What a crazy, crazy week!
So far, we did a whole lot of work just to get back over Monday's open, now we'll see if we can hold positive for the week and it's going to be tough, judging from the pre-market trading. We were loving the drop yesterday as it pumped up our ultra-shorts and gave us a chance to do some more bottom fishing, getting back to our low buy targets on many of the trade ideas I've been posting all week. As I said about X to members on Wednesday morning: "They are going to keep insisting on selling you US Steel at $40! $39.30 was the low, $195 was the high. If you really believe that the global economy is dead for the rest of your life then stay away but, otherwise, you can buy it at $40 and $20 and $10 and end up owning it at an average of $23, which would be a market cap of $2.5Bn on a company that makes about $800M a year. Since Nov $40s are $7.80, I really like picking this up at $40 and giving it a chance to bounce (you can always sell the $35s, now $10.60 if it breaks below $40)."
The covered call strategy takes advantage of the crazy option premiums in this crazy market. We are not calling a bottom per se on the market as we scoop up stocks at the 40% and 50% off mark but we are taking them with an additional 15-20% discount from here (buying X for $40 and selling the Nov $40 call for $7.80 puts you in the stock for $32.20) and we have the expectation, even if X drops another 25% to $30 next month, that we will be able to sell $5 Dec $30 calls to lower our basis to $25, then $21, then $17. Of course a very steep drop can still hurt us but there has to come a time where you step in and say "Yes, I am willing to own US steel at $30 and, even if it's down at $20 for some time, I will hold it for years."
Realistically, even with the VIX at more normal levels and even if the X goes down to $6.50 like GM, you can still pick up .25 per month selling calls that are relatively out of the money (GM $10 calls are .29). That's a $3 annual return on your $30 commitment even if the underlying stock drops 80% on you from your $30 purchase. Cramer has been telling his viewers that you can't buy and hold anymore, and the recent market action does show that we have suddenly become a nation of day-traders, but our theory is that you can hold blue-chips and undervalued companies long-term if you look at them, not for the price of the stock but for the revenue stream that stock can generate for you over time.
In Wednesday's post I talked about picking up VLO at $21 – one of dozens of trade ideas we've been looking at this week. Well it opened at $21 and fell to $16 at it's lowest point on Thursday but so what? Even if you had entered right at the top, the pair to that trade was selling the Nov $20 calls, which were $4 so your entry would be $17 and those calls sold have already fallen to $1.80 while the stock is back at $17.50. If you are nervous, you can roll the call to the Dec $15s at $4.70, which drops your basis to $14.10, although much more likely to be called away at that price. But that's how quickly this strategy can give you a 33% discount on a stock that's already trading 70% off its highs. Could the bottom be even lower? Sure it could, VLO could trade down below $10 and that's why we have a balance of ultra-shorts, as they would do very well if the market was that catastrophic because the last 30% drop on VLO came along with a 20% drop in the Dow.
A 20% drop in the Dow would take us down 1,800 points. You can cover against a drop like that by allocating 20% of the VLO position value to something like SDS (S&P ultra-short) March $90s, which are currently priced around $17 but were $45 on the 10th. At $95, a 20% drop in the S&P would cause a 40% increase in the SDS ETF which would bring them to about $133, a very nice return on $95 puts! If the market begins to recover and gets out of danger, you can take them off and even a 30% loss on this position at 20% of the virtual portfolio is just a 7% fee for insurance that allowed you to buy stocks like VLO at what turned out to be a real bottom. Don't forget that if VLO does hold $20 and gets called away at our original sale price, it's a 17% one-month return!
So you can bargain hunt in this market if you pursue a hedged strategy and you can "buy and hold" if you are also buying and holding ETFs like the DXD or SDS, which will make you 200%+ returns when the market drops 10% (an almost daily occurence lately). Of course there are more complex strategies to wring a little more out of each side but those are the basics and I think it's just a shame to see people not willing to put a little money to work out of fear of an additional downside that may never materialize. We discussed using ultra ETFs way back on October 1st, in my original "Hedging For Disaster" post (although we started with the SKFs way back in early September) and boy did those ultras take off since then! Again, I'm not saying the market will not go down, but I am saying there are ways to guard against it and still participate in the upside when it comes, rather than after the fact!
