Vad's Best Ideas

Prisoner's dilemma or why I think the Super SIV Fund might not be a bad idea

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"If you do not know where you are going, all the roads will take you there"

Now, more than ever, I believe that Ben Bernanke is making a serious mistake that will come back to haunt all of us in the months to come... I still can not believe that with headline inflation number that is so stubbornly high, Fed actually had the stomach to cut rates last week...Yes, it is true that when trying to decipher the message between the lines of the release that accompanied the cut announcement one can make the reasonable forecast that this rate cut could be the last one for a while, and that Fed pretty much acknowledges (finally) that inflation threat is now real. But it is just simply too scary to realize that Fed's decision was clearly so heavily influenced (manipulated) by a widespread cry of Wall Street Babies...

But on the other hand unraveling of the sub prime fiasco might be causing more damage than everyone anticipated. And it doesn't really matter that the losses reported by major banks are predominately paper write downs and that cash flows have not yet been affected much. The truth is that in my view the main issue with financial sector right now is not a liquidity problem/event per se (which Fed is wrongly trying to fix with rate cuts) but rather a fundamental inability to correctly perform a basic function that bank must perform every day to survive- calculating the creditworthiness of the their potential client.

Technically bank can lend money to any client even without determining what the value of the collateral using the projected income stream as a basis. But here lies another issue- you can only use the income stream as a basis only if you are reasonably sure that the net worth of the borrower is can not go below the value of the income stream (intangible net worth) minus all the liabilities. Example could be MGI - it is clear that the income stream itself would allow for a higher valuation if only one could determine how low their tangible net worth could decline?

And that's were Buffet's "financial weapons of mass destruction" term comes handy- not only there seems to be no easy way to value many of the CDOs in question, but in addition to that methods that used most widely- the one based on agency ratings and the one based on ABX index-are starting to make thing look worth right at the time where they theoretically should be getting easier.

Every day seems to bring news of new securities downgraded. But is it all bad? Looking at the language behind some of these announcements does not give us a clear cut answer. For example in yesterday's WSJ's article about the newest round of SIV downgrades Moody's said it "wasn't taking the ratings actions because of the quality of the assets in the SIV. Instead, Moody's said the SIVs problems stemmed from the drop in the market value of the assets the SIVs own as investors shun those investments amid the credit crunch."

And that could be really bad news for the whole world economy because events driven by fear always unravel faster than the ones driven by greed. It is a common knowledge that correlation of assets and markets increases dramatically during the period of declines. And with so much volume across the world driven by computers this correlation has increased even more. This creates a feedback loop-because of the reduced paper value of the collateral banks are making margin calls which in turn reduce value of the collateral even more. This in turn triggers more paper losses which lead to new margin calls.

Many of the better capitalized players have resisted selling assets at fire sale prices so far which means most of the losses to date are purely paper write downs. But here comes the prisoner's dilemma that Paulson and Co are trying to solve with a Giant Super Fund- how long could one continue to hold on to paper losses knowing that if they are the last ones to sell they will end up with nothing? We all know that rational choice leads the two prisoners to both defect even though each player's individual reward would be greater if they both cooperated and resisted selling. In equilibrium, each prisoner chooses to defect even though both would be better off by cooperating, hence the dilemma.

Could the SIV fund provide a solution? I am not sure but I want to give Hank Paulson a credit for tryin. For now the capital cushion is sufficient to avoid the meltdown - but the real danger is that this cushion is getting thinner every day and if/when the landslide is triggered it will get really ugly in a heart beat...

One might argue that Fed's rate cuts designed to cure this problem and thus Fed is doing the right thing but my argument is very simple- does any one really believes that we can potentially inflate this problem away? Doesn't inflation destroy productive economic activity at the expense of the unproductive one? Can you really slow the inflation down once you let it get out of control without jacking rates even higher? And the really big one is -isn't financial sector very sensitive to inflation, because of the potential mismatch between assets at fixed low rates and liabilities at variable higher rates triggered by inflation fighting measures?

Anyway, enough rumbling - back to stock picking- what does all of the above mean for our portfolios? I think one thing is clear- as I mentioned one of my posts before http://www.investorplaceblogs.com/users/dishwasher/2007/10/the_wordly_bubble_part_2.php
Emerging markets and high flier speculative stocks might have passed the glamour stage and now are subject to correction. I've been a China bear for almost a month now and even though recent 20% declines might seem excessive to some, I think that we still have a long way to go there.

