example, not allowing credit card companies to increase - without warning - interest rates on those who already carry balances.

Consumer Financial Protection Bureau – A board that watches for consumer scams and abusive financial practices, with the ability to autonomously write new rules and regulations.

UpFront Fund – Large institutions will pay into a fund, similar to deposit insurance, that will pay for the liquidation of a company should it fail (taxpayers will no longer pay). Until now, a financial firm could take out the equivalent of life insurance on a fellow firm, and then short-sell it to death. Now, the firm doing the killing will have to pay for it. Creating the fund will damage profits in the short term, but should enhance stability in the long term.

OTC Derivatives Clearing Houses – Former OTC derivatives will now be cleared on an exchange, similar to futures. That means fewer shady, under-the-table, interconnected deals. It also means fewer cases of institutions falling like dominoes.

Vote on Executive Pay – Gives shareholders a non-binding vote on executive pay, beyond the voting rights that shareholders currently have.


The Bad

SEC Review – Requires companies to provide a chart comparing their executive's compensation to stock performance over a 5-year period. This is a little unfair, since a company that is well run can still have mediocre stock performance. Having said that, I couldn't think of anything better myself.

Federal Reserve Oversight – The Federal Reserve will now oversee companies with assets of over $50 billion. Although the idea sounds good in theory, I’m leery of anything that causes the independent Fed to cozy up to large firms any more than they already do.

Tough to Get Too Big – Larger institutions (whose failure would create more of a threat to the overall system) will have stricter requirements for leverage, capital, and liquidity. This provision somewhat penalizes companies for getting large, which is something I don’t like. Many argue that it is a necessary evil.


The Ugly

Financial Stability Oversight Council – “Make Risks Transparent” mandate. The idea is that the council will identify systematic risks to the system before they occur. Yeah, right. If it were that easy, every financial crisis in history would have been avoided. The true crises are the ones you don’t see coming.

Office of Credit Ratings at the SEC – This office (more bureaucracy) is supposed to regulate the credit ratings agencies, and address poor performance. Good luck with that. No two analysts can look at a company and come to the same conclusion. Interestingly, the council actually has the authority to de-register a ratings agency for continued inaccuracy. Maybe in a few years all of today's ratings agencies will be gone.
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In all, I welcome the Financial Reform Bill. It is what consumers were demanding, much of it makes sense, and it could be a lot worse. Will it prevent another financial collapse? Of course not. But it should make a next one a little less disastrous.

For further information, see:
http://banking.senate.gov/public/_files/FinancialReformSummary231510FINAL.pdf

Thank you Sir, May I have Another?

It’s a terrible thing, to see a nice low limit order come tantalizingly close to being filled, only to see the stock market climb back up and away from your bid.

Financial news has been on a negativity-rampage for almost two weeks now (with a 2-day hiatus in the middle), and the markets have taken a good spanking.

Yesterday and today, news agencies pulled out all the stops, including interviews with Nouriel “Dr. Doom” Roubini, analyst Merideth Whitney (who called the market outlook “bleak,”) and even recycling frightening stories about housing from last year. Yet, the market retraced its decline today, with some financial stocks actually gaining.

Despite a stream of almost ridiculously negative headlines and advice (ex. “sell everything”), stock prices remain annoyingly unresponsive. The market is becoming desensitized. Stock news remains gloomy with stock prices to match, but another shock to the system is required.

With any luck, the U.S. financial reform bill will pass, creating enough anxiety for one more downward dive, and allowing the first tier of my low-ball orders to fill. In financial markets, one can only hope for the best of the worst.
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“You realize, you’re not in the analysis business, you are in the entertainment business.”
Fred Kittler of J.P. Morgan to analyst Andy Kessler, Wall Street Meat

Stay Away from U.S. Banks

Good advice, right?

Financial stocks are, once again, the scourge of Wall Street. There is talk of new financial regulation, rumors that the big banks will be broken up and sold, criminal investigations, and concerns about bad debts in Europe - all of which are making headlines daily. Will the horrors never end?

