Sunday, July 25, 2010

Improved Corporate Profit Margin And Profitability

The stock market was lifted in the last two trading days. Larry Hatheway, an economist at UBS, says economic growth means companies selling more things. But he thinks that is not as important as it used to be to generating the profits needed to send stocks higher. That's because U.S. firms have mastered the art of pulling more and more money from each dollar of sales.
One gauge of that success: Corporate margins, or profits per sale, are hovering near 12 percent now, by one measure -- tantalizingly close to a half-century high.

As discussed earlier, companies maintain profitability in current economic situation by means of improving operating efficiency. While the long term driving force for corporate earnings is technology innovation, short term measure is to boost profit margin when there is no room for revenue growth. During the economy booming time, proliferation of bureaucracy is inevitable in both private and government sector. The faster growth in economy usually can outweigh the negative impact of bureaucracy. However, when the economic growth reverses to recession, it would be difficult to shrink government human resources expense due to the bureaucratic hierarchy. Some private sectors may encounter great resistance from privileged parties such as top management of financial firms, etc. However, the majority of private sector are under the pressure of minority and major shareholders for public companies and the owners of private companies to maintain profitability and as a result dividend. The most effective means is through downsizing. If executed properly, the impact on productivity should be minimal because it can be achieved by squeezing the already swollen corporate hierarchy. There would be social impact but corporations are more concerned on its own existence.

Some investors with cash on the sideline are turning optimistic with the upbeat results of corporate earning. The volume of trading is slightly higher than the recent average. This may be the start of a slow market upward movement replicating the pattern during the period from early February to late April in this year. Retail and institutional investors as well as day traders buy up the stock market with light trading volume. It is cautiously optimistic on stock market and the trading portfolio is bullish with hedging on surprise downtrend.

Not everyone is convinced. Legendary investor Jeremy Grantham, the Boston money manager who called the housing bust years ago, has been telling investors for months now that profit margins will fall from their perch, sending stocks tumbling. Andrew Smithers of London researcher Smithers & Co. wrote a report warning of the same. John Hussman of the Hussman Funds wrote this month that investors buying stocks on the belief that fat margins will last are destined to "walk themselves over a cliff."

"The dark side of margins is that they're going to have to come down," says Claus Vistesen, an economist at the University of Hull in England. He adds, ominously, "And the market hasn't fully priced this."

The analyst comments in opening and ending paragraphs are quoted from Yahoo! Finance "How profits, stocks can rise as economy stumbles" published On Sunday July 25, 2010, 1:01 pm EDT.

Friday, July 23, 2010

Speculative Stock Trading

Summarizing on previous discussion in portfolio asset allocation, the maximum proportion of portfolio value percentage are 30% for small-cap stocks, 30% for mid-cap and large-cap stocks, and 100% for leveraged ETFs respectively. Due to account margin requirement, it may not be possible to achieve all maximum at the same time. Since it is expected that the majority of trading transactions will be on leveraged ETFs, its investment amount will be up to 100% of portfolio value. Mid-cap and large-cap stocks comes next in the investment since they can usually support a higher loan margin and more stable in price movement. Small-cap stocks lastly use up the remaining buying power of the portfolio. In order to maximize the use of available financial resources, the portfolio is fully invested for most of the time.

The trading and hedging strategy for stocks and ETFs are different. For stocks from small to large capitalization, the trading strategy is to purchase a stock when it appears undervalued. If the stock price drops further after purchase, then hold on if the portfolio can support the borrowing. If the stock price goes up after purchase, there are two possibilities. The simple approach is to liquidate the investment and switch to another stock. Alternatively, if the stock still have potential for appreciation, call option can be sold to realize some of the profits. Mid-cap stocks appear to be best match for this strategy as penny stocks have higher risk of falling precipitously and blue-chip stocks restrict the profit potential. The presence of stock equity in the portfolio provides certain diversification on the heavily weighted ETFs.

