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Nasser Khraishi
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I hold a PhD in Electrical Engineering (Control Theory) from Stanford University and a Masters Degree in Engineering-Economic Systems (now called Management Science and Engineering at Stanford). I have been fascinated by the stock market since I was 14 (that is 37 years ago at writing). It has... More
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  • 2013 Wrap-Up And Trading Set Review - Part IV

    To conclude this series, we will take a look at the overall market. Call it the "forest view," as we did take a glimpse of the "trees" in the previous writings. In the three previous articles (Part I, Part II, and Part III), we discussed the equities in my trading set, by going over charts and synopsis of each. Yet, it is a fact that most publicly listed issues are highly correlated with the market. In essence, as the old sailing edict goes: "The Rising Tide Raises All the Ships." This correlation with the market -- beta -- is an important factor in my trading decisions. As such, I do keep an eye on fundamentals that affect the overall market, even though I am primarily a technical trader.

    If you want to discern economic patterns from charting, then make sure you do not get lost in the short-term day-to-day charts. You need here to look at moving averages on long term charts with decent charting frequency. I feel that 10-year charts, or longer, with monthly frequency do offer good readings of the overall economic patterns. Hence, that charting setup is the one I use to make fundamental judgment on the markets.

    The 10-year DJIA monthly chart, where DJIA is the index with the closest composition to my trading set, is alarming as of end of 2012.

    (click to enlarge)

    First look at the financial crisis (marked as A on the chart). You will see that the separation between the peak pre-crisis index and the 21-period exponential moving average was around 14% towards the end of summer of 2007. This is followed by the gradual demise of the stock market, which later accelerated in Q3-2008. To remind of the scale of what transpired, the bottom of this crash, at the end of Q1-2009, saw the separation stood at around -40% (marked as B). The last recent correction, summer 2011 (marked C), started with a separation of around 15%. We are standing now (marked D) at a high separation of around 14.5%!

    Alarmingly, note that the slope of the slowest moving average on the chart changed around end of 2012 (marked E). In essence, we are running into a period of accelerated price appreciation, and unless you can find an economic reason to justify it -- which I cannot -- then you need to be on the watch for signs of a possible serious consolidation. Yes, better employment numbers, higher GDP, controlled CPI, among others, are good reasons to warrant growth, but not at the rate we saw in the last year or so.

    The DJIA is not the market. Hence, let us look at the equity markets as a whole and see if the above notes are specific to the DJIA. Unfortunately, the following chart indicates, if anything, that the DJIA is the tamest of the three equity indices that I follow.

    (click to enlarge)

    In the above chart, I used the S&P 500 as the base, with the DJIA being the light brown line, and the NASDAQ Composite as the light blue line. The first event, which I affectionately remember (marked A), is none other than the IPO of Netscape! That launched the internet bubble, which took 5 years -- till around spring of 2000 (marked B) -- to hit the NASDAQ, and a few months later -- towards the end of summer 2000 (marked C) -- to hit the general market. The change in the rate of price appreciation was beyond anything seen to date (line 1). As a matter of fact, if that rate of growth held, which the pundits were arguing at the time it should, the S&P 500 would be many thousands of points higher than it is at now. The bottom of that crash was reached around the prelude to the Iraq war in Q1-2003 (marked D).

    A very decent growth rate, and somewhat sustainable (line 2) did take place up to the subprime crisis -- end of summer 2007 (marked E). Yet, do note the rate of price appreciation change around mid-2006. This crash culminated with the Financial Crisis, and we did reach the bottom around the end of Q1-2009 (marked F).

    What followed was an even more moderate recovery (line 3), and at a very sustainable rate -- by recent standards. Yet you can easily spot two very disturbing patterns evolving over the last five years. The first is the unrealistic separation of the NASDAQ composite from the general market. The second is the slope change -- yes, the feared event in my opinion -- as of the end of 2012 (line 4). As a matter of fact, this line-4 is running almost a parallel to line-1! We have not seen anything like this since the Internet Bubble!

