Dave Landry's Market in a Minute - Monday, 12/2/13

I am one of those cheapskates who buys Christmas ornaments by the bucket load from Costco in January for ten cents on the dollar because my eleven month return on capital comes close to 1,000%. I also like buying flood insurance in the middle of the summer when the forecast here in California is for endless days of sunshine.

That is what we are facing now with the volatility index (VIX) where premiums have been hugging the 12%-14%% range for the last several months. Get this one right, and the profits you can realize are spectacular.

The CBOE Volatility Index (VIX) is a measure of the implied volatility of the S&P 500 stock index, which has been melting since the ?RISK OFF? died a horrible death. You may know of this from the talking heads, beginners, and newbies who call this the ?Fear Index?. Long-term followers of my Trade Alert Service profited handsomely after I urged them to sell short this index two years ago with the heady altitude of 47%.

For those of you who have a PhD in higher mathematics from MIT, the (VIX) is simply a weighted blend of prices for a range of options on the S&P 500 index. The formula uses a kernel-smoothed estimator that takes as inputs the current market prices for all out-of-the-money calls and puts for the front month and second month expirations.

The (VIX) is the square root of the par variance swap rate for a 30 day term initiated today. To get into the pricing of the individual options, please go look up your handy dandy and ever useful Black-Scholes equation. You will recall that this is the equation that derives from the Brownian motion of heat transference in metals. Got all that?

For the rest of you who do not possess a PhD in higher mathematics from MIT, and maybe scored a 450 on your math SAT test, or who don?t know what an SAT test is, this is what you need to know. When the market goes up, the (VIX) goes down. When the market goes down, the (VIX) goes up. End of story. Class dismissed.

The (VIX) is expressed in terms of the annualized movement in the S&P 500, which today is at 1,800. So a (VIX) of $14 means that the market expects the index to move 4.0%, or 72 S&P 500 points, over the next 30 days. You get this by calculating $14/3.46 = 4.0%, where the square root of 12 months is 3.46. The volatility index doesn?t really care which way the stock index moves. If the S&P 500 moves more than the projected 4.0%, you make a profit on your long (VIX) positions.

Probability statistics suggest that there is a 68% chance (one standard deviation) that the next monthly market move will stay within the 4.0% range. I am going into this detail because I always get a million questions whenever I raise this subject with volatility-deprived investors.

It gets better. Futures contracts began trading on the (VIX) in 2004, and options on the futures since 2006. Since then, these instruments have provided a vital means through which hedge funds control risk in their portfolios, thus providing the ?hedge? in hedge fund.

But wait, there?s more. Now, erase the blackboard and start all over. Why should you care? If you buy the (VIX) here at $14, you are picking up a derivative at a nice oversold level. Only prolonged, ?buy and hold? bull markets see volatility stay under $14 for any appreciable amount of time.

If you are a trader you can buy the (VIX) somewhere under $14 and expect an easy double sometime in the coming year. If we get another 10% correction somewhere along that way, that would do it.

If you are a long-term investor, pick up some (VIX) for downside protection of your long-term core holdings. A bet that euphoria doesn?t go on forever and that someday something bad will happen somewhere in the world seems like a good idea here.

If you don?t want to buy the (VIX) futures or options outright, then you can always buy the iPath S&P 500 VIX Short Term Futures ETN (VXX).

If you lose money on this trade, it will only be because you have made a fortune on everything else you made. No one who buys fire insurance ever complains when their house doesn?t burn down.

Market tops and bottoms are always a popular topic of conversation. There are a number of theories about how to forecast key turning points in advance, but, in reality, those theories rarely work.

While it does seem like an exercise in futility to forecast the day and price of tops and bottoms, there is valuable information to learn from studying the general nature of market turning points. This knowledge will help us understand what to look for and how to react to the market as it develops rather than provide a false sense of comfort about what we should see.

In the stock market, we tend to see tops build slowly and bottoms appear unexpectedly. This can be seen in the chart below, which shows the 2007 market top on the left and the March 2009 bottom on the right.



SPDR S&P 500 ETF (NYSE: SPY) built a top slowly, over a period of several months. The bottom, on the other hand, came unexpectedly and was greeted with disbelief.

This pattern has been seen at other significant stock market turning points. The bottom that occurred in 2002 was also unexpected and sudden, while the top in 2000 had been formed over several months. While the top was forming, stocks moved within a relatively narrow range as the transition from bull market to bear market was completed.

This behavior can be explained with investor sentiment. In a bull market, investors become conditioned to buying dips. They respond to price drops by buying, and this is why we see prices trade in a consolidation pattern at a top. Buying the dips shows up as support on a chart, and excessive valuation levels prove to be resistance levels.

Bottoms in stocks begin when sentiment is negative and selling has reached a peak. When the selling pressure is exhausted, prices rebound suddenly.

Gold and other commodities tend to behave differently, as the next chart shows.

Market tops and bottoms are always a popular topic of conversation. There are a number of theories about how to forecast key turning points in advance, but, in reality, those theories rarely work.

While it does seem like an exercise in futility to forecast the day and price of tops and bottoms, there is valuable information to learn from studying the general nature of market turning points. This knowledge will help us understand what to look for and how to react to the market as it develops rather than provide a false sense of comfort about what we should see.

In the stock market, we tend to see tops build slowly and bottoms appear unexpectedly. This can be seen in the chart below, which shows the 2007 market top on the left and the March 2009 bottom on the right.

Chase Van Der Rhoer, a Bloomberg application specialist, makes the case for an investment bubble in this morning?s Bloomberg brief:

Bubbles don?t exist without investment funds crowding into the same trades relative to liquidity. Researchers will often construct measures of market-crowding such as the ratio of the Nasdaq Composite Index price to the relative amount of volume. This ratio has increased 238% since 2009 ? showing cause for concern.

And here?s his chart:

After eight consecutive weeks of gains, it is time to consider when strength becomes exhaustion in the stock market.

Overbought Eventually Means Overbought
SPDR S&P 500 (NYSE: SPY) closed up 0.11% in a holiday-shortened trading week. This was the eighth time in a row SPY posted a weekly gain. It was also the smallest weekly gain in the winning streak and the second week in a row the rate of change has declined.

The concept of overbought is a challenging one, and traders have spent countless hours trying to understand it. Many indicators, such as stochastics and Relative Strength Index (RSI), are used to define an overbought market, but they all share a common flaw. At the beginning of a very strong up move, markets become overbought and stay overbought.

The chart below demonstrates the challenge of defining when a market is overbought. SPY is shown with the stochastics indicator. The monthly chart is used to decrease the sensitivity of the indicator, but similar patterns can be seen on weekly and daily charts.

Stochastics became overbought in 2003 and remained overbought until the end of 2007. Bollinger Bands(r) confirm that SPY was overbought throughout that time as prices stayed close to the upper Band throughout the advance.

Markets were up slightly after Thanksgiving weekend. Many stores were open on Thanksgiving Day for the first time in history and it seems like consumers enjoyed it. Several firms reported that between Thanksgiving and Black Friday, sales were estimated at $12.3 billion. Traffic on Thanksgiving Day was up 27%; this is nearly one-third of the holiday weekend shoppers, according to the National Retail Federation. Bill Martin, founder of ShopperTrak, said, ?Probably the most interesting is the amount of energy the consumer put into Thursday shopping. The retailers did a good job getting them up from the dinner table and into stores.? Analysts expect sales for the entire weekend to come in around $57.4 billion, with the average shopper spending roughly $407.02. This is down from last year?s $59.1 billion. The National Retail Federation said that there were more than 141 million shoppers throughout the course of the entire weekend. This estimate is higher than last year?s 139 million shoppers.

Online retail sales were up for the weekend as well. The Retail Federation said that there were 92 million people that shopped during the weekend. This was up from last year?s 89 million. ComScore, an analytics firm, said that online sales were up 17.3% over last year on Thanksgiving and Black Friday. Popular online purchases were tablets and big-screen TVs. Vice president of Offers.com, Howard Schaffer, said, ?Tablets were super-hot this year, which is really no surprise to anybody. Obviously the iPad did extremely well.

Bank of America (BAC) announced that they have reached an agreement to settle all outstanding claims with Freddie Mac. This will cover all of the mortgages that were sold to Freddie Mac through the end of 2009. The settlement amount? A grand total of $404 million. This agreement will cover all past losses and future losses connected to the loans. The company already has reserve money on hand to cover this amount. In November, the government urged Bank of America to pay nearly $863.6 million in damages once the federal court found them at fault for fraud over faulty mortgages sold by their Countrywide unit. In September of this year, Freddie Mac was awarded funds from Wells Fargo, $780 million, and Citigroup, $395 million, to settle repurchase claims. Freddie Mac?s Chief Executive, Donald Layton, said, ?We continue to make very good progress in recovering funds that are due to the American taxpayer, as well as resolving Freddie Mac?s legacy repurchase issues.?

That?s all for the day.
All the best,

Being prepared for a bear market takes many forms. In some cases, it can become an obsession.

Some investors always seem to be looking for a market top and forecasting a major decline only days away. While there have been two significant bear markets since 2000, these investors have been mostly wrong for many years.

Investors worried about the next bear market should remember that SPDR S&P 500 (NYSE: SPY) has only suffered three drops of 20% or more since it began trading 20 years ago. There have only been five declines of 20% or more since 1982 in the S&P 500. Bear markets are rare, and always preparing for a rare event can be very costly.

Rather than making investments right now to prepare for the next decline, you could simply make plans for what you will do to protect wealth when the market starts to fall. There are a number of indicators to define a bear market, but I think the simple 10-month moving average (MA) is an effective tool. (See This Chart Shows Where the Bull Market Will End.)

That indicator gave a sell signal less than 7% below the high in 2007, and 7.3% below the high in 2000. I don't know whether the next signal will be that accurate, but I know prices will move below the 10-month MA in a deep bear market.

I believe selling options is an appropriate income strategy in any market environment, but it will become even more important in a bear market.

A put option gives the buyer the right to sell 100 shares of a stock at the option's strike price before the expiration date. Put options go up in value when stock prices fall.

When selling puts, the trader generates immediate income, known as a premium, for taking on the obligation to buy the stock if it falls below the option's strike price before expiration.

Selling put options can provide a disciplined approach to buying stocks as prices fall, something many investors become too paralyzed with fear to do. While prices are rising, it is a good idea to make a list of stocks that would be good buys at lower prices. When SPY falls below the 10-month MA, it would be a good time to sell some holdings and put that cash aside for buys at lower prices. Then sell put options to ensure you buy when prices fall.

Selling puts is also a way to generate income that offsets the losses of a bear market. As an example, consider hypothetical stock ABC trading at $100 a share. You could sell puts 10% below the market price that expire in one month for about $1 a share.

If ABC falls below $90, the put will be exercised and put sellers will buy the stock at $90 a share. With that put sale, the actual cost would be $89 since you have the $1 a share from selling the put to reduce the cost of the stock.

If the price doesn't fall 10% in one month, which will be the outcome most of the time, the put option expires worthless, you keep the $1 per share in income, and you can sell another put option.

This process can be repeated over and over again. If the market drops slowly, the stock price might never be below the strike price at expiration, and that means the options will never be exercised. In that case, you generate monthly income from selling puts.

To recap, selling puts helps investors in two ways during a bear market.

1. They generate immediate income, which offsets losses in other positions.

2. They can be forced to buy high-quality stocks at low prices.

Many investors fail to take advantage of low prices in a bear market, waiting for even lower prices. Selling puts could force you to buy when stocks offer bargains, an action that should be rewarded with large gains in the bull market that inevitably follows a bear market.

This article was originally published at ProfitableTrading.com:
A Bear Market Defense Strategy That Works

- Amber Hestla Barnhart

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One of my favorite scenes from the classic movie "Wall Street" is the boardroom scene when Bud Fox realizes that Gordon Gekko is going to dismantle Blue Star Airlines piece by piece. A portly, bespectacled investment banker glibly says: "No sweat. We sell the gates and pawn the planes off on the Mexicans. Do we have a deal or what?"

Sure, there are more action-packed parts of the flick. But to me, that particular scene helps explain what investing is all about: buying an asset and watching as the value is realized or unlocked.

I've found a stock that fits that scenario that, coincidentally, is also in the airplane business: Fly Leasing (NYSE: FLY).

Based in Dublin, Fly Leasing is in the commercial aircraft leasing business. Airlines are increasingly turning to operating leases to supply their fleets. In fact, over one third of the world's airline fleet is leased.

Basically, the companies are renting the planes to avoid having a gigantic, swiftly depreciating asset sitting on its balance sheet. Firms like Fly assume the risk. Why? As that portly investment banker implied, you can always find someone who needs a plane.

Chart o? the Day: Stock vs Bond Yields Around the World

The one thing that should jump out at you immediately from this BlackRock chart is that the US is the only developed market in which stock dividend yields are lower than the interest rates being offered by that country?s bonds.

Over the weekend tragedy struck as movie star Paul Walker (of ?The Fast and the Furious? franchise) was killed in a car crash after which the vehicle was engulfed in flames. Both the driver and Walker, who was the passenger, are dead. There is chatter that there was a street race involved and police are investigating.

Walker was 40 years old.

This is obviously all very horrible. And peculiar, given that the driver of the car was a wealth manager at Merrill Lynch. Roger Rodas (Brightscope profile here), who was heavily involved in the street racing scene in real life, was Walker?s good friend and business partner in an auto parts business. He was also the star?s financial advisor and a 20-year veteran of Merrill.

I call this peculiar because it is not very often you encounter a financial advisor with such a high-stakes, heavy adrenaline, life-endangering hobby. Most FA types I?ve ever met or have heard of are the kinds of people who would be talking clients out of reckless hobbies and behaviors. We are all fully versed in the actuarial tables, as we must be, in order to plan retirements for people.

Here?s some information about the relationship (via Heavy.com):

An online profile states that Rodas was, ?one of America?s top wealth management advisors and portfolio managers, with an impressive list of clients,? this was in addition to his role with Always Evolving. Rodas and Walker?s friendship evolved over a shared passion for cars, it eventually morphed into a professional relationship where Rodas became Walker?s financial adviser.

A Merrill Lynch profile of the pair says:
?The two struck up a conversation when Walker noticed Rodas driving a Porsche GT3 he had previously owned. Soon the two were racing side by side, as when they teamed recently with two professional drivers in a pro-am 25-hour endurance race in Thunder Hill, Calif. As their friendship developed, Walker occasionally asked Rodas for financial advice, and they began working together formally as client and Financial Advisor in 2007. The first item on their agenda was reorganizing Walker?s portfolio, a hodgepodge of personal investments. Rodas suggested a diversified, relatively conservative portfolio of stocks, bonds, cash and alternative investments, aimed mostly at preserving capital. And because an actor?s income is sporadic, each time Walker completes another film, he and Rodas meet to re-evaluate his financial strategy to help make sure his long-term goals stay on track.?

The same profile states that Rodas had worked at Merrill Lynch/Bank of America for 20 years (the profile is undated) and has been named on a list of America?s Top 1000 Financial Advisers in 2010, 2011 and in 2012.

It?s not been my experience that Fast and Furious is typical trait of planners and wealth managers. Most of my colleagues in the business are cautious and patient by nature, content to leave the short-term thrills to others while focusing on the overarching well-being and lifelong happiness hat comes from preparation and rationality.

But who knows, perhaps the advice Rodas was giving his friend professionally was the opposite of the lifestyle the two were purportedly living on circuit.

In any event, this is sad news. Godspeed, Roger and Paul.