Monthly Archives: December 2009

Coasting toward yearend–HAPPY HOLIDAYS!!!

December 20, 2009 By in Current Market Thoughts, Recent Market Action, Technical Analysis Tags: , , , , , , , Leave a comment

If you look at a chart of the S&P 500, you’ll see that it has been moving sideways in an amazingly orderly way since mid-November.  You’ll also see that this behavior contrasts, both in monthly movements and in intraday swings, from what the index has been doing during the recovery from the March lows.  Yes, there are swings in the prices of individual stocks, but they haven’t been enough to nudge the needle up or down for the S&P as a whole.

Why is this?

One “reason” is actually a description of the market’s behavior–investors don’t see any economic factors, positive or negative, that need to be factored into today’s prices.  In particular, I think there’s still considerable uncertainty about how the global economy will play out in the early months of 2010, so investors figure there’s no rush to make a bet in either direction.

Also, I think professional equity investors have decided that they’re satisfied with the year they’ve had and have more or less gone home until January.  About the only thing left to look for in 2009, I think, are the inevitable “quirky” (read: deliberate stock manipulation) movements that may occur in small-cap stocks on the last trading day of the year–a date that will differ from market to market.

Apropos of  nothing, I think it’s noteworthy that Pimco is reported to be raising huge amounts of cash by selling Treasury bonds.  It’s also starting an equity division.  On the other hand, Pimco, you may know, has been vigorously pounding the drum for the “New Normal,”  the idea that world economic growth will be anemic for a long period of time–and that therefore investors should still be buying bonds despite the fact that interest rates are at historic lows.  Hmm?  What’s that all about?

Finally, I’d like to thank all my readers for their support this year and wish you a happy holiday season and a prosperous 2010.

Trading: how valuable is it to do?

December 18, 2009 By in Constructing a Portfolio, Getting financial advice, How your broker gets paid, Trading, trading: how valuable? Tags: , , , , , Leave a comment

For professionals, very…

The short answer:  my experience is that competent professional trading supporting an equity portfolio manager can add one percentage point to annual returns.  Conversely, poor trading can subtract about the same amount.  Good trading, then, can take a third-quartile manager and put him in the second quartile; bad trading can do the opposite.

…for us, not so much

What about for you and me, though?

I think the key question for any individual investor is how much time is he willing to devote to investing.  A typical professional spends fifty hard–that is, not counting chatting in the coffee room with colleagues–at-the-desk working hours a week on his craft.  Even so, that’s not enough to keep pace with professional competition.  So the job of investing is usually split into three parts, one of which each professional in a firm will concentrate on.  The three are:  research, trading and portfolio management.

Realistically, we’re not going to work as hard as that, no matter what we tell ourselves.  So it’s essential for us to simplify and prioritize our activity so that we can do one or two things well, rather than do a half-baked job on several.

Committing our time to investing

As far as time commitment goes, I think the three parts break out as follows:

1.  portfolio management. Learning how to formulate a strategy takes the most time initially.  Once you actually create one, you’re thinking of it in odd moments most of the time, but your real work of testing, evaluating, trying to figure out what will come up next, is only done for short periods once or twice a month.  In terms of everyday effort, this most important part of managing your money takes the least time.

2.  securities analysis. Selecting the individual stocks, if any, for your portfolio requires a considerable initial effort to learn about he companies, their histories and their prospects.  Monitoring company developments and the stock’s price action takes daily attention if you want to do things right.

3.  trading. Trading can absorb your entire day, if you want it to.  After all, investment managers pay their traders hundreds of thousands of dollars yearly to do just that–to watch the markets, from overseas and pre-market activity to after-hours trading.    The question for us is whether, if we’re going to devote, say, 15 hours a week to our investments, becoming expert in this area is the most valuable use of our time.

(I probably should mention that I do have a  trading experience.  For about five years I ran a global fund where I was the manager and also did all the trading.  I won’t claim to be a really proficient trader, but I’m not that bad.)

