Post Take-Over Announcement Plays-Part II

Yesterday we looked at buying stocks on take-over companies just after the news of the proposed acquistion was announced. We saw that if one had bought the stock at the closing price on the day of the announcement one could reap an average annual rate of return of around 8.7%. (The data was based on analysis of 57 companies during the period between March through July of last year.) At the end of the article, I wondered if one could do better by buying at the opening price. I crunched through the numbers this morning and here are the results:

You can see that you'll do better in general by buying at the open, but not because the opening price was lower than the closing price. Actually, the data showed that half the time the opening price was better and half the time the closing value was better. What made the difference were the three times when the opening price was significantly lower than the closing price, by more than 5%. There were three other times when the opening price exactly matched the closing price.

There was one instance where the opening price was significantly lower than the closing price. This happened on May 1st, 2007 when Newscorp announced their take-over bid for Dow Jones. Since take-overs of this type are unusual occurrences, I removed it to see what the numbers would like. The results are indicated by the Special Case in the above table. You can see that the standard deviation becomes a more reasonable value, although the total returns are reduced. But hey, an average annual return of 9.5% ain't too shabby.

So if you're looking to play this strategy, the moral of the story is to buy on the open. Another way to play it in shaky markets is to wait a week or two and see if the stock drops. Even take-over targets are subject to market direction and if you think the overall market is due for a breather, sit tight and wait for the price to drop.

But the mo' bettah play is to hunt for potential take-over targets. That's where you'll make the really big bucks. In an upcoming blog we'll look at the criteria inherent to take-over candidates and see if we can put together a portfolio of potential targets. Ta-ta!

Post Take-Over Announcement Plays

One of the holy grails in trading is to find companies that may be potential take-over targets because if one can correctly identify them, the rewards can be considerable. A take-over announcement can boost the acquiree's stock price by 10%-50%, although share increases in the 10%-25% range are usually the norm. That's nice work if you can get it, but it's in the getting them where lies the rub. Factors that go into trying to figure out what companies are ripe for the picking include low price to book value, companies in sectors that are undergoing consolidation, and technical factors such as unusual options volume which can be a sign that people are trading on inside information. (It's illegal but it's done every day.)

Correctly identifying a potential take-over candidate can be very time-consuming and ultimately unrewarding. More often than not you will be wrong which could wind up costing you a lot of money on many failed speculations. But I got to thinking, what about playing stocks after the take-over has been announced? Can one make any decent money on them, or will it only amount to chump change?

To test out my hypothesis, I looked at 62 companies that announced they were being taken-over between March through July of last year. I set up my simulation to buy each stock at the closing price of the day the take-over was announced. Then I checked the date the stock was acquired and the price at which it was sold. The results actually surprised me. Before I present them, I have to say that the data is based on 57 companies. Those are the ones where the acquisition was completed. In two instances, the deals fell through completely. In one case, the merger was extended and is still pending. In the last two cases, the mergers are still pending but are on shaky ground because of regulatory hurdles in one and a reduced financial outlook in the other.

So, without further ado, here's what I found:

1. The average time for a merger to complete (from announcement to the final take-over date) was about 4 months with a standard deviation of around 2 1/2 months. This means that 68% of most mergers occur between 1 1/2 and 5 1/2 months. (For you statistical wonks out there, the median was around 3 months.)
2. The average gain/loss per stock was +2.9% over the holding period. This result assumes that an equal number of shares of each stock were purchased at the closing price on the day of the take-over announcement. (This value would be different if an equal dollar amount were bought.) The standard deviation of the gain/loss was 2.75% which means that two-thirds of the stocks ended up gaining between 0.15% and 5.65%. There was one stock that gained 17% because the original offer price was subsequently raised. Two stocks actually lost value. One was due to a merger battle, and I couldn't find a reason for the other.
3. If we assume that the average holding time for each stock is four months, then this results in an average annual return of 8.7% (2.9% x 3).

You may yawn at an 8.7% return, but basically this is done without incurring a lot of risk. So far, only two of the proposed mergers have fallen through, which is a 3% failure rate. Not bad. There aren't many portfolios out there that can boast a number even close to being that low. A major drawback to this strategy is that M&A activity is at the mercy of the markets. This means that during down markets such as now and especially during the current credit crisis, M&A activity is reduced. During bull markets, this certainly isn't the best strategy to use to increase your returns, but it's still not a bad one especially for those of you who are highly risk averse.

Final Note: The above data was derived from the closing prices, but if you pounce on these at the open, you can probably do a bit better. Hey, that's not a bad idea. For tomorrow, I'll look into this further and see if there's a measurable difference in the rate of return between using the opening price and the closing price, so stick around!

Cooking Tools #4: Cup and Handle Bases

A useful tool that traders use to determine when a stock is breaking out is the Cup and Handle (C&H) base. William O'Neill, the founder of the daily financial newspaper Investor's Businees Daily (IBD), was the first to coin the phrase in his book How to Make Money in Stocks which is a valuable resource that every serious investor should read. This chart pattern forms the basis of O'Neill's CANSLIM method. It's a proven method of identifying stocks that are breaking out and one that deserves a closer look. If you're unfamiliar with this chart pattern, read on. My point here is to acquaint you with the pattern so that you'll know what to do should it arise in the chart of one of your stocks or if you see it while perusing the charts of others.

The Cup & Handle Pattern
The basic pattern looks like a rounded cup with a smaller handle and represents a triple top. The shape typically looks like a drawn-out, rounded U shape rather than a sharp V. You want to look at the overall cup shape since minor fluctuations within it are usual. The pattern can last anywhere from two months to two years, In general, the longer the cup takes to form, the stronger it will breakout. The usual correction from the top of the cup (point A on the chart below) to the bottom (point B) typically varies from 12%-33%. Downturns greater than that suggests that there is something fundamentally wrong with the stock and should be regarded with caution. The left side of the cup is accompanied by an overall decrease in volume (there may be the occasional volume spike in there due to some sort of news) , and the right side of the cup is formed on gradually increasing volume (point C).

The handle is formed after the base is completed where the price returns at or close to the left side of the cup. Traders see that the price is returning to its resistance level and begin exiting their positions, thus forming the right side of the handle (C to D on the chart). Note that the volume decreases during this period. You should note, too, that the bottom of a true handle should never be more than the low point of the base. It's okay if the right side of the cup is lower than the left side, but if it's too much lower, then the subsequent breakout needs to be stronger. The recent daily chart of Volterra Semiconductor (VLTR) illustrates the cup and handle pattern.

How to play it: On daily charts, handles typically take one to two weeks to complete their formation. The way to play this pattern is to wait until the handle has formed and the stock breaks the high point of the cup's right side (point C) or what O'Neill terms the pivot point. This breakout must occur on heavier than normal volume (at least 50% heavier) for it to be a compelling buy. If the stock breaks out on mega-volume, this is a signal that institutions are pouncing on it and you should be, too.

Caveats:
1. You may have been patiently following the stock and noting its pattern, but it is foolhardly to buy the stock before it reaches its pivot point. Why? Many stocks just do not make it back to their pivots and end up declining in value. You need to wait for the stock to prove its strength before jumping in.
2. Many stocks breakout without ever forming handles. A handle isn't completely necessary but stocks that form cups without handles are more prone to failure.

Ways to play it: When you see a handle forming, set a price alert at the pivot. When the stock hits that point, you can do any of the following:
1. Buy the stock by entering a quarter or a third of your intended position at the breakout. Wait several days or weeks to gauge the strength of the price movement. If the general trend of the stock is up, keep adding to your position on price dips (such as when it hits a supporting moving average).
2. Buy call options in increments mentioned above. You can also sell out-of-the-money puts to finance your calls.
3. Call ratio backspreads. This is a fancy term for an easy concept. Here, a lower strike call is sold (usually at a strike close to the pivot point) and two (or more) higher strike calls are purchased. I won't get into the details of this strategy here, but I wanted to mention it because it's a favorite of many options traders who use it to play breakouts. The beauty of this strategy is that it sometimes can be put on for a credit (or a very small debit) while minimizing margin. Should the stock move a lot in either direction, a profit is realized (if the stock was put on for a credit). Even if the stock doesn't move, the amount that one risks is usually less than if one had purchased the stock outright. If you're not familiar with this strategy, you can check it out using the options links on this page.

