R.I.S.E Student Investment Conference

Having just returned from the R.I.S.E Conference in Dayton, Ohio, I thought I would share some of the key points that were discussed. For those of you who don't know, the R.I.S.E (Redefining Investment Strategy Education) Conference is an investment forum that brings together leading students, faculty and professionals to discuss a range of topics surrounding the investment industry. However, due to the lack of pertinent issues facing today's investment professionals, the discussions were quite dry...I'm kidding...This year's conference will likely go down in history as one of the more interesting investment symposiums. Being a rookie, I didn't have much of a benchmark to compare this year's conference to, but I can assure you that I didn't leave disappointed. This year's conference drew 2,600 students from over 250 universities spanning 71 countries. It resembled a Mecca for those of us who live and breathe the financial markets. The keynote panels were moderated by Dr. Bob Froehlich who I thought did a great job of blending humor and gravity to the situation. The caliber of speakers was incredible. Speakers included Steven G. Desanctis, Chief Small Cap Strategist at Merrill Lynch, Patrick Dorsey, director of Equity Research at Morningstar, Dr. Roger W. Ferguson Jr., CEO of TIAA-CREF, Richard W. Fisher, President of the Federal Reserve Bank of Dallas, Dr. Andreas Hofert, Chief Global Economist at UBS, Dr. Roger G. Ibbotson, Chairman of Zebra Capital, Steve Liesman, Senior Economics Reporter at CNBC, John Surma, CEO of U.S. Steel and Durmus Yilmaz, the Governor of the Central Bank of the Republic of Turkey. Acting as a sponge and soaking up as much information as I could from these brilliant minds, I will now attempt to wring out the key points that were made. I will use a succinct bullet point format to outline the "raw" ideas. If anybody would like additional details on an idea please feel free to drop me a comment and I'll see if I can expand on it.

• Credit spreads and volatility still extremely dislocated
• Global governments are extraordinarily active, so we will likely avoid a depression-like scenario
• Inflation will be a possible side-effect down the line, but certainly not right now
• U.S. government will run up the public debt to historically high levels. There are three ways to deal with it: 1) Increase taxes 2) Reduce spending 3) Inflation
• As long as the velocity of money remains sluggish, inflation won't be a problem
• Watch out for protectionism!!! Protectionism is what solidified the Great Depression, so we must not make the same mistake twice. (this upcoming G20 meeting should shed some light on global trade intentions)
• U.S. dollar will likely remain the world's reserve currency simply because there is no better alternative (the Euro will have trouble becoming a reserve currency simply because of the disparity in the bond market)
• U.S. Dollar is here to stay in the short term, but may be challenged by an Asian currency in the coming decades
• A big question will be: How will fiscal and monetary authority respond to inflation down the line?
• Older people are more vulnerable to inflation due to their higher rates of savings (this will be an important issue as baby-boomers continue to age)
• In regards to the recently announced PPIP, it will be difficult to get the banks to sell into this program (why sell assets at below market value???)
• One also has to ask...after all of this selling of toxic assets, will the banks be adequately capitalized???
  
• Bigger government in the future will likely dampen growth and possibly volatility in the future
• Interesting point: The U.S. government is essentially a corporation with a weakening balance sheet that just happens to be able to borrow at 2%!
• Private sector will likely need to write-down approximately 3.5 trillion in bad debt. (back on February 22, I estimated the write-downs could amount to 3 trillion, so my estimate could prove conservative)
• Undercapitalized banks will be a tremendous headwind for the U.S. economy
• A nasty cycle: As solvent banks begin to pay back TARP money, other banks will follow suit, even if they're not necessarily ready, in order to stay competitive in the industry. These banks that aren't ready will conserve cash (i.e. not lend) in order to make the pay-back. Not good.
• U.S. consumption (9.6 trillion) represents about 20% of global economic activity, so as the U.S. consumer deleverages, the rest of the world will feel the pain
• The world is looking for a replacement for the U.S. consumer (Unfortunately our consumption patterns aren't easily replicated)
• Future economic growth will likely come from Asia and Eastern Europe because of the young demographics
• Developed country growth will likely remain sub par due to increased taxes and regulation
• Secure sources of income and growth opportunities in emerging markets will be the next focus
• Real assets (i.e. commodities) will play a crucial role once asset prices stabilize and inflation begins to take hold
• In the near future, real assets will be more appealing than "wild" financial products that got us into this mess
• Simplification will be a big theme..."know what you own and why you own it."
  
