Monday, August 8, 2011

When to fade a sharp

Picture of a roll of cashFair warning; I'm bringing some sports betting terms into this post because these were the terms that I felt best articulated the credit downgrade issued by S&P on Friday and Nate Silver's resulting post.

In sports betting a "sharp" is someone who knows what they're doing, they're the smart money. If you've seen the movie "Casino," Robert De Niro's character is a sharp.

Betting with the sharps is a good way to make money in sports betting, but it's not that easy. Some sharps are so well known and so good that when they make a bet the whole market reacts, and a flood of money will come in on the same side as the sharp. Most books will watch these sharps moves as well and adjust their lines accordingly.

To alleviate this, many sharps, because their bets are so influential, will purposely bet a line one way early in the week in an effort to push the line in a direction to their liking and then at the last minute money will pour in on the other side of their initial wager.

Because of these reasons betting with the sharp's isn't always easy and for many sports bettor's, finding a sharp to bet with isn't nearly as profitable as finding a square to bet against.

To "fade" someone is to bet against them with the knowledge that they are a terrible sports bettor. The key to this method isn't finding someone who loses money betting sports, anyone who picks half their bets correctly will still lose money because of the juice, the key is to find someone who is so bad they beat the market in losing.

Which brings me back to the point of this post; Nate Silver has found that rather then the sharps many figured they were, S&P is actually the square we should be fading:

In fact, the evidence from the past five years suggests that it may be worthwhile to adopt a contrarian investing strategy that specifically bets against S.&P.’s ratings. If you were trying to predict a country’s default risk today, based on the market’s perception of its default risk two years ago as well as its S.&P. rating at that time, you would find that accounting for S.&P. ratings actually subtracted value from your model. That is, if the market had priced two countries as having a 20 percent default risk in 2009, but one of them had a AA rating from S.&P. and the other had a BB rating, the country with the worse S.&P. rating is likely to have proven to be the safer bet.

The whole article is worth a read, but this is the takeaway, S&P doesn't have a clue what it's talking about and would have cost you a lot of money over the last few years if you had taken their ratings seriously.

And we can see that dynamic in action right now; France's bonds are currently rated by S&P as AAA, while the US's are rated at AA+. Meaning that even though they are much more exposed to the debt troubles of Greece and Spain and Italy, and their debt to GDP ratio is about the same as the US, S&P thinks French bonds are currently a better bet then US bonds.

To which the entire global investment community laughs and instead places their bets on US bonds.

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