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Jeffrey Dow Jones
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Jeffrey Dow Jones is the managing editor for Alpine Advisor. He has previously worked for PaineWebber/UBS and Ford Motor Credit Company, and he spent the last decade co-managing a group of hedge funds. He holds a degree in Business Economics with a specialization in Computer Programming from The... More
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Alpine Advisor
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The Trade of the Decade: A Guide to Investing in the 2010s
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  • Options Strategy: Let's Get Naked with Puts

    “Wealth is a product of a man’s capacity to think.”
    -Ayn Rand

    Retrain your BRAIN!!!

    Hopefully, Part 1 of this series on naked puts started the slow process of programming your mind to look at stocks a different way.  This is a difficult concept to grasp.  Most traders or investors look at a stock and say, “I think it is going here”, or “my research tells me it’s going there.”  Guess what?  As an option seller you don’t care where a stock is going!  You only care where a stock IS NOT GOING!  This thought process does not come to you overnight; however, eventually you will start to look at the world of equities in a completely different light.  Before you know it, oversold, high premium, quality stocks will be your drug of choice, and you will know if a stock is right for you in a matter of minutes.  But, for that to happen, you must first “RETRAIN YOUR BRAIN.”

    Selling puts on stocks is often compared to acting like an insurance company.  The goal of an insurance company is to collect premiums each month for accepting the insurance contracts to cover the risks of those they insure.  As an insurance underwriter, you find a low risk individual and insure their home, car, office furniture, et cetera, in return for collecting a monthly premium.  If no claim of loss is ever made, then you keep the premium and repeat the process.

    Following this business model month after month is how insurance companies make billions of dollars each year.  The key to their success is they make educated bets that their clients will not crash their car, burn down their house, or throw their business computer out the window.  This educated bet is based on how these individuals have performed in the past; and just in case they do break, crash, or burn something, the insurance companies spread their risk out over multiple clients.

    Pretty smart huh?  Well, this is exactly what we are going to do with our put option portfolio.  Traders will pay us a premium to accept the downside risk of an underlying stock for a short period of time.  They need protection in case the stock drops 15% in the next 30 days and we know the odds are in our favor that it won’t.  The best news of all is we get to pick the stock.  So, just as insurance companies don’t like high-risk teenage boys, we don’t like small, cheap, unpredictable companies that we cannot properly evaluate.  We evaluate a certain number of companies each month and sell puts against those companies, spreading out our risk and collecting our premiums with a smile.

    Here’s the secret:

    Screening stocks and controlling our risk

    Sounds good in theory, but what stocks do you use to set up a put option portfolio?  The following is a checklist we run through every time we sell a naked put; I recommend you do the same.

    1. How strong is the company? We have no intention of owning these companies, but selling puts on fundamentally and technically strong companies put the odds of predicting their future in our favor.  Yes, insurance companies don’t like teenage boys because they are wild and crazy, but the bigger reason is they have no history, they don’t know what they will do in certain situations.  Your view on stocks should be the same.  We want stocks with a strong history to help us better predict how they will perform in the future.  Start with the top 10 stocks in each sector; they’re in the top ten for a reason.  Starting there will help you establish your own universe of stocks to sell puts against multiple times per year.

    2. Which month do I sell options in? Always look to the next month out, or options with less than 45 days left until expiration.  Time (Theta) is always on your side, so you want to sell options during their time period of maximum decay.  This time period of maximum decay is the last 30 days of an option’s life.  I extended the time period from 30 to 45 days because it is hard to find any good premiums in a stock with only 2 weeks left until expiration, so you must look to the next month out, which is usually about 45 days away.  Venture further than that and you’re going rogue.  You’re on your own.  The Draconian is not sympathetic if you get massive heartburn.

    3. How far out-of-the-money (OTM) should my strike price be? As far out as you can go while still collecting a good premium.  I typically don’t sell less than 10% OTM.  If a stock’s price is at $50, the minimum strike price I would sell a put on is $45.  Note: the more volatile the stock, the farther OTM your strike price should be.  Again, I want the odds in my favor.  If I sell a put 10% OTM, that stock has to drop at least 10% in value in the next 30 days before I’ve made a bad trade.

    4. Is this a good premium? Keep in mind, the higher the premium the better chance it will hit your strike.  Strike prices 2% OTM have much higher premiums than strike prices 10% OTM because the odds of the stock going there are quite high.  It’s no coincidence that a Porsche 911’s insurance premiums are higher than a Honda Accord’s.  Insurance companies know which one you are more likely to wrap around a tree.  A rule of thumb is the $0.50 premium or better, however this is subjective based on the price of the stock, implied volatility, and days to expiration.  The target we use is the premium should return 1% per month on average, or over 10% annualized.  We don’t get greedy and we recommend you don’t either.

    5. Is the stock above its 200 day Moving Average and/or sitting at its technical support? It is statistically proven by your Draconian team that stocks have a much better chance of going up when they are above their 200 day moving averages, and/or sitting at their technical support levels.  Screen for stocks that have both of these parameters and again, you will put the odds of winning in your favor.

