Wednesday, March 31, 2004

The Case for War

Recent democratic campaigns have stirred the anti-war activists back into furor. In fact, there was an anti-war demonstration in central park this weekend. Not only were park visitors greeted by the usual potpourri of transvestite rollerbladers and Dominican drum circles, but also had to contend with a slough of Marxist supporters. Since the same groups are also rallying for equality and civil rights, I don't understand their arguments.

It is my understanding that both technically and legally, Iraq had nothing to do with 9/11. However, strategically, it’s a whole different story. Our motives were to topple a regime that harbors terrorists and send a message to the rest of the middle east that Iraq’s actions will not be tolerated. The only way to meaningfully rid the world of Islamist terror is to transform the entire middle east into a democratic state. If not, we will be fighting small fires forever instead of dealing with the core of the problem. (In my own experiences, both technically and legally, Sigma Alpha Epsilon national fraternity isn’t responsible for the countless bongs and kegs found by Lafayette College campus security. However, LC holds the fraternity responsible and decides to revoke the charter and turn it into the “First Year Experience” house. This is entirely based on strategy- there are no more bongs, nor kegs in the SAE house anymore, and therefore no liability!)

Isn’t it apparent that Iraq is a key territory by the way al Qaeda tries to disrupt the transition to a democratic society? The bombings in Spain were a win for the terrorists, resulting in the election of a political party that does not support the war. They are ready to bring their campaign into the homelands of those who support us- to make them cower and back away. For this, we should increase the pressure.

The last time I checked we overthrew an oppressive dictator and are currently in the process of installing a democratic constitution. We eliminated a ruler who lived in outlandish palaces and horded the country's money, while most of the nation lived below the poverty line. Dissenters of the regime were subject to torture and public execution. And you wonder why they hate Americans? They had to, in order to survive!

Friday, March 26, 2004

John Nash and Myopic Thinking

A Nash equilibrium, named after John Nash, is a set of strategies such that no player has incentive to unilaterally change his/her action. If a change in strategy would leave them to earn less than if he/she remained with the current strategy, then they are considered in a state of equilibrium.

For instance, if Batman and Superman are flying directly at one another and playing a game of chicken, each participant has two possible decisions (obviously, there are many more decisions, but for the purpose of simplification, we'll look at two). Each superhero can either choose to fly head first into their adversary or they can choose to chicken out and swerve away from the course. The three possible outcomes are: 1. a collision resulting in an injury; 2. they both swerve and its a draw; 3. if one goes and the other swerves, the one who swerves is a chicken. Both players lose in both a head on collision, and no one wins if they swerve to a draw. However, if one player chooses to fly head on, and the other player chooses to swerve, one wins and they are considered to be in Nash equilibrium. Once each player has committed to their decision (ie- Superman flies head on, Batman swerves, or vice versa), any movement by one player will leave them with less of a payoff if they had stayed with the original strategy.

Another Nash equilibrium scheme allows us to measure the amount of moves into the future that an individual takes when choosing a problem-solving strategy. In a recent study, 1000 participants were asked to select a number between 1 and 100 that would equal 2/3's of the average number chosen amongst the participants. If their number was lower than the correct number, they would receive one credit, however, a higher number would result in a loss of two credits. Since the average number chosen amongst a group will always amount to "50", the first step would be to guess "33". However, since most people are going to guess "33", a participant would need to take another step and guess "22". But since everyone is going to guess "22", someone taking another step would guess "14.6". With each progressive step occurring, in an attempt to out-think the rest of the participants- the number decreases by 2/3 (9.6, 6.3, 4.2, 2.8, 1.9), until it eventually reaches a number approximating zero. This process of reasoning, or 'backward induction' will lead to the Nash equilibrium point.

Oddly enough, the study showed an average response of "26", therefore a winning number of "17". This answer indicates that the average participant estimated that the other participants were only thinking one step into the future, and based their response on this estimate. This demonstrates the widespread myopic thinking by most individuals when implementing a strategic plan. For instance, did we consider the rise in anti-American sentiment before invading Afghanistan and Iraq, which may have created even more terrorists? Does the Fed consider the implications of free money? What happens when banks are no longer willing to lend revolving lines of credit? The market rises on the investment of baby boomers, but what happens when they take their savings out for retirement? These are the short-sighted decisions that sometimes lead us into a headfirst collision with our adversaries.

Wednesday, March 24, 2004

The Second Derivative of Sentiment Indicators

When the market sells off, traders focus on various sentiment indicators to determine when there is enough bearishness factored into the market to produce a significant bottom. The thinking is that you want to be buying when weak hands are being shaken out of the market, by the fear that the market could trade lower.

