Friday, October 31, 2008

Treat, or Trick?

Are the last several days of gains the beginning of a new bull market or is it just a breather in the current bear cycle? In other words, is this a treat or a trick?

The fundamental arguments concerning the extent of the credit crisis (perhaps for another year or more?*) and the strengthening of the greenback point to a protracted bear market. Sure, stocks may not have much farther to fall, but they probably won't be breaking out of the gate anytime soon, either. Technically, the VIX is still high but if it fails again on Monday, I strongly urge you to either protect or dump your short positions. I don't mean to frighten you, and although it's a bit too soon to tell, the market could be staging a temporary comeback.

Even if the market firms up, it's still not a green light. First, we have to get through a presidential election followed by the meeting of the G20 on November 15th. (FYI, the G20 is an annual meeting of serious financial suits from 20 advanced and emerging market countries. This year Brazil is providing the tea and scones. The major topic will undoubtedly be the global credit crisis and the rising dollar. I'm sure the talks will be accompanied by a lot of finger-pointing directed principally towards the US along with a chorus of me-need-da-money rap tunes.) Many market pundits don't know what to expect from this summit and I certainly don't. Since nobody knows anything, adopting a wait-and-see stance couldn't hurt.

The past few days of positive price movement might have been nothing more than end of the month window dressing and portfolio rebalancing. I can't tell. Next week, we could be in for another wild ride due to the elections. (Unless the Obama win is already priced into the market.) I apologize that I can't offer anything more concrete; I don't think anyone out there can either at this point.

So, protect your short positions and be judicious in taking on any long ones--just don't be left holding the bag. Unless it's filled with candy.

Happy Halloween from all of us at the Stock Market Cook Book!

*For an excellent article on the future of this recession, see Jim Jubak's column today on MSN MoneyCentral: What's scary about this recession?

Thursday, October 30, 2008

Buy & Hold vs Timing the Market

Yesterday we looked at the Buy & Hold (B&H) strategy from a historical perspective and saw that portfolio returns are a function of when one decides to enter into positions as well how long one holds onto them. Today, we'll look at how adopting even a simple market timing strategy can significantly increase your portfolio returns.

A market timing strategy
I came up with a simple market timing strategy and tested it out on the S&P 500 index tracking stock, the SPY, over the past ten years. The results were so far beyond my expectations that I couldn't wait to share the results with a few friends. Not only were they impressed, but they all said, “Hey D.K., you're not going to give this one away, are you?”

Yes and no. I'll show you the results but I'm going to keep my timing scheme proprietary because I do think it's a marketable commodity. I'm sorry, but I confess to being a capitalist, and although I do love writing my blog, my ultimate goal has always been to turn it into a money-generating enterprise.

The strategy that I devised was very simple. It identified two bull markets and two bear markets (including the one we're in now) in the past ten years. (My charting and simulation software only has data going back to 1998.) The beauty of this strategy is that it required only four trades in 10 years; on average, that's one trade every couple of years. Or if you just wanted to play up markets, that would be only two trades in ten years. Making even this minor portfolio adjustment results in a big pay-off as we'll see in the table below.

B&H versus market timing
I ran four simulations from 2/6/98 – 10/29/08 trading the SPY only. The first simulation was a pure buy and hold strategy; that is, I bought my full SPY position on 2/6/98 and exited it yesterday. In the other three simulations, I used my market timing scheme. The long-only portfolio involved being fully invested during bull markets and going into cash when the market turned down; vice versa for the short-only portfolio. The last simulation was a combination of the previous two—that is, I bought the SPY during bull markets and shorted it during down markets.

Simulation parameters:
$10,000 initial investment
100% margin requirement (essentially no portfolio leverage)
Full cash position used per trade
2% account interest; 3.5% margin interest (default values)
$9.95/trade commissions (no reg. fees included)

[Note: ARR = annual rate of return]
[Click on table to for a larger view.]

The results
Wow! You can see that the pure buy and hold strategy is vastly inferior to the market timing strategy. Even if you only played the long side, you'd be in cash during the down cycles where your money would be earning interest (especially if you put it into higher paying vehicles such as short-term CDs). By far the most profitable approach is to play both sides of the market. Here, you have the advantage of compounding your return even further than if you only play one side. Note also that the market timing scenarios resulted in much smaller drawdowns, an obvious observation as larger drawdowns are expected when the market is moving against your position.

We've shown here that even a simple market timing strategy provides superior returns to the traditional buy and hold mantra. There may be other timing schemes that offer better results, but I haven't been able to come up with one that's as simple to use nor as effective.

Wednesday, October 29, 2008

Buy & Hold: A Historical Perspective

To we continue with Monday's theme of examining the concept of buy and hold (B & H) from a historical perspective. Before we begin, I want to step on my soapbox for a moment and look at how most of us are duped into thinking that this is the superior stock strategy. I have two words for you: Warren Buffett. Don't get me wrong, I respect and admire the Oracle of Omaha for how he manages both his personal and professional life. I believe he's a person of great integrity and of course he possesses an astoundingly astute sense of business. But what I don't like is how people have taken his business philosophy and applied it to their own situation. “If it works for Buffett, it's gotta work for me.”

Why B & H works for Buffett
But does it? Is there perhaps a difference between Joe Investor and Warren Buffett? Besides $50 billion or so? Yes, there is—and the difference is a big one. First of all, Buffett has a cadre of lackeys who do nothing but pore over company financials searching for the next big bargain. When they find one, Buffett steps in and wangles a great deal. He's able to do that because he knows how to do it, he has oodles of dough, and because he is, well, Warren Buffett. Now that he owns the company, he can insert his own management team or he can “guide” current management and let them run the business with them knowing that at any time they could be ousted. You'd better believe that Buffett will try to do everything he can so that his latest acquisition won't fail, because if it did, he might lose the Oracle title and I'm sure he wouldn't be happy about that.

Can you see the difference between Buffett's buy and hold strategy and yours? You buy into a company hoping that what is written on its balance sheet accurately reflects its current condition as well as future sales projections. But unless you're very wealthy, you won't have the means to buy enough shares of the company to have a say in how it's run. For example, you can't tell the CEO that if his company doesn't meet expected benchmarks, he won't get his year-end bonus nor his stock options, can you?

Even John Bogle, the founder of the Vanguard Group (of mutual funds), firmly adheres to the buy and hold forever strategy. (See his “Little Book of Common Sense Investing.”) The key word here is “forever.” Yes, buy and hold works when your time horizon is on the order of 35+ years, but many of us don't have that luxury. So, how effective is it in the shorter term?

When B & H doesn't work
Let's take a look. Here's a chart of the Dow Industrials from 1905-2005.* You'll see that there have been three major bull markets in which the vast majority of gains were made interspersed with three bear markets where gains were negligible. Note, too, that the length of bear markets is much longer than bull markets, with the average being 19 years compared with 12.

Let's look at several examples of what a pure buy and hold strategy might have produced.