• Volatility should significantly decrease due to the halving of the Hedge Fund industry (2 trillion in assets to 1 trillion) and more limited access to leverage
  

Commercial Real Estate

Below is a visual image of the key components of GDP and how they tend to recover from a recession relative to each other. The vertical axis represents the cumulative change (100 times the natural log) and the horizontal axis represents the quarters after the beginning of a recession. The first graph displays an aggregate of the past 10 recessions. One can clearly see that, on average, residential investment has bottomed before non-residential investment. As you can see in the second graph, the current recession seems to be no exception. Residential investment collapsed well before the start of the recession, while non-residential investment only began to curtail at the end of last year. I am looking to take advantage of this pattern by shorting commercial real estate until I feel that residential real estate has initiated it's bottoming process. Many economists estimate that residential real estate will not bottom for another 6 to 12 months, leaving plenty of room on the downside for commercial real estate. The fundamentals for commercial real estate are weakening along side the economy. A recent PricewaterhouseCoopers Real Estate Investors Survey of 18 major office markets indicated that there was "too much space and too little demand." Until demand strengthens enough to sop up the excess supply, commercial real estate will likely see further price depreciation. The only way I would be able to gain "short" exposure to commercial real estate is through the UltraShort Real Estate ProShares (SRS). I usually try to stay away from the "ultra" ETFs, but this seems to be one of the only viable vehicles for this investment idea. As always, any suggestions are welcome! I would like to thank Professor Hamilton over at Econbrowser for bringing this interesting pattern to my attention. A more in-depth analysis of these components can be found at either Econbrowser or Calculated Risk.

Past 10 Recessions - Econbrowser.com

Current Recession - Econbrowser.com

Historic Equity Cycle

This is an interesting graphic provided by Jake over at econompicdata. The parameters of the equity cycle are surprisingly well defined, which leads me to believe that some sort of "irrational exuberance" is at play. I read somewhere that it typically takes around fifteen years for investors to "forget" about prior irrational decisions. An example of an irrational decision would be the equity bubble in the late 90's that paved the way for our current crisis. We are now descending the mountain (very quickly I might add) and will likely begin our climb into yet another irrational state. Could we potentially see the next bubble sometime in the 2020's?

Great interview with David Swensen (Yale University's CIO)

His approach to individual passive investment management has succeeded in the past and will likely succeed in the future. This serves as a great reminder that tactical asset allocation can be a futile game if an investor is not careful. If an investor lacks the time and interest needed to perform the necessary investment research then this extreme passive approach is likely the best alternative.

http://www.yalealumnimagazine.com/issues/2009_03/swensen.html

Interesting Trading Pattern...

The latest market conditions have brought an interesting trading pattern to my attention. After running a few back-tests, I found that this pattern has held up not only over the past couple of months, but also over the whole of 2008. Alright, so you're probably wondering what the pattern is. Well it's quite simple, and I know I'm not the first one to have researched it, however I haven't heard any mention of it over the past year or so. The pattern involves the simple behavioral tendency of retail and professional investors alike to exit, or sell, positions on a Friday (or the last day of the week, if there's a holiday) and to enter, or buy, positions on a Monday (or the first day of the week). This phenomenon recently occurred to me when I was sitting at my desk wondering whether I should enter a position before or after the weekend. Given all of the global volatility, I figured that it would make more sense to wait until Monday (just in case China decided to vacate the U.S. treasury market over the weekend : ). The underlying catalyst is simple, but the results warrant some attention. Year to date, each Monday the S&P 500 has returned an average of 1.18% compared to a -2.08% loss each Friday. This is a spread of 3.26%! Even more significant is the fact that Monday has the only positive average return out of the five trading days per week. Below I list the average year to date returns for each day of the week. Keep in mind, they may not be exactly the same day of the week due to holidays, but I just needed to get the effect of the beginning and end of each week.

Average Returns YTD:
Monday = +1.18%
Tuesday = -.30%
Wednesday = -.36%
Thursday = -.73%
Friday = -2.08%

So I continued to run this test back to the beginning of 2008 and I got similar, but not quite as astounding, results.

Average Returns (since start of 2008):
Monday = +.75%
Tuesday = -.74%
Wednesday = -.18%
Thursday = -.43%
Friday = -.54%

Another interesting finding was that 55% of the Mondays dating back to 2008 posted positive gains, which is impressive given an index that has shed half of its value over that same period of time. This figure compares to the 61% of Fridays that posted negative returns.

Remember, past performance should not be used to predict future returns, however, given the volatile times, one should not dismiss the fact that investors are looking to reduce exposure going into the weekend and re-initiate positions at the beginning of the following week. I'm sure some hedge fund could generate considerable returns by somehow leveraging this pattern, but I will simply use this data as one of my checks for entering and exiting a position. As long as nothing blows-up over the weekend, entering swing trades at the end of the day Friday might nudge the odds in your favor. As always, questions and comments are welcome!

