The Stock Surfer

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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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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Putting The Bear Goggles On

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[Note: This article was posted, with charts and pictures, on my personal blog: www.thestocksurfer.blogspot.com]

It's been a little more than 30 days since July 15th, which was A bottom but probably not THE bottom. The S&P 500 is up about 5% from its low. I don't think the rally is over, but it's possible--in January, we had a rally of +4.3% over 28 days before turning back down.

What would signal an end to the rally? I can't point to any one indicator. Bear market rallies tend to begin with a spike in the VIX and a capitulation day. Bear market breakdowns tend to occur more gradually as the indexes fail at key technical levels, such as the 50-day or 200-day moving averages.

TURNING POINT TACTICS

Turning points in the direction of the market are always difficult because they are turning points only in hindsight. If you call the turn too soon, you will (or you should) get stopped out on many of your positions. Therefore, a good strategy I picked up from Jeff Saut (check the link on the right to his site--his daily commentary is invaluable) is to slowly transition the portfolio by buying and selling in stages. So, if I think the financials are going to resume their slide into oblivion, I can buy a third of a position in the Ultrashort Financial ETF (SKF) this week, another third possibly at a better price (the rally's last gasp), and the final third when the turn is verified. That way, I'll have a full position at a good price without perfect timing. That's the theory at least.

TRADING POSITIONS SELLS

If the rally is going to end, I want to cut back on the trading longs and raise cash that can be used to go short. Again, this can be done in stages. Over the next week or two (depending on how the market acts, of course) I want to sell my ETFs completely, because any index is bound to get mauled by the bear. Goodbye biotech (IBB) and health care (RXL). With individual stocks, I want to sell strength if possible, and take half my gains while letting the other half run. Maybe that other half will turn into a long term winner, maybe not. Stocks like ISIS Pharma (ISIS) and Alnylam Pharma (ALNY) have had nice moves, but I don't want to fall in love. Here they are with the IBB over the past 3 months (click to enlarge).

BEAR GOGGLE BUYS

Now let's put the bear goggles on and see what looks good out there. Financials have not been cured, so I definitely want to be back in the SKF. It fell from a July high over 200 all the way down to 110 on Monday. It's back above 120 today, but I don't want to chase it here. Ideally, I'll be able to buy this in stages between 100 and 120. The Ultrashort S&P (SDS), Real Estate (SRS), Europe (EFU), and Russell 2000 (TWM) are also on my watch list. Check out the SKF over the past 6 months. Is it finding support around the 200-day moving average? (click chart to enlarge)

I also think the oil drop has created some trading opportunities. At some point, there could be a violent snap up as energy shorts take gains. I like Continental Resources (CLR) for a trade if and when this happens. CLR was going straight up after a big oil discovery in North Dakota. Another option could be to play the Ultra Oil and Gas ETF (DIG). But even as I write this, I'm not sure I even want to get involved in the energy sector--it's very crowded, and very unpredictable.

Day Trade Update on CLR, August 13th
DAYTRADE JOURNAL

Stock: Continental Resources (CLR)
Buy Details: Bought CLR at 45.49 because oil was bouncing today, and when oil bounces CLR moves very quickly. Add a possible short squeeze, and I liked it for a day trade.
Sell Details: Sold all shares at 48. It's above 48 as I write this, but I'm in no mood to mess with energy stocks more than necessary. I wanted a trade, and I took it.
Gain/Loss: +5.52%
Posted by thestocksurfer at 12:48 PM 0 comments
Labels: CLR, daytrade

(disclosure: long IBB, ISIS, ALNY, RXL)

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It's Not About Oil, It's About Credit

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Note: Posted at www.thestocksurfer.blogspot.com, with proper links and charts.

I've written about the relationship between energy prices and stocks for a while now, usually in off-hand remarks. Today I'd like to really flesh out where I'm coming from. Most recently, on 08/08/08, I wrote the following:

Speaking of oil, some are still saying that the oil drop will spur the market higher. Reuters today: Oil's Slide Revives Wall Street Rally. But I think we're going to start seeing more of this: Falling Oil Prices Not Necessarily Good For Stocks.

I can't take credit for my view--Minyanville was way ahead of me. Recently, Todd Harrison reiterated his view:

Pundits are quick to point to the decline in Texas Tea as the recent upside equity catalyst but few have discussed the demand destruction that is manifesting as a function of slowing global growth. Looking back, the correlation between the S&P and crude oil is -0.041 over the last ten years. In other words, arguing that lower crude is a causation of higher stock prices has no historical standing despite the tick-for-tick action we've witnessed in recent months.

Of course high energy prices have an effect on the economy, especially when we see a spike like we did. Airlines and Automakers are Exhibits A and A--those industries simply have a hard time making money when fuel costs are so high. But commodities have been rising since 2003, and so has the stock market. The real problem now is not inflation, but deflation.

I don't want to say to much and expose my ignorance, but consider the definition of deflation in the classical sense: a decrease in the money supply. You can see why this is so closely related to credit. We use credit to buy everything from groceries to Ipods to houses. When credit was widely available, we even used the houses that we bought with credit to attain more credit (in the form of home equity loans). This is all unwinding. Again, from Minyanville (Kevin Depew):

...inflation does not cause more inflation. This is a consumer-led recession. Consequently, all that "commodities demand" that Inflationistas point to as evidence of still more inflation ahead of us will recede with stunning swiftness once the slowdown in the velocity of money in our economy becomes truly apparent. ... In weak versions of the recession we experienced in 2001, consumer spending actually increased. That will not be the case this time around because the single largest factor influencing consumer perceptions of financial safety and wealth - the price of their homes - is deflating.

