Pepsico Bids to Acquire Stock of Its Bottlers: Risk Arbitrage Activity

Some stock operator out there has a bit of info that the rest of us don't have, because both PAS and PBG, which are Pepsi bottlers, are trading well above Pepsi's bids. PAS stock has almost a dollar in premium and PBG is not far behind.

White House Announces More TARP Conditions: Stock Markets Hear More Vagaries

The Obama administration just announced a further "quality test" for US banks who received government bailout money. These banks will only be allowed to pay-back money they received during the stock market turmoil if they pass a further unspecified test of their capital ratios. That means if the treasury deems that a particular bank does not have enough capital, it will not be allowed to pay back the TARP money.

This could have major implications on the stock market prices for any bank that is part of the test. Just like the previously announced bank stress test, this new test lacks specifics and may segregate banking sector stocks into two groups: those deemed by the government to have enough capital and those stocks that do not. This may place a psychological price premium on banking stocks that pass the government's tests.

The government is providing the setup for a short term panic when these tests are finally enacted. The administration has been so vague in a time when certainties are prized above all else. In a place like the stock market, especially one that has recovered so vigorously in a small period of time, this prolonged uncertainty from the most powerful financial institution in the world is just pain dangerous. The stock market will be watching the outcome of these stress tests closely.

What Government Stress Tests Mean for the Stock Market

Ever since the Obama administration took office, the stock market has waited for the treasury to conclude its much talked about "bank stress tests." The tests are designed to determine which banks need more capital and thus which stocks are likely to sell off.

When a bank needs to raise capital, it usually mean existing shareholders will get diluted. The bank either has to get more money from selling stock (which makes the price go down) or by selling debt (which makes servicing old debt harder). That means the stock market is watching the outcome of these tests with baited breath.

Given the stock market's 20% bounce off the march bottom, some view this as a time to be cautious. If the bank stress tests turn out poorly, the market may be in for a correction. But the government has a vested interest in keeping the banks solvent. This is because the taxpayer has become the de facto shareholder through the market bailout plan. The administrations unwillingness to release the results may be an attempt to make sure everything looks as good as possible.

Stock Market Investing Fundamentals

So you have decided that you want to get into stock market investing, but where do you start learning the market? As recent market events have shown, learning to invest in stocks is hard. This is true even for the professionals. So how can someone reading stock market for dummies go from losing money gambling to ruling the stock market?

The keys to successful investing are motivation, discipline, and stock market timing. You have to be motivated to learn investing from stock market professionals who have stood the test of time. You have to read voraciously, consuming stock market information constantly. It is this stream of investment knowledge that will form the basis of your stock market decisions. Watching how a stock responds to your actions in the market will help you learn about what investing theories will work for you.

Once you find a consistent investment strategy, it will be your effective use of discipline which will keep you honest to what works. Just like in the casino, when you make money investing in stocks you tend to get cocky. The feeling that you have transcended dummy status and reached market god is irresistible. Investment mistakes will be made and you will come crashing back to stock market reality. This is how you will learn to invest with discipline: with pain and suffering.

Stock market timing is the hardest technique to learn and master. Even professionals only make money 60% of the time, so the ability to survive with market timing is paramount. Stock market timing involves using past prices to forecast future returns, and is thus subject to alot of speculation. Some people use technical analysis to foresee the stock market future... and some use the fundamentals. Whichever you choose is up to your personal investment style.

Stock Market Investing Like the Pros: Arbitrage

So I'm gonna attempt to explain some statistical arbitrage (or stat arb, in the truncated parlance of the street). Depending on your experience level, your reaction to this post should range from "duh" all the way through "well uhh" straight through to the "what the fu..." Its OK, you're gonna make it, I promise. Just stick with it and you will come out a smarter person on the other side.

In finance, there are many assets which seem to be driven by the same process. The fate of a collection of oil companies will rise and fall with the price of oil. A parent company may make record profits only if its partially owned subsidiary company gets a new contract. Or it could be something as simple as company A owns a 20% stake in company B. For whatever reason, there are plenty of examples of how the price of two seemingly different assets are linked together. When an educated investor sees two stocks moving together, he should know that there is an opportunity for profit.

