Ramblings of a Systematic Trader

Baltic Dry Index has fallen off a cliff

2012-01-27T06:56:00.000-08:00

While all the recent headlines have been focusing on the Eurozone debt crisis and the "neverending" can-kicking tricks pulled by the central bankers, the Baltic Dry Index has fallen off a cliff.

It is almost at the lows reached in 2008 as shown in the extended chart below.

The Baltic Dry Index is not a tradable index. It is simply the freight rate charged by shipping companies for dry bulk shipping. This is an important distinction from other indices like the stock market or commodities indices because being non-tradable means that it is not affected by liquidity injection, at least not in the direct sense. Hence, it is a purer indicator of economic activity. Regardless of how much liquidity is being injected by central banks around the world, the Baltic Dry Index will not increase unless the demand for shipping exceeds the supply of ships.

Of course, knowing this does not mean that risky assets are not going to continue to go up with all the money printing but it does mean that no matter how much money the central banks throw at the problem, it is not helping the underlying economy but merely creating the illusion of asset prices going up. Central bankers are hoping that this illusion is enough to jumpstart the economy again but this is a dangerous game because instead of growing the economy, we can easily end up with stagflation where the twin problems of inflation (in the narrow sense of general rising prices) and low growth engulfs the entire world.

Beware of inverse ETFs that track daily moves

2011-12-23T09:38:00.000-08:00

There has been an explosion of ETFs in the retail market space. While some of these are indeed useful new instruments to have in a portfolio, some of them may not actually serve their intended purpose and some are even downright dangerous like leveraged ETFs. I shall not go into why leveraged ETFs are dangerous but I'll like to talk about a particular type of ETF that is a little bit more innocuous, the simple non-leveraged inverse ETF that tracks the daily moves of an underlying.

The reason why an inverse ETF that tracks the daily moves of an underlying is not what it seems is due to a not so obvious mathematical property where a certain percentage up move is not the same as the same percentage down move beyond the first time step. This arises from the fact that the base notional of the underlying changes differently with each time step depending on whether it is a gain or a loss. Let's use a hypothetical example where an underlying index with starting price of 100 alternates between an up move of 5% and a down move of 5% for 250 trading days, which is roughly equivalent to 1 year. The chart below shows the evolution of the price of this index after 1 year based on 3 different scenarios, buying and holding the index, shorting the index, and buying and holding the inverse ETF.

You would expect the outcome of buying the inverse ETF to have the same result as shorting the index but the chart above shows clearly that it is not the case. In fact, the outcome is the same as buying the index! Obviously, this does not happen in the real world since prices do not move in perfect alternating moves. However, there may be short periods during which prices do move in almost perfect alternating moves especially during periods of high volatility.

Let's now take a look at a real world example using the FXI ETF and its daily tracking inverse ETF which is YXI. I have plotted in the chart below the price evolution of the 2 ETFs since the YXI was launched. I have also included a synthetic replication of YXI (which does not factor in any cost of replication) just to make sure that the YXI is behaving as expected.

As of yesterday, the FXI has lost 11.8% since the beginning of the time period under study. You would expect the YXI to have gained about 11.8% as a result. However, the YXI actually lost 9.8%. This performance is not much better than FXI. To add insult to injury, the YXI performed worse than its synthetic replication which lost 2.8%. This difference is really the cost of actually replicating the YXI by the issuer plus fees paid to the issuer.

In conclusion, there are 2 things going against the buyer of the inverse ETF. Firstly, the inverse ETF does not give the inverse performance of the underlying over the long term. Secondly, the cost of replication and fees paid to the issuer seriously detract from the ETF's performance over the long term. Hence, the old adage Caveat Emptor applies here.

The US is outperforming the rest of the world. Really?

2011-12-08T07:25:00.000-08:00

Recently, I seem to be hearing that the US is outperforming the rest of the world. No doubt some are touting that this is the result of the aggressive action taken by the Fed since the onset of the Great Financial Crisis. Well, it certainly seems like it since the US is the only country that seems to be relatively resilient this year compared to the other major markets that are down between 15-25%. This prompted me to do a little study on the performance of some of the major markets relative to the US since the beginning of 2009 which is close to the start of the global recovery from the crisis, taking into account currency effects. The reason why currency effects are important is because to a foreign investor in US stocks, any loss in the value of the USD would be translated into real losses back in the investor's reference currency. Below is what I found.