The major component of the portfolio is leveraged ETFs. The reasons are higher leveraging and liquidity. Such aggressive portfolio constitution can result in a catastrophe if the market moves unfavorably against the portfolio and for extended time may wipe out the entire portfolio. The experience during the financial crisis shows that over leveraging and extended exposure to portfolio depreciation can wipe out over 90% of the portfolio value within months of time. Therefore hedging strategy is a critical part of portfolio management.

For a fully invested trading account, there is usually no problem if the market movement is favorable to the portfolio. Otherwise, the depreciation in portfolio value may drop below account margin maintenance requirement. In this case, there are two possible solutions, injection of additional fund into the account or liquidation of assets in the account. Since there is no extra resources available, the latter is the only means. And the effectiveness of hedging strategy will be tested in an adverse market environment.

Current portfolio in the trading account is active and there is some loss since the start of the year, mostly in small-cap and penny stocks. This is the reason for the preference of mid-cap and large-cap stocks in portfolio asset allocation. In subsequent trading transactions, the discussed speculative stock trading strategy will be followed and the strategy details will be refined with the knowledge and experience gained in each successful or unsuccessful transaction.

Emphasizing again, previous experience during the financial crisis indicates the importance of risk control and portfolio preservation.

Thursday, July 22, 2010

Market Volatility for Swing Trading

Waves of good corporate earning drive the stock up while the market is down the previous day. This type of violent market movement provides opportunity for speculative stock trading. However, it is difficult to predict the direction of market movement based on common sense interpretation of market financial data. The highly manipulative behaviour of market movement is better analyzed based on the behaviour of market participants.

The low interest rate makes the "well off" investors look for higher return on their accumulated wealth. The equity market would be a good choice. However, many retail and institutional investors are scared away from the stock market during the financial crisis and have not come back yet. They maintain a large proportion of the investment portfolio in cash or treasuries and wait on the sideline. Some traders do not wait for the signal of a long term market trend. The economic indicators are still mixed and do not indicate a strong recovery. Since many individual investors are still pessimistic about economy conditions, the traders will bet on the downside of market movement. However, value investors may find the stock market attractive at certain level. Therefore it is a tug-of-war between two major group of participants before a clear signal of steady economic growth is in sight.

There are numerous reasoning to explain the stock movement in either direction. Therefore for speculative swing trading in current market environment, the high volatility provides higher return on trading activities.

The probability of another big decline in stock market should be relatively low despite wishful thinking of many individuals. Until the retail and institutional investors on the sideline become optimistic, the stock market will fluctuate with minimal gain on the average. Buy and hold strategy may not give good return. Speculative trading strategy may give significant return for a well managed and executed portfolio.

Wednesday, July 21, 2010

Equity Market Performance and Economic Condition

The stock market does not respond positively to the corporation earnings of last quarter the majority of which show improvement in profits despite some decline in revenue. Normally the increase in profitability should drive the stock price higher to maintain the same P/E ratio. However actual equity market movement is the opposite. This indicates that short term market trend is manipulative and may not be directly correlated to corporation operating conditions.

The excuse for the stock market to decline is the disappointed revenue growth in many business sectors. In addition, the tone of Federal Reserve Chairman immediately sent stocks tumbling. Traders with pessimistic sentiment successfully push down the index. This indicates the unpredictable nature of stock movement and thus the consideration for an investment decision on speculative stock trading is less dependent on corporation performance but rather on the action of market participants.

However, in the long run stock valuation would reflect the earning capability of the company. Short term fluctuation in stock price is due to trading activities of diverse market participants. As discussed earlier, technology improves significantly the living standard of human being. And innovations in science and engineering has never stopped. This results in the increase in productivity of agriculture and manufacturing and thus corporate earnings.

The economy is expanding with the increased productivity and thus the accumulation of wealth in the human society. This is a regenerative process. However, the shock wave of financial crisis reverts the wealth accumulation process. Consequently the economy shrinks due to decrease in consumer spending as a result of wealth destruction. Governments are attempting to restore economic growth by encouraging consumer spending but not very successful. Consumers are spending less due to wealth destruction as well as job loss.

