Playing Dice by René Schützenberger (circa 1910).

Peter Bernstein’s Against the Gods captivating history of risk rekindled and made me look with new eyes the regression to the mean trading approach —where many good methods take their cue.

Let’s walk this through the simple throws of a six face die. The probability of landing any face after a throw is 1/6, and it’s average 3.5 (adding 1 through 6, and dividing by 6).

Now comes the good part.

The central limit theorem states that the sums of many sets of equally distributed numbers will form a normal distribution. Imagine you throw your die 30 times, and repeat this sampling 100 times. If you add up the numbers where the die lands on for each sample, you will have 100 numbers —the total for each sample. These 100 numbers will have a normal distribution even though the die throws numbers with equal frequency (1/6).

So, how can we use this information?

We know that the bell shaped normal distribution peaks at its mean, that’s why 3.5 times 30 would be the most likely occurrence of the sum total for the samples, followed by 3 and 4 times 30, followed by 2 and 5 times 30, and so on…

In other words, we expect to get more samples that hover around a 3.5 average. So, in any given sample, if the first series of numbers thrown turn out to be under 3.5, it’s reasonable to expect that the next numbers should be higher…

December 10 — A word of caution. Let’s not forget that you never want to catch falling knives, you should expect an indication of strength before entering a long side swing trade —you need to see a double bottom formation.

For securities, the first thing is to find an adequate?? average. Why?

Security price sample sums also follow a normal distribution, but, they have a bias. As Jesse Livermore would put it, “you need to know if the market is going up or down…” I would add that we also need to know if it’s going nowhere, or sideways. In essence, know the trend.

Hence, we draw a best fit straight line (linear regression) for the prices of a security —the average, with a 2 standard deviation channel around it, which tells us that a price has a rather small 2.5 percent probability of being out of the top or bottom channel boundaries.

An example of QQQQ in a downtrend. Courtesy of stockcharts.com.

The Raff Regression Channel is a good proxy for this kind of chart. Developed by Gilbert Raff, the Raff Regression Channel is a linear regression with evenly spaced trend-lines above and below. The width of the channel is based on the high or low that is the furthest from the linear regression.

In this example, the Raff Regression Channel extends from the April (closing) high to the July (closing) low. The late June high defines the width of the channel because it is the furthest high or low from the linear regression. This means the lower trend-line is set at the same distance from the linear regression as the upper trend-line.

Note that June’s high must’ve pushed to open the channel. A stop order trailing this extreme advance to sell at somewhere near these days lows would have pocketed a pretty penny! The failure of the test to break through the resistance of the top of a few days earlier —a double top failure— would have confirmed the short reversal position.

And finally, I almost forgot to mention a very important feature of the trade: we improve our chances by following the short trend. If anything goes south, the direction of the current will likely carry us to safe harbor…

Tweet, tweet.

It amazes me to see how Twitter can be so successful by focusing on providing the tiniest service possible. There’s no doubt we’re hardwired to communicate with each other, which makes a lot of sense, the more people we know, the better.

It’s a two way street, the more people we know, the more we get to be known by other people.

The advantages of our Darwinian tribal behavior are easily explained. Once we belong to a tribe, we (give and) receive the unconditional support of its members.

We are emotional, whatever our tribe members do is good, and what others are doing is wrong. We find very good examples of this evolutionary behavior in the crusades, the Spanish inquisition, the Israeli Palestinian conflict, and most religious and political group antagonisms.

Visualize the following “closer to home” scenario. You’re hiring, and you’ve narrowed down your selection process to two candidates, one that you’ve met online, commenting on a blog or twitting, the other, you’ve never met before. Wouldn’t you be inclined to have a soft spot for the former candidate —the member of your tribe?

Tweeting is a fabulous way to enlarge your tribe by making tiny (non annoying) taps on the back of potentially new tribe members.

Wouldn’t you agree that there is an enormous potential value of using twitter to lobby for you with warm tiny taps on potential investors?

I’ve recently had to recall the discussions —held when things were looking good in 2005— of the imminent derailing of the US Treasury purchasing by the Chinese. The tenets of those ideas still hold true, the Chinese will have to discontinue —at some point in the future— their mercantile policy of increasing market share at the expense of debasing their own holdings of US Treasurys.

Apparently, China is changing its portfolio policy.

Although the first months of 2010 saw foreign purchases of US Treasurys dwindle, Chinese year to year purchases of Treasuries seem to be holding. The Chinese purchase of metals during March surprised by bringing their trade balance close to zero, making it quite evident that the Chinese are diversifying their portfolio into metals without forgetting to sustain the yuan/dollar exchange rate.

Interestingly enough, the price of silver and gold hasn’t followed this purchasing lift. What’s holding these prices down?

