“Perhaps when a man has special knowledge and special powers like my own, it rather encourages him to seek a complex explanation when a simpler one is at hand.”
— Sherlock Holmes, The Adventure of the Abbey Grange (1904)
Professionals in the markets are more suggestible than a layman might imagine. Try as we might, we can never know the one thing we really want to know—that is, the future. Not knowing, we compare notes with others. Most are brave together at the tops and meek together at the bottoms.
As we finished 2006, the general consensus was that the latter half was spurred by a wave of global liquidity with U.S. and European stock markets gaining double-digit returns, and the emerging markets doing even better. Alongside the liquidity came a remarkable fall in volatility with the CBOE’s VIX index (known as the “fear gauge”) falling to 13-year lows in November and December.
All was rosy as strategists at twelve of the biggest Wall Street firms agreeing that U.S. stocks will rally in 2007. With everybody lining up in the bull camp, however, Davide and I are a little nervous about the market’s complacency—ironically the last year Wall Street strategists were this rosy was in 2001 whdn the S&P 500 Index dropped 13%.
Assuming that Bernanke has maneuvered us into a “soft-landing” and we are in a “goldilocks” economic environment, what could go wrong?
Based on last year’s actions by Goldman Sachs when they poached Lachlan Edwards, one of Europe’s financial restructuring gurus, the “smart money” is gearing up for a credit crunch—that is, a reversal of the liquidity tide that investors find themselves floating on. History shows that when mass scale restructurings occur, they tend to do so very rapidly like tsunamis—often triggered by an unexpected economic downturn or political shock.
Our main job as money managers is risk management. Looking forward we try to best assess where potential risks may come from. If the concern is about liquidity and the credit markets, then we need to understand how this sanguine market environment came about.
Monetarists such as Milton Friedman, who recently passed away at age 94, believed that “money supply” was the key to the ups and downs in the economy. Further, he thought that the Fed's sole job was to "expand the money supply in a steady manner by 3% per year."
The Greenspan legacy, however, is for the Fed to intervene in the markets strategically during times of financial crisis. He first did so early in his career back in 1987 when the Fed added heavy doses of liquidity to arrest the stock market crash. Then there was the expansion of money supply in the weeks leading up to the end of the 20th century when the so-called Y2K computer bug was expected to disrupt financial systems. Lastly, in response to the 2001 recession Greenspan lowered overnight rates to a 1958 low of 1 percent resulting in record mortgage refinancings that minimized the recession. Intervention, rather than being a brief rescue effort, seems to have become a permanent policy.
Another wave of stimulus came from the 2001 and 2003 “Bush tax cuts.” There are two ways in which tax cuts can stimulate growth—in the near term by generating extra demand, and in the long run by encouraging increased supply, labor or capital. Add to this the 108th and 109th Congress gone-amuck earmark spending as well as the increased military budget to finance two wars (the Iraq war now is estimated to have cost $350bn so far and is still costing $7bn a month), and the combination of monetary and fiscal stimulus in the first half of this decade set the stage for a tidal wave of liquidity.
The overhang of fear resulting from the 2001-2002 bear market also contributed to the current environment as money gravitated from the stock market into “safe assets” such as government and agency bonds. This in turn drove down interest rates on the long end of the yield curve which further lowered borrowing costs, and functioned to help corporations get their balance sheets in order as well as support real estate prices upwards through the 2001 recession.
Effectively, lower interest rates led to a boom in home buying which caused real estate prices to double and triple in some locations. One result was owners taking advantage of their increased home values in the form of mortgage equity loans. The impact was not insignificant on the economy. According to Calculated Risk, GDP as reported for the last six years has appreciably improved as a direct result of home equity withdrawals, a trend that first began in 2001. The process of incurring debt collateralized by an inflated asset is similar to margining a securities brokerage account as stock prices go up, the result is additional liquidity and leverage.
Because of inflated home valuations the use of exotic mortgage products such as ARMs, I/Os, etc. increased from very limited usage to approximately 50 percent of the mortgages used to finance homes in California. The seriousness of the potential fallout is not lost on the Federal Reserve Board and the Office of Thrift Supervision who recently came out with warnings regarding "payment shock," essentially “margin calls,” associated with sharp upward adjustments of a loan's interest rate after initial low-rate discount periods on exotic mortgage products. Such payment shocks are expected to increase substantially in 2007 and 2008.
In addition, the Center for Responsible Lending just published a report suggesting that 2.2m American households could lose their homes and as much as $164bn due to foreclosures in the ‘subprime’ mortgage market. To put this report into historical perspective, at the peak of the credit boom in the 1930s, home mortgage loans were offered without the usual documentation, a practice that in the last few years has again become enormously popular through so-called “stated income,” “low-doc” or “no-doc” loans. Stated income loans, originally conceived to improve access to prime credit for self-employed people with irregular income, has spread like a virus down through the lending industry, where it is a virtual invitation to fraud.
Credit fraud is a liquidity multiplier. The link between fraud and liquidity is documented by several white papers in relation to international banking. A paper written by Dr. Wimboh Stantoso, Senior Researcher at the Directorate of Banking Research and Regulation Bank Indonesia, points out that the 1998 Pacific Rim currency crisis resulted in the Indonesian government revoking permits on 16 private national banks whose “sources of problems for those banks were mainly illiquidity and insolvency as a result of credit defaults, fraud and liquidity mismatches.” Another paper by Jean-Claude Berthelemy on “Financial Reforms and Financial Development in Arab Countries” writes about non performing loan (NPLs) and “cases of fraud and liquidity problems faced by the banking sector” in regards to bad debt with a delay of servicing over one year.
The topic of NPLs brings us overseas to the shores of China. China is dealing with a mountain of bad loans—how much is the question. In May 2006 Ernst & Young reported that NPL exposure for China was estimated at US$911bn, but subsequently withdrew the report. According to the China Banking Regulatory Commission, as of the end of the third quarter of 2006, the total number of NPLs in China’s commercial banks was approximately US$160bn. However, this amount does not include NPLs that are presently held by foreign investors such as hedge funds that have been on a buying binge in Chinese distressed debt. Based on the 1999 transfers that investors have resolved, the implication is that E&Y’s NPL estimate is not miscalculated. The main inference, however, is that these NPLs represent a significant liquidity multiplier and risk.
China’s economy, in the meantime, is on track to grow by more than 10 percent for the third year in a row. In November 2006 China reported that its foreign currency reserves, the world’s largest, had exceeded $1,000bn for the first time. China has effectively outsourced its monetary policy to the U.S. resulting in talk of pressure from the incoming Democratic Congress in the form of “currency manipulation anti-subsidy laws” to persuade China’s government to revalue its currency. Even Fed Chairman Bernanke stepped into the fray with his remarks branding China’s undervalued currency an “effective subsidy” for exporters that was distorting trade. At the same time, China’s monetary policy committee complained that the main responsibility for this imbalance lies with the U.S. Treasury printing too much money. The upshot is that a fundamental change in reserve allocation/diversification away from the dollar is taking place and not just with China.
The subject of dollar imbalances brings us to the so-called Japan carry-trade. With the Bank of Japan keeping rates pegged to a measly 0.25 percent, this bubble has been ballooning in which people borrow cheaply in yen and then invest in higher-yielding assets abroad. The economic effect is again similar to leveraging your brokerage account with margin, except that this is taking place on a global scale with hedge funds leading the way. Concern is that a sudden flowback of yen, such as what happened in 1998 when the yen went from Y140 to the dollar to Y110 in just two days, could trigger financial chaos as far abroad as Iceland and India. Even the U.S. is not immune as some market participants blame the limited unwinding of the carry-trade that occurred in April 2006 as initiating the sharp decline in the stock market in May 2006.
Another liquidity multiplier is all the petrodollars that have been created with oil prices rising from the $20-$30 range to $78 dollars as of August 2006. Last year will be remembered in the Middle East for Iraq’s tragic slide into sectarian conflict and Israel’s miscalculated? war in Lebanon. Less noticed, though no less dramatic, has been the oil-fuelled economic boom in the Gulf and a surge in financial liquidity that has been transforming the face of the region. Oil wealth translates into political advantage on the world stage as petrodollars are deployed and recycled in the local region and abroad. The key question is whether oil producers can turn this boon into a lasting opportunity and create more robust economies that can sustain themselves through periods of low oil prices. Referring once again to reserve diversification, Russia and Opec have reduced their exposure to the dollar and shifted oil income into euros, yen and sterling.
