The Tycoon Report

Why This Week Could Pulverize Your Portfolio!

Tuesday, May 27, 2008 | Chris Rowe

First I would like to take this opportunity, in light of our U.S. holiday, Memorial Day, to give ENORMOUS respect to our troops who are currently serving on behalf of the United States, and OF COURSE those who have given their lives or any other sacrifice, fighting on behalf of this country. 

And now, The Tycoon Report ...

Today I want you to make your portfolio safer.  I'll show you why, and I'll show you how.

Want to buy stocks at bargain prices?

In order to buy stocks at bargain prices you need two things.  (No I'm not talking about THOSE two things). 

1. You need courage
2. You need cash

It's hard to find the courage to buy stocks on the cheap when you've just watched your portfolio lose a large percentage of its value.  But if you hedge your portfolio with a bearish bet, it's easier to think with a clear head because, although your bullish positions have been beaten down, at least one (bearish) position is extremely profitable.

You can then close that profitable bearish position out and use the proceeds to buy on the cheap with a clear head.

Here's why you want to hedge your bullish positions with deep in-the-money puts on the S&P 500. 

Below is a chart of the S&P 500 (top) and the CBOE volatility index (bottom).  I won't get into too much detail on what the VIX is, but it's considered the "fear gauge".  When investors are fearful, option contracts on the S&P 500 become more expensive.  The VIX is an index that tracks the prices of options on the S&P 500.  So when investors are fearful, VIX moves up, and as they become complacent, VIX moves down. 


The VIX is typically used to call short-term to intermediate term stock market bottoms.  (Notice when it gets up near 25-30, it correlates with bottoms in the S&P.  As you can see in the (lower) VIX chart, this "fear gauge" just reached its lowest level since the stock market's all time high (right before the summer 2007 correction).  This shows excessive complacency, and as you can see, that trend seems to be at the early stages of reversing.

STOP HERE FOR A SEC...

Before I even speculate on the stock market's next move, think about this for a second.  Let's say the S&P stayed at this exact same level for the next week, but investors became extremely fearful.  Options would get more expensive even though the S&P 500 did nothing.  Therefore, if you own put options, they would increase in value only because of the increase in fear.

Now, to speculate.  Just kidding, I don't like to speculate, especially on the direction of the market.  We are talking about hedging right now, and not forecasting the market's next direction.

But look at the red circles on the charts.  Without explaining the MACD indicator, I'll just tell you that in the chart of the S&P 500, I've circled MACD sell signals, and in the VIX chart, I've circled MACD buy signals.  Notice how they are right around the same time in the charts.

Basically, as the market moves lower (after the MACD sell signals) the VIX moves higher (after MACD buy signals).  I also drew an intermediate uptrend line on the S&P 500 chart that was recently violated, which is a bearish sign. 

On the VIX chart, after the MACD buy signal, the VIX shot up by 50-60%.  (Scroll back up and check it out please).  I'm thinking we're probably going to see another spike in the VIX.  Again, that means options become more expensive. 

So if you buy put options, which have an inverse relationship to the direction of the underlying security, which in this case is the S&P 500, and the market moves lower, you have a double whammy in your favor.  It's a double whammy because there are two forces driving put option prices higher: Fear and direction (downward).

I'll get into which options to buy as a hedge in a minute, but let's move away from the how, and get into the why for a second...

I'm typing this on Monday (yes, I work through holidays), so I don't know what the Consumer Confidence & New Home Sales numbers (announced Tuesday) are.  The trend has obviously been negative with Housing starts have dried up, with 11 months of inventory on the market for new homes and 10 months for existing homes.  That has exacerbated the weak jobs market.  The real estate market has shocked consumers because they can't use their homes as ATM machines any longer, so they have been turning to credit card debt (which is an absolute killer).

But there are other important numbers coming out this week which could send this market much lower, perhaps even through the recent lows.

