Value

One of the most difficult times a value investor can experience is when the market is bullish but confidence is low. Speculators pile into popular names, chasing the buck, and sell out of longer-term value plays. Those of us who see these depressed value names as opportunities suffer twice - first when our stocks drop in value because so many other holders are selling, and again when we watch overvalued investments trade even higher as the crowd struggles to buy in.

I've been taking it on the chin this past month and, even though I have a nice cushion from the early half of the year, it still hurts. It's not so easy to keep repeating my mantra of "in for the long term" when the short term pain intensifies. In particular, I like to time my trades such that I can be regularly rolling out of successful positions to reinvest in new opportunities. With nothing to roll out of, I have less incentive to research other trades. It's even worse, of course, when I watch trades I rejected because of specific timing issues or because I wanted to buy slightly lower. Naturally, they're all outperforming. The grass is always greener I suppose.

Just a quick point. Despite the impressive performance of the US equities markets in 2006, after adjusting for currency losses the S&P 500 was only up 1.6% last year in Euro terms. Given that the British Pound just hit $2 for the first time in about 2 decades, I'm sure that the Euro is not an outlier.

So what to do? I'm not feeling completely confident about US equities on the whole, but pulling out of the market exposes me to both inflation and currency devaluation. Looks like international is the way to go. I suppose I'm just as guilty of home bias as the next investor, although I do believe there is some degree of advantage in investing in one's home country - quite simply, I have a better idea of the legal, social, and economic framework that exists in the US than, say, Japan. Nonetheless, I definitely think there are times when one must look beyond perceived advantages and execute on behalf of a larger global strategy.

Since I don't really have the insight necessary to pick undervalued, underfollowed foreign equities, I'm going to have to defer to the markets as a whole and go for ETFs. As for what countries to actually invest in, that will take plenty of analysis and thought, although I'll say right now I'm leaning towards Japan...

Book List

I recently saw a list of the (supposedly) 100 best books of all time. I'm definitely not sure what the criteria were for that list, but given that The DaVinci Code was #1, it's obviously not gauged on literary merit. While I was thinking I'd respond by highlighting the ones I had read, the list is just so utterly bad that I simply can't bear to do it. Any list where Tuesdays With Morrie significantly outranks The Great Gatsby just doesn't deserve a response.

Instead, I've posted the Modern Library top 100 Readers' Choice, and hilighted the ones I've read. Their "expert panel's" choices seemed a bit too dense for my tastes, and I do want to give some credence to popularity as opposed to critical acclaim. Here goes:

