July 2008


If I reproduce my table, I can examine more closely the effect of war on the economy.

Year………………………………Return on Capital…………Inflation%……….Adjusted
1871-1881……………………………8.3%…………………..[-1.7%]………….10%
1881-1891……………………………6.4%………………….[-1.16%]………….7.56%
1891-1901…………………………..7.3%…………………..[-0.6%]……………7.9%
1901-1911…………………………..7.2%…………………..1.12%……………..6.08%
1911-1921…………………………..5.7%…………………..6.87%…………….[-1.17%]
1921-1931…………………………..7.3%………………….[-1.6%]……………8.9%
1931-1941…………………………..7.5%………………….[-0.3%]……………7.8%
1941-1951………………………….12.3%………………….5.84%……………..6.46%
1951-1961…………………………..7.4%………………….1.42%………………5.98%
1961-1971…………………………..5.4%………………….3.08%……………..2.32%
1971-1981…………………………..8.7%………………….8.42%……………..0.28%
1981-1991………………………….7.8%…………………..4.12%……………..3.68%
1991-2001………………………….4.1%…………………..2.66%……………..1.44%
2001-2008………………………….3.8%…………………..3.1%……………….0.7%

Now we’ll break the data into individual years.

Year………………………Inflation………Return to Capital…….Adjusted
World War I
1914………………………0.94%……………..7.13%……………..6.19%
1915………………………0.54%……………..8.7%……………….8.16%
1916………………………9.24%…………….12.9%………………3.66%
1917……………………..20.49%……………15.5%……………..[-4.99%]
1918……………………..17.47%……………15.3%……………..[-2.17%]
World War II
1939………………………[-1.42%]…………6.6%……………….8.02%
1940………………………1.01%……………10.7%………………9.69%
1941………………………4.99%……………11.7%………………6.71%
1942…………………….10.66%……………11.7%………………1.04%
1943……………………..6.13%…………….9.0%……………….2.87%
1944……………………..1.73%…………….7.2%……………….5.47%
1945……………………..2.27%…………….6.6%……………….4.33%
Vietnam
1964…………………….1.34%…………….5.3%………………..3.96%
1965…………………….1.71%…………….5.6%………………..3.89%
1966…………………….2.85%…………….6.3%………………..3.45%
1967…………………….2.90%…………….5.8%………………..2.90%
1968…………………….4.19%…………….5.5%………………..1.31%
1969…………………….5.37%…………….5.8%………………..0.43%
1970…………………….5.92%……………7.3%…………………1.38%
1971…………………….4.30%……………5.3%…………………1.00%
War on Terror
2001…………………….2.85%……………2.9%…………………0.05%
2002…………………….1.58%……………2.6%…………………1.02%
2003…………………….2.28%……………3.4%…………………1.12%
2004…………………….2.66%……………4.9%…………………2.24%
2005…………………….3.39%……………5.2%…………………1.81%
2006…………………….3.23%……………5.9%…………………2.67%
2007…………………….2.85%……………4.3%…………………1.45%
2008…………………….4.90%……………4.1%………………..[-0.80%]

There are numerous variables that have not been considered;
*existing deficit/surpluses
*demographics
*over-all size of the economy
*size [cost] of the conflict

There seems to be no immediate conclusions that can be drawn from the data across the different conflicts. It would seem that the over-all state of the economy would need to be considered as a whole. Certainly the war periods will provide significant inputs, but have no individual pattern or trend that reveal themselves from a very basic analysis.

Ugly data.

Corporate bankruptcies are starting to accelerate;

Mervyn’s and the parent company of Bennigan’s both filed for bankruptcy protection yesterday, providing more evidence that the pace of corporate flame-outs is accelerating.

Only half way through 2008, billion-dollar bankruptcies are at their highest level in five years, according to BankruptcyData.com, which tracks bankruptcy filings. It said that seven United States-based companies with more than a billion dollars in assets have filed for bankruptcy protection so far this year, according to a Reuters report.

“We seem to be in the midst of a ‘perfect storm’ leading to more bankruptcies: high levels of debt, high energy and raw materials costs and weakness in the U.S. economy,” George Putnam III of New Generation Research, which publishes BankruptcyData.com, said in a statement.

Mervyn’s, the department store chain, blamed its Chapter 11 filing on the “state of the economy and difficult operating environment for our industry.” It said its stores will remain open as it reorganizes under court protection.

Bennigan’s, a restaurant chain, filed for Chapter 7 protection; stores owned by its parent company will close their doors.

