Wednesday, December 30, 2009

The Two Secrets to Successful Market Timing

Many so-called experts would have you believe that it's impossible to "time" the markets.

That's just not true.

There's actually a secret to market timing. It's not just a matter of the economy. It's a matter of how perception and collective psychology gauge the risk of realizing a real profit - doing so with shifting economic conditions as the market's backdrop.

This works for all the markets, including stocks, bonds, commodities, precious metals and currencies.

Look back to 2007-2008 and you'll see that a handful of players got the "timing" right and made billions of dollars. Ever heard of John A. Paulson? He made what is being called the "greatest trade of all time." His hedge fund shorted the sub-prime market and raked in some $15 billion. Paulson's take was a little less. He personally pocketed $4 billion - the equivalent of $10 million a day for the relatively short stretch it took for this trade to play out.

While you wouldn't have been able to amass the capital, leverage, structured positions and risk tolerance of Paulson & Co., you could have seen what Paulson saw, and made a killing. At least you could have saved your portfolio by going to cash before what was already a bad situation got a lot worse.

As for the rally in stocks that started back in early March, there have been plenty of big winners. Goldman Sachs Group Inc. (NYSE: GS) is raking in record profits. Several hedge funds made back their losses and are gearing up both for major profits and for a resumption of the coveted performance fees they'd grown used to collecting until the financial crisis hit.

There's no reason for you to have missed this rally, either. How much you would have made, again, has to do with your personal allocation of capital and tolerance for risk. But if you had employed a "timing" strategy, you would have effectively purchased a seat on the gravy train.

Using the aforementioned examples, let's look at how to generally time market entry and exit opportunities and see how you could have called the housing collapse and correctly timed the March rally.

The tipping point for Paulson & Co. was an analysis of how far housing prices had skyrocketed from historic growth rates. Paolo Pellegrini, Paulson & Co.'s brilliant analyst, also determined how far prices had to fall, or "regress," to get back to their historic norms. And while Paulson was early to the trade - and was actually able to add to his positions even as they initially went against his fund - you didn't need to catch the very top of this play to reap the resultant windfall.

In fact, the No. 1 lesson of market timing is this: It's never a good idea to try and time tops and bottoms.

Leave that to the swing-for-the-fences professionals whose careers prepare them for such risk-taking. Joining the party after it's already started - and then riding along as the trend strengthens and plays out - is a lot safer than being hopeful your mere presence will attract a crowd.

Timing requires a big-picture, top-down perspective. Here's how I look at the big picture: Identify the largest constituent elements that move the stock, sector, industry or economy you are measuring. For housing, I look at the availability of credit, the cost of credit, the trajectory of growth, and the sustainability of those trends.

In 2007, I used Countrywide Financial Corp. and IndyMac Bancorp. Inc. (OTC: IDMCQ) as proxies for credit availability, and I used interest rates on adjustable rate mortgages (ARMs) and the profitability of big banks as a proxy for the cost of credit. I followed the trajectory of growth around the country simply by reading the real estate sections of newspapers. By the fall of 2007, it was easy to see strains on the proxies I was watching, even though closer to home everything looked rosy.

Both Countrywide and IndyMac faltered. That told me there was a problem with the sustainability of credit extension, especially in the subprime-mortgage market where both had made a giant push. You didn't need to read their balance sheets or income statements, the newspapers were full of telltale stories. There was plenty of evidence that teaser rates were giving way to higher rates and strains were developing on borrowers.

At the same time, big banks were having a harder time syndicating and selling off covenant-lite debt pools of leveraged loans. And there was plenty of noise about banks' shaky structured investment vehicles (SIVs), created to finance and hold risky mortgage-based assets off of their balance sheets. It became obvious that none of the trends that propelled housing were sustainable. You could just have easily seen it, too.

The tipping point for me was a couple of big quarterly losses at Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). The ultimate proxy for the entire housing market was flashing red; it was time.

No, I didn't catch the top. But, I told the readers of my blog to get out of the markets entirely and into cash in February 2008. Not cash proxies like money market funds. I mean cash.

If you were employing a timing strategy, even if you missed the exact turn - as I did - you would have locked in built-up profits, as opposed to losses.

You do that by applying the second lesson of timing: Because no one has perfect timing, a timing strategy requires investors to place profit-target orders and stop-loss orders across their portfolio holdings.

Lots of you had soaring profits in the run-up to late 2007. And even if you employed a "dance-‘till-the-music-stops" strategy, if you didn't take profits and didn't have stop-loss orders in place, when the music did stop you fell on your rear.
The lesson here is that exact timing is impossible. But profitably timing your exits is a simple matter of emphasizing prudence over greed.

In 2007, investors put little stock in a collapse of the housing market. That was evidenced by the tiny risk premiums investors were demanding on housing-related debt. By March 2009, quite the opposite was happening.

