VIX Drops below 100 day average

The VIX went below its own 100 day moving average on February 22. Since today is February 28, we should probably wait another 4 days of below average volatility before we call a bottom, but the market is certainly looking better. The actual bear market low was probably on January 18, when we first thought it may have occurred.

There is still plenty that can go wrong in the economy. Fundamentally, the property deflation needs to stop. The Fed has temporarily stabilized the banking system, but if assets continue to deteriorate via housing deflation, the banking problems could began to grow again requiring more big writedowns. That could put the market into another leg down. There is also a commodity bubble building, which doesn’t help inflation and hurts consumers. That will be the next big bubble to pop, but it could take years for that to happen since it just got started.

So, I am cautiously optimistic. My portfolio has recovered a little bit and I am actually ahead for the year, now. The market seems to be acting better on bad news, which is a good sign.

BTE and DAYYF

Good to see the market doing better. I lightened up a little this morning since it seems the market is stuck in a trading range. Had a chance to move some sold puts at a profit, so I did (WAG and PHM). I also sold the TSO that I had put to me a week ago. I was ahead about $1 a share for a $500 gain. I could have waited, but there is a decent chance oil will spike and refiners will get hit. Everyone is talking about the technical setup for a breakout in oil to the high side. Didn't want to get caught.

The financials are still hurting. I may sell some more puts there.

After I lighten up, I would like to see the market tank again so I can get into more of the commodity and material stocks. Looks like inflation for hard goods will be with us for a while.

The Sainthood of Warren Buffett - Part 3

In response to a defense of the Municipal Insurance bailout proposal by Warren Buffett on the grounds that he would be backstopping the bond insurance industry:

Continuing with the Buffett questions: today (February 13), he is being ridiculed by professionals in the financial industry (including Wilbur Ross this morning) for exactly the same point that I made yesterday morning. His very public supposed "bail out" of the bond insurers was very self serving (and yes, he does have a fiduciary obligation to his stockholders) and would not benefit the public or the insurers in any way. In fact, if they did for some reason agree to the extorted terms (paying a premium to Buffett for bonds with virtually no risk 1.5 or 2 times what they themselves received, which would cause even more negative cash flow for the insurers), the bond insurers would be terminally injured, their reserve capital further impaired by the negative cash flow and would thus crush the bond market, thereby extending the problems of working out the financial derivative issues here and around the world.

So, Buffett, who at one time bought out-of-favor businesses with bright long term prospects, good cash flow and very good managers, is now in the business of being a vulture of the worst kind who will make deals that enrich him at the rest of the world's (literally) expense?! It is pathetic. Almost Mafia-like and beneath what I thought was his dignity and esteem. I really have lost respect for him and want nothing to do with him or BRK.

If Buffett was willing to stand behind the CDO and RMBS liabilities in return for the nice, risk-free muni bond insurance, that would be a reasonable and semi-noble position (no one expects Buffett to take a hit for the industry or the economy). But that is not what he proposed. He proposed to relieve the muni insurers (so called monoline, but not really so since they are now in multiple lines of business) of their good merchandise and leave them with the crap. The fact that vulture Wilbur Ross is looking to be a saint compared to Buffett is the whole point. Buffett has plummeted to new lows.

His supposed rescue would not restore confidence in the market in the insurers and would not elevate them back to AAA on their CDOs, etc, it would devestate their credit rating by removing the good assets on their books which at least provide relative risk free cash flow/capital, to something in the junk range and permanently impair their ability to insure muni bonds (since all that would be left against the reserve capital requirement would be wobbly commercial and mortgage derivative paper; this, of course, is Buffett's objective. He wants to eliminate all competition in the muni bond business and have it to himself).

If the insurers go, all the liabilities they insure would go back on the originators, the banks (including the big non-USA banks like UBS, Deutsche and HSBC). This hit to the banks would probably push them over the edge and cause them to default on their capital reserve requirements, putting them in technical bankruptcy. This would affect almost all the global money center banks, and potentially precipitate a global financial meltdown and depression. It probably would not go that far because the government would run to the rescue by reducing reserve requirements and possibly buying the impaired assets onto the government's accounts, or some other means; but that means the burden would be transferred to the tax payer one way or the other, all to benefit Buffett. And he talks about the need to raise taxes! That will surely be the case if he is successful, which he won't be.

Buffett's Saintly Proposal - Part 2

Answering Part 1 by my acquantiance: "If you took the stated book value of BRK and then adjusted it by adding in the value of the float from the insurance business ( which essentially was free capital for Buffett to allocate as long as the loss ratio was below 100 ) you could buy Berkshire for roughly 1X adjusted book. I thought that was a pretty good deal and the logic made sense to me [when I first looked it several years ago]. I could effectively hire Warren to manage my money on a dollar for dollar basis, no management fee!