    As much as one wants to attribute this last slope change in the NASDAQ Composite to the game-changing events of summer of 2012 (the Facebook IPO and the Social Media Revolution), an old trader like myself has learned the hard way that: Finance and Economics will always prevail! Similarly, unless you can find an economic or financial justification for the recently sharpening rate change of the S&P 500 -- line-4 on the above chart, then you will have to agree that we are only marking time till the next correction or, worse yet, crash. After all, a 30%/year growth does mean more than doubling every three years -- read it a DJIA of 33,000 and S&P 500 or 3,600 by this time in 2017! I honestly do not think that is sustainable.

    Not only do I observe the Dow Jones Industrial Average, the NASDAQ Composite, and the S&P 500, but I also watch interest rates. These are the 5-Year bond rate index (FVX), the 10-Year (TNX) and the 30-Year (TYX). Note that as of this latest, multi-year, Fed intervention, watching short term interest rates (<= 2 years), is an exercise in futility. After all, the Federal Reserve has a stranglehold on such rates, and the Fed meeting notes will give you all the information you need about these rates.

    (click to enlarge)

    The two-decade monthly chart above does not reveal any unexpected secrets. You can see that the 5-year rates dropped faster than the 10-year, which in turn was dropping faster than the 30-year, as expected, especially since the Fed intervention in the wake of the Financial Crisis. After all, the Fed lowered short term interest rates to almost zero, and hence the shorter maturity bonds were affected more. You can also see the upward trend as of Q1-2013. The only worth-noting feature of the above chart is that the end of each Fed intervention seems to have induced a consolidation of the rates of change of the different bond yields -- call it normalization of the interest rate curve. You can see it on the lower part of the above chart. Note in particular the period from 2005 to 2007. Again, this is expected, but worth noting, as once the Fed starts reducing the level of their intervention, the 5-year bonds will suffer the most rate appreciation.

    For my trading set, as most of the issues are dividend paying, this may spell some trouble, when it happens. You see, the 5-year bonds are now yielding less than most the issues we discussed in the earlier articles. hence, for some of the more risk averse, income oriented investors, the 5-year will possibly become competitive as such rates rise.

    If you do belong to the old school that I subscribe to, then you also need to watch gold and oil. On this note, I stopped watching oil for analysis purposes as it is clear that oil prices do not make sense anymore. Just watch the BRENT-NYMEX separation, read the news relating to the new finds in highly unexpected places and of exceedingly impressive sizes -- US shale and fracking, the North Pole, Israel, Lebanon, and Myanmar among others -- then read a little about the European alternative energy revolution -- Spain, Germany, and Italy in particular, add to that the increased automobile efficiency, and you realize that all that the Economics professors taught us at school does not apply anymore for this commodity of oil: Increasing Oil Supply + Lower Demand = Higher Prices?! As a principle, if I cannot understand something, then I just do not trade it or even bother to waste my time analyzing it further. After all, investing is a very serious business and my hard-earned money is at stake!

    That leaves me with Gold -- for which I use (GLD) as a proxy -- to watch and analyze as if it were one of trading set equities. The old-school thinking is that Gold, equities, and bonds are highly correlated. If Bonds rise in value -- i.e. bond rates drop -- then economic activities should follow, as cost of funding drops, and hence equity prices should rise. As inflation risk rises with the accelerating economic activities, so does the price of Gold. This is what we were taught, but not what the charts reflect.

    (click to enlarge)

    As you can see, in the last decade, not much of this "normal economic cycle" is being reflected in the charts. If anything, exactly the opposite of what you expect happened. Look at the line I set on the chart -- end of summer 2011 -- and you will see clearly in the lower comparison sub-chart that bond rates and equities moved in a very correlated fashion, with gold suffering. I tried to explain gold behavior in a different article, but it is clear that so much excess made it into gold and treasuries pricing, and so much depreciation made it into the equities pricing, that it will take a while to work out some decent equilibrium. Yet, you need to continue to watch these measures, as in the end, proper economics and finance is the "mean" that all financial and economic activities will "revert" to, regardless of "when" this will happen.