Perception and psychology had certainly changed. The perception that we were headed over a cliff and the collective psychology to avoid any further pain created a giant spread in the risk premium investors applied over non-existent growth prospects. And again there was a flashing light that market timers saw as a beacon.

While I can't speak for the other market timers that got it right, I can tell you that although I missed the exact turn, I am on the record in calling for a strong rally from the end of March.

My timing lights were flashing because the risk premium (implied perception and psychology) for holding financial assets had created a spread so wide that even the hint of potential profitability would trigger a rally. It looked like it may have started, but I needed a macro model to analyze the whole market.

I used a simple supply-and-demand equation to stress test the timing of my desire to re-enter the market. My proxy for "supply" was the actual level of shares outstanding in the market (a level that had fallen dramatically over the previous decade) - and their newly cheaper prices. My proxy for demand was cash on the sidelines and the difference between investors' holdings of short-term U.S. Treasuries before the crisis and those same holdings at the beginning of March.

At some tipping point, it was obvious that no matter what the perception and psychology actually was in the marketplace, even a few small waves of demand had the potential to swirl into an investment tsunami that would take prices higher. When I saw prices rising on increasing volume, I knew that successive waves would continue to lift prices, regardless of actual profitability or sustainability of corporate earnings.

Given what we've learned from these recent experiences, the question is now very clear: Where do we go from here?

Well, there are two destinations in the future. One is near and the other is farther on up the road. We need to discuss them both.

In the near term, good timing will be a function of the supply-and-demand equation. Stocks should go higher as more money comes off the sidelines and out of low-yielding U.S. Treasuries. Who knows how high the markets can go if retail buyers actually become buyers again?

Make sure to employ profit targets and reasonable stops. I suggest 15% lower than your point of entry.

Timing is more important when looking farther up the road. We're going to have to see real sustainable growth in profitability - well above the anemic levels that currently pass for robust when compared to the dark days of 2008.

Frankly, it's a race. Will an economic rebound generated by massive government stimulus make up for - and even surpass - the still-stalled engines of our consumer-driven economy? Or will weak fundamentals swamp a fragile recovery when government-support systems are dismantled?

As never before in the modern era, timing is going to be critical to investors. There will be no more dart throwing, no more sitting back and watching all boats rise with the tide. There will be no more one-way bets.
The nature of an increasingly global economy will show its own propensity for swiftly moving capital. And if investors don't become adept at timing, time will run out on their prospects for grabbing and keeping fleeting corporate profits, a key part of the march to amass truly permanent wealth.

Editor's Note: The Author Shah Gilani is a retired hedge-fund manager and a leading expert on the global credit crisis

Behind Financial Reform Lies Wall Street's Latest Rouse

Anti-Wall Street sentiment makes for a good cover, but behind the scenes and rhetoric, legislators are working with the country's largest financial firms to fashion a new system that concentrates even more risk and reward at fewer banks.

And what's more, the underlying socialization of the system will guarantee the success of excess with the full faith and credit of taxpayers.On Dec. 11, the U.S. House of Representatives passed the Wall Street Reform and Consumer Protection Act of 2009, which among other things, creates a consumer protection agency, strips the U.S. Federal Reserve of certain powers and subjects it to politicization, calls for big banks to finance a $150 billion bailout fund and gives the government power to break up or coddle financial firms as they see fit.The Senate will try and reconcile the House bill with an earlier version of its own bill. Legislators are hoping to have a final bill ready sometime in early 2010.

But, in a testament to the power of Wall Street, what's on the table is what works for bankers and the Street. The resulting de-facto socialization of American banking is nothing more than Wall Street's secret agenda to eliminate competition, grow bigger profit engines and rely on the perception of a socialized system to support cheap funding.

Tuesday, December 8, 2009

Time to Bank on the Brazilian Consumer

Hundreds of millions of Chinese citizens are on a crash course with the middle class.

A study from The McKinsey Quarterly supports this well-documented phenomenon, which estimates that it will take two decades before the Chinese nouveau riche reaches its full spending potential.

In turn, they're convinced that decades worth of profits are up for grabs.

I'm not about to refute that claim here. But instead, I want to caution you: Don't be blinded by the euphoria over Chinese consumers and overlook an equally compelling opportunity in another emerging market.

Let's head down to Brazil and I'll explain why - along with the best way to profit, of course...

Sizing Up the Profits in Brazil

Okay, I get that the scale of the Chinese opportunity - a population of 1.31 billion people, compared to Brazil's 192 million citizens - dwarfs Brazil's. But that doesn't mean the profit potential is any less.

On the contrary, in fact... I'd actually say it's greater when it comes to tapping into a blossoming middle class. In this regard, Brazil boasts several notable advantages over China...

