In a posting December, 2008 I discussed how a counterintuitive event, like a "tell" in gambling, can have predictive value.
For example, suppose a company reports worse than expected earnings. Given that news, one would expect the stock to decline. If the stock goes up in the face of disappointing earnings, that is counterintuitive, and probably means the stock is in a bullish trend.
I mention this because Bloomberg News two days ago mentioned that "The China Business newspaper reported on its Web site that China will announce in August a new stimulus package of possibly 4 trillion yuan ($586 billion)." Given that the Chinese economy had advanced a whopping 11.9% in the first quarter, a growth way above trend, and China is trying to rein in a crazy real estate market, I conclude that this mention of stimulus is counterintuitive. Why mention this now? And the amount of the stimulus is mind-boggling. It is roughly the same size as the program enacted during the worst of the recession. If this news item is true, it might indicate that the Chinese government is worried about a much lower economic growth near term and is preempting any stock market downdraft by announcing that it will be ready to provide enormous stimulus in that event.
So far, this story has not gained traction. Perhaps the newspaper is unreliable. Or perhaps this is a case of my overthinking--that this story is just noise, not a "tell". However, the European sovereign debt crisis with Greece, which may spread to other EU countries, has prompted some to reduce risk in their portfolios. That usually means, as Goldman Sachs put it during the congressional hearings yesterday, "getting closer to home". The most volatile portion of my financial assets is my position in the T. Rowe Price New Asia Fund. At the close Monday, I sold enough of that fund to bring my holding down to what I consider a "core" position, one to be held for five to ten years. With this sale, I have now reduced this position by two-thirds of its peak value.
Why not also reduce my position in the T. Rowe Price Equity Index 500 Fund? After all, many companies in that fund have a growing exposure to southeast Asia; and some heavy machinery producers, like Caterpillar, and many raw material producers are heavily dependent on a rapidly growing China. Good question.
On the positive side, corporate earnings during the first quarter have far exceeded expectations; and corporate outlooks are becoming rosier. We remain in the "sweet spot" of the cycle when profit margins expand and interest rates remain low. Wall Street, as is its proclivity, is raising earnings estimates and stock price targets. Money flows, which last year heavily favored the fixed income side, are now beginning to flow back into equities due to less fear of a relapse into recession, the stock market's upward momentum, and a growing distaste for bonds when interest rates are expected to rise sometime soon.
On the negative side, as we know, the stock market discounts the future; and six months from now we will be facing withdrawal of the stimulus program, the prospect of higher taxes to reduce the ballooning deficit, and higher interest rates. The S&P 500 Index, relative to NORMALIZED EARNINGS, is 15% to 20% overvalued. There is mounting bullishness and minimal bearishness among investment advisers--at roughly the same levels as last January immediately prior to a 9% correction in stock prices. However, this contrary sentiment indicator isn't yet at the extreme reading reached in October, 2007 when the last bull market peaked.
I have decided not to reduce my equity exposure to the S&P 500 Index yet. When the monthly employment report shows an increase of more than 300,000, a buying panic may ensue, which would provide a better opportunity to reduce my equity holdings to "core" levels.
Wednesday, April 28, 2010
Friday, December 4, 2009
Rebalancing My Portfolio
Last year, utilizing dollar-cost averaging, I accumulated an equity position which amounted to 40% of my total financial assets, with the remainder in fixed income securities (90 Day Treasury Bills). Of that equity portion, 75% was originally invested in the T.Rowe Price Equity Index 500 Fund and 25% in the T.Rowe Price New Asia Fund. Due to appreciation in the equity funds and the use of some Treasury Bills to pay living expenses, the equity portion, as of yesterday, had become 56% of total financial assets. Furthermore, within the equity portion, the New Asia Fund, due to its far higher total return (71% versus 7% for the Equity Index 500 Fund), had now become 35% of the equity exposure versus the desired 25%.
At the close yesterday, I sold 29% of the equity portion to bring equity exposure back down to 40%, and sold much more New Asia Fund than Equity Index 500 Fund in order to return to the orginally intended 75%-25% breakdown.
The relevant question is WHY NOW?