But more interestingly has been the proliferation in the issuance of “sukuk” or “Islamic bonds.” Usury in Islam is prohibited, but banks today are adopting methods to get around this by combining Islamically permissible contracts to produce what is effectively interest-bearing loans. The effective result is not only the leveraging of petrodollars, but the evolution of an Islamic monetary system similar to modern Western banking system which had historically evolved from the practices of European goldsmiths in the 17th century. Back then, the receipts issued and backed by deposits of gold coins on deposit for safekeeping with goldsmiths transformed these merchants into money-lenders who manufactured “bank money” on such receipts, giving rise to the concept of money supply.
Money supply creation is no longer something constrained to banks, but now something that is easily produced between two parties through derivatives trading. When Greenspan took over the Federal Reserve Bank much attention was focused on gauges of money supply defined as M-1, M-2 and M-3. Disregarding the debate on the importance money supply as a reliable measure and indicator of future inflation, a new type of money supply which I've coined “M-0” has increased explosively alongside the growth of derivatives since the early 1990s. "M-0" is the “notional” valuation associated with a derivatives contract; that is, for example, the difference between the $250,000 nominal face value of an S&P futures contract and the $25,000 actual cash required to trade the instrument. The definition of financial leverage is liquidity magnified. Derivatives, while very effective as a risk diversifier, also has had the effect of leveraging asset values throughout the economic system.
And round and round it goes—the examples of liquidity expanding throughout our global monetary system are nearly endless. Many would argue this is all good and point to how robust the world economic landscape has been in the last few years as globablization has spread. And on an encouraging note, the World Bank recently hypothesized in a report that if growth around the world continues at about its current pace, by 2030 the number of middle-class people living in developing nations will triple to 1.2 billion.
However, the problem with liquidity is that it is like an addictive drug—initially it produces euphoria which then disappears with increasing tolerance. Once an economy is hooked it needs more and more in order to sustain itself and withdrawal can be difficult.
Key to the creation of liquidity is credit. “Credit” is a financial term with a moral lineage. Its first meaning is “debt.” John Locke once wrote “Credit is nothing but the expectation of money, within some limited time.” To credit is to believe, and to lend money it is necessary to trust someone. Yet, financial history is rife with periods when prolonged prosperity wore down the skepticism of creditors only to result in eras of economic hardships.
The riddle is whether the central banks have succeeded in breaking the cycle, not the inflationary cycle which in fact it has enthusiastically subsidized, but the deflationary cycle. Has the sheer bulk of global liquidity forestalled the kind of contraction that paralyzed business activity in the depression and demoralized speculative activity for a generation after that?
I started out this piece by asking what could go wrong…
Sudden economic downturns are typically instigated by event risks from unexpected places. Looking at the tea leaves we’ve identified several areas of concern:
The price of oil this past week has dropped to $55. A further implosion in the price of oil would undermine a major source of revenue for countries who produce this commodity. The recent windfall has allowed such nations to build foreign reserves and improve the quality of their debt resulting in lower interest rates and helping drive an infrastructure investment binge. This could unwind if investors begin to pull money from emerging equity and debt markets resulting in an increase in interest rates. In this scenario, the combination of reduced oil revenue and higher interest rates would cause infrastructure projects to grind to a halt triggering a global recession.
Another area of concern is geopolitical risk where mismanagement of monetary and fiscal policies spreads to other markets. For example, the Asian financial crisis of 1997-98 began in Thailand with the devaluation of the baht. Recently Thailand’s newly minted military government stumbled badly by imposing capital controls. Such controls demonstrate a poor grasp of such action’s consequences. In a world where China, Japan, Taiwan, South Korea, Russia and Singapore control two-thirds of the world’s reserves, we find ourselves exposed to these nation’s monetary or fiscal policies. Who knows where its starts: a miscalculation by China’s central bank in its efforts to manage excess liquidity could trigger a global recession, or the Bank for International Settlement’s Basle II standards forcing new hedge fund investment rules in Japan may trigger widespread redemptions there and an unwinding of the carry trade.
A third concern is that the U.S. economy will in fact grow as expected, but the markets come to realize that growth rate is in fact not so great. Analysts close to the Fed believe most policymakers now see U.S. potential growth as being between 2.5-3 percent, a decline from the 3-3.25 percent range commonly cited a few years ago. Many private sector analysts interpret a decline in productivity growth as likely to put upward pressure on inflation and interest rates. Given that the U.S. stock market is “fairly valued” at earnings ratios based on record productivity levels, if corporate earnings cool off the stock market could begin to melt down. Add to this an economy fueled by leveraged loans and looser lending standards, S&P warns that a sudden change in appetite from investors could force banks to absorb large leverage loans on to their own balance sheets. This in turn could cause a re-pricing of credit risk resulting in higher interest rates causing the economy to spiral downward.
Then again, perhaps given the enormous attention to the riddle of liquidity in the financial press, this is all but a tempest in a teapot—economists can’t seem to agree whether there’s too much or too little. As so eloquently said by Sherlock Holmes, “My dear Watson, there we come into those realms of conjecture where the most logical mind may be at fault.”
- Mack Frankfurter, Managing Director
Tuesday, January 9, 2007
Saturday, December 9, 2006
November 2006 Review and a Volatile World
THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
Our eleventh month of trading ended up strongly with a positive return of 1.77%, our best monthly number since inception as a result of some well-timed trades in the currencies. We like to think this bodes well for the holiday season and hopefully none of our clients’ children will be left without presents due to poor performance!
Jokes aside, market conditions and perceptions continue to diverge from the reality embedded in the economic data that is doled out each week. At the very least the data picture is mixed with the ISM Manufacturing number, released on December 1st, unexpectedly shrinking for the first time in more than three years, while the ISM Non-Manufacturing report, released December 5th and which reflects activity in the service sector, showing evidence that US economic growth was not slowing.
The various business news outlets are also emitting conflicting interpretations on economic data. Take a look at Forbes.com on November 29th and the spin is decidedly favorable. In an article entitled “Better Than It Seemed,” the author writes positively “Fed Chairman Ben Bernanke may be on to something. A day after he indicated the U.S. economy was stronger than investors appeared to think, government data arrived to support his argument.” This is posited on the same day Bloomberg reports that “The U.S. economy may head into 2007 in weaker-than-expected shape after reports showed October new-home sales fell for the first time in three months and stockpiles at companies jumped last quarter.”
Who is right? I guess it depends if you are looking at the stock market or the bond market, or how deep you want to dive below the headline numbers to get at the economic undercurrent. Either way, in our opinion more and more evidence seems to validate our long held idea of a substantial slowdown (that is, recession) in 2007. At the very least it would seem to indicate a cyclical peak in corporate earnings. Not only are economic statistics pointing in that direction but it would seem that even the inside corporate players, the ones supposedly with the best knowledge of future profitability of their corporations, are also beginning to be heavy sellers.
In the meantime, world headlines are filled with negative stories: a civil war brewing in Iraq (at least according to one channel I watch), ever growing current account deficit financed by China and oil exporters, and continued rumblings about the supply of energy from Russia. Yet in this volatile and risky world investors in the equity markets will point to soaring oil prices and a nuclear test by North Korea as “exogenous events” which the markets have barely responded, and then blithely focus their attention on mega mergers and private equity acquisitions that are taking place.
The result is that S&P 500 options have only priced in a 1% move up or down over the next month. Yet, markets have never been good at spotting and pricing political risks and at some point expectations of low volatility will turn out to be wrong.
I would argue that the massive complacency of market players, measured by one of the lowest level of volatility (VIX) in more than 10 years, is certainly misplaced. The bond market seems a bit more worried about future growth and so are forex players who have pushed the dollars to new lows for the year. Gold is following a proven inverse correlation to the greenback as it becomes more apparent that no matter who is going to be right, the bullish pro-growth camp or the bearish recessionary club, that should be negative for the currency of the world (USD) and a solid, yellow hedge (gold) may be in order. Certainly the Chinese, the Arabs and the Russians (when they are not too busy poisoning or shooting anyone who doesn’t see it their way) have all indicated a desire to diversify their foreign reserves away from the dollar.