Earlier this year, Linens ‘n Things, a retail chain backed by the giant buyout firm Apollo Management, sought bankruptcy protection after it was unable to service its heavy debt load.

One of the year’s biggest bankruptcies so far was SemGroup LP, an oil-marketing firm that Forbes has called the 12th-largest private company in the United States.

The casualties are likely to keep coming.

A recent report from Moody’s said that more than 10 percent of the speculative-grade companies whose liquidity it rates had the lowest possible rating — something that hasn’t happened in five years.

The following post describes the “Reverse Merger Arbitrage.” Actually it’s not really an arbitrage at all, as you are not selling and buying the same financial asset and locking in a guaranteed profit via a spread.

However, that being said, it is I believe an attractive speculation, albeit that you can only utilize small amounts of capital.

From http://www.gualbertodiaz.com/ Which is a sub-blog of SMB Capital in the blogroll.

I’ve been meaning to write this post for a couple of days now. This is an arbitrage opportunity that I have found to be successful and requires the minimal use of capital for about 2 weeks at a time. Rather than go public via an initial public offering, some companies are going public via a reverse merger. What these private companies do is purchase a public shell, which is a stock that is publicly traded but is basically out of business. The private company gets issued preferred stock which is convertible to normal shares on a 10:1 basis (varies on each deal).

With all these preferred shares converted to regular shares, the private company takes control of anywhere from 90-95% of the float. Talk about dilution of shares huh? So at this point you’ll have anywhere from 50 million to 300 million shares outstanding. Anywhere in the range of these numbers, the stock price will be worth pennies for years until it grows into its valuation.

So once the private company converts its preferred shares, it immediately completes a reverse merger, maintaining the private company’s equity stake of 95%. Here’s where the opportunity of arbitrage presents itself. When the company completes its reverse merger, in an effort to preserve round lots, it usually includes a provision to for any shareholders holding either 100 or 99 stocks or less to not be affected by the reverse merger.

So to illustrate how its done, let me show you what was done in the two instances that I was involved in.

In the first instance, I purchased 99 shares of MJET on May 25, 2005 at $.22 a share for a total of $21.78. In the company’s current report at the time, it stated the company’s plan of action. After the 1-29 reverse merger occurred, I then sold those 99 shares at $9.00 a share under the company’s new symbol, BLHL on June 10, 2005 for a total of $891.00.

In 17 days I received a 4090% return on my investment! In the second instance, it was still a profitable trade, although the return wasn’t as high mainly because the initial share price was so much lower.

I purchased 99 shares of TDIH at $.058 on August 25, 2005 for a total of $5.75. In the company’s current report at the time, it stated its plan of action. After the 1-21.8 reverse merger occurred, I then sold those 99 shares at $1.25 a share under the company’s new symbol, FHHI on September 1, 2005 for a total of $123.75

In 8 days I received a 2152% return on my investment. Even though it wasn’t as good as the first deal, it was still free money. I must note that later I did get back into FHHI at $.79 a share and that it is currently one of my holdings. I will be posting on the company in the near future.

So arbitrage opportunities do exist in the stock market. The reason this one exists is because so little money is involved when you compare it relatively to the rest of Wall Street. One note I need to make though: I have friends that have Scottrade and I know they had trouble with it because of some problem within Scottrade’s back office I believe. I use Etrade and experienced no problems. I believe they still kept their shares, but had to wait a little bit longer.

Although I have not been as up to date with this market as I should be, I will post on here when I know of any new reverse merger arbitrage opportunities.

Just while we are talking about allocation of capital, here are the data on current earnings;

If you actually examined the Banks margins from 1991 to the current, or peak of their share prices, it was very easy to see the massive deterioration in their margins. Compare the deterioration in margins to their “increased” earnings, and it was only one step to the question…how?

The answer was of course leverage. The rest would have been fairly obvious.

The best way to approach the consequences of deficit spending is from the perspective of “what if there was still a Gold/Dollar exchange?”

When the dollar was directly convertible to gold, a deficit in foreign trade, led directly to an outflow of gold. If China held $1Billion in paper dollars, they would exchange them for gold, thus directly reducing the amount of gold held by the US

This would then have the direct consequence of reducing the money supply [currency dollars] by $1Billion. With less currency in circulation, competition for money [currency dollars] would increase.

If I owned a business that required capital for expansion, and I wished to borrow that capital, with capital becoming more scarce, the cost of that capital would rise. Prudence would suggest that if the return on that capital would not, or could not exceed the cost of that capital, then, I would not, should not borrow that capital.