    6. How is the stock’s volatility? To understand volatility is to understand options.  I will write a “Trade School” that focuses entirely on volatility, but for now, know this: when a stock’s implied volatility (current volatility) is higher than its historical volatility that is the prime time to sell options.  Why?  Because the higher a stock’s volatility is, the more premium you will receive for selling an option against it.  So, check the stock’s volatility for confirmation before you sell an option against it.  I’m always happy to talk volatility and if you want more detail, send me an email at Kyle@DracoFund.com .

    7. Are there any earnings or news announcements on the stock in the next 30 days? I have set up the perfect option trade, only for it to be ruined by an earnings announcement.  So the rule is, stay away from stocks that have any kind of news that can surprise the market.  There are plenty of stocks to sell puts against, so move on.  You can go to www.yahoo.com/earnings to find out the next expected earnings announcement on any stock.

    8. How much margin will this trade tie up in my account? Naked puts require margin, which means you need to have a decent size trading account before you can write puts on any stock.  Most brokerages take 50% margin out of your account every time you execute an uncovered or naked trade.  I prefer you do what we do and write only cash secured puts, which means if every trade in your account went to zero, you would have enough cash in the account to cover without getting a margin call.  However, you should always know how the margin is calculated in your account so you know what is available for other strategies.  This is what the margin calculation looks like using the standard 50% for your brokerage’s margin requirement:

    Margin = ((50% x Stock Price) + Option Price  (Stock Price  Strike Price)) x # of contracts x 100)

    Plug this formula into a spreadsheet or calculate it on a trade by trade basis so you know exactly how much margin is being used when your write a naked put and how much is left for other strategies such as covered calls.

     

    Let’s do a real life example:

    Cash Requirement: $6,500 per contract sold. (We will sell 3 for this example)

    One of the companies that is a part of our core group of stocks that we continuously tap for profits is Freeport McMoRan Copper & Gold Inc. (NYSE:FCX).  Our research on FCX tells us that FCX has consistently performed better in March than any other month out of the year for the last 20 years, but to make sure it is appropriate for our portfolio of options this March lets go through the checklist from above.

    FCX Check List:

    1. FCX is a strong mining company that has been around for over 23 years. It is one of the largest capitalized and most successful stocks in the Materials sector (NYSEARCA:XLB).  This meets our criteria for only writing puts against quality stocks.

    2. February option expiration is this Friday, which means there are no quality premiums available, so it’s time to move out to March expiration which is only 31 days away.  This meets our criteria for selling options with 45 days or less until option expiration.

    3. FCX is currently trading at $75.94.  The $65 strike price is yielding a nice premium. The $65 strike price is 14% below the current price of FCX.  This meets our criteria of selling puts at strike prices 10% or more out of the money.

    4. For being 14% away from its strike price of $65, the $1.02 premium FCX is yielding is great.  Our rate of return until expiration day is 1.57% or 19.09% annualized.  This meets our criteria of selling premiums that on average return more than 1% until expiration, or 10% annualized.

    5. FCX is above its 200 day moving average and is coming off its technical support.  It is not at its technical support, but is coming off of a recent low, which is great confirmation that the short-term trend is reversing.  This meets our criteria of stocks above their 200 day MA have a statistically better chance of making a move to the upside.

    6. FCX implied and historical volatility levels run pretty close together traditionally, however there is a slight separation between the two volatilities right now.  Implied volatility is not high enough to be the sole reason to do this trade, but it does agree with the rest of our analysis.  This meets our criteria for checking the volatility levels of every stock we sell options on. (See option section of your online brokerage to find volatility charts.)

    7. The news is out on FCX!  Its earnings announcement was on January 21st is what brought the stock down to its current support level.  It has been rallying steadily ever since the 1st of February because many traders feel like it is oversold.  Keep in mind that stocks like FCX are strongly tied to the commodities markets, so it is worth taking a look at gold and copper to complete your analysis.  This meets our criteria of researching predictable news stories that could ruin our trade.

    8. If we had to buy FCX at our strike price $65 it would cost us $6,500 per contract with cash, however the margin requirement is only $2,800 per contract.  This allows me to see how much margin is still available for other options and/or strategies.  You need to know this number to complete your risk management.

    SURPRISE! FCX passes the 8 point check list. Let’s execute it.

    ItemStatsComments
    CompanyFCXFreeport McMoRan
    Stock Price$75.94 
    Put Strike Price$65The next technical support level
    Days to Expiration31 DaysAlways sell options w/ ≤ 45 days
    Premium Received$1.02clip_image001 Return of 1.57% for 31 days
    Contracts31 per 100 shares
    Cost if put to us$19,500$6,500 per contract
    Margin Requirement$8,397See formula above
    Return on Margin3.64%Premium / Margin Requirement
    Downside Breakeven$63.98Strike Price – Premium
    Stock Acquired AtAny price below $65You always keep the premium
    Maximum Gain Stays Above $65$306Premium x # of Contracts x 100
    Maximum Gain Drops Below $65$306 + Increase in FCXPremium + Stock Price Increase
    Maximum Loss Stays Above $65No Loss will occur 
    Maximum Loss Drops Below $65$306 – Decrease in FCX 

    Once you enter the trade it is your job to monitor the position over the next 31 calendar days. We set ourselves up for success, so even if the trade moves towards the downside we will receive our full premium as long as the stock stays above $65 by March 19th, option expiration day.