Example #1: A 30 year old man starts a retirement account in 1930. If he wants to start drawing from it at age 55, he will have had no gains at all! And if you count in a 3% annual erosion due to inflation, he'll have considerably less. Twenty-five years is a long time to suffer. (Yes, I know in hindsight this is the worst case scenario, buy hey, stuff happens and there's no guarantee we're not looking at a similar situation today.)
Example #2: A 38 year old woman starts her retirement account in 1966. She finds that when she wants to start withdrawing from it 17 years later there's less there (due to inflation) than when she began.
Example #3: A follow-the-herd investor finally jumps on the tech bandwagon near the end of the bubble when the Nasdaq was trading around 4500. Nine years later, his portfolio is down 63% in asset value alone.

Do not let this happen to you! Sure, asset allocation may help counteract the losses caused by poor market timing but very little in today's environment (other than holding short positions) will help you. In summary, buying and holding is for investors with extremely long time horizons and even then, I believe that a market timing scheme, even a simple one, is preferable.

Tomorrow, we'll look at some market timing schemes that anyone can use and see how they compare with each other. Don't miss the rest of this valuable series!

[Note: The chart is in pdf format which means you'll need Adobe Acrobat reader installed on your computer.]

Tuesday, October 28, 2008

A Missed Opportunity + MANDA Updates

Wah! I decided to catch up on some paperwork this morning instead of my usual routine of chart surfing and consequently missed a great one day play in MANDA, my mergers and acquistions fund. I changed my routine for two good reasons: the credit chill has put the kibosh on M&A activity and I said that I wouldn't be making any new M&A purchases until the credit market thaws.

However, rules are made to be broken and I missed a golden opportunity this morning when, out of the blue, Apria Healthcare (AHG) announced that its proposed merger with the Blackstone Group (BX) would close later today. The deal was originally announced months ago and since then the stock has steadily fallen from $20 to $14 on fears that the deal might die. In this environment, who wouldn't be afraid? Anyway, the stock opened up this morning at $20.25, sank to a low of $19.66 two hours later, and has just closed the day as well as its life as an independent company at the buyout price of $21. This was a done deal and would have returned a nifty 3.7% if I had bought on the open; had I been outrageously lucky and bought at the morning low, my return would have been 6.8%--not too shabby for a one day payout! But I missed it, and now I'm crying in my coffee. WAH!

The takeaway lesson here is to expect the unexpected, no matter what the market climate is.

MANDA Updates
Since the last update several weeks ago on October 3rd, Lincoln Bancorp (LNCB) posted a fourteen cent dividend in line with its past four years of quarterly dividends. Rohm & Haas (ROH) announced it will be paying its fourth quarter dividend in line with the previous two quarters. In my last update I said that I would set a stop/loss on Rohm & Haas if it fell below $60. Well, it did and the reason I didn't pull the trigger was that the move occurred on October 10th, the day the market fell to its lowest intraday level in years. I vowed that if the stock closed the day under $60, I would sell it but a huge end-of-day rally kept it off the chopping block. Whew! Glad I waited on that one!

I wish I could say the same for Bluegreen (BXG). In hindsight I am glad that I finally dumped it when I did as it's dropped another 30%. However, had I gotten out when I said I would when it closed under its $9 support level on September 15th, the MANDA portfolio would only be down less than 4% instead of nearly 13%. This just shows you how one bad loss can wreak havoc on an otherwise solid portfolio and why setting stop losses is so important. [I hope I'm listening to this.]

Tomorrow I'll have some results on the buy and hold strategy. So far, the results are quite interesting.

[Click on images to see a larger view.]

Monday, October 27, 2008

To Buy & Hold, or Not to Buy & Hold?

That is the question. To paraphrase Hamlet, “Is it nobler to buy stocks now or wait until complete market capitulation when there's a good chance we could miss out on a major rebound?” Financial pundits have lately been decrying that NOW is the time to get into stocks. They say that many companies have been unfairly beaten down to prices that are well below historical fundamental levels. They're looking at P/E ratios (price to earnings), price to book (how much a company's assets are in comparison with market capitalization), price to growth, price to current sales, price to projected sales, etc. And I don't disagree with them. Many stocks do look enticing, but the real question is:

Can these stocks drop further?
I believe the answer is yes. The major reason the market has dropped so precipitously is because of massive redemptions on the part of hedge funds and mutual funds. They've got to get rid of their inventory and they need to do it by yesterday. Jim Cramer pins much of the redemption frenzy blame on hedge fund of fund managers whom he feels are one step below pond scum on the evolutionary scale. These managers buy and sell hedge funds much like an investor buys and sells mutual funds or individual stocks, so when a particular hedge fund is not performing, these fund of fund managers will pull their position forcing the hedge fund to divest itself of its holdings not to mention its business. (Cramer figures that roughly 30% of all hedge funds will not be around a year from now.)

When can we expect a bottom?
To answer the above question, we need to first answer this one: Are the hedge funds done selling? It's tough to know but one way for the retail investor to tell is to look at volume. The volume on the Dow has been heavy during the past two weeks of selling. Today's volume is on the light side with the Dow essentially unchanged (as of 3:30pm ET). Every time buyers step in, so do the sellers which means the selling pressure is not over with yet.

I know I've mentioned this before but technically I believe the S&P 500 needs to test the 800 level and the Dow has to test the 8000 level. I do believe the VIX will reach 100 before the market finds a bottom. The problem is: I honestly have no idea how low this market can go. Basically, I have no clue as to how much more hedge fund redemption there is left to unwind.

The bottom line
To use CNBC's Bob Pisani's catch phrase, the bottom line is that unless you've got a very long time horizon, buying now could be detrimental to your portfolio. If you truly believe, however, that a stock you love is a bargain, try averaging into it by buying a quarter position at a time. Sure, we don't know when the bottom is going to hit and when it does, the market could rebound through the roof. Am I sure of that? I'm not sure of anything, but I do think there's a good chance it will do just that, but will that be enough for you to make money? Let's consider an example.

Example of how far the market needs to rebound
Suppose company XYZ's stock was trading at $100 just before the onset of the credit meltdown. In just the past two months, it's shed 50% of it's value and is trading at $50. You think now is the time to step in so you buy your full position. The market keeps tumbling and the stock sheds another 50%, down to $25.

Feeling like a fool, you pray for a market bottom. The Good Witch of the Market hears your prayers and stops the bleeding. A bottom is formed. How much will your stock have to rise for you just to break even? One hundred percent, of course. That's a lot to ask of a market rebound. But don't feel too bad—just think how awful you'd feel if you had bought the stock at $100 and are still holding it, like the majority of people with retirement accounts. The stock would now have to rise 300% just for you to break even, and how long to do you think that could take? According to a report I heard on CNBC earlier today, since the depression the average bear market takes three years with the longest bear market lasting eight years. Eight years! Do you want to wait that long for your portfolio to recover?

I think not. So that's why for the next day or two I'll be examining the buy and hold philosophy and comparing it with ones based on market timing and various stop/loss criteria. I'll also examine how shorting in down markets affects portfolio returns. So toss another log on the fire, wrap yourself in your fuzzy throw blanket, brew a cup of cocoa, and settle in for some analysis and discussion of this very important concept that I believe is deluding many people into thinking their retirement accounts are safe. My goal here is not to scare you but to arm you with the appropriate knowledge so that you, too, will be able to avoid “the slings and arrows of outrageous fortune.”

Thursday, October 23, 2008

Juicy Covered Calls on High Dividend Stocks

Continuing with my miniseries on capturing high options volatility by selling option premium, today we'll be looking at covered calls on high dividend stocks. I'm purposely selecting high dividend stocks so that even if the stock drops further, we have the added cushion of a dividend. So far, all of these companies have been faithful in paying their dividends. (If you're unfamiliar with options, please check out the resource links for educational info. The covered call strategy is discussed in detail in Recipe #7: Covered Call Casserole.)

The set-up
I'm looking for richly priced options on lower priced stocks that pay a decent dividend. I'm also looking for at-the-money or slightly out-of-the-money options. The further in-the-money an option is, the more downside protection you get. Here are my input parameters:

Stock price < $50
Dividend Yield > 3%
Current option volatility > Historic volatility
Open Interest > 50
Downside Protection > 5%

The results
Here's what my options search software spit out. Although none of these trades are risk-free, the top five are the ones I feel have less risk associated with them compared with the bottom two which are financial stocks. Out of the top five, three are shippers (you'll note that Diana Shipping was on the naked put list a couple of days ago, too), one jet leasing company (Aircastle), and one utility (Ameren).

All of the companies including investment house Blackstone are still paying their dividends, although Aircastle and Golar cut theirs this year. Diana Shipping actually increased its dividend. Nice! My problem with Blackstone is that its price support level is tenuous. If you still like it, you might want to wait a couple of days to see if its support level holds but note that you'll be exchanging a reduction in trade risk for a smaller options premium. (The higher the price of the stock, the more expensive the call option and vice versa.)

[In the following table, D/P= Downside Protection; % Un = % Unassigned; % Assn'd = % Assigned. Click on table for larger view.]

Other strategies
Writing calls that are deep ITM (in-the-money) is one way to decrease your downside risk. However in this scenario, if your stock doesn't fall below the strike price of the written call, you risk losing it, especially near the expiration date.

That's it for now.

Trader Alert! Time to Protect Short Positions

I'm in the midst of putting together today's blog and watching the VIX (volatility index) climb into new, uncharted territory. It just topped 78--an all-time high in this current incarnation, and the way its daily chart is looking, I don't think that 100 is out of the question. In fact, a check of the movement in the other major indices appears that another significant downturn is in the cards unless they can hold current levels which I think unlikely. Support for the Dow is 8000; for the S&P it's 800, and the Dow Transports--a leading indicator of market direction--is sitting right on support at 340. If you think things are grim now, wait until next week. It could be scarier than a haunted mansion full of trick or treaters; think Nightmare on Wall Street.

HOWEVER! This is pure extrapolation from what the charts are telling me, and I hope this time I'm not right. Even though I do feel the other shoe in the unwinding of the credit crisis hasn't dropped yet, I do think it prudent to start protecting your short positions, especially if you're holding ultrashort ETFs. BUY SOME PUTS OR COVERED CALLS ON THEM NOW! We've seen how quickly they can turn against you. Don't be left holding the bag again.

Protect your positions. DO IT NOW!!!

--A public service announcement from Dr. Kris

Wednesday, October 22, 2008

Airline Plays on Falling Oil

Oil continues its decline falling by over $5 today. I mentioned pure oil plays in last Thursday's blog ("Texas Tea Proxy Plays") and want to mention that going long the airline stocks is another ancillary way to profit from the drop in oil.

Most of the major US air carriers have staged significant comebacks on the order of 200-300% in just the past week! Many are on the verge of breaking out of their bases, most notably Airtran (AAI), United (UAUA), Northwest (NWA), Delta (DAL), Alaska (ALK), and American (AMR). Most of the stocks hit the ground running this morning and I thought that many of them would break out, but the airline rally starting losing steam by midmorning and has taken a nose dive in just the last half hour (3pm ET). Northwest (NWA), for example, was down $1.65--20% off its intraday high just a couple of minutes ago but is now charging back and is up almost a point since I began this paragraph. Talk about intraday volatility--wow! [Chartwise, I saw this turnaround coming as it put in three long bottoming tails on the 5 minute chart just before exploding to the upside.]

I'm not here to relate intraday movements but I couldn't resist as today has been an exceptionally wild ride for the group. My purpose here is to give you some airline plays that are viable for the next couple of weeks, or until oil finds a bottom and begins to turnaround.

My airline picks
The above mentioned stocks sport the best charts with Air Tran (AAI) looking to be the best of the bunch. It's also the cheapest one of the group currently trading at $3.36. The November options field isn't very robust but if you'd like to own the stock at $2.50, you could sell a cash-secured Nov 2.5 put (open interest = 10). The current price is $0.15 x $0.25 and you might be able to pick it up for $0.20 which amounts to an 8% naked yield. Plus, the option is trading at a premium which we love when selling options. (See Recipe #6 for strategy details.)

Tuesday, October 21, 2008

Selling Puts on High Dividend Stocks

As part of my mini-series on taking advantage of high options volatility, today we're looking at selling cash-secured puts to not only generate income but as a tool to buy high dividend stocks that you'd like to own. Note that this option strategy IS allowed in retirement accounts (check with your broker). If you're unfamiliar with this strategy, please review Recipe #6: Put Pot Pie located under Recipes and Cooking Tools, and if you don't know anything about options, DO NOT ATTEMPT THIS NOR ANY OTHER OPTIONS STRATEGY! At least until you paper trade it for a while. (Sorry for yelling but I can't emphasize this enough--options are not as simple as most people will have you believe. They're like anything else--you need to get some experience before you can start making consistent money with them.)

The set-up
I'm looking for rich options on lower priced stocks that pay a good dividend. Here are the parameters I input into my options strategy software:

Stock Price < $50
Dividend Yield > 3%
Black-Scholes ratio (historic) > 1 (looking for overpriced options)
Black-Scholes ratio (SIV) > 1 (looking for overpriced options)
Open Interest > 100 (to provide liquidity)

The results
Here's the chart of my four picks: (Click on chart for larger view.)

It's no surprise that it's comprised of two real-estate investment trusts (REITs) and shippers. This list is meant to be a springboard for your own research. If you like any of these, wait until the stock trades at a relative low and put in a limit order (usually between the bid and the ask). Remember to make sure that you have enough cash in your account to cover the cost of the stock should you be forced to buy it and check with your broker concerning margin requirements. (If you have the cash free and clear it shouldn't be a problem.)

All of these stocks have been badly beaten down, but that doesn't mean they can't drop further. I just think that even if you did apply this strategy and got the stock put to you, at least you'll have a juicy dividend to assuage your grief, not to mention the extra downside protection afforded by the sale of the put.

In the next couple of days, I'll be looking at other high-dividend stock plays as well as premium-rich covered calls.

Monday, October 20, 2008

Merger Monday: New M & A Activity Today

Excelon makes a stock swap bid for NRG
Two major deals were announced today. The first was Excelon (symbol: EXC), the largest nuclear power operator in the U.S., announcing a take-over bid for NRG Energy Inc. (symbol: NRG). If the merger goes through, the combined company would be the largest energy provider in the country.

The proposed deal is a $6.2 billion stock swap: 0.485 shares of Excelon for one share of NRG. Based on Friday's closing price, that translates in $26.43 for one share of NRG--a 37% premium over Friday's closing price of $19.33. I'm not buying NRG for the MANDA Fund right now for several reasons.

Fundamentally, NRG is groaning under $8.1 billion in long-term debt which could lower Excelon's credit rating. The deal is subject to regulatory approval which Excelon believes can be achieved by "modest divestitures of some assets." The unsolicited offer is currently being reviewed by the NRG suits. If it they reject the offer, a hostile takeover is likely; if they accept it, the deal will then require approval of both companies' shareholders, and most importantly, will be subject to due diligence. [Aside: It was this due diligence process that effectively tanked the BXG takeover recently forcing me to sell it in MANDA, although the deal is not completely dead.] If the energy and utility sectors keep dropping, Excelon can use the due diligence excuse as a way to worm out of the deal.

Technically, I'm not a fan of stock swap deals, especially in a declining market. Even if the deal is approved by both companies, it probably won't close until at least the first quarter of 2009 and who knows what will be the price of the market and Excelon stock? Adding to that, our new commander-in-chief may have his own ideas on energy policy and corporate taxation, as if we need to throw another factor into this already loaded equation. So, no thank you for now. But I'm keeping this one on my radar screen.

CEO of Landry's Restaurants seeks to buy outstanding shares
The CEO of Landry's Restaurants (symbol: LNY) lowered his bid to purchase the outstanding shares of his company for yet a third time this year. The first time was in January when he offered $23.50 a share. The second time was April when the price was lowered to $21 a share. Today, the offer was lowered to $13.50 a share. Sound like a bad deal? Not when you consider that $13.50 is a 49% premium over Friday's closing price. Will the deal go through this time? I don't know, but people are staying away from restaurants in droves, and if this situation continues, the prospects for financing grow dim. The deal is expected to close before February 15, 2009 which is the expiration date of the lenders' financing commitment.

At least this is a relatively “clean” deal, that is, no regulatory issues need to be addressed, there's no due diligence, and there's no stock swap—just clean, cold cash per share. I like all of that. But I'm not in this one, either. Before I make another MANDA purchase I'll need to see the credit market stabilize first...and that could take a while.

Upcoming blogs
I know I keep promising high dividend plays and hopefully tomorrow I'll be able to provide you with some good candidates for your income portfolio and/or retirement accounts. The VIX is coming down and I do also want to give you some solid covered call candidates so that you can profit from inflated options premiums. Maybe I'll tackle that one first...

Funny Video: How We Got into This Mess

If you need a good morning laugh and you're wondering exactly how we got into this financial mess, check out this informative video.* It is an interview with “investment banker” George Parr who guides us from crisis inception starting with the story of “an unemployed black man sitting on his crumbling porch somewhere in Alabama.” From there, Wall Street brokers step in and the situation quickly escalates culminating with the fall of the global capital markets. Mr. Parr does a great job of dissecting the forces behind the credit crisis and makes it so easy to comprehend that even your great auntie from Poughkeepsie should have no problem understanding it.

The video is very funny making the subject matter easy to swallow. Unfortunately, I wish there was a cure for the malady itself that is as palatable. Enjoy!

*My thanks to surfer-girl Mel for emailing me the video link.
FYI: The video comes with Spanish subtitles.

Thursday, October 16, 2008

Texas Tea Proxy Plays

Yesterday I mentioned that crude is projected to continue dropping before settling somewhere in the $45-$60 range. Crude fell to just under $74 at the close yesterday and today the price has dropped another $4 to just under $70 (at the time of this writing). The profit window on this trade is closing as we speak, so without further ado, here's a few recommendations for your consideration.

The pure play on oil
The true pure play on oil is shorting the futures. As many of you out there don't know how to trade futures and might not have the money nor are inclined to take the risks associated with futures trading, I set out to find the best proxy for an oil futures trade. I thought that buying the DUG, the ultrashort* oil and gas ETF would be the play, but that is NOT a pure play. According to this link, the DUG is based on the Dow Jones US Oil & Gas Index (symbol: DJUSEN) which “measures the performance of the energy sector of the U.S. equity market. Component companies include oil drilling equipment and services, coal, oil companies-major, oil companies-secondary, pipelines, liquid, solid or gaseous fossil fuel producers and service companies.” This is why its price movement isn't always inversely correlated to the price of oil. [FYI: The DIG is the ultralong version of the DUG, and the DDG is the short version of the DUG.]

So, is there a better proxy we can use? Well, if there wasn't, I wouldn't be writing this. There are several ETFs out there that track some type of oil futures:

OIL: Ipath ETN Crude Oil: Tracks the Goldman Sachs Crude Oil Return Index (plus treasuries).
DBO: Powershares DB Oil Fund: Tracks the Deutsche Bank Liquid Commodity Index - Optimum Yield Oil Excess Return.
USO: United States Oil Fund, LP: From MSN Money: “The investment seeks to reflect the performance, less expenses, of the spot price of West Texas Intermediate (WTI) light, sweet crude oil. The fund will invest in futures contracts for WTI light, sweet crude oil, other types of crude oil, heating oil, gasoline, natural gas and other petroleum based-fuels that are traded on exchanges. It may also invest in other oil interests such as cash-settled options on oil futures contracts, forward contracts for oil, and OTC.” A weekly chart of USO is at the bottom.

These are the pure oil plays. Their charts are fairly interchangeable, and they've all lost 50% of their value since their all time highs on July 11th. My top choice is the USO because it is by far the most liquid of the group with an average daily volume over 13 million shares. The trading volume on OIL is around 800,000 which isn't shabby unless you're playing options, and there USO is the clear winner.

Stock and options plays
I think shorting the USO anywhere under $58.00 with a protective stop at the $62.00 resistance level is a good play. The next major area of support is around $55. If it can't break through that (but I do think it will), then cover your position or protect it with a call option (see married calls below). When it gets below $56, start setting trailing stops. [One popular method is to set the stop at the previous day's closing price plus the average true range which is about $4 for USO.]

Because of the high VIX, I urge you NOT TO BUY OPTIONS unless they are part of a spread. Seasoned options traders can take in premium by using covered puts, calendar put spreads, and bear-call credit spreads. Because of the extreme market volatility, I suggest avoiding the latter unless it's an out-of-the-money spread. Though your loss is limited, you still can easily incur one for an at-the-money call spread, and who wants that?