In other words, only the most sound, profitable and productive businesses would seek capital. This immediately allocates capital in a rational manner, eliminating capital being allocated to businesses that have no basis for capital, as the probabilities lie in their destruction of said capital.

Gold is thus deflationary. The same rules that govern the allocation of capital to a business, apply in equal measure to a government. Thus gold, was above the ability of the government to control and manipulate, an impartial arbiter. Being deflationary, it increased and punished the burden of excessive indebtedness.

Today, gold is a long distant memory within the allocation of capital. Money, via fiat currencies has lowered the cost of capital through inexorable inflation and credit creation.

Inflation, cheapens debt. Inflation, promotes excessive indebtedness, as, over time, the real cost diminishes as the value of money diminishes.

With America currently struggling under the collapse in housing, a credit contraction that both have threatened the viability of the financial system, how well has America allocated capital?

Lets examine the data.

Year………………………………Return on Capital…………Inflation%……….Adjusted
1871-1881……………………………8.3%…………………..[-1.7%]………….10%
1881-1891……………………………6.4%………………….[-1.16%]………….7.56%
1891-1901…………………………..7.3%…………………..[-0.6%]……………7.9%
1901-1911…………………………..7.2%…………………..1.12%……………..6.08%
1911-1921…………………………..5.7%…………………..6.87%…………….[-1.17%]
1921-1931…………………………..7.3%………………….[-1.6%]……………8.9%
1931-1941…………………………..7.5%………………….[-0.3%]……………7.8%
1941-1951………………………….12.3%………………….5.84%……………..6.46%
1951-1961…………………………..7.4%………………….1.42%………………5.98%
1961-1971…………………………..5.4%………………….3.08%……………..2.32%
1971-1981…………………………..8.7%………………….8.42%……………..0.28%
1981-1991………………………….7.8%…………………..4.12%……………..3.68%
1991-2001………………………….4.1%…………………..2.66%……………..1.44%
2001-2008………………………….3.8%…………………..3.1%……………….0.7%

It can be plainly discerned that capital is systematically being destroyed, as it’s allocation to businesses have lowered the return. Profitability has been destroyed. This is why America is now in such dire straits, capital has been allocated to rubbish.

Also, the way in which the Gold Standard maintained a deflationary milieu, thus enhancing the returns to capital. The massive deficits that the government maintain currently, simply would not have been tolerated under a Gold Standard.

Of course, even the way that inflation is measured has been altered by successive governments, thus understating the true inflationary effects on capital.

The answer is simple, restore the cost of capital by again making businesses compete for a scarce resource. Then, once again, capital will be allocated to those who can earn a return in excess of it’s cost, restoring the allocation of capital to quality, rather than allocating capital to any fool who asks, that fool would most definitely include your elected members of government.

I’ll provide a detailed analysis later in the week. For now, just the quick basics;

American Campus Communities, Inc. is a fully integrated, self-managed and self-administered equity real estate investment trust (REIT). It specializes in the acquisition, design, financing, development, construction management, leasing and management of student housing properties across the United States. American Campus Communities conducts its business through a controlling interest in American Campus Communities Operating Partnership LP and American Campus Communities Services, Inc., which serves as a taxable REIT subsidiary (TRS). Through the TRS, the Company also provides construction management and development services, for student housing properties owned by colleges and universities, charitable foundations, and others. On June 11, 2008, American Campus Communities, Inc., completed the acquisition of GMH Communities Trust, a real estate investment trust (GMH). With the close of the GMH acquisition, it owns 88 student housing properties containing approximately 54,300 beds.

This is one guessing game that will not end with the showcase showdown. In valuing a truckload of securities at 22 cents on the dollar, Merrill Lynch & Co.’s fire sale might burn some other fingers on Wall Street.

The company Monday decided to offload $30.6 billion in securities to private equity firm Lone Star Funds at 22 cents on the dollar, producing a rare data point in the market place, where banking institutions, for months, have kept their own counsel on what their various toxic assets were worth.

In doing so, the price may now serve as a benchmark (or even a ceiling) for the value of various other collateralized debt obligations owned by banks such as Citigroup Inc. and Barclays PLC.

This is capitulation from an institutional viewpoint. Merrill have basically given in, and simply want out. Thus, sell everything, take the loss, wipe-it-off the Balance Sheet and move forward.

