Implied Markets — House Elections
Posted by Eddy Elfenbein on October 10th, 2010 at 8:39 pm

One of the topics in finance I find most fascinating is implied prices. This is when we take the prices of two or more assets and use them to find an “implied” price for another asset.

For example, that’s what the VIX is all about—implied volatility. In the options pricing model, volatility is one of the variables. So what we can do is take the current market price of an index option and work backward to see what number the market has given to the volatility variable.

I’ve noticed that we can also find some implied prices in futures markets on current events listed at Intrade. (Note: This is not — repeat, not — a political post. It’s about implied markets.)

Here’s an example. The current price for the Republicans to win control of Congress is 78.2. That’s a gain of 40 seats. There’s another contract for the Republicans to gain 50 seats. The latest price for that contract is 52.0. (Second note: I don’t take these markets too seriously. I simply see them as entertainment.)

A 78.2% probability translates to +0.779 standard deviations above the mean (that’s NORMSINV in Excel). A 52% probability translates to +0.050 standard deviations above the mean. The difference between those must be 10 seats, so one full implied standard deviation works out to 13.7 seats.

From there we can see that the mean is a gain of 50.7 seats. With the GOP currently holding 178 seats, the market therefore currently expects the GOP to hold 228.7 seats after the election.

I downloaded the historical numbers and here’s what the market’s implied outcome is for the election. The black line is 218 which is a majority. The blue line is the implied mean for the GOP. The red line is one standard deviation above the mean and the green line is one standard deviation below.

Remembrance of Stocks Past
Posted by Eddy Elfenbein on October 10th, 2010 at 3:57 pm

One of my rules of investing is: “Never worry about what stocks do after you’ve sold them.” The stocks aren’t thinking of you, so why should you think of them? That’s a wise rule. Nevertheless, I’m ignoring it for the moment.

Each year, I add and delete five stocks to my 20-stock Buy List. As it turns out, the stocks I removed from the Buy List at the beginning of this year have done far better than their replacements.

Here are the five new stocks:

Here are the five stocks I cut:

Even though I limit myself to changing the portfolio by 25% just once per year, even that was too much. If I had made no changes at all, the Buy List would be up 11.59% instead of 6.97%.

OK, I’m going back to enforcing my rule. If anyone needs me, I’ll be pretending CTSH isn’t up 41% YTD.

Gold Model — Reader Response
Posted by Eddy Elfenbein on October 9th, 2010 at 4:50 pm

Here’s a thoughtful email I received in response to my gold model:

I read your piece on your gold model and thought it was very good – really dead on. I think, however, you have the relationship somewhat backwards on two counts.

First, the dollar derives its value from its relationship to gold. So instead of the dollar price of an ounce of gold, it should be thought of as the gold price of a single dollar. (For instance, the current of gold price of single US dollar is presently about 1/1345th of an ounce of gold)

Second, on this basis, the relationship is somewhat clearer: when the purchasing power of an ounce of gold rises (i.e., when an ounce of gold commands more dollars) interest rates will be low; and, when the purchasing power of a an ounce of gold falls (i.e., when gold commands fewer dollars the interest rate will be high.

In the days of the gold standard, this meant when prices, denominated in gold backed money, fell, interest rates fell – for instance, during periods of depressions. This would also be the period when the purchasing power of gold backed money was at its highest.

When prices, denominated in gold backed money rose, interest rates also rose – for instances during periods of rapid expansion. This would have been the period when the purchasing power of gold backed money was at its lowest.

Under the gold standard, the purchasing power of money fell during expansions, or what is the same thing, prices rose. And, interest rates rose with prices. The purchasing power of money rose during depressions, or what is the same thing, prices fell. And interest rates fell with prices.

So, what you have shown is that the Gibson Paradox continues to work even in the absence of gold backed money. It did not disappear. It expresses itself through national currencies and thus reveal the underlying state of the real economy through this operation.

When the “dollar price” of gold is rising, it is likely that we are in a depression in the real economy. Hence, real interest rates should be at their lowest. And, when the “dollar price” of gold is falling, it is likely we are in a period of expansion. Hence, interest rates should be at their highest.

