Secretary Paulson has spent the better half of this week in front of congress pushing forward his plan to bail out the GSE's. After watching plenty of his testimony in adamant defense of a federal blank check to back Fannie and Freddie I would just like to point out a few disturbing facts about those two organizations.
Fannie's ratio of leverage to equity is roughly 70 to 1 whereas Bear Stearns at its worst was less than 50. With that kind of leverage one can only imagine how far underwater the loan portfolios of the companies could be.
The GSE's are responsible for 80% of new mortgages in the past 6 months and 50% of all outstanding home loans in the United States. It is concerning to think of the potential ramifications if either GSE goes bankrupt or were to stop writing new business.
The government implicitly (may soon be explicitly) backs all Fannie and Freddie debt, which totals around 5 Trillion dollars. Just to put that in perspective in 200+ years as a nation we have racked up 9 Trillion in national debt and now the tax payers of today and the future will be on the hook for what will most likely be the most rapid accumulation of debt in the history of the world.
When looking at past great empires it is easy to notice a common thread in their demise, reckless imperialism financed by national debt. Now I am no forecaster but I will say that I hope the next president puts the elimination of those two at the top of his list.
Wednesday, July 16
Wednesday, July 2
"I Have Casually Returned"
I am back due to countless e-mails and popular demand (aka Bill gave me a decent suggestion to blog on a much more casual basis and I took it).
Anyway, I have recently come across a site that I deem just short of glorious for both personal and professional interest. For investing I truly believe that most fundamental equity investors significantly disregard the effects of Capitol Hill on a given company until it shows up EBIDTA. With this in mind I am currently looking into alternative energy legislation and potential recipients of government subsidies/tax breaks. Personally I find it interesting to read the few bills that make me question my voter apathy.
Andrew
Anyway, I have recently come across a site that I deem just short of glorious for both personal and professional interest. For investing I truly believe that most fundamental equity investors significantly disregard the effects of Capitol Hill on a given company until it shows up EBIDTA. With this in mind I am currently looking into alternative energy legislation and potential recipients of government subsidies/tax breaks. Personally I find it interesting to read the few bills that make me question my voter apathy.
Andrew
Sunday, April 27
How to Buy a House
Being 20 years old I have yet to have the opportunity to purchase a home, yet as I look at this housing market with a pull back in home prices and very low interest rates I am somewhat surprised to see that a majority of buyers are still holding off and instead choosing to rent while waiting for further home price declines.
The return on buying a house is a pretty intuitive equation,
The Cost of Owning – The Cost of Renting = X
Obviously if X is greater than 0 it is probably a good idea to buy. So lets run though the specifics involved in the cost of ownership.
Cost of Ownership = Mortgage Costs + Opportunity Cost of Equity + Property Tax + Home Insurance + Maintenance - Appreciation
Just for the purpose of this explanation I will use the example of a prime borrower buying a 500,00 dollar home in my hometown of San Diego. So now let’s fill in the variables:
Mortgage
As of this writing the rate for a prime 30 year fixed rate loan is 5.86%, at this rate assuming that a home buyer puts 10% down (what a concept!) he or she would have monthly payments of $2,614.16 for the next thirty years.
Cost of Ownership = 2,614.16 + Opportunity Cost of Equity + Property Tax + Home Insurance + Maintenance - Appreciation
Opportunity Cost of Equity
Dropping down that 50 grand on a house means you can’t use it to invest, I am going to assume that a home owner would earn 7% (net of taxes) over the next 30 years on his investments had he not used them as a down payment.
In 30 years that 50k would grow to 380,048.36, but because we are focused on monthly payments lets think of that return another way.
The monthly yield on a 7% APR investment is 282.71, thus by purchasing a home the buyer would be giving up that monthly cash flow.
Cost of Ownership = 2,614.16 + 282.71 + Property Tax + Home Insurance + Maintenance - Appreciation
Property Tax
Here in the wonderful tax hungry state of California property taxes in most circumstances are roughly 1.2% of the value of a newly purchased home. So for a 500,000 dollar home that means 7,000 per year in property taxes or 583.33 dollars per month.
Cost of Ownership = 2,614.16 + 282.71 + 583.33 + Home Insurance + Maintenance - Appreciation
Home insurance
Based on an informal straw poll I conducted among Southern California home owners (i.e. I called some family friends), I think 750/year (62.50/month) is a reasonable estimate for the cost of insuring a half million dollar home. This wouldn’t include earthquake insurance.
Cost of Ownership = 2,614.16 + 282.71 + 583.33 + 62.5 + Maintenance - Appreciation
Maintenance
We can also add on another 500 a year for maintenance because you never know when a pipe will burst, an appliance will fail, or when bees will choose to build a hive right outside your front door (happened to me!). Not to mention how little things can quickly add up. 500 dollars a year means 60/month.