As those who have read my previous postings know, I feel the key to the U.S economy and stock market is WHEN the consumer resumes historically normal spending patterns after experiencing a tremendous loss of net worth from the stock market and housing busts and the discouraging effect of high unemployment. The build-up of debt throughout the economy over several decades should require more time to reverse significantly. There has been some progress in reducing consumer debt but public debt has mushroomed. Overall, there has been little deleveraging, although lower interest rates on that debt are helpful temporarily. The U.S. economy is in the worst condition since the Great Depression, and I believe nobody really can predict with conviction when normal growth will recur. Apparently, the current Christmas selling season will not be significantly better than last year, which was in the aftermath of the Lehman collapse.
The banking system is benefiting from wide interest rate spreads and the accounting change from "mark to market" to "mark to model". However, problems remain. The recent Dubai debt problem is a high profile "canary in the coal mine" foretelling the next banking crisis -- the necessity to renegotiate several trillion dollars of commercial real estate loans during the next seveal years.
Currently, the U.S. economy is in the sweet spot of: some economic growth, very low interest rates, and tremendous operating and financial leverage. The result is above-normal profits growth. Since the stock market is a discounting mechanism, the question is how much of this has already been discounted? Based on a dividend discount model, the stock market is currently between 7% and 25% overvalued depending on whether one assumes 7% or 6% annual "normal" earnings growth. At this stage in a "normal" economic cycle, that isn't so frightening, especially given the alternative paltry returns from fixed income, which tend to force investors farther out on the risk spectrum. However, given the leverage in the system and the financial plight of the consumer, this may not be a normal economic cycle. Once federal stimulus programs are withdrawn, will the economic upturn prove sustainable?
My most trusted input, investor sentiment, has not yet reached the extreme bullishness characteristic of a top.
As I have discussed previously, Fibonacci numbers are considered by some to mirror reality, although there are many detractors from this concept. Whether true or not, so many traders are believers that one must pay attention to the fact that the stock market during the last few days has retraced half of the entire bear market from the high of 1565 in the S&P 500 Index to the low of 666.
Please forgive the length of this posting. I haven't written one for roughly a half year because, until now, I didn't think there was any action to be taken. In my opinion, this rebalancing is appropriate because the stock market is no longer undervalued, and the economic uncertainty is above normal.
At the close yesterday, I sold 29% of the equity portion to bring equity exposure back down to 40%, and sold much more New Asia Fund than Equity Index 500 Fund in order to return to the orginally intended 75%-25% breakdown.
The relevant question is WHY NOW?
As those who have read my previous postings know, I feel the key to the U.S economy and stock market is WHEN the consumer resumes historically normal spending patterns after experiencing a tremendous loss of net worth from the stock market and housing busts and the discouraging effect of high unemployment. The build-up of debt throughout the economy over several decades should require more time to reverse significantly. There has been some progress in reducing consumer debt but public debt has mushroomed. Overall, there has been little deleveraging, although lower interest rates on that debt are helpful temporarily. The U.S. economy is in the worst condition since the Great Depression, and I believe nobody really can predict with conviction when normal growth will recur. Apparently, the current Christmas selling season will not be significantly better than last year, which was in the aftermath of the Lehman collapse.
The banking system is benefiting from wide interest rate spreads and the accounting change from "mark to market" to "mark to model". However, problems remain. The recent Dubai debt problem is a high profile "canary in the coal mine" foretelling the next banking crisis -- the necessity to renegotiate several trillion dollars of commercial real estate loans during the next seveal years.
Currently, the U.S. economy is in the sweet spot of: some economic growth, very low interest rates, and tremendous operating and financial leverage. The result is above-normal profits growth. Since the stock market is a discounting mechanism, the question is how much of this has already been discounted? Based on a dividend discount model, the stock market is currently between 7% and 25% overvalued depending on whether one assumes 7% or 6% annual "normal" earnings growth. At this stage in a "normal" economic cycle, that isn't so frightening, especially given the alternative paltry returns from fixed income, which tend to force investors farther out on the risk spectrum. However, given the leverage in the system and the financial plight of the consumer, this may not be a normal economic cycle. Once federal stimulus programs are withdrawn, will the economic upturn prove sustainable?