    It is important to remember that trades can always go against you no matter how great they look on day one, so you need to have a plan if FCX drops below $65. Remember that the main objective in Part 2 of this “Trade School” is to generate income month after month without using too much of the cash in our accounts.  So if FCX were to drop below $65, you have two options: close the trade out, or roll the trade to April, because we do not want to own it.  By rolling the trade to April you essentially take your loss now, but give yourself a chance to win it back the following month.  In this case, if FCX drops below $65 before March 19th, I would roll out to the April $60 strike price and use the premium I received to offset any losses I incurred in March.  Option 2 makes things really easy.  Get out if you don’t like what the stock is doing and move on.  A rule of thumb that I often use is that if a premium doubles I am most likely wrong, so I will exit the trade at that point.  With FCX if the premium for the March 65 goes to $2.04 ($1.02 x 2) then I’m out and on to the next stock.  Following these two rules will keep you out of trouble and illuminate the unlimited risk label that naked options have.  This is all part of trade management and it is important no matter what the strategy is.

    Let’s recap

    In this two-part series you first learned how to earn income while you wait to acquire stocks for your portfolio at an attractive price and then how to research and establish a naked put option on a stock for the sole purpose of generating monthly income.  You may want to follow the 8 steps above and write multiple puts per month and establish an entire portfolio of naked puts, or you might want to write a few here and there to generate some extra cash.  Either way, the naked option strategy above will add another level of experience to your repertoire of trading strategies.

    I hope you can see why we think the naked put strategy is such an important tool for the individual trader to implement.  The flexibility and short term nature of the strategy can really benefit those traders/investors who cannot sit in front of their trading screen all day.  However, position management is crucial and it is important to know the risk of your overall portfolio.

    Having said that, the next part of our mission of helping you be better traders is going to focus on the use of spreads in your option trading.  Spreads reduce your risk and provide you with a road map of your maximum gains and losses as soon as you enter the trade.

    Before we go, take a minute and congratulate yourself.  The knowledge you have learned in these first three schools puts you head and shoulders above the rest and all I can say to that is, “get used to it!”

    DracoTradeSchool

     

    Disclosure: Short FCX puts
    Mar 18 10:04 AM | Link | Comment!
  • Macro Predictions for 2010

    This week we look ahead at the year 2010 and what events might materialize.

    Upon reviewing these predictions, I realize these have a somewhat bearish slant.  It’s my view that the big theme of 2010 will be a reminder that things are difficult out there, something of a reality check for the economy and markets. It will be a reversal from the theme of 2009, which has been “things aren’t as bad as we thought in the pit of the crisis.”  Crisis, of course, was the theme of 2008.

    Most of these predictions tend to revolve around this reality check for the markets, so if I’ve got that wrong, I’m in big trouble from the start.

    As most of you folks know, the type of trading we do in our own funds is very short term in nature.  We like being able to go to cash at a moment’s notice.  While we remain cautious as ever, our current trading portfolio does have a mildly bullish bias.  Stay tuned to The Draconian throughout the year and I’ll let you all know if that stance changes and if we start looking for more areas to aggressively short.

    Now, allow me put my Nostradamus hat on and we’ll get straight to it:

    nostradamus

    1) No serious inflation materializes and the U.S. Dollar hangs in there.

    Loyal readers are already aware of our stance on the inflation debate.  Sure, it could be a problem some day.  But not for a while, a lot longer than most expect.  We’ve been banging the anti-inflation drum, warning investors not to bet too heavily on significant inflation for a while now and I’m glad to see the rest of the industry finally talking sense about inflation.

    Back in November, we discussed one of the biggest threats to the markets being a policy change and subsequent rally in the Dollar.  I didn’t think that would materialize so quickly after sounding that warning bell, but lo, that’s exactly what happened in December and suddenly betting on the Dollar and against significant inflation is the trendy prediction for 2010.  Since we launched The Draconian last summer a big theme of this newsletter has been to keep a stockpile of Dollars handy for these very reasons.

    For the record, I do believe we’ll get some expansion in the Consumer Price Index.  Betting against that would be silly.  Annual drops in the CPI very rarely happen, and usually only do so during awful, extreme environments.  It probably won’t surprise you to learn that since we got off the gold standard, the only time the CPI ever went negative for a year was after the recent financial crisis.  The Fed’s not joking around when it says one of its policy goals is to “manage” inflation.  It does a better job at this than you might realize.  No way does the CPI exceed modest 1-2% growth over the next year.

