MarketShadows

A Covered Call Concept

A Covered Call Concept

By Paul Price, Market Shadows

Everyone loves to get something for nothing. When covered calls  expire worthless that is exactly what happens. The writer (seller) received money for the call premium. An option that goes unused means the  seller ‘won’  without giving up anything (keeps premium, keeps underlying stock). 

Many people think that seeing short calls expire is the ‘best case’ result. They are wrong. Simply do the math.

We own 100 XYZ Corporation which trades at $45 per share.  The bid on the October $50 calls is $2. Selling one covered call contract brings in $2 x 100 shares = $200.

If XYZ finishes at $45, unchanged from its trade inception price, on expiration Friday:

We originally held 100 XYZ shares worth $4,500. At expiration we continue to own 100 XYZ shares, still worth $4,500. We also have the $200 from the call premium = $4,700 in total value. 

Had the underlying shares declined in price by more than the $2 per share premium we collected, our position would have less total value than when we started.

The call money received was 100% profit. Did that really represent the maximum possible gain? No.

Consider the result achieved if XYZ ends at $50 or higher on the option’s expiration date.

            

The call writer would be forced to deliver 100 XYZ shares when the option is exercised. The option owner would then pay $50 x 100 shares = $5,000.  The call seller would also keep the $200 from the call premium received.

Final position = No shares + $5,200 of cash.

Total Value = $5,200.

What would you rather have on the option expiration date… $4,700 in liquidation value or $5,200 in cash?

It does rankle when the underlying shock shoots well above the strike price. Call sellers capped their upside. They might not capture the full move.

Do not sell covered calls at strike prices lower than where you would be willing to part with your shares.

The ‘risks’ in covered call writing is the same one that occurs when you sell any stock. There is always a chance that those shares go higher afterwards.  Another risk is that the premium collected is insufficient to cover a drop in the share price.

The key concept is simple.

By definition...

Once you have sold covered calls, having the options exercised always represents the best case scenario.  

Getting Paid to Try Again

Getting Paid to Try Again

By Paul Price

A life without mistakes is an impossible dream. Investing without disappointments along the way is equally unrealistic. With stocks and options bad choices typically result in losses. We like to think of Schedule-D write-offs as the tuition we pay for our stock market education program.

There is one technique that allows, what we hope are just occasional miscalculations, to be profitable ones. How can you be wrong yet still post a profits? Sell put options on stocks you think will go up.  

Last January 29^th I thought Quest Diagnostics (DGX) looked cheap at $58.25. The shares had touched $62 - $64 four times during the previous year. I expected that they would do so again before August 16, 2013. As of today DGX is still stick at $59.12.

Here is a customized chart I put together on Jan. 29, 2013 showing what those peak valuations looked like based on trailing 12-month P/Es at those moments in time. EPS for the four most recently reported quarters (through Sep. 30, 2012) were $4.50. At $58.25 Quest Diagnostics had a trailing P/E of around 12.9x.

DGX had other very favorable metrics beyond a modest multiple. The stock offered a good risk/reward proposition. Longer-term the looming implementation of Obamacare figured to stimulate demand for lab testing services. That remains true today.

 

Selling an August $60 put for $4.30 per share committed me to buying 100 shares at a net cost of $55.70. If DGX were to close at $60 or higher on expiration date the put would expire worthless and my obligation to buy would disappear forever.

DGX shares up slightly since January but have not sustained that $60 level as 2013 estimates were reduced from $4.46 to $4.33 per share. Here is how the stock has performed since I sold the August $60 put. The break-even (a.k.a. ‘if put’ price) of $55.70 is highlighted with the green doubled-headed arrow.

With one month to go before expiration the short put is in some danger of being exercised. ‘Rolling out’ the option will lock in a decent gain while reestablishing the same put position, but with a February 22, 2013 expiration date.

‘Rolling a put’ means ‘buying to close’ (BTC) the near-term short put while simultaneously ‘selling to open’ (STO) a longer term expiration put. In this case I’m using the same $60 strike price. I think DGX will ultimately go sustainably above that level.

Extending the expiration gives DGX more time to reach or exceed the needed threshold price.

Here were the actual closing quotes of the two options involved.

 

After the rollout my obligation to buy is still for 100 shares of DGX at $60. I have sold to open twice since starting the trade last January. I bought to close only once.

The first sale netted me $4.30 per share. The second sale brought in an additional $2.70 per share. I collected a total of $7.00 per share even from start to finish. My overall break-even point has been reduced to $53 /share.

By selling, rather than buying, the put option we can ultimately make more in the end by not succeeding on the first try.

See the full details of Market Shadow’s Virtual Put Writing Portfolio:  http://marketshadows.com/virtual-portfolios/put-selling-virtual-portfolio/

 

  

Don ’t Catch the “Bond Fund Blues”

Don’t Catch the “Bond Fund Blues”

By Paul Price of Market Shadows

Open-end bond mutual funds may represent the very worst way for investors to own fixed income. Why is that?

With fixed rate CDs and Bonds:

• If rates decline, bond prices go up.
• When interest rates increase, bond values decline.

The owners of bond mutual fund shares lucky enough to buy when rates were high might have thought they would keep getting the attractive average coupon rate in effect when they bought their shares.

After rates dropped, other investors saw the high income level and flooded that fund with new money. The managers of that open-ended fund get paid based strictly on the amount of money they invest. They are always happy to take in new net inflows. 

Newly issued shares dilute out the old coupon rate because the added money must be put to work in lower interest bonds. The original holders end up with a blended rate that is worse than they started with, even though they didn’t buy or sell any shares themselves.

The bond fund’s net asset value (NAV) doesn’t go up in the same way an individual bond would have based on the decline in coupon interest rates.  

The converse is also true. If interest rates are rising the value of exiting bonds falls. Net redemptions occur as the rats flee the sinking ship. The remaining holders of open-ended bond funds will see their NAV fall. Intrepid investors who stay the course end up taking all the losses incurred because of higher coupons.