Trading takes up a lot of time

An example:  one of my sons, a twenty-something, asked me recently to sell the (small amount of) PALM that he owned and put the proceeds into ATVI.  He had bought PALM, which I consider a really speculative stock (too much so for me), after a Bono-related investment vehicle had given the company an infusion of cash that would allow it to complete and launch the Pre. My son later became convinced that the Pre was going to be upstaged by the raft of Android phones now being released–which is why he wanted to sell.

Anyway, my son gave me a limit of $12 for PALM and none for ATVI.  I placed two limit orders online, one for PALM at $12 and another for ATVI about 2% below the previous close.  I thought the market was going sideways and both stocks were volatile enough intraday that the limits would likely hit.  I then did other things.

On day one, nothing happened.  On day two, prior to the open an analyst released a buy recommendation on PALM that pushed the stock up to $12.27 in early trade.  The stock faded as the day went on and closed at about $11.65.  Of course, I had sold at $12.  on day three, ATVI fell about $.05 below my limit intraday, before closing slightly above it.

Could I have done better?  Yes.  Speaking strictly about trading PALM, I could have spent all of day one and the first couple of hours of day two watching the market.  When I saw the new buy report on day two, I hopefully would have let the stock run and sold at, maybe, $12.20.

For us, it’s too much

But that would have meant spending eight or nine hours monitoring trading in PALM to get another 2%.  As one of my first bosses told me when I was talking about making a trade that might get me 10%–our job is to look for the 30%s and the 50%;  105 is too little to waste time and energy on.

To that, I’d add that if we’re going to allocate ten hours a week to investing, it’s better to spend that time trying to find the next AAPL rather than blowing a week’s worth of time looking for a 2% that may or may not be there for the taking.

Why do all the discount broker ads talk about trading, then?

Three reasons:

1.  The obvious one.  Trading is the service a discount broker offers.  The more you trade, the more money the broker makes from your account.  (See my posts on how your broker gets paid.)  The broker will also benefit if your account grows, but he will gain more from high turnover in an underperforming portfolio than from a low turnover one that outperforms.

2.  Trading tools are easy to provide.  You can even get them for free from Yahoo or Google.

3.  Offering trading advice is much simpler than offering investment advice.  Giving investment advice to a broad range of customers isn’t cheap or easy.  The broker opens himself to the risk of litigation if the investment advice proves unsound or if it is unsuitable for the economic circumstances of a given client.  So the discount broker has to have a research staff (which will end up costing the firm a lot of money) and representatives who will do risk tolerance and other suitability analysis.  Suddenly, the firm that does this not a discount broker any more.  It’s an old-fashioned “full service” broker.

Besides, discount brokers already offer back office services to independent financial planners.  So they would be competing against their own customers.

gray market trading

December 17, 2009 By in gray market trading, Trading, Vocabulary Tags: Leave a comment

Gray market trading (or grey market, in some parts of the world) is unofficial, off-market trading in a security.  It typically occurs with equities either when official trading in the security has been suspended, or, in the case of new securities, during the period between the holder obtaining the right to the security and the time when official trading begins.

The latter case occurs frequently outside the US, where it is customary in many countries that IPOs or shares created through a rights issue do not trade for several days after they are paid for.  An analogue in the US would be “when issued” trading of a new stock created out of an already-existing parent and spun off in the form of a dividend.  In such a case the first day of trading may be a week or so after holders of the parent company stock qualify for the dividend.  The recent spinoff of AOL is an example.

The most important characteristic of gray market trading is that the official means of recording and settling a trade are not available.  In the strictest sense, the transaction cannot be completed until the official books are open, or reopened in the case of a stock suspension.  So although a broker has put together a buyer and seller who have agreed on a price, the arrangement is subject to all parties honoring their word.  Although in practice it’s unlikely, in theory it’s possible that a sharp price movement after that trade has been arranged will cause one party to “break” the trade.  In such a case, there is no practical recourse for the other party.

