Queen Elizabeth I Formed World's First Franchise 350 Years Before Ray Kroc

Fascinating history lesson in last week's Economist on The East India Company. Queen Elizabeth I chartered the company in 1600 as a way to facilitate British trade around the Cape of Good Hope to Asia. The Economist says this event marked the beginning of the modern world:

The East India Company foreshadowed the modern world in all sorts of striking ways. It was one of the first companies to offer limited liability to its shareholders. It laid the foundations of the British empire. It spawned Company Man. And—particularly relevant at the moment—it was the first state-backed company to make its mark on the world.

I found this passage particularly interesting. It sounds like QE1 invented the modern franchise.

The Company improvised a version of what Tom Peters, a management guru, has dubbed “tight-loose management”. It forced its employees to post a large bond in case they went off the rails, and bombarded them with detailed instructions about things like the precise stiffness of packaging. But it also leavened control with freedom. Employees were allowed not only to choose how to fulfil their orders, but also to trade on their own account. This ensured that the Company was not one but two organisations: a hierarchy with its centre of gravity in London and a franchise of independent entrepreneurs with innumerable centres of gravity scattered across the east. Many Company men did extremely well out of this “tight-loose” arrangement, turning themselves into nabobs, as the new rich of the era were called, and scattering McMansions across rural England.

How is this arrangement different than owning a McDonalds restaurant? You own the property, but  the french fries and Big Macs must be made precisely as the company says. And, if you work hard and keep the place clean, you're almost guaranteed to get rich. 
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Why the Republicans are Right on Payroll Taxes

News flash: the rich are getting richer, the rest of us are sucking wind. What should Washington D.C. do about it?

The Democrats want to raise taxes on the wealthiest 1%, the Republicans cry "class warfare" and decry any tax on "job creators". Meanwhile, our deficit is enormous and growing nearly $4b per day. How can we square these differing views?

How about a surtax on the rich, as the Dems have proposed. But, these lucky folks could recoup their tax dollars if they really do create jobs...anybody who employs Americans should be able to claim a tax credit of 1% of U.S. payroll against their personal income tax. This credit should be distributed to shareholders for publicly traded companies.

The net effect would be similar to a Republican proposal to reduce employers' share of payroll taxes, but doing it my way would make it more palatable for Democratic constituencies. It would also provide more of a boost to the economy than the Democrats current proposal to extend the payroll tax cut for employees into next year. That tax cut doesn't help the unemployed one whit, while giving the cut to employers encourages them to hire jobless Americans. While folks with jobs would certainly appreciate a tax cut, our biggest problem is folks without jobs! If we could fix that, the rest would take care of itself. Tweet

Our Schools Should Teach Less Math

When did schools remove weaving from the curriculum? How about abacus training? Does anybody still teach basic slide rule skills?

All of these used to be incredibly useful, until they were made obsolete by machines. We (as a society) eventually decided that these skills were no longer needed, and our schools stopped teaching them. Instead, we started teaching more relevant skills like computer programming and auto repair.

Yet, in the year 2011, we still spend countless hours teaching poor frazzled seventh graders how to do long division! Granted, being able to quickly do basic addition and subtraction without the aid of a calculator is a useful skill. But when was the last time you used a paper and pencil to divide a 4 digit number into a 5 digit number? I'll bet it was seventh grade!

Schools are slowly getting with the program, and have started teaching useful twenty-first century skills like spreadsheets, power-point presentations, Spanish, and Chinese. But there are only so many hours in the school day, and so many days in the year, and only a short 12 years to pack all this info into our children's pliable little minds. And we can't afford to waste time teaching obsolete skills like long division. In another generation, all mechanical math skills (fractions, even multi-digit multiplication, addition and subtraction) will be obsolete.

What should we teach instead? Here's an interesting article from Wired Magazine. It turns out that kids are great at using computers, but are lousy searchers:

High school and college students may be “digital natives,” but they’re wretched at searching. In a recent experiment at Northwestern, when 102 undergraduates were asked to do some research online, none went to the trouble of checking the authors’ credentials. In 1955, we wondered why Johnny can’t read. Today the question is, why can’t Johnny search?

Who’s to blame? Not the students. If they’re naive at Googling, it’s because the ability to judge information is almost never taught in school. Under 2001’s No Child Left Behind Act, elementary and high schools focus on prepping their pupils for reading and math exams. And by the time kids get to college, professors assume they already have this skill. The buck stops nowhere. This situation is surpassingly ironic, because not only is intelligent search a key to everyday problem-solving, it also offers a golden opportunity to train kids in critical thinking.

New skills are needed to navigate today's information-rich world. Critical thinking is at a premium. How can one tell if an email is presenting a legitimate opportunity, or worthless spam? How do we know if the Obama's dog really flew in a private jet to join the family on vacation? Believe it or not, a person with a professional degree actually sent me an outraged email with that urban legend. So maybe a high-school class on "Critical Thinking and the Internet" would be useful. Tweet

Rebuttal to Krugman/s "Things to Tax"

In a recent op-ed entitled "Things to Tax", Paul Krugman suggests a financial transaction tax.

And then there’s the idea of taxing financial transactions, which have exploded in recent decades. The economic value of all this trading is dubious at best. In fact, there’s considerable evidence suggesting that too much trading is going on. Still, nobody is proposing a punitive tax. On the table, instead, are proposals like the one recently made by Senator Tom Harkin and Representative Peter DeFazio for a tiny fee on financial transactions.

And here’s the thing: Because there are so many transactions, such a fee could yield several hundred billion dollars in revenue over the next decade. Again, this compares favorably with the savings from many of the harsh spending cuts being proposed in the name of fiscal responsibility.

This is so wrong-headed on so many levels.

The majority of trades are executed for tiny profits. And I'm not just talking about the machines, I'm talking about real human beings. Even a .1% transaction tax would kill this entire business in the U.S. It simply would no longer be a profitable business. Most likely it would move offshore, to non-taxed markets. If there's one thing we've learned from globalization, it's that capital will quickly move to the most profitable location.

Secondly, by removing the high-frequency traders (and believe me, I'm no fan of HFT; the deck has always been stacked against the little guy, now it's practically impossible to beat the computers) liquidity would dry up. Formerly liquid issues would start trading with wide spreads. Costs would go up for the remaining market participants, who don't have the know-how or resources to trade overseas: retail investors. AKA, the suckers who always end up holding the bag.

