CNBC interview with Nassim Taleb from earlier today. Of interest are the following observations:

1. Why trust the employment number forecasts being made? These forecasters did not forecast the downturn.
2. When the unemployment number has essentially doubled in less than a year, why worry about one monthly number? Error must be considered.
3. The current system is complex and fragile, and will eventually break and crash.
4. Instead of deflating debt, governments are trying to stimulate and inflate assets.
5. Monetary policy is out of control.
6. We need to convert debt to equity.

Source: CNBC Video

According to the recent TIM (Trade Ideas Monitor) report and the TIM Sentiment Index (TSI), institutional brokers became more bearish over the last five trading days as the TSI decreased 5.0% from 57.32 to 54.46 (see previous post or youDevise website for additional information on the TIM report). For the five trading days ending July 1st, the number of new short ideas as a percentage of new ideas sent to investment managers increased to 30.98% from 22.07% one week earlier (see last week's post), but the intra-week short trend did fall off its high of 35.26%. To date, shorts represent 41.46% of all ideas this year.

As for individual securities in the U.S. and North America, Tyco Electronics (TEL), Intel (INTC), and Electronic Arts (ERTS) were the stocks most recommended as longs by institutional brokers, while Chemspec International (CPC), Bed Bath & Beyond (BBBY), and First Solar (FSLR) were most recommended as shorts. The energy, information, and consumer discretionary sectors had increased broker sentiment for the week, while utilities and health care had decreased sentiment.

Now for a little fun (?). Below is a video of the 3 month to 30 year U.S. Swap Spread data from Bloomberg, animated and set to music. Who said Swap Spreads were not fun? Well, maybe just about everyone. This may not change your mind, but let us give a hat tip to Nick Gogerty for putting it together anyway.

Source: YouTube

Comments on electronic program trading and market manipulation from Joe Zaluzzi of Themis Trading (HT to the Zero Hedge blog). Interesting stuff.

Source: YouTube

In what is turning out to be more than just a little bit of irony, sovereign credit default swaps may end up being more widely traded when a new basket of 15 countries is launched later this year through the Markit iTraxx SovX Western Europe Index (see WSJ article). It is widely believe by many that the corporate CDS market was to blame in part for the recent financial crisis. To help clean up the mess and unfreeze the credit markets, many European and world governments have been borrowing massive amounts of money and injecting it into their economic systems in order to add liquidity. Unfortunately, the massive spending and borrowing are putting the credit quality of many these same countries into jeopardy, producing an unusual turn of events as CDS contracts are now being used to protect against default in those very countries which had too many companies with dangerous levels of CDS exposure. Now, not only can you trade CDS contracts to protect yourself against a country defaulting, but soon you will be able to trade a more diversified basket of sovereign CDS contracts. Profitable? Maybe. Of course if there is another massive default, I am not sure who will be left to bail out this market if spending continues at current levels. There is only so long you can solve a problem caused by too much debt by taking out additional debt. But, look on the bright side. At least now you can trade it. I guess financial innovation never sleeps.

Some investors in global and emerging market funds are starting to become nervous that such markets have risen too far, too fast (see Asian Investor article). After a nice run since early March, investors in emerging market funds that are tracked by EPFR Global have seen investors pulling a net $1.87 billion out of Asia ex-Japan, Latin America, Europe, Middle East, Africa, and diversified global emerging markets equity funds as of June 24th. High-yield bond and global equity funds also saw their string of consistent inflows stop, with the funds flowing into money market and U.S. bond funds. The reversal of flows has been driven in part by investor worries as to when foreign demand for manufactured goods and commodity exports will increase. Russia and Brazil equity funds, which are commodity dependent, are also posting new outflows.

As a few examples, the yearly charts for both EEM (iShares MSCI Emerging Markets Index) and the EFA (iShares MSCI EAFE Index ETF) reflect some of this indecision in the second half of June, but the trends are not unlike what has been observed in the S&P 500 Index over the same period.