Professional money managers have been busy writing articles with frightening headlines, warning you that financial stocks are dangerous and to avoid them "at all costs." Yet, at the same time as they have been telling you to stay clear, they have been buying a lot for themselves.

Institutional ownership of Bank of America is 56%, Wells Fargo 75%, Morgan Stanley 75%, and Goldman Sachs 72%. For comparison, institutional ownership of Wal-Mart is 36%, Exxon 49%, Proctor and Gamble 58%, and General Electric 50%. If you want to have some real fun, go to the disclosure section of any article that tells you to sell stocks, and check the author’s holdings. You may find that while the author is telling you to sell certain stocks, the disclosure reveals that he owns them all. So yes, he does indeed want you to sell your stocks - so that he can buy them from you.

Here are the major reasons why financial institutions are set to outperform long-term:

The U.S. housing market
In 2008 and 2009, the price of real estate was plummeting, taking the net worth of the average American down with it. But prices have now stabilized, and at extremely low levels. The painful de-leveraging of America is over. The U.S. now has some of the most affordable housing in the industrialized world, and it won’t stay that way forever.

Client Purges
In the previous two years, numerous clients of major banks received letters telling them, for example, that their line of credit would be cancelled if they did not use it within the next 90 days. Clients were outraged, and many cancelled their cards just out of spite - which is was exactly what the banks wanted. This was money that the banks could have been lending out for a profit, but that was instead locked into credit with customers who would never use it. The banks, from their perspective, got rid of a lot of dead weight. They also got rid of a lot of credit risk.

Restructuring
During the height of the financial crisis, the industry was shedding 39,000 jobs every month. Although layoffs can hurt good employees as well as bad, it can safely be said that the best, brightest and most necessary were not the first to go. In addition to the widespread layoffs, many financial institutions streamlined their processes, eliminated business segments not related to their core business, and just generally refocused. The financial industry is leaner and hungrier than it has been in a very long time.

Solid balance sheets
The balance sheets of U.S. financials have been heavily scrutinized by investors, the SEC, the government, hedge funds, and the Federal Reserve. Tier 1 Capital ratios (measures of bank safety) are well above normal. Citigroup, generally considered one of the weakest, has a Tier 1 capital ratio of 11.92% - almost double the level necessary to be called "well-capitalized." In addition, many banks are sitting on extraordinary amounts of cash and have large loan loss reserves.

Financial Reform
The proposed financial reform legislation is often portrayed as a capitalism killer in the conservative media, but it is nothing of the sort. The bill proposes larger capital requirements for those who take more risks, greater transparency in general, and a federal body for winding down companies that nonetheless fail. In other words, large financial institutions will be more subject to scrutiny, require more fallback as their risk levels climbs, and if they fail their operations will be wound down in a manner that is least disruptive to markets and paid for by the industry itself (not taxpayers). Accountability makes for good capitalism.

Valuations
Many financial institutions belong in the single digit forward P/E club. JP Morgan has a forward P/E ratio of 8.2; Goldman Sachs 7.0; Morgan Stanley 7.5, and Citibank 8.9. Citi also has $5.61 of book value per share. Imagine if someone came up to you and said, "I'll sell you this genuine $5 bill for $4 dollars." You would probably assume it was fake, since in the real world this never happens. In the world of Wall Street, however, it happens all the time. At the moment, you can buy $5.61 worth of Citibank assets for $3.81, and get all their clients, brand names, and worldwide businesses for free: Morgan Stanley, Bank of America, MetLife, Travelers, Capital One, and many others are the same.

For small investors to get significant coverage in the financial industry, you need only buy two exchange traded funds - the XLF (large institutions) and the KRE (regional banks). Due to the present worldwide housing bubble, I recommend buying mostly regional banks (KRE) first, until the full brunt of International problems hit their markets (in the short term, psychology trumps value every time). But for value investors, buying time is now.

Statistics (at time of writing):
KRE $27.32
XLF $15.35

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“You can’t make a baby in one month by getting nine women pregnant.”
Warren Buffett, 2009, explaining the importance of investment patience.
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Disclosure and Disclaimer
I own all companies listed here as individual stocks, in ETFs, or both.
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

Is Buy-and-Hold Really Dead?

