Sunday, December 27, 2009

Hyman Minsky

In academic circles Hyman Minsky is now regarded as the great exalted savant of economics, but it wasn't always this way. "Many of Minsky's colleagues regarded his 'financial-instability hypothesis' which he first developed in the nineteen-sixties, as radical, if not crackpot.", writes John Cassidy in a February 4th, 2008 article in The New Yorker entitled 'The Minsky Moment'. You can find a lot of information about Minsky's "financial-instability hypothesis" on the Internet and specifically at Wikipedia, but Robert Barbera sums it up best in his book The Cost of Capitalism: "Minsky's thesis can be explained in two sentences. A long period of healthy growth convinces people to take bigger and bigger risks. When a great many people have made risky bets, small disappointment can have devastating consequences." Barbera also explains the culmination of these consequences: "When you own risky assets that are falling in value you need cash, you have to start selling your good risky assets. If everyone does this at the same time, the price of good risky assets begins to fall, and soon it looks like all risky assets are bad assets. That is the Minsky moment.".

If we delve further into Minsky's 'financial-instability hypothesis' Wikipedia states: "Minsky argued that a key mechanism that pushes an economy towards crisis is the accumulation of debt. He identified 3 types of borrowers that contribute the the accumulation of insolvent debt: Hedge Borrowers; Speculative Borrowers; and Ponzi Borrowers. The 'hedge borrower' can make debt payments from current cash flows from investments. For the 'speculative borrower', the cash flow from investments can service the debt, i.e., cover the interest due, but the borrower must regularly rollover or re-borrow the principal. The 'Ponzi borrower' borrows based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with cash flows from investments; only the appreciating value can keep the Ponzi borrower afloat.". We were inundated with Ponzi borrowers at the height of the real estate bubble, both on the individual and institutional level, and this cut the legs out from under the stock market.

There is currently a paradigm shift in academic economic cliques because of the success of the TARP program which not only raises doubts about the conservative free-market economic theories, but also brings back Keynesian postulates. As I wrote in the last posting of this blog, Minsky amalgamates supply-side and demand-side schools of thought and brings economic thinking to a new level. There is a sea change going on and we on Main Street may not be aware of it yet, but those within the inner circles of Wall Street are surely conscious of the influence this has on our portfolios. As is, the smart money piled into the market right at the bottom in March and the little guy, or individual investor, stayed in cash or invested in bonds and in effect, was left holding the bag, although this was a good year for bonds, but nothing like the action in the market. Now that the market has rallied over 60%, individual investors will probably begin buying stocks only to have the market implode again once the government stimulus money runs out. And this is a big part of Minsky's hypothesis, that market collapses are inevitable and part of a healthy economic scenario only to be propped up by a big dose of government intervention.

To gather the material that enabled me to put together this posting I read The Cost of Capitalism by Robert Barbera and thought the book wasn't quite up to snuff. I expected more from Mr. Barbera because he is a good economist and I thought the book took a roundabout way of making his points, plus, some of the interior chapters were laborious when discussing the history of free-market economics since the late 1970's. There is an awful lot about Hyman Minsky in The Cost of Capitalism, but it doesn't warrant the outlay of almost $30 for the price of admission when a simple trip to Wikipedia or a search for Minsky on Google should do the trick. However, it should be noted that although Minsky is not currently part of the mainstream nomenclature or will he ever be, as an investor, you should be aware of his theories because they do effect your profits.

Sunday, December 20, 2009

How Markets Fail

Two weeks ago The Economist published a list of their four best finance books of 2009 and two of them piqued my interest, Too Big To Fail by Andrew Ross Sorkin and How Markets Fail by John Cassidy. Both books have been getting rave reviews in the financial press so I ordered them on Amazon and finished How Markets Fail early this morning. Boy was I disappointed. I hope Too Big To Fail is better because I just slogged through 350 pages of some of the most tedious writing I've come across this year. At the outset of the book Mr. Cassidy states he didn't want it to read like a text book, but I'm afraid this is exactly what he's done. This is not to say the book has no value because I did learn a lot from it, but it would appeal to a much broader audience if it didn't drag on for so long.

How Markets Fail is divided into three sections: the history of Utopian economics, the history of realistic economics and the inflation of the housing bubble and its implosion. In the history of Utopian economics, Mr. Cassidy gives a brief, but detailed chronology of free-market economic theory dating back to Adam Smith and culminating with the Chicago School led by Milton Friedman. The second part of the book is the history of realistic economics and how this branch of economic thinking refutes some, but not all of the doctrines of the supply-siders. John Maynard Keynes, behavioral finance and Hyman Minsky are all highlighted in this section and this is where Cassidy falls short. He devotes a chapter to Minsky when he should have extrapolated more about him because at the end of the book, Minsky turns out to to be dead on with his theory of meshing both the free-market and Keynesian schools of thought. The final 150 pages is devoted to the 2008-2009 real estate crash and this has been overdone by too many authors, so let's get back to Minsky.

As Cassidy writes: "Minsky advanced the view that free market capitalism is inherently unstable, and that the primary source of this instability is the irresponsible actions of bankers, traders, and other financial types. Should government fail to regulate the financial sector effectively, Minsky warned, it would be subject to periodic blowups, some of which could plunge the entire economy into lengthy recessions.". I first heard about Hyman Minsky in an interview on CNBC with Paul McCulley, the Chief Investment Officer at PIMCO, and had no idea about why he was so enthusiastic about him. This is partly to do to the fact that Minsky is not a very well know economist, but he is getting there. Like Mr. Cassidy summarizes: "Perhaps the biggest lesson we have learned is one Hyman Minsky taught us as far back as the 1980's: Wall Street needs taming. On an individual level, banks, investment banks and other financial companies provide essential services. Taken together, however, their self-interested actions have created and amplified economic disturbances, largely through the use of leverage and excessive accumulation of risk.".

In fact, Cassidy blames the Great Recession of 2008 on Alan Greenspan and his free market cronies because: "The notion of financial markets as rational and self-correcting mechanisms is an invention of the past forty years.". In the conclusion of How Markets Fail, Cassidy pontificates: "If Ronald Reagan, instead of appointing Greenspan to the Fed in 1987, had talked Paul Volker into staying another four or eight years, things would have turned out differently...When historians come to write about the 'Greenspan Bubbles,' they will do so with good cause: more than any other individual, the former Fed chairman is responsible for letting the hogs run wild." How Markets Fail hits the bullseye in citing Greenspan and the supply-siders for the Panic of 2008 and also whetted my appetite for more information about Minsky, but never really sated me, so next on the docket is something more substantial. There should be a place for a book like this, like in the hands of hardcore economics students, but for the average investor, you should really skip this one.

Friday, December 18, 2009

A Wing and a Prayer

As the markets have moved sideways and consolidated the past month, my portfolio has limped along with them losing roughly 35% since mid July, but treading water since October. I try to remain objective about my leveraged short positions, but sometimes I get lost in the current euphoria of a 60% run-up since early March and doubt my myself, but that's only to be expected. For every Meredith Whitney or Bill Gross in their bearish predictions, there are plenty of bulls to take the opposite side of the trade. Where this market will go is anybody's guess.