As it turns out, if we only look at the performance of global indices in their own respective currencies, it does appear that the US has outperformed other markets with the exception of Singapore. However, once currency is factored in, the picture is quite different. The US seriously underperformed Australia and Singapore while outperforming Japan and Europe (represented by Germany). The UK and Hong Kong is almost on par with the US.

Japan suffered from a devastating earthquake and its economy is still mired in long term structural problems while Europe is suffering from a debt crisis. Hence, it is hardly surprising that the US can outperform these two markets. It is only when comparing to countries like Australia and Singapore on a currency adjusted basis that shows the real performance of the US.

Hence, the conclusion I can draw is that the US only created the illusion that it is outperforming the rest of the world by sacrificing its currency through ultra loose monetary policy and money printing but the net effect is worse off than many other more monetarily sound countries.

Another credit crisis on the way?

2011-11-25T07:33:00.000-08:00

The TED spread is on a one way trajectory up and it seems to be picking up speed. As of today, it just breached the 50bps mark.

To be sure, it is still low compared to the spread during the 2008 credit crisis but it can blow out very fast as 2008 shows.

We should not be surprised with this development at all. As long as global leaders refuse to acknowledge that the issue is one of solvency and not liquidity and tackle the problem as such, we will continue to move from one credit crisis to the next until the solvency issue is resolved. And to resolve the solvency issue means taking a serious step towards reducing debt and leverage despite the necessary short term pain. But of course that remains more of a hope than reality at this present moment.

Yield curve flattening continues unabated

2011-11-23T05:33:00.000-08:00

The yield curve is at its flattest since I started tracking. This is flying in the face of those who insist that the US is different from Japan. While they are not exactly the same, they are suffering from the same issue... too much debt...

Invoking the Bogeyman

2011-10-20T08:52:00.000-07:00

Invoking the bogeyman seems to be in vogue these days. From the height of the 2008 crisis, the bogeyman was invoked to push through the $700b bailout package for banks and "important" companies. Many would argue that had the bailout not been carried out, we would have seen the end of capitalism. This is one of those instances where you can never produce the counterproof because we are not allowed to see the alternative result of not carrying out the bailout. But in any case, we can see the result of the bailout. Banks went on to pay out astronomical bonuses again, while the rest of the economy continued to muddle along with stubbornly high unemployment. Then, as the economy looks like it is going to stall in 2010, the Fed printed money in the form of QE. This led to a quick reflation of asset prices including commodities but did little to ease unemployment. Meanwhile, the USD suffered as a result of all this money printing. If the government was adamant in going down the path of printing their way out, I wonder why they did not use that money to inject into the economy directly via fiscal stimulation rather than just using a blunt monetary tool? The only conclusion I can come up with is that the money is really used to plug holes in the financial system rather than to aid the economy.

Now in the eurozone, the bogeyman is once again invoked by the European leaders to try and push through the idea of a leveraged fund to bail out troubled European nations and banks. Once again, this is an action to plug holes in the European financial system which to me will only have the same effect as what had already happened in the US, namely the banks will continue to pay out huge bonuses but the rest of the economy will still continue to be plagued by the same issues. In fact, someone has to pay for all these bailouts and it simply means that the debt burden of the supporting nations will only become greater, which further bogs down the economy.

I think it is high time to look in the closet and see that the bogeyman is really just a story concocted by "adults" to scare "children" into behaving.

G20 singing Kumbaya

2011-10-17T05:06:00.000-07:00

A word on the Dollar

2011-09-22T08:21:00.000-07:00

The USD sudden reversal must have caught many people by surprise due to the speed at which it is strengthening. I would like to say that I have seen it coming but to say that would sound like I have some forecasting ability which cannot be further from the truth.

What I however have felt all along is that the USD will strengthen and happen quickly only on 2 conditions. The first is that the world must experience a credit crunch again just like what happened in 2008. The reason is because the USD is still the global trading currency. In a credit crunch, businesses would have to pay a premium to secure USD funding because lenders are hoarding USD for fear of credit risk. In 2008, the credit crunch started from the US. Now, it is starting from the Euro zone.

The second condition is that there must be a sharp drop in risk appetite. This is because the USD has become a favourite funding currency for risky trades since it became a very low yielding currency. Basically, investors would borrow cheap USD to invest in risky assets. Such carry trades have been going on for some time since USD has been a cheap currency for a while. When risk is suddenly being taken off, due to a sharp drop in risky asset prices, investors will sell risky assets and repay their USD loans which effectively means buying back USD.

