Target
As I mentioned yesterday, I am thinking that the Dow will pull back to about 8900 giving up 50% of its gain from the past week. If it goes below that then it will probably retest the lows again.
November 6, 2008
Bizzare Episode on CNBC
I watch a lot of CNBC. Charlie Gasparino annoys me. He is often rude, he interrupts other guest, he talks over people and he's a rumor monger. Some blame him for the run on Bear Stearns. In the clip below, he totally loses it.
November 5, 2008
Disappointments (Off-Topic)
My three election day disappointments:
1. Rep. Bachmann
2. Sen. Stevens
3. Prop 8
Not Holding
By mid-day its obvious that the market is not holding up. The chart above of the Dow shows the recent up move from a low 0f 8175 to 9625, that's 1450 points or 18%. That's a big move in 6 days. It would not be surprising for some profit taking here, maybe giving back 1/3 to 1/2.
Market Sense
We had a strong gap-up opening yesterday and a strong finish. Although the market is down so far today, it is still above yesterday's open and above the Halloween high. After the strong pre-election move yesterday, if the market stays in this range, it will be a good day.
Yes We Did (and Song of the Day)
Yes We Can Can - The Pointer Sisters
And Yes We Did!
And from the NY Times:
"There is a country out there where tens of millions of white Christians, voting freely, select as their leader a black man of modest origin, the son of a Muslim. There is a place on Earth — call it America — where such a thing happens."
November 4, 2008
Cause and Effect
I wrote yesterday about the difference between correlation and cause. Today I came across this article on a study that shows a correlation between rainfall and autism. Apparently, there are higher levels of autism in rainy counties. So does rain cause autism? Here are a some unanswered questions that can give you an idea of the problem with studies like this:
1. Do people in rainy counties drink more?
2. Do people in rainy counties smoke more? Do more drugs? Take more anti-depressants?
3. Do they have children earlier in life or later in life?
4. Do they eat more meat?
5. What's the difference in levels of autism? Is it really statistically significant.
6. Do the same correlations exist in other parts of the world?
Information like this is less than useful.
The Obama Bounce
The Obama bounce is starting today but remember the market is still well within the October trading range. Also, remember, the market often buys the rumor and sells the news.
Too Much Information
Could it be that the current financial crisis was caused by too much information, not too little? James Surowiecki writes in this week's The New Yorker about more data not making investors any smarter.
Another related issue that I've thought about is the unintended consequences of too much information. The market has always been about arbitrage in one form or another. It's about finding investments that are mispriced and betting that eventually the market will correct the pricing. Value investing, the Graham/Buffet model is to find investments that are undervalued and betting that their value will rise. Shorting stocks is about finding investments that are overvalued and betting their value will fall.
On a more micro level, before the advent of electronic trading, traders on the market floor could make money by arbitraging the difference between bid and ask prices, the spread. Before electronic trading, spreads could be quite high but now, for a highly-liquid investment, spreads are mere pennies.
In the 1960s, Edward Thorp started one of the first hedge funds, Princeton/Newport Partners. He developed mathematical models to find arbitrage opportunities in the market. His fund returned over 15% a year for 19 years. The problem he ran into, and this is key, once others figured out what he was doing and started doing the same thing, the arbitrage opportunities evaporated. The mantra is - arbitrage only works if you know something others don't.
Online trading, complex computer programs that can sift through gigabytes of data, the instantaneous spread of information on the internet, have all combined to eliminate most opportunities to arbitrage.
So what is a large institutional investor to do to gain an advantage over other investors?
The answer is found in the wreckage of our current financial crisis. Create new trading instruments that are complicated, hard to analyze and hard to value. And finally, believe that you are better than others in figuring out to make money with them.
The institutions that created and were trading CDOs and CDSs (forms of credit derivatives) had a vested interest in not making the market transparent. If they believed that they knew more about the market than their competitors then they had the opportunity to make more money.
November 3, 2008
Risk Models and Portfolio Theory
Most investors probably have no idea what a risk model is but anyone who has ever worked with a stock broker probably has heard that smart investing requires a diversified portfolio. They've been told to invest in different segments of the market such as the U.S., Europe or Asian stock markets, maybe a small investment in commodities or REITS. Divide your money between growth and value stocks. Small-cap, mid-cap and large-cap stocks. Brokers probably brought out colorful charts showing how different markets have low correlation so that if one goes down the others don't.
Large financial institutions like banks and insurance companies developed complicated computer programs to slice and dice their investments to maximize their gains while minimizing their risks. And, as we now know it was all a house of cards that fell down - and here's why:
1. Correlation is based on statistics not cause and effect. In other words, just because two markets have historically behaved differently, there is no logic, science or force that will make them behave differently tomorrow.
2. When panic hits, everything is correlated. Proof: October, 2008.
3. Risk models are based on perfect information. There is an implied assumption that all information is known. Obviously, this is not true. In the current crisis, we still have no idea what the true magnitude of mortgage loss will be. On a much smaller scale, when evaluating the potential for investing in a company, do we ever really know all relevant financial detail of that company. Case in point - Enron. (I can hear someone saying: "Oh, but Enron was fraud. That doesn't count." I answer: Has there ever been a time where there has not been fraud in the financial markets?) Read this article. The father of modern portfolio theory, Harry Markowitz, says the only problem is transparency and proper oversight. Well maybe, but until that happens (which it won't) risk will never be mitigated in times of panic.
4. People are not rational. Read this article about AIG's risk models. A Yale professor named Gary Gordon developed these models. Here's the last paragraph of the article:
"On a rainy morning last week, Mr. Gordon briefly discussed with his Yale students how perplexing the struggles of the financial world have become. About 30 graduate students listened as Mr. Gordon lamented how problems in one sector caused investors to question value all across the board. Said Mr. Gordon: "There doesn't seem to be fundamental reason why.""
In other words, people are not making decisions in the way Mr. Gordon thinks they should. Risk models assume that investors make decisions strictly based on their own financial self-interest. However, people don't always behave rationally and for a risk model to even come close to working it has to model irrational human behavior and they don't.
Irrational human behavior always wins out both with upside bubbles and downside panics.
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