China Slows Purchases of U.S. and Other Bonds vs. Chinese Stock Market rally

China’s foreign reserves grew in the first quarter of this year at the slowest pace in nearly eight years, edging up $7.7 billion, compared with a record increase of $153.9 billion in the same quarter last year. Chinese reserves fell a record $32.6 billion in January and $1.4 billion more in February before rising $41.7 billion in March, according to figures released by the People’s Bank over the weekend.

On the other hand, the Chinese market rallies more than 50% in the first 4 months of 2009. The rally is under the circumstance that internal credit released by the Central bank has broken record, to 1.9T Yuan in March. Closely examining stock market performance and available credit reveals that the main driving power of the rally is from the credit funding. Sooner or later, when the credit influx wanes, the market will be ebbing too. The People’s bank had applied similar adjustment in 2007 and 2008 during the housing bubble. In short term, the rally seems to be continuing as long as the government is willing to relax credit control. The People’s bank also says they will continue these monetary policies in the coming months.

Such manual stimulation has more political manifestation than actual economic benefit. The government has been expressing their ambitious goal of “leaving the crisis behind earlier than any other nations”. On the other hand, the unemployment rate and bankruptcy rate are still hovering in the sky. Also considering the export driven market, it is hard to see how long the global market will fully recover to offset strength obtained from internal credit influx.

For those who are only looking at stock market performance, which is good time to make money after understanding the cause, they should realize that the People’s Bank cannot do this forever. When officials come out emphasizing they will continue to follow this monetary policy, that means they know such policy has influence and may pause from there. It is time to sell.

Have TIPS in your 401(K)

Treasury Inflation-Protected Securities (TIPS) are U.S. Treasury bonds designed specifically to protect investors against inflation. Both the interest and the principal payments are indexed against the Consumer Price Index (CPI). Real yields on Treasury TIPS (Treasury Inflation Protected Securities) at "constant maturity" are interpolated by the U.S. Treasury from Treasury's daily real yield curve. Like other Treasuries, TIPS pay interest every six months and pay the principal when the security matures. The difference is that the coupon payments and underlying principal are automatically increased to compensate for inflation.

Regular treasury yield has a fixed relation with TIPS’ yield. Treasury yield = TIPS yield + expected inflation. When the actual inflation is believed to be greater than the expected inflation, TIPS becomes more valuable because TIPS is more protected.

TIPS take about 11% of marketable Treasurys outstanding. Recently, a 10-year TIPS yield is between 2-2.5%, but a regular 10-year Treasury yielded about 0.5% more. That means the expected inflation is only 0.5% per year, or almost no inflation.

When the current administration passed a slew of new regulations and stimulus plans and treasury buyback, such inflation expected is slated to be changed. Bill Gross wrote in a Brron’s article expecting TIPS would rise in the middle of 2009 by 20%.

TIPS is open to public, especially for conservative investors. Besides you can go directly to federal government for TIPS, many 401(k) plans have TIPS mutual funds options. Considering wild volatility in other options, limited supplied options in 401(k), and expected rising inflation therefore rising value in TIPS, it is a good option to put it in your 401(k). For example, State Street Global’s (SSgA) TIPS index fund had a slight decline in 2008 but it is climbing up in 2009’s first 3 month.

Another coin-flipping game

The classical investment philosophy book “Random Walk down Wall Street”, by Burton Malkiel likes to tell repeatedly the coin-flipping story. Keep flip a coin and log down the sequence of heads and tails. The appearance of heads and tails is analogous to stock prices’ up and down (up or down direction, not absolute magnitude of up and down). It is not surprised to see at the end of the game the heads/tails chance even out. Given the plotting of a coin-flipping results and a real stock’s market performance to experienced trader, he can’t tell which one is which. This is a strong argument that the market moves randomly.

This experiment has one key assumption: it is no difference doing the flipping in sequence or throwing a large amount of ordered coins at once and then record the results. This is because each flipping has no effect to the previous or next flipping.

Many other coin-flipping games have been developed to prove or disapprove the random nature of the market. Most of them assume two consecutive flipping events are independent. There are some others, at minority, that assume flipping events have some connections. The fundamental is that if we acknowledge that coin flipping event’s independence and the market’s up-and-down are alike. In more practical thought, we can’t predict head-and-tail of a coin flipping but can we predict what the market will move?

