Wednesday, February 28, 2007

What Must De Done to Ensure Fair and Orderly Markets

The following originally appeared in The Edge on's Street Insight on 2/28/07

Investor confidence and the credibility of the regulatory and technological infrastructure of the financial markets were deeply tarnished yesterday. Years of regulatory and technological advances following the 1987 crash were destroyed in a matter of a few minutes. Here is what must be done immediately to ensure that fair and orderly markets ensue in the future:

1. The SEC experimental removal of short sales on common stock without an up-tick must be abandoned. I brought this to this site's attention last May when the practice of short selling without an up-tick was harmful to the markets. The up-tick rule was designed to prevent bear raids. Yesterday was one of the most egregious examples of such practices I can recall.

2.The SEC exemption of ETFs from short sale without an up-tick must also be removed with the exception of broad-based index ETFs that have similar futures contracts associated with that index such as the S&P 500 (SPX/SPY).

3. The practice of slam dunking and trading of married puts to stocks embedded in sector ETFs must also be prohibited and strictly enforced. This was also something that I brought to light on this site nearly three years ago. Jim Cramer picked up on these activities and we discussed it on the old "Kudlow & Cramer" show, making it a public issue. The SEC and SROs failed to pick up on the problem then and it has now festered for the last three years having finally hit a crescendo yesterday. No time is better than now to correct these problems.

4. Market data services and publications, which publicly disseminate index data that are broad based or underlie exchange traded ETFs or derivative contracts must be regulated under the Securities Act of 1933, the Securities Exchange Act of 1934 and/or one of the Commodities Acts. I will let the securities experts figure out which one applies. Regulations must then be established to enjoin these index providers to ensure the timely, orderly and accurate aggregation, calculation and publication of such information.

5. Electronic markets and hybrid markets are excellent forms of securities trading, given the technological advances of the Internet and desktop computing that we have enjoyed over the last decade. However, there is a flaw in the design of these markets. That flaw was the elimination of the perceived flawed component of the process -- the human element. Under the auction/specialist system, stocks could be halted in fast markets by the exchange or the specialist for order imbalances until price discovery could re-establish an orderly market. We are now in an electronic world whereby the last vestiges of the specialist system function as ATM machines rather than market participants. I suggest that all stocks must be assigned to a specialist -- whether listed or OTC -- who act as the primary market participant (PMP) for a stock and can halt trading for imbalances. The PMP would be designated by the listing company and approved by the SRO or SEC. Putting the human element back into the markets will be a positive, not a negative.

6. Enforce the circuit breaker program trading regulations that were enacted after the 1987 crash. Go a bit further and update those prohibitions for the more modern technologies and derivative strategies now in use. Fine or revoke licenses for blatant abuse of the circuit break rules.

7. Improve stock market surveillance techniques to update techniques and/or begin to monitor up-tick, circuit breaker, derivative and other violations.

8. In a similar manner that short interest is published by exchanges, require public companies to publish the amount of authorized stock buy backs and amounts remaining under these plans.

9. The Federal Reserve must modify Regulation T to reflect risk-based extension of credit. Even better would be an international standard for securities margin and stock lending much as the Basel Accords for international bank lending.

10. Remove time delays for stock quotations. Right now real-time quotes are available only through executing broker sites or through subscription. Any fees lost by the exchanges for current real time subscriptions can be made up by increasing exchange fees. In the end we will all pay but at least all market participants -- active, infrequent or passive -- will have equal access to market data.

At the time of this Blog entry and the articles, Scott Rothbort, his family and or clients of LakeView Asset Management, LLC was long shares of SPY -- although positions can change at any time.

Tuesday, February 27, 2007

Five Things That Would Turn My Bullish Perspective More Bearish

The following originally appeared in The Edge on's Street Insight on 2/26/07

I am on record saying that my S&P index growth target would be 15% for 2007 with that index closing in the low 1600s at the end of the year. Right now I am sticking to that prediction. Looking into the future, I also see a good start to 2008 followed by a prolonged sluggish several months into the presidential election with a year end bullish run. That 2008 playbook is still in developmental stages of thought and I will likely be modifying and solidifying it as this year progresses.

Here are the five things that would most turn my bullish perspective to ursine in the future:

1. Inflation. Not this namby-pamby inflation that everyone has spent the last two years arguing over. You know the constant bickering about the inflationary effects of the difference between 2.5% and 3.0 or 3.5% inflation. I am talking real, hard-core, Jimmy-Carter-is-back-in-charge, high-single-digit/double-digit inflation where you bought eggs and milk on Friday because by Monday it might cost significantly more.

2. Job losses. The US continues to create jobs, not to mention jobs that are not even reported by the Bureau of Labor Statistics. Once we endure prolonged declines in jobs, i.e. job losses for let's say 3 consecutive months, then I say trouble is at hand. Another telltale sign is once the Big 5 Broker-Dealer/Investment Banks start to cut heads.

