Tuesday, January 29, 2008

Market turning?

It is still too early to declare a market bottom, but maybe it is starting to turn.  The VIX is still up about 28 and needs to get down under 20 for several days before the bear is dead.  But that process may take many months with a confirming low of 1300 or so on the S&P (matching the low last week.  In the meantime, it is possible to play the rally which could go to 1425, the point where the market broke down previously (on Jan 10).  The next point of resistance on the up side would be at 1490 which was reached mid December.  So, there is some room to run, maybe 10% or so.
 
There is some danger the next couple days if the Fed does not come out with the liquidity that is expected.  The market wants the 0.50 basis point cut and more programs to support the financial industry, such as the increase on Fannie Mae / Freddie Mac loan limits to $800K from $470K.  But if that happens as expected, it will provide adequate stimulation to get the economy restarted.  That said:
 
There have been some big selloffs in good stock names on decent earnings reports that met or beat analyst expectations.  But they sold off on bearish sentiment and less than stellar guidance.  MCD, EMC and YRCW are among the candidates for a big bounce from oversold.  They can be played with options.  I sold short puts on EMC today.  Another I sold is RACK (Feb $10 for 1.40) as it is down 40% from a recent high of 15 and over 50 in 2005.  It has been pulled down by negative sentiment on the tech market, even though it continues to beat earnings and revenue expectations and has industry leading products.
 
SMH is still on the watch list since the semis have very bad sentiment right now.  But, once the market bottom is in, tech will be the first to recover as usual and will do so in multiples of the overall market.  Semi demand will increase with tech equipment demand.  Book to bill as reported on www.semi.org is already quite low at around 0.80, so there is room to run to the upside in semis. 
 
I am also buying LEAP calls on the financial names as they may go up 50% from here over the next 18 months.  I own BAC and C Jan 2010 calls and am looking at Wachovia and USB (though the latter did not go down much because of the Buffett aura).
 
There should be an opportunity for a quick short of the market around the end of February once the Q1 earnings reports and the Fed infusions are over.  If the S&P gets back to 1490, puts could be bought against SPY or a sector like XLF or XLY for the inevitable pullback to 1300.  That pullback might correspond to the typical summer doldrums and be fueld by more housing and financial industry problems. 
 
 
 
 
 

Thursday, January 24, 2008

VIX: A Market Timing Tool

Jake, Here is a very simple tool for timing the market. I don’t understand the complexity of some other models that are promoted, so I don’t use them. But I could have really used a simple tool to manage this bear market.

Take a look at the attached 5 year chart for VIX. Notice how VIX provides an excellent indicator for major tops and bottoms. When the daily VIX moves below the 100 day moving average and stays there for 10 days, it is a buy signal. A major buy was given by this indicator on March 31, 2003, which if you remember, was about 10 days after the market made its major low (at the start of the Iraq war) and began a five year bull run. When the opposite happens, like on February 25, 2007, it is a sell signal. VIX went back below the MA on April 2, so a buy would have occurred 10 days later on April 12. You could have bought back in for another 2 months without much conviction from the VIX.

It skidded around along the moving average until May 23 when it broke above the line for good creating another sell signal 10 days later on June 6. The July 19 top and selloff (with the Bear Stearns sub-prime hedge fund implosion) resulted in a big spike in volatility, but vol had already moved above the average. But you wouldn’t have given up much in gains by using this timing signal (DOW moved from 13,591 to 14,000 in that time or about 3%). With a 10% selling program, 80% of the portfolio would have benefited from the rise, saving 20% of the portfolio from what was to follow. Better yet, if we require a 5% move below the VIX moving average in order to buy, or 1.0 on the VIX scale, we would have not had a buy signal on April 12 and would have just kept on selling from the start on March 5 when the DOW hit 12,050. We would have had 40% of our portfolio moved out of stocks by July 19 and been 100% out by December.

As of now, we are way above the buy signal which is at about 18 on the VIX. We will need to fall back to that level and stay under it for 10 days. Then the coast should be clear, if past teaches us anything.

You will also notice there would have been a move out and back in the market in mid 2006 when the market tanked in May and June. But if you use a gradual approach in and out of the market, maybe 10% of the portfolio a month, it would not jerk you around much. Using a 10% per month rule, you would have been completely out of the market by November after the February sell signal which triggered in March (after the 10 day waiting period). It would have been hard selling in April to June as the market kept climbing, but this is why a system is so important.

