July 28, 2008
Senate to question market liberty
To question market liberty is perhaps equivocation of itself. To be precise, if one was to look up the dictionary definition of `market` they would find something on the lines of `an open place where buyers and sellers convene for the sale of goods` and while these places have rules, markets work best when price discovery is a true representation of demand or supply. As soon as that is not the case such peddlers generally go elsewhere to satisfy their disports.
Last Friday such a notion was put to the senate bill S.3268 by Leader Harry Reid on ``Stop The Excessive Energy Act`` but has not generally been received well by many traders or institutions including The Coalition to Protect Competitive Markets. Made up of eight associations including the biggies CME, ICE, ISDA, NYMEX, FIA were not supportive of the bill stating that ``Restricting the ability of U.S. investors to participate in these global markets will make it harder for American citizens, including millions of baby boomers saving for retirement, to diversify their holdings and offset losses in equity and bond markets``.
They have a point and nicely put as such baby boomers would also implicate those who might pass the notion as being affected adversely by it. Where will such people put their wealth, on the volatile equities markets, perhaps US property or the deflated fiat US dollar itself, there is really nowhere to hide on US soil. Actually that is what would happen, commodity trading would be driven offshore reducing the liquidity in the US markets and making it more expensive for hedgers to seek cover from adverse price movements.
Such a bill has more serious implications. Firstly, when is a hedge not speculation and how difficult would it be to enforce such a stance. Businesses that use raw materials such as coal, oil and gas purchase forward contracts for delivery of a commodity or mostly settlement of cash differential in the future and that allows them to crystallize their price. If say a firm purchased such contracts long using privately borrowed funds and actually showed a profit from this action would that be a better investment than a firm that priced everything on the spot. If that firm was good at doing this, it might find more investors willing to assist; it might even share a spread with them. How can you regulate that?
A forward contract is a bucolic way of raw material planning, it becomes a lot more complex than this and businesses are using options (puts and calls), caps, collars, straddles, swaps and forwards all mixed together to reduce price volatility. Each one these or the structure of many could be speculation or a hedge depending on why the firm bought them in the first place.
Let`s ask a different question; don`t all option contracts have a component of speculation within them?
Well, the instrument has `asymmetry risk` which means the most the holder can lose is their premium yet, the most they can gain is limited by how far the market moves. Is this just like a ticket in a horse race, an important horse race.
Away from financial instruments for moment, the senate is not the only group people asking this question. Only a month before in June 2008, an Interagency Task Force on Commodity Markets chaired by the Commodities Futures Trading Commission carried out an assessment into the market factors affecting the crude oil market. The interim report found that fundamental supply, demand and the roles of various market participants to be the best explanation for the recent crude oil price increases.
So finally where did the Senate end up?
Well on Friday 25th July the motion to stop speculation was not passed with only 50 yes votes being accepted and 60 being the required bar for the bill to move forwards however, this may not be the last we hear of this. The House Agriculture Committee cleared its own bill that would impose position limits on the number of futures contracts that can be owned by speculators past a price-setting role and is again going to be difficult to implement. They are going to make it mandatory for the reporting of Over-The-Counter trading and look-alike energy products which is an incredibly nebulous task. They are also only going to grant hedge exemptions for commercial purposes and that will relegate such hedging strategies as less successful if open interest in the market diminishes.
Perhaps in the end the only way to address this problem would be to solve the demand and supply differential then speculators will be less attracted to what is easily available for what they are holding onto at present will become more valuable if it is difficult to trade.
Posted by CausalEvents at 06:03 AM
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July 20, 2008
The Barometer of the US Equity Market
There is a theory in many US equity market centres known as the January Barometer which goes something like the following:
During the month of January the stock market`s direction for the year as a whole can be set by comparing the market at the end of the first month against where it began as trading opened for the year.
Barometer Definition
So firstly how did we look on the January Barometer this year?
Well, the Barometer for 2008 and the market differentials for the Dow Jones, S&P500 and Nasdaq were the following:
Dow Jones from Jan 02 to Jan 31 down 3.10%
S&P500 from Jan 02 to Jan 31 down 4.74%
Nasdaq from Jan 02 to Jan 31 down 8.17%
You can take a look yourself by following this thread QID
So what does that say about this year? (In the theme of the Equity Market Barometer, markets are obviously more complex than this)
Well if the last week`s performance is anything to go by I would say the January Barometer might just hold true just like another barometer often does. `Congress should consider legislation even before a new president takes office. The urgency is too great and markets will not wait` says Henry Kaufman often better known as Dr Doom. The president of the New York Based investment and consulting firm Henry Kaufman has been correct with predictions in the past but his comments around the US financial institutions lacking direction might just have accelerated the decline of the markets over the last week. Shares of Fannie Mae fell on its knees by 23% on Friday and Freddie Mac went out backwards as much as 51%.
In the fear that these two institutions would follow the same path as other prominent US financial corporations have done this year, the SEC issued an emergency rule limiting certain types of short selling. The regulator focused predominantly on naked shorting and not just across stocks in Fannie Mae or Freddie Mac but across all major financial firms. Nineteen institutions were targeted including Freddie Mac, Fannie Mae of course but also Goldman Sachs, Lehman Brothers, Morgan Stanley, JP Morgan Chase, Citigroup, Merrill Lynch, Barclays, Bank of America and Royal Bank ADS were also part of the list.
For those that are not familiar with short selling, it`s quite a simple although alternative trading strategy. In short no pun intended, an investor would arrange to borrow shares they consider overvalued and sell them in the hopes of making profit by buying them back cheaper.
In this case short selling might have accelerated the decline of weak organizations however; it is still claimed by many traders as being an important feature of the market especially as it self-regulates price spikes and concentrations within the market.
It all becomes a bit clearer with an example: Assume the shares of bank F&F were trading at $10 per share, a short seller would borrow 100 shares from an investor and then immediately sell those shares of F&F for a total of $1000. If the price of F&F shares later falls to say $9 per share, the short seller would then buy the 100 shares back for $900, return the shares to their original owner, pay him a fee for having borrowed his shares and make a profit of $100.
In the emergency rule that the SEC proposes, they are not directly prohibiting short selling just enforcing a strong stance against naked selling. In this case the SEC would require a short seller to borrow the securities before executing the sale and it is also going require the investor to deliver the securities on the settlement date.
This is not a first for the SEC and in the past it has considered emergency rules such as prohibiting naked short selling before. In mid 2007 the SEC attempted to implement a `tick test rule` which only approbates a short sale when the last stock price is higher than the previous quoted price but that mandate was revoked.
The SEC`s purpose here with all of these rules is obviously to avoid any additional collapses of US financial institutions and to improve confidence in the markets. Generally the industry as a whole has been struggling with tight liquidity and is still recovering from the now well known sub-prime lending crisis. If the SEC can control the steepness and acceleration of declining stock, some banks might have a softer landing and more time to react to downward pressure on their stock price.
In reality the number of banks that have actually collapsed since 2000 can be found at this address Failed-Bank-List. Those institutions such as Bear and Stearns which were acquired at an incredible discount or banks that have been pulled back from the edge of liquidation through aggressive recapitalisation techniques will not feature in this failed bank list. None the less losses to investors holding onto such stocks might still have been huge.
Posted by CausalEvents at 05:13 PM
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