Be Happy and Beware

Bears in stocks and interest rates getting slapped repeatedly as the Fed leaves no doubt it will punish anyone getting in the way of their drive to preserve a recovery being threatened by a Europe known for creating world class events which affect the world badly. Fed clearly does not believe the ECU will be able to work out of this mess without some type disaster. Thus they have to create a fall back position where the world can seek refuge. The action is really just a redo of last year for stocks and, had it not been for the ECU then, indexes such as the S&P 500 would have had a great year.

What could screw up the Fed's intent? All of us participating in the markets daily know the monster never sleeps and market direction and volatility live with randomness. Just as the Fed was sure of the health of the housing market in 2006, it is sure of its ability to corner investments into selected alternatives with more risk than the 10 year. Structural price events, flash crashes, panics, and rolling downside momentum are the unpredictable side of a sure thing intervention.

For bulls, be happy and beware.

Say Anything

Got to love the Gingrich candidacy. In motions of body type and style, he looks like a caricature of an 'old pol' but without the discretion. His interesting domestic policy of asking his then now xwife to have an open marriage is one way to have it two ways in a three way. But just in case he needs a defense, he is using one reminiscent of a fallen television evangelical; do anything just ask for forgiveness. Just like the recent luxury liner captain explaining why he did not stay with his ship and instead found himself in a life boat with fleeing passengers. He tripped, and found himself in the life boat. Like Gingrich, the captain found himself in a dilemma. How do you make a "this may look odd" moment of life into a ready to apply response? You know. Say anything, and if you have to, just ask for forgiveness.

Markets say anything all the time. Remember the New Economy of the tech nineties. Old rules did not apply to speculation and capital formation. How about real estate inflation forever. Or the financial deregulation is better for everyone. Or the efficient market theory. Or gold is a currency. Or in 2012, the worst of the financial crisis is over.

Pawn Your Stocks and Indexes

Lots of talk about an upside break out in equities and that is fine. Up, down, whatever but maybe a few comments about where we sit and what things may be worth in turns of premium or discount. Now the things that have been going up for the last 4 years will get even more interest because they are proven movers. Brand name movers AAPL, IBM, and F are darlings of the risk averse. But lets look at several stocks and play pawn shop or let's find the riskvalue, the QRV, what will they be worth if things become not so bright and beautiful. Let's throw in a few of the indexes. So here is what the pawn shop will give for the list. (Data from QRiskValue.com)

AAPL 220
IBM 113
F 7
GOOG 528
PFE 20
MSFT 26
S&P 500 1140
NQ 100 1840
DJIA 9800

Oddly, only two pigs of the last 4 years have big upside, GS 152, BAC 20

Losing Wins

Lots of bad news about sovereign debt and the years it will take to resolve decades of accrued red. Interest rates still pushing ever so quietly lower. Reported hedge fund and mutual fund problems due to under performance in 2011.

Back in the early 00s I was a founding principal in a firm which looked to develop trading strategies to keep one step ahead of the market. Along with applying strategies to various markets ,we were also a market maker approved by the exchange to provide liquidity in a new contract. We were compensated in two ways ; any trading profits and payment for volume provided. We had a simple formula. Quickly pick off mispriced bids and offers. This was of coarse just as the latency arms race was picking up speed.

Now my point of telling this story is about the confusion individuals and markets make when they believe they are in control of all the important information which determines value and direction. In our trading operation, the market making desk was run primarily by a guy believed the particular market making strategy could be enhanced by his gaming the program. While the program was fully automated, he would override the system and hit bids or grab offers, anticipating the next move. When there is a larger latency spread, this works. When it closes, it does not.

His real ultimate problem however was his absolute aversion to losses. In fact, the first year there were only two or three losing days. But as the window closed on speed and other market makers step up their strategies, the firms strategy became less competitive.

Any strategy which requires less than normal distribution of losses is an eventual disaster. That goes for sovereign debt, hedge funds, and brand name stocks. Keeping things floating will eventually bring larger problems.

There is a saying which is the key to creating successful strategies and solutions. If it wasn't for the losses, you would never make any money.

Year Ending

Year ends with trading performances whether fast or slow, algo or guesso, challenged to produce alpha mama. Now there were some standout failures by big name hedge fund managers like Harvard MBA John Paulson. Genius. All that money he made front running mortgage paper with the help of Goldman Sachs is gone and probably any other profits he has made as a manager in the last several years. All those engineered financial derivatives created by the expensive talent in banking and investing on Wall Street are still beating inside the balance sheets of banks and the prime rescuer, the Fed.

There are some positives however. Europe is looking good for a vacation next year. Oh I guess that's it.

The turbulence from volatile swings over this last year has convinced some this kind of action is here to stay. However, rarely has that been true in the over 30 years I have been around markets. The only thing for sure is the action coming in 2012 will be different enough to require trading operations to be vigilant. For most hedge funds, if up does not appear, it will be another disaster for their returns.

Traders Confounded by Opportunity

Seems hedge funds and trading organizations having trouble dealing with the volatility presented this year. According to an article in Bloomberg, Traders Confounded as Volatility Extends Run, trading has been attacked by too much opportunity.

