Standard and Poors' 500

With S&P500 breaking records after records, one must wonder if we are nearing the peak, and if so, when will it burst and when it does, how bad would it be? No one can claim to know the answer of these questions, but we can have a logical approach to it.

The Standard and Poors' 500 has the following describing the composition of the index:
"The S&P 500® is widely regarded as the best single gauge of large cap U.S. equities.  There is over USD 5.14 trillion benchmarked to the index, with index assets comprising approximately USD 1.6 trillion of this total. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization."

Even though it does not represent the entire market, but it is probably close to as best as you can get, not so because the composition is accurately representative, but because of its volume and how it is perceived. In the world of finance, how one thing is perceived matters more than what it really is, especially in valuation. After all if no one wants your painting it doesn't matter if you are Picasso, right? We will treat S&P500 as representation of the market from here on.

The valuation of an financial instrument, be it a stock, a bond or an index, based largely on two things: intrinsic value that focuses on the long term capital returns, and short term extrinsic value based on how volatile and risk factors perceived to be associated with this instrument. For the latter one, human emotion has a much larger influence on it, and also because the intrinsic value is focused on longer term, and things may very well changed over time, this human emotion part on how things are perceived becomes quite important, more important than many of the fundamental analysis, value driven investors think.

Now that we have broken up the two important category, let's examine each of them. I will attempt to focus on established methods while not too much relying on any particular models to get a balanced view. Let's start with the big picture. Where are we at now?

There is a well publicized view from presumably Warren Buffer's view of stock valuation, noted in this business insider article: Warren Buffett Once Said This Was The 'Best Single Measure' Of Stock Market Value, in which this graph is particularly interesting:

And that was in January. The market has risen much since then. so what does that tell us? Fundamentally, at least from the metrics described in the article, the market is in lofty valuation, so much so that traditional models no longer apply. Or is it? This model of representation forgets about the fact that prior to 2008, there was minimal Federal Reserve intervention, in particular the Quantitative Easing (buying bonds and asset with nothing but money printed) that we now all accustomed to. How much does that affect the valuation? If we can subtract that influence, can we get a better picture of where we may be now? From the Economist article in the link, the balance of the Fed is about $4 trillion, plus $85B-$75B per month. There has been some adjustment, and supposedly the number is being tapered down month by month. So let's put the number at $4.5T for the sake of simplicity. This number is pretty accurate according to Yahoo's news on Fed's decision to continue winding down the bond purchase, of $4.4T.

Jefferies profit hugely down on dwindling bond trades

I see this as the another sign of profit deterioration of the low interest driven businesses, starting with mortgage lenders and now with bond traders. I expect more of this news coming up for carry trade and other currency derivative trading, and them will be car sales (due to dry up of car loans thanks to higher rate) and trickle down to the rest of economy. 

From Bloomberg Sept/17

Jefferies Profit Tumbles 83% on Plunge in Bond Trading

Jefferies Group LLC, the investment bank owned by Leucadia National Corp. (LUK), said fiscal third-quarter profit tumbled 83 percent as trading revenue fell to the lowest since the depths of the financial crisis.

Net income for the three months ended Aug. 31 dropped to $11.7 million from $70.2 million a year earlier, the New York-based firm said today in a statement. Jefferies was acquired this year by Leucadia, whose quarter ends Sept. 30.

Revenue from fixed-income trading, a unit overseen by William Jennings and Johan Eveland, plunged 88 percent to $33.1 million, bringing total revenue from buying and selling securities to $184.1 million, the lowest since the fourth quarter of 2008. The biggest Wall Street trading firms are scheduled to report third-quarter earnings in October. JPMorgan Chase & Co. (JPM), the largest U.S. bank, said this month revenue from trading could fall as much as 5 percent.

“We experienced a very challenging summer in our fixed-income businesses due to the rising-rate environment, spread widening, redemptions experienced by our client base which heavily muted trading, and related mark-to-market writedowns within our inventory,” Jefferies Chief Executive Officer Richard Handler, who also runs Leucadia, said in the statement.

Handler, 52, said earlier this year that Jefferies saw a significant slowdown in fixed-income trading during March and April resulting from concern about the tapering of the Federal Reserve’s bond-buying program. Speculation that the Fed will reduce its $85 billion in monthly buying has sent the benchmark 10-year Treasury yield to its highest level since 2011.

September Improvement

“Fixed-income markets were most unsettled in June, while July and August were more balanced,” Handler said in today’s statement. “Since Labor Day, client flows have been stronger, and fixed-income performance has markedly improved to more normal levels,” he said, referring to the U.S. holiday on Sept. 2.

