SurlyTrader

1 pixel = $1 Million

SurlyTrader — Thu, 11 Mar 2010 12:29:00 +0000

A sobering perspective.

No related posts.

Is the FDIC Solvent?

SurlyTrader — Thu, 11 Mar 2010 01:52:13 +0000

Sheila Bair has to be given credit, she is working with a whole mess of financial institution failures that would give anyone nightmares. 168 failed institutions with more than $544B in assets have been seized by the FDIC in the last three years and there are 700 more “problem” institutions on the docket. To her defense, it is a bloody mess with residential foreclosure waves continuing to mount along with a commercial real estate storm that is just gaining momentum. What needs to be made clear is that the savior needs its own saving:

The FDIC's Funds have vanished rapidly

Regardless of the FDIC’s current financial situation, it has a lot of assets to swallow up in the near future:

$544B so far and $400B to go

This is not to say that $400B is all that the FDIC is left to deal with as there will be continuous financial pressure on regional and smaller community banks as they are forced to realize their losses. This does not mean that we should all scurry to distribute our cash to many financial instituions out of fear that the FDIC will not be able to back the assets, but that we should be watching to see how the FDIC gets its extra funding. To be sure, the government will be forced to backstop the FDIC just as they backstopped the large banks and the agencies.

What is interesting is that Sheila Bair is trying to utilize a solution that got us into the whole mess in the first place. Instead of selling the seized assets (and risks) from the FDIC’s balance sheet at fair market values (which are quite low), she is looking to securitize the seized assets and slap on an FDIC guarantee to assure investors. That’s right, take a pile of toxic waste and put a nice, shiny government guarantee on it. It did not work so well for MBIA and Ambac, but they did not have the luxury of tapping the taxpayers for some support. You can read about their devious plans at your own leisure.

Testing the Rate Barrier

SurlyTrader — Tue, 09 Mar 2010 01:31:00 +0000

Every few months I draw the spotlight on long-term US interest rates as they approach a long held barrier. Thirty year treasury yields have not been above 4.8% since the fall of 2007 but have tested the 4.7% level about 10 times since then. I consistently draw attention to long-term interest rates because they are intimately tied to housing affordability and the cost of servicing debt. The Federal Reserve can keep short-term interest rates low for prolonged periods of time, but they can only keep longer term interest rates suppressed for finite periods of time. In an economy burdened with debt, the level of interest rates are critical.

Testing the Rate Barrier Once Again

Interest rates have behaved the way that I predicted long ago, but now we are at a turning point. Is the rally real and can the economy actually sustain itself without government intervention? Those are the two questions that need to be answered in order to make a bet on equities or interest rates from here. If the growth does not materialize, expect choppy equity markets and range-bound interest rates. If a sovereign default or other large event risk pops up along with low to no growth, expect a retesting of the lows. If the government has ignited economic growth through low interest rates and stimulus, then we might just have a long way to go. For a hint on what might follow, I like to look at the steepness of the yield curve by comparing the 10 year treasury yield to the 2 year treasury yield. Since 1980, the steepness of the yield curve is at all-time highs:

The spread between 10 and 2 year rates seems to be a good rubber band gauge for the economy

When looking at the 10-2 spread, remember that the Fed controls the short end of the curve but has limited ability in moving the long end of the curve. When the yield curve is inverted or the spread is negative (shown in red above where 10 year yields are lower than 2 year yield) the market is saying that interest rates should be much lower than where the fed has them set which would imply less growth and less inflation going forward. When the yield curve is steep and the spread is highly positive as it is right now, the market is saying that the fed has short term rates way too low and there is going to be a larger proportion of inflation and growth (and now possibly sovereign default risk) than what short term rates are showing. I like to picture this as locking your front breaks while gunning the accelerator to spin your rear wheels; eventually you have to let go of the front breaks. Will I say that this spread dictates a high inflation rate in the next 4 months to come? No, but this signal has convinced me to increase my exposure to rising nominal prices and reduce my exposure to fixed interest rate bonds.

Noteworthy News – March 8, 2010

SurlyTrader — Mon, 08 Mar 2010 00:25:51 +0000

Politics:

Now comes the pain: Greece’s new austerity measures may prove to be enough—if they are fully implemented – Economist

Cut Pay For Government Workers – Forbes

Bipartisan financial reform deal uncertain: Dodd – Reuters

Clash Over ‘Too Big to Fail’ – Wall Street Journal

Economics:

America’s hidden debt bombs - CNNMoney

Beijing looks at severing dollar peg- Financial Times

Payrolls data buoy job creation hopes – Reuters

Volcker Says Too Soon to Cut U.S. Monetary, Fiscal Stimulus - Bloomberg

Markets:

Five world markets themes next week – Reuters

ECB’s Draghi Says ‘Serious’ Greek Deficit Cuts Convince Markets – BusinessWeek

Income from Equities or Bonds?

SurlyTrader — Sat, 06 Mar 2010 21:07:27 +0000

How the tides have changed so quickly. One year ago, the financial markets seemed to have no bottom in sight. A year and a half ago, some of the largest and most stalwart companies (GE) were having difficulty rolling their short term debt. Now, companies are holding record levels of cash and trying to figure out what to do with it. Since the fundamental outlook from a top-line revenue perspective still does not look great, companies turn to three alternatives to expansion: 1) Share Buybacks 2) Higher Dividends, and 3) Leveraged Buyouts. All three of these are bad for bondholders and mostly positive for stockholders.

