The Finance Dabbler

2011...

2011-01-03T11:39:00.000-08:00

I turned out to be wonderfully lucky in 2010. All the trades I made were great, and the VXX short made me over a 100%.

Just want to jot down my thoughts for 2011.

1. Gold is gonna go down. People will book profits early in the year. My guess is a 20% decline in Q1 2011. On that note, I just shorted a bunch of DGP.

2. US Stock market will likely go up in Q1 and Q2 and then stay flat. Will need to exercise caution before getting into new positions. even though valuations, by some historic P/E measures seem very high, I think earnings are gonna be strongly positive for the year and that ratio is justified.

3. China is going to soft-land. Too many people are worried about it already. Good move by Chinese central bank in allowing the currency to appreciate. I think there are some good value buys in China, but one should exercise caution before buying them. Note to self: check cash flow statements thoroughly.

4. Heed Jim Chanos and avoid construction materials companies supplying to China.

5. Oil... is going to skyrocket.

5 reasons why we wont see a 1987 crash

2010-05-18T16:49:00.000-07:00

Everyone seems so pessimistic these days. It's almost as if the market is unsure of its own worth, and feels sinful for returning so much in 2009. The DOW is at the same place as it was a decade ago -- but that hardly tells the story.

Anyhow, the prime concern of the day seems to be that we will witness a crash-a-la-1987 very soon (in the next 2 weeks). It's sounds rather stupid to be honest. I know that I should not be offering opinions on the market, anything, literally can happen. However, let me state why I don't think it will happen. Recognize, these are the same reasons why I am bullish on America right now.

1. The 1987 came at the end of a 7 year bull market. If someone thinks that we are in a bull market, they should think again. Dividend yield on the S&P is hovering around 3.5%, much higher than the 1.5% we have seen over the last decade. Of course, in 1986, dividend yield was also 3.5%. However, dividend yields have fallen significantly over the last three decades -- partly because of a different interest rate regime, partly because of the increased use of stock buybacks- - and the last time the dividend yield was above 3% was in 1991!

2. There is so much cheap money around. Interest rates all over the world are at levels possibly never seen before. Sure we are headed for a currency crisis. But, given that people can borrow money rather cheaply, it makes equities supremely attractive.

3. Greek crisis is over stated. I simply can not connect the dots between a Greek default and a crash of the stock market. If European governments default, why on earth should stock prices suffer. IF anything, people should be selling their debt instruments. I recognize that there is an argument for contagion and that if European banks stop lending, things could turn out to be pretty bad. But, the risks are overstated. The memories of 2008 have still not faded, Governments will do anything and everything to keep the ball rolling. And people who think that this will cause the Euro to break -- well, really, the costs of breaking the currency is just too high. I don't think Governments in Europe have the political capital/will to do so. And it would be a terrible waste of resources.

4. If the case of human affairs, if you predict an outcome it changes the outcome. In other words, if everyone has prepared for something, it just won't happen. Of course, the caveat is that everyone may be thinking the same things as I am. Hence, no one is really prepared. We shall have to see. However, I think its safe to bet against the media in affairs such as this -- and the media, or rather people who get highlighted in the media, seem very gloomy about things in general. I really wonder what George Soros is thinking... Apparently he sold of some of his Gold holdings, so I guess that reduces the risk of a currency crisis, but he has also stated that "Humpty Dumpty can not be put together again". But if everyone is attending to Humpty Dumpty, he's unlikely to break under the spotlight.

5. What we are underestimating here is the strength of the Asian savings. Over the last decade Asia has saved like there's no tomorrow. Just look at the reserves. Those things will sooner or later lay claim to "real" assets of the West, rather than just paper bonds. Might be a sad day for the US dollar, but if you want to protect your wealth, equity is the best place to be in.

Oh, one final note. America is NOT Japan. The reason why Japanese equities have lagged is because return on capital vanished from the country. The marginal utility of capital in Japan is pretty much 0. The same can not be said about America. Just compare the Japanese consumer to the American consumer and you'll know why. And, in general, I think its easier for American businesses to establish footing in other countries than it is for Japanese companies (thanks to the British Empire).

Level III and VIX

2010-04-27T00:41:00.000-07:00

I started studying for Level III exams 2 weeks ago. So far I have finished just one of the books (out of 6). The material here isn't tough (so far), but its mostly new for me. It deals a lot with behavioral finance and portfolio allocation, which I hadn't studied properly in school. Because of all the new things, I am finding Level III to be a lot more interesting.

