2012 Archive - Mad Hedge Fund Trader

My Tactical View of the Market

The abject failure of the equity indexes to breach even the first line of upside resistance does not bode well for the ?RISK ON? trade at all. Only a week ago I predicted that the markets would be challenged to top 1,340 in the (SPX) and $78 for the Russell 2000 (IWM). In fact, we made it up only to 1,335 and $77.90 respectively.

To see the melt down resume ahead of the month end window dressing is particularly concerning. That?s the one day a month that investors really try to pretend that everything is alright. People just can?t wait to sell.

Blame Europe again, which saw Spanish bond yields reach a 6.6% yield on the ten year and the Italian bond market roll over like the ?Roma? (a WWII battleship sunk by the Germans while trying to surrender to the Allies). Facebook didn?t help, knocking another $8 billion off its market capitalization, further souring sentiment.

Urging traders to head for the exits was confirming weakness across the entire asset class universe. The Euro is in free fall. Copper took a dive. Oil is plumbing new 2012 lows. Treasury bond prices rocketed, taking ten year yields to new all-time lows at 1.65%. It all adds up to a big giant ?SELL!?

It is just a matter of days before we revisit the (SPX) 200 day moving average at 1,280. Thereafter, the big Fibonacci level at 1,250 kicks in. It is also exactly one half the move off of the October 2011 low, and unchanged on the year for 2012.
I am not looking for a major crash here a la 2011. There is just not enough leverage and hot long positions in the system to take us down to 1,060. It will be a case of thrice burned, four times warned. And remember, last year?s 1,060 is this year?s 1,100, thanks to the earnings growth we have seen since then. With 56% of all S&P 500 stocks now yielding more than the ten year Treasury bond, you don?t want to be as aggressive on the short side as in past years, when bond yields were 4 or higher.

By adding on a short in the (SPY) here, I am also hedging my ?RISK ON? exposure in the deep in-the-money call spreads in (AAPL), (HPQ), and (JPM), and my (FXY) puts. The delta on these out-of-the-money?s are so low that I can hedge the lot with one small 5% position in the at-the-money (SPY) puts.

If the (SPX) hits 1,280, the (SPY) puts will add 2.25% to our year to date performance. At 1,250 we pick up 4.00% and at 1,200 we earn 7.00%. I now have the option to come out at any of these points if the opportunity presents itself, depending on how the rapidly changing global macro situation unfolds. If we get another pop from here back up to the 1,340-1,360 range, I will double up the position and swing for the fences. There?s no way we are taking a run at new highs for the year from here.

Below, find today?s charts from my friends at www.StockCharts.com with appropriate support and resistance levels outlined. If I may make another observation, when you see the technicals work as well as they have done recently, it is only because the real long term end investors have fled. There are not enough cash flows in the market to overwhelm even the nearest pivot points. That leaves hedge fund, day, and high frequency traders to key off of the obvious turning points in the market. That also is not good for the rest of us.

It?s a good thing that I?m not greedy. If I had sold short a near money call spread for the (TLT) on May 23, I would be in a world of hurt right now. Instead, I went six point out of the money. So when we get dramatic moves like we saw today that take bond yields to all-time lows, I can just sit back and say, ?Isn?t that interesting.? This spread expired in six trading days, which should be enough time to digest the big move today and expire safely out of the money and worthless. What?s better, I can then renew the trade at better strikes after expiration into the July?s and take in more money.

If you are wondering why I am not doubling up on the short Treasury bond ETF (TBT) down here, it?s because it doesn?t have enough leverage. In these conditions you need to go for instruments that can generate immediate and large profits, such as through the options market. The topping process for the Treasury market could go on for another month or two. Until that ends, I am happy to use price spikes like today?s to sell short limited risk (TLT) call spreads 6-8 points out of the money, which can handle a 20 basis point drop in yields and still make you money.

If you own the (TBT) and are willing to take a multi month view, you should be doubling up here. This ETF will have its day in the sun, it is just not today. We could see the $20 handle again and maybe even $30 within the next year. That makes it a potential ten bagger off of today?s close.

I don?t want to touch gold (GLD) or silver here. The barbarous relic is clearly trying to base at $1,500 an ounce. If it fails, it will probably only go down to only $1,450 before major Asian central bank buying kicks in. Better to admire it from afar, or limit your activity to early Christmas shopping for your significant other. We are months away from the next major rally in the yellow metal.