My most trusted input, investor sentiment, has not yet reached the extreme bullishness characteristic of a top.
As I have discussed previously, Fibonacci numbers are considered by some to mirror reality, although there are many detractors from this concept. Whether true or not, so many traders are believers that one must pay attention to the fact that the stock market during the last few days has retraced half of the entire bear market from the high of 1565 in the S&P 500 Index to the low of 666.
Please forgive the length of this posting. I haven't written one for roughly a half year because, until now, I didn't think there was any action to be taken. In my opinion, this rebalancing is appropriate because the stock market is no longer undervalued, and the economic uncertainty is above normal.
Thursday, June 4, 2009
What A Difference One Percentage Point Makes
I believe that the fair value for the S&P 500 Index is a function of normalized current earnings, expected earnings growth, dividend payout, and current interest rates. This is known as a dividend discount model. Theoretically, fair value is the future dividend stream discounted to the present at a rate (the discount rate) which reflects the current level of risk-free interest rates plus an equity risk premium. Faster earnings (dividend) growth and/or a lower discount rate would lead to a higher fair value, and vice versa.
In a posting November 14, 2008 entitled "All In--A Double Entendre", I calculated that, according to this "fair value" approach, the S&P 500 Index should reach the previous high of 1565 sometime in 2016. In that calculation I assumed a 7% annual earnings growth rate, the historical mean price to earnings ratio of 15, and normalized earnings of $64.
It has been my contention that the enormous leveraging of the last quarter century to 350% of GDP will take several years to work off. The consumer normally accounts for 65% of GDP. Juiced by this debt splurge, consumption has now become 70% of GDP. Anyone who has read my postings knows that I am a strong believer in "regression to the norm". It would seem that, at least for several years, consumption will increase at below normal growth to reestablish normal levels. Since consumption constitutes such a large percentage of GDP, there is the possibility that the long-term earnings growth rate of 7% will prove to be less during the next economic cycle--perhaps closer to 6% than 7%.
Historically, often when earnings growth slows, interest rates decline. The lower interest rates imply a higher price to earnings ratio, which tends to offset the negative impact of lower earnings growth on fair value. However, this time interest rates may not decline due to the vast additional Treasury debt required to finance the new stimulus programs. If so, it would be relevant to compare the difference in fair value with a 6% as opposed to a 7% earnings growth rate. According to the dividend discount model. with no change in interest rates, the price to earnings ratio should be closer to 13 than 15. The fair value, say in 2016, with a decline in earnings growth of one percentage point and a lower price to earnings ratio, would be 1251, compared with 1565. From today's S&P 500 Index price of 940, that would mean compound annual appreciation of 4.2% rather than 7.6%. Add in a dividend yield of 2.4%, and the annual total return becomes 6.6% rather than 10% --a huge differential. Or, in other words, rather than reaching the old high of 1565 in 2016, that level wouldn't be reached until 2020.
What is the probability that a 6% earnings growth rate will soon be perceived as the secular norm, replacing the historical 7%?--not likely at least during the economy's early recovery period when the strong positive earnings effect from our economy's operating and financial leverage will mask any change in the secular trend. I decided to undergo this exercise because of the possible very long-term implications. Even then, given Wall Street's proclivity to be bullish, it is doubtful that a lower secular earnings growth rate will become the accepted norm.
I should also mention that the S&P 500 Index departed from fair value in 1995 and stayed overvalued until fourteen years later in March, 2009. I believe strongly that this was primarily due to the enormous influx of baby boomer retirement money into the equity market starting in 1995. Demographics no longer provide a tailwind--quite the contrary, we now have a two-club length wind in our face.
In a posting November 14, 2008 entitled "All In--A Double Entendre", I calculated that, according to this "fair value" approach, the S&P 500 Index should reach the previous high of 1565 sometime in 2016. In that calculation I assumed a 7% annual earnings growth rate, the historical mean price to earnings ratio of 15, and normalized earnings of $64.