I plan to use this timing signal in the future as I did not have much discipline this last downturn. Despite a correct reading on the potential problems for the market and the magnitude (so far) of the breakdown, I kept putting my funds back into the market too soon after selling and before volatility had fully subsided, causing needless losses along the way.


CBOE VOLATILITY INDEX VIX (VIX: CBOE)
Last Price Today's Change Bid (Size) Ask (Size) Volume Trade
31.01 +3.83 (+14.09%) 0.00 x0 0.00 x0 0

CBOE Real time Quote
Last Trade as of 4:14 PM ET 1/22/08

1 Day | 3 Day | 5 Day | 1 Month | 3 Month | 6 Month | 9 Month | YTD | 1 Year | 2 Year | 3 Year | 4 Year | 5 Year | 10 Year | 20 Year
Exponential Moving Average (100)


Wednesday, January 23, 2008

VIX: Simple Market Timing Tool

Here is a very simple tool for timing the market. I don’t understand the complexity of some other models that are promoted, so I don’t use them. But I could have really used a simple tool to manage this bear market.

Take a look at the attached 5 year chart for VIX. Notice how VIX provides an excellent indicator for major tops and bottoms. When the daily VIX moves below the 100 day moving average and stays there for 10 days, it is a buy signal. A major buy was given by this indicator on March 31, 2003, which if you remember, was about 10 days after the market made its major low (at the start of the Iraq war) and began a five year bull run. When the opposite happens, like on February 25, 2007, it is a sell signal. VIX went back below the MA on April 2, so a buy would have occurred 10 days later on April 12. You could have bought back in for another 2 months without much conviction from the VIX.

It skidded around along the moving average until May 23 when it broke above the line for good creating another sell signal 10 days later on June 6. The July 19 top and selloff (with the Bear Stearns sub-prime hedge fund implosion) resulted in a big spike in volatility, but vol had already moved above the average. But you wouldn’t have given up much in gains by using this timing signal (DOW moved from 13,591 to 14,000 in that time or about 3%). With a 10% selling program, 80% of the portfolio would have benefited from the rise, saving 20% of the portfolio from what was to follow. Better yet, if we require a 5% move below the VIX moving average in order to buy, or 1.0 on the VIX scale, we would have not had a buy signal on April 12 and would have just kept on selling from the start on March 5 when the DOW hit 12,050. We would have had 40% of our portfolio moved out of stocks by July 19 and been 100% out by December.

As of now, we are way above the buy signal which is at about 18 on the VIX. We will need to fall back to that level and stay under it for 10 days. Then the coast should be clear, if past teaches us anything.

You will also notice there would have been a move out and back in the market in mid 2006 when the market tanked in May and June. But if you use a gradual approach in and out of the market, maybe 10% of the portfolio a month, it would not jerk you around much. Using a 10% per month rule, you would have been completely out of the market by November after the February sell signal which triggered in March (after the 10 day waiting period). It would have been hard selling in April to June as the market kept climbing, but this is why a system is so important.

I plan to use this timing signal in the future as I did not have much discipline this last downturn. Despite a correct reading on the potential problems for the market and the magnitude (so far) of the breakdown, I kept putting my funds back into the market too soon after selling and before volatility had fully subsided, causing needless losses along the way.

Gold: An Investment for Decades to Come

Jake, Thanks for the newsletter. I am pretty much in sync with this writer's perspectives.

My thoughts on gold have not changed much in several years. I think it is a store of wealth and will do better in times of inflation and dollar devaluation (which mostly run together). Even if gold stays steady and goes no where against other national currencies, as long as the dollar goes down, gold will go up by the same amount, just as other dollar denominated commodities do, like oil.

Additionally, there is the risk premium put on gold for an uncertain world and, probably most importantly, the future demand that will come from Asia. Gold is favored in Asia throughout history, so that is not likely to change soon. As Asians have more disposable income, they will buy more gold, and will increase global demand. Also, the Asian (and Middle Eastern) economies will grow rapidly over the next 20 years (10% a year on average, perhaps) and will probably need 10% more a year of gold reserves to back their currency, and maybe more as they lose confidence in the dollar and shift their reserves towards gold and sell dollar instruments like US Treasuries.

So, for many reasons, I think gold is good for many years. The only reason it did poorly the past 30 years was that the dollar took the role of global reserve currency and the global central banks, especially the US and Europe, sold off their gold reserves adding supply and dropping demand. I don't think the dollar will get that "Reserve Currency" role back anytime soon after all the losses incurred by governments and dollar investors around the world the past couple years.

