Archive for July, 2007

How to implement an asymmetric payoff strategy: Part 1- stop loss, the wrong way

Sunday, July 29th, 2007
Recently, in How to take advantage of an impending crash- Part 4: asymmetric payoff, we mentioned that we will slowly reveal how to implement an asymmetric payoff strategy to take advantage of an impending crash.

Today, we will begin a series on this topic. For today’s installment, we will introduce a common tool used by traders, which is inappropriate for implementing an asymmetric payoff strategy- the contingent stop loss order.

Just what is a contingent stop loss order?

Traditionally, a contingent stop loss order is a sell order that will sent to the market the moment the stock price hit at or below a pre-defined level. For example, if you bought a stock at $1 and set the contingent stop loss order’s level at $0.90, then if the stock fell to or below $0.90, then a sell order for your stock will be sent to the market to be liquidated.  Conversely, in the case of short selling, the stop loss order gets activated when the stock price hit at or above a pre-defined level (say, $1.10 in this given example).

In theory, you can sell (or buy in the case of short-selling) the stock just at the pre-defined stop-loss price level. In other words, in the given example, your loss is pre-defined at $0.10, while your profit potential is unlimited. Therefore, in theory, this is an implementation of an asymmetric payoff strategy.

However, this implementation will not work in practice, especially in the event of a stock market crash. This is because stock price can ?gap? in the real world. So, what is the concept of ?gap?? Using the above-mentioned example, let’s say you bought the stock at $1.00 and by the end of the week, the stock price fell to $0.95. So far, your contingent stop loss has not yet been activated even though you are sitting on an unrealised loss of $0.05. Let’s say, on the Monday of the following week, catastrophic news hit the company of the stock. Thus, the first traded price of the stock on that Monday is $0.20. Your stop loss order gets activated, which by the time reaches the market, means that you can only get to sell the stock at $0.19. The outcome is that your lose $0.81 on the trade, instead of the theoretical maximum loss of $0.10! This concept works the same way in the case of short-selling whereby the stock ?gap? up instead of down.

Examples of factors that can cause stock prices to ?gap? includes:

  1. Behaviour of overseas stock market in a different time zone.
  2. Black Swan events e.g. September 11
  3. Takeover announcements

Therefore, of all the implementation of asymmetric payoff strategies, this is the least that we preferred.

Signs of tightening liquidity

Wednesday, July 25th, 2007

Back in Marc Faber on why further correction is coming?Part 2, we mentioned that:

What is happening is that over the past few months, the US sub-prime mortgage lending sector is running into trouble. That means, a trend towards credit tightening is already underway in the US. Marc Faber?s view is that this trend will affect the economy by crimping back on consumer spending, which is dependent on rising asset prices fuelled by credit. That in turn will mean that excess global liquidity growth through the US current account deficit will decelerate.

As we can see from these Bloomberg news articles, KKR, Blackstone Find `Tide Is Going Out,’ Gross Says and KKR, Homeowners Face Funding Drain as CDO Sales Slow signs of tightening liquidity are emerging. With money getting more expensive, we can expect that the liquidity-fueled asset price boom will be in the process of running out of puff.

Be warned.

China at turning point?

Tuesday, July 24th, 2007

In our previous article, How does the US export inflation?, we mentioned about the price inflationary effects that the US has on the rest of the world. China, on the other hand, through its artificially low Yuan and massive growth in industrial productive capacity over the past decades, had a disinflationary effect on the rest of the world. As we said before in The Bubble Economy,

… another force was at work in curbing Australia?s consumer price inflation – the rise of Chinese manufacturing. In recent years, Chinese productivity had soared, which means overall, the Chinese economy was producing more and more goods at lower and lower costs. In China itself, that had a good deflationary effect – the fall in the consumer price levels. As China exported more and more of its cheaper goods to Australia, the effect on Australia was disinflation (decelerating growth in consumer price inflation). That helped keep a lid on the Australian consumer price inflation.

Today, this piece of interesting news caught our eye: China’s Exported Inflation May Signal Interest-Rate Pressures,

China, a source of cheap manufactured products for the past two decades, may be starting to export inflation as the world economy grows at the fastest pace in a generation.

Prices of U.S. imports from China increased 0.3 percent in May from the previous month — “the first sign I’ve seen that this disinflationary pressure” from China’s cheap goods may be fading, former Federal Reserve Chairman Alan Greenspan said last month.