So what has caused this sudden bursting of corporate coffers? Government sponsored liquidity, fast cost-cutting by corporations, and a mild rebound in the economy. The three pieces have come together to flood corporations with cash. From an investment perspective, this is very important and you only need to look towards a few signals to convince you into shifting your asset allocation strategy. I do not have great hope for strong economic growth in years to come, but many equity positions currently look more attractive than their fixed income brethren. Right now, the IShares Investment Grade Corporate Bond ETF (LQD) earns an indicated yield of 5.05% with an average maturity of over 12 years. On the equity side, the WisdomTree Dividend ex-Financials ETF (DTN) is currently earning an indicated yield of 5.04% without the same exposure to rising interest rates. Utilities alone (XLU) have an indicated current dividend yield of 4.93%. Why would you hold long-maturity fixed income bonds in a low interest rate environment on the precipice of an inflation wave when you can earn the same income from solid equity companies with upside potential?

No matter what your proximity to retirement is, the fact that many equities pay out dividends of equal attractiveness to their fixed income brethren should convince you to shift your allocation in some way from fixed income investments to large cap names with stable and high dividends. The only reason you would want to own the bonds alone would be if you felt that we were going to head into a prolonged deflationary period where interest rates fall from where they currently are or if your portfolio could not stomach any equity volatility exposure. I do not believe a deflationary period is impossible, but I would rather take the opposite side of that bet.

Stimulus Money to Foreign Companies

SurlyTrader — Fri, 05 Mar 2010 03:28:35 +0000

The Investigative Reporting Workshop has found that 79% of the $2B allocated to the clean energy grants will go to foreign wind companies. According to the report, the 1,219 turbines built by foreign companies will create 6,838 jobs overseas.

If you have not been paying attention to manufacturing in America, this is a real slap in the face to the millions of US citizens currently unemployed. The employment ratio for men ages 25-54 is at record lows:

Find the full report here.

Colbert Report – Kid Owe

SurlyTrader — Thu, 04 Mar 2010 12:39:25 +0000

Stewart and Colbert are relentless…in a good way. The website he refers to actually exists.

The Colbert Report

Mon – Thurs 11:30pm / 10:30c

The Word – Kid-Owe

www.colbertnation.com

Colbert Report Full Episodes

Political Humor

Skate Expectations

Will Volatility Spike?

SurlyTrader — Wed, 03 Mar 2010 02:37:05 +0000

When trading options, it is always useful to take a step back and assess your overall view on volatility levels. If you believe that volatility is low given market conditions, then you should probably slant towards being an option buyer. If you believe that volatility is too high, then you should overweight option selling. This might seem obvious, but many times traders get too caught up in the trades being made or whether he/she feels that the markets will continue to rally or tank. As I have stated many times, the very nice characteristic of volatility is that it is generally mean reverting. This means that when volatility gets high, it will usually revert to its longer term mean and vice versa.

In order to make mean reversion useful, you must define the time period that you will be looking at in order to establish a baseline for volatility. From my perspective, volatility experiences regime shifts. If you look at the time period from mid 2007 through today, volatility has been elevated compared to the time period between 2003 and 2006:

Before 2007 volatility was muted, but since then volatility has been elevated mostly above 20%

If I only look at the last three years then I can make general observations about this period of elevated volatility across different tenors of options. In this study, I will only look at 1 month and 3 month implied volatilities for the S&P 500, the Nasdaq, and the Russell. If I examine the daily implied volatilities of this subset, then I can see what the average implied volatilities were, as well as decile rankings of implied volatility with a visualization through a box-plot:

Implied Volatilities across the board are at or near three year lows

Before shying away from this chart, let me explain what it means. If you concentrate on the first section, SPX 1 month, then you are looking at the implied volatility distribution of the S&P 500 1-month, at-the-money options from March 2007 through March 2010. The minimum recorded value was 10.11% while the maximum recorded value was 74.49%. What provides a better feeling are the 10% and 90% deciles which are marked by the outer border of the white box. This shows that the current 1-month implied volatility of 16.46% (red diamond) is not far from lowest 10th decile (13.94%) of the distribution while being a considerable distance from the 90th decile (41%).

Does this mean that I will buy all of the options I can get my hands on? No. What this means is that from the implied volatility distribution of the last 3 years, volatility looks relatively cheap unless you believe we will be re-entering a low volatility period. With the recent cliff-diving that the British Pound and Euro have done, I would not bet on it. It also highlights the relative value of the different index options. Nasdaq and Russell implied volatilities look cheaper relative to the S&P 500. This differential could be used to create a cross-asset pairs trade or to find the cheapest place to express a view.

Banker’s Progress

SurlyTrader — Tue, 02 Mar 2010 14:59:55 +0000

Source: Doonesbury

No related posts.

Volatility Finder

SurlyTrader — Tue, 02 Mar 2010 02:32:20 +0000

One of the most difficult parts of options trading is getting a handle on all of the data. With thousands of names trading with multiple expirations and multiple strikes, the equity option universe is enormous. One of my longer term projects is to set up a few very nice spreadsheets to search and screen options with data from Yahoo Finance as well as to manage risks embedded in options strategies and eventually I will get these tools created. In the mean time, I stumbled across a free online service from the CBOE that I believe will be useful for those who do not have access to good broker tools or data services. The online tool is called Volatility Finder by TradingBlock. The pre-set screens are rather simple and intuitive:

Pre-set Volatility Finder Screens

The results lack a bit of depth, but are very useful. A few enhancements would be the ability to export directly into a spreadsheet as well as screen for options of different maturities and moneyness, but free is free:

507% vol? I'm not touching it!