The novice options trader should look to bear put debit spreads instead of buying a straight put as the spread mitigates the effect of volatility-inflated premiums. Married calls can also be used. One big advantage of this strategy is that the call limits your loss should the stock rise in price (which it could well do in this volatile market climate).

I don't have room to go into each strategy in detail; these are merely suggestions for further consideration. As always, know what you're doing before attempting to trade any of them. Since we're in a bear market and are likely to be in one for some time, you might wish to add some of these to your trading arsenal--but paper trade first!

Other related ETFs
OIH, FXJ: Both are plays on the oil services sector.
DBC: A diversified commodities ETF.
XLE: Oil and gas companies ETF.

Note: You can see from this discussion how important it is for you to thoroughly research your prospective ETF purchases so that you will have a better understanding of the factors influencing their price movement.

Weekly Chart of the USO: US Oil & Gas Fund
(Click to enlarge.)

Wednesday, October 15, 2008

Crude Plays

I've been working hard trying to finish today's blog but I'm still stuck in research muck. What I shall post tomorrow are the best ways to play the falling price of crude. Many experts feel that oil is vastly overpriced and expect to see it settle somewhere in the $45 to $60 a barrel range. This morning OPEC cut its 2009 growth estimate by 100,000 barrels a day. On top of that, the weekly MasterCard Spending Pulse report said gasoline consumption last week was 10% lower than a year ago and likely to remain low. The news precipitated a $5 drop in the price of crude, ending the day just below $74. I think this is the beginning of another leg down giving us the opportunity to profit from some type of short trade. But the question is, what trades will be the most profitable while also affording some degree of safety?

That's the question I'm in the middle of answering. I thought this would be a simple blog to write but I kept uncovering interesting and heretofore unknown facts while researching and it's changed my perspective on how to best play this sector. Tomorrow I'll share what I've found along with my recommendations. Stay tuned!

Tuesday, October 14, 2008

Options & Volatility: What it Means to You

My financial inbox is a repository for every single piece of spam spanning the entire marketplace. Every time I up the spam filter I lose crucial email. I just can't win, but being the eternal optimist, I occasionally read the spam, if nothing more than for entertainment value.

But lately, some of this spam has been more disconcerting than entertaining, especially in the options arena. Now, dear reader, if you're not into options nor do you ever intend to be, then don't read on. But if you do play options, it would behoove you to stay tuned 'cause I've got some important information that's timely to today's market.

Long Straddles and Strangles
No, this isn't a sequel to Blazing Saddles, but rather two options plays that have been papering my inbox from various financial entities who want to ultimately sell me their product. You might already be familiar with the concept of a straddle since I introduced it in my second recipe, Straddle Strudel. To recap, a straddle is an options play where you buy an equal number of calls and puts with the same strike price and the same expiration date. A strangle is the same except the strike prices are different. This lowers the cost to put on the trade but it also widens the break-even points.

These options strategies are used to take advantage of volatile markets or special events where the underlying could move dramatically in either direction—you just don't know which direction it'll be. You're probably thinking, "Hey great! This would be an excellent play in the current market." You along with a lot of other folks, including the CBOE. On the surface it does seem like a good play, so what's my beef? It's the volatility itself.

Options and volatility
In just the past month, market volatility (as measured by a basket of options on the S&P 500) has more than doubled and is currently hanging out at unprecedented levels. A high volatility means that options premiums are more expensive, although the implied volatilities for each stock (and for each month and strike price, for that matter) are different. What this all means is that a straddle put on today might cost considerably more than one put on a day or two from now (or vice versa). To drive home my point, let's consider an example that I calculated from data taken earlier today.

Example: A long straddle on the Diamonds
This morning the Dow tracking stock, the DIA, was trading at $94. At that time, the cost of putting on a March 95 straddle would have cost about $17.45 per contract. This means that in order just to break even, the stock would have to trade either above $112.75 or below $77.55. Not that either goal is impossible; it's just that the probability of either event is fairly low. But if we put on such a strategy when the implied volatility (IV) is lower, our breakeven points are narrowed and the probability that we'll make money on the trade increases. To see the effect that IV has on the price of options, I've complied the chart below by plugging in different IV values into my handy-dandy Black-Scholes options pricing calculator at a constant stock price of $94. (Click on the table for a larger view.)

These results should shock you. You can see that as volatility decreases, the difference in the price of the same option decreases dramatically, especially for calls.

The moral of the story
The moral of the story is to do your options due diligence before you even think of placing a trade. You should do this every time anyway, but it's especially important with these types of trades because the outcome is so dependent on IV. I know you're getting tired of hearing my admonitions, but please please please, do yourself a favor and paper trade these complex strategies first. There's a lot more to them than how they are being hawked in the financial spam letters which makes these sound like simplicity itself. Don't fall for it!

Resource: The CBOE (link to the right) gives historical implied volatility data for any optionable stock or ETF. Click on the Tools Tab and then the IV Index.

Monday, October 13, 2008

Today's Rally—Yay! Or Nay?

We finally got our relief rally with all of the major indices gaining 11%. The media claims the rally was fueled by worldwide bailout moves from central banks, but this market was so oversold that even a report that Paris Hilton might be retiring from the public eye could have sent stocks soaring. Historically, there is a high correlation between bond-shortened holidays (or in this case, no bond trading) and market gains. Today was no exception.

Now, the question is: Is this just a temporary correction or the beginning of a new bull market? As I mentioned last week, most market technicians (including me) are in the former camp. So, what course of action should we take assuming there's further downside?

Get rid of portfolio crud
This means dumping your dogs. How do you identify a dog? It could be a stock that has been lagging its industry. It could be a company with little cash and a high debt-to-equity ratio. It could be in a sector that is expected to especially do poorly in a recession such as retail and consumer discretionary. It could be a high-risk company--a high-tech infant with a new, untested technology or a biotech with only one product in its pipeline. These are companies to dump and to avoid buying at any cost, at least for right now. Your motto should be: If I wouldn't buy the company now, get rid of it.

Use market rallies to put on portfolio protection and dump your dogs
Looking at the action going into today's close, it appears that the major indices continue to advance albeit on declining volume. This type of action is typically followed by a bullish open on the morrow, so I expect that the market has a few days more upside to it. (The market was so overstrung that there could be a few weeks of gains, but I wouldn't bet on it.) This would be a good time to dump your dogs and protect the rest of your portfolio, if you've been too lazy or too shell-shocked to take action months ago. (See last Wednesday's blog for portfolio protection strategies.)

