Failure by design

Recently I have heard a lot of talk about double and short ETFs. There are certain things I think that most people overlook especially people with a math background that shouldn’t have been overlooked.

These instruments are not meant to be an INVESTMENT. They are there to hedge risk. They do NOT double returns of an index and will under no circumstances get close to two times the historical return of an index. They only match twice the daily returns of the index. Due to their reliance on derivatives, swaps, and futures contracts they face heavy heavy slippage under volatility much higher than implied by the 1-2% fees.

This case can be proven very quickly by charting quickly any two pairs (SSO, SDS for example) against each other and looking at the crosses. They are close to 10% annual rate for the S&P. Looking at more volatile pairs (SKF, UYG)  this approaches almost 20% slippage. If there was zero slippage the ETFs would cross almost near zero but slightly below it at a slope of 1%. Market returns are a function of expected value and volatility (risk). With volatility always representing a negative values on turns. When one multiplies a return by a scalar, expected value goes up linearly, but volatility is raised to the power of the scalar.

This can be shown by using an initial investment of $100. Lets say on day one you have a return of 10 percent and on the second day you have a loss of 10%. Overall your account is down 1%. Now lets say you have invested that in a double ETF, you would have 120 on first day and 96 in the second day for a loss of four percent. More than twice the expected loss due to higher volatility losses. Please understand that this is a super volatile example but it is there to show that you are increasing your risk by a greater amount than your reward and over the long term (hundreds of days) you will fall much shorter than twice the annual returns of the index in exchange for much higher risk.

These funds have been around for only a few years, but you will see the funds post lower values for exactly the same value of the index they are following, by double digit declines. In a volatile market where the index is flat you WILL lose significant amounts of capital due to slippage. They are their for hedging risk not as a long term vehicle for stellar returns.

Ok so taking time from my recent development in Market modeling for currency, learning about chaos mathematics and fractals, plus a bunch of consumptions models for commodities I decided to commit one of a common raids on the Jeff Mclarty blog and see what he was up to.  Instead of writing a giant comment on his page I decided to dedicated a post and kick start this blog back up.

So water, everybody needs it but no one really cares all that much about it…here, but no country has a more acute water problem than China. With over a fifth of the world’s total population (1.8 billion) sharing only 7% of the earths water they have one of the lowest volumes of water per capita in the world. But scarcity is not the biggest problem. China has developed so quickly that their infrastructure and policy has proved inadequate at best. Most of the country’s rivers are so polluted they cannot support aquatic life, much less human life.

Over half of China’s population consumes drinking water contaminated with biological waste that exceeds levels set by the WHO, giving China the highest liver and stomach cancer death rates in the world. Clean water, therefore, is the ultimate China play. It is ineleastic, and a requisite for a strong economy. There are 2 possible solutions: import water (see Great Lakes) or clean their own water (infrastructure). I personally only see filtration as viable only in rural areas and with much of China’s population moving toward urban areas, I think equipment makers will show strong promise domestically. It doesn’t make much sense for 20 million people to have filtration facilities at each of their homes, when infrastructure is already there.

Now that unclean water has become a serious ECONOMIC issue in many developing nations, government agencies and private corporations worldwide are springing into action. The U.S., alone, will spend $1 trillion over the next two decades to upgrade its decrepit water infrastructure. I recently read that 40% of the US water pipes will require replacement within 10 years. (Seems high)  For these I am looking at WTR and NWA. 

I am thinking CWW, ETF traded on the TSX with 3/4 of it’s exposure outside North America. I need to look into it more but it looks promising.

Despite the massive adoption of the Nintendo Wii and huge fan fare did Nintendo hit a home run or set themselves up for a fall?

Current culmulative sales are as follows:

Nintendo Wii – 19 million

Xbox 360 – 16.8 million

Playstation 3 – 8 million

But what is wrong with the availability, I personally know several people who just can’t buy one. This is a huge problem for Nintendo and a major set back for the stock. The consoles pricing has narrowed huge with Sony and Microsoft both cutting prices for their consoles. Microsoft sells more games per console and has a continuous revenue stream from Xbox Live. It is well known that the major manufacturers take a hit on the actual hardware sale in lieu of a 10% royalty on game sales.

By not being able to meet demand Nintendo has short itself short on the Wii by artificially limiting games sales. Console sales will also slow as news hits the markets about the next generation of consoles based on new hardware. Nintendo bet the farm on Wii’s innovative interface, made money hand over fist but could have made more. The next generation of consoles is going to focus much more on human interfaces and be less about hardware.

