2009-09-30

HOME WORKS (October 2009)

General Markets

All the leaves are brown and the sky is grey, make way for Rocktober! October, for better or worse, has a reputation in the trading circles. And I feel after a green September, there is a lot of pent up energy in these markets to blast off either way. The only sad aspect is that I wont be trading most of it as I will be away during bulk of October.

Anyways, the new homework page is here. The links have been updated on the site. Please remember to post your comments on this page. Also please remember to subscribe to comments via email on this page if you have been a passive follower. You can also subscribe to all comments on the site by adding http://feeds.feedburner.com/vs-trader-comments RSS feed to your favourite reader like Google reader.

The daily home work discipline is paying off good dividends. September Homework book performance (measured on 1 lot basis to capture efficiency, not absolute monetary results) has been best on record so far (4 months to speak off but hey! we just started). Click here Click here for HW Trades result so far. I strongly believe that this process which we have started has strong long term benefit to improve our trading performance and to teach us the discipline of planned emotion free trading. So even though there might not be much Homework from my side in October, please continue to make this process a success.

Happy trading.

VS

2009-09-19

The BORING BANK

Can a public sector utility bank be a solution to the banking crisis

Most articles you read on current financial crisis today point the figure of blame squarely at bankers and their greed with low respect for risk. It may or may not be 100% accurate accusation but the root of this issue points to the uncomfortable marriage of public deposits and investment banking industry. We loath banks for their greed and bonuses and at the same time we cannot function without them. This create the vicious circle where banks end up becoming too big to fail, and end up taking tax payer bailouts. If the come out stronger after bailout – they receive the wrath of anti capitalists for making money on account of tax payers and if they end up failing further, more tax payer bailouts are required as they are “too big to fail”.

Many would point to separation of Investment bank/retail bank or more and stringent regulation etc but I feel that it could be a papering over the cracks. The fact is as that as long as deposits are guaranteed by the tax payers/governments it implicitly puts a floor under a bank failing and therefore it will inevitably promote excessive risk taking as the cycle progresses and we will remain in this cycle of boom and bust.

Can there be a simpler solution?

Just as protecting the country’s borders is public sector enterprise (army/navy/air force), protecting public is public sector enterprise (police and fire brigade and in most of Europe – health care). Why can't protecting the public’s savings be a public sector enterprise. I can think of the following outline of a bare minimum “BORING BANK”

  • Ability to deposit money (branch, electronic)
  • Ability to withdraw money (branch, ATM, debit card)
  • Ability to make and receive payments (electronic, cheque, branch)
  • Ability to receive monthly account statement (postal or electronic)
  • Peace of mind on safety of money by an absolute government guarantee.

I propose that such BORING BANK can be placed in a public ownership. All the deposits to this bank would be backed by 100% guarantee of the government. A typical private sector bank uses the deposits to make further loans and that is how, using fractional reserves, they can leverage the depositors money and earn profits. And that is where the risk lies for a bank.

The BORING BANK would pay depositors interest at some discount to prevailing short term benchmark rates (which in today’s world would be close to zero if not zero).

The BORING BANK will not make any risky investments – not even overdraft facility on the deposit account, will not offer mortgages to public and will not do anything remotely similar to an investment bank. It will be a bare minimum, no frill deposit bank not even offering foreign currency transactions. The deposits will count towards borrowing by the Government.

Or in other words, deposit with BORING BANK is akin to buying a Government Bond, which anyone can do today, just that it will be much simpler with wider access and can be part of day to day life of people.

BUT, the key change after introduction of BORING BANK would be that there would not be any guarantee on deposits with private sector banks and no tax payer funded bailout. Also the regulation on the banks could become lighter and they would be allowed to take as much risk as their internal risk control (and depositors) allow.

Private Sector banks would still operate but without explicit government guarantee. They will still be able to take deposits from willing customer but in full knowledge that the deposit is not guaranteed by government. This would increase the deposit rates paid on such deposits with private sector banks. Customer would still rely on private sector for credit cards, mortgage, foreign currency transaction, insurance, investments and other risky transactions and any other borrowings the customer would need to go to such private sector banks.

I think such a move will ensure that the cost of capital for the private sector bank would move to a reasonable risk adjusted level and since private sector banks would be competing for capital, it will ensure that excessive risk taking would be curbed.

Government would be spared the huge cost and risk of providing the deposit guarantee and future bailouts. If a private sector bank fails it will be similar to any other private sector company failing.

so how much such BORING BANK will cost

I did a back of the envelope calculation

Adult population of UK who will be the likely account holder = 50,893,318

Assuming 1 employee per 1,000 account holder = 51,000 employees Appox.

Assuming average cost per employee = £100,000 per year (on generous estimate considering average household income is only £30,000)

Total Personnel Cost = £5.1 bln

Assuming all other costs = 2 * personnel cost gives TOTAL COST FOR BORING BANK = £15.3 bln per year.