ATLAS SHRUGGED by Ayn Rand
THE FOUNTAINHEAD by Ayn Rand
BATTLEFIELD EARTH by L. Ron Hubbard
THE LORD OF THE RINGS by J.R.R. Tolkien
TO KILL A MOCKINGBIRD by Harper Lee
1984 by George Orwell
ANTHEM by Ayn Rand
WE THE LIVING by Ayn Rand
MISSION EARTH by L. Ron Hubbard
FEAR by L. Ron Hubbard
ULYSSES by James Joyce
CATCH-22 by Joseph Heller
THE GREAT GATSBY by F. Scott Fitzgerald
DUNE by Frank Herbert
THE MOON IS A HARSH MISTRESS by Robert Heinlein
STRANGER IN A STRANGE LAND by Robert Heinlein
A TOWN LIKE ALICE by Nevil Shute
BRAVE NEW WORLD by Aldous Huxley
THE CATCHER IN THE RYE by J.D. Salinger
ANIMAL FARM by George Orwell
GRAVITY'S RAINBOW by Thomas Pynchon
THE GRAPES OF WRATH by John Steinbeck
SLAUGHTERHOUSE FIVE by Kurt Vonnegut
GONE WITH THE WIND by Margaret Mitchell
LORD OF THE FLIES by William Golding
SHANE by Jack Schaefer
TRUSTEE FROM THE TOOLROOM by Nevil Shute
A PRAYER FOR OWEN MEANY by John Irving
THE STAND by Stephen King
THE FRENCH LIEUTENANT'S WOMAN by John Fowles
BELOVED by Toni Morrison
THE WORM OUROBOROS by E.R. Eddison
THE SOUND AND THE FURY by William Faulkner
LOLITA by Vladimir Nabokov
MOONHEART by Charles de Lint
ABSALOM, ABSALOM! by William Faulkner
OF HUMAN BONDAGE by W. Somerset Maugham
WISE BLOOD by Flannery O'Connor
UNDER THE VOLCANO by Malcolm Lowry
FIFTH BUSINESS by Robertson Davies
SOMEPLACE TO BE FLYING by Charles de Lint
ON THE ROAD by Jack Kerouac
HEART OF DARKNESS by Joseph Conrad
YARROW by Charles de Lint
AT THE MOUNTAINS OF MADNESS by H.P. Lovecraft
ONE LONELY NIGHT by Mickey Spillane
MEMORY AND DREAM by Charles de Lint
TO THE LIGHTHOUSE by Virginia Woolf
THE MOVIEGOER by Walker Percy
TRADER by Charles de Lint
THE HITCHHIKER'S GUIDE TO THE GALAXY by Douglas Adams THE HEART IS A LONELY HUNTER by Carson McCullers
THE HANDMAID'S TALE by Margaret Atwood
BLOOD MERIDIAN by Cormac McCarthy
A CLOCKWORK ORANGE by Anthony Burgess
ON THE BEACH by Nevil Shute
A PORTRAIT OF THE ARTIST AS A YOUNG MAN by James Joyce
GREENMANTLE by Charles de Lint
ENDER'S GAME by Orson Scott Card
THE LITTLE COUNTRY by Charles de Lint
THE RECOGNITIONS by William Gaddis
STARSHIP TROOPERS by Robert Heinlein
THE SUN ALSO RISES by Ernest Hemingway
THE WORLD ACCORDING TO GARP by John Irving
SOMETHING WICKED THIS WAY COMES by Ray Bradbury
THE HAUNTING OF HILL HOUSE by Shirley Jackson
AS I LAY DYING by William Faulkner
TROPIC OF CANCER by Henry Miller
INVISIBLE MAN by Ralph Ellison
THE WOOD WIFE by Terri Windling
THE MAGUS by John Fowles
THE DOOR INTO SUMMER by Robert Heinlein
ZEN AND THE ART OF MOTORCYCLE MAINTENANCE by Robert Pirsig
I, CLAUDIUS by Robert Graves
THE CALL OF THE WILD by Jack London
AT SWIM-TWO-BIRDS by Flann O'Brien
FARENHEIT 451 by Ray Bradbury
ARROWSMITH by Sinclair Lewis
WATERSHIP DOWN by Richard Adams
NAKED LUNCH by William S. Burroughs
THE HUNT FOR RED OCTOBER by Tom Clancy
GUILTY PLEASURES by Laurell K. Hamilton
THE PUPPET MASTERS by Robert Heinlein
IT by Stephen King
V. by Thomas Pynchon
DOUBLE STAR by Robert Heinlein
CITIZEN OF THE GALAXY by Robert Heinlein
BRIDESHEAD REVISITED by Evelyn Waugh
LIGHT IN AUGUST by William Faulkner
ONE FLEW OVER THE CUCKOO'S NEST by Ken Kesey
A FAREWELL TO ARMS by Ernest Hemingway
THE SHELTERING SKY by Paul Bowles
SOMETIMES A GREAT NOTION by Ken Kesey
MY ANTONIA by Willa Cather
MULENGRO by Charles de Lint
SUTTREE by Cormac McCarthy
MYTHAGO WOOD by Robert Holdstock
ILLUSIONS by Richard Bach
THE CUNNING MAN by Robertson Davies
THE SATANIC VERSES by Salman Rushdie

Seems a little heavy on the Ayn Rand and Sci-Fi, no? Guess this list was written by a 16-year old male high school student who's more likely to be in the computer club than on the football team. (Not that I was on the football team either. Hey, when I was 16 I'd have loved this list.)

Diseconomies of Scale

Investing might be one of the few environments where participants can easily experience diseconomies of scale. In other words, bigger is not better. Specifically, small hedge funds and, when they're knowledgeable and have adequate resources, individual investors, can often put up better returns than the multi-billion dollar behemoths. Evidence for this claim is mixed, but I believe that as time goes on and the big funds get bigger, we'll see some more proof of this claim.

Fundamentally, there's a very simple reason for this assertion: the bigger a fund gets, the smaller the pool of potential investments becomes. A $50 million fund has a very large pool of potential investments to choose from, the only restriction being securities reserved for QIBs and other high-net worth entities. On the other hand, a $10 billion fund can't realistically put money into, say, a stock with a $300 million market cap. The fund simply can't buy enough of the investment without significantly affecting that investment's price. Any investment the firm could make simply would't "move the needle" as far as returns go, and thus doesn't justify the time and effort of the fund's analysts.

Similarly, large banks and research firms on the street aren't interested in analyzing small securities because their clients, the big funds, can't or won't invest in them. Why do the work if you won't get paid for it? To focus specifically on the equity markets, (my primary area of expertise and interest,) small-cap stocks are generally neglected by the larger banks. Many companies are covered by only a handful of analysts, and quite a few are simply not covered at all.