Source: Bigchart.com

This slowdown in the bullish trend comes just as the International Energy Agency cut its expectations for medium-term global oil demand (see Financial Times article), with the recession diminishing the medium-term risk of a supply crunch as the spare capacity cushion remains healthy. Natural gas storage is also up (see EIA article) and above the 5-year historical range.

Yet, not everyone appear as cautious or nervous, with many analysts and traders still bullish (see SeekingAlpha articles here and here and here). In addition, as hedge funds are near completing one of their best starts of the year since 1999, many managers expected capital to continue to flow into their funds, especially those funds that are focused on emerging markets (see The Australian article). Given that many emerging market funds are commodity driven, then next few weeks/months should be telling as data on the summer driving season, housing, and currencies markets will help signal if the commodity correction has indeed arrived (see SeekingAlpha article), and whether or not emerging markets will continue their recent strength.

ETF Securities is now providing levered 2X ETFs on four popular European indexes (see Financial Times article, Citywire article). The eight ETFs being offered include both long and short exposure on the FTSE 100, Dow Jones Euro STOXX, CAC 40, and DAX. The four 2X short ETFs will carry annual management charges (AMC) of 60 bps. The 2X leveraged long ETFs will carry charges between 40 and 50 bps. The company is offering the ETFs to allow fund managers the ability to hedge portfolios in place of borrowing stock or using derivatives.

According to the recent TIM (Trade Ideas Monitor) report and the TIM Sentiment Index (TSI), institutional brokers became more bullish over the last five trading days as the TSI increased 12.7% from 51.96 to 58.54 (see previous post or youDevise website for additional information on the TIM report). For the five trading days ending June 25, the number of new long ideas as a percentage of new ideas sent to investment managers increased to 72.55% from 70.92% one week earlier (see last week's post). The intra-week trend was positive. Longs now represent 66.50% of all ideas in June.

As for individual securities in the U.S. and North America, Ashland Inc. (ASH), Bank of America (BAC), and Black & Decker (BDK) were the stocks most recommended as longs by institutional brokers, while Boeing (BA), Century Aluminum (CENX), and Microsoft (MSFT) were recommended as shorts. The information technology, industrial, and energy sectors had increased broker sentiment for the week, while health care had decreased sentiment.

Below is a video by Peter Navarro which explains how he uses a select group of international exchange traded funds to better help him time trades in the domestic market, in particular, the S&P 500 (SPY). The three international indexes he follows include the FXI (following 25 large and liquid Chinese companies, sometimes called the Dow of China - betting that as China goes, so goes Asia), the IEV (following the S&P Europe 350 Index), and the ILF (following the S&P Latin America 40 Index).

While I have not back-tested these specific indexes for providing leading signals, the video does remind us of the benefits of looking at other data for helping one to spot trends and even forecast movements in domestic indexes. A number of years ago I was engaged in some research that was looking to see if the S&P 500 could be used to help predict trends in various international indexes. After all, the feeling was that as the U.S. goes, so goes the rest of the world - or so we assumed. As our research progressed, and we began doing correlation studies, principle component analysis, information-based data mining, and everything else we could throw at the problem, it became clear that in many instances we had it backwards. The international indexes were more predictive in helping forecast the U.S. market. While some of these correlations broke down over time, it nonetheless helped send the message that we could not assume that the U.S. markets were always driving the world markets, or that the influence was always consistent, in either size or direction. While this is more clear today, and less of a surprise, it still seems as though few traders and investors use such information. The three international ETFs mentioned above are a good place to start your own studies.

In an interview with the WSJ, Gary Gensler, Chairman of the Commodity Futures Trading Commission, said he believes the most critical change needed in the oversight of derivatives is the regulation of dealers involved in derivatives (see article). He goes on to say that "only through the dealer can we get the whole panoply" of information regarding derivative contracts. Such a move would require customized contracts traded over-the-counter (OTC) to go through a central repository, similar to an exchange clearing house.

