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Five Things You Need to Know That Have Absolutely Nothing to Do With Subprime Mortgages


What you need to know (and what it means)!


Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

Today's Special Edition Five Things features nothing about real estate, subprime lending or mortgages. Enjoy.

1. Nonfarm Payrolls and the Fed

The Labor Department reported nonfarm payrolls increased by 94,000 in November, more than the 70,000 expected by economists, although many had raised their forecast following this week's stronger-than-expected ADP payroll report.

  • The unemployment rate held steady at 4.7%.
  • Average hourly wages among production and nonsupervisory workers (which make up about four-fifths of the work force) rose 8 cents, to $17.63, but that put wage growth only slightly ahead of inflation.
  • Adjusted for inflation, wages have fallen over the last year, from roughly $17.69 last November.
  • And over the past four years, the inflation-adjusted hourly wage has risen by just a penny, from $17.62 in November 2003.
  • Fed Funds futures continue to price in a 25 basis point rate cut when the Fed meets on December 11, but odds of a 50 basis point cut slipped significantly.
  • More important next week for those things which we will not mention, however, is what the Federal Market Open Committee does with the Fed's Discount Rate.
  • See yesterday's Five Things for more on the Discount Rate.

2. Another Stock Market Indicator Turns Positive

Over the past week we've discussed improvement in a number of equities indicators even as the news flow increases in negativity. Yesterday's action in the markets was enough to reverse the NYSE Bullish Percent up to positive, according to data from Investor's Intelligence. This indicator now joins the S&P 500 Bullish Percent and Nasdaq-100 Bullish Percent as positive. Since reversing up on November 28, the Nasdaq-100 and S&P 500 are up 1.54% and 2.61%, respectively.

NYSE Bullish Percent

3. Quarterly Scorecard

So with equities indicators turning increasingly positive, where do we turn for potential plays into year's end? We've noted that large caps are outperforming small caps, but what about specific sectors?

Below are quarter-to-date performance figures for the iShares Dow Jones Sector exchange-traded-funds.

Energy (IYE) 0.2568%
Natural Resources (IGE) 0.3719%
Pharma (IHE) 1.3666%
Biotech (IBB) 1.99%
Consumer Goods (IYK) 2.30%
Healthcare (IYH) 2.41%
Basic Materials (IYM) 2.63%
Oil & Exploration (IEO) 6.59%
Health (IHF) 6.82%
Utilities (IDU) 7.62%
Medical (IHI) -0.2224%
Tech (IYW) -0.3772%
Aerospace (ITA) -0.8037%
Transportation (IYT) -2.06%
Oil & Equipment (IEZ) -2.48%
Industrials (IYJ) -3.17%
Brokers (IAI) -3.55%
Consumer Services (IYC) -4.51%
Insurance (IAK) -5.30%
Home Construction (ITB) -7.87%
Real Estate (IYR) -8.13%
Financials (IYF) -9.03%
Regional Banks (IAT) -10.09%
Telecom (IYZ) -12.65%

4. IMF Plans Job Cuts

The new chief of the International Monetary Fund plans to cut the staff by as much as 15%, according to the Wall Street Journal.

  • The job cuts are a bid to stabilize the fund's finances that have been weakened due to a decline in demand for loans.
  • Dominique Strauss-Kahn, the new head of the IMF, said the fund is facing an annual deficit of $400 million around 2010 if loan demand doesn't pick up.
  • More important for financial markets is the IMF's plans to continue selling part of the fund's gold assets.
  • The IMF holds 3,217 metric tons of gold.
  • Strauss-Kahn recently said the IMF would sell 400 metric tons of gold.
  • Gold aside, this is the first significant round of layoffs since the IMF was founded in 1945.
  • Incredibly, the IMF has a staggering 1,269 economists on staff.
  • Three economists went hunting and came across a bear. The first economist fired his gun, but missed by a foot to the right. The second economist fired his gun, but missed by a foot to the left. The third economist didn't fire his gun, but shouted in triumph "We got it! We got it!"