With a 20% allocation, as suggested on 10/1, when we were pretty bearish on the market, the SDS March $77s at $9.95 are now $26.90. That would turn 20% of your virtual portfolio to 54%, offsetting a 37% loss to the other 80% of your virtual portfolio. The DXD Apr $55s were $14.20, now $32.30 – "just" a 125% gain but that would add 25% to your porfolio, offsetting a 28% drop in the 80% bullish side. So, between ultra-short hedges and covered calls, it CAN be safe to put your toes back in the water. For those of you new to options, you can check out the first chapter of Option Sage's EBook "Winning Stock and Option Strategies" or, for the reading impaired, there's also an introductory video from Stock and Options Training on the subject.
Warren Buffett is with me today, writing an Op-Ed piece in the NY Times in which he discloses that, despite all the economic gloom and doom "I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities." That is a very powerful statement from Buffett!
Buffett says something similar to what I"ve been saying to members since last week: "A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now. Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over."
"You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy. Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts."
Do not mistake what Buffett is saying for hitting the BUYBUYBUY button. You need to plan on doubling down on the Valero shares you buy at $17.50 when they hit $8.75 but picking some entries here on strong companies that you don't mind owning NO MATTER WHAT THE TICKER SAYS, is a prudent way to play these volatile markets.
Speaking of volatile: The Nikkei closed up at the 2.5% rule on a chopy session but the Hang Seng was having none of it and dropped 4.44%, saved by the bell from a 5% dip but still in the zone for follow-through on Monday and finishing this week just off the lows. On the bright side for the Hang Seng, 5% is only 676 points now, not the 1,000+ point drops we got when they were closer to 20,000! Chinese traders were admonished (ie. ordered) by the government to "curtail overseas speculation." Chinese companies licensed to trade in futures markets overseas should limit their activity to legitimate hedging, and avoid speculation, said Jiang Yang, assistant to the chairman of the China Securities Regulatory Commission. "The recent global credit crisis has caused sharp volatility in commodity futures prices, causing high risks for businesses," Mr. Jiang told senior executives of the 25 Chinese firms permitted to trade overseas, according to a statement issued by the industry watchdog. This is, of course, sending commodity prices plunging.
Europe is trading nothing like the US futures (9am) and they are generally up near the 2.5% mark as LIBOR rates, which were our first crisis indicator, have been steadily improving. Laurent Fransolet, head of market strategy at Barclays Capital, saw encouraging signs emerging. "Libor fixings have started to move down in all currencies and across all tenors, albeit not by much," he said. "There have been some signs of real money market players moving back into term unsecured lending," Mr. Fransolet added. The three-month rate now stands at its lowest since October 8, when central banks orchestrated emergency coordinated interest rate cuts. Meanwhile, the overnight rate tumbled to 1.66875% from Thursday's 1.9375%, edging closer to the Federal Reserve's Fed funds target rate of 1.5%.
Bush is actually right in his speech this morning. There is no instant fix but Buffett and I see signs of improvement that keep us out of the global depression camp. Significant action has been taken, even California was able to find $5Bn in funding yesterday, earnings are simply not bad enough to justify the discounts applied to the stocks. GOOG is a great example, already over the $360 target we set in yesterday's morning post. It's not all roses, Housing Starts are the worst in 17 years and building permits aren't being filed but THAT'S GOOD – we need to burn off inventory and we're not going to do that if we keep building homes!
We continue to let the levels be our guide and those 40% lines are 8,400 on the Dow, S&P 946, NYSE 6,232, Nasdaq 1,717 and the Russell 514. The Dow and the Russell held that line yesterday and recovered nicely while the Nasdaq finished EXACTLY at 1,717 (see Trader Mike's chart above) and the S&P finished EXACTLY at 946 – not bad for targets I set ahead of a very volatile day! It was the very poor performance by the NYSE that kept us in a bearish bias as they couldn't even get back over 6,000 after opening Tuesday at 6,600. The NYSE is our broadest indicator and we MUST have a broad-based rally to put in a good bottom.
So we will remain guided by our levels and looking for Nasdaq leadership confirmed by the NYSE retaking 6,232 but I'm not expecting too much ahead of the weekend although it is option expiration day when magical things can happen. We will continue to bottom fish until we get a confirmed breakdown at which point we will mattress our ultra-shorts as well as the usual index puts. On the whole – continue to be careful out there!
Have a good weekend,
– Phil