Should a recession indeed occur next year and possibly weaken crude oil and other energy sources, I would view such a price break as a great opportunity to accumulate serious positions. After all, over the long term the world demand of more and more of a commodity of which there is less and less of is normally a characteristic of a buyer’s market… at least until we find out how to use anti-matter like they do on Star Trek.
Overall my investment tactics don’t change: look for cracks in the thesis of the majority, use common sense, diversify your plays.
Arrivederci!
-Davide Accomazzo, Managing Director
Our eleventh month of trading ended up strongly with a positive return of 1.77%, our best monthly number since inception as a result of some well-timed trades in the currencies. We like to think this bodes well for the holiday season and hopefully none of our clients’ children will be left without presents due to poor performance!
Jokes aside, market conditions and perceptions continue to diverge from the reality embedded in the economic data that is doled out each week. At the very least the data picture is mixed with the ISM Manufacturing number, released on December 1st, unexpectedly shrinking for the first time in more than three years, while the ISM Non-Manufacturing report, released December 5th and which reflects activity in the service sector, showing evidence that US economic growth was not slowing.
The various business news outlets are also emitting conflicting interpretations on economic data. Take a look at Forbes.com on November 29th and the spin is decidedly favorable. In an article entitled “Better Than It Seemed,” the author writes positively “Fed Chairman Ben Bernanke may be on to something. A day after he indicated the U.S. economy was stronger than investors appeared to think, government data arrived to support his argument.” This is posited on the same day Bloomberg reports that “The U.S. economy may head into 2007 in weaker-than-expected shape after reports showed October new-home sales fell for the first time in three months and stockpiles at companies jumped last quarter.”
Who is right? I guess it depends if you are looking at the stock market or the bond market, or how deep you want to dive below the headline numbers to get at the economic undercurrent. Either way, in our opinion more and more evidence seems to validate our long held idea of a substantial slowdown (that is, recession) in 2007. At the very least it would seem to indicate a cyclical peak in corporate earnings. Not only are economic statistics pointing in that direction but it would seem that even the inside corporate players, the ones supposedly with the best knowledge of future profitability of their corporations, are also beginning to be heavy sellers.
In the meantime, world headlines are filled with negative stories: a civil war brewing in Iraq (at least according to one channel I watch), ever growing current account deficit financed by China and oil exporters, and continued rumblings about the supply of energy from Russia. Yet in this volatile and risky world investors in the equity markets will point to soaring oil prices and a nuclear test by North Korea as “exogenous events” which the markets have barely responded, and then blithely focus their attention on mega mergers and private equity acquisitions that are taking place.
The result is that S&P 500 options have only priced in a 1% move up or down over the next month. Yet, markets have never been good at spotting and pricing political risks and at some point expectations of low volatility will turn out to be wrong.
I would argue that the massive complacency of market players, measured by one of the lowest level of volatility (VIX) in more than 10 years, is certainly misplaced. The bond market seems a bit more worried about future growth and so are forex players who have pushed the dollars to new lows for the year. Gold is following a proven inverse correlation to the greenback as it becomes more apparent that no matter who is going to be right, the bullish pro-growth camp or the bearish recessionary club, that should be negative for the currency of the world (USD) and a solid, yellow hedge (gold) may be in order. Certainly the Chinese, the Arabs and the Russians (when they are not too busy poisoning or shooting anyone who doesn’t see it their way) have all indicated a desire to diversify their foreign reserves away from the dollar.
Should a recession indeed occur next year and possibly weaken crude oil and other energy sources, I would view such a price break as a great opportunity to accumulate serious positions. After all, over the long term the world demand of more and more of a commodity of which there is less and less of is normally a characteristic of a buyer’s market… at least until we find out how to use anti-matter like they do on Star Trek.
Overall my investment tactics don’t change: look for cracks in the thesis of the majority, use common sense, diversify your plays.
Arrivederci!
-Davide Accomazzo, Managing Director
Thursday, December 7, 2006
The Lore and Legend of the Bulls and Bears
“Nothing is more admirable than the fortitude with which millionaires tolerate the disadvantages of their wealth.”
— Rex Stout, Mystery Novelist (1886-1975)
After gold was discovered at Sutter’s Mill in California, instant wealth was for the taking and all across America men made the decision to go west. Many sought and some found fortune in a camp called Hangtown, which at that time rivaled San Francisco.
Among the diversions sought by the miners on a Sunday afternoon was the bullfight that had long been a part of California’s development under Mexican rule. The bullfight, which had been introduced to Spain by the Moors in the 11th century, was brought to Mexico by the Spanish and was part of the fiesta held regularly at the mission-presidio complexes established between 1536 and 1832. The Mexicans added a wrinkle of their own by arranging fights between Spanish bulls, first brought to the new world by Columbus, and the native grizzly bear that roamed the California coast.
The Spanish longhorn cattle were brought to Mexico in quantity in 1521 and virtually ran wild until Texas became a state in 1845. The longhorn had a keenly developed sense of survival and often encountered the grizzly in the wild.
The game that entertained the miners in Hangtown was to chain a 1,000-pound grizzly to a huge stake in the middle of an arena and then turn the bull into the same arena. The fights were short and violent with the bull sometimes winning by impaling the bear, but mostly the bear won by meeting the charge between the horns and using his enormous paws to wrestle the 1,500-pound bull down to the ground, often breaking its neck in the process.
Since the gold discoveries created a flood of trading in mining shares, both in San Francisco and New York the terms “bull” and “bear” were introduced in the investment jargon to describe opponents in setting market direction. The analogy had been used before by the Spanish writer Don José de la Vega in 1688, but the active Civil War markets established the terms for all time.
The first person to be called a bear or bull was Jacob Little, who made his mark by introducing short selling in the panic of 1837. He made and lost four fortunes in the years that preceded the Civil War and was dubbed “The Little Bear” by fellow traders. One time he escaped a corner in Erie Railroad by buying convertible bonds that had been sold in England, unbeknown to the bulls, and he converted the bonds to cover his short position.
The two combatants that focused the terms for all time were the bear, Daniel Drew, and the bull, Cornelius Vanderbilt. The analogy fit perfectly the gigantic struggles between these two titans that went on for 30 years over steamboats and railroads.
Vanderbilt was as straightforward and optimistic as a bull, while Drew was devious, without scruples, and always trying to wrestle the market lower. These two bumped heads continually with a fight over Harlem Railroad during the Civil War producing a typical encounter.
Vanderbilt had been accumulating shares of the road for a number of years and introduced improvements to the line. Uncle Daniel was attracted when the stock started to move and joined in the buying to give the price an artificial boost from $8 to $100. He then cooperated with the politician “Boss” Tweed to mount a massive bear attack on the road. They went heavily short the stock, and Tweed used his influence to get Harlem’s right-of-way rescinded.
Vanderbilt let them “operate” until the stock dropped to $72. They had sold 137,000 shares, even though only 110,000 shares were outstanding. Vanderbilt then began soaking up the shares held by others and advanced the price to $179, forcing the bears to terms with the Commodore.
But then Drew attacked again, selling the stock down to $100 before Vanderbilt began to squeeze again. He raised the price to $285 and offered to settle again. Drew, hat in hand, pleaded with the Commodore and was finally excused with a $500,000 loss.
Vanderbilt advised Drew, “After this, never sell what you haven’t got, Dannie.” Which prompted Dan’l to compose his famous couplet, “He who sells what isn’t his’n, must buy it back or go to prison.”
In the gold camps, the bear defeated the bull in most fair fights. On Wall Street, the smart money follows the bull. Daniel Drew died broke, unable even to fulfill pledges to his church (he was short there too!), while Commodore Vanderbilt left his son William a fortune of $80 million——the only son he didn't disowned because he was as ruthless in business as his father and the one Cornelius believed capable of maintaining the business empire.
- Mack Frankfurter, Managing Director
— Rex Stout, Mystery Novelist (1886-1975)
After gold was discovered at Sutter’s Mill in California, instant wealth was for the taking and all across America men made the decision to go west. Many sought and some found fortune in a camp called Hangtown, which at that time rivaled San Francisco.
Among the diversions sought by the miners on a Sunday afternoon was the bullfight that had long been a part of California’s development under Mexican rule. The bullfight, which had been introduced to Spain by the Moors in the 11th century, was brought to Mexico by the Spanish and was part of the fiesta held regularly at the mission-presidio complexes established between 1536 and 1832. The Mexicans added a wrinkle of their own by arranging fights between Spanish bulls, first brought to the new world by Columbus, and the native grizzly bear that roamed the California coast.
