Tuesday, March 31, 2009

Channeling Stocks Portfolio

Here's the new Channeling Stocks portfolio. There are nineteen short stocks, and one long (the ultrashort financial ETF). Stop loss prices are determined by adding or subtracting the average true range to the cost basis, depending upon whether the position is a short or a long one.

Equal dollar amounts are assumed. Commissions are $10 per trade and the margin interest rate is 4.5%. There's no account interest.

The market is up as of Tuesday morning. I hope I don't get stopped out of these!

[Click on table to enlarge.]

Monday, March 30, 2009

A New Channeling Stock Portfolio

Last week I promised to introduce a couple of new portfolios, and today I'll be honoring that by introducing a new portfolio based on Recipe #3: Chocolate Channeling Bars. Before we start, I want you to know that I do test out each recipe either by back-testing (if appropriate), paper-trading, and/or real-time trading. I've played channeling stocks before and have done well with them, but I've never quantified my results. So, I thought I'd put my (paper) money where my mouth is and see how well I could do in real-time.

The strategy
To that end, I've designed the Channeling Stocks Portfolio according to Recipe #3. Basically, the strategy is a simple one: Identify stocks that “channel” between a lower support level and an upper resistance level and then enter a long position when the stock begins to bounce off of its low and sell when it reaches its high (or close to it). A short position can also be taken when the stock begins to roll off its high and covered when it nears support.

The set-up
The portfolio will be constructed according to the following guidelines:

1. Equal dollar amounts of stock will be used. This prevents overweighting in higher priced issues.

2.End-of-day prices will be used for simplicity, although better results may be obtained by using intra-day prices.

3.Stop losses will be set at 1 N (where N = average true range) below support levels and 1 N above resistance levels. This is an arbitrary figure but in general this approach limits losses to between 7% and 10%.

4.Short positions in stocks above $5 will be taken when indicated. This assumes a margin account and I'll be using 4.5% as the margin interest rate which is appropriate for accounts between $250,000 and $500,000 in size. An initial portfolio of $500,000 will be assumed. Note that account interest rates are effectively zero (about 0.05%) and are not worth bothering with.

5.A flat commission fee of $10 per trade will assumed no matter how many shares are traded. For computational purposes, each trade will be sized at $10,000 each. There will be no portfolio compounding.

6. Options strategies will not be used for now.

The portfolio
One good thing about this current market is that a lot of stocks have been stuck in trading channels, giving me no shortage of viable candidates. In fact, I've found 24 that fit the bill and later this evening I'll be collecting them into a table along with their entry, target, and stop loss prices. Each day at the end of my blog, I'll update you as to new portfolio additions or subtractions. An updated table including the transactions for the week will be posted each weekend. This way you can follow along in the fun and hopefully this will be an instructive lesson for both of us.

Friday, March 27, 2009

I'm still here!

Just a note to my readers to say that I've been working hard on de-kinking my website as well as putting together two new portfolios. I'll be introducing the first one either later today or over the weekend.

I'm also doing research on an exciting new technology which I think is going to have significant impact our entire lives--from the way we light our homes to how we watch TV to how we read books and newspapers. I'm working on identifying the companies at the forefront of this technology and will report on it shortly.

Great stuff so please stay tuned!

Wednesday, March 25, 2009

The impact of blow-out earnings in an unfriendly market

Dr. Kris isn't too big to admit that sometimes she can just be plum...uh...incorrect. Yeah, that's the word. One thing that I wasn't quite correct on was my analysis of post-earnings plays as given in Recipe #12: Post-Earnings Pot Roast. I claimed that the recipe of buying stocks on companies that blew-out analyst earnings estimates to the upside could be purchased and held right up until the next earnings release (barring any intermediate negative news on the company), and vice versa with negative blow-outs. (In this latter case, you would take a short position until otherwise indicated.)

This is a valid recipe but I failed to mention one major ingredient—market direction. If the market is trending upwards, then taking long positions on companies that beat analyst estimates and holding onto them up until their next earnings release generally provides positive returns. What I failed to look at was what happens when the market is trending in the opposite direction--does that have any impact on the strategy?

Yes, it does. Take a look at the price movement of Myriad Genetics (MYGN) shown below. You can see two humps (for lack of a better word) appearing in its daily chart since November. I knew when I saw them that they were most likely the result of blow-out earnings and I was right. On 2/3/09, the company reported 43 cents/share as opposed to analyst estimates of 32 cents, and on 11/4/08 they reported 30 cents/share as opposed to an estimated 14 cents. But if you had played the earnings after each announcement expecting a big pay-day, you might have been disappointed.

The chart shows that investor euphoria only lasted about a week to a week and a half before the stock retraced back to its trend line. Don't get me wrong--had you held the stock since last November, you'd be sitting pretty, but that has more to do with the company's products and fundamentals rather than momentum.

Compare this chart with that of the S&P 500 and you can see a rough correlation between the stock's price and the trend of the overall market. Yes, Myriad has moved up while the market has moved down, but you can see how relative movements in the broader market influenced the movement in the price of Myriad. I think that if the broader market had been trending up instead of down, Myriad would be trading at a much higher price than it is now and the trend line in the chart might then be situated at the high points of the humps instead of well below them.

Conclusion and apology
To those of you who might have been following my post-earnings strategy, I truly apologize for the lack of foresight in including market direction as a fundamental ingredient. Cooking without it can make for some unpalatable long-term returns. If you do wish to play this strategy against the market grain, I strongly recommend taking a quick profit as your gains could evaporate faster than an AIG executive's bonus.

Note: I'll be modifying Recipe #12 to reflect this discussion.

Tuesday, March 24, 2009

MANDA Update + New Portfolios

I'm busy working on two new portfolios that will be introduced shortly which is why today's blog is rather thread-bare. But I do want to alert all of you who are following my M&A portfolio (MANDA) that portfolio constituent, Aladdin Knowledge Systems (ALDN) today completed its merger with private equity group Vector Capital. Aladdin shareholders will receive $11.50 in cash per share. This represents a 5.3% return on the trade. Overall, the MANDA portfolio is up 2.6% since 6/26/08 inception. Compare that with -37% on the S&P 500. Woo-hoo!

Here's the list of all open and closed MANDA trades since portfolio inception.

[Click on table to enlarge.]

Monday, March 23, 2009

Trading with the Trin

Can extreme values of the Trin predict a market reversal?
In last Wednesday's blog ("Beware the Bull Trap") I mentioned that extreme values in the Trin, aka the Arms Index, typically precedes a market reversal. High values signal a short-term bottom and low values a short-term top. According to one article on trading with the Trin, the author states that extreme values in the Trin signal a market reversal roughly 90% of the time. I know from extensive experience day-trading the index futures that extreme values in the Trin generally did precede a market reversal, but I wanted to see for myself what that correlation is.

To that end, I analyzed the charts of the Trin and the S&P 500 index for the past year. The two charts below show the results of my analysis. (It also took me all day to do this which is the reason my blog is out so late.)

There is a correlation, but it's not 90%
The top table shows the correlation between a low closing Trin (<0.5) and the next day's opening and closing prices on the SPX. The market did, indeed, fall as predicted more times than not, but with a high standard deviation. If you had shorted the SPX on the previous day's close, the table suggests you'd do better not only return-wise but also percentage-wise by holding your position until the next trading day's close. Had you made every trade, you would have won 62% of the time averaging three and a half points per trade. That's not bad especially if you're trading futures. (Note that these figures do not include commissions or slippage.)

Looking at the other extreme (Trin >2.5), the bottom table shows a similar 62% success ratio for both the opening and closing trades. Had you bought the SPX on the close, you would have profited quite handsomely--over eight and a half points on average!--by holding your position until the next day's close. In fact, selling on the next day's open is a break-even proposition at best in this scenario.

Although there are only 16 data points in one case and 29 in the other, I do believe that's enough data to infer that extreme Trin values can be used effectively to trade market reversals. High Trin values especially lead to greater profits, and I think that futures traders stand the most to benefit from this strategy. Of course, judicious application of appropriate risk management techniques can reduce loss in those cases when the market doesn't move as expected as no S&P futures trader wants to get stuck with a 59 point loss!

[Click on charts to enlarge.]

Thursday, March 19, 2009

Market Update

A quick blog today as I'm in the midst of doing some new research as well as meeting with my website programmer. BTW, the new site is looking absolutely fabulous and will hopefully be up and running within the month.

Follow-up from yesterday
Yesterday I noted that the excessively high positive levels in the VWAPs combined with the extremely low value in the Trin (Arms Index) pointed to a lower opening today. That did not happen as most of the major indices opened up, but my forecase wasn't completely off-base as most of them drifted lower as the day wore. The Trin roughly mirrored the opposite movement hitting an intra-day high of over 1.60 (compare that with yesterday's values between 0.3 and 0.5). There's still more than a half hour to the closing bell. Barring an eleventh hour rally (which can happen), all of the indices look poised to close down on the day (around 1% for the S&P and the Dow 30).

Today's action
The oil, gas, solar energy, coal, and metals (gold, silver, aluminum) sectors rallied nicely today with many issues gapping up strongly on the open and rallying off of multi-year lows. The drillers especially look good. Here's some that broke out of their bases today: Berry (BRY), Dril-Quip (DRQ), Diamond Offshore (DO), Murphy Oil (MUR), and Ultra Petroleum (UPL). In the gold sector Randgold (GOLD) is nearing its all-time high set almost a year ago. The stock has already rallied 67% from its October low and its chart is showing no signs of slowing down.

The financial outlook
Bank and brokerage stocks have been rallying along with the overall market and a good question to ask is if this rally is genuine. The XLF, the financial ETF, is trading around $8.80 and the regional banking ETF, the RKH, is about $53.50. They're both getting close to overhead resistance which they need to break through in order for this rally to have any legs.

A more visual way of evaluating the status of financials is to look at the ultrashort financial ETF, the SKF.

The chart shows strong support at $100, a level it must break before the financials have a even a hope of rallying.

That's it for today.

Wednesday, March 18, 2009

Beware of the bull trap!

Today's market action seemed to echo the words of Robert Browning: “God's in his heaven, all's right with the world.” Buoyed by AIG CEO Edward Liddy's promise that some of the $165 million in employee bonuses would be returned to taxpayers (and the ones who won't be returning theirs will at least have to give back a portion of it in income tax) along with the Fed's promise to buy more mortgage backed securities and long-term Treasuries, the market was bathing in a sea of green. Pretty much every sector was up, including emerging markets and gold. There was a noticeable absence of decliners, although the dollar took a tumble. The VIX (volatility index) also closed down but still slightly above support at 40.

So, is now the time to take the money you've been hiding under the mattress and go long? Maybe, but I don't think so. Today's action was almost too good to be true and I'm betting that tomorrow's action won't be quite so rosy.

Here's why.

The Trin is very bearish
The Trin is an acronym for TRading INdex. It's a technical indicator developed by Richard Arms. Because of this, it's also referred to as the Arms Index. The Trin is easy to understand. It's given by the following equation: Trin = [# of advancing issues/# of declining issues]/[volume of advancing issues/volume of declining issues].

A Trin less than 1 is considered to be bullish because the market is advancing on expanding volume. A Trin greater than 1 is bearish for the opposite reason. The Trin typically hangs out in the 0.8 - 1.2 region, and when it moves much above or below that area, that's when traders take notice. Extreme levels on the Trin signal that a reversal in market direction is imminent. (A Trin below 0.5 signals a short-term top; a trin above 2.0 signals a short-term bottom.)

For the past week, the market has risen as the Trin has fallen. Yesterday, it hovered in the 0.4 - 0.6 range and today it fell even lower, closing just above 0.30. This is a strong signal that tomorrow's open will be lower.

The VWAPs are at extreme values
The Volume Weighted Average Price is a trading benchmark commonly used by institutions. It's calculated by taking the weighted average of the prices of each trade. What it really measures is how much interest (or lack of it) there is in a stock. VWAPs on the order of 0-80 are mildly bullish; 80-150 is bullish; and 150+ is very bullish. Stocks trading below their VWAPs are those that traders are trying to unload. VWAPs from 0 - -80 is mildly bearish; from -80 - -150 is bearish; and below -150 is very bearish.

Today we saw positive VWAPs in the +200 to +300 range and virtually none on the negative side. This is another indication that stocks may be over-bought in the short term.

The moral of the story is that it might be a good idea to sit on your hands for the next few trading sessions. My stance won't turn bullish until the VIX moves and stays below 40, although I'd really like to see it break 35. Remember that we're not even half way through this credit crisis and there's still a lot more pain to come in residential and commercial mortgage-backed securities and in the consumer credit space.

All is not right with the world just yet.

Tuesday, March 17, 2009

Notes from the IMN Distressed Debt Summit

The IMN Distressed Debt Summit commenced yesterday in Dana Point, California under sunny skies and mild ocean breezes. In IMN's words, the purpose of the conference is to “provide a forum to explore investing in funds focused on distressed equities and debt to review how public funds and institutional investors aim to capitalize on the hottest strategies emerging in today's equity and debt markets.” Many pension and wealth management funds are down by at least 20% and managers are searching for new ways to make up that deficit.

To this end, seven moderated panels were held with the morning sessions shared with the IMN Public Funds Summit being held concurrently. Panelists drawn from state pension funds and investment management firms discussed topics ranging from identifying distressed debt opportunities to taking advantage of severe dislocations in the structured credit markets. To be sure, the topics covered in these sessions were highly technical and diverse in nature but there seemed to be several themes that kept surfacing throughout the day.

Timing is critical
A major conference theme is that timing absolutely matters in terms of taking advantage of distressed debt. Using a baseball metaphor, Frank Hager, Senior Managing Director of Stone Tower Capital, said that we're in the first inning of corporate debt and the fourth inning of structured debt. Paul Lucas of Schultze Asset Management expanded further by showing which strategies should be employed as a function of the default rate as summarized in the following graph:

Right now, he likes senior secured first-lien bank debt as the best alternative to equity investing citing implied ownership at cheap rates--on the order of one to two times cash flow. Other panelists offered their own ideas. Beth MacLean, a leveraged loan portfolio manager at Lord Abbett, likes the debt on solid BB companies saying that they're trading at 80% of par due to virtually no demand. Michael Flaherman of New Mountain Capital uses a defensive growth strategy of buying companies in acyclical spaces claiming they do well in all economies. Prakash Dheeriya, a finance professor at Cal State Dominguez Hills, takes a more novel approach by suggesting investments in “distressed” assets such as movies (a la Slumdog Millionaire), sports teams, governments, and currencies.

In the following session on Structured Credit, Dean Di Bias, portfolio manager at Advantus Capital, offered his credit crisis time line:

2009: Stressed Residential Real Estate
2009-2010: Stressed Consumer Credit
2010-2013: Stressed Commercial Real estate

He says that residential mortgage-backed securities (RMBS) offer compelling opportunities as compared with high-yield alternatives, but these opportunities won't last for long, a view shared by other panelists throughout the day. The general consensus is that the 20-30% returns promised by some of these vehicles will only be realized for a couple of years at most and getting into them at the right time is critical. Richard Hocker, Founder & CIO of Penn Capital summed it up by saying “What we hate now we might love eighteen months from now.”

Many managers said that they are starting to buy at the top of the capital structure (AAA and AA rated securities), and it will be a while before they touch commercially-backed paper. John Pluta of Declaration Management & Research likes senior class non-agency prime residential mortgage-back securities. What he does not like is government mandated loan modification programs claiming that they increase risk. His fellow panelists shared his sentiment.

In the “Distressed Debt Investing” session, panelist Mark Zucker, co-founder and co-CIO of Dorchester Capital Advisors, notes that credit investing today is not distressed but more like value investing with a catalyst. He's down on value investing saying “It should be value heaven but it is value hell.”

Another panelist, Ed Burton, a trustee of the Virginia Retirement System, claims that all risk is priced too low. “Now is the time to take on risk,” he said, further stating that his pension fund is very liquid and is able to take on new positions. To him, stocks and debt instruments all look attractive because he feels they are grossly undervalued. He is especially fond of big companies with huge cash reserves. Microsoft, anyone?

Other panelists liked the area of DIP (debtor in possession) financing which is a type of financing extended to companies in the throes of bankruptcy. This type of debt instrument is very attractive now but one needs to sort through them very carefully.

Find the right manager
Do you know the difference between a CDO and a CLO? No? I don't either and neither do many financially savvy folks which is why many panelists stressed the importance of selecting a good manager. By their definition, a “good” manager is one who has a long, solid track record in dealing with these complex financial instruments and ranks in the top quartile by performance measures. Naturally the panelists working in this area included themselves among that select group. (No egos here!) But I must say that the trouble in finding the right ones can reward the investor with gains in the 20-30% range which is impressive in any market and even more impressive in this one.

In regards to the previous point on market timing, several panelists pointed out that managers are more adept at market timing, yet another reason to find a good one.

Irv Lowenberg, the treasurer of the city of Southfield, Michigan, has his own take on managers. He prefers to invest with the rising stars in the industry as well as the established stars.

There are a couple of caveats to the task of selecting a manager. Panelist Michael Levitt, Chairman & CEO of Stone Tower Capital, worries about what he terms “style drift,” or a deviation in a fund manager's investing style. He says that style drift has become a problem lately as managers try to make up for lost returns by investing outside their areas of expertise. I'm not sure how one can discern if a manager is deviating from his or her investing guidelines, but it's something to take note of.

Another caveat is in credit analysis. Some managers admitted that they do their own credit analysis instead of relying on the credit agencies such as Moody's. Many point their fingers at the credit agencies as the creators of the credit crisis so I certainly can't blame the managers for wanting to do their own analysis but the burning question is do we have any assurance that these managers are doing an accurate job?

Don't forget to diversify
Echoing Jim Cramer, many panelists stressed the importance of portfolio diversification. In the “Weathering the Economic Turmoil” session, the panelists (all of them representing pension funds) agreed that their portfolios would have suffered more had they not been diversified. However, diversification can't solve every problem. Bob Jacksha of the New Mexico Educational Retirement Board admitted that his absolute return strategy didn't work even with the inclusion of hedge funds.

Parting thoughts
There seems to be terrific opportunities in the distressed debt arena but the complexity and availability of the instruments involved is out of the reach of the retail investor. Right now, the professional consensus is that getting into the top of the capital debt structure offers attractive returns even in worst-case scenarios. The bad news is that the equity market won't shape up until the credit market stabilizes but the good news is that many conference participants see the beginning of credit stabilization.

To my blog readers:
You may see from the new sticker at the top of the page that SeekingAlpha has granted me their seal of approval. Yay!

Begosh and begorrah, I almost forgot it's St. Paddy's day. How much fun is green beer?

Sunday, March 15, 2009

More channeling stocks

I'll be at a conference on distressed debt (a timely topic, no?) for the next couple of days but wanted to leave my readers with something besides an empty page. So, for all of you who are following my two recipes (#3 & #15) on channeling stocks, I've found a few more that you can add to your list along with their approximate support and resistance levels:

EBIX: $17.75-$27.50
ASPM: $3-$5
CADX: $5.50-$8

Just broken out (to the upside):

CTRP: $18.50-$25

While the teacher is gone, please don't give the substitute too much grief, okay?

Friday, March 13, 2009

MANDA Updated Table

The table below reflects today's addition of Enpointe Technologies, ENPT. This addition is discussed in an earlier article posted today.

(Click on table to enlarge.)

M&A chart pattern recognition

One reason I love being a market technician is because every stock chart has a unique story to tell. That story is reflected by the price movement along with the trading volume. Not only are fundamental events depicted in a chart pattern, but sometimes they can even be foreshadowed. Savvy traders have been known to make lots of money on these such occurrences. (This is especially true in the case of insider trading which may be invisible to the SEC but not to an experienced chartist. See comment below.*)

I ran across this following chart that, by ordinary standards, looks...well...odd. It's the daily chart of medical imaging IT company Emageon (EMAG), and the story this chart tells is one of on-again/off-again merger activity. (Click to enlarge image.)

You can see that on 10/14/08, the price pops because the company agrees to be acquired by Health Systems Solutions (HSSO) for $2.85 per share representing a $62 million deal. The stock trades in a very narrow range until December 22nd when Emageon says that HSSO is dragging its heels and wants it to close the deal. Investors smell blood and the stock gaps down, closing 41% lower than the previous day's close. The stock sinks further until the end of December when both companies agree to extend the closing date.

Things are looking good until the other shoe drops on February 11th when HSSO says that it can't get its financing together and terminates its offer. (Don't worry, Emageon received $9 million as a consolation prize.) Two weeks later another company involved in medical imaging, Amicas (AMCS), offers $1.82 per Emageon share in a $39 million deal. So far, this deal seems to be working. The stock has been trading very close to the offer price which means that investors are quite confident that this time the deal will go through.

*If you don't believe me, look at the one minute charts of stocks who have had major news announced during the trading session. Many times you'll see that the price and volume increase significantly before the time of the news release, sometimes as much as hours or even days ahead of it.

Another MANDA addition: Enpointe (ENPT)

Yesterday, Enpointe Technologies (ENPT), a global business-to-business IT provider, agreed to be acquired by its founder and CEO Attiazaz (“Bob”) Din and his family for $2.50 in cash per share. The Din family are major shareholders owning about 26% of the outstanding shares of common stock.

The board approved the merger and is recommending shareholder approval. There is a 30 day “go shop” clause in the agreement whereby a special committee representing the company can solicit higher bids. Closure of the deal is dependent upon the usual customary requirements such as regulatory and shareholder approval as well as debt financing by Mr. Din who has already supplied a letter of commitment.

The company has made no statement as to when the transaction might close but I'm guessing near the end of the second quarter or the beginning of the third. I added the stock today to the MANDA portfolio at a price of $2.20 which represents a 13.6% return upon deal completion.

The MANDA portfolio table will be updated shortly to reflect the addition.

Thursday, March 12, 2009

Don't be fooled by this rally!

A market bottom?
Today's 239 point rally in the Dow and 29 point gain in the S&P 500 got many of the financial tongues wagging that this is could well be the holy grail we've been searching for: a market bottom. I don't think so. Before you let the bulls out of the pen, consider the following technical criteria that indicate a trend reversal.

1. Chart pattern violation. A bear market is characterized by a series of lower lows and lower highs. The weekly chart of the S&P 500 clearly shows this pattern. A bull market is indicated when this pattern is broken, i.e. when the new high is greater than the previous high and when the new low is higher than the previous low. This has not happened yet. (This point ties in with #3 below.)

2. A substantial increase in volume. At the start of every bull market, the volume of the new rally is substantially greater than that of the previous intermediate bear market rallies. This has not been the case for the DIA and the SPY (the Dow and the S&P 500 tracking stocks). Today's volume on the SPY was only 18% of its 65 day volume average (81 million shares versus 445 million shares) and 67% of that for the DIA (22 million vs 33 million).

The exception is the QQQQ, the Nasdaq 100 tracking stock, which has been trading slightly above its average volume (of 167 million shares). This could be due to its weighting in biotechs, a sector that is undergoing major consolidation. Still, recent volume is smaller in comparison to previous bear market rallies.

3. Price violation. A reversal in trend is indicated when the price retraces at least 80% of its previous decline, and the stronger the retracement, the more likely a reversal. Let's take a look at the S&P. It's last relative high was at 875 put in on 2/9/09. It hit a low on 3/6/09 at 678. An 80% retracement would mean that it would have to reach 836, and so far, it's only retraced about 37%.

4. The VIX must break support. The volatility index, the VIX, closed today at 41 and change, slightly above its major support level at 40. I firmly believe that we can't even begin to think bull market until the VIX not only decisively breaks that barrier, but stays below it. (Note: The VIX runs inverse to the market.)

Maybe this time the technicals will fail, but they rarely do. I just tuned into Cramer where he's espousing a change in market direction for fundamental reasons. I hope he's right because if this market takes another severe drop, I dread the consequences.

Wednesday, March 11, 2009

Gunning for profits

I've been hankering to write an article on gun manufacturers but a couple of my fellow SeekingAlpha contributors beat me to it. (See this article and this one.) Although I'm rather late to the party, I still want to toss in my two cents for the following two reasons: The first is the fear on the part of the public that the Obama administration will enact tighter gun control laws. The second also springs from a fear-based perception that a further downturn in the economy could fuel an increase in theft and vandalism thus providing impetus to people who want to protect their property.

Smith & Wesson
Of the major manufacturers of firearms only two are publicly traded. The first is the grand-daddy of all of them, Smith & Wesson (SWHC). The company makes everything from pistols to rifles, supporting the entire spectrum of gun owners from hunters to competitive shooters to collectors. It also arms military and security operations worldwide.

According to an article appearing today in Barron's, Wedbush Morgan Securities is maintaining its Buy rating on the company and has raised its target price from $4 to $5. It said that S&W's balance sheet should improve as increasing sales in both the retail and government sectors will help pay down debt while simultaneously reducing inventory. They value the company at a price to earnings ratio of 17.

In another article published yesterday, an analyst at Merriman Curhan Ford said that proposed legislation would target $3.8 billion to better equip law officers. He said that S&W's sales could rise by $47 million to as much as $147 million from the end of this year to the end of 2010 resulting in an earnings boost of 16 cents to 51 cents.

Smith & Wesson's daily chart certainly tells a tale. You can see how the price and volume jumped when the polls projected an Obama win several days before the presidential election. That event halted the steep slide in price and the stock began notching back upward. It broke out of a classic triangle formation on February 20th when Cabela's (CAB), a major retailer in the hunting gear space, exceeded earnings estimates which they attributed principally to a surge in rifle sales. (Note that the chart of Sturm Ruger below exhibits similar parallels.)

The stock continued upwards on much heavier than normal volume and broke the $4 barrier last Friday. Volume has been dropping off in recent days along with price. My recommendation would be to see if the $4 support level holds and to take a position if it turns back up. The next point of major resistance is at $5.

Note that Smith & Wesson will be reporting earnings tomorrow after the close.

Sturm Ruger
The second publicly traded firearm manufacturer is Sturm Ruger (RGR). Its product line is similar to S&W's but its sales are purely domestic. Although sales at S &W are higher than Ruger's ($301 million vs. $181 million in 2008), the latter sports a better balance sheet, at least so far.

After the close on February 24th, the company reported an 81% increase in revenues causing one analyst to upgrade the stock to a Strong Buy. Here's its chart:

The stock has been bouncing between $6 and $7 since December. Following its spectacular earnings announcement, the stock gapped up the next day closing at $9, a 15% increase over the previous day's close. The stock is now sitting near $10 support and a move above recent highs on decent volume would be a buy signal.

Options plays
Note that both stocks have options but S&W's are more liquid. Front-month covered calls could be a good way to bring money into your account while protecting your downside especially if you can write your calls at relative highs. A strong topping tail in either chart has been a tell that a local top has formed.

Monday, March 9, 2009

MANDA Updated Table

Based on today's addition of Gevity (GVHR) as discussed in the article below, here's the updated MANDA holdings.

[Click image for larger view.]

M&A & Channeling Stock Updates

New MANDA addition
I don't know how I missed this one but last Thursday human resource services company Gevity (GVHR) agreed to be taken private by the TriNet Group in an all-cash deal worth $4 a share nearly doubling the previous day's closing price. (The stock hasn't been above $4 since last November after falling well off it's $30 high set back in 2006.)

The deal has the approval of both boards as well as two of its major shareholders, ValueAct Capital Management LP and General Atlantic LLC which own over 13% and 9% of outstanding shares respectively. General Atlantic also happens to be TriNet's biggest shareholder. Pending Gevity shareholder approval, the deal is expected to close in the second quarter. An analyst at Roth Capital Partners said that he expects shareholders to approval the deal.

In a statement released by the company, Gevity will be paying a special 5 cent dividend on April 30th to shareholders on record as of April 16th. In light of the merger, the board postponed their annual shareholder meeting from May 20th to a time as yet to be determined.

I have a good feeling that this merger will succeed and I added the stock today at $3.78 to my M&A portfolio, MANDA. Including the proposed $0.05 dividend, this trade will yield 7.1%.

Good news on the Dow/Rohm-Haas front
The threat of a lawsuit brought by Rohm-Haas (ROH) against Dow Chemical for failure to complete their merger within the allotted time finally forced Dow into a pow-wow with the chieftains at Rohm. This was a tough one for kimosabe Dow since the financing they expected from the Kuwaiti government unexpectedly fell through and paying the proposed $78/share for Rohm stock would have put Dow's credit rating and viability as a company in serious jeopardy.

The trial was all set to commence this morning but proceedings were halted twice by the judge. Both companies finally agreed to proceed with the merger as planned especially since Warren Buffett and the Kuwaiti government both rode in on white horses throwing $3 billion and $1 billion respectively into the kitty. The two largest shareholders in Rohm-Haas also agreed to pony up $2.5 billion in Dow preferred shares plus an additional $500 million in cash. Rohm shareholders will receive their $78 per share plus proceeds from the almost $3 million per day penalty fee that Dow has racked up for not closing the deal on time.

The acquisition is set to close no later than April 1st. Let's hope this won't be an April Fool's joke on us Rohm stock holders. (ROH is a MANDA holding.)

Other Big Pharma deals
On January 23rd, Wyeth (WYE) agreed to be acquired by Pfizer (PFE) for $68 billion in a cash and stock swap deal ($33 in cash plus 0.985 shares of Pfizer). One third of the deal is being financed by banks who said they will withhold financing if Pfizer's credit rating drops below a certain level. Since the deal was announced, shares of Pfizer have dropped 25%. I don't like buying into deals involving stock swaps, especially in this negative market climate.

Two big deals today—one done and one in the works. Merck (MRK) picked up Schering-Plough (SGP) in a $41 billion cash and stock swap deal ($10.50 in cash plus 0.5767 shares of Merck). I'm not taking this one for the same reason given above.

The Wall Street Journal has just reported that the board of Genentech (DNA) is seriously considering Swiss-based drug giant Roche's $95/share bid representing a $46.7 billion deal. This deal isn't struck as of this writing and I'll be scrutinizing the terms if and when it's offered. Roche already owns 56% of DNA stock and has been trying to buy it for months.

Note: My blog on 11/4/08 cites other potential takeover candidates in the drug sector. Here are the eight stocks that I felt were attractive targets: BIIB, CRL, DNA, GENZ, GILD, LIFE, and TECH.

Channeling stocks update
For those of you following my Channeling Stock Breakout recipe, two stocks broke their lower support channels today: SWS Group (SWS) and Roper Industries (ROP). Bearish positions can be taken on these two and they're both optionable (watch out for light liquidity). Recent channeling breakdowns, Oracle (ORCL) and Paccar (PCAR) are both continuing strongly to the downside.

Tomorrow I'll be looking at a defensive play and by ”defensive” I mean it in more ways than one. You'll see.

Friday, March 6, 2009

New website, channeling stocks, M&A news, and Peter Tork

Today's blog is a potpourri of topics of which none requires much discussion. To expedite your reading time here as well as my writing time and so we can both jump directly into the weekend, I've summarized the grab-bag of topics that have been left on my Blog Idea List.

New website!
The Stock Market CookBook will be transferring over to its new home which will be www.stockmarketcookbook.com. My software engineer is closing in on the site construction which, as with any type of construction, is taking longer than anticipated. We're shooting for sometime in the next week or two. I'm proud to tell you that it's already looking byoo-tee-full and will offer all sorts of nifty new features as well as my (almost) daily blog. We're all very excited!

Channeling stocks update
Per Monday's blog regarding channeling stock candidates, ORCL (Oracle) and PCAR (Paccar) have both broken to the downside. MDTH (MedCath) and ROP (Roper) are hovering at lower support.

Dow Chemical/Rohm-Haas (ROH) merger update
It looks like Dow and Rohm-Haas are back in merger talks. Rohm is suing Dow for breach of contract and the case is set to go to trial Monday. Rohm stock closed up 18% ending the day at $63.80. (Dow agreed to pay $78/share in cash for Rohm last July.)

Invest in further education
No matter what field you're in (with the possible exception of blue-collar work), it's important for everyone to keep up with current trends. For example, today I was reading about how web designers and operators use Google Trends as an SEO tactic. Before last week, I had never heard of SEO nor Google Trends but I know now. (FYI, SEO stands for search engine optimization, something that I'm going to have to know very soon, and Google Trends is a ranked list of current search words. I just checked it and Peter Tork's* name made the top ten which is the shameless reason I put it in my title.)

The point of this is that it's important for all investors to keep expanding their knowledge, and one of the best places to do that could be right on your own broker's website. Since I trade options, I use OptionsXpress and can say that their site provides a wealth of educational and trading tools including powerful real-time charts, options chains, a virtual trading platform so you can test out your strategies, web tutorials, stock screener, strategy scanner, etc.--everything including the kitchen sink!

I'm not getting paid to say nice things about OptionsXpress (unfortunately!) but I see that most of the popular online brokers offer similar trading tools. So before you go out and spend good money on investing seminars and books, check with your broker's website to see what's on their shelves.

As they say, a little education can be a dangerous thing, but a lot of it can make a huge difference to your investing success.

*I clicked on his name and was very sorry to learn that the affable former Monkee has a rare form of cancer.

Thursday, March 5, 2009

Shorting the market: Options or ETFs?

Since it looks like the market will be handing us lemons for the foreseeable future, perhaps we could parlay this sour state of affairs into some sweet profits. There are many ways to play a bear market. Popular techniques include shorting the indices, buying index put options, and going long the short and ultrashort index ETFs. This last strategy is especially popular in retirement accounts.

We've looked at these strategies before in previous blogs (see 6/18/08 and 7/15/08) and thought it's time to compare them again since the market is much more volatile than it was last summer.

Strategy comparison
Here are the following strategies that I selected:

Short the index tracking stocks: QQQQ, SPY, DIA
Buy their short counterparts: PSQ, SH, DOG
Buy their ultrashort (2x) counterparts: QID, SDS, DXD
Buy March 2009 at-the-money (ATM) puts on the above tracking stocks
Buy 2010 ATM puts on the tracking stocks
Buy 2011 ATM puts on the tracking stocks

I wanted to look at a recent downturn so I choose the (relative) high peak put in on January 6th of this year and used today's (March 5th) closing prices. The table below summarizes the results.

Options still rule
The table reveals several interesting observations. The first is that buying the short ETF did better than shorting the underlying. (I've written before on the dangers of the short and leveraged funds (see 2/10/09 blog) so be aware that they may not perform in the way you think they should.)

The second observation is that instruments based on the S&P 500 and the Dow Industrials generally outperformed those based on the Nasdaq 100 (the Qs). Most likely this is due to the constituent makeup of each index.

The last observation is that short-term options trounced the returns of their LEAP counterparts. Using my handy-dandy Black-Scholes options calculator applet on my Blackberry, I found that the implied volatilities of the short term options are higher than that of the LEAPs, confirming my suspicion.

The effect of volatility
Before you race out and buy short-term puts, you should be aware that volatility is a double-edged sword. If you purchase an option in times of higher volatility, it's very possible that you can lose money if the volatility decreases, even if the market goes in your direction. To illustrate this point, I looked at the 2010 Jan90 put on the SPY. On 11/20/08, the VIX (market volatility index) hit a high of 80. That day, the S&P 500 closed at 752 and the put option at $27.15. Three months later on 2/26/09, the S&P again closed at 752 but the VIX had dropped to 45. What was the put worth? It closed at $22.15, 18% lower! The drop in value is due almost entirely to volatility as time decay is minimal for this LEAP.

Does this mean that you shouldn't take the options plays? Of course not! You can mitigate the volatility effect by using options spreads. A long put can be replaced by a bear-put debit spread where you buy the higher strike put and sell a lower strike put against it. One nice feature of this strategy is that your cost basis is decreased but it comes at the price of capping potential profits.

Cost basis
It's worth noting that not only do options offer you more leverage but they're cheaper than buying the underlying instrument, giving you an extra bang for your buck. Plus, your risk is limited to the price of the option unlike shorting a stock which has potentially unlimited risk. However, if you've never traded options before I strongly urge you to learn about them and paper trade them first.

I hope this exercise has been instructive. That's the long and the short of it!

Wednesday, March 4, 2009

How low can we go?

I don't mean to throw a wet towel onto today's China Syndrome rally, but I believe that this is only a temporary breather before the next leg down. Now I'm not the only bear in the forest—not by a long shot—and it seems as if I and my other furry brethren are struggling to answer the burning question of the moment: “Where do you think we'll find a bottom?” The best answer I can give to that is: Try a restroom.

Nobody knows anything right now
I don't mean to be flippant but I do think that the right answer is: Nobody really knows. The fundamentalists for sure don't know. Today on CNBC, one reporter (Bob Pisani?) said that analysts can't even come up with a reasonable guesstimate as to where earnings will be in 2009 which makes predicting any sort of support level impossible.

The technicians don't know, either. My charting program only carries ten years worth of price and volume data for the Dow Industrials and nineteen years for the S&P 500. The Dow has already broken through major support at the 7800 level and I don't have enough data to discern the next stop. The S&P recently blew through its 800 major support level as well as minor support at 755. According to its monthly chart, the next points of minor support are down around 670 and then 450.

Fibonacci levels
Technicians often resort to Fibonacci levels which are used in Elliot Wave Theory. Using the S&P 500 as an example with 1550 being the market top and 0 being the bottom, we get support levels around 960, 775, 590, and 365. The problem with Fibonacci levels is that they're not always accurate, and I especially have a problem using them over such a long time frame.

Aren't there any other places we can go to get some clues as to where a possible bottom might be?

How saving money will put us in the poor house
In his excellent column that appeared on MSN Money yesterday, Jon Markman used the Levy-Kalecki model of economic behavior to explain how high levels of saving and a decline in borrowing can lead to the devastation of corporate profits, a situation we could very well find ourselves in. Using this model, Markman came up with a couple of market scenarios--both rather grim tales. He said that if households save as little as 7% of their incomes, the S&P 500 could sink as low as 550 and the Dow as low as 5,300. If the wealthy are taxed per Obama's plan and savings rates go to 10%, the Levy-Kalecki model suggests that corporate profits will be slashed by 50% from their 2007 peak. Depending on whether investor confidence or fear prevails, the S&P could either end up around 755, a little higher than where it is today, or around 420, a lot lower.

I'm casting my vote for the fear camp and here's why.

The reason for another market downturn
The reason I think the market still has a ways to tumble is because of the VIX, the volatility index. The rule of thumb is that the more uncertain the market, the higher the volatility. Even though the volatility has been high lately, it's still nowhere near where it was last autumn. Below are daily charts of the S&P 500 and the VIX.

You can see that the VIX roughly inversely mirrors the movement of the S&P. When the S&P made new lows last October and November, the VIX made new highs (around 80). But the S&P has dropped well below those levels and what has the VIX done? It hasn't even come close to making any new highs. This divergence is a signal that the market has a lot more room to fall.

The answer to the question
So, where will we find the market bottom? The answer to this question is not where, but when. We'll find it when the VIX forms a new top, and it doesn't seem to be in a hurry to do that. So fasten your seatbelts 'cause it's going to be a bumpy ride!

Monday, March 2, 2009

Channel Breakout: Stock Candidates

Last week we looked at a recipe to profit from breakouts in channeling patterns. On Friday, I said that I'd rustle up some potential candidates for this strategy to add to your watch list. If you're playing recipe #3 on channeling stocks, you can also add these to that list as well.

I've divided the table below into four sections.

The first section deals with stocks that have just broken out of their consolidation pattern in the past day or so. You can still play them. (See Recipe #15 for strategy details.)

The second section is comprised of stocks that are on the verge of breaking out. Watch these closely.

The third section holds stocks that are currently channeling.

The last section is for illustration purposes to show you stocks that have broken out in the past couple of weeks.

Points to Note:

1. Some of these stocks have major support levels below their channeling support (the lower level), so please make a note of them. You may wish to hold off on entering a trade until they either break through or bounce off those levels. This comment particularly applies to ANW, DTV, ROP, and BRCM.

2. The market is now in a downward spiral, and attempts to play breakouts to the long side may not work out as intended. The higher percentage play is to play those to the downside, which is where the majority are headed for anyway.

Good luck!