But I must say that the writers of the curriculum waste waaaay too many words. They can't seem to get to the point. There is probably a hidden purpose to the elaborate discussions other than making me want to go to sleep. But then again, I went through some of the abridged Schweser notes that people keep talking about, and didn't find them to be helpful at all.

I have about a month left to study, and at the rate I am going I probably will end up cramming.

On a separate note, I wanted to bring attention to VXX. I looked up the documentation by Barclays a month or so ago, and decided to short it to 0. I have made over 20% in a month, and I am fairly certain its gonna continue.

VXX was basically designed to mimic the Volatility Index, but the way it mimics it is kind of dodgy. It does so by trading one and two month futures, and needless to say it fails terribly. The cost of rolling over the contracts can be quite significant (5%-10% a month), and even if volatility rises sharply in a day, its highly unlikely that the 1 month future on the vix will react in the same way. The best part is that volatility is not even a real asset and the expected return on it is 0.

To be on the safe side, I have decided to not let the short exceed 20% of my portfolio. But who knows if everything starts going down, I may be forced out of my position due to a short squeeze when volatility peaks. And in the process lose my shirt.

I have read blog posts touting the virtues of VXX as a portfolio insurance. Personally, I think the writers have no clue what they are talking about. Buying the VXX is a very very inefficient way to hedge your portfolio. If you want portfolio insurance, you are likely better off shorting the VTI or buying some puts or just taking your cash/gold and putting it under the mattress.

The Hype about Natural Gas

2009-08-26T15:41:00.000-07:00

Apparently the ratio of crude oil to natural gas is at an all-time high, literally. Its perplexing to a lot of people... 100 year events usually are.

For all I know, it may well be some ghastly anomaly. But I can see some rationale for not jumping into the long-natural-gas-short-crude wagon.

To begin with, how exactly do you long natural gas? Do you store it in a cave? You could if you owned one -- you will probably need some insurance though. And you'll need to create a pipeline to your cave. More likely, you would be doing it through one of the ETFs -- which employs some trading vodoo with futures contract. However, I really doubt that the price of natural gas futures and crude futures are really as divergent. Note to self: check before you write.

Now, what if the futures prices are actually that bad? There is stil a possibility that they may not converge. Utilities and natural gas producers can predict what the demand for natural gas will be in December. Barring some extreme weather, it should be pretty pretty easy to predict. And if it is predictable, then futures prices should be reflecting that -- ok, not in theory, because then future price is just a function of interest rate, current price and storage cost.

But what happens when natural gas can not be stored anymore? The relationship above simply breaks down and future price becomes a function of expected demand and supply in the future. There are reasons to believe that this may be the case. According to the chart here.

I actually have a feeling that the price of oil and gas wont converge. In fact, natural gas prices might drop in the winter! The speculators who are entering the market now, buying natural gas futures because they are so cheap, would sell their contracts at a fire sale when they are faced with the prospect of taking delivery of natural gas. :)

Pairs trading works pretty decently, but there is always a peso risk. You cant arbitrage two things that aren't, in essence, convertible. It's not arbitrage, its speculation.

I also have one other explanation for this phenomenon. Since the price of natural gas that everyone is pumped up about is the price of US natural gas, it is entirely possible that this price is suppressed because US's energy demands are suppressed. The price of this gas depends mainly, if not entirely, on domestic demand. However, oil isnt as geographically constrained as natural gas. US demand has an impact on the price of oil surely, but its not the only country affecting the price of oil.

So if the World's demand for energy is growing at a faster rate than that of the United States, it is entirely possible that this divergence would persist for a long time to come -- and in fact, the prices could diverge even further.

Just food for thought.

-----------------------------------

Upon further discussion with my colleague, I think I should span out this doomsday scenario a bit more.

Apparently, a barrel of oil produces produces 5.8 mmBTU of energy. Natural gas contracts are in mmBTU -- so in a world where energy was just energy, one would expect the price of a oil contract to be 5.5x-6.5x the price of a gas contract. Obviously this is a rather simplistic assumption because oil is easier to store, and requires less of an instrastucture, is used in cars etc. I am just stating the number for the sake of context. Right now, the ratio is closer to 23x -- which is the highest it has been in 100 years. For December delivery the ratio is 15x -- not really as bad, but according to some it is.