Professor Krugman has made the classic error when assessing potential revenue from a new tax: he assumes that the new tax would not change peoples' behavior. If this logic worked, why not impose a $1 tax on each U.S. text message? Golly, my daughter sends hundreds of text messages every month, this tax could retire our national debt in a matter of months!

So, a financial transactions tax, which Krugman expects to raise billiions and hurt "the bad guys", would actually raise very little revenue and hurt only "the little guys." Tweet

Is the US becoming Japan? And what's in it for me?

In 1989, Japan was flying high. Prime Tokyo real estate reached $1m per square meter. The Nikkei stock index peaked at nearly 39,000 on December 29. The Japanese snapped up American real estate, including Pebble Beach and Rockefeller Center. "Japan Inc" graced magazine covers, newspaper headlines, and books. It seemed that nothing could stop the Japanese steamroller, and that they were destined to dominate the global economy.

Then, the bottom fell out. The Nikkei plunged, and has never again approached its 1989 high. Real estate plunged as well. GDP growth has been nearly nonexistent; the "Lost Decade" has endured for more than 20 years, with no end in sight. 

In response to this unfortunate turn of events, the Bank of Japan has cut interest rates over and over, but the economy hasn't responded to traditional monetary policy. Japan is stuck in a deflationary cycle, with no end in sight. Paul Krugman and others have suggested that Japan  has experienced a liquidity trap, characterized by a lack of aggregate demand, and ultra-low interest rates that have failed to stimulate the economy.

Today, in late 2011, the United States is experiencing a similar post-bubble hangover. The Nasdaq peaked 11-1/2 years ago, the Dow 4 years ago; both are down significantly since then. US stock portfolios have (at best) stood still for more than a decade in nominal terms; in real terms, equities are underwater--even as a majority of Americans have grown to count on the stock market for their retirement savings. Real estate peaked 5 years ago, and is down 30% nationwide; parts of the "sand states" (Nevada, California, Arizona, and Florida) are down more than 50%. Unemployment has remained stubbornly high, even as Ben Bernanke and the Fed have reduced short rates nearly to the so-called "Zero Lower Bound". The Fed is giving money away, and still, there is no demand for it.  Krugman (and many others) have called an American liquidity trap. 

Naturally, students of history are wondering whether America is leading the West into a long-term low-growth era, similar to Japan's "Lost Decade". Recent US short rates have traced an eerily similar path to Japan's rates in the early '90s. David Rosenberg did a nice write-up on how the U.S. is "Turning Japanese", here's his  chart showing the two countries' post-bubble interest rates.

If you're American, you may be saying "Crap! That's terrible! I'm not looking forward to that!" And I'm not, either. But there may be ways to take advantage of the situation...if life gives you lemons, you might as well make lemonade! So, let's talk about adjustable-rate mortgages.

Adjustable-rate mortgages (ARMs) are loans designed for low initial payments, with the borrower paying the loan off relatively quickly (by selling the property or refinancing to a fixed-rate mortgage). If you're thinking of buying a home, or an investment property, or if you're thinking of refinancing your existing mortgage, it's a great time to think about taking out an ARM.

While the vast majority of residential loans are fixed-rate (usually 30 year), the rest are adjustable-rate. Interest rates on fixed-rate mortgages are determined by capital markets; they usually follow Treasuries Bonds. ARMs, on the other hand, follow short rates, which are dominated by the Fed's actions.

On August 9, the Fed announced that it would keep interest rates “exceptionally low" through mid-2013. So Ben Bernanke just told you that (if you take out an ARM before mid-2012) you will enjoy at least two years of "exceptionally low" interest payments. (ARM payments typically adjust annually, so you will have till early 2014 before your rate adjusts up.) Furthermore, if the US follows Japan into long-term economic stagnation, you will enjoy low payments far beyond 2014. Both long and short rates are likely to remain low for several years (we'll look at contrary views a little later).

Let's take a look at some numbers. My credit union offers 1-year ARMs at 2.875%, 3/1 ARMs (fixed for 3 years, then annual adjustments indexed to LIBOR), and 5/1 ARMs at 3.125%. They also offer an interesting option, the 5/5 ARM, at 3.375%. This loan would start at 3.375%, stay there for 5 years, then reset every 5 years. By contrast, a 30-year fixed is quoted at 4.375%. (All loans are 0 points, on a 30-year amortization schedule.)

If you borrowed $200,000, the 1-year ARM payment (principal and interest) would be $830. You would pay  $844 on the 3/1 ARM, $856 on the 5/1 ARM, and $884 on the 5/5 ARM. The conventional 30-year fixed mortgage would cost $998 monthly. So, if you took out a 1-yr ARM today, Ben Bernanke has guaranteed you that your payment won't go up until late 2013, and you will save $168 per month for 24 months, or $4032. This is slightly more than 2% of the original principal. Not bad! In two years you can continue to take your chances with short rates, or refinance to a fixed if the economic picture has changed significantly. If you have a lower risk tolerance, you could select one of the other options. The 5/1 ARM would save you $142 per month for 5 years, or $8520 (more than 4% of principal).  The 5/5 ARM is my favorite, it would save you $114 per month for 5 years ($6840, or 3.4% of principal). And, after 5 years (when I believe rates will still be low, a la Japan), you can lock in for another 5 years of low rates.

What are the risks in this strategy? Let's think about the future level of interest rates, and what that would imply about the economy. Until 2013, we're certain of interest rates, they will be "exceptionally low". After that, rates are less certain. We could follow the "Japan Scenario": the economy continues to stumble, Fed Funds rates are virtually zero, and long rates stay low (perhaps they'll be even lower than today, if deflation kicks in). In this case, our ARM strategy will look wise, we will have saved quite a bit of money and are perfectly poised to save more.

What if a more normal economy prevails, housing and other asset prices rebound, and both long and short rates rise? This scenario is bad for our interest-rate bet, but is positive for your home value, your career, your savings, and your other investments. So in this case, we can look at our interest rate bet as a hedge--mortgage payments will go up, but we'll better be able to afford them than we are today. And we will have enjoyed many months of savings.

