Trading and Investing

From http://www.financialsense.com/editorials/litle/2007/0815.html:

Introducing Quant’s Law

GODWIN’S LAW — more a theory than a law — speaks to the inevitable half-life of debate on the internet. Per Wikipedia, Godwin’s Law states the following:

As an online discussion grows longer, the probability of a comparison involving Nazis or Hitler approaches one.

The natural corollary to Godwin’s Law is that, as soon as Hitler or the Nazis pop up, the debate is effectively over. Whoever resorts to the cliché first is the automatic loser, being clearly void of anything more intelligent to say.

In that spirit — and in light of the latest Wall Street disaster — we propose the following “Quant’s Law.”

Whenever a quantitative fund manager makes reference to a “100 year storm (or flood),” a “10,000 year event,” or an “X standard deviation occurrence,” where X is any double-digit number, the probability of devastating financial loss approaches one.

Corollary to Quant’s Law: In the financial markets,”10,000 year events” generally occur every 5 to 7 years.

The inspiration for Quant’s Law comes from David Viniar, Chief Financial Officer of Goldman Sachs. In reference to the spectacular multi-billion-dollar meltdown of two quant-driven Goldman funds, Mr. Viniar made apologetic reference

to “25 standard deviation moves, several days in a row.”

Twenty-five standard devations, hmm. How to put such a wild statistic in perspective?

Well, considering it only takes three standard deviations to cover 99.7% of the bell curve, we unscientifically estimate the likelihood of a twenty-five standard deviation move to be on par with Britney Spears getting elected President of the United States.

Hit me baby one more time.

– defo

Well, the short answer is that they’re getting hammered in the stock market. And things are likely to get much worse before they get better. Take a look at the 5-year charts for six of the biggest New York investment banks (charts from www.marketwatch.com):

JPMorganChase:

Lehman Brothers:

Merrill Lynch:

Morgan Stanley:

Goldman Sachs:

And the crowd favorite, Bear Stearns:

Bear Stearns is getting hit the hardest after announcing that two of its largest hedge funds collapsed due to leveraged positions in subprime CDOs. The question in my mind is not whether these stocks will recover, but how and when they will collapse.

Take a look at these banks’ earnings per share from 1996 to present:

source: Valueline

Profits at these banks have shot through the moon since 2003, mostly due to inexpensive credit (think: fed funds rate down to 1% in 2003/2004) and the mass development of securitized derivative products. Who will buy these products now that the market is spooked (think: subprime mortgage products are just the tip of the default iceberg) and borrowing is much more expensive?

The answer, probably, is no one. From what I understand, there were no bids to buy Bear Stearns’ subprime mortgage securities. No more sales equals no more profits. And with American Home Mortgage (AHM) stock plunging 90% on news that they can’t pay their creditors, it’s unclear how much credit risks these banks face.

The banks are trading at P/E’s of 7-9, which seems affordable unless you consider that their earnings may soon be cut in half. Many of these stocks had earnings decline by 50% in the tech bust, and I’m thinking that the housing/credit bust will be around the same magnitude.

I was lucky enough to have bought a Bear Stearns put option two weeks ago after the hedge fund announcement but while the stock was still at $141. I sold it on Friday into the news of Bear Stearns’ stock being downgraded by S&P.

The question in my mind is how to keep playing this. I’ve been waiting for the big banks to turn, and now they’re doing it. I’m convinced that they’re going to drop by 25-50% in the short to medium term (1 month - 2 years?).

Will they (a) continue to crash, (b) hit a short-term bottom and then proceed downward, or (c) turn around for one last bull-charge before collapsing?

The other question is which banks will get hit the hardest. I think the whole sector will be damaged if market sentiment really changes, but who knows which banks will end up in the hurricane? Bear Stearns is definitely a sinking ship, but you never know which banks might survive and thrive.  It seems unlikely to me that any will survive and thrive in this environment, but I won’t rule it out.

If Bear Stearns recovers up to $120, I’m definitely buying more puts. My instinct is that a Goldman Sachs put could be a winner but I’m nervous that market sentiment may fail to turn on such name recognition.

Do you really think Bear Stearns was the only bank to have so much leverage in their hedge fund? I sure don’t…

I’ll be following the banks closely and may put something on tomorrow if the timing seems right.

- defo