Commodity Investing – Insurance for your Purchasing Power

I wanted to provide a counterpoint to some recent articles posted on Investorgeeks that have suggested commodities are not a good place to invest.  More specifically, that the commodities boom is a high risk area of investing and potentially a giant bubble.

I have a different opinion.  I personally feel that investing in commodities is the only way to ensure in the coming years that your portfolio is not decimated by hyper inflation.

The Present State of the US Economy

Before we discuss this further, we need to do a quick summary of the present state of the US (world) economy:

1.  Ben Bernanke is printing money as fast as he is able.  As a result, M3 money supply is expanding at close to 20% per year.  Inflation, literally an expansion in the money supply, is running at close to 14% per year, as calculated using a basket of goods with no hedonics and weighting adjustments.  Clearly, we have managed to export some inflation.  However, I believe that is rapidly coming to an end due to the loss of confidence in the US economy and the pummeling the US dollar is taking.

2.  A flight to quality is depressing bond yields, with real yields that are NEGATIVE, even according to the government’s own crooked CPI.  Bond fund managers are calling for bailouts (at the expense of the US taxpayer).  Low yields were supposedly a result of petrodollar recycling and the yen carry trade.  The strengthening yen and diversification away from the USA suggests this binge is now over.

3.  The Fed is now willing to take the rubbish paper sitting on the books of large financial institutions and give them “liquidity” in return.  In effect, the Fed is buying these bonds for their face value, even though they know many are drastically overvalued if not worthless.  The US taxpayer is again left holding the bag.

4.  If we examine the Federal Government, we see overspending that is funded by thin air money creation (the Treasury floats some bonds and the Fed buys them with freshly created money).

5.  The Fed continues to lower the cost of money, slashing rates in attempt to create a positive carry trade for the banks.  Wall Street banks, and now brokerages, can borrow as much as necessary to bail themselves out.  This insidious practice is most detrimental to Mom and Pop investors who are unable to utilize the freshly created money until well after it has passed through the hands of the financial sector.  With the money supply increasing at 20% a year, it is the rare average Joe who is experiencing an increase in salary to compensate for their decreased purchasing power.  In fact, given the weak economy and the layoffs in the real estate and financial sectors with the consumer discretionary sector to follow, it is likely that wages will stagnate until the public wakes up to hyperinflation.

All of these actions are achieving two things:

1.  the death of US dollar; and

2.  a rise in the price of everything tangible (aka commodities).

This is very bad news for the US consumer.  Gold and oil have both appreciated a huge amount when priced in US dollars.  However, to the rest of the world, the price increases are partially offset by currency appreciation and perceived wealth due to inflated housing markets.

In effect, the standard of living of the average US consumer is DECREASING relative to the rest of the world.  For the past century, US consumers have helped themselves to a supersized portion of the world’s goods and services.  This was justified as the US was an industrial powerhouse.  Today, most production has been outsourced, leaving the US to sell services.  Ask yourself this – how many people do you know who are selling services compared to making products?  How many of those making products work for the auto industry?  What value do you think someone in the European Union places on an US accountant, lawyer or real estate agent?  More than a Chinese built toaster?  Less than a South Korean built plasma tv?

The falling dollar and high rate of inflation act as a tax on the US consumer.  As we all know, a tax increase slows the economy – decreasing consumption (Keynesian economics) or savings and investment (Austrian economics), depending on your world view.  We have seen the economy falling off the rails for months now.

While commodity prices have increased, firms have attempted to slow the rise in prices to maintain consumer demand.  As their margins narrow, expect to see a decrease in corporate profits.  We have already seen this with refinery crack spreads and food prices.

As a result, the full inflationary effect of all the “liquidity” trickling down from Wall Street to Main Street has not yet been seen.  All of these factors point to a sorry state for the US economy, and the world economy by extension.  “Stagflation” is here again.

Why Commodities?

Now that we have placed things into perspective, why should you invest in commodities?

Firstly, and most importantly, you cannot create commodities out of thin air.  Unlike the money supply, commodities require an investment of physical effort to create.  Imagine the entire GDP consisted of a single apple and the money supply was $10.  It is easy to work out that the apple would sell for $10.  Now imagine the Fed takes a piece of paper, writes $100 on it and marks it as official legal tender.  An investment bank would now purchase that apple for $100 and sell you a sliver for your $10.  We are at that point right now.  You have a decision to make – which would you rather own?  The apple or the $10?

Now replace “apple” in the last statement with “ounce of silver”.  One ounce of silver last year sold for ~$12.  Today is sells for over $20.  Has the ounce of silver changed?  No.  Has the value of paper money depreciated relative to the silver ounce?  Yes.  If you can purchase 10 loaves of bread with one ounce of silver now, you can bet that in 5 years time, in 10 years time, in 100 years time you are going to be able to purchase about the same quantity for your silver ounce, regardless of its face value in terms of “paper money”.  There will be fluctuations – in good times the value of silver will be lower, in bad times higher, but the inverse is true of almost every asset class.