Asset prices that move in concert are known as "cointegrated." Although this term has a technical definition, the intuition is straightforward. If the price of an asset rises, we would expect the price of its cointegrated partners to be rising as well. If prices are not moving together, it is because of some temporary anomaly. Thus an investor can profit by buying one cointegrated asset and selling another.

In particular, suppose we have two related assets- A and B- and we observe A rising and B falling. The arbitrageur can then sell A and buy B. Now he has a "market-neutral" position. Theoretically he does not care what direction the market as a whole takes because he is both long and short.

The investor above is betting only that the spread between the two cointegrated assets will narrow (long and short at the same time is known as a spread) . This will occur if A decreases more than B decreases or if A increases less than B increases.

For example, suppose we're long 100 shares of B and short 100 shares of A. If the market increases, its likely that our two stocks will also increase. We will make profit if the money we make in one side of the spread is more than we're losing on the other. If A rises 2 points and B rises 2.5 points, we will have lost 200 on the short position and made 250 on the long position, netting out to a profit of 50 dollars. Else, if A rose 3 points, we would lose 50 dollars.

It is important to note that a trader can make a spread out of any two assets. You could go long gold and short gasoline for example. But it is the idea of cointegration that makes the above spread so powerful. If two assets are truly related, then the spread will eventually narrow, netting the stat arb a profit.

The risks are twofold. The first is that the spread will increase so much in the short term as to bankrupt the arbitrageur before the relationship returns to normal. This is a very real risk, especially if leverage is involved. The second risk is that the relationship will cease to exist. Perhaps company A dumped its holdings of company B. Maybe company A had a corrupt CEO who embezzled billions and takes the equity to zero overnight. Either way, the fortunes of the two companies could diverge quite strikingly.

On the whole, the cointegration trading described above is useful only for calm and stable markets. But risk profiles can be adjusted for any market. In a benign market, this strategy would seek small but frequent intraday returns. The stat arb would thus make alot of trades to capitalize off of low volatility in the size of the spread itself. In a crazy market like we have now, the number of trades would be cut down dramatically. Spreads have gotten very volatile, and opposing small moves could send one to the poorhouse. Waiting for spreads to widen significantly is the only way to implement this strategy in a high volatility marketplace.

Sector Trading: A Primer

One of my favorite stock trading setups is to watch an entire group of competing stocks. If there is a market leader, you can watch that stock and trade the laggers to make a quick scalp. This makes money because of the existence of statistical arbitrageurs who keep a sector in line.

Take the agricultural chemicals stocks, for example: POT, MOS, AGU, TRA, CF, MON. Using a statistical technique known as a minimum spanning tree, we can establish POT as the "leader." AGU is the closest lagger behind POT.

So in the beginning of the day, if POT is ripping you can buy a little AGU and have a positive expected value of your return; as long as POT keeps going you can book profit in AGU. The same works on the downside.

Do your own research; look at some good charts to verify what i'm saying. use some stats packages to establish a theoretical price for POT given AGU. the best approach is a combination of the two.

Where the Next Bubbles Will Come From and How They Will End

One of the biggest problems with our current financial system is the fact that lower interest rates -- or the reasonable expectation of falling future interest rates -- encourages overinvestment. This inevitably leads to speculation and a subsequent asset price bubble. As Kindleberger states in his timeless "Manias, Panics, and Crashes" over trading through speculation will be followed by a "CONVULSION." Oftentimes this is some outside news factor that suddenly makes the boom model untenable.

In the case of the current crisis, the exogenous news factor was the pricking of another asset price bubble: the housing market. When ripples from the housing bust hit the banks of the world, it created a chain reaction. While our banks lost lots of money on their crappy mortgage exposure, their losses were dwarfed in magnitude by those experienced in the subsequent world stock market carnage. Some 30 TRILLION DOLLARS of wealth evaporated in 2008. But how much was made on the way up? Considering the current boom can be traced to the 1970's 30 trillion is just a drop in the bucket.

One lesson must be leaned from the thousands of years humans have used money and trade to lubricate their lives. Markets will have booms. Booms will lead to busts. But when the rate of interest is near zero percent: the urge to lever up will become too great.