Today, both conditions are in place. A credit crunch is starting to unravel in Europe, risky assets are selling off and carry trades are being unwound. Therefore, the sudden strength in the USD is not at all surprising to me. Whether the USD will continue to strengthen will depend on whether these 2 conditions continue to be in place. I think the credit crunch is likely to get worse and I think the unwinding of carry trades still has some ways to go. Hence, I think USD strength is here to stay, at least in the intermediate term.

For the longer term, it would be back to fundamentals in terms of the strength of the US economy versus the rest of the world. That is not too clear to me at this stage.

Operation Twist is official

2011-09-22T07:46:00.000-07:00

Ok folks, this is it. The Fed has officially given a name to what has already been happening for some time... Operation Twist. It certainly sounds more cool than flattening of the yield curve. The subsequent sell off in equity markets around the globe just confirms that this is not what global investors have been expecting. For all intents and purposes, this is a non-event. The only thing it did was to hasten the flattening of the yield curve. Just look at what happened overnight.

Expect the yield curve to continue to flatten such that eventually, it will look exactly like Japan. Can someone say liquidity trap? Market is short term oversold now so it would not be surprising to see a rebound soon. However, do not mistake it for a recovery.

Operation Twist already happening

2011-09-19T06:17:00.000-07:00

There has been some talk that the next move by the Fed is to buy longer term treasuries using the proceeds from maturing short term treasuries. This has been dubbed "Operation Twist" for the obvious reason that it amounts to "twisting" the yield curve. Since short term rates are being held artificially low by the commitment to keep Fed funds rate at the historical low, only the long term rates can move down. This amounts to a flattening of the yield curve.

However, I suspect that even when the official announcement (assuming it is going to happen) takes place, it is going to be a non-event. The reason is because the yield curve is already flattening due to market forces. Announcing "Operation Twist" would only be acknowledging what is already happening. Take a look at the evolution of the yield curve from August to now.

Another possibility is that market is already anticipating "Operation Twist" and is positioning ahead of the actual announcement. But whatever the case is, I do not think investors should hope for the Fed to bail out the markets like what it did at Jackson Hole last year.

Liquidity trap

2011-08-11T07:52:00.000-07:00

The Fed would hate to admit it but it certainly looks like the US is unable to escape the fate of Japan. It is looking increasingly likely that the US is facing a liquidity trap, much like what happened to Japan. Just look at the development of the yield curve since the beginning of the Great Recession.

Initially, it was looking hopeful that the economy was on the mend from the lows of the recession with the long end of the curve rising. However, as time progressed, the long end started to come down and in fact went below the lows reached during the Great Recession. It certainly looks like the long end is going to go lower, especially with the commitment made by the Fed to keep rates low for the next 2 years. If you look at the yield curve of Japan, you will find that US yield curve is looking increasingly like Japan.

The Fed seems to think that they can inject liquidity to kick-start the economic engine again and they seem to think that having long term interest rates come down is actually a sign that quantitative easing is working. I think it is actually quite the opposite. The yield curve is saying that liquidity is not the problem because the US is in a liquidity trap. The problem as we all know is that the US has been over-leveraged for too long and needs to go through a period of adjustment before things can return to normal again. The more the Fed injects liquidity, the longer it would take and the more violent it would be for the adjustment process which cannot be postponed indefinitely.

Let's see if there will be QE3.

Not the time to be a hero

2011-08-10T06:19:00.000-07:00

The market has just gone through a punishing period where it can easily rival the most scary period during the 2008 crisis. It can be very tempting to try and bottom pick in this kind of environment. If you are just trying your luck with catching a rebound without the intention of holding, by all means, go ahead because markets are currently near or at oversold levels. But make sure you have a stop loss limit and play within your means. However, if you are thinking of buying to hold, now is not the time to be a hero. What makes me say that? There are two reasons, fundamental and technical. Let's start with the fundamental reason.

I've always maintained that the rebound from the lows of the last crisis was driven by liquidity rather than solid fundamental recovery. This was of course due to the unprecedented quantitative easing measures adopted by countries around the world, chiefly the United States. It is not easy to prove this but one of the key indicator is to look at the Baltic Dry Index over the past five years.