The Spanish longhorn cattle were brought to Mexico in quantity in 1521 and virtually ran wild until Texas became a state in 1845. The longhorn had a keenly developed sense of survival and often encountered the grizzly in the wild.
The game that entertained the miners in Hangtown was to chain a 1,000-pound grizzly to a huge stake in the middle of an arena and then turn the bull into the same arena. The fights were short and violent with the bull sometimes winning by impaling the bear, but mostly the bear won by meeting the charge between the horns and using his enormous paws to wrestle the 1,500-pound bull down to the ground, often breaking its neck in the process.
Since the gold discoveries created a flood of trading in mining shares, both in San Francisco and New York the terms “bull” and “bear” were introduced in the investment jargon to describe opponents in setting market direction. The analogy had been used before by the Spanish writer Don José de la Vega in 1688, but the active Civil War markets established the terms for all time.
The first person to be called a bear or bull was Jacob Little, who made his mark by introducing short selling in the panic of 1837. He made and lost four fortunes in the years that preceded the Civil War and was dubbed “The Little Bear” by fellow traders. One time he escaped a corner in Erie Railroad by buying convertible bonds that had been sold in England, unbeknown to the bulls, and he converted the bonds to cover his short position.
The two combatants that focused the terms for all time were the bear, Daniel Drew, and the bull, Cornelius Vanderbilt. The analogy fit perfectly the gigantic struggles between these two titans that went on for 30 years over steamboats and railroads.
Vanderbilt was as straightforward and optimistic as a bull, while Drew was devious, without scruples, and always trying to wrestle the market lower. These two bumped heads continually with a fight over Harlem Railroad during the Civil War producing a typical encounter.
Vanderbilt had been accumulating shares of the road for a number of years and introduced improvements to the line. Uncle Daniel was attracted when the stock started to move and joined in the buying to give the price an artificial boost from $8 to $100. He then cooperated with the politician “Boss” Tweed to mount a massive bear attack on the road. They went heavily short the stock, and Tweed used his influence to get Harlem’s right-of-way rescinded.
Vanderbilt let them “operate” until the stock dropped to $72. They had sold 137,000 shares, even though only 110,000 shares were outstanding. Vanderbilt then began soaking up the shares held by others and advanced the price to $179, forcing the bears to terms with the Commodore.
But then Drew attacked again, selling the stock down to $100 before Vanderbilt began to squeeze again. He raised the price to $285 and offered to settle again. Drew, hat in hand, pleaded with the Commodore and was finally excused with a $500,000 loss.
Vanderbilt advised Drew, “After this, never sell what you haven’t got, Dannie.” Which prompted Dan’l to compose his famous couplet, “He who sells what isn’t his’n, must buy it back or go to prison.”
In the gold camps, the bear defeated the bull in most fair fights. On Wall Street, the smart money follows the bull. Daniel Drew died broke, unable even to fulfill pledges to his church (he was short there too!), while Commodore Vanderbilt left his son William a fortune of $80 million——the only son he didn't disowned because he was as ruthless in business as his father and the one Cornelius believed capable of maintaining the business empire.
- Mack Frankfurter, Managing Director
Saturday, November 4, 2006
October 2006 Review and the Perfect Storm
THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
The often difficult month of October brought unseasonably favorable weather for the stock market, but treacherous waters for our Diversified Options Strategy program. The good news is that our risk management worked as expected in the face of what we could call the perfect storm of breakout markets and imploding volatility.
The bad news is that for October 2006 our Diversifhed Options Strategy returned just +0.01% resulting in a year-to-date return of 7.93%. Meanwhile, the S&P 500 Index (GSPC) returned a strong 3.15% for the month and is up 10.39% year-to-date. The Barclay CTA Index is reporting +0.32% for October as of this writing and is up 0.94% on the year. Please refer to our website at www.cervinocapital.com for the most recent performance numbers on our investment programs.
Whereas the Dow Jones Industrial Average (an index consisting of just 30 stocks, albeit the largest and most widely held public companies in the U.S.) was engaged in a relentless march to new highs and increasing enthusiasm on the part of investors in the stock market, our diversified approach had to deal with a number of challenging positions that found unexpected correlations and unfortunately worked against us.
Our Diversified Options Strategy is designed to be an absolute return program and is engineered to generate consistent risk adjusted returns regardless of market conditions; however, there are occasional anomalies, like unusually protracted moves mismatched by higher or lower than usual volatility, which may create difficulties.
We are proponents of diversification and think investors should have as a cornerstone of their investments a well-diversified portfolio with a mix of asset classes. The last time the DJIA and S&P 500 had this kind of uptrend slope and momentum for this long of duration was in 2003 when the market bounced off the bottom of the 2000-2002 bear market. Exposure to stocks in the DJIA during the last three months would certainly have benefited overall portfolio performance. Then again, the context is that this index has been a laggard over the past six-seven years and is only now breaking out to new highs.
While past performance is not necessarily indicative of future results, a comparison of our performance to date reveals a track record that has a low correlation to the stock market. It is well recognized that combining investments that exhibit low or negative correlations result in a more efficient portfolio, which in turn offers the highest expected return for a given amount of risk.
As to the recent strong performance in the stock market the conditions could best be described as a “melt up,” but early on the bull run began as a stealth rally. Since before the May/June correction market participants have been debating soft versus hard landing. The bond market seems to point to a not-so-soft landing as indicated by the inverted yield curve. But with the benefit of hindsight, it is easy to see that the soft landing scenario has overruled thinking in the equity markets. In essence the markets have had a classical response to the shift in Fed policy with respect to putting a hold (for the time being) on the federal funds rate.
The evolving situation was backed up by an exceptionally strong earnings season, and cash flow coming in from the sidelines. This circumstance combined with lower oil prices underpinned the institutional-led rally in the “Dogs of the Dow.” Michael Driscoll, director of listed trading at Bear Stearns said it well, “You hate to sound cliché, but this is the generals leading the troops—the big Dow uglies lead the charge and set new highs and the rest of the market plays catch-up.” More in depth research reveals that the rally was largely confined to index-related stocks, a phenomenon that in our opinion will likely persist with the increasing popularity of ETFs.
By the time we got into October, sentiment indicators reflected overbought conditions and underlying distribution with higher highs on lower volumes.
The late stages of the bull run was marked by short covering rallies probably instigated by the plethora of covered call writing closed-end funds that were launched in the last couple of years. Meaningless end of day spikes became significant fulcrums for the next day’s trading. Additional derivatives related pressure to the upside was responsible for adding more fuel to the bullish fire, not to mention the struggle of underperforming money managers trying to keep up with the indices this year (Xmas bonuses anyone?!?). All the while, sentiment revisited the irrational exuberance of 1990s as reflected by the cheering section for DOW 12000 flashing across CNBC’s screen every few minutes.
A stat that's been making the rounds is the rather amazing fact that the S&P 500 has gone more than 70 days without a 1% decline. In fact, over the past 56 years the S&P has managed only six times to duck through both September and October without a 1% daily drop. The consequence was a narrowing trend channel and a considerable decline in volatility during a period which historically has a deserved reputation for being volatile.
Invariably, it is when markets hit these types of extremes that it is most important to have included in your investment portfolio other alternative approaches that are contrarian in strategy and help hedge portfolio gains.
The Diversified Options Strategy program deals with different markets and even multiple positions in the same market in terms of direction and time horizons. Because options provide a great deal of flexibility, we can establish multi-dimensional strategies such as positions that allow us to be short term bearish while being long term bullish for example. In so doing our approach does a generally good job of smoothening out volatility in day-to-day performance.
For this reason it is unlikely for our program to suffer greatly when any one bet may turn out to be wrong. However, there are instances when multiple markets may exhibit unforeseen correlations which in concert act against our existing positions. The situation can be aggravated by low volatility levels that are historically atypical, as implied volatility is central to any option program.
It is in such periods that our diversified approach using options may not work as well and the flexibility of our program is put to test.
We entered the month of October with routine spreads on the S&P 500 which carried higher gamma on the short call side. In more simplistic terms, while we had long positions we were also a little more aggressive on the short side. Earlier in the month we felt the upside move in the S&P 500 had reached record levels and the probabilities of at least a digestion of the recent gains were higher than a continuation of such gains.