As always, it's prudent to paper trade any of these strategies for a few months before putting your own hard-earned cash on the line. For more information, check out Investor's Business Daily and Bill O'Neill's book. IBD has daily charts that include stocks that are currently forming cup and handle bases.

Day-trading C&H patterns: The cup and handle pattern isn't just the province of long-term investors; many day-traders use this pattern on five minute or even one minute charts. Usually when a stock makes a dramatic climb at the beginning of the day, it spends several hours testing its new level. This is when you might see a cup and handle form. If the overall market is still trending up, the stock may make a breakout late in the day. Sometimes the stock will break out right before the close. This is a good time to buy as the odds favor a strong breakout gap when trading resumes the next day.

The Market & The Brokers

Today we're stepping out of the ivory tower and wading back into the market moat. I was hoping that today's market action would be a follow-through on recent upward movement, but unless there's an end of day rally, it doesn't look like we're going to get it.

Last week the volatility index (VIX), a measure of market fear or risk, dropped below its 200dma and has remained there since. That's a good thing. For my taste, however, it needs to start moving below 20 and stay there before I'll be convinced that the worst is over. Also, the S&P (SPX) has been toying with its 1400 resistance level, and it will need to break that on heavy volume for me to be a true believer.

There are two high notes. One is that the Dow Transports (DTX), considered to be a leading indicator of market direction, did break through major resistance of 500 last week and has been in an upward trend since the middle of March. In fact, all of the major indices have been trending up since then, as I'm sure you know. The other bright spot is that the Q's (QQQQ), the Nasdaq 100 tracking stock, also broke its $46 resistance level. I think that if the market can hold through the next Fed meeting on interest rates scheduled for release this coming Wednesday, we may have the beginning of another bull market, albeit a tepid one considering that energy prices continue to rise, unemployment is rising, and the consumer is spending less. These are all factors that will figure into the equation so be careful about backing up your truck because you just might hit a brick wall.

Being wishy-washy is a way to cover one's butt and there's a lot of financial pundits out there who are doing just that, but this time I'm giving them a break since the financial crystal ball is very cloudy indeed. One ray of hope that the market may be turning up is to look at the current movement of the major brokerage firms. They've been rising stealthily for the past month, and if recent earnings news is any indication, their futures may indeed be bright.

Ever since the four-eyed credit-crunch ogre began to rear its ugly head early last summer, the brokers got whacked, declining 25-50% in value. Most of them put in a double bottom this January and rushed back up only to get beaten down again. Then came March 17th when JP Morgan shocked the investment community by offering a ridiculously low $2/share for Bear-Stearns. The news tanked all of the brokerage stocks, but since then they've been staging a rather nice comeback. Three of the major firms, Goldman-Sachs (GS), Morgan Stanley (MS), and Lehman Bros. (LEH), all just reported earnings that beat estimates. Only Merrill-Lynch (MER) reported earnings that were basically in-line. However, that didn't seem to hurt the stock much as it, too, has been on the rise.

So should you be a buyer of these brokerages? Except for Goldman, I would wait. All of these stocks are still trading below their 200dmas. I'll be more interested in them when they break overhead resistance on heavier than normal volume: MS at $55, LEH at $50, and MER at $50-$51. I think it was Guy Adami on CNBC's Fast Money who said about a month ago that Goldman is a screaming buy. (His words.) The company reported good earnings on March 18th and yesterday broke its all-important $180 resistance level. Today, it's flirting with its 200dma. You go, Guy! (I really wanted to say that.)

Knight Capital (NITE) is my other favorite. The firm surprised Wall Street last week with better than expected earnings, and recently broke its $18 resistance level. The stock is still climbing higher, trading up over a buck since Monday. [Note that most of the major brokerage stocks pay a low dividend except for Knight which pays none.]

What about the online brokers? Most of them have been rising in sync with the institutions, although their charts aren't quite as compelling. Perhaps this reflects the fact that they didn't beat earnings estimates as most reported in-line, except for Etrade (ETFC) which reported worse than expected earnings. Right now I'd stay away from this stock, at least until the company can trim the fat and turn around to profitability which analysts think may take at least two quarters. The star of the group is Interactive Brokers (IBKR) which blew out estimates today causing share prices to jump 10%. This is the best banana of the bunch. Both Schwab (SCHW) and TD Ameritrade (AMTD) are rising, but I can't really say if they're good buys at this level. Their performance will probably depend on the direction of the overall market.

If you're like many investors whose portfolios got whacked this year, maybe one way you can get back at your broker is to buy them. Yeah, that'll show 'em!

MPT-Part IV: Asset Class Correlation & Fund Proxies

Today is the final installment of Professor Pat's dissertation on Modern Portfolio Theory (MPT). In it, he'll be looking at the correlation among asset classes and will also provide you with fund recommendations that you can use as proxies with which to construct your own portfolio. But before I hand this over to the Professor, I want to thank him for providing us with his insight into MPT and for generating these tables which involved research trips to the local university's business library and many hours of computer modeling. I am deeply grateful for his valuable time, knowledge, and effort.

Tomorrow we will return to our regularly scheduled programming. Take it away, Pat!

Correlation Among Various Asset Classes
Additional asset classes added for consideration should preferably be uncorrelated or negatively correlated to the other asset classes for best results. The relation between how asset classes or securities move relative to each other is defined by what is known as the Pearson correlation coefficient. The table below shows the Pearson correlation coefficients for each of the asset classes to one another. A value of +1. indicates perfect correlation while a value of -1. would reveal total negative correlation in the sense that when one asset goes up in value the other would go down in the same proportion, and vice versa. A value of zero demonstrates no correlation between the two asset classes; that is, they behave independently. (Note: The Pearson coefficient assumes a Normal distribution of data.)

As expected, large stocks and small stocks are highly correlated to each other. That is, when one class goes up or down in value there is a good chance that the other class also goes up or down commensurately. On the other hand Long Term Government bonds and REITs behave as two uncorrelated processes totally independent of each other. What this table confirms is that there is a sufficient lack of correlation between the various asset classes to present a suitable set of alternatives from which to compile a portfolio that can be counted on to behave according to the precepts of MPT.

Let's now look at a comparison of the returns and risks of an optimally allocated portfolio with those that contains just one asset class. The table below shows the average annual return and volatility of the individual asset classes over the 1927-2007 time frame for the expanded list of asset classes.

We can see, for example, that a portfolio holding only large stocks would yield an average annual return of 12.3% but do so with a standard deviation (our measure of risk) of 20.0%. Compare that with an optimally allocated portfolio (given in the chart in yesterday's blog) where the return is 13% but the risk has been reduced to 19.0%. Similarly, a completely conservative portfolio of safe U.S. Treasuries would return an average of 3.8% annually with a standard deviation of 3.1%. We saw yesterday that an optimum conservative portfolio can return a higher 4.2% at an even lower risk level of 3.0% just by adding long-term corporate bonds and some REITs to the mix.

There are many interesting observations to be gleaned from these tables such as the high volatility of REITs and the counterintuitive performance of Long-Term Corporate bonds versus Long-Term U.S. Government bonds where Corporate bond returns display the expected risk premium but the volatility is actually lower. Perhaps a closer examination of the actual composition of the comparative fund holdings might provide an explanation for this.

Asset Class Proxy Recommendations
Earlier, I recommended Vanguard as an excellent family of mutual funds. I do not work for Vanguard and know them only as a satisfied customer. An investor interested in forming a portfolio along the lines of the nine asset classes discussed here will find the following Vanguard funds as suitable proxies for them. Vanguard does not currently offer an International Bond fund so a T. Rowe Price no load fund with a reasonable expense ratio is listed. (Dr.K Note: Vanguard isn't the only firm offering these type of funds. Check Morningstar for other comparable funds and note transfer fees among fund families.)

