Category: Speculation

The Shadows of the Bond Market?s Past, Part II

The Shadows of the Bond Market?s Past, Part II

Posted on by David Merkel

This is the continuation of?The Shadows of the Bond Market?s Past, Part I. ?If you haven’t read part I, you will need to read it. ?Before I start, there is one more thing I want to add regarding 1994-5:?the FOMC used signals from the bond markets to give themselves estimates of expected inflation. ?Because of that, the FOMC overdid policy, because the dominant seller of Treasuries was not focusing on the economy, but on hedging mortgage bonds. ?Had the FOMC paid more attention to what the real economy was doing, they would not have tightened so much or so fast. ?Financial markets are only weakly?representative of what the real economy is doing; there’s too much noise.

All that said, in 1991 the Fed also overshot policy on the other side in order to let bank balance sheets heal, so let it not be said that the Fed only responds to signals in the real economy. ?(No one should wonder who went through the financial crisis that the Fed has an expansive view of its mandate in practice.)

October 2001

2001 changed America. ?September 11th led to a greater loosening of credit by the FOMC in order to counteract spreading unease in the credit markets. ?Credit spreads were widening quickly as many lenders were unwilling to take risk at a time where times were so unsettled. ?The group that I led?took more risk, and the story is told here. ?The stock market?had been falling most of 2001 when 9/11 came. ?When the markets reopened, it fell hard, and rallied into early 2002, before falling harder amid all of the scandals and weak economy, finally bottoming in October 2002.

The rapid move down in the Fed funds rate was not accompanied by a move down in long bond yields, creating a very steep curve. ?There were conversations among analysts that the banks were healthy, though many industrial firms, like automobiles were not. ?Perhaps the Fed was trying to use housing to pull the economy out of the ditch. ?Industries that were already over-levered could not absorb more credit from the Fed. ?Unemployment was rising, and inflation was falling.

There was no bad result to this time of loosening — another surprise would lurk until mid-2004, when finally the loosening would go away. ?By that time, the stock market would be much higher, about as high as it was in October 2001, and credit spreads tighter.

July 2004

At the end of June 2004, the FOMC did its first hike of what would be 17 1/4% rises in the Fed funds rate which would be monotony interspersed with hyper-interpretation of FOMC statement language adjustments, mixed with the wonder of a little kid in the back seat, saying, “Daddy, when will we get there?” ?The FOMC had good reason to act. ?Inflation was rising, unemployment was falling, and they had just left the policy rate down at 1% for 12 straight months. ?In the midst of that in June-August 2003, there was a another small panic in the mortgage bond market, but this time, the FOMC stuck to its guns and did not?raise rates, as they did for something larger in 1994.

With the rise in the Fed funds rate to 1 1/4%, the rate was as high as it was when the recession bottomed in November 2002. ?That’s quite a long period of low rates. ?During that period, the stock market rallied vigorously, credit spreads tightened, and housing prices rallied. ?Long bonds stayed largely flat across the whole period, but still volatile.

There were several surprises in store for the FOMC and investors as ?the tightening cycle went on:

  1. The stock market continued to rally.
  2. So did housing.
  3. So did long bonds, at least for a time.
  4. Every now and then there were little panics, like the credit convexity panic in May 2005, from a funky long-short CDO bet.
  5. Credit complexity multiplied. ?All manner of arbitrage schemes flourished. ?Novel structures for making money off of credit, like CPDOs emerge. ?(The wisdom of finance bloggers as skeptics grows.)
  6. By the end, the yield curve invests the hard way, with long bonds falling a touch through the cycle.
  7. Private leverage continued to build, and aggressively, particularly in financials.
  8. Lending standards deteriorated.

We know how this one ended, but at the end of the tightening cycle, it seemed like another success. ?Only a few nut jobs were dissatisfied, thinking that the banks and homeowners were over-levered. ?In hindsight, FOMC policy should have moved faster and stopped at a lower level, maybe then we would have had less leverage to work through.

June 2010

15 months after the bottom of the crisis, the stock market has rallied dramatically, with a recent small fall, but housing continues to fall in value. ?There’s more leverage behind houses, so when the prices do finally fall, it gains momentum as people throw in the towel, knowing they have lost it all, and in some cases, more. ?For the past year, long bond yields have gone up and down, making a round-trip, but a lot higher than during late 2008. ?Credit spreads are still high, but not as high as during late 2008.

Inflation is low and volatile, unemployment is off the peak of a few months earlier, but is still high. ?Real GDP is growing at a decent clip, but fitfully, and it is still not up to pre-crisis levels. ?Aside from the PPACA [Obamacare], congress hasn’t done much of anything, and the Fed tries to fill the void by expanding its balance sheet through QE1, which ended in June 2010. Things feel pretty punk altogether.

The FOMC can’t cut the Fed funds?rate anymore, so it relies on language in its FOMC Statement to tell economic actors that Fed funds will be “exceptionally low” for an “extended period.” ?Four months from then, the QE2 would sail, making the balance sheet of the Fed bigger, but probably doing little good for the economy.

The results of this period aren’t fully known yet because we still living in the same essential macro environment, with a few exceptions, which I will take up in the final section.

August 2014

Inflation remains low, but may finally be rising. ?Unemployment has fallen, much of it due to discouraged workers, but there is much underemployment. ?Housing has finally gotten traction in the last two years, but there are many cross-currents. ?The financial crisis eliminated move-up buyers by destroying their equity. ?Stocks have continued on a tear, and corporate credit spreads are very tight, tighter than any of the other periods where the yield curve was shaped as it is now. ?The long bond has had a few scares, but has confounded market participants by hanging around in a range of 2.5%- 4.0% over the last two years.

There are rumblings from the FOMC that the Fed funds rate may rise sometime in 2015, after 72+ months hanging out at 0%. ?QE may end in?a few more months, leaving the balance sheet of the Fed at 5 times its pre-crisis size. ?Change may be upon us.