  • It's a democratic nation, not a communist one.
  • Its population is much younger - the median age is 28.3, compared to 33.6 in China.
  • Brazil is far less reliant on exports. Only 14% of Brazil's GDP comes from exports, compared to 35% from China.
  • It already possesses all the natural resources necessary (and then some) to support its booming economy. Meanwhile, China needs to go out and gobble up foreign assets to ensure it can keep feeding its economic machine with enough oil, gas, coal, iron ore, etc.

But most important of all is the cultural difference. The Chinese are notorious savers, yet Brazilians love to spend, spend, spend. And don't just take my word for it. As Illan Goldfajn, Chief Economist at Brazilian bank, Itaú, reveals, "If the world is looking for savers, Brazil is not much good... But if it's looking for consumers, then we might be able to help."

Conspicuous Consumption, South of the Equator

Like China, Brazil's economy is also expanding at a healthy clip. GDP growth this quarter is expected to check-in at a tidy annualized rate of 9%.

As a result, unemployment is falling and incomes are rising. And that's leading to an explosion in the middle-class.

Over the last four years alone, Brazil's middle class has swelled by 24%, lifting roughly 20 million people out of poverty, according to Brazil's Census Bureau.

Furthermore, PriceWaterhouseCoopers Consultancy expects this rapid increase to continue. So much so, in fact, that it will propel Brazil's largest city, São Paulo, from the forty-sixth spot on the world's wealthiest city list to fifth place in a little over a decade.

Monday, December 7, 2009

Auto Sales – US, China and India

Auto sales are supposedly rebounding in the U.S. I’d love to believe it. It would mean this phony recovery is about to be replaced by a real one. But it’s not yet time to travel down that highway.

The official numbers aren’t in, but November sales should reach about 10.5 million (on an annualized basis). That’s still not close to the more than 13 million cars sold last year.

Besides, it’s just one month. And one month does not make a pattern.

But at least auto sales are over the 10 million mark, the level American car companies say must be reached in order to regain profitability. And, let’s not forget, it was done without the help of the “Clunker” program.

Auto sales are coming back more strongly in Asia. However, says Andy, they’re not great over there either...

“China’s auto sales this year are way up. Recent auto sales show 84% growth in September and 72% growth in October. Thing is, that growth probably isn’t real. I heard that state enterprises are buying fleets of cars they don’t need and parking them instead of driving them.

“If you have another explanation for why gasoline consumption is flat despite the jump in car sales, let me know."

“So Andy, I’ve got the picture. Buying the auto stocks at this juncture doesn’t make a lot of sense,” I said.

“One exception” said Andy.

“There is a potential game changer from India. It’s doing stuff that no other company has ever done. As a result, it’s created a huge market for itself without any competitors.”

“Pretty big market in India?” I asked.

“Last time I checked it was somewhere around 1.2 billion people. With a growing middle class, it’s not a pretty big market. It’s huge.” Replied Andy.

Dubai is emptying out

Dubai is emptying out,” said ted.

No, this conversation didn’t take place yesterday or the day before. It took place last February.

Yesterday, he e-mailed me an article he’d read back then with this note: “I warned you.” Here’s an excerpt...

“Police have found more than 3,000 cars outside Dubai’s international airport in recent months. Most of the cars – four-wheel drives, saloons, and ‘a few’ Mercedes – had keys left in the ignition.

“‘Every day we find more and more cars,’ said one senior airport security official, who did not want to be named. ‘Christmas was the worst – we found more than two dozen on a single day.’”

That, of course, was last Christmas.

Under Sharia law, bouncing a check is a serious crime. Dubai routinely jails deadbeats. Hence, the mad rush out of town by the expat owners of those cars who’d been living beyond their means.

I couldn’t let Ted’s message go without asking him if there were any more Dubais in our future. This is what he told me...

“I expect serious debt problems from about a dozen nations. The three most serious ones should come from Russia, Ireland, and Latvia.”

Then Ted dropped this bombshell...

“Down the road, even wealthy countries like the U.S., the United Kingdom, and Japan could have trouble repaying their debts once interest rates start going up.

“Besides the governments, I’ll be shocked if we don’t see one or two more corporations with supposed backing from their governments asking for relief. And that’ll do then what the Dubai situation is doing now: raising the price of gold as investors seek shelter from the storm.”

Strategies to prevent losses in this Bull Market

As I write this morning, the S&P 500 pushes toward another 52-week high. And I'm seeing a lot of bullish indicators hit the wire...

~ U.S. employers cut the fewest number of jobs in November since the recession began more than a year ago. Payrolls fell by only 11,000 workers, trumping even the most optimistic forecasts.

~ The jobless rate was expected to hold steady at around 10.2%. However, it surprisingly declined to 10%. (Hey, in this economy, that 0.2% means a lot!)