This morning I read the Carnegie Management Group Hotline which is free to anybody with an Internet connection. They do have stock and ETF recommendations, but you must be a premium subscriber to access that. For my purposes, just reading what they had to say today was good enough for me. The hotline said: "The media and the market 'experts' would like for us to believe that the economy has bottomed and the next bull market is underway. That is simply not possible. Dividend yields are near all-time lows. The S&P 500 P/E ratio for reported earnings is an astronomical 140--the highest level in recorded history according to Standard & Poor's.". I have read on some blogs that the P/E for the S&P 500 is near 140, but I've never seen it in writing from an accredited source. I checked the S&P Web site and they have the 2009 P/E at 88 which is sky high. Where they got the 140 from, I don't know, but it was probably in the way that they read the data and calculated it. In any event, the P/E ratio is well above it's historical norm and things tend to revert to the mean. This doesn't imply that it can't go higher, just that it's going to go lower at some point.

The Carnegie Management Group Hotline also had some more interesting data: "Every decade, the markets face a grave three-year cycle....do you remember:

The recession and bear market of 1920, 1921, and 1922?
The recession and bear market of 1930, 1931, and 1932?
The recession and bear market of 1940 and 1941?
The recession and bear market of 1950, 1951, and 1952?
The recession and bear market of 1960, 1961, and 1962?
The recession and bear market of 1970, 1971, and 1972?
The recession and bear market of 1980, 1981, and 1982?
The recession and bear market of 1990, 1991, and 1992?
The recession and bear market of 2000, 2001, and 2002?"

Just because there is a pattern here, does not mean that the pattern will repeat itself, but there is a precedent. If this piece of information is worth anything, 2010 and 2011 could mean tough times ahead which would be great for my ETF allocations. However, I remind myself of what Warren Buffett said: "Beware of past-performance 'proofs' in finance: If history books were the key to riches, the Forbes 400 would consist of librarians.". For some reason, Warren Buffett always sobers me up.

Tuesday, December 15, 2009

Big Brother

In my last posting I discussed confirmation bias, which according to Wikipedia is "a tendency for people to confirm their preconceptions or hypotheses, independently of whether or not they are true.". I sometimes ask myself how much I've fallen for the stock market's doom and gloom scenario and if indeed I do tend to confirm my preconceptions by reading only those authors that fit my hypothesis of a double dip recession or worse. The problem with the books I read is that bear market meltdowns are about the only subjects available in the economic sections of your local booksellers these days, either at the mall or in cyberspace. However, I did find one this past week that is very upbeat in its outlook on the economy and that book is It's Not as Bad as You Think by Brian Wesbury. Wesbury has very impressive credentials in that the Wall Street Journal named him the nation's number one U.S. economic forecaster in 2001, and USA Today ranked him as one of the nation's top 10 forecasters in 2004. I've seen Mr. Wesbury numerous times on CNBC so I took a flier on his book and I'm glad that I did.

Wesbury never comes out and states that he's from the Austrian School of economics, only a supply-sider, but clearly his roots are there. He quotes Ludwig von Mises and Joseph Schumpeter numerous times and I found it ironic that in the past month I've read three authors that are from the Austrian School or highly influenced by it and all three have different outlooks on the market: Charles Goyette in The Dollar Meltdown believes we are headed for hyperinflation and depression, Robert Prechter in Conquer the Crash sees depression and deflation while Wesbury is very positive and has an outlook of growth for the next 18 months. In fact, Wesbury is so positive on the economy, he thinks the Dow Jones Industrial Average can rise above 14,000 in a few years time.

The implosion of the financial markets the last two years has been referred to as 'Depression 2.0' and 'The Great Recession' in the popular press, but Wesbury calls it "The Panic of 2008". A common theme throughout It's Not as Bad as You Think is that government intervention is to blame for the cratering of the markets. As Wesbury states in the beginning of the book: "What caused the crisis to spread and turn into a full-blown panic was mark-to-market accounting.". According the Wikipedia, "mark-to-market or fair value accounting refers to the accounting standards of assigning a value to a position held in a financial instrument based on the current fair market price for the instrument or similar instruments.". Mark-to-market accounting standards were reinstated by the government at the outset of the financial crisis. They hadn't been in use since the Great Depression of the 1930's. When the stock market started to rally in March of 2009, mark-to-market accounting standards were altered and Wesbury believes this is no coincidence.

Could mark-to-market accounting standards be the cause of the collapse in the financial system? Of course it could be a contributing factor, but I do not believe it is the sole reason for the panic. Wesbury takes a hard stance in his beliefs and writes: "To be absolutely, 100 percent clear, I do not believe that greed, capitalism, high levels of debt, subprime loans, credit default swaps, derivatives, criminal activity, or leverage were the root problems that caused the panic of 2008.". This is where he and I differ. Wall Street always seems to be gaming the system and I feel it was no different this time. Bankers took a lot of speculative risks and used predatory lending practices. Some banks were leveraged 40:1. Wesbury also writes about the panic: "...the interconnected nature of the financial system began to crack.". He is absolutely correct with that one. We needed government intervention in the Fall of 2008. We were on the cusp of global contagion and financial collapse.

I liked It's Not as Bad as You Think. I didn't agree with anything Mr. Wesbury said, but it was well written and gave me pause to think about my current short positions. Although the author backed up his arguments with clear and concise documentation, it didn't sway me to change my mind about my portfolio allocations. To me, the short-term damage has already been done to The Ithaca Experiment. The subtitle for the book is Why Capitalism Trumps Fear and the Economy Will Thrive and I do agree with him that capitalism will survive and the economy will prosper, but not for a few years.

Sunday, December 13, 2009

The January Effect

According to Jeffery and Yale Hirsch who publish the Stock Trader's Almanac 2010, the January Effect now starts in mid December based on data going back to 1979. If you are not familiar with the January Effect, it is a Wall Street term that states small cap stocks outperform big cap stocks from January until June and the launch date is now around December 15th. Since we are nearing that date and because I have a sizable stake in small caps with the Direxion Small Cap Bear 3X Shares (TZA), I wanted to bring it to your attention. In the two months that I have owned the Direxion Small Cap Bear 3X Shares (TZA), the ETF is down 30 cents or 2.61% and if history proves correct, it may take another hit here in the short-term. However, the January Effect does not always materialize as small cap stocks underperformed large cap stocks in January 1982, 1987, 1989, 1990 and 2008, but it is a pretty good indicator as Jeremy Siegel writes in Stocks for the Long Run. This does not mean that small caps won't go down in January if the market goes down. It just means that small caps will do better than the larger cap securities the majority of the time.

The January Effect is sometimes confused with the January Barometer, but they are not the same. To give a definition of the January Barometer, I will use the Wikepedia free encyclopedia: "The January Barometer is the hypothesis that stock market performance in January predicts the performance of the rest of the year...Historically if the S&P 500 goes up in January, the trend will follow the rest of the year. Conversely if the S&P 500 falls in January, then it will fall for the rest of the year. Since 1969 this trend has been repeated 32 of a possible 39 times.". Ken Fisher in The Only Three Questions That Count calls the January Barometer a myth and "remains wholly unsubstantiated", but this is just his interpretation of the data which is always a problem with investing. You never know who is right when it comes down to data crunching because of confirmation bias. Ken Fisher defines confirmation bias as: "cognitive error causing investors to seek evidence confirming their preset notions and reject contradictory evidence.".