The 500 Index Fund (VFINX) for Large Stocks.
The Small Cap Index Fund (NAESX) for Small Stocks.
The Long-Term Investment Grade Fund (VWESX) for Long-Term Corporate Bonds.
The Long-Term Treasury Fund (VUSTX) for Long-Term Government Bonds.
The Intermediate-Term Treasury Fund (VFITX) for Intermediate-Term Government Bonds.
The Treasury Money Market Fund (VMPXX) for U.S. Treasury Bills.
The REIT Index Fund (VGSIX) for U.S Real-Estate Securities.
The Total International Stock Index Fund (VGTSX) for International Stocks.
The T. Rowe Price International Bond Fund (RPIBX) for International Bonds.

In summary, we have shown that diversification provides real measurable benefits and that you, the investor, can use the tools of MPT to quantitatively measure reward versus risk in forming an investment portfolio that is suitable for your circumstances.

Thank you for allowing me to introduce you to the concepts of Modern Portfolio Theory.

Note from Dr. Kris: Pat has expressed a desire to provide one or two future articles on the evolution of MPT into PMPT, or Post Modern Portfolio Theory which challenges some of the assumptions inherent in MPT. (Don't worry, the information provided here is still valid.) We'll be looking forward to further installments. Thanks again, Professor Pat!

Modern Portfolio Theory-Part III: Extended Asset Allocation

Today is the third installment of Professor Pat's dissertation on Modern Portfolio Theory (MPT). In it, he'll be including three other uncorrelated asset classes that can be added to a portfolio that will not only increase returns, but lower risk as well. The floor is all yours, Prof. Pat!

Adding international stocks, bonds, and REITS to your portfolio
In Part II of this article (yesterday) I presented some options for optimum portfolios using six basic asset classes. Today we will examine the effects of adding more alternative asset classes to the list of portfolio options. We will see in quantitative terms how broadening the diversification of an investment portfolio not only increases returns but also lowers risk. Any additional asset classes added for consideration should preferably be uncorrelated or negatively correlated to the other asset classes for best results. The following asset classes meet those criteria:

1. Real Estate Investment Trusts (REITs) performance per the Dimensional Fund Advisors (DFA) U.S. Real Estate Securities Index.
2. International Large Company Stocks per the DFA International Value Index portfolio of non U.S. Stocks.
3. International Bonds composed of the DFA Five-Year Global Fixed Income Index Fund.

Using annual total return performance data for each of these asset classes from 1927 through 2007 to match the data as for the other basic six asset classes as described yesterday, I applied the mathematics of MPT to come up with the following table:

In comparing this table to the one from Part II (with fewer asset classes), you can see that the minimum return has been slightly increased with no increase in the standard deviation which is our measure of risk. Actually, for all levels of portfolio return the risk level is the same or reduced. By adding the proper mix of international stocks and bonds to a portfolio measurably decreases risk. In Part II we looked at the 11% return level. You can see the addition of international stocks reduces portfolio risk from 14.9% to 14.1%. Note that there is no downside to this--the lower risk is obtained at no cost or penalty. The portfolio at this level contains about 7% Large-cap US stocks, 21% Small-cap US stocks, 4% Long-Term Corporate bonds, 43% Intermediate-Term Government Bonds, and 25% International stocks. The overall decline in the recommended level of Large U.S. stocks in favor of Small U.S. Stocks and International Stocks is noteworthy.

From the above table we see again that Long-Term Government Bonds are an unattractive component in an investment portfolio. No wonder the 30-year treasury was abandoned!

One thing this table is telling us is that maintaining a component of international stocks or bonds in your portfolio is very beneficial. While they may not be completely uncorrelated with the movement in the US stock and bond markets, they do serve as a currency hedge against a declining dollar.

So, how do you, the investor, take in all this data and decide which level of risk and return and hence which portfolio allocation is suitable for your personal situation? One question to ask yourself is how much draw-down can you tolerate? (Draw-down is the financial term for decline in value.) There are a number of criteria you should consider in answering that question.

1. Time horizon and cash needs: These dictate how much time you can allow your portfolio to compound in value. If you won't need to tap into the assets of your portfolio for many years means that you can take greater risks, but you must also be willing to accept short term declines. If your tolerance for risk is low, then choose a slightly more conservative allocation. Folks nearing retirement should limit their risk and opt for the most conservative allocations. The precise allocation depends on how much money they'll need to withdraw from their accounts and how long they'll need their portfolio to last.
2. Standard of living: The size of the portfolio relative to the needs of the investor to maintain their living standard also plays a part in the determination of suitable allocations. A portfolio sized far in excess of the retirement needs of the investor can be more aggressive. Conversely a smaller portfolio that constitutes a safety net or is targeted for specific needs such as a child's college education or wedding should be allocated more conservatively with greater surety of being intact if or when it will be needed.
3. Current income level: The level of current income outside of the portfolio contributes to the investment allocation decision as well. If the investor is able to earn a living from income without touching the portfolio then again a more aggressive stance can be assumed. The reliability of this income is another contributing element. Those more secure in their employment can assume more risk; those who are unsure should not.
4. Risk tolerance: Your attitude toward risk and your emotional ability to see your nest egg temporarily drop in value is important as well. Investors should ask themselves if they will tend to panic and precipitously sell out when things go south thereby missing out on subsequent recoveries. Again, those with tendencies toward pessimistic gloom and doom should remain conservative and comfortable accepting lower expectations.
5. Investment knowledge: The last criterion is your degree of investment knowledge. Greater knowledge and your ability to understand the various reasons why things go up, why they go down and what to do or not to do about it allows a greater risk tolerance.*

The portfolio allocation decision is as much art as science. MPT has provided the science component but it is ultimately up to you to properly and rationally assess your individual needs and expectations in making the final selections. If you don't think you have the ability to make these decisions on your own, I would suggest finding a good financial advisor who can help. (If you don't know any, ask your friends or family members for recommendations.)

The next and final installment of this article will discuss asset class correlation, the validation of optimum allocations over portfolios dedicated solely to individual asset classes, and recommendations for specific mutual funds that can serve as suitable proxies for these asset classes. Hang in there, for the last installment is chock full of good stuff!

*Note from Dr. Kris: Savvy investors with a lot of money in their portfolio can elect to include futures and/or options trading strategies to lower their portfolio risk while increasing returns. For one example, see my April 17th blog on using derivatives to add value while reducing risk in your portfolio.

Modern Portfolio Theory-Part II: Asset Allocation

Today we continue with the column of guest blogger Professor Pat who provides us with the second installment of his treatise on Modern Portfolio Theory. Yesterday's blog provided an introduction to Modern Portfolio Theory (MPT) and today he'll be discussing how to optimize your portfolio using the results of MPT. Although the Professor doesn't like to toot his own horn, I just want to say that some of the data presented in the table today and in the next installment are derived from historical data run through the Professor's own MPT algorithms and won't be found anywhere except for perhaps in brokerage firms. So lead on, Professor Pat!

Portfolio Construction & Optimum Asset Allocation
Last time I introduced the concept of Modern Portfolio Theory (MPT) and described what it was and why it might be of interest to a certain type of investor. This time we will look at some actual data and examine the results.

The core philosophy behind MPT is to construct a portfolio of uncorrelated (or relatively uncorrelated) asset classes. Two assets are said to be uncorrelated if they react differently to market events. For example, the stock market and the bond market are two asset classes that are relatively uncorrelated as bonds usually perform better when the stock market is suffering and vice versa. The point of MPT is to construct a portfolio consisting of relatively uncorrelated assets in ratios that will give the investor the return he expects while minimizing risk.

Ibbotson & Associates, a firm with expertise in asset allocation and recently acquired by Morningstar, publishes a yearbook where they present time series data for six major U.S. asset classes back to the late 1920's. These classes are:

1. Large U.S. Stocks as currently represented by the S&P 500 Index.
2. Small U.S. Stocks defined by the Dimensional Fund Advisors (DFA) Microcap Portfolio.
3. Long-Term Corporate Bonds measured by the Citigroup High-Grade Corporate Bond Index.
4. Long-Term Government Bonds, currently a 20-year Treasury Bond.
5. Intermediate-Term Government Bonds, a 5-year Treasury Note.
6. 30-day U.S. Treasury Bills.