There are currently over 5000 publicly traded companies in the US, (probably closer to 8000 if you include bulletin board stocks, the NASDAQ SmallCap Market, and various other less-liquid listings.) I'd guess that at least one third of these companies are severely under-followed, if even covered at all by any research firm or bank. That's a huge pool of potential investments that the banks won't cover and the funds won't trade. If even one half of one percent of them are mis-valued, that's approximately 12 securities you could potentially buy. Remember, according to modern portfolio theory, more than around 15 stocks in a portfolio and you're really not getting any marginal benefit.

What's important here is that the small guy can profit in areas where the big guys can't. My belief is that there are plenty more than just 12 mispriced names out there. Take a look at some of the blogs on the sidebar - the value investors out there focusing on small cap names seem to put up some pretty good returns. I'm not as knowledgeable as most of them (yet,) and I don't have quite as much time as they do to do the research, (CFA is still eating up all my free time,) but even I've found a few huge pricing errors over the past year or 2. People - the opportunities are out there. You just have to dig a little.

Offshoring

Here's an excellent, thought provoking working paper written by Princeton economics professor Alan S. Blinder on the subject of free trade and offshoring. His thesis, that information technology will allow a much larger number of service jobs to be offshored to places like India, is one I completely agree with.

Assuming Blinder's theory is correct, how does an investor respond? Does the American equity market suffer at the expense of India as more Americans lose jobs, lowering consumption and hurting the economy as a whole? Or, do American corporations profit due to lower labor costs and a larger global market for their services? I think it depends on the rate of the shift of jobs from the US to poorer countries, and how quickly those poorer countries develop and modernize. A sudden shift in jobs offshore would probably allow the US companies to move aggressively into foreign markets before local competitors could grow large enough to capture the market. A slow drift, on the other hand, would give local businesses the time to mature.

Of course, we're ignoring any possible barriers to trade that the US government may erect in the meantime. Given yesterday's announcement of new tarriffs on Chinese paper products, the Bush administration appears to be leaning toward making trade more difficult. My suspicion is that the US government, pressured by labor unions and voters in middle-class districts, will enact more and more barriers to trade, but will concentrate on protecting the farm and manufacturing industries and will generally ignore service jobs. This will probably allow foreign service industries to grow and gain market share both in the US and overseas. Perhaps going long some Indian equities would be an ideal core portfolio holding for long-term time horizons.

As a side-note, Blinder mentions security analysis as a possible industry to be offshored. I think security analysts and investment bankers are at very high risk. The sell-side is very much concerned with pedigree, particularly in i-banking. American banks will be very slow to consider offshoring. The buy-side, however, is much more concerned with results. Put together a bank in India that provides both research and investment banking that's just as good as the American alternative and costs one third as much, and you'll see a titanic shift of commissions and fees. Perhaps I should reconsider my current employment status...

Back to the CFA...

Did Cramer Just Admit to Market Manipulation?

Looks like Jim Cramer's caused a bit of a stir due to some comments made in a recent interview at The Street. I'm not sure if this is an admission of market manipulation, but he's certainly skirting a very very thin line.

Personally, I've never been a big fan of Cramer. I'm not going to speculate on whether he is really trying to help the average investor, or if he's just using CNBC as a platform to pump up stocks that he owns in his "charitable trust." What bothers me about him is that he's teaching people very bad habits about the markets and trading. The fact is that for most people, the stock market is a form of gambling. I'd guess that 95% of the people out there buying stocks have no idea how to value a company, have never read any of the financial data on the stocks they own, and probably just throw away any proxy statements they recieve. In case any of you out there had any doubt, the important part of a company's annual report are all those boring pages of numbers in the back, not the glossy pictures of happy-looking employees and self-congratulatory remarks from the CEO. (Oh, and just so you folks out there know, by the time you get that nice glossy report in the mail, people like me have already had the information sitting on our desks for about 6-8 weeks. The SEC website posts all the corporate filings in real-time, and all of us know how to use it.)

Look, if you want to make money in the markets, you're going to have to do the work on your own. It takes lots of time, tons of reading, and quite a bit of analysis. And even then, after all that, you're still likely to be wrong a good percentage of the time. Your best bet, though, is to invest in small-cap companies that aren't covered by most research firms and I-banks. If you're dilligent, patient, and persistent, you'll find a few companies that are trading at a significant discount to their true value. Find enough of these, invest over a relatively long period, and you'll probably be successful. Trying to trade in and out like Cramer is only going to get you whipsawed and cost you tons of money in transaction costs on top of the losses you'll probably take.

If you're really one of the very few people out there who can day trade well enough to consistently make profits, then go ahead and keep doing what you're doing. For the other 99% of the population out there, just stop. The next time you want to buy a stock, do yourself a favor and go online, download a copy of the company's latest 10-K filing, and read it. The whole thing. Including all the financial data and all the footnotes. Pay particular attention to the part where it talks about prior years' results and the explanation for why the numbers are trending up (or down.) Treat every assumption regarding the future as suspect. Try predicting what will happen to the company's income if you adjust those assumptions lower.