Secondly, in most cases, “demand” for the commodity results in its destruction.  The apple is eaten.  Copper becomes part of the toaster and plasma tv mentioned above.

Thirdly, a difficulty in stockpiling (imagine how difficult it would be to store copper worth $1M compared to an electronic bank account) hinders manipulation in the commodity itself relative to the financial markets.  Very few individuals own the necessary warehouse space to store large volumes of any commodity, with the exception of the precious metals.  Doing so has costs with no yield.   It is true that markets can be manipulated through futures, but the majority of open positions are closed prior to settlement to avoid taking physical delivery (most futures dealers will do this for you automatically and do not allow physical delivery to occur).  Futures are generally available for every month, ensuring that markets are renewed repeatedly.  Attempts to “corner” the market in assets such as silver and copper have generally been disastrous.  Recently we saw such an attempt in natural gas that resulted in a hedge fund blow up and a depreciated price wiped away relatively quickly.

In short, the increase in copper from less than $1 to greater than $3 per pound is not due to manipulation, but rather supply and demand.

Lastly, the bull market is still young.  While a growing number of people talk about the commodity bull run, many are still invested in financial assets or real estate.  Each commodity normally has only a small number of companies in production.  Physical delivery of precious metals is rare.  A 25 year bear market has taught many individuals to stay clear.

Have you ever stopped to wonder why Cortez was so entranced by Aztec gold or why pieces of eight (silver coins) were a store of wealth for hundreds of years?

What and How to Invest?

In the event you are even slightly concerned about hyperinflation and want to protect your purchasing power, you should take action to ensure that around 5% of your wealth is stored in hard currency.

In short, take physical delivery of gold, silver, platinum or palladium.  As a secondary hedge, purchase some stocks who are early to mid stage producers.  Examples include Chesapeake (natural gas), CNOOC (oil), Pan American (silver) and Yamana (gold).

As another option, you can purchase the oil, natural gas, gold or silver ETFs, or invest in a broader basket of agricultural or industrial commodities.

Futures are risky and the use of leverage can blow up in your face.  However, there is no requirement for you to use the ~10 to 1 leverage.  If you had $10,000 to invest, you could purchase a contract for 100 barrels of oil for delivery in December of 2010, rather than ten contracts for 1,000 barrels.  That way you can hold through a 10 or 20% correction without forced liquidation.  If you want to take some extra risk, wait for a pull back (to say $90 a barrel) and buy two contracts.

Conclusion: Depression?

Lastly, and on a slight tangent, history shows that approximately every 100 years the world witnesses a depression.  This is normally the result of government intervention that pushes a recession over the cliff.  The last depression occurred in the 1930s.  The majority of the people who experienced the depression were so scarred, they hoarded food for the rest of their lives.  They hated debt and purchased precious metals to prepare for the next depression that never came.  Many maintained their own garden to have some control over their food supply.  Their children, the baby boomers, were less risk adverse but still heeded the lessons of their parents.  Their grandchildren, generation X and Y, have only a mild understanding of what a depression is and how bad things could become.

The world will face many challenges over the next decade – peak oil, peak natural gas, peak coal, record low supplies of foodstocks such as wheat and corn despite record production for the last decade, the retirement of many workers with the most experience and knowledge, and a population projected to increase by 50% by the end of the century.  I think it is prudent to prepare for the Black Swan that could be around the corner.

As always, good luck.

Phil

Disclaimer:  The author owns shares in all four stocks mentioned and silver and gold bullion.

This post is for entertainment purposes only. No part of this post should be construed to constitute investment advice. The author is not an investment professional and assumes no responsibility for any investment activities you undertake. Prior to undertaking any financial decisions, you should contact an investment professional.

Bed Bath and Beyond Email Exchange

Here is an email exchange I had with my step father. Note: my mother works as a Bed Bath and Beyond store manager.

Original email back in November:

BBBY is down to 29.5 your thoughts?
-Kevin (11/26/2007)

And then my response:

Short-term BBBY is a damaged stock. Unless they get back above $30 (a 5-year low point), there is more resistance going up than down. It’s likely to either sink to $20 quickly or bounce around $30 for a while. In the latter case, you should get ample notice before it moves back up to $40+.

Earnings growth has slowed (fewer store openings, some management mishaps I think).

Long term, the stock is worth $39-$49. If the price hits $19 or around there is will be a huge value play and you’ll have to buy it. If this is a real bear market, it may go that low and we’ll get a really nice entry on it.

So I would wait for either the technicals to turn around (the MAs, MACD, and Stochastic like in Rule #1) or for Mom to say something spectacular about how the company is doing before their earnings announcement (next one is Jan 3rd) before buying into this stock.

