Tag Archives: Trading

the current selloff

September 23, 2011 By in Constructing a Portfolio, Current Market Thoughts, economics, frozen by the screen, Portfolio management, Recent Market Action, Strategy, Technical Analysis, Trading, Uncategorized Tags: , , , , , , , , , , Leave a comment

concrete signs of slowdown are emerging

A few days ago, Rio Tinto, the giant Melbourne/London mining conglomerate, said some Western customers (European?) are asking the company to delay shipment of contracted amounts of industrial metals (how this works financially is an interesting, semi-complex topic, but irrelevant here) .  FedEx announced this week that orders for airfreight shipment to the US, the EU and Japan are losing momentum as customers opt for slower and cheaper ways of getting their products into retail outlets.

In other words, for the first time in two years +, some firms are beginning to worry about having too much inventory and to work it down.  In one sense, this isn’t good.  But it had to happen eventually.  And the equity markets have been discounting this development since July.  After all, FDX has lost a third of its value in the past three months; RIO has been clipped by 37% over the same span.

So this is not really news.  And as FDX said, customers’ hair isn’t on fire.  They’re just being a little cautious.

the real problem is in the EU

There, a modern version of the Iliad, sans Helen, seems to be playing out, with France and Germany taking the role of Troy and, well …Greece in the role of Greece.

In a nutshell:  the EU let Greece in about a decade ago, even though it didn’t really qualify, giving it unrestricted access to EU credit.  Greece promptly borrowed (and spent) a gazillion times what it could ever repay, funded ultimately by the ever hapless financial institutions of Germany and France.  Greece says it’s sorry and will change its ways–but is actually doing very little. It seems instead to be milking the situation for the best possible terms for default, or perhaps just for more time at the EU credit trough–which, I guess, is what almost anyone would do in their situation.

On the other hand, German politicians are on the horns of a dilemma.  They either fund a Greek bailout, in which case they’re tossed out of office, or they let Greece default and destroy their banks.  And they’ll be thrown out of office again.  So they don’t want to act, either.  Arguably, this is also their best strategy (short of actually doing their jobs and fixing things).

Having endured this stalemate for about a year, the nerve of European investors seems to me to have finally cracked.  They’re selling anything not nailed down in a classic panic.  The rest of the world is being dragged along for the ride.

If there’s silver lining to this, financial market panic may provide the political cover the EU needs to stop procrastinating and begin to act.

three stock market scenarios

I’ve sketched this out in a little more detail in Current Market Tactics this month and last.

I have three targets for the S&P over the coming year, depending on economic circumstances:

nothing wrong (hah!)     1350

muddling through          1170

recession ahead             1000.

I still think that muddling through is by far the most likely outcome.  If so, 1170 would be the central tendency around which Wall Street will revolve.  Panic aside, if an investor thought he would need a 7% return in order to be induced to take the risk of owning stocks, then he should be a buyer at an index level of 1090.  That’s about 3.5% below yesterday’s close.  Below that any selling, which I already regard as overdone, would enter into another, higher, level of craziness.

The main item on our wish list should be market stabilization.

what to do

My thoughts haven’t changed very much.

When we get to the other side of the current storm, I think the winners will be firms with Asian exposure, participants in technology-based change and companies that serve the affluent.  At some point it will be right to trade your TIF in for WMT (I own the first but not the second), but not anytime soon.

If you can force yourself to get out from under your desk and witness the carnage, look for ways to upgrade your portfolio.  When selling starts, it may be rational at first and the weakest stocks get sold off first.  But then the selling often takes on a life of its own.  When panic sets in and the bad-stock ammunition runs out, good stocks get thrown out the window at crazy prices as well.  Why?  That’s all that’s left to sell.  No other reason.

My stocks got really whacked on Thursday, so I guess I’ve got to think that we’ve entered the latter phase.

Under the desk (or the bed) is sooo much more comfortable at a time like this, but my experience is that you’ve got to force yourself to at least analyze what’s going on.

