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Monthly Archives: October 2009

I read Rishi K Narang’s Inside the Black Box, The Simple Truth About Quantitative Trading, as a person who has many, many years working with gigantic amounts of economic and financial data with the specific purpose of forecasting future outcomes.

This book is a must read for those who want an insight into the world of “high finance”. Well written, simple, clear and does not require an understanding of the mathematics of finance. He lays out the how and why of quant trading, in non-technical term, that allows all of us to appreciate that quants are here to stay. Financial services cannot do without quants, just as much as we cannot do without markets.

Valuable to both newbies and seasoned statistical modelers such as myself who have not been directly involved in trading. He points to sources of errors in financial strategies in both the quant and non-quant world. I particularly liked that he had pointed to the problems with correlations.

Narang provides an insight into the world of quants. He explains how and why quants implement strategies and the choices available to them. That at a high level there are a limited set of strategies – one can count on one hand – but at the detail level the number of choices explode.

Reading this book told me that Narang was not just another quant. He is a quant who is always asking the question, how can we build a good model with this data? As it is one thing to build a model but quite another to dig deep into the data to find out why it ticks.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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Sorry for the bad news but Nouriel Roubini’s forecast is in lock step with Goldman Sachs Tier-1 risk capital strategy, I had reported in my previous post And Goldman Sachs Does It AgainBloomberg reports:

Investors worldwide are borrowing dollars to buy assets including equities and commodities, fueling “huge” bubbles that may spark another financial crisis, said New York University professor Nouriel Roubini.

“We have the mother of all carry trades,” Roubini, who predicted the banking crisis that spurred more than $1.6 trillion of asset writedowns and credit losses at financial companies worldwide since 2007, said via satellite to a conference in Cape Town, South Africa. “Everybody’s playing the same game and this game is becoming dangerous.”

What we are missing is a concerted bipartisan public-private initiative to create jobs and get the economy rolling.  The easy part is to put our politics aside and do that. The difficult part is to get everyones’ agendas aligned to get job growth humming again.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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WSJ’s article Fed’s Tarullo Shakes Up Bank Rules states that: A regulatory clampdown could worsen the credit crunch or hurt the economy by excessively restraining Wall Street innovation.

Sorry I don’t buy that. The Wall St. crash of 2008 just blew away that argument. In my opinion subprime was not an ‘innovation’ we needed. Credit card rates at 30+% was not an ‘innovation’ we needed. And there are many more examples you can write down.

What was lacking was not the ability to innovate, but the willingness to innovate in areas where profits are sustainable.  For example, new technologies, new processes, new research, things that need real people to work on. Therefore to ensure that our financial services firms focus on economically sustainable endeavors we need regulations.

If you really believe that regulation will  hurt the economy by excessively restraining Wall Street innovation then look at Goldman Sachs. Their Tier-1 capital is now at 14.5% or about $1 for every $6 of assets . That is a serious amount of risk capital and they are not waiting for regulation, they have moved ahead of the regulators. So what is it they know, you and I don’t?

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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The New York Times reported Goldman Earns $3.19 Billion, Beating Estimates and this on a Tier-1 capital ratio of 14.5%. Goldman has the second highest Tier-1 capital ratio after State Street. Most banks are now in the 10%-12% range with US Government assistance. This is a far cry from the original Basel II requirement of 4%, and Tier-1 capital ratios of 14.5% would have been considered insane in the pre-2007 days.

Goldman Sachs is sending important market signals:

1. Well managed banks can make good profits in spite of “insane” Tier-1 ratios.

2. My guess is that Goldman Sachs is expecting a second asset value collapse soon as this firm has been steadily increasing its Tier-1 ratio and its risk adjusted capital since 2008. See my post  Quant Error! Goldman Sachs Success.

What does all this mean? Well lets look at all the facts.

1. A total of 106 regional banks failed in the United States this year, a figure not seen since 1992.

2. 15.1 million people are unemployed and counting coupled with a jobless recovery. That means prime mortgages are defaulting at unprecedented rates.