I am also not very satisfied with the performance of my portfolio recently. Most of my anti decline hedges put in place last week have not worked as I planned. So while I have my view of what's right and wrong, I am also not going to fight the Fed and the Market either. So early this week I have diversified into a more conservative portfolio: sold ETFC for MO and CG (tobacco is a staple so shouldn't decline as fast the market), sold airlines and trimmed my larger positions for small positions in PTNR, NOK, APFC, SRS, SDS and BQI.

To sum it up- I am in capital preservation mode now with most high volatility picks out and lower volatility plays in. I am probably a bit light on commodities after my sale of NXG, but you have to take a profits when your picks ran faster and higher than you expected, plus commodities have been running for a while now and thus could be subject to violent pull backs if Fed switches to inflation fighting mode...

Anyway trade safe and cheers,
Vad

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All things good to know are difficult to learn

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Rule #1- Never Lose Money
Rule #2- Never Forget Rule #1

I tend to believe that the true the investment talent could only be separated from luck in a period of bear market turbulence. It is just simply too easy to claim that one is great at stock picking just because his/her portfolio has done well during the period of widespread bull rally. As the wisdom of the world's most famous investor states, the first objective of the investment management is to make sure you do not lose your clients money. Swinging for the fences could be great for winning a short term investment contest or earning a quick bonus but not for a long term investment marathon.

As I have stated before, I am an opinionated contrarian investor who likes to disagree with the general public opinion. But I also have no problem switching my stance towards a specific stock or a sector if the facts tell me to do so. "Flip flopping" might bad if you are running for president but it is a necessary skill if you want to succeed in investing.

Unless you have developed a disciplined way to deal with money losing positions you are likely to have your gains wiped out completely or severely reduced by bear markets. I have a few basic rules that I follow when constructing my portfolio that I recommend adopting for anyone out there who is willing to listen:
1. Never have your money invested in one sector because your probability of losing money quickly increases drastically
2. If you are a contrarian and like to average down on stocks that are going through a period of a serious correction never take a full position to start. (I usually begin with roughly 1/3 of my mental maximum position) Leave yourself some room for error, as you are certain to make quite a few of them. Markets do overreact all the time but they also tend to be right over the long haul.
3. Don't invest more than 25% of your money in one stock (that includes positions were you averaged down several times as well)
4. Don't argue with the Fed- I don't care how passionate you are about it and how wrong do you think the Fed is- don't forget Fed controls the dollar printing press and thus could win any short term battle by default
5. Don't listen to fools who tell you that you can time the market- your chances to do that consistently are not much higher than winning a lottery. Stay fully invested- if you aren't feeling good about the market-hedge with lower beta stocks to reduce the overall sensitivity of your portfolio or short sell the weaker players in the same sectors you are already invested in
6. Don't be afraid to disagree with everyone with anyone except the Fed- but make sure you have enough liquidity to stay solvent, if they (general public) turn out to be right for a prolonged period of time

It has been a rough ride for the market in the last ten days. Not unexpected but still tough. I had to make quite a few trades in the last several days again to preserve my gains and was able to bounce back about 4-5% from the recent low including gains on both Thursday and Friday. It has been pleasant to see my portfolio to actually go up on the days when market was losing 200 points.
To achieve that I had to make some tough sells and hasty buys. I also told my wounded greed to shut up and to listen closely to the fear. My positions in LCC and ALK have backfired on me last week, when after a quick 5% gain the whole airline sector got shuttered by oil stubbornly climbing towards a $100 a barrel mark. I sold all of LCC and most of ALK for a hefty 10% loss. Being stubborn is not smart when investing- if you are wrong just move on.

I also sold E-Trade because between MGI and ETFC I had more than 25% invested into "catch a falling knife mode" stocks- hence I had to stick with my discipline and picked MGI as a stronger one of two. It paid off when ETFC kept going down and MGI bounced back. I trimmed/sold other positions (TSP, EMC, NXG, GILD) and reinvested proceeds into MO and CG as they are both low volatility safe-haven stocks that tend to do well when market is in the correction phase. Today I also sold most of FSIN as there seem to be better deals popping up out there now.

I also quickly reversed my NOK and BQI positions early this morning with proceeds going into ultra short hedges - I have split a 16% portion of my portfolio into four stocks to preserve capital- QID, SDS, SRS and DXD. These are not long term holding for me and I will look to reverse them when one of two things happens- they appreciate 4-5% or if/when DOW hits 12800 and/or bounces back.