If you can’t do this, or if you know you’d just do things you’d regret later–and you know your psychological makeup better than I do–find a good book.

By the way, in my view the current selling has nothing to do with year-end mutual fund housecleaning.

discounting

I want to add something about the discounting mechanism, but I’ll save that for Sunday.

 

risk controls at UBS: the case of trader Kweku Adoboli

September 20, 2011 By in Banks, Current Market Thoughts, Derivative instruments, ETFs Vs. Mutual Funds, Industry Analysis, Recent Market Action, Trading Tags: , , , , , , , , , Leave a comment

Kweku Adoboli is the UBS trader who ran up losses of $3.2 billion through unauthorized trading in stock index futures over a three-month period without being discovered.  Both the Financial Times and the Wall Street Journal have extensive accounts of what Mr. Adoboli did.

Here are my observations:

background

Legally, traders act as agents for the institution they work for.  Once an employer introduces an employee to counterparties as being authorized to trade for the firm, the counterparties have no obligation to try to figure out what the trader is doing.  Until the employer informs them otherwise, the counterparty’s job is simply to execute the orders they receive.

Mr. Adoboli worked on a small trading desk called Delta One, that processed buy and sell orders that UBS received for ETFs.  For this story, the most important characterisitics of ETFs (see my posts on ETFs vs mutual funds for more information) are that:

–ETFs trade continuously throughout the day, in large aggregate amounts but typically in many small orders

–firms that run ETFs have no direct dealings with the investing public.  They keep their costs low by having brokers do virtually all trade processing and record keeping for them.

Brokers recoup the administrative expenses they incur through the commissions and bid-asked spreads they charge customers.  Once they amass a large net position in a given ETF, they can close their exposure out by transacting with the firm that runs the ETF.  They may also attempt to make additional gains through the timing of these transactions.

Brokers routinely hedge part or all of their ETF exposure through derivatives markets.  The name of Mr. Adoboli’s unit, Delta One, signifies that the trading desk “delta,” or the change in value of the hedges for a given change in the underlying position UBS held, should be “one.”  That is, the two should match exactly; there should be no net exposure.

Mr. Adoboli

Mr. Adoboli’s initial job at UBS appears to have been in the back office, as one of the administrative employees processing and recording the activities of the Delta One desk.  One of his unit’s jobs would have been to reconcile the desk’s accounts of the trades it made each day with the confirmation notices sent by counterparties. 

Mr. Adoboli was a good enough employee to be promoted to the much higher status job of trader.  One key fact that he learned from his back office time was, surprisingly to  me, that for a whole class of plain vanilla short-term derivative contracts, counterparty banks never sent confirmations on the day of the trade.  Apparently, standard procedure was to only to send settlement instructions a few days before the contract came due.

on the Delta One desk

Despite the name, the Delta One desk had to take risk.  And, from Mr. Adoboli’s behavior we can conclude that the desk rewarded traders for successfully taking risk.  But these risks would have been small, like:

–widening the bid-asked spread slightly, or

–delaying making a hedging transcation by five or ten minutes in hopes of getting a higher price, or maybe even

–by “anticipatory hedging,” over-hedging at a favorable price, figuring that new orders would soon come in.

three months ago

That’s when Mr. Adoboli exceeded the risk limits specified by his desk.  Who knows what happened?  He may have accidentally added an extra zero to a trade.  More likely, he may have decided he wanted to quickly make enough trading profit to get a higher bonus, or to be recognized as an astute trader and promoted to a “prop trading” desk whose principal job is to try to make trading profit (“prop” is short for proprietary, meaning it trades with the firm’s own money).

In any event, at some point Mr. Adoboli’s trading went badly and he began to make substantial losses.  Rather than reporting what he’d done to his boss, he used his back office knowledge to record fake trades that offset his losses.  He selected instruments where he knew no confirmations would be sent–buying him time until close to settlement day for him to recoup his losses and enter more, counterbalancing, fake trades to erase them from the records.

