The Fed and The World Wide Food Riots

With the Fed holding a two day meeting they have an opportunity to discuss things at length and topics that they may not have the time for when they hold a one day meeting. Which temporarily brings me to another point - that the Fed should hold two day meetings all the time as the one day meeting from my perspective seems to be a bit hurried. I will have to look at that another day as today I wanted to mention that the Fed may be able to discuss the food riots that have occurred during the past couple of months. What do the food riots have to do with the Fed? Well the Fed is the steward of the US dollar (even if the US dollar is officially the Treasury's territory) and since the Fed has slashed rates so much the dollar has been in rapid descent. The lower dollar has caused many commodities which are priced and traded in US dollars to march higher. These higher costs have been passed onto the consumer and often to the consumer in foreign countries whose populace receives low wages. This has caused food riots. A terrible situation and my heart does go out to those who are suffering. Amazing though how the Fed's lower interest rates have led to food riots half way around the world. We live in a very inter-related world, actions here can be felt around the world and vice versa. Members of the Fed are aware of the problems and some in recent days have turned rather hawkish. Today's meeting and the Fed's communique that follows will be all the more interesting because of these factors.

The Bouncing $ - Another Prop Removed From the Manhattan Housing Market

With the dollar taking off in recent days, albeit from extremely cheap levels, the high end of the Manhattan Real Estate market may experience a pull back from the foreign buyer, especially from the European buyer. The European high end purchaser has feasted on the Manhattan condo market for the past 4 years due to a combination of rising apartment prices and a sliding US dollar (especially vs the Euro where it has been killed during the past 5 years or so). With apartment prices in Manhattan already sliding and the dollar rallying, the European high end buyer will likely be giving second thoughts to buying any future Manhattan apartments.

Q1 2008 GDP - My Guess = -0.5

The Q1 GDP first estimate will be released this week. From Yahoo Finance I picked up the following:

Briefing Forecast: +0.7

Market Expects: +0.4

Prior #: +0.6

Important to note that these are annualized numbers (so they were multiplied by 4). I will throw my hat into the ring and say that the GDP Q1 2008 will have shown a decline.

My Guess: -0.5 (Made on Sunday April 27th)

I only am going off of the earnings reports that I have followed and the economic reports I have followed for the quarter also a ton of anecdotal information in the NYC tri state area. I talk to everyone when I buy something and here around New York City businesses all tell me that things have fallen off pretty hard. On the positive side there are the agricultural commodities and the boom in infrastructure related equipment related to commodities. Also the tech sector was very strong as Google, Intel and others said they have not any pull back. So a large propeller will be the exports. Starbucks has felt the consumer retrenchment though as the ultimate discretionary item moves lower on the list of consumer must haves. In combination with a weak dollar the exports really helped the economy out. Locally here in the US though the consumer was getting beaten around from all sides as the Bear Stearns storm hit, the employment picture sharply weakened and wage growth was weak.

The Fed's Bag Of Tricks

The Federal Reserve meets this coming week. The Fed's interest rate cuts may be only slightly helping the borrowing problems that exist in the economy. This is occurring because liquidity in the credit markets continues to dry up. This dried up liquidity has been caused by loss of confidence from the lenders. Who are the lenders that have loss confidence? And why are they snake bit? In this case the lenders are all of those entities all over the world that participated in the securitization process during the past 5 - 6 years or so. The lenders are snake bit because their loans that they owned decreased sharply in value and large losses were taken. So now they have become more careful. Also they have less capital to give because of the large losses they have sustained already. This brings me back to the Fed. The Fed sees the problems and they know that until the log jam from the credit markets breaks free that the system will not be able to be fully repaired. They know that further interest rate cuts may not help much if at all. Maybe the Fed will come up with some other weapon to work on the credit market problems or maybe the Fed will revert back to one of its other weapons that seem to have given it some traction. Those special auctions seemed to have helped get the Fed some traction. what will they come up with this time?

The WSJ on Friday mentioned that some credit spreads have come down. Notably the junk bond spread which had been up at 9 points fell back to the 7 - 7 1/2 points. They note though that this spread is still way above normal levels of 2 points or so. Another part of the credit markets that I have observed more closely is the Ted Spread. I have both the WSJ and Bloomberg TV to thank for pointing this out - that the Fed watches the TED Spread very very closely. The bottom line - TED under 0.50 is normal, TED above 2.0 is very worrisome, and in between is well in between. What is interesting is that the TED Spread has not stayed this elevated for this length of time since the 1987 crash. It currently is around 1.56.

Why Did An Institution Buy 10,000 Call Contracts on AMR

Today's Wall Street Journal had a blurb in their Option column on AMR. They reported that an institution purchased 10,000 contracts at about 2.60 on the January 2009 7.50s. This is a $2.6 million bet. For the purchaser to make money on these contracts the stock would have to get over 10.10. The big question is why did this institution make such a large bet?