If all this sounds too burdensome, stop immediately. Managing your own stock portfolio probably isn't for you. Put your retirement fund into some index funds, and maybe a few actively managed mutual funds. If you still feel the need for some action, get on a plane and head to Vegas - your odds of making any money are about the same, and Vegas treats you a lot better when you lose. (Try getting your stockbroker to comp you a hotel room and a free meal.)

If, on the other hand, you sit down and read that filing and, to quote Obi-Wan Kenobi, you feel like you've just taken your first step into a larger world, keep going. Start reading all you can about valuation and analysis. Read more 10-Ks, read conference call transcripts, read, read, read. You just might have what it takes...

Study Time

A few months ago, in a fit of frustration about the apparent lack of traction I was feeling along my career path, I decided to sign up for the CFA exam. Despite a warning from my boss that the CFA is "the hardest test you'll ever take" and various foreboding sodomy-related similies, I decided to take the plunge. Right now, sitting on the shelves above my desk, are about 40 pounds of textbook that must be read, comprehended, and fully regurgitatable by the first weekend in June.

Clearly I must have been out of my mind when I came up with this bright idea. The sheer volume of material that must be learned is staggering. That said, none of it seems to be particularly difficult, and a good deal of it, particularly the economics and statistics sections, are primarily review. Nonetheless, reading 3500 pages of dense, poorly written, uninteresting financial text in a span of about 3 months is not my idea of a fun time. In fact, it really sucks. (Especially the accounting part - I hate accounting, and it's the largest section of the test.)

I'm sure I'll have more to say as we get closer to crunch time, but I'm already feeling the pressure. I signed up for a 3-day cram session at the end of April, which will hopefully be enough to get me past this thing.

End of the Year Musings

Clearly it's been a while since I've posted, but until recently there hasn't been much of interest to say. Work-wise, there are interesting developments, but until things are definitive I really can't mention them here. (Fear not, I'm not planning on switching jobs again anytime soon.) I'm technically barred from discussing anything related to my employer online as per the details of my employment contract, but I will at least mention that our corporate structure is likely to change significantly in the near future.

Otherwise, with the year drawing to a close, I feel it's a good time to take stock of what I've accomplished. I can't really say 2006 was a success, but it doesn't quite feel like a failure either. My brief foray into the world of hedge funds may appear to be a failure, but I don't think it really was in the end. I definitely learned a lot, despite the fund manager's insanity, and I definitely learned not to take the next opportunity that comes my way just because it's an opportunity. (The ability to negotiate my way to a higher pay-scale was also kind of nice.)

Trading-wise, this year has been a disappointment. While the results aren't final yet, I'm probably looking at about a 10% return overall. That's not bad, all things considered, but I felt very frustrated. A lot of my ideas that I acted on ended up not panning out, and many of the ones I passed on were big winners. I feel like I could have easily doubled my returns had I simply made just a few different decisions. Had I bought CLDN instead of VTSS, for example, or had I pulled the trigger on AAI under $10, it would have been a very different year. I guess the lesson is to be more confident in my ideas and stick with what I know.

In other news, I'll be forgoing the usual trip to DC for New Year's Eve this year. Rather, we'll all be flying out to Chicago to visit my friend Alan. For those who aren't in the know, Al was a friend of mine from college who trained professionally to be a chef. He makes some pretty amazing food, including the world's best ice cream, bar none. (He sells containers of it for $50 a pop, and I completely believe that people would pay for it. It's simply extraordinary.) Anyway, Al is planning an 11-course meal for all of us on NYE, which I wouldn't miss for the world. I feel totally justified in going to Chicago in the dead of winter and shivering for 3 straight days if there's one of Al's meals involved.

10 Years

This past Friday was my 10 year high school reunion. I'll spare you the details - suffice it to say that some people were fatter and/or balder than they were 10 years ago, but there were no major shocks or surprises. A signicant number of my classmates were either doctors, lawyers, or bankers, with a few aspiring actors thrown into the mix.

The whole event though got me thinking again along the same lines that I've been mentally writing for the past year or so - I think my generation really dropped the ball. In particular, I'm thinking about the people who I grew up with - mostly priveleged, intelligent kids who went on to some of the best colleges and universities in the country. We should have been the cream of the crop. Yet, somehow, it didn't seem to turn out that way. I think that somewhere along the line we all collectively lost our drive. Maybe it's the fact that everything was always provided for us by our parents. Maybe it's because our elite secondary institutions coddled us too much, or let us slip through the cracks, finding half-assed work acceptable enough for a grade-inflated B. Whatever the reason, I'm disappointed, in my generation and in myself.