Not only that, we will need to save more to buy a home in the first place. Again, Depew:

But if we're looking for reasons why the societal shift in risk appetites and consumption will be so broad and encompassing over the next decade, we need look no further than this Bloomberg piece on the housing market:

New 20% Down Payment Makes Savers From U.S. Spenders

"The U.S. housing crisis may accomplish what years of parental hectoring couldn't: Turn Americans from spenders into savers."

Some interesting data points from the article:

* Lenders will issue 53%fewer purchase mortgages this year than in 2006
* Mortgage lenders are increasingly requiring 20% down for a home.
* The average household, which puts away less than 1% of after- tax pay, will have to save 10% for 10 years to buy a home.

Deflation can be a huge problem when it is severe. There was severe deflation in Japan in the 1990s (as a result of stock and real estate bubbles) and in the U.S. during the Great Depression. I'm not saying we're in the exact same situation--I don't know and the past is not always the best guide to the future. But I am saying deflation deserves a larger dot on your economic radar than the price of gas. If you want oil to go down, be careful what you wish for because it's probably a sign of a slowing economy.

Credit contraction is hurting financial institutions as well, to make the understatement of the year. Just as Joe Blow can't get a mortgage at 4% with no money down anymore, businesses can't borrow money as easily either. From Bennet Seddaca:

Financial entities like banks, broker/dealers, regional banks, finance companies and insurance companies need credit at reasonable rates in order to finance themselves. I've been concerned for many years that the door to raise new capital in debt markets would finally shut on banks, brokers and others.

For many regional banks like KeyCorp (KEY), Zions (ZION), Regions (RF) and National City (NCC), the door is already shut; if they wanted to raise capital in the debt market at the levels at which their outstanding issues regularly trade, they would have to pay 12 to 15% - hardly economic levels. GM (GM) bonds trade near 27% yields. Washington Mutual (WMU) trades north of 15%.

Then there are the "good banks," like JPMorgan (JPM) and Wells Fargo (WFC). JPMorgan recently sold $600 million of preferred stock at 8.75%; Wells Fargo sold $1.3 billion at 8 5/8%, plus underwriting fees.

The bottom line is that the economy needs credit, and credit is getting more expensive. And it's likely to stay that way for a while.

So what does all this mean for stocks? If you're looking for an indicator for the stock market, look at the financials and not oil. I expect the financials to lead the general market lower, so as this bear market rally ends (if it hasn't already), I will continue to sell long trading positions into strength and buy the Ultrashort Financials ETF (SKF) on dips.

[Disclosure: Position in SKF]

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Breaking News: Attempts To Call A Bottom In Financials Unsuccessful

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Note: This article posted simultaneously at www.thestocksurfer.blogspot.com.

Everyone wants to know when the financials will bottom. Despite many guesses and months of speculation by experts on CNBC and amateurs in my office, no one really knows. The folks at Investor Place Blogs have asked me several times to write on the prospects for financial stocks, and every time I have given a similar response. I'm going to review those responses below, not for the sake of saying, "I told you so," but for the sake of putting the discussion into context. The context is this: Despite many guesses and months of speculation by experts on CNBC and amateurs in my office, no one knows when the financials will bottom and all attempts up to this point have proven premature, if not foolish.

LEHMAN

At the beginning of June, I was asked about Lehman Brothers (LEH). I wrote:

As an investor, I can't rely on a strategy dependent on Fedbailouts. Nor can I rely on company statements that their "books remain liquid." I've heard that one before. Therefore, with hundreds of stocks to choose from, I see no reason to play LEH on the long side.

Back then, LEH was trading up around 33. Today LEH will open around 14.

BANKS

Around June 24th, I was asked to comment on the banks.

The banks are at the epicenter of our financial crisis. Other than making a very short term trade, what is the investment strategy of buying bank stocks here, other than the hope that it can't get any worse?

The S&P banking index is down around 9% since then, which is not terrible. Unless you held Indymac stock (the bank failed on July 11th). But can it get worse? Maybe not, but consider this from the Wall Street Journal today:

New Credit Hurdle Looms for Banks
By CARRICK MOLLENKAMP
August 27, 2008; Page A1

U.S. and European banks, already burdened by losses and concerns about their financial health, face a new challenge: paying off hundreds of billions of dollars of debt coming due.

...The Federal Deposit Insurance Corp. said on Tuesday that its list of "problem" banks at risk of failure had grown to 117 at the end of June, up from 90 at the end of March. FDIC Chairman Sheila Bair said her agency might have to borrow money from the Treasury Department to see it through an expected wave of bank failures.

We should not be surprised if there are more bank failures. Why invest there?

AIG

On August 7th, I was asked about AIG, and I wrote.

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.

Back then, AIG traded above 25. Today it opened at 19.66.

CONCLUSION

Trade financials with caution. When there is extreme panic, you can buy them for a trade if you like using the XLF or UYG (double long). But be careful, a bank could fail tomorrow and send the sector down. When they show strength, you can bet against them for a trade using the SKF (double short). But be careful, the government could step in and send the shorts running. Either way, be careful.

Disclosure: I'm long SKF.

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