Another Wall Street phenomenon that will supercharge your holdings in the short-term this time of year is the Santa Claus rally otherwise known as the "December Effect". This is a rise in stocks the last week of the year, between Christmas and New Year. Because I am not a trader, I generally don't pay attention to these things, but they will move the needle in your portfolio. I am currently down 43% in the ProShares Ultra Short S&P 500 Exchange Traded Fund (SDS) and this Chris Kringle flurry surely won't do much for my ego if history repeats itself, but as I've been stating right along since the beginning of this blog, we are long overdue for a correction. If the market corrects 15%-20%, I'm back to square one, but that's just wishful thinking right now. You may be wondering how far I will let my losses run in the ProShares Ultra Short S&P 500 Exchange Traded Fund (SDS). Well, indefinitely. It is always best to go with your convictions and since this is a leveraged ETF, it can go up just as fast as it went down.

Friday, December 11, 2009

Blood From a Stone

Back in 2002-2007, terms like prime, subprime, Alt-A, option ARMs, jumbo prime and second liens became part of the mainstream verbiage as middle class citizens started flipping houses like degenerate gamblers. 2008 was not a pretty picture for the hot real estate money and speculators started singing a different tune as the entire financial system teetered on the edge of the abyss. More Mortgage Meltdown by Whitney Tilson and Glenn Tongue explains the build-up, implosion and future scenarios of the domestic housing situation along with the ramifications on the economy as a whole. The book is divided into two parts, the first half covering the housing bubble and the second half a series of case studies on different companies and how to evaluate them for investing purposes through the eyes of a value investor.

Tilson and Tongue demonstrate that although subprime loans were the brunt of much populist anger after the housing bubble burst, they only accounted for 20% of all mortgages issued at the peak of the bubble, and it is the other 80% of mortgages we really have to worry about now. The height of the real estate frenzy was in 2006 and since subprime loans reset after 2 years, they were the catalyst for the collapse in 2008. However, the equally toxic Alt-A and option ARMs reset after five years so in 2010, we will begin to feel the effects of another round of defaulting mortgages and these defaults will continue until 2012. In essence, we are in the eye of the hurricane right now, the calm before the storm.

More Mortgage Meltdown was published in May of 2009, three months after the market lows reached in March and although the authors didn't predict the current surge in security prices, they do acknowledge that stock prices are cheap at the time of publication: "Based on data from Yale economist Robert Shiller, U.S. stocks on March 3, 2009, were trading at a cyclical price-earnings (P/E) ratio of 12.3, their lowest level since 1986 and well below their historical average dating back to 1870, of 16.3. (The cyclical P/E compares stock prices to average earnings over the past ten years in an attempt to smooth out booms and busts.)". Well, that was in May and now it's December and Barron's reports that the P/E for the S&P 500 is 85 after a 9 month run up. We are in nose bleed territory where valuations are concerned and this market is ready to roll over like Beethoven. In fact, at the time of printing Tilson and Tongue argue that "the cyclical P/E ratio, while below its historical average, is well above previous bear market lows of 6 - meaning stocks could almost get cut in half again.".

I have been reading Whitney Tilson's column he writes with John Heins in Kiplinger's for a couple of years now and have always enjoyed his long-term value investing perspective in a market where traders live in the moment. I also enjoyed it in this book, but all in all, I was disappointed in More Mortgage Meltdown. Granted, the first half of the book was brimming with valuable statistics and insights on the housing crisis, but the second half of the book wasn't up to par. The last 150 pages of the book is filled with case studies on individual stocks to both the long and the short side and I thought that these studies were too technical for the beginning investor. For the experienced investor, the case studies were not that interesting and tended to get tedious which bogged down a potentially good book.

Tuesday, December 8, 2009

Value Line

I have been reading Value Line for twenty years now and have been a subscriber of their service for the past decade. From the late 1980's to late 1990's, I didn't have enough money for the subscription and would go to the public library to read their reports and because most libraries carry Value Line, that option is still there for you, too. If you are not familiar with Value Line, it is a collection of research reports on 1,700 companies that are updated on a quarterly basis. Peter Lynch calls it "the next best thing to having your own private security analyst.". Warren Buffett says of Value Line: "I don't know any other system that's as good.". In his book One Up on Wall Street, Peter Lynch gives a pretty good description of what Value Line can do for you: "Value Line is easier to read than a balance sheet...It tells you about cash and debt, summarizes the long-term record so you can see what happened during the last recession, whether earnings are on the upswing, whether dividends have always been paid, etc. Finally, it rates companies on a simple scale of 1 to 5, giving you a rough idea of a company's ability to withstand adversity.".

Since the early 1930's Value Line has been publishing their research reports and they read like Cliff Notes combining the company's 10-K , 10-Qs and sell side analyst reports all bundled up in one nice package. Companies are broken up into industry segments like pharmaceuticals, biotechnology and medical devices and industry reports are updated quarterly along with the individual security summaries. Although I am currently investing in ETFs, I read the reports religiously to keep my watch lists updated in anticipation of getting back into the market at some juncture in the future.

Value Line enabled me to make a considerable amount of money before and after the dot com bust of the late 1990's and if you are interested in sampling some of their products, just go to their Web site and you will be able to download free Value Line reports of all 30 stocks in the Dow Jones Industrial Average. However, I want to state explicitly that although I made some serious coin with them, I also lost a considerable amount in the short run, too, because they didn't predict the dot com bust or the current real estate fiasco. Value Line is very good at giving approximate price appreciations for five year stretches, but they are not good market timers. As a long-term investor I have stuck with them because you can't fly on one wing. I need somebody to shine a light for me.

Sometimes Value Line gets a knock that they concentrate too much on the larger cap Blue Chip stocks, but that's a fallacy. Yes, they do review a large selection of Blue Chips, but they also have a sizable offering of mid cap and small cap stocks in their main investment survey. If you are interested in mid and small cap stocks, Value Line also has a service called The Value Line Small and Mid Cap Edition, but I don't recommend buying this because they don't provide enough research in these reports. What The Value Line Small and Mid Cap Edition gives you for a considerable sum, you can obtain on Yahoo Finance for free. If you are a short-term trader and are interested in the smaller high fliers, Value Line may not be your best bet, but Investor's Business Daily will do the trick.

Sunday, December 6, 2009

Storming the Gate

CNBC's Matt Nesto recently reported the latest acronym to hit Wall Street is DOG: dollar, oil, gold - these are the main subjects in Charles Goyette's new book The Dollar Meltdown along with his strong stance on the end of the American Empire. Like Robert Prechter who I wrote about a few weeks ago, Goyette is a disciple of Ludwig von Mises and the Austrian School of economics, but with a gaping philosophical difference. Prechter believes we are headed for a depression and will be in a deflationary period while Goyette presumes we are heading for hyperinflation and the end of the world as we know it with the collapse of the worldwide system of fiat currency. Not only does Goyette assume a return to the gold standard once the current financial system implodes, but also seeks to abolish the Federal Reserve and world's Central Banks.

This annihilation of the World Order is coming sooner than later according to Goyette and he strongly encourages investors to liquidate their holdings in dollars and stocks and bonds and invest in gold bullion, silver coins, oil ETFs and commodity ETFs. He talks specifically about Ludwig von Mises' dictum of "the crack-up boom" when people realize their paper money isn't worth anything and the price of gold can triple or quadruple within days or weeks. Even at today's spot price of gold at roughly $1,200 an ounce, Goyette believes it is still undervalued when you take history into consideration and it would have to climb to $2,500 an ounce in inflation adjusted terms to reach the price it obtained a generation ago. His solution is to purchase a core position in physical gold bullion coins, preferably the U.S. Gold Eagle, the Canadian Maple Leaf or South African Krugerrand.

