I lost my Internet connection at home recently. As I'm going to finish my study here and move out of town soon, I'll stop updating this blog until late August. For all interested in visiting this site and reading on the articles shared here, have a nice summer and see you all later this fall!

Trading the VIX

The VIX estimates volatility on the SPX itself for the next 30 days.

VIX futures are a bet on where that estimate will be on the day the future expires. In other words, it's a snapshot of what the market expects for volatility 30 days after the future expires. If it's a September future for example, you're guessing how the market prices volatility 30 days forward from September expiration. You're not betting on SPX volatility between now and September. That's a common misconception.

VIX options are cash settled, meaning you get delivery of nothing, just a debit or credit. They're also European exercise, meaning you can't do anything other than trade them between now and expiraiton.

They price off the futures, not the VIX you see on the screen. And since futures carry premiums to the VIX when the VIX has an extended decline, VIX calls here look fat to the naked eye that only compares them to the "cash" VIX. The reverse is true when the VIX runs high; VIX calls can (and do) trade under parity and puts looked pumped.

Of course moves in the cash VIX have some effect on VIX futures and options, but the further out you go in time, the more limited that effect. Think of this weather analogy. A hypothetical October Weather future let's you predict the average temperature in Al Roker's Five Day Forecast on October 15th. Would an unseasonably warm or cold day today effect your prediction of his prediction? Not a whole lot. Same way a move in the "cash" VIX should not have much impact on your prediction where traders will price volatility looking forward in October.

So bottom line; trade VIX options and you're trading a derivative (the option itself) on a derivative (the VIX future) on an estimate of a derivative (the VIX itself is merely a statistically calculated estimate of a theoretical SPX option with 30 days until expiration).

Volatility always assumes mean reversion, but often incorrectly. Right now, with options baked, mean reversion assumes the VIX goes higher. So ergo all VIX futures currently trade at premiums to the actual VIX. And since options price off the futures, all calls look too high to the naked eye, and all puts look low.

It is important to note this condition has existed for 6-7 weeks now. So not the best timing indicator if you spot it.

If you consider the market too high and/or volatility too low and want to fade "cheap" options into the morass, my strong recommendation is to use options on actual stocks/indices/ETF's. My personal preference right now is something that expires in the Fall.

Voodoo Banking Part 1

By Satyajit Das

Citigroup (C) recently announced that it was seeking Board members who had “expertise in finance and investments.” What was the experience and expertise of the Citi Board and senior management that has registered over $45 billion in losses? Shareholders, especially the ones that have provided over $40 billion in new capital, will be hoping that the new recruits also possess “magic” to restore Citi’s fortunes. The same applies to the banking sector generally.

Banking, especially investment banking, has delivered strong returns to shareholders in recent years. The “high” returns of financial stocks and the future earning prospects need careful examination.

Until the late 1970's or early 1980's, banking was highly regulated. It was the world of George Bailey (played by Jimmy Stewart) in It’s A Wonderful Life. Community banking was the rule. The banker could dip into his “honeymoon money” to stave of a potential bank run. It also fueled jokes - the “3-6-3” rule; borrow at 3%, lend at 6%, hit the golf course at 3 p.m.

Once de-regulated, banks evolved into complex organizations providing varied financial services. De-regulation brought benefits for the economy (better access to capital and more varied investment opportunities) and the banks (growth and higher profits).

Over the last 15 years, increased competition (within the industry and increasingly from non-banking institutions) and the reduction of earning from the commoditization of products forced banks to rely on “voodoo banking” - performance enhancement to boost returns. Focus on risk adjusted returns (introduced in the early 1990s by JP Morgan (JPM) and Bankers Trust) changed the “business model”.

Traditionally banks made loans that tied up their capital for long periods - e.g. up to 25/30 years in a mortgage. In the new “originate to distribute” model, banks “underwrote” the loan, “warehoused” it on its balance sheet for a short time and then parceled them up with other loans and created securities that could be sold to investors (“securitization”). The bank tied up capital for a short time (until the loans were sold off) and then the same capital could be reused and the process repeated. Interest earnings over the life of the loan could be discounted back and recognized immediately. Banks increased the “velocity of capital” – effectively sweating the same capital harder to increase returns.

In the traditional model, banks earned the net interest rate margin over the life of the loan – “annuity” income. When loan assets are sold off and the earnings recognized up-front, banks need to make new loans to be sold off to maintain earnings. This created pressure on banks to find “new” borrowers. Initially, creditworthy borrowers without access to credit in the regulated banking environment entered the market. Over time, banks were forced to “innovate” to maintain lending volumes.

Banks created substantial new markets for borrowing:

• Retail Clients: Expanding traditional lending (housing and car finance) and developing new credit facilities (credit cards and home equity loans).
• Private Equity: Providing borrowings in leveraged buyouts and sundry other highly leveraged transactions.
• Hedge Funds / Private Investors: Providing (often) high levels of debt against the value of assets.

Banks increasingly also out sourced the origination of the loans to brokers, incentivized by large “upfront” fees.

The expansion in debt provision relied increasingly on quantitative models for assessing risk. It also relied on collateral - the borrower put up a portion of the price of the asset and agreed to cover any fall in value with additional cash cover.

The model allowed banks to expand the quantum of loans and allowed extension of credit to lower rated borrowers. Banks did not plan to hold the loan long term and were only exposed to “underwriting” risk in the period before the loans were sold off. Where the loan was collateralized, the value of the asset and the agreement to “top up” the collateral where the asset value fell was considered to provide ample protection.

Favorable regulatory rules (the capital required was modest), optimistic views of market liquidity and faith in models underpinned this growth in lending.

Riding the Elliot Wave

By David Waggoner

(Observer's note: This is again by David Waggoner on Elliot Wave. Later I'll post more about "golden spiral" when I see some good articles on it.)

Eliminate all other factors, and the one which remains must be the truth.
– Sherlock Holmes, The Sign of the Four

I am an Elliottician. I believe there's a deterministic natural rhythm to the markets that's called the Elliott wave principle (Ewp). I believe it to be truth. Unlike many other technical indicators, it works all the time and it's only the analyst's interpretation of it that fails. The pattern is always there and it's always correct. Everything else is periphery; fundamentals, all other forms of technical analysis, even social evolution itself. Everything that's rooted in behavior follows the natural rhythm of the Elliott wave principle. It's a law like gravity and electricity. And like gravity and electricity, we don't have to fully understand it in order to use it.

I call myself TheMarketDetective. I spend each day, every day, tracking and interpreting the truth. I report my sleuthing in my analysis. I will attempt to explain my analysis for those who want to learn my methodologies, but I will also present actionable opportunities based on clues I uncover in the market that anyone can use.

Forecasting the future with the Elliott wave principle is scientific in its approach; there are 13 simple patterns to the Elliott wave principle that connect and combine in a limited number of possibilities. By identifying Ewp patterns in charts, we can use logic and Fibonacci mathematics to deduce which other Ewp patterns most likely will follow suit. Often, there are several alternatives, but sometimes we can fine tune it to only one possible outcome.

There are two types of wave combinations that occur, impulsive and corrective. Impulsive combinations are found in the direction of the larger trend in force, and corrective patterns are primarily in the direction opposite that trend. Therefore, the manner in which the patterns come together can provide important clues regarding the primary direction of trend.

In order to get to the scientific part you must first correctly interpret the wave patterns - not always an easy thing to do. In fact, this part may be more art than science. For me, being right more often than being wrong came only after thousands of hours of practice. Perhaps I can shorten the learning curve for you. If you want to learn more about the Elliott wave principle, the best place to start is the biblical text; Frost and Prechter's: Elliott Wave Principle.

The wave principle spans the whole of social evolution. I'm only going to focus on the part we can trade. In the three charts that follow, I will provide my perspective of current cycle, primary, and intra-day Ewp patterns.

I'll start with the cycle trend. I call this chart, Prechter's revenge. Robert Prechter Jr. believes that 2000 was the top of the Super Cycle: a 5 count impulse wave up that started in 1932. When the market rallied back from the 2002 low and made a new high, most market watchers quickly dismissed his thesis (and with it the Elliott wave principle). More recently he suggested that 2000 was in fact the top and we are in the midst of a corrective flat. In a classic case of crying wolf syndrome, no one believes him. I do.

I have never seen anyone else attempt to provide a detailed wave count to substantiate his flat theory, but I have done so here. I have also added a probable path of decline based on common Fibonacci wave relationships (in price only: not time).

Prechter's Revenge

It's tempting to go all in short and wait it out isn't it? There are other possibilities however, so it's probably best to focus the lens on multiple timeframes in order to maintain a total perspective, and trade the cycle trend one wave at a time.

