Trading Platforms & Slot Machines

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

One sure sign of the market's getting "frothy" is the number and silliness of TV commercials for on line trading from  brokerage firms.  My all time favorite is an ad aired in the late 1990s during the dot com bubble which featured a plumber driving his truck to a job and  talking about the island he had just purchased with the money he had made trading on line with a brokerage firm.  It seems that as the market rockets upwards, TV ads increase proportionately, promising easy, quick profits.  As with most advertising, this message must be taken with a grain (or tablespoon) of salt.

On line brokers tout their trading platforms and low trading costs.  The platforms offer computerized technical analysis with moving averages, volume and price charts, breaking news services and whatever other indicators a trader might want to see on the screen.  Some people make small trades and use leverage (margin loans) to increase profits.  Given the costs, many traders give most of their profits, and more, to the broker in interest expense and trading costs.

Traders have different trading periods.  Position or trend traders can hold their positions for several months to several years.  The goal is to find a stock which is trending upwards and hold onto it for the duration of the run.  A second type of trading is called swing trading (the new name for the old strategy of momentum trading) with near term time frames of several days to several weeks and intermediate terms of up to six months.  The shortest time frame is the day trade in which the trader holds a position for anywhere from several minutes up to a day.  The day trader will close out all of his or her positions at the end of the day.  They avoid losses they might  otherwise incur if their positions remained exposed to the action of after hours markets.  Markets now follow the sun and are open for trading twenty-four hours a day around the world.

The look and feel of trading screens is similar to that of slot machines with flashing lights and beeping alerts.  In my opinion, the similarity is not coincidental.  The gaming industry has spent a considerable amount of time and money determining what sort of display will keep a person feeding coins into a machine.  I believe that on line trading on your home computer and playing the slots in a casino share many characteristics, the fundamental one being that both activities are just gambling.

The Securities and  Exchange Commission has posted comments about day trading.  Their advice included several statements, two of which I will share with you:  Be prepared to suffer severe financial losses and Day trading is an extremely stressful and expensive full time job.  Granted, these are from a regulatory agency, but they should give pause to anyone interested in those supposed easy and quick profits touted by the brokerage firms.

If it were that easy and profitable, why would they share their secrets with you for just $7.95 a trade?  One advantage of slot machines - you need not pay a fee to pull the lever or hit the button.  You just drop in your coin and play.

Comments are always welcome.

If The Cook Leaves For Lunch

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

A cook who is paid for quantity not quality and does not have to eat his own cooking will probably not follow the recipe all that carefully.  A mortgage lender in the same position will have little concern for the quality of the loans being made.  This was the situation during the last years of the US housing bubble of 2001 through 2005.

Anyone who has seen Frank Capra's Christmas classic, It's a Wonderful Life, knows how a bank operates.  Back then, if a person wanted to buy a house, he or she would go to the lending institution and apply for a mortgage loan.  The banker would carefully check the applicant's credit rating, job history and stability, get an appraisal of the property and decide whether to make the loan.  The bank lent money and expected to be repaid since the lent money came from the collective deposits of the bank's customers.  The bank recycled one person's savings into another person's home loan and made money on the spread between the interest rate it paid on the savings account and the interest rate it charged for the loan.  The bank had to be conservative in its lending practices since it still had to meet the daily withdrawals of its customers regardless of the borrower's repayment of the home loan.

In 1938, late in the Depression, the government established the Federal National Mortgage Association (Fannie Mae) to stimulate the moribund economy and to support the national policy of encouraging home ownership by making it easier to get a home mortgage.  The Federal Home Loan Mortgage Corporation (Freddie Mac) was chartered in 1970 to expand the government's efforts to provide funds for home loans. These agencies would purchase billions of dollars worth of mortgage loans from lenders across the country, repackage them into pools of securitized bonds which were then sold to debt investors.  The bond proceeds would then be used to buy yet more mortgage loans from the banks.  The theory was that the availability of this money would lower the cost of home loans.  

Wall Street copied the Fannie/Freddie models and got into the mortgage backed securities game during the housing bubble years in a big way.  Earlier, Congress had passed laws to make home loans affordable for many people whose credit was not strong enough to qualify them for a home loan.  These were referred to as subprime mortgage loans which provided very low "teaser" rates of interest for the first two years before the interest rate jumped to a market rate.  This increase would almost double the rate.  Mortgage lenders offered what were called "low doc" and "no doc" loans, i.e., loans made without credit checks or other traditional lending considerations and documents.  These loans were cynically called "liar loans" since the information on the credit applications was rarely, if ever, verified.  In an effort to keep them "honest," the mortgage brokers were required to keep a small percentage of their loans on their books. Despite this exposure, most brokers saw no reason to worry about repayment and creditworthiness.  