Central-bank stimulus has helped drive a global equity rally, with the Standard & Poor’s 500 Index (SPX) rising more than 150 percent from its bear-market low in 2009. The U.S. gauge fell as much as 4.6 percent from an Aug. 2 record as speculation increased that the Fed would begin winding down its monetary support.

“This quarter is going to be a quarter where banks differentiate themselves on how they manage risk and execute,” said Charles Peabody, an analyst at Portales Partners LLC in New York. “Execution is going to be key in differentiating who did well and who didn’t.”

Stock Trading

Jefferies’s revenue from trading stocks also declined, falling 28 percent to $151 million from the year-earlier period. Investment-banking revenue climbed 23 percent to $319.3 million amid increases in fees from underwriting and advising clients.

Jefferies recorded negative revenue from principal transactions of $24.9 million in the quarter. That compares with $297 million in revenue in the same period of 2012.

The firm marked down its investment in the former Knight Capital Group Inc. by $16 million in the fiscal third quarter amid declines in that firm’s stock price, Handler said in the statement. That mark-down was recorded in the firm’s equities net revenue, he said.

JPMorgan said last week that third-quarter revenue from trading stocks and bonds could be unchanged to down as much as 5 percent from a year earlier. September 2012 was “particularly strong, and we’re not necessarily expecting it to be as strong this year,” Chief Financial Officer Marianne Lake said at an investor conference.

Shares of Leucadia fell 0.9 percent to $28.05 at 4:15 p.m. in New York, after rising as much as 1.6 percent before earnings were released. They declined about 21 percent in the three months ended Aug. 31 amid a surge in interest rates. In that same period, yields on the benchmark 10-year Treasury climbed from 2.1 percent to 2.8 percent. The S&P 500 was little changed.

To contact the reporter on this story: Laura Marcinek in New York at lmarcinek3@bloomberg.net.

To contact the editor responsible for this story: Christine Harper at charper@bloomberg.net; David Scheer at dscheer@bloomberg.net

Technical Analysis verses Fundamental Analysis

One can view the market as a complex man-made system with evolving dynamics which are intertwined with each other. Unlike natural system however, attempt to model it is can be more difficult than existing systems in nature in the way that human is involved as part of the dynamics, and thus a seemingly successful model may soon be exploited and be factored in as another input dynamics, thereby altering the whole system.

There are unlimited ways to cut through the mustard, but in general we can categorize the majority ones into two: technical analysis and fundamental analysis. I would consider market emotion as part of TA. Some count it as the third one. Anyway here is what I think of these two type:


For a graph technician who works in the field of technical analysis, he does not need to know what the company, which the stock represents, does. In fact, it is better not to know, because the extra information will skew his judgment. In performing TA, the technician would mainly consider historic trade transaction data consisting of price movements and volume. And that's it. There are a lot of derived data created from these pair, the most famous being the candle sticks, moving averages and stochastic oscillators, depending on your taste, but fundamentally, these bells and whistles are all coming from these two simple entries: price and volume, on different horizon or time frame.

Now arming with these tools the technician can plot support and resistant levels, determining trend and then make his projection -- at this point this is really more art than concrete mechanics.

Comparing to TA, an analyst performing fundamental analysis has a lot more data to consider. Let me throw in the important ones: company past earnings, debt/liabilities, cash flow, market outlook, credit and the list goes on and on. To put a price on it, there are a few generally accepted models, like the discounted cash flow and the discounted dividend model, with the premise that assuming the company will exist forever, what is the present value of the company considering all the future revenue? There are many weak points in this assumption, but let me point out the one that academia likes to avoid: in calculating the discounted future value, how do you know what the discounted rate (most use the inflation rate) is? Usually they would resort to historic average, but is that it? Can't I just take the historic average of P/E ratio of S&P and assume the board market will drift back to this mean, assuming that these are cointegrated? Wouldn't life be much easier then, ha. But even assuming the rate will remain relatively constant, and that the company would not deviate from its past performance too much, this projected price is only the backbone of price estimation. Overloaded with all the information from earning reports, the analyst must decide and pick the important ones to calculate how much the company is worth based on his projection from the mountains of data. Popular metric includes Return On Equity (ROE), Economic Value Added (EVA) and Price per Earning ratio (P/E), comparing to the company's peers in the industry. These are all levers and knobs to adjust the projection. Unlike TA, these are actually based on sound (at least on the surface) financial theories to calculate how much a company is worth.

In the end as you may have figured, it is all approximation and guess work. I would not say this is logical guess work because you cannot prove any of the above really work. Let's not inflate and rape the rigor of logic.