Using annual total return performance data for each of these individual asset classes from 1927 through 2007 and applying the mathematics of MPT to that data, I was able to construct the following table.

To use this table, you must choose the desired rate of return incorporating your tolerance for volatility or risk. (The standard deviation, the second column in the above table, is the measure of portfolio risk.) You should not merely chase the highest potential return; you should also consider your ability to accept years in which sharp draw-downs in the overall portfolio value may occur. This is the major tenet of MPT.

Investors nearing retirement, when they will start to withdraw investment funds, will need to avoid the possibility of those declines happening just when they will be selling. In that case an aggressive allocation should be converted to a more conservative one. For example, the average return from the most conservative portfolio would be 4.1% which would be achieved with a portfolio of 1.7% Small Stocks, 5.4% Long-Term Corporate Bonds, and 92.9% Treasury Bills. This represents the safest possible portfolio in that it provides the smallest variation in return from year to year. In any one year there is an approximate 68% chance (see the last installment of this article) that the actual return will be within one standard deviation. In this case, the return can be expected to vary between 1.1% and 7.1% (4.1% +/- 3.0%) In other words, the chance of a decline in overall portfolio value over any given year is small.

A more aggressive investor with a longer time horizon, such as a person in his 20s -30s, might choose a higher yielding allocation but he must also be willing to accept the risk of short-term market declines or intermediate-term lackluster returns. He must do this so that he will be properly invested during those times where the previously underperforming assets become out-performers.

Small stocks have historically produced the highest overall returns over the long haul as indicated by the table. We can see that an average annual return of 17.3% can be achieved by a portfolio that is 100% invested in small-cap stocks. This return, though, is realized at the cost of very high volatility. In 1973, for example, the loss in the small stock asset class was about 31% followed in the next year by another 20% hit. The following nine years, however, saw a nice recovery with a whopping average annual appreciation of 36%. Regardless of your risk tolerance, the table does indicate that some exposure to small-cap, high-growth stocks is advantageous.

It is interesting to note that the above table recommends that Long-Term Government Bonds are not an attractive investment to hold in any portfolio. Who knew?

Most investors will want to choose an allocation that moderates the volatility risk while still providing a healthy average return. One such selection is at the 11% level. For such a return there are chances of small declines in any one year but reliable gains over time for most years. The portfolio would consist of approximately 27% Large stocks, 30% Small stocks, 16% Long-Term Corporate Bonds, and 26% Intermediate Term Government Bonds. This allocation has the advantage of including one additional asset class over the 10% level for greater diversification.

If the reader is interested in following a course of action along the lines of MPT using these asset classes I recommend the Vanguard family of funds for their low expense ratios and respectable performance. (Note: I have no affiliation with Vanguard other than being a satisfied customer.) It's also good to note that index funds have very low to no year-end capital gains distributions which means your taxes on them will be minimal to none.

In my next installment, I'll discuss the effects of expanding the number of asset classes to include international stocks and bonds as well as real-estate investment trusts (REITs). See you tomorrow!

Modern Portfolio Theory: An Introduction

In last Thursday's blog we looked at the concepts of alpha and beta in terms of maximizing portfolio returns while minimizing risk. Those concepts are an integral part of a larger subject known as Modern Portfolio Theory, or MPT. This theory determines how investors should allocate their holdings to achieve a specified return with the least amount of risk. Since my knowledge of MPT is minimal, I thought I'd turn over today's blog to Professor Pat, a colleague of mine who is well acquainted with MPT and uses it to allocate his own investment portfolio. For the record, Pat is not technically a professor in the usual sense of the word. He doesn't teach MPT on the university level but his knowledge on the subject is so vast that he probably could. I'm using the term here in its second definition as one who professes or instructs. So, without further ado, I'll let Professor Pat take it away and perhaps we'll all learn something from his elegant discourse.

Modern Portfolio Theory (MPT): The Background
Thanks, Dr. K, for letting me present the ideas behind MPT. Since this is such a large subject, I'm going to split it up into several segments. Today, I want to describe the theory in general and its importance to you, the investor. In subsequent columns, I'll present concrete strategies using results that have not been published anywhere that you can easily implement in constructing your own investment portfolio.

Modern Portfolio Theory (MPT) was first conceived by Harry Markowitz in 1952. For his inspiration and hard work he was awarded the 1990 Nobel Prize in Economics. Markowitz proposed that investors should be concerned not just with investment returns but also with investment risk, and put forth a strategy on how to achieve optimum performance using a mathematically derived allocation of asset classes.

MPT asserts that investors could and should balance the returns they receive on their investment portfolios with the risks those investments present. As such, and for the first time, a way to actually quantify the notion of risk was available. The new idea was that risk could be equated with volatility or the variation in returns from one time period to the next. The beauty of MPT is that it was also now possible to take this one step further and mathematically determine an optimum investment portfolio that delivers the desired long-term rate of return while simultaneously minimizing risk. The benefits of portfolio diversification in terms of risk reduction could now be mathematically derived. [Note from Dr. K: The math used in MPT is quite hairy and is beyond the scope of this discussion. For those of you who are mathematically inclined, you can research this further. Wikipedia gives a good overview of the math used in MPT. Good luck!)

An investment portfolio consists of various asset classes, some of which appreciate and some of which may depreciate within any specified time interval. The rate of change, or volatility, in the value of each class varies as well. Some investments move up and down together, some move up when others move down, while others are completely uncorrelated to each other. MPT takes advantage of this fact to determine not only which investments to invest in but how much of each you should hold relative to one another.

MPT can also be thought of as a type of portfolio insurance. As an investor, you hope that all of your investments will increase but you also know that this is an unrealistic expectation. MPT insures your portfolio against unreasonable losses by holding asset classes that can counteract losses in one class with gains in another. The way to achieve this is to select investment vehicles that are uncorrelated with each other. (More on that later.) A properly diversified portfolio also includes relatively low yielding assets (like treasuries) that can be counted on to produce steady and reliable gains. An important assumption of MPT is that the future will, on average, be just like the past.

MPT: The Theory
The techniques that are used in MPT to solve the optimum asset allocation problem is a branch of mathematics known as quadratic programming. There are two inputs to this program: 1. The actual historical returns of the various candidate assets input as a time series, and 2. The desired average rate of return that portfolio is expected to produce. The output of the calculations is the percentage to be ascribed to each asset class so that the entire portfolio will produce the input return while minimizing risk. MPT quantifies that level of risk with a number called the standard deviation.

The standard deviation, denoted in statistical terms by the Greek letter σ, is a number that provides a bracket range for the desired return. One standard deviation represents approximately 68% of the values around the the expected outcome. A basic assumption in MPT is that investment returns follow a pattern known as a normal distribution commonly found in natural processes.* Graphically, it forms a shape that looks like a bell as depicted in the illustration below. For example, if the desired annual rate of return is 10%, MPT might reveal a certain asset allocation strategy that would result in a minimum standard deviation of 11.7%. This means that approximately 68% of the time the actual return in any one year would fall in a range from -1.7% to +21.7%. (10% +/- 11.7%) The normal distribution also tells us that about 95% of the time the return will be the average return plus or minus two standard deviations, or between -13.4% to 33.4% in this example. The image below depicts these concepts. The dark blue region is one standard deviation,and the light blue region extends to two standard deviations. The symbol μ on the image is the average rate of return, or 10% in our example.















MPT is a useful tool for investors who prefer to remain somewhat passive in their investment activities. That is, they are not concerned with market timing. The optimum asset allocation technique tells them that they can remain comfortable with fluctuations in the market and limit their activities to quarterly rebalancing to preserve the correct allocations following increases or decreases in the value of individual assets held.

When we get to presenting the reality of these results, the data will confirm what everyone already knows: there is no such thing as a free lunch. That is, the higher the rate of return you wish to achieve, the more risk you have to be willing to take on. But we will see with numbers just how much more risk we'll have to take to achieve those higher returns or how much return we need to give up to achieve more safety.