Repackaging subprime mortgages into bonds became a huge money machine for the investment banks.  In his book, The Big Short, Michael Lewis explains how billions of dollars in fees were earned by the mortgage companies and the investment banks by recycling money between American home buyers and bond investors worldwide.  The goal was booking loans, earning fees and converting the mortgage debt into bonds for sale around the world.  With those bonds went the risk of default.  Bond buyers were lulled by Triple A credit ratings for the bonds despite the subprime quality of the mortgages backing the bonds.  The poster child for this lending orgy, according to Lewis, was the California farm worker making $14,000 per year who received a home loan of over $700,000.  The underpinning of this debt debacle was the belief that home values would continue to rise, allowing otherwise unqualified borrowers to either refinance the debt or sell the property at a profit in less than the first two years.  When the teaser rates increased after the first two years, the loans became unaffordable.  Since the mortgage brokers and investment bankers had only a fractional interest in the loans and bonds or they had laid off the risk with credit default swaps, they did not believe they would suffer any loss.  What they failed to appreciate was the fact that a even a small fractional interest in hundreds of billions of dollars is still a large number.

The results of this played out when the housing bubble burst and an unexpectedly large percentage of the loans went into default.  The other part of this perfect storm was the rapid decline in home values.  Mortgage debt exceeded the value of the collateral with the obvious result - billions of dollars in losses for the holders of the mortgage backed bonds around the world.  As the music started to slow down in 2007, several very large publicly traded mortgage companies went out of business.

Two signs that the party was truly over were the failures of the venerable Wall Street firms, Bear Stearns and Lehman Brothers in 2008.  Lehman's September 15, 2008 bankruptcy filing, considered the largest in history, foretold the credit crisis to come.  The exposure of both Bear Stearns and Lehman to the subprime mortgage market played a significant role in their failures.

Comments are always welcome.

Markets and Birds of a Different Feather (2)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

Dr. Taleb described his trading philosophy as one in which he limited his losses and left open the possibility of large gains if and when an unusual event should take place.  He complimented traders who bought options, which meant a loss was limited to the option fee paid, but which provided the trader with the opportunity to reap an out sized profit if something unexpected were to occur.  Taleb's investment strategy was to always look for a Black Swan even if he was not sure in what form it might appear.

He likened the unknown risks inherent in the strategies of many investors/traders to the dangers of inductive reasoning noted by the philosopher Bertrand Russell and symbolized by the life of a chicken.  Inductive reasoning begins with observations which lead to inferences, then to perceived patterns which lead, ultimately, to theories to address an issue or problem.  Dr. Taleb retells Russell's story from the perspective of a turkey:

Consider a turkey is fed every day.  Every feeding will firm-up the bird's belief that it is the general rule of life to be fed every day by friendly members of the human race "looking out for its best interests," as a politician would say.  On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey.  It will incur a revision of belief.

(Author's emphasis in bold)

I have heard two stories which illustrate the same point.

In the first anecdote, an individual returned from the west coast to his small Midwestern hometown after both his parents had passed away.  He had decided to live in his childhood home.  He deposited his savings in the local bank in which he had opened his first Christmas Club savings account as a child.  The very next day, the bank failed and was taken over by the Federal Deposit Insurance Corporation (FDIC).  This was his Black Swan.  The FDIC guaranties that, in the event of a bank failure, the depositors will be refunded their money (with some limitations).  Although he ultimately received his deposit back, he was heard to complain about the bank officer who had gladly taken his deposit less than twenty-four hours before the bank closed for good.

In the second one, a widow owned a small amount of stock in her local bank.  The shares had been purchased by her husband years before.  The local bank was purchased by a larger bank in the area, which in turn was purchased by a regional bank, which was itself purchased.  With stock splits, several subsequent bank mergers and a steadily rising price for her shares in the larger, publicly traded institutions along the way, she had accumulated a substantial number of shares worth a significant amount of money.  At one point, she sold enough stock to buy a new car.  The downside was that those holdings represented a fairly large percentage of her portfolio.  Aside from the car purchase, she refused to sell any more shares since the capital gains tax would have been substantial.  Things went well until the day the financial institution failed due to "accounting irregularities."  The market price of her shares dropped to less than a dollar per share within days of the public announcement that management had been "cooking the books."  Another Black Swan.