BBBY is kind of a sad story. They have a huge strangle hold on their market of kitchen, bath, and linens, but have been struggling on other fronts. They need to find a way to grow other than opening new stores. That’s probably the biggest thing on investors’ minds. I get mixed signals from Mom on whether the Harmons thing is a + or -.

If you are thinking longer term (like 1-3 years), I might buy 25% here and some more as it creeps down towards $20. When the economy turns around, the stock will take off. There’s just a lot of potential to make money going forward.

– Jason (11/26/2007)

And later I wrote back last week:

The stock got bitch-smacked this week. It’s down to $24. This is like an 8-year low or something. Crazy. I think it could bounce at $20… it could bounce here in just a few days. In any case, I would hold off on making any action in this stock for a bit. The reason is that most analysts still have BBBY as a hold, buy, or strong buy. All these analysts have to now revise their guidance and call BBBY a sell. It’s counter-intuitive (if you liked it at $35, you should like it ore at $25 right?). Well not for analysts, they just need to be able to cover their ass and say they were saying “sell” like everyone else.

Anyway, all these downgrades are going to keep BBBY from moving up and could push it lower. The next level of “support” is around $20.

If you are thinking of investing some more, here is a way to do it. Invest 25-50% now, invest 25% at $20 and then another 25% once it’s “officially turned around”. There’s no risk of the company going bankrupt is there, ma?

This reminds me very much of the Microsoft action a year ago. MSFT was at $30. The company was spending money to get into other markets. Some products slipped launch dates and MSFT simultaneously took a profit hit one quarter and announced they were spending like $3 billion dollars on “non-core” products. The stock slipped to $27, then $24, then $22, and turned around just above $20. It was a 5-7 year low for them too.

Less than one year later, all those investments started to pay off. The slipped products launched and made money. And now MSFT is back up at $35 territory.

Totally different markets and companies, but a good analogy I thought.

So, ma, if you still believe in the company (and now that you’re back to work they should be doing better 😉 and understand how the company is going to continue growing at 15%+ without opening as many new stores, then hold your ground. Since you have so many options, I think the strategy is to hold them and hope the stock turns around.

– Jason (1/4/2008)

p.s. Do you mind if I post these emails on InvestorGeeks?

Disclosure: I do not own any BBBY shares now, but my mother does through an ESPP.

Book Review: Vitaliy Katsenelson’s Active Value Investing

Question: are we in a bull market or bear market? What if there was a third option? In Active Value Investing: Making Money in Range-bound Markets, Vitaliy Katsenelson makes a case that the current market is actually a "range-bound market" and then gives you the tools to take full advantage of the fact.

What is a Range Bound Market?
Range-bound markets are characterized by their roller-coaster-like volatility and the fact that despite this volatility, money invested in the beginning of the cycle will have close to 0% gains by the end of the cycle. In fact, range-bound markets are more common than bear markets. Katsenelson says:

"…if you look at the U.S. stock market during the entire twentieth century, most of the prolonged (greater than five years) markets were actually bull or range-bound markets. Prolonged bear (declining) markets happened in the past only when high market valuation was coupled with significant economic deterioration, similar to what was going on in Japan from the late 1980s through 2003 or so."

This chart from the book shows the past 107 years bull, bear, and range-bound markets as labeled by Kevin A. Turtle.

Bull, Bear, and Range-bound Markets from 1900-2007
Chart by Kevin A. Turtle

You’ll notice that each of the big bull markets was followed by a dip into a prolonged range-bound market. Our current market looks like it is trading in a range (with us on the upswing right now). And though we’re at an all-time high, the market-wide average P/E is still way below it’s pre-2001 levels.

The past shows us that we are due for a range-bound market. I’m not a huge fan of the "since this is how it worked in the past century, this is how things will work now" argument. Many authors stop at just that. Luckily for Katsenelson, he kept my interest by going deeper into things and explaining WHY he thinks the cycle will continue.

This was huge for me. Instead of using faith in history to predict the market, VK discusses human psychology and how the act of going through a long-term bull market (where you never lose going long and your biggest weakness is taking things too slow) affects your investment decisions going forward. What follows is a market of investors who are just more conservative than they were in the bull run, and the end result is a long period of "PE contraction". VK explains this in easy-to-read, convincing language.

Another great summary of why range-bound markets exists comes on page 168:

"If we can agree that the difference between low- and high-P/E stocks is the expectation of growth, this means that in the beginning of a range-bound market investors are willing to pay 200 percent premium for growth, whereas at the end of a range-bound market investors are willing to pay only a 40 percent premium."

Why do I care? What should I do?
Learning about range-bound markets will give you several "aha" moments that will help you think of the current market environment in new ways. But, understanding range-bound markets is just the first part of the book. The more applicable lessons come in the later sections.