Both the movement of gold prices and interest rates are determined by the expansion or contraction of the real economy, and by an inverse relation between them. When the real economy is expanding, gold prices will fall and interest rates will be higher. When the real economy is contracting, gold prices will rise, and interest rates will be lower.

What rising gold prices are telling us today, and for the last decade, is that we are in a depression in the real economy – one that has lasted about a decade at present, and shows no signs of ending as yet. Layered over this real economy depression has been two monetary recessions – the first in 2001, and the present one; with, one period of monetary expansion between them.

Ella Fitzgerald – Summertime
Posted by Eddy Elfenbein on October 8th, 2010 at 9:02 pm

Taleb Says Investors Should Sue Nobel for Crisis
Posted by Eddy Elfenbein on October 8th, 2010 at 2:45 pm

I’ve long argued that Nassim Nicholas Taleb is a crackpot and that his books are subliterate garbage. I’ve felt like I’ve been in a tiny minority, but slowly, it seems like others are finally catching on.

Nassim Nicholas Taleb, author of “The Black Swan,” said investors who lost money in the financial crisis should sue the Swedish Central Bank for awarding the Nobel Prize to economists whose theories he said brought down the global economy.

“I want to make the Nobel accountable,” Taleb said today in an interview in London. “Citizens should sue if they lost their job or business owing to the breakdown in the financial system.”

Taleb said that the Nobel Prize for Economics has conferred legitimacy on risk models that caused investors’ losses and taxpayer-funded bailouts. Sweden’s central bank will announce the winner of this year’s award on Oct. 11.

Taleb singled out the Nobel award to Harry Markowitz, Merton Miller and William Sharpe in 1990 for their work on portfolio theory and asset-pricing models.

“People are using Sharpe theory that vastly underestimates the risks they’re taking and overexposes them to equities,” Taleb said. “I’m not blaming them for coming up with the idea, but I’m blaming the Nobel for giving them legitimacy. No one would have taken Markowitz seriously without the Nobel stamp.”

Sharpe, a professor of finance, emeritus, at the Graduate School of Business at Stanford University, and Markowitz, a professor of finance at the Rady School of Management at the University of California, San Diego, didn’t return phone calls seeking comment. Miller, who was a professor at the University of Chicago, died in 2000 at the age of 77.

In his 2007 bestseller “The Black Swan: The Impact of the Highly Improbable,” Taleb described how unforeseen events can roil markets. He warned that bankers were relying too much on probability models and disregarding the potential for unexpected catastrophes.

‘I Will’

“If no one else sues them, I will,” said Taleb, who declined to say where or on what basis a lawsuit could be brought. (Well done Bloomberg, well done – Eddy)

The Nobel prizes in physics, chemistry, medicine, peace and literature were established in the will of Alfred Nobel, the Swedish inventor of dynamite who died in 1896. The first awards were handed out 1901. The Swedish Central Bank founded the economics award in 1968 in memory of Nobel. Previous winners of that prize include Milton Friedman, Amartya Sen, Paul Krugman, Robert Merton and Myron Scholes.

A former derivatives trader, Taleb is a professor of risk engineering at New York University and advises Universa Investments LP, a Santa Monica, California-based fund that bets on extreme market moves.

What a peerless buffoon he is.

Dow Breaks 11,000
Posted by Eddy Elfenbein on October 8th, 2010 at 12:16 pm

This headline also could have worked on May 3, 1999. At the time, gold was at $285.

95,000 Jobs Go Bye-Bye Last Month
Posted by Eddy Elfenbein on October 8th, 2010 at 10:16 am

The economy lost 95,000 jobs last month. Unemployment held steady at 9.6%. The real jobless rate, however, jumped to 17.1%.

The steep drop was far worse than economists had been predicting. Most estimates expected a loss of only a few thousand jobs.

“September’s U.S. payroll report adds to the evidence that the recovery is losing what little forward momentum it had,” said Paul Ashworth, senior United States economist at Capital Economics.

While total government jobs fell by 159,000, private sector companies added 64,000 jobs last month. The unemployment rate, which measures the percentage of workers who are actively looking for but unable to find jobs, stayed flat at 9.6 percent.

