June 16, 2009 Stock Market Recap

We got a little more technical damage today. I saw an increasing number of stocks slipping below important moving averages, especially the 50-day. The S&P 500 made a clean break below its June range and is just a few points above its 200-day moving average. The index is approaching a 20 point zone which should be tough to break through. There's potential support from the round number of 900 plus the 200 (at 908) and 50-day (at 892) moving averages.

Yesterday the S&P 500 broke its March trendline and today the Nasdaq followed suit. Other than that it still looks in pretty good shape. It's got room to pullback without threatening its 50 & 200-day moving averages.

I was asked about First Solar, Inc. (FSLR) earlier today. It looks like it just broke down from a descending triangle. I think it's in serious danger of filling that late April gap.

Trend Table

No changes.

TrendNasdaqS&P 500Russell 2000

(+) Indicates an upward reclassification today
(-) Indicates a downward reclassification today
Lat Indicates a Lateral trend

*** I'm simply using the indices' relations to their 200, 50 and 10-day moving averages to tell me the long, intermediate and short-term trends, respectively.

LogMeIn Could Become First Tech IPO of Third Quarter

LogMeIn looks to become the first tech IPO of the third quarter. It set the terms of its sale this morning, with its July 1 debut on Nasdaq expected to raise more than $100 million for the company. Its underwriters, JPMorgan Chase and Barclays Capital, say they’re planning to sell 6.7 million LogMeIn shares at $15 a share.

The Woburn, Mass.-based startup, founded in early 2003, makes remote desktop applications that allow both Mac and PC users control and access their files remotely, either from another computer or an iPhone or, soon, a Blackberry Storm. The company offers both a free version and advanced versions for people needing to use the same PC at once.

LogMeIn – whose net revenues doubled between 2007 and 2008, from $27 million to $51.7 million, putting the company in the black for the first time in the first quarter of this year — should provide a nice if not extraordinary return for its VC backers, including Integral Capital Partners, Intel, Prism VentureWorks and Polaris Venture Partners. They’ve given the company $25.29 million over the years, and they plan to take some cash off the table immediately, too. (The company plans to sell five million shares in its IPO, with investors expected to sell an additional 1.7 million shares, according to a Dow Jones report.)

Though LogMeIn is hardly a household name, the digerati have long been a fan of its technology for its ease of use, and its range. For example, users can not only transfer files between computers but listen to music housed on a remote computer, as well as view and control the remote computer’s desktop.

The latter features were especially handy for Newsweek reporter Joshua Alston, whose laptop was stolen from his home earlier this year while he was indulging in a long bathroom shower.

As it happens, Alston had installed LogMeIn’s application on his computer, and he wound up using it to track down the thief — someone who Alston discovered was both “young” and “handsome” after he remotely launched his computer’s Webcam and began spying on the guy.

Alston writes about his experience —  and provides a great overview of LogMeIn’s capabilities —  in an entertaining recounting here.


In defence of naked short selling – or why the crackdown on a phoney problem is costing taxpayers at least a billion dollars

Brief synopsis: a misguided government policy driven by fraudsters in the stock market is making the market less efficient at a cost to taxpayers of at least a billion dollars.

This post has two start points – a start point for people unfamiliar with the basic operation of short selling and risk arbitrage – and a start point for most my readership (who seem to be hedge fund managers).

Start point for readers without a financial market background

There are readers that do not know what short selling is – and what naked short selling (allegedly) is. So to help readers out – imagine I think for some reason a particular stock will go down – and I want to bet that it goes down. Then there is a mechanism by which I can make that bet. I can “borrow” the shares (say some shares in Citigroup). Then I sell those shares in the market (selling what I do not own – and have only borrowed). If the shares go down I can buy identical shares back in the market and return the identical shares. Rather than aim to “buy low and sell high” I just reverse the order – I aim to “sell high and buy low”. As an ordinary shareholder I can stuff up by “buying low and selling lower”. As a short seller I can stuff up by “selling high and buying (back) higher”.

When I buy back the shares (either at a profit or loss) I close out the transaction by returning them to the person I have borrowed them from. At all times my account is collateralised so the risk to my broker is minimal. [The risk to me unfortunately is not.]

Naked short selling is a much promoted – but in my view almost entirely fictional problem – whereby people do the short selling but without actually borrowing a share first. When they do so they will inevitably fail to deliver the shares to the exchange on the due date. The existence of fails is – at least according to the proponents of the “naked short selling hypothesis” proof that there is a major problem. But fails have happened since time immemorial (including in highly liquid markets such as Treasuries). There is usually a requirement to post cash collateral if you fail to deliver the actual security – and historically a small fine from the exchange (increasing over time).