The third case, which I view as quite unlikely at this point, is one of inflation. In this case, both long and short rates will be higher than they are today. The Fed may raise short rates above long rates to slow inflation. In this case, your house will have appreciated and your bank savings will be doing well. It's not as favorable as the second case, but your ARM will have acted as an effective hedge.

Of course, the further out in time we go, the less visibility we have. We can say with a high degree of certainty that we will still be in a low interest-rate environment in two years, but we're less certain in 5 years, and even less sure in 10.  The 5/5 ARM seems the best balance of interest rate risk with a guaranteed long run of low rates (5 years) and another 5 years of very probably low rates.

Disclaimer: This strategy is quite risky, and may not be for you. It's appropriateness depends on many factors: your age, income, marital status, tax status, local real estate market, credit rating, and some I'm not thinking of. DO NOT use an ARM's low initial rate to buy a property that you can't otherwise afford!!! That approach is responsible for many of the recent tsunami of foreclosures. Only take out an ARM if you can afford the worst-case payments.

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Investor Sentiment and other Dumb Statistics

 I just read an interesting post on this weekend's Saints-Texans game (National Football League). The writer (Kerry J. Byrne) says

The 2010 Texans, for example, were dead last in Defensive Passer Rating (100.5), the best way to measure pass defenses because it consistently has a high correlation to wins and losses. Champions throughout history are almost always among the very best in the league at Defensive Passer Rating.

But, do teams win because they have good passing defenses? Or, do teams get ahead, then sit back in a "prevent defense" (5 or 6 defensive backs), against which it is more difficult to throw the ball? Also: the defensive linemen can "pin their ears back" and go after the passer, knowing that their hapless opponents are trailing late in the game and don't have time for a long, time-consuming drive.

To test Mr. Byrne's theory, we need to look at the data in a slightly different way. Does Defensive Passer Rating in the First Quarter also have a high correlation with wins and losses? Presumably, the game is more likely to be competitive in the first quarter than in the fourth. Does DPR show a better correlation to success than other statistics? Obviously, a team with a good pass defense will win more than a team with a lousy pass defense, but is this stat really a superior predictor? I'd be really interested to see the data broken down this way.

My favorite dumb football statistic is the  relationship between having a 100-yard rusher and winning the game (not so common these days, as the NFL has become a passing-dominated league). It used to be that, when a back reached 100 yards rushing, a graphic would flash on the screen, like "Bears are 53-24 (.688) when Walter Payton rushed for at least 100 yards and 58-58 (.500) when he doesn't." Maybe the Bears won because Payton went for 100. Or, maybe they got ahead, then ran out the clock by giving "the rock" to one of the NFL's all-time greats.

Investor Sentiment numbers are a dumb stock market statistic. If you pay attention to these numbers, you will see that sentiment follows the market. Investors become fearful after the market goes down, and greedy after it goes up...sentiment is worthless as a predictor! This chart from wallstreetcourier.com illustrates this point perfectly.

So, when you find a correlation that seems too good to be true, ask yourself if A really causes B, or does B cause A, or maybe an external factor C causes both A and B.

The lesson, of course: Correlation does not mean causation. Tweet

Trading Home Depot around Hurricane Irene: Post-Mortem

On Friday, I outlined a few HD options strategies to profit from the weekend super-storm Hurricane Irene (The Perfect Storm: Trading Home Depot around Hurricane Irene).  Today (Monday 8/29 11:30AM EST), the storm has passed. As expected, implied volatility in HD has collapsed back to it's historical average (32.5%). Let's take a look at how the various recommended strategies fared.

"For long-term HD shareholders: Sell out-of-the-money calls, like the Sept 35 Calls for .70.  By selling out-of-the-moneys, you won't run afoul of the IRS and won't owe any taxes on the underlying shares unless they're exercised. If they're called away, you'll have benefited from this week's 7% gain,  plus .85 appreciation (2.5%), plus .70 options premium (2%). Total profit since last Friday: 11.5%. Profit from today: 4.5%. Not bad in a low-return world. You can also buy back the calls on Monday, after volatility collapses, if you're married to the stock."

Sept 35 Calls are now at .46 (IV is now 31%). Close the position for .24 profit (34% on the options or .7% on the underlying).

"For short-term HD shareholders: Sell slightly in-the-money calls, like the Sept 33 Calls for 1.85.  This gives you a .70 (2%) premium in a pretty sleepy stock, and it can drop nearly 4% before your protection runs out.  Of course, you're giving up any upside if Irene is even worse than expected, and HD adds to it's already impressive run.  Still, you will benefit from collapsing IV."

Sept 33 Calls are now at 1.45 (IV is 34.7%,  time premium is .45).  Close the position for a .40 profit (24% on the options, or 1.2% on the underlying).

"For non-directional options traders: Sell high-IV options, and protect yourself with lower IV options. For example, sell the Sept 30 Puts for .27 (IV=50%) and buy the Nov 30 Puts for .97 (IV=40%) for a net debit of .70. Cover early next week for a small profit as IV collapses. Even bigger bump if HD fades."

Sept 30 Puts now .21 (IV=47.44%), Nov 30 Puts now .90 (IV=38.72%). Spread is now .69, basically break-even with Friday's spread of .70. Not worth the trouble.

"For bullish options traders: Sell high-IV puts. For example, sell the Sept 32 Puts for .54 (IV=41%). If HD rallies next week, pocket the .54. If it drops, you can buy it 9.4% cheaper if it falls through 32 (your breakeven is 31.46, 10% below today's price). Don't be afraid of selling naked puts! It's a very conservative strategy; Warren Buffet uses it to buy companies he likes at a discount, and generate income to boot."

Sept 32 Puts now at .47 (IV=38.5%). Close the trade for .07 profit (13%). Probably not worth it, on a risk-adjusted basis.

"For bearish options traders: Sell high-IV calls, like the Sept 33 Calls for 1.80 (IV=38%). If HD drops next week, pocket the .65 risk premium, plus whatever the drop is, to a max profit of 1.80 at 33 or below. If it rallies into expiration, your effective short price is 2% higher than today's price."

Sept 33 Calls are now at 1.45 (IV is 34.7%,  time premium is .45).  Close the position for a .40 profit (24%).