I agree with Goyette that as Americans, we have accumulated too much debt on both personal and governmental levels and maybe you should keep some gold coins in your safe to bribe the guards at the border, but that's about as far as it goes. Most of the ideas in the book could have been written by the Al-Qaeada public relations department because quite frankly, he doesn't discuss the societal ramifications of what would happen if indeed we went into hyperinflation and the world economy collapsed. If what Goyette says is true and does pan out, there will be no winners and believe me, you won't be able to keep your gold. There will be martial law and if the government doesn't confiscate your bullion, then some band of marauders will take it from you by force.

Besides the accumulation of gold (silver coins, too), The Dollar Meltdown suggests appropriating a large portion of you finances in commodity ETFs, specifically oil and agriculture. The problem with this thesis is that if there is a collapse of the financial system, most brokerage houses and banks will probably go bust too, making your investments worthless. If you believe in the apocalyptic future, it's better to stock up with gold bullion and a cache of arms. We live in the era of the Jetsons, not the Flintstones, and to suggest going back to a finacial system that was utilized over one hundred years ago is not the answer to our problems.

Tuesday, December 1, 2009

Out of the Past

Back in the late 1920's Fred Schwed was a Wall Street stock broker and left the business after the crash in 1929. In 1940, ten years after his exodus, he wrote Where Are the Customers' Yachts? about his experiences in the market. The book has gone through numerous reprints and editions and is endorsed by the likes of Michael Bloomberg, Jason Zweig, Michael Lewis and Jane Bryant Quinn, all glowing about Schwed's keen market insight and humorous prose. After 70 years, it's tough for an investing book to hold up, but this one seems to pass the test of time by not only being funny, but by talking about the specifics of the market in more of a general overview.

Where Are the Customers' Yachts? touches upon some of the age old investment topics such as options, short selling, technical analysis and investment trusts (mutual funds). It is ironic that the same problems that haunt the market today were prevalent generations ago. According to Schwed, options are confusing and unprofitable, mutual funds don't make money the majority of the time, technical analysis is unreliable and short sellers are to blame for everything wrong in the market, or at least that is the public sentiment. Sound familiar?

This past weekend in Investor's Business Daily there was an article about the evolution of financial applications available for the iPhone and Blackberry offered by some of the discount brokers. Now you can trade stocks, get price alerts and receive up to the minute articles and press releases on your favorite securities while on the go. In Fred Schwed's day traders stared at the trans-lux during trading hours for price movements and volume spikes, usually on the floor of the exchange or in a broker's office. You can be anywhere and be a trader now.

I'm no Luddite and a big fan of smartphones, but the portfolio churn you'll experience by paying too much attention to the day to day market fluctuations can't be good for your profits. Even Fred Schwed made comments on the perils of trading too much in Where Are the Customers' Yachts? and cautioned that the only parties that consistently make money in the market are the brokers with their commissions. Schwed also warned about bear raiders with their pump and dump schemes, statisticians with their misleading charts and graphs and economists who speak a lot and say absolutely nothing. Except for the computers and smartphones, it sounds like we are back in the 1930's again, doesn't it?

I've written ad nauseam about the poor performance of The Ithaca Experiment portfolio the past two months and will continue to do so for the foreseeable future. In actuality, the past two months my profits and losses have been in a stalemate, it's the two months before I began writing that took the largest losses. The reason that I include these losses in the blog is that it's where I started tracking the investments and I want to keep these posts honest and transparent. It would not be fair to me or you readers if I fudged the books. A geo-political event or a long overdue correction and I'm back in the ballgame. I may be in a standing eight count, but I'm not ready to throw in the towel yet.

Saturday, November 28, 2009

John Paulson

When it comes to risk, Warren Buffett is famous for saying "It is better to be approximately right than precisely wrong" and in 2007 and 2008 hedge fund manager John Paulson was approximately right with a personal gain of 6 billion dollars and a profit for his clients of $20 billion. The bonanza dwarfed George Soros' billion dollar gain in 1992 when Soros wagered against the British pound. Paulson's bet on the collapse of the housing market propelled him from mid-tier hedge fund manager to king of the jungle on Wall Street and is the subject of a new book The Greatest Trade Ever by Gregory Zuckerman. In The Greatest Trade Ever, Zuckerman goes into great detail of how Paulson accumulated huge positions in Credit Default Swaps enabling him to make large bets with minimum risk in the real estate market. Unfortunately, as retail investors, we can't do the same. It's an area of finance that is reserved for the players with tens of millions of dollars.

However, retail investors do have options as to how to bet against the real estate market with ETFs. No, you won't get the kind of results that John Paulson did, but you can pick up a significant amount of money if you believe there is still another leg to drop in both the commercial real estate and retail housing markets. The most notable would be to bet against mortgage backed securities. After all, 23% of mortgages nationally are now underwater, meaning that the price of the house is worth less than the mortgage. The probability of an increase in defaults still a high percentage wager. There are currently two mortgage backed security ETFs that you can short, the iShares Barclays MBS Fixed (MBB) and newcomer Vanguard Mortgage-Backed Securities Index Fund (VMBS). I wouldn't recommend shorting these ETFs because for one, you would need to have a margin account with your broker and two, this play may not be that liquid. Instead, I would opt for a simpler tactic by purchasing either the ProShares UltraShort Real Estate (SRS), which is 200% the inverse of the Dow Jones U.S. Real Estate Index, or, the Direxion Daily Real Estate 3x Bears Shares (DRV), which is 300% the inverse of the MSCI REIT Index.

When Gregory Zuckerman isn't writing books, he is the scribe for the Wall Street Journal's 'Heard on the Street' column and last week updated the John Paulson saga. It seems that Mr. Paulson believes the high energy gold trade of late still has a lot of mileage left on it and is starting a new hedge fund dedicated to the precious metal. In fact, Paulson is investing between $200 and $250 million of his own money in the new fund that launches January 1st. I couldn't disagree more with Paulson on his new investment. I think gold has run it's race and if it's not at the finish line, then it is certainly on the home stretch. The SPDR Gold Shares (GLD) currently fetch $115 on the open market up from $41.50 in January of 2005. That's a triple for an asset that didn't move for 15 years. The mass media has recently picked up on the gold frenzy and we are being bombarded with stories about the price of gold on TV and in newspapers and magazines. To me that is a contrary indicator. I would stay away from gold or short it using ProShares UltraShort Gold ETF (GLL) which is 200% the inverse of the price of gold.

I am not suggesting I get into a pissing match with John Paulson concerning his investment decisions, I just don't see eye to eye with him on his new endeavor. It seems as if he is trying to chase performance here when spent the last few years as an outlier. Whether he is right or wrong on his bullion bet is of little consequence because he's worth about $6 billion and losing ten or 20 or even 50 million dollars would be a drop in the bucket to him. If you have been following this blog, it will be of no surprise to you to know that The Ithaca Experiment portfolio is on life support. I still believe that asset prices are divorced from fundamentals and that the market is due for a major correction. In a psychological victory, the portfolio has been treading water for three weeks now with a meager gain of $400. At least it's not going down, but with December looming and the traditional Santa Claus rally on the horizon, we may be in for rough sledding.