I will put some possibilities out, but they are really guesses:

- The institution believes AMR will get taken over.

-This is not a bet but rather a hedge to offset a large short position in AMR.

- The institution believes the business is going to soar and that profits will follow.

- The institution believes that fuel prices will collapse.

Lets say for a second that this institution is not making this bet to hedge a position. In this case the belief that the stock would go up must be so strong that this size bet was deemed reasonable. Maybe a hedge fund who has come upon a thesis that seems likely to happen. Very interesting.

* Note I do not have a position in AMR but may take on at any point. I also may decide to not do anything. I am not aware of any position that the firm I work for has.

The Advantages and Disadvantages To A 130/30 Hedge Fund

Not long ago I attended a presentation at Columbia University that included a discussion on Equity Hedge funds and the percentage allocations that are popular. One of the popular allocations seems to be the 130% Long 30% Short fund. So what does this type of fund attempt to accomplish? A close examination brings to light some interesting observations.

First, what does this 130/30 break down mean? It may be easier to first look at a 100% Long only fund. A 100% Long fund means that every dollar of the assets is invested in equities. For example, if the fund had $10 million in assets, then the fund would own $10 million worth of equities (as close as reasonably possible, less commissions). Let's move from the 100% Long fund to the 130/30 fund. This fund would use leverage and would increase its Long exposure by 30% and initiate a Short position of 30%. If the fund had $10 million in assets, the fund would own $13 million in equities and simultaneously be short $3 million in equities. The leverage in this case would be 60%.

Another way to look at the 130/30 fund is to back out the leverage for a moment. In this case the fund would be 81.75% Long and 18.75% short. This is the same ratio as the 130/30 fund. The 130/30 fund is just an 81.75/18.75 fund on steroids. The important question is why do such an elaborate percentage as 130/30? If the fund is really an 81.75/18.75 fund in disguise why not just make the fund 81.75/18.75? The first reason is the potential for increased return. Instead of using only 100% of the assets, by using 160% of the funds assets the fund manager is levering the portfolio and therefor increasing potential returns. There is tremendous upside potential with this type of leverage. For example in a down market, the upside exists if the fund manager is able to pick longs that decrease less than the market and or pick shorts that go down more. If the fund managers wits exactly match the market then the fund will match the market exactly. The market and the fund will move identically.

However there is potential risk as well. The largest risk is that the extra 60% leverage goes against the manager. For instance in a worst case scenario lets say that the manager made poor picks. In this case the 130% Long positions decrease in value and simultaneously the 30% Short positions decrease in value (as the stocks the manager is short go up). Let's say that the longs go against the manager by 20% and the shorts go against the manager by 20%. The $10 million fund would drop to $6.8 million for a drop of 32%. If the fund had not used any leverage the fund would have only lost 20% and the assets would have been $8 million. In this case the manager would have been better without the leverage.

Tread carefully when using leverage. I have seen my fair share of problems arising from too much leverage and returns can definitely increase when used properly. Again it all comes down to risk management. Make the positions too big and your problems could cascade. Even if you think you are 100% Long via a 130/30 fund if there is a problem such that the extra 60% margin is really neutralized reality may be completely different if both the longs and the shorts go against you. In that case, action should be taken to lower the leverage and quickly.

The Dollar Strikes Back

Good to see the US dollar flex its muscles. In the short run the direction of the dollar will depend on the Fed. The strength of the economy and the rate of inflation will also factor in. Over the longer term the dollars position in the world will depend on the deficits it runs.

I am still a believer that the US is will be in the throes of a deflationary spiral and that the early stages of a deflationary spiral exist and can be seen through the housing market. However the deflationary run although deep in the housing market has not yet begun for either of two reasons. One: I am plain wrong and deflation will not spread from the housing market to the rest of the economy or two: My synopsis was just early and deflation has not made its way through yet. I am not sure of the answer but still believe deflation is coming and I was just very early. I think another sign to look out for will be the local and state governments and their budgets. If the state and local tax revenues fall off precipitously these local governments will be forced to do one of two things. They will either have to find a way to raise more revenues which likely means higher taxes or two they will have to make cuts to their budgets. Neither of these scenarios are of the pleasant variety. If deflation does take hold expect to see the dollar g on a tear and the model Giselle may then wish to rethink her wishes to getting paid in Euros.

TED Spread Again Moving Higher

The TED Spread is again moving higher. It is still below that important '2' level but it is showing tremendous nervousness again. Maybe there is nothing behind this but fear, but if there is something behind this move higher in the TED then caution is the word.

US Equity Indexes Year To Date

The stats here are from the close of trading on Friday April 18th 2008 and are taken from Yahoo Finance ( http://finance.yahoo.com/ ). The calculations are from me.