The "analytics" section introduces the QVG framework (for quality, valuation, and growth). The basic gist is that because market-wide P/E depreciation is going to eat into profits, you need to be more diligent across these three "vectors" to choose outstanding stocks that will provide greater returns.

Some of the material in the QVG section may be familiar to those of you have read a few investment books. But I think it is still valuable to read these sections closely as there are a lot of good gems in the details. I found VK’s treatment of stock buy backs especially pertinent to some of the tech stocks I trade.

I also appreciated the discussion on sources of growth. We all know to look for Google-like stocks with high earnings and return on investment capital (ROIC) growth rates, but it is also important to know where a company’s growth is coming from so we know how long the growth will last or if something material might happen to affect that growth.

These are the types of details you’ll get out of the book. And even if you’ve been exposed to this stuff before, it is always great to be reminded of it. Additionally, thinking of things from the range-bound angle will bring new meaning to old concepts.

Putting the Value in Active Value Investing
The chapter on value has a cute story about "Tevye the Milkman" and his cow "Golde", which does a great job of explaining how stock evaluation work. It’s a bit elementary, but a fun read anyway. Later in the chapter VK gets into a discussion of "Relative" vs. "Absolute" valuation tools. An example of a relative valuation tool would be the P/E, which is a measure of price relative to earnings. Absolute valuation models are great because they ground your observation in the real world. This is similar to Peter’s Main Street vs. Wall Street analysis or my balking on my GOOG analysis (though I still went long GOOG then and am long now).

If you are a numbers geek (like me), you’ll really like Katsenelson’s treatment of "Absolute P/E". We always say stuff like "I am willing to pay more for the quality of stock x". VK puts specific values on statements like these. What is quality management worth? What is best of breed worth? All of these impact V’s "absolute P/E" calculation, which is very much like calculating the base P/E that we are used to and then adding or docking points based on how the company stands up across a number of factors.

I also like some of the additions VK makes to the typical margin of safety (MOS) discussion. In general stocks with higher growth and dividends can be invested in with lower MOS because less of the gain in stock price will be due to MOS. whereas a stock with 0 growth will gain ALL of its price from MOS.

The typical Graham/Buffet/Town rule-of-thumb is to shoot for a 50% MOS. Katsenelson gives a method for adjusting the required MOS (based on a number of risk factors) before jumping into a stock. This is great because in bull runs, it can be very hard to find solid companies with 50% MOS. Phil Town will tell you that "if you are more familiar with a company, you can lower your required MOS". Vitaliy Katsenelson gives you mathematical way to figure out the exact MOS you can buy at.

Math!?
Again, the math in the book isn’t too complicated, but it’s there. It shouldn’t scare anyone away from reading the book, but it may get those of you who thrive on quantitative frameworks excited. One of the reasons folks like me like bringing math into investing and other activities like playing poker, is that it allows us to remove our emotions from the game. The goal is to find a formula that makes money that you can replicate over and over. If your formula loses money on a trade (because we’ll all lose money on trades some of the time) it’s easier to handle than if you make the decision based on "feeling" or other less concrete methods.

The Formula. The Strategy.
The strategy section of the book puts forth a pretty simple three-part strategy and then dives further into each part.

  1. Assemble a portfolio of the right companies.
  2. Buy them at the right prices.
  3. Sell them at the right prices.

By the time you get to this section, you’ll have all of the tools (based on the QVG framework) to achieve each of these objectives. The remaining pages include a number of anecdotes and examples that will help you execute the strategy. You’ll see headings like "Think Long Term, Act Short Term", "Decide How the Game Will End Before It Starts", and "Location of Corporate Headquarters Abroad May Not Constitute a Foreign Company". Again, these are anecdotes you may be familiar with. Chances are there are a few in there, you’re not. I enjoyed VK’s fresh view on these concepts and came away with a greater understanding than I had before.

Overall, Active Value Investing is a good read. The concept of a range-bound market is one that you may not have been exposed to yet. Understanding how the range-bound market comes to be and the properties it has will help you understand the current market.

Additionally, while the active value investing model is presented as the best strategy to use in a range-bound market, it’s also not too shabby in a bull (or even bear) market. You’ll have to dig into the book to learn why, but the system VK describes will earn you the most money in a highly volatile market like we are in and save you the most money in a full on bear market. In bull markets, you might be giving up a few % points of return, but this may be worth it for the extra sleep you’ll be getting. And it will defiantly benefit you when the market eventually falls.

This book was a risky one for Katsenelson to write. As he admits in the introduction, books about bull markets sure do sell better… they’re just more exciting. Also, if the market continue to shoot up, VK runs the risk of having a book on the market with a failed prediction at the core. I admire and appreciate VK for writing this book. I think it’s an especially good read in today’s market environment but also a book that you could learn from no matter what.

Buy It
At $50 for the hard cover, you might want to go-in on this with a buddy or spend a couple days at your local bookstore. If you’re rich, you can buy it now from Amazon and support our site a bit. Link below.