"For neutral options traders: Sell at-the-money puts and calls.  Sell Sept 34 puts for 1.10, Sell Sept 34 calls for 1.13. (HD now at 34.30). Trade is a winner if HD closes between 31.77 and 36.23 on 9/16. Or, exit the trade early next week. Seems like a nice risk/reward here as premium covers +/-6.5% move in 3 weeks."

Sept 34 Calls at .86 (IV=32.67%), Sept 34 Puts at 1.15 (IV=33.2%). Close the combination for a .22 profit (10%).

Of course, you can also let the trade run, either for a few more days as damage estimates are fine-tuned, or even all the way to expiration. The advantage to the last approach is you save money on commissions and "slippage", and the result may fit your overall portfolio strategy.

Conclusion: 4 wins, 0 losses, 2 ties. Not too bad! To re-emphasize the most important point from the original post, never go long options into an approaching natural disaster! Everybody knows it's coming, but nobody knows how bad the damage will be. You will be paying a high price to gamble on Mother Nature, as premiums will be inflated. Those premiums are sure to return to their baseline when the event has passed.
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How is Greece like your brother-in-law?

You've worked hard your whole life. You've scrimped and saved and, by the grace of God, you've managed to buy a nice home, provide a comfortable life for your family, and put a little away for a rainy day. Things have worked out for you.

Your wife has a big family, and you love them dearly. Her brother Billy has 7 kids, and they're beautiful and engaging. Everybody loves them. Unfortunately, your wife's brother is a deadbeat. He likes to gamble, smoke pot, get drunk, and can't keep a job. You've tried to talk to him about these problems, but he gets very defensive, says things are about to turn around. But they never do.

Your deadbeat brother-in-law has really done it this time. He bet $5,000 on the Steelers to win the Super Bowl. Thought they were a sure thing. Turns out they weren't. Of course, Billy has no money to pay the bookie, who's very large and not very empathetic. So of course, Billy wants to borrow money from you.

You'd love to tell your brother-in-law to f**k off, let him get roughed up (or worse). He deserves it. Maybe he'd even learn a lesson. But your wife, and her whole family, are very protective of him. If you don't save him, you're the jerk. If anything were to happen to Billy, your wife and her whole family would hate you forever. But, if you bail him out, he'll never change. Even now, he's unapologetic. It's the bookie's fault for being so tough on him, his ex-boss's fault for firing him, even Ben Roethlisberger's fault for not playing better in the Super Bowl. You now hate his friggin guts.

As you've guessed by now, your wife and her family are the Eurozone, your brother-in-law is Greece, and the bookie is the Greek bondholders. And you're the German government.  To make it even worse, if you bail out the deadbeat, the rest of the family will stop paying their bills, and will expect you to bail them out too. And one more thing--even if you decide to bail out your brother-in-law...I mean, Greece...you still have to convince the hardworking, thrifty German people to go along with the plan. And you'll probably be tossed from office for your trouble.


What do you do?

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The Perfect Storm: Trading Home Depot around Hurricane Irene

Today, we have a very nice setup for trading Home Depot (HD).  Hurricane Irene is currently bearing down on the Outer Banks of North Carolina,  a lovely stretch of beach in the midst of vacation season.

A brief history/geography lesson on the Outer Banks.  A famous vacation spot, The Outer Banks is a thin (usually less than 1/2 mile wide) barrier island separating the Atlantic Ocean from Pamlico Sound and mainland North Carolina.  It has been the scene of many vicious storms in the past; an 1846 hurricane opened , which is now the site of a 2-1/2 mile long bridge:

"Whoa!" you may say.  A storm did that! Unbelievable! I would never build a nice house there.  And for many years, people didn't.  Here's a typical 1960's-era cottage:

Nice! Small but comfortable, close to nature, and no big deal if it gets washed away. But, as usual, people forgot how powerful Mother Nature can be, and she fortuitously chose to ignore the Outer Banks. By the 2000's, people were building homes like this:

Ridiculous! Talk about hubris! Or maybe stupidity. Needless to say, if Hurricane Irene is anything like the 1846 storm, this million-dollar home will be reduced to splinters.

Anyway, Irene is currently headed directly for the Outer Banks. After that, it's projected to roll through the heavily-populated Northeast USA, from Washington to Boston. Damage is projected to reach the billions. And when residents wake up Monday morning, and start repairing windows, doors, shingles, and possibly rebuilding homes, where will they start?  Yup, Home Depot.

Of course, if I know this so does every wit and half-wit with a brokerage account. Consequently, as the storm track has crystallized, HD stock has been ramping up. It is currently trading at 34.15, up 7% from last Friday's close at 31.88. Here's the kicker: since Irene's full thrust will be felt mostly tonight and this weekend, the ultimate damage will be done while the market is closed. This means that a nimble options trader can profit a bit more from a post-storm "sell the news" move in HD.

HD's historical volatility is about 32%. September around-the-money options are trading at implied volatilities from the high-30s to nearly 50 (Sept 30 Puts). The smart(?) guys are betting on the weather! I expect implied volatility to collapse back to it's long term average on Monday. So the play today is to sell volatility. Here are a few possible strategies.

For long-term HD shareholders: Sell out-of-the-money calls, like the Sept 35 Calls for .70.  By selling out-of-the-moneys, you won't run afoul of the IRS and won't owe any taxes on the underlying shares unless they're exercised. If they're called away, you'll have benefited from this week's 7% gain,  plus .85 appreciation (2.5%), plus .70 options premium (2%). Total profit since last Friday: 11.5%. Profit from today: 4.5%. Not bad in a low-return world. You can also buy back the calls on Monday, after volatility collapses, if you're married to the stock.

For short-term HD shareholders: Sell slightly in-the-money calls, like the Sept 33 Calls for 1.85.  This gives you a .70 (2%) premium in a pretty sleepy stock, and it can drop nearly 4% before your protection runs out.  Of course, you're giving up any upside if Irene is even worse than expected, and HD adds to it's already impressive run.  Still, you will benefit from collapsing IV.

For non-directional options traders: Sell high-IV options, and protect yourself with lower IV options. For example, sell the Sept 30 Puts for .27 (IV=50%) and buy the Nov 30 Puts for .97 (IV=40%) for a net debit of .70. Cover early next week for a small profit as IV collapses. Even bigger bump if HD fades.