Dow = 12,849.36, -3.13% YTD

Dow 50 DMA = 12,366.02

Dow 200 DMA = 13,093.80

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S & P 500 = 1,390.33, -5.31% YTD

S & P 500 50 DMA = 1,340.87

S & P 500 200 DMA = 1439.78

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Nasdaq = 2,402.97, -9.40% YTD

Nasdaq 50 DMA = 2,300.42

Nasdaq 200 DMA = 2,536.14

The Ted Spread

Interesting Ted Spread Chart I picked up from Bloomberg. The TED Spread refers to the difference between the London rate or LIBOR and the 'risk free' 3 month TBill. The spread usually stays around 0.50 or less. When it is in this 0.50 vicinity it means that there is less risk in the system. Currently at around 1.58 it is elevated. It has come down from the 2.4 in August 2007 and the 2.3 in December 2007 and the 2.05 in January 2008 but it still is relatively high. This means that there is still fear in the system and that the credit markets are still under considerable strain. The Fed watches this closely. The topic has popped up a lot since last August due to all of the market turmoil. There was an article in today's Wall Street Journal on this topic.

http://www.bloomberg.com/apps/cbuilder?ticker1=.TEDSP:IND

Could China's GDP Decline?

This is a pretty far out title. Many times in the markets I take a contrarian position. At times it looks like the dumbest call on the planet. Often I am wrong. It goes with the territory of being a contrarian. However when my contrarian view is correct often the position goes in my favor by a large amount.

Back to this title about China's economic output actually dropping. This is such a contrarian view point that I have not heard it - any where. Nobody thinks this could happen. But if the facts are examined closely even though it is an unlikely scenario it may not be as unlikely as people think. First let's look at the stock market. The Shanghai index has been clocked losing at least 35% from the top. The stock market is considered by some to be a leading indicator. Is it saying that China's growth will slow down sharply? Not necessarily but at least it is something to think about. What about the theory that a country that is growing so fast can't fall into recession. Well that doesn't hold much water since the US in the late 1800s and early 1900s had a very fast growing economy whose output was derailed a number of times as recessions ensued. If the US in its hyper - growth spurt a hundred years ago could fall into a recession, couldn't China? The Chinese currency (the Yuan or Remnimbi, not sure why there are two names but there are) has been appreciating as the Chinese authorities try to curb inflation. This is starting to hit the Chinese exporters. Lastly the US economy is rapidly falling deeper into recession. As a consequence the US consumer is pulling back sharply. The US consumer (according to Fred Hickey in Barron's in the Round Table) is about 19% of world GDP. A large portion of China's GDP is exports to the US consumer. Doesn't that mean that China is feeling the pull back too?

China falling into a recession is unlikely. I went through this thought process though to show that although unlikely it is not as unlikely as most believe. China go into recession? What would Jimmy Rogers do? He just packed his bags left New York and moved to China. He could always come back.

Gross Domestic Income - Mr. Nalewaik of the Fed

Looking for a date for the Q1 GDP release date I stumbled on this amazing paper titled, "Estimating Probabilities Of Recession In Real Time Using GDP and GDI." It was written by Jeremy Nalewaik in December 2006. Mr Nalewaik works at the Fed and this paper was part of the staff working papers in the Finance and Economics Discussion series. One always hears about these brilliant people in the background at the Fed. Well this looks like one of these really bright economists that that no one really hears about. Let me check that. After reading Mr. Nalewaik's bio, which says PHD University of Chicago. Well that pretty much says it all. Also here is a link to the paper:

http://www.federalreserve.gov/pubs/feds/2007/200707/200707pap.pdf

I just skimmed it a little. I found it interesting because from the anecdotal data I have been getting in the NYC tri-state area I have come to the guess / conclusion that the depth of the current recession may be much steeper than most think. My data may well be skewed because the tri-state area around New York City is heavily influenced by what happens in finance. And it is pretty easy to say that currently the world of finance has experienced some massive pain. Regardless it is still my gut opinion that Q1 GDP may be really ugly.

Now back to the paper by Mr Nalewaik. The main idea of the paper is that GDI may be a leading indicator for the strength or weakness of the economy. Now again I have not gone through the entire paper but it does seem intriguing. The next question someone may ask is well when does the GDI stat come out and where is it at the moment? It looks like it is released with the GDP number so we will have to wait. Since we already have Q4 2007 a GDI number must have been released from that. I will try to dig some more on this.