We can make a new coin flipping gain. In the game, if a series of heads appears, say we’ve seen 3 heads in a row, the probability of a 4th head is diminishing exponentially. And if there are 4 heads in a row, the probability of a 5th head is also further less likely. The probability can be modeled in many ways. And let the game go on for large amount of data. The eventual outcome is not as easily as the game described in Malkiel’s book because that involves how we describe the probability is modeled. No one can do that correctly because that means he can predict the market accurately.

But this new game is more realistic to the market.

Say it, Mr. Bear, it is over

After a powerful 20% rally in the past two weeks combining Wells Fargo’s upbeat earning prediction, it is time for Mr. Bear to say, ‘sorry, my time is over. Mr. Bull you can take it over’.

Although there are still doubts and challenges that question the realness of the rally. That is simple NOISE. The uptrend has been established, somehow shaky. But it is there. Consider GE, who has been consistently climbing in the past three weeks from single digital back to double digit. It basically has ignored the noise, which is a typical example on the rally.

Investment should not fixate on particular pattern in terms of market trends. It was easy to stick with the trend *after* it is there. However, it is not easy to face the trend reverse. Many don’t appreciate the change or ignore it. My system had been developed after taking plenty of time to develop it and it was working and it should be continuing so. Not, that is not so. There is not still strategy.

The most fundamental change in market mood is that the government is using all and every means, long-term or short-term, to stimulate the market. It is said never fight with the Fed. Think about there is someone who has 10 times of power more than the Fed, the chance of winning the game is zero, no chance at all.

So it is time to change thinking and strategy. Think long.

Thriftville vs. Squadervill --- revisit

Warren Buffet had this story about trade deficit. Two countries called Thriftville and the deficit-spending Squanderville. Squaderville buys more from Thriftville than they are selling to Thriftville. The difference was paid by borrowing money from Thriftville. The debt is an IOU. That means Squanderville’s net worth had been transferred to Thriftville. It would be happy for both if this went on forever. However, he said, “sooner or later, the Thriftville citizens who were buying Squanderville Treasury bonds started wondering if Squanderville was good for the money. When that happened, they still traded with Squanderville ---- but instead of bonds, they took less risky hard assets: land, business, office buildings. And eventually the Thrift own all of Squaderville.”

Buffet not only figured out the two hypothesis countries, but also proposed “Import Certificate” to balance trade deficits. That is hard to implement ‘cause it is a tariff. The resolution part is not related to our problem --- we can have millions of solutions but the problem still persists. The most fundamental question is if the IOU trustable or not. There is no written rule stating that Squanderville can’t devalue their IOU but mutual trading relationship should honor their own responsibilities.

It is not difficult to see who is Squanderville and who is Thriftville and what had happened in 1990s on Japan or what is happening now on China. Though Chinese are still committing buying more treasury bonds (Chinese need the US market but Japanese don’t as they don’t need it as needed as Chinese do), they started to question the value of these bonds overtly. With growing US deficit and Fed’s decision to buy more Treasurys by devaluating current ones, it is no doubt but just about time when Chinese and others would diversify their investments. That is exactly what Buffet has figuratively said about the less risky properties.

Expanding what Buffet said about ‘less risky properties’, we would include these as long term investment: land, business (in format of high grade corporate bonds), office buildings (in format of REIT), commodity (gold and oil), currency (Japanese Yen).

Investing dilemma

Investment performance is defined as seeking to get better than average results over a fairly long period of time – consistently, according to Institutional Investors magazine. Along the thinking, value of investment advice is substantial. For example, professional sophisticated investors would do return analysis, business analysis, and earning estimation etc. These analyses have extended to tiny details so that these investors have better grasp of their investing. For example, Return analysis has progressed from annual to monthly and ultimately to daily data, including dividend payments and adjustments for stock splits, stock dividends, and other capital adjustments. The scope of analysis now embraces small company stocks, a wide variety of bonds, real estate, and the financial markets of other nations.

Somehow ironic, are those investors or analysts willing to share this information? As Fama pointed out, “if there are many analysts who are pretty good at this sort of thing, they help narrow discrepancies between actual prices and intrinsic values and cause actual prices, on the average, to adjust ‘instantaneously’ to changes in intrinsic values… although the returns to these sophisticated analysts may be quite high, they establish a market in which fundamental analysis is a fairly useless procedure both for the average analyst and the average investors”

In other words, it is fruitless to do that much analysis because the Market is efficient. The Market is in the process of self-learning. As long as whatever theories have gained tractions, the Market will learn and saturate the theories. The advancement of communication technologies doesn’t change this rule at all.