For bullish options traders: Sell high-IV puts. For example, sell the Sept 32 Puts for .54 (IV=41%). If HD rallies next week, pocket the .54. If it drops, you can buy it 9.4% cheaper if it falls through 32 (your breakeven is 31.46, 10% below today's price). Don't be afraid of selling naked puts! It's a very conservative strategy; Warren Buffet uses it to buy companies he likes at a discount, and generate income to boot.

For bearish options traders: Sell high-IV calls, like the Sept 33 Calls for 1.80 (IV=38%). If HD drops next week, pocket the .65 risk premium, plus whatever the drop is, to a max profit of 1.80 at 33 or below. If it rallies into expiration, your effective short price is 2% higher than today's price.

(Updated 1:30pm; just thought of another one)
For neutral options traders: Sell at-the-money puts and calls.  Sell Sept 34 puts for 1.10, Sell Sept 34 calls for 1.13. (HD now at 34.30). Trade is a winner if HD closes between 31.77 and 36.23 on 9/16. Or, exit the trade early next week. Seems like a nice risk/reward here as premium covers +/-6.5% move in 3 weeks.

Note that the "wise guys" are betting on a post-Irene drop, as IVs are higher on the put side than on the call side. They're expecting a "sell the news" reaction early next week, regardless of Irene's ultimate damage. Whatever you do, don't buy options outright in this environment! You could easily be right on HD's direction, and still lose money to collapsing volatility!

Also, stick to the more liquid strikes/expirations, as volume is likely to dry up post-Irene and you may be stuck having to leg out of a multi-leg option into an illiquid market...another good way to turn a winner into a loser!

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Bernanke Knows His Keynes

"Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement which can be made in the technique of monetary management."

Keynes, John Maynard (2010-12-30). The General Theory of Employment, Interest and Money Tweet

Germany Now Running the Euroshow

Fascinating read from Peter Zeihan and Marko Papic, courtesy of John Mauldin.  If you don't get John's free e-mail letters, sign up now at http://www.frontlinethoughts.com/subscribe.  He's always thought-provoking and non-partisan, with a long view. Anyway, back to Zeihan and Papic's article, "Germany's Choice: Part 2".

An introduction:

"However, with the end of the Cold War and German reunification, the Germans began to stand up for themselves once again. Europe’s contemporary financial crisis can be as complicated as one wants to make it, but strip away all the talk of bonds, defaults and credit-default swaps and the core of the matter consists of these three points:

• Europe cannot function as a unified entity unless someone is in control.
• At present, Germany is the only country with a large enough economy and population to achieve that control.
• Being in control comes with a cost: It requires deep and ongoing financial support for the European Union’s weaker members."

On Germany's policy dilemma:

"It is easy to see why the Germans did not simply immediately write a check. Doing that for the Greeks (and others) would have merely sent more money into the same system that generated the crisis in the first place. That said, the Germans couldn’t simply let the Greeks sink. Despite its flaws, the system that currently manages Europe has granted Germany economic wealth of global reach without costing a single German life. Given the horrors of World War II, this was not something to be breezily discarded. No country in Europe has benefited more from the eurozone than Germany. For the German elite, the eurozone was an easy means of making Germany matter on a global stage without the sort of military revitalization that would have spawned panic across Europe and the former Soviet Union. And it also made the Germans rich. 

But this was not obvious to the average German voter. From this voter’s point of view, Germany had already picked up the tab for Europe three times: first in paying for European institutions throughout the history of the union, second in paying for all of the costs of German reunification and third in accepting a mismatched deutschemark-euro conversion rate when the euro was launched while most other EU states hardwired in a currency advantage. To compensate for those sacrifices, the Germans have been forced to partially dismantle their much-loved welfare state while the Greeks (and others) have taken advantage of German credit to expand theirs."

On the new EFSF  (European Financial Security Facility):

"In practical terms, these changes cause two major things to happen. First, they essentially remove any potential cap on the amount of money that the EFSF can raise, eliminating concerns that the fund is insufficiently stocked. Technically, the fund is still operating with a 440 billion-euro ceiling, but now that the Germans have fully committed themselves, that number is a mere technicality (it was German reticence before that kept the EFSF’s funding limit so “low”).

Second, all of the distressed states’ outstanding bonds will be refinanced at lower rates over longer maturities, so there will no longer be very many “Greek” or “Portuguese” bonds. Under the EFSF all of this debt will in essence be a sort of “eurobond,” a new class of bond in Europe upon which the weak states utterly depend and which the Germans utterly control. For states that experience problems, almost all of their financial existence will now be wrapped up in the EFSF structure. Accepting EFSF assistance means accepting a surrender of financial autonomy to the German commanders of the EFSF. For now, that means accepting German-designed austerity programs, but there is nothing that forces the Germans to limit their conditions to the purely financial/fiscal."

Long term, this is very good news for the euro and Eurozone countries, though it may slow down Germany's growth somewhat.  There's more in the article, including an analysis of Germany's newfound heft on her neighbors. Download the whole thing here.

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Gold is the New Cash

August 3, 2011: The Day the Fiat Currency Died.  It's not as poetic as , and Don McClean won't be writing any hit songs about it, but it is a milestone in financial history.  For on 8/3,  Switzerland became the last of the strong money countries to throw in the towel, as they lowered rates “as close to zero as possible” in order to weaken the Franc and improve Switzerland's competitive position.  The prim-and-proper, all business, tight-money Swiss have given up the ghost.  There are now no safe haven currencies left.



It all started with the Asian economies, principally China and India.  China has become an export powerhouse by pegging the yuan to the dollar at an ridiculously low exchange rate.  Of course, China's gain is the rest of the world's loss, as manufacturing jobs have been lost all over the world to China and other East Asian countries that have emulated China's policies.  India has been just as effective at importing jobs by adopting the same strategy, only India's strength is in the service sector:  customer support, engineering, legal services, etc.

What is the magnitude of this currency manipulation?  Economists estimate that the yuan is about 50% undervalued compared to the dollar. The Economist magazine has just updated it's Big Mac Index, and a Big Mac costs just $2.27 in China.and $1.89 in India*!  This sandwich will set you back $4.07 in the U.S. (too damn much, IMHO) and $8.06 in Switzerland!  No wonder the Swiss decided to weaken their currency; the Swiss love them some Big Macs!  (Big Mac arbitrage, anybody?  All you need is a few hundred yuan, a big suitcase, and a one-way ticket from Beijing to Geneva.)

