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Harnessing Uncertainty….. Riding out the Storm Outside the BOX!

Recs

24

August 28, 2011 – Comments (14) | RELATED TICKERS: TBT , XIV , CIS

Hurricane Irene hasn’t been “too tough” inland in New England, a little tree pruning by Mother Nature, some river flooding nearby and clearly some people are contending with more waves and getting a rougher ride than I am, so I’m hoping for the best for my Foolish Friends. 

Yesterday I blogged about how the fear in the market was a self-fulfilling prophecy. If government keeps signaling massive budget cuts and economists continue to give measurable odds for a double dip recession then consumer/investor confidence will continue to oscillate.  Uncertainty/fear will result in an economic decline that could trip us lower, even if we would not have.   

I’m still fairly bullish, but cautiously so.  I agree with Binve’s recent blog that earnings still look good, but many company’s are hesitating with guidance during the uncertainty. The Fed may tinker in September and the President is working on a job stimulus package bound to meet Legislative resistance.  Some would argue that stimulus doesn’t help the economy.  I don’t believe that one time items will help either, but if we can find some programs that support some job growth then it might be beneficial, if nothing else, to help minimize uncertainty. 

Personally, while technical levels may get tossed around and “blown through” by worldwide economic events, I’m “looking/hoping for the S&P” to stay above 1100.  If it does then I’m looking for a slow up drift until next earnings in late Oct – Early November. In particular I’ll be looking for “uncertainty” in sectors affected by government spending  retail/restaurants and other consumer areas hold up.  In January, I’ll be doing the same.  I’d be quite happy if we can end this year with S&P above 1265. 

portefeuille assured me in yesterday's blog that Germany could singlehandedly hold up the EURO, but just in case the rest of the world caves during this uncertainty I’m looking at some “out of the box” ways to “play” the markets. I don’t consider these investing, but I’m doubting what “investing” is the next year or so.  For those doing methodical, buy/hold, dividend seeking, buy on dips and staying the course, I don’t know if these outside of the box ideas will help you or not.   

Premise:  “Playing for a double dip” can cause you to miss considerable upside on investments that would be better longer term. A double-dip, however could crop another 20-30% off of equities in a short period of time. 

I’m looking for areas I can “trade” where downside risk is minimal, (much less than a double dip).  This means forming a Theory on how low “something” could go. Betting on how “high something” could go, (such as Gold)  is a bit more Foolish.  Playing against Gold for example would be a bad move for two reasons. There is no way to call a top and the harm you can incur doing so is not worth the risk. Second, the gold/precious metals bugs here on CAPS would crush me. 

WARNING:  The following involves the use of ETF’s.  Leveraged, ultra/3X ETF’s are subject to Decay/Contango  They are for “short term” “plays” and not for buy/hold. 

STOPS:  Normally I don’t like Stops, especially on my longer term holdings that have capital gain implications, may have an undershoot sell off due to over reaction to earnings, may be due to pay dividends, may get hit by computer induced flash crashes……etc……..Trading Stops don’t help you on a gap down like we are seeing in many examples in this market. 

  When “trading” stops are key.  I prefer to set them about 3-5% below my buy price, then “walking the stop up  if my buy is increasing in value.  If my trades move upward initially and I move my stops appropriately I can break even or secure a profit most of the time and a "runner" or moderate up period can be productive.  When using ETFs I prefer to have 2-3 options within a “play”.  If I get stopped out of one at a loss, I can use an equivalent to “try again” without a “wash sale”. 

1.  Interest Rates:  I firmly believe that interest rates have a definable bottom.  Using the 10 year index, I don’t believe interest rates can go below 2.00.  Yes, I understand that the FED has indicated that they would leave rates alone for at least two years, but there is a relatively large amount of “movement” that can occur within the Fed’s “meddling” boundaries.   I’m not very good at embedding pictures, but I would call your attention to the ^TNX 10 year (TNX without the carrot works on Yahoo), and overlay a non-leveraged index such as the Barclay’s 7-10 year IEF.  Spread this out over 5 years.  You can see that even in the worse of Oct 2008 – March 2009 that the flight to bonds bottomed out TNX at about 2.10.  At no time (until this past week) did IEF go much above $100.     The yeild usually oscillates off the bottoms and a patient entry can avoid a quick stop out.