The breakdown looks like this; selling $8.5Bn in stock (half of which is being bought by management and Temasek holdings), a fire sale of assets and an additional write-down of $5.7Bn. This write-down is comprised of a $4.4 billion loss associated with the sale of CDOs, a $0.5 billion net loss on the termination of hedges with XL Capital Assurance and an approximately $0.8 billion maximum loss related to the potential settlement of other CDO hedges with certain monoline counterparties.

This is a huge step forward, and other Banks, as stated, may well be forced, willing or not, to also chuck in the kitchen sink and take the “big bath quarter.” If they do, it will mark a return of the value investors who know their business.

The previous post highlighted the probabilities side of the trading equation. Now probabilities are calculated based on statistical data. That is, if you haven’t gathered enough data to generate a statistical probability, with a correctly calculated confidence factor, then you are not trading a probability based expectation.

I suspect that many of the trading plans are not “system” trades, in the context of not being exhaustively back-tested in a systematic manner, rather, they are empirically tested.

For those that are systematically back-tested, we run into the second problem. This problem can be a little difficult to overcome without at least a Monte Carlo generator, and that is the distribution that one utilizes when generating the probabilities. Mandelbrotion is the one you want, Gaussian, as has been proven in crisis after crisis, will see you have problems.

Utility, a term associated with economics, actually originated with the birth of “Probability Theory” and it’s originator Daniel Bernoulli. In essence, it describes the “value of risk.” This is a rather elegant approach to describing what is commonly referred today as “fear & greed.”

Behavioural finance, increasingly important today, has ressurected this concept, as through the years the utility of risk was ignored over the expectancy of risk.

Morgan Stanley, for some 20yrs now has being peddling their “Value at Risk” [VAR] system, an expectancy based methodology to all and sundry. No matter how many times it has failed, and failed spectacularly, as it has again in this crisis, it seems to remain the industry standard.

Part of this phenomenon must be attributed to the money that it loses, doesn’t actually belong to those who lose it, viz. they get paid regardless, thus the utility component is completely absent.

Common to the participants in the previous post is this; they are all trading their own money. Thus, the utility component of the equation weighs heavy. Possibly so much so that it has overwhelmed the expectancy side of the equation.

How to find the correct balance? Food for thought, I may provide some answers, as I fall into the overly concerned with utility camp, but, through the years have modified the factors that fall under the expectancy side of the calculation. They now fulfill the “investment” criteria.

I have no intention of opening the eternal debate twixt speculation and investment as it normally stands. Rather, to take possibly the best definition of investment ever written, and contrast it with speculative practices. The initial quotes simply highlight from the blogosphere the most difficult aspect of speculation.

Today I had a couple of trades that ran well. A little while back I really want to milk these kind of trade for big profits. Since I am trading small, 100-200 share positions, I always want to capture $1-2 moves. I usually end up giving back all my gains by holding too long. A lot of times the stock would pull back and stop me out before it runs again. In many of my trades I would be up over $1 if I had taken profits, but end up with only 1/3 of that. Now I am not going to be that greedy.

I think taking profits is helping me psychologically, since I am taking in steady gains during the day. I am able to see things more clearly and take more trades.

The same problem.

On to the weekly recap of my trading. I ended the week profitable but only slightly. I missed my weekly goal of $1,000.00 in profits by about $800.00. That’s a big miss!!! The problem came from an old cliche about trading: Let your winners run. There were multiple instances of me being in a winning trade and exiting before there was any sign that the trade was slowing down. I’m not talking about instances where a trade will pause during the middle of a trend, trade sideways to slightly up and then resume in its current direction. No, I’m talking about taking a short trade and the stock does not print a single green bar but I am exiting anyway, only to see it move straight down another dollar. I even go back and watch the video and hear myself saying: ” I think I’m getting out now even though I believe it will keep going my way and has showed no signs of moving against me”. That’s messed up. So I know I have to figure out why I am doing this and either be able to fix it mentally or mechanically, i.e. trailing stops. Also i have found multiple instances of over trading during the middle part of the morning. I want to make money so I am attempting trades when the market has no real direction and just chops around. Got to fix that!! There were also two or three times when I would exit a trade before my stop was hit only to see the trade go my way very quickly. I would feel anxious about losing money on the trade, even though my stop loss was well within my average loss limit, and just bail so I would not have to feel the anxiety of having a possible loser. And then when the trade would start to go without me I would revenge trade and lose money. So instead of keeping the winner and making $400.00, I exit, jump in another stock and lose $160.00. Another problem to fix.