While the world economy grew, the USA looked the other way.  Sure, we lost jobs to Asia, but the economy was growing, Wall Street was getting rich, home values were soaring, and corporate profits were surging.  And (maybe most importantly), presidents, senators, and representatives were being re-elected.

That all changed in 2008.  The world plunged into The Great Recession, featuring the worst job losses since the 1930's.  Rich-world GDP plunged, while China and India continued to grow.  Helicopter Ben Bernanke, Tim Geithner, and President Obama pulled out all the stops: they turned the Mint's printing presses up to 11, orchestrated QE and QE2 to drive both short- and long-term interest rates into the dirt, and flooded the world with dollars.  The hope was that this would prop up housing prices, get businesses to invest and hire again, and restart the economy.  (It hasn't really worked, as housing prices bounce along the bottom and much of the new investment has taken place in China.  But that's a story for another day.)

Europe was faced with many of the same challenges, but with a twist.  Creation of a common currency had encouraged reckless borrowing by the less-productive members of the Eurozone (the so-called PIIGS).  As I write this, Europe is enmeshed in a full-fledged currency crisis.  Greece is broke and has no chance to repay large loans from big European banks.  Portugal, Italy, Ireland, and Spain are vying for second place in the race to the bottom.  Consequently, the Euro is in mortal danger, and has dropped like a stone since 2008 against the Yen, Franc, and gold.  Nobody believes in the Euro anymore, and the smart money has left town.

Now that the Swiss have given up, where can cash be safely stashed?  The dollar?  Fuggetaboutit.  The Euro?  See above.  The Yen?  Only because Japan has been in the ditch for 20 years, and have gotten comfortable there. You'll get no yield there.  The Canadian and Australian Dollars, or the Brazilian Real?  Maybe, but they're totally levered to commodity prices.  The "full faith and credit" of the USA isn't what it used to be, but we haven't sunk below Brazil yet, have we?  In the early '80's, Brazil converted the Crusado to the Cruizero by stamping "000" on their paper money...I kid you not!  When the Fed stamps "000" on Dollars and starts calling them Dollaroos, I'll move my meager savings to Brazil.

So what does that leave?  Nothing!  There are no reliable currencies left, where you can relax in cash and get paid a small amount of interest to wait. 

Wait a minute, I forgot about one currency...gold!  The has represented money since before it was called money.  It's heavy, clunky, and you can't buy a Big Mac with it, but it has held it's value better than any currency the last ten years.  Of course, it yields nothing and is difficult to store.  But today, one can buy electronic versions of gold (as easy to store as cash) and the non-existent yield matches the Dollar, Swiss Franc, and Yen.


Here's a couple of interesting graphs.  First, a few commodities priced in Dollars:

Corn and copper have more than doubled since 6/2010 and oil has been flat, indicating a healthy world economy.  Not so fast...here are the same commodities priced in gold:

Corn and copper are still up, but oil is down a third since March, and both copper and oil have fallen off a cliff the last two weeks.  The market smells a recession coming!  US Treasuries have rallied strongly and the stock market is down 8 days in a row, further signs of a coming recession.

Gold is the new cash!  Keep your idle savings in gold, rather than one of the fiat currencies.  It will preserve your purchasing power without geopolitical risk, earthquake risk, tsunami risk, Obama risk, Bernanke risk, Merkel risk, or Greek risk. 


*Actually, it's called the "Maharaja Mac" in India, presumably containing no beef.  Sounds gross. Tweet

Take Some Francs off the Table

On June 14, I shorted the Euro against the Swiss Franc (EURCHF) at 1.21.  The Euro has obediently fallen to a low below 1.08, before staging a massive rally overnight when the Swiss dropped interest rates to nada%, matching the rest of the world. (Expect this headline soon: "Swiss Bankers Head to Rio, Excited to Dance in Carnival Parade")  EURCHF is currently trading just under 1.11, time to unwind the position.

The Swiss Franc is still an unrivaled safe haven, but has gotten way ahead of itself.  We recently met some American expatriates living in Switzerland, they were stocking up on Ugh boots as they could buy three pairs in the US for the price of one in Switzerland!  Another data point: a small Diet Coke costs $12 in Zurich! We'll continue to watch the Franc for a good re-entry point.

Some of the European safe haven money will look elsewhere on the Swiss Central Bank news.  Look for the other safe havens to rally today:  US Treasuries, gold, silver. Tweet

D.C. Fiddles While the Economy Burns: What the Market is Telling Us

As the endless debt ceiling nonsense continues unabated this morning, the markets are telling an interesting story.  SPY (which represents the S&P 500) is down .75%, while TLT (ETF for 20-year treasuries) is up 1.34%!  What's going on?

The message is split.  If the current "Capital Hill Circle Jerk"© proceeds through Aug. 2 (only 4 days away!), the government will be forced into a partial shutdown: workers will be furloughed, parks will be closed, medicare and medicaid reimbursements may be held back, and social security checks may be reduced or delayed.  Certain to cause an economic slowdown, or maybe a double-dip recession!

Whether or not a deal is reached before "Tim Geithner Turns Into A Pumpkin Day", it's becoming more and more clear that real spending cuts are coming down the pike, and they'll hurt.  Contrary to Tea Party rhetoric, austerity is not good for the economy (at least in the short term).  So, regardless of the timing of a debt deal, this will exacerbate an economic slowdown.

On the other hand, the sturm and drang over potential default has been overdone.  Interest payments are not due till August 15, nearly two weeks after Geithner's spending cuts kick in.  Well before that time, the entire country will be in a lather, the political pressure will be too much, and a deal will certainly be made.  Additionally, if Uncle Sam tries to stiff bondholders, expect the courts to issue an injunction preventing default, as I suggested here. Treasuries are gaining further strength because the market anticipates economic weakness, as mentioned above.

So, I was wrong a few weeks ago.  Buy treasuries here. Tweet

Dr. Doom Hits the Chinese Nail on the Head

I don't usually agree with Nouriel Roubini but he nailed this one.  A sample:

The problem, of course, is that no country can be productive enough to reinvest 50% of GDP in new capital stock without eventually facing immense overcapacity and a staggering non-performing loan problem. China is rife with overinvestment in physical capital, infrastructure, and property. To a visitor, this is evident in sleek but empty airports and bullet trains (which will reduce the need for the 45 planned airports), highways to nowhere, thousands of colossal new central and provincial government buildings, ghost towns, and brand-new aluminum smelters kept closed to prevent global prices from plunging.