Because of the portfolio pricing complications that would arise from a broken gray market trade, portfolios that have daily inflows and outflows, like mutual funds, may hesitate to participate in the gray market.

standard (i.e., exchange-traded) vs. OTC derivatives: what the issues are

December 16, 2009 By in OTC and exchange-traded derivatives, Vocabulary Tags: , , , Leave a comment

The financial crisis and OTC derivatives

During the financial crisis, the world found out that many of the “toxic assets” held by commercial and investment banks were OTC (over-the-counter) derivatives.  Worse than that, the holders were unable to say with any degree of certainty how much they potentially owed or to whom.  Even more distressing, the CEOs of the banks appeared to be unaware that they held these things or what the problems with them might be.  This came in spite of what was supposed to be a clean-up of derivative documentation forced by the Fed several years earlier.  As a result of this stunning negligence, during the crisis the authorities were working pretty much in the dark when they were trying to come to grips with the extent of the toxic derivative problem.

Congress is now in the process of crafting regulations about derivatives to try to prevent the country from getting into a similar mess in the future.  The simplest, and most extreme, proposal is to in effect ban OTC derivatives and force all derivative contracts to be standardized and all trading to take place on formal exchanges.  The idea is being opposed by bank lobbyists as well as by some corporate customers.  What are the issues?

What  OTC and exchange-traded derivatives are:

Exhcange-traded

The options market or any of the commodities exchanges are examples of how a standard or exchange-traded derivatives market works.  Central to its operation is a clearinghouse or exchange, which has three main functions.  It:

1. sets the characteristics of the instruments traded:  size of contract, settlement dates, manner of settlement and pricing.  No deviation from the rules specified by the exchange is allowed.

2. keeps track of all the contracts outstanding, so that it knows the daily details of who owes what to whom, and the world at large knows the aggregate information about each type of contract.

3.  sets and enforces margin requirements, to ensure that no parties default on their obligations.  This involves daily pricing of all contracts and settlement of any resulting requirements for additional margin.  Margin money consists of cash or liquid securities that can be sold, if need be, to cover losses on the derivative contracts held.

OTC

OTC derivatives, on the other hand, are private contracts between two parties, typically either between the proprietary trading desks of two banks or between a bank and one of its customers.  The attributes of an OTC derivative are:

—flexible structure as to the object being speculated in/hedged and the length of the contract.  In the equity arena, for example, it was very common at one time for foreigners to use OTC derivatives to circumvent local regulations that made it difficult for foreigners to buy stocks in India or Taiwan.

—no margin requirements.  The bank writing the OTC derivative might (or might not) require its counterparty to provide collateral to protect against default.  But a bank involved in an OTC transaction likely wouldn’t provide any itself.  Settlement would typically only occur at the end of the contract.

Why Congress wants standard derivatives

Transparency–the idea that regulators can know precisely at any time what the overall market position is, as well as what risk each individual participant in the market is taking–is the main reason.  Also, the existence of the exchange/clearinghouse as an independent third party to compel participants with losing positions to supply additional cash to their margin accounts is a significant protection against default.

Why the banks don’t

The OTC derivative business is very profitable under normal circumstances.  Customers may find it difficult to comparison-shop for complex products.  They may also fear that in doing so they will make their intentions widely known, drawing too much attention to a market inefficiency they hope to exploit.   Thus, they will tend to deal with only one or two banks and not worry that much about price.  Also, in really complex transactions, a non-expert customer may not be able to figure out very accurately how much of the price is cost and how much is profit.

Some customers may find the cash requirements of daily margin settlement too cumbersome.  Some may have contracts with clients that don’t allow them to borrow money.  This precludes setting up a margin account.   OTC derivatives are a way of getting around the restriction.  In these cases, you’d figure the bank charges a higher fee for providing a service the customer can’t get by other means.

Exchange-traded derivatives are less profitable because the contracts themselves are a commodity.  Also, gains would be split among the owners of the exchange, in proportion to their equity shares.  So there’s no possibility for firms with more skillful marketing to gain a higher market share.