Since the credit crunch began, many a financial professional has suggested that the buy-and-hold approach to investing is dead. You cannot, they say, simply buy a stock and forget about it. You will lose money.

The most powerful argument against buy-and-hold, popularized during the heat of the crisis, is that if you invested your money in U.S. stocks in 1999 and held them until 2009 (a ten year period), you would have made absolutely nothing: your stocks would not have increased in value at all. Many people found this statement shocking. I also found it shocking, but for a different reason. 1999 was the peak of the Internet bubble. 2009 was dead bottom after the housing bubble. So basically, they were saying that if you were stupid enough to buy stocks at the worst possible time, and then stupid enough to sell those stocks at the worst possible time, you’d still come out even. Truly remarkable.

In reality, buy-and-hold has never meant buying a stock and forgetting about it. Buy-and-hold means buying the stock of a great company at a good price, and holding it for as long as it stays a great company at a good price. If the company's competitiveness declines, sell it. If there are serious “accounting irregularities,” sell it. If the company becomes overvalued, sell it. This is buy-and-hold. So, why does the press always suggest that trading is better? Partially it’s because of ego (surely a complex strategy must be more effective than a simple one); but mostly, it’s because of commissions.

If you buy a stock and sell it several years later you may have a large capital gain, and the government may receive tax income, but Wall Street gains almost nothing. Commissions and trading spreads are the way that Wall Street makes money, and buy-and-hold doesn't encourage either.

You may notice that when you open an account at an online brokerage, they always have free seminars about level II quotes, day trading, chart reading, and anything else that encourages people to trade more. They also have special benefits and pricing for “frequent traders.” In contrast, I have never seen an online brokerage offer a value investing or buy-and-hold seminar, ever. And I probably never will.

Trading certainly has its place, especially in choppy markets. And it’s fun. But for those who can’t marry their computer screens or who do not have a degree in economics, buy-and-hold is the great equalizer. Buying stocks of excellent companies at times of great pessimism, and holding them until times of great enthusiasm, is a moneymaking strategy par excellence.
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“Cash combined with courage in a crisis is priceless.”
Warren Buffett

Power of the VIX

In recent days, newscasters been talking a lot about the VIX – commonly known as the “fear index,” and as an important gauge of investor sentiment.

But, just how well does the VIX measure investor sentiment? More importantly, what relevance does it have to investors? We explore these things and more...

Part 1 - What is the VIX?

The CBOE Volatility Index, or VIX, is a measure of the short-term expected volatility of the S&P 500 stock index. In simple terms, the VIX measures the likelihood that stocks of America’s largest companies will go up and down in value in the near future. The higher the VIX, the more likely it is that stock prices will fluctuate.

Part 2 - Is the VIX a good measure of investor sentiment or fear?

Mostly yes.

Using volatility to measure fear is one of those idiotic things that result when mathematicians attempt to measure human psychology. They do this by creating a model that is relevant most of the time, and assume that it is relevant all of the time.

The VIX makes the grossly inaccurate assumption, common in investing circles, that “volatility” and “risk” are the same. If you ask an average person what they are afraid of, they will not tell you that they are afraid their stocks will go up and down. What they are afraid of is that their stocks will go down and never come back up; that is, they are afraid of a permanent loss of capital.

Having said all that, investors often forget their beliefs and flip out when stocks temporarily drop in value. For practical purposes then, it can be said that while the VIX doesn’t measure what investors are truly afraid of, it does a reasonable job of measuring what they actually react to.

Part 3 - Does the VIX anticipate the future?

While some claim that the VIX anticipates the future, what it actually measures is today’s expectations of the future: so really, it measures the present. Expectations of the future change daily, and so does the VIX.

Part 4 – Is the VIX useful to options and futures users?

If you trade options or futures, it is vital to know the level of the VIX. Options that are far out-of-the-money increase in value only when the underlying stock gets close to the strike price. If volatility is high, the likelihood that your strike price will be reached is also higher. Thus, volatility tends to increase the price of options and futures.

