Safe Trading Blog

EUROPE: We expect the European markets to open 1.3% higher Wednesday. The US stock indices gained more than 1.5% after close and the S&P future is currently trading flat. US financials rebounded 4.74% after the close in Europe and we believe that the banks will lead the gains in Europe as well. Market volatility is very high and the movements depend on the rumours at large. Monday’s speculations about Fannie Mae and Freddie Mac were rejected after a regulator said the mortgage-finance companies shouldn’t have to raise more capital. We recommend buying Bank of Ireland, Royal Bank of Scotland and Deutsche Bank.
GERMANY: German financials are expected to benefit from the general European trend. We expect UBS, Commerzbank and Hypo Real Estate to outperform companies such as Deutsche Postbank. US parcel service companies gained yesterday on the back of the oil price drop. We expect Deutsche Post can benefit from this trend as well. Actelion, Switzerland’s biggest biotechnology company, is being added to the country’s benchmark SMI Index on Sept. 22, the SWX Swiss Exchange said.
US: U.S. stocks rallied the most in a month, led by banks and transportation companies, after JPMorgan Chase & Co.’s CEO said credit market losses will ease and oil posted its biggest drop since March. Bank of America Corp. advanced the most since 1990, leading financial shares to their best gain in more than three months, after JPMorgan’s Jamie Dimon said buyers are returning to some types of mortgage products.
ASIA: Asian stocks rose the most in almost three months, led by banks and industrial companies, after JPMorgan Chase & Co.’s CEO said that credit market losses will ease and oil prices had their biggest drop since March. Macquarie Group led a rebound among financial stocks, which yesterday traded at their cheapest in at least a decade. Korean Air Lines climbed for the first time in 12 days as crude tumbled more than USD 5 per barrel. Komatsu Ltd., the world’s second-largest producer of earthmovers, gained in Tokyo after Japan’s machinery orders rose more than economists forecast.

The USD lost its way yesterday as new woes in the mortgage industry surfaced and soured the greenback’s rally attempt. This time around, the news centered on the 800-pound gorillas of the US mortgage industry, the so-called government sponsored enterprises (GSE’s) Fannie Mae and Freddie Mac. The fear is that the two companies will fall victim to new accounting rules that will require them to raise huge amounts of additional capital. This news overshadowed what should have been very USD-supportive developments, namely, a chunky drop in the oil price and a surprising and sizeable drop in May German industrial production data. By the end of the day, however, a hefty drop at the short end of the US yield curve sent the yield differentials back in favor of the EUR.  Still, the technicals suggest that EURUSD needs to punch through the 1.5750 weekly pivot level and 1.5800 Fibo retracement levels before it looks in danger of fully wiping out the recent sell-off. To the downside, we focus on the 1.5680 overnight low and the 55-day moving average just above 1.5600, which seemed to be the excuse for support yesterday.

Meanwhile, a G-8 meeting is underway, though one that only includes heads of state rather than central bank/finance ministers. Bush reiterated the tired strong USD position of the US. While we can all scoff at the US talking up the USD, the macro regime has recently been dominated by the implications of a weak USD - especially in the pressures of commodity prices on inflation in both the emerging and developed economies - and it is increasingly evident that it is in the entire world’s interest to see the greenback stronger, so there may be a floor in the USD in place in the bigger picture, if not at present levels. Still, we need to see more signs of multilateral verbal intervention at minimum if we are to believe that a real agreement to do something about the situation has been taken. (not just coordination between the Fed and US Treasury, who have taken the first baby steps).

The highlight of the week may be the Bernanke/Paulson testimony on Thursday as we watch for the Fed’s view of the economy and monetary policy and for any further signs of strong USD rhetoric. We may see a test soon on how much the market continues to react to the same old interest rate differential story as opposed to other potential developments down the road (capital flows and risk aversion on the implication of the global growth slowdown, for example: there’s more to the world than yields!).

At the risk of beating a dead horse, we are absolutely astounded at the resilience of the JPY crosses to bad news and wonder how long this jaw-dropping performance can continue. AUDJPY showed some signs of weakness, but the classic risk appetite crosses like EURCHF are still lollygagging in no-man’s land. What gives? We’re supposed to place the blame at the foot of commodities, it seems, but something desperately strange is going on here - EURJPY should be about a thousand pips lower. These JPY crosses should be getting absolutely hammered in this environment…we can only drum our fingers in frustration for now, but can’t help but wonder if we should be putting on some JPY calls. AUDJPY and GBPJPY downside anyone? We keep seeing uglier and uglier data from Australia and the UK….