If this is true, then it means that China’s industrial productive capacity may be reaching its limits.

As we had warned before in Have we escaped from the dangers of inflation?, with central bankers around the world ?printing? so much money, there will be no escaping of price inflation in the long run. Modern central bankers’ discourse have consistently failed to make clear the root cause of price inflation?monetary inflation. Thus, we urge our readers to read this article of ours once again: Cause of inflation: Shanghai bubble case study.

The reason why central bankers could get away with not raising interest rates despite the ballooning supply of fiat money is because of China. Now that China has its own price inflation problems to worry about and may be reaching the limits of its own productive capacity, the global economy may soon be paying the price (forgive the pun) of irresponsible central banking, principally the Federal Reserve of the United States.

Therefore, we see that in the months and years to come, barring a serious deflationary crunch, the era of cheap money will be ending i.e. interest rates will be rising. With that, the heavy gears of the global economy will change gradually and the business cycle will turn (see our articles on the Austrian Business Cycle Theory).

Consumers paying for the implosion of dumped risk

Sunday, July 22nd, 2007
In our previous article, How to dump risk to consumers: securitisation, we said that:

With the recent financial ?innovation? of debt securitisation, lenders can now aggregate their loans, and through dicing, slicing, splicing and divesting, repackage it into an ?investment? product.

These ?investment? products are then sold to retail investors (i.e. consumers) directly and indirectly (through their retirement funds). As with all financial products, these ?investment? products come with ?management? fees.

Today, we are seeing the implosion of such ?investment? products due to the sub-prime crisis in the US (see How did the US sub-prime lenders get into trouble?):

  1. Bear Stearns’s two hedge funds has collapsed and are not worth a combined 9 cents to the dollar (i.e. value fell by 91%).
  2. Basis Capital, an Australian hedge fund manager, has two of its hedge funds in crisis: Basis Yield Fund and the Aus-Rim Dividend Fund. Both of which were exposed to the sub-prime market.

According to the ?cockroach theory,? if you see one cockroach in the kitchen, then there must more of them somewhere else. In the same way, if we see some of these crises in hedge funds coming to light, then there must be more of such rot somewhere else. In one of the news article, Warnings over hedge fund crisis, it was reported that (in the context of Basis Capital’s crisis):

… fallout was the first instance of ripple effects from the implosion of the US sub-prime market reaching these shores.

… the situation was “serious already”, but difficult to accurately assess because “opaque” secondary credit markets made it hard to track risk. “From a systemic point of view, though, the problems are quite manageable so far,” he said.

There are two main causes of the turmoil in the sub-prime market, and its increasing relevance for local investors.

First, poor lending standards resulted in mortgage lending to risky customers with only a limited capacity to repay.

Second, and most important for Australians exposed to the crisis, the loans were repackaged through securitisation and sold throughout the world, finding their way into the portfolios of largely unsuspecting investors, according to Schroders.

This led to a complete disconnect between the originators of the loans and the eventual holders of the risk.

The disconnect was further enhanced by complex structuring mechanisms, transposing the loan parcels into CDOs.

Mr Hodgson linked the cascading effect of turmoil in the sub-prime market to the wider debt market, particularly highly leveraged private equity deals.

“Leverage is always the first thing that catches a cold first, and there’s probably been some pretty toppy multiples paid for some of those businesses,” he said.

“With a rising interest rate environment and toppy multiples, it’s going to be tough for some of those deals.”

Mr Hooper said it was going to be difficult to get a handle on the depth of the sub-prime problem, and where the impact would be most seriously felt, because of the opacity of the secondary credit market.

“The first question is whether or not this is the tip of the iceberg in sub-prime, and we have (US Federal Reserve chairman) Ben Bernanke saying this is a fairly major credit problem,” Mr Hooper said.

“But the second issue is where – and the extent to which – this will work its way through the securitisation and collateralised loan market.

“It’s a bit difficult to call at this stage on both counts.”

Foreign banks, including Lehman Brothers, Merrill Lynch, Citigroup, JP Morgan and Morgan Stanley, have the biggest exposure to Basis Capital.

Mr Hooper said the banks’ right to sell assets quickly would be at the expense of investors’ interests.