Some other quick market observations that are a bit of a puzzle for me as we move through the next few days:
• Retailers have reported dismal October sales and forecast even slower growth- how can that be good news for anyone?
• MasterCard's announcement that sales at gas stations dropped off significantly during the last three weeks went almost unnoticed- another notch in the recession belt? Negative for commodities?
• Mining stocks are hitting new highs, heh? If the world is going into a recession how you would expect the most cyclical industry to behave once it actually becomes clear we are there?
• Do you really believe that China is recession proof with only 16% of GDP supported by its own consumers? If you do - I wish you luck. Petrochina at a $1 trillion market cap? Not a bubble? Duh?
• Yesterday's high fliers are declining significantly faster than the rest of the market- first Chinese stocks, followed by dry shippers and now technology? Miners next?

More to follow in the next few days but for now trade safe and cheers,
Vad

P.S. The next time your mouse nervously moves towards a negative rating because you disagree with my assessment of the job Ben & Co are doing, please remember that we all will be proven right and wrong eventually, the main goal in the end is to make money and to have fun doing it. Remember an old saying "A bird does not sing because it has an answer. It sings because it has a song"

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Quick thoughts on the market

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- ETrade has injected a very healthy amount of fear into the market yesterday- not a bad time to reload- buy ETFC
- Commodities have finally started a decline... It does not smell like a mere correction - it smells like a real decline here- wait for a quick dead cat bounce and short RTPs and BHPs of the world...With most of the world slowing down dramatically how could commodities go up?
- At the time of fear correlation on the downside increases dramatically hence any markets with high Beta (BRIC) will decline faster than the US. The question here is whether we are up for a 4-5% short term bounce? I am not sure yet, so I'll wait before loading on FXP (ultra short China 25) - sold all ultra shorts why are they are still up...
- Watch for retailers on any signs that demand is picking up- WMT and TJX first sings today?
- The rebound will be led by tech decliners- RIMM and AAPL? Again I would not expect the commodities decliners (FCX, POT etc )to rebound all the way back for now...Some gains are certainly in the works but not enough to take the risk...
- Financials leading the pack? How long could it last? We have not yet heard from several banks on the write offs? Are those priced in now?
- Everyone expects the Fed to cut rates- what if they don't? How hard could the market fall? Will commodities lead the sell off again?
- 50BP rate cut is now widely expected? Why? Market tends to overreact so this could be the bad one...No Santa Clause rally here in my book...
- Goldman has started unloading the emerging markets, I am in a full agreement at this point- all rallies one day come to a rest...

Anyway trade safe and cheers,
Vad

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"You don't get harmony when everybody sings the same note"

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Today's rally made the big picture quite a bit murkier for me...Markets shined with momentum darlings rebounding incredibly strong. But is it real? What has changed since yesterday? Is it really a dead cat bounce or are we seeing the usual year-end rally? I am not completely sure yet, and think that while today's snap back could have hardly been any more convincing on the surface, it was not triggered by solid data, but rather was simply an opportunity for bottom fishers to pick some deeply discounted (compared to last month) shares.

Let's be realistic and reasonable- while Goldman's comments that it does not expect any write offs seem to have triggered a "cheerful rally" in the financials, I still don't understand, whether people simply can't or don't want to read the whole story. The only reason GS is not writing CDOs off is because it maintains a net SHORT position in US mortgage market? So the maestros of the herd say that they are SHORT and the stocks that are most heavily exposed to this short position, rally in double digits? Heh? I had to actually drink several beers followed by two cups of coffee when trying to think it through... Several "Foster's" six pack and a mad wife later, I still came up with no convincing explanation other than simply assuming this was a typical "greed" rally...

Another puzzle today- commodities declined but commodity stocks and ETFs rallied- again not sure why? Smells like people were first getting burned in their short position this morning and then kept jumping into yesterday's losers- momentum darlings. Same thing with retailers- WMT and TJX did offer good numbers, but a large chunk of it has been the lagging indicator of performance during the last quarter. My observations and available data so far seem to suggest that real slowdown in the economy has only started to show in mid October...So WMT's report doesn't really mean much as a leading indicator...

Anyway, back to the original forgotten intent of this post- Ken's FNM question. I'll try to keep it short - "Kai's" style...- FNM- fundamentals- neutral; momentum- poor; risk- medium high; insider selling-neutral- overall recommendation is weak hold.

