Tag Archives: premium

The ‘dash for trash’ is on, as the near-record low yields available on safe assets has prompted investment professionals to move further out the risk spectrum in a desperate bid to earn nominal returns that satisfy client needs.  Cautious optimism persists among buy-side commentators, but actions speak louder than words, and market movements suggests investors are behaving quite differently than their rhetoric, as robust demand continues to outstrip supply and push the yields on lesser-quality bonds ever lower.  The resulting valuations confirm that a substantial part of the market for fixed income securities has entered the speculative phase of the credit market cycle.

It was all so different not so long ago, as the bullish complacency apparent at the height of the credit bubble, turned to all-embracing fear following the collapse of Lehman Bros.  The first tremors of what would soon become the worst financial crisis in seventy years erased the irrational exuberance evident in the prices of risky debt, but the failure of a major investment house proved lethal; the credit markets ceased to function, as forced selling – and the resulting illiquidity – pushed yields to unfathomable levels.

Extreme risk aversion prompted investors to flee the market for corporate credit en masse, which saw investment-grade bonds suffer double-digit losses in a matter of weeks.  The carnage in high-risk segments was far more punishing, as the spike in the yields of junk bonds to more than twenty per cent resulted in losses of some 45 per cent for their unfortunate holders.

All told, the default rates implied by the yields available on even the highest-quality credits moved to levels that were without modern precedent, and savvy investors could bank on equity-like returns with bond-like risk.  Of course, outsized rewards could be expected if, and only if, the Bernanke-led Fed’s unconventional monetary policies could unfreeze the markets, and return risk appetite to more normal levels.

Near-zero interest rates, in tandem with credit-easing policies proved successful, and the spread on lesser-quality credits versus default-free Treasuries dropped from a peak of more than six per cent at the end of 2008 to below three per cent just eight months later, as investors priced out an economic and financial apocalypse.  Fed policy ensured a quick return to ‘business-as-usual’ on Wall Street.

Corporate bond pricing may not seem excessive to many on first glance.  After all, the credit spreads on lesser-quality corporate bonds have made little progress in the past three years, hovering around three per cent for most of that time, while current spreads are more than one percentage point above the lows registered at the height of the credit bubble.  This observation has seen many buy-side commentators argue that the bull market has further to run.

However, vigorous demand for safe assets, in concert with aggressive central bank purchases, has pushed the yield on ten-year Treasury debt deep into negative territory, when adjusted for long-term inflation expectations implied by the yields available on Treasury inflation-protected securities (TIPS).  As a result, current spreads for lesser-quality corporate credit imply a real yield of just two per cent – a level of return that rewards investors for delaying consumption, but provides little to no compensation for default risk.

It is quite clear that risky corporate debt is dangerously overpriced, but identifying a trigger that changes the status quo is always difficult.  Nevertheless, the trigger could well be a peak in corporate profitability, which may not prove sufficient to derail the equity market, so long as aggregate earnings do not come in too far below expectations, but a wide dispersion of profit outcomes across the individual constituents that comprise stock market indices, could punish corporate bond investors.

To appreciate why, it is important to grasp the financial theory that explains the pricing of corporate credit.  The Nobel laureate, Robert Merton, increased our understanding of corporate debt pricing, when he applied contingent-claims analysis way back in 1974.  He argued that owning a corporate debt claim is analogous to owing a risk-free debt claim of the same maturity, and issuing an option to default to the company’s shareholders – an option to put the firm at the value of the risk-free claim.

The value of the put option is determined by total firm volatility – both firm-specific and market-related – unlike equity prices, which only incorporate the latter.  Thus, if firm-specific or idiosyncratic risk increases on the back of a wide dispersion of earnings outcomes among equity index constituents, the value of the put option will increase and benefit shareholders at the expense of bondholders.  In other words, if stock market volatility and firm value remain unchanged, wealth will simply be transferred from the holders of debt claims to the company’s shareholders.

