World Markets 101

Have we bottomed?

The market’s recent bounce has caused many to question whether or not the U.S. markets have bottomed.  Trying to indentify bottoms is difficult, but one tool I like to use is something that I like to call the “Fear Index”.  It is a simple calculation I created to try to indentify fear in the markets.  I want to buy stocks when other people are selling simply because they are scared of some potential event. 

The Fear Index is created by multiplying equity put/call ratios by the volatility index, pretty simple.  Equity put call ratios represent the number of equity puts being bought relative to the number of equity calls being bought on a given day.  For those of you who are not option savvy, a put enables a holder to profit from falling equity prices and a call enables a holder to profit from rises equity prices.  The volatility index represents the markets expectation of volatility over the next 30 days.  So if people think the market will go down fast in the near term, puts will be high relative to calls and implied volatility will be high as well. 

Looking at the chart I created, I’ve highlighted the three largest spikes since October 2003.  As you can see, the market has gained over 10% several months after the spike and each time it has represented at least a short term bottom.  The largest spike during this time period was in mid-March following the failure of Bear Stearns, which many thought was the bottom, until it wasn’t.  You’ll notice that the most recent bounce is not coming off a spectacular amount of fear, in fact we’ve been to these levels several times before in the last six months.  So while many may think this has been the bottom, it may just another bear market bounce. 

Become a Billionaire in a Day

That’s right, with the introduction of the new $100 billion Zimbabwe bank note we can all call ourselves billionaires; one U.S. dollar can be exchanged for a new $100 billion Zimbabwe bank note.  Mind you that a loaf of bread in Zimbabwe will set you back $2 billion dollars, a gallon of milk will cost you $12 billion dollars, and how about 30 eggs? Try $45 billion dollars. With the amount of money Zimbabweans pay for a loaf of bread, just ten years ago, they would have been able to purchase 12 new cars. 

The last inflation report, which was in February, pegged inflation at 165,000 percent, but independent estimates put the real figure closer to 4 million percent.  Many calculators can’t be used to calculate simple transactions in Zimbabwe because of the shier number of zeros.  The country is the only country in the world that routinely carries out transactions in the quadrillions (1 quadrillion = 1,000,000,000,000,000).

Several factors are to blame for the soaring inflation; large unbudgeted payments to the veterans of the war liberation, the country’s military intervention in the Democratic Republic of the Congo, and a land reform program that began in 2000.  Up until 2000, agriculture was the country’s leading economic activity, but a program designed to dispossess white commercial farmers of their land for the resettlement of blacks without land, caused the entire agriculture industry to collapse. The new land owners have failed to maintain production due to lack of capital for materials, lack of farming knowledge and multiple droughts.  The devaluation of their currency has made imports more expensive.  Analysts say the only way for the country to get back on its feet is to begin producing at full capacity and to do that they need a political change.

Could the inflation in the U.S. get as bad as the inflation in Zimbabwe?  Fortunately for us that scenario would be highly unlikely, but if I am wrong, you can sue me, and I will gladly pay you $100 billion dollars.

When the Unthinkable Happens

This article is in response to the many questions I have received regarding bank failures and money market funds.

FDIC Insured Banks

When a bank fails, the bank charter is transferred to the FDIC, then the FDIC works to carve out problem loans and works with the failed bank until the bank is sold to an acquirer.  Accounts held at insured banking institutions are covered up to $100,000 per account holder (includes CD’s, savings, money market accounts and checking accounts).  The FDIC does not guarantee coverage above this amount, but at IndyMac the FDIC has said it will cover 50% of the amounts held over $100,000.  Retirement accounts at insured banking institutions are covered up to $250,000.