On the other hand, simple logic would suggest that professional investors who devote full time and substantial resources to the task must be adding something of value. There seems a dilemma in this regard. The average little guy has no chance, therefore that investors hear little of value from broker. Also, agreed that everyone can’t do better than everyone else and the speed of price adjustments to other obviously public available information is too great to provide consistently profitable trading opportunities. However, there is a group of people seems working again this.

Even when the high performance is for rent --- John Neff and Peter Lynch have managed money for others --- the ability to combine financial acumen with an acute sense of timing and assessment of risk seems to be non-transferable. Rarely has an investment firm continued to produce superior results after the departure of it star.

These considerations don’t close the case in favor of the efficient market, however. Stock will be priced at what they are worth only when a sizable number of investors, with big sums at play, know how to values correctly. But does everyone know “how”? The lucky ones are obviously those who know “how” well better than average.

If everyone is a noise trader, the market will be chaotic. No theory about a market that is possible. The presence of avid and intelligent investor is a necessary condition for a market that lends itself to systematic analysis and understanding. The unhappy part of the story is that the more avid and intelligent those investors are, the more difficult they make life for one another. We are all blessed that there is just enough opportunity for one or another of them to win just often enough that the game takes on its zest. A little inefficiency goes a long way in making the game worth playing.

Luckily, there is always plenty of inefficiencies.

It was the Portfolio Insurance in 1987, what is that now?

The outburst of sub-prime crisis in 2007 has not been well understood. There is no official report that explained what had happened. Numerous hearings on CEO’s and governing bodies show it was about credit frozen along a long food chain. However, do we know what exactly caused this? How do we prevent this from occurring again? These unanswered questions may haunt us in the future.

Whenever there are new financial products that lure in customers, there are some unexpected by products that stirred up the market sooner or later. The 1987 Crisis comes to mind to remind us what had happened. A congress report, conducted by Nicholas Brady, a then-new portfolio insurance trading (essentially a hedge trading with futures involved) was the root cause. In the report, 20% of transaction on Oct 19, 1987 was initiated by a few accounts. Because these accounts were hedged by the Portfolio Insurance, which relied heavily on market liquidity. In other words, there must be enough buyers to support the Portfolio Insurance’s sell side.

The Portfolio Insurance was invented by two UC Berkeley professors. They initially tried to protect their portfolio by switching stock and cash positions according to returns. It worked perfectly at the beginning and their customer base expanded. Later, due to cost and leverage reasons, they switched to using futures and cash position balancing. As described above, the method got into bedlam in extreme situation. Their firm was hurt. No one knows this in advance until the Brady report. On the other hand, Wells Fargo still used stock and cash position hedging so Wells didn’t get hurt too much in that crisis.

Since then, the portfolio insurance has been used rarely in the US. But Japanese still use them. It is said that it is because they took longer to understand how it works. These new products are good tools if it is well understood. So why not the sub-prime trigger crisis?

Trading style and information

Trading, by large, can be grouped as buy-and-hold and swing trading. The centruary buy-and-hold is seen everywhere from individual investors. Despite of what entry point, buy-and-hold would ignore temporary ripples and focus on long term. The basic idea is that as long as companies invested are not folded, they would find next investor who is willing to pay higher price. For current investors, it shun off loads of efforts to the companies. That is two way: investors may not have resources to obtain abundant company information but focus on very fundamental stastistics. This method always get 100% win rate since no one wants to sell when they are at loss but till gain.

On the other hand, swing traders like professional investors spend lots of time doing research. They believe they have advantage over others, including other professional investors in a way such as the availability of critical trading information. For these investors, every trend or momentum of the market is more predictable and shouldn't be ignored. In other words, active trading can beat buy-and-hold as long as they have more information than others.

Investment theory quite often presumes that all investors share all information. That is not true because even the resource is the same for all investors but the reading of public information is not. Some professional investors can always decipher useful trading tips and remain them as upper hand in trades. This has nothing to do with insider trading information. As said by Jack Treynor, the long-time Financial Analysis Journal editor, you may not get rich by using all the available information, but you surely will get poor if you don't.

Professional investors can have another advantage, they can distinguish noises out of information. It is naive to say there all market information is relevant or rational. Individual investors often are influenced by market fluctuations and emotions and scarcy of relevant information. On the contrary, professional investors are full-time and performance driven. As experience grows on the market, it is little doubt that they will have edges over others.

What are the exact changes in the account rules?

