"KISS" Model: Alive and Well

The "KISS Model" went bearish back in January 2008. Since then, the DJIA is down 21.9%, the S&P 500 is down 23.9%, and the NASDAQ 100 is down 26.2%.

If you recall, the model is based on two moving averages, the 15- and 40-week Exponential Moving Averages (EMA). If the 15-week EMA is above the 40-week EMA, the market trend is up. Likewise, if the 15-week EMA is below the 40-week EMA, the market trend is down. It is very simple, yet very profound in identifying the trend for the market. By looking at the following chart over the past decade, investors would have done very well in following the "KISS Model," especially after yesterday when the DJIA declined nearly 800 points. For a refresher, you may want to read the two posts from January 15, 2008 and May 11, 2008 entitled, "The Market Has Spoken! and How Does One Identify the Underlying Trend of the Market," respectively.

In light of the $VIX, (see the following chart), the broad market may have capitulated yesterday or in the process of doing so. Notice that today's reading of 46.72 was higher than the 2001/02 reading.

The $VIX options index is an excellent measure of investor greed and fear. When it reaches these extreme levels, such as above 40 (fear) and under 20 (greed), it behooves traders to go in the opposite direction of the extreme. That is with a reading of above 40, traders should be looking for a sharp short-term rally. A reading below 20, traders should be looking for a short-term decline. Therefore, given the extreme reading of yesterday, look for the market to bounce from here. The rally, however, would be a counter trend move, because according to the "KISS Model," the major trend is still down; and will remain trending down as long as the 15-week EMA is below the 40-week EMA.

For investors, stay the course in money funds. The "KISS" will eventually give a buy signal when the 15-week EMA moves above the 40-week EMA.

In closing, I bet those of you who have followed this model and invested according to its signals, probably had a pretty good-night sleep last night.

Worst One Day Percentage Losses: Where Does Today's Decline Rank?

Michael Seneodza over at "Trader Mike" provides some interesting perspectives on where today's percentage declines relate to past market declines.

"On days like today we always see headlines about how the day’s point losses rank for the financial indexes. But what is more important is where the moves rank on a percentage basis, because that’s the only way to do a comparison against history. A 778 decline in the DJIA today, while a record point loss, was only a 7% loss and doesn’t rank in the top 5 all-time but it is the 5th worst post 1940 or so. We’re certainly seeing historic moves right now. So here are some of the worst percentage days for the major financial indexes:

NASDAQ: Today was the third worst one-day decline for this index. Here are the 10 worst percentage losses for the Nasdaq:
1. October 19, 1987: -11.35%
2. April 14, 2000: -9.67%
3. September 29, 2008: -9.14%
4. October 26, 1987: -9.01%
5. October 20, 1987: -9.00%
6. August 31, 1998: -8.56%
7. April 3, 2000: -7.64%
8. January 2, 2001: -7.23%
9. October 27, 1997: -7.16%
10.December 20, 2000: -7.12%

S&P 500: It had its second worst day since 1950. (The data’s from Yahoo Finance and only goes back to 1950. The S&P 500 index was created in 1957, but it has been extrapolated back in time.) Here are the 10 worst one-day percentage losses for the S&P 500::
1. October 19, 1987: -20.47%
2. September 29, 2008: -8.79%
3. October 26, 1987: -8.28%
4. October 27, 1997: -6.87%
5. August 31, 1998: -6.80%
6. January 8, 1988: -6.77%
7. May 28, 1962: -6.68%
8. September 26, 1955: -6.62%
9. October 13, 1989: -6.12%
10.April 14, 2000: -5.83%

DJIA: I’m not sure where today’s drop ranks but it’s not in the top 5.
1. October 19, 1987: -22.61%
2. October 28, 1929: -12.82%
3. October 29, 1929: -11.73%
4. November 6, 1929: -9.92%
5. December 18, 1899: -8.72%

From the data I pulled from Yahoo Finance, which only goes back to 1928, today was the 17th worst day since 1928.. It was the fourth worst in modern times — which is probably a better measure given how different the world is now. Given all the circuit breakers put in post the 1987 and 1989 “market breaks,” it would be real difficult (if not impossible) to get another 22% down day. Here’s the modern top five worst DJIA days:

October 19, 1987: -22.61%
October 26, 1987: -8.04%
October 27, 1997: -7.18%
September 17, 2001: -7.13%
September 29, 2008: -6.98%"

Did you notice that there are a lot of September and October dates in that list! From a seasonal standpoint, many markets have a tendency to bottom in the October/November time period.