As you can see, after the crash in 2008, BDI has been bouncing around the bottom. Now, if the sharp rebound in commodity prices is really due to fundamental economic growth, we should expect the BDI to rise along. After all, commodities need to be shipped around the world to where the demand is. As far as I know, teleportation has not been invented yet. Therefore, the rise in commodities is really driven more by liquidity finding a resting place. Another major clue is of course the job situation in major western economies. It is true that part of the reason is due to structural unemployment but seriously, unemployment shouldn't be as dire as it is so many months into a recovery.

Now on to technical reasons. Actually, there is really nothing more than the fact that market rarely makes it so convenient for people to hop on for those who feel they have missed out on a bull market. Therefore, if the market were to do what it has done recently, it usually portends something more sinister than just a normal correction. Furthermore, the theory of reflexivity may kick in given the kind of psychological damage on people that such a drastic move can create. Another factor is the VIX. Volatility tends to cluster which means that periods of low volatility follows periods of high volality and vice versa. We have just started to enter a period of high volatility which means we should expect volatility to remain high for the near future.

I would expect markets to have a rebound from here but I would use that opportunity to prepare for an oncoming downtrend.

Yield curve is below ultimate low in last recession

2011-08-08T18:27:00.000-07:00

With the downgrade of US credit rating, instead of yields going higher, they are coming down meaning it is cheaper for the US government to borrow. This is probably due to the short term flight to the "safety" of US treasuries. We can either view the glass as half full which is that the US govt credit is still untouched by the downgrade, or view the glass as half empty which is that the spectre of deflation is rearing its ugly head again.

Generating Returns from Correlation

2011-07-04T05:48:00.000-07:00

Correlation is a mathematical construct that looks at how closely 2 time series move in relation to each other. Correlation is measured by a number that ranges from -1 to 1. A correlation of -1 means that the 2 time series move exactly opposite of each other. If A goes up by 1%, B should go down by 1% and vice versa. A correlation of 1 means that the 2 time series move exactly in tandem. If A goes up by 1%, B should also go up by 1%. Anything in between -1 and 1 is a measure of the strength of the correlation. A correlation of 0 means that there is no relationship between the 2 time series. Correlation is calculated using a data set comprising data points over a period of time because it measures how 2 variables relate to each other over this period of time which can be any number of days. Therefore, you can have 30-days correlation or 100-days correlation. You can then have a rolling correlation which simply means that the window period is constantly being rolled forward. Therefore, you can see the change in correlation over time by rolling the window period forward.

An absolute return strategy attempts to capture potential returns by having the right correlation with underlying markets during different market conditions. When underlying markets are in an uptrend, the strategy tries to be positively correlated to the market so that positive performance in the markets translates into positive returns. When underlying markets are in a downtrend, the strategy tries to be negatively correlated to the market such that negative performance in the markets also translates into positive returns. The chart below illustrates the point using a rolling 30-days correlation.

When the passive index was in an uptrend from 2005 to 2007, the strategy had a positive correlation to the index although the magnitude can be varying. When the passive index was in a downtrend from 2008 to early 2009, the strategy had mostly a negative correlation to the index. Then when the passive index started to recover from early 2009, the correlation became mostly positive again.

Traditional funds like mutual funds or any long only funds would not be able to benefit from negative correlation. They can only at best reduce their positive correlation to the passive index. The ability to benefit from negative correlation is the main edge of an absolute return strategy over relative return strategies.

Obviously, the Achilles heel of such a strategy is when there is no trend. However, in a trendless market, relative return strategies would find it hard to generate returns as well. The trick for the absolute return strategy is not to get whip-sawed too much in a trendless environment.

Is the weak USD starting to help the US economy?

2011-06-09T10:10:00.000-07:00

Despite all the negativity and pessimism about the state of the US economy and news headlines about how the new investment opportunities are all outside the US, it seems that the only victim of such sentiments is the USD. However, it seems like the weak USD is starting to help the US economy if stock markets are any indication of the health of the economy. Take a look at the following one year chart of selected currency pairs and their corresponding country stock market performance relative to the Dow Jones Industrial Average.

Singapore

Australia

Japan

United Kingdom

China

The above observation should hardly be surprising because there is a very good economic principle underlying it. As a country's currency weakens, its exports would become cheaper and it would make the country more competitive. However, there is a caveat to this. This only works for countries whose raw materials can be sourced domestically. Another beneficiary of the weaker currency are the MNCs whose revenues are sourced from overseas. As the reporting currency is in the local currency where the headquarter is based, even if the revenue stays the same, it would be higher when reported in the local currency. Companies whose operations are based overseas would also benefit because even though the bottom line stays the same if the end market is in the same location as the cost base, it would show an improvement when translated back to the local currency.

