Thursday, October 9, 2008

What in the world?

I think every woman I know is asking right now, "What in the world is going on with the US stock market?" Basically, many analysts and commentators blame a huge part of it on the deregulation proposed under Alan Greenspan. So, what does that mean, exactly?

A hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. When I worked at Morgan Stanley, something not entirely uncommon to do is "short sell" stocks, meaning that you actually sell them at the price they are at that day, counting on the fact that the stock is going down in the future. Once they do go down, you purchase them lower and make money based on that difference. You are counting on a falling price. It is obviously different than the traditional buy low {hold}, sell high mentality. Stay with me here, people. I have a point, I promise.

Now, many people think selling short is pretty risky. So, how do you reduce the risk? You hedge it. I found this illustration on WIKI:

A stock trader believes that the stock price of Company A will rise over the next month, due to the company's new and efficient method of producing widgets. He wants to buy Company A shares to profit from their expected price increase. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation.

Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares × price) of the shares of Company A's direct competitor, Company B. If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a call option on Company A shares) the trade might be essentially riskless and be called an arbitrage. But since some risk remains in the trade, it is said to be "hedged."

The first day the trader's portfolio is:
Long 1000 shares of Company A at $1 each
Short 500 shares of Company B at $2 each
(Notice that the trader has sold short the same value of shares.)

On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. Company A, however, because it is a stronger company, goes up by 10%, while Company B goes up by just 5%:

Long 1000 shares of Company A at $1.10 each – $100 gain
Short 500 shares of Company B at $2.10 each – $50 loss
(In a short position, the investor loses money when the price goes up.)

The trader might regret the hedge on day two, since it reduced the profits on the Company A position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash – 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B:

Value of long position (Company A):
Day 1 – $1000
Day 2 – $1100
Day 3 – $550 => $450 loss
Value of short position (Company B):
Day 1 – -$1000
Day 2 – -$1050
Day 3 – -$525

Without the hedge, the trader would have lost $450. But the hedge - the short sale of Company B - gives a profit of $475, for a net profit of $25 during a dramatic market collapse.

For years, Alan Greenspan has been the driving force behind NOT regulating companies that took out far more debt than they should have.

From the article The Reckoning,
"On a grander scale, such contracts allow financial services firms and corporations to take more complex risks that they might otherwise avoid — for example, issuing more mortgages or corporate debt. And the contracts can be traded, further limiting risk but also increasing the number of parties exposed if problems occur.

Throughout the 1990s, some argued that derivatives had become so vast, intertwined and inscrutable that they required federal oversight to protect the financial system. In meetings with federal officials, celebrated appearances on Capitol Hill and heavily attended speeches, Mr. Greenspan banked on the good will of Wall Street to self-regulate as he fended off restrictions. "

Greenspan was the driving force behind keeping the government, or really any regulatory agency, from doing anything about it. Now, I remember the Clinton years well. The prosperity, the surplus, the little blue dress. Oh, wait. That is something else. I digress. Anyway, Alan Greenspan was touted as a genius during these times because all this hedging was leading to a BOOMING market. And us Americans...we love a booming market.

Well, turns out that the Wall Street Fat cats Greenspan was betting on not only did not have good will, they had horrible ethics. As said by Alan Greenspan: "The villains, he wrote, were the bankers whose self-interest he had once bet upon" Giving out mortgages to people that could very obviously not pay them back and offsetting the risk through hedge funding is leading to this meltdown of the US market.

“The sudden failure or abrupt withdrawal from trading of any of these large U.S. dealers could cause liquidity problems in the markets and could also pose risks to others, including federally insured banks and the financial system as a whole,” Charles A. Bowsher, head of the accounting office, said when he testified before Mr. Markey’s committee in 1994. “In some cases intervention has and could result in a financial bailout paid for or guaranteed by taxpayers.”

I have two main thoughts:

One: the dow, off its high last year at almost this same time, has fallen 40%. 14000 to 8000 in a matter of 12 months. That is concerning.

Two: I saw broker after broker repeatedly put clients into funds for an entry into a vacation getaway or Lakers tickets. With the financial boom of the 90's, it was not a big deal. Now, all these clients are scratching their heads because they wonder where their 401K went. How could ONE fund be the perfect solution for EVERY client. Some brokers have been mishandling money for a lot longer than just these downturns. Now that these funds are so far in the red, people that are at retirement age that were put into these bunk funds have lost in two months the money they worked their entire life to build.

Is it time to panic yet? Please, Please, Please. DON'T PANIC. Thankfully, none of us are retiring soon. Much of WHY a stock market crashes is due to widespread panic from investors. Crashes are driven by panic as much as by underlying economic factors (Wikipedia). We do have 25, 30, some even 40 years before we need to cash in on the stocks we have picked out so diligently. I was told when I first got in the business, "Seek out the stable, solid companies. Invest and hold." It remains the same today.


Lara said...

wow you are smart!

Wendy said...

great post! thanks!