Apparently, toward the end, Mr. Adoboli was making speculative trades covering as much as $5 billion in securities, all without being detected.

What appears to have tripped Mr. Adoboli up was that the back office noticed it was not receiving settlement instructions for fake trades set to settle on September 22nd.

observations

In the mid-1980s as I was beginning to learn about bank stocks, a colleague who was an excellent bank analyst told me she had one main criterion for separating good banks from bad.  In a good bank, when someone makes a mistake and reports it, he’s rewarded; in a bad bank, mistakes are punished, so employees hide them.

It’s hard for me to believe that Mr. Adoboli was able to conceal his unauthorized trading from his direct supervisor–in a five- or six-person section–for so long.  That person must have been asleep at the switch.

It’s also surprising that there was such an unaddressed loophole in UBS’s trade reconciliation procedures–and that no one noticed that one person was doing so much unreconciled trading.

five reasons we may be in a trading-oriented market for a while yet

September 19, 2011 By in Constructing a Portfolio, Current Market Thoughts, day trading, market timing, Portfolio management, Recent Market Action, Strategy, Trading Tags: , , , , , , , , , Leave a comment

By a trading-oriented market, I mean one where:

–the indices generally move sideways within a narrowly defined range, and

–individual stock price movements are strongly influenced by traders who have short-term holding periods–a day, a week, even a few hours–and who buy and sell very rapidly.  As a result, both individual stocks and the markets can exhibit sharp up-one-day, down-the-next patterns.

Why should a market like this persist? 

Five reasons:

1.  The economies of the developed world have slowed a lot and are no longer providing clear up or down signals.  And, at the moment, the EU’s continuing bungling of the situation in Greece is producing alternately hopeful and despairing news headlines that short-term traders are using to help them ply their trade.

2.  Pension plan sponsors continue to shift money from traditional investors to “alternatives” like hedge funds, many of which are run by traders and employ a short-term trading style.  This shift continues despite the fact that alternative managers are more expensive and in the aggregate have produced inferior returns pretty continuously for almost a decade.  Don’t ask me why.

3.  Fundamental information about individual companies has become harder to get.  Over my thirty years in the business, brokerage houses have become progressively more dominated by traders.  During the 2007-2009 market downturn, they gutted their research departments as a way to cut overheads.

Also, the shift by individual investors from mutual funds to ETFs and by institutions to alternatives means the research budgets of traditional long-only institutions are not what they once were, either.

4.  Discount brokers offer mostly trading tools and technical analysis to their clients.  Why?  They make most of their money from customer transactions, not from clients outperforming the market.  Also, setting up a research department is complicated and expensive, and it potentially exposes the firm to lawsuits if investment recommendations go awry.

5.  Many mutual funds still have big accumulated losses–both recognized and unrecognized.  In large part, these losses come from individuals buying mutual fund shares at high prices in 2006-07 and then redeemed them at much lower levels in 2009.

As counterintuitive as it sounds, these losses are a big asset to current shareholders.  They allow a manager to change the structure of his portfolio without generating net taxable gains.  This fact also permits–and, in my opinion, should encourage–mutual fund managers to take a more aggressive trading stance to use the losses more quickly.  This maximizes their value to shareholders.  And some newer funds may have years and years worth of losses to avail themselves of.

The result of this is that even the most buy-and-hold-oriented taxable investors may be trading much more than usual.

investment implications

One of the first pieces of Asian investing lore I encountered years ago (and one of the few I’ve found useful) is that the daily market action is like a rapidly turning wheel.  You can stay away from the wheel and not be hurt.  You can jump on the wheel and not be hurt.  They only way you can be severely injured is to try to jump on and off.  In other words, if you dabble in trading and don’t devote your life to it  you’ll get your fingers badly burned.

For the vast majority of us, as individual investors, the best approach is to take a longer investment horizon than the market does–to endure short-term volatility rather than try to profit from it.

Juergen Stark quits the European Central Bank and stocks sag: why?