Here are some of the points;

" Hedge funds are on track to post their second-worst year on record......."

"U.S. mutual funds are headed for their weakest year in two decades......"

"....banks posted their worst quarter in trading and investment banking since the depths of the 2008 financial crisis."

The underlying theme of the article is based on the idea that continued volatility has hurt managers and traders not because of they are not accustomed to volatility events, but the markets have not " established or returned to a medium to long-term trends....". In other words, they have not started going back up. For all the supposed skill claimed over the years by hedge fund types, they are simply bulls, and anything but up does not work.

Another reason for slumping trading skills given in the article is just not volatility, but correlation behavior. All things are moving in lock step, individual company stocks, asset classes, and such. This it is reasoned, does not reflect unique individual values and all things bright and beautiful. There is simply no opportunity to pump and dump.

If things were not bad enough, option traders it seems are having a difficult time because of the cost to finance the implied volatility. The fear of a world financial event has created a bid/offer gap as a result of a liquidity drain driven by price uncertainty. Geez.

Maybe this is all true. But the problem is primarily with the traditional methodology of pricing risk. First of all, market volatility is simply a part of the randomness of price discovery. The options market has always done a terrible job of predicting price moves as represented by the price of a particular strike. The VIX is the greatest example of telling you what just happened. So it is good to remember that option pricing is to pricing risk as brake lights are to forward vision. In the end, it is simply a hedge of chance.

As for increased correlation between asset classes, it is the natural progression of all trading markets. They are all tied together not because they all have the same investment make up but because they all now live at the same address. The proximity of the market maker used to be in the trading pits, next to the broker, next to the other traders. Now it is everywhere and that is forever. All edges are dulled, all information is free, and transaction costs are scant.

Money will find those entities making great returns consistently, in all types of markets. Not just those that eventually go back up.

Corzine/ Trades Worse Than He Drives

Some idiot Congressman today ask Corzine if he had read the MF mission statement when he first took the job. That kind of fool question is a peek into the mindset of a politician playing to a theme or image of a world they want you to believe is out there. In the fools world Corzine would have responded, " Yes, I read it. And then I prayed about it with my family and we asked for guidance. "

While formulating his actual answer, Corzine was clearly thinking, " Do you think I read it? I am the freaking head of the company not some sh--head who's just walk off the street. Next question."

The important questions will be asked in the discovery process and then repeated in court years from now. But the only important questions for Corzine are rhetorical. Do you really trade worse than you drive? How come all you guys from Goldman keep screwing up so much? I thought you all were so smart?

Utilties That Pay You

Risk is all about choices. Everyone knows people can look at the same market data and get different views of the risks lying ahead in any trade or investment . Why? Value and opportunity are rarely what you think. The person who asks the right question wins, as long as they have created the ability to maximize a utility which captures those opportunities. To build great utilities however is expensive both in time and money and few have the ability or desire to contribute to such efforts.

While there are many proprietary utilities on Wall Street, it prefers to use another utility to make money . They collect from opportunities created by tapping into wealth reserves of the general public. 401ks, home equity markets, and the sub prime market have been a source of great profits. But not better than the latest, the Fed. If the trades go bad in the other aforementioned areas, the Fed will not only cover it, but continue to feed you. Bloomberg reported yesterday that Wall Street investment banks made an estimated 13 billion dollars from access to secret, practically free money from the Fed.

Wall Street may have discovered their best utility yet.

Buffett

Warren Buffett has announced he has amassed a huge 5.5% piece of IBM, although it was kept from all of us under the double secret exclusion act derived through natural law, but implemented by special permission by the SEC. Normally, companies such as Bershire would have to disclose their purchases. But now we know why Buffett wants the rich to pay more in taxes. It is to pay for the special treatment and subsidization they receive from the government each year.

Warren touts the great free markets whenever possible and wants everybody to operate fairly in the market place, except when he is amassing a huge stock position. Now it may be he wanted to merely surprise us with the great news that he, much like the great JP Morgan had helped the banks and US Treasury in the Great Panic of 1907, was continuing to support the economic recovery.

Maybe we should all be thankful for Warren and his ability to possibly be illuminating a top by infusing billions at purchase prices which were initiated in March of this year after a 150% rally in the stock since 2008. Maybe he really want us to join him and help support the position he is now lugging.

Giving Them What They Demand

Since August of 2010, just after the Jackson Hole speech by Ben, and shortly before QE2 began, Nasdaq 100 stocks became the focus of an upside play where the index has gained over 34% as opposed to its neighbor the S&P500 gain of just over 20%. This of coarse on top of a massive rally in 2009. Odd price technicals, such as the QRiskValue chart shown to the left, continue to reveal unusual bloated positions where billions of dollars in share values sit on a thin perch fully expecting to be paid by the intervention strategies of the Fed and Treasury.

Given that the test of all governments these days is to placate Wall Street, all demands seem to be met. But even cash monster stocks such as AAPL are vulnerable to a large downside sell off if there is an event which triggers an unraveling by all the well laid demands of the markets