The theory helps explain why the market for corporate debt typically leads the equity market at important turning points.  Indeed, credit spreads bottomed in the spring of 2007, or more than half a year before aggregate stock prices reached their apex.  A similar dynamic could well be in the offing today.

The Federal Reserve’s unconventional monetary policies may well underpin the excesses apparent in the pricing of lesser-quality corporate credit for now, but liquidity is a dubious concept at best, and can disappear in a heartbeat.  Stormy weather may not be far away.

www.charliefell.com

 

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Japanese asset prices have jumped onto investors’ radar screens of late; the return of the Liberal Democratic Party (LDP) to power late last year has sparked hopes that the new leadership might match their pre-election rhetoric with actions that help to bring years of economic stagnation to an end.

The Diet was dissolved last November, and the LDP, under Shinzo Abe, secured a landslide election victory four weeks later, as voters expressed their disillusionment with the Democratic Party of Japan and backed the LDP’s promises to wage a determined battle against deflation through aggressive monetary easing, alongside flexible fiscal management.

Mr Abe harangued the Bank of Japan (BOJ) during the election campaign, arguing that the monetary authority has been far too timid in its efforts to combat long-term deflation.  Further, he threatened to amend the 1998 Bank of Japan Act if the central bank does not soon accede to a two per cent inflation target, and after he assumed the post of Prime Minister, he taunted the monetary policymaker with the words, “There is no future for a country that abandons hope for growth.”

The need for bold action on both fiscal and monetary fronts is not difficult to understand in the context of an economy that has been in relative decline for more than two decades, and recently slipped into its fourth recession since 2000.  Real GDP growth averaged more than four per cent a year from 1974 to 1990, but has averaged barely half a per cent a year ever since, as the economy continues to languish in the aftermath of the bursting of a joint asset and credit bubble more than twenty years ago.

The damage inflicted upon private-sector balance sheets by the implosion of the bubble led to a pronounced and protracted deleveraging that saw private-sector savings surge relative to investment.  The resulting deflationary impulse has seen the GDP deflator drop almost 18 per cent from its 1994 peak, while nominal GDP is almost ten per cent below the peak registered during the fourth quarter of 1997.

The BOJ cut policy rates to near-zero by 1995, and shifted to a zero-interest-rate-policy (ZIRP) in the spring of 1999, which was followed by the adoption of a quantitative easing policy that persisted from 2001 to 2006.  However, the unconventional policy failed to prevent deflation from taking hold and the resulting strong demand for precautionary money balances ensured that the private-sector’s financial surplus persisted at high levels.

High private-sector savings relative to investment contributed to large fiscal deficits that have seen the public-sector debt ratio jump to close to 240 per cent of GDP, a level that is in a class of its own – even compared to the euro-zone’s troubled periphery.  Fortunately, the preference for low-risk assets in a deflationary environment ensured that the growing government debt could be financed by private-sector savings at a low interest cost.

Looking forward however, projections of future fiscal deficits and household savings rates as the population ages, suggests that it is only a matter of time before the Japanese is forced to tap foreign capital markets, which are far less likely to provide funding at today’s historically low rates.

An upturn in borrowing costs would have a large adverse impact on the financial sector’s health.  Indeed, the central bank estimates that a one percentage point increase in yields would wipe out roughly two years of banking sector profits.  Thus, the need to revitalise the Japanese economy is a matter of some urgency.

There is no doubt that the world’s third-largest economy is beset by many structural issues that need to be addressed if nominal economic growth is to be lifted to a level that will put the fiscal position on a more sustainable path.  Constructive government policies are required to raise real growth, but ending deflation is the purview of the central bank, and the time for credible action is now.

Sceptics will argue that increasing the inflation target to two per cent will have little durable impact, since the BOJ has already failed to meet its current target of one per cent.  However, the central bank has all too often been the architect of its own failings, and has snatched defeat from the jaws of victory on more than one occasion.