Another positive boost to the local stock market as currency weakens is that local stocks would be cheaper for foreign investors to buy. This is because 1 unit of a foreign currency can buy more of the local stock which is denominated in the weaker local currency.

Ironically, the more competitive a country becomes due to its weakening currency, the more the currency will be supported and in fact may even face upward pressure since importing countries would need to buy the weaker currency in order to purchase the exports. Foreign investors would also add to this upward pressure as they exchange their currency for the weaker currency in order to invest in the local stocks which are looking cheaper due to the foreign exchange as well as higher earnings.

There are obviously other factors at play that contribute to currency movements but the above are some factors that contribute to the mean reverting nature of currencies.

Interesting Read

2011-06-07T07:09:00.000-07:00

I've recently read a book by Richard Bookstaber titled "A Demon of Our Own Design". In my opinion, this is a fabulous book that gives you an insight into the world of financial engineering, the seeming progress we have made in this field but yet still unable to tame the beast of uncertainty and in fact, even contribute to a higher frequency of market crisis.

But one of the takeaway from this book that made the biggest impression on me is the part about cockroaches unfortunately. I say unfortunate because I happen to hate cockroaches since they are most often found in unhygienic and dark places. But after reading this book, I realised that this is precisely the reason why cockroaches are probably the only creature that goes back to the age of dinosaurs. Let me share the passage from the book that talks about cockroaches.

The best measure of adaptation to unanticipated risks in the biological setting is the length of time a species has survived. One that has survived for hundreds of millions of years can be considered, de facto, to have a better strategy for dealing with unanticipated risks than one that has survived for a short time. In contrast, a species that is prolific and successful during a short time period but then dies out after an unanticipated event may be thought of as having a good mechanism for coping with the known risks of one environment but not for dealing with unforeseeable changes. (hmm... think LTCM)

By this measure, the lowly cockroach is a prime case through which to study risk management. Because the cockroach has survived through many unforeseeable changes - jungles turning to deserts, flatland giving way to urban habitat, predators of all types coming and going over the course of the countless millennia - it can provide us with a clue for how to approach unanticipated risks in our world of financial markets.

What is remarkable about the cockroach is not only that it has survived for so long, but that it has done so with a singularly basic and seemingly suboptimal mechanism: Its defence mechanism is limited to moving away from slight puffs of air, puffs that might signal an approaching predator. This risk-management structure is extremely coarse; it ignores a wide set of information about the environment - visual and olfactory cues, for example - that one would think an optimal risk management system would take into account. The rule the cockroach obeys is so simple that it depends only on its giant fiber nervous system; it is a reaction that does not need to be filtered through its brain, but rather goes directly from the sensory hairs that detect the puff of air to the thoracic ganglia controlling its leg motion.

In this context, it becomes clear why cockroaches are the way they are. Imagine if the world were to enter another ice age where the sun is blocked out for many years, most of the species will die out due to the lack of sunlight. Why, the cockroaches will still be happily going about their business in an environment where they are already used to. Cockroaches feed on rubbish. How unhygienic is that. But that is precisely why the cockroach is not under the threat of a sudden lack of food due to the sudden disappearance of species lower down the food chain.

Perhaps I should add another principle called the Cockroach Principle to my Investment Philosophy though it does not make me hate them less.

2011 1st half difficult for hedge funds

2011-06-03T19:15:00.000-07:00

Going by the HFRX indices performance for the 1st 5 months of 2011, it looks like the 1st half of 2011 is turning out to be a difficult one for hedge funds. Below is the performance of the various hedge fund strategies for May and YTD from HFRX.

HFRX Indices May 2011 performance notes

Global commodity and equity markets experienced broad based declines in May, reversing gains from the previous month. The US dollar strengthened against most major currencies, while US yields fell and the yield curve steepened. M&A activity proceeded despite credit spread widening, and most commodities across Agricultural, Energy and Metals posted losses. The HFRX Global Hedge Fund Index posted a decline of -1.39% for May, with negative contributions across all strategy areas.