Roubini's  post vividly illustrates some of the reasons I'm quite bearish on China.  How can the whole world be so excited about a command economy?  Has there ever been a centrally-directed economy that creates long-term prosperity?  Tweet

It's Clear: Default on Debt is Unconstitutional

If all else fails, and DC can't agree on a formula to lift the Debt Ceiling, the U.S. Constitution will save us again.

Section Four of the 14th Amendment says that “[t]he validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.”   Seems pretty clear to me--Congress can't interfere with paying interest on the debt.

Who has standing to file suit to enforce this?  Anybody that owns Treasuries and doesn't receive scheduled interest.  When would they file suit?  If the Administration announces plans to suspend interest payments, I would think that major bondholders (mutual fund companies, rich people, maybe even the Chinese government) would apply for an injunction to keep the cash coming.  They'd probably choose a pro-business venue like the 8th Circuit Court.  The plaintiffs would win, then the appeal would be fast-tracked to the U.S. Supreme Court, where the plaintiffs would win again.

So, the government would be forced to keep sending out interest payments while stiffing Social Security recipients, U.S. Servicemen, federal employees, etc. etc. etc.

IF this highly unlikely result comes to pass, it would be loaded with irony (the most delicious taste on earth, IMHO).  The Tea Party base, mostly made up of old white folks, would be sputtering with rage.  The President would ride this "defeat" to easy re-election, as he can easily paint himself as the guy who tried to keep the SSS (Social Security Spigot) turned on.  The Supreme Court would render the Debt Ceiling null and void, permanently ending revivals of the recent silliness...and permanently prohibiting Congress from using this lever in the future (tasty, no?).  And last but not least, the People's Republic of China may defeat the U.S. House of Representatives in front of the U.S. Supreme Court (it just doesn't get any better then that!).

So Bill Long, Jeff Duncan, and the rest of you newly-elected Representatives--try reading the Constitution some time, instead of just carrying it around. Tweet

Hey, D.C.: Would Dow Down 1000 Get Your Attention?

As I write this, Congress and President Obama are engaged in a high-stakes game of chicken on the debt limit.  Congressional Republicans (mostly Tea Partiers) refuse to increase the nation's credit limit without major spending cuts.  Further, they've rejected any tax increases as a way toward fiscal sanity.

The media is in an absolute tizzy over the possibility of default.  Will interest rates skyrocket?  Will our economy grind to a halt?  Will social security checks and Medicare reimbursements be scuttled?  And what about the Armed Services?  Will our brave fighting men get paid?

Interestingly,  the markets have largely yawned over the whole thing.  US Government bonds (after a week-long plunge on the heels of QE2 expiration at the end of June) have rallied back to where they were in mid-June.  The stock market has done it's usual midsummer random walk/drunken stagger.  In short, the markets think that a deal will be reached (after each side makes a big show of storming out of meetings, a few Tea Party nuts threaten to let the country default, and the Congressional Cots are dusted off for an all-nighter).

But, what if the markets are wrong?   I know, I know, the markets are always right.  But what if the Tea Partiers really are crazy enough to let the country default?  What if the Dennis Kucinich Democrats decide to go to the wall over entitlement cuts?  What if we really get close to Tim Geitner's Aug. 2 drop-dead date without a deal?

As this possibility dawns on Wall Street, expect yields to rise on all fixed income (corporates will follow Treasuries).  Slowly at first, then more vigorously.  The stock market will follow suit.  It could get really ugly.

Then, after the Dow is down about a thousand points or so, and TLT down 10, The Washington Wankers will finally get it!  It's time to get a deal done.  Because if they don't, nobody's getting re-elected. Tweet

A report from the Framingham Fed

My personal economic indicators:

• Traffic is brutal!  Normally, things start to slow down this time of year, as the college students leave town and the rest of us take vacations.  Not this year...my commute going against traffic on 128 is usually 35-40 minutes.  The last three weeks it has been over an hour.  I've been doing this drive off-and-on for 20 years, and traffic has always been a very good economic indicator.
• Headhunters have been calling.  As a computer hardware engineer, things were flying in the late '90's and even into 2000 and 2001.  Then, it was as dry as the Sahara Desert for a few years.  Now, there seems to be more demand than supply of experienced engineers in my field, as the phone and email have been buzzing.
• We're avid skiers, and own a small house in Vermont that we love to get away to whenever there's time.  We also rent it on vrbo.com to help pay the bills. (Vermont is a wonderful but very socialist state, with a perverse system of paying for education, leading to ridiculous real estate tax bills in ski towns like Stowe.  But that's for another blog post.)  Our calendar is almost full this summer, far and away our best in the five years that we've had the house.  We even raised prices, hoping to discourage bargain-hunters and save some weekends for our own use!
• My co-worker just moved to a bigger house in a better town.  He sold his old house in four days:  day 1, listing; day 2, broker tour; day 3, open house with multiple offers above asking; day 4, signed the papers. (added 6/29/11)

Massachusetts is loaded with high-tech and other knowledge industries, and was hit hard by the 2001 recession.  However, we're much less dependent on housing and building than the Sun Belt, and have weathered "The Great Recession" better than our unfortunate brethren in Las Vegas, Florida, and Arizona.  Based on on my own observations, it seems that the local economy is really starting to pick up steam. Tweet

A second chance at the Trade of the Decade

Last September, Doug Kass called "The Trade of the Decade":  short US long bonds.  TLT was at 106-ish when he made the call; it dropped to 88 before trading recently around 97.

 Since bottoming in February, TLT has meandered its way back up.  U.S. equities have been running in place since then, the euro is a mess, and the economy has flatlined, leading to talk of a Japan-style "Lost Decade".  Most importantly, the Fed has been printing money, and using it to mop up supply of U.S. treasuries, in order to keep borrowing costs low and stimulate the economy.

Who else is buying treasuries?  As it turns out, nobody, as this chart from the Global Macro Monitor shows:

Bill Gross, Pimco's bond guru, has had his company out of treasuries since March.  The  Russians and Chinese, among others, consider US government debt radioactive (though the Chinese have recently resumed some lukewarm accumulation).  American individual investors read the news from Washington every day, no way they're buyers.  So, Ben Bernanke is backstopping the whole market...and he reiterated today that there would be no QE3 when QE2 expires at the end of this month!