The Book - Beat The Dealer and Money Management

A couple of weeks ago I read the weekend edition of the Wall Street Journal and there was a great interview / article with Bill Gross and Edward Thorp. Bill Gross is the billionaire bond manager who controls the bond firm PIMCO on the West coast. Edward Thorp is the author of the book 'Beat The Dealer.' Edward Thorp was an MIT professor and wrote 'Beat the Dealer' after studying Black Jack and writing a paper about it. The book was written in the 1960s and it explains in elaborate detail how to win at the game of Black Jack. Bill Gross came across the book and studied the method then went to Vegas and applied it and won. What I found interesting is that Bill Gross who now manages about $1 trillion in assets uses some of the techniques to manage money at PIMCO. The big rule that he uses is the one about money management.

In the book Thorp teaches that unless your edge is strong to 'play' a small hand but that once the odds increase in your favor to then increase the bet size. I have read over and over again in many trading books about money management and that sizing the bet is one of the most important factors to longevity and success in the money management business. I personally believe that it is the most important factor. The reason is that if one makes bets that are consistently too large without having a consistent edge in all of those positions then the chances are very high that the trader is going to blow up. This was LTCM's problem in 1998 when they 'blew up'. No matter how strong their edge was it was not strong enough to outlast the negative forces that overtook their portfolio. Their bets were simply too large and they ran out of money before the positions came back to their favor. This was the SocGen problem with that trader Kerviel as well - position size.

Learn to size trades and you may be successful in this brutal business. Thanks to the Wall Street Journal for writing that great article and to Edward Thorp for writing that amazing book and to Bill Gross for explaining again the importance of money management. If you want an entertaining book and want to show off to your friends when you go to a casino, read Thorp's book 'Beat The Dealer'. It cost me $12. Definitely up there with some of the best $12 I have ever spent.

What Does the $13 Trillion Notional Value Derivative Contracts of Bear Really Mean?

I have previously written about counterparty risk and how the financial system is intertwined. Well Bear Stearns was one of these larger twine turners. The approximate notional value of their underlying derivatives was about $13 trillion. This does not mean that they were on the hook for $13 trillion but rather this $13 trillion represents the value of the underlying assets behind the derivatives had the derivatives been converted into that underlying asset. If this doesn't make sense then I will provide an example. Since most people understand stock options I will use that as an example. Before I begin I want to reference the Wall Street Journal for the $13 trillion. Around the week of March 17th they ran an article explaining the meaning of the $13 trillion notional value of Bear's derivative book. It helped me understand what notional value means. When large numbers get thrown around (and trillions of dollars are fairly large numbers) then people may not understand the actual risk behind these derivative contracts.

I will use the example of a call stock option. I am going to assume that the reader understands how a call option works. If not, then I may write an article explaining stock options, but that will be for another day. I will use IBM. I will also use the IBM 110 call with one week left to expiration. I will assume IBM is trading for 100 per share and there is about 1 week left before the contract expires and that the price of the call option is going to be very inexpensive. It may be 'Bid' 0.03 'Asking' 0.05. Let's say I wanted to be very daring and thought that the stock could jump over 110 by week's end or prior to expiration. Assume I am willing to risk $50,000 (note this is a bad bet as it is extremely unlikely that IBM moves 10 points higher in 1 week's time and that I am likely to lose $50,000). So I buy 10,000 contracts for 0.05 per contract. (Lets assume that there is no commission) then I have a position that gives me tremendous leverage. With a $50,000 position I now control 10,000 contracts or 1 million shares. With IBM trading for $100 per share the notional value of this position would be 1 million shares x $100 per share or $100 million dollars. Am I liable for $100 million? No. Is the entity (or counterparty) on the other side of the trade liable for the $100 million? Very unlikely, but they are liable for a portion of the contract if it went into 'the money'. For instance, if IBM went to 120 before the week's end my counterparty would have to pay me $10 million. Back to my side of the trade and what I receive. Essentially I now have exposure to the stock that if it were to clear that level of 110 that would give me leverage and exposure as if I owned 1 million shares. Notional value of a derivative assumes the full price of the underlying asset instead of just a portion of it. This is sort of what the $13 trillion of notional value that Bear was exposed to means.

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Another way to look at the notional value of the swaps market is that it represents the amount that the swap is insuring. On one side of the transaction a payment stream is often assumed. Therefor the notional value is not something that is paid out but rather just what is insured. I give credit for this further clarification to the CFA program curriculum. In recent days after reading the CFA derivatives book in preparation for the CFA exam I have a better understanding of notional value.

S&P 500 - Q1 Volatility

The number of days in which the S&P 500 had at least a 1% move in Q1 2008 was 51%. This was the largest percentage for a Q1 since 1934 and the 5th highest percentage for a Q1 in history. I read this stat in an article in yesterday's journal recapping the first quarter US equity markets.

What does this stat mean? An analogy may help explain what this means. On about 51% of the days in Q1 I felt like I was a piece of laundry in the washing machine spun around in all different directions and speeds. Not really the most pleasant of feelings. Basically this means that for a Q1, the S&P 500 volatility was at unprecedented levels and at the highest levels since the heart of the Great Depression.