The HFRX Relative Value Arbitrage Index posted a decline of -0.28% for the month, paring the YTD gains to +1.92%, with positive contributions from multi-strategy credit funds and fixed-income sovereign exposure offset by losses in yield alternative and fixed-income corporate and convertible arbitrage strategies. Fixed income strategies generally benefitted from falling yields and low net exposure, which was offset by widening credit. The HFRX RVA Multi-Strategy Index posted a gain +0.12%, while HFRX Convertible Arbitrage Index declined -0.41% for the month of May.

The HFRX Event Driven Index posted a decline of -0.62% for the month, its first negative return in the past 6 months, with negative contributions across all ED sub-strategies, paring the YTD gains of the strategy to +2.79%. Event Driven strategies were impacted by weak equity markets and a widening credit and deal spreads associated with increasing risk aversion. The HFRX Merger Arbitrage declined -0.78% for May, while the HFRX Special Situations Index and the HFRX Distressed Securities Indices declined by -0.67% and -0.55%, respectively.

The HFRX Macro Index posted a decline of -2.11% for May, also posting its first monthly decline since November, and paring the YTD gains to +0.21%. Macro strategies were impacted by sharp declines in commodity and equity markets, and continued weakness and concerns in Euro-sovereign fixed income markets; systematic trend following strategies pared intra-month losses but still declined -2.39% for May, reversing gains of +2.97% from the prior month. Macro discretionary and active trading strategies posted mixed performance which only partially offset declines in systematic strategies.

The HFRX Equity Hedge Index posted a decline of -2.63% for the month, with losses across all substrategies. Factor-based and behavioral equity market neutral strategies posted a decline of -0.51%, paring the YTD gain for the HFRX Equity Market Neutral Index to +1.81%. Fundamental Growth strategies declined by -1.47%, also paring YTD gains to +0.89%. The weakest areas of EH performance came from Fundamental Value strategies, which posted a decline of -2.62%, with negative contributions from energy and commodity sensitive exposures only partially offset by Japanese exposure.

Comments reference performance figures as posted on June 3, 2011.

Professor Yield Curve still saying bull

2011-05-23T07:07:00.000-07:00

Recently, the market seems to be caught in a doldrums. In fact, it started to sell off today due to some jittery news out of the eurozone. This prompted me to look at the yield curve thinking that there might be some major movements there. However, lo and behold, it turns out that the yield curve is still showing a healthy upward sloping shape and has not really moved at all. In fact, what is surprising is that the yield at the long end is coming down which is remarkable against the backdrop of the hitting of the debt ceiling in the US.

This leads me to lean towards the belief that what we are seeing is likely only a knee-jerk reaction to the not so happy news in the eurozone which will only temporarily halt the uptrend in equity markets.

Economic assets vs speculative assets

2011-04-23T02:29:00.000-07:00

Hi there, nothing much to add on markets except that the path of least resistance is still up despite plenty of negative headlines out there. However, the caveat is that this is still not a "rising tide lifts all boats" scenario and careful stock selection can still make the difference between participating in this uptrend or not. But that is not the topic of today's post as the title suggests.

So, why do we need to differentiate between economic assets and speculative assets? Not a whole lot of difference if you are approaching markets with a gambler's mentality, looking for a quick buck. However, if you are approaching markets with a calculated risk-reward mentality, it can make a difference. To know why it makes a difference, we have to first understand what are the characteristics that makes an asset an economic asset and not a speculative asset.

An economic asset is one where there is an intrinsic value to holding it. This intrinsic value is derived from the underlying growth in value of the asset. There is a fine difference between value and price. The best way to think of growth in value is to think of a business. Let's use Microsoft as an example. When Bill Gates first started Microsoft, the world still doesn't really know the Window's operating system and as a result, the intrinsic value of Microsoft is still low. However, as Window's operating system becomes a critical software in computers and every household started to own computers, the intrinsic value of Microsoft grew in exponential terms. This is a very good example of value growth. This is reflected in the exponential growth of the company's stock price. Theoretically, there is no limit to how high the stock price can go as long as the business growth justifies it. For info, Microsoft shares has grown 31,800% since it was listed back in 1986 adjusted for all the stock splits. Another characteristic of economic asset is one where it provides economic benefits. An example I can think of is a house. Everyone needs a roof over their heads. If you own a house, you derive the economic benefit of having a shelter. If you do not own a house, you can derive the same economic benefit by renting from an owner. The rental you pay is to exchange for this benefit. At this point, it is necessary to differentiate assets where you deplete them in order to derive economic benefits. Examples are commodities such as oil, coffee beans, sugar, etc. There are no economic benefits to simply hoarding commodities other than the security of knowing that you can use them when you need them. I would argue that they belong to speculative assets rather than economic assets. I shall elaborate in my next paragraph. Another characteristic of economic asset is one that involves intellectual property. Examples include royalties and franchise fees. It takes intellectual capacity to be able to produce works where others derive satisfaction from and in return, they are willing to pay royalties to the creator. In the same way, it takes effort to be able to develop a successful business where others can replicate as franchises. Franchise fees are fair payment to replicate an already successful business model.