    With that, I think we see the Dollar firm up a little.  We’ll be discussing this much greater detail in the coming weeks, but for now, I think people will be surprised at the relative strength the ol’ Greenback shows in 2010.  Last year everybody seemed to convince themselves that with all this money printing and government stimulus that the Dollar was facing certain doom.  I didn’t agree then and don’t agree now.  Inflating our way out of all this debt is a viable solution, but not when we need to keep borrowing a trillion dollars a year to support a decade of projected budget deficits.

    There are too many other deflationary headwinds at present as well.  Real estate is still a drag.  Wages are going down.  Monetary velocity is still low.  Retailers have zero pricing power as consumers are still reluctant to consume unless a supersale or government incentive is attached.  The job market still looks bleak.  The CRB commodities index has been stalling out.  The bond market is still forecasting minimal inflation.  And don’t forget that Japan has been printing Yen like madmen for decades now and their currency has actually gone up!  I think that reports of the death of the U.S. Dollar are being exaggerated.

    In 2010 we will all be reminded that runaway inflation is farther away than we thought.  Like our friend the Chupacabra, it will remain a spooky story we tell ourselves late at night.

    elchupacabra

    I think by next December it might even be the case that hardly anybody is talking about dollar weakness.

    2) The stock market disappoints.  Big time.

    To quantify this, all I’ll say is that I think the market ends the year lower than it began.  Even still, that qualifies as a very contrarian forecast right now.

    I know that the brilliant John Hussman put the odds of a “crash” at 80% in 2010 based on a Bayes’ Law interpretation.  But I’m reluctant to agree for semantic reasons.  I think there is virtually no chance of a repeat of what we saw after Lehman went down; that’s my definition of a “crash”.  That said, I do think the S&P finishes lower this year, possibly even down double digits.  I think the odds of witnessing a single drawdown of 20% or more at some point in the year is probably higher than any time since the 1970’s.  If that, coupled with continued economic and credit problems qualifies as a “crash”, then yes, I do agree with Mr. Hussman.

    On a side note, if you don’t already follow his weekly commentary here, it’s time for you to start.  I am awed by his intelligence, economic acumen, and writing ability.

    No, that

    That chart looks pretty familiar, huh?  It looks a lot like what we’ve seen in the last couple of years, doesn’t it? 

    A lot of investors are completely baffled and mystified by the gigantic rally in 2009, but it’s pretty much exactly what the market did back in 1930.

    Let

    As you can see, the next leg of that chart is pretty ugly – the Dow would go on to lose roughly 90% of its value.  I don’t think that will happen today, but with all the economic mess that still needs sorting out I have a hard time believing that the market soldiers on to new highs from here.

    I’ll now ask a question: do you think that the market and the economy will be better than it was in the 1930’s but worse than it was in the 1970’s?  That’s certainly the political consensus with all the “it’s the worst [whatever] since The Great Depression” rhetoric.  I’d say it’s also public consensus, and it’s probably the reality of the matter as well.  Not as bad as the 30’s but worse than the 70’s. 

    Sounds reasonable to me.

    If so, the above chart is the worst-case scenario, and the below chart is the best-case:

    Best case scenario: not words typically associated with the 1970

    On top of that, bearish sentiment at present is the lowest it has been in a long time, lower even than the summer of 2007 when everything in the world was hunky dory.  You probably already know that bearish sentiment correlates very well with market action, often bottoming at market peaks, and peaking at market bottoms.

    What we see this year is really anybody’s guess, but I think the market will disappoint.  Regardless of what happens in 2010, you can see why I’m so skeptical that today is the beginning of the next great bull market for equities.

    3) Real Estate falls further.

    But then stabilizes.  Maaaybe.  Earlier this summer, amidst the enthusiasm of the homebuyer tax credit (which can’t keep getting extended forever), I said that there was still more downside in real estate and I think that’s what we see in the first part of 2010.  If you haven’t read Some Straight Talk on Housing, give it a look, especially if you’re thinking about buying a new home.

    Foreclosures are getting worse, not better, and will keep getting worse and not better, especially as a gigantic wave of mortgage resets is set to wash over the market in 2010.  All the homebuyer tax credit did was just push back the date at which housing finds a bottom and, for better or worse, that date now coincides with this new round of mortgage resets.

    Rate pressures are also likely to rise as the government scales back its Fannie/Freddie purchase program and ratchets the Fed Funds rate upward.  Higher rates mean higher monthly mortgage payments which means that buyers can’t pay as much money for a house.  That’s the cruel and simple calculus of the matter.  I don’t expect dramatic rate pressure, but whatever pressure we do see will be a drag on home prices.

    If you’re the sort of person who needs a chart for convincing, check these out.

    image

    The blue line is the actual Case-Shiller home price index and the red line is the value predicted by inflation + real wealth expansion.  Over the long-run, by definition, housing cannot appreciate more than the inflation rate + any real gains in wealth.  Over the short-run, home prices can be dramatically influenced by speculative factors and expansions/contractions in credit or changing lending standards.

