Friday, May 30, 2008

On Wisconsin!

Next week I'll be spending time with the folks in the place where I grew up--America's Dairyland, aka Wisconsin. In general, when we're not battling mosquitoes or shoveling snow, we Wisconsinites are genial people probably because of our diets. Beer, brats, cheese, and an oompah band will put a grin on anyone's face...well, maybe not the oompah band. (Use an accordion, go to jail is my motto.) And we're not known as the Home of the Braves (until they upped and moved to Atlanta--grrr!) for nothing. I mean, how many other people are willing to risk making fools of themselves by wearing holey foam hats on their heads? Some people may label us as ridiculous but I prefer to think of ourselves as being courageous touched with a soupcon of self-deprecation. (Actually, it's probably just the beer talking.) Anyway, in honor of my homecoming, I decided to devote today's blog to Wisconsin-based companies.

When you think of Wisconsin companies, beer, sausage, dairy, and Harley's probably spring to mind. But unfortunately, one of the beers that made Milwaukee famous, Budweiser, is based in St. Louis although they do own a brewery in Milwaukee. The only other major state brewery is Miller but that company is privately held. As for sausage, Johnsonville is the largest and that, too, is a private corporation. Same with the major dairy companies. So what's left to talk about? Plenty. Of the state's major iconic firms, only Harley-Davidson (HOG) makes the list, but Wisconsin isn't just made up of artery-clogging, DT-inducing companies. The most widely held public companies have nothing to do with personal consumption. Their focus runs the gamut from large farm and mining equipment to paper products to computer technology to auto parts to business services to retail. I looked at 25 of the most actively traded Wisconsin firms and there's a quite a few that would make juicy additions to anyone's portfolio. I won't bore you with every one I like--just my top picks.

The Cream of the Crop
In my March 12th blog, we looked at heavy metal stocks, i.e. those companies engaged in large-equipment manufacturing. I cited Joy Global (JOYG) and Bucyrus (BUCY) as being the pick of the litter among the mining manufacturers. They are both based in Wisconsin and since I recommended them, they've both been in a steady uptrend hitting new highs almost daily with JOYG gaining 22% and BUCY up 31%. Although they've been huge winners for the past couple of years, their charts aren't giving any indication of exhaustion. An analyst at BMO Capital raised JOYG's price target from $85 to $95 citing not only positive earnings and a solid back-log but future growth due to the resurgence in coal-mining. The situation is identical with BUCY with a Lehman Brothers analyst initiating coverage of the stock at “Overweight” (that means the stock is a strong buy) with a price target of $140. That's double the current price! He says that the company is well-positioned to take advantage of the world-wide growing commodities demand especially coal which accounted for 73% of the companies 2007 sales. I'd be a buyer of these stocks on any sort of pull-back.

Actuant (ATU) is a diversified machinery company that makes hydraulic and electrical tools as well as motion sensors for a wide range of commercial and industrial applications. On March 19th, it blew out earnings and raised yearly guidance. Since then, the stock has risen 20% and just recently broke above its all-time high.

If you're a handyman (handygal? handyperson?), chances are you're familiar with my next pick: Snap-on (SNA). This company makes tools for the home-based DIYer (do-it-yourselfer) as well as diagnostic and test equipment for the automotive industry. It also provides loans and financial services to its franchisees. Although the Commerce Department today released figures that showed a sharp decline in personal income growth, this didn't hurt Snap-on's stock as the price is now bumping up against its all-time high. The reason for this is that 44% of the company's first quarter sales came from overseas markets which more than offset falling US sales. According to Snap-on's CEO, the company is working hard to improve its global supply chain and sees “a strong and sustainable platform for future growth.” The company also recently raised 2008 guidance and Zack's put it on its buy list. Note that this company pays a nice dividend (2% dividend yield) to boot.

You might not have heard of the next company but you've probably seen their products. Brady (BRC) makes identification systems such as bar-coded tags which identify and protect products, premises, and people. The company's stock suffered a 34% decline from its August 2007 peak, and has been digging its way back since mid-February. It finally broke out of its trading range on May 22nd when it reported record earnings on improving margins and raised 2008 revenue and earnings guidance. In March, the company announced a one million share buy-back program. The stock has risen sharply since its earnings report (over 15% from its pre-announcement level) and because of this rapid rise, I'd wait to see if it pulls-back before buying. (Note: Brady has a 1.6% dividend yield.)

Pork sausage isn't the only type of hog product made in Wisconsin. Consider motorcycle manufacturer Harley-Davidson (HOG). While Jim Cramer has been tough on this company lately, the stock's chart is painting a rosier picture. It's put in a triple bottom from the middle of January to the middle of April and has since then it's been making a series of higher highs and higher lows. One more up day and the stock will have broken out of its base. A rise through its next major resistance level of $45 will be a sure signal to go long. Perhaps the rising price at the pumps has something to do with renewed interest in the company's products? Sure, many regard motorcycles as a purely recreational vehicle but they can also be viewed as an energy-efficient form of transportation. International sales have helped Harley fend off declines in the US market, and increasing global market share can only improve its bottom line. Just today US Senator Russ Feingold from Wisconsin urged the government of India to ease import tariffs on Harley products. If further tariffs can be eased, that would bode well indeed for hog aficionados world-wide. (I'd hate to be at a world-wide Sturgis meet!) The company also pays a respectable dividend (current yield is 3.2%)

See? There's more to Wisconsin than just cheese. By adding a few of these Dairyland Darlings to your portfolio could be gouda for your bottom line. (Sorry!)

Since I'll be gone next week I'm turning my blog over to my guest contributor, Professor Pat who will be delving into the finer points of Modern Portfolio Theory as well as introducing concepts of Post-Modern Portfolio Theory. All you math-geeks out there get ready and dust off your propeller hats.

Wisconsin Jokes
Q: What do they call a thin person in Wisconsin?
A: Tourist.

There are two seasons in Wisconsin--winter and road construction.

Have a good weekend!

Thursday, May 29, 2008

Protective Put Pesto on the Energy Sector

In Recipe #3 we looked at portfolio hedging techniques, including using put options on ETFs as a way to hedge the portion of your portfolio that's heavily weighted in one particular sector. Now, the energy sector has been a stellar performer this year, but rampant speculation has many Wall Street analysts worried that it might be setting up for a nasty tumble. Their concerns may be justified as oil dropped over $4/barrel just today.

So what's an investor who's heavily weighted in energy stocks to do? If you're in this boat and you still want to hang on to your positions, one strategy that can help you sleep at night is to purchase puts on the XLE, the Energy ETF.

The method that I'm proposing here isn't restricted to the energy sector. If you have significant holdings in any sector--be it healthcare, international stocks, software, networking, biotech, etc.--it's well worth purchasing some insurance on it especially if that particular sector is looking a little “toppy” as is the energy sector right now. Now not all ETFs are optionable, but most are. The XLE especially offers highly liquid options which makes this an attractive candidate on which to purchase protective puts. Let's consider an example on how this strategy would work.

Protective Put Example
Let's say that you have a portfolio of oil and gas stocks worth $50,000. You think that the price of oil will continue to climb over the long term but you're concerned that the speculation bubble might burst causing a price tumble in the near future. You can protect your position by buying at-the-money (ATM) puts on the XLE. Currently, the XLE is trading near $87 with one September 87 put trading at $6.80. Since one options contract represents 100 shares of the ETF, the value of a single contract at $87 is $8700.

