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We all do it, maybe because its in our nature to be pessimistic of the ‘obvious’ trends, or maybe its because we’ve been brainwashed into thinking that the only big gains to be made in the market are realized when you find a big move before it happens.  Whatever the cause, the root of the problem is that we often trade stocks in the wrong direction because we convince ourselves that what goes up must come down, or vice-versa.

The point of this post is to convince you to stop this technique and embrace a simpler, safer one.  We should all be looking for stocks that have performed well over days, weeks, months, and have a reason to continue performing well.  Rather than buy a sideways trending stock, buy an upward trending stock.  Don’t assume that a falling stock is bound for a reversal - instead, convince yourself that an upward trending stock will probably keep trending up… at least in the short term.  Go for the easy trade, not the hard one.  The easy one is the one that is obvious and has a lot of supporting evidence.

To better illustrate this point (as simple as it is) let me present two examples.

First, a typical hard trade:  RIMM has been trending up for years now.  Its split multiple times, its price to earnings ratio is absurd.  All signals indicate that it just can’t sustain this kind of upward movement.  You convince yourself that a reversal is imminent and you buy Puts.  Wait, what??  Puts?? Why would you buy puts?  The stock has been skyrocketing.  The stock is surrounded by buzz and hype.  In order for this trade to win, either a huge amount of market sentiment jeu de poker a telechargerjeu de streap pokerregles poker holdemjouer video pokerforum poker en ligneguide poker en ligneworld poker tournamentapprendre a jouer au pokervideo poker onlinetelecharger poker holdtournoi de poker gratuitesregles poker pdfpoker gratuites macparty pokerles r�gles de jeu pokermalette jeu de pokerwinamax pokeryahoo france jeuxplay poker onlineplay 7 card stud onlinejeux gratuites poker texastournoi poker onlinesalle de poker en lignetournoi texas holdempoker en ligne argent virtueltelecharger gratuitement jeu de pokerjeux frtricher poker en lignestrip pokerjouer au poker parisjeu poker gratuites a telechargertelecharger poker starsregles du poker texasjeu poker tour gratuitesjeux poker en lignepocker texas holdemplay seven card studstreap poker onlinestrip poker en ligne gratuitesjouer au poker sans telechargertexas holdem rulesgagner poker en ligneregles stud pokerjeu de poker en francaisworld poker series tournamentjeux poker en ligne gratuitesapprendre poker gratuitesapprendre a jouer o pokerpoker totalement gratuitestelecharger jeux poker gratuites has to change or something really bad has to happen.  You’re trading pessimism in an obviously hopeful, euphoric environment.  That’s a huge stretch.

Second, an easy trade:  RIMM has been trending up for years now.  Its split multiple times, its price to earnings ration is absurd.  Another split is coming up.  Trade it.  All evidence is indicating that, irrational or not, the stock is going up and will continue to do so (at least in the short term).  Make a short, 10-20 day trade on the stock, trying to capitalize on the trend line that the stock appears to be following.  It’s even better if you wait for a short term pull back to get in, then you can try to maximize your profits.

In the first example, we were trying to capitalize on the unsubstantiated, small chance that something bad will happen or that market sentiment will suddenly change.   In the second, we were just riding the tide.  While the potential upside for the first trade is undoubtedly much larger, the potential down side is as well.  We’re investors and traders, not gamblers.

So, how do we build a strategy around this?  Keep up with stocks that are splitting in the next couple months.  Disregard anything that doesn’t have an apparent trend on both the weekly and daily charts.  Establish a trend line and look for short term pullbacks or bounces to use as entry points.  Usually this type of trade can be successfully performed over the course of 5 to 10 days.  Only look to make as much as the trend indicates you should be able to.  A good stock to look at as an example of this technique is MedcoHealth Systems (MHS).  The stock has a strong weekly and daily trend, its moving up despite the general market trend, and its moving into a split.

Happy Trading.

Introducing Quant’s Law

GODWIN’S LAW — more a theory than a law — speaks to the inevitable half-life of debate on the internet. Per Wikipedia, Godwin’s Law states the following:

As an online discussion grows longer, the probability of a comparison involving Nazis or Hitler approaches one.