I ran into this startling interview. Andrew Maguire, an independent metals trader at the LME, whistle-blowed his findings of a concerted effort to short the silver market to the CFTC, which has received very little attention from the authorities, nor press coverage.

Apparently, central banks through HSBC and JP Morgan have wholeheartedly shorted the silver (and potentially the much larger and shadowier gold) COMEX market in an attempt to avoid the debasement of their currencies.

Is this too far fetched?

I don’t think so, and it gets worse. In a meeting attended by Andrew, Adrian and GATA members, one of the CFTC officials spilled out the fact that… the ratio of paper gold to the actual physical holdings is… 100 to one.

Which leads me to believe that there is an enormous naked short silver and gold position… held by no other than the Fed… and supported by Chinese US Treasury purchases.

The Fed is a tough hand to bend; but, not impossible under the right set of circumstances. We tread in very thin ice. In these past couple of weeks we’ve seen the largest US trade deficit in history and the largest drop in Treasury prices in a year. We also know that bank fraction reserves are being thrown in to cover the commercial real estate debt crisis. Greece is also a non resolved issue. I don’t dare imagine what would happen if the holders of these gold foil papers got antsy, and attempted to get actual delivery of the metal.

On the other hand, I read the good news that AIG is closer to paying its debts.

But we need to realize, that globalization and technology have made our world much more fragile by increasing volatility —there are no filters for contagions.

It doesn’t help to see that the authorities are no closer to getting the regulations to avoid the recurrence of a new financial crisis. I recommend you watch this Taleb – Kanehman video on why this is so. I’ll give you a couple of hints: managers and traders at these financial firms still get paid huge bonuses even when their companies are on a path to fail; and these companies are winning the fight to stay in a size too large to fail.

Even as it has been overwhelmingly demonstrated with the advent of this recession that economists still have no idea of what they are doing, I wish Ben Bernanke the best —he’ll need all the help he can get.

Under the new mortgage program, the Fed will buy up to $100 billion of debt issued by government-sponsored mortgage enterprises Fannie Mae, Freddie Mac and the Federal Home Loan Banks.

It will also buy up to $500 billion of mortgage securities backed by Fannie Mae, Freddie Mac, and Ginnie Mae.

The central bank also launched a $200 billion facility to support consumer finance, including student, auto, and credit card loans and loans backed by the federal Small Business Administration. This will lend to investors who hold securities backed by this debt.

Great news, although somewhat anticipated by Paulson's change of heart in the direction of the spending of the previous $700 billion USD bailout plan.

Under the current ominous economic conditions, one could almost say, that no one is willing to lend. It's not worth the return on the interest rate —nor any other compensation—, to risk losing it all. Or, lenders are asking themselves: how will borrowers be able to pay back their loans if the economy is spiraling down out of control? 

So, the Fed is playing its role as lender of last resort, lending to Freddie and Fannie, and any lender guaranteed by them, which in turn provide the mortgage funds  to homeowners. It is also buying (or lending to) credit card, student, car and consumer loans, guaranteed by the SBA.

It is a step in the right direction, which I whole-heartedly support, the Fed has to reach the final consumer to stimulate the economy. There will be no trickle down, whilst the intermediaries are too afraid to lend, and are much too worried covering their huge wrong sided derivatives positions.

It also makes sense to bailout the consumer, he carries the weight of 2/3 of our GDP growth, he has the power to jump-start the economy, unlike financial institutions which are proving to be a stumbling block under the current environment.

We must also expect the government to step up its fiscal stimulus by building and repairing  US infrastructure, which happens to be in dire need of TLC.

Instead of the 3 pager proposal to request $700 billion, 1 page for the title, 1 for the thank you and goodbye, and 1 single page with the gravy of the plan; now, he doles out an “I’m not afraid to make changes if the facts change”.

Granted, I think he’s right in trying to get ahead of the curve, or putting the carrot ahead of the cart, or in laymen terms: making the loans available to those who will buy things –making it easier to buy a house or a car.

So, it’s with mixed feelings that we move on. On the one hand, there are still all those derivatives left behind littering the landscape like a mine field, and, on the other hand, the new consumer oriented lending is sure to give some needed traction to the economy.

And you already know that the markets reacted bitterly to the waivering Paulson attitude. If you stop for a minute to think about it, trillions are at stake, and Paulson reads like he’s thinking it out for the first time… I mean, we could’ve had a couple of DC buildings full of well paid geniuses, like they do in the military, working out all the possible economic what if scenarios.

But, we didn’t. Human nature, I guess. High price to pay, though.

