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?  

How does one identify the underlying trend of the market for optimizing profits?

As of May 9, 2008, the market as measured by the S&P 500 (SPX) is currently in a major correction or bear market. In determining the market trend, the relationship between the 15-week and 40-week EMAs (Exponential Moving Averages) is a very useful investment tool. If the 15-week EMA is above the 40-week EMA, the market trend is up. Conversely, if the 15-week EMA is below the 40-week EMA, the market trend is down. Take a look at the following ten-year chart that illustrates the significance of the relationship between the 15- and 40-week EMAs:

Clearly, the 15-week EMA lies below the 40-week EMA. Therefore, from a market trend perspective, the market is in a major correction. Over the past ten years, this investment approach has been excellent. If the investor would have sold his/her S&P 500 investment in late 2000 at approximately 1,450 and then purchase it back in early 2003 at approximately 925, that investor would have eliminated a 36% lost. Purchasing at 925, early 2003, and holding the investment until January 2008, you investment return would have been 57%.

Currently, investors would be out of the market and in a money market fund or an inverse ETF, such as DOG, DXD, SDS, or QID.

It's Not Over Until It's Over

As promised from Thursday’s post, the identification of the graphs is as follows (Contrary Investor and StockCharts:

Over the twelve plus year period the 50- and 200-day EMA lines have crossed four times. Once in 1998, the 50-day EMA briefly pierced the 200-day EMA to the downside, suggesting a move into bear territory. The next cross to the downside was seen in late 2000 (dot.com debacle), warning of an equity market plunging into its largest and most extended bearish episode in many years. It was not until May of 2003 that the 50-day EMA crossed back up through the 200-day EMA. And, in January 2008, we have seen a cross to the downside. Until the 50-day EMA moves back up above the 200-day EMA, my position is to assume a defense investment position, such as being invested in a money market fund and/or inverse ETFs like DOG, SDS, DXD, and QID. Also, had one followed this very simple indicator over time, one’s financial health could have been greatly enhanced.

Double Your Pleasure or Double Your Pain

Since January 2008, my position has been that the market is either in a major correction or the start of a "Bear Market."  Therefore, I thought it was about time to revisit that position.

When it comes to the stock market, I am a trend follower, or momentum trader.  I adhere to moving averages as a technical tool to determine and identify the trend of the market, i.e., Bull Market and Bear Market.  Overtime, the 50-day EMA and 200-day EMA has been very useful in identifying the underlying trend of the market.  That is, when the 50-day EMA is above the 200-day EMA, the market trend is up.  Conversely, when the 50-day EMA is below the 200-day EMA, the trend is down.  (You may want to read some of my previous posts on the subject of moving averages.  You may find them very educational and profitable to your financial well-being.)

Referring to the above two charts, I have left off the time in terms of when the two charts were created.  Both charts are depicting that the 50-day EMA has turned up, even though it still lies beneath its 200-day EMA.  Is this a foreshadowing event of the start of a new "Bull Market?"  The market, as depicted by the S&P 500, has rallied over the past month, as indicated by one of the two above charts.

Tomorrow, I will reveal the dates and the results of the above charts.

Assurance from President Bush

Bush gives assurance that the U.S. is "on top" of the financial situation. Wow! Isn't that reassuring as the dollar plummets against the EURO and the price of gold exceeds $1,000. Thank you, President Bush. This is the same type of rhetoric that we heard a year ago about the "sub-prime mortgage" problem. Let's put the blame where it directly belongs. That is squarely on the shoulders of the Federal Reserve System.

The Impudent Boldness of Greenspan

Former Federal Reserve Chairman, Alan Greenspan, warns that we face the worst financial crisis since 1945. This is the same man whose tenure at the Fed gave us the dot.com debacle and the sub-prime debacle through his expansionary monetary policy of excess liquidity. So much for accountability, Mr. Greenspan.

Market Update

The market as measured by the 15-week EMA in relation to the 40-week EMA continues to correct. As long as the 15-week EMA lies beneath the 40-week EMA, this market correction or bear market will continue. Therefore, investors must continue to take a defensive posture during this time. Either stay very liquid (Money Market Fund), short selective securities, or purchase inverse ETFs, such as DOG, SDS, SIJ, and/or DXD.