This yield curve shape tends to happen over my survey period at a time when change is about to happen (4 of 7 times — 1971, 1977, 1993 and 2004), and one where the?FOMC will raise rates aggressively (3 of 7 times — 1977, 1993 and 2004) after fed funds have been left too low for too long. ?2 out of 7 times, this yield curve shape appears near the end of a loosening cycle (1991 and 2001). ?1 out of 7 times it appears before a deep recession, as in 1971. 1 out of 7 times it appears in the midst of an uncertain recovery — 2010. 3?out 7 times, inflation will rise significantly, such as in 1971, 1977 and 2004.

My tentative conclusion is this… the fed funds rate has been too low for too long, and we will see a rapid rise in rates, unless the weak economy chokes it off because it can’t tolerate any significant rate increases. ?One final note before I close: when the tightening starts, watch the long end of the yield curve. ?I did this 2004-7, and it helped me understand what would happen better than most observers. ?If the yield of the long bond moves down, or even stays even, the FOMC probably won’t persist in raising rates much, as the economy is too weak. ?If the long bond runs higher, it might be a doozy of a tightening cycle.

And , for those that speculate, look for places that can’t tolerate or would ?love higher short rates. ?Same for moves in the long bond either way, or wider credit spreads — they can’t get that much tighter.

This is an unusual environment, and as I like to say, “Unusual typically begets unusual, it does not beget normal.” ?What I don’t know is how unusual and where. ?Those getting those answers right will do better than most. ?But if you can’t figure it out, don’t take much risk.

A Few Investment Notes

A Few Investment Notes

Posted on by David Merkel

Just a few notes for this evening:

1) I’ve been a bull on the long end of the Treasury curve for a while. ?It’s been a winning bet, and the drumbeat of “interest rates have nowhere to go but up” continues. ?Here’s an argument from Jeffrey Gundlach on why long rates should remain low, and maybe go lower:

Gundlach, however, was one of the very few people?who believed rates would stay low, especially with the Federal Reserve committed to keeping rates low with its loose monetary policy.

It’s important to note that U.S. Treasuries don’t have the lowest yields in the world. French and?German government bonds have yields?that are about 100 basis points lower than those of Treasuries. In other words, those European bonds actually make U.S. bonds look cheap, meaning that yields have room to go lower.

This will trend toward lower rates will eventually have to end, but neither GDP growth, inflation, or business lending justifies it at present.

2) From Josh Brown, he notes that correlations went up considerably with all risk assets in the last bitty panic. ?Worth a read. ?My two cents on the matter comes from my recent article, On the Recent Anxiety in High Yield Bonds, where I noted how much yieldy stocks got hit — much more than expected. ?I suspect that some asset allocators with short-dated or small stop-loss trading rules began selling into the bitty panic, but that is just a guess.

3) That would help to explain the loss of liquidity in the bond market during the bitty panic. ?This article from Tracy Alloway at the FT explores that topic. ?One commenter asked:

Isn’t it a bit odd to say lots of people sold quickly *and* that there isn’t enough liquidity??

Liquidity means a number of things. ?In this situation, spreads widened enough that parties that wanted to sell had to give up price to do so, allowing the brokers more room to sell them to skittish buyers willing to commit funds. ?Sellers were able to get trades done at unfavorable levels, but they were determined to get the trades done, and so they were done, and a lot of them. ?Buyers probably had some spread target that they could easily achieve during the bitty panic, and so were willing to take on the bonds. ?Having a balance sheet with slack is a great thing when others need liquidity now.

One other thing to note from the article is that it mentioned that retail investors now own 37%?of credit, versus?29% in 2007, according to RBS. Also that?investment funds has been able to buy?all?of the new corporate debt sold since 2008.

There’s more good stuff in the article including how “matrix pricing” may have influenced the selloff. ?When spreads were so tight, it may not have taken a very large initial sale to make the estimated prices of other bonds trade down, particularly if the sales were of lower-rated, less-traded bonds. ?Again, worth a read.

4) Regarding credit scores, three articles:

From the WSJ article:

Fair Isaac?Corp.?said Thursday that it will stop including in its FICO credit-score calculations any record of a consumer failing to pay a bill if the bill has been paid or settled with a collection agency. The San Jose, Calif., company also will give less weight to unpaid medical bills that are with a collection agency.

I think there is less here than meets the eye. ?This only affects those borrowing from lenders using the particular FICO scores that were modified. ?Not all lenders use that particular score, and many use FICO data disaggregated to create their own score, or ask FICO to give them a custom score that they use. ?Again, from the WSJ article:

Fair Isaac releases new scoring models every few years, and it is up to lenders to choose which ones to use. The new score will likely be adopted by credit-card and auto lenders first, says John Ulzheimer, president of consumer education at CreditSesame.com and a former Fair Isaac manager.

Mortgages are likely to lag, since the FICO scores used by most mortgage lenders are two versions old.

The?impact of the changes on borrowers is likely to be significant. Accounts that are sent to collections, including credit-card debts and utility bills, can stay on borrowers’ credit reports for as long as seven years, even when their balance drops to zero, and can lower their scores by up to 100 points, said Mr. Ulzheimer.

The lower weight given to unpaid medical debt could increase some affected borrowers’ FICO scores by 25 points, said Mr. Sprauve.

But lowering the FICO score by itself doesn’t do anything. ?Some lenders don’t adjust their hurdles to reflect the scores, if they think the score is a better measure of credit for their time-horizon, and they want more loan volume. ?Others adjust their hurdles up, because they want only a certain volume of loans to be made, and they want better quality loans at existing pricing.

