What happens in this situation...

So I was thinking today, what happens when the AAA rating of US Treasuries get downgraded?

The part that I am thinking about is pension funds. They have to have an average weighted rating, and the usual pension portfolio holds some amount of long-dated treasuries to duration-match their portfolio with the duration of their obligation. So, when treasuries get downgraded to AA, the average weighting of the portfolio will thus fall. Pensions will then try and get rid of them and exchange them for AAA bonds that will push them back up to an adequate rating.

Two questions then arise:

1) How illiquid would the market become when all pension funds start dumping treasuries?

2) Are there enough AAA corporates /agencies/munis to cover the new increased demand?

The effects would then be a rising US treasury yield and a falling AAA everything else yield. Maybe play the spread?

Let me know your thoughts.

**UPDATE**

The answer to this question is that pension funds usually use and average of the 3 credit rating agencies as a rating for holding in the portfolio. Thus, this situation would only occur on the second rating agency downgrading the US (like that will ever happen), or if S&P decides to move US below A rating... which isn't going to happen either. Thus, it looks like we're safe for now.

What does it mean?

So just the other day, I decided to take a big position in a firm I was bullish about. I did my research and knew that the company was going to blow the socks off the estimated earnings. I knew further that the debt ceiling crisis had taken a toll on this stock as well as the greater market, this past week alone the stock had fallen ~ 5% and taken me from big gains to moderate losses.

Well after the close was the moment of truth. At then it hit. EPS was 22% above estimates. Actual revenue beat estimated revenues by 10%. Annual earnings revised up 40%. The stock was up 8% after hours. I had a BUNCH of naked calls. I slept well that night.

I woke up the next morning and saw that the bid/ask were nowhere near the highs of the prior afternoon. This was a stock with a daily avg volume of roughly 1 million shares, so I knew there might be some big spreads... but there wasn't. The spread was 5 cents, and it was flat compared to yesterdays close (read still down ~5% for the week). I was in disbelief.

The stock opened 1% up and proceeded to fall to -3.5% for the day, on average trading volume and no new information. I listened in on the conference call and all the analysts congratulated the company on a stellar quarter. The guidance was positive. WHAT is going on?

Well, rather stay in and find out, I got out before it dipped negative, though I lost out a lot on the costs of flat earnings when playing options. Now that I have some time to review the trade, I still can't seem to figure out what went wrong...

TTM and forward P/E are <10, good history of beating estimates, no real cost headwinds or economic slowdown forseen, CEO fielded questions in earnings call cleanly and positively, stock had been rising in the past month and had taken a turn when the impending debt ceiling had become a lot more of a reality than something to be aware of.

I still have a long-dated option in play, taking my nasty -8.5% tumbling this week. In options territory that's roughly a 20% loss. I am still bullish on the stock, and maybe I'll buy in more conservatively right after this debt fiasco is over, but this was one of those textbook stocks and textbook stories that you are supposed to tell at the dinner table - you do your homework, you're on the right side of the call, you get rewarded. Turned out not to be that way.

If you have any idea why a company (not this company in particular) would act in such a way... please give me some guidance. Thanks.

Gold is getting shinier Pt. 2

Eurozone Crisis

Congrats to Greece for getting a bailout package. An effective kick of the can down the road.

What's actually happening? Here's my understanding of it:

If you have a Greek bond that matures in a couple years, 30% of that you keep as cash, 70% gets rolled into a 30 yr Greek government bond. The coupon will be 5.5-8%.

Greece will take a portion of that 70% and put that in a "special purpose vehicle" - which will invest that into AAA govt / agency bonds - for a 30 yr 0-coupon bond.

This SPV is to guarantee the principal of the 30-yr Greek debt.

Though you might not like it, it might be shady, and what not - it's better than the current alternative. According to what I've read "More important, the accounting rules allow you to pretend that you are not making any losses at all."

What happens when that becomes unsustainable? Also, what about Italy and Spain? All this causes instability in the markets, and people look for safe investments in such circumstances. Such safe investments are the USD/US Treasuries, gold/silver, JPY/Japanese bonds.

USD might be a good investment right now, cause of the US debt crisis - lots of dollar shorts on - if stuff really hits the fan, there will be a massive short cover that will cause a significant dollar rally. However, there are multiple risks with that.

Gold is still the investment of choice for me.

Leon was right

Ladies and gentlemen. This doesn't happen often, but Leon was actually right. As we speak, shares of Google are trading at roughly 10-12% above their closing price today due to a stellar earnings report.

Shares spiked close to $600 during the earnings call and have settled down a bit now. But wow, what a party.

Gold is getting shinier

There are three big themes going on in the world right now, and a lot more other ones (not saying they're less important, but I will not be covering them in these next few posts). I will cover one topic each post... though don't expect the posts to be caulk-full of figures and cited arguments. They're still just broad strokes which can be backed up by sound logic and figures if you look/read around.