Fund management can’t take advantage of the new higher rates as they are forced to sell existing paper to meet redemption requests.

In good environments bond fund investors don’t benefit fully. In poor rate climates they get doubly punished.

What can you do to avoid these problems? If you insist on owning fixed-income vehicles…

1)      Buy individual CD or bonds rather than open-end bond mutual funds.

2)      Buy closed-end bond funds that are selling for discounts to NAV. They are typically not subject to the problems that money flow creates.

Don ' t be Acrophobic

According to history, the stock market is not in dangerous territory.

Courtesy of Paul Price of Market Shadows

Chart of the Day published a contextual look at all the best bull markets since 1900. Based on that we could see quite a bit more upside.

Don't let a 'fear of heights' keep you from making money in the market.

 

Don ’t Feed the Bears

Don’t Feed the Bears

By Paul Price

That’s the motto of 2013’s bull market so far. Traders who were bearish and heavily in cash last fall, ahead of the Fiscal Cliff deadline, have had few chances to get into stocks on pullbacks.

                   

The week ended July 12 was no exception. Decent gains on Monday and Tuesday were followed by a flattish Wednesday. Anyone praying for a major sell-off had their hopes dashed when the DJIA & NASDAQ surged on Thursday to new all-time records.

 

Gains have been almost non-stop in 2013. The late-April pullback was shallow. The May through June sell-off was significant but anguished bears were too busy hoping for ‘the big one’ to buy into a mere 6% decline.

When market timers had their best buying opportunity of the year they often passed on taking action. Yogi and Boo Boo must be getting very hungry and frustrated.

We were not fooled by our politicians last fall. We refused to be hoodwinked by Chairman Bernanke’s Taper talk in June (see Don't Fear the Taper).

By remaining fully invested we’ve managed to compile an excellent track record without employing any leverage or options.

As of July 13, 2013, our Virtual Value Portfolio is ahead by 25.3% since its October 26, 2012 inception date. The $100,000 initial stake has grown to $125,319.

See full details about all open and close-out positions here.

 

In our Virtual Put Selling Portfolio, we have been collecting premiums through put writing. That portfolio has been doing well since we got it started in January of this year.

Type in your email on our home page and we will put you on the list for instant e-mail alerts when we post new articles, including those with trading actions. 

The Good, the Bad and the Ugly of Put Option Writing

The Good, the Bad and the Ugly of Put Option Writing

By Paul Price

Every investment technique can be useful in the right circumstance. Understanding how to use short options adds a valuable tool to your skill sets. If your portfolio includes options, the way you structure it may be even more important to your results as stock selection. 

Using options magnifies the effects of stock movements. The higher volatility relates to the smaller principal amounts involved in option trades versus outright purchase of shares. This quality, known as leverage, is a wonderful thing when you are correct in both your assessment of future price movement and correct in your timing.

Leverage can be painful, however, if you are wrong on direction or timing. Employing proper strategy allows you to establish positions you can live with while waiting for the ultimate results to play out.

Following two simple rules regarding put selling doesn’t guarantee profits, but does allow you to hold on to the position long enough to see if the reasoning behind the trade was valid.

Rule #1 applies to solid underlying stock selection based on fundamentals. If you can’t outline a well thought-out case for a  higher 6 – 18 month target price, don’t sell the puts.

Rule #2 is crucial. Never sell more puts than you could comfortably afford to have exercised. The dollar amount needed in an ‘if put’ scenario should be reasonable in relation to the size of your typical equity position size.

If your normal size buy equals about $10,000 worth of shares, limit your put writing to 1 contract on a $100 strike (1 contract represents 100 shares), 2 on a $50 name, 4 on a $25 issue, or 10 contracts on a stock priced at $10 etc. Everyone’s portfolio size is not the same. Adjust the number of puts you sell to be in accordance with your portfolio size.

Fight the urge to trade too large a quantity of options. Many people violate this principle by looking only at the premium received, rather than the ‘if put’ commitment in dollars.

Here is a real-life example of a ‘stock plus puts’ sale I made for my personal account just weeks ago.

Cognizant Tech (CTSH) has a stellar growth record yet had pulled back to relatively cheap levels in May this year. I bought 200 shares outright for $63.02 on May 17, 2013, while simultaneously selling three contracts of the Jan. 2014, $65 strike price puts. My account was credited with a $7.50 per share premium for those puts.

On May 28, 2013, I went back and sold 2 additional CTSH Jan. 2014, $70 put contracts. They represented an additional, bullish bet on the future movement of Cognizant Tech. For simplicity, those extra contracts will not be part of the discussion that follows.

 

Below is a chart I constructed to demonstrate CTSH’s cheap relative valuation just prior to the time of my trades. I was lucky enough to catch a weaker opening the next morning. That allowed for buying shares a bit lower than the previous day’s close. It also made for excellent put premium.

 

It cost $12,606 including commissions for the 200 share purchase at $63.02. The sale of the three $65 strike price put contracts brought in $2,247 in net cash.

The shares have no specific time commitment. The puts have an eight-month duration before their Jan. 18, 2014, expiration date. The worst-case scenario for those puts would force me to buy another 300 CTSH at a net price of $65.00 - $7.50 = $57.50 /share. That would require a cash outlay of $19,500, if exercised, less the $2,247 I collected from selling the puts.

  

In the best case (CTSH closing at $65 or better), I’ll be sitting on paper gains of at least $1.98 per share on the shares I owned outright. There is no upper limit on that profit. As of 4 PM on July 11, 2013 Cognizant was trading at $71.05.

In addition, I will have made $2,247 on the expired puts without needing to buy any additional shares.

The worst case scenario, in which CTSH closes less than $65 on expiration date, is not a negative because I believe the shares are worth more.

The break-even price of the 500 total shares would be $59.74. That is $3.28 per share below the trade inception price of $63.02. This gives me a 5.2% margin of safety.