September 12, 2011 By in Banks, Current Market Thoughts, Industry Analysis, Recent Market Action, Strategy Tags: , , , , , , , , , , Leave a comment

resignation last Friday

Jürgen Stark, a respected and politically-connected economist representing Germany on the ECB, resigned from that body’s board on Friday at about the time US markets opened for trading last Friday.  You can see the sharp drop in stocks that followed the announcement of this news.  Why?

some background

1.  Deeply scarred by the hyperinflation of the Weimar years after WWI, Germany has always been the strongest advocate of price stability (i.e., no inflation) in modern Europe.  Unlike the US, which is willing to accept a moderate amount of inflation (currently the upper bound is 2% or less–and we wish it could get that high) in return for faster GDP growth, Germany is willing to sacrifice almost any amount of growth to maintain stable prices.

As a result, Germany has traditionally acted as the economic “policeman” of Europe, enforcing sound fiscal and money policy rules and acting as a lightning rod to deflect local political criticism in the rest of the EU for governments taking unpopular but necessary economic actions.

Mr. Stark’s resignation from the ECB for “personal reasons” –but apparently in protest over the ECB’s decision to prop up the finances of weaker EU member states by buying their bonds–suggests the ECB is deciding/has decided to break with the traditional no-inflation-first policy stance.

2.  Mr. Stark is the second German official to resign from the ECB in recent months.  In February, Axel Weber resigned as head of the German central bank and withdrew from consideration to head the ECB–apparently with similar concerns to Mr. Stark’s.

3.  The Stark resignation may cause enough political fallout inside Germany to force the Merkel government to say openly whether it approves of ECB actions.  So far, Germany has been pretending it doesn’t see the drift away from the traditional German policy stance and just, little by little, letting the drift continue.  I’m not an expert on internal German politics.  But it doesn’t seem clear whether Germany would back Ms. Merkel vowing unconditional support for a Greek bailout–meaning German taxpayers would foot a large part of the bill.

stock market reaction

World financial markets are acting as if the Stark resignation is the tipping point that will force the EU to stop hoping the problem disappears and confront the fact that Greece can’t service the large amount of euro-denominated sovereign debt it has amassed since joining the EU.

possible solutions

In general terms, two approaches to resolution are possible:

–the German price stability mentality holds.  If so,

Greece will be allowed to default.  Holders of Greek sovereign debt, including big EU banks which are stuffed to the gills with these bonds, will suffer large losses.  The problem with this solution is that the markets will just turn to the next country with wobbly finances–Portugal or Spain–and the whole destabilizing question of bailout or not arises anew.  Look at the Asian debt crisis of 1997 if you don’t think so.

–the EU as a whole assumes responsibility for the sovereign debt of weaker members.  There’d have to be some mechanism for ensuring that a repeat of their debt expansion doesn’t happen.  To the stronger countries’ eyes–and certainly to Germany’s–this has to look like a rerun of the reunification of the two Germanies after the fall of the Berlin Wall.  A decade of economic stagnation followed.  So this solution (which I think is more likely) probably also entails a bias toward a weaker euro and tolerance of a bit of inflation.

what do investors do?

Solution 1 is bad for Greece, and bad for banks and other financials that hold Greek debt.  It might just shift the focus of worry away from Greece to Portugal or Spain.

Solution 2 is bad for the less-indebted EU members and bad for the euro.

The intersection of the bad-ness is the financial companies in the less-indebted EU countries.  So for traders, selling them is a no-brainer.  Even if these stocks are the epicenter of weakness–and they have been so far–arbitrage tends to drag everything down.  So just selling anything in the EU is a close second choice.

If there’s any silver lining to the selling, it’s that it may force a resolution to the Greek debt issue.  A sharp market decline may provide the political cover EU authorities feel they need before they act in a way that could threaten their ability to be reelected.  Also, as the selling exhausts itself, there may be an opportunity to pick up the stocks of well-run EU-based multinationals at a cheap price.