Megan McArdle at Bloomberg View asks a different question as to whether it is good to extend more credit to marginal borrowers? ?Didn’t things go wrong doing that before? ?Her conclusion:

That in itself [DM: pushing for more loans to marginal borrowers as a matter of policy] is an interesting development. Ten years ago, politicians were pressing hard for banks to extend the precious boon of homeownership to every man, woman and shell corporation in America. Five years ago, when people were pushing for something like the CFPB, the focus of the public debate had dramatically shifted toward protecting people from credit. Oh, there were complaints about the cost of subprime loans, but ultimately, on most of those loans, the problem?wasn?t the interest rate but the principal: Too many people had taken out loans that they could not realistically afford to pay, especially if anything at all went wrong in their lives, from a job loss to a divorce to an unexpected illness. And so you heard a lot of complaints about predatory lenders who gave people more credit than they could handle.

Credit has tightened considerably since then, and now, it appears, we?re unhappy with that. We want cheaper, easier credit for everyone, and particularly for the kind of financially struggling people who have seen their credit scores pummeled over the last decade. And so we see the CFPB pressing FICO to go easier on people with satisfied collections.

That?s not to say that the CFPB is wrong; I don?t know what the ideal amount of credit is in a society, or whether we are undershooting the mark. What I do think is that the U.S. political system — and, for that matter, the U.S. financial system — seems to have a pretty heavy bias toward credit expansion. Which explains a lot about the last 10 years.

Personally, I look at this, and I think we don’t learn. ?Credit pulls demand into the present, which is fine if it doesn’t push losses and heartache into the future. ?We are better off with a slower, less indebted economy for a time, and in the end, the economy as a whole will be better off, with people saving to buy in the future, rather than running the risk of defaults, and a very punk economy while we work through the financial losses.

Not Apt, Not Teed Up, Not Going

Not Apt, Not Teed Up, Not Going

Posted on by David Merkel

Okay, let’s run the promoted stocks scoreboard:

Ticker Date of Article Price @ Article Price @ 6/27/14 Decline Annualized Splits
GTXO 5/27/2008 2.45 0.022 -99.1% -53.3%  
BONZ 10/22/2009 0.35 0.001 -99.8% -72.8%  
BONU 10/22/2009 0.89 0.000 -100.0% -85.1%  
UTOG 3/30/2011 1.55 0.000 -100.0% -92.3%  
OBJE 4/29/2011 116.00 0.069 -99.9% -89.7% 1:40
LSTG 10/5/2011 1.12 0.010 -99.1% -81.2%  
AERN 10/5/2011 0.0770 0.0001 -99.9% -90.5%  
IRYS 3/15/2012 0.261 0.000 -100.0% -100.0% Dead
RCGP 3/22/2012 1.47 0.045 -96.9% -77.2%  
STVF 3/28/2012 3.24 0.340 -89.5% -61.8%  
CRCL 5/1/2012 2.22 0.008 -99.6% -91.7%  
ORYN 5/30/2012 0.93 0.026 -97.2% -80.7%  
BRFH 5/30/2012 1.16 0.779 -32.8% -16.8%  
LUXR 6/12/2012 1.59 0.006 -99.7% -93.0%  
IMSC 7/9/2012 1.5 1.220 -18.7% -9.5%  
DIDG 7/18/2012 0.65 0.042 -93.6% -74.0%  
GRPH 11/30/2012 0.8715 0.073 -91.6% -77.4%  
IMNG 12/4/2012 0.76 0.015 -98.0% -90.6%  
ECAU 1/24/2013 1.42 0.004 -99.7% -97.8%  
DPHS 6/3/2013 0.59 0.007 -98.9% -97.9%  
POLR 6/10/2013 5.75 0.050 -99.1% -98.4%  
NORX 6/11/2013 0.91 0.090 -90.1% -86.9%  
ARTH 7/11/2013 1.24 0.200 -83.9% -82.2%  
NAMG 7/25/2013 0.85 0.085 -90.0% -89.6%  
MDDD 12/9/2013 0.79 0.060 -92.4% -98.2%  
TGRO 12/30/2013 1.2 0.150 -87.5% -97.1%  
VEND 2/4/2014 4.34 1.500 -65.4% -88.7%  
HTPG 3/18/2014 0.72 0.100 -86.1% -99.5%  
WSTI 6/27/2014 1.35 0.735 -45.6% -99.8%  
  8/1/2014   Median -97.2% -89.6%

 

Now for tonight’s loser-in-waiting: Apptigo [APPG]. ?This is a company that ?until four months ago was a development stage company for selling Irish horses in the US. ?This is a company that has never earned any money, and only has positive net worth at present because of raising capital when the prior company acquired Apptigo in a reverse marger, and renamed itself Apptigo.

This is a company that says it will make money off of selling apps. ?Well, they have one app at present, and it is called?SCORE – Match Maker. ?It has a grand total of seven likes at the iTunes Store. ?Now let me hazard a guess here, and say that it is difficult to create a broad network for matchmaking. ?The value of a network goes up proportional to the square of its nodes. ?How will they attract enough attention in the iTunes ecosystem to make ?a significant network? ?Even if this is a legitimate company, I don’t see how it will be easy to make it work, as the promoter said it would be easy.

The promoter also said this in tiny type:

Important Notice and Disclaimer: Flying Under the Radar Stocks is an independent paid circulation newsletter. This report is a solicitation for subscriptions and a paid promotional advertisement of Apptigo, Inc. (APPG). Flying Under the Radar Stocks received an editorial fee of twenty five thousand dollars from Micro Cap Media Ltd. APPG was chosen to be profiled after Flying Under the Radar Stocks completed due diligence on APPG. Flying Under the Radar Stocks expects to generate new subscriber revenue the amount of which is unknown at this time resulting from the distribution of this report. Micro Cap Media Ltd. paid nine hundred forty-eight thousand, three hundred sixty-three dollars to advertising agencies for the cost of creating and distributing this report, including printing and postage, in an effort to build investor awareness. This report does not provide an analysis of a company’s financial position, operations or prospects and this is not to be construed as a recommendation by Micro Cap Media Ltd. or an offer to buy or sell any security or investment advice. An offer to buy or sell can only be made with accompanying disclosure documents and only in states and provinces for which they are approved. Do not base any investment decision based solely on information in this report. Although the information contained in this advertisement is believed to be reliable, Micro Cap Media Ltd. makes no warranties as to the accuracy of any of the contents herein and accepts no liability for how readers may choose to utilize the content. Readers should perform their own due diligence, including consulting with a licensed, qualified investment professional. Further, readers are strongly urged to independently verify all statements made in this report APPG?s financial position and all other information regarding APPG should be verified directly with APPG Audited financial statements and other relevant information about APPG can be found at the Security and Exchange Commission’s website at www.sec.gov. It is recommended that any investment in any security should be made only after consulting with your investment advisor and only after reviewing all publicly available information, including the financial statements of the company. The information contained herein contains forward-looking information within the meaning of section 27a of the Securities Act of 1933 as amended and section 21e of the Securities Act of 1934 as amended including statements regarding growth of APPG. In accordance with the safe harbor provisions of the Private Securities Litigation Reform Act, statements contained herein that look forward in time, which include everything other than historical information, involve risks and uncertainties. ?All forward-looking statements are based upon current assumptions that are believed to be reasonable. In the event any such assumptions turn out to be incorrect, forward-looking statements based upon those assumptions will not be accurate. Flying Under the Radar Stocks presents information in this report believed to be reliable, but its accuracy cannot be guaranteed. More information can be found at APPG’s website www.apptigo.com. (underline emphasis mine)

I actually like this disclaimer, except for the fact that it is in tiny type, while the proclamation of the investment’s fake virtues are in big type. ?So, I have a simple proposal for the SEC regarding newsletters like this: the type size of any disclaimer must be as large as the the largest type in the document.

This is fair, and consistent with other laws that regulate “the fine print.”

I emailed the CEO of Apptigo to ask him whether he knew about the stock promotions (there are three going on), and whether the company, its major shareholders, or its management was benefiting from the promotion. ?There was no answer, though I wrote to him on Thursday.

Regardless, avoid promoted stocks, dear friends. ?No company of any good reputation pays anyone to promote their stock. ?Avoid promoted stocks.

On Current Credit Conditions

On Current Credit Conditions

Posted on by David Merkel

This should be short. ?Remember that credit and equity volatility are strongly related.

I am dubious about conditions in the bank loan market because Collateralized Loan Obligations [CLOs] are hot now and there are many that want to take the highest level of risk there. ?I realize that I am usually early on credit?issues, but there are many piling into CLOs, and willing to take the first loss in exchange for a high yield. ?Intermediate-term, this is not a good sign.

Note that corporations take 0n more debt when rates are low. ?They overestimate how much debt they can service, because if rates rise, they are not prepared for the effect on earnings per share, should the cost of the debt reprice.

It’s a different issue, but consider China with all of the bad loans its banks have made. ?They are facing another significant default, and the Chinese Government looks like it will let the default happen. ?That will not likely be true if the solvency of one of their banks is threatened, so keep aware as the risks unfold.

Finally, look at the peace and calm of low implied volatilities of the equity markets. ?It feels like 2006, when parties were willing to sell volatility with abandon because the central banks of our world had everything under control. ?Ah, remember that? ?Maybe it is time to buy volatility when it is cheap. ?Now here is my question to readers: aside from buying long Treasury bonds, what investments can you think of that benefit from rising implied volatility and credit spreads, aside from options and derivatives? ?Leave you answers in the comments or email me.

This will sound weird, but I am not as much worried about government bond rates rising, as I am with credit spreads rising. ?Again, remember, I am likely early here, so don’t go nuts applying my logic.

PS — weakly related, also consider the pervasiveness of BlackRock’s risk control model. ?Dominant risk control models may not truly control risk, because who will they sell to? ?Just another imbalance of which to be wary.

Book Review: The Secret Club that Runs the World

Book Review: The Secret Club that Runs the World

Posted on by David Merkel

la_ca_0506_the_secret_club_that_runs This is a very good book; I learned a lot as I read it, and you will too.

In this book, Kate Kelly takes on the economic sector?of commodities. ?This involves production, distribution, trading, hedging, and ultimate use.

There are many players trying to profit in many different ways. ?There are hedge funds, commodity trading advisers, investment banks, producers, refiners. ?Some do just one facet of the commodities sector; some do everything.

This book is replete with stories from the run-up in commodity prices, and all of the games that went on. ? It tells of those who made a lot of money, and those that want ?broke working in a very volatile part of the economy.

It is a book that gives a testimony that information is king, and those that understand future supply, demand, and transportation costs can make a great deal of money by buying cheap, transporting, and selling high.

That said, the math can get overly precise versus the real world… the book gives examples of hedging programs that were too clever by half, ending in disaster when prices moved too aggressively.

With hedging, simplicity is beauty. ?But after some success in trading well, companies think that instead of hedging, let trading become a profit center of its own . ?Far from reducing risk, risks rise beyond measure, until the scheme blows up.

The book also considers non-market players like politicians and regulators, and how they are almost always a few steps behind those they regulate. ?A key theme of the book is whether market participants can manipulate prices or not. ?I would invite all market participants to consider my writings on penny stocks. ?Can the price be manipulated? ?Yes. ?For how long? ?Maybe a month or two at best. ?In bigger markets like commodities, I?suspect the ability to manipulate prices is less, because there are more players trading, and the power is equal between buyers and sellers. ?There are powerful parties on both sides seeking their advantage.

The Glencore/Xtsrata merger and Delta Airlines hedging program/buying a refinery occupy a decent amount of the book. ?Glencore/Xstrata illustrates the desire for scale and control in owning production in trading assets in commodities. ?Delta Airlines illustrates the difficulties involve in being a heavy energy user in a cyclical, capital-intensive business that carries a lot of debt. ?It’s too early to tell whether owning their own oil refining operation was the right decision or not, though typically companies do better to specialize, rather than vertically integrate.