I would say this is much better deal to tax payers compared to the £1.4 trln bailout money already on hook and will be money well spent. Considering that this BORING BANK is providing a bare minimum services, I am sure the cost can be much lower. Someone with experience of running a bank can comment on this aspect.

Conclusion

What I am talking is not unique. The process is already in place. If you want absolute security on your money, you have the option of buying government bonds from Debt Management Office (DMO). Just that the process is not easy for every one and cannot be used for day to day purposes. What I am proposing is a radical change to extend remit of DMO to convert into providing the services required by the BORING BANK and extend its reach to all population and at the same time remove the costly government guarantees on private sector bank.

Make no mistake, I am not calling the end of private sector banks or investment banks. I am merely asking them to operate on pure private sector basis – paying the true cost of capital for funds they play with. After that, if someone earns a bonus of £100 mln good luck to them! They deserve it.

Can this solution work? I think it can. It is not about removing competition but promoting competition. Just like we have National Health Service does not mean that private sector insurance/health care is dead in UK. And just because we have police does not mean some one with extra security requirements and money to pay for that cannot hire a private security company.

Same way with the BORING BANK, any one who needs better returns on their capital will turn towards the private sector banks with full knowledge that they are taking risk with their capital. Same way people invest in stock market or even start a business. Rest of us who just want to sleep well without worrying about their savings or unnecessary tax payer bailout wastage can leave the money in the BORING BANK.

I would like to know what you think on this and also why such an idea cannot fly?

2009-09-13

When they are only half way up they are neither up nor down!

GOLD (GC) S&P500 (ES)

goldvsnp130909 The markets are always divided into two camps, bulls and bears. The bear camp for a long time has been calling the top in the stock markets and wants to see S&P500 dropped much below the March 2009 lows whereas the bull camp is calling for bears blood. In between we have analysts who have created an alphabet soup of recovery (or expected recovery) U, V, W, L are quite common.

There is a case by bears for “Grand Super Cycle” of stock market reaching an end and a catastrophic drop coming in not so near future to take out all excesses since the Industrial Revolution. Bulls seem to discount that as “gibberish” and keep putting their faith (and money) on unstoppable expansion of global economies (barring timely set backs but not catastrophe) as human race has managed so far since the day they walked out of African plains as apes.

A minor flaw in Bear analysis is that it relies on S&P 500 as measured in US Dollar terms. This is good for few years but for longer term data, the effects of inflation, deflation and other effects starts creeping in distorting the picture. For the danger of valuing a market in a debasing currency, just look at the performance of Zimbabwe Stock Exchange. It might look great in local currency terms but would be pathetic if you take into account inflation and foreign currency terms.

A reasonable alternative would be to pay attention to S&P500/Gold ratio, assuming (and a separate discussion required on this assumption) GOLD as stable store of value. I had written a note about this subject late in March 2009 here discussing the S&P500/Gold ratio. There I posed the following questions

a) Stocks are very cheap relative to GOLD (i.e. at the level they were nearly 20 years ago) and time to buy stocks.

b) Stock have dropped like stone and there is no faith left in these pseudo measure of wealth and time to pile into "real" assets like GOLD.

c) At least one of S&P or GOLD is overvalued relative to the other and therefore an inflexion point can be in offing.

Since then the ratio has started heading up, after hitting low in March 2009 indicating a faith in Stocks (over Gold). However over longer term perspective the current trend in S&P50/GOLD ratio is down (since 2000). On Elliot Wave perspective, the 5-3 wave correction appears to be over and therefore there is a point in the case that March 2009 was indeed the longer term bottom for the stock markets (in Gold terms) and even if a severe correction is in pipe line, the current direction points to stocks outperforming GOLD for some time (until the ratio is 1.81 – 3.125 range). That could mean Gold is due a severe correction and/or stocks are due a severe ride up (at current price of Gold, it implies S&P 500 at 1810 at least – taking out its all time high).

These appear certainly “mind boggling” at current stage but just to get the perspective, imagine this analysis in 1984 when the ratio was .45 and people who were long S&P short Gold made 12.10 times return in GOLD terms. I (accidently or by good fortune) was able to ride a very small part of this curve in 2007-2008 being long GOLD, short S&P500 and still managed to do very well in that trade.

So what appears as next steps: There are the following trades:

i) Sell Gold, Buy S&P500  and put stop loss at S&P500/GOLD ratio of 0.86

ii) Buy Gold, Sell S&P500 and put stop loss at S&P500/GOLD ratio of 1.81

iii) Buy GOLD, Buy S&P500. Even in the severe down turn in stock, this trade has only lost 4% since 2000 peak.

iv) Sell Gold, Sell S&P500. This is opposite of trade iii) and therefore with inverse performance.

Like before, I still do not have a firm bias as to which trade to take but I know that there is money to be made in this trade if traded correctly. I will take a cautious position on trade ii) with some hedges built with options in case it goes against me. I would also like to do more analysis on this subject. I could only get data up to 1984. I am sure the truth is out there if I try harder to get data going back a lot further but my laziness is getting better of me. Any readers want to present a table of closing numbers for GOLD and S&P500 for years before 1984?