One such indicator is the weekly Investor's Intelligence survey of fund manager's sentiment. The amount of bulls has recently fallen to 45.5 from 52.5 last week, while the amount of bears has risen to 23.2 vs 21.8. If you want to zig while others are zagging, here's your scenario.

Another indicator is the Equity and Index Put/Call ratio. The belief here is that when the amount of puts traded rises dramatically against the number of calls, there is enough fear in the market to produce a meaningful bottom. Last Tuesday (3/16), for instance, the Equity Put/Call ratio closed at 0.91, while the Index Put/Call ratio closed at 1.34. Not only was the Equity ratio the highest year-to-date, but it marked the fourth day in a row that both ratios were showing bullish readings. Definetly a time to buy, right?

The VIX is another measure of investor sentiment, measuring the amount of implied volatility priced into the options market. Since it typically rises when markets sell off, a dramatic upswing in the VIX also produces a buying opportunity for investors looking to buy when others are selling. From a 13.83 low on 3/5, the VIX rose nearly 40% in 12 sessions, suggesting a decent level of fear is being priced into the market, and arguing for a buying opportunity.

Finally, the TRIN (Short-Term Trading Index) is a contrarian indicator used to detect overbought and oversold markets. It intimates whether changes in the relationship between advances and declines are taking more quickly or more slowly than changes in the general volume movements of a market. A TRIN less than 1 indicates a bullish market, while a reading greater than 1 indicates a bearish market. An astute trader would thus buy the market at extreme bearish readings (TRIN over 2.0) like the four times in five days that we saw between March 9-15.

As a devil's advocate (but not an advocate of the devil), what happens when the general investing public is cognizant of these bearish readings? In other words, how is a reading "contrarian" when it is also "mainstream" thinking? When the investment community anticipates bearish activity amongst fund managers, is it prudent to go along with everyone else? If Bob Pisani on CNBC is reporting on "contrarian" indicators, then how are they contrarian anymore? An examination into Nash equilibrium (yes, Russel Crowe in "A Beautiful Mind") and the short-sightedness of human thinking will soon follow...

Monday, March 22, 2004

Productivity and the Growing Pains Associated with Job Growth (not the Kirk Cameron sort)

The standard equation for employment growth is thus:

Rate of Employment Growth = Rate of Growth of the Overall Economy - Rate of Growth of Productivity

Sen. Kerry's recent adoption of protectionist policies limiting the amount of outsourceable labor is simply absurd. It's anti-productive. I recently came across an economic study (Berkeley) which postulated that it takes 60 years for income growth to double at a 1.2% productivity growth rate. However, it only takes 25 years for income growth to double when productivity is at 3%. More income implies more growth and thus more jobs. So although there are growing pains associated with a growth in productivity in the short run, it improves our quality of life in the long run. In the interest of keeping our title as the #1 country in the world, our policies need not be so short-sighted and near-term.

Wednesday, March 17, 2004

Reasons why the civilian aircraft was 'shot down' over PA on 9/11

1. The air force knew the plane was headed straight for Washington (this was after both towers were hit, so they knew there was a target involved). They couldn't gain communication with the plane, and there orders were to take it down. Why not take it down in the middle of no where rather than wait until it nears the DC area?

2. Even if there was a scuffle in the cockpit, and no one was manning the controls, the plane would have continued flying on somewhat of a straight course (at least not have gone straight down).

3. If the terrorists decided to crash the plane into the ground (and they would never do this) - nose first, it would have created a crater like when a large meteor hits the earth.

4. And this relates to #1... the al qaeda mission was to hit the white house/capitol building, and this was of greater importance than the 200 lives on the plane.

5. The US gov't made it so obvious that it was shot down by proclaiming them "heroes". They were purposely glorified by the media as part of the govt detracting attention from what the F-16s did and what the passengers supposedly did.

Tuesday, March 16, 2004

Zapatero’s Socialist Party crushed PM Jose Aznar’s Popular Party on Sunday. The voters disagreed with the incumbent party’s alliance with the US in the Iraq war after al-Qaeda’s apparent act of retaliation on 3/11. The anti-American views of the voters and the declining demographics in Spain are a win for radical Islam.

Spain’s fertility rate of 1.12 births per female is the lowest in the world, a dramatic change from 30 years ago when the rate stood at 3 births per female. By 2050, Spain will have lost ¼ of its population. (Germany and Italy, whose fertility rates fell earlier than Spain’s, will lose 1/3).

The danger in losing population is this – by 2050, every Spanish worker will support one pensioner, and the lack of workers will bankrupt the system. Spain has no choice but to add 5 million additional immigrants to save the pension system. This number also includes a recovery in the fertility rate to 1.5. Economists believe that the demographic catastrophe of the last 30 years puts the pension system on a crash course towards bankruptcy.