At this point, I have a pretty substantial gain in BRK and I am concerned what Hillary/Obama and a Democrat [party] congress might do to me. They seem determined to raise taxes on capital and drive more capital and jobs overseas as a result. I love to point to Ireland as the antithesis of this warped way of thinking. Low taxes and favorable treatment of capital attracts capital and creates jobs. You know this as well as I do of course. Anyway - long winded way of saying I'm not sure what I might do with my holdings given the valuation, Warren's age, and the chance that taxes may go up. I would like to re-run the analysis on the value of the float however. It is an interesting viewpoint."

My response to the idea that BRK was still a good value:

"Your analysis / logic of BRK and mine are about the same. I read everything ever written on Warren Buffett during the mid 1990s. I became quite a student on his technique, and by extension, his mentor (Ben Graham). But, I also read the quips that he thought his own company was overvalued and wouldn't buy it himself. But you did choose the right time to buy (2002-03) his stock. That was near the end of a eight plus year plateau in BRK during the dot com bubble when insurance and consumer durables were too boring and that culminated with Katrina and concerns over his exposure through General RE. That period included a few mistakes like US Air and Solomon Bros that damaged his reputation as the untouchable / invincible investor.

But since that time, the B shares have spiked from $2000 to $5000 over a two year period as he has come back into vogue with his timely utility, CNOOC and railroad investments. At the same time, nothing special happened with BRK's fundamental value to justify that spike (the deals that went his way did not double the cash flow). This is a company that probably can't grow earnings / cash flow more than 10 to 12% annually, just based on its size, no matter how smart individual deals. So, a 150% pop in stock price has probably taken it past fair value. But I haven't done the analysis either, so can't say that for certain. I am also concerned about his age, and, irrationally, his politics.

You express concern about Hil-Obama. But Warren is a major benefactor to Hillary's campaign, and would back Obama, if not Hillary. He also came out with the ridiculous and dishonest position supporting raising income taxes on the wealthy, even though he shows very little income the way he compensates himself (minimized by paying no dividend). He is a hypocrite on this point and it was a big disappoint to me when he took this position. I wonder if he would support a wealth tax just as readily. The idea that the government can do a better job taking care of society than people of means, like himself, is against what he has always stood for. If he really believes his own hyperbole, Buffett should have just donated his wealth to the government rather than to the Gates Foundation. It would be more genuine for him to campaign for be tter treatment of charitable giving than to bash wealth. (BTW...he was notorious for being a skinflint and not giving anything to charity until the last few years when he finally realized he couldn't take it with him)."

On BRK and Buffett's Proposal to "Assist" the Mortgage Insurers

In response to a positive comment from an investor acquaintance on Berkshire Hathway, Warren Buffett's investment vehicle:

So, you have thrown in the towel and are riding Buffet's coattails? I know that is enticing. I had BRK-B until a few weeks ago when I sold it to raise cash. It was one of my few winning positions. But I thought at that time (near $5000) that it was probably a little overvalued and I had owned it since the low $3000s. People pay a big premium for BRK, more than the sum of the parts. Some of those parts won't be doing well for a while. He owns a lot of homebuilding materials companies, including furniture. His newspapers probably aren't worth too much any more, either.

The best time to buy BRK the past few years was after Katrina, when all the insurers got knocked down. That is when we got in. BRK has to have some very bad news to lose any of its market premium, there are so many people that want to own it. Maybe there will be enough bad news in consumer durables that will cause BRK to lose some premium, at least that has been my thinking. It is too big to grow much on its own, so it has become more of a valuation game to make money on BRK. (Buffett himself has said in the past at times that he would not buy BRK based on its over-valuation).

I think his proposal to reinsure the bond insurers (AMBAC, MBIA, PMI, etc), but only the municipal bond pool, is very interesting. Reinsuring something that doesn't need insurance in the first place is quite the joke. It is a typical Buffett move, intended to give him a lot of money, quickly, at very low risk. He is asking for $12B (1 1/2%) for extending 30 days of protection on a portfolio that is not at risk (the $800B of AAA municipal bonds insured by the group). But his proposal does not address the real problem with the bond insurers, the CDOs, et al.

It seems to me that if the insurers take the deal, they are admitting defeat: they are in such bad shape that only their very best, the municipal bonds, is worth anything at all, the rest is worth nothing. If the insurers tank, it will cause significant additional damage to the financial markets, and to the economy by extension. While I don't blame Buffett for trying to extort the insurers (that is exactly what this is), they should turn him down and work on deals that address their real problems.

