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Archive for October, 2008

I’ve been preparing for the “FED Challenge” which takes place on November 5th, down in Baltimore. If we win this first   round, we’d go to the regional competition, and then (improbably) to the national competition, which was won by Harvard last year. I thought I’d post the general points I’m going to make, but keep in mind, as the FOMC, we only make a decision about the Federal Funds target rate, nothing concerning a bailout package.

1. Keeping rates low for an extended period of time will:

o Steepen the yield curve; sign of future economic prosper, and a favorable development for the banking system.

o Should lower the interest rates on ARM’s pegged to prime.

o In time, as panic subsides, LIBOR will drop – many loans are pegged to LIBOR.

2. Today, the Federal Funds rate has become second fiddle to the unprecedented action taken by the treasury, and our Federal Board of Governors to insure commercial paper markets.

3. Fed target rate may be at 1%, but the effective rate is at .3% from the new initiatives of paying interest on bank reserves. This has rendered the targeting of the funds rate somewhat less important than before.

4. In terms of Foreign Exchange Markets, despite our low interest rates, the dollar should remain strong relative to the Euro nations and EM, since they are very unstable – in part due to the nationalization of much of their banking system. While a stronger dollar will likely hamper the 5.9% increase in real exports we saw in the 3rd quarter, the dollar strength should place a ceiling on commodity inflation, since much of the increase in commodities over the summer was tied to a weak currency.

5. Reverting back to 1980 is something that few want to see; the recession was severe, with the economy contracting at a 7.8% pace in the second quarter of 1980. The unemployment rate by November 1982 moved to 10.8%, which thankfully has not been surpassed. This time around, GDP is seen contracting at a pace in a range of 2% to 4% over the next couple of quarters, and unemployment is expected to move up to about 7.5%, or possibly over 8%.

6. A scenario of even greater concern is deflation.

o We have sustained tremendous asset depreciation across all sectors of investment, resulting in an evaporation of wealth. Japan’s period of deflation was sparked by a large price bubble in real estate and equity markets (very pertinent to today…When assets decrease in value, the money supply shrinks, and this is deflationary).

Many worry that this could trigger a downward spiral of falling prices, since aggregate demand would be crippled from lack of disposable income and insufficient access to credit. I, however, do not foresee this happening. Only if the banks hoard the money provided from the TARP could we experience an extinction of liquidity, and possibly lead to deflation. Another worry is that the bailout plan will ignite a period of hyperinflation, since more money is being added to the economy everyday. however this fear may not materialize either, since the cash infusion will ultimately serve as a replacement for money which was lost in aggregate investment.

Given all of this information, we should leave the federal funds target rate at 1%. As a central bank, we have done as much as possible for the time being – we will need to wait to see how our actions are greeted by the macro-economy. Further, it is not the cost of money which is the problem, it’s the availability. We should not treat the matter of cutting rates below 1% lightly. The FOMC would virtually surrender all monetary policy. We have seen, and continue to see that Japan has been trapped within a period of near zero interest rate policy for over 10 years. Therefore, in order for rates to stay at 1%, we should consider maintaining our position on quantitative easing (flooding commercial markets with liquidity to promote private lending) and reevaluate our stance should economic conditions deteriorate beyond our current expectations.

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Macro Man returns…

He posted a very well reasoned analysis of the recent market swings on Seekingalpha.

“it seems that the dawning of the latest bear market rally is here. Perhaps it’s driven by month-end rebalancing considerations. Perhaps it’s driven by the forthcoming election of St. Barack. Or perhaps it’s just driven by bear fatigue. Yesterday’s late session swoon by US equities notwithstanding, it does seem like it’s here. (Of course, there’s also been news…but since when did that matter?)

There are some very good charts that are worth seeing…

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Down 300 points in 10 minutes to close one day, up 700 points in 2 hours to finish the next.

Gains of 10.88% in the Dow Jones are to be expected as a good annual growth rate, not as an intraday move. Explanations include nothing particularly helpful (short covering, pricing in a FED rate cut, relief rally) given the sentiment of late.

My take on the market has been (since September 15th) to stay in cash – or a money market fund – and sit this one out. Even if you have enough time to sit in front of a computer screen and make quick trades, you can get wiped out in a single day…Look at one of my favorite market plays, SKF (shorts financials at 200%):

…Down $41.99 in a day.

After a day like today, there are very few investments which are “cheap.” The market is trading in too great a range to decipher where it could go next – technical analysts, or people who like to study movements in charts, haven’t been able to conclude anything meaningful since the TARP program was passed.

The obvious question, in the very short term, is this: can we hold most of the progress we made today, without establishing a lower low? The best means of judging this will be the Volatility index, or the VIX. It has been in a range of 60-80 for close to a month, when the highest it had reached was 37 in months prior. Should the VIX abate below 30, and the market sustain a tradeable range, then this would be the best signal for an entry point with a tight stop on losses.

*If it seems weird that I’m writing about an investment timetable, it’s because this is a market summary for the Lehigh Investment Management Group, a club I’m affiliated with…figured it might be interesting to others as well.

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Just found a cool site: www.arbitrageview.com

In addition to defining all of the different forms which arbitrage can take, this site has a section which lists all of the announced M&A deals which are awaiting approval; useful for a strategy called “risk arbitrage,” or betting that announced acquisitions will actually close – you purchase the stock of the targeted company, and short the acquirer (like Yahoo being targeted by Microsoft).

The name in itself is quite appropriate, because should the deal fall through (as the Yahoo and Microsoft did), you lose money on both sides of the bet (Microsoft goes up, and Yahoo goes down…this is the opposite of what the risk arbitrager thought would happen).