The majority of Spain’s current immigrants are from North Africa, with Latin American immigrants making up a small minority. 200,000 Muslims now reside in Spain, having built 100 new mosques in the last 10 years. Unless Spain attempts a recolonization from Latin America, it cannot do without more Muslims.

Socialist voters in Spain may have not worked out the arithmetic. They would rather not be burdened with distant wars, especially if the war is brought to their homeland. As evidenced by the fertility rate, why will they lay down their lives for future generations when future generations will not be there?

Monday, March 15, 2004

Inflation- Is the Fed Cooking the Books?

As the economy has recovered and the Fed has remained lax on monetary policy, its rhetoric has sought to quell fears of a resurgence in inflation. In a recent speech in Washington, Fed Governor Ben Bernanke, claimed that inflation is "under very good control". With the recent runup in the M3 money supply, primarly due to a Bush presidency that operates "as if money grows on trees", its only a matter of time until economic growth slows and the unlimited pools of capital we've harvested have a dramatic effect on prices. Or are we there already?

The US Consumer Price Index, over the last 6 years, has traded in a range from -0.3% to +0.6%. The latest reading in January registered a 0.5% increase in the "price of all goods and services purchased for consumption by urban households." Seems quite obvious, given the 50% runup in commodity prices in the last year and our ridiculously low rate policy. But should it be higher?

A component of the CPI that skews the data is how they account for Housing. The Bureau of Labor Statistics claims that Housing encompasses "rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture". Does anyone else find it odd that the CPI doesn't account for housing prices, which is the largest purchase that Americans make? Aren't there signs of an obvious "bubble" in real estate. In addition, the rental market has become depressed, since most people choose to buy in lieu of renting. This decision, influenced by rates that are abnormally accomodative, skews the CPI downward even more.

Transportation is another component of the CPI that "seems" to be "under control". This statistic is comprised of "new vehicles, airline fares, gasoline, motor vehicle insurance", with new vehicles making up the majority of the purchases. However, motor vehicle dealers are becoming increasingly scrutinized for generating the majority of their profits through auto loans, and not the sale of the vehicle. They borrow from the govt cheaply, acting as a finance company, and markup the auto loan to the consumer. The advancement of these dealings in recent years has curtailed the price of vehicles, thus obscuring the CPI even more so. It will be interesting to see how auto dealers operate in a higher rate environment.

Recent data including consumer confidence and wholesale inventories point to a slow down in economic growth. The money supply outgrowing the growth of the economy is a recipe for an inflation disaster. If the Fed doesn't recognize the obvious signs of inflation and halt the printing presses, they'll have to replace the picture of Ben Franklin with the Monopoly guy on the $100 bill!

Wednesday, March 10, 2004

The VIX, The VIX, The VIX

Four days ago the Volatility Index hit a 52 week low of 13.83. Since then it has risen 35% and closed at a 3 month high of 18.70 today. If there was ever a sign of panic, and also an opportunity for a short-term longside trade- here's your entry point. However, although we may see higher prices in the near-term, the long-term outlook is bleak...

Thursday, March 04, 2004

The Employment Situation

The first Friday of the month gives us a look at the employment situation in the US. The dems have been focusing on this number in their bid to oust the GOP, and their so-called "jobless recovery". The jobs data in the next few months will be crucial to the Bush campaign. The street is looking for 130k new jobs added in Feb. Based on the positive data of the last few months (consumer confidence, housing data, and manufacturing), our firm is higher than the street at 200k+. It is interesting to note that the street has overestimated the number and gotten burned the last two months. So it seems as if they are 'gun-shy' and have significantly backed away from stronger estimates for the Feb number. Bond market bulls are running at a very high level of 72% (ie the market is very long), concocting a remedy for a selloff should a stronger number hit the tape.

Wednesday, March 03, 2004

Interesting trade in bond options today. The Lehman IShares 1-3yr treasury bond (SHY - 82.60) is an exchange traded fund which corresponds to the price and yield performance of the short-term sector of the US Tsy market. This morning, a hedge fund paid .30 for the Sep 81 puts, betting that short rates would be higher in 6 months, thus lower bond fund prices. Quite interesting, since the fund has traded 81 only once (Aug 2002) since its inception in Aug 2002.

At low yields, prices rise at an increasing rate as yields fall and at higher
yields, prices fall at a decreasing rate as yields rise. This behavior creates
the convex shaped price/yield curve.

