Personally and professionally I have experienced things I never dreamt I would ever experience. The lessons learnt over these last twelve months are numerous and priceless. The events that have unfolded in the financial markets, and by extension, the economy have been absolutely amazing. We witnessed volatility on a scale never before seen as the global economy came very close to imploding. The volatility has subsided somewhat, but it doesn’t mean we are out of the woods and it certainly doesn’t mean that the threat of a global financial meltdown has abated. I keep getting questions about what caused all this. That, I think, is a subject that has been adequately aired by now so I will not go into too much detail. In fact, I scarcely think there is anyone who has been paying at least scant attention who does not know about the collapse of the housing market (a subject I addressed in a previous article here) and the leveraged risks that were taken by some players in the financial sector who really should have known better.
The Genesis of the Crisis In 4 Stages
1) Briefly put, various debts such as mortgages, student loans etc were packaged by financial institutions and sold off as securities to just about anybody who would buy them for the attractive yield. In the case of mortgages (which is often cited as the real problem), both good loans (people who could afford to pay their mortgages and had good credit) were packaged with bad loans (so called subprime borrowers or people who were likely to default). When the actual debt holders started to default on their debt (like Jane Doe in my previous post) the instruments that were sold as investments became worthless.
2) The problem was that these instruments were sold far and wide and ended up on the books of just about every major financial institution, pension fund, and municipality in the world. So when the defaults were triggered it cascaded and forced everyone holding them to take huge write downs on their assets. Think about this, if you bought bonds that were worth 10 million dollars (backed by the value of the houses and the homeowners promise to pay a mortgage) and the value of the houses fell, as they did, and the ability of the homeowners to pay the mortgage became severely impaired- then its obvious those bonds were no longer worth 10 million dollars right?
3) It gets even worse when you consider the fact that the institutions or entities who held these bonds, in many instances, borrowed huge sums of money using the bonds as collateral. So, naturally, when the bonds fell in value those loans were called in. Of course they were some companies (Bear Stearns (BSC) and Lehman Brothers (LEH): may they rest in peace) and many others that could not pay up and simply went out of business. This ripped through whatever remaining confidence there was in the global credit markets as no one was willing to lend to anyone when they didn’t know their level of exposure to these bonds.
4) Needless to say, this dried up the flow of money (credit) from those who had it to those who needed it. In fact the share prices of companies who depend on credit to finance and operate their businesses fell significantly and since a large percentage of publicly listed companies do operate on significant credit (corporate debt) the overall effect was the Stock Market Crash. This is what happened to the likes of General Motors (GM) and General Electric (GE) and countless others when it became apparent that their inability to secure financing and run their operations would hurt the bottom line. And from all indications, many more will follow.
Ok. So what’s Next?
Well once you understand that what we have is crisis of confidence in the Global Credit Markets (that’s where it started) and the way the world governments are trying to deal with the problem then you can pretty much see what is likely to result form this. In my humble opinion, the next phase of this crisis is inflation. Maybe even hyperinflation. How is this? The governments of the world have sought to deal with this problem by cutting interest rates and pumping large sums of money to prop up the debt markets and boost liquidity. Remember that private institutions are not lending to each other because the risks are still unknown and undefined. So what the central banks are doing is pumping money into the system and hoping that the supply of money will reach a level where the banks (outlets) have no choice but to start lending to each other and the general population again. It is that simple. There are many financial strategists and so called “market mavens” who believe that this action by the government signals a turning point in the markets and that the worst of the credit crunch is behind us. I, on the other hand, think that it signals the possibility of worse to come and I will tell you why.
Let’s look at the US government for instance. They have made it clear that they will try to put a halt to the decline in the economy. The reasoning here is that when there is sufficient credit, the companies and individuals can borrow to produce and purchase goods and services which will lead to growth. This, for the most part, is true. For this job they have only two tools: fiscal policy (budget and taxes) and monetary policy (interest rates and money supply). They have been using the latter. To date, more than ten trillion dollars have been pumped into the economy through various channels to prop up the debt markets and bailout various financial institutions. Just take a look for your self:
This is a chart of the growth in the money supply in the US. The money that the government is printing is being added to the stock of green backs floating around out there and money, just like any other commodity, gets less valuable when there is too much of it floating around or when there is no meaningful production to underpin it. We know there is too much out there because the growth of the money supply outpaces the rate of production of goods and services and that is where inflation is born (a subject I addressed in a previous article). Since it’s obvious that Uncle Sam is likely to persist, then further inflationary pressures in the economy are inevitable. Simply put, this means a weaker US dollar, costlier food, higher fuel prices, and just a general higher cost of living for you and yours. Not trying to scare you. Just telling you the truth.
A Pause For A Cause
I am affiliated with a small and dynamic software and web development company (Director & Shareholder: for full disclosure) They have created and are testing a toolbar that delivers Jamaican content. I have been using it and find the streaming news and access to hundreds of free radio stations to be quite useful. In fact it has a feature where you can search for live streaming radio stations by genre. It is very small and fits perfectly and seamlessly on your browser window. Ultimately, it will be a portal to Jamaican news, sport, business entertainment etc. And, we hope, a powerful advertising tool. As I said it is in Beta so there are still a few kinks. You can download it here:
Only for Those of You Who Are So Inclined
I know that not all my readers share my passion for the financial markets, so this next segment is for my fellow aficionados.
