Shock And Awe

Democrats in Washington are reacting with amazement that the freshman Republicans are refusing to take the usual bribes (code word “negotiate”) and instead are representing the voters that elected them. This may not last, but it is an encouraging sign that democracy may not be totally dead. Vote buying and selling has become so ingrained that it is incomprehensible to the money-rotted incumbents that anyone would choose not to monetize their “thing” – as Blagojevich would put it.

Lasciate Ogni Speranza

Just watching the intra-Party politicking, as usual amazed at the contempt that politicians have for the citizenry. The deficit reduction plans are basically all premised on stopping a couple of wars with no structural changes to anything else. Does anyone really believe that the defense industry will not find new wars that need to be started in the next ten years? Obama has no plan except to avoid the spending issue coming up before the next election so that he can buy votes with our money. Meanwhile, the economy is quietly sliding over the brink.

Just make it simple

We met a friend for an informal financial chat. She has some stock, a condo, a small business and no time. She is financially conservative. She has friends who have had some hair-raising speculation experiences – penny stocks and Florida condos. Here are the references for topics of conversation.

General reading

Reminiscences of a Stock Operator

The thinly disguised biography of Jesse Livermore, a remarkable character who first started speculating in New England bucket shops at the turn of the century. Livermore, who was banned from these shady operations because of his winning ways, soon moved to Wall Street where he made and lost his fortune several times over. What makes this book so valuable are the observations that Lefèvre records about investing, speculating, and the nature of the market itself.

Fooled by Randomness : The Hidden Role of Chance in Life and in the Markets
by Nassim Nicholas Taleb

In this look at financial luck, hedge fund manager Taleb (Dynamic Hedging) addresses the apparently irrational movement of money markets around the world. Using his own investing experience and examples of others’ successes and disappointments, he discusses theories like Monte Carlo math (easy; considered cheating by purists) and the concept of Russian roulette. Taleb tells interesting, well-wrought stories about individual behavior: “While Nero has succeeded beyond his wildest dreams, both personally and intellectually, he is starting to consider himself as having missed a chance somewhere.” While serious investors and mathematics enthusiasts will be intrigued, readers looking for practical investment strategies will be disappointed by this rambling intellectual discourse.

Market timing

Yes, You Can Time the Market!
by Ben Stein, Phil DeMuth

A smart, commonsense guide to investing. Stein and DeMuth’s primary dispute is with the old adage that one can never tell when the market is going to go up or down, something they attempt to disprove with a wealth of charts showing how to buy stocks cheaply over the long term (as in decades). This is no get-rich-quick scheme, merely a case being made to, in essence, treat the Street like many fans treat baseball: work the numbers. In between the sizable chunks of data, Stein and DeMuth drop in bits of advice, e.g., pay more attention to the S&P 500’s trends than frequently slippery P/E ratios; invest in bonds before stocks-they’re more stable; and always, always buy low. Best of all is a three-page cautionary list that should be required reading for anyone even thinking of investing. Some of the better nuggets: “Does the word `synergy’ appear in the prospectus?… Run!”; “Never accept any unsolicited financial advice”; and “Do not invest in a store because you see a lot of customers there at the mall or because you like the coffee or blue jeans or jelly beans. Sales do not equal profits.”

Beating the Dow with Bonds : A High-Return, Low-Risk Strategy for Outperforming the Pros Even When Stocks Go South
by Michael B. O’Higgins, John McCarty

O’Higgins is no Chicken Little–rather, he’s a market contrarian with a proven and profitable track record. If you think the stock market will go up forever, then look elsewhere for advice. But if you believe in gravity, then get this book and read it soon.

TIPS

Treasury Inflation-Protected Securities (TIPS)

Treasury Inflation-Protected Securities, also known as TIPS, are securities whose principal is tied to the Consumer Price Index. With inflation, the principal increases. With deflation, it decreases. When the security matures, we pay the original or adjusted principal, whichever is greater.
TIPS pay interest every six months, based on a fixed rate applied to the adjusted principal. Specifically, each interest payment is calculated by multiplying the adjusted principal by one-half the interest rate.

Why to sell the condo

Sell Now! : The End of the Housing Bubble
by John R. Talbott

Sell Now! analyses the evidence and offers clear explanations of these perplexing issues. Overly aggressive mortgage lenders have fueled this overheated market by extending too much credit to home buyers and by offering ever-more exotic forms of mortgages. Many home buyers have been caught in a never-ending race to achieve status, often overpaying for homes in the “right” neighborhoods. And people’s pursuit of easy profits has pushed prices to unsustainable levels.