The natural corollary to Godwin’s Law is that, as soon as Hitler or the Nazis pop up, the debate is effectively over. Whoever resorts to the cliché first is the automatic loser, being clearly void of anything more intelligent to say.

In that spirit — and in light of the latest Wall Street disaster — we propose the following “Quant’s Law.”

Whenever a quantitative fund manager makes reference to a “100 year storm (or flood),” a “10,000 year event,” or an “X standard deviation occurrence,” where X is any double-digit number, the probability of devastating financial loss approaches one.

Corollary to Quant’s Law: In the financial markets,”10,000 year events” generally occur every 5 to 7 years.

The inspiration for Quant’s Law comes from David Viniar, Chief Financial Officer of Goldman Sachs. In reference to the spectacular multi-billion-dollar meltdown of two quant-driven Goldman funds, Mr. Viniar made apologetic reference

to “25 standard deviation moves, several days in a row.”

Twenty-five standard devations, hmm. How to put such a wild statistic in perspective?

Well, considering it only takes three standard deviations to cover 99.7% of the bell curve, we unscientifically estimate the likelihood of a twenty-five standard deviation move to be on par with Britney Spears getting elected President of the United States.

Hit me baby one more time.

– defo

JPMorganChase:

Lehman Brothers:

Merrill Lynch:

Morgan Stanley:

Goldman Sachs:

And the crowd favorite, Bear Stearns:

Bear Stearns is getting hit the hardest after announcing that two of its largest hedge funds collapsed due to leveraged positions in subprime CDOs. The question in my mind is not whether these stocks will recover, but how and when they will collapse.

Take a look at these banks’ earnings per share from 1996 to present:

source: Valueline

Profits at these banks have shot through the moon since 2003, mostly due to inexpensive credit (think: fed funds rate down to 1% in 2003/2004) and the mass development of securitized derivative products. Who will buy these products now that the market is spooked (think: subprime mortgage products are just the tip of the default iceberg) and borrowing is much more expensive?

The answer, probably, is no one. From what I understand, there were no bids to buy Bear Stearns’ subprime mortgage securities. No more sales equals no more profits. And with American Home Mortgage (AHM) stock plunging 90% on news that they can’t pay their creditors, it’s unclear how much credit risks these banks face.

The banks are trading at P/E’s of 7-9, which seems affordable unless you consider that their earnings may soon be cut in half. Many of these stocks had earnings decline by 50% in the tech bust, and I’m thinking that the housing/credit bust will be around the same magnitude.

I was lucky enough to have bought a Bear Stearns put option two weeks ago after the hedge fund announcement but while the stock was still at $141. I sold it on Friday into the news of Bear Stearns’ stock being downgraded by S&P.

The question in my mind is how to keep playing this. I’ve been waiting for the big banks to turn, and now they’re doing it. I’m convinced that they’re going to drop by 25-50% in the short to medium term (1 month - 2 years?).

Will they (a) continue to crash, (b) hit a short-term bottom and then proceed downward, or (c) turn around for one last bull-charge before collapsing?

The other question is which banks will get hit the hardest. I think the whole sector will be damaged if market sentiment really changes, but who knows which banks will end up in the hurricane? Bear Stearns is definitely a sinking ship, but you never know which banks might survive and thrive.  It seems unlikely to me that any will survive and thrive in this environment, but I won’t rule it out.

If Bear Stearns recovers up to $120, I’m definitely buying more puts. My instinct is that a Goldman Sachs put could be a winner but I’m nervous that market sentiment may fail to turn on such name recognition.

Do you really think Bear Stearns was the only bank to have so much leverage in their hedge fund? I sure don’t…

I’ll be following the banks closely and may put something on tomorrow if the timing seems right.

- defo

“…the sell-off the past couple of weeks has brought the market back down in line with the fundamentals. ”

“The sell-off the past few weeks is not an overreaction to credit concerns that creates another buying opportunity. It is a reasonable re-assessment of what had been unrealistically optimistic hopes for stronger economic and earnings growth in 2008.”