The next installment in this series will present actual results using common investment classes and will show you how to assemble a portfolio needed to achieve your desired rate of return. Stay tuned!

*Dr. K Note: Post-Modern Portfolio Theory (PMPT) challenges this assumption, but for right now, it's a good-enough one.

REIT Covered Call Portfolio-Update

In my blog on March 17th, I constructed a portfolio of six high-paying dividend stocks and wrote the April covered calls against them. Since today is options expiration, I want to examine the portfolio and see how we did.

The stocks I chose all had to have dividend yields greater than 3%, pay a dividend between then and today, be optionable, and not be in a down-trend. All of the candidate stocks were REITs (real-estate investment trusts): Avalon Bay (AVB), Cali Realty (CLI), Developers Diversified (DDR), Entertainment Properties (EPR), Essex Property Trust (ESS), and UDR (UDR). I constructed a virtual portfolio of all of these stocks by buying 500 shares of each at the March 17th closing price and writing 5 call contracts on each at the option closing price. The call strikes were either at-the-money (ATM) or slightly out-of-the-money (OTM).

Fortunately, all of the stocks selected did quite well, gaining between 5-15% in value since then. I did make one mistake in selecting UDR. The information that was given to me from a person who shall remain nameless (Dimitri) stated that the UDR dividend was to be paid on April 15th. That was inaccurate as the dividend pay date is April 30th. Since the pay date is later than today, the day of options expiration, I'm not going to include it in this discussion. But if I had owned the stock, it would have returned over 5% with the covered call strategy which is not too shabby.

Here's how I set up the portfolio:
1. Used end of day data on 3/17 for the stock and options prices.
2. Used middle of the day data today (4/18) for the stock prices (I'm writing this before the close.)
3. Bought 500 shares of each stock and sold 5 April call contracts.
4. Commissions are included ($10/stock trade; $15/options trade).

The following is a chart of the parameters that were used. Note that all prices are on a per-share or per-contract basis.

Since all of our options expired in the money, all of our stocks will be assigned. That means that if we want to own them again, we'll have to go out and buy more. It also means that we didn't get to participate in any price movement above the strike price which is unfortunate since all of the stocks did very well.

The next chart shows you the difference in portfolio performance. The first column shows the returns on a portfolio with no covered calls, assuming that you would have sold your stocks today to realize these gains. The second is the covered call portfolio. Note that although the total return is a nice 7% gain, it's 4% short of the uncovered portfolio.

So what have we learned from this lesson? That covered calls aren't such a good idea? Well, yes and no. We would have done a lot better if we had waited to sell calls when the stock was making a new high, but if course one never knows when a stock is at a local high or is poised to go higher. Certainly, when the stock is taking a breather is not the best time to cover.

Perhaps a better strategy is to combine the two. That is, when your stocks and the market are moving up, you refrain from covering. During this time you'll own the stock and collect the juicy dividends. After your stocks have enjoyed a long run-up is when you might consider writing calls. This will offer you some downside protection just in case things start to unravel without digging into your profits.

The point I really want to make here is that paper trading your strategies will allow you to make better investment decisions when you do decide you're ready to put them into practice. I hope this exercise has done just that.

Alpha & Beta: It's All Greek to Me!

If you watch CNBC or read some of the financial journals, you've probably stumbled across the word alpha. Most non-institutional investors don't know what it means but they should since the attainment of alpha is the goal of every investor, whether he or she realizes it or not. So what is alpha? Alpha is nothing more than the excess return of a stock, portfolio, or fund over a given benchmark. I won't bore you with the mathematical equation for alpha, but it takes into account the price risk, or volatility of the stock or fund and compares its risk-adjusted performance to a benchmark, usually the S&P 500. The price risk is given by a coefficient named beta. Sometimes you'll see the beta of a stock listed under the company's profile. Beta is a measure of a stock price's volatility as compared with the overall market. Since the S&P is the typical benchmark, it has a beta of 1. A beta of 2.50 represents price movement that is 150% more volatile than the market; a beta of 0.50 represents a movement that is half as volatile as the market. Beta can be viewed as a measure of risk so that riskier stocks such as high-tech stocks typically have beta's greater than 1 while less risky stocks like utilities have betas less than 1. With me so far? Good.

Now let's get back to alpha. In the hedge fund world, alpha is of primary importance. Hedge fund managers are rated according to how much alpha their fund generates. (They're also rated according to their Sharpe ratio which is defined below.) A positive alpha of 1.0 means that the fund outperformed its benchmark index by 1%, and a negative alpha of -1.0 means that it underperfomed it by 1%. Alpha can be viewed as a measure of the fund manager's ability to generate profits in excess of market returns. This isn't that easy to do and sometimes the process of seeking alpha requires taking substantial risks which is why a lot of hedge funds that have invested heavily in mortgage-backed debt are in serious trouble right now.

Fund managers are usually paid in accordance to how much alpha their fund generates. The higher the alpha, the higher their fees (usually). Hedge fund managers with stellar alphas and high Sharpe ratios can take up to 50% of the profits! That's why many of them have homes in the Hamptons worth tens of millions of dollars, bid up oil paintings to ridiculous prices at Sotheby's, and flitter to and fro on private jets. But hey, if you're a high net worth individual with money in their funds, you're probably hob-nobbing with them, too.

If you're not a part of the jet-set, is there a way that an individual investor can increase alpha without increasing portfolio risk? Yes, via the theory known as “portable alpha.” In essence what this means is that an investor would invest some of his portfolio in securities (or other instruments) that have no correlation with the existing portfolio. (They're separating beta from alpha.) This typically involves leveraging part of the portolio using futures. I know that most people shy away from futures, but it's not as formidable as it sounds. Really. Let's look at an example.

Adding Alpha without Adding Risk
Let's say you have a portfolio of $200,000 invested in Treasury bonds (which are essentially risk-free) that are currently yielding 4%. You're not happy with that rate of return and would like to increase it without adding risk. You think that although the S&P has been lousy, things might be looking up and you'd like to invest 30% of your portfolio into the index. You believe that a 10% return on the S&P for this year is reasonable, if not even a bit conservative. So, instead of investing $60,000 into an S&P index fund, a better approach is to buy $60,000 worth of the S&P Emini futures. Although margin requirements for buying futures varies among brokers, we'll use 10% here. (My broker charges about 7%.) What this means is that you'll only need $6000 to buy the futures. So what do you do with the leftover $54,000? You buy more treasuries.

These leaves us now with a portfolio of $194,000 in treasuries and $6000 allocated to margin for the futures. At the end of the year assuming everything works out as planned, your rate of return will be 6.9% instead of 4% had you only owned treasuries. (4% x $194000 + 10% x $60000) You've increased your return by nearly 3% without adding portfolio risk. (Actually, your return will be slightly less since there's a built-in premium to futures contracts.)

However, you do take on another risk--that of event risk. If the stock market takes a nasty drop, you might be faced with a margin call in your futures account. In the event that this happens, you'll need to deposit more money into your margin account. To do this will require you selling some of your T-bonds to make up the difference. If the market corrects and you have now excess capital in your margin account, you can reinvest that into treasuries. Your new projected rate of return will be different and probably less than expected depending on the going T-bill rates.

That's it for the example. I want to emphasize that I've only scratched the surface on the discussion of alpha and beta. People have won Nobel prizes developing these concepts, so take heart if you don't quite understand them, but be assured that institutions do.

Portable alpha is used regularly by fund managers to add alpha to their funds without increasing risk. They do this by using futures to generate money that they can use to purchase other instruments they feel will generate positive returns, thus increasing alpha. And now, so can you!

The Sharpe Ratio
The Sharpe ratio is a measure of risk-adjusted return. Essentially, the Sharpe ratio tells us whether returns are due to smart investment decisions or are a result of excess risk. The higher the ratio, the safer the strategy. (Sharpe ratios greater than one are considered to be good.) It can viewed as a measure of the fund manager's consistency. Two funds may have the same alpha, but the one with the higher Sharpe ratio has better risk-adjusted performance. If you're comparing funds with similar focus and performance, look at their Sharpe ratios. The ones with the highest ratios will be the safer investments, although past performance is no guarantee of future results...