5. Horse Racing and Financial Markets

Last night on Fox's Happy Hour, Cody Willard and I talked about horse racing and the similarities between betting on races and speculating in financial markets. I've written quite a bit about horse racing and financial markets in Minyanville over the years. The discussion with Cody reminded me of something I wrote a few years ago about the similarities between racing and markets, and on a quiet Friday today is as good as any to revisit it.

The Saratoga Bounce
July, 30, 2003

All things being equal, Saratoga Springs would be just a typical resort town nestled snugly near the entrance to the Adirondacks if it were not for the racetrack that was built here in the 1800's. As it is, the racetrack ensures that all things are most certainly not equal. Kentucky has Keeneland, a track so picturesque that it was used as the backdrop for Seabiscuit's match race with War Admiral in the 2003 film. Southern California has Del Mar, a beach resort where watching Hollywood's weekend gamblers is as entertaining as watching the horses. Each has its own unique charm, but they simply can't compare to the history and tradition here at the Spa. Saratoga's history and tradition are chief among the reasons I come here.

During the racing season, which lasts a mere 36 days, the small town of Saratoga is inundated with racing fans. If your only familiarity with horse racing is a weekday afternoon at Belmont Park, a cavernous racetrack that sits mostly empty even on the weekend, then it's probably difficult for you to imagine what those 36 days are like. Day in, day out, during the afternoon the track is filled to near capacity. Families with their children set up mini camps behind the grandstand and clubhouse area, near the paddock, while the rails are standing room only when the horses turn for home. If you were new to America and your only experience with horse racing was Saratoga, then you would conclude that horse racing is the most popular spectator sport in America. You would be wrong, of course, but your conclusion would at least have an element of logic to it.

Before I became involved in financial markets I was a handicapper/page editor for the Daily Racing Form. I graduated from college in 1991 with a degree in philosophy. If you recall, there was a fairly deep recession in 1991-1992 and since none of the big philosophy companies were hiring, I naturally went to work for the Racing Form. Once racing finds its way into your blood it's impossible to get it out, especially if, like me, you refuse to go to court mandated counseling. Relax, I'm kidding about the counseling…your honor.

The similarities between technical analysis, fundamental analysis, and handicapping horses are numerous. As in the analysis of stocks, handicapping can be broken into roughly two separate, though related, camps – the fundamentalists, and the technicians. Not to belabor the similarities but at the track, the fundamental analysts are those who make their selections based on the horse's class, the trainer, the horse's record over the surface and at the distance, their workouts, etc. The technicians on the other hand, focus almost exclusively on speed or performance figures. I primarily rely on the technical approach. Also, like anyone who operates in the stock market, I have a methodology for handicapping horses and I try to exercise my methodology in a disciplined manner.

In a sense, my methodology is based on the charts of the horses. I use Len Ragozin's "The Sheets" performance figures. Ragozin's figures are refined speed figures that theoretically allow a handicapper to identify patterns based on those numbers. It's like technical analysis, except for horses. The idea is to look for patterns that suggest whether a horse is going to run a poor effort (also called a bounce), a medium effort, or a top effort. Sometimes fast horses lose to slower horses simply because the slower horse was ready to run a "good" race while the faster horse "bounced." In my experience the Ragozin Sheets afford handicappers the best possibility of identifying a longshot that other handicappers disregard, perhaps because the horse looks "slow" on paper according to, say, Beyer speed figures, which are now so widely used they are questionable value in a parimutuel system, or because of some other conventional wisdom.

I'm a "value" handicapper. In other words, I look for horses that are under-appreciated by the betting public, and are therefore going off at odds higher than what their true chance of winning suggests. Sounds easy, right?

Consider, for example, a horse whose odds are 2-1. Odds of 2-1 mean the public believes that if the race were run 10 times, the horse would win 33% of those races. Suppose, however, that you believe the horse's true chances of winning should be, say, 50%, or expressed in track odds, 1-1. In other words, you believe the public is underestimating the horse's true chances of winning the race. Using the standard $2 betting unit as an example, the horse, if it wins, should return $2 on your $2 bet for a total of $4, but because the public has underestimated the horse's true chance of wining, a $2 wager will actually return $6. That is what is called an overlay: a horse whose true chance of winning is underestimated by the public. An underlay is a horse whose true chance of winning is overestimated by the public.