Still some people have argued that a collateralised fail-to-deliver in a financial market has the ability through price manipulation of a stock to bring a business to its knees. Sorry – but generally the business does not care who owns the stock or what is going on the stock market unless the business is weak and needs capital. [This is the corollary of the old Wall Street truism: “the stock doesn’t know you own it”.]

Most short selling is mere speculation – but sometimes it involves arbitrage. Arbitrage is kind of useful and goes on all the time in financial markets. For instance if Company A agrees to buy Company B for stock the price should converge – over time – on the agreed stock swap deal. But if for some reason it does not arbitragers could buy company B’s stock and shortsell company A. When the Company B stock converts into company A shares they could just deliver the new Company A shares in satisfaction of their short-sale agreement. This allows the holders of company B to sell their shares at full price whilst the details of the takeover are sorted out. Arbitrage is the process which makes financial markets more efficient – it makes it so there is one price which means markets treat people more fairly. Arbitrage is by-and-large a good thing. Perfect arbitrages rarely (if ever) have substantial profit for the arbitrageurs. Indeed at best you are picking up pennies. Efficient markets reduce the profits of market participants at least on a per-transaction basis. That is usually a good thing if the public doesn’t want to subsidize sophisticated money market types.

Start Point for people with decent financial market knowledge

“Naked short selling issue” was a phoney issue – promoted by flim flams, stock promoters and other market slime-bags invented a problem which did not exist but helped them to promote their stock or justify the failure of their own businesses. The idea was that “miscreant” short sellers sold stock that they did not own in order to drive down the stock price and drive the company out of business. Bloomberg (and others) have taken the idea seriously. Gary Weiss has done a great job on his blog of exposing the slime-bag proponents of the imaginary naked short selling problem for what they are (which is usually crooks).

The story was that selling stock you did not own was producing “counterfeit shares”. I have yet to see mischievous naked short selling of any real business – though I have seen some fails-to-deliver (that is not actually being able to borrow the stock on the delivery date) remedied a few days later and with all obligations to the exchange cash collateralised over the interim period. There were plenty of “fails” but no real naked short selling “problem”. Hard to borrow stocks did fail regularly – but I assure you – and I have been doing this for years – when there were fails to deliver my broker called my short back and hey – presto – a few days later I had settled. If there was a “counterfeit share” it was cash collateralised and it was cancelled a few days later (in exchange for the cash collateral). The person who purchased the share from me got all the economic benefit of owning that share – and a full voting share was delivered to them within a modest time.

Fails to deliver now are – with electronic settlement – a far lesser and far quicker remedied problem than they were in the days of paper certificates. And with the speed at which they are settled – and the ability to demand cash collateral when a party fails to deliver they cause no economic problem at all.

Nonetheless the SEC took the slime-bag stock promoters seriously – at one stage issuing subpoenas to journalists who called the slime-bags for what they were. Journalists who got subpoenas – and who have considerably more demonstrated competence than the SEC include Herb Greenberg (unfortunately no longer a journalist) and Joe Nocera (New York Times).

Nonetheless in response to the well-promoted bogus threat of “naked short selling” the SEC radically tightened the delivery rules for stock. Now you have to locate a borrow before you actually short the stock (rather than having to locate a borrow before you deliver the stock) and if you can’t maintain a borrow you must cover the stock immediately – rather than fail (and pay fail-fees) for a couple of days.

Well and good you might say – but you would be wrong.

At the moment there is a well publicised arbitrage in Citigroup stock. There are four classes of Citigroup Preferred Shares which – on tendering to Citigroup – convert to common equity. And – surprise – you can buy Citigroup cheaper if you buy those preferred shares rather than buy the common. As of last night it was 18% cheaper to buy the Citigroup preferred than the common. So – with seemingly free money on the table we at Bronte Capital decided to short sell Citigroup common and buy the preferreds. An 18% return over about a month looks pretty darn good for a pure arbitrage. (So good it should not exist… its billion dollar bills on the sidewalk.)

But alas there is a problem. This deal is large - $20 billion – and as a result Citigroup common has become modestly difficult to borrow. You can’t short-sell the Citigroup common with certainty because you might not be able to borrow the shares and hence you might be forced to buy it in. And if you buy it in before you get the new (and identical) shares from tendering your preferred you could get “squeezed”. You will be forced to buy back your Citigroup stock at the same time as the other arbitragers (who have also been called on their borrowed stock) and you will pay a high price.

