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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June 15, 2008
Its not an oil crisis, its a dollar crisis
If you want to boil a frog as the saying goes you put it into cold water and raise the temperature slowly for if you throw a cold frog into hot water it will leap out. The US dollar is such an animal and over the last few years there has been some speculation on the deprecating value of the dollar but such talk until lately seems to have been background noise. Like our boiled frog until the temperature raises too high no one notices but in the last five years the US dollar has depreciated against the Euro by 35%.
We are going to look at what has caused the US dollar to collapse, how this affects international trade and what a business can do to protect itself in another article. Before any of this and to understand how the world found itself in this mess we have to look back in history, just a touch.
`A nation taxes its own citizens, while an empire taxes other nation-states` writes Krassimir Petrov and is probably the best summation I have read on what brought us to this place today and very much inspires this article considering the state of the US dollar at present. In the Early 20th Century the US dollar was tied to gold and so the value of the dollar would be entirely pegged to that of the commodity however, after the great depression there was a spout of inflation and with an increase amount of currency in circulation the Roosevelt government was forced to decouple the dollar from gold, well nearly decouple. Some years had to pass until 1945 when the Bretton Woods agreement was engaged and other governments could impress on US reserves that the dollar be convertible to gold on demand. During the years of the Second World War the US had supported many of its allies and been insisting on gold as payment so its reserves of the commodity were bountiful, well abundant enough that conversion of commodity to currency should not have presented a problem.
What is important about all of this is that up until recently the US currency has been looked at by the rest of the world as the reserve currency of the world. It`s a perception but such a strong vista in that a convertible paper (paper for goods) has base value and the US dollar became the status quo underline on a quote in trade. If the dollar supply was kept vaguely close to the market price of gold in store this perception would have been real but during the Vietnam War the supply of the dollar volume was increased to finance the extension of US forces overseas and the currency was handed over to foreign businesses in huge volumes in exchange for imported goods. The catch here is, without the ability to buy the US currency back at the same value once it was sent off shore. In 1970 when foreign governments demanded payment of dollars in gold the link between the US dollar and gold was ``severed`` and the US would be in debt to the world, well theoretically.
So why didn`t the global community unwind at that point?
Well the argument is that in 1971 the US government made an agreement with Saudi Arabia for accepting US dollars for oil and that is a resource that the rest of the world was addicted on. When the remainder of OPEC followed by settling oil contracts in US dollars there was a reason to hold the currency and the switch from gold to oil was achieved. The currency in effect had moved from one base commodity to another and in today`s market this is a significant link and as the dollar weakens the price of oil is going to have upward pressure. There are many of those in the markets that are saying we don`t have an oil crisis, we have a dollar crisis. The market place is much more complex than this as you can obviously imagine and that the rising prices of oil are due to many factors some of which are indirectly orbiting around currency differentials and some of which are positive feedback loops.
For example, one would expect that as the price of oil raises (in USD terms) the demand for such a commodity would fall off however oil is generally ``a necessity`` rather than ``a want to have`` for the commercial world so price increases are often passed on in the value chain and become inflationary catalysts for the consumer. These inflationary measures often end up contributing to the cost of imported goods where US dollars are sold for another currency and add to the bottomless hole of the US trade deficit.
We`ll look at oil and trade deficits in detail later the big question here apart from the positive feedback loops, is; why is the dollar falling?
It is argued by some that what broke the dollar away from gold to oil is perhaps the same cause that has driven its deflation this time, war. Instead of Vietnam in this case it is Iraq. The irony in it all is that Saddam Hussein demanded Euro as a settlement currency for his oil and that a war with Iraq stood to free Iraq from his grip perhaps a good thing in hindsight but, it also stood to protect the sovereignty of the dollar even though engaging such an act might actually put the very currency at risk.
To be concise then if this is the case, the underlying problem with the dollar lies with the large federal budget deficit and the huge growing trade deficit.
Later on we are going to look at the implications of a weak US dollar on the global economy and why the dollar is struggling to recover.
Posted by CausalEvents at 02:37 AM
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July 17, 2007
Is this the demise of Dow?
Like all things in the universe nothing is forever and an era that stretches out a hundred and eighteen years is about to come to closure. Dow has been so tied to that of markets, market risk and trading that I felt it worthy to pay homage to something that has been the very genius loci ('The Spirit') of the American markets for over a century.
To be precise Rupert Murdoch's News Corp is making a bid of USD $5Bn for the ownership of the Bancroft's Dow Jones business. While this occurred a couple of months ago, News Corp has been battling accusations that the paper won't remain independent. Tomorrow the Bacroft's family will hold a meeting to discuss the latest offer by Murdoch and the very future of Dow Jones is tied to that outcome. The directors of Dow Jones are of course searching for a bidder to rival the News Corp pitch and for many reasons however no-one has come forward with an offer that puts a lid on News Corp's $60 a share.
So you are probably wondering what has any of this got to do with risk ... Well a hundred or so years ago the very reason Dow Jones existed was because of risk, perhaps today that still is still the case.
In November 1882 Charles Dow and Eddie Jones, two aspiring journalists with an analytical bent clambered into bed with a banker of that time known as Charles Bergstrasser. It certainly does sound like a precarious bunch for a brokerage publishing business but within two years they had their own hand cranked printing press and the company had so many clients they updated their brokerage news feed into an electronic news ticker which was originally referred to as 'broad tape'.
Peter Bernstein's book Capital Ideas puts it this way:
'At heart Dow was a scholar rather than a speculator. He was more interested in interpreting the history of the stock market than in devising a system for predicting its future. The world has read his interpretation otherwise.'
This journalist Mr Dow was a market publisher that contributed to the world of risk by creating the Dow Jones Averages. In its essence it consisted of closing prices grouped by company type to provide an overall measure of the performance from trading activity throughout each day on the New York Stock Exchange.
As Dow was known to put it 'The industrial market is destined to be the great speculative market of the United States' and the embodiment of a mean for daily risk taking that Dow published day in day out became the auspicious paper for traders both in and out of the United States. The approach was eventually coined Dow Theory and it attempted to explain trends in stock prices by aggregating indicator variables within the market.
Now many market risk people of today run around with Gaussian copulas and complex netting systems to explain volatility in overall trades and they are likely to see this as really quite a primitive explanation of what goes on in the market place. Yet, it was a very first publication attempt to introduce central limit theorem to investors when back then speculation printed on carbon paper was all the rage.
Some months before Dow died his analytical publication business was sold to Clarence Barron for the sum of $130,000. Barron was so proud of the business he was quoted saying 'Savings in the United States may become investments, when guided by financial knowledge' and apparently passed away holding the posts of the Dow Jones and Wall Street Journal. The business was handed down to Barrons daughter and has remained in the Bancroft family till today, well perhaps Thursday this week. A successful bid by News Corp will bring Dow Jones publications and the Wall Street Journal into the same realm as News Corp's New York Post and The Times in the UK.
One does ponder what Dow would think of such a deal if he were here today?
Posted by CausalEvents at 10:28 PM
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