“A full blown credit crunch is unlikely, and we are therefore not adopting a bearish outlook for the stock market. But credit conditions have indeed tightened. ” –Briefing.com’s Dick Green

What we experienced last week was an appropriate reaction to the frenzied gains we’ve seen over the last few months. What we will be experiencing over the coming months is a sideways to down market with moves in both directions, but a primarily downside bias.

I stand by my view that the trickle down effect of rising energy costs and decreased availability of inexpensive credit will put more and more pressure on consumers, forcing them to begin scaling back on spending. These factors combined with the slump in the housing market will begin to hurt the general market with the non-necessity markets being hit first (retail, technology, home improvement, etc).

2007 Weekly Dow Jones Industrial Average

1997 Weekly Dow Jones Industrial Average

It doesn’t take long to see the similarities.  Now, lets take a look ahead into 1998…

So, volatility ahead?  I feel strongly that we are going to be sideways to down for the rest of the year, but that this winter may bring more record breaking days.  Whatever the case, its interesting to observe this kind of correlation in years.

Hussman’s funds take risk in two ways. First, they buy/short US equities that they think will outperform/underperform. The fund’s top ten holdings are as follows:

Top 10 Holdings

Security	% Net Assets	Cost Basis
Coca-Cola Company (KO)	2.44%	48.00
ExxonMobil Corporation (XOM)	2.30%	75.45
Johnson & Johnson (JNJ)	2.25%	60.26
Kellogg Company (K)	2.18%	51.43
Nike, Inc. B (NKE)	2.16%	106.26
Archer Daniels Midland (ADM)	1.99%	36.70
Nokia Corp. (ADR) (NOK)	1.94%	22.92
PepsiCo, Inc. (PEP)	1.94%	63.56
Campbell Soup Company (CPB)	1.89%	38.95
GlaxoSmithKline plc (ADR) (GSK)	1.87%	55.26

source: http://finance.google.com/finance?q=HSGFX

The second way the fund takes risk is by varying it’s exposure to the overall market. When the fund is “fully hedged”, the fund should not lose or gain value from an overall market movement. When the fund (or some fraction of the fund) is unhedged, the fund’s value is affected by overall market moves. Hussman varies the fund’s exposure based on a “Market Climate” assessment, which includes measures of valuation and short-term market movements.

Essentially, the fund takes more market risk when conditions match historically good times to do so and takes less market risk when conditions match historical times when risk has not paid off.
Hussman has a Ph.D. in Economics from Stanford and was a professor at U Michigan for a while (that’s probably why I like him). In addition to managing his funds, he writes a weekly column that I’ve been reading for about 6 months now. He’s been trying to tell people that the U.S. stock market is overvalued for some time. At the present, his funds are fully hedged, meaning that Hussman does not want to take *any* market risk. The hedging has cost his shareholders a bit in the short run, but his analysis claims that the stock market gains of late are not worth the market risk.

His article, A Who’s Who of Awful Times to Invest, compares today’s market conditions with 7 previous market times:

December 1961 (followed by 28% market loss over 6 months)

January 1973 (followed by a 48% collapse over the following 20 months)

August 1987 (followed by a 34% plunge over the following 3 months)

July 1998 (followed abruptly by an 18% loss over the following 3 months)

July 1999 (followed by a 12% loss over the following 3 months)

December 1999 (followed by a 9% loss over the following 2 months)

March 2000 (followed by a 49% collapse in the S&P over the following 30 months)

The defining characteristics of these instances were:

1) price/peak-earnings multiple above 18

2) 4-year high in the S&P 500 index (on a weekly closing basis)

3) S&P 500 8% or more above its 52-week moving average (exponential)

4) rising Treasury and corporate bond yields

Depending on how we define the interest rate trends, we can include two additional historical instances of these conditions: October 1963 and May 1996, both closely followed by 7-10% corrections.

One more instance completes the list: July 2007.

…

The article doesn’t claim to be calling a market top or trying to predict the short-term future. But he is claiming that the stock market has historically performed terribly when market conditions look like they do today. And that’s the important take-away.