~ U.S. factory orders notched its sixth gain in the past seven months, also surprising forecasters. The data gives bulls their proof that the manufacturing sector is beginning to emerge from the storm.

~ Bank of America (NYSE: BAC) just raised $19.3 billion - at $15 a share - in the largest sale of stock by a U.S. public company since the dawn of the millennia. It's been nearly 10 years since we've seen a successful sale of that magnitude.

Like a dog getting out of the ocean, the market's current reaction to bad news is to simply shake it off and run onto the next thing.

Dubai can't pay its bills? No worries - the market immediately recoups its one-day losses.

Government spending set to increase even further to pay for healthcare reform and more troops in Afghanistan? The Dow tacks on another few hundred points.

Tiger Woods' wife goes upside his head with a 5-iron? Tiger is the biggest celebrity endorser of Nike(NYSE: NKE), yet the company's shares remain unaffected.

Even weak companies have shuffled up to the trough and are getting fat. Take financial firm Zions Bancorp (Nasdaq: ZION), for example, which has more than doubled since March. Same goes for shares of poorly run retailers like Sears Holdings Corp. (Nasdaq: SHLD). Even Continental Airlines(NYSE: CAL) and other beleaguered airlines, which are hemorrhaging money, have also posted 100%-plus gains from the lows.

The situation reminds me of the hobo fantasyland in Harry McClintock's "Big Rock Candy Mountains" song. But instead of free hooch, food and handouts, the market is dishing out gains indiscriminately.

Here's what you can do to participate in the upside, while also protecting yourself in case the party gets messy...

Survey results showed that 50.6% of advisory services were bullish, versus 17.6% that were bearish. There were 2.88 bulls for every bear. To put that in perspective, the 39-year average is 1.73 bulls for every bear.

The last time the reading was this high was October 17, 2007 - one week after the market topped out.

Back then, we were swimming along, aware of what dangers lay beneath the surface, but naively ignoring them. As long as we couldn't see them, we couldn't be hurt, many people thought.

Sound familiar?

Just two years later, after the housing and credit crisis reared their ugly heads and extracted many tons of flesh, it's ludicrous to not at least acknowledge that we could be in for some trouble ahead.

Question is... How do you prepare for it?

Three Ways to Protect Gains and Grab Big Upside

Here are three ways to play defense and attack the market at the same time...

~ Tighten Your Trailing-Stops: When you've got gains of 78% on one stock and 37% in another, you'd be foolish to let them evaporate.

If you have winning positions in your portfolio, be sure to place your stop level at least at your entry price, so you won't lose money. And if you already have stops in place that are pretty generous, you might want to consider tightening them up, particularly if the stocks are not especially volatile.

~ Buy LEAP Options: LEAPS are options that have expiration dates of a year or more into the future. The great thing about LEAPS is that they allow you to control shares for a fraction of the price you'd pay if you bought the shares outright.

For example, let's say you're bullish on Apple (Nasdaq: AAPL). At the current price, you'd have to shell out $19,700 (plus commissions) to buy 100 shares. Alternatively, you could buy a January 2011 call option with a strike price of $200 for $32.30. That means you can control those same 100 shares of AAPL for just $3,230 instead of $19,700.

The difference is that with the LEAPS, you only control those shares until January 2011, whereas if you buy the stock itself, you own them indefinitely. Just like a stock, if the price of AAPL rises, your LEAP options should, too. And if AAPL declines, so should your LEAPS.

~ Sell Put Options: Selling puts is an excellent strategy when you're looking to own a stock, but want to do so at a lower price than it's currently trading. By selling put options on the stock at a certain strike price, you're selling the right for someone to "put" (or sell) the stock to you at that pre-determined price.

Let's say you like (Nasdaq: AMZN), but at $145, you think it's too expensive. However, you'd be willing to buy it for $130.

In this case, you could sell the July 2010 $130 puts for $13.20. That means you'd receive $1,320 in your account for the right to have 100 AMZN shares sold to you for $130 by July expiration.

If the shares remain above $130, it's very unlikely that you'll have to buy the shares, and you simply keep the $1,360. But if AMZN shares dip to $130 or below, you may have the stock sold to you at $130. But remember, you've already collected $13.60 per share from selling the put option contract, reducing your buy price to $116.40.

Selling puts is an excellent way to invest in any market - but particularly one that's overheated. It reduces your risk by only getting you in the stocks that you want if the price falls to your chosen level. It also generates income while you're waiting.

I suspect that at some point in the not too distant future, we're going to see a sizeable market correction. But that doesn't mean you should sit on the sidelines and watch it happen. You can be proactive - and the three strategies above will reduce your risk, while still letting you participate and giving you the opportunity to make money.