October 03, 2009

Market Insights - 3 October 2009

Dear Friends & Fellow Investors

Here is our new issue of market insights.
In case of questions, please email: info@fxistrategies.com.  Enjoy reading!

In This Week's Issue
▪   Weekly Snapshot
▪   Chart Of The Week
▪   US Labor Pains 
▪   Recommended Read 
▪   Currencies Unplugged 
▪   Meritocracy
▪   Signposts

Weekly Snapshot
• US job losses  worse than expected at 263,000, lifting the unemployment rate to 9.8% (Reuters)
• Sharp Drop in U.S. Auto Sales in September: GM -45%, Chrysler -42%, Ford -6% (Washington Post)
• US 30-year fixed mortgage rates dip below 5% on Thursday (AP)
• Ken Lewis, CEO of Bank of America, to step down at year's end (AP)
• Euro area inflation estimated at -0.3% (Eurostat)
• US GDP fell 0.7% in 2nd Quarter - better than market expectations of a 1.2% drop (Reuters)
• Industrial new orders up by 2.6% in euro area (Eurostat)
• US Consumer confidence in September fell back to 53.1 from 54.5 in August (Bloomberg)
• US home prices in 20 major cities rose 1.2% percent in July. Prices are still 13.3% below July 2008 (Reuters)
• Almost 1m US homes in some stage of  foreclosure; completed foreclosures exceed 130,000 (Economist)
• Germany set for centre-right coalition - Merkel pledges swift income tax cuts (FT)
• The Japanese Yen advanced to an eight-month high against the US dollar (Economist)

Chart Of The Week
A reminder of where we stand...  

unemployment-SP-Composite-since-1948-large

Source: http://dshort.com/articles/2009/unemployment.html# 

US Labor Pains 
US jobs have now contracted for 21 straight months and the unemployment rate hit 9.8% in September.  Since the beginning of the recession, 7.6 million have been added to the now 15.1 million unemployed.  As the chart above depicts, unemployment being a lagging indicator, is somewhat inversely related to stock prices.  If history were to repeat itself, and assuming the low of March 2009 was indeed the bottom of the current bear market, we should see an improvement in the labor market sometime soon.  The rate of increase in job losses has been declining but jobs are still lost each month which adds to the quagmire of the real economy.  

nonfarm-payroll-2009-09

Since the US economy is largely consumer driven (roughly 70% of GDP depend on consumption), any real and sustainable recovery will depend on jobs.  That might also spill over to the markets, at least to certain sectors which are more vulnerable to a long-term decrease in consumer spending.

Mike (Mish) Shedlock has a good summary of the current US employment situation at his Blog Post: http://globaleconomicanalysis.blogspot.com/2009/10/jobs-contract-21th-straight-month.html

The report by Bureau of Labor Statistics is available here: http://www.bls.gov/news.release/empsit.nr0.htm

Recommended Read 
Please consider reading: Wanted: new model for markets 

John Authors’ article in the Financial Times is somewhat lengthy but it is an excellent summary of some of fundamental flaws with the theories of modern finance.  Modern Portfolio Theory, efficient markets and “normal” bell curve distributions have not only been at the core of the curriculum for finance and business education, they have also formed the basis of pricing a vast array of financial products.  As with all theoretical models, they are based on certain assumptions; when assumptions are not met in the real world, the models fall apart.

Over 40 years ago, Benoit Mandelbrot, the mathematician who invented fractal geometry, proved that markets did not follow a normal distribution as in the typical bell curve.  He noted:

If stocks really followed a bell curve, he observed, then a swing of more than 7 per cent in a day for the Dow Jones industrial average should happen once every 300,000 years.

John Authors added that “there were 48 such days during the 20th century.”

Let’s go one step further and look at the daily swings of the Dow since 1928.  Based on widely accessible data at Yahoo! Finance, we can examine the daily prices of the Dow and we found that there were 83 days when the Index moved 7% or more.  In fact, 16 days exceeded a move of more than 10%.

Dow Jones Industrial Average Daily Trading Ranges

Date Open High Low Close

Daily Range

19/10/87 2164.16 2164.16 1677.55 1738.74

22.48%

20/10/87 1738.74 2067.47 1616.21 1841.01

21.83%

29/10/29 252.38 252.38 212.33 230.07

15.87%

21/07/33 96.26 98.69 84.45 88.71

14.43%

10/10/08 8568.67 8989.13 7773.71 8451.19

13.52%

28/10/29 295.18 295.18 256.75 260.64

13.02%

24/10/29 305.85 312.76 272.32 299.47

12.93%

06/10/31 87.51 100.49 87.51 99.34

12.92%

30/10/29 230.98 260.93 230.98 258.47

11.48%

13/10/08 8462.42 9501.91 8462.42 9387.61

10.94%

13/11/08 8281.14 8898.41 7947.74 8835.25

10.68%

28/10/08 8178.72 9112.51 8153.79 9065.12

10.52%

09/10/08 9261.69 9522.77 8523.27 8579.19

10.50%

18/12/31 73.79 81.1 72.62 80.69

10.46%

20/07/33 103.58 105.65 94.76 96.26

10.31%

07/11/29 232.13 242.1 217.84 238.19

10.02%

With just a few crude statistical calculations, we can easily spot how far off the assumptions of normal distribution are.  A 7% move every 300,000 years means 1 in 75 Million days or 0.00000133%.  By contrast, the Dow moved 83 times over 7% in one day, that’s 83 times in 20,342 days or 0.41%.  Still a very slim chance that the markets won’t follow normal distribution, but 306,017 times more likely than traditional models suggest (email info@fxistrategies.com if you like a copy of the data) .

Another hallmark of modern portfolio theory is the assumption that one should diversify risk by investing in asset classes and markets that are not (highly) correlated.  This makes obvious sense as well.  The problem with the assumption however is the fact that correlation, unlike some models suggest, is not static and it changes over time.  Since last year, many asset classes, previously thought to be highly uncorrelated, have moved in tandem.  We discussed correlation before (Market Insights 31 May 2009, 11 July 2009 & 22 August 2009).  The charts below depict how big of a problem correlation was during the crisis.

 diversification-failure     Diversify2

A new theory known as adaptive markets hypothesis might find an answer to this dilemma.  However, it remains to be seen how well the theory fares in practice when markets are flying again next time.

Currencies Unplugged  
Merk Mutual Funds have a neat outline of some key concepts of currency trading.  Often misunderstood, a main feature of currency trading emanates from the fact that currencies are always traded in pairs.  Hence it brings about different sets of advantages and challenges when examining these types of transactions.

What Does it Mean to Buy a Currency?  < >  What Does it Mean to Short a Currency?

To clarify further, very few investors do a physical exchange of currencies when they trade.  The majority of currency transactions these days are done on a margin basis.  So you don't actually give up one for another; instead consider it a leveraged trade as if you were to trade commodities futures. 

Meritocracy 
Think you live in a meritocracy?  Think again.  CNN Money has a list of the 5 most overpaid CEOs.

AFN  2BJS 3CMCSA 4IP 5NBR

Signposts
In our quest to look for signs of things to come, here’s a thought:  Despite considerable efforts by US President Obama to promote his home town of Chicago, Rio de Janeiro will be hosting the 2016 Olympic Games instead.  Coincidence or another sign that the US is slowly handing over the baton in terms of global dominance?  No pun intended, but compare the Brazilian Stock Market versus the US benchmark Index.

BVSP_vs_SPX

Good luck & good trading!

Disclaimer
Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance.

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