In order to fully shield yourself from a price downturn, you'd need to purchase 6 put options ($50,000/$8700 = 5.75) to fully protect yourself. (You could buy only 5 contracts but then you're not completely covered.) The total cost of this insurance is 5 x $6.80 x 100 = $3400 which is 6.8% of your portfolio's value. This may seem a high price to pay, but consider the consequences. Suppose oil does fall in the near future resulting in your portfolio losing $5000, or 10% of its current value. What are your options going to be worth?

The answer is that it's difficult to pinpoint the value exactly since neither will your stocks march lock-step with the price of oil nor will the XLE. Comparing the chart of XLE to the chart of light sweet crude shows that the XLE does indeed follow the price of oil fairly well. When oil dropped a certain percentage, so did the XLE by roughly the same margin. That means if oil drops by 10%, then the XLE will drop by roughly the same amount. Using my handy-dandy Black Scholes options calculator and assuming that this 10% drop occurs a month from now, the value of your puts will be roughly $11 per contract. Since you have 6 contracts, that's a total value of $6600. You paid $3400 for the insurance giving you a net profit of $3200. That doesn't quite cover the loss in your portfolio, but as I said, it's difficult to gauge the exact numbers here, and it sure beats not having any insurance at all.*

I hope you take the time to understand this strategy, especially if you have a lot of money placed in the energy sector. Tomorrow, I'm hoping to get back on track with the results of my stop-loss research, but I felt that today's drop in oil prices warranted the resurrection of the protective put recipe.

*Technical Note: In calculating the expected value of the XLE put option, I used today's value for the option's implied volatility. This value can change and will affect the results. An increase in volatility will raise the price of the option and a decrease will do just the reverse. If you're unfamiliar with options this will have no meaning for you which is why I strongly encourage anyone who wishes to use options to learn about them first. (See the links at the top.)

Wednesday, May 28, 2008

My Apologies

I'm mired in stop-loss research which is taking a lot longer than I had expected (it always does). If I'm able to finish in a reasonable period of time, I'll post the results later today. If not, then tomorrow. Sorry about that!

Tuesday, May 27, 2008

Whoa Nelly! Setting Stops

From time to time in my blog I've mentioned the importance of setting stops. In the articles I wrote about the Turtle trading system (see May 14-21 blogs), we saw that setting stop-losses was an integral part of their system. They defined their stops based on volatility and they knew precisely at the point of purchase what their stops would be for each trade. This is just sound money management practice and setting the appropriate stop can make all the difference between portfolio profit and loss.

If you don't like the Turtles' method of defining stops based on a stock's volatility, are there are other methods that can be used effectively? That's the question I'll be tackling in the next few blogs, but first I'd like to give an overview of the different types of stops that are the most popular among investors.

The Gain/Loss Stop
This is the easiest stop to understand. You define the amount of profit (gain) at which you'll sell your stock and also define the maximum loss you're willing to take. The amount that you specify is up to you. In general, a long-term investor will probably specify a larger loss amount than a short- term investor because he or she wants to capture long-term gains and is more willing to ride out short-term market fluctuations.

There are two different stop-losses to consider: One is the stop-loss per trade and the other is a stop-loss on the overall portfolio. One popular method of setting both is the 2%/6% system. In this method, you would define the stop-loss per trade as 2% of your overall portfolio value. If, during a month, your overall portfolio losses exceed 6% , then you would exit all your positions and stop trading for the rest of the month. The next month you would start again but with an overall lower position value and stop-loss amount.

Let's consider an example. Say you have $100,000 at the beginning of May with which to trade. If you abide by the 2% rule, then you'll be limited to trading only 3 positions, but if you limit your risk per trade to 1%, then you're allowed to trade up to 6 positions. If, say, May isn't going so well for you and your portfolio loss reaches or exceeds $6000, then you would exit all your positions and stay out of the market until June. The good point about this system is that the time you spend out of the market will give you an opportunity to analyze what went wrong with your trades and also to identify new potentially winning trades for next month. Personally, I know very traders who use this system but it could be just the ticket for the novice investor who is unsure of his trading skills. Not only does this system limit damage to one's portfolio but also to one's confidence.

The Ratchet Stop
A ratchet stop is one whereby the stop-loss is adjusted upwards as the stock moves up (or downward in the case of short positions). The ratchet stop is never adjusted downwards (in the case of long positions) and if the stock happens to trade under its ratchet stop price, the stock is sold. The problem with this method is that it can lead to whip-sawing and my simulations (which I'll be presenting in the next few days) show that it's an inferior method of setting stop-losses.

The Trailing Stop
The trailing stop is probably one of the most common methods of setting stop-losses. A trailing stop maintains a stop-loss order at certain percentage below the market price of a stock (or above it for short positions). For example, if you have a 10% trailing stop on a stock trading at $100/share, then your stop-loss point is $90. (Note that most brokers will let you set trailing stop-losses.) This method sounds easy, but there are a few points to keep in mind.

The first point is determining how much of a trailing stop is appropriate? That depends on the volatility of the stock in question and the length of time it's been trending. Initially, you may want to set a very loose stop, say 20%. This will keep you from being taken out of the trade too soon. As the stock begins to move in your favor, you can tighten up the stop. If it's been in a significant uptrend (for long positions) for a long time, you may wish to tighten up your stop even further to protect your profit.

The second point is what is the best percentage to use? More volatile stocks, like lower priced stocks, require a larger trailing stop while less volatile stocks such as large-cap companies require a smaller stop. In upcoming blogs, we'll see which trailing stops are the most appropriate for these cases.

The Parabolic SAR
The parabolic SAR (an acronym for “stop and reverse”) is an indicator plotted on a price chart. Many charting services provide this feature and it's used as a tool to set stops. The parabolic SAR is a mathematical formula that calculates the stop-loss levels for both sides of the market. It moves incrementally in a parabolic (curved) fashion each day along with changes in stock price. When the price intersects the parabolic SAR, the position is stopped out and the other side of the trade can be taken. This is a really good method for setting stops except in two instances--it's ineffective in choppy and non-trending markets. Choppy markets leads to a lot of whip-sawing. In non-trending markets, your stop may never be reached and your profits won't be locked in. Note that if you can't watch the markets everyday, this method is not for you since I don't know of a brokerage firm who will accept stop-loss orders based on the parabolic SAR.

Other Stop-Loss Methods
In addition to the above methods, there are other technical factors to consider. Although some of these rely on the trader's technical expertise and experience, they're well worth the effort to learn and are not that difficult to understand. The following considerations refer to long positions but the reverse logic can be applied to shorts as well.
1. Long-term trend break. If a long-term uptrend line is broken or it breaks a major support level on larger than average volume, consider selling all or part of your position. This is especially true of your stock is showing a head and shoulders break.
2. One day price drop. If your stock has risen substantially and makes a large drop, consider exiting all or part of your position. (This is where experience comes into play.)
3. Sell-off on heavy volume. If your stock has been selling off on heavier than normal volume, consider selling all or part of your position.
4. Staying below its 10 day moving average. If a stock persists in staying below its 10 day moving average, then consider lightening up your position or exiting.
5. Moving average cross-overs. If the stock's 50 day moving average moves below its 100 or 200 day moving average, it's time to get out.