Indeed, Ben Bernanke, then a professor at Princeton, remarked as far back as 1999 that “Japanese monetary policy seems paralysed, with a paralysis that is largely self-induced.”  He noted “the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work.”

Little has changed in the intervening years, as the BOJ consistently argues that deflation is not the result of timid monetary policy, but stems from structural issues that have lowered the economy’s potential growth rate.  The central bank’s rhetoric has signalled to economic agents that it cannot defeat deflation alone, which has almost certainly reduced the potency of its unconventional policies.

Central bank credibility may well be restored under a change of leadership orchestrated by Mr Abe, but deflationary expectations are deeply engrained and the battle will not be easily won.  Nevertheless, monetary developments in Japan merit close attention in 2013.

www.charliefell.com

 

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

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Since the Currensee marketing department is approximately 75% Crazy Cat Lady, you know we were excited by the Guardian headline, “Ginger moggy beats the professionals and a team of students in the Observer's share portfolio challenge” (Note to confused Americans: moggy means cat in British)

Here’s what happened: two investment professionals took on a roomful of schoolkids and an orange cat in a stock-picking contest set up by the Observer.  Each team invested 5,000 (fake) GBP for a year, and was allowed to reallocate quarterly.  The final ROI : Cat, 10.8%; professionals, 3.5%, and students, -3.2%.

Aha, you cry! It’s the triumph of the Random Walk!  After all, what’s more random than the behavior of a cat? Economist Burton Malkiel's book A Random Walk Down Wall Street is a popular one, and it pretty much says that share price moves, if not actually random, are sufficiently complex as to be practically random.

Hold on, put down the catnip, even if the market behaves randomly, does that mean that random picking is the best market strategy?

If you had bought and held the entire FTSE all-shares index (the universe from which the teams picked their stocks) for 2012, you’d have earned 8.2%.  That reduces the cat’s edge to just 2.6%, still nothing to sneeze at, and makes the professionals and kids look pretty bad.  Maybe “buy the market” is the way to go.

Let’s look at the rules of the Observer’s game.  Players were restricted to stocks in one index – not ideal diversification - and could buy or sell just once per quarter. It doesn’t say for sure, but I don’t think they could do any short selling or avail themselves of future or options on the stock in that one index.  Would you pay a money manager to apply those rules to your hard-earned nest egg?

Clearly the game has been simplified for the school children and perhaps the cat, too.  It’s a fun illustration of randomness, but it was like a poker tournament stopped after the first four cards were dealt.  Trading and money management are long-term full-time jobs, and real professionals need access to all the tools and markets they can get to create diversified portfolios for their clients.

Or, you could always just throw your favorite toy mouse at a grid of numbers and hope for the best.

 

 

 

 

 

Retail spot forex trading is financially zero sum for the market as a whole. That means any profits made by one individual must come at the expense of someone else (or multiple someones). Actually, when you factor in the costs of bid-ask spreads, commissions where charged, and the bid-ask spread in carry interest rates (yes, they have a bid-ask spread there too!) for positions held overnight, retail forex trading is actually negative sum for the market as a whole. This is something to keep in mind as you think about your participation in it. (Feel free to use the comment section below to voice your arguments against the above statements. I will happily refute them. J )

Why should you care?

Because it means retail forex is a game driven by skill. While just about anyone can make money in the stock market by holding a mutual fund or index ETF in a bull market (or even in an overall flat market when factoring in dividends), nothing can be further from the truth in forex. It’s a lot like poker where in the long-run the money will tend flow from the weak players to the strong ones. As a result, you want to be among the strong players to have any reasonable expectation of long-term success in the market.

Of course one of the things many folks have relied upon to keep the trading profits flowing is the constant influx of new traders into retail forex trading. They are weak players for the most part, and their losses feed the stronger ones. Of late, however, the growth in forex trading (retail and overall) has stalled out. We’ve even started to see contraction in places. That means those weak newbies aren’t flowing into the market the way they were, and they may even be leaving on net. That will tend to make the market more competitive if it continues, requiring a higher level of skill.

