Steve Jobs offered me one third of Apple for $50,000 and I was so smart that I turned it down. It?s funny when you think about it now, except when I?m crying,? said Nolan Bushnell, the founder of game company Atari and Jobs? first employer.
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December 3, 2013 ? Quote of the Day
Steve Jobs offered me one third of Apple for $50,000 and I was so smart that I turned it down. It?s funny when you think about it now, except when I?m crying,? said Nolan Bushnell, the founder of game company Atari and Jobs? first employer.
Buy Flood Insurance With the VIX
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.
Has Gold Reached An Inflection Point?
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.
Has Gold Reached An Inflection Point?
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.
Nasdaq Composite: Performance vs Volume
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:
Stocks Shifting From Strength to Exhaustion?
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.
Bank of America (BAC) Announces Settlement With Freddie Mac
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,
