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


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


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.