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.]

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.

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.

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.

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

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

In general, I don't recommend buying on the way down. However, sometimes there are opportunities where risk/reward should be considered. These opportunities should be played with money one can afford to lose, or at least take a small hit on.

I am not crazy enough to buy Fannie Mae (FNM) or Lehman Brothers (LEH) here. But I am crazy enough to buy some biotech on this dip. Elan (ELN) is down 4% today, and Celgene (CELG) is down 2.5%. They are in strong uptrends, and this is a dip to buy. I'm also crazy enough to look at a credit card company, like Visa (V). In times like these, people need the plastic. Visa has been finding support around 75. Finally, check out THQ (THQI)--trading up today after hitting near its 52-week low. Of course, I'm hedging these longs with the Ultrashort S&P 500 (SDS).

Look, I'm a bear over the next year, or two, or three. I think we'll see Dow 9,999. I think we'll see bank failures. I also think we'll see bear market rallies and continued volatility. At some point, sellers will be exhausted and value players will step in.

I highly recommend reading this article by Jeff Saut of Raymond James, courtesy of Minyanville. For those that won't, here's his conclusion (and he's been remarkably correct most of the year).

The call for this week: I began this week's report with a quote from the Wall Street Journal: "The nerves mean not panicking or getting swayed by fear, at the bottom, or greed, at the top." Last November, my firm wrote about the Dow Theory "sell signal" when prices were high yet participants wanted to "buy." Now we're writing about the Dow Theory downside non-confirmation; prices are low, yet participants want to let stocks "go" (sell stocks).

Meanwhile, it's session 33 in the "selling stampede"; my firm's proprietary oversold indicator is more oversold than it was at the March 2003 "low" (we were bullish there as well); the spread between Lowry's Buying Power Index (demand) and Lowry's Selling Pressure Index (supply) is the widest in the 75-year history of Lowry's (indicating that stocks are severely oversold); corporate insiders' selling is at rock-bottom lows; and I'm seeing numerous indices not confirming the Dow Jones Industrial's "downside dive."

It's not that I'm turning aggressively bullish, but I think that, unless the markets are in "crash mode," it's time to consider a corrective stock market rally. B.J. Thomas is warming up the song "Raindrops" in the wings.

There will be a bear market rally at some point. The beginning of a bear market rally never feels good--usually you're so sick of the downtrend that you want to puke up your stocks at the first sign of better prices. Are we close to that point? I don't know. I should mention that I didn't sell any of my short ETFs today, although I was tempted. What stopped me? The panic didn't seem panicky enough.

The market's been going down--almost straight down--for around a month now. Sentiment is terrible, and the word "bear" is being used more than the word "bottom." These are ingredients for a counter-trend bounce. Even a smallish bounce could cause shorts to cover, which would push stocks up quickly. The sharpest rallies, they say, occur in bear markets.

Traders want a big capitulation day (extreme selling) and a huge reversal (extreme buying) to signal a turn in the bearish trend. This type of volatility is measured by the Volatility Index, a.k.a. "the VIX", a.k.a. the "fear gauge." As a rule of thumb, when the VIX is high, fear is high, and extreme VIX levels are usually good buying opportunities. In August, November, January, and March, the VIX hit 30, which is panic territory. That signaled a 2-month rally August 15-October 9 (+9.7% in the S&P 500), a choppy "sort of" rally November 12-December 10 (+4.3%), another choppy rally January 22-Feb 26 (+5.4%), and the sharp 2-month Bear Stearns rally March 14-May 19 (+10.8%). Bottom line: buying these spikes is usually profitable. Another bottom line: The S&P 500, despite those rallies, is still down -11.6% since March 15. That's a bear market.

There's a strange similarity between the last 3 trading bottoms: they all occurred around holiday weekends. November 12--Veteran's Day; January 22--Martin Luther King Day; and March 15--St. Patrick's Day. Put that in the "meaningless but interesting" category. Could we see the same situation play out around the 4th of July?

Again, I don't know. In the current round of selling, the VIX got up to around 25, but it hasn't yet scaled previous panic peaks above 30, suggesting we're not yet ready to rally. But I'm trying to keep in mind that many great opportunities don't "feel right" at the time. I'm also trying to keep in mind that there will be plenty of time to participate in the rally if it shows some legs.

Sorry to ramble on here, but I'd like to reiterate that we are in a bear market, and even if we see a tradeable rally, I think it will eventually fail--remember that when everyone starts saying "blah, blah, bottom, blah, bottom." The financials still have huge problems. The housing bubble has greater implications than the tech bubble, so we should see at least a similar level of pain over at least similar a period of time. Oil is an issue, and the Fed is in a box trying to stop it. Normally the Fed would raise interest rates to fight inflation, but that also hurts lenders (which are already hurting) and cools the economy (which is already cool). Normally the Fed would cut interest rates to encourage the economy, but that also spurs inflation (which is already high in people's minds). So the Fed has few options.