Update: Amazon has been selling the book in the low $30s, which is a good deal. Follow the link below to get the latest price.

Active Value Investing by Vitaliy Katsenelson

Rating: 4 out of 5 stars
Best Suited For: Value-minded folks managing their own portfolios.
Buy the Book: Active Value Investing: Making Money in Range-Bound Markets (Wiley Finance)

Hedging – good for the soul.

I shorted down a burning ring of fire
I went down down down
And the flames went higher

Black Thursday? Or will The Fed return and carpet bomb the market with money?

I still maintain this has a few more months to run – watch the Shanghai Composite. We may have a head and shoulders pattern that is going to break down from an overall peak of 4910. If that rolls over and the market hasn’t had a big down day already, I am predicting more carnage.

My hedging is working somewhat well. I am still losing money, as I am net long overall, but it is acting as an anchor and letting me enjoy the show that is unfolding.

The real question? How is it that I managed to go short, while the hedge funds, qants and other foolish managers couldn’t see the forest for the trees? (Which raises the next question – Why am I not being paid millions of dollars per year?)

Jim Cramer and James Altucher (thestreet.com) seem to have woken up to the problem now, but couldn’t see it 3 months ago?!? I enjoy listening to their discussions, but it seems surreal that they weren’t sounding the horn before the crash.

Bounce

Hey everyone,

We are seeing a nice bounce in the markets this morning. The S&P500 is at 1485 as I write this(!!!). If you look at the 5 day chart, you will see this could take us back to part way through the crash we saw last week. The market is saved!

To me, this feels like a dead cat bounce – one formed by a pump in liquidity and a jump in premarket futures.

Last week I managed to scalp $1 out of my short position in SDS (entry at $54, exit at $55). I am now preparing to go short again with a buy order in at $53.75. I am not sure if it will reach that high in today’s trading, but I would not be surprised. I am also considering a short position in SKF – double short the financial stocks.

Both of these positions are risky and should not be held for the long term.

Fundamentals Unchanged

However, my underlying belief is unchanged. The US economy is slowing and the housing market is going to get worse, a lot worse, before it gets better.

In my opinion, the consumer is going to get crunched by the following:
– rising borrowing rates as risk is repriced and lending institutions either dry up, or are prevented from selling risky CDOs at riskless values;
– falling home values that prevent refinancing of debt (and hence equity extraction);
– a rise in loan repayments as ARM loans reset and investors are unable to refinance to more favourable terms; and,
– increased fear and feelings of insecurity.

Reduced Consumption and Risk Appetite

All of these will depress consumption and the appetite for risk. As I pointed out previously, the highest level of ARM resets are still on the horizon. The good news is we are into “fear” on the business cycle, so are about half way through the housing correction. I have mentioned previously that some financial pundits have suggested the housing market will be fine by 2008. I am still leaning towards 2010 as the bottom in inflation adjusted terms, with nominal pricing reaching the bottom around 12 months earlier.

Plunge Protection Going Forward

Ultimately, I believe the Fed will step in and flood the market with money over the next six months. This will lift the market to an artificial high. However, if you want a real measure of the S&P500’s performance, price it in Canadian dollars.

As you can guess, I would be surprised if last week was the extent of the correction over the next 2-3 months. If you haven’t already taken up a defensive position, this is a golden opportunity to do so.

For those of you who want a contrary viewpoint, here is an article by Dr Jeremy Siegel about why the market is fairly priced. I have less and less respect for him recently (it was he who suggested Alt-A mortgages would be fine – Countrywide Financial has popped that fantasy), but I still love his ETFs.

Happy investing,

Phil

This post is for entertainment purposes only. No part of this post should be construed to constitute investment advice. The author is not an investment professional and assumes no responsibility for any investment activities you undertake. Prior to undertaking any financial decisions, you should contact an investment professional.

Separating Prediction From Fact

We are told time and time again that you can’t predict the market. And time and time again people try to predict the market. Many model the market using stochastic principles, and use it to predict the market. I find this completely amusing (stochastics is about multiple destinys based on a single context.)

TraderFeed a favorite blog of mine had the following to say (Are We Making a Bottom).

There is both the sense that we could go much lower in a washout (a “Black Monday” scenario) and that we could be seeing an important bottom in the making.

Fair enough, good point we might be at an inflection point.


To give a bit of perspective on this one-sidedness, we’ve only had 75 other occasions since 1960 (!) in which 70% or more of the volume has been in declining stocks over a two-week interval. That is out of almost 12,000 trading days. Stated otherwise, the current market is in the top 1% of all market occasions since 1960 for bearish concentration of volume.

This is where I say, so what! That was then and this is now. In fact if I thought about this completely I would say, “stay out of the market…” Though his statistics seem to say the following:

If we look across all 75 instances, the market was up 41 times and down 34 after a five day period for an average gain of .87%. When we look three weeks out, however, the market was up only 36 times and down 39 times, for a subnormal gain of only .08%.

This statistic tells me that we are in a crap shot and it could go either way. When you are up almost as many times as you are down I get the feeling that whatever you do will be both right and wrong. You could play this market by creating a straddle, but with an average gain of 0.87% I would be tempted to believe that you could not get the option premium paid for.

In the end TraderFeed says the following:

That tells me that the current weakness offers risk as well as reward for shorter timeframe traders, but also is a heads up for investors seeking value.

Which reminds me of a horoscope… Worded in such a way that everybody sees something they want. Look I am not harping on TraderFeed. In fact I think TraderFeed is very diplomatically saying, “Beats the crap out of me of what the market will do next.”

TraderFeed is not the only one trying to make predictions. Neural Market Trends referenced an article on Ugly, which referenced an article on New Scientist. You should read what each party has to say on the topic and you will see that each has their own take on the same topic matter.

What I see is an attempt to use AI to make predictions or find patterns, where as I have written before none exist. But wait, I want to prove to you that you can’t make predictions EVEN if you have 100% solid evidence of where to make trades.

Consider the following image:

This is my profit level for an average day of the algorithmic trading system doing its thing. On this day I happened to make a daily profit of 0.85%. I have days where I do much better, and much worse. As I wrote, this is an average day.

Look at the signals that indicate whether I should buy or sell.

When the signals are above I buy, below I sell. Now compare the profitability of my trading system, and the signals. Notice a pattern? The pattern, and it is a solid visual pattern, if the two signals diverge stop trading! Whenever my profitability drops notice how the signals diverge. Its not only like this once or twice, but whenever the signals diverge STOP trading!

From a visual perspective it should be pretty easy to spot this pattern and stop trading, right? WRONG! I have tried many statistical analysis (eg T-Test, F-Test, etc, etc) and they prove nothing. My signals end up looking like the following images:

All of the filters and statistics when applied result in me making quite a bit less money than taking my lumps. So why if my pattern is 100% rock solid and apparent can I make my trading system not be more profitable?

The answer is that you cannot predict the market!

When I presented my graphs to a person who studied statistics he had the following to say.

Statistics are great for knowing what has happened in the past. For example you can ask, “how many kids fell down the stairs in the past year.” But they are horrible at predicting the future. Statistics cannot be used to tell you what the problem with the stairs are, and it cannot predict how many kids will fall down the stairs. It could happen that you do nothing and less kids fall. Statistics will tell you something changed and that now less kids are falling down stairs.

When I look at your graphs I think that you can’t automate it and will have to rely on visual means.

What he was saying is that by applying statistics to predict, the noise of the data will get in the way of figuring out what is relevant and not relevant. The filtered signals are not wrong, but are being influenced by data that does not interest you. I could filter out the noise, but then I do what you should not do, which is over-fit the data to create the required signals. The problem is what is relevant data and what is noise?

Does this mean I need to take my lumps? Yeah it does…

[email protected]$54

Well, I was right (see Wednesday’s post). That at least feels good. However, I thought the market would make a decent recovery. I had raised my limit price to $51.20 (from $50.20) yesterday, realising the recovery was probably not going to be as strong as I wished.

However, when I logged on tonight (it’s after midnight in Australia), SDS had already moved up to $53, and as I watched it shot towards $54. I got out the calculator, changed the volume and bought in just as it crossed $54. As I hit refresh now, it is in the mid $54s, heading back down.

Was this wise? Perhaps not. I did it on a high of emotion (I was at least aware of it) and there is a good chance the plunge protection committee will step in tomorrow and push the market higher. In fact, they may do so today (watch for a 2pm spike in the price). However, if that happens I urge you to consider unwinding any positions you are overexposed in or that you do not want to hold on to for the long run.

I have been selling down my largest holding for the past few months, moved my meagre retirement account to cash about a month ago, and convinced my parents to do the same with their not so meagre retirement account.

That said, I am not a “trader” – I am a longer term investor. So, I have held my positions in companies in the oil and gas sector as well as my ETFs.

I still think this is just the tip of a serious correction that is going to knock another 10% off the market. If that happens, I am expecting SDS to hit the mid 60s (maybe even into the 70s – but that is less likely). Remember – 10% corrections are not that uncommon!!! At the least, I think we will knock off the last 6 months of gains.

For me, this is the last serious move I hope to make until August. If the market corrects over the next month or two, I am hedged and my portfolio should stay roughly where it is right now in terms of value. I’ve taken a hit, but not enough to make me cry… or to need to explain to the little lady why our account says “minus” followed by “thousand”. If the market trends higher, I will miss out – my gains on my stocks are going to be countered by my losses on SDS.

Sure, I’ll miss out on some gains, but, to me, the peace of mind right now is worth it.