Anyway, so here is the doomsday scenario:

Assuming that natural gas is really cheap for December delivery -- everyone who needs it for December would buy enough future contract today to offset their expected requirement in December. Effectively this shuts down the spot market for gas in December because there wont be any buyers. By buyers here, I mean genuine buyers -- entities that will actually use that gas, such as utilities. Might be too much of a sweeping generalisation, but its easier to explain the point.

Now, given that prices are so low, natural gas producers would be inclined to sell more volume to remain profitable. So they keep selling their futures contracts to whoever wants to buy them.

That takes care of the genuine parties. Now there is a group of speculators who want to make money from trading natural gas. Given that natural gas prices are at an all-time low, more speculators are likely to belong to the buying side of the trade than on the selling side of the trade. By speculators, I mean people who are buying futures -- not those who are in the business of storing gas from Summer to December.

In the absence of enough sellers of futures contracts, a significant amount of speculative purchases would lead to increase in prices in the short run. However, if the natural gas producers are selling futures contracts, the price could remain unchanged. Assume that the latter scenario happens.

So we are now left in a market where there is actually a mismatch between real demand and real supply. The speculators have no use for gas, but their counter-parties are gas producers who are willing to settle on their contract by actually delivering gas in December. There are no real buyers as the utilities have enough futures to satisfy their needs.

So, in December, on the on set of the freezing period -- the speculators would be rushing to close their contract. But their wont be many counterparties around. Eventually what may happen is that the natural gas companies would buy back most of these contracts -- but only at prices for which it is profitable for them to not produce.

And the natural gas prices would diverge even further from oil prices.

Not saying that it will happen, or I expect this to happen. Just that it can.

So I passed Level II

2009-08-20T01:46:00.000-07:00

I got my results yesterday, and guess what, I passed. I actually had a feeling after the exam that I would. Not at all surprised that I got less than 50% in Fixed Income -- as I hadn't taken Fixed Income classes at school. So there, no PIMCO for me.

Now I have one year to study for Level III. I have decided that I will not even think of it until after December. The exams take a mental toll, not because I study hard for them -- but because I am thinking of them most of the time. In any case, I cant seem to prepare for them until the week before the exam. And setting mental benchmarks don't help at all, I always manage to procrastinate.

I may well pass Level III next year. But the charter will probably take a bit longer. Not sure if they hand out charters for specifying the underlying mechanism behind a software.

I do have bits and pieces of rants to write about. But I feel no motivation to do it. Who really would read it? Yes, yes procrastination. It always gets to me.

Back Again

2009-07-14T20:32:00.000-07:00

I have realized that I am not very passionate about writing. While I do have a bit of a philosophical dent, writing is not my way of expressing it. In fact, "not expressing it" is probably my way of expressing it.

But I do value good writing and hope to be a good writer some day. Why? Because its a allows me to organize my thoughts, and more importantly, remember them. Thoughts like "DOW at 9644 is surreal". Well, I still think 9644 is surreal, but not exactly for the same reasons.

Anyways. Enough meandering. To update my non-existent readership:

I passed my Level I CFA exam. I honestly felt that it was a very easy exam. I studied for 80 hours and voila. I also sat for my CFA Level II in June and am waiting for my results. But that was an easy exam too. I was expecting to fail it, but now I am hopeful about actually passing it.

People make too much of a deal out of these exams. Ok, I can see how it might have been difficult had I not had finance as a major. But still.

Speaking of which, people make too much of a deal out of financial knowledge. I wont profess to have a lot of it, but I think the most important lesson in finance is common sense. And the formal curriculum just does not focus enough on it.

Take investment banking for instance: despite being touted as a hardcore financial profession, the most important skill required for banking is not financial knowledge, it is people skills. The excel models that the bankers build are just tools for negotiations. The profession boils down to people skills and showmanship: figuring out what someone wants, behaving nicely with the clients, fuzzing their brains with complex models, creating nice "books". I daresay one could be a pretty good i-banker without ever studying valuation. At the end of the day, the value really is not what the model says but what you can bargain it to be. If investment bankers really had any superior skill in valuation, they would not have to spend so much time on creating presentations and complex models.

In my humble opinion, most models have way too much assumptions built into them to be of any use than to show someone else that the banker has put some thought behind it. It builds confidence in the banker and his/her clients -- and stops others from accusing them of hasty decision making.

Consider on the other hand, Warren Buffett who can decide on an investment in 5 minutes. I am pretty sure that he does not have msft excel implanted in his brains. He doesnt spend brain power deciding whether to use weighted average cost of capital (WACC) of 5% or 6%, because he knows that its useless. And the gibberish about CAPM, he hates it.

