Back to Reality

I was at my annual boys golf tournament the past 3 days. We call it "Party At The Pines" at a resort in northern Minnesota. This is the 14th year we have gone north with 16 or 20 guys and played non-stop golf for 3 days. It is a great way to get away from it all. You can't think stocks or trouble at work, when you are focused on hitting that little white ball about 400 times over those 3 days.

Now that I have missed all the stock market fun this week, I have a little chance to consider what has happened and where we go from here. One thing is for sure, the market has left its moorings. It has entered the irrational phase when anything can happen. The one thing I know from all the reading I have done, is that at times like this, it is best to just stand still and do nothing.

I am not a disinterested bystander, by the way. I thought I was fairly well protected from this eruption (which I suggested was a possibility as early as 2005, based on the housing bubble bursting), but I have been more or less fully invested since I believe it is impossible to pick a bottom. And honestly, this market situation is at the extreme end of what I thought was possible. There has always been a doomsday scenario suggested by some analysts, that would be triggered by this type of loss of confidence in the financial system. But I never really thought it would go as far as it has.

You know that I have been buying high dividend stocks and funds and reinvesting the large dividends in the same stocks to average down my cost if the price goes lower. I am very diverse in my holdings so that the risk is spread. But still I am getting hurt badly in this market because even the babies are now getting thrown out. Even cash is no longer safe, as some big money market funds are now "breaking the buck" and unable to return $1 of principal.

But this has all the look of capitulation. VIX peaked at near 40 today, which is its highest level since the 2000-03. Generally any spike over 30 signals fear in the market and a buying opportunity, though note how long high market volatility went on in the Tech Bust:



What needs to happen to change the direction of the market? There are a few basic actions to look for. The basic need is to break the vicious feedback loop in which the market is now engaged. The actions need to come from the government as they are regulatory in nature and in most instances, the government initiated the rules or regulations that have precipitated this crisis.

1. Suspend the "Mark-to-Market" rule: It came out of Sarbanes-Oxley legislation and was implented by the accounting board, FASB. Mark to Market is the primary culprit for circular market action, since the action of marking down assets weakens the capital structure of a bank and causes it to decline in value. As assets decline in value based on the weakness in the institutions backing the financial assets, the market price declines requiring another round of markdowns. This has gone on until some banks have broken their statutory capital requirement level and become insolvent in the process. This must stop to repair the market, so look for a loosening here and the option of "Marking to Model"

2. Clamp down on short selling: Although I have been doing some short selling to provide protection, and believe in it from a free market perspective, but it can really exacerbate the snowball effect of a downward spiraling market. Because financial institutions use the equity on their balance sheet as capital against their book of bank financing, they are exposed to damage by short selling more than other businesses which don't leverage their equity to do business. The "uptick" rule should be reinstated and I see that there are further restrictions on Market Makers put into effect by the SEC today so that shorts have to have claim to the physical stock in order to short it (that is, no naked shorts).

3. Continue infusing liquidity into the market: The Feds need to continue flooding the market with capital so that the financial engine does not seize up. Money is like a lubricant to financial institutions and business in general. If it ever stops flowing, then business freezes. The Feds have many ways to put money back into the financial markets.

4. Back more institutions with capital as needed: AIG and Fannie/Freddie were both bailed out with large US government loans. But these are not necessarily bailouts that will cost the taxpayer over the long term. This is the modern equivalent of the Resolution Trust Corp (RTC). The Feds are giving capital loans at a high percent interest ($85B at 12% in the case of AIG). This paper can later be sold on the open market at a big profit once the market panic passes and the company's balance sheet is repaired, just as any bond can be sold.

Goldman Sachs (GS) and Morgan Stanley now look like the two that need the most help, though they were thought to be top of the heap a few weeks ago. GS just beat expectations with its earnings report on Tuesday. Apparently their CDSs (credit default swaps which are like loan insurance) sold to other banks to hedge risk in loan portfolios, are jumping in cost. The Fed can help them here by buying the CDSs onto the Fed's balance sheet and later reselling to the market at a profit, to the taxpayer's benefit.

Even though they have so far avoided attack by the short sellers, USB and Wells Fargo are not out of the woods. In this market, the shorts can ruin any bank.

5. Coordinate Central Banks globally to take a similar approach with their own national banking companies. There is so much linkage in the financial system this is not an exclusively American problem, though it may have started here. The Central Bankers should be talking to each other (I am sure they are) to coordinate actions for the maximum positive effect. The Euro can be used to prop up European banks and the Chinese and Japanese central banks are flush and should do the same for their home banks.

6. The Central Bank should not worry about inflation right now. Everything happening right now (not 6 months ago) is Deflationary, not Inflationary. Financial contraction, in terms of deleveraging of financial institutions and dropping real estate prices, is inherently deflationary. The Fed can pump as much money into the banking system as it wants without adverse effects today. Once there is recovery, the Fed then would need to take money back out of the financial system by calling its loans, or selling them off.