Good luck!

Philip John

This post is for entertainment purposes only. No part of this post should be construed to constitute investment advice. The author is not an investment professional and assumes no responsibility for any investment activities you undertake. Prior to undertaking any financial decisions, you should contact an investment professional.

Retreat!

Just a quick note to say I think the market has had its major top.

I am going to wait for a pullback tomorrow (Wednesday 25th July) and have an open order to go short SDS at $51. Hopefully this will get filled in the next day or two.

My reasons for going short via SDS are two fold. Firstly, I am happy with my current gains and wish to lock them in. At this level, rather than sell positions and incur the taxable gains, I can retain them and go short via one ETF. Secondly, SDS gives me exposure to twice the movement of the S&P500. The S&P500 is the weakest of the major indexes currently and is well off its high of 1555. I would hate to be in this ETF when the market is moving up (just take a look at a 1 year chart!), but in corrections or where you want to hedge against a fall, this ETF is perfect.

I have suggested previously that investors raise cash, which I have now done, and prepare for a correction. In buying SDS, I hope to ensure I receive some protection for the stocks I have retained.

Good luck,

Philip John

This post is for entertainment purposes only. No part of this post should be construed to constitute investment advice. The author is not an investment professional and assumes no responsibility for any investment activities you undertake. Prior to undertaking any financial decisions, you should contact an investment professional.

The Fall of the All Consuming Yankee

The consumer is tapped out. After consistent 25 basis point increases to the Federal Funds Rate, we are finally starting to see the effects on the stock market.

Yesterday morning we saw three headlines that caught my attention. The first detailed Sears’ guidance for this quarter – a reduction from $2.12 to from $1.06 to $1.32 per share. These revisions are, at best, a 30% reduction and, at worst, a 50% reduction from their previous optimistic estimates.

Notably, declines were across all categories. If you follow the theory that the consumer is on thin ice, then it is hardly surprising to find big ticket items are not being purchased. Sears is having trouble selling new stainless steel fridges and widescreen TVs because consumers do not feel confident about their financial situation. The only sector that wasn’t hit as hard was women’s apparel and footwear – suggesting stressed housewives may be engaging in retail therapy.

The second headline noted that Home Depot is now expecting a 15% to 18% drop in earnings per share for fiscal 2007, as opposed to their previous guidance of 9%. This is a further example of a, supposedly wise, management team who were unable to predict the severity of the downturn.

All should take note – when pundits tell you the housing crash will be over by Q4 of this year, they are making a foolish guess. Furthermore, even if they are right, do not expect the market to rebound. Burnt fingers will not be so quickly back into the fire.

Home Depot’s response to this downturn was particularly ironic:

Home Depot, which has more than 2,000 stores in the United States, Canada, Mexico and China, said Tuesday it will open approximately 108 new stores in fiscal 2007.”

Lastly, this tidbit was to be found in Yahoo’s summary of the Best of Today’s Business:

More than 2 million subprime, adjustable-rate mortgages will be reset to much higher interest rates over the next several months, raising monthly payments for people with weak credit. In October alone, a record $50 billion in ARMs will reset, said Mark Zandi, chief economist of Moody’s Economy.com. Consumer groups fear this could spark a new wave of foreclosures.” (emphasis added)

Many commentators speak about the small impact of subprime foreclosures (e.g. here) as if somehow the problems stop with subprime. However, the problem is a continuum, beginning in subprime and extending all the way into Alt A.

The housing sector is in far worse shape than the experts on Wall Street realize – yesterday we saw a pull back in the market, and the futures this morning point to a similar flat or down day. However, over the past months, Wall Street has failed to price in the poor economic outlook. Yet, here is an example of the situation consumers face:

Arizona’s only publicly traded home builder must write off $100 million on land and operations after a second quarter in which home orders fell 28 percent and new-home cancellations climbed to 37 percent, according to preliminary numbers released Friday.

New-home cancellations have left the Valley’s housing market with at least 20,000 homes built but unsold. Builders have offered hefty incentives of $50,000 and more to sell the houses, but many potential buyers can’t sell their existing homes.

The result is a glut of homes for sale…”

Granted, Arizona is one of the worst locations, but it isn’t the only region to suffer this problem. While subprime mortgagees have low credit ratings, they don’t necessarily purchase in low socio-economic areas. Subprime foreclosure properties can not be neatly segregated into a single suburb.

We are just starting to see the fall out.

With Wall Street starting to show signs of reduced consumer spending, both due to fear and also due to rising costs (see “M3 money supply”), businesses will be reducing inventory and preparing for leaner times. This will sap at business confidence and reduce capital expenditure. As more home loans reset from teaser rates to rates approaching double digits, consumer disposable income will further decrease. If foreclosures continue to rise, we may witness further financial strain, as seen with Bear Sterns two weeks ago.