So, why has TLT been drifting up recently, rather than heading down?  After all, none of this is a secret.  Well, the Eurozone is even more screwed up than the USA, so there's some "flight to quality" going on. Even though TLT doesn't really represent quality any more, old habits die hard.  Secondly, the old saw "don't fight the Fed" has governed many market participants; even though Bernanke says there will be no QE3 people don't believe him.  If things get bad enough, QE3 could be turned on as soon as enough 

currency stock and green ink can be trucked in.  Thirdly,  Congress is a wildcard.  The market thinks that there will eventually be a deal on the debt ceiling accompanied by spending cuts.  When and if this happens, market participants don't want to be short US Debt.  My feeling is that Congress will reach an 11th-hour deal, but it will be watered-down and short-term.  It's impossible to reform our entitlement system on a short deadline, and both parties think they have staked out a winning position for next year's election.

Interesting clue in today's trading.  Bernanke spoke at 2pm today and was quite downbeat on the economy, trimming growth estimates for this year and next.  Normally, great news for the bond market; this time, nary a peep:

Like Sherlock Holmes, we can learn a lot from the dog that didn't bark.  A market that doesn't rally on good news is destined to go down.  This looks like a great time to enter "The Trade of the Decade" if you missed it late last year.  If you need an extra adrenaline rush, buy TBT (Proshares UltraShort 20+ year Treasury ETF).  If you prefer a more sedate lifestyle, short (or buy puts) on TLT.

Disclaimer:  I'm short TLT as of this afternoon.

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How to Trade a Greek Default

In a thought-provoking piece, Andrew Lilico writes:

"What happens when Greece defaults. Here are a few things:

- Every bank in Greece will instantly go insolvent.

- The Greek government will nationalise every bank in Greece.

- The Greek government will forbid withdrawals from Greek banks.

- To prevent Greek depositors from rioting on the streets, Argentina-2002-style (when the Argentinian president had to flee by helicopter from the roof of the presidential palace to evade a mob of such depositors), the Greek government will declare a curfew, perhaps even general martial law.

- Greece will redenominate all its debts into “New Drachmas” or whatever it calls the new currency (this is a classic ploy of countries defaulting)

- The New Drachma will devalue by some 30-70 per cent (probably around 50 per cent, though perhaps more), effectively defaulting 0n 50 per cent or more of all Greek euro-denominated debts.

- The Irish will, within a few days, walk away from the debts of its banking system.

- The Portuguese government will wait to see whether there is chaos in Greece before deciding whether to default in turn.

- A number of French and German banks will make sufficient losses that they no longer meet regulatory capital adequacy requirements.

- The European Central Bank will become insolvent, given its very high exposure to Greek government debt, and to Greek banking sector and Irish banking sector debt.

- The French and German governments will meet to decide whether (a) to recapitalise the ECB, or (b) to allow the ECB to print money to restore its solvency. (Because the ECB has relatively little foreign currency-denominated exposure, it could in principle print its way out, but this is forbidden by its founding charter.  On the other hand, the EU Treaty explicitly, and in terms, forbids the form of bailouts used for Greece, Portugal and Ireland, but a little thing like their being blatantly illegal hasn’t prevented that from happening, so it’s not intrinsically obvious that its being illegal for the ECB to print its way out will prove much of a hurdle.)

- They will recapitalise, and recapitalise their own banks, but declare an end to all bailouts.

- There will be carnage in the market for Spanish banking sector bonds, as bondholders anticipate imposed debt-equity swaps.

- This assumption will prove justified, as the Spaniards choose to over-ride the structure of current bond contracts in the Spanish banking sector, recapitalising a number of banks via debt-equity swaps.  

- Bondholders will take the Spanish Banking Sector to the European Court of Human Rights (and probably other courts, also), claiming violations of property rights. These cases won’t be heard for years. By the time they are finally heard, no-one will care.

- Attention will turn to the British banks. Then we shall see…

Whether or not you believe Lilico's full cause-and-effect chain, it's clear that a Greek default will not be good for the euro or the core eurozone countries (principally Germany and France).  Greece's problems are well documented; indeed, the market's opinion of Greek government debt seems to be falling by the day, with the 10-year yielding 16.72% as I write this.



So, the market should be discounting the likelihood of default when valuing the Euro...is it?  Here's a chart of the Euro vs US Dollar:

 Ooops, the Euro is strengthening when it should be weakening...why?  My guess is the market is more worried about US Govt. debt than it is about Greek debt.  Let's compare the Euro to a couple of resource-backed currencies issued by countries with comparatively strong finances, Australia and Canada, and to the Swiss Franc, a traditionally strong currency:

 We see that the market has discounted EUR against each of these currencies to some degree...long CHF/ short EUR has been a huge win since Greek debt started to plunge in late 2009.  Europe's elite saw the writing on the wall, sold their euros in favor of the good old Swiss Franc.  (Switzerland's banks are not free of problems, but that's a story for another day.  Just being outside the Eurozone seems to be good enough.)

How long will this currency trend continue?  Until the market perceives a resolution of some kind is coming.  Given policymakers' fondness for "kicking the can down the road", I don't see this happening soon. Greece is out of options, and its politicos are whispering about leaving the Eurozone (many Northern Europeans would wish them good riddance). 

One solution making the rounds recently:  extend maturities on Greek debt, reducing current interest payments and buying time for the Greek Government to come up with more cash through cost-cutting, more efficient tax-collecting, and asset sales.  A couple of problems with this scenario:  recent austerity measures have caused massive dislocation in Greece--skyrocketing unemployment, striking employees, and angry protests.  GDP is shrinking.  How will Greece be better positioned to pay its debts in a few years than it is now?  And how will angry, unemployed Greeks feel about the Acropolis being sold to the highest bidder?  Sounds like more "can-kicking" to me.

Bottom line:  short the Euro on rallies against one of the safe-haven currencies (AUD and CHF look best).  Be very careful with CHF, however, as Switzerland's proximity to the Eurozone is likely to cause a furious counter-rally after Lilico's dominoes start to fall.  Tweet