One you have read this book, you will have a good top-level view of how the commodities sector operates, and thus I recommend the book.

Quibbles

The book title is vastly overstated. ?There is no secret. ?Just becuse many people don’t know about them doesn’t mean they are secret. ?There is adequate data about them if you look.

There is no club. ?Yes, some move from one position in one firm to a position in another. ?Some even become regulators. ?That is common to most industries.

They don’t run the world. ?At most, they have a weak hold over commodities markets, because the traders have better data on global supply and demand than most large producers and consumers do. ?That information allows them to profit on spreads, but it doesn’t let them move markets.

Summary

Given my quibbles, I thought it was a great book. ?A marketing guy probably wrote the title, so I give the author a pass on that. ?If you want a readable high-level view of the commodities markets, you can get it in this book. ?If you want to, you can buy it here:?The Secret Club That Runs the World: Inside the Fraternity of Commodity Traders.

Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

A Stream of Hot Air

A Stream of Hot Air

Posted on by David Merkel

Let’s roll the promoted stocks scoreboard:

Ticker Date of Article Price @ Article Price @ 6/27/14 Decline Annualized Splits
GTXO 5/27/2008 2.45 0.022 -99.1% -53.9%  
BONZ 10/22/2009 0.35 0.001 -99.8% -72.7%  
BONU 10/22/2009 0.89 0.000 -100.0% -83.4%  
UTOG 3/30/2011 1.55 0.001 -100.0% -90.7%  
OBJE 4/29/2011 116.00 0.083 -99.9% -89.9% 1:40
LSTG 10/5/2011 1.12 0.011 -99.0% -81.6%  
AERN 10/5/2011 0.0770 0.0001 -99.9% -91.3%  
IRYS 3/15/2012 0.261 0.000 -100.0% -100.0% Dead
RCGP 3/22/2012 1.47 0.080 -94.6% -72.4%  
STVF 3/28/2012 3.24 0.430 -86.7% -59.3%  
CRCL 5/1/2012 2.22 0.013 -99.4% -90.7%  
ORYN 5/30/2012 0.93 0.026 -97.2% -82.2%  
BRFH 5/30/2012 1.16 0.620 -46.6% -26.1%  
LUXR 6/12/2012 1.59 0.007 -99.6% -93.3%  
IMSC 7/9/2012 1.5 1.000 -33.3% -18.6%  
DIDG 7/18/2012 0.65 0.047 -92.8% -74.2%  
GRPH 11/30/2012 0.8715 0.077 -91.2% -78.6%  
IMNG 12/4/2012 0.76 0.025 -96.7% -88.8%  
ECAU 1/24/2013 1.42 0.047 -96.7% -90.9%  
DPHS 6/3/2013 0.59 0.008 -98.7% -98.3%  
POLR 6/10/2013 5.75 0.051 -99.1% -98.9%  
NORX 6/11/2013 0.91 0.110 -87.9% -86.8%  
ARTH 7/11/2013 1.24 0.213 -82.8% -84.0%  
NAMG 7/25/2013 0.85 0.087 -89.8% -91.5%  
MDDD 12/9/2013 0.79 0.097 -87.7% -97.8%  
TGRO 12/30/2013 1.2 0.181 -84.9% -97.9%  
VEND 2/4/2014 4.34 2.090 -51.8% -84.5%  
HTPG 3/18/2014 0.72 0.090 -87.5% -99.9%  
6/27/2014 Median -96.7% -87.8%

 

My, but aren’t they predictable. ?Onto tonight’s loser-in-waiting Windstream Technologies [WSTI]. ?This is another company with negative earnings and net worth, though it has a modest amount of revenue.

Think of it for a moment: this company has a “breakthrough technology,” and yet they were a hotel company within the last year or two. ?That’s not how real businesses work. ?I you have an incredible technology, but little capital, private equity investors will happily fund you. ?You won’t try to do it in some underfunded corporate shell which tempts crooked financial writers to write fantasy.

Now, you might look at the disclaimer in the glossy brochure which came to my house, which in 5-point type takes back all of things that they about in bold headlines and readable text. ?For example:

  • It begins with:?DO NOT BASE ANY INVESTMENT DECISION UPON ANY MATERIALS FOUND IN THIS REPORT.
  • The Wall St. Revelator is neither licensed nor qualified to provide financial advice. As such, it relies upon the “publisher’s exclusion” as provided under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws.
  • The Wall Street Revelator and/or its publisher, Andrew & Lynn Carpenter, dba The Wall Street Revelator has received a total amount of twenty five thousand dollars [DM: $25,000] in cash compensation to assist in the writing of this Advertisement, as well as potential future subscription and advertising revenues, the amount of which is not known at this time with respect to the publication of this Advertisement and future publications.
  • Mandarin Media Limited paid nine hundred thousand dollars [DM: $900,000]?to marketing vendors to pay for all the costs of creating and distributing this Advertisement, including printing and postage, in an effort to build investor and market awareness.
  • Mandarin Media Limited was paid by non-affiliate shareholders who fully intend to sell their shares without notice into this Advertisement/market awareness campaign, including selling into increased volume and share price that may result from this Advertisement/market awareness campaign.
  • The non-affiliate shareholders may also purchase shares without notice at any time before, during or after this Advertisement/market awareness campaign.
  • Non-affiliate shareholders acted as advisors to Mandarin Media Limited in this Advertisement and market awareness campaign, including providing outside research, materials, and information to outside writers to compile written materials as part of this market awareness campaign.

The disclaimer exists to cover the writers from legal risk, and what it tells us is that there are largish shareholders looking to profit by running up the stock price as a result ?of the advertisement, enough to cover the $925,000 cost.