A perfect example of the importance of the VIX occurred last March with UYG (a U.S. financials exchange traded fund), where I made one of the biggest investing mistakes of my life. U.S. financials had just hit a new low and everyone was talking about the end of capitalism, so I knew that financials would soon be going up. To capitalize on this, I bought UYG call options with a strike price of $40, at a time when the price of UYG was $15. And I waited.


Even as UYG climbed from $15 to $35, my call options hardly increased in value at all. The reason? Although the ETF was growing closer and closer to the strike price, the VIX was declining at the same time. My option prices hardly moved, and didn’t substantially increase in value until they hit the strike price. It is an important lesson to all those who would buy options during a time of market turmoil: be aware that during times of large market fluctuations, you will be paying a premium for your options. I would have been better off buying at-the-money options or UYG itself. It was a lost opportunity of regrettable magnitude.

Part 5 - Can the VIX be used to hedge my portfolio?

For those who run their own portfolios like a hedge fund, the VIX is tradable under the symbol “VIX,” and has a negative correlation to equities of about -.80. Reread that last line in case you missed it. VIX or VIX call options can therefore be bought in anticipation of disaster as an excellent hedging tool.

Conclusion

The VIX is vitally important if you buy options or futures, important if you want to hedge your portfolio, and useful if you want to put a number to how much gray hair you just got by watching CNBC. As a measure of investor psychology and market sentiment, however, the VIX has little predictive value: it mostly measures what just happened.
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Note to Journalists reading this blog: Please do me a favor and stop printing the headline, "VIX jumps as stocks fall." The VIX will always jump as stocks fall, since it is part of the calculation. It's like reporting, "Body falls as man jumps out window."
Thank you.

Greek Debt Bailout – What Happens Now?

The Greek (actually Euro) debt crisis has been, at least temporarily, averted via a $1 trillion rescue package that could really be looked at as a “render predatory traders useless” package. Now what? Is the EU set to recover? Is everything just fine?

Despite these efforts, much of the world including the U.K., Canada, Israel, Dubai, Korea, China etc. (see: World Housing Bubble) are set to stagnate and/or enter recession within the next 18 months. In these countries, economic recovery has been more about new housing bubbles and consumer credit growth than real recovery.

Although the U.S. was the instigator of the worldwide collapse, it is now in the best position to move forward (no one said life is fair). The U.S. has inexpensive housing, low interest rates, a devalued dollar, moderately valued stocks, citizens with reduced debt, and increased productivity - all of which give the U.S. economy plenty of upside potential.

Under normal circumstances, a multinational recession would not bode well for U.S. stocks and I would say, “sell.” However, the current situation is more complicated than that. American stocks today are priced at levels that reflect modest post-recessionary income and a definite lack of euphoria. Even if world markets slow down, it is already priced into U.S. stocks at this level.

Secondly, you may have noticed that although world markets are global and affect each other, it is mostly the U.S. market that affects the rest of the world – and not the other way around. Even when a powerhouse like China experiences market drops, for example, the effect on the U.S. market is negligible. I suspect that when world markets decline it will bring down the American market only temporarily, until everyone realizes that U.S. growth is sustainable domestically at a level that supports and even exceeds today’s stock prices.

In short, most Commonwealth, EU, Arab and Asian countries have, at this point, little or no room on the upside, but plenty of room on the downside. Conversely, U.S. stocks that grandmothers around the world are still afraid to buy are the best investment opportunities around.

Many high-quality U.S. stocks, including members of the Dow 30, remain at single digit or low-double digit P/E levels, even on modest sales. If prices drop from here and you are a long-term investor, I recommend going against the grain and buying more, since any dip below today’s reasonable prices is a blessing. If you are afraid of volatility in your portfolio (there is sure to be plenty), ignore all this advice and stay away from the cheap-stocks party.

PS - The International cheap stocks party should begin sometime next year.

Statistics (at time of writing)
Dow Jones Industrial Average: 10,785
Hang Seng: 20,320
FTSE 100: 5,385

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"These high prices [in the Dow] were the cause of great jubilation on Wall Street, but I found them depressing. I was happier with a good 300-point drop that created some bargains."
Peter Lynch, Beating the Street
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Disclosure
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

Ready for the Kill

On Thursday, a comedy of errors (see: Whoops!) caused one of the largest same-day market crashes in history.