The Roma

Time to Puke Out Again

May 31, 2012 - Quote of the Day

Quote of the Day

?What?s going on with Facebook? We had better IPO standards when Don Draper was on the scene,? said Sallie Krawcheck, former head of wealth management at Merrill Lynch.

Trade Alert - (SPY) May 30, 2012

Trade Alert

As a potentially profitable opportunity presents itself, John will send you an alert with specific trade information as to what should be bought, when to buy it, and at what price. Read more

Apple Redux

Diary

The news out this morning that Apple (AAPL) may launch its HD television product in time for the Christmas holidays caused a nice pop in the stock this morning, so I thought I would quickly review the fundamental case behind owning the company. The story originated from rumors in China that its main manufacturer, Foxcon, had already placed orders for key component parts. It will be another web to lure consumers into the Apple ecosystem and then trap them there for life. It also makes my 25% core long position in an August deep in the money call spread look pretty good.

Apple earnings have grown at a rate of 76% a year for the last seven years, and there is no sign that ballistic growth rate will abate anytime soon. The iPhone 5 launch in September will be an absolute blowout and the firm?s biggest new product launch ever. Even I have lined up a buyer of my almost new iPhone 4s at a big discount so I can get the vastly more powerful upgrade.

There are longer term strategic considerations too, such as the fact that Apple has only scratched the surface in China, the world?s largest cell phone market. A China Mobile (CHL) deal looming which will give Apple access to 600 million potential new subscribers. After refusing to support Apple products for decades, corporations are now adding Apple products in large numbers, urged on by the convenient and imminent demise of (RIMM)?s Blackberry.

The real icing on the cake here is that Apple is still one of the cheapest stocks in the market. Back out the $120 billion in cash it will soon have on its balance sheet, and you have in your hands a hyper growth company that is selling at an earnings multiple of only 8X. Look at a full year earnings target of $110 a share and rerate it up to a 10X multiple and you get a 12 month price target of $1,100.
There are some outliers that could pee on Apple?s parade. If the Android operating system somehow takes off that could slow growth. You also have to wonder how much of this amazing story is already baked into the price and when will the law of large numbers kicks in for this $532 billion company.

Time to Buy JP Morgan

Newsletter

This is far and away the world?s premier banking institution. Estimates of the huge trading losses by the London ?whale?, initially pegged at $2 billion, have since skyrocketed to $6 billion. I?ll ignore the Internet rumors that speculate about a $30 billion hickey. As you well know, almost everything on the net is not true, except what you read in my own newsletter.

Back in the 1980?s when I was at Morgan Stanley, the inside joke was to look for nice office space for ourselves whenever we visited clients at (JPM). The expectation was that they would take us over when Glass-Steagle ended, as they were both the same institution before the Securities and Exchange Act broke them up in 933. When the separation of commercial and investment banking finally came in 1999, Morgan Stanley had grown far too big to swallow and the egos too big to manage.

I?ll tell you another way to look at this trade. (JPM) lost 4.7% of its capital, so Mr. Market chewed 30% out of its capitalization. Sounds a bit overdone, no? The bad news is already in the price. A large part of the offending position has already been liquidated.

I have known Jamie Diamond for a long time, and can tell you that he is the best manager of a financial institution anywhere. I have been warnings him for years that his traders were understating risk and leverage in esoteric derivatives in order to boost their own bonuses. It was just a matter of time before they blew up. Presumably, by now Jamie has tightened up internal controls and in the future won?t pay so much attention to presentations by wet behind the ears traders pitching schemes that are too good to be true. As a result, you can now buy (JPM) at the blow up price.

I have analyzed the specific trade that got (JPM) into so much trouble, the now infamous ?Investment Grade Series 9 Ten Year Index Credit Default Swap.? The chart of its recent performance and its hedge is posted below. It was in effect a $100 billion ?RISK ON? trade that came to grief in early May.

The trader involved, Bruno Iksil, broke every rule in the trading Bible: too much leverage in an illiquid credit derivative with no real risk control and hedges that were imprecise at best. As I never tire of pointing out to hedge fund newbies, when your longs go down and your shorts go up in a hedge fund, you lose money twice as fast as a conventional long only fund. Play at the deep end of the pool, but be aware of the risks.