It has been my contention that the enormous leveraging of the last quarter century to 350% of GDP will take several years to work off. The consumer normally accounts for 65% of GDP. Juiced by this debt splurge, consumption has now become 70% of GDP. Anyone who has read my postings knows that I am a strong believer in "regression to the norm". It would seem that, at least for several years, consumption will increase at below normal growth to reestablish normal levels. Since consumption constitutes such a large percentage of GDP, there is the possibility that the long-term earnings growth rate of 7% will prove to be less during the next economic cycle--perhaps closer to 6% than 7%.
Historically, often when earnings growth slows, interest rates decline. The lower interest rates imply a higher price to earnings ratio, which tends to offset the negative impact of lower earnings growth on fair value. However, this time interest rates may not decline due to the vast additional Treasury debt required to finance the new stimulus programs. If so, it would be relevant to compare the difference in fair value with a 6% as opposed to a 7% earnings growth rate. According to the dividend discount model. with no change in interest rates, the price to earnings ratio should be closer to 13 than 15. The fair value, say in 2016, with a decline in earnings growth of one percentage point and a lower price to earnings ratio, would be 1251, compared with 1565. From today's S&P 500 Index price of 940, that would mean compound annual appreciation of 4.2% rather than 7.6%. Add in a dividend yield of 2.4%, and the annual total return becomes 6.6% rather than 10% --a huge differential. Or, in other words, rather than reaching the old high of 1565 in 2016, that level wouldn't be reached until 2020.
What is the probability that a 6% earnings growth rate will soon be perceived as the secular norm, replacing the historical 7%?--not likely at least during the economy's early recovery period when the strong positive earnings effect from our economy's operating and financial leverage will mask any change in the secular trend. I decided to undergo this exercise because of the possible very long-term implications. Even then, given Wall Street's proclivity to be bullish, it is doubtful that a lower secular earnings growth rate will become the accepted norm.
I should also mention that the S&P 500 Index departed from fair value in 1995 and stayed overvalued until fourteen years later in March, 2009. I believe strongly that this was primarily due to the enormous influx of baby boomer retirement money into the equity market starting in 1995. Demographics no longer provide a tailwind--quite the contrary, we now have a two-club length wind in our face.
Thursday, March 5, 2009
To Rebalance Or Not To Rebalance? --That Is The Question
Most every investor who operates only from the long side has suffered significant losses on the equity portion of his or her financial assets during this bear market. At some point, to preserve one's chosen equity-to-total financial assets relationship, one should rebalance the portfolio. In down markets, that would mean adding to equities and, in up markets, selling some equities. A vicious bear market "makes cowards of us all." Investors are balking at adding to equities. However, unless one has strong conviction that we are beginning a deflationary spiral (what the economists call a "deflatonary adverse feedback loop"), rebalancing during a bear market can enhance long-term performance AS LONG AS THE SECULAR TREND OF EQUITIES IS UP.
Those of you who have read my previous postings know that I am betting that enough of the government's spaghetti thrown at the wall will stick to avoid a depression. It might be beneficial to give an example of rebalancing. In mid-October last year when I reached my 40% equity allocation, or "all in", the S&P 500 Equity Index stood at roughly 840. Unfortunately, I had purchased half the position at a higher price, so that my average cost was at an S&P 500 price of 1080. To simplify this example, I am not including dividends on equities or interest on fixed income investments (90 day Treasury bills in my case). Let's assume there was $100 of total financial assets when the S&P was at 1080, with $60 in fixed income and $40 in equities. Let's also assume that I rebalance now when the S&P is at 700. The original $40 equity position would now be $25.92 and the original fixed income portion still at $60, for total financial assets of $85.92. To rebalance, one would have to bring the equity position up to $34.37, which is 40% of $85.92. That would mean a 33% addition, or $8.45, to the current equity position ($25.92).
At what S&P 500 level should one rebalance? This is an especially difficult decision right now. I still believe that the market is in a bottoming process and that October 10 was a breadth and volume climax. However, the recession continues to deepen. S&P 500 operating earnings for the 2008 fourth quarter were negligible now that AIG has reported. Tangible book value for the S&P 500 is difficult to trust because no one knows whether there is any "book value" left in many financials. I have been using normalized earnings, around $64, as one metric. Another has been the trendline connecting the bottoms of 1974 and 1982, which currently is in the 600-650 area.