There are several ETF’s that allow you to “play interest rates.   TLT/TBT  ;  IEF/PST  ; TYD/TYO ; TMF/TMV  are bull/bear pairs with for the various bond yields with varying leverage. My current “plays” are TYO and TBT, two bull ETFs.   

Ranges on Interest Rates:   “Norm” on the ten year ^TNX even with Fed intervention is about 3.00 to 3.20.  A change from 2.10 to 3.00 is 30% upside. 

Why a 2.00 Bottom:  Diminishing returns for investors. At anything below 3.00 in the long run and 2.00 in the short run, there is no appetite for bonds.  The rating drop on bonds did not scare away investors, but some return is demanded. 

In reality, I don’t expect the FED to be able to control interest rates long term.  I believe inflation in occurring now and is inevitable to some degree. This particular “play” however, is based on a shorter term “max bottom” premise. 

2.  OIL.   I use a similar approach to Oil.  I don’t believe crude can go below $80 per barrel and Brent below $110.  My theory is that the majority of our “easy oil” is still the Middle East. The governments in those areas have “promised/given” oil revenue to their populace to achieve a certain level of stability.  Most need $85 per barrel to meet current goals without risking more unrest.  Oil that is “less easy” to obtain is expensive. The risk/cost of drilling in other areas requires $80 plus oil to make a reasonable risk/reward profit. 

Using a “straight unleveraged” ETF such as OIL we can see a low in Feb 2009 near peak market selloff at 15.68.  A month later OIL was at $20 and never dropped back below $20 the last 28 months. The high was $30.  Using an ultra ETF, a play here might be UCO sub $31.00  Oil bounced off the $81-82 to $84-85 this week.  Tight moving stops could net a good return even if we get several cycles. 

Another reason I like oil as a play is that if the economy does improve, oil should drift upward with the markets, so I have upside opportunity in a downward or upward market. 

3.  VolatilityVIX, also known as the FEAR GUAGE has spiked to a level that makes an interesting “play”.  Looking at the best known index, ^VIX  (again, no ^ needed on Yahoo) on a five year view we see that it oscillated leading up to the crash between 20 and 30. It broke out to above 60 during the “fear peak” October 2008.   In 20 years, except for this one occurrence, it only hit 40 three times.  So more panic means we could go higher, but fear eventually settles down.  While you can’t be certain where “the top” is, you can be certain that VIX will fall at some point. It typically takes 2-3 months to drift back down to sub 20.  This is due to two months of options rolling off.  While you can play VIX with puts/calls, they are expensive and therefore high risk. Keeping things more simple my preference is VIX.  One problem with ETF’s is decay/contango  and VIX has only been around for nine months. Overall VIX can go up even when the markets are going down.  The play here is that volatility/fear will come back down, even when markets are selling.  With VIX spiking XIV has been selling off hard and it’s easy to get stopped out on this one. There are not other options that play VIX dropping directly, so a wash sell is more likely, but acceptable.  Without additional market catalysts XIV could drift back up 30-40% in the next 8-12 weeks and should have minimal downside if the markets drift lower. (Could see steeper selloff in a “fear crash, so stops….!!). 

4.  Distressed and Broken:   This one is a little harder to “explain” and I see that I’ve gone beyond wordy even by TSIF standards.  

Distressed:   The theory here is that equities that sell off hard due to analyst recommendations, missed earnings, reduced outlook, especially when these are reported on a severe market down day, have much of the “bad news” priced in for “awhile” and have even if they broke through technical’s to a new low could better survive additional market sell-offs and should rise quicker in a more stable market.  Examples of these that I’ve written fairly extensive pitches for are Dolby (DBY),   American Eagle Outfitters (AEO), Inphi Corporation (IPHI, no pitch yet, deferred revenues).  Hard selloffs help for a new base, but again, it can still get broken. Dolby and American Eagle both pay good dividends that will help stabilize them.   