3. A big credit crunch. Not just sub-prime problems but an across the board removal of liquidity from the system. I think that the real key is in the commercial credit markets rather than the consumer credit market. Once commercial credit dries up we have a huge problem. The current sub-prime issue is similar to that of Long Term Capital Management which I was involved with. LTCM's failure caused a revaluation of credit requirements for OTC derivatives and extension of credit to hedge funds as asset classes but did not shut down liquidity across the entire system. In fact, quite the opposite, the FOMC increased liquidity to combat fear over a systemic failure emanating from LTCM.

4. An exogenous event. The unpredictable. It could be another oil embargo. Perhaps a terrorist attack. Maybe one of those Dr. Strangelove wannabes in South Korea or Iran or elsewhere does something really stupid.

5. Capitulation on the part of the shorts. Large-scale reductions in short interest. Closing down of several large dedicated short funds. When these guys have felt too much pain, the tipping point will have been reached.

Monday, February 26, 2007

The Government Should Not Pick Up The Tab For Slackers

My wife and I enjoy watching certain reality TV shows together. One of those I record weekly on one of our DVRs is Trading Spouses which airs every Friday evening on Fox. It is great to see the pairing of off-beat, mismatched and/or dysfunction families. The show is in a two part format. At end of part 2 the wives who traded places are given $50,000 which they then “disburse” to their surrogate family.

This past two weeks a wife from a working class family in Boston swapped roles with a wife from a middle aged punk rock household in Washington State. The punk rockers had a home schooled daughter who was studying ballet. That was offbeat without the mommy swap. The Boston family had 3 children, two adult (early 20s) daughters and a boy in high school. As is typical, the swapping mom will allocate some of the $50,000 toward education for the other family’s kids. That makes plenty of sense and is good for everyone involved.

The two Boston daughters were real slackers. They lived at home, worked part-time evening jobs and owed their mom plenty of money for things like cell phones and a lifestyle above their means. In addition they did not lift a finger to help their mom or dad around the house. The daughters were not in college though both were of college age. At least one the daughters dropped out of college (I can’t recall). The surrogate mother provided money for one of the daughters to go back to college, causing the young lady to throw a tantrum. Her reasoning was because she did not want to spend “her” money on college but wanted the government to pay for it.

This really got me upset. I worked hard to be able to afford college. It was not the government’s responsibility to send me to college; it was the responsibility of my family and me to do so. My father died before I went to college and left my mother in a new (3 month old) house and a big mortgage. He had no PMI (could not qualify). I received some loans and qualified for work study jobs but it was not until senior year did I get a $1,000 government grant. So I worked two jobs during the school year and all summer long to pay for college. The University of Pennsylvania cost me $40,000 in 1978-1982 dollars.

I see many kids at Seton Hall, where I am a Professor of Finance who are first generation college students or come from families that cannot afford a college education. Some get government aid, some do not. However, no matter how their tuition is paid, their attitude and those of their families (some of which I have met) is to work hard, get the most out of their education and then start a career or go to graduate school.

The young lady from Trading Spouses who has already dropped out once, lives high off the hog from her parents and expects the government to pick up her tab, in my opinion does not deserve to college. There are too many more deserving kids other there which the government can make a better investment in.

Wednesday, February 21, 2007

Misplaced Dominance

Twenty years ago this month, I packed up and moved to Tokyo, Japan when Morgan Stanley (MS) sent me over to help establish a beachhead in Japan and Hong Kong The Japanese economy and markets were the rulers of the roost across the global economy. The opening up of these markets to foreign brokerages was the biggest changes to the financial markets probably since the deregulation of fixed commission in the US markets several decades ago.

MS sent me out for “1 year” and after being there for 3 months wanted me to commit for 2 years. So, I had to adjust my own personal agenda and my wife and I got married in August 1987. We had a delayed honeymoon in November which we took in Bangkok and Phuket, Thailand (before both became popular). In Phuket, at the Club Med we had dinner with 3 other couples – one couple each representing Canada, Australia and the United Kingdom. The discussion turned to the dominance that Japanese companies and individuals were developing over the global economy. The other couples were convinced that Japan would gain control over the world’s economy. I disagreed. I said that if we sat around the same table 10 years before that, the same would have been argued about the OPEC nations with their petrodollars. Perhaps before World War I, the same might have been argued about the British Empire. And so it goes.

Now the same discussion is centering on China. Time and time again, a country’s economy finally begins to emerge and grow at a tremendous pace. These economies will attract and amass huge amounts of capital leading one to the incorrect assumption that they will dominate. On many occasions, the explosive growth is unsustainable and sometimes results in a contraction as we have seen in Japan for the better part of the last 15 years. Japan’s problems and mistakes were too numerous to mention in short order in this blog right here and now. Sometimes, those economies need to grow and fill a void left by the rest of the world. Many might have argued that the US grew too fast after WWI. That has been anything but the truth. However, we did have an awful depression in the 1930s. Considering an economy like China with well over 1 billion citizens, I have to conclude that there is more growth in its future and we are in the early stages of such growth. There will be some volatility along the way. On the other hand, as we saw with Thailand in the 1990s and now with Vietnam, such growth is speculative and unsustainable.

Wednesday, February 14, 2007

Global Warming ?

