Foreclosure reality

The chart speaks for itself. Keep in mind this will not slow for the next 4 freaking years!

About Joe Pesci

Things (relevant to the financial markets) I've learned from Joe Pesci,

1) Learn who the Patsy (fall guy) is

2) If you can’t figure out who the Patsy is, YOU are the Patsy

3) Figure out how the game screws the Patsy

4) Find ways to always take opposite sides of the Patsy

5) Once you’re “in”, keep your mouth SHUT

6) Be wise, stay low, profit off the game

Oklahoma University royally screwed

Apparently, the supposed $160Million in donations from T. Boone Pickens to Oklahoma State University once hit $300M before crumbling to $ZERO$, today. What makes it worse is that the university has borrowed a whole lot of money against it as collateral... OUCH! hence the "royally screwed" status.

Lesson here

Hand outs hurt, whatever that could go wrong, WILL go wrong. Leveraging against uncalculated risks invariably ends badly. When it comes down to it, you can't rely on anyone but your own abilities and convictions.

Nations face difficulty

Robert Peston at BBC News has mentioned some interesting points that today we are looking at credit risk imposed by countries, namely Iceland, Hungary, Pakistan, Ukraine and Belarus, Argentina, and lastly but most importantly, South Korea.

This could affect YOU and me. If you have a pension fund, you should find out if the investments involve any debt issued from the above mentioned countries; and if so, time to make some changes to your hard earned retirement fund. Government debt is NOT risk free, and the existing fund managers are not adequately prepared for proper risk management. The level of incompetence behind institutional doors is shocking, I tell ya, SHOCKING. But that's for another article.

Option expiration week

The following statistics offer mean S&P Index returns and associated skew values for each trading day within the 3^rd week of the month (AKA Option Expiration Week), for the decade starting from 1998. 1 While you should not anchor on these figures entirely, they do provide a pretty good picture of how the stock markets move for the week.

Data source: Advanced Option Pricing Models

Mean Return

This gives the return of highest frequency for the studied period. Most would conclude that this points to expiration week Tuesdays as favorable buying days, and vice versa on Friday. I would highly advice against that sort of presumption. Historical price movements have little if any affect toward that of the future.

Expiration week Friday however, is another story. This is what often happens…

At the last hour of trading of Thursday, many option traders sell Out-of-the-Money Index Put Options, expecting them to expire worthless within a day, thereby keeping the premiums, and of course dismissing the risk of a dramatic volatility jump. The big players buy these OTM Puts, being on the other side of the trades. Then Friday comes and the big guys pump the markets full of selling orders, forcing these options into money as the index drops, and they invariably end the day with up to 5,000% profit from the options (while the sellers lose their shirts, remember Niederhoffer?)

Neat trick huh!

Skew

These numbers, in my personal opinion, offers more value than the former. It comes in the form of standard deviations. OK, we all know normal distributions do not apply to financial markets, still this figure provides one of the most vivid imagery of the fat tails. The highly negative values suggest that even while the markets had moved upwards more often, when it drops, it drops like there’s no tomorrow.

I suppose that added to another reason why I usually prefer short selling than taking upside bets. Anyway, while these numbers do not provide a “holy grail” sort of thing, they do offer a bit more reality of how markets actually perform.

Lehman Joke

I still frequent Elite Trader, and this got me cracking up all morning.

Quoted from Nutmeg

"If life hands you a Lehman, make Lehman-ade."

Lured by pennies

Most corporations today shell out tens of millions consulting specialist think-tanks for continuous innovation; Microsoft does it for practically no cost with Imagine Cup. I attended the seminar today, and witnessed (expectedly) many computer science majors falling for the lure.

Incentives

The competitors form 2-4 person teams, and present solutions in software and/or hardware concerning some (supposedly) critical issues today. So according to the speakers, winners within NZ gets roughly $10K worth of downloads off MS. The global winner gets $25K USD. Of course the experience helps with their resumes/CVs, and yadda yadda yadda… That is pretty much it.

Pennies instead of dollars

Microsoft is one clever SoB, offering pennies while expecting millions in return. According to one of the speakers, 60,000 teams of 2+ staff engaged in the event last year. So a 120,000+ strong R&D dept. handing over their intellectual properties along with blood and sweat, all in hopes of $25k USD (unadjusted for inflation) and some downloads in return. That is the basic run down.

Nassim Nicholas Taleb was right about many things. What really struck me was how he pointed out that people naturally focus on the pennies instead of the dollars. Those who buy stocks for the dividend yield, good example; Imagine-Cup, perfect example.

Critical analysis

It doesn’t make any sense. If you have an awesome solution to an existing problem, a product that people want but are not getting, then you could easily attract 7-8 figure private funding and possibly retire within a couple of years, never having to work again. Why the hell would you give that to Microsoft for next-to-nothing?