Cooking Tools #3: Using the CCI as a Timing Indicator

Probably the most important decision regarding trading stocks is when to get into a trade and when to get out of it. Traders use many technical indicators to determine this. The more popular devices are moving averages, support and resistance levels, price patterns, and candlestick chart patterns. (Price patterns and candlesticks were the subject of Cooking Tools #1 & #2.) Today we'll be looking at another tool to add to your arsenal of timing tools: the CCI which is short for the Commodity Channel Index.

The CCI was developed by Donald Lambert who introduced it in an article in the October 1980 issue of Commodities magazine (now Futures). It has since grown in popularity and is used by traders to identify cyclic trends not only in commodities, but in equities and currencies as well. Although it works best in cyclic markets, it can be also be used in trending ones too as we'll see shortly.

What is the CCI?
The CCI is an oscillator and like most oscillators it is used to identify overbought and oversold conditions. It does this by measuring the relation between price and the mean deviations from a specified moving average:

CCI = (Price - Moving Average)/(0.015 x Mean Deviation)

Essentially, the CCI measures how far away price is from the moving average and how fast it moved to get there. If the price is right at the moving average, the CCI value will be at zero. The constant (0.015) is used in the above equation as normalizing factor. It restricts about 80% of the values to be between -100 and +100. The theory here is that when the CCI goes way outside either of those two boundaries, the stock is either oversold or overbought.

Most advanced charting services offer the CCI. On a chart, it is commonly represented by a series of bars that are centered around a zero point. (See chart below) The trick to setting up the CCI is in the choice of moving average. Lambert suggests using 1/3 of a price cycle where a price cycle is defined as the number of days (or other time unit) between successive price highs or lows. For example, if a stock makes a low about every 90 days, then a 30 day moving average is used. From my experience, however, sometimes you need to play around with it to get the best fitting moving average. Be aware that sometimes the stock will change its cyclic rhythm, so what time interval has worked in the past may not work as well in the future. (Note that most charting services use a moving average of 20 as the default.) The following is a weekly chart of the S&P 500 comparing a CCI with a 57 day moving average (which I derived from using price lows) with a CCI with a 20 day moving average.

How to interpret the CCI
There are two ways to interpret this oscillator--one as a straight indicator and the other as a divergence indicator. There are many ways that this can be used as a straight indicator. One way is to go long when the CCI rises back above the -100 level and to sell when it drops below the +100 level. However, this can lead to a lot of whip-sawing. A better way is to go long when the CCI crosses into positive territory (above zero) and exit the long position when it falls below zero. I like to wait a day or two on either side for confirmation before entering or exiting a position. You can see from the above chart that if you were long the S&P, the CCI(57) would have kept you long until this past January when it finally dropped below zero for two weeks.

But the divergence in the CCI for the months preceding the drop would have clued you in to the fact that the market was heading for a reversal. This is the other way to use the indicator. If the stock is making new highs but the CCI isn't, the two are said to be divergent and a price reversal is on the horizon.

Another way to identify when a stock is greatly overbought or oversold is to look at the magnitude of the CCI. Extreme values--over +300 or under -300--signal that a stock has moved way beyond its moving average making a correction highly likely. This “tell” is especially useful if you have a short position. Any move off an extremely negative CCI number is a signal to cover.

Day traders will find the CCI to be a useful entry and exit tool, too, especially if several time-frames are viewed simultaneously. I used this method along with other indicators to daytrade the S&P Emini futures. It took me a month to get the hang of it, but it eventually worked out very well (although it burned me out!).

Because it's an oscillator, the CCI used by itself works best in sideways markets; in trending markets the CCI alone will lead to false buy and sell signals. This is when you need to loosen your interpretation of the indicator and only pay real attention to it when it crosses the zero line. Other indicators (like the ones mentioned at the top) used in conjuction with the CCI will help you to winnow the false signals from the real ones.

This has been a brief introduction to the CCI and by no means is it meant to be definitive. There are plenty of books on technical analysis that have expanded descriptions and uses of this indicator. Online, check out Woodie's CCI club which contains a lot of info on trading with the CCI. (www.woodiescciclub.com)

Good Golly Miss Mol(l)y!

If you've been keeping up with the financial news you'll know that infrastructure has been a hot topic in the past year or so. The reason for this is that emerging markets especially and China in particular are hastening to construct new roads, buildings, communications, etc. Their appetite for construction materials, natural resources, and equipment has been voracious and is expected to continue unabated for the foreseeable future. The stocks of companies engaged in providing these resources and services have, for the most part, been stellar performers and their names have become common via the financial media. But what hasn't been covered much (at least to my knowledge) are the companies engaged in the mining and refining of molybdenum, affectionately known as “moly” in the metals industry.

What is molybdenum and why should we consider it from an investing point of view? Molybdenum is a metal similar in appearance to lead. It's number 42 on the periodic table and has the sixth highest melting point of all the elements which makes it perfect for use in high-strength steel alloys. It's mined in sulfide form as molybdenite. It can be mined as the principal ore but it's also recovered as a by-product of copper and tungsten mining. Canada, the US, Russia, and China are the largest producers of moly. The metal trades as a commodity as molybdenum oxide. Only five years ago, the commodity was trading around $8 per pound. It hit a high of $40/lb several years ago, traded down to a low of around $25/lb and has been rising steadily since then. It's currently trading in the $33-$34/lb range.

Molybdenum has replaced tungsten in steel alloys because of its cost-effectiveness and effectiveness as a corrosion inhibitor. Because of its chemical and physical properties, it's used in other alloys that operate under severe conditions such as aircraft engines, heavy equipment, and high-speed drills. It's also used as a catalyst, lubricant, and pigment.

Currently, the supply of moly is meeting demands, but a shortfall is imminent according to some reports. Western demand is increasing by about 3% annually; globally, it's about 4.5%. The projection for demand in China is for a 10-20% annual increase. Add to that the fact that there are 48 nuclear reactors scheduled to be built by 2013 and 100 by 2020 which will require between 500,000 - 800,000 pounds of moly (used in the steel alloy) depending upon reactor design. One thing is for sure, if mines don't step up production there will be a shortage in the near future.

So what publically traded companies are actively engaged in moly mining? There are two companies devoted exclusively to moly mining:

Thomson Creek (NYSE; TC): Owns and operates mines in the US and Canada. It changed its name from Blue Pearl late last year.
General Moly (AMEX: GMO): Changed its name from Idaho General Mines in 2006. Owns moly mines in the US and also holds gold, silver, and copper properties.

Other companies that engage in moly mining are Freeport-McMoran (FCX), Rio Tinto (RTP), and to a lesser extent Southern Copper (PCU), and BHP Billiton (BHP). There are two foreign-based moly miners that trade over the counter: Grupo Mexico (GMBXF) and Antofagasta (ANFGY) which is based in Chile.

All of the above mentioned stocks have been doing very well. My picks of the litter are Thomson Creek and Rio Tinto, but I don't think you can go wrong with any of them. (Just be careful of the OTC stocks as they are very thinly traded.) Since February, Thomson Creek is up 43% and is trading at a new high; Rio Tinto has gained over 50% since January and is also threatening to make a new high. (Note that Rio is not cheap at $477. Has anyone suggested a split?)

If you're loathe to buy just one or two stocks, there's a basic materials ETF (AMEX: PYZ) which includes PCU and FCX among its top ten holdings. Although this isn't a pure moly play, you do get the benefit of diversification across the materials sector.

So let's make some profits from Miss Moly, by golly!

Sovereign Bank (SOV) -- An Update

Last month (March 13) we looked at Sovereign Bank (SOV) as being a potential candidate for an inverse head and shoulders formation. I was excited at finding it because as the normal formation is fairly rare in itself, the inverse pattern is even more uncommon. A colleague of mine, Carl, who heads a local hedge fund, said he didn't quite share my enthusiasm. He was chomping at the bit to short the stock, citing lousy fundamentals. I said that it might be prudent to wait to see if the formation completes itself before initiating a short position. I don't know if he took my advice, but his analysis of the company seems to have born him out.