A broader measure of unemployment, which includes people who are working part-time because they cannot find full-time jobs and people who have given up looking for work, rose to 17.1 percent from 16.7 percent in August.

Of the loss in government jobs, 77,000 were temporary Census Bureau employees while 76,000 worked for local governments. State governments lost 7,000 jobs, as well.

Splitting out the decimals, the unemployment rate dropped from from 9.642% to 9.579%.

Morning News: October 8, 2010
Posted by Eddy Elfenbein on October 8th, 2010 at 7:47 am

Prepper Mania: Retail Behemoth Costco Offers Survival Food Packages

Universal Travel Group: The Auditor Resigns Edition

Told Ya So: The Currency Volume Bubble in Full Bloom

How Speed Traders Are Changing Wall Street

Gold Hits Our $1350 Target; Now What?

Summary of Third Quarter EPS for S&P 500 Stocks by Sectors

Wall Street Futures Mixed Ahead of Jobs Report

UAE Says BlackBerry Dispute Resolved Before Deadline

Technology Replaces Banks as Better Dividend Bet for Investors

Japan’s Cabinet OKs $61 Billion Economic Stimulus

U.S. Companies Buy Back Stock in Droves as they Hold Record Levels of Cash

CHiPs Star Charged by SEC for Kickback Scheme

In Tarpum Memoriam
Posted by Eddy Elfenbein on October 8th, 2010 at 12:07 am

Now that the spigot phase of TARP has come to an end, Felix Salmon has some wise words. Personally, I have conflicting feelings about TARP. It was an awful thing to do and I hate, hate, hate how it was done, but ultimately…yes…it was necessary and the right thing to do.

Felix writes:

TARP might have arrested the global panic for long enough that Bernanke’s policies had time to start working, but that’s about it.

That’s about it? I think that was TARP’s most important accomplishment—it gave us time. The ballgame changed once people knew there was some sort of backstop even if it was a dysfunctional one.

Let’s take a step back and remember that it wasn’t until 30 years after the Great Depression that Milton Friedman untangled what really happened. Policy makers have to move a lot faster than that. To paraphrase Donald Rumsfeld, you save the banking system with the policy makers you have.

The key yardstick to measure the effectiveness of the TARP program is, in my opinion, the TED spread—and make no mistake, that improved dramatically. Yes, I fully understand that the improved TED spread may have simply correlated with TARP and not have been caused by it. I get that.

The problem is that we don’t have a petri dish to run the economy through 5,000 different scenarios. Perhaps at some point in the distant future, some young economist will put all the pieces together and conclude that TARP was a terrible mistake. Until that happens, I see TARP as being 1 for 1.

I’m surprised at much of the outrage that people have about TARP. Not that it isn’t outrageous, but what the hell did they expect? When the market crashes, why do we expect policy makers to behave more reasonably? Of course they’re going to be craven and inefficient! That’s why they’re policy makers.

Felix blames TARP for “generating a broad-based mistrust of institutions: the government and the financial-services industry certainly, and the judicial system possibly as well.” Well…in my book, that’s a good thing.

The most recent estimate is that TARP will cost the taxpayers $29 billion. Let’s remember that last year, Goldman Sachs (GS) paid taxes of $6.4 billon, plus they kicked in another $2.5 billion so far this year. Should that be included in TARP costs? I don’t know; maybe, maybe not. But I do know that Goldman and many other banks are still in business, employing people and paying taxes. Without TARP, it’s quite possible they wouldn’t be.

In the end, I hope we never, ever have to do another TARP. But I’m pretty sure that my hopes won’t be the deciding factor.

When Is the Best Time of Day to Buy Stocks?
Posted by Eddy Elfenbein on October 7th, 2010 at 4:43 pm

Here’s a quick quiz for all investors: What’s the best time of day to buy stocks?

Ha! It’s a trick question, the best time isn’t during the day. Believe it or not, the stock market, in aggregate, has done horribly during the trading day over the past 18 years.

This is one of the most stunning statistics about investing: the market’s entire gain—and then some—has come when the exchange is closed (the difference from the closing bell and the next day’s opening bell).

Obviously the transaction costs of buying and selling each day would eat your shorts, but the moral of the story is clear.

The great MarketSci blog has the deets and this chart: