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This may be a tradable rally, but non-traders should stay away, this is no time to be buying new long positions for a long term hold. Why?

1. Notes on a Scandal: A Brief Chronology of the Latest Rally

For those lacking the time or technical background to follow some of the superb Seeking Alpha contributions on the dubious origins and nature of the current rally, here's a simple summary and explanation of how the current rally developed. I omit much technical detail and encourage readers to look at the articles referenced below.

Surprise bank profits spark optimism. In early March, the Major Banks surprised the markets by actually showing profits. Because rapidly growing losses from subprime loans in the financial sector and an ensuing lack of affordable credit were the immediate cause of the bear market, this very positive surprise sparked a rally. It appeared that the root problem was being resolved.

PPIP adds fuel. As the rally was stalling out at resistance (around 800 on the S&P index), on March 23 the government announced its Public-Private Investment Program ((PPIP)), which gave the rally an additional push over that level.

Rising stock prices set off short covering. This rise set off computer programmed purchases of shorted stocks to close these positions at predefined prices to limit risk of loss by quant funds. These are investment funds that trade based on quantitative models, a fancy term for computer programs that automatically trade based on sophisticated and complex mathematical formulas or algorithms. While this "short squeeze" buying by short sellers to limit their losses is a normal part of a rally, it is usually a short term reaction to limit risk, not a genuine basis for a sustained rally.

These purchases fueled a continued rally on unconvincingly low volume until about May 11th. Sustainable rallies tend to show above average volume on up days, and lower volume on down days.

Since May 11, the markets have been dropped back and are trading in a tight range.

2. Argument Against the Rally

Again, here is a very basic summary of why going long is especially dangerous for anyone but those seeking a quick trade while the rally lasts.

A. The major banks are neither profitable nor healthy

As was first publicized by fellow SA contributor Tyler Durden then further discussed by others, these results were essentially falsified by a combination of:

Manufactured one time profits: Manipulated trades using taxpayer funds funneled through AIG that produced fixed income department trading profits large enough to outweigh the losses in every other area of operations, thus producing an overall profit

Government regulators allowing assets to be misleadingly overvalued and / or classified as less risky. The ultimate example of official collaboration in this charade was suspension of mark-to-market accounting, a rule which required the banks to value their assets (outstanding loans in particular) at actual market prices as determined by the most recent sale of similar assets, just like on the stock market. Now the banks were allowed to value these assets at or near full value as long as the loans kept up their payments. How surreal is this? For example, as of this writing GM bonds have not missed a payment and therefore could be valued at or near par value. In fact, these bonds sell for about 8% of par, reflecting the market's justifiable concern that GM will soon be unable to make payments. It's like saying a terminally ill patient is healthy as long as he's breathing.

B. Low trading volume shows few believers

The rally was stalling out at resistance (around 800 on the S&P index) when on March 23 the government announced its Public-Private Investment Program (PPIP), which gave the rally an additional push over that level. The continued rise, however, was on low volume which suggests a lack of popular belief in the rally.

C. Insider selling

According to the Washington Service, in April, NYSE listed company insiders have been selling into this rally at the fastest rate since October 2007. As pointed out in an earlier SA article, Why This Rally Is Unsustainable,

To give that some context, the S&P topped out on October 11, 2007 and declined 57% before hitting March 2009 lows.

In other words, those most knowledgeable about their company's prospects are not buying the stock.

D. Further residential mortgage defaults coming

As James Quinn pointed out in Suburban Housing Markets are Unsustainable Part 2, the financial sector is facing a further wave of residential mortgage defaults, because the decline in home values and the value of the mortgages on them is far from over.

  • There is an all-time high, 13 month supply of new homes, and a 10 month supply of existing homes for sale.
  • There will be an estimated 2.1 million foreclosures in 2009 versus 1.7 million in 2008, and 7 to 8 million more people will lose their jobs in 2009
  • In 2010 and 2011 the payments on millions of adjustable rate mortgages (ARMs) will reset, often at 50% higher or more. Most of these homes are already worth less than the debt on them, and thus millions of new foreclosures are coming as homeowners walk away and leave the banks with even more bad debt.

E. Commercial mortgage defaults growing

This was highlighted by the bankruptcy of General Growth Properties (NYSE:GGP), formerly the largest mall operator, which was burdened by too much commercial real estate debt. As I noted recently in Must-Know Info for Investing in Commercial REITS, If You Dare:

There’s plenty of potential for more trouble with the commercial REITs. Per Deutsche Bank, two thirds of about $154 billion of securitized commercial mortgages coming due between now and 2012 will not qualify for refinancing due to the 35% - 45% decline in property values since their 2007 peak. This estimate could get far uglier if even about 10% of mall properties need to be sold off. There are relatively few buyers for such big ticket properties. Thus commercial property values would drop further, thus lowering the value of the surviving commercial REITs and making financing harder still.

F. Credit card losses-another ticking time bomb

Worst case bank stress tests estimated that America's 19 biggest banks could lose nearly $82.4 billion in credit card losses by the end of 2010. This is likely to be an underestimate because:

If unemployment exceeds 10%, which many economists predict and may already have occurred (depends who you listen to), these losses could go far higher.

G. Bank stress tests ignore much of the coming credit card defaults

Worse still, the bank stress tests published losses only for credit cards held on bank balance sheets. They ignored tens of billions in losses tied to credit card loans that was packaged into bonds and held OFF the banks' balance sheets.


  • There is over $ 5 trillion languishing in money market funds earning nothing, and at least some of it is waiting to buy on a dip.
  • There have been nine bear rallies since 1970. The average length is four months. So far, this rally has lasted just over two months.