Although there are typically over a hundred bank failures throughout the US every year, there was no reason why the depositor should have anticipated the failure of a bank that had served his hometown for more than sixty years.  Given the years of increasing share price and the conflicting market proverbs to (i) let profits ride and (ii) diversify a stock portfolio, the widow saw no reason to sell shares and increase her taxes.  In the final analysis, she let the tax tail wag the investment dog.

Both stories, if true, are apocryphal examples of Black Swans.

Excerpt from The Black Swan The Impact of the Highly Improbable, Nassim Nicholas Taleb, copyright 2007, published by Random House, page 40.

Comments are always welcome.

Markets and Birds of a Different Feather (1)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

Dr. Nassim Nicholas Taleb has been described as "part literary essayist, part empiricist and part no-nonsense mathematical trader."  He received his MBA from Wharton and his PhD from the University of Paris.  He was a successful derivatives trader on Wall Street, but his real talent is as a writer.  He is most famous for his books, Fooled By Randomness, The Hidden Role of Chance in Life and in the Markets, published in 2004, and The Black Swan, The Impact of the Highly Improbable, published in 2007.  Both books, which take on conventional financial theory, are best sellers.

In his Prologue to Fooled By Randomness, Dr. Taleb, a self described Levantine (born in Lebanon), explains that his book is about luck, which is mistakenly perceived by those lucky souls as evidence of their personal skills, and about randomness  which is mistakenly seen as a surprising event which might have been, but was not, anticipated.  Something unusual (good or bad) happens in the market, shocking everyone, and market professionals immediately reach for explanations.  The response "We don't know why." is an unacceptable answer in the public media.  That would make for a fairly short television broadcast or newspaper story with a concomitant loss of advertising dollars.

Taleb criticizes economists, journalists, financial television analysts and others for refusing to acknowledge that the one-in-ten billion (or higher) possibility really can happen.  Their statistical analyses and Gaussian distribution (bell curve) charts do not take such extremely rare probabilities into account.  Although armed with reams of data based on computer analysis of vast numbers of probabilities, they do not know that they do not know.  Or, viewed more cynically, if they do know that they don't know, they won't admit it.

All swans were thought to be white until in 1697 the Dutch explorer, Willem de Vlamingh, discovered a black one in Australia.  One ugly bird destroyed a belief previously held by everyone in the ornithological world at that time.  Dr. Taleb uses the term Black Swan to identify an event with three characteristics.  First, the event is an outlier, which means that it is beyond the expectations of most, if not all, people.  It will not be revealed in a standard bell curve distribution. Second, it will have a significant effect or impact (think September 11, 2001 or the market crash of October, 1987).  Finally, it is an event in the wake of which people immediately demand an explanation.  The phrase "Sh_t Happens." is not an acceptable answer to "How could this happen?" for most on Wall Street.

One of the premises of the Black Swan is that events of this type actually happen with greater frequency than previously imagined.  It might be that, as a species, we humans need to perceive that we have order in and control over our lives.  Black Swans serve to remind us that we are not in total control, a terrifying thought for many.  The implications of this for the stock market are significant.  Taleb provides two rates of return in a single graph.  One line shows the return in the US stock market over the past fifty years.  The second one charts the return without the ten most volatile days (up or down) over that same fifty year period.  The reduction in return without those ten days is dramatic.  Individual investors should bear this in mind when formulating their investment strategies.

We will continue our look at Dr. Taleb's ideas in the next blog.

Comments are always welcome.

From Essays to Equations (2)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

Another financial author known for writing ability, not equations, is Peter L. Bernstein.  He received his degree in economics from Harvard, but is known as a financial historian.  Several of his ten books became best sellers.  In 1992 he wrote Capital Ideas - The Improbable Origins of Modern Wall Street.  In this work, he chronicled the evolution of modern investment theories.  Starting with Louis Bachelier's 1900 Doctoral dissertation, The Theory of Speculation, Bernstein traces the evolution of Bachelier's dissertation with its formulas, which was "discovered" by later economists about sixty years after its publication, into the Modern Portfolio Theory (MPT).  Using MPT and its supporting mathematical equations, investment professionals try to assemble a portfolio of assets to either maximize return at a certain level of risk or minimize risk while achieving a desired rate of return.  It should come as no surprise that the use of equations in financial investing came at the same time as computers capable of executing those complex equations became the financial weapons of choice on Wall Street.