At the time I profiled the stock, the chart had completed the left shoulder and the head, and was in the process of forming the right shoulder. I said that if the stock was able to trade above the neckline level of $13.30, a long trade to the $17-18 range would be viable. Unfortunately, the stock never did rise and the pattern was invalidated. Last Friday the stock traded under its previous low formed by the low point of the head ($8.71) and is trading lower today. For me, this would have been the signal to go short.

So if you're reading this Carl, kudos to you for the correct call! I bring this up to show that not every chart pattern works out as planned. You can see why it pays to be patient and wait until a pattern has completed itself before jumping in.

A Lemon-Drop Cookie

Yesterday I gave a recipe on how to play stocks that have suffered at the hands of price-crushing news. I said that it was a highly speculative play but I forgot to give my reasons on why I felt that way. Usually when the stock drops on bad news, it has a tendency to keep falling. Sometimes the stock will rally back, luring investors into taking long positions, only to have it tank shortly thereafter. This can be a devastating trap. To avoid damage to your pocketbook, you need to be vigilant and watch the stock movement on a daily basis. You also need to have a firm stop/loss in place which is something that many investors don't do even though they know better. But if you paper trade this strategy, read the news, and watch the charts, you'll develop a feel for knowing when a trade set-up has increased profit potential. Also, it helps to select stocks in rising sectors or sectors that are at least not in decline. As the saying goes, a rising tide lifts all boats so it helps, too, if the overall market is trending upward.

At the end of yesterday's recipe I said that I would illustrate this strategy with an example. The chart of Integrated Device Technologies (IDTI), a semiconductor stock, is a good recent example. Here's its chart:

You can see the stock (along with the semiconductor sector) has been in serious decline, losing half of its value in six months, from last August to this January. The company reported third quarter earnings after the market closed on January 24th. Although their earnings were inline with estimates, their outlook for 2008 was lackluster, citing weaker demand for its products. Two analysts promptly downgraded the stock from a buy to a hold. You can see what effect all of this had news had on share price: the stock gapped down the next day on five times normal volume and remained at this level for several days. One analyst was quoted as saying that the bad news was already out there, and apparently investors started feeling the same way as the stock began to rise. Ten days after the drop, the stock broke its flush-out day high point. This was the day to take action. The following are two scenarios that could have been employed. (Note: All prices quoted are closing prices. Commissions and fees are not included.

Initial Investment: about $800
Buy Date: 2/8/08

1. Buy 100 shares of stock @ $8.02/share = $802 initial cost
Current price: $9.80/share ($980 total value)
Gain (unrealized): 22%

2. Buy 7 May 7.5 Calls @ $1.05/contract = $735 initial cost
Current price: $2.40/contract ($1680 total value)
Gain (unrealized): 129%

You can see that buying calls would have been much more profitable than if you had just bought the stock, which is usually the case. However, if the stock drops below $7.50 by the third Friday in May, you will lose all of your investment. This is the risk of buying options.

If I had just bought calls, I would probably do two things at this juncture. If I was still bullish on the stock (and there's no reason not to be since it's still trending upwards), I'd roll-out my calls by selling the ones I have now and buying new calls at a strike price of $10 several months out. The reason is that about a month near expiration, options begin losing value due to time decay. The August 10 call is now being offered at $0.90 which would give me a net profit of $1.50/contract should I elect to do this.

If, on the other hand, I had only bought the stock, my action today would be to buy some puts as protection. Buying one May 10 Put contract at $0.60 would lock-in my profit. If the stock declines, the rise in value of the put will protect my position. I could also buy the May 7.5 Put at a nickel. Although this would help reduce my loss should the stock tumble below $8/share, it wouldn't protect me entirely. (If an $8 strike price was offered, I'd buy that.)

There isn't time nor space to go into every trading strategy I mentioned yesterday. My goal was to show you how the trade sets-up and to give you a taste of how to profit when a lemon cookie does drop into your lap. Happy snacking!

Tuning into the Media

Every day my financial inbox is crammed with newsletters, market updates, and the usual spam. Since my lackey Dimitri refuses to read them, I'm left with the task, and I have to say that I don't really enjoy most of it and usually try to find something else to do as well. However, there are a few that I find to be worthwhile and one of them is from a company called Investment U.* (Disclaimer: I have no personal or professional affliation with them.)

Yesterday's newsletter featured an article written by Floyd Brown concerning the status of the media sector, in particular radio and print. He is a contrarian, meaning that he buys stocks when everyone else hates them. How do you know when a sector has been grossly oversold? You know when you see articles in newspapers and magazines and the talking heads on financial news shows saying there is no hope for it. That, claims Mr. Brown, is currently the case with radio and print, and I might have to agree with him. Stocks in this sector are down 30-80% since a year ago.

But where my views digress with his are in the stocks themselves. He thinks that Clear Channel (CCU) is a screaming buy below $30 and gives very good reasons why. Despite a negative article in Fortune saying that Clear Channel's prospects are grim, the company grew revenues over 5% last year. They are starting to sell their underperforming assets (they sold 217 non-core radio stations just this February), and if they were to sell their billboard advertising business, Mr. Brown claims they could wipe out their debt. He says the company is a steal below $30. Maybe so, but looking at the chart, I'd wait until it goes back up to $30. Actually, I'd wait until there's some confirmation on the lawsuit mess they're in concerning their bank and private equity buyout which probably won't happen until the case goes to court in early May.

In addition to Clear Channel, Mr. Brown also likes Time Warner (TWX), Citadel Broadcasting (CDL), and Gannett (GCI). He says that the upcoming presidential elections as well as the Olympics will increase the earnings of these media giants along with their share prices. Sounds reasonable to me. My pick of these three is Citadel. The stock has lost over 80% of its value in a year and is now staging a comeback. Last year's acquisition of the ABC radio network along with the resignation of their CFO late this January has burdened the stock, but the company's plans for major restructuring of its radio stations is looking like it's starting to pay off. Time Warner looks like it just put in a double bottom and needs to push through its $15 resistance level for a rally there to be confirmed.

Other stocks that look promising:
The best looking charts among the more heavily traded stocks in the broadcasting group are the following:
EMMS - Emmis Communications: The chart showed not one but two bottoming tails in January and the stock has risen steadily, up 47% since then.
CMCSA - Comcast: The stock is up 25% since its January low and is bumping up against resistance at $21.
WON - Westwood One: This chart, similar to Emmis's, has been steadily advancing and broke out of resistance.
DISH - Dish Network: The stock looks to have put in a double bottom and is pushing against minor resistance. If it can start filling the gap at $33.50, I think it'll be heading northward for a while.
DTV- Direct TV: This stock took a nasty tumble last fall, staging an incredible 44% comeback since January. It's now trading at its pre-tumble level. I'd be a buyer if it falls back to its $24 support or breaks overhead resistance at $27.

For the moment, I'd leave Sirius (SIRI) and XM Satellite (XMSR) alone until their merger is finalized. The stocks are just too volatile, although if you want to play one of them, my pick would be Sirius as it's closing in on its $2.65 major support level. Also, it seems to have the most to gain from the merger. I'd also leave the print sector alone as many of the stocks are just now putting in bottoms...or are they? The New York Times is the one bright spot, enjoying a 28% gain since January.

I do agree with Mr. Brown that the rumors of media's demise are greatly exaggerated. I mean, these guys are no dummies, and I'm sure they'll find ways to streamline and reinvent their business models that include more of the emerging media technologies on the internet as well as in the marketplace. It's time for us to tune into these companies.

Now back to your regularly scheduled programming...

*For more info on Investment U and to sign up for their free newsletter, go to investmentu.com.

Earnings Etouffe Candidates

Since today officially kick-offs earnings season, I thought I'd go back to my first recipe, Earnings Etouffe, to see if we can't come up with some candidates for this strategy. The essence of this strategy is to identify companies who have raised guidance and then either buy the stock or buy call options on them. The stock or option is then sold just before the earnings release date. (For more info, see Recipe #1.)