Change always starts at the smallest degree and ripples out to the larger degrees. Let’s look at the chart below labeled primary trend for more clues.

At the level of primary trend, based on the evidence of Elliott wave rules, guidelines, and Fibonacci ratio analysis, we have probably completed five waves down and three waves up. The question now is have we resumed the down trend, or are we in a downward correction of the counter-trend correction (which is up), which I will call a correction of the correction.

Primary Trend

The wave patterns are often difficult to interpret short-term at this degree, so I will focus the lens one degree lower to see if the evidence is clearer. Elliott wave patterns are believed to be fractals. Different time frames fit together like Russian nesting dolls. By examining the smaller time frames we can gain detailed insight into the probable direction of the larger ones. Conversely, we sometimes rely on the larger ones to see the forest through the trees when the shorter time frames become too complex. It is a constant balance of interpretation.

In the chart labeled 60 minutes, we can see that on April 7th of this year, we completed the counter-trend corrective combination up called a double zigzag. The end of this pattern clearly indicated a turn, but is it the turn?

Again, based on the evidence of Ewp rules, guidelines, and Fibonacci ratio analysis, I interpret the recent downturn to also be more corrective in nature than impulsive. The wave count shown on 60 minutes is another double zigzag with a close to perfect 11 Fibonacci ratio (outside numbers). It is the cleanest interpretation I can identify on intra-day charts.

However, we're at a crucial test point. We can only sustain a very limited continued downside without a significant 3-wave bounce for this to remain the highest probability. A small extension of the last wave down into Monday’s close, say 1320-1322 would be the preference. This happens to coincide nicely with a .500 Fibonacci retracement of the entire counter-trend double zigzag up from the bottom (inside numbers), a common retracement.

60 Minutes

If this thesis is correct, and we bounce, one of two things will happen. We either resume the counter-trend rally up toward our next Fibonacci target (Read about Fibonacci ratio targets here), or get a significant 3-wave bounce, similar in degree to the bounce on April 10th, and then turn back down. If we bounce and turn back down, it will be the last wave of a correction of the correction. The Ewp rule states that corrective waves can only extend to 3 corrective combinations. We've either completed or are a fraction away from completing two of the three allowed in this wave set. Another turn down after a bounce would also most likely end at 1322 or 1307.

It's important to always look for alternatives with Elliott wave analysis. When I have options to choose from, then I'm confident that good detective work will guide me to the correct one. If and when my preferred option fails, however, I usually have an alternate count/thesis to fall back on. Unfortunately, this happens more often than I would like.

There is a technically feasible impulse wave count combination down from the April 7th high on an intra-day basis (see the chart below: Ugly Duckling). It's undesirable in its symmetry and it contains minor rule breaches. It's clearest on a chart of the E-minis. On the other hand, the Fibonacci ratios are acceptable, and the daily time frame is starting to look like it could turn into an impulse swan.

This is our alternate wave count. It increases in probability if we're unable to get the expected bounce before turning down again. If the slide continues without a significant bounce, and we don't bounce until 1307 -- and we will bounce at 1307 if we go there on this trip down -- then I give the ugly duckling a higher probability. The reason is simply that a 1:1.618 Fibonacci ratio is more common for an impulse wave3 than a corrective wave. It can still be a corrective wave, but the odds will have shifted in favor of our possible swan.

If it comes to this, then the bounce from 1307 will be the next critical test. If we can bounce above 1352, then a correction of the correction thesis returns to front and center. If we can’t, then the ugly duckling will remain our primary thesis and we prepare to head lower. The reason is another rule: wave 4 never moves beyond the end of wave 1.

An impulse wave count down from here would also slightly diminish the cycle trend 2nd wave count thesis. If we are in the 2nd wave at cycle degree, a .382 retracement of wave1 is the least common Fibonacci ratio target.

Ugly Duckling

I've covered a lot of material. If you do not have prior exposure to Ewp, and you are still reading this, you might think that there is Kool-aid in my water supply. No doubt about it, this is extreme technical analysis. Predominant thinking cannot even clear the first hurdle of considering that the markets are deterministic, let alone that the pattern can be interpreted by a lone trader with a data feed and a PC rather than the world’s fastest super computers and a room full of quantitative analysts.

All I ask is that you keep an open mind. I'm confident that I will present you with some accurate market calls that cannot be derived from any another type of analysis.

I've already condensed the unlimited possibilities of a random walk down to just a few probabilities.

Stocks Love Symmetry

By Divid Waggoner

“Beauty is Truth, truth beauty, - that is all Ye know on earth, and all you need to know.”

-Ode on Grecian Urn, John Keats

“God does not play dice with the universe.” -Albert Einstein

The mathematical basis for the Elliott wave principle is Fibonacci mathematics. Leonardo Fibonacci was a 13th century Italian mathematician who is credited with the sequence of numbers bearing his name: 1,1, 2, 3, 5, 8,13, 21, 34, 55, 89 and so forth. Beginning with the number 1, each new term is the sum of the previous two.

It is believed that Fibonacci learned of the additive sequence while studying with Arabs in North Africa. He introduced it to the Western world in his famous book Liber Abaci (Book of the Abacus). The more relevant contribution of the book at that time was the introduction of the Arabic numeral system, which is now used throughout the world as the decimal system. It replaced the Roman numeral system that was in use at the time in Europe.

The additional mathematical fact of the Fibonacci sequence is that the ratio of any two numbers in the sequence approximates 1.618, or its inverse, .618 after the first several numbers. The higher the number, the closer to .618 and 1.618 are the ratios between the numbers. The Fibonacci sequence can be visualized geometrically as a mathematical grid growing larger (or smaller) in which each new unit always bears a relationship of .618 or 1.618 to its predecessors.

The number .618, or to be more exact, .618034... is an irrational number that is known as the golden ratio or "Phi." The Greeks held this ratio to be divine. Plato establishes it in his Socratic dialog of creation, Timaeus, as the mathematical basis of all creation.

The Golden Ratio In The World

The divine ratio was central to Greek thought and the works of Pythagoras, Euclid and Eudoxus. It governs geometry’s golden section, golden rectangle and golden spiral. In Greek architecture, its proportions are responsible for the incredible symmetry of proportion found in the Acropolis and the Parthenon. 2,000 years before Greek civilization, the Golden ratio is found to consciously be incorporated in the construction of the Great Pyramid of Cheops(2,560 BC) and other structures of ancient Egypt. (This is also explained in Timaeus.)

In nature, the Fibonacci sequence and ratios are found in vertebrate, tree branches, honeybee populations, the flight path of birds, the swimming path of fish, pinecones, sunflowers, shells, pineapples, hurricanes, whirlpools, ferns, clouds, flower petals, ocean waves, spiraling galaxies, lightning, snails, animal horns, DNA (the double helix), and, as depicted in Leonardo da Vinci’s Vitruvian Man and On the Divine Proportion, the human body.

Many great thinkers throughout the ages have been obsessed with the golden ratio. Famous scientists were in awe of how it repeated persistently throughout their work. Famous artists, recognizing its aesthetic quality in nature, reproduced it in their work.

Johannes Kepler, the famous astronomer, believed that the golden ratio described virtually all of creation. Isaac Newton, physicist, had the golden spiral engraved on the headboard of his bed. Pythagoras, mathematician, chose the 5-pointed star, in which every segment is the golden ratio to the next smaller segment, as the symbol of his order. Jacob Bernoulli, mathematician and astronomer, directed the golden spiral be etched on his headstone when he died. Leonardo Da Vinci used the golden ratio in much of his art to enhance its aesthetic appeal; the Mona Lisa employs the golden ratio. Mozart consciously used the golden ratio in his sonatas.

The golden ratio is central to arithmetic, algebra, geometry, trigonometry, proportion, architecture, electronics, and music. (According to H.E. Huntly, author of Divine Proportion, the golden ratio naturally appears in the relationship of the intervals or distance between notes in music.)

Fibonacci numbers and the golden ratio are evidenced and accepted as fact to exist in the progress of the cosmos, botany, physics, geophysics, astronomy and biology.

Therefore, is it too much of a leap to accept that human progress might also have form? And if human progress has form, then isn't it a logical conclusion that the stock market, which is a representation of man's progress on this Earth, would embody that form? And wouldn't that form show up in a chart?

The Golden Ratio in the Markets

R.N. Elliott discovered the golden ratio and Fibonacci sequence of numbers, the same persistent, repeating structure and unity evidenced throughout the universe, in the charts of the stock market.