As you know, I own gold through VGPMX, GGN and best of all, BEARX. Even though BEARX is a bear market fund, it held its own even in the years when stocks were in bull mode because of its gold holdings. It is half shorts and half a gold / precious metals fund, with lots of junior gold producers that will do very well if gold prices continue higher.

Hope this helps.

Tuesday, January 22, 2008

Asian Market Selloff - Is This the Bottom?

Brian, Any feeling for the bottom? What is interesting is as I talk to business people nationwide; not including selling or buying a house or selling a mortage.
Business is fine. No major layoffs. Are we just having a 20% correction to bring things back to reality?

Jake, I think we are pretty close to the bottom, though Tuesday could be a “limit down” day with a selloff in the Dow of over 500 points. This is what the futures say, and what is happening in Asia right now. We could be in the 11,500 range by tomorrow night, but that may be it.

Here are the indicators I will look for: a big pop in the VIX (which I think we will see tomorrow) to over 35 followed by a gradual reduction in volatility indicating the storm has passed. Looking back, I can see that most bottoms occur about the time the VIX goes below its 20 day moving average for good. You can see that average on a good charting program.

I will also look for the spread between the US Fed Funds rate and the 2 year Treasury to approach 0. Right now, it is almost 2.0, with Fed Funds at 4.25 and the 2 year around 2.50. I bet 2 year approaches 2.0 tomorrow with a panic.

The Fed will have to cut rates before the next meeting and may go 1.0 given the problems with global markets. That would bring the Fed Funds to 3.25. With another cut to 3.0 or even 2.75 in February, the 2 year might strengthen and narrow the gap towards zero. Remember back in 2003 when the bull began, the Fed Funds were at 1.0 and the 2 year was around 2.0 and went on up to 4.0 before the Fed Funds rate followed. A steep yield curve shows a strong economy and likely a bull market.

If the Fed does nothing (hard to imagine), then the bear goes on and 11,000 is not even safe. But for those who have lots of cash (you, but not me), that will just mean better deals. I have about 5% in cash on the sideline and another 10% in the BEARX funds, though that percentage increases every day as my long portfolio shrinks and my bear fund increases. I think this selloff will also show how dangerous Asia and basic materials have become, at least in the short term. Glad I am out of both.

Monday, January 21, 2008

Problems with Mortgage Bond Insurers

Jake asked me about the problems with mortgage / bond insurers. Here is a good article that briefly explains the problems with the mortgage insurers and the implications for our economy. The big dooms-dayers like David Tice (manager of my BEARX fund) and Robert Prechter have actually outlined the scenario that has begun to unfold, on their website: http://www.prudentbear.com/ in a PPT posted there (see: “The Case for a Secular Bear Market”) that I reviewed in 2003 and shared with you in my annual newsletter that year. Those two have long been leaders in campaigning against the dangers of fiat currencies and the prospect for uncontrolled inflation and dollar devaluation in the United States. The scenario began somewhat like is currently unfolding, with the inability of the insurance companies to back up the banks’ lending hedges, precipitating a financial calamity. This is the reason I own quite a bit of BEARX as a hedge. I figure that Tice will construct that fund to benefit from the disaster scenario he foretold, IF IT HAPPENS.

And that is a very big if. Even Tice has always conceded that the government had the ability, by turning up the printing presses and calling on its trading partners, to forestall or stop his worst-case scenario. But he also warned that if the Fed slipped up and miscalculated, the downward spiral could get away from them and become impossible to stop. Is Bernanke, President Bush and Congress up to the task? That is a very important question. So, just in case, I have a hedge. Ultimately, if Tice is right and as he outlines, even the dollar will become worthless (as has happened in other economies which mismanaged themselves into hyperinflation by overprinting currency, like post WW1 Germany and 70s Argentina). If the worst case occurs, the only safe haven is gold, as the historical store of value. But gold miners and ETFs are no good according to Tice as they are transacted in fiat currencies. If events get bad enough, only physical gold is really safe, as the fund companies sponsoring gold bullion ETFs (like XAU or GLD) can go broke on a cash flow basis have the physical gold reserves in bankruptcy court. My youngest brother buys gold coins because he instinctively does not trust the government. Maybe he will turn out to be right.