Bernstein summarized investment by equation as follows:

There is Louis Bachelier in 1900, holed up in the Sorbonne scratching out eternal verities about the behavior of speculative markets.....Fischer Black, Myron Scholes, and Robert Merton change the whole world of finance by staring at differential equations.  Through it all, the only sound we hear is the clanking of primitive computers...The clatter of the computer and the roar of the trading floor are the sounds of a great battle in which investors compete with one another to determine who can buy at the lowest and sell at the highest....If the final product of the efforts of the financial theorists was only an assemblage of abstractions, those abstractions are the essential insights into how people do act and how people should act as they engage in the competitive battle.*

One of a growing number of critics of formulaic financial theories is the Wall Street veteran and author, Nassim Nicholas Taleb.  In his 2004 best seller, Fooled By Randomness -- The Hidden Role of Chance in Life and in the Markets, Taleb takes economists to task for their reliance on equations as follows: 

What has gone wrong with the development of economics as a science?  Answer: there was a bunch of intelligent people who felt compelled to use mathematics just to tell themselves that they were rigorous in their thinking, that theirs was a science.....Indeed the mathematics they dealt with did not work in the real world, possibly because we needed richer classes of processes -- and they refused to accept the fact that no mathematics at all was probably better.**

Criticism of computerized, equation driven investing has grown after several highly publicized investment disasters.  It has spawned a new branch of economic study called Behavioral Finance.

*  Excerpts from Capital Ideas / The Improbable  Origins of Modern Wall Street, Peter L. Bernstein, copyright 1992, published by The Free Press, a division of Macmillan, Inc., page 305.  A new edition of the book was published in 2005 by John Wiley & Sons, Inc.

**  Excerpts from Fooled by Randomness, Nassim Nicholas Taleb, copyright 2004, published by Random House, page 177.

Comments are always welcome.

From Essays to Equations (1)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

I did not study economics in school.  The books I have read on the subject since then have all been geared to people with no background in what is sometimes referred to as the "dismal science."  One of the earliest and most enduring books on economics, An Inquiry Into the Nature and Causes of the Wealth of Nations, was written by Adam Smith and first published in 1776. A Scot educated as a moral philosopher, Smith took ten years to research and write his classic.  Referred to popularly as The Wealth of Nations, the treatise is considered the foundation of many modern economic theories.  The 1,200 page book contains several tables of goods and their prices in Smith's day, but unlike many books on economics today, Wealth of Nations does not contain one mathematical equation to demonstrate the movement of money through a country's economy.

Possibly  the most studied and documented event in the history of Wall Street is the October, 1929 market crash.  It is the standard by which all other U.S. market melt downs continue to be measured.  In my opinion, the best and, certainly, the most entertaining analysis of this event is Professor John Kenneth Galbraith's work The Great Crash 1929.  It was first published in 1955 and has remained in print ever since.  Galbraith, a professor for many years at Harvard, wrote over 40 books on the subject of economics.  In his wry, self deprecating way, he attributed the long running success of The Great Crash to the fact that, every time sales of the book would slip to the point of going out of print, there would be another market bubble and subsequent drop which would rekindle public interest in the financial devastation of 1929.  I would like to share with you his analysis of why brokerage firms offered their customers margin loans, which were also referred to as "call loans" since they could be terminated or "called" at any time by the lending broker.  In describing the purpose for these loans, Professor Galbraith wrote as follows: 

The purpose is to accommodate the speculator and facilitate speculation.  But the purposes cannot be admitted.  Margin trading must be defended not on the grounds that it efficiently and ingeniously assists the speculator, but that it encourages the extra trading which changes a thin and anemic market into a thick and healthy one.  At best this is a dull by-product and a dubious one.  Wall Street, in these matters, is like a lovely and accomplished woman who must wear black cotton stockings, heavy woolen underwear, and parade her knowledge as a cook because, unhappily, her supreme accomplishment is as a harlot.*

Who would think that you could find yourself chuckling while reading a book on economic history?   With humor and insight, Galbraith lays out the events in America during the "Roaring Twenties" and their tumultuous conclusion.  Galbraith, like Adam Smith, used prose, not mathematics, to explain economic events.