Here is another one which I discovered reading the Financial Times yesterday. In his column, John Authers said that "US stocks have shown a strong trend for more than a century, growing by 6.75% per year after inflation, with income reinvested." He then refers to a study by London's Lombard Street Research that points out that there have been only 26 months during the last 140 years (1,680 months) when the S&P 500 was further below this trend than it is now. All of these 26 months except six, three each in 1932 and 1982, occurred during world wars.
Since this recession is probably going to be worse than in the early '80s, let's forget about 1982 and look at what happened in 1932. According to this study, "stocks fell another 25% more after becoming this cheap compared with trend--but then doubled in a matter of weeks." If this phenomenon were to repeat, the S&P 500 would drop to 522 and then double to 1044 in a matter of weeks.
Trying to synthesize all of this into action is difficult. My opinion is to rebalance at roughtly 600 in the S&P 500.
Those of you who have read my previous postings know that I am betting that enough of the government's spaghetti thrown at the wall will stick to avoid a depression. It might be beneficial to give an example of rebalancing. In mid-October last year when I reached my 40% equity allocation, or "all in", the S&P 500 Equity Index stood at roughly 840. Unfortunately, I had purchased half the position at a higher price, so that my average cost was at an S&P 500 price of 1080. To simplify this example, I am not including dividends on equities or interest on fixed income investments (90 day Treasury bills in my case). Let's assume there was $100 of total financial assets when the S&P was at 1080, with $60 in fixed income and $40 in equities. Let's also assume that I rebalance now when the S&P is at 700. The original $40 equity position would now be $25.92 and the original fixed income portion still at $60, for total financial assets of $85.92. To rebalance, one would have to bring the equity position up to $34.37, which is 40% of $85.92. That would mean a 33% addition, or $8.45, to the current equity position ($25.92).
At what S&P 500 level should one rebalance? This is an especially difficult decision right now. I still believe that the market is in a bottoming process and that October 10 was a breadth and volume climax. However, the recession continues to deepen. S&P 500 operating earnings for the 2008 fourth quarter were negligible now that AIG has reported. Tangible book value for the S&P 500 is difficult to trust because no one knows whether there is any "book value" left in many financials. I have been using normalized earnings, around $64, as one metric. Another has been the trendline connecting the bottoms of 1974 and 1982, which currently is in the 600-650 area.
Here is another one which I discovered reading the Financial Times yesterday. In his column, John Authers said that "US stocks have shown a strong trend for more than a century, growing by 6.75% per year after inflation, with income reinvested." He then refers to a study by London's Lombard Street Research that points out that there have been only 26 months during the last 140 years (1,680 months) when the S&P 500 was further below this trend than it is now. All of these 26 months except six, three each in 1932 and 1982, occurred during world wars.
Since this recession is probably going to be worse than in the early '80s, let's forget about 1982 and look at what happened in 1932. According to this study, "stocks fell another 25% more after becoming this cheap compared with trend--but then doubled in a matter of weeks." If this phenomenon were to repeat, the S&P 500 would drop to 522 and then double to 1044 in a matter of weeks.
Trying to synthesize all of this into action is difficult. My opinion is to rebalance at roughtly 600 in the S&P 500.
Sunday, February 15, 2009
A Startling Earnings Report
It has been a month and a half since my last posting; and I wanted to update my thinking.
With 85% of the S&P's 500 market value having reported fourth quarter earnings, operating earnings are down 62%. That is a startling number. The drastic earnings reduction is due primarily to the financial sector's swing from profit to large loss. In previous postings I had estimated that, at some point in 2009, operating earnings for four consecutive quarters would be roughly $48. Corporations often throw in everything imaginable in the fourth quarter results. Even allowing for that, I now feel that the lowest operating earnings for four consecutive quarters in 2009 will be closer to $40 than $48. While this news is disheartening to the bulls, it does not alter the normalized (i.e., trendline)2009 operating earnings estimate of $64.