On Thursday we have revised Q1 GDP.  This revision could be very disruptive for the stock market.  We have crude prices that are relentlessly gunning higher.  Goldman Sachs is predicting higher energy prices, but that doesn't mean Crude has to jump that high immediately.  But you can be sure that the notion that crude will spike much higher will push up inflation expectations.  That tends to lead to increased pay demands, and that's causing my institutional trader friends to fear that it would trigger a wage-price spiral, as we saw in the 1970s.

While the GDP revision is my biggest concern this week, we also have Durable Goods announced tomorrow (Wednesday) and on Friday, Agricultural Prices, Chicago PMO, Personal Income Spending, and Consumer Sentiment Numbers. 

Let's get back to hedging your portfolio, shall we?

Do you remember my article in early 2006 titled "Why the Oil Boom is Just Beginning"?  Tycoon Report readers sent me hate mail because I said $60.00 oil would eventually look cheap.  Now the same people are telling me I'm crazy because I keep telling you to reduce your exposure to commodities and buy them back cheaper. 
 
But I'm not calling the top, so with Crude gunning through $135.00/barrel last week, and the stock market running into resistance right around the old support level (below) along with the revised Q1 GDP on Thursday, you should consider hedging your account with deep in-the-money puts on the S&P 500.


To learn more about "deep-in-the-money puts," you can read an old Tycoon Report article of mine by clicking here: "Why "In-The-Money" Puts Are Not as Risky as Shorting Stock.

But I will make a recommendation here.  Hedge your bullish stock portfolio by purchasing the SPDR S&P December 148 puts.  Symbol JBG XR.  After checking the quote, enter the trade at the asking price.  It closed on Friday with an asking price of $14.80.

Please note that I can't give further advice on this.  I can't legally answer individual questions about it, and I can't tell you how much to buy.  I most definitely will not be telling you when to sell out of these put options - this is something you'll need to decide for yourself, based on your own personal financial situation and your own tolerance for risk, etc.  The only advice I can give you on when to exit this hedging position is that you may want to follow the VIX closely ... when it approaches 26-30 again, this level is typically indicative of a short-term low in the market.

Above all, remember that this is a hedge.  That means that I'm not telling you to be 100% bearish right now.  If I had a $100,000.00 portfolio with $40,000.00 in cash, and $60,000.00 in bullish stock positions, I would probably buy 10 of these put options.  But that is an approximation.

Also, please note that this is a general recommendation for the average investor.  I hedge the Trend Rider portfolio in ways other than what I described here.  I won't be recommending this specific trade to TTR members.  Instead, we own put options on the weakest stocks within the weakest sectors with weak chart patterns.  If you're interested, when TTR opens its waiting list back up again, jump on it.  (There's a 30 day $ back guarantee.)

Please feel free to comment on this article and tell me if you agree or disagree.  If you have no opinion, then just comment on how cute my daughter Maya is:




“Profit from the Trend”

Chris Rowe
Chief Investment Officer
The Trend Rider


Mark Your Economic Calendar: What's ahead for the week of May 27, 2008
Economic Calendar for the Week of May 26 - May 30

Tuesday, May 27

10:00AM - Consumer Confidence

Release Details

• Importance (A-F): This release merits a B-.
• Source: The Conference Board.
• Release Time: 10:00 ET on the last Tuesday of the month (data for current month).
• Raw Data Available At: http://www.tcb-indicators.org/.

The Conference Board conducts a monthly survey of 5000 households to ascertain the level of consumer confidence. The report can occasionally be helpful in predicting sudden shifts in consumption patterns, though most small changes in the index are just noise. Only index changes of at least five points should be considered significant. The index consists of two subindexes - consumers' appraisal of current conditions and their expectations for the future. Expectations make up 60% of the total index, with current conditions accounting for the other 40%. The expectations index is typically seen as having better leading indicator qualities than the current conditions index.

10:00AM - New Home Sales

Release Details

• Importance (A-F): This release merits a C .
• Source: The Census Bureau of the Department of Commerce.
• Release Time: 10:00 ET around the last business day of the month (data for month prior).
• Raw Data Available At: http://www.census.gov/const/newressales.pdf .

The report indicates the level of new privately owned one-family houses sold and for sale. New home sales usually have a lagged reaction to changing mortgage rates. They also tend to be stronger early in the business cycle when pent-up demand is strong, and they fade later in the cycle as the demand for housing is sated. In addition to home sales, the market monitors the number of homes for sale relative to the current sales pace. As this inventory measure falls (rises), housing starts tend to rise (fall). Finally, the median home price provides an indication of inflation in the housing sector, though only year/year changes provide any meaningful information.

The home sales report is quite volatile and subject to huge revisions, making any one month's reading very unreliable. The report rarely prompts a market reaction. The market prefers the existing home sales report, which has a sample data pool four times as large and is released earlier in the month.


Wednesday, May 28

8:30AM - Durable Orders

Release Details

• Importance (A-F): This release merits a B.
• Source: The Census Bureau of the Department of Commerce.
• Release Time: 8:30 ET around the 26th of the month (data for month prior).
• Raw Data Available At: http://www.census.gov/ftp/pub/indicator/www/m3/index.htm.

The durable orders release measures the dollar volume of orders, shipments, and unfilled orders of durable goods (defined as goods whose intended lifespan is three years or more). Orders are considered a leading indicator of manufacturing activity, and the market often moves on this report despite the volatility and large revisions that make it a less than perfect indicator. These problems can be minimized by looking at the breakdown of orders. The total number is often skewed by huge increases in aircraft and defense orders. An increase based solely on strength in one sector tends to be discounted, while the market is more impressed with broad based increases in orders.

Also notable in this report is the narrow category of non-defense capital goods. These goods mirror the GDP category producers' durable equipment (PDE) -- the largest component of business investment. Shipments of non-defense capital goods are a good proxy for PDE in the current quarter, while nondefense capital goods orders provide an indication of PDE growth in the quarters ahead.


Thursday, May 29

8:30AM - GDP and Chain Deflator-Preliminary

Release Details

• Importance (A-F): This release merits a B.
• Source: Bureau of Economic Analysis, U.S. Department of Commerce.
• Release Time: Third or fourth week of the month at 8:30 ET for the prior quarter, with subsequent revisions released in the second and third months of the quarter.
• Raw Data Available At: http://www.bea.doc.gov/bea/dn1.htm.

Gross Domestic Product (GDP) is the the broadest measure of economic activity. Annualized quarterly percent changes in GDP reflect the growth rate of total economic output. The figures can be quite volatile from quarter to quarter. Inventory and net export swings in particular can produce significant volatility in GDP. The final sales figure, which excludes inventories, can sometimes be helpful in identifying underlying growth trends as inventories represent unsold goods, and a large inventory increase will boost GDP but might be indicative of weakness rather than strength. The broad components of GDP are: consumption, investment, net exports, government purchases, and inventories. Consumption is by far the largest component, totaling roughly 2/3rds of GDP.

In addition to the GDP figures, there are GDP deflators, which measure the change in prices in total GDP and for each component. Though the consumer price index is a more closely watched inflation indicator, the GDP deflator is another key inflation measure. Unlike CPI, it has the advantage of not being a fixed basket of goods and services, so that changes in consumption patterns or the introduction of new goods and services will be reflected in the deflator.

With both GDP and the deflator, the market tends to focus on the quarter/quarter change. Year/year changes are also cited frequently, though they do not provide the most timely indications of economic activity or inflation. The bond market often reacts to GDP, though the price moves are typically small, as much of the GDP data is easily predicted using monthly economic releases such as personal consumption, durable goods shipments, construction spending, international trade, and inventories.

Quarterly GDP reports are broken down into three announcements: advance, preliminary, and final. After the final revision, GDP is not revised again until the annual benchmark revisions each July. These revisions can be quite large and usually affect the past five years of data.