Customers have access to the insured amounts, but are not able to gain access to uninsured balances. At this point, customers with excess balances are creditors to the bank; as the FDIC sells off assets, periodic payments are made to the creditors.  The good news for depositors is that they are at the top tier to receive payments from asset sales.  On average customers receive .72c on excess balances after all assets are sold from the failed bank. 

www.fdic.gov

SIPC Insured Brokerages

SIPC is the first line of defense in the event that a brokerage fails as a result of bankruptcy or financial difficulty.  SIPC works to return cash, stocks and securities to investors as quickly as possible. Ineligible investments from the SIPC are commodity futures contracts and currency, as well as investment contracts.  Customers of a failed brokerage get back all of the securities that are registered in their name.  If sufficient funds are not available in the firm’s customer accounts to satisfy claims, the reserve funds of SIPC are used to supplement the distribution, up to a ceiling of $500,000 per customer.  Many brokerages supplement this amount with additional coverage through insurance companies like Lloyd’s of London.

www.sipc.org

Money Market Funds

Money market funds are not FDIC insured and can fall below NAV (net asset value).  Typically only the yields will move up and down based on the holdings.  I’ll give you an example of what would happen if a money market fell below a $1.00 NAV per share. Let’s say you put $10,000 into a money market fund and the NAV is the $1.00 industry standard.  So you’ve got $10,000 in your money market fund and you will receive some rate of interest on this balance.  Now let’s say you decide to pull the money out six months later (maybe the economy is collapsing), but the NAV is now .95c, which would mean in this case you would only get back $9500 (.95c*$10,000) plus the accumulated interest on the principal. 

Money market funds are required by law to invest in low risk securities such as CD’s, government securities, commercial paper and other highly liquid low risk investments.  As a result money market funds are thought of being as safe as cash.  Since the credit crisis began, assets in money market funds have swelled to $3.5 trillion an increase of 35% since the same time last year. 

You may be surprised to learn that financial companies have spent $10 billion in the last year trying to ensure their money funds don’t “break the buck”.   Legg Mason, Bank of America and Credit Suisse have all spent over $2 billion a piece bailing out their funds.  You may be wondering why they don’t just pass along the losses to investors given that there are no guarantees?  The reason is simple, investors will flee any financial institution that “breaks the buck” and that would be devastating to the bank. 

The last time a financial institution “broke the buck” was in 1994, when a small institutional fund was liquidated at a .96c per share NAV.  This is largely as a result of the 2a-7 rule, which was amended in 1991 to make money market investing a safer place. 

A Decade of Investing and Nothing to Show for it

Had you invested in the S&P on July 20, 1998, by 10 AM on July 15, 2008, one decade later, you would have made (drum roll please), nine points, that’s right, not ninety, not nine hundred, but nine points, a 0% return essentially. At least we’ve got our dividends, right? Wrong, since the late eighties the average dividend yield on the S&P has been less than 3%, so that covers inflation, maybe.

So what happened to the old saying “stocks return 10% a year on average over the long run”? Was a decade not quite long enough? Investment professionals love to quote the long run returns, but somehow buried deep in their paperwork they always work in the caveat “past returns don’t predict future results.”

This past decade highlights the importance of creating a diversified portfolio and reallocating consistently over a defined period of time to maintain the original allocation percentages. This decade has seen its share of booms and busts, had a portfolio been reallocated, say every six months, much of the gains in the respective areas would have been captured. I’ll give you a simple example, a portfolio has a 50% weighting in stocks and bonds, as the markets climbed in 2000, the 50% weighting in stocks would have grown to a larger percentage of the overall portfolio. By simply reallocating the portfolio to stick to the defined allocation percentages, these gains would have been realized and you would have something to show for your decade of investing.

Google and Microsoft Sink the Nasdaq Afterhours

Google and Microsoft worked together afterhours to erase $28 billion in shareholder wealth by posting weaker than expected 4^th quarter earnings. 

The number of paid clicks fell at Google for the first time ever as the company missed estimates by 11c, the resulting $40 drop wiped out over $13 billion in shareholder wealth.  The company said it has cut back on hiring; Google hired just 358 people in the most recent quarter compared to a 3 year quarterly average of 1200 people.  Google went so far as bringing in their chief economist to talk about the sluggishness in the economy and how it has affected the company’s results.  Over half of Google’s revenue now comes from outside the United States, which has helped the company somewhat avoid the slowdown in the U.S. economy.   

Microsoft missed their estimates by a penny and reduced their 2009 estimates to reflect higher operating expenses within their online businesses causing their shares to fall 6% in after hours trading.  Their online unit has been eating up significant amounts of cash trying (the keyword here is “trying”) to compete against Google.  The bright spots of the report were Vista sales and server software, both of which saw double digit increases.