Since the second week of October, I have maintained that most NYSE stocks bottomed on October 10 at an S&P 500 Index price of 840 and the S&P 500 Index itself bottomed on November 20 at a closing low of 752. Since then, any test of these bottoms has been successful. The recent earnings news should provoke another test.
Whether that test is successful will depend on whether Geithner soon fleshes out a feasible plan to bolster the financial system. The roughly $800 billion stimulus plan to be signed tomorrow will not be nearly enough to pull us out of this recession. Freeing credit is far more important. Mr. Geithner advocates "bold" action. Bold action to me means setting up an entity to purchase "toxic assets" from the banks at a price low enough to attract private equity capital, yet high enough to persuade banks to sell. Once banks sell the toxic assets, TARP money should be made available to replenish the banks' capital. If private equity's top price is too low for the banks, then those banks which are technically insolvent should be forced into reorganization. I consider myself a believer in the free market system, but desperate times call for desperate measures.
If any test of the aforementioned bottom fails, then the next anticipated bottom for the S&P 500 Index would be in the 600 to 650 range, which would be an intersection of the trendline from the 1974 and 1982 bottoms. Until now, those bear markets were the worst since the Depression. We are in the midst of a deleveraging process that has resulted in a global recession. To be long equities, one must believe that government action will prevent a deflationary spiral. As of now, I am still willing to make that bet.
With 85% of the S&P's 500 market value having reported fourth quarter earnings, operating earnings are down 62%. That is a startling number. The drastic earnings reduction is due primarily to the financial sector's swing from profit to large loss. In previous postings I had estimated that, at some point in 2009, operating earnings for four consecutive quarters would be roughly $48. Corporations often throw in everything imaginable in the fourth quarter results. Even allowing for that, I now feel that the lowest operating earnings for four consecutive quarters in 2009 will be closer to $40 than $48. While this news is disheartening to the bulls, it does not alter the normalized (i.e., trendline)2009 operating earnings estimate of $64.
Since the second week of October, I have maintained that most NYSE stocks bottomed on October 10 at an S&P 500 Index price of 840 and the S&P 500 Index itself bottomed on November 20 at a closing low of 752. Since then, any test of these bottoms has been successful. The recent earnings news should provoke another test.
Whether that test is successful will depend on whether Geithner soon fleshes out a feasible plan to bolster the financial system. The roughly $800 billion stimulus plan to be signed tomorrow will not be nearly enough to pull us out of this recession. Freeing credit is far more important. Mr. Geithner advocates "bold" action. Bold action to me means setting up an entity to purchase "toxic assets" from the banks at a price low enough to attract private equity capital, yet high enough to persuade banks to sell. Once banks sell the toxic assets, TARP money should be made available to replenish the banks' capital. If private equity's top price is too low for the banks, then those banks which are technically insolvent should be forced into reorganization. I consider myself a believer in the free market system, but desperate times call for desperate measures.
If any test of the aforementioned bottom fails, then the next anticipated bottom for the S&P 500 Index would be in the 600 to 650 range, which would be an intersection of the trendline from the 1974 and 1982 bottoms. Until now, those bear markets were the worst since the Depression. We are in the midst of a deleveraging process that has resulted in a global recession. To be long equities, one must believe that government action will prevent a deflationary spiral. As of now, I am still willing to make that bet.
Tuesday, December 30, 2008
A Cautionary Note
Many money managers feel that, at this juncture, there is an anomaly-- "investment grade" corporate bonds are more attractive than stocks. At the long end of the maturity spectrum, these bonds may have 8% yields to maturity. While I prefer my strategy of 40% in stocks and 60% in treasury securities (at this time, 90-day treasury bills), I can understand the attraction of corporate bonds SO LONG AS THEY ARE COUNTED AS PART OF THE EQUITY EXPOSURE AND NOT PART OF THE FIXED INCOME EXPOSURE!
The U.S. economy is currently in what will turn out to be the worst recession since the depression of the Thirties. While I believe that efforts to stimulate the economy will gain traction in late 2009, there is more than a de minimus probablity that monetary and fiscal policy will prove ineffective in offsetting the secular deleveraging effects, with a deflationary spiral ensuing. Under this most dire circumstance, many corporate bonds, currently "investment grade", could fall into default, and, even worse, eventually be worthless. An investor with a portfolio of 40% stocks and 60% corporate bonds could be wiped out!