Setting up stops is an integral and important aspect of proper portfolio management. In upcoming blogs we'll be looking at what types of stops provide maximum portfolio returns under various conditions. Don't stop now!

Friday, May 23, 2008

Bring Back Arbor Day!

Today's blog is a departure from my usual fare. One of Dr. Kris's alter-egos, Miss Grumpypants, asked me if I would run a public service announcement. Fearing her wrath if I didn't, I meekly acquiesced but must admit that she makes some excellent points. It's a gloomy Friday anyway and I myself wanted a break from my usual market squawk. So, in an eco-friendly spirit, I turn today's blog over to Miss Grumpypants.

If there's one thing that really gets my goat is environmental hypocrites--you know, those holier than thou folk who claim to recycle their coke cans while housing a garage full of gas-guzzling, greenhouse gas emitting SUVs. Celebrities are some of the worst offenders. They say they have gone green but that doesn't stop them from boarding their private jets to have lunch a thousand miles away with one of their pals. Okay, I may be exaggerating, but not by much, and pardon me for venting. But what I really don't understand is how the Greenies haven't yet embraced Arbor Day. They're all over Earth Day but yet Arbor Day, the mother of all Green holidays, is snubbed for some inexplicable reason. I mean, if you're interested in immediately decreasing global warming, reducing if not nearly eliminating world hunger while at the same time beautifying the planet why wouldn't you be embracing Arbor Day with open arms? Why indeed! After you see the facts I'm about to present, you'll wonder why Arbor Day isn't right up there with Christmas or Thanksgiving because if we followed the tenets of the holiday we'd be blessed with cleaner air, a reduction in global warming, an abundance of food, and a more beautiful planet. Doesn't this sound like the spirit of Christmas and Thanksgiving rolled into one so how can you not embrace it?

Arbor Day: A brief background
Arbor Day was the brainchild of Julius Sterling Morton, a Nebraska journalist and politician, who felt that Nebraska's wind-swept landscape and economy would benefit from a wide-scale planting of trees. Because of Morton's political influence (he was Secretary of Agriculture under Grover Cleveland) he was able to convince the Nebraska board of agriculture to set aside a special day dedicated to tree planting and increasing awareness on the importance of trees. Nebraska's first Arbor Day was born on April 10, 1872 and was an incredible success with more than a million trees planted. A second Arbor day took place in 1884 after which the Nebraska legislature made it an annual holiday. Today, Arbor Day is celebrated in all 50 states, but the dates vary from state-to-state. Most state Arbor Days are held at the end of April or beginning of May. California and a few southern states hold theirs earlier and Hawaii's is in November. At the Federal level, the last Friday in April is proclaimed to be National Arbor Day.

Why planting a tree is good for you and the planet
Trees are one of the very best ways to combat the effects of global warming because they absorb carbon dioxide (CO2), a key greenhouse gas emitted by our gas-guzzling SUVs and power plants, before it has a chance to reach the upper atmosphere where it traps in heat. While all living plant matter absorbs CO2, trees are the most efficient because of their larger size and extensive root systems. During its lifetime, a single tree will absorb approximately one ton of CO2. Some trees are better than others at CO2 absorption, but scientists agree that planting any tree that's climate appropriate will help offset the rise in global warming. In addition, trees provide other health, economic, and aesthetic benefits:

1. Because of photosynthesis, trees not only absorb CO2, but purify the air by emitting oxygen which is what we humans need to breathe. We've all heard about the continuing destruction of the Amazon rain forest which scientists refer to as the lungs of the planet. If the rain forest is totally destroyed (and I hope we can prevent that from happening), the earth will literally be gasping for breath but by planting our own trees, we might be able to replace one giant lung with many smaller ones. I don't know if this would work but it certainly can't hurt.
2. Trees block cold winter winds and provide cooling summer shade, both of which help lower home heating and cooling costs. Have you ever noticed the difference in temperature between the sunny side of the street and the shady side? This is called the urban heat island effect, and it can be significantly reduced by planting trees in heavily concreted urban areas.
3. Their root systems protect soil from erosion and help to clean ground water.
4. They provide shelter for our furry and feathery friends, and add grace and beauty to our communities which increases property values.
5. They provide an indirect source of recreation: a place to hang your hammock or swing your swing. And how can you build a tree-house without a tree?

I'm telling 'ya, what's not to love?

Where to plant trees
You can plant them anywhere: around your home or property; in your community such as parks, schools, churches, downtown areas, concrete parking lots, around stadiums; and in our local, state, and national forests. The latter option is a good one for urban apartment dwellers with limited or no balcony space.

What else can I do?
Ever hear of a Victory Garden? These were vegetable, fruit, and herb gardens grown at home to help the war effort during WWI & II. Did it work? Oh, yeah. Victory Gardens were grown by nearly 20 million Americans during WWII and accounted for up to 40% of the produce grown annually. Forty percent! If we could all pitch in and do something like that today, we could probably put an end to hunger in America if not make a significant dent in the current world food crisis, especially if we can convince other countries to follow suit.

A friend of mine with a small backyard has several large fruit trees that not only provide cooling shade in the summer but so much fruit that she's able to supply a local homeless shelter with citrus for months. Growing up in the Midwest, our family always had a large vegetable garden and let me tell you that there's nothing better than eating a sun-ripened tomato plucked right off the vine or freshly picked buttery green beans. Besides being fun for the whole family, growing your own fruits and vegetables is much cheaper, tastier, and healthier than buying stuff from the grocery store that has been sitting around for weeks or even months. If you have a garden and find yourself with too many vegetables, donate them to charity or have your kids operate an after-school fruit and vegetable stand. It's a fun way for them to earn money while learning the basics of entrepreneurship. Also, you can save significantly on flowers if you grow your own. I had two dozen rose bushes plus pots of cymbidium orchids around my last house and never wanted for fresh cut flowers. Plus, the flowers enhanced the look of my yard. And yes, I did have a Victory Garden which I called a garden. Besides white peaches and nectarines, I grew asparagus (the only patch in Southern California that I knew of), herbs, tomatoes, peppers, beans, and pumpkins that vined their way down my back slope. Different varieties of grapes twined over my back fence and provided the most exquisitely delicious fruit--like nothing you'd ever get in the store or even the farmer's market. Yum-oh! (Grapes are so easy to grow that if you don't watch it, they'll take over everything.)

This concludes my brief public service announcement. I hope you can see that planting trees and other edibles is a very cost-effective way of not only benefiting the earth but us as well. So please mark Arbor Day on your calendar and let's give the holiday the respect that its due, but you don't have to wait for the next Arbor Day to plant a tree or a garden. So indulge your green thumb. Let's go green by planting green. We can save the planet, one tree at a time.

For further information on tree planting and global warming, go the the Arbor Day Foundation website:

Thursday, May 22, 2008

Is There Still Gold in Them Thar' Hills?