There was an interesting article in WSJ today about FNM and FRE that quoted Fannie calling itself "Shelter in a storm". The overall tone of it was mildly positive and I tend to agree with its thesis in general-FNM isn't a bad stock to own at a right price. The two fundamental questions are- is it cheap and if it is what is the difference between FNM and private mortgage insures? The answer for the latter is simple- default risk so comparing it to TGICs and PMIs of the world is simply irrelevant. Fannie is virtually guaranteed by the US government and thus would be bailed out in a case of severe trouble. I don't have a clear answer for a first question today- while it is certainly cheaper than it was a few weeks ago, the increased provision for credit losses moved earnings into a negative territory on a tune of $1.5b... Dividend yield is hefty 4%, but can it be sustained another potential 12 months of trouble? Equity is strong $39B but I would expect up to 10% could be gone within 2 quarters... Overall I would not expect FNM to outperform the other big name Financials in the near to mid term, so your money might be safer with WFC, WB or BAC...

Anyway, hopefully most of you guys/gals had a good day today, so trade safe and cheers,
Vad

P.S. Looking at pre-market movement I might be selling FXP, SMN, DUG this morning as it is not in my interest to lose a bunch of money by betting against the market...

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"A ship is safe in harbor, but that's not what ships are for"

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One might have sensed quite a bit of sarcasm in a most recent link from the Strategy Lab writers that pointed to the SLO home page- "Open players learn some hard lessons" the line read. My initial reaction wasn't exactly positive - I have spent the last three weeks trying hard to preserve the gains accumulated over the last few months and felt that I have done a very decent job at it ,or so I thought, as my fund has outperformed the SP500 during the last week, month, three months and four months.

Yes it is true, recently my fund has been pretty much stuck in neutral, but there is a good reason for that- DOW is down 1400 points since the high reached in October and is trading at a very important psychological level. My prediction here is simple- whichever direction the Market finally takes off in- the move will be swift and quite possibly painful...So I have positioned my portfolio accordingly- hedged with ultra shorts that minimize my downside while probably taking some upside out of the equation as well.

Preserving capital is a paramount of an intelligent investor's strategy, and so I if that means I have to give up some upside for a significant downside protection -so be it. I wish we could short stocks outright in the competition as that would give me an opportunity to truly protect the downside as well, but utlrashorts could serve that purpose as well.

Anyway, back to the original message- after my initial reaction, I started to calmly analyze the statement of the MSN writer by trying to look closely at the returns of several former Top players. It turns out I realized he/she might have had a point unfortunately...

My personal strategy in this competition has been pretty consistent and reasonably successful- identify good contrarian opportunities (never to exceed a quarter of my portfolio) while positioning the remainder of the portfolio to benefit from the major market events (in effect similar to a sector rotation strategy...)

Since the beginning of this contest, this strategy has frequently put me at odds with other players competing for the spot in the Top 5. During the first several weeks Andrew Carlson (Demonhawk) and I have frequently exchanged positions at the top, until I decided that it was time to bail out of the sub prime. I obviously did not sell all of my sub prime holdings because I thought it was a nice thing to do- the risks of further deterioration at the time have simply outweighed the benefits... Andrew countered with what was a very well written but dangerous post saying some like this -"When buying junk, buy junk".

I thought at the time that this strategy was reckless and was very disappointed. I mentioned that in several of my blog posts already, but anyway I'll repeat it again, I honestly wanted to compete with Andrew all the way to the end, but now it seems highly unlikely given that his fund went all the way down to the bottom 20 of ALL funds in the SLO...Same thing happened to MagickNiner whose stories have been fun to read. Robert has invested purely in one sector- and based on my experience in the world of investing -diversification is a must because not a single sector goes up all the time...

Same thing happened to the Chinese sector investors, as well as with the ones loaded with various momentum plays... I mean, I hate to admit it but the MSN person was right- hopefully there have been many hard lessons learned here in SLO contest during the last few months ... I hope that in the next contest starting in January we'll prove to the "Pros" out there, that the phenomenal performance many players have demonstrated over shorter periods of time here, could be sustained over a longer period as well.

Anyway- back to business - I will posts my thoughts on the market overall in the next 24 hours but here is the overall punch line- I still do not understand how could one expect commodities (especially basic materials) to outperform the market if the whole world economy is slowing down? Hence my advice is- be careful with anything related to materials (including shippers). I personally bought DUG and SMN yesterday on the unjustified strength of oil. I do not necessarily buy into the hedge against rate cuts arguments- as these expected cuts imply weakness of the economy-hence less demand for commodities in the near term.