Reading here and there, trying to get my bearing on Paulson’s comments, I ran into this fantastic piece by Michael Lewis, which he wrote in his early twenty’s and is self explanatory…

[T]he willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital—to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue.
[...]
I’d never taken an accounting course, never run a business, never even had savings of my own to manage. I stumbled into a job at Salomon Brothers in 1985 and stumbled out much richer three years later, and even though I wrote a book about the experience, the whole thing still strikes me as preposterous—which is one of the reasons the money was so easy to walk away from. I figured the situation was unsustainable. Sooner rather than later, someone was going to identify me, along with a lot of people more or less like me, as a fraud. Sooner rather than later, there would come a Great Reckoning when Wall Street would wake up and hundreds if not thousands of young people like me, who had no business making huge bets with other people’s money, would be expelled from finance.

Why are we getting half baked plays from the ones we should be getting double chess plays?

It can't all be that bad, short term Libor rates have dropped dramatically, signaling that the Fed's bypass surgery to the clogged arteries of the bank to bank lending has been a success –we have eluded the worse, a sudden death of the financial system.

Now, will they be able to stop the bleeding of AIG, GM, Chrysler..?

I’m sorry, but, I’m not buying. Nice try and nice gesture, though.

Out of the top of my head, I know this would be a significant portion of their PBOC reserves, which stand at $1+ trillion USD, give or take. It’s not like they’re printing the USD, they can’t, for them it’s hard currency.

And, if my wetted thumb estimates do not betray me, their average labor costs still lie below 15% of their western counterparts, so what in the hell are they going to build to spend an equivalent seven times in labor –another Chinese wall?

Sorry, I’ll pass on this one.

On a related note, Bloomberg had this short video with professor Frankel’s opinion on the subject and the extension of the ongoing recession –bleak was the word that kept coming up.

In other words, if I wanted to insure $10 million of General Motor’s debt, I would have to pay upfront $6.7 million, plus a yearly premium, in the order of $800,000.

Courtesy of Prophet

From this Bloomberg article I learn the tally on the markets pain, so far…

Stock markets and commodities have tumbled along with currencies this year amid growing concern that governments, central banks and finance ministers are powerless to counter eroding corporate earnings and a global recession.

Oil-producing nations haven’t escaped the carnage as crude plunged 56 percent from its July peak to $64 a barrel.

More than $10 trillion has been erased from the market value of equities so far this month, accounting for about one-third of the total value wiped off stocks this year. MSCI’s index of developed and emerging stock markets plunged 48 percent in 2008 and is heading for its worst year on record as credit-related losses topped $660 billion.

The Standard & Poor’s 500 index is down more than 40 percent this year, poised for its worst annual retreat since 1931. The S&P 500 has lost 26 percent since U.S. investment bank Lehman Brothers Holdings Inc. declared bankruptcy on Sept. 15, while the U.K.’s FTSE 100 has fallen 25 percent, Japan’s Nikkei 225 has tumbled 37 percent and Germany’s DAX has dropped 29 percent.

I'm trying to make sense of this BIS September report, so, please bear with me and my ramblings.

Toni, from Prudent Investor had this wonderful piece about the size of the derivatives markets, which for December 2007 stood at $596 trillion –what an alarming figure!

It's important to understand that these are notional values, which are leveraged with good faith deposits of around 1.25%, or $7.2 trillion for each side of the trade.

Trouble is, that the 4 to 7% daily movements that we have been experiencing lately in the underlying stock markets, send shocks of 3.2 to 5.6 times their derivative stakes in one day! Worse, CDS involved in debt defaults, which are occurring at a brisk pace, represent much larger payouts, in the order of 833 times!

Now, if you've been paying attention, the above $596 trillion are the more shadowy counterparty OTC derivatives, which do not include an additional $84.3 trillion from the less riskier exchange traded derivatives (from page A108 Table 23A).

Another salient issue is that the interest rate derivatives are the
heaviest item weighing in the derivative's total, with $393 trillion
outstanding notional value, and a net trade stake of $3.6 trillion by
the end of last year.

Courtesy of Economagic

If (the short term) Libor violent movements are a reflection of the interest rate sector derivatives, with an enormous 170% rate increase during the last month or so, then, holder's of interest rate derivatives are making a 136 (170 / 1.25) times profit or loss –depending on the holder's side of the trade, which if outstanding deposit volumes had unwound an estimated 50% to $1.8 trillion by September, would represent a $244 trillion payout to clear these trades (= 136 x $1.8 trillion).

Of course I'm thinking out loud. But, the above figures are reasonable. If these numbers are close to reality, then, someone has been either clearing their positions out of $200 trillion or so, has gotten horrible margin calls, or is praying to all gods and the devil that these rates come down while holding to what can only be called staggering unrealized losses!

In any case, it's definitely a mess out there.

Update October 24:

Ok, so $244 trillion is too much. On a spike in voltage, breakers should go off. Since we can't  tell where these stop limits or margin calls are, let's suppose an average stop at 10%. Then, losses would be in a more sanish $14.4 trillion (= $1.8 trillion x 10 / 1.25), which is quite distressing anyhow.