Traders take the opportunity to make profit from equity market by driving the market down. The high volatility and volume in the equity market during the financial crisis indicates the participation of corporate and retail investors.

Although economic growth suffers temporarily during the financial crisis, the trend of technology driving living standard has not been changed. Corporations see a decline in revenue growth and thus earnings. However, companies attempt to maintain profitability by means of improving efficiency, in other words, company downsizing. This creates a social problem.

It is unknown when the shock wave of financial crisis will fade away. Traders keep on using various excuse to manipulate the stock market despite the fact that eventually economy will resume growth which is driven by technology. Structural change in the economy may cause social problems. The private and national debt may also be concern of the society. Although these factors have little impact on actual economic growth, they are excuses for short term market movement.

There is a financial blog site, In the post dated Tuesday, June 15, 2010, titled Bubble, Bubble...Where's the Bubble?, it mentions current companies financial status and the enormous wealth of investors to manipulate the equity market.

“The Federal Reserve reported Thursday that non-financial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest-ever increase in records going back to 1952. Cash made up about 7% of all company assets, including factories and financial investments, the highest level since 1963.”

Just one other point on this: I believe that what is happening in European financial markets is a part of this “bubble” activity. International investors are not acting like they are scared and strapped for funds. Their aggressiveness, to me, indicates that they are flush with money and hence have the confidence to be aggressive in attacking the financial condition of euro-zone countries on the sell-side. Investors “in dire straits” do not take on sovereign nations. This indicates, to me, that there are plenty of “well off” investors in the world that can move money around and “make things happen.” The European situation is a result of the U. S. “quantitative easing”. Further “quantitative easing” just exacerbates the problem!

Friday, July 16, 2010

Strategic Rules On Portfolio Management

After establishing the objective for speculative trading strategy, following will be to specify the conditions for profitable speculation in the equity market with stocks and derivatives. It derives the unique strategic rules from the initial two-choice situations in a given environment with complex structure involving arbitrage in iterative plays for speculative profits.

Since the initiative for the development of trading strategy is inspired from the collapse of investment portfolio during the financial crisis, the creation of rules will be more emphasized on actual experience than theoretical approach. The former is exploited mostly to minimize risk to the portfolio when the market movement is unfavorable to the investment objective. The latter, as well as speculative intuition, is used to analyze the market movement trend and to arrive at an investment decision.

This approach will render the actual transaction a highly subjective process which in turn means that the result is highly unpredictable if the underlying event is more or less random in nature. The market environment and sentiment can infer an investment mistake from emotion. Therefore it is important that before an investment decision is made, the market condition has to be thoroughly analyzed for short term movement trend estimate. After an investment decision is made, if the market movement is favorable then the next decision is when to liquidate the investment to take profit. If the market movement is unfavorable, the impact on the next decision is more complicated due to leverage and hedging consideration.

There may exist theories to analyze market and construct a portfolio for speculative profit. But for the average retail investor, there is neither the knowledge nor the financial resources to execute those plans. However, an individual with correct estimate of market movement for over half of the transactions and adequate risk control should be able to make appreciable profit.

Rules in managing the portfolio is to control the risk and avoid emotional mistake. Therefore it is important that they are strictly followed. The investment portfolio for development and experiment of speculative trading strategy is remnant of the investment portfolio after the financial crisis. Although it is much smaller than initial value, it is real asset and the transactions will incur monetary gain or loss.

Since the speculative trading strategy is under development, the initial draft is mainly based on past experience and is subjected to modification upon review of actual performance. Nevertheless it is guideline for managing the portfolio and risk control in adverse market condition. As previously mentioned, the objective is highly speculative. The major component in the investment portfolio is leveraged ETFs. Other components include small, medium, and large capitalization stocks and derivatives.