3. Many banks are in denial about their current viability and are resorting  to giving incorrect information to their customers. In particular:
3.1 These banks’  credit card operations are telling their customers that they are not part of the banking business and therefore did not receive TARP, when the banks did receive TARP.
3.2 Some banks are telling their customers to take out loans on the other collateral they have and use it to pay off their existing loans.
3.3 Other banks are telling their customer that they have no access to TARP funds or any government assistance and therefore have to foreclose on their customers’ properties.

Points 1, 2 & 3 by themselves just show that the mortgage mess is pretty bad. But add that to what Goldman Sachs is doing – Tier-1 of 14.5% – then that, in my opinion, suggests that Goldman Sachs does not have much confidence in the economy. I hope I’m wrong but it is better to be aware of the downside risk then to walk around in rose tinted glasses.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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The New York Times Economic Adviser Predicts 10% Jobless Rate reported yesterday that,

“Unemployment is likely to remain at its severely elevated level” through the end of next year, predicted Christina Romer, chairwoman of the White House Council of Economic Advisers, at a hearing of the Joint Economic Committee of Congress

…And she warned that the rebound in jobs could actually be even slower than what White House officials and private forecasters had been predicting.

Well, in my October 2, 2009 post (3 weeks earlier than anyone else) 14.5 million Jobless and Counting I stated exactly that. The situation is so bad that Obama Administration should start thinking whether they will make it to a second term.

Why is it so bad? Well, if the Obama Administration does not do something radically different from the previous Administrations of the last 50 years, unemployment will only reduce at the time tested average rate of 0.06% per month after it stops increasing. Or 0.72% per year and 5 years to get 6.1%.

The unemployment will be around 7.6% on re-election day assuming unemployment peaked last month. This is not good news for the Obama Administration. These numbers are optimistic as they assume that the prime mortgage foreclosures do not accelerate bank closures and subsequent credit tightening and financial services layoffs. That is unemployment will most likely be at or above 8% on re-election day. My guess is that the financial services industry will lay off another 30,000 people in the next 18 months.

Quoting the New York Times, “the rebound in jobs could actually be even slower than what White House officials and private forecasters had been predicting“. Economist and private forecasters have been consistently too optimistic and that has eroded our ability to recognize the seriousness of this unemployment problem.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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My earlier forecast agrees with a National Association for Business Economics survey of top business economists:

1. In my post 14.5 million Jobless & Counting I had shown that if the Government does not do anything radical from historical responses our unemployement rate will take until June 2014 to reach 6.1%. 87% of the business economist surveyed expect that unemployement will drop to 4.7% by 2012 or later. That is, the history of President Carter suggest that President Obama is looking to be a one-term president, too. I hope not but that is what it appears as of today October 12, 2009.

2. In my post Have We Hit the Housing Bottom? the business economist concur that home prices will experience a gain from 2010.

3. In my post Have We Hit the Housing Bottom? I forecasted that banks will have difficulties until 2012, and will thus be a drag on the economy. The business economist concur that this will be the case as they expect financial markets to return to normal sometime between 2011 & 2013. 

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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The Department of Labor statistics shows that the long term (1970-2008) annual unemployment is about 6.1%. Not good. 

USEconomicStatistics

Figure 1: Annual Unemployment & Annual GDP Growth. 

 

When Will Unemployment Return To Normal?
Using 6.1% as a bench mark this data show that the unemployment recovery rate after a peak, averages at 0.06%/month. From a May 2009 of 9.4% unemployment, it will take until November 2013 for unemployment to come down to 6.1%. Today’s (10/02/09) news Jobless Report Is Worse Than Expected; Rate Rises to 9.8% or 15.1 million jobless, suggest that it is more likely to be June 2014. Not good. Definitely not good.