“It’s the glory of leverage in reverse,” he said.

We warned our readers before in Spectre of deflation and Liquidity?Global Markets Face `Severe Correction,? Faber Says, and our suspicion is that in the months and years ahead, we will see a rising trend of such collapses.

 Investors beware!

Should you purchase first home whilst asset price inflation?

Thursday, July 19th, 2007

Recently, we received an email from one of our readers,

Having read many of your topics on the housing market it seems that it would be a bad idea to invest in housing at the moment – given the slow deflation of the housing bubble, coupled with cheap credit inflating prices to an unstable level, it would seem likely that any investment in this area carries a fairly high level of risk.

But I’m curious to your thoughts on those first home buyers (such as myself) that aren’t looking so much to invest as a business, but are simply looking to start a home.

The way I see it, the options of my partner and I are limited.  We can continue renting, and risk having to pay even more for a house in a few years if prices continue to raise – or we can look at purchasing a house now, at an artificially inflated price, and risk having the bubble burst on us.

The context of this email is on the many articles that we had written on the Australian housing market.

As we all know, there are talks about the un-affordability of housing in the Australian media and this has become a political issue in an election. The sky-rocketing property prices over the past several years is part of the global crack-up boom in asset prices (see Epic, unprecedented inflation).

As to whether investing in Australian residential property is ?risky? or not, we cannot say much in the general sense except that when the inevitable deflationary crunch comes for global asset prices, residential property prices are likely to tag along as part of the overall downward forces on prices (see Spectre of deflation).

On the other hand, if we decide to remain invested in this period of cracked-up boom of asset prices, Australian residential property is one of the last places for us to put our money in because there are better places to do so.

 Now, what about those who are planning to buy their first home?

The risks faced by first home buyers are different from investors because there is no return on investments to consider. However, the risks they face are of a different nature. In fact, there is only one root risk to the first home buyers?the ability to service the mortgage. We will look at the various factors that may affect this risk:

  1. Interest rate rise? As we said before in Have we escaped from the dangers of inflation?, at this rate the supply of money and credit is expanding globally (including Australia), it is inevitable that price inflation will rear its ugly head sooner or later. We recommend that you read our earlier article, Cause of inflation: Shanghai bubble case study to learn more about the root cause of price inflation. Therefore, for people with mortgage, it is prudent to arrange their finances with the assumption that interest rates are going to be in an upward trend for at least in the medium term. Having said that, it is still possible for interest rates to be cut? when the economy is hit by a threat of recession or depression, which is possible Black Swan. This brings us to the next point.
  2. Unemployment? Let’s say there is a recession (or depression). Unemployment will surely rise, depending on the severity of the economic slowdown. It is very likely that asset prices will fall in such economic condition. Unemployment will result in loss of income, which will mean the inability to service the mortgage debt. Worse still, in times of asset price deflation, when the property is foreclosed and goes into a fire sale in a depressed market, the borrower can end up in a situation called negative equity. This is the situation whereby even after the property is forcibly disposed of in a sale, the delinquent borrower is still faced with debt because the sale price is far below the originally borrowed amount.

Can the economic boom still continue? Remember, Australia’s economic boom had been going on for more than 16 years, which is by far the longest stretch of boom (see Another sign of the business cycle top). Our belief is that now is the time to be more careful with our finances (i.e. fatten ourselves financially for the inevitable economic winter).

Begining of trade war?

Monday, July 16th, 2007

In Using fear as a proxy for import controls?, we reckoned that the US was firing the first shot in a possible trade war with China. Today, in this news media article, Beijing suspends US meat imports, China looked to be firing the retaliatory shot.

Connecting monetary policy with home loans

Saturday, July 14th, 2007

In this news media article, Home loans on tap: no deposit, no inspection, it said that:

THE mortgage stress crisis is being worsened by the boom in easy credit, with lenders approving loans without inspecting properties, offering large amounts to borrowers who have no deposit and encouraging buyers to take on debts that would eat up half their income.

How effect does monetary policy has on the average person on the street? Today, we will talk about that.

In our last article, What makes monetary policy ?loose? or ?tight??, we said that:

…the central bank cannot control the demand for money and credit. It can supply whatever amount of them that it wants, but it cannot force business and people to desire them. Put it simply, you can lead a horse to the water, but you cannot force it to drink.

