Equity Markets

Many of us would be no stranger to equity or more commonly financial instruments known as stocks. Before venturing into trading and investing in the equities market, it is imperative for us to have a basic understanding of why companies issue equities and how we may study a company through its stock price.

A key mistake many traders may make including myself initially is that we are overly fixated on the price. We believe that buying higher priced shares would mean that we can buy fewer of them, and hence make lower profits when a price run up occurs. However, this is untrue because as traders, the % price increase is a bigger factor in determining P/L and hence, the only reason why prices should be taken into consideration would be to determine the legitimacy of the firm. For many penny stocks, there is a high likelihood of insider trading and manipulation which is a big no-no to retail investors.

Personally, a rule of thumb i abide by is dealing less with penny stocks unless they are backed by venture capitalists or have other sources of legitimate fundings. For such firms, the nature of how their industry work largely dictates that they raise fundings through private investors and venture capitalists rather than raise capital through issuing equities. One such example would be in the case of biotech, where medicinal breakthroughs are largely reliant on company internal funding or private investors rather than rely on the broader market.

As a beginner, there are many areas that I have to learn on my own before setting up my own equity trading account. These may be listed in the points below

• What is the commission rate for my brokerage?
• What is my time horizon?
• What is my maximum risk?

1.  Commission Rates : Depending on the brokerage services used, there are varying commission charges and this could affect your realized P/L when you trade. FOC brokerages that I have taken note of so far would be RobinHood which many US traders make use of due to its commission free structure. However, do take note that it offers very minimalistic features and the app isn’t very well built unlike other services such as CMC Markets or IG.
2.  Time Horizon: Do I require this amount of money in the next month? How long can i leave my investments to grow? These are questions that needs to be addressed in order to build an investment strategy accordingly to realize profits/ take losses when necessary
3. Risk: Avoid being an emotional trader. Instead of relying on emotions to take profits and losses, look at them objectively and take losses/profits when they hit a specific threshold set earlier. I have faced situations where i made an emotional call and it hit me hard in the face but I cannot emphasis how important it is to make a tough call when necessary. Taking a loss on my FL share has probably been one of my toughest call yet but it was one that was necessary after making a rational decision listening to its earnings call.

The equity market is a booming marketplace where we hear people screaming BULL, BULL on a daily basis, with skeptics in the background warning us of an impending meltdown. My personal anecdote is to wash out these white noises and analyze the firm fundamentally on a financial basis. Looking at the firms’ future outlook, its cash balance and management, this allows us to have a holistic view of what we are vested in for the near future.

There are many methods to value a firm and some of the more common tools would be using P/E ratio, CAPM model for intrinsic stock value or DCF to predict the future cash flows. Analysts have been largely unable to agree on one specific analytical strategy to take but my personal favorite is to compliment fundamental analysis alongside short-term technical analysis to better position myself in when market strength is weaker and share prices are dipping. However, do not panic if u bought a share when it dips and it dips further. Many well-known investors like Joel Greenblatt have even came out to say that they rarely buy at the absolute dip point, but rather they buy it at a price where they are comfortable with the ensuing dip given the future potential of the firm.

 

Understanding the Subprime market crisis

The subprime market crisis evolved to be one of the largest financial breakdown for our financial markets between 2007-2010. Market crisis can be one of the largest opportunities for investors and to some, the worst nightmares. Equity prices fell and many who went long in the market fell short as the looming bear crashed upon them.

To truly understand the subprime mortgage crisis, we need to first break down the key players involved. “House-owners” held mortgages, “Financial Institutions” such as Investment Banks bought these mortgages and structured them into products and “Investors” referring to Hedge and Trust funds bought these products.

The Bull market was running strong at that time, with equity, bonds and money market growing more liquid. This injection of liquid cash was exacerbated by Alan Greenspan’s decision to lower interest rates to 1%, which led to two different response by the market. For investors, they were no longer interested in purchasing T-bills due to the lower rate of returns (R.O.R) while for corporations and banks, borrowing power strengthened due to the cheaper interest rate. Investors now seeked a new haven to grow their money and this eventually led to them buying mortgages over which would be covered below.

Money was highly liquid, meaning it was able to move quickly from one party to another and it was the key leading to the crisis. When liquidity froze, the parties are no longer able to meet their obligations and this led to the subprime mortgage crisis. So what exactly is a subprime mortgage? A subprime mortgage refers to banks underwriting loans to individuals who are deemed to be unsuitable, SIMPLY due to their wish to generate more income through selling these mortgages. This income can be generated easily through commissions as intermediaries such as investment banks and banks matched the home owners and investors together. In exchange for purchasing these mortgage contracts over, the investors are promised payments from the homeowners who pay their monthly requirements.

At this point, it is important to understand what a Credit Default Swap is and its impact on insurance companies such as AIG. A credit default swap functions similarly to an insurance policy, in the sense that it provided security for investors to take over the mortgage contract in exchange for maturity value in the case of a default. Cheap premiums led to high uptake rate and premiums on CDS were cheap simply because the risk was perceived to be low at that time.

Things went fine for a while as investors, financial institutions and homeowners were happy, believing it was a win-win situation. When a subprime owner defaulted, banks were fine with it, since housing values were increasing at that time and this meant they still had a growing asset on hand. However, the housing market functions like any other markets. The growing number of vacant houses due to subprime defaults meant that the supply of houses outgrew the demand, leading to a fall in property value. This was the first sign of the many troubles to come for Financial Institutions.

As an existing homeowner, many saw the value of their houses dropping and realized it made no sense to pay a loan of $400,000 for a home when the market value is now way below that. These homeowners soon decided to default as well. Overnight, FIs are now faced with a new problem, their income stream has popped and turned into physical assets, which has little value given the plummeting prices of housing. The FIs are unable to structure them into meaningful products for investors and investors realizing the severity of the issue, no longer bought these mortgages.

Credit froze as money stopped flowing through these financial channels and physical assets like housing lost their values. The end result was the collapse and bankruptcy of major players such as Lehman Brothers. Even for companies such as AIG, they suffered heavy losses due to the CDS and had to be bailed out by the US government.

The subprime mortgage crisis was an ugly page for the financial markets but one filled with lessons to be learnt. In fact, the Dodd-Frank act was erected soon after to regulate bank activities to prevent similar crisises from reoccurring in the future. Many has said that a financial crisis only occurs when there is a trigger point and in this case, I believe it to be the burst of the housing bubble due to oversupply of housing. Given our 7 years of bullish market that has followed since the crisis, could a potential crisis be on the horizon for us?

P.S. It is interesting to note how the final transcript for Lehman Brothers’ final earnings call mentioned how they were still feeling good about the mortgage exposure, showing how many failed to foresee the impending demise for Lehman Brothers which was understandable, simply because we believed that they were too BIG to fail.

Attached below is the URL to the transcript for those interested.

Click to access LBHI_SEC07940_1139550-1139578.pdf