Few outside the industry are aware that this was a $6 billion gift to two dozen hedge funds who are now shouting about record performance. It is, after all, a zero sum game. Didn?t Bruno get the memo to ?Sell in May and go away?? He obviously doesn?t read The Diary of a Mad Hedge Fund Trader either.

Even if the worst case scenario is true and the $6 billion numbers proves good, that only takes a 4.7% bite out of the bank?s $127 billion in capital. It is in no way life threatening, nor requiring any bailouts. These shares at this price are showing an eye popping low multiple of 7X earnings, and have already been punished enough. Getting shares this cheap in this company is a once in a lifetime gift, and twice in a lifetime if you count the 2009 crash low.

You don?t have to run out and bet the farm right here. Scale in instead, and if the market drops, you can always cost average down. If Greece forces us into major meltdown mode, we can also hedge this? ?RISK ON? trade through taking more aggressive ?RISK OFF? positions, like selling short the (FXE), (SPX), (IWM), (GLD), or the (SLV) by buying puts.

Short Red and Long Black Was Not Good

May 30, 2012 - Quote of the Day

Quote of the Day

?A lot of new economics involves the reading of a lot of old books,? said Nobel Prize winning economist Paul Krugman.

Trade Alert - (JPM) May 29, 2012

Trade Alert

As a potentially profitable opportunity presents itself, John will send you an alert with specific trade information as to what should be bought, when to buy it, and at what price. Read more

What Hot?and Not

Newsletter

My friend, Tom Dorsey of the technical research boutique Dorsey Wright, inundates me daily with a never ending stream of market sensitive data which has been helping me make some of my more successful market calls. For example, when the S & P 500 hundred broke 1,380 in April, he completely nailed the 1,280 bottom in the current move.

So, I thought I?d pass on the asset class performance table below for the last 1, 6, and 12 months for your edification. The top performing three categories are all in bonds, with the 30 year Treasury easily taking the number one spot at 35%. They have continued the hot streak this year, clocking 7% year to date. All equity classes are showing negative YOY returns, not a surprising result in the middle of a lost decade in a low growth economy.

Which asset class gets the booby prize? No surprise that its European equities, down a hair raising 21%, whose travails have been eloquently detailed in these pages.

You can see this performance mirrored in the mutual fund cash flows table next. Money continues to pour into fixed income like Niagara Falls, with the taxable sector soaking up a stunning $112 billion in cash this year. The money is flocking to debt at negative real interest rates. This has been at the expense of domestic equity mutual funds, which suffered $44 billion in outflows. I liken this to driving 80 miles an hour, but only looking in the rear view mirror. It can only end in tears.

These numbers are a major reason why I turned bearish so early this year. Retail investors clearly aren?t drinking the Kool-Aid any more. It further bolsters my belief that the stock markets permanently lost a generation of investors after the gut churning trauma of the 2008 crash. The disastrous Facebook (FB) IPO just threw more fat on the equity bonfire.

Finally, for the sake of levity, Tom listed all of the possible responses to be heard around a Memorial Day BBQ, and the strategic response you should adopt. Read it for a good post-holiday laugh. To visit Tom?s ever useful website please click here at http://www.dorseywright.com/ .

Watch Out for That BBQ Advice

Playing at the Deep End With the Euro

Newsletter

I never wanted to join any club that would have me as a member. That is the little nugget of wisdom comedian Groucho Marx imparted to me during his visit to the UCLA campus 40 years ago. It is also what came to mind when I saw the shocking Commitment of Traders Report for Euro futures that came out last Friday.

Short positions in the beleaguered European currency soared to another all-time high. From the May, 2011 peak, they have swung from a long position of 120,000 contracts to a short position of 220,000 contracts. That is a reversal of $34 billion in cash money.

Here is the problem for Euro traders. A position this large means that the risk/reward of selling the Euro versus the dollar is running against you. In the current environment bad news brings slow, grinding, marginal new lows. It is not exactly a secret that Europe is having problems these days. Good news brings furious, frantic, and large spikes up. Welcome to a hard market to trade, even if you are running a global 24 hour multi time zone desk with the best talent that money can buy. It is also why I covered my own Euro short for a big profit on the initial breakdown last week.

Watch for this week?s Friday report. They will probably show even greater record highs.

Groucho

May 29, 2012 - Quote of the Day

Quote of the Day

?Europe has been diagnosed with cancer and they are attempting to treat it with massage, yoga, and carrot juice. If they go into recession, that affects us,? said Michael Farr of Farr, Miller, & Washington.