I've avoided mentioning gold since it had such a terrific run-up in the past year, but lately it's been languishing. If you don't happen to own any gold positions, is now a good time to jump in? Perhaps, considering that black gold, otherwise known as crude oil, is jumping over barrels everyday reaching new highs. There are economic differences between yellow gold and black gold. You want to own the yellow variety as a hedge against inflation, and so far, inflation hasn't been much of a concern to economists. But if the analysts are correct in predicting that oil could rise to $150/barrel if not $200/barrel, that could have a considerable impact on inflation. And according to yesterday's minutes from the last FOMC meeting, the Fed signaled that there will be no more rate cuts. If oil prices keep rising, you can bet that inflation is going to rear its ugly head.

If you do agree with Wall Street that oil is heading higher, what gold stocks look attractive right now? Well, this morning I pursued the charts in the gold sector and sad to say that most of them look tired. Many are well off their recent highs with some losing between 50-70% of their peak value. The good news is that the GLD (the gold ETF) looks like it's putting in a double bottom and if it can break through its $94 resistance level, then it's likely clear sailing until the next resistance level at $100.

There are a few bright spots among the gold mining slag. One plus about the stocks I'll be mentioning is that they are cheap price-wise with most of them trading under $10/share. That's a lot cheaper than the GLD which is currently at aroung $91/share. Here are my picks of the rock pile:

Top Picks
MRB, Metallica Resources: Not only did this stock not suffer along with the rest of the gold group, it's been on a juggernaut since breaking out of its base in late 2005. Since then it's risen over 300% and is currently trading at its all-time high of $8.25. The company not only is a gold producer, but is involved in silver and copper production as well, and with the world demand for copper exploding, this stock should do well even if gold demand starts to fade.

EGO, Eldorado Gold: This stock chart parallels that of MRB. It, too, broke out late in 2005 and has since racked up over a 200% gain. It gapped up today breaking short-term resistance to set a new high at $8.14. This company does not mine anything other than gold and its chart closely reflects the movement of the XAU, the gold and silver index.

Other Good Picks
AZC, Augusta Resources: This stock has doubled in price since its November 2006 inception. It broke out of its 2 1/2 month trading range just a few days ago and it, too, is making a new high around $4.70. Not only does the company produce gold, but copper, silver, and molybdenum as well.

GBN, Great Basin Gold: Similar story for this stock. It's almost doubled in value since late 2005 and is testing its recent high of $3.75. It produces copper as well as gold.

GRS, Gammon Gold: This gold and silver producer lost half of its value from its October peak of $12. Since the February low, it's managed to recoup most of its loss and is nearing minor resistance at $10.50. If it can break that then chances are good it will at least rise to its previous $12 high.

AAUK, Anglo American: This stock has risen 150% since the fall of 2005 and is nearing its all-time high of $38.75. This company has a smaller exposure to gold than the ones given above and could make an attractive adjunct to other gold stocks by providing a bit of diversification within the industry. The company has diverse mining interests, including platinum, silver, copper, molybdenum, vanadium, coal, diamonds, and iron ore plus other metals used in the production of steel. If you're looking for a diversified mining play in one package, consider this puppy. It's also the only one of this bunch that pays a dividend. (Current divident yield is about 2.5%.)

Of the above mentioned stocks, only EGO, GRS, and AAUK are optionable and would be good candidates for a covered call strategy. To answer the title question, “Is there gold in them thar' hills?” I would say yes, but you gotta pick the right hill. Happy prospecting!

Tuesday, May 13, 2008

The Legend of the Turtles

One day back in the fall of 1983, famed trader Richard Dennis was shooting the breeze with his trading partner and pal Bill Eckhardt. The conversation followed the lines of the age-old nature versus nurture tack with the central question being, “Are good traders born or can they be made?” Eckhardt was of the opinion that somewhere there's a trading gene, and either you have it or you don't. Dennis expressed his disagreement by flicking a paper airplane at him (okay, I made that up but I like the image) saying that a good trader can be made. At heart, one thing that I've discovered is that all good traders have a touch of the gambler in them, and that was true for our pair. They made a bet. Dennis told Eckhardt that he could teach people to trade and thus launched the saga of the Turtles. But before we get into that, we need to know a little about the man behind the magic, Richard Dennis himself.

Richard Dennis--A Brief Background
Richard Dennis began his career as a runner on the floor of the Chicago Mercantile Exchange (where commodities futures are traded) at the early age of 17. He began trading his own account shortly after using his father as the broker since he was still underage. In just fifteen years, he grew his initial investment of a few hundred or a few thousand dollars (depending on which source you read) into a fortune of a couple of hundred million bucks. How did he do it? He was a sharp guy, and yes, I do think he did have that trading gene in spades. With no formal training or guidance, he instinctively knew when a trade “felt right.” (In college, he majored in philosophy so understanding the ideas behind the ideas must have been an essential pursuit of his.) He took calculated risks, and when he liked a trade, he bet the farm. To avoid making decisions based purely on emotion, he developed mathematical tools to calculate risk and then used them to his advantage, and gradually a complete trading system evolved. That system was the one he taught to his students and become known as the Turtle Trading System. (The Turtle name came from Dennis himself who said that he was going to grow traders just like they grow turtles in Singapore. Personally, I don't think that's a great analogy, but the name stuck nonetheless.)

The Turtles
Getting back to our story, Dennis placed ads in several major financial newspapers and journals looking for people to train. The response was tremendous with over a thousand applicants. He narrowed the field down to 80 prospects and asked them to complete a true/false test comprised of 63 questions. The questions looked inocuous but were actually quite tricky. (I've seen the questionnare and they are, indeed, tricky. Some of them are still being argued in the financial arena.) From this group, he made his final selection of ten plus three that he already knew from outside the group. They were all from diverse social, educational, and professional backgrounds, so he couldn't be accused of selecting just from a specific group, say mathematicians or gamblers (although he did take one gambler into his second training group whom I know personally). He spent two weeks teaching them his system and then let them loose in his office to start trading. Initially, they were given small amounts of money to work with but after they got their sea legs, they were given larger amounts. Many of them did very well. In fact, some of them did so well that they went on to have successful, highly lucrative careers on Wall Street. The ones that didn't fare so well were the ones who didn't follow the rules of the system exactly. Dennis proved himself right--that nurture can indeed triumph over nature, at least as far as trading a rigid system of rules is concerned. I don't know what the bet was, but I hope Dennis cleaned up on it.

The Turtle Trading System: A Complete Trading System
I can't be sure if the concept of the complete trading system was around before Dennis, or if Dennis invented it. Dennis was heavily influenced by the work of Richard Donchian, the subject of yesterday's blog, which is clearly evident if one compares the trading parameters of both systems. Although Donchian did have a set of twenty trading guides composed of eleven general guidelines and nine technical guidelines, he left it to the trader to fill in some of the blanks which were to be deduced from the trader's analysis of market conditions. Dennis took Donchian's guidelines and formed them into a complete set of rigid rules. He did this for one very good reason: to remove all emotion from the process. This is why he won his bet with Eckhardt. As an analogy, my grandmother, when asked how she learned to cook so well, said succinctly, “ If you can read and follow directions, you can cook.” That about sums up the philosophy of the Turtle Trading System.