Cost of Ownership = 2,614.16 + 282.71 + 583.33 + 62.5 + 60 - Appreciation
Rent
The cost of renting a half million dollar home is San Diego is on average 1800 per month. We won’t include things like electricity and cable because a potential buyer would be paying for that regardless of whether he chose to buy or rent.
So what does our equation look like now…
Mortgage Costs + Opportunity Cost of Equity + Property Tax + Home Insurance + Maintenance – Appreciation = Rent
2,614.16 + 282.71 + 583.33 + 62.5 + 60 – Appreciation = Cost of Rent
3602.70 – Appreciation = 1800
Appreciation = 1802.70
Now from here it is simple high school algebra, what rate of appreciation do we need in order to make the benefits of ownership equal to the benefits of renting.
So we take 1802.70/500000 to find out what monthly return on investment (i.e. house appreciation) we would need to set the costs equal. Based on the equation we would need a monthly return of .3605%. Which calculates out to be a yearly return of
(1+.3605)^12 = 4.41%
Now you may not see a 4+% return on your San Diego home next year but over the next thirty that seems like a pretty safe bet.
Obviously there are many other non financial factors to consider when buying a home, and in normal circumstances the 4.41% rate of return in Southern California is not that ridiculous given that nationwide prices tend to rise at around the rate of inflation and Southern California has tended to appreciate at an above average rate.
So right now it may seem wise to wait until the real estate turmoil clears, but I remind you of the famous words of Warren Buffet “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”, it is when everyone else panics that deals can be found.
The return on buying a house is a pretty intuitive equation,
The Cost of Owning – The Cost of Renting = X
Obviously if X is greater than 0 it is probably a good idea to buy. So lets run though the specifics involved in the cost of ownership.
Cost of Ownership = Mortgage Costs + Opportunity Cost of Equity + Property Tax + Home Insurance + Maintenance - Appreciation
Just for the purpose of this explanation I will use the example of a prime borrower buying a 500,00 dollar home in my hometown of San Diego. So now let’s fill in the variables:
Mortgage
As of this writing the rate for a prime 30 year fixed rate loan is 5.86%, at this rate assuming that a home buyer puts 10% down (what a concept!) he or she would have monthly payments of $2,614.16 for the next thirty years.
Cost of Ownership = 2,614.16 + Opportunity Cost of Equity + Property Tax + Home Insurance + Maintenance - Appreciation
Opportunity Cost of Equity
Dropping down that 50 grand on a house means you can’t use it to invest, I am going to assume that a home owner would earn 7% (net of taxes) over the next 30 years on his investments had he not used them as a down payment.
In 30 years that 50k would grow to 380,048.36, but because we are focused on monthly payments lets think of that return another way.
The monthly yield on a 7% APR investment is 282.71, thus by purchasing a home the buyer would be giving up that monthly cash flow.
Cost of Ownership = 2,614.16 + 282.71 + Property Tax + Home Insurance + Maintenance - Appreciation
Property Tax
Here in the wonderful tax hungry state of California property taxes in most circumstances are roughly 1.2% of the value of a newly purchased home. So for a 500,000 dollar home that means 7,000 per year in property taxes or 583.33 dollars per month.
Cost of Ownership = 2,614.16 + 282.71 + 583.33 + Home Insurance + Maintenance - Appreciation
Home insurance
Based on an informal straw poll I conducted among Southern California home owners (i.e. I called some family friends), I think 750/year (62.50/month) is a reasonable estimate for the cost of insuring a half million dollar home. This wouldn’t include earthquake insurance.
Cost of Ownership = 2,614.16 + 282.71 + 583.33 + 62.5 + Maintenance - Appreciation
Maintenance
We can also add on another 500 a year for maintenance because you never know when a pipe will burst, an appliance will fail, or when bees will choose to build a hive right outside your front door (happened to me!). Not to mention how little things can quickly add up. 500 dollars a year means 60/month.
Cost of Ownership = 2,614.16 + 282.71 + 583.33 + 62.5 + 60 - Appreciation
Rent
The cost of renting a half million dollar home is San Diego is on average 1800 per month. We won’t include things like electricity and cable because a potential buyer would be paying for that regardless of whether he chose to buy or rent.
So what does our equation look like now…
Mortgage Costs + Opportunity Cost of Equity + Property Tax + Home Insurance + Maintenance – Appreciation = Rent
2,614.16 + 282.71 + 583.33 + 62.5 + 60 – Appreciation = Cost of Rent
3602.70 – Appreciation = 1800
Appreciation = 1802.70
Now from here it is simple high school algebra, what rate of appreciation do we need in order to make the benefits of ownership equal to the benefits of renting.