The golden ratio in the stock market is the proportionate relationship of one wave amplitude to another. There is also evidence to support that these relationships exist in time. In my experience, the proportionate amplitude of waves can be detected more easily and consistently for forecasting than time. (But, it doesn’t stop me from trying to figure out time also.)

The following Fibonacci ratios are the most commonly found ratios in the stock market: .382, .500, .618, 1.00, 1.618, and 2.618. These ratios can be applied as either extensions or retracements of wave patterns to forecast price action.

For example, the structure of a motive or impulse wave is 5-3-5-3-5. The most common expression of the golden ratio in a motive or impulse wave is that wave 3 extends to a 1.618 ratio of wave 1, and, in such cases, wave 5 tends toward a .382 ratio of the entire length of waves 1 through 3. Let's take a look at the primary trend wave count thesis to see if these desired proportions are present.

Using a Fibonacci extension tool available with most charting software, one can determine that the actual proportions of the waves are consistent with my thesis: wave 3 is very close to a 1.618 ratio of wave 1, and wave 5 is close to a .382 ratio of waves one through three. That is a powerful confirmation that we have completed five impulse waves down and an example of how the golden ratio presents in the stock market.

Golden Ratio Present in Stock Market

Continuing with my primary trend thesis, I suggested that we were probably in the process of a counter-trend rally second wave. We will now use Fibonacci ratio analysis to target probable turning points. First I will apply a retracement of the entire move from the top.

The inside band of Fibonacci numbers are the resultant retracement levels. Last week I identified a completed counter-trend double zigzag at the 60min level, and I suggested that the downward move from that point was probably a correction of a correction. I then deduced that since we were almost finished with another double zigzag, and near the .500 Fibonacci retracement level, we had a strong set up for a turn. That was in fact correct. With a confirmed turn, I can now project a Fibonacci extension of the double zigzag from the bottom (W-X-Y).

The double zigzag is now part of a larger combination at one higher level of degree, and I have new information to include in our calculations for probable targets. In doing this I have an overlap of two Fibonacci relationships. Both the .618 retracement level and the 1.00 extension are at the same level. This is now my most compelling target for two reasons: 1) A 1:1 ratio is the most common extension of a corrective combination. 2) A .618 to .81 retracement is the most common retracement for a second wave.

New Probability Target for Retracement

Here is one more example of Fibonacci ratios in the stock market on the same chart. I mentioned earlier that second waves most commonly retrace .618 - .81. Take a look at the ratios of all the second waves down from the top.

Repeating Fibonacci Ratios in Stock Market

The relationship between accurate wave counts and the golden ratio is key. It is the best method for proofing wave counts. If the symmetry isn’t there on some level, the wave counts are probably wrong. Nature loves symmetry and proportion, and so does the stock market. Coincidence? What would Isaac Newton think?

References:

Elliott Wave Principle: A.J. Frost and Robert R. Prechter

Secrets of the Great Pyramid, Peter Tompkins and Livio Catullo Stecchini

A Conversation with Nobel Laureate William F. Sharpe

Recently IndexUniverse.com Assistant Editor Heather Bell spoke with William F. Sharpe, the recipient of the 1990 Nobel Memorial Prize in Economics for the development of the Capital Asset Pricing Model [CAPM]. Dr. Sharpe is the STANCO 25 Professor of Finance, Emeritus at Stanford University and the founder of Financial Engines, Inc., a provider of investment advice and managed accounts to defined contribution plans. He is also the creator of the Sharpe Ratio.


Index Universe [IU]: Can you tell us a little bit about your recently published book Investors and Markets: Portfolio Choices, Asset Prices, and Investment Advice?


William F. Sharpe [Sharpe]: I was invited to give some lectures at Princeton University and turn that into a book. I decided this would be a good opportunity to think about equilibrium and capital markets and what that means for investors and investment strategy and policy. What did I think I had learned, not only in the mean variance days of the capital asset pricing model and Markowitz, but also from all the things that people have done since then? I wanted to bring it all together. That seemed like a great undertaking; little did I realize where it was leading.


In the course of working on the lectures, I leaned more and more toward writing a simulator and just going back to first principles. The premise was that you had people coming together and trading with each other until they didn't want to trade anymore. What could you say about the outcome and prices and risk and return? I started writing this simulator, and it became a lot of fun but a lot of work.


In the old days, we made a lot of simplifying assumptions. Harry Markowitz decided to assume people care only about the mean and the variance of portfolio returns. And I thought if that were true, we should figure out what we could say about equilibrium, risk and return, and the CAPM.
In this setting, I asked if people care about something other than the mean and variance of portfolio returns, and what if return distributions could be anything? What's left? What can we say about how prices are determined? And more importantly, once you've got prices determined in a competitive market, what does that imply for what we ought to do with our money when we invest?


I also wanted to make it accessible, and I wanted to try to show academics in particular that this in many ways was a better way of teaching finance than the traditional way—in some ways simpler and certainly more general and potentially more fun—and push the notion of simulation as opposed to analytic closed-form mathematical models as an interesting way to look at things and make them seem more plausible.


IU: How should investors approach asset allocation?


Sharpe: The first thing you have to do is figure out what your objectives are. This isn't trivial: What are you trying to accomplish? What are your preferences for risk and return? What are your needs for things like liquidity?


Second, you have to figure out what your pre-existing sources of risk and return are. Do you own a house? If so, where is it and what risks are likely to impact its value? What about your job and other assets that are not in the portfolio?


One of my favorite diatribes is, "How can you possibly do your asset allocation without looking at the market values of the asset classes out there today?" That's probably the most valuable information you can get as to the future prospects of those asset classes, and what astounds me is the fact that many people—many of them very sophisticated—do asset allocation without even checking to see what the relative values of the outstanding shares in, say, European securities, U.S. securities, emerging markets, etc., are.


IU: Should investors index?


Sharpe: I think that indexing covers a multitude of sins, but I also think indexing is a good idea for a nontrivial part of your money. I'm not saying you have to index everything, but I'm a big proponent of indexing. It also has to be cheap indexing. There are index funds that egregiously charge 100-plus basis points, which is insanity.


IU: Are there asset classes where it makes sense to go with active management or is across-the-board indexing a good way to go?


Sharpe: Whenever you're doing active management, you have to think of it as you're betting your manager is enough smarter than the average active manager in that sector to overcome all the added costs. You could make the argument that if a sector is really well researched and there are a lot of people trying to find mispriced securities, the chance of finding an active manager that can cover costs and provide a net alpha is much smaller than in an area which is under-researched and under-examined. A number of consultants used to advise indexing the big markets and going active in the little ones or the obscure ones. Nowadays, however obscure the market is, there seem to be a lot of people studying it, so that game is a little harder to play, I think.


IU: Do you think fundamental indexes are a valid way to represent the market?


Sharpe: No. I love the way you stated it because I can answer it unambiguously. There are so many shares of IBM and so many shares of General Motors and so many shares of Little Widget Manufacturing, and to represent the market you buy 1% of the shares of IBM and 1% of the shares of General Motors and 1% of the shares of Little Widget Manufacturing—and then you've represented the market. Anything else can't represent the market, because when you add it up, you don't get the market. If you want to represent the market and if you want a return equal to the return on all the money invested in that market, you're going to own the same proportion of the shares outstanding of every security in the market period. A fundamental index is going to get a different return: If it is value-tilted, as most of them are, you're going to win when value stocks do better than growth stocks, and the index fund people will get the market's performance.


If you beat the market, some dummy somewhere who has taken the other side of your trades is going to be beaten by the market before it balances out. There's no magic in it: Basically, for everybody who overweights small cap or value, somebody else is going to be underweighting those relative to the market cap, and the index fund people are going to be fat and happy in the middle. You can call it whatever you want to call it, but it is a deviant position from the market, and if it beats the market, somebody else is going to get beaten by the market. It's that simple. But this sophistry that it's more representative of the market makes no sense at all, unless you suspend all the rules of logic.


IU: How important is international diversification?


Sharpe: I'd have to say probably less than it used to be. I think what we're seeing is a lot more correlation of markets around the world, and it makes a lot of sense. We've got much more integration of trade, and we've got much more integration of financial markets. In some ways, if you buy shares in all the companies that are headquartered in the U.S., then you've got probably a more global portfolio than if you'd done that 25 or 50 years ago. The benefit of having companies headquartered in different countries in your portfolio is probably less than it used to be, but that is not to say that it isn't there and it isn't worth doing.


IU: Do you think commodities have a place in the average portfolio?