Gensler believes that "central clearing will further lower risk," but will it? While this is probably true initially, the long-run benefits could disappear. How so? Given that dealers will need to abide by stricter capital and margin requirements, the capital requirements will no doubt continue to grow as the added liquidity risk of less actively traded contracts is accounted for. While again this seems sensible, the extra cost will force even more contracts to move on to the exchanges. This will in turn reduce the amount of OTC contracts that are likely to be offered. Once again, all good, right? Not necessarily. One of the benefits of OTC contracts is that you can develop a specialized contract that better matches the risk you are trying to hedge. Standardized contracts do not offer the same flexibility, causing a company to enter into less than perfect hedges, thereby making the company more risky over the long-run. This has the effect of causing risk management to be more expensive and less efficient for companies, just at the time when additional risk management is being encouraged.

Once again, raising capital requirements on risky assets has some obvious benefits, but hopefully the added burden is not so much as to eliminate the efficient use of the OTC market. If this happens, regulators may find themselves dealing with yet another problem. In the mean time, I guess at least the exchanges (NYX, NDAQ, CME) will be happy as the potential for increased order flow continues to rise.

That great American philosopher Mike Tyson was once asked about whether it worried him that his opponent was training hard and seem to have developed a fight plan against him. Tyson respond with something to the effect of "Everybody has a plan until they get punched in the face". So true. Once you get knocked back on your heals, everything changes, with your plans often getting scrapped in the process. Traders and investors know the feeling all too well. Even the best made trading plans and analysis can be ignored after the market throws you a curve ball and administers the equivalent of a punch to the face.

All of this came to mind today as I was watching what seemed to be a muted reaction to the Fed decision, and more importantly, a reaction that did not fit well with the plans or expectations of many of the traders I was following on Twitter. When this happens, it is easy to start improvising, but of course, this is were new traders, and even those with experience, start to get into trouble. On such days I always find it useful to remind myself of some common mistakes to avoid, three of which are nicely presented in a new wallstcheatsheet.com article based on interviews with traders Joe Donahue and Joey Fundora (see article). While most mistakes fall into the category of common sense, it is still good to remind ourselves of them from time to time. The three mistake given by Donahue and Fundora, along with some added comments, include the following:

1) Not Selling Fast When You Are Wrong: Here it is important to remember that one of the most important metrics is knowing what you can lose on a given trade or investment. Of course, having an idea what you can make is also important, along with knowing what the risk-reward of the trade or investment is, but knowing when to cut your losses will keep you in the game. The old adage of "let your winners run, but cut your losses quickly" applies here. If you let the winners run, but have tight 8-10% stops on your losses, it is possible to be right less than half the time and still make money since you have kept yourself in the game for those times when your due diligence pays off, and the market finally realizes how smart you are.

2) Using Multiple Approaches or Strategies: This ties in somewhat with the Mike Tyson quote. While it is important to have a trading/investing plan and strategy in mind, you need to remember that every once in a while the market is going to punch you in face. During these times it is important to remember why to got into the trade and try not to stray or trade aimlessly or recklessly, simply chasing. Sometimes the best contingency plan is to simply walk away from the computer and shut your engines down for the day, giving yourself time to evaluate your strategy.

3) Trading Too Large: Trading small, or even paper trading, is always good advice for new traders. Stepping back on the amount of capital at risk is also good for experienced traders who have hit the wall and are not seeing trades and investment opportunities quite as they should. Even baseball players that consistently hit over .300 will lay down a bunt just to help them get out of a slump. Trading is no different - except you often don't get paid when in a slump, making it all the more tempting to swing for the fences. Discipline is key.

A few other common mistakes worth repeating include the following (adapted from here and here):

• Mistake 4.) Committing too much capital per trade
• Mistake 5.) Not effectively using different time frames
• Mistake 6.) Not using technical analysis (using only fundamentals, especially for short-term trading)
• Mistake 7.) Not paying attention to what the market indexes are doing
• Mistake 8.) Not being selective enough, and taking the time to screen for the best opportunities
• Mistake 9.) Not paying attention to volume
• Mistake 10.) Not paying attention to sectors (and industry trends)
• Mistake 11.) Not knowing what to expect from the trade (risk versus reward)
• Mistake 12.) Being greedy and not leaving the party soon enough
• Mistake 13.) Following the crowd too long, or too late in the move (chasing the market)
• Mistake 14.) Immediately reversing the trade once it goes against you
• Mistake 15.) Trying to pick tops and bottoms
• Mistake 16.) Losing your cool and letting your emotions cloud your thinking
• Mistake 17.) Waiting too long to pull the trigger after the analysis is done
• Mistake 18.) Trading too many markets at once
• Mistake 19.) Assuming the news you just read has not already been discounted by the market
• Mistake 20.) Relying on tips or talking heads without doing your own analysis.