 

What Does This Mean?
The US economy is 70% dependent on consumer spending, so we can expect GDP growth to much lower when this recession is over. The recession is expected to be over possibly this quarter 4Q 2009 or next quarter 1Q 2010. Then the “real” economic growth i.e. the job growth (job growth is what really counts) becomes the main driver and indicator of this economy. Without the job growths, mortgages are hampered, and banks, are constrained  and . . .

 

How Can Your Company Help?
1. Don’t downsize your jobs: Downsize your pay & benefits (temporarily) starting from the top.

2. Pay down your debt: This helps banks with their recovery.

3. Don’t ship jobs overseas: This is probably the single most important lesson from history. Jobs follow markets and markets follow jobs. Of course there are some jobs where the domestic-foreign pay diffference is so great that companies have no choice but to out-source overseas.

4. Invest, invest, invest: Good investments lead to better run companies. A good approach to becoming competitive with overseas costs is to invest in technology or capex that substantially increases productivity.

 

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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Our GDP contracted very severely this recession. To understand the severity of this contraction the Federal Reserve of St. Louis data shows that the Annual Percentage Change in GDP has not been negative this last 50 years, until 2009, but the Quarter to Quarter Percentage Change in GDP has 4 times.

 

Economic Outlook
There is some good news though. It is not all bad. Figure 1 shows that the updated moving average of Home Price Growth will likely turn positive 4Q 2009, which is about 1Q earlier than my original forecast 2 months ago. That is Home Prices will bottom in 4Q 2009. Lets hope.

HomePricesNONREVNS

Figure 1: Home Price (Composite-10 CSXR) Growth & Total Non-Revolving Credit Outstanding

However, the Total Non Revolving Credit is still contracting, but the lag to Home Prices appears to be around 2-years, or we can expect Total Non Revolving Credit to bottom in 4Q 2011. This is much better news than my preivous forecast. But we are not out of the woods yet.

 

What to do?
The necessity for caution is reinforced by the lack of near term job recovery & non-revolving credit in my forecast. Here are several suggestions on how to reduce business risk:

1. Manage your cashflow: Cash flow is what pays the bills, not profits, so watch your cash flow.

2. Be careful: Cost cutting is temporary and will unravel the moment you stop wacthing and it can affect what little revenue you are generating.

3. Manage labor wisely: Reduce your man hours but not your manpower. Seek voluntary temporary pay cuts with the biggest cuts at the top and reducing amounts to the lower ranks. This will allow you to bounce back quickly when your sub-segment of the economy turns around because the human asset of your company is still intact. Remember it takes 3 years to bring a fresh graduate engineer up to par. Therefore though it looks cheaper, it will take that much longer to recoup any costs or savings.

4. Reduce dependence on debt: Non Revolving Credit Outstanding shows that banks will continue to have difficulty lending for at least until 4Q 2010 and more likely until 4Q 2011. Pay down your debt as much as you can because it reduces your costs and it gives banks more breathing room to lend to someone else and thereby hastening the turnaround of the Non Revolving Credit Outstanding and the unemployment situation.

5. Watch your A/R: A/R is how your customers borrow while you pay the interest on their credit. A/R is also reflective of your downstream customers, so take care. I have seen companies go under because they did not manage their A/R until it was too late.

6. The Goldman Sachs mini case study shows that we can change the how and why we do things to be more successful, and that we don’t have to wait for eveyone else before we make internal improvements. If we wait we still incur the cost but have lost the competitive advantage.

 7. Slope of the Pay Cuts: Biggest proportion at the top and smallest proportion at the bottom. Why? First, that is how risk-returns (or risk-reward) works there are no two ways about this. Second, large pay cuts at the top of the company have a bigger impact on saving the company but small impact on consumer spending. Pay cuts at the bottom of the company add up to real slow down in consumer spending, save the compnay in the short term but generally leads to negative future effects. There was a study done some time in the 70’s or 80’s (I forget the name and year) that showed that companies that retrench/layoff labor on a regular basis generally don’t last very long.  

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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