Sharpe: Probably, but there are a couple of caveats. When you buy publicly traded equities, you're getting commodity exposure. Sometimes it's as an input, sometimes as an output. When you buy some of the energy companies, you're getting exposure to oil. Sometimes the companies are hurt more when oil goes up; sometimes the companies are helped when oil goes up. But it's not as if you don't have commodity exposure in a traditional equity portfolio.


Also, if you look at the value of the commodity exposure that maybe you don't have in your portfolio, that may not be a huge amount of market value. Things that don't have much market value—if they have low correlation with other assets and are therefore desirable on the risk front—in an efficient market would also not have particularly high expected returns.


IU: What do you think of ETFs?


Sharpe: In general, I think they're a great idea to the extent that they can provide a real index fund that makes sense and do it at least as cheaply as a traditional open-end mutual fund. I have nothing against them.


But I'm with Jack Bogle on the fact that people use them as trading vehicles. It's just obscene what the turnover is of ETFs. Of course, it's also these wildly narrow ETFs, short funds and tiny little sectors. What's that all about? You could say that they allow you to customize your funds so they complement your job, your house, your mortgage, etc., and maybe there's some of that. But I think, as with anything else, here's a good instrument for "investing" that a lot of people are using to make bets.


IU: Are people saving enough for retirement?


Sharpe: Many people are not saving enough. You have to start with what you think you are going to get from public programs like Social Security and Medicare. Then you have to work your way back to what you've got to provide on your own. Everyone who looks at the financial situation of the entitlement programs in this country realizes that somebody is going to have to put more money into this system or somebody is going to have to get less money out of the system.


You start with the publicly financed part of your lifestyle in retirement, and then you have to look at what you have to provide to complement that to provide for a sensible lifestyle after you retire. If people continue to put aside as little in their individual savings and in their 401(k) plans as they are now doing, then you come to the conclusion that they're either going to have a miserable retirement or they're going to work a lot longer than previous generations worked—or they're going to have to figure out a way to die sooner.


At Financial Engines, when we see what people are doing in terms of their investment strategy and their current savings or 401(k) plan, we sometimes show them if they keep doing what they're doing, the chances that they'll have a retirement with, say, more than 50% of their pre-retirement real income are 31%.


Once they see the implications of what their current course is, many will choose to save more. That's a pretty direct indication that many people are not being counseled or given good projections of the range of outcomes.

Learn the Best Times of the Day for the Best Trades

By Kunal Vakil from TradingMarkets.com

Developing a trading methodology and rigidly following your money management rules represent only part of the struggle in becoming a successful day trader. Equally important as the question of "how" is "when." You may have very proficient trading systems and be able to follow your rules, but understanding when to place trades can take your game to the next level. As an active trader, you need to be aware of these different time zones as some of them may be more prone to generating legitimate breakouts and breakdowns while others may be more conducive to range-bound trading.

I want to cover the market dynamics that occur during the different segments of the trading session. Remember, make the game come to you; do not chase the game. Most trading systems will work better in either trending or range-bound markets, but not both.

The Opening Bell - 9:30am to 9:50am

Exercise caution during this time frame; it is the most volatile trading period of the day. Unless you are an extremely talented day trader, it is best to stay out of the market and wait for the imbalances created from overnight news or earnings releases to settle down. The extreme nature of the volatility renders many technical indicators useless. In most cases, volume will also be the highest of the day during this time, and price swings will make it very difficult to set appropriate stop-loss orders.

The Morning Reversal- 9:50am to 10:10am

The first reversal zone of the day begins at around 9:50am and lasts for about 20 minutes. Day traders need to pay close attention to this time frame; many traders will put on continuation trades, or buy stocks which set new 30-minute highs and short stocks setting new 30-minute lows. Other traders may look to buy stocks that have had small retracements after a large morning gap and short stocks that have had minor retracements off strong gaps to the downside.

Once the dust has settled from the opening bell, you will be able to more clearly see what the traders in this security will want to do. Volume will drop off a little bit compared with the opening 20 minutes but will still be very high during this time. This time period is my favorite for trading as the price stability returns to the market but volatility is still present for profitable trading. In strongly trending markets, reversals may be small or non-existent. This can especially be the case when an index gaps higher on the open and continues to break to new highs during this time period.

Low Risk Trading - 10:10am to 10:25am

During this day-trading time zone, volatility shrinks again and you want to look for clues in the Dow, S&P, and Nasdaq as to the direction that the market wants to take. This is an opportune time for bigger traders to move the market the way they choose. Keep a close eye on the time and sales window of the stocks you are tracking and look for an indication of strong buying or selling to help you gauge the direction of the next move.

Which Way Will You Go? - 10:25am to 10:30am

By this time, the markets will be settled for the most part and most of the day's volatility will have passed. There may have been a few reversals in the first hour, but during this small zone many traders will cash out of profitable positions and finish the day while others will position themselves for the next move in the market. Consolidation and preparation for the next move describe this time period. This can last until lunchtime.

Final Move of the Morning - 10:30am to 11:15am

This time zone will be the final major time zone as far as morning trading is concerned. This time zone is safer in relation to the other zones in that technical indicators such as the slow stochastic or RSI will have a more pronounced effect than in some of the earlier time zones. Be careful near the end of this range as it leads right into the lunch hour, which can start early or start late. A general rule of thumb is that the more volatile the preceding day-trading time zones are, the greater the chance that this move will extend further into the 11 o'clock hour.

Take a Break & Take Lunch - 11:15am - 2:15pm

Lunchtime trading can be a tough trading environment. False breakouts and choppy sideways moves characterize this time period. If you must trade, tread lightly in this time zone until you develop consistency. Also, please let me know how you do it! The risk-to-reward ratio is very high here. Volume will fall out of the market as floor traders and other institutional traders will take their lunches. Don't let this time zone turn profitable morning trading into a loss.

Back to Work - 2:15pm - 3:00pm

Traders will work their way back into the market during this timeframe. For the most part, trends have been established and trading during this timeframe will provide you with opportunities where the use of technical indicators is applicable. Remember, the CME closes at 3:00pm so you will see a pickup in volume due to some of the bond traders coming into the equity and futures markets. Keep in mind, a low volatility morning session usually portends low volatility during the afternoon. Stay cautious in this situation.

It's GO Time - 3:00pm - 3:10pm

Bond market closes and bond traders will flood the equities markets; watch for sharp moves in either direction. Moves can be fast and large.

Use Caution & Stay with the Trend - 3:10pm - 3:25pm

During this day-trading time zone, use caution as you are approaching the 3:30pm timeframe, which tends to produce a reversal or a stall of the prior trend. During this zone, you want to stay with the trend that has been established from the 2:15pm and even 3:00pm timeframe but don't get attached to the positions.

Portfolio Re-balancing - 3:30pm - 4:00pm

I tend to recommend traders not trade during the last half-hour of the day. There are many funds and institutions rebalancing their portfolios, and it can get a bit tricky. If you're day trading, you only have 30 minutes max to get out of your trade and I don't like working under that type of pressure. If your an action junkie or like putting on very short term trades, the volatility is there for you do so.

Conclusion

As you can see, the chart setup or systems that you look at are not the only factors in putting a day trade on. Remember, day trading is not absolute; it is a game of odds. Your job is to put the odds in your favor and by using the different day trading time zones, your trading will become more consistent and profitable.

See you at the top.

Kunal Vakil is the co-founder of www.mysmp.com (My Stock Market Power) which provides free trading articles and videos to investors covering a broad range of trading topics. Prior to becoming a full time day trader, Kunal designed bond trading systems for one of the largest secondary mortgage market participants and provided management consulting services to many top financial services companies.

From the S&P to Tiffany: Big Plans? Start Investing Now

By Scott Rothbort at thestreet.com
This month, many a college graduate will have completed the academic aspect of his or her life and will soon move on to the "professional" phase of life. Whether you're a recent graduate or know a college grad, let's take a look at how to invest upon entering the labor force, with a few big-budget plans in mind.
Your Wedding

I am now about to tell you something which will no doubt in my mind, rip the heart out of young brides to be. At the same time, it will be among the best financial advice that any young couple will ever receive.

Imagine buying that dream car you always wanted. You scrapped and saved $50,000 for this heavenly vehicle. You paid for it, drove it out of the show room, motored around for four hours and then proceeded to push it off of a cliff.

Now imagine doling out $50,000 for a four-hour wedding reception. After the four-hour party, other than a good meal, some photographs and probably useless wedding gifts, all that you have managed to do was toss $50,000. However, perhaps you will receive some nice cash gifts.