Though largely an "accidental" meltdown, superstitious traders seemed to think that the market dive was a premonition, and they responded by continuing to sell. The crash also made the regular (non-financial) news, prompting retail investors to awaken from their post tax season slumber.

Currency Exchange employees told me that on Friday, small customers were exchanging their U.S. dollars for other currencies en masse - over $3 million in half an hour. Other clients who had their eyes glued to CNN called me to ask, half-jokingly, if they still had any money. No one was quite in panic mode, yet all were clearly unnerved.

Filling the demand for negative news, Friday's headlines were about market meltdowns, Greek debt woes, the Euro collapsing, foreclosures, and bomb scares in New York. Major news agencies completely ignored the positive news of the day, which included solid employment numbers, stellar earnings for conglomerate Berkshire Hathaway, and the fact that AIG (which received $182 billion in government aid) has returned to profitability. This weekend more negative news stories are scheduled to be broadcast, including CNBC's "Markets in Turmoil: Is your Money Safe?", which should add further to investor angst.

In just two short days, the U.S. market has gone from potentially-overvalued to definitely-undervalued, and the selling may not be over. It's difficult to say how fast the turn will occur, since ratings for negative news can change overnight. Yet one thing is for certain: after the market stabilizes, opportunities will exist in abundance (they already do).

Despite short positions on the Chinese market, I've lost $8000 (on paper) in two days - and I couldn't be happier. I sold some stocks for cash two weeks ago and am ready for round two. Only fools are pleased when the market goes up before they are finished buying.

If you missed the first run, this will be your second chance to buy great American companies at low prices. Happy hunting.

UPDATE - The expected turnaround began on the first trading day following this article, with the S&P 500 gaining back its entire loss and more in 3 trading days. Buying at the lows was indeed a good bargain.

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"The price of the stock must reflect a majority view that conditions affecting the company will be bad, or soon will be bad, or will continue bad."
Gerald Loeb, "The Battle for Investment Survival," explaining when to buy stocks.

Whoops! My mistake.

Back in January 2010, I wrote an article (What the News Doesn’t Know) about the fact that the stock market is interpreted via “reverse attribution.” That is, market action occurs first, and then the news agencies try to determine why. Frequently, they are wrong. A near-flawless illustration of this phenomenon occurred today.

U.S. markets, which for most of the day had been experiencing a calm, orderly decline, suddenly began plummeting at 2:40 pm. Media outlets scrambled to determine what was going on.

First it was believed that the sell-off was inspired by TV interviewees saying that Greek debt defaults would spread. Headlines like, “Greek debt contagion spreads” and “Stocks plunge on Greek worries” inundated the headlines.

Then, realizing that such a dramatic plunge would probably not occur due to an issue that had already been discussed for days, the news agencies added a second reason: “Huge selloff caused by worries about new financial regulation.” It was thought that the combination of Greek debt and the uncertainty caused by financial regulatory debates in Congress was the culprit.

Finally, the most probable cause of the carnage came to light: a trader at a large financial institution had pressed the wrong key on his keyboard.

Yes, the nationwide market meltdown was apparently caused by a trader who wanted to sell Proctor & Gamble stock, but accidentally pressed “b” for billion shares instead of “m” for million. At future cocktail parties, this trader can now boast that a single keystroke error caused every financial newscaster in the U.S. to go ballistic, and caused the value of one of America’s largest and most beloved corporations to drop by 19 billion dollars in five minutes.



Interestingly, seeing the sudden drop in P&G stock and unable to explain it, traders scrambled to find excuses for that, too. One rumor was that P&Gs new Dry Max baby diapers cause rashes and skin irritations. But alas, realizing the error, the trader quickly backtracked on the sell order, causing P&G stock to rally just as quickly as it had dropped.

Just another fun day at the office - and a great example of why you can't rely on the news.

UPDATE - Friday, May 7th 2010 (the day after the carnage): News agencies are now reporting that the drop may not have been caused by a trader error. Or maybe it was. No one is really sure.