    I also submit the next chart for your consideration, where we relate a buyer’s income to the price of a house:

    image

    There’s a very good reason for this metric to remain relatively constant over time and oscillate around a historical mean.  By definition, an individual cannot indefinitely pay more for a house than he can afford nor will lenders lend what they don’t expect will be paid back.  This metric will obviously fluctuate as things like interest rates and lending standards rise and fall. 

    Over the long run, however, both of these charts are highly mean-reverting.

    At the end of 3Q09, home prices were still roughly 7-9% above their historical norms according to these metrics.

    You can also see that these two metrics can overshoot in either direction.  Assuming that the economic path before the U.S. and her people is a rough one, home prices might have another 10-15%+ to fall.  It gets worse if you live in one of the key bubble states, like us here in Nevada.  It also gets worse if you start making assumptions about lending standards becoming more strict and household incomes actually falling a bit.  To me that sounds reasonable, but who knows.

    This is all consistent with what we wrote last summer.

    4) Hedge funds return to prominence (of sorts).

    Basically, they outperform the markets and the world of traditional investments this year.

    Asset flows into hedge fund strategies has been picking up serious steam, with the industry now back above $2 trillion in assets.  Keep in mind that the consensus view was that hedge funds would be a disaster in 2009, with up to half of the industry either blowing up or closing down.  A lot of funds did shut their doors last year, but as a whole, the industry surprised the world with remarkable resilience and even responsibility

    These guys have solved their problems the old fashioned way: the good ones survived and the bad ones failed.  I haven’t heard of a single hedge fund bailout so far, and I’m much more comfortable making long-term bets on any industry where actual merit is the arbiter of success.

    Yes, there are still problems in hedge fund land right now, but most of that is traced to legacy positions that are still illiquid.  The dominant theme in 2009 was a renewed emphasis on investor-friendly policies.  Pretty much every hedge fund I know did everything they could to increase their transparency, liquidity, accountability, and proper alignment of incentives.  In essence, they’ve done everything the banking system and government hasn’t.  This is no longer the mysterious, elitist, exclusive industry it once was.  These talented capitalists have rebuilt their industry around giving investors what they want. This is the wonderful side effect of unfettered competition and minimal government mingling.

    Over the long run, I want to bet on industries like that.  And that do this:

    image

    Hedge funds had their own credit-related problems during the financial crisis – they had some painful deleveraging like everybody else.  But this year people remember that these things aresuperior ways to invest, especially during standard bear markets.  The really sophisticated investors never forgot that lesson anyway, and they’re now actively reallocating to the sector.  That trend will continue through 2010, and through the next decade hedge funds will be the place to be.

    You guys all know we’re biased, because our business is managing a family of hedge funds.  We run this kind of business and have essentially all of our personal investment net worth invested in the funds that we manage because we believe that over the next ten or twenty years, the blue line in the chart above continues to outperform the red one.

    Send me or Kyle (Kyle@DracoFund.com) an email if you have any questions or want to learn more about how and why to get access to some alternative strategies.  We’re also happy to talk to you about how you can implement some alternative strategies in your own portfolio – this is the goal of Draco Trade School.

    5) The Democrats lose their stranglehold on American politics.

    Unless, of course, the Republicans bungle it again.

    When Obama & the Democrats took office in such decisive, dramatic fashion, I thought that they had wrapped a tidy ribbon around what would become a new era of political dominance.  At the time, I thought that the Republican party had suffered too much permanent damage from the baggage of the Bush administration, an administration which, beyond the tax cuts, demonstrated so many un-Republican characteristics.  Many of the folks that I know that voted Bush in 2004 had begun in 2007-2008 to feel a frustrated sense of betrayal.  (Anybody wonder why John McCain, a man who had frequently, loudly, and publicly clashed with the Bush administration was chosen to be the Republican candidate?)  I thought the Republican party would need to completely reinvent themselves to ever regain the power they lost in 2008.

    But now I am not so sure.  I’m astonished at how quickly Obama’s approval rating has slid, and approval ratings for the Senate and Congress are bouncing around all-time lows.  I expected that Obama and his gang would play the "blame the previous administration" card for a while, as any savvy gamesman would suggest.  But there wound up being a lot less juice in that strategy than I initially thought.  It seems as though more and more people today are blaming the currentadministration for our economic woes in addition to administrations past.

    Obama

    I think my perspective here is fairly neutral.  As a lifelong registered libertarian, I haven’t once voted for a major-party presidential candidate since graduating high school.  I have equal contempt (and hope) for both parties. 

    But deep down I am just a tired, political cynic.  These two parties are far more similar than most partisans would be comfortable admitting, and all the effort we expend to bifurcate ourselves is wasteful and inefficient.  I’ve found that for the most part, Americans want the same basic things.

    I also know too much about incentives and how improperly aligned they are in a democratic system.  The wonderful thing about America is that we can literally vote ourselves what we wish, and these politicians are keenly aware of that.  They make decisions that help them keep their jobs, which are not always decisions that are responsible.  America is a candy store where the kids call the shots.  This, more than the idealistic partisanship of modern politics, is why I’m such a cynic.

    This year, get ready for more partisanship and more selling out.

    The Democrats will try and make the current economy seem great, or at the very least, on the road to a better place.  The extent to which reality confirms this political spin doctoring will be what determines their fate this November.

    The Republicans, naturally, will fight the perception of recovery tooth and nail, though I’m not entirely sure this will be the best long-term strategy for them.  Fear is a powerful manipulator, and to their credit, few administrations in history wielded that power more effectively than Bush & Co.  But now is a time when people (voters) are responding to optimism coupled with results.  We all have enough fear at present.

    Increasing numbers of people seem to be demanding more fiscal responsibility from our government, but in truth, we are far less concerned about responsible public policy than with feeling safe and confident.  Truly responsible public policy would mean forcing sacrifices on the American people that would incite riots.  As kids calling the shots in the candy store, the idea of “sacrifice” is unfortunately a foreign concept to most of us. 

    Rather than act as responsible parents and make tough decisions, politicians will chicken out and resort to the delivery of bread & circuses and the promise of more stimulus.  That’s been working pretty well in Japan for a decade or two, and there’s no reason to think it won’t keep working over here.  This November, we’ll vote for whomever makes us feel better about our future, and any real data that confirms this will circled, highlighted, and underscored in bold.

    Right now, that’s jobs.  As I’ve written before, there is nothing more valuable today than a steady, reliable job.  A job that pays $40,000 per year might not seem like anything special, but that’s a million dollar asset when you consider how much capital you’d need to reliably generate an equivalent amount of passive cash flow.

    Part two: next week.

    I’m bumping up against my self-imposed word limit, so you’ll have to stop back next week to see the 5 final predictions!




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    Disclosure: No stocks mentioned.
    Tags: Macro
    Jan 06 1:15 PM | Link | Comment!
  • Long Term Investors: What to Expect
     Here at The Draconian, a lot of our commentary is relevant for traders because we’re traders ourselves.  That’s not to say we don’t understand long term investing, because we have to do plenty of that as well.  Trading is a tough business, but odds are it probably isn’t your business, so there’s a good chance that long term investing strategies are of more relevance for somebody like you.

    If you consider yourself a long term investor, then what you’re doing is making an investment today based on some kind of guess about what you think it’ll be worth far in the future.  What should you expect?  If you’re making an investment today, what will it be worth in 2020?

    As you can imagine, this is a highly relevant question, especially for people who would someday like to retire.

    What to expect

    Today we share with you a simply fantastic chart, one of my favorites to work on.

    Get ready to have your mind completely blown away:

    image

    What this chart does is look first at the current Price/Earnings ratio of the stock market.  PE ratios come in a variety of flavors, and for this study, I’m relating the current price to the previous decade’s average earnings to normalize things a bit.  I like looking at the Price/Earnings ratio because it gauges the “value” of the stock market – it measures the price that an investor is willing to pay for $1 of corporate earnings.  Since a share of stock is nothing more than a claim on a stream of future earnings, this is a popular measure of whether a stock or the market is expensive or cheap.  We then relate that to actual return seen in the market over the subsequent decade.

    Here’s what’s going on behind the scenes:

    The data starts ten years ago in the summer of 1999 (those were the good ol’ days, weren’t they?) and looks at the PE ratio using average earnings for the previous decade.  At that point in time it was a little over 40, which is pretty high.  In fact it was near the all-time high.  In the 90’s people were paying a lot of money for one dollar of earnings, and in the case of the dot-coms, a lot of money for zero or negative earnings.  In our chart we assume that an investor bought the market at that moment in time and then we fast forward a decade to 2009 to see what theyactually earned over that period.

    The stock market was really, really expensive back in 1999 and someone that made an investment in the market at that point in time was punished over the next decade to the tune of about a –21% total return.  Ouch!  That’s also assuming that they bought and held, and didn’t buy more during market frenzies and didn’t panic-sell during declines.  In reality, the average investor’s rate of return over that period is probably worse than the -21% loss in our study.

    Each little dot on this scatter point plot represents a different month, every month in the 20th century in fact.  We took a snapshot of how expensive or cheap the market was at each month, and then measured the actual rate of return over the next decade.  I used the Dow Jones Industrial Average for this study because the data is very reliable and the Dow divisor also automatically includes returns from dividends.

    As you can see, none of the decades where the total return was negative began when PE ratios were very low.  For the last century, a PE ratio below 15 has pretty much always signaled a decade of, at the very least, positive future returns.  Conversely, none of the great decades began when the market was very expensive – when the PE ratio was above 25, the market has never done better than double over the next ten years.

    Where we are today

    So is the suspense killing you?  Are you just dying to know what the current ratio is for the market?  Would you like to know how big your investment might grow in ten years assuming you make it today?