It is about this time that I get the horrific looks and emotional pleas, explaining to me how special a wedding is. I am usually told that I am devoid of romance. My response is that with more that 50% of marriages doomed to failure, there is no correlation between the amount of money spent on a wedding and the success of the marriage. Long term, what really counts, is not the money you put into your wedding day, but the money (and everything else) you put into the actual marriage.

Now, if you can get over the wedding issue, then Bar Mitzvahs, anniversary parties, sweet sixteen parties and other big-budget social events will be financially easier to navigate.

Despite my admonitions of spending too much on weddings, people will continue to do so. That said, how can you invest in the engagement and wedding market? Here are a few ideas:

Jewelers: Take a look at Tiffany (TIF) which not only sells diamond rings, but is also a big destination for bridal registry. If you want to profit off of the less upscale market, research a a mall-based jeweler, such as Zales (ZLC) or Web-based jeweler, such as Blue Nile (NILE).

Caterers: While most weddings take place at local catering halls, religious houses of worship or private clubs, many hotels are in the wedding catering business as well. If you're interested in this investment theme, then investigate Marriott International (MAR) or perhaps Starwood Hotels & Resorts (HOT).

Flowers: What would a wedding be without flowers? Maybe FTD Group (FTD) has the right investment assortment for you.

Your Wheels

Rather than buying a $50,000 dream car, you might want to save and invest for your dream house instead. So before you blow your hard earned money on a car, consider these two points:


Leasing an automobile is expensive and is a short term solution because most leases have finite life spans, which are far less than the average life span of a car. Only in certain circumstance, such as when the car lease is in the name of a business, will leasing a car make sense because of the inherent tax benefits.

I believe buying an automobile is the correct financial decision. This big question: Buy a new car or a used one? This is a judgment decision of which there are pros and cons to each side. A new car is more expensive, but gives the owner the peace of mind that the car is in factory condition. A used car is less expensive, but could have problems associated with wear and tear or damage from the prior owner.
A happy middle ground is to purchase a factory authorized used car, which includes warranties that are not available from a typical used car dealer.

In the terms of investing in the auto market, I would not point you in the direction of any domestic or international auto-makers. However, on the basis of some research that some of my students at the Stillman School of Business at Seton Hall University performed last semester, there are two stocks in a related industry that are intriguing:


Advance Auto Parts (AAP): This company sells automotive replacement parts. With more used cars on the road and as new car sales decline, companies like Advance Auto Parts will benefit from increasing part sales. Advance Auto Parts has had a solid record of low double digit earnings growth.

CarMax (KMX): CarMax is the largest retailer of used cars in the United States. If the public is not buying new cars, then they are buying used ones. However, when you consider investing in CarMax, be careful. In addition to selling used cars, the company is also involved in auto loans, through its financing arm. Given the current state of the credit markets, especially asset-backed securities , the auto loan part of CarMax's business could be problematic.
Your House

There is a very simple maxim that I will pass on to you. A house is a place to live. Unfortunately, too many people got caught up in the housing madness of the 2000s and thought otherwise.

Many homeowners simply do not have a detailed enough understanding of the costs of home ownership -- above and beyond mortgage payments.

In recent years, people were buying overvalued homes with no money down. This varied dramatically from the typical down payment requirement of 20% for a conventional mortgage. My wife and I put down 40% on our first home, which we purchased not long after we got married.

How did we accomplish that while still in our twenties? Here is how we did it:


We saved a lot of money from not having an extravagant wedding. Our wedding was at a nice suburban caterer and cost a little over $5,000. However, our guests were very impressed with the affair and thought it cost much more than that.

We both saved money from working hard for seven years.

Personally, rather than spend money received from a grandparent on frivolous goods and services, I started to invest at an early age.
Now what can you do to afford that dream home?

Let's make a few assumptions: the house will cost $300,000, you will put down 20% ($60,000) and you plan to buy the house in eight years.

Now let's say that you can get a 6% return on your invested money per year. With the average return of the S&P500 over the long term at about 9%, you can earn 6% with a blended portfolio of fixed income investments and the market return, which can be earned in an index fund or an ETF like the SPDR Trust (SPY). Assuming this 6% target rate of return, you would have to invest $488.49 every month to earn that down payment in eight years.

Whether your goal is to accumulate enough money for your own home or any another big-budget dream, there are ways to accomplish your financial objectives. The key steps:

1. Start saving and investing money as early as possible.

2. Avoid costly expenditures that will not yield any future benefit.

3. Take advantage of savings and retirement plans (see TheSreet.com's Retirement section and BankingMyWay.com)

Editor's note: For more on weddings, don't miss "Wedding Loans: Till Death Do You Owe."

Survived The Finals!!!

This place has been deserted for the past month while I was buried under tons of deadlines to meet ... I'm glad that I've survived all of that and am ready to add posts regularly again.

During the past few days I've been thinking over this blog and want to classify my future posts into three major aspects: fundamental analysis, technical analysis, and quantitative analysis. Articles on financial planning and bond markets will also posted as my interests expands but won't be the mainstream here. My goal is to post ideas of others here and gradually (and hopefully) to start writing my own ideas down sooner than later.

Exploiting Behavioural Bias with a Quantitative Model

By Todd Kennedy, Senior Portfolio Manager, SSgA - Australia

(Observer's note: I happen to find this interesting article on behavior finance while searching information on quantitative modelling. The biases mentioned in this article are commonly found among inexperienced individual investors, and therefore worth of being recorded here.)

Markets are not fully efficient, and investors are not always rational. In recent times the body of evidence supporting behavioural finance models that attempt to explain market inefficiency and the nature of investor irrationality has been mounting. If we understand the behavioural biases at work in equity investing, we can not only avoid making the same mistakes ourselves, we can profit from the mistakes of others.

Following on from the recent essay by Arlene Rockefeller1, this essay discusses the SSgA active Australian equity model, and explains the underlying behavioural biases that we attempt to systematically exploit using our quantitative approach.

We use growth factors to exploit the fact that in the short-term, stocks under react to market information. We use value factors to exploit the fact that in the long-term, stock prices over react, and we use a quality factor to avoid value traps.

Behavioural Biases that Lead to Mis-Pricing
There are numerous behavioural biases that are displayed by people generally. Some of these lead to poor investment decision-making and, collectively, these biases work to cause mis-pricing in equities. A brief description of the biases that affect stock prices follows.

Anchoring Bias
Anchoring is the bias whereby people irrationally cling on to some fact or information that should not affect decision-making. Experiments have demonstrated that when people are shown a number they know to be meaningless, that number still has influence over their decisions2. If this is true, then it is particularly hard to ignore such powerful anchors such as daily share prices when they are so readily observable. If a stock rises or falls significantly in one day, the stock is viewed as more expensive or cheap relative to the previous day, ignoring or discounting any new information that has become available. This leads to short- term under reaction to new information as stocks price in the new information gradually rather than instantly.

Herding Bias
We know that people in society tend to conform to the behavior of others even when the behavior is irrational, forsaking their own judgment in preference for following the actions of others. History supplies numerous examples of extraordinary group behaviour such that the power of herding can not be ignored. We may think that the madness of the tulip bubble in the mid 17th century, when people risked their life savings to speculate on the price of tulips3, would never be repeated in modern times. However, aspects of the recent technology bubble present uncomfortable parallels. Herding perpetuates stock price momentum and leads to long-term overshooting of share prices on both the upside and downside.

Belief Perseverance/Confirmation Bias
Once momentum has set in from the above biases, it feeds upon confirmation biases. When a person buys a stock and the stock's price subsequently rises, they don't look for reasons to contradict their belief in its value, but rather they tend to seek confirming information only to reinforce their existing belief.

Prospect Theory
Prospect theory deals with how investors behave when faced with the prospect of a gain or a loss. Investors are generally more conservative with gains, and more reckless with losses than they should be. This leads to selling winners too soon to lock in gains, and holding onto losers too long to avoid losses. This is understandable as locking in a gain creates a feeling of joy, and removes the possibility of the position becoming a loss. With losses, a paper loss is often viewed as only a “potential” loss, but once the loss is crystallized, it becomes real and leads to feelings of regret. These natural human emotions work against us in an investment setting when being rational and dispassionate is required.

Mental Accounting
People tend to put gains and losses into separate mental accounts and treat them as individual positions, ignoring any offsetting positions within a portfolio. An undue emphasis is placed on the current gain/loss when making an investment decision instead of looking at the future prospects of the investment on its own merit.

Disposition Effect
The disposition effect is the effect that prospect theory and mental accounting has on asset prices. This behaviour generates short-term under reaction to news in the market4. Positive news for a stock generates excess irrational selling pressure as the stock rises, slowing its ascent to a new equilibrium as investors lock in gains and sell out too early. The slow march to the new value rather than a sudden jump to a new level is observed as positive momentum. Negative news has a similar effect. The reluctance to sell losers slows the stock price from reaching equilibrium. The additional marginal selling remaining creates negative momentum.