Neither technique can be judged right or wrong, better or worse, until you know where the shares close on the option expiration date. Here’s a ‘cheat sheet’ to help you compare which does best under various final price points.

Option savvy traders have alternative ways to play the same bullish opinion on the identical underlying company. It is always good to have choices.

Disclosure:  I executed the trades described above in my personal account. I am long CTSH shares and short CTSH puts.

 

Packaging a New Put Position

Packaging a New Put Position

Courtesy of Paul Price

United Parcel Service (UPS) shares were hit hard today after the company pre-announced that quarterly results will be less than previously forecast. Management now indicates $4.65 - $4.85 for the full year 2013 versus previous guidance of $4.80 - $5.06 per share.

                       

The shares may have over reacted. UPS was down $5.87 ( -6.42%) as of 3:15 EDT. Market Shadows used the drop and today's high volatility to sell a January 2015 $80 strike price put @ $6.30 per share.

If UPS closes at $80 or above on January 17, 2015, we will keep the $630 premium without having to buy any shares. That is our maximum gain.

If UPS closes below $80 on expiration date we are committed to buy 100 shares at a net cost of $80.00 - $6.30 = $73.70 per share.

UPS could decline by a further $11.88 per share without causing a loss on this trade.

See details of all our open and previously closed-out option positions here. 

Saturday's Barron's noted that the reduced estimate from UPS would still be a 5% increase from 2012's EPS from continung operations.

Disclosure:  I sold UPS Jan. 2015 $80 puts @ $6.30  in my personal account this afternoon.

Self-explanatory

 

 

When is ' early ' just plain ' wrong ' ?

When does being 'early' make you 'wrong'? 

Courtesy of Paul Price

Originally published at Guru Focus. 

Does being 2.5 years early mean being wrong?

The latest issue of Forbes magazine chose to feature a duo of money managers that have failed miserably since they took their Ranger Equity Bear ETF (HDGE) public in January of 2011. The ticker symbol is cute. The article is titled…

[ Enlarge Image ]

A version of this story first ran on forbes.com on June 26, 2013. The bearish suggestion came after a five-week pullback had turned most media outlets negative. Highlighting a 100% bearish play following a big decline was, as things turned out, a great contrary indicator.

This two-month chart of the S&P 500 ETF tells the story. 

[ Enlarge Image ]http://www.forbes.com/sites/baldwin/2013/06/26/is-a-short-seller-after-your-stock/

Columnist William Baldwin did note that the fund had lost a lot of value since inception but suggested that sometime soon it might make a good play. The fund bets 100% on the bear side of the market which was a terrible place to be over the past 2.5 years.

Baldwin figured that the higher prices for the shorted stocks might lead to a big correction whenever some actual bad news besets them. HDGE is an actively managed ETF. It charges a higher than typical, for ETFs 1.5% annual management fee. The fund incurs charges for borrowing the shares they short. Any dividends earned by the underlying shares must be paid by HDGE shareholders. 

[ Enlarge Image ]

What did HDGE shareholders get for their money?

(Hint: it isn't pretty)

Full article: When does being 'early' make you 'wrong'? - GuruFocus.com.

For much serious education on how to invest in the stock market visit me at marketshadows.com
See my virtual value-oriented stock portfolio here: marketshadows.com

The main question is...?

At what price am I willing to sell this stock?

This is a great question to consider before you ever buy or hold shares in any particular company. Determining the prices at which a stock is undervalued, fairly valued, and excessively priced, is the first step in deciding on a credible target price for a specific time horizon.

A famous rule of ‘safe’ forecasting is to never put both a price and a date into the same prediction.

Forecasting a price without a date means you can never be wrong. For example, if you predicted that Apple (AAPL) was ‘on the way to $1,000’ you could still be correct as long as you had not specified a date for attaining that milestone. 

Some, but not all, research firms give ‘fair value’ estimates and/or 12-month price targets. When they are provided, the firms rarely disclose how they arrived at their numbers.

Here are my steps for setting a 12-month goal.

Accomplishing those tasks is tougher than it appears.

My favorite sources for establishing typical P/E multiples are the Value Line Investment Survey and Standard & Poors research. They often give very different viewpoints on the same historical data. Value Line shows ‘average annual’ P/Es for each stock during the past 10 – 15 years. S&P gives the ‘annual high and low multiples from the most recent decade.

Here are excerpts from both sources' research reports on Whole Foods Market (WFM) in regard to historical Price to Earnings ratios:

In the wild market of 2008, Whole Foods shares ranged from a high of $42.50 to a low of $7.00. S&P’s indicated P/E range lists from 9 to 52. That assumed you had accurately predicted its earnings. That would have been difficult in FY 2008. EPS on this growth company dropped from $1.29 to $0.82 as the recession took hold.

Value Line’s average annual P/E for 2008 is listed as 40.4x. That number reflected a time-weighted average price of $33.13 on the fiscal year earnings that finally unfolded.

The takeaway lesson? Even mathematically simple ratios involve judgment calls as to what true ‘normal’ is. That’s why computer generated stock picking has never proven superior to techniques employing human input. Annual averages often mask huge intra-year swings in P/E. That is due to the combination of price fluctuations plus changes in corporate profitability.

10-year median multiples can correct for near-term valuation volatility just as moving averages smooth out daily price variations. Value Line calculates this number for you at the top of each full page report they publish. They also show a hybrid (most recent 6-months’ actual + next six months’ projected EPS) Price to Earnings ratio [the largest, bolded P/E number] along with the standard trailing 12- month number.

 

Obtaining earnings estimates is relatively easy. Yahoo Finance, MSN Money Central, Zacks, Morningstar, Value Line, Standard & Poors and others all supply forward projections.

What are the problems? These sources don’t always agree on the numbers. Even when they do, those estimates may prove to be inaccurate. Some companies are fairly predictable, while others have a history of making earnings forecasts seem more like guesses.

Value Line provides each company a percentile ranking in the category of ‘earnings predictability’. Value Line's worst percentile rating is 5 and their highest percentile ranking is 100, as defined below.

