Derivative-based market indicators

It seems the importance and speculative value of using derivatives as an indicator of risk increased tremendously following the credit crisis, which, for the most part, I think is due to rating agencies maintaining AAA ratings before the panic. Considering the volume of derivatives contracts (MBS, CDO) amplified during the real estate boom, and rating agencies failed to respond and adjust their ratings, investors now view the strategy of financers as a way to judge market risk. The logic: if derivative volume is growing, investors must be preparing for default (or a significant drop in the market).

Some derivatives, such as typical stock options, trade on exchanges.  But many are private contracts between banks or other investors.  As a result, it is hard to know the total volume of derivatives now outstanding. That is both an advantage and disadvantage of using a derivative-based index to measure risk. While price discovery is stimulated and there is a greater degree of market “completeness,” volatility increases since a larger number of derivative participants leads to speculation and raises impulsiveness in the markets (compare historic VIX charts and you’ll see that a majority of spikes have taken place in the last 5 years). Moreover, since OTC derivative trading is still going through massive international regulation, I think derivative-based indicators, as well as other market breadth indicators, should be used with reservations when making an investment decision.

For instance, consider the charts below. The first displays a comparison of OTC derivative markets in 2010 and 2013. The second is a breadth charting showing an Advance-Decline (AD) line for the NYSE.

Short sellers using derivative-based market indicators over the last few years have not profited. The derivative market has grown by over $100B, but AD indicators show no sign of slowing down. We are definitely experiencing a bull market. However, 2008 showed us that breadth charts could move rapidly, and bulls can turn to bears in seconds. A market/bubble “pop” is always something to consider. Who knows, maybe there is another Mike Burry lurking and waiting to capitalize on the next bear market.

A bit off-topic, but since the subject of short selling, derivatives and risk management is on the table, what are your thoughts on inverse and leveraged ETFs?

References used:

http://business.time.com/2013/03/27/why-derivatives-may-be-the-biggest-risk-for-the-global-economy/
http://www.risk.net/risk-magazine/feature/2332503/otc-reforms-numbers-only-tell-part-of-the-story
http://www.financialsense.com/contributors/matthew-kerkhoff/market-breadth-indicators-important

The $1 billion bet on Herbalife’s collapse

Lobbying to bring down Herbalife

There’s an interesting event taking place in the activism world: Bill Ackman is attempting to use every weapon that Washington has to bring down Herbalife, a vitamin a health supplement company. I’m sure most of you have heard the story – Ackman is accusing Herbalife of being a pyramid scheme that stays afloat by means of recruiting new distributors, many of whom are low-income individuals. Fraud reports and business investigations are common, but what makes this case interesting is that Ackman’s hedge fund recently took a $1B short position that will only pay off if Herbalife’s stock drops. Ackman’s attack, the value of the attack, and the lobbying attempt at hand is unprecedented in its scale.

Ackman has pressured state and federal regulators to investigate Herbalife by helping organize protests, news conferences, and letter-writing campaigns in California, Nevada, Connecticut, New York and Illinois. His team has also paid civil rights organizations at least $130,000 to join his effort by helping him collect the names of people who claim Herbalife victimized them, doing so to send the reports to regulators. Ackman’s team also provided the money used by some of these individuals to travel to Washington to participate in a rally’s against Herbalife. Ackman has presented investigators in New York with a year’s worth of financial research that he said showed that Herbalife was misleading investors by failing to disclose that most of its sales were generated by simply recruiting more distributors, rather than by selling large amounts of its product to consumers.

Nevertheless, Herbalife has grown into a powerhouse, with a worldwide team of more than 3 million members and distributors who operate as independent contractors through a system that rewards many of them not only based on actual sales, but also on their ability to recruit more distributors. Currently, Ackman has little to show for his fight: Herbalife’s stock has climbed higher over the years, which is partly due to billionaire investor Carl C. Icahn buying a large stake in the company. In addition, regulators lobbied by Mr. Ackman have not taken any formal action against the company.

While this is not “traditional” activism – traditional meaning a large institutional shareholder using its power to influence and make decisions, such as proposed M&A, compensation, and other strategy – Ackman is trying to find a way to undermine public confidence in Herbalife so that his $1 billion bet will produce an equally enormous return. What makes Herbalife interesting is that other known activist investors, such as Carl Icahn, are betting that Herbalife will continue to grow. The chart below illustrates how "active" Herbalife has been in the activist investor community.

What are your thoughts? Who will win this battle?

Cheers, Josh

Reference used: http://www.nytimes.com/2014/03/10/business/staking-1-billion-that-herbalife-will-fail-then-ackman-lobbying-to-bring-it-down.html?_r=0

Strange Phenomena in the Bond Market

Detroit, Puerto Rico, and the Madness of Crowds 

Municipal bonds have, traditionally, been much less volatile than Treasury yields – and muni yields have (like bond yields in most other markets) rose with Treasury yields. The chart below illustrates rolling one year changes in Treasury and 10 year AAA muni bond yields between 1986 and 2012.

As shown above, the sensitivity of muni to Treasury returns is roughly 0.5. Many investors believe this relationship exists because investors tend to compare the after-tax returns of Treasuries to municipal yields. Why has that relationship changed recently? Fundamentally, the answer is because of the fear of default. Specifically and recently, last year investors ran worried as interest rates began rising - and that fear intensified after Detroit filed for bankruptcy and concerns for the finances of Puerto Rico ascended. Puerto Rico is one of the largest issuers of muni bonds with $70B of debt, and US investors have pulled over $20B from muni funds containing Puerto Rico’s junk-rated debt. These events have and heavy outflows have forced municipal bond managers to keep bigger positions of well-known and highly-rated securities. For that reason, prices fell sharply and muni yields rose more than they usually would, to include faster than Treasury yields, explaining the rise to these unusual circumstances.

This strange relationship is beginning to wind down. Currently munis have returned 2.2 per cent year-to-date, ahead of the broad US Treasuries index which has delivered 1.2 per cent. Investors deposited a net $342 million in January, a significant improvement from the nearly $10B that flowed out of muni funds in December. Nevertheless, the gains this year have come from interest rates dropping - the yield on the 10-year Treasury note has sunk to about 2.73 percent from 3 percent in early January. Most major news network and financial advisory firms are praising an investment in municipal bonds this year, and most retail investors will surely tag along. A Google News search will present numerous articles journaling the pick-up in the muni marker. While there are certainly opportunities in munis this year, there are some significant concerns that could limit returns and further prolong this unusual muni market:

• Credit concerns: muni-bond fund managers say they are hearing more questions now from investors about Puerto Rico. Although the default rate for municipal bonds in Puerto Rico remains below 1 percent, a reoccurrence of negative attention can be devastating for the muni market.

• Tax exemption: Congress is debating whether to strip away, or at least reduce their tax-exempt income. If the proposals turn into law, it could drive down demand.

References used:

1. http://www.bostonglobe.com/business/2014/03/09/can-calm-last-municipal-bond-market/pePmcosGXSuLq5YgeFI6MO/story.html

2. http://www.reuters.com/article/2014/02/21/us-puertorico-funds-idUSL2N0LP2MK20140221

3. http://www.ft.com/intl/cms/s/0/35f47b76-93ed-11e3-a0e1-00144feab7de.html#axzz2voEP7jem

4. http://blog.alliancebernstein.com/index.php/2013/07/25/municipal-bonds-equipped-to-weather-rising-rates/