Chart: EURJPY
EURJPY rose to a new record recently, but failed to find increasing momentum there. From a fundamental perspective, both in terms of interest rate differentials and risk aversion, this cross should be headed lower, but needs to take out another couple of support levels before it shows more decisive signs of negative momentum. The rising trendline seems to be the most significant support and could come into play soon as a trigger.

Inflation

Widespread is the notion that inflation is back for good.  Many assume that the relative price stability of the past two decades has been irrevocably shattered by “peak oil” and the surging demand by developing economies. Improvement of living standards in those developing countries has caused, and will continue to cause, increasing demand for calories, and final demand for food will outstrip supply. Additionally, the cost of basic materials is lifting production costs, and the cycle of higher food and fuel costs means that the prices of all imported goods to the United States will continue to rise. The fixed income investment conclusion is that inflation is endemic, and since the market does not currently reflect such dire inflation prospects, long dated Treasury securities should be sold. We would be among the first to move to the short dated part of the curve if the economic statistics supported the above view. Our conclusion is that deflation, not inflation, is, and will continue to be, the essential problem for the U.S. economy and that the optimum fixed income portfolio should consist of treasuries with the longest possible maturities.

Reality

Twelve months ago the annual increase in the CPI was 2.6%.  Today it is at 4.1% and rising. The Reuters/Jefferies CRB Index fell 7.3% for the year ending last June. Today the 12 month change is 36% higher.  Nevertheless, the 30 year bond yield fell to 4.5% on June 30 of this year, well down from 5.1% one year ago. This provided a remarkable 15% return for investors. How is it possible that bonds, which have the ultimate sensitivity to inflation, would decline in yield and rise in price in such an inflationary environment? The short answer is that in the broadest terms, insufficiency of demand has, and will continue, to overwhelm inflationary forces, creating deflation in many categories.

In the second quarter, current dollar gross domestic product totaled an estimated $14.3 trillion, about $572 billion greater than a year ago. Of this gain, $359 billion can be attributed to price increases and $213 to higher real output. There are times, however, when GDP is not the final arbiter of the economy’s performance, and this is one. The seemingly large gain in GDP pales in comparison to the loss in wealth, which GDP does not capture. Over the past fiscal year, holdings in the stock market, as measured by the Wilshire 5000 Stock Index, lost more than $2.1 trillion.  Simultaneously, the 15.3% contraction in the Case Shiller Home Price Index suggests the wealth loss in value of household residences was a staggering $3.1 trillion. Without including the negative wealth impact for declining prices of automobiles and other durables the total wealth loss was approximately $5.2 trillion. Obviously, the sum of dollars being erased from our economic system has overwhelmed the amount of dollars being increased by inflation by a factor of more than 14 to one. Thus, once again, the bond market had it right–deflation is in ascendancy. Treasury bond yields fell, and they will continue to trend lower, creating an even more profitable environment over the next four quarters for long-term Treasury bond holders.

+52% today… what a run!

Bernanke cautiously pushes for new powers for Fed
8:01 AM ET, Jul 08, 2008 - By Greg RobbWASHINGTON (MarketWatch) — Federal Reserve chairman Ben Bernanke stuck his toe into the shark-infested waters of Washington regulatory battles and cautiously suggested that the Fed be given new powers to oversee financial markets. In a speech at a FDIC conference, Bernanke said Congress would have to give the Fed new powers if it wanted to give the central bank the job to limit the impact of financial market turmoil on the economy. Bernanke bent over backwards to suggest rather than demand any new powers from Congress. In a major development on another topic, Bernanke said the Fed was considering extending its emergency loans to broker-dealers beyond 2008 to help stabilize the market. The Fed’s emergency primary dealer credit facility is now set to expire in mid-September.

S&P 500 FUNDAMENTALS

The real P/E for the S&P 500 is based on “as reported” or GAAP earnings (calculated using Generally Accepted Accounting Principals), and it is the standard for historical earnings comparisons. The normal range for the GAAP P/E ratio is between 10 (undervalued) to 20 (overvalued).

Standard & Poors has introduced a version called “core” earnings, which is more critical than GAAP and will probably become the standard in the future.

Market cheerleaders invariably use “pro forma” or “operating earnings,” which exclude some expenses and are deceptively optimistic. They are useless and should be ignored.

The following are the most recently reported and projected twelve-month trailing (TMT) earnings and price/earnings ratios (P/Es) according to Standard and Poors.