Whole Food Markets rates a mediocre 60 in this metric. Less volatile stocks like Coca-Cola (KO) and Kellogg (K) rate in the top 1%. Highly cyclical US Airways Group (LCC) merits only a 5.

Using low predictability estimates in establishing target prices can lead to huge misses in terms of future share price action. The GIGO (Garbage In, Garbage Out) principle definitely applies to these low-predictabilty companies. Investors need to to question all assumptions.

Consensus estimates for Whole Foods’ 2013 fiscal year are now centered on $1.45 (FY ends Sep. 29, 2013).  That estimate along with a regression to its 10-year median P/E  suggests a split-adjusted goal price just above $49 (around $98 on the pre-split basis). WFM closed on June 28, 2013 at $51.47. The shares appear more than fully priced at today's quote using my method for analysis. 

Will WFM meet estimates? Is a 34 P/E a conservative assumption? Only time will tell. This was simply an exercise to illustrate a logical method to determine rational price targets. Every projection depends on assumptions that may, or may not, play out as assumed.

Shares in companies with hard-to-predict earnings per share (EPS) and highly variable P/Es (price/earnings) are particularly volatile.  Be sure to get paid for the extra risk. Companies with high predictability and stable multiples are generally safer and less volatility. Bargain prices in those stocks most often come during broad market selloffs.

 A good stock market guru doesn't paint himself into a corner by assigning dates to price predictions. He leaves the future to unfold on its own schedule. 

Disclosure:      Long KO shares, Short KO covered calls

GAAP vs. Anything Goes

GAAP vs. Anything Goes

By Paul Price

It used to be simple. Companies reported earnings in accordance with GAAP (Generally Accepted Accounting Principles). Media sources published the results in press releases. Traders and investors voted with their buy and sell orders, and the stock moved in the direction of the general reaction.  

Over the past decade, company managements and sell-side analysts have been increasingly adjusting the GAAP data higher, using Non-GAAP numbers to show larger than officially accounted for profits. 

The nonstandard measures of financial performance are far looser than GAAP numbers. Many times, these inflated results are the  only ones widely circulated by the press. 

Financial website Investopedia explains GAAP as follows…

"GAAP are imposed on companies so that investors have a minimum level of consistency in the financial statements they use when analyzing companies for investment purposes. GAAP cover such things as revenue recognition, balance sheet item classification and outstanding share measurements. Companies are expected to follow GAAP rules when reporting their financial data via financial statements. If a financial statement is not prepared using GAAP principles, be very wary!

On Non-GAAP numbers, Investopedia writes:

"Many companies report non-GAAP earnings in addition to the required GAAP earnings stating that the alternate figure more accurately reflects their performance. Some common examples of non-GAAP earnings measures are cash earnings, operating earnings, EBITDA (earnings before interest, taxes, depreciation and amortization) and pro-forma income.” 

Managements must always disclose GAAP earnings, to make comparisons between companies easier. Often, however, the GAAP figures are buried in the footnotes of SEC reports and transcripts of earnings calls.  Non-GAAP numbers are often more publicized. Companies would rather have analysts focus on higher ‘adjusted’ earnings per share (EPS) in order to make their stock valuations look cheaper. 

Restating EPS in non-GAAP terms by adding back the very real cost of employee stock option expenses is now a common practice. It obscures true compensation levels, including those of company officers, while raising the EPS number. 

 

Differences in reported data can arise from many sources. Other common adjustments come from merger-related expenses, revenue recognition decisions, any or all non-recurring items, and even the most appropriate number of shares outstanding to be used in calculating EPS. 

On-line financial sites don’t always disclose when they are not using GAAP figures. This can make a huge difference in the reported P/Es that various research services carry for the same stock.

Pharmacy benefits management firm Express Scripts (ESRX) provides an example. Its shares closed at $62.98 on Monday, June 17, 2013. Here are the ‘Analyst Estimates’ sections for ESRX as shown on that date from Yahoo Finance, MSN Money and Value Line.

 

Yahoo Finance used Non-GAAP estimates in showing 2013-2014 projections of $4.30 and $4.93 respectively. It did not mention, or even footnote, that the numbers were not GAAP estimates. Readers using those numbers would come up with reasonably low P/E multiples of 14.7x and 12.8x expected earnings for this year and 2014.

MSN Money Central showed an almost identical set of estimates. Current year and 2014 multiples also look low for ESRX as a high-quality, conservatively financed growth company.

 

Value Line provides a very different set of estimates. Value Line’s research used GAAP accounting in coming up with 2013 and 2014 expectations of $2.70 and $3.30. Based on those numbers, this year’s P/E is 23.3x. The 2014 multiple would be 19.1x. 

 

Value Line noted that Express Scripts’ management has said publicly that they project EPS of $2.80 for 2013, including any additional amortization charges from their 2012 purchase of Medco Health Solutions. It is mainly these non-cash charges - accounted for in the GAAP numbers but not in the non-GAAP numbers - that created the large discrepancy in reported EPS. 

How would an investor know? You would expect that well-regarded sources of financial data could be relied upon for accuracy. How about two-out-of-three? Consulting MSN money would break the tie between Yahoo and Value Line, with estimates based strictly on non-GAAP numbers.  

Taking time to read official company reports, with all their footnotes, will make you a better informed investor.

Deciding if a stock is reasonably priced means comparing apples to apples. Don’t get caught thinking a valuation is low by viewing adjusted figures against previously reported GAAP data.

Express Scripts is a large personal holding of mine. Whichever way you choose to calculate its earnings, the company appears to offer solid growth prospects.

Disclosure:      Long ESRX shares

 

Keep Your Head

Keep Your Head

By Dr. Paul Price

Large one-day selloffs can make investors nervous. 

Make sure your own mind is firmly grounded – just not in the way shown above.

Don’t lose your head, stick to fundamental analysis.  

Click here for the educational article index.

(Sorry for posting this a number of times. It's one of those mysterious posts that seems to mess up the site, but I've yet to figure out what feature is the problem....)