The three themes:

• US debt ceiling
• Eurozone crisis
• China's inflation

Today's theme: US debt ceiling

If you read the "guest post" on Friday, you would know how things stand on the debt ceiling. Suffice it to say that if the US doesn't raise its debt ceiling and defaults on its loans... the credit rating of the US will go kaput, and yields should rise.

Sure, USD is a supposed to be a safe haven for money as the world's reserve currency, but how safe is it when the country's government can't agree on paying back those loans? Sure we're at an unsustainable spending spree brought on by our understanding of the capital markets, but still... stop looking further down the line when you are about to shoot yourself in the foot.

What does this mean? New safe havens of money. The JPY and the Singapore Dollar look to be the favorites of the smart money, and of course things that hold universal value... such as gold. Even if the debt ceiling is raised, there will most definitely be the cautions of "having a close one", and investors might decide to take a little away from their US Treasuries safe-haven into other "safe" investments.

August 2nd is the date of reckoning. That leaves 3 more weeks to reach a compromise. What do I think is going to happen? They're going to come up with something. The US government might be obtuse, but they're not stupid. However, gold is king in moments of uncertainty... and there are plenty of uncertainties to pick from.

Earnings Season is RIGHT AROUND THE CORNER

Hello All,

Since AA　reported rather mixed earnings as of yesterday, July 12, the markets have been a bit wobbly in terms of hovering around positive and negative. The next two weeks will definitely set the tone for the rest of 2011, as Greece, Japan, and national debt crises have rocked the first half of a highly volatile year.

Companies set to report earnings within the next two weeks are reporting for the past quarter, during which many analysts believe that a cooldown has occurred since the tsunami that hit Japan in mid-March. Analysts have also had to constantly lower their estimates of EPS and revenues multiple times as many companies have lowered guidance as well.

Even in the coolest of earnings seasons, many companies have a tendency to jump in a +/- direction sometimes of almost 20%, which proves to be ripe for initiating straddles or spreads that can earn lots of money. If you want to do it, you must do it now, for the time-decay of options may have already made it to expensive for entry. I leave you with a list of the most volatile stocks after earnings as seen on a post on seeking alpha. Have fun and let's hope you bet correctly!

Most Volatile Stocks on Earnings

Guest Post (not really)

I am letting someone else take the limelight today. As much as I hope that he knows me, Mohamed El-Erian (CEO of PIMCO) has no idea I exist. But I know him, I like him, and I read his literature.

He spent an hour doing a Q&A with Reuters this morning, which was, I feel, the best hour of news I read this week. His answers to all sorts of questions are very well thought out and seemingly effortless in response. He sure knows his stuff and is willing to let us pick at his brain for our own edification.

Trust me, the twenty or so minutes you spend reading the Q&A will be better than countless hours reading my thoughts. So without further delays, here's the link to the Q&A:

http://live.reuters.com/Event/Mohamed_El-Erian_Live_QA?Page=0

Why I Think There's Going to be a Correction

Before the crash, a lot of foreign central banks bought Treasuries to maintain the exchange ratio and keep exports strong. However, since the crash, many of the foreign central banks have stopped buying Treasuries, and the burden was placed to the Federal Government to keep interest rates low by buying up all the issuances.

QE1 ended. Now QE2 has ended. Foreign central banks have not rekindled their interest in Treasuries, and the Federal Government has stopped footing the bill. So, the private sector has been expected to account for the ~$370 billion supply of Treasuries each quarter.

Well, let's think what happens if they don't?

If the private-sector demand does not match the supply of Treasuries, the yield will go up and the price of the Treasuries will go down until equilibrium.

What happens when yields go up? Interest rates go up, and the cost of borrowing goes up.

What happens when the cost of borrowing goes up? Companies cannot borrow cheaply anymore, people cannot borrow cheaply anymore, and banks don't enjoy the huge spread between the short-term and long-term yields that have been fixed in their favor.

Because of higher interest payments, a smaller piece of the pie is left for equities, and money will flow towards the higher yielding debt.

Hence a correction in the equity markets, and higher yields in the bond markets. So I would suggest you prepare for it. With the end of QE2, it is only a matter of time before the correction arrives.

Sites that you read for market information

I think today I'll share some of the sites I go to for information about the markets. I am all about reading brilliant thoughts and seeing how others are viewing the market. Some are daily reads, some are weekly reads, and some are quarterly and annual reads. Let's share resources so that we can all understand the market a lot better.

Daily:

• Wall Street Breakfast: Must-Know News on Seeking Alpha. Great source of what's going down today and what happened last night while you were asleep.
• Wall Street Journal. This one is self-explanatory.
• Zero Hedge. More thoughtful, pessimistic, and angry commentary about the current and future conditions of the markets. The comments are the best.
• Rolfe Winkler's Twitter Page. Followed him back when he was at Reuters. Now that he's at WSJ, it's nice seeing his articles come up in "Heard on the Street".