Sequel to "Another One Bits the Dust: Wachovia"

My Friday's post, September 26, Credit Default Swaps (CDSs): The Next Financial Crisis?, stated, "The four most active banks in the Credit Default Swaps (CDS) market are as follows: JP Morgan Chase, Citibank, Bank of America, and Wachovia (WB). (I would definitely keep an investment eye on Wachovia.) Indeed, according to the "Time" article, the top 25 banks hold more than $13 trillion in credit default swaps, or approximately 22% of CDS market."

Well, we did not have to wait long, because Wachovia has just been acquired by Citigroup. The FDIC stated that Wachovia did not fail. Technically, that is correct, but it was just a matter of time before failure would have been a reality. Wachovia made two bad investments, which precipated it demise. First, it acquired Golden West Financial in 2006. Even at that time Golden West Financial had "tons" of toxic loans on its balance sheet. Second, Wachovia acquired A.G. Edwards, a regional brokerage company with headquarters in Florida. A.G. Edwards brought it own set of problems to Wachovia.

Who is next on the so-called "hit parade?" My guess is National City Bank (NCC) out of Cleveland, Ohio, which could happen within the week (probably sooner rather than later). My best guess is that National City Bank will be acquired by Wells Fargo and Company (WFC).

Credit Default Swaps (CDS): The Next Financial Crisis?

What are Credit Default Swaps (CDS) and its potential impact on the economy? According to two excellent articles in Business Week (September 25, 2008) and Time (March 17, 2008), CDS are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They apply to municipal bonds, corporate debt, and mortgage securities that are usually sold by banks and hedge funds. The buyer of the credit default swap pays premiums over a period of time to the seller (typically a bank), knowing that losses will be covered if a default happens. In other words, the CDS is similar to someone taking out a home insurance policy to protect against losses.

According Harvey Miller, senior partner at Weil, Gotshal & Manges, "the CDS market has exploded to more than $58 trillion, which is almost three times the size of the U.S. stock market ($20 trillion) and far exceeds the $7 trillion mortgage market and $4 trillion U.S. Treasury market." Problem? The CDS market is not regulated. This market has no oversight to ensure that the parties involved have the financial wherewithal to cover losses if the security defaults. Solution? This market must be regulated just like other financial markets and securities.

The four most active banks in the CDS market are as follows: JP Morgan Chase, Citibank, Bank of America, and Wachovia (WB). (I would definitely keep an investment eye on Wachovia.) Indeed, according to the "Time" article, the top 25 banks hold more than $13 trillion in credit default swaps, or approximately 22% of CDS market.

The current financial focus on the mortgage debacle is well placed and deserving. However, given the size of the CDS market ($58 trillion) versus the mortgage market ($7 trillion), a potential meltdown of this market would have draconian ramifications for the economy.

The Top Ten U.S. Bank Failures

From Reuters: The following is a list of the top 10 bank failures since 1934, based on the size of their assets, as reported by the Federal Deposit Insurance Corp.

1. Washington Mutual of Henderson, Nevada and Park City, Utah; seized Sept. 25 with $307 billion in assets as of June 30.

2. Continental Illinois of Chicago, collapsed in 1984 with $40.0 billion in assets.

3. First RepublicBank Corp of Dallas failed in 1988 with $32.5 billion in assets.

4. IndyMac Bank FSB of Pasadena, California, collapsed in July with assets of $32 billion.

5. The American Savings & Loan Assoc. of Stockton, California, failed in 1988 with assets of $30.2 billion.

6. Bank of New England Corp collapsed in 1991 with assets of $21.7 billion.

7. MCorp of Dallas failed in 1989 with assets of $15.6 billion.

8. Gilbraltar Savings of Simi Valley, California, collapsed in 1989 with assets of $15.1 billion.

9. First City Bancorp of Houston failed in 1988 with assets of $13.0 billion.

10. Homefed Bank FA of San Diego failed in 1992 with assets of $12.2 billion.

Another One Bits the Dust

Washington Mutual (WM) was taken over by J.P. Morgan Chase. "Regulators were hoping to fend off a collapse of WM, which, with more than $300 billion in assets, would mark by far the largest banking failure in U.S. history." Just over a year ago, WM was selling for $41, today WM closed at $.45, a decline of 99%. Oh, how the mighty fall.