Reversal of the reversal?

Reversal of the reversal?

By Paul Price

Last Thursday's selloff brought insider buying back into vogue. The Thomson-Reuters Insider Sell/Buy ratio is now back into bullish territory. This indicator, like all others, is not infallible, but it has a decent record at calling medium-term (weeks to months) broad market moves.

Perhaps the abrupt selloff was a short but sweet disruption in a long-term uptrend rather than an early warning of impending doom. Market Shadows was a buyer, not a seller, during Thursday's decline.

 

Stocks & Bonds Plunged, Precious Metals Lost Luster, Oil Tanked

Stocks & Bonds Plunged, Precious Metals Lost Luster, Oil Tanked

Courtesy of Paul Price of Market Shadows

After no changes in actual Fed policy were made yesterday, markets around the world reacted badly to the non-news.

Stocks, bonds and commodities went down in unison across the planet. Did the values of any of those assets change by 2% - 8% overnight? Nope.

    

Did you sell into weakness? Traders might have, but investors should welcome the chance to buy assets at better prices. There are still no good alternatives to stocks in the quest to preserve wealth. (We discussed the reasons we're not worrying in the most recent newsletter, Don't Fear the Taper.) 

Market Shadows Virtual Value Portfolio is still ahead by 19.5% (+30.0% annualized) since our Oct. 26, 2012 inception date, even after today’s carnage.

We used the sell-off to put our remaining cash reserves into shares of the Vanguard FTSE Emerging Markets ETF (VWO).

 

The Jury is Still Out

The Jury: Still Deliberating

Courtesy of Paul Price 

Five weeks ago I wrote that the Thomson Reuters Insider Transaction Ratio was screaming ‘caution’. An excerpt of that May 11, 2013 column is shown below:

"A normally reliable short-term indicator is looking bearish.  

"Insiders, on balance, always sell more shares than they buy because they receive so much stock through employee compensation and bonus plans. The Thomson Reuters Insider Transaction Ratio considers it bullish when company officers and 5%+ holders, as a group, sell less than twelve times the dollar amount that insiders are buying. When that ratio exceeds 20:1, it is considered to be bearish, signaling widespread distribution.

"This indicator has proven fairly accurate looking out weeks to months. It is too volatile  to be useful for longer periods. I matched up the past 12-months signals to the movement of the SPY (S&P 500 ETF) to illustrate where it went right and wrong.

"The twin bearish insider selling peaks last September and October appeared to have provided valuable advanced warning of the sell-off that ended in mid-November. The short burst of intense insider selling that took place this past January ended up being a false negative. Five of the six major ‘buy’ signals worked out well.

"Both the SPY and Dow Jones Industrials closed at new all-time highs last week. Company officers have been active sellers. The Thomson Reuters Ratio is back in dangerously high territory. Will this be a good signal or a misleading one? Only time will tell."

*******

That extremely bearish signal turned out to be less than perfect.

The S&P 500 and the DJIA both moved higher for another seven or eight trading sessions before reversing trend. They have, however, gone sideways since the insider signal flashed the yellow caution light.

What is the insider transaction ratio saying about the mid-June market? It has come back into neutral territory.

It appears that the last year’s signals have been more predictive on the bullish side than the bearish side.

Stay tuned for further updates as the remainder of 2013 unfolds.

Trade Less, Make More

Trade Less, Make More

By Paul Price

Frantic in-and-out trading is a very popular technique for those who like to feel they are making a living while sitting at home in front of their computers. Scalping a percent or two on huge principal amounts seems tempting when you simply total up the dollar amounts of gains as they are booked.

What could be simpler? But what happens when your $200,000 block of shares gets caught in a downdraft before rising? Do you get stopped out and eat a big loss? Or do you turn your ‘trade’ into an ‘investment’ hoping it rebounds before getting worse?

Unless you have sufficiently large trading capital, it won't be possible to diversify adequately with positions that size ($200,000). 

What if the company announces an earnings miss? What if Japan craters or some European bank or government goes does in flames?

It might be difficult to sleep at night worrying about what might happen on the next day’s opening. It might be even more difficult to sleep the next night after seeing what did happen.  

Proper portfolio construction and patience allows for a saner existence, much lower trading expenses, and improved mental health.        

Click to enlarge:

 

While “You’ll never go broke taking a profit,” you will also never have the chance to make big percentage gains.

Our Virtual Value Portfolio is profitable in large part because we had an investment horizon that allowed that to happen. Buying value means picking stocks that are underappreciated by others at that time. Typically, it takes months to years to realize your expectations. Market Shadows has been lucky, good or both since we started our portfolios last fall. The most important decisions we made were to get invested and to stay invested. We didn’t try to time the market. We ignored Fiscal Cliff, Sequestration, and other assorted media scares.

Trade less, make more, sleep more.

Your psychiatrist will be the only one who suffers from the change in technique.

See full details of our Virtual Value Portfolio and our Put Selling Portfolio.

Buy the Fear

Buying low. Easier said than done.

By Paul Price

Thursday might be the first three-day losing streak for the broad market in quite some time. Many stocks that you were hoping to buy a few weeks ago ‘if they ever pulled back’ have come down in price. Not surprisingly, many of the same traders that were praying for chances to get into stocks cheaper are now hesitant to do so. That’s the conundrum of investor pyschology. Higher prices instill confidence that shares are going up.

Declining quotes often make us question our investment thesis. Falling stars also make it hard to pull the trigger as waiting might result in even better entry points.

Two similar but non-identical indicators say you should be putting some cash to work right now. As of yesterday’s close, the S & P 500’s 10-day advance/decline line was near its best levels (when used as a contrary indicator) since the exact bear market low set on March 9, 2009.

                       

I linked many of the most oversold time periods to their respective places on the chart of the S & P 500 ETF (SPY). Clearly, anyone with a reasonable time horizon would have been much better buying than selling once the cascades of panic had cleared shares held in weak hands. I expect the current sell-off will lead to the same result.