I ll have to end here and catch some zzzzzzs. But I know what to write on next.

The Pasta Pitfall Predicament

2009-01-16T05:55:00.000-08:00

The past year has been gloomy for most investors. But the brave souls who bet on American Italian Pasta Company (AIPC) would disagree.

As you may have deduced, the company produces pasta — 300 different varieties of it. Its stock price jumped by over 350% in the last 9 months, while the S&P 500 plummeted 40%. Historically, such stunning results have been confined to companies that became overnight monopolies by virtue of research. In most cases, however, those companies did not produce pasta.

It makes one wonder whether AIPC has invented some sort of revolutionary hi-tech pasta. While an awesome concept, more likely is that investors have been gravitating towards consumer staples for fear of recession. Pasta is about the cheapest filler food Americans know – almost like the end of the line in terms of saving costs – and, should the economy continue to degenerate, more and more people would find it appetizing.

While I cannot claim to be an oracle for American dietary fad, I find the story of the superstar pasta company to be baffling. With a market capitalization of $471 million and earnings of $19 million in 2008 the price to earnings ratio for the company stands at a stellar 24. To put that into perspective, both Google (GOOG) and Kraft Foods (KFT) have P/Es of 19. Traditionally, higher P/Es have been the prerogative of companies expected to grow rapidly. Thus the ratio, in this case, would indicate investors are expecting AIPC’s growth to outpace both Google’s and Kraft’s.

And amazingly, odds are they’re correct… but only in the short term. If the recession positively affects America’s love of pasta, AIPC is well placed to be a beneficiary. The real question is whether the benefit is worth a 350% premium over last year’s price? After churning in loses of $100 million in 2005 and another $30 million in 2006, the company became profitable in 2007. Revenue growth between Sept. 2006 and Sept. 2008 was nearly 30%. What this suggests is that the company needs to maintain production above a certain level to cover its fixed costs. Once that has been achieved, its high gross profit margins allow it to pocket most revenues.

Readers will notice that AIPC’s growth has correlated with the tanking of the US housing market. However, no recession lasts indefinitely, and thus we can hardly expect AIPC to continue doubling its net income every year. In order to maintain its stellar revenue and earnings growth, the company needs to add production capacity. That does not happen overnight. Additionally, the possibility of increased US prosperity (and decreased pasta consumption) means that the management has to be careful about this option. Even if AIPC doubles its net income to $40 million in 2009, the company would find it difficult to maintain that level of profitability in the long-run. This is because the company does not operate as a monopoly — there are other pasta producers in US, including Kraft Foods, the Goliath of the food industry. Basic economics suggest that, due to competition, high margins do not last forever. Basic economics also suggests that Wal-Mart (WMT) will wrangle out every bit of margin from its suppliers. Unfortunately for AIPC, Wal-mart accounts for 23% of their sales.

To their credit, the company does have a decent operating cash flow. But a 13x price to operating cash flow is hardly impressive, especially for a company that pays no dividends and makes minimal stock buybacks. Investors could do better by holding on to corporate bonds.

AIPC tells a great story. But it is yet another stock that made its investors forget that a share is not a claim on just next year’s earnings, but on earnings forever. Unfortunately, in this story, the forever is not so thrilling.

Disclosures: None

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When leverage ends...

2008-10-06T05:37:00.000-07:00

8:37 AM (EST) I never expected to see the DOW back at 10,000. But chances are we will. Today. Asia and Europe are both down 5 percent. The DOW needs a 3.14 percent fall from Friday's closing price. The last time we were in this vicinity was in late 2003. Did America just lose half-decade of wealth creation? 3:00 PM (EST) DOW at 9644. That's it I am calling a bottom here. The nutcase Jim Cramer is up to is asking people to pull-out. Put him behind the bars, please.

Finally a blog!

2008-08-05T02:58:00.000-07:00

Yes, I made it. I have been envious of a few top bloggers for the past few days, and thought that I should try my hands on writing a blog. I guess its customary to start a blog by outlining its aims. Well, I just registered for my level I CFA exams a couple of hours ago, and thought that it might be a good idea to keep track of my progress. I also plan to use this blog to vent out my frustration on the world of finance and its quirkiness. But most importantly, I want to use this blog to keep score -- to keep track of when I am right and when I am not. I plan to write a post on Google (which closed at $463 today) and all its real options, but its rather late today. It shall have to wait till tomorrow. So Hurray world! I now have one more way to kill time.
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