The Stock Surfer

AIG: Another Example Why Anything Related To Financials Must Be Sold

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Volatility brings trading opportunities--some good, some bad. So is it a good idea to buy AIG on this dip? First, let's look at the facts.

According to Reuters:

American International Group Inc (NYSE:AIG - News) said on Thursday potential cash losses on its portfolio of credit default swaps tied to risky mortgage debt could be as high as $8.5 billion, much more than previously disclosed. Under two revised ways of assessing risk, losses were estimated at $5 billion to $8.5 billion, finance executive Steven Bensinger said. The estimates are much higher than the $2.4 billion worst-case scenario disclosed by AIG, the world's largest insurance company, in the first quarter.

I do not pretend to know anything about credit default swaps, but I know what I don't know, which is more than AIG can say. In the first quarter, they estimated $2.4 billion in losses as a worst-case scenario. Now, evidently, the worst case scenario has doubled or tripled. Just stop and think about that for a moment--they underestimated their worst-case scenario by as much as 6 billion. Until further notice, AIG has no credibility whatsoever.

I've heard a lot about a bottom in financials, and I respectfully disagree. Several pundits and CEOs have stated that financial conditions could improve, but that improvement is contingent on a recovery in the housing market. Frankly, I don't see how years of excess in real estate can be worked off this quickly. How many Adjustable Rate Mortgages (ARMs) are going to reset higher in the next few years? Beyond that, all indications show that people are still barely making payments, and unemployment is rising.

So you have two choices. You can trust that AIG has a handle on its business (despite all information to the contrary), and that housing is about to turn around (despite all information to the contrary). Or, you can stay far, far awA-I-G.

[posted simultaneously, which charts, at thestocksurfer.blogspot.com.]

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Bear Market Trading Rules

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Chatting with a friend yesterday, we agreed that this bear market is a good learning opportunity but not necessarily a good time to make money. The volatility is extremely difficult to manage. I'm slowly learning that a bear market requires its own set of trading rules. Here are a few that I'm beginning to incorporate.

1. Buy the big drops, and sell the big rallies. In a bull market, you can buy strength. In a bear market, if you buy on a big up day you will likely get whiplash and be stopped out very quickly.

2. Trading gains must be taken. If you buy a stock for a trade, keep that in mind and take the gain. It can disappear quickly. This goes for both long and short positions. The SKF gained 20% from July 8-15, then went down 36% from July 15-22. Volatility brings opportunities, but it can also bring pain if you're not anticipating the next move.

3. Stay heavy in cash. This will smooth out performance and give you dry powder for the moments when risk / reward is in your favor.

4. Hold only your best investment positions. A bear market is no time to fall in love with stocks. I watched Gamestop (GME) plummet as it was thrown out with the retail bathwater, but I failed to see reality and sold too late. I'm fine holding Activision (ATVI) because it has not broken its uptrend.

5. Trade less if it's not going well. If you're behind the curve in a bear market, you will suffer from a thousand small losses. You buy on the up days and sell on the down days, which is exactly backward. It's better to do the opposite.

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What To Do Behind The Woodshed

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If you've been trading this market at all, you've probably been taken behind the woodshed once or twice. I certainly have. Today, for example, Nintendo (NTDOY) is my woodshed buddy, and we are feeling the pain of a 10% drop. At least we're in it together.

Most often this happens after an earnings report or a piece of big news, and there's nothing you can do about it. Sometimes the news isn't even that bad (NTDOY had a solid quarter). Doesn't matter. The stock gaps down and you are helpless. You've woken up on the wrong side of the shed.

WOODSHED REACTIONS

You have 3 options when reacting to the pain. You can:

1. Sell (some of your shares, or all of them)
2. Buy more
3. Sit and do nothing

Your response will depend on your personal style and your relationship with the stock. With Sohu.com (SOHU), I sold immediately because I bought the stock for a trade only. With NTDOY, I do not plan on selling because it's an investment. One is much more patient with a girlfriend than a blind date.

WOODSHED PROTECTION

Of course, you can try to be more proactive by preparing ahead of time for the bad days. If you see the earnings report on the calendar (Yahoo and Google both provide the dates), you can sell some of your position ahead of time. I did this recently with THQ (THQI) and Electronic Arts (ERTS), and I'm glad I did. You could also buy a put option on the stock for protection, but options can be complex if you're not used to them (I have no expertise whatsoever in options). In both strategies, you will lose money on something (either the stock or the hedge) no matter which way the stock moves. There's nothing you can do to avoid the anguish altogether.