I am sure there are many more, some that you think don't apply, and probably even a few other mistakes not mentioned that I continue to make myself. Here is hoping that looking at the list causes you to remember why you have succeeded in the past, and why you continue to be a successful trader / investor - or at least reminds you to walk away or just bunt every now and then.

Traders who are clients of StreamBase are using software developed by the company to scan Twitter for information that can be utilized by their algorithm-based automated trading platforms (see Telegraph article). While the company is not specific about who is using the software to follow Twitter feeds, current clients of the company include the Royal Bank of Canada and hedge fund BlueCrest Capital Management. Those using the software to monitor the Twitter feeds hope their automated trading platforms can utilize breaking news that has not yet been filtered by providers such as Reuters Thomson or Bloomberg. One trader mentioned how using a broadcast tool such as Twitter would allow them to further take advantage of the ability to "buy on the rumour and sell on the facts." Given the volume and variety of the content you find on Twitter, or for the matter, any message board or social networking site, the term "rumor" is probably a little generous in many cases. For their sake, let us hope that those firms following any social networking site have a good AI system for separating the wheat from the chaff. This tasks is hard enough when all you are following are those slow "filtered" news sites.

The Institute for Financial Analysts polled its members and found that they no longer believe in efficient markets, or at least that prices reflect all information (see hedged.biz article). So, is stock investing based on fundamentals a waste of time? After all, information is more prevalent now than every before, and new information (for the most part) is suppose to be shared equally. If prices are not reflecting fundamentals, then surely, efficient market theory is lacking. As a kind of compromise, some will argue that while the markets are efficient, the participants are not, each analyzing the news, information, and data differently. It is felt that this is where some of academia has gone wrong - assuming that all participants interpret new news in the same way (although those in behavior finance might beg-to-differ).

Unfortunately, this view usually creates more confusion given that for many the participants are the market, such that as long as there are human traders, there will be fear, greed, and pricing anomalies. This is why it is often felt that being a fund manager is as much about understanding historical patterns and psychology, as it is about knowing the fundamentals. The irony is that as the flow of information has become more efficient, given the Internet and the 24-hour new cycle, one could speculate that the market may have actually become less efficient. Now freshly armed with new information, you have even more traders and investors trying to figure it all out, each with their own biases, over-reactions, and in some cases, somewhat predictable herd behavior. Such inconsistencies will no doubt keep market participants looking for alpha, all the while allowing fund managers and technical analysts to continue to thumb their noses at those in the ivory tower.

Over at the Clusterstock blog (poster John Carney), there is an interesting discussion/insight from Michael Lewis into the new regulatory reforms being introduced by the Obama Administration (see article here, original video link here, and embedded video below). A few days old, but worth a look. Interesting, and a little depressing.

According to the recent TIM (Trade Ideas Monitor) report and the TIM Sentiment Index (TSI), institutional brokers became less bullish over the last five trading days, trending towards neutrality by the end of the week (see previous post or youDevise website for additional information on the TIM report). For the five trading days ending June 18, the number of new long ideas as a percentage of new ideas sent to investment managers declined to 70.92%, compared to 73.66% one week earlier (see last week's post). The intra-week trend was positive. Longs represent 64.92% of all ideas in June.

As for individual securities in the U.S. and North America, the US Natural Gas Fund (UNG) and Endo Pharmaceuticals (ENDP) were the stocks most recommended as longs by institutional brokers, while General Electric (GE), CEMEX (CX), and Palm (PALM) were recommended as shorts.