Hot Hand Fallacy/Law of Small Numbers Representativeness
People have a natural tendency to rely on recent observations more so than past events. They extrapolate this information too far into the future, when in fact more reliable longer-term averages are appropriate. In sport, this is known as the hot hand fallacy. A player is often selected for a crucial task on the basis of a good recent performance rather than a player with good long run statistics5. This is true in investing as well. People mistakenly believe that if a stock has gone up ten days running, it is hot and will continue to rise.

When only small numbers of observations are available, people form a belief that these observations are representative of a larger population of events. In reality, statistically random clustering of events occurs which can mistakenly be identified as a trend. Chance plays a larger role in investment returns than people tend to believe. At the portfolio level, this is known as idiosyncratic risk. The only defense against this is diversification.

Overconfidence Bias
Forecasting with skill is a very difficult thing to do. The error in a forecast, no matter how well made, is generally quite large. It has been shown experimentally that as people try to improve forecasts with a greater volume of information analysed, they often end up only increasing their confidence in the forecast rather than increasing the accuracy of the forecast itself6. Once a stock has been recommended or bought, a rising share price supports overconfidence as people generally discount the possibility that they are wrong. People tend to stay overconfident because they attribute success to skill, and failure to other external events that can be blamed.

Overestimation of Skill
It is common for people to overestimate their own skill. Studies have shown that 90% of car drivers think that they have above average skill7. In investments, 75% of fund managers think they are better than their peers8. Analysts and investors usually miscalculate the probability of their forecasts being wrong, and also underestimate the degree to which they can be wrong. As a result, inappropriately large portfolio bets may be taken based on a misguided belief of one's own skill.

SSgA Australian Quantitative Model: Growth, Value and Quality
The SSgA Australian quantitative model has two growth factors, two value factors, and a quality factor. The relationship between each factor and the behavioural biases that drive their success as investment tools will now be explained.

Growth Factor 1 - Momentum
Momentum is the observed phenomenon where rising stocks tend to continue to rise, and falling stocks continue to fall. It is a well researched effect, but many investment professionals struggle with understanding why it exists. Behavioural finance supplies the answers.

We have seen that Anchoring Bias, Prospect Theory, Mental Accounting and the Disposition Effect all act to create short-term under reaction to market information. The residual trading that is left to occur, as investors capitulate to accept the re-rated stock valuation, acts as a pressure on the stock price. This gradual rather than sudden price adjustment is how momentum is initiated. Once momentum has developed in a stock price, it is perpetuated by the actions of investors displaying Herding, Belief Perseverance, Confirmation and Representativeness biases. This leads to long-term over reaction to market information.

The collective action of investors following these natural human behavioural biases support the hypothesis that momentum will persist for the foreseeable future.

Momentum is exploited by buying stocks that are rising, and selling stocks that are falling. There are many variations available on the exact manner in which to do this, but all essentially work by picking short-term trends and following them. However, it is wise to look at other factors when engaged in momentum investing. We need to keep an eye on the deviation from fundamental value when deciding on how far to pursue stocks on a short-term basis.

Growth Factor 2 - Earnings Outlook
Our earnings outlook factor is used to monitor changes in analyst forecasts for a company. In some markets we monitor changes in analyst recommendations. In Australia we monitor the changes in forecast future earnings as we find that these have better explanatory power over future stock returns in the local market. However analyst forecasts are susceptible to Overconfidence and Overestimation of Skill biases.

Since we know that these biases act to create short-term under reaction to new information, we can incorporate new information into our model instantly with a factor that targets the changes in analyst estimates. Targeting the changes in the forecasts rather than the actual forecast also helps to avoid systematic behavioural biases in analyst forecasts.

Value
Whilst momentum makes trend following work in the short-term, it also has the characteristic of overshooting fair value, which in turn makes value investing work over the longer run. When people have succumbed to behavioural biases and pushed prices too far from fair value, it's time for rational investors to step in and force prices to revert to reasonable levels.

The trigger for mispriced assets to mean revert can be either dramatic news which impacts broad sentiment, it could be the combined action of value investors, or it could come from the listed company itself. A company's board is in the best position to assess their own future earnings potential. When they observe their share price being driven unreasonably high, they may issue additional shares. When their share price is unreasonably low, they may buy shares back.

Our value model has two components. They are Forward Earnings Yield and Dividend Yield. Our value factors attempt to profit from the mistakes of others by identifying these mispriced securities and trading in the opposite direction.

Value Factor 1 - Forwards Earnings Yield
One method of identifying stocks at extremes of valuations is to analyse the forward earnings yield a company is on. More conventionally, this is similar to looking at a company's Price to Earnings (PE) ratio. Low yielding (high PE) stocks tend to under perform high yield (low PE) stocks in the longer run. We collect forecast future earnings from a broad range of brokers to diversify the opinion base, and convert this information into yields. We then reduce the influence of behavioural biases by normalising the data so that all forecasts are forced into a standard normal distribution. This helps protect against anchoring biases in the data. The normalization process debases the anchors by forcing a mean zero value for estimates. We can then assess what is relatively expensive against what is relatively cheap.

Value Factor 2 - Dividend Yield
Dividend yield is a value factor that acts as a positive anchor for stock selection. If we expect a certain minimum yield to be paid for a company, we won't be drawn into paying too much for its stock. It is insurance against overvaluation as high stock prices would need to be supported by high dividend payments to be justified.

Quality Factor
One problem with value investing is identifying when a stock is getting cheaper for a good reason. These types of stocks are known as “Value Traps”. They appear to be good value on stock selection screens, but are actually investments that should be avoided. For example, high yielding stocks may be high yielding because they are about to stop paying dividends and their price has fallen already in anticipation of this expectation. Or as this factor seeks to identify, the quality of a company's earnings may be deteriorating and that deterioration is being concealed in the balance sheet. Our quality factor acts as a defense against earnings deterioration lead value traps.

Avoiding Biases with Quantitative Processes
Investors are influenced by behavioural biases. Some of these biases lead to predictable outcomes. Stocks are observed to under react to new information in the short-term, and over react in the longer-term.

We systematically capture these inefficiencies in the market by producing models that exploit these biases whilst using disciplined risk control and optimisation techniques to construct portfolios objectively and dispassionately. As long as the market continues to be influenced by behavioural biases, our models which are built to exploit them should continue to work. Consider the following.

Anchoring can not occur in a quantitative process if you do not supply anchors.
Overconfidence can be avoided by applying strict and systematic risk controls in the portfolio construction process.

Overestimation of Skill can be avoided by statistically calculating it. With a good estimate of the skill a process has, we can build portfolios that exploit the actual level of skill we have rather than the level of skill we think we have.
Prospect Theory will not be followed by a quantitative process that does not reference past gains or losses of individual positions.

Hot Hand Fallacies, Law of Small Numbers and Representativeness Biases can be replaced with back-testing of investment factors over significant time periods, and the predictive power of the model factors can be measured. Another way of avoiding the Law of Small Numbers problem is to keep an out of sample period which avoids overfitting.

Quantitative processes also remove the human constraint of the limit of brain power. People can only focus on a limited amount of information at any one time. This is why portfolios built by bottom up stock pickers are often concentrated portfolios.

The power of quantitative processes lies is in the rationale that if you can get the input data for every stock you can invest in, you can apply the process to all stocks simultaneously and build the best portfolio possible given forecasts of risk and return.

Summary
Markets are influenced by the behavioural biases of investors. It is possible to identify and measure the extent to which these biases are present in the market. It is also possible to construct quantitative processes that are not susceptible to these biases, and can systematically exploit the inefficiencies which irrational investment produces, whilst simultaneously controlling for risk.


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1 Rockefeller, A., (2006). “SSgA's Approach to Quantitative Active Equity Management,” State Street Global Advisors, 2006.
2 Tversky, A. and Kahneman, D. (1974). “Judgement under Uncertainty: Heuristics and Biases”, Science, 185, 1124-1130.
3 Mackay, C., (1841). “Extraordinary Popular Delusions and the Madness of Crowds”, Chapter 3, Tulipomania.
4 Grinblatt, M. and Han, B., (2005). “Prospect Theory, Mental Accounting and Momentum”, Journal of Financial Economics, 78, 311-339.
5 Gilovich, T., Vallone, R., and Tversky, A., (1987). “The Hot Hand in Basketball: On the Misperception of Random Sequences”, Cognitive Psychology, 295-314.
6 Oskamp, S. (1965). “Overconfidence in Case Study Judgements”, Journal of Consulting Psychology, 29, 261-265.
7 Kahneman, D. and Riepe, M., (1998). “Aspects of Investor Psychology”, Journal of Portfolio Management, Vol. 24, No. 4.
8 Montier, J., (2005). “Seven Sins of Funds Management” Dresdner Kleinwort Wasserstein, 16.