Somewhere, sometime in the future, some trader at some bank will figure out that he can borrow from the fed for zero percent and lend for two percent. He will make a huge bonus and all his trader friends will do the same type of trade. The next year many traders will leave this bank and go to other banks and hedge funds. There they will tell tales of their trade, and they will borrow money at zero percent and lend money at two percent. Except when EVERYBODY does this, we will have another credit bubble.

The money lent out at 2% won't just sit in a drawer some where. It will be invested in some asset. If the speed at which money is being lent creates more money that needs to be invested than the supply of existing assets, prices will rise. But we can't use classical economics here. This is because while the supply of assets will certainly increase from bankers hocking IPO's and new bond issues, financial assets are not normal goods.

When a normal good or service rises in price, people consume less of it. When the price of a stock goes up, more people want to buy it. They see others making a killing and want a piece of their own. Likewise, when prices go down people sell more: they don't want to lose even more money. This means that credit bubbles become unstoppable reinforcing "virtuous cycles." These, of course, are followed by horrifying unrelenting market declines (vicious cycles).

Prices will stabilize. Money will be relent at too low interest rates. Money will be borrowed by firms and investors which will push up asset prices. More money will be lent. Some will go to increased demand for borrowed funds by speculators. They want to take advantage of rising prices. More money will be lent...

The Opening Bell Effect

There is the most trading volume per second during the first and last thirty minutes than during any other point in the day. This means that if you are a fund manager, or large investor, or whale you want to buy/sell during the opening or closing of the market in order to maximize the amount of your inventory that you can accumulate/liquidate.

For example: assume that during 9:30-10:00am you could sell 5 million shares while depressing the market two dollars. During 10:00-10:30 that 5 million would move the stock 10 points. When do you want to sell it? Exactly: during the open. Since you can buy/sell more off the open, price becomes a non-factor. Moving stocks up or down a few percent is a function of how much size people have to accumulate (buy) or distribute (sell) at any given moment.

Since the open and close represent the greatest opportunity for large shareholders to enter and exit quickly, you will always see large orders towards the opening and close of the market.

Fundamental Analysis

Fundamental analysis is an stock market investment strategy that uses a company's underlying financial condition as a guide for its future earnings prospects. Fundamental analysis assumes that a company's stock market price is a function of these future earnings forecasts, and so predictions for stock performance can be modeled.

Some of the greatest investors of all time subscribe to this model. Warren Buffet is perhaps the greatest example. His mentor was Benjamin Graham, who wrote some of these value investing bibles.

These investors believe that information can be gleaned from price to earnings ratios, debt ratios, and many other financial metrics. Like Technical Analysis, value investing involves heavy mathematics. Analysts model past earnings against a larger set of microeconomic variables to predict future stock market prices.

The proliferation of online trading applications and easy to use data modeling software has brought value investing to the masses. Arm yourself with knowledge and you might be able to invest online like the masters.

Technical Analysis for Online Stock Trading and Investment

Technical analysis is any online trading strategy that uses past prices to predict future stock market returns. You can check out these books on technical analysis, but here we will focus on some introductory technical analysis tools for online stock investment and trading.

In one of its simplest forms, the moving average convergence/divergence (MACD) indicator can be a powerful stock market strategy that uses technical analysis. A moving average is the average of a price over the last X units of time. For example, an online stock trading strategy might use a thirty minute moving average: the moving average at time T is the average of the last thirty minutes of prices. If we take the actual price at time T (which is not necessarily the same as the moving average at T) and subtract the moving average, we have the MACD.

Intuitively, this online trading strategy says that when the MACD gets to a large positive or negative value, the stock is likely overbought or oversold, respectively. So a large positive MACD might mean that stock XYZ is going to go down in price. Likewise, a large negative divergence might mean the stock is likely to rise.

There are an infinite number of online stock trading strategies that can rely on technical analysis because you are limited only by your imagination and knowledge of mathematics.