Such it is with a pump and dump. ?One thing is virtually certain, though. ?This is not a stock to hold onto. ?Look at the stocks in the table above. ?No winners, and most are almost total losses in the long run. ?Manipulators love working with stocks that have no earnings and no net worth, because they are impossible to value for the grand majority of people. ?New buyers, if they come in a group, can create a frenzy that raises prices.

That’s the goal of the advertising campaign: a short term “pop” that the sponsoring shareholders can sell into, letting a bunch of muppets take losses.

Again, never buy promoted stocks. ?If they have to buy the services of others to promote the stock, it is a fraud. ?Good stocks do not need promotion. ?It’s that simple.

PS — the pretentiousness of the word “revelator” should be replaced by the simpler “revealer.”

The Tails of the Distribution do not Validate the Mean

The Tails of the Distribution do not Validate the Mean

Posted on by David Merkel

17 months ago I wrote a post?How to Become Super-Rich?? Now, many of my articles are timeless — they will still have value 10 years from now. ? I like to write for the long-run. ?Teaching basic principles is what this blog is about.

The surprise for me is that article is the most?popular one at my blog. ?That says something about the desires of mankind. ?Now, if you do want a chance to become super-rich, you create your own company, and focus your efforts on it exclusively. ?Diversification is not ?a goal here. ?We are swinging for the fences here.

But just as in baseball the guys who swing for the fences to hit home runs, they also tend to strike out the most. ?The same is true of businessmen. ?Many start companies, put their all into it, and end up broke. ?Many end up with marginal businesses that give them a living, but not much more. ?A few prosper and become moderately wealthy. ? A tiny amount of them create a hugely profitable company that makes them super-rich.

Anyway, after I was cold-called by Militello Capital, I reviewed articles on the blog, including one called?CRACK THE WEALTH CODE. ?I’ll quote the most relevant portion of the post:

According to?Get Rich, Stay Rich, Pass It On: The Wealth-Accumulation Secrets of America?s Richest Families?by Catherine McBreen and George Walper Jr, ?Building up a nest egg with the equity in your home is a fine thing. But what distinguishes the model for getting rich, staying rich and passing it on is its emphasis on investing in current and future income-producing real estate?. Andrew Carnegie, the wealthiest man in America during the early 20th century, said that ?90 percent of all millionaires become so through owning real estate.? If that?s not enough to peak your interest, consider this: ?The major fortunes in America have been made in land?, coined by John D. Rockefeller. What does he know?..his net worth in today?s dollars is?onlyaround $300 billion. Invest in areas you know. Real estate gives you the opportunity to visit and connect with your investment. When?s the last time you connected with your mutual fund?

Don?t forget about the second part of the winning combo: private companies. Open your eyes to entrepreneurial opportunities. McBreen and Walper advise that at least one-quarter of your investment dollars should be in enterprises that develop products and services or invent breakthrough technologies. In?10 things billionaires won?t tell you, number seven?s title, ?We didn?t get rich investing in stocks?, hits the nail on the head. Billionaires like Steve Jobs, Bill Gates, and Mark Zuckerberg made their fortunes in start-ups, says Robert Klein, founder and president of Retirement Income Center, a retirement and income planning firm in Newport Beach, California. The article confirms that ?you?re far more likely to become a billionaire in Silicon Valley than on Wall Street.?

In one sense, I agree with what they say. ?If you want to become super-rich, pursue one goal with your one company. ?Less than 1% will succeed. ?Maybe 5-10% will attain to being multi-millionaires. ?Most will muddle or fail.

Running your own business, including real estate investing, is not a magic ticket to riches. ?A lot depends on:

  • Solving problems people didn’t know they had.
  • The time period that you invest during — were financial conditions favorable for speculation?
  • The ability to manage a large enterprise is an uncommon skill.
  • The ability to be an entrepreneur is also not common. ?Most people don’t want to take that much risk.
  • Discipline, hard effort, taking time away from family and friends.

There is a cost to trying to be super-rich, and most people die at that altar of greed. ?I suspect that most that succeed, did not aim to be super-rich, but pursued that task because they found it interesting. ?They were idealists who happened to be in business, and their ideals matched up with what would enable society to pursue its goals more effectively.

So does it make sense for average people to invest in private equity funds or private real estate funds because the wealthy ran their own companies and invested in commercial real estate?

No. ?First, remember that the super-wealthy were swinging for the fences. ?They were the rare success stories.

Second, note that those who invest in?private equity funds or private real estate funds are diversifying. ?As such, they are seeking more certainty, and will not gain an abnormally large return.

Third, recognize the data bias. ?Those who succeed with?private equity funds or private real estate funds, their data exists, while those who fail disappear.

There is no advantage to being public or private as a business. ?Private businesses can keep things secret, but public businesses have a lower cost of capital.

Conclusion

Just because the wealthy got that way by making big bets that most people lose, does not mean that average people should do that. ?Alternative investments like?private equity funds or private real estate funds are not an automatic road to wealth, and are less transparent than their liquid alternatives on the stock exchanges.

Average people should avoid low probability bets — they tend to impoverish, with high probability.

PS — that said, I like commercial real estate as a diversifier, but it won’t make you rich.

On Bond Risks in the Short-Run

On Bond Risks in the Short-Run

Posted on by David Merkel

From a letter from a reader:

Hi David,

I’ve been following your blog for the last few months and the articles are extremely insightful.

I’ve been working with fixed income credit trading the last few years but I feel that I have not been measuring risk well. I only look at cash bonds

Right now I’m only looking at DV01 and CR01, but my gut tells me that there’s a lot more to risk monitoring that can be done on a basic cash bond portfolio.

From your experience as a bond portfolio manager, what other risk metrics have you found useful?

I’d really appreciate if there were a few pointers you could give or just a trail that you could show me and I’ll follow it.

First, some definitions:

Basis Point [bp]: 0.01% — one one-hundredth of a percent. ?If you have $10,000 in a money-market fund, and they pay one basis point of interest per year, at the end of the year you will have $10,001. ?In this environment, that’s not uncommon.