So we take 1802.70/500000 to find out what monthly return on investment (i.e. house appreciation) we would need to set the costs equal. Based on the equation we would need a monthly return of .3605%. Which calculates out to be a yearly return of
(1+.3605)^12 = 4.41%
Now you may not see a 4+% return on your San Diego home next year but over the next thirty that seems like a pretty safe bet.
Obviously there are many other non financial factors to consider when buying a home, and in normal circumstances the 4.41% rate of return in Southern California is not that ridiculous given that nationwide prices tend to rise at around the rate of inflation and Southern California has tended to appreciate at an above average rate.
So right now it may seem wise to wait until the real estate turmoil clears, but I remind you of the famous words of Warren Buffet “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”, it is when everyone else panics that deals can be found.
Wednesday, April 23
Where has all the Volume Gone?
Monday this week we saw the markets test their January and February highs only to pull back and continue their sideways “trend”. The most notable factor in this recent sideways move has been the completely lack of volume which also means the absence of big players in the markets. When I noticed this theme a couple days ago I wasn’t completely sure what to make of it, initially I assumed it was a bearish signal but I decided to run a back test to see how these situations had played out in the past.
I designed a system that would buy if we saw a 3 percent rise in the S&P 500 over a 5 day period followed by a day in which the volume was at its lowest point in the last 30 days. The blue arrows on the chart below show examples of entry points for this system.
and here are the results:
As you can see we had rather negative short term results (2 and 3 days out) with the market lower 60% of the time during that period. One thing that did surprise me however was the high percentage of profitable trades as we moved further out in the study. This most likely means that in the past low volume days have served as a period of consolidation after the previous market move, during this time institutional investors sit on the sidelines before reentering on the next leg up.
If this test is any indication investors should be cautious near term while looking out for potential upside in the weeks ahead.
Andrew
I designed a system that would buy if we saw a 3 percent rise in the S&P 500 over a 5 day period followed by a day in which the volume was at its lowest point in the last 30 days. The blue arrows on the chart below show examples of entry points for this system.
and here are the results:
As you can see we had rather negative short term results (2 and 3 days out) with the market lower 60% of the time during that period. One thing that did surprise me however was the high percentage of profitable trades as we moved further out in the study. This most likely means that in the past low volume days have served as a period of consolidation after the previous market move, during this time institutional investors sit on the sidelines before reentering on the next leg up.
If this test is any indication investors should be cautious near term while looking out for potential upside in the weeks ahead.
Andrew
Monday, April 21
Small Cap Short Interest
Friday topped off a rather nice week for all the major indices with the DOW marking its highest point in over three months. Any time I see a decent short term rally amidst longer term downward/sideways action I begin to wonder what affect short covering had in the rally. In addition to looking at the typical metrics (breadth, net A/D, new highs/new lows) I like to run through some of the data for small cap names with high short interest. Below is spreadsheet for the 30 small cap securities that had the highest short interest as of April 1.
As you can see I have included their percent change from April 1 to April 18 as well as the overall change in short interest.
In running this screen I am looking for a couple things:
- Stocks which have seen a swift rise in price coupled with a decline in short interest. A situation like this could signal a nice re-entry point for many shorts as the weak short holders have been pushed out and buying has dried up.
Stocks to note: NTRI, SPF, CTCT
- I also look for stocks which have declined significantly with increased short interest. These stocks could be prone to strong short covering rallies if solid earnings or good news hit the stock.
Stocks to note: DSL, CROX
- Lastly I like to check for irregularities, something like CONN, where the stock has risen over 10 percent and yet the short interest is up almost 30. Again this gives us no clear indication of future direction but I would expect to see some sharp moves in the stock going forward.
Of course all of this analysis should be done in the context of both fundamental and technical analysis for any of these companies. But often times including other forms of analysis can help improve an investor’s insight into the overall direction of a security.
Andrew
As you can see I have included their percent change from April 1 to April 18 as well as the overall change in short interest.
In running this screen I am looking for a couple things:
- Stocks which have seen a swift rise in price coupled with a decline in short interest. A situation like this could signal a nice re-entry point for many shorts as the weak short holders have been pushed out and buying has dried up.
Stocks to note: NTRI, SPF, CTCT
- I also look for stocks which have declined significantly with increased short interest. These stocks could be prone to strong short covering rallies if solid earnings or good news hit the stock.
Stocks to note: DSL, CROX
- Lastly I like to check for irregularities, something like CONN, where the stock has risen over 10 percent and yet the short interest is up almost 30. Again this gives us no clear indication of future direction but I would expect to see some sharp moves in the stock going forward.
