January 31, 2009

Liquidity Puts and Other Quant Gems

I remember wondering why some banks and especially Citibank, after things started to go very wrong during the summer of 2007, were so stupid as to take back on their books all sorts of toxic CDOs they had sold to other entities. Well, last week's Economist gave me the answer to that conundrum (emphasis mine):

"Citigroup came a cropper when it sold "liquidity puts" along with its CDOs. These gave the buyers the right to hand the CDO back at the original price if the market collapsed. They looked like a tweak that would enable the bank to extract a slightly higher return, and Citi's most senior managers knew nothing about them. The liquidity puts ended up costing the bank a king's ransom when $25 billion-worth of CDOs came back on the balance sheet."

Citibank didn't take back those CDOs out of a misplaced and almost suicidal attempt at safeguarding its reputation as I thought back then but simply because it was contractually obliged to do so. The stupidity had occurred a long time before, when some genius designed, mispriced and marketed those protective puts.

Speaking of genius quants, how about this modelling gem (emphasis mine):

"A BBB tranche in a CDO might pay out in full if the defaults remained below 6%, and not at all once they went above 6.5%. That is an all-or-nothing sort of return, quite different from a BBB corporate bond, say. And yet because both shared the same BBB rating, they would be modelled in the same way."

January 30, 2009

This is a comment I posted following this Great Depression-related entry on the Toro blog:

The problem with comparing our current predicament with the Great Depression is that such a comparison can, paradoxically, breed complacency as in: "We're not doing as bad as we were in 1931 or '32 or '38, therefore we're going to be OK". It's like the alcoholic saying: "I'm not a heroin addict therefore I'm OK".

January 29, 2009

What a difference one little trendline makes! All of a sudden, it is no longer a bullish potential head and shoulder bottom forming, it is a deadly bearish continuation symetrical triangle. Obviously, until and unless the formation is actually complete, all this is just speculation (the intellectual kind only and not the monetary one). To recap, the key levels for the SPY ETF are, as of today, 82 and 93.

Head and Shoulder Bottom, Follow-Up 2


Trader's Narrative has apparently bought into a revised head and shoulder bottom scenario. The way I and other bloggers saw it play out on 12/28/2008 had unraveled by 1/15/2009.
Is this recycled inverted H & S more likely than the original? Maybe so. It looks more conventional than the previous one and the volume picture fits pretty well with a spike in volume for the right shoulder that's smaller than the spike for the head. So we'll keep an eye on this. A decisive break above 92 would presumably complete the formation.

January 24, 2009

Abelson and the Aftermath Paper

In his latest Barron's piece Alan Abelson picked up and commented on, a little late but we'll cut him some slack (better late than never and all that), the fast-becoming classic Rogoff and Reinhart paper titled The Aftermath of Financial Crises.

So it's fair to assume the notion that we will have a long, protracted and painful recession is in the public now. Granted, Abelson has a well-deserved reputation as a congenital bear and his detractors are prompt to say about him that a broken clock is bound to be right at some point. However, he's been right on the money for the last couple of years and people are definitely paying attention to what he writes about.

From a contrarian point of view therefore, now that the possibility of real ugliness has seeped into the collective unconscious, we would deduce that any new data that even hints at a less than extremely ugly economic future should power some kind of rally. The question in my mind though is that I have the gnawing feeling that even those who have read and accepted the conclusions in the Aftermath paper still hope for something less painful unfolding. Others actually believe the coming stimulus package will thwart the bleak predictions in the Rogoff and Reinhart study. The spirit of hope that has engulfed the nation lately might thus, for better or for worse, foil any contrarian analysis.

January 21, 2009

Unconventional unconventionals

We had Donald Rumsfeld and his unknown unknowns. We now have Bank of England Governor Mervyn King's "unconventional unconventional [monetary] measures" (Dow Jones Newswire).

Unconventional monetary tools are used when the zero-bound has been reached and cutting interest rates is no longer possible, which is already the case for the Fed and just about for the BOE. They are also known as Quantitative Easing.