Why to sell stocks

Valuation – Where we are in the stock market cycle. Just a note, when I talk about value changes in the stock market and real estate market, I’m talking about real prices, that is prices adjusted for inflation as against nominal prices, the unadjusted prices.

Schwab strategist sees cash as king ahead of sucker’s rally

Specifically, she recommends investors “underweight” stocks, remain “neutral” on bonds and be “maximum overweight” on cash.
“Keeping some powder dry makes a lot of sense,” the Schwab (NASDAQ: SCHW) strategist said. “There is likely to develop a great buying opportunity at some point this year. We just feel there’s more pain between now and then.

Investment and Speculation

From one of the earliest posts in the blog:

“We often hear the terms “Investment” and “Speculation” used interchangeably and casually. “Speculation” is often used as a derogatory term for activities considered somehow wrong or extreme. But both these words have relatively well-defined meanings. An “Investment” is a transaction which is entered into primarily to yield an ongoing income stream. While in many cases capital gains may also be a hoped-for result, they are secondary. A “Speculation” is a transaction which is entered into for the primary purpose of a capital gain on sale. Income, if it exists at all, is a secondary consideration and often will be negative, a “carrying cost”. So if I buy an apartment building for rental income, believing that the rents will yield a net return on my capital after expenses, then that is an investment. If I buy a house with the intention of “flipping” for a higher price as soon as possible, then that is a speculation. It is important to define the terms because they will be used frequently, but carefully, for their particular meanings.”

Delightful evening! Hope this helps.

Options trading

The warning label says: Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital.

It is like drinking wine – drinking responsibly is enjoyable and has demonstrated health benefits. Options provide opportunities to control and manage risk or even to speculate (which is why options trading is viewed as risky by many). Options trading can be very useful in addressing the unknown market risks in a retirement portfolio. Like now for instance.

Stocks, commodities hit by risk aversion
Investors dumped stocks, commodities and emerging market assets on Tuesday on worries that economic growth will suffer from higher inflation and interest rates. Equity markets were punished as investors ditched riskier assets in favor of safe-haven government bonds and cash, with Japan’s Nikkei average plunging more than 4 percent in its biggest one-day fall in two years. ..Reuters

The market is declining. There is a good chance of a significant decline sometime in the future – Fall 2006, perhaps. Between now and then, there will proabably be a rally of some sort. What to do? So this isn’t a good time to get short in anticipation of a fall decline. But what if the market doesn’t wait for fall for the big decline? Options!

Finacial Reality explains a very cool strategy for addressing the current situation with options. More expensive but less complex, just covering the downside with put options is insurance against a worst-case scenario.

Some options trading strategies

• straddle – An options strategy with which the investor holds a position in both a call and put with the same strike price and expiration date. The strike prices may be the same or different. The fact that there are offsetting puts and calls makes it a straddle.
• out-of-the-money puts – relatively low-cost way to control risk. If there is a big change in the value of the underlying security, the option would be in-the-money and have value, potentially offsetting loses incurred in the underlying security position.

Do the math…

Using NASDAQ-100 Index (NDX) options with September 06 expiration, the cost to implement the straddle strategy with overlapped the strikes with both puts and calls in-the-money (NDX 1526.54) is shown. The example uses puts and calls at different strike prices but both are in-the-money when the options are purchase and expected to be in the money at expiration.

Yes, I had help with this. I retrieved the Quotes for Chains for the NASDAQ 100 Index (Symbol NDX) and selected Expiration Sep 06. As of today, calls less than 1526.54 are in-the-money. Puts greater than 1526.54 are in-the-money. The positions were chosen to be in the expected range for the NASDAQ through September.

At expiration, the calls or the puts are expected to be in-the-money so I should get money back. The difference between the strike prices is 100 points (1575-1475). So long as the the NASDAQ is in this range, I get $10,000 back (100 units x 100 points).

Calls 1475.00	$111.80	100 units	$11,180
Put 1575.00	$81.30	100 units	$8,130
Total	$19,310 but $10,000 is in-the-money, so the premium is only $9,310.

Straddles can be purchased with a put and call at the same strike
price. However, it may cost more as only one – the put or the call,
will be in the money at expiration.