7. Shut down the ratings agencies: Moody's, S&P, and other ratings agencies are doing more harm than good. They were big contributors in blowing up the real estate bubble by rating sub-prime securities as AAA, thereby attracting cheap money from abroad into our housing market. And now they are over-reacting the other direction and are dropping ratings on good companies because their stock price is declining and it is decreasing capital ratio coverage (see points 3 and 4). The function of agencies is to provide constructive guidance to investors based on their research departments. But the agencies have not lived up to that promise for more than a decade. They missed the Tech Bust as well.


8. Finally, remember that when the market does get over its panic, the rebound will be substantial. It may not bounce back to 14,000 Dow anytime soon, but it could bounce back to 12,500. The Financials that are left standing can double or triple over a 6-12 month period as they regain the irrational / non-fundamental losses. So, financial index UYG, as one suggestion, will do very well at some point.

I hope Bernanke and Paulsen work quickly on the above, plus anything else they can think of that I have not. They need to do so to keep us from crashing into a Depression. I think we have the right people at the top to avoid a real crash with Bernanke an expert on deflations and Paulsen an expert on investment banking finance. Watch for any or all the above and when you see action taken, it should solve the problem.

Until I see what comes from the Fed, I am sitting on my hands trying to avoid doing any more damage to my accounts by selling low, but also not sure if we are at the bottom, so not willing to buy, other than through the methodical reinvestment of dividends that I have set up.

Watch VIX Today

I think VIX will cross 30 today and on a bit of panic will set a new market low. This low will be in the same range as the market low on July 15 at around SP500 (1180-1200) and will set up a reasonable period of market recovery. This is a continuation of the bottoming process that started back in March, with the Bear Stearns takeover by JPM. Because of the severity of the financial crisis, and its continuing ripple effects around the world, this bottoming can take a long time.

If we remember back to the 2000-2003 market decline at the end of the Tech boom, there was ripple after ripple that unwound separate excesses, from the Teleom sector, to the Internet sector, to the Large Cap growth sector, to Enron and Tyco. One after the other of these segments came apart until all the previous excess was exhausted.

This is what we are seeing again. It started with the riskiest of the mortgage companies (those specializing in sub-prime) and has continued through home builders, banks, insurance companies and then spread overseas causing export declines in Asian and European economies, leading them to recession and market declines (check out China, FXI, which has declined by 70% from its peak last year). Now, the energy, metals and commodities sectors, which were overheated, are getting taken down because of the reversal of the Yen and Euro carry trades against the US dollar (with the strengthening dollar). The Hedgies are dumping their commodity positions and some of those hedge funds will crash.

But, we are getting closer to the end of the chaos. It is hard to think about any other sectors that were run way up that have not already come down. So, the bottom will likely hold (1200) and we will rebound once again. Eventually, I am saying after the election uncertainty is eased in November), the market will rebound and continue working its way higher. The Fed is now in a position to drop interest rates (with spreads stabilizing with the GSE rescue) and the Euro in trouble with recession in Europe. That should signal the turnaround. Expect the Fed to drop by at least 0.25% by year end.

Missed it By THAT Much!

Okay, so I missed the breakout by one day. After the great results on Wednesday afternoon and post-market announcements by IBM and EBAY, I thought Thursday would be the BIG DAY. So, what did we get? One measly point on the DOW. Some big breakout day. Maybe just a breather for big things to come.

I have been pointing to today for a couple of weeks. Today is the day for Citibank to announce earnings. It started looking good for Citi a couple days ago as its price starting creaping up. Great insight, or leaked information? Who knows, but good news is usually working into the price before the news is official.

So, this morning the news is out. It isn't stunningly great and was a loss of $1 per sahre, but is apparently good enough. New CEO Viktor Pankrit said the credit markets have become much more liquid and Citi is able to move its paper now. He is confident in their future. Citi is up to over $26 in the pre-market, up from around $20 on March 19 (the BSC bottom day). It can move up with a loss and a small miss because many traders were short figuring that Citi was going to zero.

Google also announced much better than anticipated earnings this AM. GOOG is another market leader, like it or not. It is now considered a metric on the economy since a large percentage of corporate advertising budgets has moved to Google. What is good for GOOG is good for the economy.

These two stories, along with other better news and a generally more positive vibe on Wall Street means a good day is coming (the day I thought would come yesterday!!) The good news is improving the case for the end of the bear. The S&P500 is now above its 50 day moving average. As it continues to move above its 100 and 200 day averages, the price action creates a floor for traders. Averages that at one time were ceilings become foundations. The critical psychological level for S&P is 1400. It could go through that today on a big rally.

We also are now 18 days out from the turn in the VIX signal (breaking below its 100 day moving average on March 31). The further out we go, the stronger that signal is. If you look at charts going back a couple decades, the market never turns on this signal when it is two month long (VIX is below its 100 day average for that length of time).

I think we will all be a lot happier (financially and hopefully otherwise) at the end of today.