The U.S. economy is currently in what will turn out to be the worst recession since the depression of the Thirties. While I believe that efforts to stimulate the economy will gain traction in late 2009, there is more than a de minimus probablity that monetary and fiscal policy will prove ineffective in offsetting the secular deleveraging effects, with a deflationary spiral ensuing. Under this most dire circumstance, many corporate bonds, currently "investment grade", could fall into default, and, even worse, eventually be worthless. An investor with a portfolio of 40% stocks and 60% corporate bonds could be wiped out!
Sunday, December 21, 2008
There Is No Such Thing As A Free Option!--At Least For Any Length Of Time!
In this week's Barron's, there is reproduced almost in entirety an article written in 2001 raising questions about Bernie Madoff. (By the way, what a great name for a swindler who "made off" with other people's money!) In it, there is a description of Madoff's strategy as a "split-strike conversion". This involves the purchase of an underlying stock, the purchase of an out-of-the-money put option, and the sale of an out-of-the-money call option. Upon reading this, I started to reminisce....
More than a quarter of a century ago, I was drawn to an arcane form of hedging using listed options. As I have mentioned in a previous posting, I am risk averse, and was attracted to the original concept of a hedge fund, which attempted to beat the market with less than a market risk. The Chicago Board Options Exchange ("CBOE") began trading in the early 1970's, and The American Stock Exchange ("AMEX") started to trade options a few years later. Many of the options traders on the CBOE were used to hedging due to their having traded on the Chicago Mercantile Exchange. Due in part to this "hedging mentality" the options traded on the CBOE became efficiently priced very quickly--that is, they traded at or close to their theoretical value as determined by complex formulae using integral calculus, such as the Black-Scholes model. The traders on the Amex, however, were by and large speculators who "didn't know from theoretical values". This allowed disciplined hedgers to take advantage of option price inefficiencies. One could go long an underpriced option and short a less underpriced option in a ratio of options sold to options bought that was "market neutral", wait until the two prices became closer to theoretical values, then close out the position for a profit. This activity is known as option spreading.
I rented an AMEX options seat and started trading in these spreads. As a market maker on the floor, I could trade with very little margin and almost no transaction costs. A retail client of an options trader could not compete with a market maker of equal skill due to the above advantages. The commissions alone would eat up the profit potential.
I started making some money, and raised capital from several people who knew me from the past. During this period, I could put the spreads on without any time elapsing between transacting the long and short positions. This was a form of arbitrage--which is the simultaneous or nearly simultaneous purchase and sale of equivalent securities for profit.
The window of opportunity for making money in this comparatively riskless way was quite brief. After all, money is fungible. If a casino allowed a bet whose payoff exceeded the odds of winning, so much money would flow into that bet that the casino would be bankrupt very quickly. In the case of AMEX option trading, the best bridge, chess, and backgammon players in the country descended on the AMEX floor to become market makers. After all, many of these people were "bridge bums" who made a paltry living playing their game for money or were hired by lesser players to win tournaments for them. My first hedge fund experience was as a junior general partner in a fund managed by a very famous bridge player, who was then in his sixties. He hired as a "gofer" one of the best young bridge players in the country. A few years later, that gofer started trading options on the AMEX, made a small fortune, and then staked some of his bridge buddies, and made a large fortune.
With the onslaught of these games players, the AMEX option market became efficient. One could establish juicy spread positions only by "lifting a leg", which required estimating which way the underlying stock was going, taking half the spread immediately,, and the other half after time elapsed. This increased the risk of options hedging and required short-term trading skills that I did not possess. I shut down my options firm and returned the capital to my investors.
Now let's discuss the "split-strike conversion" strategy purported to be Madoff's way of generating those consistent, high returns for his accounts. A "conversion" refers to transforming a put into a call. Long stock and long put is mathematically
equivalent to long call. So Madoff allegedly created a call with a lower strike price than the call he sold. Sound familiar? That is simply a call option spread.