A Brief History of Time Part 1: The Beginning of Floating Exchange Rates

Our history begins in 1968 during the Tet Offensive. The rising US government expenditures for the Vietnam war was placing strain on the international monetary system, which at the time was based off of the Gold Standard (hereinafter referred to as GS) and the Bretton Woods Agreement. Under the GS and Bretton Woods, national currencies were either convertible at a fixed rate into gold, or "pegged" to the US dollar. A pegged currency would be actively manipulated by the government to maintain the exchange rate to within +/- 1% of parity with the dollar. The dollar, while still based off its convertibility into gold, became the default reserve currency of the world.

The benefit of the GS was that it was self-correcting. If a country maintained a current account deficit, gold would flow out of the country to those with surpluses. This would contract the domestic money supply, decreasing lending, and pushing the country into recession. This led to a decline in domestic consumption thereby reducing the deficit. An add on effect came from the resulting devaluation in the deficit currency, which made their goods more competitive and helped reverse the current account deficit. Likewise if a country experienced prolonged surpluses, its money supply would increase, leading to increased inflation and a strengthening currency as international money would flow into the surplus currency to take advantage of rising asset prices. This led to a decline in export competitiveness and a reduction in the surplus.

The downsides all stemmed from the fact that it was ultimately the supply of gold which determined the money supply. Unlike today's system, money could not be created at will. Keeping the supply of gold constant, an economic boom would cause demand to outstrip the money supply. The prolonged boom after the end of WWII created what was known as a dollar shortage, because convertibility ensured that the supply of dollars was constrained by the relatively constant supply of gold.

Back to vietnam: by 1968 there began to be widespread concern that increased levels of US military spending was creating a currency crisis and a run on US gold reserves. The US had been maintaining a current account deficit for several years, and as dollars were flowing out to pay for the war, so was gold. Since other major world currencies were pegged to the dollar, the decline in gold reserves began to jeopardize the stability of the fixed exchange rates. As we mentioned earlier, under the GS, a deficit creates negative pressure on the currency of the net importing nation. Normally this would adjust itself naturally by the self-correction mechanism: the dollar should decline and other currencies rise against it. But we were under the Bretton Woods pegging system, which meant that other governments had to spend large amounts of money to maintain the lower exchange rate in the face of a gold run in the US.

Some revaluations were enacted in a piecemeal fashion: the German mark was formally appreciated by 9.29% on September 20, 1969. But the manipulation that governments had to engage in as the US balance of payments deteriorated represented a dead weight loss of productive capacity; the money spent could have been productively employed elsewhere. Moreover government budgets experienced strain as the money flowed into manipulating exchange rates. Since governments have always been huge participants in debt markets, the distortions created by increased government borrowing were transferred to the real economy, and crisis ensued. As Vietnam dragged on, non-governmental actors anticipating devaluation placed extreme pressure on the monetary system.

Finally, during the summer of 1971, the Nixon administration formally suspended the convertibility of the dollar into gold. Thus began the rapid advance of the floating exchange rate mechanism. Under this new system, currencies would float freely against one another. Exchange rates would be determined primarily through market forces, with some government intervention during crises. Most importantly, the supply of dollars would not be constrained by the amount of gold in the world, allowing the government to regulate the money supply as needed.

Structural vs Fundamental Causation: A Look at Hedge Fund Redemptions

Depending on what sources you use, hedge funds face redemptions of 10-20% of their assets under management from disgruntled investors. When an investor redeems their capital from a hedge fund, unless the fund has excess cash it must sell some of its positions. If the market is depressed to begin with, and a herd of investors rush for redemptions all at once then we can see how the market could turn ugly quickly (e.g. the last 2 days).

This provides an excellent opportunity to contrast two different classes of causation in the market: structural vs fundamental. Everyone is familiar with a fundamental reason to make an investment decision. An investor could buy a company because their earnings look good. The return on investment might be higher with one company vs another. The economy could be expanding or contracting. These are all fundamental qualities.

Structural causation comes from things like the massive hedge fund redemptions: they are causes of a not necessarily fundamental basis. They may be caused by fundamentals; a rash of redemptions was caused by a fundamentally crappy market. But structural causes often appear disconnected from fundamental reality. The government has intervened in unprecedented scale and scope; net interest margins will be improved by coordinated worldwide rate cuts. But there are some firms that still need to sell things to raise cash. Until they are able to get the cash they need in loans or by selling inventory, the crash will continue.