One of the most prevalent misuses of arbitrage came out of the Long Term Capital Management debacle. The members of the hedge fund had specialized in bond arb, by which they would use tremendous leverage (often 30 to 1) and make millions on very small moves in the fixed income markets (by selling one country’s debt short, and buying another). But once the rest of Wall Street got wind of their strategy, the already small margins were pinched by the increase in market participants.

This is what prompted the beginning of many dumb decisions they made over the next 2-3 years; They decided to apply their knowledge of market volatility from the world of bonds to the incongruous world of equities. They tried to find irregular relationships between companies, then act accordingly. Their stint with risk arbitrage resulted badly, as you might imagine…here’s an excerpt from the book which explains it all, When Genius Failed (p.146):

“Long-Term had dubiously invested in Ciena Corporation, a telecommunications company that was planning to merge with Tellabs Inc., and had continued to hold the stock even when it had crept to within 25 cents of the acquisition price. On that same day, August 21, the merger was postponed and Ciena stock plummeted $25.50 to 31.25 a share. Long-Term lost $150 million.”

That was one of their smaller losses in the grand scheme of things…

Even before the depth of this financial crisis unfolded, I’ve always believed that this is one of the most important books that one could ever read to have a broader understanding of the sheer greed and irrationality which exists in financial markets, to understand why it can does happen again continually, and how the culprits respond as it’s all going wrong.

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Cramer called out!

This has been making its way around today:

The next chapter in the Jim Cramer saga comes courtesy of Deal Journal, in the form of a letter to the Jerry Springer of finance from AIG CEO Ed Liddy. Just imagine those chairs flying.

Edward M. Liddy
Chairman and Chief Executive Officer
AIG October 20, 2008

Mr. Jim Cramer Mad Money
CNBC
[Address]

Dear Mr. Cramer,

I was deeply disappointed last Thursday when you urged your viewers to harass AIG employees, saying:

‘We should hound them in the supermarket, we should hound them in the ball park, we should hound them everywhere they are. We should make fun of them and we should point fingers at them and we should tell them that you have no shame.’

Those comments are outrageous. I demand they be retracted and that you apologize to AIG’s employees. It is one thing to criticize the executive leadership of AIG – that’s fair commentary. But it is way out of bounds to incite people to confront and harass other AIG employees – hard-working, dedicated people who are running good businesses and are committed to our success. The employees of AIG did not cause this mess, but they are paying for it – in diminished 401K savings and in some job losses as we sell companies to repay the Federal loan. The irony is that AIG employees did not cause the problem, but they will solve it. For that they deserve our praise and our gratitude.

I await your prompt response.

Sincerely,
Edward M. Liddy

Of course, both Cramer and AIG have been under pressure recently — the first fending off criticism of his erratic investment strategies and the latter for the same hosting partridge-strewn parties like these.

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“Chrysler to Shut Delaware Plant a Year Early, Drop Shift at Ohio Factory”

“Goldman May Slash 3,200 Jobs, 10% of Workforce, as Credit Turmoil Worsens”

Not to drive this idea into the ground, but headlines like these (which we see with great frequency these days) show that the unemployment reading of 6.1% will soon be very understated. Nouriel Roubini, who is becoming a more vocal and recognized economist of late, has predicted that unemployment may top 8% before the end of the recession. Besides the obvious downside of people not having jobs, it is important to remember that our historically forceful consumer has been able to exist partly because of low rates of unemployment:

Notice that the 2001 recession did not have much of an impact on consumer spending; however the last recession driven by a housing crisis, in 1990-1991, did…

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The WSJ has a good article in Monday’s paper talking about the dwindling short term prospects of industries in the renewable energy sector:

“The sudden reversal in crude prices has removed — at least temporarily — a key rationale for investors to pump billions of dollars into alternative fuels, industry analysts say.”

With the demise of Lehman Brothers and AIG, two of the biggest lenders in the renewable energy sector, wind farm developers find themselves short of liquidity.

“The credit crunch deals a negative blow to the whole [wind] sector because it’s heavily dependent on debt financing,”

The extension of tax breaks from the rescue plan (yeah, there were a lot of things in there you probably didn’t know about. Look up the provision about arrow heads) will be beneficial, but it is becoming more clear that private investment may not prop up the future of the industry with tight credit and $70 oil (with energy prices at these levels, alternative energy isn’t cost effective in an immediate time frame). This is why peak oil enthusiasts cringe when oil drops below the $100 mark; the investment in wind and solar energy will likely be deferred to a later time, probably when it is too late. Of course the peak oil quire was more forceful when crude traded at $145 a barrel, but many of these very same members are now the people who buy into the notion of “demand destruction” (This is the Wall Street sheep mentality and its effect on the markets I constantly allude to). We had a pretty rude awakening of what life is like when gas is $4.50 per gallon, and a more pertinent realization about long term sustainability – houses which are 50 miles away from a major city with no rail system are worth much less, meaning less collateral to borrow against to pay for things (at least that’s how it would work if you could still borrow against your house).

While important, this issue is not one which takes precedence; our human capital is put to much better use in diagnosing our financial crisis. Why, might you ask, can we disregard the proper planning? Because the security of alternative energy’s future is pretty simply dealt with; Unlike the credit crisis, it’s clear what  will happen when you throw money at the problem – how do you think oil companies got so big? Should Obama land in office, we would likely see an increase in spending on governmental programs, like we do with most democrats, and much like we saw under FDR. If this doesn’t happen, we’ll likely have a lost decade in terms of developing technology for alternative energy. We witnessed this at the end of the United States’ stagflationary period in the early 80’s, when all of the energy conservation tactics were almost instantaneously scrapped. But I’m not worried – I don’t think that we’re stupid enough to do that again.

***Something very relevant: read this article about the relationship between low oil prices and deflation.***

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