Once again, the TIM Report appears to be an interesting idea and new source of data. I will continue to monitor it to determine its use for trading - i.e., whether the data is too lagging, or has some leading information, or whether is can be used as a contrarian indicator.

Now that the Obama Administration has released its proposed Financial Regulatory Reform: A New Foundation for updating the regulatory structure of the financial system (pdf file of reform, WSJ article), the public debate will begin in earnest regarding the details and proposals in the document. Ironically, while the public seems open to new financial regulation, the release of the document is coming at a time when some citizens are starting to worry about growing deficits and government intervention (see WSJ/NBC poll article), with almost seven in 10 people surveyed saying that they had concerns about federal interventions into the economy. Nonetheless, finding ways to limit risk and prevent another credit crisis through added regulation of banks and hedge funds still rings a populist tone, and is likely to continue to receive support.

Like many others, I feel that there are aspects of the new regulations that seem appropriate and make sense, with others that seem counterproductive. As for those that concern me, I agree with some who point out that it seems odd that the Fed is going to be given greater power (and responsibility) to fix some of the very problems it may have caused or contributed to (see Larry Kudlow article). I also worry that the new proposed Consumer Financial Protection Agency could end up just adding new and potentially unnecessary regulations and red-tape paperwork, along with producing counterproductive limits on rates and fees that will do less to protect individual consumers and more to reduce the availability of needed products that are offered to such individuals. Such restrictions, if not properly crafted, are likely to reduce the earnings of financial services companies, and even worse, limit their ability to effectively manage risk (through fee and rate changes).

The idea of requiring companies to retain 5% of all structured product offerings also has me concerned, even though this specific proposal seems to be generating some of the most support, at least initially. Recently I wrote that I have worries about forcing companies to retain a stake in each securitized product they develop since I believe it could actually make companies more risky (since they cannot off-load and manage all their risk, see previous post). Furthermore, while I agree that forcing companies to have some "skin-in-the-game" would make it less likely that they would offer risky products, it also makes it more likely, in my opinion, that they would offer less structured products. While this may be a desired outcome for some, the impact of this would be less liquidity and available credit at a time when the country can least afford it.

Another area that is generating support involves the idea of controlling systemic risk. I too believe that this is a good idea in theory, but am unclear exactly how this would be measured and acted upon. As recently reported in the WSJ (see article), one potential area to start with is leverage. As the chart below illustrates, financial sector borrowing increased steadily between 2004-2007, before dropping in 2008 as companies began unwinding leveraged positions. It is now well known that banks, hedge funds, and average citizens were carrying too much debt, thereby helping to increase systemic risk, and trigger the credit crunch.

Source: WSJ, Fed data
Yale economist John Geanakoplos, who has studied leverage in the economy, believes that regulators need to gather daily data from all market participants and then publish aggregate data. The feeling is that if market participants knew that leverage values were getting to extreme levels, they would be more likely to begin backing-off their own debt and leverage levels in anticipation of eventual market corrections, or restrictions imposed by regulators. Focusing at least in part on debt and leverage seems to make sense.

Unfortunately, measuring system-wide daily leverage changes at banks and hedge funds may be difficult at best, and suspect at worst. Yet, maybe the focus does not need to be on the three person hedge funds that are investing $10-50 million in capital. Getting comprehensive data which includes smaller players may not be necessary. Risk manager Richard Bookstaber - whose book "A Demon of Our Own Design" is recommended reading - believes that focusing on just the largest financial firms and hedge funds would cover roughly 80% of the risk, allowing you to see systemic trends.

At this point it is unclear if such trending information on leverage levels would be enough. Other related areas that could also cause potential cascading effects, such as specific derivative use (i.e., CDS) and counter-party risk, should also be examine - although regulating that which has not yet been developed is obviously difficult. Nonetheless, looking for new ways to measure leverage might be a good place to start for spotting worrisome trends. Such a signal could allow investors, funds, and the Fed (or other regulator) to take action. Of course, what action they take is another area of debate, and potential new area of concern.