What is a complete trading system? We touched on the components of it yesterday under the section on trading rules. Today, I'm going into them in a bit more detail. This is because in the next few blogs I'll be using them to give you the recipe for the Turtle Trading System. Here they are again:

1. What are my markets? Your first decision is what markets to trade. Although the Turtles traded futures exclusively, this method can be applied to equities as well. You need to spread your trades around so that you don't miss out on any potential major moves. In other words, you need to diversify among different, uncorrelated sectors. You also don't want to trade any market or equity that has low trading volume or that historically doesn't trend well. You want something that has shown potential for fairly rapid movement since you don't want to wait years to realize a small profit.
2. How much should I buy or sell? This is known as position sizing and is the crux of the Turtle system. It involves spreading risk over different asset classes or sectors through diversification and controlling risk through proper money management. If you don't take away anything else from this discussion, please take note of this component. Money management is something that many training books and seminars either gloss over or don't even bother to teach you, but it's something you need to know to stay in the game. I can't stress this enough.
3. When do I buy or sell? The Turtle System provides exact entry criteria which eliminates the guesswork out of when to buy and at what price.
4. When do I get out of a losing position? The basic tenet of the Turtle Trading System is: Cut your losses and let your profits run. This system tells you the exact price at which you cut your positions and tells you this before you even enter into one.
5. When do I get out of a winning position? As I just mentioned, the Turtles believed that the way to make money is to let your winners run, but they do have rules as to when to exit a winning trade. Any system that does not address this question is not a complete trading system. The lack of any exit criteria would then allow the trader's emotions to come into play and the system ceases to be truly mechanical.
6. How to buy or sell? This topic covers tactical problems such as order execution, what to do during fast markets, and if several markets are breaking out at once, which are the best ones to buy.

I know this might seem like a lot to grasp but once we get into the exact recipe, you'll see it's really pretty simple. Even though you may not agree with the Turtle timing scheme, I think you'll gain a lot from learning their money management techniques. The Turtles themselves have gone on to much success and many an investment firm has their trading philosophy rooted in their rules. But the Turtle System isn't entirely immune to the occasional failure. Even Richard Dennis himself suffered huge losses during the market crash of 1987. That's because in futures trading, losses can be larger than the size of your trading account as opposed to equities where the price of a stock can't go below zero (although your loss is technically unlimited if you're on the short side). Tomorrow, we'll begin cooking up some Mock Turtle Soup so clean up your kitchen. To paraphrase my grandmother (who made the absolute best German potato salad ever, ohmygod!), "If you can read and follow directions, you, too, can cook up a tasty batch of Mock Turtle Soup."

Monday, May 12, 2008

The Trend: Is it Your Friend?

Much has been made in the financial literature of the advantages of trend trading, but what exactly is it? Although trend trading, also known as trend following, systems have been around for almost fifty years, many investors don't have a clue as to what they are or how trend trading can help increase the size of their porfolios. Most if not all trend trading systems are comprised of two crucial components: the trading algorithm itself which dictates when to enter and exit trades (timing), and how to enter and exit positions along with how much to trade (portfolio management). To completely understand trend trading, we must first look at its historical roots.

Richard Donchian--The Father of Trend Trading
Richard Donchian is considered the father of trend following and is still considered to be one of the most respected technicians on Wall Street. He started life working as an assistant in his family's oriental rug business after graduating with a degree in economics from Yale. But it was after reading uber-trader Jesse Livermore's fictionalized biography Reminiscences of a Stock Operator* that Donchian became hooked on studying the financial markets. His interest in technical analysis bloomed after he suffered losses following the market crash in 1929, shortly after which he began his career on Wall Street. During this time, he developed a system of trading commodity futures which he termed "trend following", and wrote numerous articles pertaining to it.

One of Donchian's students, Barbara Dixon, outlined his trend following philosophy in the December, 1974 issue of Commodities Magazine which can be summarized as follows:

1. The trend follower makes no attempt to forcast the extent of a price move.
2. Once a trend begins, it has a tendency to persist in the same direction for some time.
3. The trend follower studies the trend and devises precise rules when to enter and exit trades. He or she then acts on these rules to the exclusion of other market factors, thus eliminating emotion from the equation.

In short, trend trading is a mechanical system. The reason that you may not have heard the term used for a while is that it has been replaced by other terms such as momentum trading, mechanical trading, systematic trading, or algorithmic trading. (Agorithmic trading is sometimes referred to as program trading which is a slightly different beast--it's a way for institutions to trade large blocks of stock without (hopefully!) disrupting the normal flow of the market.)

Characteristics of Trend Trading Systems
Any trend trading system is characterized by the following set of four components:

Price: The price of an instrument, be it commodities futures, stocks, bonds, etc., is of primary concern. Other indicators are of minor importance as it is only price that tells you what the market is doing at the moment. (A side note: Donchian noted that even in his day the Transportation Index (back then it was just called "the rails") was a leading indicator of overall market direction and that factored into his set of rules.)
Risk Control: Positions are downsized according to market volatility and strict rules are applied to cut losses. Preservation of capital is the key to trend following systems since in most cases, there are a greater number of losers than winners.
Money Management: What size positions to take and when to take them is a key factor here.
Trading Rules: Trend trading is systematic, based on a technical determination of the trend. A trend following scheme must answer the following five questions:
1. How do you determine what market to buy or sell at any given time?
2. How large a position should you take at any given time?
3. How do you determine when to enter a market?
4. How do you determine when to exit that market if the trade is profitable?
5. How do you determine when to exit that market if the trade is unprofitable?

You can see that any trend trading system follows precise rules of trade timing and risk management. In order to develop a viable trend trading system, one must apply the scientific method.**

The Advantages of Trend Trading
The real advantage to a trend trading system is that it removes the emotional component from the equation which is usually the downfall of many investors. But it does require discipline to stick to the rules and not chicken out when the market moves against you. How successful are trend trading schemes? Very. Consider the track records of the following four trend following firms:***

Abraham Trading: 1988-Present: +5,524% vs S&P500 +429%
EMC Capital: 1985-Present: +19,871% vs S&P500 +696%
Campbell & Co.: 1983-Present: +2047 vs S&P500 +771%
Winton Capital: Late 1997-Present: +579% vs S&P500 41%

The reason that trend trading is effective is that it capitalizes on market inefficiences, but that is the subject of another discussion. Note that although trend trading schemes are most often applied to commodities futures, one can apply them to other markets, including equities, with similar success.

The Downside of Trend Trading
The most obvious downside to this type of investing is what if the market is trading sideways? Two things could occur: The trend trader will rarely if ever get a trade signal, or else will get whip-sawed. (Whip-sawing occurs during fluctuating markets.) The result of this is that the investor will either not even have the opportunity to make any money or worse yet will suffer a string of losses.

Another disadvantage is that for the rules to work, a trend must already be in place. In this instance, the investor loses out on the initial movement which can result in an overall decrease in profits. If, instead, an investor uses indicators such as a breakout from a cup and handle formation that we looked at a while back, he or she will be able to participate in price movements much sooner.

The other major disadvantage is that any trend trading system requires strict discipline on the part of the trader. Following the rules can at times be nerve-wracking especially if the position is temporarily moving against you. An investor must be able to weather sizable draw-downs to his or her portfolio which requires nerves of steel. If a large draw-down happens to occur at the beginning of an investor's trading career, he or she may never be able to fully recover from the loss.

I hope I've shown you that trend trading can be a viable way for you to trade your portfolio. If you're new to trading and afraid of making your own investment decisions, then having a strict set of rules to follow may just be the ticket. In upcoming blogs we'll be going into the trading system used by the most successful trend follower in history--Richard Dennis, the founder of the Turtles.