Another example of a book which is an easy and enlightening read for non-economists is Yale Professor Robert J. Shiller's best seller, Irrational Exuberance.  The title is a reference to the comment of Alan Greenspan, then Chairman of the US Federal Reserve, describing the state of the stock market in 1996.  Shiller described the history of bull markets in America as follows: 

As we have noted, there have been only three great bull markets, periods of sustained and dramatic stock price increases, in the U.S. history: the bull market of the 1920s, culminating in 1929; the bull market of the 1950s and 1960s, followed by the 1973-1974 market debacle; and the bull market running from 1982 to the present.** 

His work hit the book stores in March, 2000, the month during which the last mentioned bull market hit its peak.  In a 2001 Afterword to the paperback edition of Irrational Exuberance, Professor Shiller described how, despite the severe drop in stock prices in the months following publication of his book, people still believed the market would ultimately resume its 18 year rise.  As we know, market results over the next few years proved them wrong, very wrong.

We will continue looking at economics in the next blog.

* Quote from the edition of The Great Crash 1929 by John Kenneth Galbraith published in 1997 by Houghton Mifflin Company, page 20.

** Excerpt from Shiller, Robert J.; Irrational Exuberance, copyright 2000 Robert J. Shiller, published by Princeton University Press, reprinted by permission of Princeton University Press.

Comments are always welcome.

The Risks of Debt Investing (2)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

Some Wall Street professionals devote their time to buying debt at one market interest rate and selling it at another.  They trade based on their expectation of the direction of interest rates in the short term.  Bond prices and interest rates move in opposite directions.  As we learned in the last blog, if market interest rates rise above a bond's rate, the market price of the bond will drop.  Conversely, if market interest rates drop below a bond's rate, the market price of the bond will rise.  Bond traders look for a profit in the interest rate fluctuations rates and the resulting movement of bond prices.  Although the security being traded is a bond, the profit is based on interest rates.  Another way to trade on interest rates is the purchase and sale of bond futures contracts.  This is too complicated for me to explain so I provided a link, but, obviously, it is a market strategy for professional traders, not individual investors.

So, what is an individual investor to do?  

One of the basic rules of investing is asset allocation.  This means dividing your investment portfolio into three categories, equities, debt and cash.  Conventional wisdom holds that a person should have the equivalent of three to six months of monthly wages put aside in savings for the inevitable "rainy day."  This war chest should be accumulated before a person considers any equity or debt investing.  As to the division between equities and debt, the old rule of thumb is that you deduct your age from 100.  Your age is the percentage of your portfolio to be invested in debt and the difference is put into equities.  If you are young, the majority of your investments will be in stocks.  As you age, your portfolio allocation shifts to keep the percentages of debt and equity in line with the rule.  Generally, stocks, like bond prices, and interest rates move in opposite directions in the market.  Although stocks are viewed as riskier than debt instruments, they have generated annual returns of somewhere between nine and ten percent over several decades.  If interest rates are high, in double digits, investors move into the debt market to garner these returns without the perceived risk of equities.  When interest rates are at levels below the expected returns on stocks, investors gravitate back to the stock market.

This general rule provides an answer to the question of what to do; however, it provides no answer to the question of why to do it.  Why an individual is making an investment is the most important issue to resolve before actually investing.  Since trading debt is really an interest rate game, it is probably best left to the professionals, as I said earlier.  The individual investor should view debt more as the place to put a portion of his or her money to keep it "safe" rather than as an investment with an interest return.  The fact that the money is "safe" from equity market risk is more important than the yield made on the debt.  Many people liken the stock market to a casino.  There are very few big long term winners in either.  As Kenny Rogers sang in his hit song, The Gambler, "You never count your money when you're sitting at the table."  When the stock market is on a roll and your equities are soaring, it is counter intuitive to sell some of that stock.  However, if you want to keep those gains, take some of the chips off the table.  You should put some of those profits in a place where, as my Father used to say, "Wall Street can't get it."

Savings accounts and certificates of deposit in federally insured institutions and short term US Treasuries (maturities of less than a year) are dull, pedestrian investments, but they provide the individual investor with places to put their money with little risk of principal loss.  If an individual investor wants to buy US Treasuries without incurring a brokerage fee or commission, he or she can buy from the US Treasury at Treasury Direct. 

Comments are always welcome.