Tom Armistead's  Instablog

The following chart demonstrates that CAPE has considerable explanatory power with respect to 10 year returns, provided the data used is from the modern era, which I define as commencing in 1987, the year of the first computerized market crash.

(click to enlarge)

The R2 is 0.78, high enough to get some respect. If data from prior periods is added, R2 declines significantly. I believe the explanation lies in the combination of more stable monetary policy and quicker communication of data.

Disclosure: I am long SPY.

Speculative value can be problematical during market declines. My position in Hartford Financial (HIG) has been developing poorly, and a review of its behavior during the 2008-2009 crisis makes it suspect if the going gets really ugly over the next several months.

Meanwhile, I saw an article by ZetaKap, a screen directed at companies that have high quick and current ratios, and are trading at low P/E's. Of the six stocks mentioned, I own two - Corning (GLW) and Power One (PWER). I previously owned another - Entegris (ENTG) - briefly but profitably.

I wrote the stock up favorably at the time, mentioning a diagonal call spread which proved to be profitable.

Today, with shares at $7.56, I did the following vertical call spread on ENTG:

Sold 10 ENTG Nov 17 2012 7.5 Call @ 1.02

Bought 10 ENTG Nov 17 2012 5.0 Call @ 2.82

At a net debit of $1.80, there is a profit of 70 cents if the stock stays above $7.50, for an IRR of 85%. Break-even is $6.80. With implied volatility at 51.09%, there is a nice combination of volatility and margin of security, due to the excess of current assets over and above what is required to operate the business in a prudent and orderly fashion.

Three year average EPS is 73 cents. Applying a P/E of 12, I get $8.76, to which I add $2.32 for current assets above a 2:1 current ratio, arriving at a target price of $11. The 52 week high is $10.58.

I also closed out a diagonal call spread on HIG, locking in a loss. I completed my transaction log for the trade, finding that I lost money at a -43.8% IRR. While painful, the options trade hurt far less than would have been the case if I had owned the shares. It amounted to $5.15 per share controlled, compared to $13.01 I would have lost by owning.

This type of switch makes sense to me. You don't have to get it back where you lost it. At (or near) market bottoms, there are many undervalued situations, and they aren't all created equal.

Disclosure: I am long HIG, ENTG.

Additional disclosure: While I closed out the HIG diagonal call spread, I'm still holding some TARP warrants, which are easier to manage in a down market.

As a Red Sox fan, I learned about the "eephus blooper" when Bill "Space Man" Lee used it. The eephus pitch is a long, high, excruciatingly slow junk ball that is particularly effective against power hitters.

There are a number of amusing anecdotes involving the pitch, including the 1946 All Star game when Rip Sewell, who perfected it, embarrassed Ted Williams, who asked for another chance. Sewell obliged, and Williams stepped forward into the ball (leaving the batter's box) and hit it out of the park. The umpire missed the call, although Williams later confessed to being out of the box.

Here's a link to a good article on the topic.

Investment Implications

Some, most notably Nouriel Roubini, see the turmoil in Europe, and the resulting decline in the US markets, as a slow motion train wreck. I see an eephus pitch.

This could be a long slow process, waiting for the ball to come down over the plate. Some hitters swing multiple times, and miss. Some swing so hard they fall to the ground, while missing the ball. Logically, it shouldn't be much harder than hitting a slow pitch softball.

The ball is drifting slowly toward the plate...

Disclosure: I am long SPY.