DV01:?A?bond valuation?calculation?showing the?dollar?value?of a one?basis point?increase or?decrease?in?interest rates. It shows the?change?in a?bond’s?price?compared to a decrease in the bond’s?yield.

CR01: Credit Sensitivity ? Credit Default Swap [CDS] price change for 1bp shift in Credit par spread — same as DV01, but applied to CDS instead of a bond.

Now, onto the advice: when you manage bonds, the first thing you have to do is understand your time horizon. ?Is it days, weeks, months, or years? ?When I managed bonds for a life insurer 1998-2003, the answer was years. ?Many years, because the liabilities were long. ?That gave me a lot of room to maneuver. ?You sound like you are on a short leash. ?Maybe you have a month as your time horizon.

When the time horizon is short, the possibilities for easy profits are few, and here are a few ideas:

1) Momentum: yes, it works in the bond market also. ?Own bonds that are rising, and sell those that are falling. ?Be sensitive to turning points, and review the relative strength index.

2) Stick with sectors that are outperforming. ?Neglect those that underperform.

3) If you have significant research that has a differential insight on a bond, pursue it with a small amount of money if it may take a while. ?If the change might happen soon, increase the position.

4) Try to understand when CDS is rich or cheap vs cash bonds by issuer. ?Look at the price history, and commit capital when pricing is significantly in your favor.

5) Set spread?targets for your investing. ?Decide on levels where you would commit minimum, normal, and maximum funds. ?Be generous with the maximum level, because markets are more volatile than most imagine.

6) Look at the criteria for my one-minute drill:?http://alephblog.com/2010/07/17/the-education-of-a-corporate-bond-manager-part-ii/

(and look at the end of the piece, but the whole piece/series has value.)

7) Analyze common factors in your portfolio, and ask whether those are risks you want to take:

  • Industry risks
  • Duration risks
  • Counterparty risks

8 ) Look at the stock. ?If it is behaving well, the bonds will follow.

Maybe your best bet is to trade CDS versus cash bonds, if the spread is thick enough to do so. ?If not, I would encourage you to talk with more senior ?traders to ask them how they survive. ?Trading is a tough game, and I do not envy being a trader.

The Good ETF, Part 2 (sort of)

The Good ETF, Part 2 (sort of)

Posted on by David Merkel

About 4.5 years ago, I wrote a short piece called?The Good ETF. ?I’ll quote the summary:

Good ETFs are:

  • Small compared to the pool that they fish in
  • Follow broad themes
  • Do not rely on irreplicable assets
  • Storable, they do not require a ?roll? or some replication strategy.
  • Not affected by unexpected credit events.
  • Liquid in terms of what they repesent, and liquid it what they hold.

The last one is a good summary.? There are many ETFs that are Closed-end funds in disguise.? An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.

Though I said ETFs, I really meant ETPs, which included Exchange Traded Notes, and other structures. ?I remain concerned that people get deluded by the idea that if it trades as a stock, it will behave like a stock, or a spot commodity, or an index.

What triggered this article was reading the following article:?How a 56-Year-Old Engineer?s $45,000 Loss Spurred SEC Probe. ?Quoting from the beginning of the article:

Jeff Steckbeck?didn’t?read the prospectus. He?didn’t?realize the price was inflated. He?didn’t?even know the security he?read?about?online was something other than an exchange-traded fund.

The 56-year-old civil engineer ultimately lost $45,000 on the wrong end of a?volatility?bet, or about 80 percent of his investment, after a?Credit Suisse Group AG (CSGN)?note known as TVIX crashed a week after he bought it in March 2012 and never recovered. Now Steckbeck says he wishes he?d been aware of the perils of bank securities known as exchange-traded notes that use derivatives to mimic assets from natural gas to stocks.

?In theory, everybody?s supposed to read everything right to the bottom line and you take all the risks associated with it if you don?t,? he said this month by phone from Lebanon,?Pennsylvania. ?But in reality, you gotta trust that these people are operating within what they generally say, you know??

No, you don’t have to trust people blindly. ?Reagan said, “Trust, but verify.” ?Anytime you enter into a contract, you need to know the major features of the contract, or have trusted expert advisers who do know, and assure you that things are fine.

After all, these are financial markets. ?In any business deal, you may run into someone who offers you something that sounds attractive until you read the fine print. ?You need to read the fine print.? Now, fraud can be alleged to those who actively dissuade people from reading the fine print, but not to those who offer the prospectus where all of the risks are disclosed. ?Again, quoting from the article:

Some fail to adequately explain that banks can bet against the very notes they?re selling or suspend new offerings or take other actions that can affect their value, according to the letter.

[snip]

?My experience with ETN prospectuses is that they?re very clear about the fees and the risks and the transparency,? Styrcula said. ?Any investor who invests without reading the prospectus does so at his or her own peril, and that?s the way it should be.?

[snip]

The offering documents for the VelocityShares Daily 2x?VIX (VIX)?Short Term ETN, the TVIX, says on the first page that the security is intended for ?sophisticated investors.? The note ?is likely to be close to zero after 20 years and we do not intend or expect any investor to hold the ETNs from inception to maturity,? according to the prospectus.

While Steckbeck said a supervisor at Clermont Wealth Strategies advised him against investing in TVIX in February 2012, he bought 4,000 shares the next month from his self-managed brokerage account. The adviser, whom Steckbeck declined to name,?didn’t?say that the price had become unmoored from the index it was supposed to track.

David Campbell, president of Clermont Wealth Strategies, declined to comment.

Steckbeck, who found the TVIX on the Yahoo Finance website, doesn?t have time to comb through dozens of pages every time he makes an investment, he said.

?Engineers — we?re not dumb,? said Steckbeck, who founded his own consulting company in 1990. ?We?re good with math, good with numbers. We read and understand stuff fairly quickly, but we also have our jobs to perform. We can?t sit there and read prospectuses all day.?