Sadly I have met more close-minded persons at the Dept. of Math & Science than their business school counterparts. It appears that conventional education depresses critical thinking, regardless of the area of study. Oh well, if anyone opts to remain naïve, that is their choice. Hell, it’s less competition for the rest of us.

TED spread

The TED Spread explains the difference between 3-month US treasury bills and LIBOR (London Interbank Offered Rate). It is useful in identifying current credit conditions, and below entails a graph if it in the past year off bloomberg compared to the VIX index.



The chart shows a positive correlation between the TED Spread and the VIX, where we can conclude that it holds a significant negative correlation to US stock indexes. Furthermore, the above suggests that banks have become increasingly unwilling to lend to each other.

So from this standpoint, as long as financing remains difficult and (very) expensive, the big players will keep selling. Trying to pick local bottoms and going long would be very dangerous.

About inflation

A number of independent writers have expressed concerns of deflation, while others such as Peter Schiff have repeatedly maintained that developed nations, particularly the US, face unprecedented inflation. So who is “correct”? Who cares. The more important question lies in mechanics of staying profitable alongside this uncertainty.

Exploring both scenarios

In an exaggerated inflationary period, we expect the following:

• Bullish stock markets
• Very bullish commodity prices
• Very bearish debt instruments (treasuries, corporate bonds, etc.)
• Real estate bubble build up
• Lowered general market volatility
• Bankrupt companies fall, but the execs go away and have another go easily

Conversely, in deflationary periods (or inflation slow downs) we have seen the below:

• Sharp declines in stock markets as volatility increases
• Commodity/real estate prices come back and adjust to the actual rate of inflation
• Fixed income debt instruments tend to rally
• Financially unstable firms go down, alongside the long-side investors

Traditional hedges

Many investors hedge against exchange rate risk by holding a basket of different currencies. This still leaves the risk of currencies losing value collectively like what we have seen the last few weeks, though they have more to gain if inflation slows.

Some solutions

Commodities and real estate are probably the “safest” in this period. As they have intrinsic value, and true “deflation” would never occur with the current credit based financial system. Inflation slows or picks up pace, either way over the long run (years), commodity and land prices will always adjust and rise with respect to paper money.

Shorting companies on the verge of insolvency “works” regardless of inflationary concerns. Badly managed, heavily geared, non-performing businesses inevitably lose investors’ confidence. These stocks head toward $0 as statistical eventualities, the rate of inflation simply determine the speed of it. So even in the case of high inflation, a “slow death” via a thousand cuts (I think that’s a line from some Kung Fu movie) would still reward the short seller with a nice return.

Short term arbitrage of course works regardless of any market or monetary conditions. This just takes much more critical thinking and probably physical work to both search out and exploit discovered inefficiencies. Now that the Chinese stock markets have started experimenting with short selling, many new opportunities have opened.

That’s all for now.

Strategy tweaking

Regardless of all the hype of discipline, having a solid trading strategy (or business model) remains the critical key to trading profitably. The next logical step then lies in continuous improvements, where vulnerabilities, unexpected risks are not only addressed by also resolved.

The confirmation fallacy

Mentioned in “The Black Swan” by Taleb (great book by the way), historical “confirmations” of where the strategy had succeeded means nothing. A large string of winning trades as result of a particular strategy suggests little if backed by purely quantitative means alone; likewise, just because you have survived another day does not suggest you are an ageless immortal.

Remedying weaknesses

You should instead search for incidences in the past where the interested strategy has failed (spectacularly), however improbable they may seem for the future. Once analyzed, you must create ways to adapt to these implausible but unavoidable events so that when they occur the next time, the strategy would result in break even or a net profit anyway. Like all business models, creativity is crucial.

Examples:

Someone who believes in long-term investment in the stock market might find the improbable yet inevitable fundamental risk of bankruptcies highly damaging. The investor then decides to only invest in index futures and ETFs. As a result, he experiences no more devastating portfolio losses from single company failures.

A typical trend following strategy carries very low winning rate as it depends on low-probability fat-tails off return distributions. As a solution, the trader could keep track of historical and implied volatilities, and exploit it to improve winning rate significantly. See here for more details concerning Trend Following improvements.

Revelations

As mentioned via a comment, the content of this blog has drifted away from the mathematical side of things for a good while now; I wanted to express some personal thoughts toward the financial industry at this point. Nothing is as it seems.

Pure Quantitative Studies are Over-Rated

The search for an elegant mathematical system to both explain the past and exploit future moves of the financial markets continues, yet so far I have not found anything of significant value to study historical prices. Too many assumptions regarding distributions, probabilities, rational trading behavior, and etc. have done more harm than good (e.g. consider the credit crisis and the half quadrillion derivative shenanigans).