Note: This essay is based on the SSgA active Australian model. SSgA is constantly producing and updating active models around the globe that function in similar ways, but specialised for the individual markets in which they operate.

This material is for your private information. The views expressed are the views of Todd Kennedy only through the period ended August 23, 2006 and are subject to change based on market and other conditions. The opinions expressed may differ from those with different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results.

This is No Longer Funny

By Paul Wilmott

I’ve been critical of much of quant modelling for many years. I don’t like the assumptions, the models, the implementations. I’ve backed this up with sound reasons and wherever possible tried to find alternative approaches that I think are better. I don’t honestly expect to change the world, much, but, hey, I do what I can. Human nature is such that very often things have to go from bad to worse to bloody awful before the necessary paradigm shift happens. I hope we are close to that point now.

Who am I kidding? As another hedge fund disappears thanks to mishandling of complex derivatives, I predict that things are going to get even worse.

When it was just a few hundred million dollars here and there that banks were losing we could all have a good laugh at the those who had forgotten about convexity or whatever. But now the man in the street has been affected by these fancy financial instruments. It’s no longer a laughing matter.

Part of the problem is that many of the people who produce mathematical models and write books know nothing about finance. You can see this in the abstractness of their writing, you can hear it in their voices when they lecture. Sometimes they are incapable of understanding the markets, mathematicians are not exactly famous for their interpersonal skills. And understanding human nature is very important in this business. It’s not enough to say "all these interacting humans lead to Brownian Motion and efficient markets." Baloney. Sometimes they don't want to understand the markets, somehow they believe that pure mathematics for its own sake is better than mathematics that can actually be used. Sometimes they don't know they don't understand.

Banks and hedge funds employ mathematicians with no financial-market experience to build models that no one is testing scientifically for use in situations where they were not intended by traders who don’t understand them. And people are surprised by the losses!

I realized recently that I’ve been making a big mistake. I’ve been too subtle. Whenever I lecture I will talk calmly about where models go wrong and where they can be dangerous. I’ve said CDO models are bad because of assumptions about correlation. I’ve pointed out what you can do to improve the models. I’ve talked about hidden risks in all sorts of instruments and how sensible use of mathematics will unveil them. I’ve explained why some numerical methods are bad, and what the good methods are. But, yes, I’ve been too subtle. I now realise that one has to shout to be heard above the noise of finance professors and their theorems. Pointing people in the right direction is not enough. Screaming and shouting is needed.

So here, big and bold, gloves off, in capital letters (for this seems to help), are some fears and predictions for the future.

THERE WILL BE MORE ROGUE TRADERS: While people are compensated as they are, while management look the other way to let the ‘talent’ do whatever they like, while people mistake luck for ability, there will be people of weak character who take advantage of the system. The bar is currently at €5 billion. There will be many happy to stay under that bar, it gives them some degree of anonymity when things go wrong. But that record will be broken.

GOOD SALESMEN WILL HOODWINK SMART PEOPLE: No matter what you or regulatory bodies or governments do we are all a pushover for the slick salesman.

CONVEXITY WILL BE MISSED: One of the more common reasons for losing money is assuming something to be known when it isn’t. Option theory tells us that convexity plus randomness equals value.

CORRELATION PRODUCTS WILL BLOW UP DRAMATICALLY: This means anything with more than one underlying, including CDOs. Stop trading these contracts in quantity this very minute. These contracts are lethal. If you must trade correlation then do it small and with a big margin for error. If you ignore this then I hope you don’t hurt anyone but yourself. (I am sometimes asked to do expert-witness work. If you blow up and hurt others, I am very happy to be against you in court.)

RISK MANAGEMENT WILL FAIL: Risk managers have no incentive to limit risk. If the traders don’t take risks and make money, the risk managers won’t make money.

VOLATILITY WILL INCREASE ENORMOUSLY AT TIMES FOR NO ECONOMIC REASON: Banks and hedge funds are in control of a ridiculous amount of the world’s wealth. They also trade irresponsibly large quantities of complex derivatives. They slavishly and unimaginatively copy each other, all holding similar positions. These contracts are then dynamically hedged by buying and selling shares according to mathematical formulae. This can and does exacerbate the volatility of the underlying. So from time to time expect to see wild market fluctuations for no economic reason other than people are blindly obeying some formula.

TOO MUCH MONEY WILL GO INTO TOO FEW PRODUCTS: If you want the biggest house in the neighbourhood, and today not tomorrow, you can only do it by betting OPM (other people’s money) big and undiversified. There are no incentives for spreading the money around responsibly.

MORE HEDGE FUNDS WILL COLLAPSE: You can always start a new one. Hell, start two at the same time, one buys, the other sells!

POLITICIANS AND GOVERNMENTS WILL REMAIN COMPLETELY IN THE DARK: Do you want to earn £50k p.a. working for the public sector, or £500k p.a. working for Goldman Sachs? Governments, who are supposed to set the rules, do not even know what the game is. They do not have the slightest clue about what happens in banks and hedge funds. Possibly, for the same reason, London will lose out to New York as a world financial centre.

GE: Quintessential American Finance Company

Does Ge (GE) finance company stand a chance in today's worsening economic environment? What blasphemy is this?!? Are these the words of yet another gloom-and-doomer pouring on the coals when we've already had enough bad news?

Why, GE is the bellwether of U.S. industry. It's the triplest of all triple-A companies! It's the quintessential American manufacturing company!!

Correction. GE is the quintessential American finance company. And highly leveraged at that.

Lending Activities

Just look at the balance sheet. Of 12/31/07 tangible assets of $698 billion, $461 billion, or 66%, are loans, leases, or some other explicit lending activity (i.e. as separate from, say, trade credit related to manufacturing activities). Another $57 billion, or 8% of total tangible assets, are real estate investments. Does this sound like a manufacturer? For perspective, this $461 billion in lending activity would make GE about the eighth largest bank in the country. Further, while perhaps not as risky as some of the largest banks' holdings of sub-prime mortgages, SIVs, and other exotic vehicles, GE's portfolio probably carries more risk than those of many smaller banks. This assertion, while admittedly somewhat speculative, is based upon the more transactional nature of GE's lending activity compared to the more relationship-driven lending activity of the typical commercial bank. Not to mention GE's own assessment in its 12/31/07 10-K report that one-third of its $30 billion U.S. portfolio of credit cards, installment loans and home equity lines of credit (through its GE Money subsidiary) could be considered sub-prime. Another $10 billion charge-off anyone?

Leverage

Referring again to the 12/31/07 10-K, total Liabilities of $672 billion compare to absolutely puny tangible Shareholders' Equity of $18 billion. A simple debt/tangible worth calculation suggests an astounding leverage extreme of 37:1, or its inverse, a capital ratio of 2.7%. Admittedly, discounting net worth by the entire amount of intangibles of $97 billion is probably overly conservative, but what, after all, is goodwill but accounting for the amount overpaid in the purchase of assets? Didn't we see enough write-downs of goodwill in the early 2000s to make us at least marginally suspicious of its value? Does goodwill provide any relief whatsoever in a liquidity squeeze?

For some perspective on leverage, the average commercial bank has a capital ratio of approximately 10% (admittedly with definitions of capital as generous as those used by GE), which equates to a debt/worth ratio of 10:1. I've always been amused when people say that we couldn't have a 1929 style crash today because we no longer allow 90% margin in the stock market. This is true, but it completely ignores the fact that virtually the entire remainder of the economy is leveraged at 90%. GE's Capital Services (i.e. the lending side of the company) is much more leveraged than most banks, and with much riskier assets. Something tells me we haven't seen the last of the forest fires started by playing with this kind of leveraged tinder.

Cash Flow

Ah. Cash Flow. The bottom line. Where the rubber meets the road. What is business all about except for cash flow? The manufacturing side of GE is strong, no doubt. But the real question here is GE Capital Services [GECS], which is what the numbers that follow are based upon, as separately disclosed in the 12/31/07 10-K.

A quick look at the ratio of EBITDA / Interest ($44 billion / $22 billion) looks pretty good at almost exactly 2.0X. However, adding Short Term Borrowings (of $192 billion) and Long Term Borrowings maturing in 2008 (of $56 billion) to that Interest Expense results in an atrocious ratio of EBITDA / Principal and Interest due in 2008 of .16X.