Given that those spreads became pretty efficient, either Madoff was prescient in "lifting a leg" or he was very good at trading around his position once it was established, or both. While it is mathematically possible to achieve those impressive returns, the probability of doing so is de minimus given the fact that Madoff charged his clients commissions. Even if Madoff were the world's best trader and the fiftieth best trader were a market maker with far less friction costs, that market maker would have had Madoff for lunch. And this doesn't take into account the amount of money that can be profitably managed this way. Certainly, $17 billion leveraged would be a stretch!
My take on Madoff is that he started out generating excellent returns, but found that increasingly difficult to achieve legitimately. He then turned to more nefarious strategies.
More than a quarter of a century ago, I was drawn to an arcane form of hedging using listed options. As I have mentioned in a previous posting, I am risk averse, and was attracted to the original concept of a hedge fund, which attempted to beat the market with less than a market risk. The Chicago Board Options Exchange ("CBOE") began trading in the early 1970's, and The American Stock Exchange ("AMEX") started to trade options a few years later. Many of the options traders on the CBOE were used to hedging due to their having traded on the Chicago Mercantile Exchange. Due in part to this "hedging mentality" the options traded on the CBOE became efficiently priced very quickly--that is, they traded at or close to their theoretical value as determined by complex formulae using integral calculus, such as the Black-Scholes model. The traders on the Amex, however, were by and large speculators who "didn't know from theoretical values". This allowed disciplined hedgers to take advantage of option price inefficiencies. One could go long an underpriced option and short a less underpriced option in a ratio of options sold to options bought that was "market neutral", wait until the two prices became closer to theoretical values, then close out the position for a profit. This activity is known as option spreading.
I rented an AMEX options seat and started trading in these spreads. As a market maker on the floor, I could trade with very little margin and almost no transaction costs. A retail client of an options trader could not compete with a market maker of equal skill due to the above advantages. The commissions alone would eat up the profit potential.
I started making some money, and raised capital from several people who knew me from the past. During this period, I could put the spreads on without any time elapsing between transacting the long and short positions. This was a form of arbitrage--which is the simultaneous or nearly simultaneous purchase and sale of equivalent securities for profit.
The window of opportunity for making money in this comparatively riskless way was quite brief. After all, money is fungible. If a casino allowed a bet whose payoff exceeded the odds of winning, so much money would flow into that bet that the casino would be bankrupt very quickly. In the case of AMEX option trading, the best bridge, chess, and backgammon players in the country descended on the AMEX floor to become market makers. After all, many of these people were "bridge bums" who made a paltry living playing their game for money or were hired by lesser players to win tournaments for them. My first hedge fund experience was as a junior general partner in a fund managed by a very famous bridge player, who was then in his sixties. He hired as a "gofer" one of the best young bridge players in the country. A few years later, that gofer started trading options on the AMEX, made a small fortune, and then staked some of his bridge buddies, and made a large fortune.
With the onslaught of these games players, the AMEX option market became efficient. One could establish juicy spread positions only by "lifting a leg", which required estimating which way the underlying stock was going, taking half the spread immediately,, and the other half after time elapsed. This increased the risk of options hedging and required short-term trading skills that I did not possess. I shut down my options firm and returned the capital to my investors.
Now let's discuss the "split-strike conversion" strategy purported to be Madoff's way of generating those consistent, high returns for his accounts. A "conversion" refers to transforming a put into a call. Long stock and long put is mathematically
equivalent to long call. So Madoff allegedly created a call with a lower strike price than the call he sold. Sound familiar? That is simply a call option spread.
Given that those spreads became pretty efficient, either Madoff was prescient in "lifting a leg" or he was very good at trading around his position once it was established, or both. While it is mathematically possible to achieve those impressive returns, the probability of doing so is de minimus given the fact that Madoff charged his clients commissions. Even if Madoff were the world's best trader and the fiftieth best trader were a market maker with far less friction costs, that market maker would have had Madoff for lunch. And this doesn't take into account the amount of money that can be profitably managed this way. Certainly, $17 billion leveraged would be a stretch!
My take on Madoff is that he started out generating excellent returns, but found that increasingly difficult to achieve legitimately. He then turned to more nefarious strategies.
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