Unfortunately for us, the S&P 500 continued sailing higher forcing us to reset our shorts at higher levels in accordance with our risk management rules. Simultaneously, we booked our profits on the long side but the uncontested up-move of the market also had the effect of pushing the VIX (the premium paid by option buyers) to extremely low levels making it unattractive from a risk-reward point of view to take new positions on the put side.
We eventually did hedge our shorts by selling some December put premium and we let some long November calls run with the bulls.
While we were fighting the strong directional move in the equity market we also had to manage a volatility explosion in the corn market. We bet correctly on the direction of this commodity (up); but while we were long March 2007 calls, we played as a hedge the short side on the December 2006 contract. Seasonally this was the correct move; lower prices normally occur in the midst of the harvest and this was going to be the second or third largest crop in US history. Unexpectedly an unprecedented move for this time of the year was sparked by a drought in Australia which affected wheat and by reflection U.S. corn. The parabolic move that ensued made our spread go out of line and we had to cover. To put this move into further perspective, the 22.1% move in December Corn in the month of Ocotber was the biggest single month jump in last 32 years.
As if these two moves–statistically very rare by historical standards–were not enough, we've been struggling with long crude oil positions which is in the midst of forming a base after a 20% plus correction. Long and intermediate term we feel the odds are surely in favor of higher prices but in the short term the battle is still undecided.
So there you have it. While the stock market was enjoying balmy weather, we were hit with storm clouds. In the end, however, we came out of it still on the upside with a one basis point return—the slightest of gains.
You may now understand why we think that the way our strategy worked in the face of these rare crosscurrents is a silver lining.
My business partner and I often find ourselves in meetings being asked the question of how we think we would do in extreme situations. While perfect storms can always be perfected by future ones, we think our Diversified Options Strategy program now has a strong point of reference to answer that question.
When we designed this trading strategy we ran stress-test calculations. We allowed for far greater havoc in our simulations—expect the unexpected, prepare for the worse. This past month real world tested our approach under strenuous circumstances. Having sailed through this storm, I feel very positive about our methodology going forward.
As far as our predictive views on the markets, I still expect the U.S. economy to hit a recession next year, yet believe oil prices will stay high relative to its average price over the last ten years. I also believe that the correction in the housing market has only just started and will have a negative impact on our economy just as it was a positive influence when real estate was booming.
Arrivederci!
-Davide Accomazzo, Managing Director
The often difficult month of October brought unseasonably favorable weather for the stock market, but treacherous waters for our Diversified Options Strategy program. The good news is that our risk management worked as expected in the face of what we could call the perfect storm of breakout markets and imploding volatility.
The bad news is that for October 2006 our Diversifhed Options Strategy returned just +0.01% resulting in a year-to-date return of 7.93%. Meanwhile, the S&P 500 Index (GSPC) returned a strong 3.15% for the month and is up 10.39% year-to-date. The Barclay CTA Index is reporting +0.32% for October as of this writing and is up 0.94% on the year. Please refer to our website at www.cervinocapital.com for the most recent performance numbers on our investment programs.
Whereas the Dow Jones Industrial Average (an index consisting of just 30 stocks, albeit the largest and most widely held public companies in the U.S.) was engaged in a relentless march to new highs and increasing enthusiasm on the part of investors in the stock market, our diversified approach had to deal with a number of challenging positions that found unexpected correlations and unfortunately worked against us.
Our Diversified Options Strategy is designed to be an absolute return program and is engineered to generate consistent risk adjusted returns regardless of market conditions; however, there are occasional anomalies, like unusually protracted moves mismatched by higher or lower than usual volatility, which may create difficulties.
We are proponents of diversification and think investors should have as a cornerstone of their investments a well-diversified portfolio with a mix of asset classes. The last time the DJIA and S&P 500 had this kind of uptrend slope and momentum for this long of duration was in 2003 when the market bounced off the bottom of the 2000-2002 bear market. Exposure to stocks in the DJIA during the last three months would certainly have benefited overall portfolio performance. Then again, the context is that this index has been a laggard over the past six-seven years and is only now breaking out to new highs.
While past performance is not necessarily indicative of future results, a comparison of our performance to date reveals a track record that has a low correlation to the stock market. It is well recognized that combining investments that exhibit low or negative correlations result in a more efficient portfolio, which in turn offers the highest expected return for a given amount of risk.
As to the recent strong performance in the stock market the conditions could best be described as a “melt up,” but early on the bull run began as a stealth rally. Since before the May/June correction market participants have been debating soft versus hard landing. The bond market seems to point to a not-so-soft landing as indicated by the inverted yield curve. But with the benefit of hindsight, it is easy to see that the soft landing scenario has overruled thinking in the equity markets. In essence the markets have had a classical response to the shift in Fed policy with respect to putting a hold (for the time being) on the federal funds rate.
The evolving situation was backed up by an exceptionally strong earnings season, and cash flow coming in from the sidelines. This circumstance combined with lower oil prices underpinned the institutional-led rally in the “Dogs of the Dow.” Michael Driscoll, director of listed trading at Bear Stearns said it well, “You hate to sound cliché, but this is the generals leading the troops—the big Dow uglies lead the charge and set new highs and the rest of the market plays catch-up.” More in depth research reveals that the rally was largely confined to index-related stocks, a phenomenon that in our opinion will likely persist with the increasing popularity of ETFs.
By the time we got into October, sentiment indicators reflected overbought conditions and underlying distribution with higher highs on lower volumes.
The late stages of the bull run was marked by short covering rallies probably instigated by the plethora of covered call writing closed-end funds that were launched in the last couple of years. Meaningless end of day spikes became significant fulcrums for the next day’s trading. Additional derivatives related pressure to the upside was responsible for adding more fuel to the bullish fire, not to mention the struggle of underperforming money managers trying to keep up with the indices this year (Xmas bonuses anyone?!?). All the while, sentiment revisited the irrational exuberance of 1990s as reflected by the cheering section for DOW 12000 flashing across CNBC’s screen every few minutes.
A stat that's been making the rounds is the rather amazing fact that the S&P 500 has gone more than 70 days without a 1% decline. In fact, over the past 56 years the S&P has managed only six times to duck through both September and October without a 1% daily drop. The consequence was a narrowing trend channel and a considerable decline in volatility during a period which historically has a deserved reputation for being volatile.
Invariably, it is when markets hit these types of extremes that it is most important to have included in your investment portfolio other alternative approaches that are contrarian in strategy and help hedge portfolio gains.
The Diversified Options Strategy program deals with different markets and even multiple positions in the same market in terms of direction and time horizons. Because options provide a great deal of flexibility, we can establish multi-dimensional strategies such as positions that allow us to be short term bearish while being long term bullish for example. In so doing our approach does a generally good job of smoothening out volatility in day-to-day performance.
For this reason it is unlikely for our program to suffer greatly when any one bet may turn out to be wrong. However, there are instances when multiple markets may exhibit unforeseen correlations which in concert act against our existing positions. The situation can be aggravated by low volatility levels that are historically atypical, as implied volatility is central to any option program.
It is in such periods that our diversified approach using options may not work as well and the flexibility of our program is put to test.
We entered the month of October with routine spreads on the S&P 500 which carried higher gamma on the short call side. In more simplistic terms, while we had long positions we were also a little more aggressive on the short side. Earlier in the month we felt the upside move in the S&P 500 had reached record levels and the probabilities of at least a digestion of the recent gains were higher than a continuation of such gains.
Unfortunately for us, the S&P 500 continued sailing higher forcing us to reset our shorts at higher levels in accordance with our risk management rules. Simultaneously, we booked our profits on the long side but the uncontested up-move of the market also had the effect of pushing the VIX (the premium paid by option buyers) to extremely low levels making it unattractive from a risk-reward point of view to take new positions on the put side.
We eventually did hedge our shorts by selling some December put premium and we let some long November calls run with the bulls.
While we were fighting the strong directional move in the equity market we also had to manage a volatility explosion in the corn market. We bet correctly on the direction of this commodity (up); but while we were long March 2007 calls, we played as a hedge the short side on the December 2006 contract. Seasonally this was the correct move; lower prices normally occur in the midst of the harvest and this was going to be the second or third largest crop in US history. Unexpectedly an unprecedented move for this time of the year was sparked by a drought in Australia which affected wheat and by reflection U.S. corn. The parabolic move that ensued made our spread go out of line and we had to cover. To put this move into further perspective, the 22.1% move in December Corn in the month of Ocotber was the biggest single month jump in last 32 years.