I have spent a tremendous amount of time over the last year studying Economic Cycles Theory and Mean Reversion. My primary reason for studying these things is to make money. It’s that simple. In fact I am currently building a trading program that is primarily based on the concept of Mean Reversion. It is something I started about two years ago and initially tried working with programmers and software developers to get it going. That failed miserably. I put it aside for a while and then returned to it about 7 months ago. I committed myself to learning basic programming language (Excel BVA, R and C++). These long hours have cost me dearly in just about every way (relationships, money and even my eyesight LOL) but the program seems to be working.
However, I see this as an investment in the future and whoever/whomever was wronged or felt slighted because I spent so much time and money developing this program should know that this is a necessary sacrifice and expect that all will be made right in the not so distant future ): . I am currently back testing and running simulated trades with pretty decent results so far. I found the things I learned studying these concepts to be quite fascinating. In fact I would go as far as to say life changing. The application of these concepts goes way beyond trading futures and options. I will give you a basic definition, share with you what I learnt and pose my conclusion.
1) Program trading: This is basically computer driven automatic trades. The value of a well written program trade sequence is that it effectively strips out human judgment and emotion from the decision making process and the trade execution. Add to that the speed with which it analyses data and does computations and you can appreciate the usefulness of such a thing in today’s volatile markets.
2) Mean Reversion: Is the concept that all securities have an average price at which they trade over different time frames and that any divergence from this mean, whether up or down will eventually be corrected. I know some might be asking: is this not what the RSI does? The answer is NO. I have compared the two in real time. They are like night and day. I now realize why I lost money using RSI. LOL. My program is built to 1)calculate the mean over various time frames for a given security 2) give a signal when a security is in extreme divergence and 3) confirm divergence with other technical indicators. The next stage of development is to have it fire off a trade, upon confirmation, based on certain entry and exit parameters. The thing eats memory as it has to constantly store data and continuously calculate the mean (in short time frames). But it is a thrill to watch it crank out numbers and signals and know that each is potentially profitable.
Some Things I learnt
I learnt that the conditions have to exist for reversion to take place. For instance in short term trading (shorter time frames) the demand/supply balance in terms of the available units of a security (stocks, option/futures contracts etc.) has to be severely skewed, and that technical tools rule the day. In this day and age plain vanilla technical tools won’t do, we are talking about far more advanced TA tools. On the other hand, over the longer term, the fundamentals dictate to the market/asset class that it is time to revert.
Ø To put the previous thought in context, let’s look at the financials vs. commodities in today’s market environment. For financial stocks the fundamentals indicate that there is more trouble ahead, so even though my program is showing extreme divergence levels and a high probability trade set up, the fundamentals are saying that there will be no meaningful reversion anytime soon. You see, the program is not aware of the situation in the credit markets as it was not a variable that was written in its code. It only knows today’s price action relative to previous price action. The commodities on the other hand pose a more likely trade. For instance, we know that we might very well see a spike in inflation in the medium term which is usually good for commodities. The program doesn’t know this, but it knows that the Oil ETF, USO, is in extreme divergence. In fact the program reveals a mean price of $64.05 over the life of the ETF and now it trades at around $28. A simple reversion to the mean would bring a $36 profit. For this trade I would go long call options with a distant strike. It is actually a trade I am looking at now. Of course every trade should be hedged (because black swans aren’t that rare these days). That I have to do old school discretionary style because my program has not “learnt” hedging yet.
Ø I also learnt that program trading is VERY influential in short term market activity. In fact if you trade short term and ignore or strip out the program trading factor, you are making a big mistake. Program trading moves a significant amount of the volume on exchanges all over the world everyday. One statistic I saw said program trading could account for as much as 50% of all transactions in the next decade. The programs being used today are very powerful, they are programmed with multiple variables (unlike my binary variable simpleton) and are capable of generating signals and firing off millions of trades in a fraction of a second. Talk about swimming with sharks. The future for short term trading is program trading.
The Most Important lessons
The most important lessons I learnt is that everything operates in cycles and that there are cycles in everything. There is a pattern that life forms on earth have followed from day one and continue to do so. And since the cycle, by its very definition includes a top and a bottom, mankind and just about everything else continuously fluctuates around the mean, the average, the so called equilibrium. And any extreme divergence from the mean WILL correct itself. When the economy overheats and grows too fast we have fall outs like the one we are having now. When it sinks too far in a depression we have tremendous growth spurts like that experienced after WWII to around 2002. Understanding these things has really helped me understand what is going on today. My tentative conclusion (since I am still studying) is that mankind’s mean is rest. We are born. We live. We die. By virtue of the fact that we spend far more time at rest (the avg. human lives to about 72) suggests that our mean, to which we must revert, is at rest (death). My conclusions may yet change but it certainly gives me something to think about. I hope it does the same for you.
Monday, March 30, 2009