Straddle 1525.00	$137.90	100 units	$13,790
Return if NDX 1500	$25	100 units	$2,500 (1525 strike less 1500 close)
Total cost	$11,290 ($13,790 straddle price – $2,500 return)

The cost of the out-of-the-money puts as protection against a sudden
significant decline (NASDAQ 1450 or below.) Puts less than 1526.54 are
out-of-the-money.

Puts 1450.00

$36.00

100 units

$3,600

It gets a lot more complicated than this, but this scenario is an interesting demonstration.

There is good news and bad news. If options are out of the the money at the expiration date, that premium is lost. If the options were a hedge or risk control, that may have been a small price to pay for a good night’s sleep. If this was a big gamble, well… yes, all the money is gone.

More than 90% of all options expire out of the money, so the option writers make money. Occasionally, the option writers are wrong and they lose a lot of money. But if used appropriately, opions can be a very useful investing tool.

Learn more…

• Options Trading Tips for Success – requires three key elements – bargain-hunting instinct with the ability to identify undervalued and overvalued options, sound and well-designed game plan that provides consistent action over time and that works in all market conditions and discipline to follow the game plan.
• OptionsXpress Educate – links to educational information about investing in general and specificly about trading options
• Options Basics Tutorial – An introduction to the world of options, covering everything from primary concepts to how options work and why you might use them.

Refis Forever

“In the first quarter of 2006, 88 percent of Freddie Mac-owned loans that were refinanced resulted in new mortgages with loan amounts that were at least 5 percent higher than the original mortgage balances, according to Freddie Mac’s quarterly refinance review.This percentage is up from the fourth quarter of 2005, when the share of refinanced loans that took cash out was a revised 81 percent, and is the highest since the third quarter of 1990, the mortgage giant said.

“The share of all mortgages that were for refinance fell slightly in the first quarter of 2006 to 44 percent from 45 percent in the fourth quarter of 2005. Over

that same period interest rates on all mortgages increased between 0.02 and 0.25 percent,” said Frank Nothaft, Freddie Mac vice president and chief economist.

“Almost no one is refinancing to reduce their interest rate in today’s environment. In fact, the first quarter of 2006 is the first time in 20 quarters in which the new mortgage rate was higher than the old one for more than half of refinancing borrowers,” Nothaft said. Inman News

Watching The Dollar

I’ve often thought, and previously mentioned, that it is not unlikely that we will have a dollar crisis to bring an end to this nonsense.

The last few days, have certainly weakened the Fed’s credibility. Yesterday’s episode of Maria Bartiromo relaying Bernanke’s dinner party remarks set a new low, both for Fedspeak and for market idiocy in listening. Individually these things don’t mean much, but over time they have a corrosive effect as market participants cast a wary eye over the Emperor’s new clothes.

The dollar was down again today. CAD went through 0.90. DX is in the 85s. How low can it go? Well no real panic until it gows through 80, I think.

The Bubble Lives

Couple of interesting data points. Pending home sales today (NAR) was down over last year, but only 6%. Really in the noise. No bubble burst there. The BEA’s report yesterday implied an estimate of $300 billion increase in mortgage debt outstanding in Q1 (an annual rate of increase of about 13%). So at any rate the home ATM has slowed a bit, but it is still pumping out a huge amount of money to support the overspent consumer.

Caution Is Setting In

CNNMoney did an informal online poll as to whether now was a good time to buy a house. Interestingly, 56% answered that it was better to wait.

CNNMoney Poll

Hedging

This term is often used but not understood. Hedging is a technique for removing specific risks from a position by entering an offsetting short position. Most often, it is used to remove market risk – beta – from a stock position, so that the return on the position becomes that of the outperformance of the position (plus the interest on the proceeds of the short), its excess return or alpha. In the trivial case of a perfect hedge, where the hedge is identical to the original asset, then the net position should earn the market risk-free return, typically the T-bill interest rate.

For example, to hedge a stock portfolio one might short the S&P futures, in effect going short the S&P 500 index basket of stocks. The return on this position would then be the risk-free return plus the performance of the portfolio relative to the S&P 500 index.

Mean Reversion

The philosopher Georges Santayana wrote: “Those who cannot remember the past are condemned to repeat it.” There is a corollary in the financial markets – those who do remember the past are condemned to frustration and underperformance in manias, like the bubble in which we find ourselves today.

Nassim Taleb’s book “Fooled By Randomness” describes this phenomenon, where the short-term success enjoyed by the novices fools them in to believing that they know what they are doing, when in fact they are so incompetent that they cannot recognize their own incompetence.