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Recent Updates from Pemberley Post

• Trader's View - Is the Bull Real?
• The Goldman Conspiracy
• Quant Hedge Fund Update - Shrinking Liquidity

Big money investors have been on the sidelines

We have talked to so many bewildered clients about the massive equity market rally from the March lows that we’ve lost count. Few, if any (especially in the hedge fund community) seem to be celebrating the fact that the S&P 500 has rallied 30%, which tells us that big-money investors have been on the sidelines through this entire move. From our lens – and you can see this clearly from the twice-monthly NYSE data – the buying power for this market has actually come from severe short-covering as the bears head for the hills.... Trader's View - Is the Bull Real?

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The other drama in play: "Hank the Hammer" Paulson, iconic Wall Street hero, a Trojan Horse placed inside Washington by Goldman Sachs as Treasury Secretary in control of America's $15 trillion economy. Goldman, a modern dynasty with vast financial powers much like those once used by the de' Medici, Rothschilds and Morgans to control nations.... The Goldman Conspiracy

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"Anyone who is doing anything sensible right now is either losing money or is out of the market entirely." These are the words of a quant trader, who is seeing something scary in the capital markets. Scary enough to merit a warning that we could be on the verge of another October 87, August 2007, or January 2008.... Quant Hedge Fund Update - Shrinking Liquidity

Recent Articles from Pemberley Post

Capital Markets

• Trader's View - S&P 780
• Jim Rogers talk on China, Dollar and Commodities
• Chart of Bear Markets in Our History
• Deflation? We won't let it happen
• Complete Plan Against Recession
• Trader's View - Jan 2009
• The Agricultural Commodities Boom
• Buffett on Taxes and Trading

Investment Research

• Goldman Betting On Distressed Debt
• Berkshire 'Junk' ?
• Sears' Surprising Results
• Taking Stock in H&R Block
• Resource America Buyback
• Sears' Real Estate
• Sears' Brands Securitization
• Auto Economics, Eddie, and the Microsoft Founder

Life & Career

• Tax Time for Investors - 1040 Schedule D
• Why people trade with losses - Prospect Theory and...

Pemberley Post Website Link

Dear Investors,

I have created an independent website for our Pemberley Post at www.pemberleypost.com. You can also find it using the direct link www.pemberleycapital.com/phpcms/index.html. It contains the latest trader's reviews on the financial market, portfolio manager's investing ideas, and some food for thoughts on life and career.

Thank you for your consistent support to Pemberley Post!

Best Regards,
Andrew

Why people trade with losses - Prospect Theory and Poker

Traditional finance theory is based on the assumption of efficient market and rational players. With the effort of many dedicated economists, the framework of modern finance has been established. The revolution of financial engineering further provides us deeper understanding on exotic derivatives pricing, risk management, and a wide array of proprietary strategies used by hedge funds and prop desks. However, the theory does not explain the fact that some people trade with negative expectation of return, such as lottery ticket and slot machine. The anomaly does not agree with the "rational players" assumption. If it is an irrational behavior, why people still do it even they realize the case?

Prospect theory, developed by Daniel Kahneman and Amos Tversky, is one of the fundamental theory of behavioral finance. It shows individuals have different prospects for gains and losses. In other words, one's happiness does not increase with gains in the same speed as one's unhappiness grows with losses. A couple visiting Las Vegas for Christmas may feel somewhat indifferent with $100 and $200 gains, but may feel more grieved with $200 losses than $100.


In poker, one need to be patient enough to be profitable consistently. Never look for a quick profit with high risk, which usually has negative expected return. I have been wondering why someone consistently collects profit at our regular Friday poker party. As a rational player, I identified some players called others bets even they knew they had a small chance to win. They bet at uncompetitive odds because they receive utilities other than expected profit, which is playing the game instead of watching. I usually do not mind watching, and provide a small "fold"ing profit to bluffers, which encourage them to gamble loosely and enjoy their smart bluffs. Then as the time comes in, I take a large gain with good hands.

Trading is a zero-sum game

Trading is a zero-sum game. Traders must trade with people who will lose to become profitable. Profit-driven traders therefore must understand why losers trade to know when they should trade.


Profit-driven traders trade only because they rationally expect to profit from their trades, including speculators and dealers. Utilitarian traders trade because they can obtain some benefit from trading besides trading profits. Investors move money from current to future. Borrowers move money from future to current. Asset exchangers need to exchange assets. Hedgers want to lower the risk. And gamblers trade for the joy of trading. The profit-driven traders are rational, and they theoretically profit from providing the utility to the utilitarian traders. Identifying a general utility need is very helpful to identify opportunities. In the 2008 crisis, banks deleverage and few people have cash. It is the perfect time for Berkshire to make strategic deals as they are flushed with cash. In this sense, it is good to be different.

Deflation? We won't let it happen

Deflation in Japan started in the early 1990s. On March 19, 2001, the Bank of Japan and the Japanese government tried to eliminate deflation in the economy by reducing interest rates (part of their 'quantitative easing' policy).Despite having interest rates down near zero for a long period of time, this strategy did not succeed. In July 2006, the zero-rate policy was ended. In 2008, the Japanese Central Bank still has the lowest interest rates in the developed world and deflation has still not been eliminated.

Systemic reasons for deflation in Japan can be said to include:

• Fallen asset prices. There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.

• Insolvent companies: Banks lent to companies and individuals that invested in real estate. When real estate values dropped, many loans went unpaid. The banks could try to collect on the collateral (land), but due to reduced real estate values, this would not pay off the loan. Banks have delayed the decision to collect on the collateral, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks make even more loans to these companies that are used to service the debt they already have. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy.

• Insolvent banks: Banks with a large percentage of their loans which are "non-performing" (loans for which payments are not being made), but have not yet written them off. These banks cannot lend more money until they increase their cash reserves to cover the bad loans. Thus the quantity of loans are reduced and less funds are available for economic growth.

• Fear of insolvent banks: Japanese people are afraid that banks will collapse so they prefer to buy gold or (United States or Japanese) Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.

All the reasons listed above are currently existing in the US. We know the disastrous effect of deflation and the Fed will not let it happen. In the recent FOMC meeting, it is clear that Fed becomes more aggressive. As 2008 Nobel Prize winner Paul Krugman suggested, a deliberate hyperinflation may be the best solution, and dollar devaluation is inevitable. What do you invest in when the government starts printing money? A broad range of real assets, Asian stocks, and commodities.

Investment Returns in 2008

The only strategies that made money this year are Short Bias, Volatility Arbitrage, and High Frequency Statistical Arbitrage. Other well known strategies, such as Fundamental Value, Emerging Markets, Commodities, Quantitative Equity, Fixed Income Relative Value, have suffered losses. Many managers are stopped out because of leverage and redemption.

At the end of November, Yahoo! Finance reported the results of some big name investors:

• Warren Buffett (Berkshire Hathaway): -43%
• Ken Hebner (CMG Focus Fund) -56%
• Harry Lange (Fidelity Magellan): -59%
• Bill Miller (Legg Mason Value Trust) -50%
• Ken Griffin (Citadel): -44%
• Carl Icahn (Icahn Enterprises): -81%

Comparing with them, our losses in 401K or house value is not that bad. Who is wrong? The market or us? Why even the savvy investors suffered? The answer is not simple. However, we should understand the bull market in the past decades no longer lasts. Experience, or backtest based on this period is illusionary. One either views the market movements as irrelevant like Warren Buffett, or respects the volatility in the market and admits that we do not understand everything. Be humble and safe. It is not easy to sail in the financial waves.