    This concludes this series of articles, hoping that you did find value in the discussions. To recap, the basic themes touched upon:

    • There are plenty of investment-grade issues listed on the public markets. Enough that a Silicon Valley technologist like myself does not need to have more than 10% of his portfolio in his own sector.
    • Dividends are not only good for the investor, where at least it pays you to wait while a company is working through some unexpected events, but also enforce a very severe and tangible measure on profitability and hence good business conduct on companies and management.
    • Do tend to your "trees" very well, but watch for "forest fires" that can burn good and bad. The macro-view is as important to the short term technical trader as it is to the long-term investor.
    • ETFs are great to play a sector for which there is high per-issue risk, but nothing beats having a real company, with real equity, for which you can do an old fashioned analysis.
    • A company good enough for long term investment is still good enough for short term technical trading. As there are more of these than one can handle, one may as well stick to investment grade issues for all one's market activities.

    Finally, remembering that charting is always "market following," and since the past only reflects the statistical nature of the future but not what will actually transpire, I do treat the equity markets with enough respect and humility, and I hope that all traders and investors do the same.

    Disclosure: I am long GERN, NLY, T, VZ, GPS, ANF, JWN, TGT, MCD, BA, CSCO, WM, CNW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Additional disclosure: It is important that you understand and agree that all information provided in this newsletter rely on publicly available data and tools with no guarantees of quality or suitability for any purpose, and that I can be long or short in any of my trading-set equities, at any time, with or without regard to indicated trends and described analytics, and that I do not give buy or sell or any other financial recommendations, and that any and all actions based on this commentary are solely the responsibility of the reader.

    Tags: GLD
    Jan 06 2:37 PM | Link | Comment!
  • Annaly: Understanding The Effect Of Interest Rates On Profitability

    Despite being an investor in Annaly for years, I have accepted the summary presentation of what affects an mREIT as a given. I have to admit that it was not until I wrote my earlier article that I did spend the time on trying to work out the details myself. Mind you, I did do my due diligence as far as history, disclosures, financials, management, etc., prior to my first buy. Yet, I accepted the common wisdom blindly when it boiled down to what affects a REIT's profitability.

    In my prior article, I discussed the not-so-surprising observation that the well-being of the Real Estate market can have some negative correlation with the fortunes of Annaly. I also discussed the (somewhat unexpected) fact that the 30-year treasury seem to have correlation with Annaly's fortunes, as shown in this chart.

    (click to enlarge)

    You see, what I was taught in the ancient past was that 10-year instruments are used to hedge the 30-year MBSs -- called expected life, hence shielding the mREIT from the 30-year exposure. To confirm, the company's lastest disclosures indicate a mainly repurchase agreement (REPOs) debt liability with an average debt maturity of around 200 days. Interest rate on very short maturities did not really change much since the Fed action began in the wake of the Financial Crisis. The disclosures indicate that the bulk of the assets (MBSs) are fixed rate very long term (20+) maturities.

    What I failed to see in the past -- and this article is an attempt to address that failure -- is that the long term-short term interest rate spreads are not the most important factor. Actually the levels of the current market interest rates of each maturity term, and in particular the longer-term market rates, are far more important.

    If you are as surprised as I was, let me walk you through the logic. For those who are more analytically inclined, I have included a section at the end of this article that goes over am Excel model, albeit simplistic, of a simple term-swap; that is when shorter maturity debt is exchanged with a longer term one.

    As a note, even though my focus is on Annaly (NLY), this discussion addresses how to analyze any mREIT, be it Annaly or American Capital Agency (AGNC). Personally, I now believe that by accepting that spreads are the focus, I failed to protect my investment.

    The logic goes as follows. An mREIT works, normally, by using short term debt to buy longer term, higher paying mortgage backed securities ((MBSs)). Depending on the sophistication of the organization, they can engage in different forms of derivative arrangements to either enhance or insure the basic portfolio. The basic portfolio can be simply viewed as being "long" longer-term bonds (MBSs), and "short" short-term debt securities. In Annaly's case, the disclosures indicate that the bulk of their MBS portfolio is fixed rate with 20+ years to maturity and the bulk of their debt is REPOs. Since no financier would pay more for insurance than their main income, we can concentrate on the main portfolio, and, unless it is a gambling organization, we can safely assume for the purposes of this discussion that the impact of the insurance should be a few percentage points of the cashflow.