The Overbought/Oversold Oscillator flashed an almost identical signal on the close Wednesday. Today’s action sent it to even more extreme readings.

 

The chart showing the Overbought/Oversold Oscillator along with the S & P 500 (above) is visually cluttered and hard to read. I added the exact same time period for the DJIA ETF (DIA) below the Oscillator chart for further clarity. I marked the five previously most oversold readings with stars. Four of those periods were followed within days by major upturns in the broad market.

The outlier, marked on the charts with the yellow star, saw a 30-day bounce that was then followed by a 45-day fairly significant decline. I’d call that signal a draw.  Six months later the indices were flattish. Twelve months later the indices were much higher.

Being right 80% of the time can make you a lot of money in this game. The trick is to think in terms of months rather than hours or days. What has changed fundamentally since Mid-May to justify all the sudden negative vibes? Nothing much, unless you are basing your buy-sell decisions on Japan’s Nikkei 225 index. What will you do with the cash generated if you sell your stocks? If you are like most traders, you will put it back into equities again once some indicator tells you it is safe to get back in.

 

It ' s a confidence game

Paul Price discusses the "Confidence Game" being played in the stock market and how to read the indicators; some commonly used indicators are contrary indicators (e.g. individual investors' sentiment). 

Paul made this video for Real Money Pro about a year and a half ago, so his closing thoughts on the market are out-dated. 

It's a confidence game

Courtesy of Paul Price 

Note to Paul Price ' s Readers

Dr. Paul of Beating Buffett is now featuring articles in our Market Shadows Value Investing Section.

Find Model Portfolios, Stock Ideas, Option Trades & Education, Economic Commentary, and an index of excellent Educational Articles on various investing topics. 

Bookmark this page. 

 

Sea of Money - Educational Article Index

Sea of Money

This week's Market Shadows Newsletter provides an index of educational articles on various aspects of investing. In this collection, Paul Price shares his methods of building a stock portfolio and his strategies for using options. 

The full Market Shadows Newsletter, Sea of Money, is here >. 

EDUCATIONAL ARTICLE INDEX 

BUILDING A VALUE STOCK PORTFOLIO

Building a Portfolio from the Ground Up – Part One. Basic portfolio building rules. 

Building a Portfolio from the Ground Up – Part Two. Allocate wisely.

Make Money – Adopt a Dog. “And the last shall be first.”

“You’re Nuts to Average Down.” Not true, but keep your position sizes under 5%.

In Love with TINA. Why love stocks? Because There Is No Alternative. 

Why We Diversify. To avoid disaster. 

The Trouble with Tech & the Dethroning of Darlings. APPL is transitioning from Darling to value stock. 

Whether stocks are cheap is besides the point. Owning equities provides a chance to preserve value as paper money is marked down. 

P/E 10 as a Valuation Gauge = Incomplete Information. Price/Earnings ratios are not set in a vacuum.

Individual Investors Remain Perfect Contrary Indicators. Buy only when you find good value for your money.

Unloved Stocks Rocked in 2012. The requirement that shares exhibit technical strength prevents analysts from naming the best bargains as their top picks.

Never Met a Rich Pessimist: Interview with Dr. Paul Price. Trying to predict the unpredictable is a fool’s game.

Recognize Market Insanity. This time it's different shouldn't be your game-plan. 

 

WHEN TO BUY STOCKS

Frustrations and Rewards of Value Investing. Buy the unpopular. Sell the beloved.

Equities not yet pricey enough to entice retail investors. We’re still bullish, but looking for values. 

“You’re Nuts to Average Down.” A myth.

Make Money – Adopt a Dog. The least loved equities often outperform. 

Year–End: Investors were Penalized for Holding Cash. Waiting for better prices proved costly.

Recognize Market Insanity. Pricing isn't efficient; it's better seen through the prism of "Extraordinary Popular Delusions and the Madness of Crowds." 

When a Great Company is NOT a Good Stock. Buy bargains. 

 

WHEN TO SELL STOCKS

Sell Discipline - Have a plan. And don’t ditch it at the last minute. 

Call Me Maybe - Covered calls impose “sell-discipline.” 

 

SELLING PUTS

Shares plus Covered Calls Vs. Selling Naked Puts? Selling a covered call (buying a stock and selling a call against it) versus selling a naked put.

Selling Puts on Value Companies - A New Virtual Portfolio Selling a put is a bullish position. It is similar to a below-market limit order to buy a stock. 

Selling Puts on Value Companies (Part Two). 

 

COVERED CALLS 

Call Me Maybe. Selling a call against a long position brings in income and imposes sell-discipline.

Covered Calls – The Hidden Risk for 2013 and Beyond. It was not a good time to sell calls. 

Shares plus Covered Calls Vs. Selling Naked Puts. Selling a covered call versus selling a naked put.

 

HEDGING & TIMING 

The High Cost of Hedging. Why pay those high insurance premiums?

Year–End: Investors were Penalized for Holding Cash. Waiting for better prices proved costly.

March Madness and Your Trading Decisions. Flipping your positions has more downside than you think. 

 

INFLATION

Washington’s Biggest Lie. Yes, Virginia, there is price inflation. 

 

GOLD

What have you done for me lately? Precious (metals) little. It’s hard to quibble with having portion of overall net worth in something tangible.

All That Glitters… Avoiding being hit by falling gold bricks. 

Hidden Dangers in Gold - Part One. When the guy loading wholesale beer knows the price of a gram of gold instantly, worry.

Hidden Dangers in Gold - Part Two. Gold is not a great hedge against inflation.

Gold’s ‘Highly Inflated’ Track Record. Gold’s track record is highly inflated.  

Mettle Trumped Metal. Fundamental investing won.

 

BEWARE OF MARKET GURUS AND DON’T CHASE HEADLINES

Schizophrenic ‘Rear-View Mirror’ Covers from Barrons. Invest based on fundamentals rather than whimsical backward-looking data.