If you are investing, you need to read prospectuses. ?No ifs, ands, or buts. ?I’m sorry, Mr. Steckbeck, you’re not dumb, but you are foolish. ?Being bright with math and science is not enough for investing if you can’t be bothered to read the legal documents for the complex contract/security that you bought. ?I read every prospectus for every security that I buy if it is unusual. ?I read prospectuses and 10-Ks for many simple securities like stocks — the managements must “spill the beans” in the “risk factors” because if they don’t, and something bad happens that they didn’t talk about, they will be sued.

In general I am not a fan of a “liberal arts” education. ?I am a fan of math and science. ?But truly, I want both. ?We homeschool, and our eight kids are “all arounds.” ?They aren’t all smart, but they tend to be equal with verbal and quantitative reasoning. ?Truly bright people are good with both math and language. ?Final quotation from the article:

?The whole point of making these things exchange-traded was to make them accessible to retail investors,? said?Colbrin Wright, assistant professor at?Brigham Young University?in Provo,?Utah, who has written academic articles on the indicative values of ETNs. ?The majority of ETNs are overpriced, and about a third of them are statistically significant in their overpricing.?

So, I contacted Colby Wright, and we had a short e-mail exchange, where he pointed me to the paper that he co-wrote. ?Interesting paper, and it makes me want to do more research to see how great ETN prices can be versus their net asset values [NAVs]. ?That said, end of the paper errs when it concludes:

We assert that the frequent and persistent negative WDFDs [DM: NAV premiums] that appear to be driven by?uninformed return chasing investors would not exist to the conspicuous degree that we observe if ETNs?offered a more investor-driven and fluid system for share creation. We believe the system for share?creation is ineffective in mitigating the asymmetric mispricing investigated in our study. Hence, we?recommend that ETN issuers reformulate the share creation system related to their securities.?Specifically, we recommend the ETN share creation process be structured to mirror that of ETFs. At a?minimum, the share creation process should be initiated by investors, rather than by the ETN issuers?themselves, as we believe profit-motivated investors will be more diligent and responsive in creating?ETN shares when severe mispricing arises.

Here’s the problem: ETNs are debt, not equity. ?To have the same share creation system means that the debtor must be willing to take on what could be an unlimited amount of debt. ?In most cases, that doesn’t work.

So I come back to where I started. ?Be skeptical of complexity in exchange traded products. ?Avoid complexity. ?Complexity works in favor of the one offering the deal, not the one accepting the deal. ?I have only bought one structured note in my life, and that was one that I was allowed to structure. ?As Buffett once said (something like this), “My terms, your price.”

To close, here are four valuable articles on this topic:

So avoid complexity in investing. ?Do due diligence in all investing, and more when the investments are complex. ?I am astounded at how much money has been lost in exchange traded investments that are designed to lose money over the long term. ?You might be able to avoid it, but someone has to hold every “asset,” so losses will come to those who hold investments long term that were designed to last for a day.

To Live off of, and Die from, the Equity Premium and Alpha

To Live off of, and Die from, the Equity Premium and Alpha

Posted on by David Merkel

I’m working on my taxes. ?I’m not in a good mood. ?Okay, writing that made me chuckle, because I am usually in a good mood.

Let me divide my working life into four segments:

  • 1986-1998: Actuary — reasonably well paid, and significantly underpaid compared to the value I delivered.
  • 1998-2007 — Investment risk manager, Mortgage bond manager, Corporate bond manager, and Senior Analyst at a long/short hedge fund. ?Paid well for my efforts, and the ?rewards to clients were far more than what I was paid.
  • 2007-2010 — Almost no pay, as I deal with home issues, provide research to a small minority broker-dealer, and try to gain institutional asset management clients. ?Living off of assets from earlier days.
  • 2010-2014 — Living off of asset income as I slowly build a retail and small institutional client base for my value investing.

The last two periods are the most interesting in a way, because I was drawing more income from investments than I was from any other source. ?Even during my time at the hedge fund, I made more money from my own investing every year than I was paid, and I was paid well. ?That said the mid-2000s were a hot time, particularly if you made the right calls on a growing global economy.

My net worth today is roughly where it was at the peak of the markets in 2007, despite my low wage income. ?I have been bailed out by the returns of the equity market and my alpha.

This is not a comfortable place to be, because general equity returns are not predictable, and alpha, though I have had it for years, is not predictable either. ?That said, my client base has been growing, and in another year or so, my practice should support my family even if the markets don’t do well.

=-=-=-=-=-=–==-=-=–=-==-=–=-==–=-=-=-=-==-=–=-==-=-=-=-=-=-=-=-=-=-=-

Though I just told a story about me, the real story isn’t about me. ?Think of all of the people who are trying to manage their lump sum in retirement. ?They are relying on strong equity markets; they are hoping for alpha. ?They are not ready for setbacks.

Unless you are seriously wealthy, when you are not receiving reliable income from a wage-like source, you can feel like you are in a weak position. I have felt that on occasion, but in general ?I have not worried.

I write this because equity outperformance over bonds will likely be limited over the next ten years. ?I peg equities at about a 5%/year average nominal return, with a diversified portfolio of bonds at around 2-3%/year. ?Also the ability to add alpha is limited, because alpha is zero in total, and are you smart enough to find the managers that can do it?

In desperate times desperate men do desperate things. ?Low interest rates are leading many to speculate more than they ordinarily would. ?Equity allocations go higher. ?Allocations to “alternatives” go higher. ?People start using nonguaranteed income vehicles as if they had the structural protections of bonds.

As I always say, be careful. ?Those trying to manage a lump sum for income in retirement are playing a dangerous game where if you try to draw more than 3.5%/year with regularity will prove challenging, because that is playing at the boundary of what the assets can deliver, and leaves little room for an adverse scenario. ?Be careful.

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