Of course all of this analysis should be done in the context of both fundamental and technical analysis for any of these companies. But often times including other forms of analysis can help improve an investor’s insight into the overall direction of a security.
Andrew
Wednesday, April 16
KBE System (Part 1)
This week the theme of correlation among banking names has once again presented itself, and as I noted in my last post I have begun programming a strategy that I believe could take advantage of these correlations and mean reverting tendencies. Here is a breakdown of my strategy as it stands:
Purpose
First and foremost I designed this strategy exclusively for short term intra day trading as a complement to my other trading strategies. For the time being I am using discretionary execution of the strategy and so far have only traded it in simulated accounts.
Setup
I first look for a defined intra day trend in the KBE etf, I choose to identify this market state with a simple two moving average crossover.
(below is the KBE chart for last Friday 4-11-2008)
I am currently using a longer 20 period SMA and a shorter 8 period SMA, these were selected because my back tests indicated those values to be efficient as a preliminary filter for trend.
I next apply Keltner channels to each of the 24 components of the KBE etf, an alert is set to notify me anytime one of the components touches a Keltner band on a strong counter trend move. At this point I am using a moving average of 5 for the center of the Keltner bands and an average true range of 2.05, again these values were selected based on my back tests and fell within a range of values that I deemed acceptable.
Entry
Once these conditions have been met I set a stop limit order at the current value of the average true range, this is done to ensure a reasonable entry price and to minimize the effects of slippage.
As the strategy develops I shall incorporate a pyramiding entry system, however for my initial testing I am limiting myself to only a one time entry.
Above is an example of two triggered signals (indicated by the red arrows) that occurred last Friday (4-11-2008), this is the same date as the KBE chart in this post so you can compare the component to the index.
In my next post in this series I will discuss my stop placements, profit targets, and position sizing.
Andrew
Purpose
First and foremost I designed this strategy exclusively for short term intra day trading as a complement to my other trading strategies. For the time being I am using discretionary execution of the strategy and so far have only traded it in simulated accounts.
Setup
I first look for a defined intra day trend in the KBE etf, I choose to identify this market state with a simple two moving average crossover.
(below is the KBE chart for last Friday 4-11-2008)
I am currently using a longer 20 period SMA and a shorter 8 period SMA, these were selected because my back tests indicated those values to be efficient as a preliminary filter for trend.
I next apply Keltner channels to each of the 24 components of the KBE etf, an alert is set to notify me anytime one of the components touches a Keltner band on a strong counter trend move. At this point I am using a moving average of 5 for the center of the Keltner bands and an average true range of 2.05, again these values were selected based on my back tests and fell within a range of values that I deemed acceptable.
Entry
Once these conditions have been met I set a stop limit order at the current value of the average true range, this is done to ensure a reasonable entry price and to minimize the effects of slippage.
As the strategy develops I shall incorporate a pyramiding entry system, however for my initial testing I am limiting myself to only a one time entry.
Above is an example of two triggered signals (indicated by the red arrows) that occurred last Friday (4-11-2008), this is the same date as the KBE chart in this post so you can compare the component to the index.
In my next post in this series I will discuss my stop placements, profit targets, and position sizing.
Andrew
Thursday, April 10
Rise or Fall the Banks Tell It All
As I mentioned in my previous post I have begun testing a basic system that I think might be able to take advantage of the herd like behavior (i.e. inter-market and intra-sector correlations) that seems to have increased significantly in recent months.
For inter-market correlations I refer you to a great post by Brett Steenbarger which discusses current inter-market themes.
As for intra-sector correlations, anyone who has been following the market the past couple months has certainly noticed that the banking industry has quickly become a very good short term metric for the health of the overall market. Not surprisingly both the volatility and severity of movement within the industry (KBE etf) has increased significantly as the index’s components get crushed on down days and spike up when we see optimism in the broader indices. I have also noticed qualitatively what seems to be a much greater correlation within the 24 components of the KBE etf along with fewer sustained countertrend divergances from the overall industry trend on an intra day basis.
above is a weekly chart of the KBE etf and the average true range over that time which illustrates the significant rise in intraday volitility.
These observations gave me the basis for the system I am currently testing. My working theory is as follows:
The current fears of CDO write downs, counterparty risk, capital ratio’s and the opacity of bank balance sheets have caused many short term investors to treat all banks as one in the same, especially during intraday sell offs and rallies. This increased correlation if valid should cause short term counter trend price movements of the etf's components to have a greater probability of reverting back to the overall trend of the etf. My intention is to identify these countertrend price movements and then enter trades (either long or short) that would profit from the reversion to the mean.
This weekend I will post some of the statistics of my findings and how I plan to identify and profit from the previously mentioned price movements.
Andrew
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