    Today we’re at PE of about 20.4, which I’ve marked with a red line.

    image

    The mean in this entire sample is about 13.5, so a PE of 20.4 is definitely on the higher end of the historical spectrum.  That’s pretty obvious from the chart, but the market today is not extremely expensive, not the way it was in 2007, 2000, or 1929.  Clearly, investors who bought at those peaks were using something other than this chart to justify their purchase.

    What’s interesting is that even back in March, when we were at the nadir of the black abyss and the world seemed to be coming to an end and the stock market was at a new lows, it still wasn’t a historically cheap time to buy.  The PE ratio only got down to about 13.  Not bad, but not cheap enough to get the real Value Hounds baying.  The only song those dogs are singing today is one where the market might resume its secular bear trend and erode to new lows.  Life as a hardcore value investor is difficult because the stars so rarely align in pleasing fashion, but when they do… oh boy, great fortunes are usually made.

    If we look at a channel around that red line we find an average total return of around 50-75%, which is about 4-6% per year.  That’s not bad either, but our data set has a bit of positive skewness thanks to the phenomenal dot-com bull market and credit bubbles that began with already-high valuations.  If we look at the median of dots in the neighborhood of that line, the expected annual return is closer to zero, ranging from –0.5% to about 1% per year.

    I also added a regression line, which broadly describes the data set as a whole.  If you look at the value predicted by the regression line, it’s forecasting a ten-year total loss somewhere in the neighborhood of -50% based on today’s valuations.  That’s an average annual rate of return for the next ten years of about –5% to -6%.

    Investing is both an art and a science, and so far I’ve given you all the science.  We can’t make a decision strictly on the results of a study like this, and so we must run it through our own “artistic” filters.  I actually think the real story lies somewhere between those statistical conclusions, total rate of return for the decade in stocks of about 25-50% or around 2-4% per year.  I know that yields are pretty depressing right now, but you can match that with risk free U.S. Treasuries.

    It won’t be a steady 2-4%/year by any stretch of the imagination.  You regular readers know that our vision of the future is one where the market moves up and down, trapped for the most part in a great range.  It will be a decade where, ten years from now, investors will look back and say “Oi, I should have just stayed away and avoided all that heartburn!”

    I think this study reaffirms that long forecast.

    Here’s the “but”

    This analysis does make a few assumptions which you may or may not be comfortable with.  As our custom typically dictates, I will allow you to come to these conclusions of comfort by yourself.

    The first is that it assumes that earnings for the next decade will resemble the level of earnings seen on average during the last decade.  If you think the next decade won’t be as profitable for corporate America as the last (one of the most profitable in history), then you’ll need to lower the denominator of our PE ratio a bit.  That would mean that the market today is even moreexpensive than the 20.4 we calculated earlier and would lower our prospect for the next decade’s returns.

    The second assumption that we make is that investors are willing to pay, on average, what they historically have for a dollar of earnings over the last century.  In recent years – a generally low-yielding environment, mind you – investors have consistently exhibited willingness to pay more for a dollar of earnings than they had in the past.  Should investors continue to display the above average tolerance for risk that they have since the mid-90’s, then permanently higher valuations may be justified.

    You’ll also notice that the data in those charts above appears somewhat bifurcated, with two separate “curves.”  That second “curve”, the series of points that appears to be shifted up and to the right, is pretty much entirely from the mid-90’s through 2007.  That was a very unique period in history where valuations began at high levels and had the ten-year window terminate in 2006-2007 which was in the middle of a totally artificial bubble in risk assets that was driven almost entirely by increasing leverage and an economy that exhibited almost zero economic growth when adjusted for mortgage equity withdrawals.  We covered that and more in our newsletter onthe state of the housing market.

    Keep in mind that that period also had a nasty bear market in the middle.

    If we discard that bizarre, artificially-fueled window and take our data back even further, to 1871 this time using the S&P Composite, the story is ridiculously clear.

    Behold:

    image

    Note that the S&P doesn’t include returns from dividends the way the Dow automatically does, so for this you’ll need to use your imagination and shift that whole curve to the right a little bit.  But still, inside that chart is a story of staggering power that many investors have never heard before.

    You might be asking, “why does this chart look like this?”

    The answer is that fundamentals matter.  As I said above, a share of stock is nothing more than a claim on a future stream of earnings.  Fundamentals are often thrown out the window in the short run, especially in speculative environments.  But over the long run, fundamentals are the onlything that matters.  There is no greater fundamental investor than Warren Buffet, and this concept is the heart of his famous quote,

    In the short term the market acts as a voting machine, but in the long term it acts as a weighing machine.

    What WE are doing about it

    As I’ve mentioned before, our real business is asset management and not professional newsletter writing (as you may have guessed!).  Every single one of our currently-active trading systems is very short term in nature, with average trade durations lasting from a day or two to about 30 days into the future.  Our long-term investment strategy is one where we intend to rely on short-term, skill-based tactics. This is where the bulk of our personal investment net worth is allocated, via the funds that we manage.  The fact that we:

    1. don’t use any outside leverage to generate our returns,
    2. are diversified across stocks, bonds, foreign currencies, commodities futures, and options,
    3. and have the under-appreciated ability to convert our entire portfolio to cash with basically a few button clicks,

    really helps us sleep soundly at night.  Regardless of what the future looks like.