8:30AM - Initial Claims

Release Details

• Importance (A-F): This release merits a C .
• Source: The Employment and Training Administration of the Department of Labor.
• Release Time: 8:30 ET each Thursday (data for week ended prior Saturday).
• Raw Data Available At: http://www.dol.gov/opa/media/press/eta/main.htm.

Initial jobless claims measure the number of filings for state jobless benefits. This report provides a timely, but often misleading, indicator of the direction of the economy, with increases (decreases) in claims potential signaling slowing (accelerating) job growth. On a week-to-week basis, claims are quite volatile, and many analysts therefore track a four week moving average to get a better sense of the underlying trend. It typically takes a sustained move of at least 30K in claims to signal a meaningful change in job growth.

There are two other statistics in this report -- the number of people receiving state benefits and the insured unemployment rate; neither is watched closely by the market. Some analysts track the number of people receiving state benefits from month to month as a guide for job growth, though this series has a poor track record in predicting the monthly employment report. The insured unemployment rate changes little on a weekly basis and is never a factor for the market.


Friday, May 30

8:30AM - Personal Income, Personal Spending, PCE Core Inflation

Release Details

• Importance (A-F): This release merits a C .
• Source: The Bureau of Economic Analysis of the Department of Commerce.
• Release Time: 8:30 ET around the first business day of the month (data for two months prior).
• Raw Data Available At: http://www.bea.doc.gov/bea/rels.htm -- see personal income release.

Personal income measures income from all sources. The largest component of total income is wages and salaries, a figure which can be estimated using payrolls and earnings data from the employment report. Beyond that, there are many other categories of income, including rental income, government subsidy payments, interest income, and dividend income. Personal income is a decent indicator of future consumer demand, but it is not perfect. Recessions usually occur when consumers stop spending, which then drives down income growth. Looking solely at income growth, one may therefore miss the turning point when consumers stop spending.

The income report also includes a section covering personal consumption expenditures, also known as PCE. PCE is comprised of three categories: durables, non-durables, and services. The retail sales report will provide a good read on durable and nondurable consumption, while service purchases tend to grow at a fairly steady pace, making this a relatively predictable report, and ranking it well below retail sales in terms of market importance.

9:45AM - Chicago PMI

Release Details

• Importance (A-F): The Chicago PMI merits a B.
• Source: Chicago Purchasing Managers Association.
• Release Time: Last business day of the month at 10 ET for the current month.

In Brief

There are many regional manufacturing surveys, and they tend to be ranked in order of timeliness and the importance of the region. The New York and Philadelphia Fed's surveys are the first each month followed by the Chicago purchasing managers' report on the last day of each month. A few, such as the Atlanta and Richmond Fed surveys, are released after the ISM and are of little value. The purchasing managers' reports are measured like the national ISM -- 50% marks the breakeven line between an expanding and contracting manufacturing sector. For the New York, Philadelphia and Atlanta Fed indexes, 0 is the break-even mark. These surveys can be of some help in forecasting the national ISM.

In Depth

The market has been bombarded with a bevy of surveys purporting to measure manufacturing activity in every nook and cranny of the country. First it was Philadelphia, then Chicago, and Detroit, Milwaukee, New York, Cincinnati, Richmond, Atlanta, Boston, and there might as well have been a Nome survey. This hodge-podge of releases is begging for someone - namely us - to come along and cut this group down to a more manageable size.

10:00AM - U. of Michigan Consumer Sentiment-Revised

Release Details

• Importance (A-F): This release merits a B-.
• Source: The University of Michigan.
• Release Time: Preliminary: 10:00 ET on the second Friday of the month (data for current month); Final: 10:00 ET on the fourth Friday of the month (data for current month).

The Michigan index is almost identical to the Conference Board Consumer Confidence index, though there are two monthly releases, a preliminary and final reading. Like the Conference Board index, it has two subindexes - expectations and current conditions. The expectations index is a component of the Conference Board's Leading Indicators index.