Weekend Update – Are We Bear Yet?

October 1, 2011

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I have a fear of 2008 repeating, don't you?

Not so much from a portfolio standpoint, we can always hedge for the downside, but from an economic, end of America, end of the World as we know it standpoint. We survived the last Global economic collapse by plunging most of the Global Governments Trillions into debt yet all those Trillions went towards saving the top 1% (people AND Corporations), who promptly turned around and told the bottom 99% they'd better tighten their belts to pay down the debts they incurred.

Back in December of 2009, I wrote my "2010 Outlook – A Tale of Two Economies" where we discussed the early stages of the Wealth Transfer that was taking place from the bottom to the top as well as the bifurcation of the US Economy into one for the Rich, that was doing very well and one for the Poor – that would continue to get worse. I'm not going to get into the whole thing again, that's what archives are for and the most relevant quote from that post I will repeat here so we can move on with today's topic:

OK, liberal rant over now – I feel better having indulged my Dickensian side and identifying with the plight of the workers but workers don’t buy stock market newsletters so f*ck them, right? We are investors and we shouldn’t be worried about if it’s FAIR or RIGHT that we have established an economic engine that funnels the wealth of the nation to the top – if you are reading this article, then chances are you are on or near the top and our job is to figure out how to maintain or improve our position and my biggest failing of 2009 has probably been worrying about the long-term repercussions of impoverishing 295M people when really it’s just us (me and my 9,999,9999 economically close friends) that we need to worry about and we have jobs and money and assets and stocks so, once again – F*ck those people!

Yes it's very cynical but we have to be very cynical if we intend to dispassionately analyze the markets and pick up and discard stocks as if they were bridge cards. It does make me feel better to occasionally rant and rave about the injustices of the system but, as I noted almost two years ago – that's not what's going to make us money. More and more it is becoming clear that, in this country and indeed the World – you either have money or you are screwed. So it's our job to make sure we first – preserve our capital and second – increase our capital.

Back in that December of 2009 post I pointed out: "So let’s not kid ourselves that anything in this country is being done for the benefit of the 90% who serve us. We provide the basics and there are even many fine companies who can make money selling those basics like KO, MCD, JNJ, WMT… that we can invest in." Since that time, we have soured on WMT and JNJ – WMT because the poor have become so poor that they can't afford Wal-Mart anymore (and inflation is pushing their margins) and JNJ because they are essentially incompetent in the medical device division that keeps cranking out defective products that make them a ticking time bomb. Even so, WMT and JNJ are up 10% since Dec 2009 but MCD is up 60% and KO is up 30% – all winners using our standard buy/write strategy of buying stocks for a 15-20% discount to start.

IHI was our pick as a medical device ETF based on the macro view that Obamcare would drive 40M more people into the doctor's office where many of them would need testing and, while IHI was a nice winner (as were many of it's components) – we still haven't really implemented universal health care so the premise is blown and we've lost interest (however, Pharmboy has been knocking them out of the park with individual Biotech picks all year).

We also liked luxury goods and travel at the time but CCL, MAR, OWW, BID, etc. have already had their runs and are pulling back – some all the way back to where we started and we'll have to wait for this new wave of global panic to subside before we go speculating the way we did 2 years ago. In fact, we shifted our strategy on many of the stocks we liked back on August 23rd and began SHORTING some of the best performing stocks as they bounced back up to the top of our channel. That became our Long Put List and we triggered about a week later, on September 2nd, in our afternoon Member Chat, as the market began to seriously deteriorate and the S&P failed to hold 1,200. Those puts were (and the "was" price is the 2009 lows, "now" price was the price on 9/2):

AXP (was $12, now $48) Jan $35 puts are $1 – now $1.65 (up 65%)
BIDU we already did (was $11, now $139) Jan $61 puts are $1 – now $2.75 (up 175%)
CAT (was $24, now $86) Jan $62.50 puts are $2.30 – now $4.80 (up 108%)
CMG (was $40, now $307) Dec $200 puts are $3 – now $8.50 (up 183%)
DECK (was $15, now $86) March $50 puts are $2.30 – now $1.30 (down 43%)
FCX (who I like LONG, was $9, now $45) Jan $37.50 puts are $2.40 – now $9.10 (up 279%)
GOOG (was $250, now $522) Jan $300 puts are $2 – now $2.20 (up 10%)
IBM (was $70, now $167) Jan $110 puts are $1.05 – now $1 (down 5%)
ISRG (was $80, now $372) Jan $200 puts are $2 – now $2.20 (up 10%)
KO (was $40, now $70) Jan $60 puts are $1.12 – now $1.70 (up 51%)
MA (was $120, now $322) Jan $160 puts are $2 – now $2.30 (up 15%)
MMM (was $42, now $77) Jan $55 puts are .85 – now $1.65 (up 94%)
NFLX (was new, now $211) Jan $120 puts are $3.95 – now $22.85 (up 478%)
PCLN (was $150, then $30, now $525) Jan $300 puts are $5 (bonus on PCLN is they also make good terrorism protection) – now $10.10 – up 102%
QQQ (was $26, now $53) Jan $45 puts are $1.45 – now $1.95 (up 34%)
V (was $42, now $85) Jan $65 puts are $2 – now $2.40 (up 20%)
WYNN (was $20, now $147) Jan $95 puts are $2.75 (also good against terrorism) – now $8.50 (up 209%)

What we did here was pretty straightforward as we simply took a lot of stocks that were on a very good run but stretching the top of their channel and took long-term put positions that were pretty far out of the money. That made them easy to take off the table with a 20% loss (low delta) when they didn't work but, as you can see, they give you very nice returns when they do work!