Rally Time?

There's been a lot of talk about an impending rally in the equity markets and yesterday we finally got our first taste of positive tape. It seems to me that this rally (if it is realized) will be more of a self-fulfilling prophecy than a fundamentally sound move higher. Over the past month we've experienced a dearth of even half-decent economic data, so the oversold level may have been breached. As in all bear markets, there will be rallies. We rallied after the Bear Stearn's "capitulation," we then rallied over 20% through the new year and it looks as though we're due for another rally in the near future. The only factor that these rallies have in common is the fact that they each succeeded in making new lows after the subsequent rallies. I wouldn't be surprised if we see another 20%+ rally, but be prepared for market participants to take advantage of a prime selling opportunity. Until there is sound fundamental improvement in the underlying economy, a significant rally will not be sustained (see leading economic indicators). Remember, with over $4 trillion on the sidelines, rallies are inevitable, but there will only be one bottom. Below is a rather depressing chart (no pun intended). I am not saying we're entering the next Great Depression, but this chart just goes to show how many false starts there can be before the engine finally gets going.

Mark to Market vs. Mark to Model

There's been a lot of talk recently about how "mark to market" accounting is "forcing" financial institutions to write-down assets at fire-sale prices. Mark to market accounting requires that firms value their assets in accordance with current market prices, even if that means pennies on the dollar. Since the beginning of this crisis, the market for mortgage backed securities and the like has literally dried up, forcing firms to take massive losses on these illiquid instruments. Some say that "mark to market" should be suspended for a given period of time and replaced by the so called "mark to model." Mark to model is a form of "accounting" that allows the firm to price their assets based on internal assumptions or models. If I remember correctly, these models that priced these mortgage backed securities over the last five years were using inputs like double-digit real estate growth in the form of a perpetuity. This is known as severe modeling error! In my opinion, until we find a better alternative to "mark to market," we should let the free market system adjust instead of interfering and creating yet another mess. Again, this is a very controversial topic so any comments are welcome.

By the way, I'll be out of town the next few days, but should be back in business by early next week. When six feet of snow falls in less than 36 hours you just can't pass it up!

S&P 500 Poll

Thanks to everybody who took the time to vote in the most recent poll (located in the right hand column). The results (see below), as negative as they are, are about right in line with current market sentiment. So that leaves us with the million dollar question..."Where will the S&P 500 be on January 1, 2010?" There are a lot of estimates out there, most of which are higher than the current value, so how do we determine which estimate is correct? In my opinion, you'd have much better luck going to Vegas than trying to predict the value of the S&P 500 at years-end, however, there are a few ways that you can "nudge" the odds in your favor. An approach that I have been experimenting with uses a conditional probability model to forecast a "very rough" year-end estimate (link to Excel listed below). As of recently, there's been quite a bit of talk about a potential depression (assume dep'n = 10% unemployment, -10% GDP growth). Using a probability model, I can ask myself, "What is the probability of a depression?" and alternatively, "What is the probability of a Deep Recession?". By the way, I'm assuming we are already in the midst of a deep recession. As you can see from my model, P(depression) = .15 and P(remaining in a deep recession) = .85. For each scenario (recession and depression), I then predict an optimistic value and a pessimistic value given the prior outcome. For example, given a deep recession (85% chance), I came up with an optimistic value of 900 on the S&P by year-end and a pessimistic value of 750 (values are completely based on your outlook). Using probabilities, I can estimate the chance of the index reaching the optimistic value versus the index reaching the pessimistic value (by the way, we are assuming that these scenarios are mutually exclusive and exhaustive, so probabilities must sum to 1). Once you have your values and your probabilities, you can then just take the weighted average using your probabilities as your weights. The math will make more sense once you view the embedded equations. I encourage you to plug your own estimates into my model and see what you come up with. Just remember...this is a VERY rough estimate, but for a guy who enjoyed stats class, it serves as a basic tool for linking an economic forecast to a logical estimate for the S&P 500. As always, any comments or critiques are welcome.

Poll Results:

>1100 (33.3%)
900 (0%)
700 (66.6%)
<500 (0%)

To download the Excel file, please visit the link below and click on the Download tab located at the top, then choose Microsoft Excel.
http://www.scribd.com/doc/12966663/Conditional-Probability

Interesting article on spending...

http://news.goldseek.com/RonPaul/1236025831.php (courtesy of Brian Belcher)