Morgan Stanley is attempting to lure hedge fund clients back to its prime brokerage (see WSJ article). As a carrot, Morgan is planning to announce that hedge fund clients will be allowed to hold some of their assets in the MS Trust National Association, instead of being held in the brokerage units of the firm (for a small fee, of course). This could be significant given that many hedge funds are worried about their assets being held in a brokerage unit after the collapse of Lehman Brothers. Of interest is that assets held in the trust will not be federally insured, like deposits, but will still nonetheless probably be considered safer given their separation from the brokerage operations. It will be interesting to see if in the months to come whether or not more financial firms follow suit. In the mean time, it is one more indication (among others, see second WSJ article) that the hedge fund industry is starting to get back to normal. You can decide whether that is good or bad.

In a recent Bloomberg article, it was mentioned by the Credit Suisse Group that the Federal Reserve could consider selling options to primary dealers in order to help them ease imbalances in derivative positions that are amplifying swings in interest rates (see Bloomberg article). This sounds interesting, given that a similar strategy was used in 2000 in the form of liquidity options to help head-off potential Y2K funding problems. In addition to options, investors could also use swaps, swaptions, and Treasuries to help hedge interest rate risk.

Of course, such a hedge position may not be possible for others if the new regulation being proposed by the Obama Administration is put in place (see the Washington Post article). One aspect of the new proposed regulatory framework would require firms to retain a stake in each securitized product that is developed. Furthermore,

"The plan also would prohibit firms from hedging that risk, meaning that they could not make an offsetting investment"

While I understand the reasons for proposing such a restriction - the hope that it will cause investment banks to develop less risky, less leveraged, and less opaque products, thereby preventing another 2008 credit meltdown - it seems this could be achieved in a less restrictive, yet more focused way. Forcing companies to keep a piece of the structured security (and subsequent risk) on their books appears counterproductive when it makes more sense to allow and encourage companies to hedge this risk, even if it means passing the risk onto another investor such as a hedge fund willing to take on the risk (and reward). Forcing companies to keep risk on their books will only repeat some of the same problems that various investment banks faced in 2008 when they were unable to sell and shed structured product risk once the credit crunch unfolded.

While forcing these companies to keep some of the structured securities on their books could make it more likely that they would offer less risky products, is this what we really want? One of the benefits of securitization is its ability to free-up capital for more productive uses. While this process certainly got out of control and was misused in some instances, placing a blanket restriction on what can be sold also places similar restrictions on risk reduction and the flow of capital into more productive hands - something we cannot afford to restrict, especially at this time. Here is hoping that the current proposal is just that, a proposal, and that any final legislation will consider the unintended consequences and be more focused on the specific problem that needs to be addressed - uncontrolled risk taking.

36 South Investment Managers, the hedge fund managers who made 234 percent betting on "black swan" events in 2008, are now placing their bets on hyperinflation (see Bloomberg article). The new fund, called the Excelsior Fund, is targeting returns that will be five times the average inflation rate for the France, Germany, Japan, U.K., and U.S. economies. The Excelsior Fund will make its bets on inflation by buying long-dated options that are currently cheap (i.e., typically deep-out-of-the-money options). The fund will be using the options to look for increases in commodities and equity prices, along with increases in bond yields and currency volatility. Given that the options are deep-out-of-the-money, the fund will be very high risk, but carry the potential for very high returns.

Actively managed mutual funds have done well this year, rising 9.9% through June 10, compared to the S&P 500, which was only up 5.3% over the same period (see WSJ article). This comes after a year in which the average stock fund was down 38.9%, dropping 1.9% more than the S&P 500. What is causing the out-performance? It appears to be growth stocks, which are up approximately 11% this year, compared to less than 1%gain for value stocks. Many widely-held tech stocks, such as Apple (AAPL), Cisco Systems (CSCO), Google (GOOG), Hewlett-Packard (HPQ), and Microsoft (MSFT) have helped juice returns. Nonetheless, even with the current out-performance, active funds are still losing business to index funds as investors continue to remember their poor fund performance in 2008 (really poor in some instances).