We could be facing a perfect storm of economic trouble. Todd Harrison of Minyanville spoke recently of the potential for a major dislocation in the market, such as a 10% drop for the major indices in a few days. The thought of some type of crash or major panic has crossed my mind--no predictions here, just context. We could rally, we could crash, or we could simply grind along slowly. The point is, what are you and your portfolio ready for? And what if you are wrong? I ask those questions of myself frequently.

If you're wondering where I'm positioned, I'm about 50% in cash and bonds overall, including my long term retirement funds. In my more active trading portfolio, I'm around 25% cash, 20% short ETFs, and 13% Gold (GLD) and Natural Gas (UNG), which are obviously defensive / inflation plays. And I'm ready to adjust quickly.

Good luck out there.

[Positions in GLD, UNG]
Visit my personal blog for pictures and links: www.thestocksurfer.blogspot.com

Of course, that only works for active traders and may not work going forward, but I found it interesting nonetheless. It's as if the market is trying to find a direction, and not succeeding. I have been quite bearish for a while, which hurt me in April but paid off in May. Since May 16th, the S&P 500 is down 4.5%, and more importantly the financials (represented by the XLF) are down 12.9%. On May 9th, I wondered aloud if the calm represented the top of a bear market rally, and it just goes to show that even a blind squirrel finds a nut occasionally.

But how does one play defense now that we are back near our lows? Do we prepare for further downside, or anticipate an upside bounce? I have no idea. The easy downside trade (although it never feels easy at the time) is over, but there was insufficient pain, in my opinion, to justify a relief rally similar to the one we saw in March. Therefore, I'm trying to take a patient approach that will not lose me money in the short term as I wait for a fat pitch to hit in more extreme circumstances.

What does this mean practically regarding how to invest?

* Hedging. Cash is an excellent hedge if you are primarily a long only investor. For the more aggressive there are short ETFs, such as my personal favorite, the Ultrashort Financials (SKF) which goes up as financials go down. It's very volatile, though, so be careful.
* Non-stock ETFs. ETFs that track things like Gold (GLD), Oil (USO), Natural Gas (UNG), or soft commodities (DBA) will help your portfolio avoid being tied completely to stocks. Oil seems too crazy to me right now, so I much prefer natural gas.
* Under the radar sectors. Biotech and drug companies strike me as a good play because they to trade more on their own news than on general market direction. I would avoid big pharma, however, as they can seemingly do nothing right. I'd rather look at growth companies that are also potential takeover targets. Illumina (ILMN), Elan (ELN), and Isis (ISIS) come to mind.

Posted (with video!) simultaneously on my personal blog, www.thestocksurfer.blogspot.com.
Disclosure: I am long SKF, UNG, DBA, ILMN, and ISIS.

For my money, financials are plague-ridden and to be avoided at all costs. The actions of the Fed have resulted in a quarantine of sorts. One could argue this quarantine prevented the disease of the credit crisis from spreading too quickly. As March panic turned into May complacency, volatility went way down and the cries of "The worst is over!" went way up. Oil took center stage and the financials moved down near their lows. The fall of LEH should get our attention.

A quarantine is not the same as a cure. 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. Unless you know something I don't, all indications are that LEH is sick and could create more problems for the sector. A better bet, in my opinion, is to give your portfolio a vaccination with the Ultrashort Financial ETF (SKF). Or, stay in cash and out of financials entirely.

Disclosure: Position in SKF.

* Pro: GME's earnings and outlook are consistently better than expected.
* Con: Who cares? The market is looking ahead. Consumers are in trouble, and the video game cycle is on the way down.
* Pro: With the cost of traveling going up, people will stay home and play games. Besides, GME has high margins on used games, so it helps them when people look for deals. The video game cycle is not on the way down yet--there's no sign of a new console anytime soon, and it's still hard to find a Wii.
* Con: What about game downloads? Won't that hurt GME?
* Pro: Maybe someday, but you can't yet download the great games like Grand Theft Auto or Super Mario Galaxy.
* Con: The market looks weak, and all retailers will get punished.
* Pro: Agreed, but GME has been punished already. In the mid-40s, GME is $20 below its 52-week high. With a PEG ratio around 1, GME is not expensive.
* Con: The stock is broken technically, having sliced through its 200-day moving average.
* Pro: No argument there.