Monday, November 23, 2009

Don't Blame The Shorts

Robert Sloan's Don't Blame The Shorts not only delineates the history of short selling in America, but also chronicles the centuries old chasm between Main Street and Wall Street. Sloan starts spinning his yarn right after the Revolutionary War and states: "Many felt in 1790, as many do now, that compensation made through financial speculation is unjust, and short selling is the most unjust of all.". So begins the tale that is not an edge of your seat page turner, but a clear and concise historical account that will be of interest to students and participants in the capital markets system.

A common thread throughout the book is that after each boom and bust cycle in the stock market, populist fervor against short selling explodes in the aftermath of the crash. As Sloan notes: "The argument against the shorts were designed to appeal to the uninformed and easily scared masses, and history would allow this particular scapegoat strategy to be so effective that it would resurface with each subsequent financial crisis through the twenty-first century.". Time and time again the government would become involved with Senate subcommittee hearings, but could never prove that short selling was a cause of stock market implosions.

As to be expected, a good portion of the book covers the 1930's and The Great Depression. Both Hoover and FDR spearheaded investigations into short selling and the bear raids that were supposedly the cause of the country's economic strife even though short selling only accounted for 5% all exchange transactions from 1929 - 1932. There was such a stigma attached to being a short seller in the 1930's, that in 1932 the New York Times published the names, addresses and photos of those who were short more than 2,500 shares of a stock. However, the author does not believe our current crisis reflects the era of the 1930's, but more or less parallels that of the Crash of 1907 when overpriced real estate caused a run on the banks.

You can infer from the title Don't Blame The Shorts that author Robert Sloan is pro short selling and in fact, is of the opinion that shorting is good for the markets. As Sloan remarks in the epilogue: "Short sellers function as the police officers to markets - the editors - the very checks and balances our forefathers envisioned. The shorts are a disinfectant, shedding light where there is only corporate darkness.". I liked this book. It was short and to the point and very well researched. As we are living in an era of history repeating itself, Mr. Sloan depicts the negative market psychology that has transcended Wall Street since the birth of our nation.

Thursday, November 19, 2009

The Wages of Fear

"Beta Slippage" is fairly new to the financial lexicon. It is associated with the effects compounding will do to leveraged ETFs and leveraged mutual funds. I was aware of its attributes and consequences long before I invested in ProShares Ultra Short S&P 500 (SDS), but noted a detailed explanation of it in Robert Prechter's Conquer The Crash. It basically states that because leveraged ETFs are rebalanced daily, you may or may not replicate the performance of the index you are invested in if you hold these instruments for the long haul. I think it is stated best in a ProShares FAQ: "Due to compounding, the return of these funds over longer periods may be more or less than the daily market multiple. Compounding tends to help returns in upward and downward trending markets and tends to reduce returns in volatile markets. The positive and negative effects of compounding are significantly magnified in leveraged funds.".

Here is an example from an article by Michael Iachini from the Schwab Center for Financial Research on a long leveraged ETF: "Consider a hypothetical ETF that promises twice the return on an index. Let's say you buy a share of the ETF for $100 while the underlying index is at 10,000. If the index goes up 10% the next day to 11,000, your ETF should go up 20%, to $120. If the index goes from 11,000 back down to 10,000 the next day, that's a decline of 9.09%, which means the ETF should go down twice as much, or 18.18%. A decline of 18.18% from the $120 price of the ETF should leave it at $98.18. So even though the index ended up right back where it started, the ETF is down 1.82%!". Caveat emptor. Let the buyer beware when investing in leveraged ETFs because you are playing with fire.

As I reflect on the negative returns in this portfolio the past four months, expressions like numb skull, chowder head and lame brain come to mind, but I digress. The objective of this blog is not to track my original investment in the short-term, but over a multi-year period. The market could boomerang any day now causing a seismic shift in investor sentiment. I refuse to pull the plug on my original investments because I've only held them a few months. Many influential analysts are currently bearish on the markets and believe we are in a bubble no matter how optimistic the government is. My belief if that if I were to sell my shares of ProShares Ultra Short S&P 500 (SDS) and go into cash or go long, I'd only be whipsawed when the smoke clears. Housekeeping is not in order at the moment, although in a what have you done for me lately world, it is difficult not to second guess myself.

My last post was a review of the above mentioned book Conquer The Crash and I will continue to review books on this blog as long as they cover the subject of investing and remain within the spirit of the overall milieu of my original premise. In fact, since I am an infrequent trader and not an economist, I will probably be reviewing many investing books here to keep the content fresh and the readers coming back for more. At least that's the plan for now. Next on the docket is Don't Blame The Shorts: Why Short Sellers Are Always Blamed For Market Crashes and How History Is Repeating Itself by Robert Sloan. It will be posted next week.

Sunday, November 15, 2009

Conquer The Crash

The second edition of Robert Prechter's 2002 New York Times bestseller Conquer The Crash was released last week with 200 pages added to the original tome. A student of Ludwig von Mises and the Austrian School of economics and leading proponent of the Elliot Wave Theory, Prechter is the prognosticator of an upcoming depression that will be more severe than that of the 1930's, or at least this is what his research leads him to believe. If you are not familiar with the Austrian School of economics or the Elliot Wave Theory, a brief explanation will tell you the former believes in free-market capitalism and the latter is a form of technical analysis engaged in the prediction of long-term business cycles. A subtitle for the book is "you can survive and prosper in a deflationary depression" and in essence Conquer The Crash is a survivalist bible for financial Armageddon.

The first 270 pages of the book is an exact reprint of the first edition of Conquer The Crash where Pretcher predicted the bust of the banking system this past year and a half and how to avoid financial loss in the economic apocalypse. The remaining 200 pages updates safe havens for your finances and reprints excerpts from his newsletter The Elliot Wave Theorist from 2003-2007. What is interesting to note in the latter half of the book is that he reevaluates the upcoming low for the DOW Industrial Average from 1000 to 400, based on Elliot Wave patterns, at least from his calculations. He postulates that we are at the end of the fifth wave of an Elliot Wave Cycle (five waves complete the cycle), and we will now go back to test the low of the DOW Industrial Average that was put in at the beginning of the wave in 1974.

What differentiates Pretcher from other bears is that most bears believe we are heading for an inflationary period while Pretcher predicts we are at the outset of a deflationary spiral. In fact, he seems to be a lone voice in the wilderness with his stance. Deflation, as you may recall, is a contraction in the volume of money and credit relative to available goods - prices go down. As Prechter states in March 2007: "The size of today's credit bubble is so huge that it dwarfs, by many multiples, all previous bubbles in history. The developing deflation will be commensurate with the preceding expansion, so it will also be the biggest ever.". Throughout the book he emphasizes that this will be the biggest deflation in history by a huge margin.

One thing that perplexed me about Conquer The Crash is that Prechter reprints excerpts from his newsletter from 2003-2007 and the book was published at the end of 2009. That is a two year gap. I would have liked to have seen his take on the market during the crash in the latter half of 2008 and the early part of 2009. Like the author, I too am a bear and believe that the market is overvalued. Prechter notes "P/E ratios for the S&P 500 have ranged from around 7 at bear market bottoms to the low-to-mid 20's at bull market tops.". With the S&P 500 P/E ratio currently over 20, a correction here is warranted if history has anything to say about it.