This is why I sometimes feel like I need a vacation from life for a while - not to escape, or to be lazy, but to regain that drive that I know I once had. I used to love to win; now I hardly feel like playing the game.

Decisions

Oh, yeah, about that news. Um, right. Well, I got my old job back. You see, the guy who was running that hedge fund I was at turned out to be a complete lunatic - it's no wonder that nobody wanted to work for him. At any rate, while returning to the sell side wasn't really part of my long-term strategy, my sanity and personal happiness have skyrocketed over the past few weeks as I've smoothly transitioned back into my old spot. Granted, there were a few changes at the old place, most notably a major personnel shift on the trading desk, but I'm overall happy to be back.

After thinking about it a lot over the past few weeks, I've come to the conclusion that I wasn't quite ready to make the transition over to, essentially, running a hedge fund. I think I'm capable of working on the buy side, and one day I intend to be quite successful at it, but right now I need a bit more seasoning. Were there a situation where I could work on the buy side but in a more structured environment, where I would have a mentor and be guided and taught, things would be very different and I'd be able to make that transition now. However, without some more experience, I'm not ready yet to jump all the way to the top. Well, I don't think so at least. Who knows? Maybe I could have done it. I find often that trial-by-fire brings out the best in me. Still, my mental health is more important than that, and it wasn't worth what I had to put up with.

So, now that I've switched back, the more important question is: what do I do now so, when the next time comes around, I'll be ready? I figure I have at least 18 months to 2 years before I'll be making another move, so I should be making the most of this time. Maybe the CFA? Hell of a lot of work, but opens a lot of doors. Unless, of course, I decide to do b-school, in which case it's a waste of time. But, realistically, do I really want to go back to school and take myself out of the workforce for 2 years? A multi-year vacation sounds pretty nice, but so do big bonuses. Decisions, decisions...

Boom

Earlier this week, Amaranth, a major hedge fund, announced massive losses in the energy markets, effectively destroying about $6 billion of their investors' capital. If anyone wants the exact machinations behind the trade that went wrong, feel free to ask and I'll explain offline. The basic gist of it, though, was that one trader took one huge bet, and it went wrong.

What I find interesting about the whole situation is that while the name of the trader, Brain Hunter, has been all over the news, I haven't seen one mention yet of the name of the firm's chief compliance officer. There are sins of comission and sins of omission. Hunter is clearly guilty of the former, but Amaranth's complaince department is just as guilty of the latter. By letting Hunter put on a position of this size, compliance allowed Hunter to put the firm at risk of collapse. Any attempt to say that Hunter hid his position size from compliance is both naive and misguided - not only were Hunter's positions so big that it would have been nearly impossible for compliance not to know about them, but it's their job to make sure they know if anyone at the firm is taking risks like that. Any trading firm worth it's salt should have a policy that the trader never has the final say in how big the positions should get.

When a trading firm has a weak compliance department, traders take advantage of the situation. I saw it when I worked on the floor, and it looks like the Amaranth situation played out the same way. I knew options guys who would strap on a huge position and hope it would work out. If it did, they got paid. If not, they'd get fired. So what? There's always another job. It seems that the Amaranth situatuion is the same thing. Basically, the story I heard from some energy guys is as follows - last year Hunter took a huge position right around hurricane season that natural gas prices would spike if a big storm hit the gulf. Nobody stopped him, so why not take a shot? At risk of losing his job, a correct bet on the weather would make Hunter a wealthy man. And, as anyone in New Orleans could tell you, that's exactly what happened, and Hunter got paid out. Big. Around $100 million, from what I heard. So, this year, Hunter strapped on the same position again. Except, the weather didn't work out as planned, and the position got killed.

Keep in mind, I don't know this actually to be true. This is the story I've heard, and while most of the facts can be confirmed, I don't actually know what Hunter was thinking. I can say, though, that given a coin toss where heads you get $100 million and tails you blow up your firm and you're never working in finance again is a pretty good bet, especially when you've already made enough money to retire on. I also can say that I know plenty of traders who'd do the same thing.

Right now I'm sure that the compliance departments at every hedge fund in the nation are reviewing their procedures to make sure this doesn't happen again. I just hope that the media and the general population also are made aware of who all the guilty parties are here.

Nothing deep or philosophical here. Just that 5 years have passed, and I still don't recognize the skyline. They can put up new buildings, but there will always be something missing.