Why non-financial companies don’t, either

Non-financials are contending they should be exempt from any requirement to use exchange-traded derivatives.  Their main argument is that, unlike the banks, they had no role in causing the financial crisis.  At present, they use OTC derivatives because their financial strength means counterparties don’t demand cash collateral.  Using exchange-traded derivatives, which would demand large amounts of cash margin, would be much more expensive.

What will likely happen?

I think Congress will order a massive move away from OTC derivatives to exchange-traded, in order to curb the activities of the banks’ proprietary trading desks.  Non-financial firms will likely be able to conduct business as they have done before.

If so, the result will be substantially lower profits for commercial and investment banks, but a more stable world.  Of course, the other major banking powers around the globe must enact similar legislation, or the high-risk, potentially toxic portion of the derivatives business will migrate offshore–just as it was drawn to the UK by relatively weak regulatory supervision this time around.



Dubai World update: Abu Dhabi to the rescue

December 15, 2009 By in Banks, Current Market Thoughts, Recent Market Action Tags: , , , , Leave a comment

Abu Dhabi bailout

The government of Abu Dhabi announced on Monday that it is giving US$10 billion to the government of Dubai.  Dubai, in turn, will give the money to 100%-owned Dubai World.  DW will forward about US$4 billion of that to its property development subsidiary, Nakheel, to repay a large sukuk that came due on the 14th.  DW will use the rest of the money for debt payments and working capital while it tries to restructure itself.  (See my earlier posts for more background on the Dubai World debt problems.)

The Nakheel sukuk was suspended from official trading after the standstill request made late in November.  But gray market transactions were reportedly done at just above fifty cents on the dollar.  Courageous buyers will have doubled their money in less than a month.

I think it’s reasonable to conclude that three weeks elapsed between the time Dubai requested a debt standstill and yesterday’s bailout announcement because Dubai didn’t have the funds to bail DW out.  It had to get them from Abu Dhabi.  We don’t know if any strings were attached to the $10 billion gift, or if more money will be forthcoming, if needed–and it probably will be.  My guess is that the answer to both questions is “yes.”  (I’m not alone in thinking this.  See Bloomberg’s comments.)

Why a bailout?

Why not default?  I think there are four reasons:

1.  the possibility of cascading defaults. We know that a lot of DW debt was held within the United Arab Emirates.  If Nakheel defaulted and this triggered a disorderly process of unwinding of more of the DW group’s debt, the negative impact on UAE banks could have been severe.

2.  the sharia supervisory board. All sukuk activities, including presumably liquidation, are overseen by a group of scholars who ensure that they are sharia-compliant.  Because there have been virtually no prior sukuk defaults, it would be impossible to predict what actions the supervisory board would recommend.  Suppose it decided that because of negligent management by DW (or some other reason), sukuk holders could make claims against all the assets of DW, not just Nahkeel’s?  A ruling in this case might also set a precedent for other sharia boards in Dubai to follow.

3.  some holders apparently didn’t want to negotiate. Nahkeel sukuk was originally sold to few if any Americans.  But as Nahkeel’s problems emerged, it appears that some US and UK hedge funds accumulated positions at lower prices in the secondary market.  Armed with credit default swaps that would pay off in the event of a default, these owners had different interests from the rest.  For them, the worst outcome would be a protracted negotiation that resulted in a decline in sukuk value but no default.

4.  reputational damage. Despite the facts that the Nahkeel sukuk was issued by a Dubai entity and that the prospectus clearly said the government assumed no obligation to guarantee repayment, possible default was giving the entire UAE a black eye.  I’d bet that Abu Dhabi was less concerned that foreigners thought the sukuk had a sovereign guarantee that buyers in the UAE thought it did, too.

One odd consequence of the DW troubles is that the rating agencies have begun to focus more carefully on the financial problems of Greece. Greece is a short step away from having its government bonds downgraded to a level where the EU will no longer accept them as collateral for borrowings by the Greek central bank, thus shutting off credit from the rest of the EU.  This is an issue, but it has nothing to do with Dubai.  Go figure.