That is the concept of value at the track. As you can see, it's not much different from the stock market. At the risk of oversimplifying things, value investors buy stocks that they believe are undervalued by the investing public. Value handicappers bet on horses that they believe are undervalued by the betting public.

Identifying underlays and overlays is necessary in order to reach a judgment on risk versus reward. To add a slight twist to things, there's also the magnitude of the risk/reward calculation that must be taken into consideration. Traders must be keenly aware of the risk/reward relationship of their positions at all times. The best handicappers approach the races the same way.

There are traders who play by the tick, and as short-term day-trippers they wouldn't dream of spending more than a few hours in a position. There are also position traders who couldn't care less about the minute-to-minute ticks and instead focus on moves of a greater magnitude.

For the professional horseracing bettor who is at the track every day, an overlay is an overlay is an overlay. It doesn't make a lot of difference if the overlay in the race is 2-1 or 20-1. As a weekend player, however, I am uninterested in an overlay for the sake of an overlay. Instead, I focus more on identifying underlays that I can bet against, or overlays going off at pretty big odds. The reason for this is that being a weekend player with a day job, I have the luxury of not being forced to bet dollars to win nickels. The guy who makes his living at the track doesn't always have that luxury. The same goes for the short-term trader. If the market is giving you ticks, you don't always have the luxury of sitting things out and waiting for points. You have to take what the market gives you.

Below is a standard odds line with the odds on the left and the percentage of winning to which those odds correspond. The only way to determine if the horse you like is an overlay or an underlay is to construct your own odds line.

In order to construct your own odds line, simply assign the percentage chance of winning to each horse in the race based on your own beliefs. The total of your odds line must equal 100%. The first difference you may notice between your personal odds line, and the morning line odds in your program, is that the morning line odds do not total 100%. The total SHOULD be 100% of course since there is a 100% chance, and only a 100% chance, that one horse will win the race. The track odds maker is burdened with the task of not only making a line that he believes will correspond to the way the public bets the race, but also with attracting capital into the betting pools. You may notice that morning line odds typically total around 120-125%. The extra 20-25% accounts for track takeout, about 17%, and breakage. When you factor in the takeout, you are down 17-20% as soon as you place a bet, win or lose.

Of course, personal odds lines are subjective, but constructing one helps you avoid betting on underlays. As you can see, with a track takeout of 17%, you are down significantly before the race is even run. If you bet on horses who are going off at odds that overestimate their chance of winning then you further compound the uphill battle you are already fighting from the onset, and the race hasn't even been run yet! If betting on horses is ultimately a path to the poor house, then betting on underlays is the quickest route there.

Now, some people prefer plain vanilla positions, while others like things to be a bit more exotic. Oh relax, I'm talking about their betting strategies. I am an exotics player and rarely place straight win bets unless I like a horse that is 10-1 or more.

Straight win bets are like long-only stock positions that are all-or-nothing propositions. If you buy a win ticket on your horse, then the horse must finish first or you get nothing. A slightly hedged approach is to bet your horse to win, place, and show. If your horse finishes third you will lose your win and place bet, but at least get a small amount of your money back.

Exotics wagers, though, are like the options market of the racetrack. The basic exotics wagers are the exacta, where you pick the first and second place finishers in order; the trifecta, where you pick the first, second, and third place finishers in order; and the superfecta, where you must pick the first four finishers in correct order. Because these wagers are more difficult to predict, the potential reward is much greater, corresponding of course to the increased risk. They also give you some degree of leverage since the payouts compensate for the higher degree of risk. A $2 win bet on a 20-1 longshot will return $42. A $2 straight exacta that selects a 20-1 shot over an even money favorite may return as much as $160. Leverage.

Like options strategies, exotics wagers can be as simple or as complex as you like. Let's look at some examples using the trifecta. Remember, a straight $2 trifecta requires you to select the top three finishers in exact order. This bet is inexpensive, and features the potential for great reward, but is very risky since it offers absolutely no margin for error. Your selections must finish in order, or you get nothing.

