Monday, March 30, 2009

Here and Now Valuations Versus the Reasonable Range of Future Forecasts/GM/

I would not view Obama's tough love approach to GM and Chrysler as a negative but as a net positive development.  Yahoo! FinanceSure, both of them may end up having to file for bankruptcy but that is the only viable option for them without more substantial changes in their business models and cost structures.   Chrysler is not a viable company as a stand alone, and trying to save it as a separate entity is not a viable option.   Maybe it would be a viable option if there was no Honda, Toyota or Hyundai.  I do not see any reason to create an alternate reality with taxpayer's money as if time had shifted back to the early 1970s.  I am actually glad to see that Obama is taking a sensible approach to them rather than just showering them with more money as wards of the State. 

Turning back to my discussion about managing risks for the consumer staple stocks from last nightDuality of Long Term Risks/Stocks Under $5: Per Se Lottery Tickets/, I have not yet taken full positions in most of the ones that I want to own for the long term period.   I still see opportunity risk.  When I am concerned about significant further downside risks, and a realistic possibility of being able to purchase shares at a lower price, I will frequently slice and dice the acquisition of a full position into multiple orders.  For example, Nestle would be a position where I would hope to own at least 150 shares, but I currently own just 30.    Another way that I manage risk when I am concerned about opportunity risk is to trade the position to arrive at lower cost basis.  The shares that I own of Coca Cola now, after my recent tradeSold 1/2 KO at 44.2: Risk Reduction/BOUGHT 30 WL=Lottery Ticket/Bernanke on AIG/Disney Downgrade by GS, have an acquisition cost of $38.72. Stocks & Politics: Buy of KO at 38.72/Newt Gingrich & GOP Ideology on Financial Regulations/UTX/

Sometimes I refer to the "here and now" method of valuing a security, to be distinguished from a rational valuation using reasonable predictions about the future.  Maybe if one starts to engage in predictions about the future, then you need to make a lot of them just to be right about one or two.  I am not so much as talking about a specific prediction, like GDP falling 6.15% this quarter or unemployment peaking during this down cycle at 10.2% in January 2010.  Instead, I am referring to a reasonable range of likely occurrences,  so there is nothing specific about the forecast except a reasonable range of probabilities.  An illustration may be helpful.  I have previously referenced Federal Reserve data on three month treasury bill rates since the early 1980s.  This is a link to the weekly data since the early 1980s.   http://www.federalreserve.gov/releases/h15/data/Weekly_Friday_/H15_TCMNOM_M3.txt
What conclusion can I draw from this data?  Can I say that in December 2010 the rate will be 3.5%?  I can not make any specific forecast about the future course of this rate, except that it is likely to be low for several months.    I can say with some reasonable level of confidence that the rate will bounce all of the place over the next twenty five years, and an average yield of 3 to 4%, as a low prediction, over the course of that time span would be a reasonable forecast.   A 1% to 3% forecast would have a low possibility attached to it, while a 4 to 6% would be more likely than 1 to 3%.   Now what does this have to do with anything?

Recently, I bought a few floaters tied to the 3 month treasury bill.  One had a guarantee of 3% and a float provision of 1% over the 3 month treasury bill rate, GJN.  Another floater tied to the three month bill without a guarantee is GJR.   Now, if the three month T Bill was currently 5%, what is the likelihood that the here and now valuation would be $12 for this security which would then have a current yield under this hypothetical of 12.5%, plus another 100+% at maturity in 2035.    Now, remove the concern that J P Morgan may not survive.BUY 50 GJN/Japan Sinks Deeper into the Mire/CBG Upgrades/Law Enforcement On Vacation for Mortgage Fraud/New Home Sales Up   I suspect the security would be priced significantly higher based on the perceptions of those here and now assumptions.   When the three month treasury bill was higher than now, say in the summer of 2007 when it was close to 5%, and there was no concern about Morgan's survivability, this security was priced near its $25 par value GJN Stock Charts - Strats Tr Jpmorgan Cap Xvii Stock Market Charts - Free Stock Charts.  I would have zero interest in it at that price, because I am not looking at the here and now when making my decision whether or not to buy it.  I am looking at the range of possibilities over the life of the security, and then calculating my potential average yield taking into the consideration the discount to par value.   So, when I ignored the here and now rate and calculate instead a reasonable range of future possibilities based on past experience, I found that a mere 3.3% average treasury bill rate over the life of this security would generate a total return, if held to maturity with par value paid then, of almost 13.25% per year until 2035, with an acquisition at $12.    

 

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