They do need a capital infusion (Buffet's proposal does not provide them any more permanent capital, but only temporarily shifts capital coverage requirements) and a return of confidence by the market, but the best way is a gradual unwind of their positions in a rational way rather than a fire sale of their best assets as in a "going out of business" sale. They can always find a buyer for a municipal bond insurance portfolio.

Short Hedge of the Week and TSO Short Puts

Today's trading note: I have exposure to high beta Tesoro (TSO) on the Feb 45 for a $7.10 premium.  It is very volatile. I am expecting the price of oil to pull back on economic uncertainty and as predicted by T Boone Pickens.  As oil pulls back, the refiners will see their margins increase which will quickly drive the refiner stocks higher.  I think TSO at 45 by the end of February is a strong possibility.  But I will make money at any price over 38 by Feb expiration.

 

The May 30 TSO sold Put is very low risk, I agree.  If I didn't already have the Feb 45, I would consider writing the May 30 Put for $1.50 a contract.

 

I did another one of my Short Sale, Long Hedge specials this morning. This is an excellent way to hedge the downside expecting a market correction.  Because the financials have run a long way off the Jan 22 bottom and are due to pull back, I sold big bank, Washington Mutual (WM), short at 21.75 (it was already down to 20.80 this morning) and then did the collar at a 0.50 debit (1.33 on the bought Call for Mar and 0.83 on the sold Put for Mar).  The collar was for 17.50 on the put and 22.50 on the Call, so that I have almost $4 of downside oppty on the short for a cost of only 0.50.  My risk is only about 0.75, which is the difference between the call price of 22.50 and the owned price of the short at 21.75 minus the cost of the net debit (0.50).   

 

So, a 4.00 upside to a 0.75 downside is a very good upside/down ratio (anything more than a ratio of 3 is good for me).

 

Brian

 

Short Sale - Long Collar: the Perfect Hedge

This may be the perfect hedge: Short Sell a weak stock and then use a long collar to protect against it going higher.  I have been experimenting with this strategy and it is so far working very well. 

 

Here is how it has gone: on January 15 I sold short 300 shares of Radioshack (RSH) at 14.17.  RSH has shown weakness for over a year, though it did have a good spike the middle of 2007.  But lately, it has done poorly along with the rest of specialty retail.  Because the risk on a short sale is unlimited to the upside, I wanted to provide protection, so I bought (3) Feb $15 Call contracts for $0.75 each (each contract covering 100 shares).  To help pay for the Calls I sold (3) Feb $12.50 Put contracts for $0.40.  This left me some room to the downside to profit from continued weakness in RSH (14.17 - 12.50).  If the price of the stock continued to drop below the strike price of the sold put, I would realize a profit of $1.67 + 0.40 - 0.75 = $1.32 per contract (or $396 for all 3) when the put was assigned, taking out the short.  Over the one month time frame, this would provide an annualized gain of over 100% (using only margin, as shorts and sold puts require no capital).

 

But what would happen if the price of RSH rose in the meantime?  I just found out and am pleasantly surprised.  The fear of all short sellers is a rising stock price.  But using the collar, I guaranteed upside protection with the Call contracts.  I sold those contracts yesterday as the price of RSH had risen to $16.80 at the time of the sale.  Here is how the math has worked out on this transaction:  Call price on 15 Feb strike rose to $2  on Feb. 1, 2008 (it was at $2.70 earlier in the day but I have job and wasn't monitoring the contract price).  I closed out the Call contract for $2 and also closed out the short Put contract at $0.05.  My total gain on the Put and Call option contracts was (0.40 - 0.05 + 2.0 - 0.75) $1.60.  In effect, this raised the basis on my short to 14.17 + 1.60 = 15.77.  

 

I turned around and did another collar, though quite a bit higher, with a March expiry sold Put with 17.50 strike for $1.53 and a collaring $20 Call for a paid premium of 0.68.  The worse case scenario is a close below 17.50 on March 22 in which case the put option would be assigned and the Call would expire worthless.  In this case, the total possible loss is $17.50 - 1.53 + .68 = 16.65 - 15.77 (new basis) = 0.88 a share, about the same risk as for the Feb contract, so effectively rolling the strategy forward even in a market with rising prices.  But if it closes above 17.50, the sold put premium will be booked and will again increase the basis on the short position. 

 

Bottom line: this is a reasonable way to put in shorts against weak stocks while mitigating risk.  The weakness of this strategy is limited profits on a dropping stock price.  But it will do very well with flatish prices (renewing the collar will generate profits each month) and will provide protection with rising prices.  It might be possible with this short strategy even to profit with rising prices with good timing (which was not the case here as I gave up 0.70 in profit with bad execution on Friday). 

 

I will keep you posted to performance future months, and may add a couple more candidates, like Washington Mutual (WM), Garmin (GRMN) or CROX.