As an initial guidance, the proportion in the portfolio value is 30% for small-cap stocks and 30% for mid-cap and large-cap stocks and 100% for leveraged ETFs. Derivatives such as stock options are for hedging purpose and constitute only a small portion of the portfolio. The leverage multiple will be about 1.6x which may not be achievable in realistic account because of FINRA restrictions in trading account margin requirement. Since higher leverage is desired, the major equity for speculative trading is leveraged ETFs and thus have a maximum portfolio value of 100%. The total percentage for equity stocks in the portfolio will be limited by account margin requirement.

Hedging has an important role in risk control. The meltdown of the investment portfolio during the financial crisis is mainly due to over leveraging without adequate hedging. Although similar strategy works well in the aftermath rally in favor of the investment, the seriously damaged portfolio cannot recover much of the previous loss. Therefore the process of asset allocation and portfolio hedging is critical in the investment decision.

Friday, July 9, 2010

Portfolio Composition, Leverage Multiple, and Hedging

Although small-cap stocks fit into the philosophy of small and aggressive portfolio, it is observed that many small-cap stocks have peaked recently and stayed below for extended period of time. Therefore small-cap, mid-cap and large-cap stocks will make up portion of the portfolio. Options trading and short selling will be used as hedging for the stocks.

Leveraged ETFs are gaining popularity among individual investors and traders in recent years. The liquidity and leveraging power makes them suitable for speculative trading. Therefore the portfolio will comprise mainly of leveraged ETFs which be traded for short term profits.

Since there are stringent rules for portfolio liquidation in the case of wrong investment decision, the risk control allows maximum use of leverage for magnified gain/loss. Nevertheless, the risk of leverage will be reviewed periodically in order to avoid repeating the mistake that leads to the nearly wiped out of the portfolio during the financial crisis.

Since leveraged ETFs consists of regular as well as inverse indexed fund, hedging is not limited to option trading. Selection of ETFs and hedging strategy will be discussed in more details.

Above are based on stock trading experience in the past. It is believed to be optimal for a small portfolio with maximum growth potential. Since the stock market is very dynamic and financial products are evolving quickly, the trading strategy will adjust accordingly to match with market environment.

Adhere to Strategy Regardless of Market Condition

During the financial crisis, the portfolio value drops dramatically within short time. The use of leverage increases the rate of drop and thus shrinks the portfolio components. As a result, the recovery capability of portfolio is reduced if the market changes to favorable condition. Even worse, if the market condition is against the portfolio for extended period of time, the fulfilment for margin requirement with portfolio liquidation will quickly diminish the portfolio due to leverage.

If the market moves against an investment decision, some people may not admit the mistake and even bet more against the market. This scenario is commonly seen in casino gaming where the outcome of an event is random. In stock trading, such attitude coupled with the destructive power of leverage can easily wipe out the entire portfolio. Therefore it is most important that in a properly managed portfolio, the rules should be strictly followed to avoid this from happening.

For a small and aggressive portfolio, use of leverage is inevitable. Otherwise the commission fees will be significant drag on profitability. To reduce the risk of forced portfolio liquidation before recovery, reduce the use of leverage or use hedging to protect against unfavorable market movement. Since use of leverage is inevitable for a small portfolio, hedging would be the preferred means of risk control although it would reduce overall profitability.

Since it is speculative stock trading, the round-trip trade is typically accomplished within hours or days, at most weeks or months. The trading strategy is to make an investment decision and hedge at the same time. There are three possible outcomes for the trade.
1. Market goes into a stall.
2. Market moves in favorable direction.
3. Market moves in unfavorable direction.

If the market goes into a stall or drifts only a little amount, wait for new sign of movement trend. If market moves in favorable direction, wait for the momentum to exhaust or sign of reversal and then liquidate the investment. The portfolio will increase in value. If the market moves in unfavorable direction, the scenario is more complicated because of margin requirement and hedging operation.

If the investment is fully hedged, there is usually a premium for the hedge. Therefore, the maximum loss is confined. On the other hand, the expense of premium means that investment transactions have to be made with higher percentage of right decision in order to make profit. Random decisions with 50/50 chance of profit will result in overall loss to certain extent.