What are effects of the new mark-to-market rule, which is now at "orderly" sale rather than fire sale. These changes are openly expressed by committee members that were under the congressional pressure and banks' complaints. Such yielding to these pressure is unusual. Intuitively, as an independent institution, it is biased to make such conclusions.

However, how much banks can be benefit from such rule change is not clear. Investors are not sure if they have realized the actual impacts. The details of the rule will be released in coming a few weeks, according to the New York Times. Citigroup states that the new rule would change their balance sheet.

At the same time, FASB also acknowledged investors' concern. One change adopted by the board would require banks to disclose the effect of the changed interpretation, although the final wording has not been released and it is not clear how detailed that disclosure will be. For some other assets, banks must write them down to market value only if they conclude that the decline is “other than temporary.” The measure that drew dissents will allow banks to keep part of such declines off their income statements, although the decline would still show on the institutions’ balance sheets. While it was the banks who pressed for the rule, it will affect all financial institutions. But the board said it would make small changes to assure that it did not change accounting in mutual funds, which must mark their assets to market value every day.

On the other hand, the Bank Association show appreciation after the announcement. Various investor groups expressed their concerns.

Long term recovery or Long term trouble?

The Financial Accounting Standards Board voted to allow companies to price assets at what they would sell for at an “orderly” sale, as opposed to the lower values of a forced sale. This announcement, in addition to Fed’s decision to buy up $1T treasurys, sent DOW to 7500 then over 8000.

While the Market has enjoyed rallies by these policy changes and claimed that the financial markets have been stable. The next step would be heading to a recovery. However, they cultivate seeds for long term trouble.

For $1T treasurys, inflation (after bursting deflation problem) can be seen. On the other hand, the FASB rule change, according to two members, was passed by the pressure from the government and congress. This rule is a complete confliction to whatever the government has proposed tightened regulation. The “orderly” sale would give banks more power to log their balance sheets, even arbitrarily.

That is bad as investors don’t know what the banks are doing. What is the difference between risky gambling on sub-prime mortgages and the banks’ making up numbers? From these two rule changes, the government has run out of ways except policy changes.

That is also dangerous as no one knows what politicians would do at their political will. So be cautious.

How is Sirius XM doing?

Sirius XM has come to a point to stream their contents to Apple’s iPod and iPhone in Spring 2009. Recalling that iPhone has changed their pricing policy, it is actually a good sign for Sirius XM. Sirius’s previous auto market is in danger and they can’t afford to see subscribing number free fall anymore (they have never made any money). It’s fourth quarter has $248.5M loss, better than $405M a year earlier. The CEO said it would book a $300M EBITDA earnings in 2009. This should be treated cautiously though given the auto market is diminishing. The key is to see if subscriber loss. The bottom line is that Sirius doesn’t have danger of bankrupt in 2009. They also need to change their business model. It would be difficult to roll over its huge debt again and again at low rates in the foreseeable future until it can make a profit.

Some compiled facts about Sirius XM:
$5B in assets, $3.25B in debt, 20M subscribers or $2B revenue, CEO Karmazin bot 2M share at $1.37 in August 2008. Before that, he had purchased 20M at average price $5/piece. That means he had put in over $100M.

Sirius and Liberty Media nailed a deal to fund its current debt in Feb 2009. Here is that deal.
$250M term loan to Sirius from Liberty Media, funded on 02/18/09. Interest rate is 15%/yr till 12/20/2012. A second loan to Sirius is a $30M purchase money loan, also with interest rate at 15%/yr till 12/20/2012.

A separated loan to the old XM Radio and Liberty Media is made with different terms:
Liberty Media will provide a $150M term loan, not closed with subject to conditions with interest rate of 15%/yr till 05/01/2011. Conditions mean renegotiation of XM’s other credit agreements to extend their terms and Liberty’s going out and purchasing in the market another $100M of this debt. The second loan is also conditioned on Sirius’s auditors’ not issuing any “going concern” opinion on the company with respect to its 2008 audited financials. A “going concern” caveat in an auditor opinion is code that a company is likely to go bankrupt without additional financing.

As a result, Liberty Media receives 40% stake in Sirius in connection with the second loan. The stake is in the form of 12.5M shares of convertible preferred stock in Sirius. Upon clearance, the stock becomes convertible into common stock of Sirius.

Siruis needs to pay $175M on convertible notes on 02/18/09. $400M debt will be due in 12/2009. It is no danger after these two loans in 2009.