* Reminiscences of a Stock Operator, by Edwin LeFevre (1923). This book gives a fictionalized biography of legendary trader Jesse Livermore's rise on Wall Street. Still in print with updated editions, this book is required reading for any trader but I must confess that I had a tough time reading it and ultimately had to put it down because of the stilted writing style. But that was years ago and I should probably give it a try again.

**The Rules of the Scientific Method:
1. Define the question, such as “How do I make money in a trending market?”
2. Gather information, such as looking at charts of trending markets and noting the best times to enter and exit trades
3. Form an hypothesis, such as “If I buy this stock (or commodity or whatever) ten days after it hits a new high, what type of profit, on average, can I expect to make and when is the best time to exit?”
4. Look at many trending charts and collect the appropriate data
5. Analyze the data and draw conclusions. If your initial hypothesis doesn't work, go back and modify it and test it again. Repeat until you have a viable model.
6. Test out your theory in real-time by paper-trading first.

***Data obtained from the following article in May, 2008 issue of Stocks, Futures, and Options Magazine: Trend Following: It Works!, by Michael Covel. (

Friday, May 9, 2008

On Blogging

You know what I did this morning? Well, after my first good night's sleep in a week, I finally got up. This was the first time I arose after 8am in recent memory. Then I made a breakfast of fresh-squeezed grapefruit juice and oatmeal and sat down and read the paper. This may sound like an ordinary morning to most, but for me it was pure luxury.

Usually, my day goes as follows. I wake up at 2:30 am and fret for one to three hours about what I'm going to blog about the next day. My mind races and typically I come up with bupkus. Frustrated, I toss and turn, and if I can pull my mind into a meditative state, sometimes Morpheus will open his arms and I'll fall back asleep.

In the morning, my first order of business is to tune into CNBC to check out the market. I never eat breakfast...or lunch for that matter. My sole luxury is that Fifi prepares my coffee, enabling me to race right to the computer without interruption. I give my personal inbox a quick once-over to see if there's anything pressing before heading off to scour my financial inbox in search of something that might generate an idea for the day's blog. If I don't find anything that tickles my fancy, I turn to my charting program and begin looking through hot lists of the day's highs and lows, stocks trading on unusual volume, sector lists--you name it. If there's a chart that looks interesting or a trend that I see developing, I note that. Whatever I find to be the most appealing out of all those inputs, I write about. Usually, something will leap out and the topic of the day becomes clear.

Whatever topic I do decide upon is followed by research, and lots of it. When all of the facts have been gathered together and organized, I whip out my quill and inkpot and begin the writing process. One of my previous incarnations was as a freelance journalist and screenwriter. You would think that writing comes naturally to me, but it doesn't. Unlike many of my writer friends who can toss out a 2000 word article in two hours or a feature-length screenplay in three days, I struggle over every word. What would take my esteemed colleagues oh about a half an hour to pen takes me several hours...and I'm still never satisfied with the final result.

What I'm saying is that at least for yours truly, blogging is hard work besides being nearly a full-time job. I also have other responsibilities like managing several portfolios and another part-time job doing financial analysis. Can you blame me for tossing and turning at night?

My goal with this missive is not to whine or complain but to say that sometimes I just get burned out. That happened yesterday. I turned on the computer, went through my usual routine...and nothing. Nothing! I stared at the screen with a blank expression before finally turning it off. I was just burned out. So, I decided to take the day off and become a soccer mom (without the mom part). I window shopped, got my nails done, and took my time at the grocery store which usually I'm rushing through like Mario Andretti at the Indy 500. I came home, put away the groceries, and slipped into my holey sweats and fuzzy socks. Oprah's show had just started and I had a ball sacking out on the couch watching Cher and Tina Turner sing together. (They both still look and sound mahvelous, BTW.) In short, I was a slob and loved every minute of it.

What I'm trying to say is that if I do miss a day or two here and there, you'll know why, barring any real illness. Blogging is a tough and demanding avocation, and in keeping with my philosophy of providing fresh and interesting content, I need the occasional break to recharge my batteries. So forgive me if I'm only human and can't blog every day. I'll do the same and forgive you if you don't read it every day. Deal?

Next week (assuming I don't turn into a soccer mom for good), we'll be back to our regularly scheduled programming where we'll be investigating trend trading systems. Ever hear of a guy named Richard Dennis? He was the founder of the famous Turtles, and I'll be giving recipes for his trend-trading algorithm and system of money management. Enjoy your weekend! I'll be sleeping in...hopefully...

Oops! Correction to the MPT Tables

In a series of articles from April 21st through the 24th, my guest contributor, Professor Pat, introduced us to Modern Portfolio Theory. Using data collected from 1927 to 2007, he generated allocation tables among various investment classes to determine the optimum portfolio given an investor's risk and return requirements. Yesterday, he phoned me in a panic, saying that one piece of data was input with a plus sign instead of a minus sign. Oops! His bad. Well, given all of the data he had to handle, he can hardly be faulted for one slip-up. He spent the better part of last evening re-crunching the numbers to come up with new tables. These tables and the discussions that correspond to it have been modified in my blogs to reflect the new values. The corrections were made to the blogs covering Parts II, III, and IV of his discussion of Modern Portfolio Theory (April 22-24). He profusely apologies for the error. According to him, the graph of the efficient frontier in Part V (May 7th's blog) is not appreciably affected.

Again, I want to thank him for all of his efforts and his effort to correct this error in a timely fashion.

Wednesday, May 7, 2008

Modern Portfolio Theory Part V: The Sharpe Ratio

In the April 21-24 blogs, one of my guest contributors, Professor Pat, tackled the esoteric subject of Modern Portfolio Theory (MPT). Using data from 1927 to the present, he derived an asset allocation table that an investor can use to construct his or her own optimally allocated investment portfolio according to an investor's requirements for portfolio return versus risk. Today, he's extending his presentation to include the Sharpe Ratio and how that can be used to further increase portfolio returns while simultaneously minimizing risk. Take it away, Professor!

This installment in the Modern Portfolio Theory (MPT) series will discuss the concept of the efficient frontier, the Sharpe ratio as applied to MPT and how to add a riskless cash component to your portfolio. The discussion is applicable to interest rates and optimum portfolio allocations and returns current to today.

The Efficient Frontier
In Part III of this series (see April 23 blog) a table was presented entitled ”Optimum Asset Allocation Among Investment Classes” whose first two columns were Required Return and Standard Deviation. Let's now plot those two columns (and many more data points in between) on the graph shown below. The resulting magenta line is known as the “efficient frontier” as is represents those optimally efficient portfolios that provide the least amount of risk for each level of return in today's market. The shaded area underneath the curve represents the possible space of less efficient allocations of portfolio assets.

Note that the efficient frontier is a curved convex line. This is a result of the lack of correlation (see Part IV, April 24 blog) between the various assets in the portfolio and how that results in an optimum portfolio characterized by an overall standard deviation less than it would be for one of completely correlated assets. Remember, for uncorrelated assets when some are up in value others are down in value and the overall portfolio therefore exhibits reduced variation. For a portfolio of totally correlated assets a combined linearly weighted standard deviation would result and the efficient frontier curve would be straight rather than curved. It is the existence of optimum allocations that pulls the line to the left for a lower standard deviation at each point that creates that convex shaped curve. The end points of the curve do not benefit from this left pulling because they are dominated by portfolios containing a high percentage of a single asset class--at the high end of the curve, the optimum portfolio is composed of 100% in Small Stocks and at the low end by 93% in Treasuries. The convexity of the efficient frontier curve therefore graphically demonstrates the beneficial effects of diversification.