Along with others, I have certain misgivings with technical analysis like the Elliot Wave Theory because where you place your range lines on graphs is entirely arbitrary. It can be very easy to massage the data. However, the book is chock full of charts and graphs and it is interesting to see where the range of price movements lie for the major indexes over the long-term. We are clearly in the upper echelon of valuations if you track them over a hundred year period. Many of us bears are betting that the market will retest the lows of March 2009, but most of us feel it is a stretch to believe the DOW Industrial Average will be going down to 400 like Prechter predicts. If Prechter is right, there will be blood on the streets and that can't be good for anybody.

Friday, November 13, 2009

Medium Cool

As I'm whistling past the graveyard with my short positions, the market continues to rally. I remind myself that you should never invest more than you can afford to lose, but right now I've lost nothing because I haven't sold anything although I'm taking a whopping paper loss. It is with absolute certainty that I doubt myself every day, yet I still forge on with my convictions of a double dip recession. I know it's touch and go for the next month or two if history is any indicator because the market tends to rally in November and December. Right now there are two divided camps on Wall Street on where the market is heading untill New Year's Eve. The bulls believe that mutual fund managers and retail investors will continue to chase momentum forcing the market higher. The bears think that money mangers will start to sell stocks to lock in their yearly profits and the market will correct. How do I know all of this? By watching CNBC.

Financial networks like Bloomberg, CNBC and the fledgling Fox Business News are a relatively new phenomenon for both the individual and institutional investor. CNBC came of age only 20 years ago with the advent of the national cable television build-up. Before the birth of CNBC, you'd get your business news the day after in print from newspapers like The Wall Street Journal. Now information is absorbed instantaneously as it hits the airwaves and the Internet. I am not implying that it levels the playing field because the institutional investors still have the inside track with the Old Boy Network, but it does help.

I'm a stock junkie. I watch CNBC all day, but don't recommend it for most retail investors. A majority of financial experts agree that for your Average Joe on the street, you should check your portfolio once a month or once a quarter and re balance if need be. Watching the vicious swings in the market makes you apt to trade more frequently especially as guests on the financial networks discuss the minutia of a one point move either up or down for a security. Trading more frequently makes you lose money which is why women tend to be better investors than men - they trade less often. Watching networks like CNBC can make you trigger happy if you are near a computer and have an on-line account with a brokerage firm. It is too easy to trade, particularly when you are inundated with "experts" jawboning about the virtues of a stock that may or may not be a good value. Rarely do I get a stock tip I can bank on from watching CNBC, but I do get plenty of economic news.

It has been said that astrology was invented to give credibility to economics. Take a piece of economic data, give it to 30 economists and you'll come up with 30 different interpretations. This is proven time and time again on CNBC where nobody agrees on anything. It is great for an open discourse, you will get both sides of the story, but who is right and what advice should you follow? This is the hard part. The power of persuasion by some of these economic alpha dogs is second to none whether they are right or wrong or what track record they have. I still watch CNBC because you do get valuable information, but you have to know how to parse it. That is why I believe you should get most of your economic information through reading. Any financial portal on the Internet will do.

Tuesday, November 10, 2009

2 and 20 rule

The 2 and 20 rule is the standard fee arrangement at most private equity funds. Hedge fund managers typically get 2% of the assets they place at risk for you and 20% of any profits, hence 2 and 20, a scam if there ever was one. Although this is a fairly well known axiom throughout investing circles, I was originally made aware of it by reading Barton Biggs' Hedgehogging which is an insider's account of the hedge fund industry. The book states that besides the astronomically high management fees, private equity funds don't beat the S&P 500 index the majority of the time. If you are interested in reading a good investing book, especially about hedge funds, Hedgehogging is highly recommended. It should be noted that here at The Ithaca Experiment, the only fees incurred are taxes and broker's commissions. After all, this is do-it-yourself investing.

As I crawl from the wreckage of a miserable week for my portfolio, I think back to Benjamin Graham who is the father of Value Investing and his allegory of Mister Market. To Graham, Mister Market is a manic depressive who comes to the stock market each day with shares to trade. Some days he is an especially upbeat mood and will offer shares at extremely high prices and other days he is depressed and will low ball his offerings. Right now Mister Market is in an elevated state and there is no way, shape or form the indexes should be so high based on the P/E ratio of the S&P 500. I understand there is a lot of bullish market sentiment and in the short term, I am losing money, but I am not going to chase performance.

Graham is also famous for saying in the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine. What he means is that after a duration of time it is the earnings of a stock or index that matter most. The current P/E Ratio for the S&P 500 is 20, very high by historical averages, and the growth rate is projected to be 35% for next year according the the Standard and Poor's Web site. With an unemployment rate of over 10% and growing, I do not believe the S&P 500 earnings will increase at a rate of 35% next year no matter how much cost cutting the companies have done.

The market could rally 5 to 10% by year's end because November and December tend to be the two best performance months for the stock market, but I've taken my stand and so did General Custer at the Little Big Horn. If I were to sell my short positions now and go long for say a month or two, I'd be defeating the purpose of holding my shares for more the 365 days for long term capital gains and losses. Sure, there is a certain amount of anxiety involved when you are going against the popular momentum, but I am willing to take my chances.

Wednesday, November 4, 2009

Diversification

In the twenty years I have been investing, I'm currently the most diversified as I've ever been in any of my portfolios. I only own two ETFs, but these two Exchange Traded Funds mirror the performance of major domestic indexes and both are to the short side. The ProShares Ultra Short S&P 500 (SDS) tracks the S&P 500 which consists of the largest 500 American securities by market cap and the Direxion Small Cap Bear 3X Shares (TZA) emulates the return of the Russel 2000. I tend to be an aggressive investor, so I am usually running a concentrated portfolio with very little diversification. If I had been diversified throughout the years, I wouldn't have tripled my portfolio in a matter of one or two years twice in previous bubbles. I also wouldn't have lost as much after the party was over as I hung onto my positions like Captain Ahab harpooning the great white whale. Always remember that tried and true Wall Street adage of "don't confuse brains with a bull market". I learned the hard way which is why I'm short right now because I really believe in my convictions of a double dip recession.

I have been asked what I would do if I wasn't so aggressive in my investments and took more of a laissez-faire attitude in portfolio management. After all, this is what most people would prefer to do, take a hands off approach and let their money compound at a reasonable rate. Investing in the stock market can be very confusing with all of the choices available and even if you know what you are doing, you can get burned like the majority of people did this past year. If I didn't have an ego large enough to think I can beat the market, then I would be as diversified as possible with index ETFs covering domestic and foreign securities as well as good old American bonds.

Which ETFs would I purchase to build a diversified conservative portfolio? For me the prudent course of action would be to invest in ETFs offered by Vanguard because they have the lowest expense ratios. As a side note here, it should be mentioned that pioneer discount broker Charles Schwab launched some index ETFs this week with a slightly lower expanse ratio than the Vanguard offerings, but they are new to the game and will have very low volumes at the outset. Vanguard is synonymous with index funds and really knows what they are doing are far as managing their product is concerned. I'll stick with the tried and true.

For my laissez-faire portfolio, I would divide my cash into the equal parts of roughly 33% each and invest my money in the following three ETFs offered by Vanguard. For domestic coverage, the Vanguard Total Stock Market ETF (VTI) tracks the MSCI U.S. Broad Market Index. This contains 1,200 - 1,300 of the largest cap American stocks. For foreign exposure, the Vanguard Total World Stock ETF (VT) tracks the FTSE All-World Index of 2,900 stocks from 47 countries. Finally, for a bond allocation, the Vanguard Total Bond Market ETF (BND) tracks the Barclay's Capital U.S. Aggregate Bond Index. I could easily invest my money in a strategy like this and come back in 20 or 30 years and be ahead of the game as long as there was no Nuclear Winter. Would I ever use this strategy? Maybe some day down the line, but right now I've got my mojo working on something more active. Stay tuned.

Monday, November 2, 2009

Schadenfreude

The first rule of investing is not to lose any money. With the performance I've had the last three months in my short positions, I would probably have been given the pink slip or at the least be in a major dog house if I'd been managing a mutual fund or hedge fund. After all, investors want results. With a mutual fund, you may experience a quarterly churn of clients for under performance. With a hedge fund, investors want profits every single day. The beauty of being an independent investor is you can be patient. You can also invest in whatever you want to. With mutual funds, you are pigeonholed with restrictions such as being a small cap fund or a value fund or sector specific and when your investing style goes out of favor, you get crushed. The independent investor can be nimble or slow or both depending on your portfolio allocations. Right now I'm in the slow lane with index funds.

If you don't know the gist behind the rationale of investing in index funds and index ETFs, I'll try to give it to you as succinctly as possible. Simply stated, index funds outperform actively managed funds in the long run the majority of the time once you take taxes and expense ratios into consideration. This was proven in Charles Ellis' classic investing primer Winning the Loser's Game in the mid 1970's and restated in John Bogle's The Little Book of Common Sense Investing in 2007. In fact, John Bogle launched the first S&P 500 index fund in 1975 with the Vanguard Group. If you've got money in the market and haven't read either of these books, I strongly suggest you do so. You'll save yourself a lot of time and aggravation by taking the hands off approach if you are not inclined to do your own research. Warren Buffet, Peter Lynch and Jim Cramer all recommend index funds.

The first Exchange Traded Fund was an S&P 500 index fund. Commonly referred to as the Spider, the S&P 500 Standard and Poor's Depository Receipt, or SPDR (SPY) was launched in 1993. This is the new widows and orphans fund. It's liquid, it's diversified, it contains the 500 largest American companies and it mirrors an index that has produced returns of 10% on average over the last century before taxes and expenses. If I didn't know a lot about investing and had a long term time frame, this is where I'd put my money. If you think the market is going to correct and you want to place your bets on the short side of the S&P 500, then there is the ProShares Short S&P 500 (SH) ETF.

For you thrill seekers out there, ProShares also offers leveraged ETFs for the S&P 500 to both the long and short sides. With 200% leverage, there are the ProShares Ultra S&P 500 (SSO) and the ProShares Ultra Short S&P 500 (SDS). They recently introduced 300% leveraged ETFs with ProShares UltraPro S&P 500 (UPRO) and ProShares UltraPro Short S&P 500 (SPXU). If the market is going your way, you can make a lot of money very quickly, but you can lose it just as fast, too. I'm on the short side with a large portion of my portfolio in ProShares Ultra Short S&P 500 (SDS) and on paper, have lose a considerable sum of money. With leveraged funds, invest at your own peril.

Friday, October 30, 2009

The Voodoo That You Do

One of the reasons I chose to invest in the Direxion Small Cap Bear 3X Shares (TZA) is that it primarily contains small cap stocks and small cap stocks traditionally have a high BETA. What this means is that if the market starts to tank, you will get more of a gain if you are on the short side. So if the market does go down, not only will I be leveraged 300%, but I will also make much more than if I would have shorted the S&P 500. However, it also means you will lose more if you are short and the market begins to rally. For those of you unfamiliar with the BETA or BETA Coefficient I'll give you the definition supplied by my trusty Barron's Dictionary of Business Terms. "BETA Coefficient: Measure of a stock's relative volatility. The beta is a covariance of a stock in relation to the rest of the market. The Standard and Poor's 500 Stock Index has a beta coefficient of 1. Any stock with a higher beta is more volatile than the market, and any with a lower beta can be expected to rise and fall more slowly than the market". I couldn't have said it any better myself.


At the present, I am up 24% for the month that I have owned the Direxion Small Cap Bear 3X Shares (TZA). Up 24%. Maybe it's time to take some profits? I don't think so. I tend to let my holdings run for more than 12 months to take advantage of the tax laws. If you sell before the 365 day holding period, you are subject to capital gains at ordinary income rates which run around 35%. If you hold your positions for over a year, you can take advantage of the long term capital gains rate which varies on your income level from anywhere from 5% to 15%. There are circumstances when you have to sell before 12 months, like when you are in a big mover that triples or quadruples in just a short period of time and you think it's going to come back to earth, but for the most part, it's better to hang onto your shares for 365 days.

The portfolio I'm working with here is in a taxable account and I have to make investing decisions that take the IRS into consideration. I feel strongly enough about the economy taking a double dip in 2010 that I am willing to let my leveraged holdings run until after the 365 day holding period. However, you know what they say about best laid plans. I'll just let the shares follow the economic cycle until I feel it's time to get out and go long or go into cash for awhile. Most of the information I've come across about leveraged ETFs states you should hold the shares for short periods of time, even just days on the 300% leveraged products. I disagree in this circumstance because I believe the market will be considerably lower a year from now. I may get my head handed to me, but I'm willing to take that chance.


When putting my remaining cash to work last month, I considered buying 2,000 shares of the Direxion Small Cap Bear 3X Shares (TZA) ETF, but decided to go with 1,000 shares instead for the simple reason that I chickened out. Half of the portfolio leveraged 300% was too much risk for my blood. I really don't know where this market is going. Nobody does. Not George Soros, not Warren Buffet, not Carl Icahn and certainly not me. I can only make an educated guess and I've been wrong so far, but I'll stick to my guns. I had a good week, up $5,400. It's a step in the right direction, but I've got a long way to go before I'm back to even.

Leveraged ETFs

Exchange Traded Funds or ETFs are basically mutual funds that trade just like stocks which makes them much more liquid than your run of the mill mutual fund. ETFs primarily come in three flavors: country based, sector based or index based although this past year there has been an influx of commodity and specialty ETFs introduced to the investing community, but these new funds are in the minority. In addition, actively managed ETFs are starting to make their way into ther market. Besides the liquidity factor, a low expense ratio has made ETFs a very popular way to invest your money the past five years. Personally, I prefer to be a stock picker, but sometimes circumstances dictate a change in strategy which is why I've utilized ETFs for the past six months.

I'm currently in leveraged ETFs to the short side and as a retail investor, this can be a boon or bust to your portfolio. Until last year this would have been almost unheard of for a small retail investor because leveraged index funds to both the long and short side had high minimums for investing. For example, ProFunds (the parent company of ProShares) required a $15,000 minimum for each of their leveraged funds and Rydex required a whopping minimum of $25,000 for each leveraged mutual fund. Now all you have to do is pay a commission for the trade (which is nominal at a discount broker) and whatever the cost of the shares you purchase at the market's going rate. The major players in leveraged ETFs are ProShares, Rydex and Direxion. To find out what products they offer, just go to their respective Web sites and download the prospectus that is applicable to your needs.