In short, the situation is unlikely to improve from here. The next 6 months do not look good.

If you haven’t already, take a look at the S&P500 over the last 6 months – notice the recent double top and the market’s inability to rise to new highs. My thoughts? Consider moving at least a portion of your holdings to cash if you can.

Philip John

This post is for entertainment purposes only. No part of this post should be construed to constitute investment advice. The author is not an investment professional and assumes no responsibility for any investment activities you undertake. Prior to undertaking any financial decisions, you should contact an investment professional.

Watch List Notes for 26JUN07

I’m writing this one directly into the blog, and with any hope it will go up before market open today. Let’s what we have on dee plate.

AMGN
Notes from late last week: “Stoch sell. MACD still strong. I think this guy is recharging.”

I’ve since changed my theory from “recharging” to “dropping”. It’s looking bleak for this guy short term. 30DMA is providing resistance and Stoch and MACD are signaling sell. Lots and lots of support at $52. And although it’s well below my MOS of $65, I sold my 60 share stake last Friday at $55.62. There’s a lesson there on trusting your instincts while selling, as I could have sold it at $60 and kept $22 more, but that’s another story.

I have a bit of sellers remorse though. This really was a value play. I sold it in my trading acount, which means full tax on the $5 I made, not to mention E*Trade’s high fees. And I’m reminded of a bad sell I made on YHOO last summer where I avoided a $1 loss that was coming, but then missed the $6 run up. That could be happening here.

In any case, I thought it would be good to have some cash on hand going into this little bear run so I dropped this one too. Though my gut tells me I should possibly be selling this next stock to lock in some real profit.

GRMN (I own 75 shares)
Notes from late last week: “Can anything stop these guys? My higher sticker price was around $75, so I’m looking for any reason to sell. I want to let it run, but I’ve “made my year” on this one stock already. I’d like to ensure that I don’t give it all back. Need to figure out a good stop placement: $69.90?”

I’m glad I didn’t set that stop because I would have been stopped out and the stock has gone up since. But I haven’t made nothing until I sell right? But then what am I going to do after I sell? Put it back into GRMN? I need a better alternative, and I’m just going to watch this carefully for a more pessimistic sign. The thing is flying high right now.

AMD
Looking strong here. MACD and Stoch have thrown buys. The price is above the 30DMA, but I’d like to see a full bar there. I have some cash on hand, maybe this is where it should go. Seems like the news about AMD outsourcing fabrication went over well. Was it enough to turn the stock around? I’d be looking for the stock to reclaim the 200DMA at around $17.50, but there’s a lot of resistance on the way up. Plenty of support at $13.

ERTS
I second guessed myself, when ERTS went above my selling price of $49 last week. But it seems that was on the back of a stronger market, and the price is south again. This is a troubled stock (at least short term) that I don’t need the headache for. The 30DMA seems to be giving a lot of resistance. This one is going on the back burner until I gain my confidence back in EA. Technically, I’d like to see a full bar above the 30DMA and the 10DMA cross above the 50DMA before jumping back in.

EBAY
30DMA is showing resistance, but this stock is also in a nice little up channel. A break of the 30DMA could be very bullish. Look for more resistance at $34, support at $31.40. I think could see a large run here like we had with Amazon earlier. eBay is another tech business that Wall Street (and Main Street) doesn’t understand. Why did they buy Skype? Why did they buy this or that? What are they doing? Is the toning down of Google advertising going to hurt them or a good sign of their strength? I might buy some of this now and hope they can break $35 this time. Going to do some MOS calculations to check my risk here. Read here for Phil Town’s eBay analysis from last year (when the stock was at about the same price). My numbers are a bit more conservative, but they are still saying buy buy buy.

Current Earnings: $1.05
EPS Growth: 22%
Average PE: 44
EPS in 10 Years: $7.67
Future Value: $337.47
Sticker Price: $84.37
MOS 50%: $42.18

I’m going to be looking to buy this fella today. I’ll let y’all know how it goes.

QQQQ (I own 90 shares)
Staying the course. One of the major indexes above its 30DMA. I think we see a bounce here or after one more bad day. Holding this to keep pace with market.

ACN
My notes from late last week: “3 Buys. Looking good. $40.45 entry o short-term pullback. Need to do a MOS calculation.” And the stock is doing great. Still need to do that MOS, so here it is:

Current Earnings: $1.61
EPS Growth: 17%
Average PE: 20
EPS in 10 Years: $7.74
Future Value: $154.78
Sticker Price: $38.69
MOS 50%: $19.35

ACN is a great company and great stock, but it’s trading at around or just a little above sticker price (according to my off-the-cuff here). So I can’t invest now. My Average PE is a little low, so I might look into it more to double check. A PE of 34 (twice my EPS growth estimate, but higher than the historical average) gives us a sticker price of $65.78… which would be more room to grow.