Weekly:

• Payden & Rygel: Weekly Update. Found out about this when I went doing due diligence for my interview there. Updates every Friday morning.
• Barron's. Enough said.

Quarterly/Annually/Whenever available:

• Howard Marks (Oaktree Capital): One of the best distressed debt investors on the face of the earth.
• James Montier (GMO): Great commentary, very easy to read.
• Jeremy Grantham (GMO): One of those perma-bears, but you gotta love him for it.
• Warren Buffet (Berkshire Hathaway): Shareholder letters. Read all of them. They all have great points worth noting.
• Bill Gross (PIMCO): Anything he says you have to read; everyone else does.

Hedge Fund model vs Prop Shop model

I have been talking to a couple prop shops recently, and I got a chance to sit down with the owner of a prop shop that specializes in fixed income derivatives. Since to be a part of the shop you have to put up your own capital (typically $500k to get a seat and play with the house's money), and I only have a fraction of that in the market, our conversation was more towards the prop shop model vs the hedge fund model.

The owner has spent his time around big banks, hedge funds, and prop shops - and aside from running the prop shop he is a professor at a top business school. I took lots of notes through our conversation, and I've decided to share a bit about the hedge fund vs. prop shop model.

In the hedge fund model, you are using client money to try and make more money. However, the structure is setup such that the fund manager gets all the spoils. You can compare such a hierarchical structure to those found in mail-order catalog networks and knife selling agencies. There are the work horses and the decision makers, then there's the guy who gets to decide who the decision makers are and call shots on the shots. The example I have seen used for this model is the pyramid of wine glasses, where the top glass always gets filled first before the second tier glasses get filled. Furthermore, the lions share of profits from the hedge fund model comes from not the 20% profit but the 2% management fee; getting paid just to play.

In contrast, prop shops pay significantly more based on performance. You pay to play upfront, usually contributing some form of capital to play with company money. You lose, you don't get paid; you win, you keep 35-80% of your profits depending on various factors. The owner compared himself to the house: people pay to play, play with house money, some win and some lose, but the house gets a cut off each bet. The traders get the research and execution they need, and the house gets paid. +1 Props.

Personally I don't trust hedge fund managers who don't have their own skin in the game, there's a real moral hazard there. Prop shops have the "better" model in that regard as well, as losses are shared between your self and the shop. Mallaby argues in More Money Than God that the hedge fund model is better than big banks in terms of moral hazard, and I agree, but that's not saying much. +1 Props.

After we finished the conversation, it seemed that we agreed on one thing. You should definitely go spend some time in the big banks/hedge funds to learn how to trade. However, once you know how to and are finding/making profitable trades, the prop shop model is a better alternative compared to staying in a hedge fund. That is, of course, unless you start your own fund.

The owner's approach? Find the market and become the house. As long as people are trading, the house gets paid. And the house gets paid well.

Why I bought GOOG and you GOOG too!

Greetings fellow traders!

Exactly one week ago on June 24, Google was trading at a puny $474. Fresh off of a huge end of May plummet, I decided that it was time to move in for the kill. Google, the largest search engine in the world takes up over 2/3 of total searches on the internet. With a 52-week high of almost $700, it was trading at a P/E ratio of 18. Let's break this down a little further:

As of March 2011, Google has, on-hand, $12.4 BILLION in cash. No debt, and 20% revenues in search engine growth year over year. The latest was $5.9 billion. Pretty much anyone and everyone on this planet knows what Google is. The piece of information is a dealmaker - According to current valuations, Google stock price should be valued at $663.

So I thought to myself, $474? $30 off a 52-week low? You've got to be kidding me. Now, a week later, Google has broken the 500 mark and is well on it's way to hitting $520 as we roll into this July 4th weekend. Should I take profits? I believe this stock will be rolling well into the future.

Let me know your thoughts in the comments section!

The hedging company

For the moment I am not adhering to the strict deep value strategy. I am very pessimistic about the upcoming months, and am waiting for a large correction soon. This week we have seen four consecutive days of 1% gains in the large indexes, and that is preposterous to me. I am not sure when this bubble is going to burst, but I have positioned my portfolio to be cash heavy, and all my bets have some form of hedging associated with them.

Of the portion of my portfolio that I am investing, roughly 70% of the funds are in long-dated options expiring in December or January. The implied volatilities are slightly larger than normal market conditions, but laughable when you consider how bad things can become. Thus my hedged positions also double up as volatility plays.

As for sectors, I am net long the healthcare and basic materials sector and net short natural gas.

My strategy is about relative value. Look for companies within sectors that have some momentum, good fundamentals, decent future prospects, and have lower beta relative to the sector in bad times. Holding period is 6 months, in which I will screen for new long/shorts and turnover 50% of the portfolio every 3 months. Long the company, short the sector.

Simple enough, we'll see how it performs. I turned over the portfolio to this strategy 06/28/2011, and so far I am net positive 1%. I will update regularly.