Eureka

I think I may have stumbled on a hell of a trade. It's obscure, and it involves a fairly diverse set of skills and market knowledge which, coincidentally, I happen to possess or have access to. It was just one of those moments that happens so infrequently, but you know it when you see it. I was looking at a trade that our portfolio currently has on, considering taking profits. It's a derivative, so I had to set up a quick little calculator on my Bloomberg to price it out. Just as I was about to start making some calls to the sell-side to get rid of the trade, I decided to stop for a second and check the price of a related security, just for the hell of it.

I jumped out of my chair.

Can there really be a mis-pricing so blatant and so obvious? I checked my numbers 6 times to be sure. Each time, it was the same as before. Staring me in the face was the thing every trader hopes for - the sure thing.

After sleeping on it, I went back to check my numbers again. There must be something I'm missing. It can't really be that easy, can it? So far, everything I've seen confirms what I'm looking at. I checked out some similar situations, and about half of them were also mis-priced. That's actually good - the fact that half of them are trading properly indicates that the relationship does exist, and that if I trade these mis-pricings, they'll hopefully come back into line eventually, creating profits.

The boss is on vacation next week, so I'll have time to do some serious research and make sure this thing is viable. If it works, I'm hoping to be testing the strategy on paper by the middle of September, with a relatively short period, maybe 2-3 months, before commitment of capital.

Sometimes you have to explain things to other people before you truly understand them yourself. I was talking on the phone to a friend just now, telling him about the new job. He asked me why the former trader quit before I started, rather than stay on a few months to train me, as we had originally planned.

My initial explanation was that he had just become fed up with the fund manager, and decided that he couldn't take it anymore and wanted out. Certainly plausible, given what I've had to deal with over the past 2 weeks, but not likely. The trader had been there for 15 months - if you don't quit on this place after 6 weeks, you're probably in for the long haul.

My second thought was that he felt he got too small of a bonus relative to his returns. The trader had mentioned to me that I would have to fight for my bonus, so this seemed pretty plausible. However, a bit of sleuthing on my part turned up a significant withdrawal of cash from the main trading account right around when the trader left. The figure, at around 10% of the fund's profits for the year, was hefty, to say the least.

Other speculation on my part included an unwillingness of the fund manager to seek additional capital, desire for more stability, or any number of other things which, while theoretically possible, didn't seem like quite a good enough explanation on their own. Even the combination of all these factors just didn't seem like quite enough of a reason, especially since the trader is now starting a new job as a sell-side analyst. Not a likely career move for a successful buy-side trader.

Then, while on the phone just now, it hit me. The fund manager isn't making the effort to find a new PM!

Now, I've said in passing to other people that the Portfolio Manager quit a few months ago, and that I'd be trying to fill in for that role as well as trading until a new PM could be found. Howver, it's pretty tough to do both those jobs at once, even if you have a lot of experience. The old trader, while very smart, still never worked as a true researcher, and probably didn't have time to manage both jobs at once. In fact, trying to be head trader and PM at the same probably was cutting into his returns! I've seen the numbers for the past few months, and there definitely was a drop-off over the past few months. I attributed that mainly to shut-down costs and a decaying market conditions, but what if it's simply the lack of a PM that's causing the problems?

This also explains another thing - why did the trader decide to become an analyst instead of pursue opening his own shop, like he had mentioned to me in the past? Again - the answer becomes apparent. To open your own fund, you need to be able to manage the portfolio as well as trade. By doing research for a year or so, he'll get the experience he needs on someone else's payroll, and keep his performance numbers from the old shop intact! It's such a simple plan, yet it should work remarkably well.

So, now that the reasons for the old trader leaving so soon have become apparent, so too does my dilemma. Without a PM, will I have the ability to both be head trader and generate ideas? It's daunting, to say the least. However, it also provides me with a backdoor out of the firm earlier than I may have planned. Leaving a firm after 6 months or less doesn't look particularly good on a resume. However, leaving a hedge fund because the manager isn't serious about finding a PM is the logical thing to do. Not to mention, poor returns at a fund that has no PM are quite easily explained. While I may not be thrilled about resorting to a quick exit, I feel it's a lot less damaging than it could otherwise be.

And if we get a PM after all, most of my problems will rapidly disappear...

Big Changes

As I hinted at in my most recent post, (God has it really been that long?) there have been some big changes around here. It's been a hell of a time the past few weeks.

July 28th I skipped out of work a little early, hopped the subway to JFK International, and dug in for 22 hours of flight time which deposited me, completely jet-lagged, in beautiful Sydney, Australia. And, yes, in case you were wondering, I did take about 3 dozen pictures of the Opera House beacuse, quite honestly, it really is that spectacular. While 1 week really isn't enough time to spend in a place like Australia, I managed to get in a lot. I'm still trying to put together a whole travel-essay page, replete with photos and all, but until then, I'll just mention a few highlights:

• Seeing an opera at the Opera House was very interesting, and culturally edifying. Australians pronounce Turandot as if it's not a French word, and really stress the "t" in the "dot."
• Dinner at Tetsuya's, possibly the finest restaurant on the continent. Worth every penny, especially with the wine pairings.
• 
  Bondi Beach. Too bad August is winter in Australia. (Winter in Sydney, by the way, means it's 55 degrees and sunny.)
• Hiking through the eucalyptus forests of the Blue Mountains. Totally amazing.