So maybe the rally will go on for a few months more? So what? The key point is this rally is doomed and thus strictly for traders or those seeking to take some kind of short position as a hedge for when the decline resumes. Buy and hold income investors should generally avoid taking long positions until prices either retest March lows or there are genuine improvements in underlying fundamentals


OK, so what do we actually do? Here are some ideas:

A. Steps to protect profits or limit losses

1. Place stop loss orders

Use stop orders on positions for which you want to protect profits and would be willing to try waiting to repurchase at a lower price, either using a fixed price level or a trailing stop to protect profits. Ideally, these should ALWAYS be set soon after you buy the stock, so that the sale is automatic when the stop loss is hit or exceeded, thus removing emotion the sell decision.

How important is this simple risk management? In the words of Bernard Baruch:

If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he is wrong.

2. Sell Covered Calls

Sell covered calls to partially protect profits – an alternative to selling outright shares that you really don't want to sell or have bought at much lower price so you can lock in some of that profit plus gain the cash from the sale of the covered call. If prices fail to breach your strike price, you can continue to sell calls and milk the shares for additional income if the lower strike price still leaves you with a profit making the sale worthwhile. For those unfamiliar with selling covered calls, see 3 Must-Know Options Strategies for Dividend Investors.

3. Sell your stocks short

This is strictly for those who want to trade and have the time and expertise to watch these carefully. Higher reward, but higher risk and more time needed to watch these. Of course, place stop losses on these as well – always.

B. Prepare to buy at conservatively low prices

When the next move down shows signs of stabilizing, that will be the time to buy income stocks with cash you can afford to let sit in case of further declines. Remember, cash earns nothing, and inflation will erode it badly, so at least some of your investing capital should be deployed when fear is high and the market is bottoming. I know, easier said than done, but that is the goal.

Sell puts (right to sell to you) at or near a support price. While this can be done in advance, you get the highest price when the stock price has already come down near the strike price you want (price at which you've sold the right to sell to you). Even if price doesn't fall that far, you still get paid. This beats just sitting with cash that gets nothing while you wait for orders that may or may not get hit.

Set buy orders at likely support to take partial positions. Put options aren't always available (especially on more thinly traded foreign shares) or not available at a strike price you want. A bit above the March lows would be a conservative starting point to take partial positions.

C. Hedge your overall portfolio

If you don't want to bother shorting each individual position or selling covered calls on each stock you own, do so on stock indexes that resemble your portfolio or parts of it. That is, protect your long positions by taking positions that profit when the market or stock drops. The usual methods of shorting individual stocks or indexes include:

1. Sell covered calls on stock index ETFs you own at strike prices above your cost to lock in profits.

You get the highest premiums for these when the market is rallying and there are investors anticipating higher prices, while the rally limps along this is an ideal time to sell covered calls. If the stock is below the strike price on the expiration date, you just keep the cash and can repeat the process, possibly milking the same shares for repeated covered call shares sale revenues. If the market price is above your strike price, your buyer will exercise the right to buy at that lower strike price. Perhaps you miss some profits from possible additional appreciation above the call price, but you lock in the rest. Good for when you already have profit at the strike price. Also can be a great way to milk a stock for extra income if you're good at calling near term price tops and then selling the calls (which sell for more when the stock is high and buyers anticipate additional price increases).

2. Sell Contracts For Difference (CFDs) on a stock index that best resembles your long position.

This will be a new idea for many of you.

What are CFDs? As the name suggests, CFDs are based on the change in prices of futures contracts, just like a futures contract or option is a bet on the price movement of a commodity, index, or stock.

For example, to hedge a portfolio of US stocks, sell a CFD on the S&P 500. You profit as the S&P declines. While not mentioned much in the mass media in the US, they're well known outside North America. Essentially they are bets on the direction of futures contracts on various instruments like commodities or stock indices. Like any derivative product, you MUST do your homework to understand the pros and cons. Used correctly, CFDs can be cheaper than buying puts and better suited for long term hedges than ultrashort ETFs.

One of their key benefits and risks with these is that the online brokers grant very large leverage on these. The upside is that you can take positions with little capital, and can make very large gains when you're right. The downside is that you can lose money quickly if you don't manage your risk carefully with stop losses, which you should ALWAYS use with these.

The best free educational sources on CFDs are on some of the various online forex and commodity brokers and market makers at their web sites. A Google search using terms like "online fx trading platform" will give you a list of sites to consider. Some criteria to evaluate them include:

  • No commissions or fees
  • Great educational resources
  • A wide variety of CFDs
  • Telephone and live chat support

If you look for reviews of various online forex and commodity sites, there are lots of complaints about most of the sites out there. I don't know if these are justified or not, but clearly you need to do your homework about which are legitimate, and ideally get some personal references.

Here's a sample table of offerings (click to enlarge).

Sample Table of Contracts For Difference (Courtesy of AVA FX)


3. Buy ultrashort ETFs for a short term trade.

This option is only for the traders among you. As mentioned in earlier posts, these are easy ways to take short term short positions on various indexes or sectors. Again, these are for those with more risk tolerance. If you think you can catch the next leg down early, consider some of the Proshares ultrashorts like the SDS (rises at 2x the rate of decline of the S&P 500). Given the above mentioned issues regarding the financials and the sheer manipulation of their stock price rise, the SKF (like the SDS for the financial sector) could be rather lucrative.

WARNING ABOUT THE SKF: Of course, given the amount of, ahem, "purported" outright conspiracy between the banks and Washington, one could draw the opposite lesson and avoid shorting financials, fearing further likely bailout/rescue/trading suspension/ whatever.

I'm being perfectly serious. It's quite conceivable that shorting financials could again be banned, more one time profits manufactured, etc. Remember, when Wall Street and Washington band together, it's risky to get in their way. Who said life was fair?

Disclosure: The author has positions in the above instruments.