Here is a key passage:

…

 

In any event, the fact is that current conditions fall into a fairly narrow sliver of historical experience, but one that has enough observations to draw clear conclusions. That conclusion is that overvalued, overbought, overbullish conditions (even short of the unusually extreme ones listed above) have resulted in market returns below Treasury bill yields, on average. Our strategy is not to try to predict whether the current instance will be different. To admit that there is risk is to admit that there is a range of possible returns, some better than the average, some worse. But an average outcome below Treasury bill yields, and risk to boot, is not a good combination. Consistently taking risk in such environments provides no long-term edge, only volatility.

 

Our strategy is to align ourselves with the prevailing return/risk profile of the market, knowing that there will be many, many attractive periods in which to accept market risk, and that these periods have historically provided more than enough opportunity to capture strong returns over the full cycle, with subdued risk (see the remarks of recent weeks for some instructive examples).

 

Frankly, I don’t know whether investors will drive the market even higher in the weeks ahead. My opinion is that whatever gains emerge (and indeed, much of what has already emerged) will ultimately prove quite temporary. What I do know is that certain factors have reliably identified egregiously bad times to accept market risk, and that every historical instance similar to the present has been a disaster. The current instance may very well prove to be the exception, but I do not invest shareholder assets on the hope that the future will be entirely at odds with all available historical evidence.

…

Then again, Hussman and I probably have too “academic” an outlook for the stock market anyway…<sigh>.

– defo

This Time It’s Value Traps
John Rubino
6/13/2007

Most financial bubbles are pretty easy to spot: An asset class climbs way beyond what old-fashioned valuation measures used to define as reasonable, market participants start acting like idiots, and pundits rationalize the madness with learned “new era” theories. Think late-90s tech stocks or California houses in 2005 or today’s Shanghai stock market. This kind of bubble announces itself loudly, making it easy to ridicule and/or bet against.

But today’s U.S. stock market is a different, trickier, far more dangerous kind of bubble, because the stocks that are wildly overvalued actually look pretty cheap by traditional measures: Banks and brokerage houses at 12 times earnings, homebuilders at 1.5 times book, retailers at 1 times sales. In terms of historical trading ranges, there seems to be nothing here to get excited about.

But look a little closer and you see that these are classic “value traps,” stocks that seem cheap but are actually wildly overvalued because their underlying earnings, book value, dividend yield or whatever are artificially inflated. Value traps are common at the end of long expansions, when corporate earnings have spiked because of supply constraints, but stocks haven’t, as investors begin to suspect—rightly—that demand is about to slow, thus compressing profit margins and sending earnings off a cliff. Hence the juicy-looking valuations.

…

Despite the fact that the US stock market is at one of its highest P/E levels in history, the real danger here is in the artificially high company earnings that underly the inflated prices. Stocks look cheap when in fact they are expensive.

Let’s take a look at a few examples. The data below come from Valueline, Yahoo! Finance, and Marketwatch.

==================================================

Example 1: KB Homes (KBH)
Stock price: $42.18
Earnings per share: $4.13
P/E: 10.21
Price/Book: 1.31

On first glance, KBH looks like a steal, trading nearly 50% lower than its peak price of $83.45 in July 2005. Its P/E and Price/Book also both look reasonable. But let’s examine some key company statistics for the last ten years:

Sure, the stock looks cheap now at a P/E of 10.21, but it is not unreasonable that earnings might drop 50% or more in the next few years, especially given the record high housing inventory on the market right now. If earnings per share drop to the 2008 Valueline estimate of $1.55, the current price of $42.18 will produce a P/E ratio of 27.21. Who is going to want to hold KBH at a P/E of 27.21?

Pick your favorite home builder stock and the analysis looks pretty much identical. Home builders will be a bargain at some point in the next few years, but we’re nowhere near the bottom yet.

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Example 2: Goldman Sachs (GS)
Stock price: $225.89
Earnings per share: $21.43
P/E: 10.54
Price/Book: 2.79

Goldman Sachs is the 200-pound gorilla that leads a financial sector that contributes 28 percent of the S&P 500 income. I wouldn’t want to bet against the smartest minds in the business, but then again, nobody expected Long Term Capital Management (LTCM) to blow up either.

Check out the revenue and earnings growth in the past 4 years. Incredible!! But is it sustainable?