What?!? Can they be this far under water? Not so fast. You see, they won't actually retire those short- and long-term borrowings of $248 billion as they come due. They'll simply refinance them with new short term borrowings as they've been doing for years. Aye, there's the rub then. GECS seems to have a major mismatch on its balance sheet. They've got $114 billion more in Current Liabilities than in Current Assets. If they didn't issue any new debt this year, they'd need until early 2010 to pay everything that comes due in 2008.

But that won't be a problem, right? With credit markets so stable and all, they'll have no problem rolling over all that debt, will they? Debt, that is, like the 12/31/07 commercial paper balance of $106 billion. Not that there's been any jumps or jitters in the commercial paper markets in recent months… But it's GE, you might say. Who wouldn't lend money to GE? Indeed. Who wouldn't? Anyone would. Everyone would. Everyone will, right? Yes. Of course they will. Until they don't.

Perhaps we're on to something here. Perhaps it's the very historical strength of GE that allowed it to borrow as much as it wanted. At some pretty good rates, too. The proverbial drunken sailor on shore leave. The strength, reputation, and aura, that is, that allowed GECS to increase its lending portfolio (plus a few other assets, like real estate) by $148 billion (from $360 billion to $508 billion) from 12/31/04 to 12/31/07 by borrowing $146 billion of it. Hmmm. One hundred percent financing on the incremental portfolio growth. Why does that sound so familiar?

So, in the end, what do we have? We have a historically strong manufacturer (with $92 billion in Liabilities of its own, mind you, and in what appears to be developing as a uniquely challenging environment) wrapped (smothered, some may eventually say) in a massively leveraged portfolio of loans and similar beasts that includes home mortgages, auto loans, credit cards, prime and sub-prime home equity loans, and, last but not least, a boatload of commercial and industrial loans that seems recently to have contracted a bit of seasickness, particularly in the latter stages of Q12008.

Is this warning premature? Yes, almost certainly. But there's no benefit in yelling Fire! after the barn's already burned down. To borrow a phrase, predictions of GE's demise may, at this point, be greatly exaggerated, but don't expect it to fare any better than the average high-risk finance company if this economy gets much worse.

Volatility versus Technical Analysis

(Observer's note: a good point made by Bill Luby. I really enjoy reading his posts now. The comment below is from his 4/14 post.)

...... To answer the question "Is the VIX Impervious to Technical Analysis. I have to say that I am largely in agreement on the three main points made in the post:
Support and resistance don’t matter
Long term moving averages don’t matter
Correlation does not imply causation"

"... ... Last but not least, Tom Drake has an indicator that he calls the 2CS, which combines the VXO (the original VIX, prior to the 2003 modifications) and the CBOE combined put to call ratio to get a two dimensional view of options sentiment. In The 2CS Revisited, Tom discusses how he uses the 2CS to help identify market bottoms. His approach appears to be similar to mine in many respects. Also, the 2CS is clearly a relative of the OSI (Options Sentiment Indicator) that I publish and discuss in my subscriber newsletter.

I suspect the increased interest in the VIX is a by-product of the ongoing discussion in many circles that the VIX has not spiked enough to signal a textbook capitulation bottom, particularly given the magnitude of the macroeconomic concerns. I continue to think that while a VIX spike of 40 or more would placate many of those who are waiting for a more obvious sign of capitulation, this is not necessary to confirm a bottom, particularly given the current trading range of the VIX in the low to mid-20s."

Microsoft Undervalued, With Or Without Yahoo

(Observer's note: I don't currently have a position on Microsoft, but have been watching this stock for the past few months. This article is a good one for my own record.)

By Ben McClure

Yahoo (Nasdaq:YHOO) is scrambling to avoid being swallowed by Microsoft's(Nasdaq:MSFT) software empire. The Wall Street Journal reports that Yahoo and Time Warner (NYSE:TWX) subsidiary AOL are edging towards a deal aimed at spoiling Microsoft's takeover plans.Of course, Microsoft has a lot to gain from a buyout of Yahoo, but Microsoft investors shouldn't be overly dismayed if Yahoo escapes its clutches. Even without the internet company, Microsoft's stock is still strong. By my reckoning, Microsoft, sans Yahoo is still substantially undervalued.

Less Than The Sum Of Its Parts

Microsoft provides plenty of disclosure and guidance on its various software business realms, so let's consider the value of the sum of its parts. Start with Microsoft's client business, which concentrates on the Windows operating system. Of course, this would continue as a quasi-monopoly that pumps out loads of cash. Assuming sales growth of 13% in 2008, operating systems will produce about $16.9 billion in sales and operating profits of about $13 billion. Valued like a regulated monopoly, with an operating multiple of say 14, this group is worth $183 billion.

For convenience, we can lump together Microsoft's Office software unit with its enterprise server and tools business. Together they represent another cash cow. Assuming 17% growth this year, it will bring in about $40 billion in sales and operating profits of about $8.9 billion. Valued on the same conservative utility multiple, it's worth $124.6 billion. Give it a valuation multiple along the lines of software peers like Oracle (Nasdaq:ORCL), SAP (NYSE:SAP) or Red Hat (NYSE:RHT) and you get a higher number.

The online business holds Microsoft's email and instant messaging services, plus its internet offerings such as Live Search and the MSN portals and channels. While this group has yet to show signs of profitability, it ought to deliver more than $3.4 billion in revenue in 2008. Of course, it won't fetch Google's (Nasdaq:GOOG) 9-times sales multiple, or even Yahoo's multiple of 7. But even valued at just 4 times sales, the online business is worth nearly $13.6 billion. Throwing Yahoo into the mix yields a much bigger online business and valuation.

The final group holds Microsoft's new-fangled entertainment and device businesses, including the Xbox video games. Growing at 32% this year, sales could swell to $7.7 billion. Operating profits should top $900 million, easily justifying a multiple of 20-times and price tag of $18 billion.

The total value of the sum-of-the-parts, not including Microsoft's $23 billion cash pile, amounts to $339 billion in market value more than 23% higher than the stock's price today. (For a crash course on these calculations, check out Use Breakup Value To Find Undervalued Companies.)

Bottom Line

A market value of $339 billion, or $35.67 per share, represents a multiple of 16.5 times 2009 earnings. Considering that Microsoft is expected to lift its bottom line EPS to $1.87 from $1.43 this year, and to $2.11 in 2009, it's fair to say the stock is trading at a sizable discount.Investors shouldn't be shaken by the uncertainty surrounding Microsoft's pursuit of Yahoo The outcome doesn't change the fact that the software titan has a low valuation on its side. That alone should be enough to get investors to take notice.

To learn more, check out Conglomerates: Cash Cows Or Corporate Chaos?

Ben McClure is director of McClure & Co., an independent research consultancy. Before founding McClure & Co., Ben was a highly-rated European equities analyst at city of London-based Old Mutual Securities. He also spent several years as a business/technology journalist at the Economist Group. Mr. McClure graduated from the University of Alberta School of Business with an MBA.

At the time of writing, Ben McClure did not own shares in any of the companies mentioned in this article.

Blockbuster (BBI) tries to buy Circuit City (CC)

(Observer's note: I'm wondering whether this implies the ultimate triumph for Netflix (NFLX). The imposed merger between BBI and CC doesn't seem to make any sense to me. )

By Douglas McIntyre

Some mergers make less sense than others. The Blockbuster (NYSE:BBI) effort to buy Circuit City (NYSE:CC) makes no sense at all. It is based on the hope that putting together two zombies will create one live person.

According to Reuters "Blockbuster Inc. said on Monday that it has offered to buy electronics retailer Circuit City Stores." The price for the offer was in a range of $6 to $8 pending due diligence.

Why putting a consumer electronics business together with a movie rental company makes sense is anyone's guess. Each company is having remarkable trouble staying in business.
Blockbuster's current share price is just above $3, down from a 52-week high of $6.67. The company is being ruined by competition from online DVD sales and VOD products delivered over the internet or by cable companies. In its last fiscal year, Blockbuster made only $39 million on revenue of over $5.5 billion.

Circuit City is even worse off. It made a tiny profit in its most recently reported quarter, but has been losing customers to larger operators like Best Buy (NYSE:BBI) and Wal-Mart (NYSE:WMT). Circuit City shares are down from a 52-week high of $19.12 to $3.44
It is hard to see how a merger would allow for either cost cuts or revenue enhancements.

1+1=0

Douglas A. McIntyre is an editor at 247wallst.com.