Adding a Cash Component and The Sharpe Ratio
The Sharpe Ratio, S, is named after William Sharpe, who won the 1990 Nobel Prize for his work on the Capital Asset Pricing Model which shows how the market prices individual securities in relation to their asset class. Here the discussion is limited to the Sharpe Ratio which, for a particular investment, is a direct quantitative measure of reward to risk. It is a measure of how much excess return a portfolio provides above a riskless investment considering the additional risk it entails. It is defined as:

S = (Portfolio Average Rate of Return – Current Rate of Return of a Riskless Investment) / Standard Deviation

Let's look at the line of best capital allocation on the graph above. This line represents the best way to incorporate a riskless cash component into an already optimum portfolio thereby reducing the risk even further albeit at a reduced overall rate of return. As of this writing, the annual rate of return on a 30-day United States Treasury Bill is about 1.2%. This is considered the safest investment for the short term and is considered to be as riskless as cash. The line on the graph therefore starts at 1.2% plotted at zero standard deviation (it's riskless!) and is drawn so that it contacts the efficient frontier curve at a point such that the slope of the line is a maximum. This is the point on the efficient frontier with the greatest Sharpe Ratio and is known as the market portfolio. The slope of the line is the Sharpe Ratio for the market portfolio and the current riskless rate of return. As seen on the plot above, the market portfolio provides about a 5.0% return which has a standard deviation of 3.4%. You can confirm this in the table from Part III. The Sharpe Ratio for this investment is therefore (5.0 – 1.2) / 3.4 = 1.12 which, as we have noted, is also the slope of the line of best capital allocation.

Note that the black line is straight because the riskless investment has no standard deviation and there is no better “optimum” allocation that will produce a resultant combined reduced standard deviation that would produce a convex curve like that for the optimum allocations of the other investment classes.

Investments anywhere on the line of best capital allocation give you the overall return and standard deviation of an optimally allocated investment combined with an additional riskless cash component (the optimum allocation for the 5.0% return already has about a 70% 30-day T-bill component which in the long term has a nonzero standard deviation but that is immaterial for this analysis of the current state of interest rates and the market). In this way you can easily construct a composite portfolio that is also optimum but that has a reduced standard deviation resulting from adding a riskless cash component. This is of course at the penalty of a lower overall portfolio return. The percentage of cash to include in the composite portfolio is easy to determine since the standard deviation is reduced linearly according to the slope of the line (the Sharpe Ratio). For example, a portfolio of assets at risk returning 5.0% with a standard deviation of 3.4% can be reduced to one with a standard deviation of 2%. From the graph, such a portfolio returns about 3.2% and is constructed by reducing the component of optimally allocated risky assets to 64% (3.2 / 5.0) x 100% and by adding a 36% (the rest) cash component.

Increasing Potential Returns Through Margin Borrowing
Instead of adding a cash component to your portfolio you can choose to borrow against the market portfolio and realize increased potential returns. Naturally, doing this also increases risk.Whereas a portfolio with an added cash component and lower risk resides on the line of best capital allocation at or below the market portfolio, a portfolio that has been borrowed against will reside on the line of best capital allocation above the market portfolio. A higher risk, but still optimum, portfolio can be formed by borrowing against the market portfolio on margin (assume the rate of borrowing is also at the riskless rate of interest). You then reinvest the borrowed cash right back in the market portfolio in the same proportion as assets that portfolio already holds. So now you have a portfolio allocated exactly the same as the market portfolio but it now has a higher value. But you have margin debt to pay at a lower rate than the portfolio is expected to produce on average. The standard deviation of returns this portfolio will exhibit is greater than the market portfolio as seen as you climb up the line of best capital allocation. Hopefully the result will be positive. This expanded portfolio residing on the line of best capital allocation which has a slope equal to the Sharpe Ratio exists in a region above the market portfolio contact point on the efficient frontier. It is there on that line that you can decide the standard deviation and thus the amount of additional risk you'll have to take in order to achieve a higher return.

Dr. Kris Note: I know that these discussions on MPT might be flying over the heads of many of you, but it is something that every serious investor who does his own portfolio asset allocation should try to understand because these tools can be used to effectively increase returns while minimizing risk. I think that's a good enough reason to merit these discussions.

Tuesday, May 6, 2008

Better Than A Money Market

In today's turbulent market environment, many risk-adverse investors have wisely moved into cash, parking their money in money market accounts. Currently, money markets are paying two to three percent on average, but might there not be other investment vehicles that pay more while still being low-risk? The answer, of course, is yes. (If the answer was no I wouldn't have an article.)

So, what are these investment vehicles? They're are old friends, the exchange-traded funds (ETFs). If you don't know what an ETF is, it's a mutual fund that trades on the American stock exchange (AMEX) just like a stock. That means that you can buy them at any time during market hours unlike a mutual fund which only trades at the end of the day. ETFs are linked to an index which means that they are passively managed (although the underlying index might not be) which keeps expense ratios low, much lower than their mutual fund counterparts.

The past several years has seen an explosion in the ETF universe. If there's an index out there, there's probably an ETF that tracks it. The largest fund issuers are PowerShares, Vanguard, State Street Global Advisors, and Barclays. For income investors as well as the gun-shy investor, here's a list of ETFs that are relatively risk-free and pay higher returns than a money market. The good news, too, is that some of them are completely tax-free or are taxed at lower rates.

1. State Street's Lehman Muni-Bond (TFI): Tracks the Lehman Brothers municipal bond index.
Current NAV (net asset value): $22
Current Yield: 4.52%
Tax-equivalent Yield: 6.05%
Expense Ratio: 0.2%

2. PowerShares Insured California Muni-Bond (PWZ): Based on the Merrill Lynch California Insured Long-Term Core Municipal Securities Index, which is designed to track the performance of AAA-rated, insured, tax-exempt, long-term debt publicly issued by California or Puerto Rico or their political subdivisions. (Puerto Rico is tax-free for all states.)
Current NAV: $24
Current Yield: 4.21%
Expense Ratio: 0.28%

3. PowerShares Insured New York Municipal Bond (PZT): Based on the Merrill Lynch New York Insured Long-Term Core Municipal Securities Index, which is designed to track the performance of AAA-rated, insured, tax-exempt, long-term debt publicly issued by New York or Puerto Rico or their political subdivisions.
Current NAV: $24
Current Yield: 4.17%
Expense Ratio: 0.28%

4. PowerShares Insured National Municipal Bond Portfolio (PZA): Based on the Merrill Lynch National Insured Long-Term Core Municipal Securities Index, which is designed to track the performance of AAA-rated, insured, taxexempt, long-term debt publicly issued by U.S. states or their political subdivisions. This fund can be considered safer than the TFI since all of the bonds here must be insured compared with only 46% in the other.)
Current NAV: $24
Current Yield: 4.19%
Expense Ratio: 0.28%

5. PowerShares Emerging Markets Sovereign Debt (PCY): Based on the Deutsche Bank Emerging Market U.S. Dollar Balanced Liquid Index, an innovative index developed by Deutsche Bank Securities Inc. that provides intelligent access to the sovereign debt of approximately 17 emerging market countries. Although you may think this portfolio is high-risk, it's not because it invests in sovereign debt as opposed to corporate debt making it much lower risk.
Current NAV: $26
Current Yield: 5.59%
Net Expense Ratio: 0.50% (This is the highest expense ratio of the bunch, but note that it's the same as the Lehman International Treasury Bond ETF.)