As if these two moves–statistically very rare by historical standards–were not enough, we've been struggling with long crude oil positions which is in the midst of forming a base after a 20% plus correction. Long and intermediate term we feel the odds are surely in favor of higher prices but in the short term the battle is still undecided.
So there you have it. While the stock market was enjoying balmy weather, we were hit with storm clouds. In the end, however, we came out of it still on the upside with a one basis point return—the slightest of gains.
You may now understand why we think that the way our strategy worked in the face of these rare crosscurrents is a silver lining.
My business partner and I often find ourselves in meetings being asked the question of how we think we would do in extreme situations. While perfect storms can always be perfected by future ones, we think our Diversified Options Strategy program now has a strong point of reference to answer that question.
When we designed this trading strategy we ran stress-test calculations. We allowed for far greater havoc in our simulations—expect the unexpected, prepare for the worse. This past month real world tested our approach under strenuous circumstances. Having sailed through this storm, I feel very positive about our methodology going forward.
As far as our predictive views on the markets, I still expect the U.S. economy to hit a recession next year, yet believe oil prices will stay high relative to its average price over the last ten years. I also believe that the correction in the housing market has only just started and will have a negative impact on our economy just as it was a positive influence when real estate was booming.
Arrivederci!
-Davide Accomazzo, Managing Director
Friday, November 3, 2006
What Ever Happened to the Loyal Opposition
“Politics is the art of looking for trouble, finding it whether it exists or not, diagnosing it incorrectly, and applying the wrong remedy.”
— Sir Ernest Benn (Publisher, 1875-1954)
As I write this, there are only four days left until the mid-term election—it cannot come soon enough.
And so, with some trepidation, and despite our blog’s focus on economic and investment concerns, I am allowed, this once, at the risk of alienating certain readers, to banter in political discourse and comment on that which should not be discussed amongst friends.
Let me begin by first addressing the pollsters and ideologues who feel it necessary to categorize Species Americana Voter and box us into political affiliations and “liberal” or “conservative” leanings—I recently reregistered for “Other” writing in the Whig Party.
[The Whig Party existed from 1832 to 1856, and was formed to oppose the policies of President Andrew Jackson and the Democratic Party. In particular, the Whigs supported the supremacy of Congress over the Executive Branch and favored a program of modernization and economic development.]
This is just another way of saying I’m an Independent without inadvertently becoming associated with the American Independent Party, a party with a specific platform I do not entirely agree with.
But seriously, I’m in total agreement with Will Rogers when he said: “The more you read and observe about this politics thing, you got to admit that each party is worse than the other. The one that’s out always looks the best.”
And so there you have it; per chance you may even agree: something is rotten in the state of U.S. politics, as it seems all has become fair play with our representatives’ desire to win at any cost. That cost is getting very, very expensive, and I’m not just talking dollars.
Spreading hatred and lies about one’s opponent has become a routine and accepted part of running for office. According to factcheck.org, a respected website that reviews the accuracy of ads, this year stands out for the sheer volume of personal assaults.
No wonder some of the most intelligent and capable people in our country don’t want anything to do with politics.
Watch CNN, MSNBC and FOX regularly, and you cannot but admire the skill of punditry that permeates dialogue on all issues and even non-issues. Hyperbolic, distorted and divisive rhetoric is the rule along with blatant bias in anchors’ “reporting.” Guests with the loudest retort are implicitly declared the debate winner, notwithstanding any obvious hypocrisy in a particular “expert’s” positioning of “truth.”
Sure, it makes for good TV. But the next thing you know Rolling Stone is declaring Comedy Central’s Jon Stewart and Steven Colbert America’s most trusted “news anchors,” as a reprieve from the likes of FOX’s Sean Hannity and Bill O’Reilly, whose self-declared authority on everything under the sun conjures up a McCarthy-era redux of mistrust toward our fellow Americans.
Yet this malady of cynicism is not particular to our times. Davy Crockett (1786-1836) is quoted as saying “There ain’t no ticks like poly-ticks. Bloodsuckers all.”
Fact is, I’m mad as hell and I’m not going to take it anymore.
What we need is a return to the center. We need to quiet the shrillness emanating from the vocal minority and replace it with intelligence, moderation and mutual respect.
Unfortunately, the current trend in American politics is not encouraging in this regard.
A French economist by the name of Frederic Bastiat once suggested that when social policies turn out to be harmful to the citizenry, it is because politicians often react to problems that they can see, without any regard for the unforeseen consequences of their solutions to those problems.
Mark Twain also had a thesis about politicians and wryly wrote circa 1882 “Reader, suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.”
No doubt both Twain’s and Bastiat’s sentiments apply to the 109th session of Congress.
Regardless of the outcome in the House or Senate races, there are many serious issues that need to be addressed. The biggest dirty little secret everyone in Washington knows is the budget deficit.
Politicians don’t like to talk about the nation’s long-term fiscal prospects—the subject is complicated and it reveals serious problems and offers no easy solutions. This is not a partisan issue. But the problem is tied to the country’s three big entitlement programs: Social Security, Medicaid and Medicare. At the same time, the burgeoning cost of the war in Iraq is not helping matters.
Fortunately for us there are true patriots like David M. Walker, head of the Government Accountability Office (GAO), which makes him the nation’s accountant-in-chief. Walker’s job is not in jeopardy if he tells the truth (he is serving a 15 year term ending in 2013), and what he has to say is scary.
Washington has dug itself a fiscal black hole. Combine that with the “demographic tsunami” that will come as the baby boom generation begins retiring with the recklessness of borrowing money from foreign lenders (such as China) to pay for the operation of the U.S. government, and you’ve got a recipe for disaster. Not facing this issue, squarely and honestly, will irreparably damage our great country for future generations to come.
Given the current climate I have little hope anything meaningful will be accomplished in the next two years unless the rhetoric is toned down and replaced by sensible dialogue between those with contrasting positions. Worse would be another session of Congress that kowtows to the President and legislates without transparent and meaningful debate.
Luckily, voting anti-incumbent is a great American tradition. The focus should be on electing politicians who are willing to work more than three days a week and forge bipartisan solutions, not engage in endless fund raising and political upmanship.
However the election manifests itself, given the current state of affairs, what we need most is new leadership in Congress and a return to principles of mutual respect.
Long live the loyal opposition!
- Mack Frankfurter, Managing Director
— Sir Ernest Benn (Publisher, 1875-1954)
As I write this, there are only four days left until the mid-term election—it cannot come soon enough.
And so, with some trepidation, and despite our blog’s focus on economic and investment concerns, I am allowed, this once, at the risk of alienating certain readers, to banter in political discourse and comment on that which should not be discussed amongst friends.
Let me begin by first addressing the pollsters and ideologues who feel it necessary to categorize Species Americana Voter and box us into political affiliations and “liberal” or “conservative” leanings—I recently reregistered for “Other” writing in the Whig Party.
[The Whig Party existed from 1832 to 1856, and was formed to oppose the policies of President Andrew Jackson and the Democratic Party. In particular, the Whigs supported the supremacy of Congress over the Executive Branch and favored a program of modernization and economic development.]
This is just another way of saying I’m an Independent without inadvertently becoming associated with the American Independent Party, a party with a specific platform I do not entirely agree with.
But seriously, I’m in total agreement with Will Rogers when he said: “The more you read and observe about this politics thing, you got to admit that each party is worse than the other. The one that’s out always looks the best.”
And so there you have it; per chance you may even agree: something is rotten in the state of U.S. politics, as it seems all has become fair play with our representatives’ desire to win at any cost. That cost is getting very, very expensive, and I’m not just talking dollars.
Spreading hatred and lies about one’s opponent has become a routine and accepted part of running for office. According to factcheck.org, a respected website that reviews the accuracy of ads, this year stands out for the sheer volume of personal assaults.
No wonder some of the most intelligent and capable people in our country don’t want anything to do with politics.
Watch CNN, MSNBC and FOX regularly, and you cannot but admire the skill of punditry that permeates dialogue on all issues and even non-issues. Hyperbolic, distorted and divisive rhetoric is the rule along with blatant bias in anchors’ “reporting.” Guests with the loudest retort are implicitly declared the debate winner, notwithstanding any obvious hypocrisy in a particular “expert’s” positioning of “truth.”