If the investment is only partially or indirectly hedged, the premium may be less or even none. There is still the overhead of commission fees but it is relatively small amount in comparison. In this case, the portfolio value will decline as the market moves further away resulting in larger loss. The portfolio can wait for market reversal or the bad investment can be liquidated if there is no sign of recovery. If the unfavorable market movement extends and the portfolio drops below margin maintenance requirement, There are possibilities of liquidating the investment, hedging, or both in partially or completely.

The objective of setting the rules for a trade with loss is to limit the impact on the portfolio value when a wrong investment decision is made. Above is general guidelines. Specific details depend on the leverage multiple and hedging tools.

The investment decision is critical to the portfolio growth. Each correct decision and timing will boost the portfolio value while each wrong decision and timing will shrink the portfolio value. The more accurate the stock movement estimate and investment decision, the more profitability and hence portfolio growth.

Speculative Stock Trading

The investment portfolio will be solely on stock market because of the liquidity for speculative trading. For long term investment, stock market shows a characteristic of secular growth in value. In short term period, the movement as well as volatility is highly unpredictable. Therefore the scenario of short-term speculative stock trading is like a zero-sum game with the possibility of wealth transfer among the participants. In the very long term, stock investment can create wealth from the appreciation of equity.

Since the investment objective is aggressive in order to recoup the significant loss in prior trading activities, the growth potential in portfolio value by long term equity appreciation is not an important factor to be considered. However, it is believed that the fall in stock market has overshot in early 2009. The stock market has since then recovered some of the drop from the peak in 2007. There is still potential for stock value appreciation in medium term.

The long term growth in stock market is driven by innovations in technology. The living standard of human beings is advancing over the years and in history. The growth in stock market is a symptom of wealth accumulation through the process of improved productivity. Based on this argument, the longer term trading strategy is a positive outlook on stock movement direction.

Since the trading strategy is aggressive and the use of leverage amplifies the gain/loss, each investment decision is risky and has significant impact on the result. The market condition and participants sentiment has to be thoroughly analyzed in order to increase the probability of correct decision and timing. Some means of hedging is used to reduce the negative impact of a wrong decision. Therefore if the ratio of correct versus wrong investment decision is larger than unity as in random event and evenly distributed, the overall result will be growth in the portfolio. Appropriate hedging will help to minimize the impact of overly aggregate wrong decisions on portfolio performance.

In speculative stock trading, the strategy is to consider two factors. The first is the short term movement trend of a stock on which an investment decision is made. The second is the longer term in movement trend. This property is exploited in the hedging process against an immediate wrong investment decision.

In summary, the trading strategy is to make an investment decision based on a stock immediate movement trend. Hedge against wrong decision is made based on a longer term perspective of relevant stock movement.

The quality of investment decision is critical to the success of strategy. Market information and participants competition have to be assimilated in the decision thinking. The selection of appropriate hedging tools is important to the defensive protection against wrong decision.

Objective On Stock Trading Strategy

The objective of developing a stock trading strategy is to recoup the loss during the financial crisis in the period 2007/2008/2009. The total loss amounts to over 90% of total investment. Use of leverage contributes to the dramatic decline in portfolio value when the market moves in opposite direction against investment objective.

The experiences learned in the financial crisis would be beneficial to investment, or more appropriately stocking trading, strategy development. It will be emphasized on not to make the same mistakes again.

It may appear that an increase in an order of multiple in portfolio value is unachievable in short time. But real experience exists that a portfolio can drop to less than 10% of value within a time frame of less than two years . Hypothetically, if the investment were made in the reverse direction, it would result in a gain of over 1000%. Therefore, the most important factor is the right choice in investment decision.

The equity market was very volatile during the financial crisis and economic recession. Currently, the stock market is less volatile and investors are very cautious on their investment portfolio. Since the available investment fund is significantly reduced, a more aggressive investment strategy is needed in order to grow the portfolio value significantly. Also leverage will be used to magnify the trading result. However, the destructive impact of leverage to the portfolio value is observed during the financial crisis. Therefore cautions on the use of leverage should be emphasized.

Saturday, July 3, 2010

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