As with any stock, arguments exist on both sides. I favor the pro side, because I think Gamestop is executing well even while expanding overseas. In addition, the video game industry is still strong, and the stock is cheap in the mid to low 40s. If it dips under 40, I would even use the 'screaming buy' cliche. If you are a pure technical trader, you'll want to wait for the chart to improve. As for me, I'm buying a partial position today, and hoping to buy more lower later. I think it's a good strategy to build the position through the summer, before the big fall game releases and the holiday shopping hype.

Disclosure: Position in GME
Posted simultaneously on my personal blog.

I'm not usually a value investor, because that discipline requires patience and, preferably, the ability to carefully analyze a company's financial condition. I have neither. But the idea of SBUX being similar to MCD got me thinking. Back in 2004, the notorious Super Size Me movie came out and proved what everyone knew, that McDonald's food is not healthy. The damage to the stock had been done already--from late 1999 to early 2003, MCD lost over 60%. Since then, unhealthy and unloved MCD is up 300%.

SBUX began its slide in late 2006, and nothing seems to be going right. McDonald's, speak of the devil, is now selling coffee that some people claim is good. I disagree that it's any good, but the point is there's competition out there. The cost of milk is making those Starbucks lattes very expensive to make, and it's tough to raise prices when they are already ridiculously high. Consumers are spending so much on gas, are they cutting down on coffee? I don't know, but all of this is giving SBUX CEO Howard Schultz a really tough job. Here's the bright spot: Starbucks is a household name selling an addictive product. Like McDonald's, SBUX isn't going anywhere. It's simply making the transition from a high-growth company to an established American staple.

Using MCD's timeline as a guide, it could take SBUX another year or so to bottom out, somewhere around the end of 2009 (total time around 3.5 years). If one goes by price as an analogy, SBUX could fall to $13-$12, which would be another 20%-30% from here. But this is more art than science, so it's time to patiently watch for "bottoming action" (whatever that is--like art, it's subjective). The recent low is $15.39, and I'd like to see this puppy lose a couple more points before dipping my toe in the hot pool of java. The stock will start to turn around before the company does, but if you believe a deeper recession than expected could send stocks down in general over the next several months like I do, SBUX should fall further. There's no rush here, so one can ease into this stock by looking for big drops below $15 to pick up shares.

Disclosure: No position in SBUX or MCD.
Article also posted on my personal blog, with pics: www.thestocksurfer.blogspot.com.

I've been asking myself, what would a top (meaning a top to the Bear Stearns rally) feel like? Maybe something like this:

* Calm. Volatility is low. Wasn't it silly to panic?
* Complacent. Those financial stocks aren't so bad after all. Why not buy them?
* Confident. Uncle Sam and Uncle Ben got your back, and the check is in the mail.
* Cocky. Recession? No worries. Short and shallow.
* Crazy. $125 dollar oil is no big deal. No problem there.

I didn't intend to use all C's there, but once I started I couldn't stop. Sorry about that.

The point is, while I haven't been spot on as far as anticipating changes in sentiment, I wonder if we won't look back at this week consider it the end of a bear market rally. Isn't this what it would feel like? I'm not predicting, I'm just thinking out loud.

[Simultaneously posted on my personal blog.]http://thestocksurfer.blogspot.com/2008/05/what-would-top-feel-like.html

Because of my honeymoon, I was able to pry myself away from the daily market banter and reflect on my general market strategy. Although my time away didn't help me in the Strategy Lab contest, I think the bigger picture ideas that enlightened my brain will help me be a better trader in the long run. (I also realized that the time I was spending on the contest was taking away from my quest to make money in the real world--I'm putting a stop to that!) Here are a few of my reflections, heavily influenced by my beach reading, Fooled By Randomness by Nassim Taleb. In any order:

* Our minds want to see cause and effect in randomness. You see this every day in the market headlines. "Dow falls on recession worries." "Oil rises on Nigerian violence." Cause--Effect. The journalist wants to write a coherent story, and our mind wants a linear explanation. The problem is, there so many factors at play--buyers and sellers with their own perspectives, companies with agendas we can't see, governments with competing priorities--that we can't possibly identify a single cause. This doesn't mean there is no cause and effect, it simply means we must be skeptical of the simplicity and aware of uncertainty.
* We make our decisions out of emotion and try to explain them with reason. Taleb talks a lot about this, and how difficult it is to make a truly rational decision. As much as we try, we tend to act first and talk about it later. This is not necessarily a bad thing, but can lead to delusions. When we make good choices we like to credit our genius, when we make bad choices we blame our emotions or the weather.
* It's the size of the gain that matters, not the frequency. You can be right on the market 80% of the time, but if you lose all your money when you're wrong it does you no good. Taleb's style is to be right rarely, and make a lot of money when that happens. I'll no doubt hear more about this in his other book, The Black Swan.
* Most information is meaningless. The amount of information thrown at us is increasing every day, but is it making us smarter? Which data points or expert opinions should be trusted? Avoid CNN for a few days, and see if your life suffers.
* Price fluctuations always show volatility, but only occasionally show a meaningful move. This is similar to the cause-effect fallacy. If we watch a stock in real time, we see it go up and down within a certain range very rapidly. This is often little more than volatility with a number of random causes. A guy could be selling because he is moving to Australia, or buying because he typed in the wrong ticker symbol. We simply don't know, and should avoid reading too much into simple price fluctuation.