Before I knew it, the week was over, and it was time to return home.

Tuesday, August 8th, at 8:30 AM, I walked into the president's office at work and quit my job. By 9:00 I'd shaken hands with all my coworkers, walked out of the building, headed across town, and installed myself at my new desk, as head trader of a small NY hedge fund.

Yes, that's right. Hedge fund. Head trader.

While it's not exactly as glamorous as it may sound - I'm the only trader there. Hell, I'm the only employee there besides the secretary, I am referred to as the head trader by both my employer and our various sell-side accounts. And, while we're managing a pretty insignificant amount of money, it is a buy-side gig.

I have to admit I'm a little wary of this move. It's a big change, and a lot of work. Further, I'm potentially walking away from a lot of money, given the speculation of my former coworkers regarding what my bonus should have been had I stayed out the year at the old shop. But, like I said to my old boss when I left, this job is about opportunity, not money. And while mid-six-figures is always nice, even in NYC, I don't need to tell you what real hedge funds pay, and that's where I hope to be in a year or two. I'd been spending the past year or so trying to figure out how to get over to the buy-side, and now my opportunity has been handed to me. Granted, it comes with a cantankerous old man who's chewed through 2 traders, a PM, 2 accountants, and at least 3 secretaries in the past year or so, but nobody said this was easy. If I wanted easy, I'd have stayed at the sell-side shop, surfed the web all day, collected my $200k, and probably made VP at the end of this year.

What the hell have I done???

4th Round

I am this close to making something happen. More tomorrow...

Timely

So far, the options trade I put on the other day hasn't worked out that well. I managed to find the only semiconductor company in the entire world that didn't miss earnings. Oh well, I still have 2 more expiration cycles - no point in trading out of it now, and I still think my thesis is correct.

On the positive side, I just barely avoided taking a loss on Friday. I'd been looking at some upside calls on SkyWest due to an upcoming event. Continental Airlines was looking to replace ExpressJet as their subcontractor for short-hop flights. The contract had orignially gone to RJET but, due to a series of complicated events involving subleases and availability of planes, the contract needed to be re-awarded. I recently spoke to an industry analyst, who said that since RJET didn't have the planes, it was almost a given that the contract would go to SKYW.

Since the contract was due to be awarded any day now, I figured some upside calls in SKYW would be a good idea. With the stock around 23.5, maybe some cheap 25 calls would be worth a shot. Unfortunately, Friday was expiration. The Julys were trading as if worthless, and I really didn't want to pay up 0.35 for the Augs. If we only got a small move in the stock, vol would collapse and I'd barely make any money. Not worth it. If I could pay 0.20 or 0.25, I'd probably try to buy 100 calls.

Just as I was cursing the timing of the whole trade, and debating whether dropping a 0.25 bid for the Augs would get hit out or just scare away the offers, one of our salesguys called out "CAL on the tape!" "Shit," I thought, "I just missed it." I pulled up the story on my newswire.

Continental Airlines Selects Unit Of Republic Airways For Regional Jet Contract

Guess that's $2500 back in my pocket.

Odds and Ends

For a so-called derivatives trader, I've really been a spectator in the options market for quite a while. A lot of that has to do with my current job - I've been trading a lot of equity-based derivatives that are internally structured and which don't have any characteristics of traditional derivatives. It's also because, when I left the AMEX, I was very frustrated with the state of my trading. Some of it was because the AMEX was a giant black hole of spiralling depression where trading careers go to die. Some of it also was the realization that TASR was dead and was never coming back - no more $100,000 weeks ever again. And, maybe most importantly, some of it was because I felt like I had lost my edge. I wasn't excited about trading any more. I felt like I was going through the motions, like I didn't care whether I made or lost money.

To traders, this is the kiss of death. We love to win. No, really, we need to win. Ever play a board game with a trader? It's not fun, is it? We gloat when we're up, and refuse to admit defeat when we're down, even if the odds of a turnaround are so long we make the NY Knicks look like they have a good shot of winning the championship this year. We simply love winning so much at trading that it takes control of anything else competitive in our lives.

When I stopped caring about winning at trading, I knew I had to leave. I left the floor and got a job that I hoped would be intellectually stimulating and, maybe, rekindle that flame. While the job itself hasn't turned out to be as exciting as I'd hoped, some of the people I've worked with have reminded me about that competitive desire. I broke myself down, and started back at the beginning, with simple equity plays. I tried a few experiments, made a few mistakes, and got a little lucky.

