Stock Market Downside Bets

As mentioned in “Prisoner’s Dilemma” I posted a while ago, most efficient teamwork requires absolute faith and discipline from every player. Conflict between individual and collective payoff exists in continuous time. On top of all this, majority of people do not act rationally. It then makes sense that most business type games do not operate in the most efficient manner where maximum potential payoff could occur. The next logical suggestion sets forth that the average multi-staff business has a higher probability toward failure than success.

OK, the question lies in how we can exploit this for profit. Most simply, downside bets on the stock markets. Allow me to illustrate why and how it is done.

An economist visited AUT early 2007 and lectured regarding corporate crisis management. He mentioned that 1 out of 3 corporations experience a crisis every 5 years that it will never recover from. Sounds pretty serious. Enron, WorldCom, AMD, CROX and the New Zealand finance companies come to mind.

David Birch, former head of a business data mining firm, proposed the following Survival Rate of new businesses.

• First year: 85%
• Second: 70%
• Third: 62%
• Fourth: 55%
• Fifth: 50%
• Sixth: 47%
• Seventh: 44%
• Eighth: 41%
• Ninth: 38%
• Tenth: 35%

The numbers show that the conventional “90% failure rate” stands completely unfounded. Despite that, new businesses in general have the odds against them after five years of operations. According to this data, 1 in 2 businesses face failure after first 5 years of operation. This also concurs generally with the “business cycle” theory of economics majors.

Keep in mind if the business goes completely under, your investment on the downside bet would profit close to 100%. E.g. in the last couple of bullish years, a downside bet on the NZ financing companies would have taken losses of 10%-15% each year; and as the funds became fudged, the downside bet would have made well over 50-90%, hence a positive expectancy.

What moves the prices of stocks? The gist of it lies in supply and demand on the exchanges. When volume in initiated buy orders overwhelms sell orders, price moves up, and vice versa. Rational long term investors or short term traders may put in large buy orders making price climb, but sooner or later they will want to take profit, or cut losses. All the while, there is absolutely no guarantee whether the seller would repurchase the stocks.

In other words, there is certainty that stock holders will eventually initiate sell orders creating price drops, yet there is not of anyone recommitting in buying shares of the same stock needed for a rally. This observation alone puts the downside bets at better odds than upside.

Behaviorally speaking, even the professional fund managers “panic” when it comes to low grade holdings. As soon as they realize how worthless anything has become, they would want to dump as much of it as possible while trying to preserve capital. Of course the potential buyers would demand substantial discounts for taking on further risks. This phenomenon explains partially why asset values tend to decline at higher velocity than growth. Another advantage toward the downside bets.

Two simple approaches exist to accomplish this for individual stocks.
1. short-selling positions
2. Put options

I will not get into details of what they mean. Look them up, a sea of information on them exist on the internet.

Research becomes easy when you look for a hopeless business. With the past corporate accounting shenanigans, we all know companies like to fudge their financial statements to appear profitable with promise of further growth. However, they do not have as much incentive to present misleading negative information as demand for their stocks is needed in order to finance business operations.

With that, if the financial statements look great, it still remains questionable; yet if the numbers seem awful, they are probably true. I would suggest the following to precede downside bias for a listed company.

• Low total cash holding vs. Market Cap
• High P/E ratio
• High Debt/Equity ratio
• Low Short Interest

Low cash means the company will not likely able to afford any repurchase of their own stocks, drying up supply. A high P/E ratio would give institutional traders a sentiment of “over-valued”, and consider selling to take profit. A high debt/equity ratio displays how financially disconcerting the company has become. Lastly, the earlier you get in on the short action, the more you will likely make in profit. You do not want to come “late to the party”.

Of course a wealth of additional information could provide a trader with higher winning rate. The above would give anyone a definite edge compared to some newbie “investor” who buys and holds hoping for some Warren Buffet pipedream.

Jesse Livermore, a great stock trader, made several hundred million dollars in 1929 shorting the railroad stocks. Goldman Sachs made several billion dollars last year making downside bets on mortgage backed credit derivatives. When the fudge comes, it becomes a game of hot potato. The buy and holders face blowing up, while the downside bets rake in profits. Which side will you take?