A more complex trifecta bet is a $2 trifecta box where the three horses you select can finish in the top three in any order. This may seem like a good idea at first, but with a trifecta box you've simply increased the number of your bets from one to six since you're simply covering all six potential combinations that include the three horses you've picked. This, of course, requires more capital outlay. A straight trifecta, one bet, will cost $2. There is only one way to win with a straight trifecta. A trifecta box is six different bets covering all possible combinations of finish with the three horses you've chosen. The cost, therefore, is $12.

You options fans may have already noticed the real problem with the trifecta box bet: it weights equally all possible combinations. If you believe the three horses you've selected all have an equal chance of wining the race, and all three horses are going off at overlaid odds, then that's not a problem. In reality, however, it is rare that you will find three horses in the same race with an equal chance of winning. If you do, there's likely something wrong with your methodology.

The answer to this weighting problem, similar to common methods of portfolio management, is to choose a core position and then trade around it to mitigate near-term directional risk.

I know that you're thinking this is quite a stretch of our analogy, but bear with me and follow this closely. I don't think it makes financial sense to bet multiple exotics combinations that equally weight all potential outcomes. To solve this problem I focus on selecting a core position, called a key horse, and then trade around this core position with other horses who I believe have the potential to disrupt things. This reduces the total cost of the bet, allows me to use more than three horses when I need to, and places the bulk of the weighting where I want it to be, on my key horse.

This bet is called a trifecta part wheel. With this bet, I'll typically use my key horse on all trifecta tickets in first, second and third. I then choose other horses with which to trade around this key horse. As long as my key finishes in first, second, or third, and two of the other horses I select land in the other two money spots, then I will cash the ticket.

This is what it looks like in its simplest form:
$2 trifecta part wheel where 1 is the key horse.

1, 2-3-4, 2-3-4 = 1 must win and 2, 3, or 4 must finish in second and third for $12.
2-3-4, 1, 2-3-4 = 1 must finish second and 2, 3, or 4 must finish in first or third for $12.
2-3-4, 2-3-4, 1 = 1 must finish third and 2, 3, or 4 must finish first or second for $12

Of course, this is a simplified part wheel. I'm not limited to using only 2, 3, or 4. I can vary the horses, add more horses in the third spot, etc. As I mentioned, exotics strategies, like options strategies, can be as simple or as complex as you like.

In the world of options equivalency, you may have already noticed that this is really nothing more than a synthetic win, place and show bet on my key horse with some leverage built in. Since I'm a weekend player, and an inveterate longshot bettor at that, I look for homeruns not singles, so this fits my style.

In some respects, an individual race can also be looked at as similar to, say, a sector index. "Whoa", what?!? Stay with me. A typical race may have anywhere from 6-12 starters, or components. Given my style, to me the most attractive betting situation at the track is when the public chooses a "false" favorite, or a horse at very low odds, that my methodology suggests has a dramatically lower chance of winning the race than the public estimates.

Similarly, a powerful combination for an equity trader may arise when she believes a particular component in a given sector index is likely to seriously underperform the other components in the index. (For ease of argument we'll assume this is an equal-weighted index in this overly simplified example). One way to profit from this thesis is to go long the index, and strip out the weak stock by selling it short. If the thesis proves correct, the short will make money and add some juice to the positive movement of the index.

At the track, this same phenomenon can be especially lucrative if the favored horse finishes out of the money. Exotics combinations that include favorites typically pay at underlaid odds because the public overemphasizes the favorite in their own exotics wagers. By selecting a key horse in this situation, and then including the other potential combinations that exclude the favored horse, I can effectively strip the horse out of the index and profit at overlaid odds if the favored horse finishes out of the money.

And you thought betting on the horses was strictly for cigar-chomping retirees with white shoes! Oh, it's still possible to have a nice day at the track betting on the colors of the jockey silks. It's just that I prefer my entertainment to be a bit more thought-provoking than that.

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