Now you may be wondering why I use leveraged ETFs as opposed to just playing the options game or shorting indivisual stocks. The answer is that it's safe and easy (if you consider being leveraged 300% safe). Only professional traders should use options and I don't care what the pundits on CNBC and Bloomberg tell you. Statistics show only 15% of retail options traders make a profit. Not only do you have to pay capital gains at ordinary income rates for your derivative trades, but you also have to be glued to your computer to try and beat the market. If you short individual stocks (yes, you can short ETFs, too), you have to have a margin account and can have the shares called in at any time by your broker.

With leveraged ETFs, and this is for both long and short positions, you let the issuing ETF company do the heavy lifting by not only shorting the shares, but also playing all of the derivatives games. No muss, no fuss, no wear and tear. Leveraged ETFs let you take very risky bets without the hassle. On a tax basis note, one of the ETFs I am currently invested in, the ProShares Ultra Short S&P 500 (SDS) pays a yearly dividend, so you will have to pay attention to the dividend date to reinvest your shares if this is an option for you. I do not recommend using the dividend reinvestment option with your broker because it a nightmare at tax time when you sell with all of the fractional shares. If you have an IRA, then that's a different story.

Tuesday, October 27, 2009

P.T. Barnum

P.T. Barnum is famous for saying "there is a sucker born every day" and that quip could probably be applied to me when you consider I'm down nearly 30% of my original investment in only three and a half months. But you must consider I'm playing with fire when I'm in ETFs that are leveraged 200% and 300% to the downside. The game I'm playing is financial Russian Roulette with heavy bets that I don't put the bullet in my temple. Believe it or not, I am primarily a value investor. I don't agree with the Efficient Market Theory where investors believe that stocks are always fully priced and you can never beat the market. I'm from the school that stocks go on sale and can also become overvalued and this holds true for the indexes like the Dow Jones Industrial Average and the S&P 500, too.

The historical average for the Price to Earnings Ratio on the S&P 500 is 12 according to Jeremy Siegel and the Standard and Poors Web site's 2009 projection is very high with an estimate of 20. The market has risen for seven straight months with no correction greater than 4% until yesterday when it hit 5%. This is unheard of after a 60% gain and I know that John Maynard Keynes said "the market can stay irrational longer than you can stay solvent", but I'm willing to take my chances. I'll stick with my short positions and take the ribbing and peer pressure that goes along with going against the grain.

I know there are a lot of hucksters in the market and I may very well be one of them, but I've been through two major crashes in twenty years and stayed long when all of the potentates said it was different this time, to hang in there because stocks would keep going up. I went against common sense and ran with the herd. Oh, it was sweet when my portfolio was climbing, but boy did it hurt when I clung to my holdings and watched my profits fall into the abyss. Not this time. No thank you. It is time to circle the wagons.

To the uninitiated, short selling can be considered Un-American. You are betting against your country and countrymen. I'm a firm believer in the American Way, the American Dream, God Bless America and most importantly, the American Business Cycle. Approximately every forty years we get a purging of the bad debt in the monetary system and we go into deep recession or depression. It happened in the 1890's, 1930's, 1970's and now the chickens have come home to roost. The stock market is a big casino and if you don't think so, just look what happened to your portfolios in 2000 and last year. It's not like putting your money in the bank. You are taking a calculated risk when you buy securities. Buying, selling and shorting stocks is a zero sum game. There is a winner and loser on every trade. It's is just the way the system works and by no means is selling a stock short Un-American.

PortfolioLive

Any good carpenter will tell you you need the right tool for the right job and so it goes with portfolio monitoring. It is no secret for those technically inclined that we are in a convergence of the cell phone and the desktop computer with the smartphone. It is also no secret that the national rage in smartphones is Apple's iPhone. I don't own an iPhone because the service plans are too expensive for my budget at the present time, but I do own an iPod Touch which Steven Jobs calls "an iPhone with training wheels". Basically, the iPod Touch is an iPhone without the cell phone capabilities - you can still do e-mail and run all of the applications if you are in a WiFi hub. Good enough for me because I'm usually within stone's throw of a WiFi hub.

I have tried many of the portfolio trackers available for the iPhone and iPod Touch including the one that comes standard with all Apple mobile products. Most of them are free and do a decent job of giving you real time quotes in a watch list and some also give you news feeds and charts, but they just don't cut the mustard if you are serious about your investments. PortfolioLive is different. It really does the job and although it does cost you $5.99 at the iTunes App Store, it is money well spent. I'd highly recommend it. Produced by Turing Studios, their programmers just know what they are doing.

There are 45,000 applications and counting for the iPhone and it is difficult to discern which ones are best for business news. There are a few freebies that are just outstanding not only in their news content but in the manner that the application is laid out. The ones I use the most and count on for up to the minute financial information are The New York Times, The Associated Press and Bloomberg. CNBC just released a new app for the iPhone with video feeds and portfolio tracking, but it is only in its first incarnation and needs some work. However, the video clips from the day's broadcast are a good bonus if you can't get to a television during the day.

What happens if you happen to be in the other camp and have a Blackberry? I have never owned a Blackberry, but I do know that TinyStocks offers StockManager for portfolio tracking on the Blackberry, Windows Mobile and the Palm operating system. I had a Palm Pilot years ago and used StockManager and thought it was a terrific application. Here is another group of programmers that know how to build an investing application.

Monday, October 26, 2009

Introduction

On July 10th the Dow Industrial Average hit 8,100, up from a multi-year low of 6,600 on March 6th. It was a nice 4 month run if you were long stocks and I thought it had run out of gas so I cashed out my positions and put some of the money to work in short positions. At that time I had $73,000 in a discount brokerage account and I invested approximately $49,500 in 685 shares of the ProShares Ultra Short S&P 500 Exchange Traded Fund (SDS) leaving me with $23,000 in cash. Three months later that $49,500 was almost cut in half as the DOW raced to 10,000.

A paper loss or a realized loss is easy to do when you are in leveraged ETF's which ProShares Ultra Short S&P 500 (SDS) is and the market is going up. With ProShares Ultra Short S&P 500, if the S&P 500 goes down 1%, you make 2%. If the S&P 500 goes up 1%, you lose 2%. It is very simple mathematics, but very risky if you are on the wrong side of the trade which I have been for three months now. This temporary loss has not has not soured me on my initial investment decision although my ego is bruised and I am subject to ridicule and embarrassment since I am making my investment decisions public here on the Internet. In fact, I recently put the remaining $23,000 of cash in my brokerage account to work in more short positions.

For the record, that $23,000 was used to purchase 280 more shares of the ProShares Ultra Short S&P 500 (SDS) and 1,000 shraes of the Direxion Small Cap Bear 3X Shares (TZA) which is leverages 300% to the downside of the Russel 2,000. All of the cash in my trading account is now in leveraged short positions because I firmly believe we are going to retest the lows we saw in March if not go lower in the next two years. As I write this, my cost basis for the ProShares Ultra Short S&P 500 (SDS) is $62.70/share and the Direxion Small Cap Bear 3X Shares (TZA) is $11.50/share.

The purpose of this Web site is to track the $73,000 invested in July over a three or four year period using whatever tools are available to a retail investor and see what happens to the money. In addition, it will be a forum for discussing investing and most specifically my philosophies on investing. I originally wanted to call this blog the do-it-yourself hedge fund, but that name has already been taken, but you get the drift. Anything goes. A note of caution, I have been investing for almost 20 years and tend to take outsize risks so what I am doing with my money is not recommended for most accounts. Three months after the beginning of this experiment my initial $73,000 is now $49,000, down 32%.