    As bonds, including MBSs, have a certain coupon associated with them, the income the company gets is based on that coupon payment. The spread in interest rate between coupons received for long term and those paid for short term debt - minus hedge or insurance -- gives you the net, or effective coupon payment you receive. Clearly, if the spread between the debt securities narrows, then the income that the mREIT receives will suffer. Conversely, if the spreads widen, the company makes more. This is what we are taught, and it makes perfect sense.

    The above is also how I fell into the trap! You see, I forgot to include GAAP and FASB. Accounting standards mandate that losses/gains on equity be included in the total P&L. Not to fault the company, in the above mentioned disclosures they do list all such details. It is that I was fixated on the spread and not actual Fair Market Value of assets and liabilities.

    Ignoring the hedge and insurance, proper accounting principles state the equity of the company is not only based on the "real equity" or what we, the investors, paid the company for IPO and secondary offerings plus whatever reserves the company accumulated over the years. Equity also must include obligations - that would be the short term debt and interest rate swaps. Also, equity must include assets - that would be the long term debt purchased.

    If interest rates on the short term rise, then your obligations drop in value! After all, your "existing" obligations can be treated as fixed-rate bonds -- read it cashflows, and these drop in value if equivalent market rates rise. Yes, you pay more for the coupons of new issues and debt, but you have just made money on the fair market valuation of existing obligations.

    What will happen if long-term interest rates stayed the same and short term rates went down? That will increase the spread to your advantage. Yet, the rise in the fair market price of the short-term debt -- your obligations, will more than offset that. Hence, in the net, you will lose money.

    The reverse happens on your existing assets, which are the long term MBSs you bought with your equity and debt. That is, if long-term interest rates rise, even though your receipts on new debt rise, you will end up losing more on the valuation of the assets you already have on your books. Conversely, if long-term rates drop, then you will end up more than making for the loss of new receipts by the gain on the existing assets.

    An interesting scenario arises, though, when the short term financing expires, while the longer term one is still on the books. That means, you have to finance new debt at the then current rates. In this situation, the new debt will be "fairly priced" at purchase. Hence, the effect on profitability is due to cashflow (spreads). As we have been discussing how the cashflow due to coupons is dwarfed by the interest rate movements and such effect on fair market value, you can see that cashflow impact is much more manageable than the impact of interest rates on valuation of existing assets and liabilities.

    In short, with minor regard to the spread - a very strong statement indeed - your mREIT will mainly make money on dropping long-term interest rates. Yes, widening spreads help, but only if the change of the value of existing - on the books -- assets and obligations do not offset that.

    How can a REIT stay in business if they do not renew their balance sheet? If rising new short-term debt is coinciding with a dropping long-term, that will squeeze the new swap margins. In the meantime, their overall "profit," which includes cashflows as well as equity loss and gain, should be blossoming enough to over compensate for such margin drop. Yet, you would expect that they will do less swapping if the incremental margin does not cover cost. That is healthy deleveraging.

    To cap the qualitative part of the article, the typical question would be: how would I trade this?

    I have gone on record stating that I believe that long term interest rates should be rising to around 2-3% above inflation. This is what the Fed is working hard to achieve, and I believe that in the next couple of years, they should be able to. Unfortunately for the Fed, most of human history is deflationary. Further, the Japanese experiment does not reflect well on quantitative easing. That is, for the longer term, interest rates are going to go back down, possibly close to zero.

    As far as my investment in Annaly is concerned, I believe it is going to be a hard environment for the next couple of years. Yet, afterwards, I believe that they will be rewarded well if they manage to build a marginally profitable high-interest rate portfolio. Yes, they will need to manage their redemptions well during that deflationary period that may follow, but dropping interest rates, after the Fed shock is absorbed, should reflect well on the book-value of their existing investments.

    Hence, I am not looking to add to my holdings in the near future, despite the highly depressed price. My trigger to add would be a stabilizing interest rate environment, preferably with dropping long-term rates.

    Simplified Model

    To carry this discussion further for those who are analytically inclined, let me walk you through a somewhat simplified model that I created. I assumed that I have a $100 equity on 1/3/2011, the first trading day of that year. At that time 5-year yield (FVX) was 2.02%, while the 30-year (TNX) was 4.4%. I (hypothetically) bought a (fresh) 30-year bond for $100 at that yield, and simultaneously sold $100 of a (fresh) 5-year bond, with my equity as collateral. Effectively, this is how an mREIT works: you finance the purchase of long term, higher yielding debt, with short-term, lower interest rate borrowing.