    I talk about it all the time on here, and we recommend that individuals get highly diversified and stay liquid in their own investment portfolios.  Get access to multiple asset classes, and multiple strategies with each asset class.  Keep your cash reserves up and get some alternative strategies if you can.

    As a hedge fund, we are legally restricted in the things we can say about what we actually do, and as a result it can make it a little difficult at times to give investment advice.  But if it’s the sort of thing you’d like to learn more about, or if you have some questions about how to improve the diversification and sophistication of your own investment portfolio, don’t hesitate to contact us.  You can always reach me with any comments or questions at Feedback@TheDraconian.com.  If you have some more specific questions, you can reach Kyle Ferguson, author of Draco Trade School, directly at Kyle@DracoFund.com.

    We’re nice guys, too!  Old-school Nevadans with old-school Nevada values.  We love talking to other people because it helps us understand the issues that are at the forefront of investors’ minds.  It helps us become better traders.

    Should I buy stocks now?

    If you’re looking to the market as a long-term investment right here – and many of you might be, especially those of you a decade or so away from retirement – temper your expectations.

    Part of me actually wants to say prepare to be disappointedAt best, today’s valuations could be considered “fair.”

    Based on the historical data in this study, you’ve got a tiny chance of making significant money, a reasonable chance of actually losing money, and a most-probable outcome of fairly mediocre returns.

    If you think that language is a bit wishy-washy, you’re correct.  It’s because a lot of things can happen over the next 10 years, but given present valuations, some outcomes are more likely than others.  It’s also because I think the stock market is a pretty wishy-washy investment right now, though probably not a terrible one for investors with sufficiently long horizons.

    21

    Being a long-term investor is a lot like playing a really, really slow game of blackjack.  Assuming you’re employing basic strategy and at least some form of card counting, you want to place larger bets when the deck is in your favor and smaller bets when the deck is unfavorable.  When the count is high i.e. there are lots of aces and tens in the deck, the odds of receiving a good card are high and your bet should be larger to reflect those favorable odds.  So here’s some language that isn’t wishy-washy:

    Avoid buying stocks when they are expensive and load up when they are cheap.

    Sounds simple, right?  It isn’t.

    Investors were buying stocks like mad in 1929, 2000, and 2007, exactly when they should have been avoiding stocks!  No investor in his right mind was considering stocks after the mess of the 1970’s or in the late 1940’s when valuations had been compressed to historic lows.

    Unfortunately, the average investor is impatient and highly emotional.  And so he generally makes bad decisions about his investments, displaying remarkable aptitude for doing the wrong thing at the wrong time.  He’s also a greedy and fearful little bugger, Mr. Average Investor.  Usually, he wants to possess more, MORE dollars! But every so often he panics and does crazy things to protect the dollars he still possesses.  Within that dichotomy the seeds of his portfolio’s undoing are sowed.  Whether or not it’s a good idea to make a long term investment in the stock market, buy-and-hold is a style of investing that isn’t even appropriate for his true psychological makeup.

    It’s probably a subject for a separate, more philosophical piece, but we’d probably all be much better investors if we didn’t care so darn much about money.

    Yikes.  I think I just blew my mind.

    Seeya next week, friends.

    —-

    A few brief postscripts

    I know I linked above to the lousy film, 21, which was a much better book than movie.  If you’re looking for a great film about gambling, check out the way-under-the-radar 1998 thriller, Croupier, from Mike Hodges and starring Clive Owen before he was Clive Owen.  It’s low budget and very British, but if you a) appreciate excellent writing & filmmaking, b) enjoy film noir, and c) are fascinated by both the practical and psychological aspects of gambling, I’ll guarantee your satisfaction.  It’s a favorite of mine for those exact three reasons.

    croupier2

    If you agree or have some hate mail, lemme have it at feedback@thedraconian.com.

    You also might get a kick out of knowing that our firm’s founders spent their college years in the casino, “researching” ways to beat the house.  In addition to their success at blackjack, they famously broke the roulette wheel one of the local casinos.  The old wooden wheel had some physical imperfections, and after months of watching and collecting data they noticed that certain numbers did in fact come up more frequently than others.  The wheel’s distribution wasn’t random.

    They organized a betting team, put their plan into action, made a bunch of money, and then got chased out of the casinos.  We’re pretty sure that Deane & Bruce and their buddies were the reason for the entire state of Nevada pulling its wooden Roulette wheels from the casino floors.

    Unlike gambling, investing is serious business.  But today, nearly all of the trading and investing we do is based on the general idea of taking risk when the odds are in our favor and passing when the odds are against us.  We don’t win on every trade and every investment, but over the last several decades, it’s worked out pretty well for us.

    It makes for a colorful heritage, too.




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    Disclosure: No positions

    Disclosure: No positions
    Dec 16 2:26 PM | Link | Comment!
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