You don’t need a weatherman. Tune out the noise. 

Always Question Assumptions. The rationale for a price goal may be built on quicksand.

Wall Street Cheats – Don’t be fooled. We can all be market geniuses with the benefit of hindsight. 

You only see what they want you to see. Selective advertising.

Market Comments: Lots of Words, Little Meaning. The market always goes either up or down.

Individual Investors Remain Perfect Contrary Indicators. Train yourself to ignore the news. 

Scare Tactics – Prepare Yourself to be Bombarded. Bad news sells. 

 

Sea of Money - Glimpse into Future

Sea of Money

Glimpse into Future

In this issue of the Market Shadows Newsletter, we index previous educational articles by Paul Price for easy access and review recent moves in the virtual portfolios. Lee Adler provides an update on current market conditions. 

Read the whole newsletter: Sea of Money: Market Shadows Newsletter 5-7-13

Excerpt from Glimpse into Future

Lee Adler of the Wall Street Examiner reports that the Federal Government is “rolling in cash” due to higher-than-predicted tax collections and possibly reduced spending due to the sequester cuts. In Wildly Bullish Liquidity Flows Should Benefit Stocks More Than Treasuries (subscription required), Lee noted,

“Overall, the TBAC sees a net paydown of $21 billion from now through the end of the second quarter. That’s a far more bullish forecast than they had in February for this period when they were expecting that the Treasury would need to raise cash from net new supply of $83 billion from now until the end of the quarter. That’s a positive swing of $104 billion from the last quarterly TBAC update until the one just released at the beginning of May.”

Thus, the Treasury’s revised projection that it will pay off $21 billion in net borrowing by the end of June resulted from higher than expected tax revenues and the much maligned sequester cuts. This is equivalent to a family being able to reduce their credit card's monthly balance by paying more to the bank in a given period than they incur in new charges.  

Reduced federal borrowing will free up $21 billion investor money that would have been soaked up by new T-bond issuance. A good part of that sum will likely find its way into the stock market, providing fuel for a stock market melt-up. This excess liquidity is bullish for stocks, as Lee Adler explains in the following excerpt from The Irony Of The Fed’s Manipulation – Professional Edition (subscription required): 

The only change in today’s FOMC statement was the addition of some words to the effect that the Fed would consider increasing quantitative easing (QE, colloquially known as ‘money printing’). Apparently its strategy of jawboning and manipulating commodity prices worked too well, so now instead of threatening to end or taper QE, it now must resort to threatening to add to it to keep commodities from continuing the decline that the Fed seemed to want. 

It would seem that too little inflation is a worse fate than too much. 

Regardless of all the words, the policy remains the same. Print mass quantities of money and jam it into the accounts of the Primary Dealers every month. Today (May 1) there’s some profit taking as traders and algos digest weak economic data, but I’m sure that once they’ve had a chance to consider and recalibrate the implications of the Fed continuing to increase the size of the numerator that goes into the pricing equation, they’ll be back at the table shortly. 

The composite liquidity indicator rose last week, mostly from the Fed’s weekly Treasury purchases. 

Gains in most indicators were slight. April, the period of the strongest liquidity flows of the year from the massive paydowns of Treasury debt, has now ended. Liquidity will slack off a little in May as the Treasury returns to being a net borrower, but river of cash will continue until the Fed ends QE. The Bank of Japan’s (BoJ) massive new QE program will also add to US market liquidity." 

The biggest surges of cash come after the Fed settles its MBS purchases around mid month. That pattern will go on until the Fed ends this round of QE. News flow will cause stock and bond prices to continue to fluctuate around the liquidity trend. Buyers will get fatigue from time to time, as they did today. No doubt there will be more efforts to manipulate commodity prices, particularly gold and silver, but now that the Fed sees that it may have been too successful in scaring speculators away from commodities, they’ll probably try to say stuff that gets them buying again. Fed policy is nothing if not ironic...

Some of the money that the BoJ prints not only can but does move into US paper, whether Treasuries or stocks. It will show up in the Foreign Central Bank measure and in banking measures. There’s a strong correlation between the BoJ balance sheet and US stock prices, both over the long term, and in intermediate swings.” 

The correlation between the direction of stock prices and the size of these central bank balance sheets is remarkable.  

Fed Cash to Primary Dealers measures the flow of cash into Primary Dealer accounts from Fed securities purchases. This indicator has the heaviest weighting in the composite. The current growth under QE3/4 is the fastest in history. It will be bullish until the Fed ends QE. Stocks will stall or pull back from time to time, hemmed in by resistance and news flow, but the Fed’s cash will find its way into equities sooner or later.

*****

Read the whole newsletter: Sea of Money: Market Shadows Newsletter 5-7-13

Get regular updates the machinations of the Fed, Treasury, Primary Dealers and foreign central banks in the US market, in the Fed Report in the Professional Edition, Money Liquidity, and Real Estate Package. Click this link to try WSE's Professional Edition risk free for 30 days!

Special offer for readers: Click on this link to try Phil's Stock World FREE! 

TA = BS

TA = BS

Courtesy of Paul Price

Everything works sometimes. Nothing works every time. 

Stock market chartists (technical analysts) claim they can predict the future by studying past action in share of stock, indexes or commodity prices. They can draw lines showing that specific, key levels are ‘support.’  Others are ‘resistance.’ 

The problem with technical analysis (TA) is that it doesn’t work most of the time. Technical analysts constantly trot out their ‘broken clock’ winners to suck you in to the idea that you can profit without understanding what you are investing in on a fundamental basis. 

What does a TA practitioner do when a presumed support level is violated? They note the next support price that they have identified from past trading. If the new, lower price holds, they can declare victory. If not, it’s on to another cheaper target. 

Does price action indicate that the ‘smart money’ knows how a quarterly report will look, or how the market will react to it? Take a look at just a few days of trading last week in the shares of the infrastructure play Aegion (AEGN).

