Planning for a 2008 Recession

March 7, 2008, Financial "Engineering", Investing Assumptions — Tags: , , — @ 5:54 am

The media talks about individuals defaulting on subprime and Alt-A (e.g. liar loans) loans, but this is clearly a freezing of the overall credit market. There has not been a new CLO created since May of last year; almost a year ago. I don’t see how this lack of credit liquidity could not cause a recession as businesses and municipalities are unable to finance new projects.

Understanding that the credit market is a leading indicator of the stock market is the stock market priced for a recession? I don’t think so. In one of John Maldin’s recent letters the S&P 500 earnings are discussed. Let me summarize; all numbers are for one share of the S&P 500. In January 2007, S&P estimated that the earnings would be $89.10 (FP/E = 16) for 2007. They were actually $71.56, down 20% from the estimate at the beginning of the year and down 12% from the actual 2006 earnings. The 2008 estimate has gone from $92.30 (in March 2007) to $83.90 (in December 2007, a FP/E = 17.5) to a current estimate of $71.20 (FP/E = 19.2). The scary part of S&P’s estimates is that it expects earnings will grow 20% in both the Q3 and Q4 of 2008; very doubtful if we are in a recession.

The S&P is currently at 1,304.34 assuming earnings fall 20% from their highs which appears very reasonable from 2006’s historical peak in margins to a recession in 2008, then earnings will be roughly $65 in 2008. That would give the S&P 500 a price/earnings over 20. Expecting at least a bear market drop to a P/E below 15 seems reasonable. So, I don’t think the market has yet to price in a recession.

My approach to the current market is one third cash, one third stocks (mostly tech), and one third short derivatives (options and inverse ETFs) and gold. Since the fall last year gold has been my biggest position and has cushioned most of the drop in my stocks. If gold keeps going up at the rate it has lately you wonder if it moves into bubble territory.

I think as other central banks start cutting rates late in 2008 the old greenback will rally some. Honestly, I’d rather have less money in straight cash, but my 401K has horrible options…only one bond fund (Who designed that!?!) and I do not have the option to go self-directed, so I’m working with what I can in that account.

 

Note: The UltraShort Real Estate ProShares (Symbol SRS) was up almost 10% today so that was a nice gain. I’m still waiting to increase my stock holdings, but prices keep getting more appealing. F5 (FFIV) dropped below 20 today giving the company a valuation around ten times cash flow. Not sure how much cheaper I can expect F5 to get. Especially considering that their much panned acquisition of Acopia Networks might actually pay off.

Calculating Risk

March 5, 2008, Financial "Engineering", Investing Assumptions — Tags: , — @ 9:12 pm

I don’t accept the assumption that risk is well understood in financial markets. That the risks are just priced in.  I don’t think risk is nearly as mathematically quantifiable as the many financial engineers, hedge fund managers, and quant funds managers argue.  While I’ll admit I don’t understand much of the math behind the PhD’s risk management theorems I read enough econ white papers to have a vague enough idea to recognize many of the assumptions enabling this math.  Many of the assumptions are so large that it makes the whole mathematical exercise mute.

Calculating risk is still more art than science which is largely being proved out by the failure of Moody’s and banks to accurately gauge CDO and CLO risk. Moody’s and others just follow trend lines. As Egan Jones has asked, when have the major bond rating firms ever anticipated a market inflection point?  In addition, the lack of transparency exacerbates the problem.  On top of that I-bankers and analysts are paid annually so they are rewarded if years of investor’s profits are eventually destroyed through bankruptcy. 

Greenspan had one great call (understanding productivity was dramatically increasing) and one horrible call (exuberantly supporting OTC derivatives and dramatically increased leverage). The increased leverage was justified by the financial engineers’ fancy new models that were just assumed to work; but have now been refuted. So what has happened? The financial engineers just adjusted the models to the new trend lines.

Many financial parties break risk down to nearly a purely mathematical equation.

  • Quant funds (e.g. Goldman claiming two consecutive days of 10 standard deviation events)
  • Hedge funds (e.g. Citadel whose computers often account for more than 10% of daily U.S. listed equity options contract volume)
  • Ratings firms (e.g. Fitch’s models for MBS’s did not account for falling house prices…prices never decrease?)

These models never anticipated the apparent shock of the housing bubble. Even though the cover page of every magazine at Barnes and Noble exclaimed the current housing bubble, but the models did not see it. Risk will always be much more than a mathematical equation. We don’t need better math or better data; we need better analysts.