J.P. Morgan will get Washington Mutual's deposits and branches. The deal isn't expected to result in a hit to FDIC, the bank-insurance deposit fund, according to a person familiar with the arrangement. However, it's likely that another arm of government would have to pick up the tab problem close to $20 billion. So what else is new!

Do Credit Institutions Really Need $700 Billion?

Robert Higgs has written an interesting and enlightening article on his blog entitled, "Credit is Flowing, Sky Is Not Falling, Don't Panic."

Bush, Bernanke, and Paulson tell us that if we don't pass the $700 billion bailout plan that bank credit will cease, and the economy will collaspe. Let's look at the facts of bank credit and see if perception and reality are one in the same. In the above article, click-on the URLs for each of the following categories, which will illustrate the growth of credit at all commercial banks:
1. Commercial and Industrial Loans
2. Consumer Loans
3. Real Estate Loans
4. Bank Credit.

By the way, Congress just passed a bill that gives the U.S. auto industry $25 billion without any questions raised from the financial media. Wow! Where is all this money going to come from? I guess we better get ready for hyperinflation, higher taxes, higher interest rates, and a lower standard of living.

How to Circumvent the Short Ban on Financial Stocks

This piece of information comes by way of the "Financial Ninja." "The short selling ban is no such thing. The ban prevents the shorting of the cash equities on the banned list. However, futures contracts were never included in this ban.

Suppose I really wanted to get short the banned financials and had the financial wherewithal, like hedge fund. How do you suppose I go about doing that? Well, quite simple really. How about I short the entire market using the S&P futures contract, and then go LONG everything I don’t want to be short via different equity baskets, ETF’s, options, and swaps. This would leave me NET SHORT ONLY THOSE VARY SAME BANNED FINANCIAL STOCKS. (Granted, this is terribly inefficient, but it works.)

How long do you suppose it took those hedge funds to figure that one out? You think just maybe they poured over their models over the weekend and tweaked them real quick?

Furthermore, option market specialists have been exempted from the ban. This means I can buy puts in quantity while the specialist then goes out and shorts cash equities to hedge his/her exposure to the puts he/her just wrote me.

So what has changed? Not much, except that it is a little more difficult and a little more complicated. Perhaps just difficult and complicated enough to keep the “Little Investor” from getting and staying short, but not nearly difficult enough for the “Professionals.” The “Little Investor” is screwed again."

There you have it. If you have the financial wherewithal, you can get completely around the ban on shorting financial stocks; and, that is exactly what is happening.

$2.5 Billion Bonus for Bankrupt Lehman's New York Staff

Failure does pay in this upside, downside financial environment. Up to 10,000 staff at the New York office of the bankrupt investment bank Lehman Brothers will share a bonus pool set aside for them that is worth $2.5 billion. And I thought you give bonuses for success, not failure. Give me a break!

Wall Street: Greed is Good

From the 1987 movie entitled, "Wall Street," Gordon Gekko spoke before the Teldar Paper Stockholder's meeting about what is wrong with America and what the solution should be to fix it.

Gordon Gekko was by no means a saint. As a matter of fact, he definitely had major ethical flaws in his character. However, his 1987 comments to the shareholders of Teldar Paper definitely resonate with many of us today in the financial community.

FASB 157 Primer

Federal Accounting Standards Board (FASB) Statement 157 requires all publicly-traded companies in the U.S. to classify their assets based on the certainty with which fair values can be calculated. This statement created three asset categories: Level 1, Level 2, and Level 3. Level 1 assets are the easiest to value accurately based on standard market-based prices and Level 3 are the most difficult. FASB 157 was passed to help investors and regulators understand how accurate a given company's asset estimates truly were.