Sure, it makes for good TV. But the next thing you know Rolling Stone is declaring Comedy Central’s Jon Stewart and Steven Colbert America’s most trusted “news anchors,” as a reprieve from the likes of FOX’s Sean Hannity and Bill O’Reilly, whose self-declared authority on everything under the sun conjures up a McCarthy-era redux of mistrust toward our fellow Americans.
Yet this malady of cynicism is not particular to our times. Davy Crockett (1786-1836) is quoted as saying “There ain’t no ticks like poly-ticks. Bloodsuckers all.”
Fact is, I’m mad as hell and I’m not going to take it anymore.
What we need is a return to the center. We need to quiet the shrillness emanating from the vocal minority and replace it with intelligence, moderation and mutual respect.
Unfortunately, the current trend in American politics is not encouraging in this regard.
A French economist by the name of Frederic Bastiat once suggested that when social policies turn out to be harmful to the citizenry, it is because politicians often react to problems that they can see, without any regard for the unforeseen consequences of their solutions to those problems.
Mark Twain also had a thesis about politicians and wryly wrote circa 1882 “Reader, suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.”
No doubt both Twain’s and Bastiat’s sentiments apply to the 109th session of Congress.
Regardless of the outcome in the House or Senate races, there are many serious issues that need to be addressed. The biggest dirty little secret everyone in Washington knows is the budget deficit.
Politicians don’t like to talk about the nation’s long-term fiscal prospects—the subject is complicated and it reveals serious problems and offers no easy solutions. This is not a partisan issue. But the problem is tied to the country’s three big entitlement programs: Social Security, Medicaid and Medicare. At the same time, the burgeoning cost of the war in Iraq is not helping matters.
Fortunately for us there are true patriots like David M. Walker, head of the Government Accountability Office (GAO), which makes him the nation’s accountant-in-chief. Walker’s job is not in jeopardy if he tells the truth (he is serving a 15 year term ending in 2013), and what he has to say is scary.
Washington has dug itself a fiscal black hole. Combine that with the “demographic tsunami” that will come as the baby boom generation begins retiring with the recklessness of borrowing money from foreign lenders (such as China) to pay for the operation of the U.S. government, and you’ve got a recipe for disaster. Not facing this issue, squarely and honestly, will irreparably damage our great country for future generations to come.
Given the current climate I have little hope anything meaningful will be accomplished in the next two years unless the rhetoric is toned down and replaced by sensible dialogue between those with contrasting positions. Worse would be another session of Congress that kowtows to the President and legislates without transparent and meaningful debate.
Luckily, voting anti-incumbent is a great American tradition. The focus should be on electing politicians who are willing to work more than three days a week and forge bipartisan solutions, not engage in endless fund raising and political upmanship.
However the election manifests itself, given the current state of affairs, what we need most is new leadership in Congress and a return to principles of mutual respect.
Long live the loyal opposition!
- Mack Frankfurter, Managing Director
Wednesday, October 4, 2006
September 2006 Review and Buying the Bull
THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
Our Diversified Options Strategy program for September 2006 returned a positive 0.77% resulting in a year-to-date return of 7.92%. The S&P 500 Index (GSPC) returned 2.46% adding to the gains from the prior month and is up 7.02% year-to-date. Meanwhile, the Barclay CTA Index is down as of this writing with a return of -0.20% for September; for the year the CTA Index is up only 0.64%. Please refer to our website at www.cervinocapital.com for the most recent performance statistics on our investment programs.
BUY BUY BUY!!!! The Wall Street trumpets and the airwaves of CNBC are at work again. The meaningless Dow is at historical highs and the S&P 500 is up 10% in practically a straight line since the lows of June. Volatility is again MIA as market players perceive the total absence of potential threats to this picture perfect situation.
Not to be cynical but the indices rallying so strongly in the name of suddenly “defeated inflation” and the much vaunted “soft landing” scenario seems naïve at best. Aficionados of this blog know well my tirades on how inflation is dramatically underestimated by official statistics. Again I will point out the rise in most of your daily living expenses and monthly bills…
For the bulls out there: yes, I acknowledge the rather significant decrease in oil prices, but I have to wonder on the timing given that on July 12th Goldman Sachs revised their benchmark commodity index (GSCI) from 8.45% dollar weighting in unleaded gas to 2.30%. This little noticed event forced hedge funds and institutions tracking the GSCI to sell 75% of their gasoline positions in order to conform to the reconstituted index. Mmmm... Goldman Sachs... Treasury Secretary Paulson... Elections anyone?
But seriously, the key question regarding oil is what will be the average price range going forward. Are oil prices settling into a much lower range or is this just a trading correction? Considering that some short term problems may indeed have been resolved, a re-pricing of the commodity may be justified. But then again, the ongoing imbalances of this depleting resource in the face of projected long term rising global demand supports my thinking that this current “re-pricing” is just temporary.
Another interesting fact is that soft landings in the history of this country have only been achieved once, in 1994, under much better structural contingencies. My fear of a potential “bull trap” seems to be justified by the “technicals” of this market. The rise is narrow and is concentrated in a few index related names. New highs have been hard to come by and the CNBC cheerleading thermometer is rising too far too fast. I suspect a lot of seasonal players and retail investors were caught on the wrong side of the fence after Labor Day and the oil drop added fuel, excuse my punt, to the fire.
Only time will tell if my thesis is correct.
As far as the other markets, gold seems to be searching for a floor and I believe it will have problems flying high until the dollar starts weakening again. I am not in the camp calling for the destruction of the dollar and the fiat money system but I do think gold should eventually benefit from a reallocation of foreign central banks’ reserves. This is a long term theory and I’m reminded of what J. M. Keynes once said: “In the long run we are all dead.” So in light of such wisdom we will continue to play the currencies (gold included) on a very short term and very technical basis.
It’s a short missive from the trenches this month but I am sure you would like me more engaged managing your hard earned money than fueling my vanity with these scripts.
I rest my case. Until next time...
Arrivederci!
-Davide Accomazzo, Managing Director
Our Diversified Options Strategy program for September 2006 returned a positive 0.77% resulting in a year-to-date return of 7.92%. The S&P 500 Index (GSPC) returned 2.46% adding to the gains from the prior month and is up 7.02% year-to-date. Meanwhile, the Barclay CTA Index is down as of this writing with a return of -0.20% for September; for the year the CTA Index is up only 0.64%. Please refer to our website at www.cervinocapital.com for the most recent performance statistics on our investment programs.
BUY BUY BUY!!!! The Wall Street trumpets and the airwaves of CNBC are at work again. The meaningless Dow is at historical highs and the S&P 500 is up 10% in practically a straight line since the lows of June. Volatility is again MIA as market players perceive the total absence of potential threats to this picture perfect situation.
Not to be cynical but the indices rallying so strongly in the name of suddenly “defeated inflation” and the much vaunted “soft landing” scenario seems naïve at best. Aficionados of this blog know well my tirades on how inflation is dramatically underestimated by official statistics. Again I will point out the rise in most of your daily living expenses and monthly bills…
For the bulls out there: yes, I acknowledge the rather significant decrease in oil prices, but I have to wonder on the timing given that on July 12th Goldman Sachs revised their benchmark commodity index (GSCI) from 8.45% dollar weighting in unleaded gas to 2.30%. This little noticed event forced hedge funds and institutions tracking the GSCI to sell 75% of their gasoline positions in order to conform to the reconstituted index. Mmmm... Goldman Sachs... Treasury Secretary Paulson... Elections anyone?
But seriously, the key question regarding oil is what will be the average price range going forward. Are oil prices settling into a much lower range or is this just a trading correction? Considering that some short term problems may indeed have been resolved, a re-pricing of the commodity may be justified. But then again, the ongoing imbalances of this depleting resource in the face of projected long term rising global demand supports my thinking that this current “re-pricing” is just temporary.
Another interesting fact is that soft landings in the history of this country have only been achieved once, in 1994, under much better structural contingencies. My fear of a potential “bull trap” seems to be justified by the “technicals” of this market. The rise is narrow and is concentrated in a few index related names. New highs have been hard to come by and the CNBC cheerleading thermometer is rising too far too fast. I suspect a lot of seasonal players and retail investors were caught on the wrong side of the fence after Labor Day and the oil drop added fuel, excuse my punt, to the fire.