So how will this help my trading? I'm not completely sure, but I keep coming back to the theme of risk-reward. This year I've been focused on risk management, but have not always been aware of the reward side of the equation. Sometimes, even if it's likely that I will be wrong on a trade, I may want to attempt it simply because the reward will be high if I'm right. Conversely, I may want to avoid the easy trade that will not make me any money even if it works. In addition, I want to learn to avoid getting pushed into or out of trades due to meaningless bits of information or tiny price fluctuations.

Now then, why am I bearish? The rally since Bear Stearns Day has taken the market back to around 1400 on the S&P, which appears to be a significant technical level. I would be foolish, after what I just wrote, to give a firm reason for the rally. From a psychological perspective, my best guess is that investors were relieved that the financial system would not collapse, and shorts have been covering. But I am very skeptical of interpreting this move as a signal that the economy is in good shape and a bear market has come and gone. Doesn't the housing bubble/credit crunch have broader implications than a quick recovery would suggest? I think so. Interest rates can't go much lower. The dollar, if it strengthens, will create a headwind for the bright areas of the market (commodities and exports). Deflation could be the real "flation" to worry about.

On a risk/reward basis, I'm looking to short financials (SKF), short oil and gas (DUG), and short real estate (SRS). And I'm open to being wrong.

[Posted simultaneously on my personal blog.]

Here's what I came up with, explanation to follow:

Consumer Staples: 37%
Wal-mart (WMT), Philip Morris Intl (PM), Colgate-Palmolive (CL), General Mills (GIS), CVS Caremark (CVS), Kraft (KFT)

Energy and Royalty Trusts: 25%
Petrobras (PBR), Permian Basin (PBT), Prudhoe Bay (BPT), Precision Drilling (PDS)

Video Games: 20%
Activision (ATVI), Electronic Arts (ERTS), Gamestop (GME)

Short ETFs: 10%
Ultrashort Financials (SKF), Ultrashort S&P 500 (SDS)

Cash: 8%
Dry powder ($$$)

As uncomfortable as I am with this market, I can't ignore the change in street sentiment. As Jeff Macke has said, you need to trade the tape you have, not the tape you think you should have. I think the market should go down. I think the Bear Stearns (BSC) buyout prevented disaster but socializing risk will not, in the end, prevent a potentially deep recession. I think the consumer is in trouble and deflation is the real "flation" to worry about. I think LDK Solar (LDK) is unsafe. The tape says I'm wrong. For now. That's ok, but I don't want to chase hot sectors and get burned. A few weeks ago, I was tempted to "go for the gold," but in one day all the gold-heavy portfolios were obliterated. This is how I feel about solars and metals and even fertilizers. So what do I do?

My organizing principle for a snorkel-friendly portfolio is the money version of the hippocratic oath: Do no harm. Consumer staples, in my opinion, will do no harm. They are insulated against a weak consumer, and margins for companies like GIS and KFT should increase if commodities deflate. Video games will do no harm. I have written extensively about the strong video game cycle and won't repeat myself here. I only wish I could own Nintendo (NTDOY.PK) for the SLO contest. Energy trusts will do no harm, mostly because of their attractively high dividends. Ultrashorts actually may do me harm when looked at individually, but as part of a portfolio they will act as a protective hedge against disaster--sort of like an automated external defibrillator (that machine that shocks the heart back into rhythm, you know, after the doctor yells "Clear! Clear!").

I have no doubt that someone will pass me atop the SLO leaderboard, but I like my chances of remaining near the top even as I sit on the beach and enjoy some light reading, like Reminiscenes of a Stock Operator and Fooled by Randomness. I also look forward to spending some time underwater--as long as it's me with flippers on, not my portfolio. See you in a few weeks!

(PS--After seeing Dennis Gartman on Fast Money, I may add some steel and coal plays. Why? He's smarter than me...)

[This article simultaneously posted on my personal blog, with pictures.]