Most definitely a large part of this can be attributed to a growing securitized derivatives market, increased leverage, and a robust broader financial sector. Say what you will about Goldman Sach’s brand name, but the earnings per share dropped by a third in the 2001 recession. If the US economy experiences a similar recession in 2007 or 2008, GS earnings (and stock price) could easily drop by 50%.

Pick your favorite investment bank and the analysis looks almost identical. It seems unlikely to me that Goldman can double or triple company earnings again like they’ve done in the past few years, even if the economy stays strong. As for the downside risk, I think it’s much bigger than most people realize.

==================================================

Example 3: J.C. Penney (JCP)
Stock price: $74.11
Earnings per share: $5.13
P/E: 14.45
Price/Sales: 0.83

Ahhhhh, J.C. Penney, a retail favorite. This stock certainly has name brand recognition, but it by no means has the market power of a Goldman Sachs. Let’s check out the last decade of company earnings:

Look how much earnings suffered after the dot com bust in 2000. Why? It’s easy to spend money at J.C. Penney when you’ve got hundreds of thousands of dollars in tech stocks in the bank. But once you realize that your tech stocks aren’t worth as much as you thought, it’s just as easy to cut back on your retail shopping. Earnings per share fell 90% from 1999 to 2000, and the stock price fell 70% in the same time period.

Currently, we’re at the tail end of a housing boom that has had a similar wealth effect for consumers. With a few hundreds of thousands of dollars of home equity, who needs to save? Let’s spend money at J.C. Penney instead! But a negative national savings rate and home equity rapidly disappearing will eventually catch up to the American consumer. And the impact on JCP earnings? Kerplunk!

The artificial explosion of earnings for J.C. Penney has been even stronger in the housing boom than it was in the tech boom. The JCP stock price has more than tripled since it’s July 2003 low. Is it just me, or do things look eerily like 1999?

==================================================

So what is the point? Not only is the stock market expensive relative to earnings, but even the earnings themselves may be temporarily bloated. Rubino’s value trap analysis is right on the money, and it represents a greater risk than most stock investors realize.

– defo

data from www.marketwatch.com

A few comments:

[] The stocks listed above are ordered by P/E ratio, but if I were listing them in terms of investment potential, I’d probably list Google, Apple, and maybe Mastercard at the top and Amazon, Bankrate, and Priceline at the bottom.

[] Did I miss something with Amazon’s stock lately? The company releases a single good earnings report and the stock takes off like a rocket ship. Welcome to 1999 but 8 years later. Amazon has been around for too long not to be making greater profits. Unfortunately, this company will never live up to the expectations required to justify a P/E ratio of over 100.

[] And Priceline? Sure, the stock costs less than it’s Nasdaq-bubble peak of $1,000 a share, but it’s still 47 times earnings, with the stock price doubling in the past year. Does anybody really think this company is a long-term winner?

[] Who cares about P/E ratios? I certainly do. In my view, a P/E ratio higher than 30 can only be justified by a small minority of companies for whom future earnings are likely to greatly exceed current earnings. While it’s true that some of the companies above may fit this description ex-post, the majority of them have future earnings paths too unpredictable to justify such an extreme P/E.

Earnings ratios may not matter for short-term market trends, but when the music stops you’d better be holding stocks that are backed up by real profits. If not, there’s no telling how much prices can fall.

[] I’m still not a buyer of Google, even though I think it’s a great company. Even if Google earns spectacular earnings growth for the next 5 years, the company stock price still won’t be justified in my mind. Call me when the P/E ratio is down below 20.

[] I commented on possibly shorting RIMM in March when it was trading at $135. The price has since risen 20% in three months. Does that mean I was wrong to think the stock price was too high? Maybe, maybe not. The timing of these things is very difficult. But I do know that unless this company’s earnings shoot to the moon, the price will come back to earth eventually.

———————————————————————-

I’m going to be following these stocks closely in the weeks and months to come. At some point, it will be time to take some short positions on them. Ryan is seeing indicators for a short-term market correction, so maybe that time is sooner than later.

- defo

I could be wrong, but I figure I’ll draw a line in the sand and see if I’m right.