WOODSHED OPPORTUNITIES

Sometimes you'll see an unlucky victim behind the woodshed, and if you are a benevolent soul--or even if you are a conflicted and reluctant hero like the Dark Knight--you can try to rescue the battered stock. This should be done with care, lest you get hurt "catching a falling knife." But with a sensible stop-loss, this can also be a great opportunity. Last year I picked up some cheap Take-Two (TTWO) after the delay of Grand Theft Auto.

Some folks I actually like to see out back are small to mid-sized biotech stocks. When one of these companies has bad news regarding a drug, they get absolutely whacked. But if you pull up 6-month charts of REGN, ISIS, ONXX, MYGN, BIIB, and ALNY, you'll see big moves down on big volume (a.k.a. capitulation) followed by nice recoveries. Here's an example--notice the drop, the volume, and the recovery in ISIS (click for chart).

Yesterday, it was Elan (ELN), a stock I was eager to buy for months, down 40%. Ouch. This was more than woodshed, this was the final scene in Braveheart. Mercy, William! Mercy!! But am I thinking of a rescue attempt? To the Batcave!

Disclosure: Long NTDOY, ISIS, ALNY
Note: Posted simultaneously on my personal blog, with charts and pictures.

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Reader Question: Do I Have A Selling Problem?

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[Note: The following was posted on my personal blog, with charts].

Dr. Stock Surfer,

I've gradually come to see the light on Trading Rule #1: No big loser. The 8% rule (or 5%, whatever one's tolerance) has stopped me out of more positions that turned out to recover soon than those that plummeted, but I haven't had any more 20+% loses (See AXP, AIG). However, what about losses on stocks that have done well? Exhibit A: I bought JRCC early in 2007, and was thrilled to watch it go up 120% in about 4 months. However, I then watched it slide over the next few months and ended up exiting with something like a 60% gain. (We've dated many times since then, and though most dates have had happy endings, I tired of the volatility and decided to "move on" this spring.) I've since placed stops - or partial stops - on some other winners with mixed results.

This seems to be somewhat a psychological question: While I won't tolerate a 8% loss from scratch, I seem to willing to overlook a 20% drop if the stock has already appreciated 80%, when the only real difference in the two positions is that I happened to purchase stock B at a more opportune time. What's the Rx? Do you use the 8% loss rule on winners?

Signed,
Investing student with a selling problem

Dear Investor,

You pose an important question that has no easy answer. Indeed, there may be no "correct" answer. Some people make money using a buy and hold strategy, others make money day trading--in each case their rules for selling match their time horizon and tolerance for pain. I will try to lay out my own selling philosophy, which I don't always stick to but I try to.

PHILOSOPHICAL REASON FOR SELLING DISCIPLINE?

The most compelling reason I have for my own selling discipline (i.e. using rules) is that I recognize my own ignorance, skepticism, and limited resources. I am not a financial analyst and cannot determine the "fair value" of a company. Furthermore, I am skeptical of those who are financial analysts and think they can determine what a stock price should be. Exhibit A is Bill Miller of Legg Mason, who beat the market for years before holding Bear Stearns (BSC) and Countrywide Financial (CFC) all the way down. He's a smart guy, but perhaps overconfident in his analysis. Take a look at his top holdings, and shudder. Finally, I am not Warren Buffett, so I have limited resources. I'm not prepared to wait for 5 years for Starbucks (SBUX) or Whole Foods (WFMI), once market darlings, to return to glory. That money is better used elsewhere.

IMPATIENT WITH LOSERS AND PATIENT WITH WINNERS

I don't think it's a contradiction to treat winners and losers differently, because the goal is to make money. As Dennis Gartman says, "Be patient with winning trades; be enormously impatient with losing trades. Remember it is quite possible to make large sums trading/investing if we are "right" only 30% of the time, as long as our losses are small and our profits are large."

A good rule of thumb to consider is to use a percentage stop-loss for selling losers, and a trend break for selling winners. That way, you avoid any big losers, but give your winners room to run. A related question, of course, is this: When did you buy the stock? If you bought a dip close to a trend line (say, the 50-day), it's easy to set a stop just below that level. If you bought a parabolic move, you are more likely to get stopped out even if the trend remains intact. Thus, it is wise to buy dips on strong uptrends, or near technical support, because it gives a clearer plan for the exit. Don't let a bad trade turn into a long term "investment".

I generally will sell losers with a 7-8% loss. Sometimes the stock will then turn around, and although that's frustrating, "Opportunities are made up easier than losses." (quoting Todd Harrison of Minyanville.com and his Trading Commandments). And yes, it is mostly for psychological reasons, as I've had losing positions become monkeys on my back in the past, tying up both my money and my emotions. I know myself: If I don't sell a stock with rational discipline at an 8% loss, I will puke it up in disgust at a 15% loss. Again, Dennis Gartman: "Capital comes in two varieties: Mental and that which is in your pocket or account. Of the two types of capital, the mental is the more important and expensive of the two. Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital."

