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Harnessing Uncertainty



August 29, 2011 – Comments (0)

Location: TSIF's CAPS Blog

Author: TSIF


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 single-handedly 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 technicals 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

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