This is a sampling of some of the ETFs that you can substitute for a money market. Although you don't have some of the conveniences that a money market offers, like writing checks for example, you do have the ability to liquidate your positions easily if you do need some cash.* And compared with mutual funds that can require several thousand dollars to buy their product, there's no required minimum investment.

So when's the best time to buy these products? Well, when the net asset value (NAV) is low. Duh. All of these ETFs hit their historic lows on February 29th and have been recovering since then. If any of these products interest you, now would be a good time to buy. Although it may seem counterintuitive, the Emerging Markets ETF, the PCY, has been the least volatile of the bunch, trading in a very tight range between $25 and $26. It also adds a bit of diversity to the above products as the international market is less tied to the US market (less correlation).

Now you don't have any excuse to keep all of your cash tied up in a low-paying money market!

*A note on trading liquidity: Some ETFs, notably the PWZ and the PZT, have low trading volumes (<10,000 shares per day) but please don't confuse low volume with liquidity. ETFs are open-ended investments as compared with closed-end funds. A closed-end fund can suffer dramatic changes in their NAVs if there is a spike in trading volume, but not ETFs since new shares can always be created. This maintains the stability of the NAV which in essence should reflect the value of the portfolio's holdings. Moral of the story: Don't be afraid to buy into an ETF that trades on low volume.

Monday, May 5, 2008


As I'm sure you already know, internet giant Yahoo! this weekend rejected Microsoft's take-over offer after they upped their bid by two bucks to $33/share. The suits in charge at Yahoo! felt that their company was worth at least $4/share more and felt slighted by the paltry increase. Of course the question on everyone's minds is not if Microsoft will still pursue the merger but if any sort of merger will be happening with either of the companies. Both sides of this question are currently being bandied about in the financial media and I'm not going to regurgitate the arguments here.

What I do want to focus on is if there's a possible play in all of this. In my blog on February 1st when the proposed merger was first announced, I suggested buying Yahoo stock at the going price of around $28/share and writing the April 30 covered call (trading then in the $1.50-$1.60 range) against it. That call would have expired worthless on Friday, April 18th and if you had again written the May 30 call in the $0.80 - $1.00 range on the following Monday, you would have at least cushioned yourself against today's 15% drop in Yahoo! share price. Had you written these calls, your cost basis would have been lowered to around $25.50 thus limiting today's loss to about 5% instead of 15%. This is one good reason to use covered calls on controversial take-over targets.

This play is a no-brainer in retrospect as hindsight is always 20/20. But is there still a way to profit from this situation? It's anyone's guess but the word on the street is that some sort of merger is probably in the offing since they're highly skeptical that Yahoo! will be able to live up to its financial targets. Perhaps in the short term this could put downward pressure on Yahoo! shares, but if the price falls too far, the board can surely expect a bunch of shareholder lawsuits (some are already suing the company). Whether or not Microsoft steps back into the picture is immaterial; what really matters is that someone will and probably sooner rather than later.

If I believe this (and I do), here's how I would play it. If I'm still short the May 30 calls, I'd buy them back today for ten cents. I'd wait a day or two and if the stock doesn't tank, I'd either write the July 25 calls or buy them outright. (These calls are trading today for around $2/contract.) In the event that a merger is announced between now and the middle of July, the share price will go up and at worst my stock will be called away at $25/share. Since my current cost basis is $25.50/share means that I'll have pocketed an extra $1.50/share which translates into a 5-6% return. If I buy the calls instead of selling them will give me a much larger return. Even if Yahoo! accepts a price that is close to Microsoft's original bid of $31/share means that at on or before expiration, my calls will be worth at least $6/contract giving me a minimum 200% return on my investment. (($6 final price - $2 cost)/$2 cost basis x 100%). I like that type of return. The only possible wrench in the gears is that Yahoo!s share price falls substantially but I really don't think that the Yahoo! shareholders are going to let that happen.

Actually, Mister Softee might have done us a favor by letting us turn a Ya-Boo! into a Ya-Hooooo!!!!

Friday, May 2, 2008

Tech Talk: A Portfolio of Technology Stocks

Well, it appears that the Fed didn't disappoint and either did today's jobs report. The news cheered up a gloomy Wall Street as evidenced by recent market action. With the S&P breaking through its all important 1400 ceiling yesterday combined with the VIX (volatility index) hanging below 20, it appears that we have the making of the next bull market. As always, the perennial question is: What to buy?

A guest commentator on CNBC yesterday said that institutions are returning to the market and are rotating some of their positions out of sectors that have been performing well, such as materials and commodities, and pumping money into technology stocks. Although disappointing earnings from Sun Microsystems stalled the tech rally today, I still think the entire sector has been oversold and is poised for a turnaround. (Many of the tech ETFs were down 25%-40% from just a year ago.) If you look at their charts, you can see that they've all been rising steadily since the middle of January when the overall market hit its nadir. Rather than buying these ETFs outright, I thought it might be fun to cherry pick the best of each and construct our own portfolio.

Portfolio Construction
What I did was to look at the charts of the top ten holdings of each of the following ETFs and then select the top one or two stocks whose charts I found to be the most compelling:

IAH & XLK - Internet Architecture/Technology: Cisco (CSCO) & Network Appliances (NTAP)
SMH - Semiconductors: Intel (INTC) & Xilinx (XLNX)
TTH - Telecom: AT&T (T) & Verizon (VZ)
BDH - Broadband: Research in Motion (RIMM)
IIH - Internet Infrastructure: RealNetworks (RNWK)
IGV & SWH - Software: Adobe (ADBE)
HHH - Internet: Earthlink (ELNK)

You're probably wondering why Apple and Google aren't on the list. The main reason is that I wanted to limit the portfolio to more reasonably priced stocks so that the portfolio will be more equally weighted in terms of price. (All the stocks listed above are under $40.) Also, Apple has run up almost 30% in just the last two months, although that's not to say that it can't go a lot higher which I think it will.

What I'm going to do is to set up a dummy portfolio using 100 shares of each of the above ten stocks at today's closing prices. We'll be checking in periodically to see how its doing and if, indeed, techs are ready to rock 'n' roll as some think they are. One plus of constructing your own fund this way is that it offers a bit of diversity across the tech sector. If you buy just one ETF, you're restricting yourself to that one niche within the entire tech realm. This way, at least, you're spreading your risk over a wider area. The negative to this approach is that it's costlier in terms of the overall dollars you'll need to invest and commission costs will be greater, too. The fun part of this, though, is that you get to be your own portfolio manager. Of course, if your fund doesn't perform well, then you'll have nobody to blame but yourself, but if it does, then you'll be able to own your bragging rights. Just don't be a bore about it at cocktail parties, okay?