Note: It can take 2-3 days for an equity to settle after a sharp selloff. Eventually the volume will decline and you can find the tipping point where those on the sidelines are looking for the best price, but someone eventually blinks and the buying starts. A 2-3% climb, new sell off as the final sellers jump, and then a climb can occur, so don’t jump in too fast! 

Broken:  There are times during a selloff where an equity goes down so hard and so fast that it triggers additional events that can force an “undershoot”.   In particular when an equity has “enjoyed” a period of time in the $6 - $12 range and a catalyst drops it below $5 it’s subject to: 

  1. Some brokerage firms will not allow margin. Hedge funds or other holders of large blocks using margin are forced to sell.

  2. Some mutual funds, (NOT ALL, I hear all to often that “NO mutual funds can..)” by charter do not hold equities that have a sub $5 share price. 

Both of these lead to “forced” selling well below the $5 mark.  In some cases, conditions may warrant for the drop to continue.  The items I am looking for to determine if the equity is dead or temporarily broken include those I outlined in this pitch for Camelot Information Systems (CIS). 

   1.  Is profit Negative?  Was a revenue drop due to what is most likely, (no guarantees no matter what management says) temporary.

   2. Are they a bankruptcy candidate or flagged as a fraud.  Is cash flow positive, are there reserves??

   3.  Is volume dropping, did the float get turned over??  Was there strong institutional holding before the selloff.

Other examples of potentially “BROKEN” Equities recently: RAIT Financial Trust New Common  (RAS) AND Navios Maritime Holdings Inc. (NM)

 (Watching, held $5 so far but would be interesting if they drop below $5...... MU, AMD, OMX)  

There are other “outside the box plays”, but these are the areas where I feel downside risk is most minimal and upside risk/reward makes them interesting. Please heed the warnings, examine the theories, understand about ETFs, and note that there is no such thing as minimal risk, (except 2% bond yields) and risk/reward varies from individual to individual.

TSIF  The Sky isn't Falling Today, and Mother Nature's storm appears to be clearing.  Hold on, stay strong, we don't know what tomorrow will bring, nature or investment, but we can prepare.

Disclaimer, if I knew anything, would I be posting here?  ;) 

PS. Good night Irene

14 Comments – Post Your Own

#1) On August 29, 2011 at 5:32 AM, portefeuille (99.64) wrote:

see comment #24 here.

http://chart.finance.yahoo.com/z?s=^TNX&t=5y&z=l

http://chart.finance.yahoo.com/z?s=^TNX&t=5y&z=m

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#2) On August 29, 2011 at 8:21 AM, TSIF (99.96) wrote:

Thanks Port!!!!  ;) 

 But i'd still have to get pretty with the overlay of the ETF and then add annotations!  ;)

Maybe Binve will help me if I buy him a case of his favorite Brew or it's almost October, maybe I should come visit you and get a first hand look at the German Economy....!!! ;)

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#3) On August 29, 2011 at 12:53 PM, Teacherman1 (47.01) wrote:

TSIF

That's a great strategy, and I'm sure you "youngsters" can pull it off, but I'm afraid it's way too much work for an old man like me.

I will just have to keep on with my "plain vanilla" form of investing and see how it goes.

On second thought, with your reference to "Goodnight Irene", you may be older than I think.

I thought only us old foggys would be familiar with that song.

I will be watching with interest as you implement this strategy, and of course, will feel free to "poach" from time to time.

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#4) On August 29, 2011 at 1:11 PM, TSIF (99.96) wrote:

Thanks Teacherman1, but I'm willing to bet that if you had someone better at 'plaining that you'd take right to some of these strange ETF thingies.  ;) After all, you figured out bloggin'. 