Level 1 Assets have readily observable prices and therefore a reliable fair market value. These assets include listed stocks and bonds or any assets that have a regular “mark to market” mechanism for pricing. Publicly traded companies must classify all of their assets based on the ease that they can be valued, with Level 1 assets being the easiest.

Level 2 Assets that do not have regular market pricing, but whose fair value can be readily determined based on other values or market prices. Sometimes called “mark to model” assets, these asset values can be closely approximated using simple models and extrapolation methods using known, observable prices as parameters. Part of an overall requirement of publicly traded companies is that they are required to report to investors the makeup of their assets based on certainty of fair value calculations.

Level 3 Assets whose fair value cannot be determined by using observable measures, such as market prices or models. These assets are typically very illiquid, and fair values can only be calculated using estimates or risk-adjusted value ranges. I like this method of determining fair value assets as "mark to myth," or "mark to management's best guest," or "mark to a hope and a prayer."

Prior to the implosion of the past several weeks, Merrill Lynch stated that it's most difficult to value Level 3 assets (First Quarter of 2008). Its percentage of Level 3 assets to total shareholders' equity was 130%. Bear Stearns' percentage of Level 3 assets to total shareholders' equity was 314%. Goldman Sachs' percentage of Level 3 assets to shareholders' equity was 192%. Lehman Brothers' percentage of Level 3 assets to shareholders' equity was 171%. Morgan Stanley' percentage of Level 3 assets to shareholders' equity was 235%.

The dynamics of the past couple of months demonstrate that the financial community has forgotten what they should have learned in any basic finance course is that leverage is a "two-edged sword." It enhances profits during the expansion phase of the economy but exacerbates the overall profitability during economic downturns.

All companies must immediately disclose the dollar amount of Level 1, 2, and 3 assets to the public. I am not talking about this disclosure in the 8-Ks, 10-Q's or 10-Ks. What I am recommending is that financial service sites, such as Morningstar, Yahoo Finance, Wall Street Journal Online, Barron's Online, etc., incorporate this data when they provide balance sheet information to the public.

SEC and Financial Leverage

Want to get really mad? Up until 2003, all investment banks were allowed only 12 to 1 leverage (Equity Multiplier). If you recall from our session last week, that a leverage factor of 12 means that asset values would have to decline in value by only 8.3% to completely wipe out a firm's capital (net worth). Then in 2004, the SEC basically gave just five investment banks the ability to leverage up to 30 or even 40 to 1. At 40 to 1, asset values would only have to decline by 2.5% to completely wipe out a firms capital. Anyone want to place a bet on naming those five investment banks? They were Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sacs. (Three down and two to go)

Barry Ritholtz wrote in the Big Picture: "So while the SEC runs around reinstating short selling rules, and clueless pension fund managers mindlessly point to the wrong issue, we learn that it was the SEC who was in large part responsible for the reckless financial leverage that led to the current crisis." (Don't get me started on blaming the short sellers. Let's put the blame on where it directly belongs. That is the SEC for allowing investment banks to increase their leverage and the individuals who leveraged their companies 40 to 1 with bad investments to enhance profits.)

What the SEC has to do immediately is to have all investment banks reduce their leverage factor to the pre-2004 level of 12:1 from the current 30-40:1.

Don't Bail Them Out!

Conventional wisdom states that our government did not have a choice. It had to "bail" out FannieMae and FreddieMac, because according to this wisdom it was a natural disaster. It had to come to the rescue by pouring billions, if not trillions, of dollars at the problem. If our government did not intervene, this wisdom states our economy would suffer the consequences of another "Great Depression."

Non-traditional wisdom states that the price system through market operations should prevail, not government intervention that usurps the market's ability to determine asset values. "This wisdom states that what should have happened in 1929 is precisely what should happen now. The government should completely remove itself from the course of action and let the market reevaluate resource values. That means bankruptcies, yes. That means bank closures, yes. But these are part of the capitalistic system. They are part of the free-market economy. What is regrettable is not the readjustment process, but that the process was ever made necessary by the preceding interventions, which will make the underlying problem worse!"