Only time will tell if my thesis is correct.
As far as the other markets, gold seems to be searching for a floor and I believe it will have problems flying high until the dollar starts weakening again. I am not in the camp calling for the destruction of the dollar and the fiat money system but I do think gold should eventually benefit from a reallocation of foreign central banks’ reserves. This is a long term theory and I’m reminded of what J. M. Keynes once said: “In the long run we are all dead.” So in light of such wisdom we will continue to play the currencies (gold included) on a very short term and very technical basis.
It’s a short missive from the trenches this month but I am sure you would like me more engaged managing your hard earned money than fueling my vanity with these scripts.
I rest my case. Until next time...
Arrivederci!
-Davide Accomazzo, Managing Director
Options: A Three Dimensional Chess Game
"Could we look into the head of a Chess player, we should see there a whole world of feelings, images, ideas, emotion and passion"
— Alfred Binet (French Physiologist, 1857-1911)
One of my favorite pastimes is playing chess, which unfortunately I have not had the time to indulge as of late. To experience the full brunt and emotional psychology of the game try a five minute speed match against a chess hustler in Washington Square Park, NYC. Unless you’re rated 1800+ you will likely walk away feeling beat-up.
Don’t believe me? Bobby Fischer, the only US-born chess player ever to win the World Chess Championship, once said “Chess is like war on a board. The object is to crush the opponent's mind.” Even more revealing is what he said during a Dick Cavett interview, “I like the moment when I break a man's ego.”
For the uninitiated the inner nature of this multidimensional game is nicely explained by David Norwood in his book Chess and Education:
“It is often supposed that, apart from their ‘extraordinary powers of memory,’ expert players have phenomenal powers of calculation. The beginner believes that experts can calculate dozens of moves ahead and he will lose to them only because he cannot calculate ahead so far. Yet this is utter nonsense. From my own experience I can say that grandmasters do not do an inordinate amount of calculating. Tests, notably de Groot’s experiments, support me in this claim. If anything, grandmasters often consider fewer alternatives; they tend not to look at as many possible moves as weaker players do. And so, perversely, chess skill often seems to reflect the ability to avoid calculations. It is, in truth, not clear that chess is a game of calculation. Of course there are times when intense calculation is called for, and often the master is better at dealing with these situations than the amateur. No wonder, he has had more practice than the amateur, but all the same his innate calculating ability need not be any greater. Most of the time it is something quite different that is required, something akin to ‘understanding’ or ‘insight.’”
Interestingly, the analytical yet intuitive nature of chess and trading is very similar, and many great traders happen to also be fanatical chess players. In fact, the introspective process is so alike that Norwood’s description could have been written about trading.
The psychological aspect of trading is something that serious investors should spend time studying. Generally, investors have three choices when trading an asset directly:
(1) stay out of the market
(2) buy and “go long”
(3) sell and “go short”
Once either “long” or “short” the next decision becomes whether to stay in the position or get out; technically this is known as “liquidating the long” or “covering the short.”
The confluence of investor agendas results in historical market prices which can be tracked by charts. Anyone who has looked at charts can easily recognize markets that trend up or down versus markets that move sideways within a range. Charts are great tools, but don't forget they look backwards. As the regulators regularly remind us “past performance is not necessarily indicative of future results.”
From an emotional perspective such tactical investment alternatives, seemingly simple trading decisions, present an array of contexts. Remaining un-invested is neutral, but psychologically the trader is thinking in terms of greed or fear: “Should I stay out or get in? Is the reward worth the risk? What if I buy it here and it goes lower? Is it too expensive? What if I wait for it to go lower before buying?”
Common sense wisdom says “buy low, sell high,” but how many investors feel more comfortable “buying high, selling higher?” Unfortunately, most of the time we end up buying high and selling low, emotionally trapped by the “come back to breakeven before selling” curse. Chartists call this "resistance" because investors sell at these levels, while "support" levels exist because there are no more sellers as investors are willing to hold until a better price.
Purchasing an asset is the easy part; alas most investors don’t think about an exit strategy. The “trend is your friend until the trend ends,” but how far should you let a stock “run” before you sell it? How would you feel if you sold it but then it goes up further? What if it was higher, but now lower… Would you wait until it goes back up? What if it doesn’t go back up? What if it goes lower still? At what point would you feel forced to sell?
Thomas Huxley, known as "Darwin's Bulldog" (1825-1895), once quipped that “The chessboard is the World, the pieces are the phenomena of the Universe, the rules of the game are what we call the laws of Nature and the player on the other side is hidden from us.” The same sentiment could easily be applied to trading.
As you can see, there are many emotional dimensions to just buying and selling an asset. And when a trader has the sophistication to “go short” the thought process doubles.
This psychology underpins every day decisions/actions of markets participants. Quite a few books analyze the phenomena such as the 1841 classic “Extraordinary Popular Delusions and the Madness of Crowds” by Charles MacKay. Successful investors learn to discipline their emotions and act contrarian to natural tendencies.
Yet when all is said and done, for most investors the choice is simple: stay out of the market, go long at a certain price, go short at a certain price, or get out at a certain price (liquidate the long or cover the short). As with chess there is vast complexity behind such decisions, but in the final analysis the rules to game are simple.
Not so with derivative trading! If directly trading an asset is like playing chess, then as my business partner likes to say “option trading is a three dimensional chess game.”
An option is a contract whereby one party (the holder or buyer) has the right, but not the obligation, to exercise the contract (the option) on or before a future date (the exercise date or expiry). The other party (the writer or seller) has the obligation to honor the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer pays a premium for such right.
Because options are indirectly related to the underlying asset and have many more components for an investor to consider, the result is an unlimited variety of ways to structure trading strategies as compared to just buying or selling the asset.
● First, options are a wasting asset and therefore have a time component. If not "in-the-money" at expiration, they're worthless.
● Second, part of their value is determined by the relationship of the underlying asset’s price versus the option’s “strike price.” The degree of correlation between the pricing of the asset and option is a function of the distance between the asset price and strike price.
● Third and fourth, there are multiple options representing different strikes prices—this is called an "option series"; further, there are multiple expiration dates for each option series.
● Fifth, their price, while related to the underlying asset’s price, is also tangentially influence by the underlying asset’s volatility.
● Sixth, double up all of the points above because there are two basic types of options: “calls” which give the holder the right to purchase the asset at a certain price, and “puts” which give the holder the right to sell the asset at a certain price.
● Seventh, double up everything again because option traders can either be purchasers of options or sellers (“writers”) of options.
So how do all this option background work together in forming three dimensional trading strategies?
Suppose the S&P 500 is trading in a narrow sideways range and volatility is extremely low. Bullish and bearish sentiment is equal and you think that the market is going to breakout either to the upside or downside—but your not sure which way.
If you were trading the Spyder (ETF contract that is linked to the S&P 500 index) you could either go long and hope the market goes up, go short and hope the market goes down, or stay out of the market all together. Limiting yourself to three choices could be frustrating.
But with options you could purchase both a call and a put at the same time. Since your cost is limited to the premium of the option you have limited downside either way if the market rallies or crashes. But if the market does breakout to the upside or downside you will be positioned to take advantage of that move. The key is that you don’t have to be right on the direction—your betting both ways at once.
Now buying options can be expensive, so how do you pay for the right to be a holder?
Let’s say that in the above scenario you think the market is going to go up or down, not in the next month, but maybe three months from now. You could “write” options (both calls and puts) with a nearer expiration date to help pay the cost for purchasing options (both calls and puts) with a later expiration date.
With this situation you’ve got four different positions operating at the same time on the same underlying S&P 500 index. Each of these positions will increase and decrease in value differently depending on the price action of the underlying S&P 500 index.
The above two option strategies are just a sampling of the position combinations that can be created with options, thereby expanding a trader’s tactical repertoire exponentially.
But take note, because of the volatile nature of markets, the purchase and granting of options may involve a high degree of risk. Option transactions are not suitable for many members of the public. Such transactions should be entered into only by persons who understand the nature and extent of their rights and obligations, and of the risks involved in option transactions.
As you can imagine the variety of trading strategies that options offer are limitless and multidimensional. It is that variety that attracted Cervino Capital Management to develop its Diversified Options Strategy. For more information this investment program, visit our website at www.cervinocapital.com.
- Mack Frankfurter, Managing Director
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