I am not paranoid or pessimistic enough to think the worse will happen, so my position is more moderate as mentioned. I think the government will backstop the financial system by guaranteeing the loans / insurance as they did during the S&L crisis when the formed the Resolution Trust Corp to do the same with the S&Ls (and this was a less serious problem to our national economy than the current global banking crisis). But I am monitoring the situation, and if it gets bad enough (say, DOW below 10,000), I will probably use my reserve cash to start buying enough gold bullion to survive an ultimate financial meltdown. But I won’t go all the way and build an underground bunker with food for 3 months, like my brother has.

Here is the article:

Bond-insurer woes may trigger more write-downs, turmoil By Alistair Barr Jan 18, 2008 18:08:00 (ET)

SAN FRANCISCO (MarketWatch) -- Just when you thought it was over, trouble in the $2.3 trillion bond-insurance business could trigger another wave of big write-downs from banks and brokerage firms, experts said Friday.

Leading bond insurers Ambac Financial (ABK, Trade ) and MBIA Inc. (MBI, Trade ) look increasingly likely to lose their AAA ratings. While almost unthinkable just six months ago, such concerns are also causing turmoil in the $2.5 trillion municipal-bond market.

Bond insurers agree to pay principal and interest when due in a timely manner in the event of a default -- a $2.3 trillion business that offers a credit-rating boost to municipalities and other issuers that don't have AAA ratings. Without those top ratings, their business models may be imperiled.

A more worrying consideration is that when a bond insurer is downgraded, all the securities it has guaranteed are, in theory, downgraded as well.

If Ambac and MBIA lose their top ratings, billions of dollars of muni bonds will be downgraded, and the guarantees that have been sold on mortgage-related securities such as collateralized debt obligations, or CDOs, will lose value.

Bond insurers guarantee roughly $1.4 trillion worth of muni bonds and more than $600 billion of structured finance securities, such as mortgage-backed securities and CDOs, according to Standard & Poor's. Ambac alone has guaranteed about $67 billion of CDOs.

"The destruction of the bond insurers would likely bring write-downs at major banks and financial institutions that would put current write-downs to shame," Tamara Kravec, an analyst at Banc of America Securities, wrote in a note Friday.

Kravec cut her rating on Ambac and MBIA on Friday because she thinks that ratings downgrades are "highly probable" now.

Indeed, Fitch Ratings cut Ambac's AAA rating to AA on Friday, becoming the first major agency to take that step. Fitch downgraded 137,390 muni bond issues and 114 other securities guaranteed by Ambac soon after.

Merrill Lynch & Co. (MER, Trade ) took a $3.1 billion write-down on Thursday related to the firm's CDO hedges. Merrill had bought CDO guarantees from bond insurers including ACA Capital, a smaller player that's now struggling to survive. Most of the write-downs were related to ACA.

CIBC (CM, Trade ) and French banking giant Credit Agricole unveiled similar write-downs in December, related to guarantees they bought from ACA.
But ACA is much smaller than Ambac and MBIA. If the two larger bond insurers are downgraded, banks and brokers that have bought guarantees from them may have to write-down their exposures further.

Merrill has net CDO exposure of $4.8 billion. But that includes a lot of hedging, mainly through guarantees bought from bond insurers. Excluding those hedges, the brokerage firm still has a "whopping" $30.4 billion of CDOs on its balance sheet, Brad Hintz, an analyst at Bernstein Research, noted on Friday.

"We remain very uncomfortable with Merrill's CDO balance sheet exposure," the analyst wrote in a note to investors. "If the counterparties are downgraded, and they cannot post additional collateral, we would expect that Merrill Lynch would have to take a valuation reserve against that specific exposure."

Citigroup (C, Trade ) set aside $900 million during the fourth quarter to cover heightened credit risks related to counterparties it uses to hedge CDO risks.
The impact on the muni-bond market may be just as big, experts said Friday.
There are $2.5 trillion to $3 trillion of muni bonds. Roughly half of those are insured by bond, or "monoline," insurers like Ambac and MBIA.

So more than $1 trillion of muni bonds are now in danger of being downgraded. That could trigger losses for muni-bond investors.

"Assuming the "monoline" insurers lose their triple-A ratings, underlying insured muni bonds could be susceptible to downgrades and downward repricing, leading to losses for muni-bond mutual funds," Michael Kim, an analyst at Sandler O'Neill, told investors in a note Friday.

Shares of big muni-bond fund managers, including Franklin Resources (BEN, Trade ) and Eaton Vance (EV, Trade ) have already been hit by such concerns, Kim said.