                                             Est       Est       Est
                               2007 Q4   2008 Q1   2008 Q2   2008 Q3
TMT P/E Ratio (GAAP)…….:      18.9      20.7      21.7      20.1
TMT P/E Ratio (Core)…….:      17.7       N/A       N/A       N/A
TMT P/E Ratio (Operating)..:      15.2      16.3      16.8      16.1

TMT Earnings (GAAP)……..:     66.18     60.39     57.66     62.34
TMT Earnings (Core)……..:     70.80       N/A       N/A       N/A
TMT Earnings (Operating)…:     82.54     76.77     74.55     77.67

Based upon the latest GAAP earnings the following would be the approximate S&P 500 values at the cardinal points of the normal historical value range. They are calculated simply by multiplying the GAAP EPS by 10, 15, and 20:

Undervalued (SPX if P/E = 10):    662
Fair Value  (SPX if P/E = 15):    993
Overvalued  (SPX if P/E = 20):   1324

DIVIDEND VALUE RANGE ANALYSIS

The yield for the DJIA, DJTA and the S&P 500 has historically moved between a range of 3% (overvalued) and 6% (undervalued). The normal yield range for the DJUA is between 3% and 12%. Decision Point expresses this
range as an RVR (Relative to Value Range) value of between 0 (undervalued) and 100 (overvalued). Values can fall outside that range, and, when they do, indicate even greater extremes of market valuation.

                                     S&P 500     DJIA     DJTA    *DJUA
———————————–  ——-    —–    —–    —–
Current Closing Price………….:     1252    11232      511       60
Current Yield…………………:     2.3%     2.9%     1.5%     3.2%
Current P/E…………………..:       19       79       22       16
Current Payout Ratio…………..:      0.4     34.1      0.3      0.5
Current RVR…………………..:      125      102      150       98

Price at  1.5% Yield…………..:     1920    21715      511      128
Price at  3.0% Yield (RVR 100)….:      960    10858      256       64
Price at  4.0% Yield…………..:      720     8143      192       48
Price at  5.0% Yield…………..:      576     6515      153       38
Price at  6.0% Yield  (RVR 0)…..:      480     5429      128       32
Price at  8.0% Yield…………..:      360     4072       96       24
Price at 12.0% Yield  (RVR 0 - DJUA)…………………….:       16

For those interested in model building, I have selected 2 references. Among thousands of articles and books, I think those 2 are the one to be read… They give the essential concepts and mathematics. Of course, this post is focused on experts in financial model building.

Article1.pdf

Article2.pdf

If you are interested by ideas and a reformulation of all this without any mathematics, first read or free ebooks free_ebooks.pdf…

Contact: thestockcode@gmail.com

In the future, I will give some references that I find interesting on this blog… sometimes for pure model builders, most of the time for anyone interested on financial markets with no mathematical background. If you have any question, do not hesitate to contact me @ the email address above…

The market will rise and the market will fall, but not necessarily in that order

in French
Le marché montera et le marché baissera, mais pas forcément dans cet ordre là

A few of my market lessons compacted in one DOCUMENT

free_ebooks.pdf

Contact: thestockcode@gmail.com

If you follow us, you must not be worried by the erratic behaviour of financial markets at the moment, whatever the weights we put on fundamentals of the economy and artefacts of technical analysis. That reason why is explained below.  When examining financial markets, they are all very different with non-deterministic behaviour… But, there is one common universal feature that can not be contested: financial markets are never following a quiet path. On the contrary, for all of them, they are either super-exponentially accelerating or crashing. In our education series, we have illustrated this FACT with many graphs… For all of them, we can observe the succession of accelerations followed by crashes. This basic feature stands at the heart for financial markets. This is a central point, and most probably THE central point of the modern aspects of financial markets…  Just to give the bottom line of the complete explanations that you can find in our documentation, available on this web site, we can say that financial markets are fed on volatility. In fact, with no volatility, the free markets would not exist: both are intrinsically related. In order to generate some volatility, there is a need for bubbles and anti-bubbles (or crashes) with a periodic wave. Financial markets need to generate such extremes… Remember the famous history of the tulip bubble 400 years ago! In a certain way, this general behaviour is largely independent of a precise trigger or catalyst that gives the turning point of the extreme towards another direction.  Then, the game is very simple: one needs to catch the train and to jump off before it explodes! We know this game! And we can play it by limiting the risks at the lowest levels…

Main US indices over last 18 years (daily)… Essential if you need to define own strategies or test the ideas provided on this blog…

spxcsv.GZ

inducsv.GZ

ndxcsv.GZ

compqcsv.GZ

Do not hesitate to contact us for more data or strategies: thestockcode@gmail.com