You own ultrashort ETFs and got hammered today—what now?
First of all, I feel your pain, especially those of you who were in the foreign markets and commodities ultrashorts, some of which lost between 25-45% today. (The EEV, the emerging markets ETF was the biggest loser.) But the incredible gains of last week should have clued you in to the possibility that this situation might occur soon. Okay, so you didn't lighten up or take steps to protect them—now what? I would get out as soon as possible, even if all of your potential profit has been wiped out. Sure, you could hang onto them, but I think that they've got a lot further to fall, and getting back to your break-even level might take some time...if ever.

You'll be able to recoup some of your losses by selling out-of-the-money cash-secured puts when the market looks like it's about to tank again, provided you still want to own the ETF. (See Recipe #6: Put Pot Pie on how to use cash-secured puts to buy stock as well as the attendant risks.) This might ease the pain of today's loss. Remember that the ultra ETFs are double-edged swords!

Note: You can use the cash-secured put strategy on any optionable stock that you wouldn't mind owning. This is one way to generate cash into your account but the major risk to this strategy is that the stock can move below the strike price. While this isn't the best strategy while the market is still trending lower, it is a great one to use at the beginning of a bull market, so keep that one on the back burner.

Update on Friday's Morgan-Stanley Plays
Morgan Stanley sweetened its deal offering which Mitsubishi accepted this morning, one day earlier than expected. (I'm sure that the Treasury Department along with other foreign banks making aggressive moves into their banking systems didn't hurt, either.) On Friday, I mentioned a covered call play that would work if the deal went through and a covered put play if you believed the deal wouldn't go through. If you made a play that the deal would be consummated, then you're probably pretty happy. My suggested covered call play would have returned 100% with 67% downside protection—not bad! However, if you made the opposite trade, you'd be suffering a loss unless you managed to exit the trade near the open (as I advised) in which case you would have broken even. (The trade's break-even point was $15.20.) Had you just shorted the stock, you would have woken up to a nasty loss of $5.75 over Friday's close for an ugly 60% loss!

Friday, October 10, 2008

Quick & Dirty Weekend Plays

I wanted to get this out ASAP so that all of you gamblers can have something to play before the weekend. Note that the following are speculative options plays and should NOT be attempted by the uninitiated. A high VIX screams for options selling strategies, and here are a couple.

Morgan Stanley (MS) Covered Calls or Covered Puts: Shares in investment bank Morgan Stanley fell an additional 40% to around $7.50 this morning on worries that its bailout deal with Mitsubishi UFJ might not go through. Flaming the worry fire were concerns that Moody's may cut Morgan Stanley's credit rating. Two weeks ago Mitsubishi offered $9 billion for a 21% stake in the company At that time, Morgan was trading for $25/share. The deal is set to close on Tuesday. If it goes through, the stock is set to pop; and if not, it'll drop.

If you think that the deal will go through, then a covered call is a good bet. Remember that the lower the strike price of the call, the greater your downside protection. But this protection comes at a premium—selling a higher strike call will increase your returns if the stock is assigned. A covered call combination that I like is to sell the 2010 January 5 call (option symbol WWDAA) at $5 (bid $4.40, ask $5.70, open interest =113). If you can get the stock around $7.50 this will give you approximately 67% downside protection and 100% return if assigned. Your breakeven point is $2.50 below which you'll start losing money. The most you can lose is $2.50.

If you strongly believe the deal won't go through, write a covered put. A covered put is similar to a covered call except the situation is reversed and there is the possibility of unlimited losses. In a covered put, you short the stock and simultaneously sell a put. The April 12.50 put (option symbol: MSPV) has decent open interest of 478 and is currently selling for $7.40 bid by $8.30 ask. If you can pick up the option for say $7.70, your breakeven point (the point at which you'll start losing money if the stock goes higher) is $15.20 ($7.70 for the option premium plus $7.50 for the stock). Although this high premium gives you a lot of downside protection, note that if the stock takes a huge jump above the breakeven point, you will begin to incur a loss which will escalate as the stock rises.

Although the risk profiles for both the covered call and covered put are similar (but inverse to each other), the loss an investor can incur on a covered put is theoretically infinite while the loss is capped on a covered call (a stock can't go less than zero).

Exiting the trade
I'd get out of this trade as soon as possible after the deal status is announced on Tuesday. If you find yourself on the wrong side of it, I believe it's best to limit your loss as the stock will most likely keep trending in that direction. If you're on the right side of it, then I'd still take my profit as who knows what can happen in this market. In any case, writing in-the-money calls and puts is my favored course of action here since they offer the most protection.

Other Plays: I don't have time for more detailed plays, but you can employ the same strategy to index tracking stocks and ETFs with liquid options. Who knows? Something important may actually occur at this weekend's G7 meeting.

Market Note: The market may be setting up a relief rally (barring any further bad news) as the Dow Transports have formed a long bottoming tail and have hit the next major support level. (See chart below.) A covered call on the Diamonds (DIA—the Dow tracking stock) could be a nice play for the next couple of days, although holding anything over this weekend will be risky.

(Click on image for larger view.)

Wednesday, October 8, 2008

Bear Market Strategies—A Reminder

Just a quick blog today to alert my faithful readers as well as newbies to some strategies that can be employed in today's highly volatile market. The strategies I'll be mentioning all involve options, so if you don't know how to use them, please use the resource links to the right to educate yourself first. Now is a great time to employ trading schemes that take advantage of the high volatility, such as anything involved with selling options (especially puts).

If you want to buy a stock but are afraid that it'll still go down
Check out Recipe #6 on cash-secured puts. This is a great way to buy stocks, especially high-dividend paying, good growth stocks you'd like to own. The only requirement is enough cash to cover the cost of buying the stock at the strike price (and I dearly hope you have some cash left!) along with the approval from your broker. This type of trade is legal in retirement accounts, and it really depends on your brokerage firm if they'll allow you to do this. If not, you can easily transfer your account to a broker who will. (OptionsXpress is one firm who specializes in options trading. My IRA is with them and I've been very happy with their service and trade executions, and no, I'm not getting any compensation for the plug—alas.)

The major downside to this strategy is that the stock may trade right through the strike price and you could potentially be left with a loss. However, some insurance is already built into the trade in the form of money collected on the sale of the put. You can avoid further loss by buying a married put or an equity collar as soon as possible. (See next section for further info.) The upside to this strategy is that the stock will remain above the put strike price (write only front-month puts please!) and you can keep writing puts and collecting premium until the stock is eventually assigned.

If you want to protect a stock from further loss
Recipe #4, Part I suggests ways to hedge an entire portfolio using index options. Part II looks at ways of hedging a particular stock using married puts or equity collars. Since we're in a high volatility environment, I suggest using the latter strategy. Why? Because you'll be paying a high premium to buy the puts, but selling calls against it will mitigate that effect. Plus, if the stock keeps dropping, you have the added advantage of buying back the covered calls (at a much reduced price) and selling more calls at a lower strike. So, if your stock keeps dropping, not only will the value of your put increase (unless volatility decreases drastically) you'll also keep collecting premium on the sale of the calls. If you're vigilant on rolling down those calls, you might just end up with a tidy profit on the transaction!