After paying a high price to borrow the stock you will receive your (now unhedged) new Citigroup shares at the same time as the other arbitragers (most of whom will be sellers) and – inevitably you will sell the shares then too as your plan was not to “own” Citibank. You will sell at the same time as the other arbitragers (presumably at a low price).

In the old days it would be easy. You would simply fail to deliver your Citigroup common for a few days whilst the new shares were delivered to you – and then you would deliver the new shares.

What was a perfect arbitrage has become an imperfect one.

So what you say – why should arbitragers like us at Bronte Capital be given a free ride? Well – hey we were not being given any ride – but now we are. Currently we are earning 18% on face value in a month for taking this risk – in the old days the price would have equilibrated almost instantly and people like me would not be making that money.

And that money comes from somewhere. Largely the difficulty in equilibrating the price through arbitrage makes it harder for Citigroup to raise the capital it wants. It has thus made that capital more expensive (by the bulk of our expected profits on the arbitrage).

Alas – even if you do not own any Citigroup you should be worried by this. The government is and remains the biggest holder of Citigroup stock – and when Citigroup has to pay more to raise private sector equity capital that “more” is effectively “less” for the existing shareholders. That is less for you the taxpayer.

So – in pursuing the bogus issue of naked short selling not only has the SEC diverted resources from its real job (which is chasing the real crims in the financial market such as Madoff) but it has imposed significant and real costs on the taxpayer and made it harder and more expensive for banks to raise capital in a financial crisis.

But – I should not complain. It has put a reasonable risk arbitrage our way – and I hope to report back that – thanks to the SEC crackdown on a bogus issue our clients are just that little bit richer.

Nonetheless I will know a commentator who really gets it when they defend modest levels of cash collateralised fails to deliver as a normal part of a normally functioning financial market. Naked short selling is good for markets, good for taxpayers and good for capitalism.

Quantifying the loss to taxpayers

Consider who bears this loss? There is 18% discount for buying the common over the preferred. To anyone who swaps preferred for common there is an 18% profit. As this is a 20 billion deal this profit is 18% of 20 billion or $3.6 billion.

The market is a zero sum game – that $3.6 billion is paid by someone. Well that someone is two groups. The first group is the existing preferred shareholders who should have got more for their shares. The other someone is Citigroup who get a less good price for the shares they are issuing. The incidence is hard to determine but given the recent history of squeezing shorts on preferred conversions is obvious enough that Citigroup bears at least half of the incidence.

As half of the loss is born by Citigroup who gets to issue the shares at a price that is too low. That is the loss is borne by Citigroup shareholders.

The cost to the taxpayer – well 18% of 20 billion raised is 3.6 billion. Just over half of Citigroup is owned by the taxpayer – and more than a half of that arbitrage profit comes from the issuing company (Citigroup). The cost to the taxpayer – a neat gift to hedge fund operators – is at least a billion dollar.

These days I guess that is small change. Either way – as a recipient of this gift I wish to thank the slime-bag proponents of the naked short selling hogwash.


Correction. I have been emailed to say that Joe Nocera did not get a subpoena.

Correction 2 - in the comments - if you account for the borrow cost on Citi the profits to the arb are originally about half (now well under half) of the profits indicated in this post. [We put it on with a wider spread than this. And the spread has narrowed for a few days. Also the borrow cost has been rising.] That just reallocates the profits to prime brokers - who really deserve it anyway.

The current borrow rate on Citigroup is just over 100%. We may take the trade off when the numbers make no sense any more.

PPS. The spread narrowed and the borrow rate on the Citi remained high. We covered this for a small profit. Trivial really. The biggest profit is being made by the prime brokers who get to lend out the shares.

Where Are Profits Going?

This blog's position has always been that the US economy's performance post-2000 has been due to ever-increasing assumption of debt, particularly by households to finance real estate purchases and personal consumption. I don't think anyone can dispute this any more: just look at the chart below (click to enlarge).

The Debt Boom Finally Begat The Bust
Charts: FRB St. Louis

Debt kept accelerating while GDP remained "stuck" at around 5% annually (these are nominal figures). In the end, the debt boom created its own bust and dragged down the entire economy. Cement shoes come to mind...