Speculative assets are those where there is no intrinsic value to holding them. The only way to recognizing economic benefits from these assets is to convert them into usable products and in the process deplete these assets. As mentioned earlier, commodities fall into this category. These assets only have a price attached to them and this price is determined by pure demand and supply forces. The significance of this is that prices tend to revert to an equilibiurm. Economics teaches us that in the event that supply falls and demand stays the same, prices will rise in the short run. However, in the long run, if prices were to rise enough, demand may adjust itself either through substitution or simply using less, and prices will revert to a more sustainable level. It is this demand and supply interaction that tends to make prices revert to equilibrium point. This is why there is a natural ceiling to how high oil prices can rise in contrast to Microsoft share prices where the limit is how big the business can grow. Microsoft can never become too expensive as long as the business justifies it. The only illusion that Microsoft shares are becoming more expensive is when its stock price rise to alleviated levels. This can easily be solved by going through a stock-split to make the share price numerically lower with more shares in circulation. However, it is not possible to split the price of oil in 2 and increase the supply of oil by 2 overnight. Hence, oil can indeed become too expensive and demand will have to adjust eventually. Another characteristic of speculative assets is a controversial one. It is an asset class that is only accessible to the privileged few. I am referring to those assets where the value really depends on the eye of the beholder. Works of art, antiques, luxury items, wines (really should belong to commodities), etc. all belong to this category. It is very subjective in pricing these items because it is really a question of at the margin, how much a HNWI values these items and it is really a function of his net worth. So if you are rich enough to own these assets and you wish to realise these assets at a profit, you better pray that there is someone out there richer than you who share the same taste and is willing to pay a higher price. These assets have another not so nice economic name called "ostentatious goods". An ostentatious good is a good where an increase in price leads to an increase in demand because people believe it is now better. An extreme example of an ostentatious good is the tulip bulb back in the 16th century.

As an investor who approaches markets from a calculated risk-reward mentality, it makes more sense to invest in economic assets rather than speculative assets. The reason is because economic assets can grow in value and hence it is not a zero-sum game whereas speculative assets can only grow in price (not value) and it depends on the greater (or richer) fool or demand/supply forces to keep the game going and so it resembles that of a zero-sum game. From a risk-reward stand-point, it seems like the odds are better investing in economic assets rather than speculative assets. Another way to look at it is for every unit of risk that you bear, you are better off being exposed to economic assets than speculative assets because the upside for economic assets is theoretically unlimited whereas the upside for speculative assets depends on how far the madness of crowd is willing to bring it.

It has not been an easy ride for these guys

2011-03-22T05:56:00.000-07:00

Just in case you think we are in an all out bull market where the rising tide lifts all boats, have a look at these one year charts of some US stocks and some foreign stocks listed as ADRs.

AU Optronics Corp

Bank of America Corp

Cisco Systems Inc

Hewlett-Packard Co

Korea Electric Power Corp

China Life Insurance Ltd

Sterlite Industries India Ltd

United Microelectronics Corp

I'm glad that I'm not stuck in any of these names thanks to my investment philosophy.

Mindset in trading

2011-02-11T19:37:00.000-08:00

It's been a while since I posted. There are 2 main reasons for this. The 1st reason is because I just had a major operation and had to rest for a while. The 2nd is because there really isn't much to say on markets except that it is going up almost everyday. The more exciting story seems to be in Asia now where markets are selling off due to the threat of inflation and the measures that are being taken by these countries to fight inflationary pressures. However, even this is nothing new since you can read about it in the media.

Markets are still the same but I am going to talk about the importance of mindset in trading. Everyone of us have views. We can even develop strong convictions on those views. This is what makes each one of us unique and creates diversity in the world. We will often take actions based on the views that we have and that is what makes the world a beautiful place. Imagine a world where everyone have no views about anything. Life will be so boring.