The "conventional unconventional" measures would be for the BOE to buy government securities.
The "unconventional unconventional" measures would be targeted purchases of any asset whose market has become dysfunctional. The BOE is considering paying above current prices for some assets, which it would presumably have to do since most of those "dysfunctional" assets are priced at, you guessed it, zero.

January 15, 2009

Global Liquidity Trap?

One thing ECB Czar Jean-Claude Trichet has just said during his press conference kind of surprised me: "A Liquidity Trap would not be appropriate for us".

This from a man who until today treated any talk of deflation in the Euro-zone as preposterous science-fiction and was very proud of the fact that his central bank, unlike his colleagues across the ponds, still had ample ammunition. Can non-traditional monetary tools and quantitative easing be very far?

Head and Shoulder Bottom, Follow-up


As a quick but urgent follow-up to a previous post, it is now obvious after yesterday's rout that the potential head and shoulder bottom scenario as I imagined it has unraveled. The breakout above 90 did happen but it turned out to be a head fake. The rationale behind being long having been smashed to smithereens, bailing out of that position would be the disciplined thing to do.
What is going to happen now? I have no idea. Some people think that a failed signal is often a very strong signal that the opposite of what was supposed to happen will happen, in this case SPY should go down hard, but it's mostly anecdotal evidence so I personally would wait and see what develops.

January 13, 2009

Not to show off or anything but one of my posts was picked up by Seeking Alpha. Interestingly, they had previously rejected a couple of my articles because they were too technical analysis-oriented. I guess contrarian investing isn't considered pure technical analysis and therefore is more palatable for publication. Anyhow, I'm not complaining, just musing.

January 12, 2009

Barron's Bashing, Part 267

I was going to do yet another post bashing Barron's and their kind of silly Roundtable. Then I came across Tim Kight's epic post about that very subject and he just nailed it! He even mentions Abby Joseph Cohen's new hairdo! A must read rant.

The only Roundtable participant whose picks actually made money last year, Fred Hickey makes a good point on gold. He said we haven't had a blow-off phase in gold as opposed to the other commodities. It's been an orderly bull for the last 8 years, so he thinks that there's more to go. He sees gold reaching $2,000 an ounce at some point.

January 10, 2009

Contrarian Investing: Pitfalls and Misconceptions

The old quip "Just because you're paranoid doesn't mean they're not out to get you", to which I'll add: "and even less that they won't get you" nicely illustrates a very common misconception when it comes to contrarian investing. In its simplified version, the misconception goes something like this: if a majority of people think something bad is going to happen then it won't happen.

On the face of it, this sounds ludicrous, doesn't it? And yet that is essentially what many market strategists have been saying for the past month in one form or another. They point out that an overwhelming majority of economists, various pundits, and now even our President-elect have been warning us that 2009 will be a disastrous year with rapidly rising unemployment, rapidly falling economic activity and more generally alarming statistics all around. This, the would-be contrarians contend, is proof enough that all the bad news have been discounted and that investors should position themselves, against the majority, for a better-than-expected 2009.

The problem with this line of reasoning is that its underlying assumption, essentially the folk version of Contrarian Theory, that most people are wrong most of the time is just plain wrong. Martin Pring, in his excellent Investment Psychology Explained, reminds us that the Theory of Contrary Opinion says that "the crowd (i.e. the majority of investors or traders) is actually correct most of the time; it is at turning points that they get things wrong". As any behavioral economist will tell you, accurately gauging the majority opinion is extremely difficult to start with. And even if one could correctly (and not only anecdotally) assess what the majority opinion actually was, "this knowledge [would] still result in frustration, because the crowd frequently moves to an extreme well ahead of an important market turning point". As John Schultz wrote in a 1997 Barron's article: "The guiding light of investment contrarianism is not that the majority view - the conventional, or received wisdom - is always wrong. Rather, it's that majority opinion tends to solidify into a dogma while its basic premises begin to lose their original validity and so become progressively more mispriced in the marketplace". In other words and to paraphrase Keynes, the crowd can stay irrational much longer than a trader can stay solvent.