So for anyone starting out and trying to figure out patterns, wedges, flags, trend-lines, let me save you some time and suggest that it is all a waste of time. Studying prices and price derived “dependent” variables will not result in consistently profitable trading.

Some Things that have “worked”

The news. Trading against mainstream financial media has worked exceptionally well. All you have to do is put yourself in their shoes, and think critically of motivations behind each public announcement, and more often than not obvious answers lie behind the veils of deception. Remember my article on Goldman Sachs and oil?

Quantified sentiment. Only by observing what most traders are actually doing, can one truly assess realistic likelihood of liquidity in the markets and therefore directional bias. One example of such would be the ISE sentiment index.

Credit risk assessment. An easy way to find good candidates for shorts is to look for a company that issues bonds of very high Yield to Maturity. The higher the YTM, the more willing investors “imply” high credit risk of the issuing business. At the same time, if the company is willing to pay such high interest for borrowing, it MUST be desperate for cash. This can not be faked by playful accounting.

Market depth of ECNs. Observing bid/ask volumes off BatsTrading or ARCA do provide a significant edge in day trading, unfortunately my current schedule does not allow for late nights every week day.

Existing research

My research this moment lies applying Support Vector Machines in neural networks for financial forecasting. Sounds impressive, though the mathematics gets so convoluted I get easily lost within the numbers, let alone trying to predict the markets for the next day or two. Nevertheless, I still search for something that “works” on the very short horizon.

I believe that method(s) MUST exist to determine high probability direction of stock indexes at any point in time, and finding answers from pure mathematics is improbable. From this point my interest has turned toward that of economics, politics, and behavior of the financial institutions, and this explains the change in the title.

Californian challenge

Not surprised, Arnold had "hinted" it when he tried to cut state employee wages to the federal minimum. People there remain oblivious of the need to honker down, buckle up, and start saving instead of consuming needless things.


LOS ANGELES — With the credit crisis cutting off access to short-term financing, California officials said the state may be forced to ask the United States government to lend it $7 billion, warning that the state could run out of money in a few weeks without it.

Asked what would happen if the markets or the government did not come through, Mr. Schwarzenegger replied, “This is no such thing in my vocabulary as ‘what if not.’ We will."
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Another columnist provided a main street perspective of the Californian situation (via an alternative media outlet).

California going broke - California is broke, but most Californians don’t know it. College students know it because their tuitions have gone up. Teachers received layoff notices in May, but many of those notices were rescinded when teachers agreed to benefit cuts to save fellow teachers jobs.

However, the majority of Californians are clueless that their state is broke.

Reality arrived recently for everyone who owns an operable car or pickup. The governor’s finance director just tripled registration fees for every registered vehicle in this state. If you paid $150 to register your car last year, the next notice will be for $450. This was no arbitrary decision, but a statutory trigger in a law passed during the last, Republican administration that says basically when the state cannot pay its bills, license fees triple.

California is looking at a budget deficit of somewhere between $35 billion and $38 billion, roughly one third of its annual budget. Anyway it’s sliced, the fifth or sixth largest economy in the world, depending on who is doing the boasting, is broke.

What does that mean? For many state administrators, it means no paycheck until a budget is approved. For many union state workers, it means minimum wage paychecks until the budget is passed.

For University of California Cooperative Extension farm advisors and specialists, it likely means you are out of a job or you may be working out of your pickup or a rented trailer in a county equipment yard.

Layoff notices are about to go out to 400 California Highway Patrolmen.

A new era is beginning in county and city governments because their pipeline of state money is dry. It is called outsourcing. This is not simply contracting with someone to clean buildings or service city cars. It means city and county-owned facilities like convention centers and exhibit halls will be run by contractors and not employees paid by tax dollars. Cities cannot afford to operate their own properties and are turning them over to outsiders in hopes of cutting expenses and hopefully generate revenue to meet budget shortfalls.

California is facing a fiscal crisis only a very few really understand. Can California be broke?

Oh yes it can and because of it there is an even chance the governor of one of the largest economies in the world is facing recall. Gray Davis is no corrupt, local politician. He a savvy, cat-like politician who seems to land on his feet more times than a cat thrown out a first floor window. He is the governor of the largest state in the nation and he may be kicked out of office mid-term. It is not all because of the current budget deficit. The energy crisis of two years ago still has people seething.

Recall proponents already have enough signatures (about 900,000) to recall Gov. Gray Davis. They want many more signatures to guarantee that the recall goes on to the ballot.

The recall seems more certain than the prospect of getting a state budget any time soon. Hang on because you are about to see a state government for more than 32 million citizens go broke. Recalling the governor will not put $35 billion in the bank. It will only add to the financial chaos that seems to have no easy solutions.

e-mail:hcline@primediabusiness.com

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Stephen Colbert