This equity collar strategy can also be used to start protecting any ultra-short ETF positions. Most of these ETFs are optionable; however, liquidity with some of them can be an issue. This is when you must know what you're doing. NOTE: I wouldn't put on an equity collar until your position gets into the exhaustion phase, i.e. extreme price movement accompanied by very heavy volume.

Why should I use these strategies now?
Many market technicians feel that we're only in the middle of this bear scenario and have a good six months to a year of further downside. Based on what the charts of the major indices are telling me, I completely agree with them. Sorry to be the bearer of bad news, but by reviewing and using some of these recipes, you could possibly spare your portfolio and/or retirement account from major losses.

Tuesday, October 7, 2008

How Low Can We Go?

That's the $64,000 question, or more appropriately, the $1 trillion+ question. Judging from the charts, it looks like there's a lot more downside to this market, as I've been saying for a while. Stock prices are going into freefall and where they land is anybody's guess. The market environment is of galactically ugly proportions. Consider the following:

The VIX continues to rise to levels we've never seen before (the VIX was recalibrated in 2003).

The buy/sell ratio is at lifetime lows of around 0.05. This is in part due to the next fact.

Forced hedge fund and mutual fund redemptions is adding pressure to the market's downward momentum.

The Arms Index (aka the Trin) has been running at extremely high levels. Historically, a high Trin was a leading indicator of a market reversal—but this hasn't happened yet.

The Tick has been trading mostly below zero, sometimes hitting below -2500. The Tick reflects the high negative VWAP values we've been experiencing. Extremely negative VWAP values are also a sign of heavy institutional selling.

If you've been invested in energy or materials stocks, you've gotten your butt kicked. But you don't need me to tell you that. Virtually the only winners in the past few weeks have been the short and ultra-short ETFs. As I've been saying, I don't know how much longer we can rely on them to perform. Some of the gains are really getting out of hand, but yet, I believe some of them are poised to move much higher, like the SKF (discussed below).
Chartology: the Dow Transport message
Let's see if we can make some sense of the weekly chart of the Dow Transports.

The next support level is around 380 followed by 340 and 290. I firmly believe that we'll be seeing the 380 mark (or very close to it), the reason being that it's roughly the same 90 point difference between the top of the double top formation to the neckline (540 – 450) as it is from the neckline (at 450) to that support level. (See chart.) At the end of the previous bear market in 2003, the Transports hit a low of 200. That's about 50% from here and I'm hoping we won't see it reach that point again. On a cheerier note (relatively speaking), both the S&P 500 and the Dow Industrials only have to drop another 17% or so to reach their 2003 lows.

Another fly in the ointment
The ban on naked short selling is being lifted tomorrow so we can expect to see more stocks take a hammering especially the financials, the previous darlings of naked short sellers. This will only send the market lower.

Isn't there any good news?
Maybe. Earnings season kicks off today and if across the board results aren't as nasty as some predict, they could provide a shot in the arm to this ailing market. Also, the Fed is meeting in a few weeks to discuss interest rates, but I think the effect of that decision is going to be secondary.

Until we get that final spike in the VIX signaling a market turnaround, staying on the sidelines ain't a bad place to be. But if you have to be in the market, buying the ultra-short financials ETF, the SKF, wouldn't be a bad short-term play. For you options gamblers, the April 135 call is attractively priced at about 80% of its Black-Scholes value and has decent open interest (1659). If you do elect to buy some options, be prepared to get out fast as this trade could quickly turn against you.

Monday, October 6, 2008

MANDA Fund Holdings as of 10/06/08

(Click on image for larger view.)

VIX Alert!

Just want to slide this in before the market closes. We're getting a nice topping tail in the VIX today and some good looking bottoming tails in the major market indices. Does that mean we've reached a bottom? I don't know. Last time the VIX spiked on Sept. 18th, I thought we might have some sort of relief rally. We did...if you count one up day as a relief rally.

Will this time be different? Have we reached the bottom of the market? I don't know, but I have to say that I still don't think all of the fear has been eliminated. Sorry to say that I do believe that we haven't scraped the bottom of the barrel as yet.

But that doesn't mean we stand still and take no action. The VIX is alerting us to the fact that the market may turn around any minute and we need to come up with a game plan now! For starters, those of you in short ETFs or in short positions in general, NOW IS THE TIME TO BEGIN TAKING CHIPS OFF THE TABLE!!!

For you more conservative investors who (hopefully!) are sitting in cash, now's the time to start lining up your buy plays. In the next day or so, I'll be looking at some juicy dividend stocks to put on our watch lists so that we are ready to pounce when the time is right. (Note that dividend stocks are ideal plays in retirement accounts.)

So, keep your eyes peeled for potential upcoming bargains and whatever you do, keep the faith. The market will turnaround one day.

Let's just hope that day will be soon.

Heads-up: Many of the CNBC talking heads pointed out today that government muni bonds, specifically of the general obligation type, are safe and attractive buys right now.

Friday, October 3, 2008

MANDA Fund Updates

The tightening of global credit has pretty much killed any new M&A (mergers and acquisition activity) and has significantly raised the level of uncertainty regarding deals already cooking. The hemorrhaging of investor confidence has bled into the M&A arena, as evidenced by the dramatic sell-off in the market combined with the VIX at unprecedented levels. In short, very few take-over candidates are looking safe, and this includes some of the holdings in my MANDA portfolio.

Here's a review of current positions.

Photon Dynamics (PHTN): Well! After all of the speculation surrounding the sudden drop in the price of the stock on September 10th, it appears that whatever accounted for it had nothing to do with the fundamentals of the deal as it closed last Thursday just two days after receiving regulatory approval from the government. The acquistion was priced at $15.60/share in cash resulting in a nice 8% return on the trade. Glad I hung in there! But alas, I can't say the same for...

Bluegreen Corp. (BXG): I did not follow my own advice the first time when the stock dropped below $9 a couple of weeks ago and watched in misery as it slid to its pre-takeover level near $6. I finally threw in the towel last Friday when the price fell below its $6 support level and exited the position at $5.62 for a 53% loss. Although this was an ugly loss, I'm glad I did pull the trigger on Friday as the stock has shed another 20% today. Ugh. This may indeed be a dead deal...or a chance for the acquiring company to offer significantly less than the initial $15/share price. I'll be interested to see what happens as the November 15th due diligence deadline approaches.

Rohm & Haas (ROH): The stock has been doing fine until today when it gapped down along with the rest of the market. There's no new news and as far as I know, the deal financing is not in jeopardy. The stock reached an intra-day low of $62.43 but has staged a strong comeback in just the last few minutes. It's now trading at $65.25. Heaven forbid the stock drops any more and I'll be forced to sell it if it trades below $60 support. For now, I'm hanging onto it and not adding to this (nor any) position. For the bold and the brave out there, should you pick some up at this level, you could realize a return of almost 20% if the deal goes through.