A “Mechanical” solution?

Taking the trades tomorrow will feel like I’m getting back on the same big ass bull that just bucked me, except now I’ve got my tailbone shattered, my chest gored, and hands rope-burned.

But what else can I do? If I do not take the trades, then I may miss a crucial turning point. Or not. They may just generate more losses. In fact, if all 5 trades stop out, they will erase all of my gains from the last 2 months.

The point is, one doesn’t trade a system if he can see the future, or if he can accurately predict market turns. One trades a system because it provides an edge that is assumed to be better than what can be offered from his mental faculties.

In other words, when one overrides a system, a variable is introduced which has typically not been tested. To make matters worse, this variable is more likely to introduce error and chaos, due to the fact that it is usually discretionary, a byproduct of one’s psychology, biases, etc. Remember, one would not be trading a system in the first place if he was programmed mentally to trade with an edge. What I have found is that intervention seems to capture the worse elements of the system, and magnify them.

What makes system trading hard for me is that it is very difficult to reject the urge to intervene. I’m not sure why I’m having a problem with it. It may be that I’m relatively new to the concept and just have not gotten used to being completely mechanical.

Let me now reproduce an older post [posted under expectancy]

Expectancy is your profit percentage per win multiplied by your win rate minus your loss percentage per loss multiplied by your loss rate. I will use an example of Expectancy from Dr. Van K. Tharp’s Book: Trade your way to Financial Freedom:

Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss) Expectancy = (PW*AW) less (PL*AL)

PW is the probability of winning and PL is the probability of losing.
AW is the average gain (win) and AL is the average loss

So let’s do an example using another basic approach (assume $12,500 per position, a $100,000 portfolio using 1% equity risk):

If my trades are successful 40% of the time and I realize an average profit of 20% but I lose an average of 5%, my expectancy is $625 per trade.

(0.4 * $2,500) – (0.6 * $625) = $1,000-$375 = $625

I lose 60% of the time yet I show a profit of $625 per trade. If I have a system that produces 65 trades per year, I would realize an annual gain of $40,625 (hypothetical scenario). A 40% gain on the original $100,000 (minus all commissions, fees, taxes and compounding).

Let’s look at the calculation one more time using only percentages:
PW: 40%
AW: 20%
PL: 60%
AL: 5%
(40% * 20%) – (60% * 5%) = 5.00%

What this tells me is that I have a positive expectancy of 5% or $625 per trade from the original $12,500. It doesn’t mean that I will make $625 on every single trade but my system will average a profit of $625 per trade over the course of a year with a combination of winners and losers. I can always make more trades or fewer trades in a year so my total profit will be adjusted accordingly.

I also wish to add to this post with “the” definition of investment, made almost 100yrs ago, quite remarkable that in the intervening years, rather than being surplanted by an improved definition, it has simply been proven through the passage of time;

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

There are some similarities twixt the rules of “expectancy” and the definition of investment. Are the similarities enough to qualify the rules of expectancy, rigorously applied, the sobriquet of an investment operation?

I’ve listened to this track hundreds, possibly thousands of times over the years, but somehow the lyrics never really penetrated. Rather describes the “average” persons grip on the world in which they live. Quite a concern really, as at some point they will retire, only to find that they are now living in abject poverty, having not taken any or the correct measures to protect themselves and their families, thus, it is dedicated to them;

Harmlessly passing your time in the grassland away;
Only dimly aware of a certain unease in the air.
You better watch out,
There may be dogs about
Ive looked over jordan, and I have seen
Things are not what they seem.

What do you get for pretending the dangers not real.
Meek and obedient you follow the leader
Down well trodden corridors into the valley of steel.
What a surprise!
A look of terminal shock in your eyes.
Now things are really what they seem.
No, this is no bad dream.

The lord is my shepherd, I shall not want
He makes me down to lie
Through pastures green he leadeth me the silent waters by.
With bright knives he releaseth my soul.
He maketh me to hang on hooks in high places.
He converteth me to lamb cutlets,
For lo, he hath great power, and great hunger.
When cometh the day we lowly ones,
Through quiet reflection, and great dedication
Master the art of karate,
Lo, we shall rise up,
And then well make the buggers eyes water.

Bleating and babbling I fell on his neck with a scream.
Wave upon wave of demented avengers
March cheerfully out of obscurity into the dream.

Have you heard the news?
The dogs are dead!
You better stay home
And do as youre told.
Get out of the road if you want to grow old.

Next Page »