The fact that so many people are making the contrarian argument that 2009 will be better than expected compounded with the fact that many things that are widely expected to go right could go very wrong, the most important of which, in my opinion, being the stimulus package (remember how it was supposed to be signed on Inauguration Day, then before February and now before March) lead me to be very wary of the contrarian bullish case. I don't doubt that the market could mount a few technical counter-trend rallies throughout the year but the idea of a sustained bullish move seems a little extravagant.

After being so wrong for so long, the majority opinion may unfortunately get this one right: 2009 may indeed be a very bad year.

January 8, 2009

The Farcical Swan

Decent article in the New York Times dealing with the shortcomings of Value at Risk. Nassim Taleb is frequently quoted but does not come out as well as the other more measured and cogent experts consulted for the article.

I think the problem with Taleb is that he pushed a good concept (the Black Swan) to its farcical extreme (which incidently is exactly what happened with VaR). Nothing illustrates that better than when he says: “Any system susceptible to a black swan will eventually blow up”.The problem with this statement is that most of the systems we use and live in are susceptible to a black swan (a meteor could hit us, a nuclear bomb could go off, etc...). So what are we supposed to do, never take another risk, never plan another project, hide in a cave and pray?

And how about positive black swans (which Taleb talks about in his books but seems to have forgotten lately)? In trying to avoid negative black swans, we may also deprive ourselves of potential positive black swans and a missed positive black swan can be just as costly as a realized negative one.

January 6, 2009

The Aftermath

No, not the Dr. Dre classic but a great NBER paper titled The Aftermath of Financial Crises that goes over about 20 historical examples of banking crises to try and chart the course of the next few years. The surprising thing is that, historically, the outcome of each major financial crisis has been pretty homogeneous worldwide and there is no reason to believe this time will be different. As the authors nicely put it in their conclusion, "one would be wise not to push too far the conceit that we are smarter than our predecessors".

Basically here's what we should expect (the averages for the historical comparison group):

- A real housing price decline of 35% with a downturn lasting about six years.
- An equity price decline of 55%, downturn lasting three and a half years.
- A rise of 7% in the unemployment rate over a 4-year employment downtrend.
- A GDP fall of over 9% over a 2-year downtrend.
- An explosion in the real value of government debt of 86% due, not to bailouts, but to the collapse in tax revenues and countercyclical fiscal policies.

And this, it would seem, no matter what our good friends in Washington concoct for us.

Randomness and Quackery

Many people equate random with non-predictable and reflexively consider anyone claiming to have an insight into future prices a quack.

However, it has never been demonstrated that prices can never be predicted, only that they can't be easily predicted, all the time. It kind of makes sense to me that there are some windows of opportunity where prices are easier to predict than others. Talented traders/analysts will find more of those windows of opportunity and profit more from them than less talented ones.

January 5, 2009

Deflation begets Inflation

Interesting 2009 forecast on the Accrued Interest blog. He doesn't see any inflation in 2009 since the Fed will be spending most of the year fighting deflation. However, "to suggest that the Fed will provide just enough stimulus to avoid deflation but not create a significant inflation problem down the road is ridiculous".

This is the important point: the harder the Fed fights deflation (and it's a given at this point that "there will be no limit as to how far the Fed goes to fight deflation") the more certain a nasty bout of inflation awaits us when the cycle turns.

January 3, 2009

Laszlo Birinyi, Technical Analyst

Barron's:

" You put out a piece in 1996 asserting that technical analysis had failed. What's your stance on that today?"

Laszlo Birinyi:

" A lot people (sic) think I'm really anti-technical analysis but I'm really anti-technical analysts.Analysis of the stock market really should be somewhat comparable to a physical where you spend as much time diagnosing as you do prescribing. I find that too many technicians prescribe and really don't try to understand what they are looking at. I also find that a lot of technical indicators are not predictive. For example, an advance-decline line tells you that a lot of stocks are going down but it doesn't necessarily tell you about what's going to happen."

I feel the only adjective that does this justice is: lame. In my book, what Mr. Birinyi does IS technical analysis which makes him a technical analyst, though obviously a self-hating technical analyst.