Therefore, when setting an interest rate, the central bank supplies (or withdraw) whatever amount of money to (from) the financial system at a given quantity demanded for money. Therefore, money supply can only expand as far as the willingness of the central bank to supply additional money, and the economy is willing and able to take in more money in the form of debt and credit.

What is the demand for money?

For today’s article, we will look at one example of a demand for money?demand for home loans. Home loans are basically debt for the borrower and credit for the lender. They form part of the aggregate demand for money in the economy. In the above-mentioned news article, lenders are getting complacent in their credit standards. If the quantity of money (credit) is fixed in the economy, then any increase of demand will have to result in higher interest rates (price/cost of money). The fact that interest rates had not risen means that the quantity of money (credit) had to increase to accommodate its increased demand. If you look at the Australia’s M3 money supply (see Financial Aggregates – May 2007), you can see that money supply has been increasing steadily.

What does this mean?

In the case of home loans, the increase of easy credit offered to borrowers can have the effect of further inflating the prices of homes. But borrowers can never take on more debt indefinitely. It will come to the point when the debt-servicing burden of the economy will exceed its capacity and energy to repay. By then, the risk of debt defaults will increase, which can result in asset price deflation (see What can tip Australia into a downward property price spiral? and Spectre of deflation).

At this point, it looks to us that Australian borrowers may be at their limits of debt burdens. Therefore, any further increase in easy credit means that the risk of deflation led by debt defaults has to increase.

How the folks in the finance/economics industry became turkeys?Part 3: Consequences of turkey thinking

Thursday, July 12th, 2007

Back in our earlier article, How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud, we said that:

Yet, the finance and economics industry uses them [Bell curve] as if they are the gospel truth. What is the consequences of all these? We will talk more about it in the next article of this series.

To understand the consequences, we first have to understand the importance of an event. With a correct understanding of its importance, we can then allocate our priorities to prepare for it. There are two components in deciding how important an event is:

  1. Probability of it happening
  2. Impact it will cause when it happens

Therefore, the importance of an event is the probability of it happening multiplied by its impact when it happens. For example, while it is probably very unlikely for another hurricane that is worse than Katrina to strike again, the consequences, should it happen, is very devastating. Therefore, it is important to prepare for it. This is the very definition of the Black Swan event?an event that is highly improbable but having colossal impact (either good or bad).

The problem with many in the finance and economics industry is that through the use of the Bell curve, the probabilities of Black Swan events happening become severely underestimated. As a result, some risks are wrongly deemed to be extremely unlikely and thus, there are completely no preparations for them.

That is the difference between the mainstream and us. We do prepare for Black Swans.

Are the sub-prime crisis contained? Not so easy!

Tuesday, July 10th, 2007

Today, we saw this article on the news media, Mortgage resets: Record bill coming due:

More than two million subprime adjustable rate mortgages (ARMs) are poised to reset at much higher rates in coming months, worsening an already suffering housing market.

It pays to revise what we said earlier on our earlier article: Marc Faber on why further correction is coming?Part 2.

Prepare for more food price inflation

Sunday, July 8th, 2007

In today’s globalized world, the adage that “everything is connected to everything else” has never been truer. So, today, we will look at this interesting question: what has the oil got to do with food price inflation?

As we all know, oil prices had been rising steadily over the years. Our view is that in the long run, despite the short-term fall of oil prices (see Analysing recent falls in oil prices?real vs investment demand) oil is going to be more expensive (see Is oil going to be more expensive?). The fact that there is a major push towards biofuels (e.g. ethanol) tells us that the security of the world’s oil supplies is not something that major countries are taking for granted any longer. Indeed, the list of oil worries includes: Peak Oil, Global Warming, rise of Chinese and Indian demand for oil, Middle-East geopolitical risks, etc.

Recently, we saw this news article: Biofuels ‘to push farm prices up’:

The rapidly growing biofuel market will keep farm commodity prices high over the next decade, a key study has said.

As we said before in Can ethanol replace oil?,

With these factors in mind, although ethanol will have its limited role to play in the world?s energy problems, we are not confident of it supplanting petrol in a mass-scale in the foreseeable future.

In fact, any major concerted effort towards this will have repercussions on the price of food. Indeed, the US efforts to produce ethanol from corn have caused corn prices to rise (see Corn as food or as fuel?).