Capitulation is Near?

The market has been very bad the past several months. It is hard to know when there is a bottom and it can begin going back up. But one thing is for sure, before it can, most people have to become truly discouraged. The AAII tracks investor sentiment. Sentiment is normally very bullish, since investors must normally be positive about the market (or they wouldn't invest). But right now, the sentiment is bearish, with many more investors skeptical about the market than positive. This is a good sign and points to a bottom.

In the latest poll, Bullish sentiment was 34.3% (long-term average is 39.2%). Neutral sentiment was 20.4% (31.7%) and Bearish sentiment rose to 45.3% (29.0%). Bearish sentiment exceeds bullish by more than 10 percent.

If we get a big one day capitulation in the market, shown by a spike in the VIX index, we will know we are very close to a bottom.

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.

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. 

 

 

 

 

 

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)

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.

November and the Market is Ugly

Brian, Today was wild! Do you think we test the lows on the S & P? Does someone step up and buy a Canroy? Oil to mid 80's, old to 760?. VIX to 37?, Candian dollar down 2.3%. Any thoughts on the future?

My gut is this is just a correction but all fundementals are in place for lower dollar, higher gold, higher oil and another buyout of a Canroy...

Jake, I agree this is a pretty ugly market and another leg down in what began in July. Amazing how all the gains of 3 months (since the recovery in mid-August) can be wiped out in a week. This is not a very confident market. People are looking for any reason to sell and are sure getting out now. There is a lot of fear about the housing and financial markets taking down the economy.

I think this market action is showing a rotation from real estate to consumer durables to finance to retail and now on to tech and commodities, including oil and gold, as fear of a global recession spreads (though not much evidence of that). The good news for our commodity plays is they are all high yield, which makes this whole process easier to deal with. The finance stocks bounced a little today and were up against this lousy market. The home builders are also kind of washed out, though I think there must be another leg down for them and I wouldn't get close to them until there are some bankruptcies, signalling the end of the collapse (as supply is taken off the market).

I definitely think we will test the lows of August in the Dow and S&P, which aren't that far away now. We could break through and fall back to the March lows. But I don't think the environment is nearly bad enough to fall to the 2002 lows (7500 on the Dow and 800 on S&P). The financials will establish the bottom and lead the market back, maybe within the next 3-4 months. They always lead the market back.

The big question is do we go into recession and if so, how big a recession? If the rest of the world continues to grow and doesn't collapse, it will help pull the US stock market out by continuing to purchase our goods keeping our exports strong and helping the industrial base build employment.

I think the bigger banks will end up consuming the weaker banks once most of the trouble is on the table. But we still don't know how bad the trouble is, so all the banks are getting whacked. I have picked Citibank and Bank of America to survive and eventually thrive. But they are both hurting now and I was early on them, so it has hurt me. But their 6% yields make it a little better.

The good news in all of this is that the market P/E never got that high in this cycle (20) and has come down now to around 16. If we hit 11,500 on the Dow and the earnings just stay flat (no growth), we will be back under 14 for the first time since the early 90s. That was a good time to be investing in the market since the Dow was only about 3000 then (1992) and is now 4x higher.

I don't know where all the commodities could go if we get the R word going. There is a lot of fundamental reasons for gold and oil to go higher in the long term (growth of demand in the BRIC economies and ever more expensive to produce or limited supply). But over a period of a year or two, reasons for price are more technical and speculative in nature. I think 760 is the minimum pullback, but 650 is a lot more likely. If you do a chart on gold for seven years, you see that the bottom of the uptrend channel is about 650 right now.

Same thing with Oil, you can look at the channel (http://www.chartsrus.com/chart1.php?image=http://www.sharelynx.com/chartstemp/free/chartindCRUvoi.php?ticker=FUTCL) and see the lower trend line is about 65. Oil stocks, like drillers, could go down 35-40% (I am cutting my exposure to drillers) and the Canroys could go down 15-20%, though the dividend should keep them from falling too far. I am looking at writing (selling) more puts on PWE if the price gets down to $27, which it might the next couple of days. I would try to get a $1.50 premium on the $25s (maybe on the March contract). That offers me protection down to 23.50. I think the chance of the dividend on PWE getting cut is very small, so that price would be super secure since the annual dividend is over 3.00, putting the yield when the price is at $25 a t over 12%.

When VIX hits 37-40, that is the bottom, as it was last time (in August) and almost every correction before. That shows a lot of volatility that can only happen when there is some "sell-off" panic in the market. VIX was at 31 today, so on its way.

If you really want some excitment and have your options account set up, try buying at-the-money calls on your favorite names, especially if they are high volatility. Citibank (C) and BAC would be two good ideas. Cisco is another one. You can buy the March 08 $35 C call for $3 right now. That means the break even is $38 on March 17. If the stock goes back above $41 between now and then, which it definitely could, it will be a double on your bet (and if it got back to $44, it would be a triple $9 divided by $3). But if it ends up less than $35, you lose the investment.