And therein lies the crux: How do you know if these deals are in jeopardy? It's not easy to tell, based on public information. Sure, you can call the companies' investor relations departments to inquire about deal status, but good luck getting to speak to a human being. And if you're lucky enough to catch one, how to you know you'll be getting a truthful answer? I don't, which is why I'm holding off on making any new acquisitions until there's more credit liquidity, not that I have any choice in the matter since there's nothing out there worth buying.

Thursday, October 2, 2008

When to Exit Your Short ETF Positions

I was planning on discussing long index strategies for when the market turns around, but looking at today's dramatic declines, I decided to focus on short ETFs instead. At the beginning of July* we noted that the VIX had risen above 25 into bear market territory and suggested some of the more compelling short and ultra-short (ultra-short means double the return as well as the risk) ETFs that stood to profit most from the anticipated market decline. If you had bought some of these, you'd be whistlin' Dixie today as they are all trading well into the green. Many of them are up dramatically with roughly half of them gaining over 7%. Wow! The dozen that were mentioned in the July blogs are all up 7-18% today, including the SMN, the ultra-short materials ETF which is leading the pack just ahead of the DUG, the ultra-short oil & gas ETF.

The ultra-short ETFs aren't the only ones leaping higher. The VIX also took a 15% jump and is looking to go higher. Yep, you know what that means--a market bottom is a ways away. The Dow Transports, the DTX, is rapidly closing in on major support at 415. If it breaks that, then look for the index to fall to its next support level around 385. I'm focusing on the Transports because historically it's been a leading indicator of market direction, although it's not infallible.

Okay. Supposing the Transports break current support, what should you do? Risk-takers can buy more of the ultra-shorts. If you already own them, I'd recommend hanging onto them until you see a huge topping tail on the daily chart of the VIX. If we don't get that, then wait for the Transports to turn around and the VIX to fall below 35. Sure, today's action was dramatic. Traditionally, dramatic price movements tend to be an early indicator that the end is looming as investor fear is accelerating. My crystal ball has been on the fritz so I can't exactly tell you when we'll see capitulation, but when we do I think it's going to come fast and hard. This is why I want to put you on alert to begin dumping your short positions. As reggae-meister Jimmy Cliff said, “The harder they come, the harder they fall,” and I don't want you left watching a great profit turn into a mediocre return or—heaven forbid!--a loss 'cause this can easily happen especially with ultra-short funds.

So what should you do if you can't watch the market all day long? Set stop-losses!--be it a trailing stop, one based on support/resistance levels, or one based on other technical indicators such as the popular parabolic SAR. Whatever your choice of weapon, draw it now. Procrastinators will be punished!

*See following blogs for more on short and ultra-short ETFs: September 9, July 1, and July 2.

Wednesday, October 1, 2008

Market Turnaround Strategies: Steady Eddie Stocks

Continuing with this week's mini-series on how we can profit when the market turns around, today I'm going to take a slight detour to focus on stocks that we can buy now or as soon as Congress puts together some sort of bailout package. I'm doing this for two reasons: One is I know that some people need to trade no matter what the market condition is and the other is that if the stocks I'll be mentioning can perform well in this highly volatile environment, just think of what they'll be able to do once Congress gets its butt in gear. (They're going to pass something; we just don't know what it will entail.)

Okay, here's what I've found. Some of you might be very surprised that the regional banks have been faring quite well in the past several months. I've been meaning to devote an entire blog to them, but have held off because I felt that you wouldn't have believed me. But charts don't lie and despite the fact that many stocks have sold off a bit recently, they're still continuing their uptrend. In fact, the uptrend has been so steady that I refer to these stocks as “steady eddies.”

My favorite Steady Eddies
I just tuned into CNBC's Fast Money show which I haven't seen for a week and a half and guess what? Pete Najarian (the guy with the goatee and ponytail) recommended the regional banks, too. I was going to say that great minds think alike but his favorite stock in this group is National City (NCC). He must be basing his recommendation on fundamentals because no technician would ever pick this one out. Although the stock did gain 65% today (from $1.75 to $2.89), that's still half of last week's value.


Here are my favorites. These stocks have been on the rise for the past few months, looking very attractive (compared with everything else) on a technical basis. Remember to do your due diligence before you buy them and make Pete Najarian, Jim Cramer, and Dr. Kris happy.

Best of the Regional Banks
[Note: “Last” is today's closing price. “Change” is relative price change since 7/15/08. “D/Y” is the dividend yield.]

UCBH, UCBH Holdings. Last: $7.25. Change: +129%. D/Y: 2.2%
PACW, Pacwest Bankcorp. Last: $31.57. Change: +147%. D/Y: 4.1%
SUSQ, Susquehanna Banc. Last: $20.22 Change: + 82% D/Y: 5.1%
UBSI, United Bankshares Last: $34.50 Change: + 77% D/Y: 3.4%

Best of the Savings & Loans
STSA, Sterling Financial Last: $14.69 Change: +467% D/Y: 2.7%

Best of the Money Center Banks (the big guys)
PFBC, Preferred Bank. Last: $11.30 Change: +161% D/Y: 3.5%
USB, US Bancorp Last: $36.68 Change: +62% D/Y: 4.6%
BAC, Bank of America Last: $38.13 Change: +106% D/Y: 6.7%

The regional bank ETF, the RKH
You can also buy the regional bank tracking stock, the RKH. I'm wondering why this is called a “regional bank” ETF since its top-weighted holdings are USB, JPM, and WFC—all large money-center banks. It also holds a 15% stake of preferred stock in Affymetrix (AFFX), a biotech company. I don't know what that holding is doing in its portfolio—perhaps some type of hedge? Looking at the chart of AFFX, the only good position here is a short one, unfortunately. If you like the regional banks and have the necessary capital, I'd suggest creating your own basket of stocks and eschew the RKH.

Other Steady Eddies
There are several other stocks that have been showing great resiliency which I'll toss out for your consideration. Three are in the insurance group: Life Partners (LPHI), up 161% since mid-March; LandAmerica (LFG), up 110% since August 1; and Radian (RDN), up 562% since July 2. These all pay a modest dividend.

Others include the following: 99Cents Only Store (NDN)*, up 91% since July 15, Retail industry; ICx Technologies (ICXT), up almost 100% since mid-March, maker of advanced sensor technologies; and Unifi (UFI), up over 100% since the beginning of July. This company makes fibers that are used in textile manufacturing. Sounds boring, doesn't it? But the company is very interesting for a couple of reasons: One is that it's moving up on heavier than normal volume on no discernible news (in fact it missed last quarter's earnings estimate). This is usually a sign of institutional buying. The other interesting fact is that Wall Street big-wig Ken Langone sits on the company's board and has bought over 550,000 shares of its stock in the past year. (There has been a rash of insider buying in the past year, all under $3/share, and no selling. Board member Bill Sams purchased 1.18 million over the past 10 months.) Pretty interesting for such a dull company, no?

*NDN was featured in the 9/5/08 blog entitled "No More 99 Cents Store."