If you truly want to hedge against the weak dollar- buy US based large cap stocks with significant presence overseas...They would be the true beneficiaries of the dollar weakness, not commodities. I am also starting to warm up to a thought that US Financial Sector might be nearing some kind of temporary bottom- so I am trying to look out for opportunities there as well. I bought a small position in FRE today as it has underperformed FNM and could be up for a short term rebound as one could reasonably expect that protectionist Congress might push OFHEO into providing some kind of relief to the pillars of the mortgage world- decrease a capital requirement, increase caps etc. If FRE keeps declining without any new significant negative news I might buy more...

I also sold my ultra short China play FXP today for a very nice 20% gain. I still fully expect emerging markets to underperform the US in the short term in most of the downside scenarios, but I also think that given a steep decline in many solid stocks over the last several weeks, one might have quite a few better individual stock picking opportunities out there. So putting in MagickNiner's terms -I am starting to slowly navigate my ship out of safe harbor waters towards its original purpose of actually sailing and making money...

Trade safe and cheers, Vad

P.S. Don't try to time the market -stay fully invested at all times and Happy Thanksgiving

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"The safest way to double your money is to fold it over once and put it in your pocket"

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It seems like the above quote from Hubbard could some up an overall mood of some of the most recent blog posts here at SLO. People are frustrated with themselves for selling too high and/or too low, furious about the illogical behavior of their stocks, and for not following their stated discipline... I share the sentiment overall but think that people here underestimate just how well many of them have done so far.

SP500 is down 4.5% since the start of the competition but look into rankings page- over half of the more or less active contestants have actually beaten the market. And we all know that over 75% of professional money managers actually fail to beat the market, so don't feel bad- we, as group are doing quite well for now.

However, good or bad, it seems like turnover in most portfolios has been increasing day by day. And with turnover this high I would guess more people will start feeling pain of trying to outguess the market. We all (most of us anyway) agree that timing the market over the long haul is extremely tough but we all still trying to do it one way or another.

Unfortunately the nasty "Mr. Market" keeps playing tricks with investors during times of extreme volatility- when it seems like stocks are almost ready to start going up - they go down, and then during the next day when people move into a net short position - the DOW goes up by 200 points... Dow Theory says "sell", most "experts" say "buy" etc... I bet you can really lose your mind if you are actually listening to all of experts at the same time.

My recipe for dealing with a market is very simple -good investors should keep their portfolios fully invested at all times. When at cross roads- like now- its ok to protect the downside with short positions, but don't go into a 100% short position or move your portfolio a 100% into cash. Moving into cash is a very tricky move that could be only managed profitably by someone who has an iron will and applies a very well thought out and consistent strategy- no exceptions. My advice to most investors - don't waste money on commissions -those damn brokers make too much money as at is.

Now back to business again. The question on everyone's mind seems to be whether or not US will end up in recession? Fed and most economists seem to believe that the economy is strong enough to weather the storm; others disagree. Some now (finally) think that inflation is an issue, some do not. Given the historical prediction track record of an average economist I would not pay too much attention to their individual ramblings but overall change in ton could be an important indicator.

The fact of the matter is simple- US will end up in recession - it always does - the only real question should when? I think the main factor determining this will be whether the domino effect of the financial sector write downs is going to be mitigated fast and aggressively enough. I'll repeat myself though- Fed rate cuts won't solve this- they would merely postpone it and fuel more inflation a long the way...

The cure unfortunately lies in taking more quick write downs to restore confidence in quality of the remaining assets, as well as in bringing the off-balance sheet liabilities (SIVs etc) on the books quickly. Finally it also requires cutting dividends and raising new capital by diluting the existing shareholders to restore capital ratios to more appropriate levels. It also requires Fed supplying sufficient liquidity in the form of unlimited short term borrowing secured by good collateral but at penalty rates. And finally it might also require for politicians to shuffle their newly proposed regulations somewhere deep in side their bodies for long enough to actually give the sector time to recover a bit...I am not sure all of the above could actually happen so for now I would be very carefull with the banking sector...

P.S. Quick notes on my portfolio- sold GRMN and DUG, bought more PTNR and now looking into buying some more GEOY- it went on sale today for no particular reason...

Anyway, trade safe and cheers,
Vad

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