Wells Fargo Pulls a Rabbit Out of the Hat

Bank stocks had their best day in 16 years today as Wells Fargo announced better than expected earnings and in a shocking move, raised their dividend. Many had expected the bank to report much higher than expected losses, ignoring the fact that Warren Buffet had recently added to his position in Wells and that the Chairman of the company had purchased over 40,000 shares in early June.

My Biggest Worry; People are Getting Worried

The collapse of Bear Stearns and IndyMac highlight the destruction that a crisis of confidence can cause at a bank.  I worry that this could happen again to any of the well known “on the edge” banks whose stock prices keep plummeting.   This could cause a snowball effect as customers get burned, confidence erodes and people begin to question our banking system and the leverage that is used these days. 

Bank failures have occurred typically in the same fashion throughout history; a bank wants to grow fast, which is done by taking on more risk, usually some major assumptions are made that are proved wrong over time and once they are proved wrong, investors and customers lose confidence and all flee at once causing the bank to become quickly insolvent.  I don’t mean to sound all gloom and doomy, I’m not that guy, but I think it is a risk worth highlighting, especially on the day after the Federal Reserve told financial institutions they are done with the “bailouts”.

In case you’ve always wondered how a bank works, I’ll break it down in the simple terms so that you can see just how much a banking relationship relies on trust.  Here is how it works; you deposit money into your bank and maybe earn interest on your balance, then the bank uses a multiple against your cash to loan out more money than you deposited at higher interest rates than you are receiving, not a bad deal.  Despite the inherit risk of the model; most of us have total trust in our financial institutions to give us back our cash when we need it.

Ironically, I bought a book for one cent just two years ago, during the times when the private equity guys were the smartest in the room, bank leverage didn’t matter, anyone could get a loan, house prices only went up and exotic mortgage loans were all the rage, ironically that book, called “Belly Up; The Collapse of the Penn Square Bank” was left on the shelf, as a piece of forgotten history, how quickly we forget.

Sub-Prime Slide Show

Hilarious slide show on sub-prime and how the credit crisis began, using stick figures, you've got to check it out.
The slideshow

Fannie and Freddie not Feeling so Well

Fannie Mae and Freddie Mac have been vomiting investors all week, each hit fresh 52 week lows today on news that the government could take over the companies and wipe out the value of their equity completely; scary thought if you are a shareholder. One of my favorite gurus, Jim Rogers, has been short the shares for quite sometime. Freddie hit a low today of $3.89 off $63 from their year high, not a bad return if you were short.

The U.S. Federal Reserve is considering allowing Fannie and Freddie to borrow directly from the central bank in an effort to help with potential capital shortages. Fannie raises money by selling bonds, then loans those funds as mortgages and keeps the spread on the interest rates. As a result of this structure, sharp moves in interest rates could cause Fannie to lose a substantial amount of capital very quickly.

It is almost unimaginable how leveraged Fannie Mae is; for every $1 in equity capital they have $50 in debt capital, which works fine as long as things go as planned. Many financials like Fannie rely on massive computer models to manage risk. One wrong turn and their entire equity could be wiped out.

Don’t be misled into thinking that these two companies will cease operations; the government would not let that happen, it would be catastrophic for the U.S. economy. Fannie and Freddie are the largest buyers of home loans in the nation; they provide the liquidity for the U.S. housing market. Worst case scenario, the government would bail them out with our tax dollars. It’s nice to know that our government allows companies to operate recklessly at the will of our tax dollars, thanks!

Third Largest Bank Failure in U.S. History

Today, after the market closed, mortgage lender IndyMac Bancorp was seized by U.S. banking regulators.  IndyMac is a thrift/mortgage bank that provides mortgage products and services in the United States.  Angelo Mozilo co-founded the company; his name may be familiar to you because he also was a founder of Countrywide financial, another over-leveraged bank that loaned money to anyone.  IndyMac specialized in adjustable rate mortgages, low doc loans and subprime loans; the heart of the credit crisis.  IndyMac was experiencing a modern day run on the bank and it had become apparent that being 100% invested in the mortgage market with no capital was probably not going to work out so well.

The cost to the Federal Deposit insurance fund, which currently holds approximately $53 billion in assets, is estimated to be between $4 and $8 billion.  The FDIC will insure up to $100,000 per regular account at a qualified institution.  According to Reuters, at the time of closing, IndyMac had about $1 billion in potentially unsecured deposits.