My Take on the Goldman Sachs Allegations

BACKGROUND: here is Felix Salmon going in to really great depth on the Goldman Sachs S.E.C. allegations for those of you unfamiliar with the story.

I'm personally long Goldman Sachs (GS) after they lost almost $13 billion in market cap today. The settlement is expected to be in the hundreds of millions of dollars, and GS as a whole only made $4 billion off of subprime bets in general.

Obviously the market is expecting this to have residual effects on their other lines of business, however when I look at the landscape for the business they're involved in I think they've got a pretty good lock down. I would expect GS to distance themselves from the ABACUS events, and potentially blame it on the actions of a few individuals rather than GS internal protocol.

They may end up being liable, however if the trial of the former Bear Stearns hedge fund managers is any indication, some times it's hard to get these charges to stick. Especially since Goldman is going to throw A LOT of money at this to try and make it go away.

This may be my own personal bias, but Goldman Sachs has the ability to snap up the best and brightest minds. If you get a job offer from them, you think long and hard about dropping everything to give it a shot. I'm not going to say I necessarily morally agree with the sorts of things they do, but in terms of having the capacity to make money, they certainly have it. When you have the best minds and a corporate culture that rewards you very well for making contributions to the P/L, you're going to continue to have success in the financial services industry.

Is Volatility Getting Cheap Again?

One of the indicators that I like to watch, if for nothing else than for entertainment value, is Barron's Investor Sentiment readings. Last week, depending on which indicator you look at, Bullish consensus ranged from 41.3% to 70%.

One of the questions I constantly want to be asking myself is whether the market is getting complacent, which I would argue is the primary cause of bubbles. I would posit that if the market starts to get too single minded, market efficiency starts to weaken and you start seeing opportunities to take advantage of the follies of other market participants.

Just looking at the way the Dow Industrial Average has been moving (i.e. in terms of scale of the movements), things seem to be quieting down in the market. The standard deviation of daily returns for the Dow Industrial Average has dropped from 2.38 percentage points (from the beginning of 2008 to the end of 2009) to 0.82 percentage points (YTD).

Even when you look at the Dow during a more "pleasant" period of time (mid 2003 to end of 2007), standard deviation of daily returns is 0.74 percentage points, not that much lower than where we are now.

But the key test for whether the market is getting complacent or not is to look at implied volatility. The most common metric for this, the VIX, does so by backing out volatility expectations from S&P 500 put and call options expiring in 30 days (CBOE methodology). When you look at historical VIX levels, the answer to this question is debatable.

Will the Future Be More like 2004 to July 2007 or 1992 to 1999?

These are the two times periods for which there is VIX data that I would call "good" for shareholders. What I was curious about was what the VIX level looked like during these periods.

For 1992 to 1999, you have a geometric mean of 17.03, arithmetic mean of 17.90, and standard deviation of 6.02. For 2004 to July 2007, you have geometric mean of 13.52, arithmetic mean of 13.71 and standard deviation of 2.35 for the VIX.

These are obviously very dramatically different numbers, and the most reasonable explanation for the higher values for the 1992 to 1999 period was the tech boom, and the volatility that that presented. That was a bull market the likes of which was unseen previously, so perhaps an expectation that that will happen again in the near future is foolish. So if you're looking at 2004 to July 2007 as the most likely market climate for the upcoming future, the VIX, which closed at 16.23 today, is still a little bit high.

That being said, 16.23 is the lowest level the VIX has closed at since December 10th, 2007. Depending on how you're feeling about the economy, now might be an interesting time to try and profit off of volatility underpricing.

Trading Strategies

The simplest option would be to buy futures on the VIX, or check out the VXX or VXZ, two ETNs managed by iPath (Barclays).

Another option would be to literally buy options on the S&P 500 to perform a straddle. This would be done by buying a put and call at the same strike price, presumably with the strike price at the current market price. Your hope would be (presuming strike price is market value on day of purchase) that the closing price on the day your option expires would be the strike price plus or minus the sum of the premiums paid for the put and call options.

I've also written another article on volatility: Getting Exposure to the VIX as a Hedge: Is it Conditionally Correlated to S&P 500 Returns? if you're interested in reading it.