Whenever I hear discourse about global warming in the media I don’t ignore the message but I have to chuckle a bit. If I recall, the Earth has been warming since the ice age ended millions of years ago. When we had one of the warmest months on record recently everyone was pointing to global warming as the culprit. Now that February is colder by several degrees than usual, where are the global warming alarmists? To top it all off, it snowed in Katmandu for the first time in 63 years. Let’s not also forget that global cooling can also occur. If you ask me, we need to point fingers at iced tea which may be the culprit for all weather variations and problems.

Tuesday, February 13, 2007

My Thoughts On The Housing and Sub-Prime Mortgage Debate

Here are some of my thoughts on the very intense and emotional debate continuing on the subject of the housing market and sub-prime loans:

Housing is going to crash. Our society will soon be living in cardboard boxes. No wait, housing has bottomed and is getting better. Never mind, sub-prime foreclosures will be creating plenty of inventory for the Toll Brothers (TOL) homeowner-wanna-bes. I better check the housing blogs and chat rooms to be sure of what the real story is.

Hasn't this housing debate become more heated than a judicial appointment on Capitol Hill? It sounds like my children arguing over who gets to pick the movie we watch from On Demand. I prefer to take the higher ground. Here is what I think:

· Housing overheated about two years ago (as does any asset class that tends to attract too much speculation). The margin morons got into the real estate game and that signaled a top.

· Homebuilders recognized that:

· They needed to shrink inventory in speculative hands and slowed down construction to absorb the oversupply.

· They held too much land or land options in areas in which land was plentiful and needed to adjust and write-down accordingly.

· Housing is regional, not national. You can't compare housing in Florida or Las Vegas or Phoenix with that in suburban Chicago or New Jersey or Metro DC.

· The secondary market for housing is still strong where the jobs are. Take a look at the towns located along the Metro North or NJ Transit Midtown Direct commuter lines to New York City. New homes are being built out further on those lines and I don't expect that to diminish until all that land is built on. If the Midtown Direct could expand to Phoenix, that would be another story.

· A surge in sub-prime housing was created as:

· Hurricane relief brought a huge surge in demand for lower income sub-prime housing such as trailer homes and lower income private homes.

· Improved financial, infrastructural and crime conditions in urban centers combined with government tax and other incentives have created a environment conducive to inner city lower income single family home construction and purchasing.

· Increased employment pushed more people from rental to home buying on the margin.

· Homebuilders are in the "kitchen sink" part of the cycle in which they will write-down, sell off and reserve as much as they can. Throwing everything into the kitchen sink comes at the bottom, not the top, of a cycle.

· Our population is growing by 3 million to 4 million people per year. That amount is likely to increase, not decrease, as we age and immigration continues. Where are they all going to be housed?

Think about all the above when we consider KB Home (KBH), which is reporting. To be fair, I have a buy-write on Hovnanian (HOV). When I put it all together, I see a mixed bag -- some good, some bad -- and we may be close or at equilibrium. The top of the housing market is behind us. The bottom is here or near but those betting that the worst is yet to come will be proven wrong. What we are not at the bottom of, but are near the top of is the emotion attached to the housing and mortgage market.

Epilogue: KBH reported its 4th quarter results. My thoughts of the earnings report and conference call is summarized below:

You cannot characterize KBH’s quarter as pretty. Cancellations are still running high even though management tried to put rose colored glasses on the fact that they seemed to decline sequentially. Gross margins were putrid. As always, we need to look forward not back. The two most informative parts of the conference call came from the peek in 1q07 and the Q&A with Ivy Zelman. So far, if the traffic and sales for 1q07 is only of about 10% then one can argue that the deterioration in the housing market is slowing down and that the worst may already have occurred. The interaction with Zelman on sub-prime was interesting. It confirms my belief that sub-prime housing is a category onto its own and is also part of the localized nature of real estate. I would expect homebuilders to begin to abandon certain states that are in secular economic decline, such as Michigan and Ohio, while waiting out the storms in Phoenix and Las Vegas.

Favoring the housing bulls is the fact that this quarter was definitely a "kitchen sink" quarter for KBH. They tossed so much out the window as part of the company's impairment and write-down that you know that the company is cleaning up the balance sheet and getting ready for the next upturn in the market. When you back out the impairments and write-downs, KBH earned about $2.26 down 34% year over year, which was less than the drop in cancellations. Furthermore, revenues rose 13% and ASPs increased as well, another point for the bulls.

My opinion is that the cyclical decline in housing is near or at an end. Furthermore, the big meaty shorts trades have already been booked. We will continue to have a high level of volatility in the sector and more trading opportunities will present themselves as the sub-prime, housing and interest rate dramas continue to unfold. The next step for this sector is going to be takeovers especially if the bears continue to push shares lower.

Finally, KBH has its own specific issue of the departure of a respected CEO and the ascension of a new individual to that role. That is always a risk for any stock. I am maintaining my positions in HOV for now.

At the time of this Blog entry and the articles, Scott Rothbort, his family and or clients of LakeView Asset Management, LLC was long shares of HOV and short calls of HOV -- although positions can change at any time.