Franklin stock has slumped 22% so far this year; Eaton Vance is off 27%.
Most muni bonds insured by Ambac and MBIA are now trading as if there isn't any insurance, Richard Larkin, a municipal-trading desk analyst at JB Hanauer & Co., commented Friday.

"The market has lost all faith in bond insurance and the ratings agencies," he said. "Prices are being discounted because people wonder whether there is any value to the insurance."

That's a big problem, because there are no official ratings for many of the underlying issuers of muni bonds, such as cities, school districts and utilities, he added.

When municipalities sold debt, they asked agencies like S&P and Moody's to evaluate the securities with bond insurance attached.

If the insurance on this debt becomes less valuable, muni bond investors have few ways of checking the new creditworthiness of the issuer, Larkin said.
That's creating an "information vacuum" because the rating agencies aren't going to re-evaluate muni bond issuers unless the municipalities request and pay for new analysis, he said.

"The lack of public underlying ratings on insured debt is a big problem, and if more bond insurers are downgraded, the rating agencies are not likely to fill the vacuum and publish underlying ratings unless they are paid additional fees to do so," Larkin explained.

"Trades are being made based on people's best guesses of the creditworthiness of issuers," he added. "And if these downgrades happen, that will be the environment going forward. Not a good one."

Saturday, January 19, 2008

Survival of AMBAC and the Mortgage Insurers

This gets so complicated almost on one can figure it out, which is the whole problem. Interestingly, David Tice at Bear fund actually predicted this whole scenario several years ago. But very few people saw it coming, me included. I should have believed him, and Doug Kass. I thought they were overdoing it, but I guess they were always right.

The mortgage insurers are on the hook for the “Credit Swaps” that were written to insure the companies writing the CDOs and RMBS, the securities created by packages of loans. If you were like Lehman, Citi, Merrill or JP Morgan issuing those securities, you could insure them with companies like MBIA, MGIC and Ambac. This would be similar idea to the PMI insurance that is written on individual mortgages (Private Mortgage Insurance) for loans with less than 20% equity, or the insurance on mortgages sold by Fannie Mae or Freddie Mac. In the case of FNM and FRE, the insurance policy is backed by the American government.

The problem for the commercial insurers is they don’t have enough capital to cover the insurance claims. If the government doesn’t back them up, it will be big problems for the financial system. But I think the government HAS to find some way to support them. I don’t know if $250B is the number, or not. But it would help the banks, too, if some one helped with the insurers. The banks would like to collect on their insurance policies. It would help their capital situation and would also help get the market for commercial paper moving. All this is tied together.

As for Buffett, he is creating an insurance company to insure municipal bonds, not mortgages. Most of these commercial paper insurers were doing municipal bonds till they got the mortgage bug. Now there is no healthy company to insure municipal bonds, so Buffett is stepping in.

As scary as all this sounds, it has to get resolved by the government. This is no different than the S&L crisis when the government stepped in with a $500B rescue. In fact, it is more important this time than that time, since now the money center banks are affected, not the less important S&L industry. So, I would think $250B would be a cheap bailout. Put another way, if they don’t fix this problem with the insurers and the money center banks, there won’t be much of an economy to worry about and I am not sure the dollar will be worth anything either.

The day the Feds announce a comprehensive plan to fix the problem (instead of just promises which is all we have had so far), bailout the insurance companies, the market will rebound and probably in a big way for the financials.

Wednesday, January 16, 2008

On Prudent Speculator and Prudent Bear

Of all the newsletter writers I read, the Prudent Speculator comes closest to matching my own personal outlook, so is the easiest one for me to follow in principle. Pru Spec also has a long term record that is very good, one of the top 10 newsletters of the past 25 years, according to reviewer Mark Hulbert. John Buckingham and his staff follow the ideas of famous value investors like David Graham. They use valuation metrics that sometimes recommend a stock too early. Still, there are almost no examples of a correction like this one (over 15% on the Dow and almost 25% on the Russell 2000 small cap), where the stocks were not higher after two years. Only during the Great Depression was this not true.

So, rather than worrying about the market valuation tomorrow, I am thinking about market valuations in 2010. I am sure they will be higher, then. But just in case this market turns out to be a rerun of the Great Depression, I am hanging on to my BEARX mutual fund holdings. If the market declines by 90% like it did in 1929 to 1932 (DOW 1400?), I expect my BEARX to do the opposite and increase by 1000%, almost offsetting all my other losses.