So, now what? What does the future hold? In particular, I am referring to corporate profits, the fundamental driver of stock market performance. We can analyse markets using a multitude of perspectives from astrological to psychological but, when it's all said and done, what matters is profits.

Since 1997, or so, households assumed ever more debt in order to consume and, thus, increase corporate profits. At the top in 2006 it took an additional $1.3 trillion in household debt to generate an additional $300 billion in profits, i.e. a ratio of 4.3 times (see chart below). The debt intensity of corporate profitability was huge, but it weren't corporations themselves that were going into debt; it was their customers.

Annual Increases In Household Debt and Corporate Profits ($ Billion)

We are now deep in a debt-bust crisis and it is the first time since at least 1953 that household debt is decreasing in absolute numbers, year on year. What does this mean for corporate profits? Based on the relationship above, I expect they have quite a bit more to drop, perhaps after a (very) brief period of stabilization due to cost cutting (see chart below).

Corporate Profits After Tax

I would thus not be at all surprised to see after-tax profits go back to around $300 billion/year, where they were in 1992 at the beginning of the debt acceleration cycle. What does this mean for stocks? Look at the chart of S&P 500 below (click to enlarge).

S&P 500 Share Index

In 1992 S&P 500 was around 400, or 57% lower than current levels. Of course, this is a pretty simplistic and one-faceted approach to corporate profits and the market, dealing as it does only with debt. (But then again... KISS has always been pretty good guidance.)

There is another macro approach to corporate profits, however. As a share of GDP pre-tax profits had reached a record 13% in 2006: corporate greed had reached a peak, indeed.

Data: FRB St. Louis

If the ratio of profits declines to a new low, say 5%, and nominal GDP declines another 10% to $12.6 trillion (not at all impossible in this crisis, it was there at the end of 2005), then we are looking at pre-tax corporate profits of around $630 billion.

Now, include a boost in tax rates from the Obama administration and the $300 billion after-tax number mentioned above does not look so outlandish, all of a sudden.

June 15, 2009 Stock Market Recap

We had some significant price drops today with more than 2% losses on the indices today. But all that did was bring those indices back to the bottom of their June ranges. Volume remained below average, as is so typical of Mondays. Because those ranges haven't broken it's too early for the bears to claim victory. The timing of this selloff was interesting though. The Dow finally joined the other indices by turning positive for 2009 on Friday. Today it got smacked back into negative territory and back below its 200-day moving average. The S&P is now within reach of its 200-day moving average too. If the bulls can't defend that line things could get ugly real quick.

Trend Table

I'm finally flipping the short-term trends to down since the indices all closed below their 10 DMAs. Despite that, in the short term I still see this market as sideways until the indices break the June lows.

TrendNasdaqS&P 500Russell 2000

(+) Indicates an upward reclassification today
(-) Indicates a downward reclassification today
Lat Indicates a Lateral trend

*** I'm simply using the indices' relations to their 200, 50 and 10-day moving averages to tell me the long, intermediate and short-term trends, respectively.

How Much Money Does One Need to Trade for a Living?

There's a good discussion about trader capitalization needs over on Dr. Brett's TraderFeed blog. (The discussion now spans these three posts: Capitalization and the Economics of Trading Success, The Capitalization of Traders: Why It Is Crucial to Success, and The Psychology of Leverage ) That topic is probably the one I get the most email about. It's one of those classic questions that deserves an "it depends" answer. At the very least you need to know how much the person needs to live off of and their system's expectancy. The type of trading and whether the trader holds positions overnight will probably also come into play.

As a general rule I used to tell people that they'd need an absolute minimum of $50,000 but $100,000 is probably more realistic. But years ago, after reading Dr. Brett's thoughts on the matter (which he's based on working with so many traders) I modified my response to add that "Dr. Brett recommends over $200K". You'll see comments by Michelle B (remember her?) on Dr. Brett's posts. Her comments match my thoughts on the matter almost exactly for a very specific situation -- a true daytrader, who doesn't take overnight risk and is willing to max out on 4x leverage. (If you're trading with a prop firm you may get 10x leverage, so the numbers could be adjusted accordingly.) If you're holding overnight you just can't be as aggressive with leverage and thus your capital requirements will need to increase.

Obviously people will have to analyze their own situations and come up with a number for themselves. Dr. Brett provided some links to some Monte Carlo simulation tools which are invaluable for doing that kind of analysis. As with so many things, one's own mileage will vary. One's risk of ruin should decrease with more capital and it will also be easier to make the amount of money necessary to make a living.