UPDATE - Saturday, May 8th 2010 (two days after the carnage): News agencies are now reporting that the drop was indirectly caused by the New York Stock exchange and computerized trading. The NYSE halted trading for 10 minutes, forcing trading computers to look for bids at alternative exchanges where no bids existed. Finding no bids, trading computers began buying and selling at random prices.

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"Advertisements contain the only truth to be relied on in a newspaper."
Thomas Jefferson

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Two Stocks I Like - BioPharmaceutical

When it comes to stocks, I’m of the Peter Lynch School, which says that you shouldn't purchase a stock unless you can, a) rationalize your purchase in few sentences, and b) draw what the company does with a crayon. These companies fit the bill.

I have no idea whether these stocks will go up or down in the next 6 hours, days, or weeks, and don’t know anyone who does. My intention is to hold them (I own both) until at least the peak of the next market cycle, or until the company proves to be something other than what I thought (for example, the dreaded words, “accounting irregularities.”)

Note that both of these companies are relatively unknown and relatively low-priced, which puts them squarely in the "speculative" category.

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CRTX – Cornerstone Therapeutics Inc.

To quote from the 2004 10-K report (honesty at its finest): “We were incorporated in Delaware on July 14, 2000. Since our inception, we have incurred significant losses each year. As of December 31, 2004, we had an accumulated deficit of $58.5 million. We expect to incur significant and growing losses for the foreseeable future…we expect our operating losses to continue to increase over the next several years as we continue to fund our development programs and prepare for potential commercial launch of our product candidates. We do not expect to achieve profitability in the foreseeable future; and we cannot assure you that we will achieve profitability at all.”

In those heady days of rising housing markets and consumer glee, Cornerstone (formerly Critical Therapeutics) was trading at about $70 per share, despite having no earnings whatsoever. That was then. Fast-forward to 2010, and Cornerstone touts rapidly increasing sales at great margins and with no long-term debt; yet, its share price is only 1/10th what it was as a purely speculative play in 2005.

Cornerstone’s specialty is respiratory ailment medications. Although Cornerstone is engaged in research, it is more interested in acquisitions. That is, CRTX finds established products that are poorly marketed, and re-launches them for a quick earnings boost. It also acquires late-stage development products that it can push for FDA approval and bring to market. Once products have been acquired or approved, Cornerstone uses a highly focused sales force of 113 agents to market these products.

The only thing I don’t like about Cornerstone is that, like many growing companies, is has been regularly increasing its number of outstanding shares (essentially printing money) for acquisitions. Having said that, when it does issue shares the purpose is to acquire product rights for added revenues – a good sign.

CRTX Statistics (at time of writing):
$6.77 per share
P/E of 8.8
No long-term debt
Gross margin 76.6%

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SKBI – Skystar Bio Pharmaceutical

Skystar is a Chinese pharmaceutical company (incorporated in Nevada) that primarily engages in medicines, vaccines and related health care for animals, both personal (pets) and commercial (livestock and poultry).

In one of those ridiculous transitions that can only happen in the world of speculative stocks, Skystar was incorporated in 1998 as “Hollywood Entertainment Network,” which was an independent film company. In 2000, riding the wave of the technology boom, it changed it’s name to “Cyber Group Network Corp” and became a security hardware and software developer. Several paragraphs of 10-K report later, and Skystar is now a bio pharmaceutical company. Normally I wouldn’t invest a dime with a change-your-line-of-business-a-thousand-times company, except for one important factor: Skystar is now legitimate.

In 2009, Skystar had over 33.8 million in revenue at 51% gross margin. Skystar manufactures a long list of products, including medications, microorganisms, feed additives and vaccines, while employing over 200 people. It has research and development facilities in China. And it has solid, growing earnings.

I suspect that Skystar's shaded past has a lot to do with its low stock price.

China's stock market is firmly in bubble territory and volatile of late, so expect this share price to move around a lot.

SKBI Statistics (at time of writing):
$9.75 per share
P/E of 7.17
No long-term debt
Gross Margin 51.09%

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Disclosure
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.