But oh that feeling when I hit that first home run again. PWEI - I was in that name before Cramer had even heard of it. Long from $7.14 right before the run-up. I was back, dammit. It was like a drug - but better. I nailed on the head. My coworkers, who I'd told to get in on the name, were cheering me on for weeks after that one.

For the next year or so, my trading in my personal account picked up a lot. I had winners and losers, but overall I perfomed well. My confidence was back; I found my swagger. And today, for the first time since leaving the AMEX, I slapped on an options trade.

Nothing too exciting. Just bought a put spread in a name that I think is due for some disappointing earnings later this week. Still, it felt good. I could tell, though, that I'm a little rusty. I didn't check the vols before pulling the trigger, nor did I look at the earnings cycle to see how many shots I get. Still, it was a good feeling to be back in the game.

IPO Dude

This morning The NY Merc filed an S-1 with the SEC. The long-awaited IPO is finally moving forward. The stock is expected to trade on the NYSE, ticker symbol NMX. I have a more than passing interest in this particular name, as some of you know, and I've been waiting for this news for a while.

So what's this thing really worth? While it's still too early to talk pricing, NYMEX shares are already changing hands in the neighborhood of $40, so we have a decent starting point. Unfortunately, we don't know how many additional shares, if any, the Merc plans on issuing as part of the IPO. Thus, we can't really come up with a price target. We can, however, talk about multiples, to some extent. Comparing the NYMEX to its peers, (CME, BOT, ISE, NYX, NDAQ,) we get an average P/E ratio of 85.17 - pretty rich. The NYMEX shares are currently trading at about 44 times, so in theory, the exchange could double the shares outstanding on the IPO and still be in line with the average of its peers.

On the other hand, the peer average EV/EBITDA ratio is about 22.69 times - very high by any standard. Using a back-of-the envelope calculation, I get to a current value of about 21x for the NYMEX as is. Granted, this number will change dramatically, as the exchange will see a significant influx of cash after the IPO, but presumably also see its market cap soar.

The upshot of these quick calculations is primarily that exchanges in general have very rich valuations. Perhaps this is justified, since these companies have always been privately held up until now, and it's likely there will be significant improvements in margins as well as growth as the pressure of being public forces management to become more aggressive. Perhaps not.

Talking Trading: New ETFs

There's been a lot of buzz on the street recently about a series of new ETFs from ProFunds Group. These new Proshares allow the investor to take a leveraged bet on the major indecies on either the long or short side. Very interesting stuff. I can tell already that the portfolio theorist in me is going to have an absolute ball with these puppies. Aside the obvious ramifications of being able to be short the market as well as to generate leverage in an IRA for the first time in history, there are several hypotheses I'm hoping to play around with. While there is still nowhere near enough data to work with, I am planning on quite a bit of number-crunching. Some hypotheses include:

• Taking advantage of outlier days - if the UltraQQQ, for example, really produces double the return of the regular QQQ on a consistent basis, can one buy the UltraQQQ and short the regular QQQ in order to take advantage of higher volatility? Should one hedge with 2 QQQ contracts for every one UltraQQQ? Is there a correlation with the VIX?
• If, as many retail brokerages like to claim, the market historically returns 9-10% annually, shouldn't we all just throw 100% of our portfolio into the UltraQQQ and, in the long run, earn a rate of return that is significantly higher than the rate of inflation, allowing us to retire quite comfortably on our own private islands somewhere?
• Are there arbitrage opportunities between the Ultra long and Ultra short ETFs?
• If the market has a huge runup, similar to the Nasdaq circa 1999-2000, does the UltraShortQQQ go to zero?

A lot of these questions would be easy enough to answer via Monte Carlo Engine if we knew the exact methodology that ProFunds uses to price these ETFs. For now, all I've seen is that the pricing is determined through the use of various derivative products that may include futures, swaps, and other instruments, and that there is no guarantee that the actual value of the ETF will really be equal to what it should be. Acting on the assumption that the Ultra ETFs will behave exactly as they should can give me a decent idea of what to expect, but I'd rather be able to back-test with actual data. (I am well aware that backtesting can often turn into "backfitting" the data, but I am also a very firm believer that markets are neither perfectly rational nor perfectly efficient, and these mysterious derivatives that ProFunds is using to reach the expected levels for its Ultra funds sounds exactly like the sort of thing that will make spreads get all sorts of funky because actual values and theoretical values don't quite add up.)

Anyway, these new ProShares look pretty interesting, and not just from an academic standpoint. If business is as slow tomorrow as it has been all month, I should have plenty of time to mess around with these things.