Although there have been many companies that have recently raised guidance, the following table lists the ones that I felt had the most compelling releases, meaning that they raised guidance significantly more than most. Note that the earnings date followed by an “a” means that the company will be reporting after the market closes; a “b” means that they'll be reporting before the market opens; and a “u” means that the date is still unconfirmed. Companies will issue press releases to state exactly when they expect to report earnings, so if the date is unconfirmed, keep checking their press releases.








Which ones do I like? All the companies listed above have been doing well, and I'd be a buyer on any sort of pull-back. The only stock that concerns me at the moment is FCN. It's been in a down-trend for the past week and is closing in on its $62.75 support level. If it breaks that, then I'd wait until it turns around. Also, the chart of MANT shows recent volatility despite its long-term upward bias so if you want to play this stock, I'd wait for it to swing down to the $42-43 level. All of the above stocks are optionable except for PPO, and if you do decide to go the options route, make sure that the stock has liquid options (open interest > 100-200).

Note that this strategy is really only as good as the overall market. If indeed this is the beginning of a bull market, the likelihood that this strategy will pay off increases along with the strength of the bulls.

Now go out there and whip up some earning etouffe!

Are the Home Builders Constructing a Comeback?

CNBC this morning gave a quick report on the current rebound in the homebuilding stocks. Since I 've been busy getting my taxes together (argh!), I thought I'd take the easy way out today and look at this sector in more detail. The credit crisis took a wrecking ball to these stocks, with many of them losing 70-90% of their value in a little over a year. That's ugly. But recent Fed easing moves and with Congress getting into the act, the crisis looks like it's starting to abate. This could bode well not only for home buyers but home builders as well.

So, what are the charts of the home builders telling us? Naturally, one would expect major similarities among them, and there are. Most of them formed double bottoms in November and January. From their January lows, the stocks quickly sprung back until the beginning of February when they began oscillating in a trading range. The chart below of Standard Pacific (SPF) typifies this behavior.

In just the past few days, the following stocks have broken short-term resistance levels: SPF, Meritage (MTH), Beazer (BZH), M/I Homes (MHO), and Lennar (LEN). Those that have just broken short-term resistance and are approaching their next resistance levels are Ryland (RYL), Hovnanian (HOV), Toll Brothers (TOL), and Champion (CHB). Those nearing or butting up against resistance are Brookfield Homes (BHS), D R Horton (DHI), KB Home (KBH), Pulte Home (PHM), and Centex (CTX). If you're itching to get into these, I'd go with the those in the first or second group above. These stocks in general have been volatile and I particularly don't like the action in CHB. It's subject to extreme oscillations which is why it wouldn't be one of my top choices. Note that some of these stocks do pay dividends, with LEN, BHS, DHI, and KBH having dividend yields between 2.3-3.7%.

Hopefully these stocks are out of the basement and from here they can build us some profits!

Update on yesterday's candlestick play:
XRIT's hammer formation is invalidated as the stock is trading below yesterday's close. Now you can see why it's so important to have the follow-through day.

Candlestick Trend Reversal Patterns: Chart Examples

Yesterday I introduced the concept of using certain candlestick patterns to identify potential reversals in price trends. These patterns included shooting stars and hanging men which occur at the end of an extended rise in price and signal a bearish reversal. Scanning the charts this morning, I found one example that contains both of these patterns. It is the VIX, the volatility index. It's customary for these candlestick patterns to occur on heavier than normal volume, but since the VIX is an index, there's no volume associated with it, alas. I'm showing it anyway because it is just such a textbook example of these two patterns. Here it is.

You can see from the chart that both patterns are confirmed by the next day's follow-through where the price (volatility) gapped lower. (As a note, hammers and shooting stars occur much more frequently that the hanging man which is why I used the VIX.)

The chart of Freeport-McMoran (FCX) provides not one but two classic examples of a hammer. A hammer will appear at the end of an extended decline, again on heavy volume. The pattern is confirmed if the next day is up, preferably gapping up at the open. In this scenario, the bulls are gaining the upper-hand and many times the follow-through day occurs on heavy volume as well because of short-covering. These criteria are all met in the following chart.

You should note that these patterns are formed after an extended price trend; if you see them in the middle of a trend, they usually aren't very significant. Also, the charts of highly volatile stocks can produce false candlestick patterns, so be skeptical if you see a chart with a lot of topping and bottoming tails. As with all charting techniques, candlesticks aren't one hundred percent accurate. With practice, you'll be able to spot when a pattern is more likely to be valid than not.

I tried to find some charts today that looked like they might be setting up in one of these patterns. The only stock I found was that of X-Rite (XRIT) which looks like it formed a hammer today. The hammer isn't exactly a textbook example since it has a bit of a top wick, but it did trade on five times normal volume. We won't know for sure if the bulls are gaining control until tomorrow. Here's the chart.

Cooking Tools #2: Candlestick Trend Reversal Patterns: Hammers, Shooting Stars, and Hanging Men

If you're a beginning investor, you're probably looking at this title thinking that a candlestick is something used by Mrs. Green to off Colonel Mustard in the library. In the non-Parker Brothers world of investing (although successfully identifying chart patterns does involve a bit of detective work), candlesticks are a graphical representation of price and price patterns. Whereas a point and figure chart is represented by a series of vertical lines with horizontal handles that represent the opening and closing prices over a specified time period, a candlestick chart represents the same information but more graphically as illustrated in the diagram below.

The main portion of the candlestick is called the body. If the closing price is lower than the opening price, the body is typically shaded either black or red. In the reverse case where the closing price is higher than the opening price, the body is typically either white or green. (Some charting programs will let you select the colors for your candlesticks. I prefer the green/red schema.) The lines above and below the body are called the wick or shadow. They reflect the high and low price for that time period. Candlestick patterns are a graphical representation of investor psychology, and learning how to interpret them provides insight into market movement. Although there's an entire field of chartology devoted to candlesticks, I'm just going to touch on a few of the more useful and predictive patterns, specifically those that signal a market reversal after an established trend, so that you will be able to identify them and know what to do if these patterns crop up in your charts.

Bullish Reversal Pattern: Hammers
When a hammer is formed at the end of a long price decline, you can bet that a turnaround is imminent, especially if the next day's price action is to the upside. A hammer consists of a lower wick that is at least twice the length of the body and little to no upper wick. (A long wick is also called a tail.) The body of the hammer can be either color, but a white (or green) body is usually better. Why does this formation occur? During an extended down-trend, investors are understandably bearish. The stock opens and heads lower. Then the bulls step in and push the price of the stock back up, thus creating the long wick. The bears are now questioning whether the decline is still intact. A white body the next day would confirm that the bulls have taken control, especially if the price gaps up on the open. Note that the longer the bottoming tail, the more bullish the pattern. Here's what a hammer looks like:

Bearish Reversal Patterns: Hanging Men & Shooting Stars
Let's look first at the hanging man. A hanging man pattern looks exactly like a hammer, except that it occurs at the end of a long up-trend. The formation criteria is the same as well with the body at the upper end of the trading range. The color is not important although a black body is a stronger signal meaning that the bears are gaining control The pattern is confirmed if the next day is a black body or better yet, if it gaps down with a lower close. Again, the longer the tail, the higher the potential of a price reversal, especially if accompanied with higher than average volume. Typically, the volume on a reversal day can be quite large. Here's what a hanging man looks like:

A shooting star is just like the previous patterns except that the direction of the tail (wick) is reversed. It, too, signals the end of a bull run. The criteria for formation are just like the hanging man. The signal is enhanced if it gaps up from the previous day's close on heavier than normal volume. A lower open or a black candle the following day reinforces the fact that the bulls are losing control. Here's what a shooting star looks like:

This is just a brief introduction to candlesticks. There are many books and websites that cover candlestick interpretation for those interested in learning more. I wanted to introduce these concepts to you because I'll be mentioning these chart patterns throughout my blogs.

Tomorrow I'll see if I can find some charts that illustrate these patterns so that, unlike Colonel Mustard, you won't get clobbered by an errant candlestick should it appear in your stock charts.