Important factors to take into account:
1. The lower the coupon rate, the greater the bond's duration (ie more cash
flows later in the life of the bond), and the greater sensitivity to changes in
2. The longer the bond's maturity, the higher the duration. (more cash
flows are at risk to changes in rates).
3. The lower the coupon rate, the higher the convexity. Zero's are more convex
than bonds of equal maturity, therefore have greater price sensitivity.

In this low rate environment, a rise in rates will have less of an effect on the
SHY than if we were in a higher interest rate environment. Also, the higher
coupon off-the-run bonds which compose 33% of the portfolio (5 3/4 11/05, 6 1/2
10/06, and 6 3/4 05/05) lowers the convexity, and also the price sensitivity.
These are important factors to take into account when paying for implied
volatility (ie buying an out of the money put).

The duration of the portfolio, by my calculations, is around 1.3. That is, for every 100 basis point move in the 2yr, the price of SHY should move 1.3 points. The Sep 81 puts for .30 are 1.90 out of the money, so the short end of the curve would have to sell off 146 bps in 6 months to break even.

The positives of this trade, however, are that you get a look at 4 Fed meetings before expiration, with the last meeting in September occuring 1 day before expiration. In addition, a possible raise in rates in June followed by a subsequent fall in price of the underlying would add more implied volatility to the puts and create the possible scenario of trading out of them before expiration.


The ISM Non-Manufacturing will be released today, with the market anticipating a
63.5 reading vs 65.7 in Jan. This number is important for the jobs market as
Non-Manufacturing jobs account for 70% of the labor force, and spending in the
manufacturing sector (durable goods) had been running at a higher pace than
service sector spending.
Over the past three quarters, the service sector has underperformed the durable
goods sector, with personal spending growing at a pace of 2% vs 15%. The disparity
in growth explains the slow pace of job growth in 2003, assuming that a shift in spending to service oriented companies would also lead to the creation of more jobs.
This shift is becoming apparent in the sluggish car sales (durable goods), but robust chain store sales (services), with Feb the best in five years. Look for this shift in spending to eventually trickle down to the all-important jobs number in coming months.

Tuesday, March 02, 2004

Here's a new strategy for the CEOs of failing companies- cheat, lie, and steal all you possibly can. When you eventually get caught and the stock gets hit, just announce your leave and take a severance package loaded with options! It seems as if every stock underperforms and ousts the CEO trades higher. Take King Pharmaceuticals (KG), for example, who currently remains under investigation by the SEC for underpaying the Medicaid program. The CEO steps down to spend more time with his family and the stock rallies 20%! Another example is ADRX, which changed CEOs last month and has rallied 20% as well. Rumors of a management shakeup in Biovail (BVF) drove prices higher as well today. I have a hard time understanding why the marketplace would choose to reward an internal hire...
The dollar's rally vs the yen needs to be closely monitored by bond market participants and anything interest-rate sensitive. Asian central bankers have attempted to devalue thier currencies (to the benefit of exporters) by buying dollars. After they buy dollars, they also buy our debt, of which they have a mandate to buy $500 bln of US Tsy's in 2004. However, the recent strength in the dollar vs the yen and euro (mainly due to technical factors and an ECB rate cut), limits their need to buy dollars, and is a negative for bonds and interest rate sensitive stocks. We continue to recommend a short 10yr strategy.

Monday, March 01, 2004

Sean Penn and Timothy Robbins take notice...

The Sedition Act of 1918 - Sec. 3. Whoever, when the United States is at war, shall willfully make or convey false reports or false statements with intent to interfere with the operation or success of the military or naval forces of the United States, or to promote the success of its enemies, or shall willfully make or convey false reports or false statements,...and whoever shall willfully advocate, teach, defend, or suggest the doing of any of the acts or things in this section enumerated, and whoever shall by word or act support or favor the cause of any country with which the United States is at war or by word or act oppose the cause of the United States therein, shall be punished by a fine of not more than $10,000 or the imprisonment for not more than twenty years, or both."
The Academy Awards might possibly be the worst produced show on TV. I couldn't figure out why they didn't just list all the categories and then have the LOTR crowd come up on stage and get their awards. Why is it that Ben Stiller and Owen Wilson get 5 minutes to do the same played-out routine and promote an upcoming movie? Why does the guy who wins for art direction get his 20 seconds of fame cut off after 15 secs? Why do actors (Sean Penn, Timothy Robbins) always promote their political agenda instead of taking the time to sincerely thank those who helped get them onstage in the first place? I think that additional mention in lieu of an anti-war message could have surely helped out someone's career. They should put a warning label on the show: "Warning: Some political content may not be suitable for most viewers." Why does the show spend more time commemorating those who have passed than celebrating the living? Why are there more highlights from past shows than actual current content? Finally, what the hell is Katherine Zeta-Jones thinking?

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