We also use the Pony Express system for rotating through our picks so that when you are stopped out of a winner, you rotate into one of the losers as our original premise holds true – that they are stretched to the top of their range and IF the market is collapsing, even great stocks like IBM, ISRG, KO and GOOG will not be immune from a pullback.

As you can see from our winners, so far – we don't need our shorts to go anywhere near their 2009 lows to make good money on a minor pullback. One reason for that is we bought the puts when the VIX was low and just the VIX going up from 30 to 40 gives us a nice bump in a long put. That's why we stress UNDERSTANDING how options work at PSW – not just following picks – if you truly understand WHY you are making a trade – it's going to make you a much better trader over time!

Balance is also key and it's been a major theme in the month of September as we've moved up and down within our range (see Range Trading Posts). Back on Sept 2nd, when I wrote Range Trading 101 – we were 20% bullish and 15% bearish and that's still about right but our bullish picks are hedged for 20% drops at least while our bearish side is generally more aggressive and short-term (see our recent 9/15 $25,000 Portfolio and update in comment section), medium term (see above Long Put List) and long-term (our long Disaster Hedges) to cover us for various sorts of market pullbacks.

As long as we are long-term INVESTORS and our long-side plays are stocks we want to buy more of (and if they are not, then we simply stop out at 20% losses and we're done), then we can put the cash we make from our short-term TRADES into improving our long-term INVESTMENTS, dollar cost averaging into our VALUE plays as their PRICE declines (another theme we've been stressing in September). We will be going over that technique in more detail when I update our low-touch and conservative Income Portfolio this weekend.

That virtual portfolio was designed, above all else, not to lose money for people in my Mom's situation, where no income is coming in and she has to count on her Portfolio to cover her spending needs as well. It was also designed to be well-balanced at all times so that no day trading was required (Mom likes to take trips). In fact, we sometimes go weeks at a time without touching it at all – making it the polar opposite of our $25KP! Our goal was to take $500,000 and invest it in such a way as to throw off at least $4,000 a month in income. We recently took advantage of the dip and cashed out our primary hedge (IYR) and that gives us a lot of cash to put into rolling and adding to existing positions that have gotten cheaper in PRICE – but not VALUE.

Keep in mind we are still around 2/3 cash in our allocations. That keeps us flexible but it's no reason to be careless so our main job now, as we re-test the bottom of our range for the forth time since early August, is to decide if "this time is different" or, in this case the same as 2008 when the Global Economy is going off a cliff and we can just throw VALUE out the window as panicked traders sell their stocks at any PRICE or if this is just another opportunity for us to be greedy when others are fearful and pick up some great VALUES at low PRICES. I've added some simple top and bottom channels to our Big Chart, illustrating the trend shift we've had since early September. One of the nice things about our "Cashy and Cautious" positioning since the Summer is that the cash portion of our Portfolios has gone up 10% in PRICE (as the Dollar is currently perceived to be stronger) while we've waited and that has dropped the PRICE of certain stocks significantly that we want to buy.

We anticipate the rising Dollar to have a negative impact on the earnings of companies that earn a lot of revenues overseas. Clearly in this environment, it is very difficult to push through price increases and, if revenues are the same in Euros, then they will be lower when the company reports them in Dollars – a simple enough premise.

So we expect to see some real bargains in October, whether the markets improve or not but, if those -10% lines fail to hold (and they are long-gone on the Russell and NYSE already) – then we're really not going to be interested in anything that isn't a dividend-paying blue-chip back at the past cash lows. That will make for some boring times in October for our long-term investments but that's OK because, in a real crash – those long-term Disaster Hedges kick in.

Our last Hedging for Disaster post was back on August 11th, when we were worried those 10% lines would not hold. That was a false alarm and so were the dips of Aug 22, Sept 2nd, Sept 12th Sept 21st and maybe Friday but now the trend is no longer the bulls' friend, we're now going to be wanting some evidence before we dip out toes back in the waters to do any more bottom fishing.

As I said, more of that kind of stuff in the Income Portfolio update to come but, meanwhile, it's a good idea to change horses on Disaster Hedges as well. On Friday I mentioned our TZA Oct $31/42 bull call spread that was net .10 and is now $20 in the money (up 19,900%) – definitely time to switch to something that has room to move! That's the point of taking a few of these long-term 5:1, 10:1 and, in this case 200:1 payoff trades as dedicating just 1% of your portfolio to protection like this gives you 5%, 10% or more of your portfolio in cash to shop with when you cash out your short plays at the bottom. This is very much like spending $1,000 a month for a $1,000,000 life insurance policy – you HOPE you don't need it but it comes in pretty handy when you do (well, not so much for you but you know what I mean)….

With 500-point weekly swings and 1,000 point monthly swings since July – it's a fantastic market to trade in but you have to have that balance and, if we do begin to fail our major supports – we also have to have restraint because what looks like a bargain today may not seem like one after Greece defaults or a major bank fails or AAPL misses earnings or some other kind of major catastrophe.

We're not quite bear yet but let's continue to be careful out there and let's use the comments below to discuss the Global Macros as we begin a new month and a new quarter.