On top of that, social trading has gained a lot of traction recently. That effectively increases the portion of the market controlled by the better skilled traders as more accounts mirror their trades (assuming, of course, those traders being mirrored are in fact skilled).

Combine a market where the weak players may be leaving on net with an increasing proportion of the market under control of skilled players and you have the makings of rising competition among traders. This is something would could actually create a feedback loop whereby traders who don’t feel they can compete personally will allocate funds to programs like Trade Leaders. Furthermore, it will make increasingly clear those who really are highly skilled and those who are only pretenders.

Something to think about as you ponder you own involvement in the markets.

Hedging risk is an integral factor in any intelligent investment strategy. Since no one knows for sure exactly where the markets will move, who’s to say components of your equity portfolio won’t crash and burn when faced with market volatility?

In the game of beating the stock market, many will play and very few will win.

Speculating on potential gains you could achieve on certain investments really isn’t practical. What is practical, though, is assuming an opposite position in single stock futures against your current cash market security position to hedge risk you might encounter. This can be achieved in various ways, one of which is the writing or purchasing of options on single stock futures contracts.

If you’re bullish about single stocks, consider using a synthetic long call strategy. Here, the investor simultaneously assumes a long position and put option on a single stock futures position. Together, the two create a something comparable to a long call. The very attractive benefit of this move being that your maximum loss is limited to just commission plus the premium paid on the option, while your maximum gain is virtually unlimited.

Say you are very confident that the share prices of company X will rise. Instead of buying stock outright at $49 per share, which runs you the risk of loss should the market move against you, you purchase one single stock futures contract on company X. you then take it one step further by buying put options on your futures position. For the premium paid, a long put gives you the right to sell the underlying instrument (future) at the puts strike price, should you choose to exercise it.

Three months later, you learn that you were correct; company X’s share prices have gone up and are now trading at $54 per share. You can now sell your single stock futures contract, which has increased in value along with the underlying security, for a profit. The put you purchased will simply expire unexercised at no harm to your position.

But what if you were wrong? What if the whoopie pies that company X produces have recently been discovered contaminated by salmonella and the result of the news on stock prices is devastating? Well, here is where the put would come into play.

Since the value of the futures contract is correlated with the underlying security, it has also plummeted in price and is now virtually worthless. However, by exercising your put option, you may sell your worthless futures contract at the strike price previously establish when the stock was trading healthfully. Even though company X’s stock price crashed and burned, taking your single stock futures position with it, you can sell it for a loss of only the premium you paid for it along with commissions.

Below is a chart showing a protective long put for visualization of potential outcomes. The red line is the put, and the blue is the spot market, but we will assume it’s the futures position for purposes of the example described above (since spot and futures move together). As you can see, should the stock position continue on an upward trend, you will profit with your long futures position. However, should it take a bearish turn and drop past your purchased put strike price (red) you will have the right to exercise and sell your futures at the strike, which will be more than it is worth.

So why don’t more people establish synthetic long call positions? Is it too much effort? Or do they just not know they exist?

One possibility could tepid congestion. Suppose the cash market stock drops a just few points; enough to sink below your futures purchase price, but not to the point of permeating your puts strike. Then, should congestion ensue until both derivatives reach expiration, you’re stuck with a loss. Granted it would still be limited to 1) the scope of the futures minus the strike of the put and 2) the put premium plus commission, but still, a loss nonetheless.

If you’re bullish, a synthetic long call could possibly serve as a well-protected strategy. Rather than buying the stock outright and risking a hefty loss should the market move against you, for the price of a few fees, you could purchase a put, combine it with a long futures, and limit your losses. Knowledge is power – a well-educated investor has a far better chance of success than an overzealous better.

 

 

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.