 

The company was due to report after the close on Wednesday April 24th. By mid-morning on Monday the stock was down 3.2% from the previous Friday’s close. Did that mean ‘get out’ because somebody knew the news was going to be bad? By 11:00 am on Wednesday the shares were up to $21.63, 5.8% higher than the previous week’s close. Did that make them a buy because insiders were sure the quarterly report would be great? 

Keep reading > 

 

There ' s One Born Every Minute

There's One Born Every Minute

By Paul Price 

"Let us break their bonds asunder, and cast away their cords from us." Psalms 2:3

Most Americans would have a hard time locating Rwanda on a map. Here is a visual aid. 

Investors would be smart to adhere to this biblical advice. Last week Rwanda, a tiny speck of an African nation, issued $400 million with an interest rate of 6.625% in U.S. dollar denominated paper. The order book was 8.5 times oversubscribed. 

The 10-year bond was sold at a yield of 6.875%. The bonds dropped off slightly early on Friday before finishing up the week near par.

Fitch rated the bonds at "B."

What chance does the country have of repaying this principal at maturity? The Wall Street Journal noted that foreign aid accounts for about 38% of the country’s budget. That suggests that 100% of the debt just incurred can be payable only due to gifts from American and European politicians.

Ordinary citizens are thus funding involuntary transfers of their hard-earned money to Rwandan officials. Whatever is left after deductions for graft and corruption will be used, at least temporarily, to pay generous interest to wealthy investors. There is zero probability that Rwanda could pay even the interest, let alone repay the principal a decade hence without this Ponzi-like, foreign aid financing.

Keep reading >

 

 

Focus on the Big Picture

Focus on the Big Picture

Keep things in perspective. The charts below illustrates that last week’s action simply brought the broad indices back from nominal all-time highs set earlier this month. Looking at the DJIA and the Nasdaq Composite, it is noteworthy that almost 100% of their 52-week performance came from movement just since the start of this year.

[Click on images to enlarge]

IBM’s greater than 10% one-week drop and Apple’s regression to under $400 dragged down the tech index by 4.36%.

 

The summer of 2012’s market lows were set as expectations for worldwide recession were being priced into industrials and materials. Buyers of those stocks last May and June ended up big winners even though the economic conditions haven’t changed much since then.

Industry leaders like Deere (DE), Cummins (CMI), Caterpillar (CAT), and Schlumberger (SLB) now trade nearer to low points than to highs.  Fertilizer companies Agrium (AGU), Potash (POT) and Mosaic (MOS) are similarly offered at near multi-year low valuations.

If you missed making money in these by passing on them last spring, you are now getting a second chance to acquire positions at great prices. “Buying low to sell high” requires actually getting in when the news is bad and expectations are low.

It’s better to buy when shares of solid companies are out-of-favor. Ironically, that’s when yields are best and risk is diminished.

Any stock could go lower in the short run. World-class companies that supply needed goods and services will always come back up when the cycle plays out. In an environment dominated by in-and-out trading, those who take a longer-term view are more likely to outperform.

See our Market Shadows Virtual Value portfolio here.

 

A Little Strategy, a Little Action

Here's the latest newsletter: A Little Strategy, a Little Action, 3/24/13

Strategy: Averaging down in a quality company has been a successful market technique according to recent evidence. However, a prerequisite is that you don't overweight your portfolio with an outsized initial position.

"During the year, 100% of the DJIA companies traded below their annual peaks. The intra-year declines ranged from as little as 5.8% (JNJ) to as great as 62.2% (HPQ). 30 out of 30 closed last week above their 2012 nadirs. 

"The biggest recovery came in last year’s biggest dog (HPQ). Other large percentage rebounds occurred in lower quality BAC, old-tech companies (CSCO & IBM) and the controversial bank JPM. While those stocks were ‘falling knives,’ the old adages about never averaging down were certainly quoted numerous times. Adhering to that advice was a hedge against prosperity." (Of course buying at the absolute bottom is better than averaging down, but catching that bottom requires luck and we can't count on that...)

 

Strategy:  Selling puts, for those comfortable with selling options, is a way to either profit by keeping the premium, or enter a stock at a lower price than it's currently trading at. We have our Virtual Put Selling Portfolio up and running. 

Actions: 

Paul sees less bargains than he did several months ago. However, he still likes Express Scripts (ESRX), Quest Diagnostics (DGX), Lab Corp. (LH), Coach Inc. (COH) and Calamos Asset Management Inc. (CLMS) at current prices.

Patient investors may find better bargains if this toppy market sells off – which wouldn’t surprise us. We’ve built our cash position in the Virtual Value Portfolio up a little bit for this reason; sold our position in ICE. 

In the meantime, however, Paul has sold a put in SLB, CMI and ORCL. 

 

Trends for next week courtesy of Lee Adler: 

Liquidity Sufficient to Keep Bid In Treasuries AND Prevent Stock Selloff 

• Treasury supply will be heavy this week, while support from the Fed is reduced at the end of the month. This would normally unsettle the market a bit. But much of the $100 billion in Fed pumping from mid month may still be available for deployment. That could keep bids under both Treasuries and stocks. 
• Foreign central bank (FCB) buying (US Treasuries) is in the weak side of its short term buying cycle but renewed fears over the European financial crisis are likely sending more private foreign capital flooding into the US Treasury market, and more Fed cash will be on the way, so weak FCB buying should not be enough to slow the markets. 
• Recent strength in withholding taxes are resulting in a windfall for the government. Withholding tax collections for the 2 week period ended March 21 were up 11.5% over the corresponding period of 2012. That compares with a gain of 9.2% a week ago. This suggests that some sectors of the economy are much stronger than anybody realizes and may be overheating. Tax collections remain well above what can be attributed to the tax increase alone. 
• The sequester could reduce Treasury supply by a small amount, which would be a bullish factor for both Treasuries and stocks. With less Treasury supply, more Fed QE cash would be available for stock and commodity speculation. 

 

Read Market Shadow's A Little Strategy, a Little Action here.