I'm willing to bet that you could play interest rates and oil prices as well as anyone if you tried, but I don't blame you for sticking to the "tried and true".

Poach away....some of these are time sensitive....XIV hopefully will not get this low again for a long time. Oil might cycle in and out of my "bottom" range, but seems off the bottom for now.  Interest rates may trip back near my bottom, but I think not awhile, and there's always an interesting equity that might get bruised or broken.

P.S.  Frank Sinatra's 1950 version was a little before "my time" but not my parents.....  ;)

Thanks!

TSIF

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#5) On August 29, 2011 at 1:56 PM, Momentum21 (78.83) wrote:

thanks for the post TSIF! Great stuff as always...

My only criticism of the 3x ETF strategy is that even in a short-term horizon you are still using a faulty instrument where the odds are stacked against you. The more long bets you play with these ETFs the closer your results will revert to the mean...which is underwater. : )

And when volatilty is high using a stop loss can be crushing since markets will make wide turns without rhyme or reason. One bad bet typically wipes out 8 to 10 good ones.

I realize that you "get it" but I would contend that over the long haul these ETFs will only deliver a net loss and that any strategy involving them (outside of shorting one) is not sound. 

   

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#6) On August 29, 2011 at 2:28 PM, TSIF (99.96) wrote:

Thanks for the feedback Momentu21, but I believe there is some room for the 3X ETF in short term windows when you are using them near the bottom of "the parents" range, such as Interest Rates or Oil and on an equity that has already had a hard fall.  These items, for the most part are not going to make as wide of a swing, and in general will make MUCH LESS of a swing than an equity I might be holding.  These ETF's are also less linked to decay.  As I noted XIV goes UP even when the S&P is going done.  Links to futures contracts have more stability than ETF's that are made up of mythical leverage!  ;)

I agree that I don't like stops, but again, you'd use a walking stop and these (oil and interest rates) are issues that don't jump in big moves...they may open a percent or two higher/lower, but generally "walk" with the market. 

On an equity that is due an earnings report or that moves hard with other equities, the gap can be 5,10, or even 20% of late.  I don't believe oil or interest rates are going to gap more than a few percent.

If I bought my XIV at $7.20 on open Friday and it dropped to $7.06 on Friday at 10am I might get stopped out for a slight loss, if not, then when it moved to $7.60 at 12:20PM I'd move my stop up a few percent, at $7.93 this morning I'd move it up another few percent.  At some point in the next week if volitility takes a dive then I might get stopped out, but still, in this example several percent higher than when I started. If we are in for a good run then I could be considerably higher as I expect VIX to continue to stabilize.  If I get stopped out on a few percent loss, I can reevaluate and reenter if I choose. 

I can't do this on my favorite equities if they drop 5-10% in a short period of time.

So far, I'm also up on my interest rate bottom call and I'm walking that one up.

So, I agree with the dangers of ETF's, certainly of holding them.  I disagree that ones after non-direct sectors, such as Oil, interest rates, and volitility can't be used on market swings with relatively low risk, (if you have time to walk your stops and some disciple).  I'm finding in this market that before I buy anything I should have a plan and I should not get wed to my equity. 

Again, thanks for the feedback, I fully understand your points, I think there are a few exceptions to the rules if done carefully with non-sector ETF's.

TSIF

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#7) On September 06, 2011 at 6:36 PM, ImpetuousFool (< 20) wrote:

Great stuff as ever, TSIF. And I want to note that of my favorites, you were the only one to work your picks on Labor Day weekend. That is true dedication, my friend. Total mad chill dedication.

-- Impetuous Fool


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#8) On September 07, 2011 at 9:21 AM, TSIF (99.96) wrote:

The "mad" part is no doubt true....  ;)

Dedication vs Anal???  I'm not to sure about which!  ;)

That was probably the least time "I put in".  I really needed the market closed for a day!   A few minutes here and there between the three cookouts.....none at my house this year ...so it worked out well!  It's hard to check in on CAPSs and get the hamburgers the right shade of red...!

 Thanks!