If setting a percentage loss seems too arbitrary, you can set stops just below moving averages. Most pros use the 50-day moving average. When the 50-day is decisively broken (meaning the stock tries and fails to get back above it), you may be looking at a change in trend. Here are some examples. First, your boy James River Coal (JRCC). During the bull run, it didn't break the 50-day decisively. Now it clearly has (click for chart).

I had a similar experience with Dryships last year. Since the break, DRYS has been muddling with no clear trend (click for chart).

Of course, keep in mind that those are examples of 2 extremely volatile stocks that had meteoric rises. If you pull up charts of oil (USO) or Chipotle (CMG), you'll see the same thing. For the slower moving broad indexes (indices?), like the S&P 500, many pros use the 200-day moving average. For my long term retirement account, I'm using the 200-day as my guide. Example from the 5 year chart of the S&P (click for chart).

One final point. This is a bear market, and a very volatile one at that. It is not surprising that if you have selling discipline you will be whipped out of many new trading positions. I would not recommend dollar-cost averaging down in individual stocks during a bear market. Save that for very long term investments in index funds.

I hope that was stimulating--I'd be interested to hear any feedback, whether in agreement or dissent...

PS: I leave you with 2 more bits of wisdom, somewhat related, once again from Gartman:

To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.

Keep your technical systems simple. Complicated systems breed confusion; simplicity breeds elegance.

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Same News, Different Reaction

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In my trading portfolio, I'm currently taking more risk on the long side than I've taken in months. I don't think we've bottomed out and started a bull market, trust me. I think that the market will end the year lower than where it stands today. Do not listen to those who say the worst is behind us. I think eventually we could see Dow 9,999. So what gives?

Stocks are in demand right now. Since May, investors have been dumping stocks like crazy, and the selling reached a point of exhaustion. Many shorts had to cover because of the Fannie / Freddie plan and some new government regulations targeting short selling. It doesn't really matter why for now, what matters is that some calm has been restored. This is what a bear market rally looks like.

Another sign that the rally could hold for a few weeks is that we continue to have bad news and the reaction isn't that bad. American Express (AXP) and Wachovia Bank (WB) reported terrible earnings, and yet the financials are up. Even Apple (AAPL), Google (GOOG), stocks that people love to love, have disappointed the street with their earnings reports--yet, the market is taking it in stride. (The drop in oil helps, but I consider that more of a red herring compared to stabilization in the banks.)

I said on July 17:

--Since August, we've had 4 rallies, documented in a previous post. During those rallies, the S&P 500 has gone up an average of 7.5% over an average period of 45 calendar days. The shortest rally was +4.3% over 28 days, the longest was +10.8% over 65 days. Remember that, when all seems well.

So, I'm playing this move with time and price in mind. When mid-August comes around, it'll be time to start getting defensive once again. Even now, I have skepticism and tight stops.

One last point: individual stocks are still quite dangerous due to earnings season. Even a decent report can send a solid stock down 10% (as I experienced with Gilead Sciences (GILD) last week). One way to play the rally but avoid this is to focus on ETFs. My picks:

* Biotech (IBB): One of the strongest sectors right now. It's not economically sensitive, and there's merger activity to boot.
* China (FXI): I like the FXI above clear support (at 120) with the Olympics on deck.
* Ultra Mid-cap (MVV): Mid-cap has been outperforming both the Dow and S&P.

Note: Article also posted on my personal blog, which charts and pictures!
Disclosure: Long IBB, FXI, MVV, GILD

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Update On Current Action, Starring Morpheus

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So, the market *might be* bouncing today. Perhaps I was a mere 2 trading days early in my call for a bear market rally. Alas, still wrong as I had to respect stop-losses.

Then again, by the end of the day it could be down 200. We just don't know. As Morpheus says, "What is real?"

That's why the wise approach (in contrast to my prediction on Friday) is to wait and have dry powder in those guns. If it's a real rally, there will be follow through in the days to come. It will last a few weeks, perhaps more, like previous bounces, and we will have ample opportunities to buy. Buying too soon will result in getting whipped around, and probably triggering very appropriate stop-losses.

It'd be tempting to jump into the Ultra Financials (UYG) today. It'd also be quite a gamble. More banks could fail tomorrow. I'm looking at other areas that have been strong all day: biotech and video games. Trading especially well today: Activision Blizzard (ATVI), Nintendo (NTDOY), Gamestop (GME), Biotech (IBB), and Gilead (GILD).

Take the blue pill. Or was it the red...?

Disclosure: Long ATVI, NTDOY, GME, IBB, GILD
Posted, with pictures, on my personal blog: www.thestocksurfer.blogspot.com

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