However, when it comes to trading or investment management, you are better off if you are able to separate your views on market from the actual trading itself. This thing about having conviction in your trades is overrated in my opinion. The reason is because I feel that having a strong conviction is detrimental to managing risk. The more convicted you are about a trade, the more you are likely to stick to that trade even if it goes against you. Worse still, you might even want to double down on that trade. This is one of the most dangerous behavioral biases around. This boils down to the mindset you have on markets. Whether you are able to give up your ego to say that the market is always right or you think that you are always right and market is wrong. It took me a while to understand that it doesn't matter whether market is right or wrong because it determines your account balance even if it is wrong and that is the reality. So by definition, the market is always right.

I have my strong views on what's going on in the world right now as you can probably tell if you have been following my previous posts. But my trading/investment decisions can be quite different from my views because I recognise that the market is always right so I prefer to react to it rather than act on my convictions. This ability to react to market is what I hope will keep me in the game for a long long time to come and hopefully have a healthy growing account balance. As Bruce Lee said before, "Be like water, my friend".

Someone who dares to speak the truth

2011-01-26T05:24:00.000-08:00

He may be wrong or right in his predictions but I admire him for having the guts to speak the truth.

2004 all over again

2011-01-13T00:26:00.000-08:00

History seldom repeats itself but it certainly feels like 2004 all over again even though it is less than a decade ago. This is thanks to a Fed Chairman who is adopting (or more precisely pushing the boundaries of) the same playbook used by the previous Chairman that ultimately led to the Great Recession. If there is ever any doubt, just look at the 2 charts below.

Commodities' prices are soaring through the roof and yet the Baltic Dry Index is falling almost everyday. Commodities are mostly used as raw materials to make goods that eventually become common household products. It can either be in the form of consumables or non-consumables. Consumables include food items such as corn, wheat and cocoa. Non-consumables include metals such as silver, gold, aluminium; and non-metals such as timber, rubber, oil, etc. Most of these commodities have futures contracts which are traded on public exchanges such as the CME, LME, LIFFE, and so on. Merchants use these futures contracts to hedge market risk when they conduct their business. However, a large part of these contracts are traded by speculators who hope to profit from the futures' price movement. Commodities are thought to be a good hedge for inflation. Therefore, if the speculators expect an inflationary environment, they will bid up the prices of commodities. A low interest rate environment can only add fuel to this by creating the incentive to borrow cheap to speculate on the prices going up. This is precisely what is happening now.

What is the significance of the fact that the Baltic Dry is falling? Well, commodities are seldom produced and used in the same country. Most of it is exported using dry bulk ships and the Baltic Dry Index indicates the freight rate charged by the shipping companies. The index is not traded and therefore the only determinant for the rate is pure demand and supply for the shipping services. While I must say that I'm not familiar with the supply side of the equation, it is probably fair to say that the demand side is lacking. The reason for saying this is because coming out from the recession, a lot of shipping companies have decommissioned a fair number of ships, thereby reducing fleet size. It is quite unimaginable to think that there is an over-supply situation in such a short amount of time. What is scary is that the higher prices for commodities should contribute to higher freight rates. The rationale is that ships should be able to charge more for the higher value being carried. However, this is not the case indicating that demand is even more dire than it seems. Hence, I think it is fair to conclude that the loose monetary condition created by the present Fed Chairman has led to rampant speculation in the commodities market which will eventually feed into higher prices for the end products. This is where the inflation will come into play. Not so much because of the insatiable demand for commodities but because of the flood of liquidity introduced by the Fed. We are already seeing food price inflation in China and other parts of the world.

Bernanke says that he is 100% confident that he will be able to control inflation when it rears its ugly head. However, inflation is more like a coiled spring whereby when it does happen, it usually happens suddenly and drastically just like what happened back in 2007. And the energy released from a coiled spring is so powerful that the momentum is hard to stop just like that. The only thing that stopped the inflationary force back in 2007 was the onset of the credit crisis. Unfortunately, I think that something similar to the credit crisis is more likely to stop inflation in its track than whatever policy the Fed can come up. Meanwhile, buckle up and enjoy the ride while it lasts.

Printing or Not Printing?

2010-12-10T17:54:00.000-08:00

I am confused after watching this video…

Buy the dip (Not a recommendation)

2010-12-07T06:06:00.000-08:00

Cute video

Enough said…