Since as long as I have been around the key to console sales was powerful hardware. Nintendo proved that creativity will win and differentiated themselves from their competitors. Sony PS3 sales are improving due to the win by Sony on the bluray format, which is huge disadvantage for Microsoft who bet on HD-DVD. A Sony PS3 at current prices is almost free if you were in the market for a Bluray player from the beginning.

I wonder if Microsoft will ever flex its patent rights on direct human interfaces and bring out something truly groundbreaking.

Ever since the slide in February from the China price shock, I have probably been one of the most bearish people on the US and their trading partners. I have gone long in a few instances since then, but not long term by any means or in a fashion that I would have deem highly intelligent today. However, through possibly hundreds of hours in economic research I have come to the conclusion that there are more reasons to be a bear on the US than to be a bull at these price levels. Until, the foreign markets decouple from the US markets I see major declines in the Chinese, Brazilian and Japanese markets. This will be a very long post, but I will try to make it complete and as unbiased as possible.

So the media is making it seem like the recent slide in the market is a recent occurrence. The truth of the matter is that in the greatest bull market of this decade, the DOW has been out paced by the Canadian dollar and almost any other non-US asset. The value of US denominated stocks has been on a landslide for well over 3 years. Unfortunately, I don’t have access to more data but here is the S&P 500 standardized to a US-Dollar on the Gold standard. Unfortunately every rise in US stocks has occurred not because the indexes gained value but because the price of gold changed. Fortunately, or unfortunately, depending on what side of the coin you are on, if US assets continue to slip 1 of 2 things may happen: Foreigners put a floor on US assets by putting the Billions of “dollars” to work or 2. They see things getting worse and switch to a Euro reserve currency in the better interest of their citizens and the dollar falls to more realistic levels.

The most likely scenario in my opinion, is that debt plagued Americans will emerge out of this with all their valuable assets being owned by foreigners and seeing their standard of living fall. This is already beginning to take place and it is causing havoc in the markets, but putting an invisible floor under them. Citigroup and several other major banks facing a liquidity crisis have been forced to take expensive capital from sovereign wealth funds in Dubai and the middle east in order to shore up their balance sheets.

“Unrealistic Expectations”.

There is much evidence that human expectations tend to be linear. Most of the time, most people expect current conditions to continue for the indefinite future. It is almost an unnatural act for a man to leave home with an umbrella on a sunny day. Call it optimism, faith in the future, or just a reluctance to see the party end, there is a presumption that the environment we live in is stable. This is why cities are built on floodplains and fault lines. A similar presumption makes the gambler double his bet or the farmer plant additional crops on reclaimed land the year after a good harvest hoping for things to continue to eternity.

Whenever prosperity exists, it is natural for people to expect prosperity to continue. For this reason, much of the history of human society is a record of astonishment. Time and again, people have marginalized their affairs, rendering themselves increasingly crisis-prone.

They have gone into debt, extending claims on resources to an extreme that could be supported only if current conditions were sustained uninterrupted into the future. Leveraged themselves so highly that a tiny price shock eliminates them from the markets. Time and again these hopes have been disappointed. Whenever prosperity has seemed permanent, some apparently minute change could produce astonishingly large nonlinear shifts in the organization of human society. The failure to recognize or anticipate these nonlinear transformations has been a common characteristic of almost all societies and is readily apparent in the human tendency to allow history to repeat itself.

When the dynamic and nonlinear world adjusts itself to the linear thinking used daily by governments and other institutions such as corporations, banks, insurance companies, the church, and so on, the result can be sometimes catastrophic and can translate into unemployment, inflation, monetary devaluations, market crashes, world wars, civil wars, depressions, and even chaos. The Federal reserve and the government are thinking very short term, and using the same archaic tools to fight new battles.

Change is a fact of life, yet many people don’t want to think about it because they feel threatened by it. So when change comes, it takes them by surprise. By then they can only react to it, and unless they’re lucky, they suffer losses. Only the greatest minds think outside the box, and consider possibilities that others consider impossible.

What is very interesting in this case is that the currencies in question are fiat versus fiat…

Every tick down in the dollar is getting closing to the sweet spot on the guitar with regards to the EURO, the Yen , and all other currencies to feel the same US pain. There is no more standard that holds up the Forex.

This is a very interesting shift in that although the prices are changing, the buildings with the changing price tags wake up tomorrow the same as when they went to sleep. There appears to be no end in sight for the US housing problem and it is translating into large losses in disposable income. This is being seen in the large drop in consumer spending from 75+% down to the most recent reading of 66%. This may not seem like a lot but it is significant and corporate earnings will fall. Hopefully people can use this opportunity as a chance to down their debt before it consumes them.