    This image summarizes this simple sheet.

    (click to enlarge)

    The sheet itself can be found as a link on this page on my personal blog site.

    To get to a 5-fold leverage limit, I went ahead and (hypothetically) entered into similar arrangements, at the then current fair yield. This was repeated on the first day of each following half-year. On 1/2/2013, I (hypothetically) purchased the last (fresh) 30-year bond at 3.05% yield, and sold a (fresh) 5-year bond at 0.76% annual yield. This is again how you would expect a REIT to work: as debt matures, they will need to either buy more assets or finance more debt. At this point I would have a net of $5.69/period guaranteed semi-annual coupon payments, and my on-the-books equity would have been $135.14. Yet, that is a net loss from the previous period, mainly due to rising interest rates. Also, note that you would have lost money on 7/1/2013, again due to rising interest rates.

    Seven different scenarios for 12/31/2013 are then proposed. I have used the first scenario, which assumes interest rates on that date to be similar to 11/26/2013, as a reference. The last row in the sheet indicates how the other six scenarios would have fared compared to this reference scenario. You will see that the only alternative scenarios that will make you money involve dropping long-term rates or higher short term, even with shrinking margins!

    The most important simplification here is that I used only "then Net Present Value" of remaining cashflows in my valuation. Further, I assumed that all bonds are at 100 at the time of purchase.

    In effect, as simple as this model is, it strengthens my view that traders of mREITs should make long-term interest rates a primary focus.

    Disclosure: I am long NLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Tags: AGNC, NLY, reits
    Nov 29 11:48 AM | Link | Comment!
  • Why I Write Articles...

    As my last article (Gold Long-Term: Nowhere To Go But Down) seems to have stirred emotions, more so than the academic presentation intended, I feel I need to explain why I do actually write these things.

    Invariably, each article is directed towards answering a question that I, a family member, or a close friend asked. Once I have done the research to get the answer, writing the article itself is only 20% of the road away.

    As such, if I feel that an answer to a question may have larger audience and be of value to others, then I do spend that extra time to assure that it is written well enough to be published. Otherwise, it either makes to a blog or dies away in my research notes.

    So, the "Gold Long-Term: Nowhere To Go But Down" article was because a family member, at $1600/ounce asked me how to trade gold, and I simply answered: use the gold ETF (GLD)! When gold hit $1300, it was clear to me that I was an accomplice in his demise, and hence I needed to answer the fundamental question about the direction of the price of gold. After all, I did let my relative fall prey to someone who planted in his mind that gold was too cheap at $1600.

    The "QE: How Will It All End?" was because an aspiring hedge fund manager friend asked the exact question, literally. He was surprised of the answer I gave. As such, I did the research to convince him, and I felt the answer needed to be shared.

    The "Annaly: Never An Investment Vehicle For The Fainthearted" was because a friend asked: what is going on with Annaly? Since I and many family members are stock holders, I thought it deserved real research to find out if it is a management issue (hence run) or a market issue (hence hold).

    Finally, my first article on SA was "Geron: A Changed Company With Significant Potential" and it was intended for me. You see, I have been an investor for 15 years, and the news of last year and price movement did not make sense at all, especially, in the wake of the management and portfolio changes. I needed to answer the question of whether I should throw in the towel or continue to hold. After all, at the then current prices I would have made a significant amount of the actual paper loss (not the opportunity loss unfortunately). The research was an eye opener, as it revealed that the company has finally changed into what I was hoping it becomes a decade or more ago.

    No agenda, and no prepositions before writing an article. Simply do the research, finalize it into an article, and publish it, while trying to be as academic as you can!

    As a matter of fact all of the stocks I trade, except for GERN and STON, are listed on my personal blog and my holdings updated weekly. Further, the performance of my auditable portfolio is updated monthly.

    You cannot get more transparent than that, and I am truly proud of it!

    Disclosure: I am long NLY, GERN, STON.

    Nov 24 3:24 AM | Link | Comment!
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