The Dangers of Anecdotal Evidence

Perhaps it's something that has been embedded in us by the process of evolution, but humans seem to really enjoy articles, snippets, and stories from real human beings rather than data.

Consider every instance you've ever heard of someone doing something that objective reason and presumably some sort of data would suggest is wrong. This could include driving very infrequently yet choosing to lease, or buying a can of Coke every day from the local corner store when one could save 50-75% of this cost by buying a twelve pack and bringing the soda from home.

Now think of when those instances match up with a story or personal experience that seems to fly in the face of data or statistics. "Well my friend blah-blah bought her car and then the engine went out and she had to pay (large sum of money), so I just lease now". Or "my sister so-and-so used to bring her sodas from home, but then one day some of the cans exploded and ruined everything in her pantry, so now I just buy my soda from the corner store on the way to work".

These stories are extremely appealing, because we can identify with them. You imagine yourself in that situation, and since it happened to your friend/family member, it seems to suggest the probability is high that it can happen to you. If you look at this person's experience as a foretelling of what will happen to you (i.e. probability of negative event = 100%), then making a choice that goes in the face of objective data makes sense. However, it could just be that the probability of the effect is fixed, and your friend or family member just happened to be on the wrong end of the probability distribution.

While citing personal experiences to show how personal anecdotes are oftentimes blatantly false is a logical absurdity in and of itself, consider the following article that was on the front page of Yahoo! Finance this Saturday. Entitled: "How My $499 iPad Purchase Became a $1,170 Credit Card Bill", by Jeff Fox from ConsumerReports.org, the article instantly grabs your attention because of the large change, as if to suggest Apple is tricking you.

The article itself is a misnomer because one of the first things Jeff says is that he decided to get the $829 64GB 3G model (because you can use it with more than just Wi-Fi) that evidently releases later in April. Right there, the article should have simply become "How a $829 purchase became $1,170", but Jeff seems to suggest that he was "lured in" with the $499 version.

The other $341 comes from a greater insurance and tech support plan and accessories, all of which Jeff had the choice to purchase. I personally resent the fact that he seems to be suggesting that Apple made him buy these additions. To make his point even more ridiculous, if you go to the Apple website and begin trying to purchase an iPad, all of the accessories are defaulted as "no", which is counter-intuitive if Jeff is right and Apple is trying to pull a fast one.

Outside of the error in trying to make Apple sound like a baddie is the justification for his splurging on additional memory. Jeff states: "As for stepping up to the 64GB iPad, my philosophy is that you can never have too much memory. I have no doubt that I will fill much of that 64GB within the next year or two. Speaking only for myself, the breathing space was worth the extra couple of hundred dollars."

I find this comment particularly hilarious, because if Jeff was most concerned about memory, why not have simply bought a net book, which for around $360 dollars can give you 290% of the memory and 60% more processing power than the 64 GB iPad? (the iPad only has a 1 GHz processor whereas most net books baseline at 1.6 GHz. The iPad beats net books in weight however by being roughly a pound lighter).

Jeff had essentially narrowed down the known universe of purchasable products to between the the higher and lower memory iPad 3G models because of prior selections he had made. When you consider the additional price he paid for the memory in the spectrum of the computing world, the extra cost/amount of memory added seems like highway robbery.

I think that Jeff speaks for a lot of Apple consumers in that his purchasing decision seems to have been driven by the presentation of the product and its ease of use. I'm personally too practical to buy a product who aside from it's touch screen and lower weight is already obsolete from a processing and memory standpoint, yet costs more than double that of competing net books. (granted tablets and net books are by definition not the same, but do accomplish similar tasks by being "mini-PCs")

This isn't the first time I've written about Apple products (see: Is Apple Really the Fourth Most Valuable Company in the United States? ), partly because I find the cult of product so fascinating with this company. If you were to ask a robot which he/she would be willing to pay more for, my guess would be the one that was the cheapest in terms of computing power/dollar (presuming the two products were made with the same quality of components). This doesn't play out the same way in the real world, and I think it's a perfect example of the impact of the "human factor": how presentation and ease of use can put value multipliers on products that are inferior from a hardware perspective.