When trillions in credit and actual losses are taken out of the valuation equation, deflation has to be endured unless of course the same pricetags are to be maintained by dilution. Which is exactly what the Federal reserve is currently doing. By flooding almost a trillion dollars on the market and with the government stimulus plan (funded by debt), the US mint has been kept busy. House prices will bottom sooner, not because their value has stopped falling but because the expansionary policy has degraded the dollar and increased the money supply. As soon as people step outside, their borders they will quickly realize the extent that the monetary experiment of the 21st century has degraded their buying power.

Thus school is out as to whether this is mostly a singled out US event or a somewhat even worldwide distribution. At the moment Bernanke is creating a Bill Seidman approach to the bank bailout by forming a spread between the very short versus intermediate rates and dilution. I personally think, and told a good friend of mine, that if Carlyle Capital collapses, many other funds/companies/banks will follow. Carlyle deals purely with government backed securities from Freddie Mac, which are almost considered risk free. Yet, due to the current credit crisis they couldn’t get the same financing and will be forced to liquidate their assets. This is a problem of remarkable proportions, since these funds are not marked to market and by forcing a sale they will be dissolved. Ah yes but Bernanke’s thoughts, let’s negotiate a refinancing on these mortgage backed securities as their value deteriorates, something akin to ‘keep throwing money into this hole and watch it disappear’. The financial engineering of a black hole is upon us, but first watch bond funds/hedge funds/banks supernova one by one. Sure enough, I woke up this morning to see Bear Stearns down 47%. This “used” to be one of the biggest banks on Wall Street cut in half! There will surely be more to come.

An excerpt from a Carlyle group release:

“Negotiations with lenders effectively ended late Wednesday when the pricing service used by certain lenders reported another drop in the value of mortgage-backed securities. That’s expected to trigger another $97.5 million of margin calls Thursday, on top of the roughly $400 million of demands it received in the previous week.”

And that kind of stuff is what’s going to happen to ALL THESE BIG INSTITUTIONS…day after day after day…until the $516 TRILLION of Worthless Derivatives are FINALLY marked to the REAL MARKET…not some computer algorithm. Several economists are calling for them just to write-down the value of the assets, and get this past us. Bernanke, is also in this camp but there is just no motivation to prematurely blow your companies balance sheet up. These banks made a grave mistake by lending to the wrong people, they cannot take these loans back and they are not worth the amount they are claiming, but they need the margin that these assets allow them to take or their liquidity will dry up.

In the short term, the best hope is that the availability of the Fed as a short term buyer may, for a time, provide enough comfort that brokers will maintain margin lines of credit for their clients who hold mortgage linked securities. The real question is whether the fear engendered by the collapse of Carlyle will outweigh the potential comfort of basically having short term Fed-backing on this very sickly class of securities. It is difficult to speculate what will happen over the near term, but if Carlyle couldn’t reach a standstill with the backing of its parent and with the Fed standing in the wings as a potential buyer of mortgage securities, is there any strong probability that there will not be more and more margin calls, and waves and waves of forced selling, over the near term? Let’s not forget the almost $400 billion dollars in LBO paper that the major investment banks underwrote but couldn’t sell after the credit crisis. GS, BSC, MS and others hold large amounts of LBO funds in their accounts that they could not sell. Currently they are marked down to 90 cents on the dollar, is it impossible to see them down to 80 cents or less to get them off?

Thus the rest of the world will have to react to try to move toward equilibrium, much like globalization theory. Globalization looks and smells like it works ok in the short run, but in the long run it is just a form of shifting money around within the same geographical boundaries. A coca cola may cost $3 in some countries and 50 cents in others but coca cola is coca cola and that spread will go to zero.

For the investor: stay out of the US equities market entirely until signs point to a bottom. The bottom may be years off, so, you may end up holding onto cash for a long time, earning less than the soaring rate of inflation. The CPI is a great tool, but it is flawed. During the housing boom, people criticized it for not accounting for the boom in housing, but now that has changed and the falling in the housing markets is the only thing keeping it in check. It is not real folks, inflation is upon us. Look at gold, corn, beef, electronics and car prices. They are all going up. Kelloggs, PG and may others were forced to carry double digit percentage increases on their products to protect margins. You can try to hedge with TIPS and commodities, but the commodities gamble could come to a wild and abrupt reversal at any time. The moment global demand shows a downturn, and it will, prices for many of the “priced to perfection” commodities will decline. To the extent you invest in equities, maintain exposure to select emerging markets that are net exporters and that sell their exports in dollars. Limit your exposure elsewhere, although holding some Pan-Asian (developed markets) and European indexes may be prudent since equities markets will start to climb in many months anticipation of a resolution of the credit crisis and one never really knows when that might transpire.

Thiago Avila