TSIF

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#9) On September 07, 2011 at 1:12 PM, JPAKolypse86 (< 20) wrote:

Rec. TSIF, your blogs are incredibly thorough. Some thoughts on interest rates though. It is theoretically possible to push interest rates into negative territory. The fed can do this by lending to banks at a negative interest rate. The effect should be that banks then lend out this cash in order to push more capital into the system. This method has never been tried before, but with record low approval ratings for both congress and the executive branch, these branches may pressure the fed to do something drastic if things continue to get worse going into election season. Since QE2 wasn't well recieved, its possible that bernanke may try something crazy in place of a QE3. I'm not saying its likely to happen, but we do live in strange times.

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#10) On September 07, 2011 at 2:54 PM, TSIF (99.96) wrote:

Thanks JPAKolypse86, I've been working on the interest rate item in this blog a little bit more.  Some analysts think we could push the 10 year down to as low as 1.75 with the TWIST, so I'm being cautious, but I think it will more likely be sell on the news IF the Fed even does anything, which I'm starting to doubt.

Pushing yields using unorthodox tricks as you mentioned is certainly possible, but all the talk from all the FED members/banks is pointing to less and less intervention. 

The fear of inflation so far is low, (not in my household!!!), but it wouldn't take much to tip the scale, so that's another reason I think the Fed doing anything rash is also unlikely. In reality there is already enough inflation for the 2% 10 year to be "NEGATIVE" yield. 

I follow that your point was unlikely to occur and I agree that we live in strange times, but my risk/reward matrix with tight stops still favors interest rates moving up, possibly sharply.

Thanks for the comments!!!!

TSIF 

 

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#11) On September 07, 2011 at 4:48 PM, anchak (99.86) wrote:

Hey TSIF .....Rethink the XIV strategy - as I mentioned before - it seems to be a really broken  ETF.....it weathered the first drop in May - very well - and horrendous in August.

I am holding it - and want to get out ASAP.....The only thing that will work short term is a TVIX short .

 

The inverse math - playing funky.

 

I am in the Yield trade - so we shall see!

 

All the best

 

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#12) On September 07, 2011 at 6:44 PM, TSIF (99.96) wrote:

I agree Anchak, XIV does appear to be broken. Unfornately with these type of ETF's it's difficult to determine if it's broken because investors are skiddish and not bidding it to it's real level or if it's broken due to the pattern VIX took and the elements.

I think we need 2-3 up market days with VIX dropping to get a better pattern, but I've been stopped out of it for small loss (gain the first time, loss the second on a walking stop),  the last two times I tried it. I was back in yesterday so we'll see if third time is charm, but I'm thinking I'll give up on it if I get stopped out again.

I'm gettting more confused on the "yield" trade with all the talking heads and the TWIST talk, but I still have enough confidence in it to keep my stops lose and play it out.  I'm fairly confident that it will be "sell on the news" on the FEDS and/or it will rise as more investors move to stalks on end of year optimism.

On the plus side my "broken stocks" are playing well, but I got stopped out of one of them with a 15% gain in a few days, and then it went up again after I was stopped out on a short term drop.  Par for the course.

Thanks!!!

TSIF 

 

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#13) On September 07, 2011 at 8:21 PM, anchak (99.86) wrote:

My Yield trade is based on a mech tracker I have - sure  the "TWIST" can make it go horribly bad....

 

But then conventional thinking @ S&P Downgrade dictated that US Yields should rise - because of it - yet see how Treasuries performed. I overruled my tracker on one of the strategies - which wanted to buy the treasuries at that time....

 

Any way I am sure - given I went mech this time - the TWIST - will wring the hell out of me!

 

All the best

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#14) On October 15, 2011 at 10:01 PM, jimhsu77479 (90.57) wrote:

Holding XIV @ the 6 level since September. This ETF really needs patience; selling volatility when the market can't seem to get enough of it is a tough, but ultimately rewarding proposition. In these types of declines, make sure to start small and scale up positions on further declines.

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