The Spending Explosion: Will it ever stop?

Interesting article today in the "Wall Street Journal." From its "Review and Outlook" section, they analyze the spending debacle coming out of Washington, D.C. as promulgated by the Congressional Budget Office.

Oil Prices: WTIC (West Texas Intermediate Crude)

From the post of Monday, September 8, I illustrated the close relationship (inverse) between the dollar and oil over the past year. That is, when the dollar strengthens, oil prices weakens. The following "Point and Figure Chart" on oil, which is the type of chart I use to discern long-term price trends, reinforces that relationship. Major support has been broken significantly. The downside price objective is now currently at $96. Who would have thought back in July when oil was at $145 that we would be discussing oil under $100. And, who would have thought a few short month ago that the dollar would be one of the strongest currencies in the world. I have learned many lessons in trading stocks over my investment career, but the best "lesson learned" is to always let the market tell you what to do, rather than trying to tell the market what to do.

Fannie and Freddie: Understanding the Financial Crisis

FDIC insured banks have about 8% of capital (net worth) for their outstanding assets (equity/asset ratio), which are mostly loans. Fannie and Freddie had an equity/asset ratio of 2%. What this means is that for $50 of assets, they had debt of $49 and $1 of equity. In other words, Fannie and Freddie used a lot of debt (leverage) to purchase their assets (mortgages).

What this means is that for every $1 million in capital (net worth), Fannie and Freddie can lend out $50 million. The profit is the difference in the cost in acquiring the debt and the interest rate that Fannie and Freddie received. Let's assume that Fannie and Freddie earned 8% on its assets and had to pay 4% for its debt. The difference of 4% is its gross profit, or 4% times $50 million is $2 million. Now keep-in-mind, Fannie and Freddie had $1 million in equity but earned $2 million. Nice profit!

Of course, you have to be able to take some losses, which, of course, Fannie and Freddie were not prepared to do given the sub-prime debacle of the past year. If they had a $3 million loan go bad, they would have completed depleted their profits and wiped-out all their capital. If Fannie and Freddie were going to exist, they would have had to raise additional capital, which no one wanted to do, or sell off their assets (mortgages), which, of course, no one wanted. And that is the reason why the government intervened. The government is not calling it a "bail-out," but else would you call it.

Dollar, Gold and Oil "Price" Relationships

The relationship between the dollar (UUP) and both gold (GLD) and oil (USO) over the past two two years has been inversely related. See the following chart:

From the chart, one can observe that the peak in oil and gold corresponded to the low in the dollar in July 2008. Since then, the dollar has rallied and both oil and gold have decline. The key going forward from this point must be to track what happens to the dollar. We will definitely follow this relationship.

GDP: Growth Adjusted Upward by 3.3% for Second Quarter

The initial version for second-quarter GDP growth was an increase of 1.9%.  This growth was revised upward to a very robust 3.3%.  Should one start singing "Happy Days are Here Again?"  I for one will not start singing the chorus.  The key to the revised figure is the "GDP deflator," which is a macro inflationary statistic.  (Side Bar: The lower the deflator, the greater the growth of GDP will be.)  Now, according to this deflator (inflationary measure), inflation grew at only 1.33% during the second quarter. Does anyone believe that?  John Williams of the Shadow Government Statistics points out that the supposed 1.33% increase would represent the lowest inflation rate in five years.  Interesting that the CPI number for the same quarter was up 8%!  I guess the two computers that measure the GDP deflator and CPI numbers don't communicate with each other.  By John's calculations, the GDP would have contracted by 2.9% year-over-year.

World Oil Reserves (May 2008)

Future Price of Oil

From the following chart of West Texas Intermediate Crude Oil, what is your estimate for its price?  Explain how you arrived at your forecast.

Price of Gas: Facts and Economic Logic

Read the following article entitled, Economics 101: The Price of Gas.  Prove by using the price calculator from the Federal Reserve Bank of Minneapolis that based on just "inflation and taxes" that the price of gas today should approximate $3.28.

Based on the profit margin of major oil and gas companies in relation to other industries, why do you think that the oil companies are being singled out by the media?