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

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.

Goldman Sachs - Buy or Sell?

GS has taken a beating recently, both with the public flogging its members have taken from Congress as well as its stock price. Just how much is Goldman’s image damaged? Is it the same company it was? For my opinion, I refer you to the MS Outlook note I scheduled for myself next week:

"Buy more Goldman Sachs if share price has stabilized."

Goldman is a company of sharks, whose ambition is to make money no matter what the circumstances: usually, this is one of their selling points. Goldman taking bets against its own large clients is similar to college girls flashing their breasts during spring break: shocking, but not surprising.

In a large financial institution it’s common for one arm to take a position opposite to another, sometimes without either side knowing. For example, in one bank I know, the brokerage arm was recommending natural gas stocks to clients, as well as taking long positions in its own portfolio. The trading arm of the same firm was shorting natural gas futures. Traders for large firms are given significant independence.

Salespeople at brokerages generally have to go with the recommendations of their analysts, even if the salespeople themselves think the investments are garbage. As strange as this may sound, it is a necessity. Investing is an art, not a science, and it is highly unlikely that all brokers at a firm would agree whether a stock is a “buy” or a “sell.” For obvious reasons, a firm can’t have one broker advising clients to buy a stock while the broker at the next desk is advising them to sell it. In addition, if a broker sells something they personally recommend (but analysts of the firm don’t), they can be sued if that investment turns sour. For all these reasons, brokers must sell whatever their company’s “squawk box” is touting. Yet, when investigators find evidence of a broker selling stock that they personally hate, it’s presented in the media as “proof” that the company is corrupt.

Goldman is the same company that it was two weeks ago, only a) it could owe a large fine and face criminal charges, and b) its stock price is 27% lower. Unless Goldman is fined 20 billion dollars (the approx. market capitalization it has lost since 2 weeks ago) its stock is now a bargain.

Goldman Sachs is no angel, and never has been. It is still a company of sharks, intent on making money. It is still the firm that every broker wants to work for. And its P/E ratio is 6.1.

Goldman is a buy.



Price (at time of writing): $145.20

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“As a public company, Goldman Sachs will have the financial strength and strategic flexibility to continue to serve our clients effectively as well as to respond thoughtfully to the business and competitive environment over the long term.”
Henry (Hank) Paulson, former U.S. Treasury Secretary, during his time as Goldman Sachs CEO, June 1998.
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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.

Sell the Chinese Market SHORT!

China has been making headlines recently with its amazing economic numbers.

Production, capacity, exports etc. are all up and the economy looks fantastic. It appears to be an economic marvel. Why then, would anyone of sound mind want to sell it short?

In fact, I believe that although the Chinese economy appears to be a roaring bull, it is in fact a bloated, sickly beast. And, the Chinese stock market may soon become of the single greatest short-selling opportunities in history. Here are five reasons why:

5) Social Security – The Chinese are gambling with their social security funds (worth $102 billion US), in the stock market and risky ventures. In 2009, the rate of return on social security investments was 16.1% (a ridiculously high rate for someone’s life savings), prompting Vice Premier Zhang Dejiang to call for “prudence” and “stronger management” (Xinhua, March 15th 2010).

4) Inflation – According to a recent poll (Xinhua, March 16th 2010), 51% of Chinese consumers feel that prices are “unacceptably high,” the highest percentage to say so since the survey began in 1999. Despite this already unacceptable level, inflation continues to escalate, with the Producer Price Index on track to rise 5.2% year on year.

3) Overcapacity – Like Japan after their economic collapse (where stimulus building included lining rivers with concrete blocks), the Chinese have built massive amounts of currently unusable infrastructure. The problem, according to many, was that once a project was announced it could not be cancelled, since any cancellation would cause local officials to lose face. So, projects went ahead, even if it was clear from the beginning that the capacity would not be used.

The result is unoccupied office blocks, newly built factories producing unwanted goods, and toll highways with no traffic. According to Government officials, the areas where the most overcapacity exists are iron and steel, cement, glass, coal chemical, solar energy materials, and wind power equipment – although 17 industries are listed in all.

2) The Housing Bubble – There is almost an unlimited number of things I could say about this one, but I will keep it simple. Housing prices are out of reach for most every Chinese citizen, and prices keep rising even while large housing projects remain virtually unoccupied (since so many units are owned by speculators). In Beijing, housing prices nearly doubled in 2009 alone. The Government’s attempts to stop the problem (including measures to prevent house flipping, and implementing lending restrictions to developers) have all failed.

The situation has gotten so severe that in March, China’s banking regulator simply said that Chinese banks "should not extend loans to home buyers who intend to use the money for speculative purposes," or unless they make a down payment of 40% or more and are charged higher interest rates to compensate for the risk (Xinhua, Mar 15th 2010). One recent headline (April 3rd 2010, Xinhua), simply read, "Collapse predicted, welcomed as housing prices continue to skyrocket."

1) The Chinese Government– The people of China are not Communist, but their Government is. China’s wonderful economic numbers are at best misleading, and at worse inaccurate or simply wrong. As worrisome as some of these facts are, the real ones are probably worse.
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Crisis: "Danger and opportunity" (literally translated from Chinese).

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Disclosure
Do not buy stocks, sell short, 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.