Geldpress

I wrote about some of the great stock screening tools in previous posts, but those free tools seem to get better all the time.  If you are looking for some great screening tools, start off with the following:

• Easy stock picks using free screening tools
• The best free technical stock screen from etrade
• Free technical analysis stock screens

In today’s volatile environment, I look for medium sized companies with solid earnings and a decent dividend.  Here is the criteria I used just today, as shown from the google finance stock screener. The criteria I use in today’s market is going to be very similar to the above.  For a medium sized company, I’ll search for market caps between 1 and 50 billion.  I don’t like to buy companies that are losing money, so I search for positive price to earnings ratios between 5 and 15.  Dividends are king so I make sure to look for ones that are paying something back to me as an investor, and a dividend yield between 3% and 5% should do the trick.  And to top it off, I like to screen for the 52 week price change.  I like beaten down stocks, but not ones such as financial institutions that have lost 90% of their value and losing money hand over fist.  I set the threshold at negative 40% on the low side.  And on the high side, I prefer to stay away from bubble territory, so a positive 20% is good enough on the high side for 52 week change. For diversification, you can also limit the results for a particular sector or exchange.  It’s best to take a look at your own portfolio distribution.  If you are currently heavy in energy, you can limit the google screen to healthcare, conglomerates or another sector that balances your portfolio out a little more. The screen above returned 65 matches that you can do additional research on to find something to buy.  Some of the additional things I like to do are the following:

• Screen out anything based on personal biases or current portfolio weightings - If you only want American companies, you can rule out Honda Motors.  If you are fearful of anything related to the auto industry, you can rule out Genuine Parts.  You can also eliminate ETF’s which sometimes come up in the results.  The particular results above returned several iShares ETF’s.
• Limit the search to specific sectors as a tool to diversify your own portfolio - Use the drop down sector box to pick a specific industry you feel you need to buy in order to balance out your own portfolio.
• Take a look at the google finance Income Statement (example income statement here).  I personally look at the Net Income in the middle of the page and the Diluted Normalized EPS.  I like to see positive and somewhat stable numbers for the last 5 quarters.  Currently, google only has quarterly data available going back 5 quarters, but you can also look at the yearly data to go back a few years without the quarterly breakdowns.
• Take a look at the google finance Balance Sheet (example balance sheet here).  I personally like cash rich companies so I look at the Cash and Equivalents at the top of the page.  This is especially important in today’s very tight credit markets.  I also look at the Total Debt numbers in the middle of the page.  Is it a manageable number as compared to their existing Free Cash Flow?  Is their total debt increasing, decreasing, or stable?
• Take a look at the google finance Cash FLow Statement (example cash flow statement here).  I look to the Net Change in Cash near the bottom of the statement.  I like to see positive numbers for all viewable quarters and annual periods available.  I won’t necessarily rule out a company with an occasional negative cash flow, but I may have to dig deeper to justify the negative cash flow.  I also like to compare the annual positive cash flow in relation to the long term debt.  A good rule of thumb is the number 3.  If a company is capable of paying off their entire long term debt with 3 years of positive cash flow, then their debt levels are manageable.  Note, I’m not implying that a company needs to pay off their long term debt, only that they are capable of doing so.
• Optional - If you have any faith in efficient market theory, you can stop here and pick one of the results that matched your additional and manual screens.  The other approach is to analyze yourself into a corner by digging deeper into the quarterly and annual reports, listening to the conference calls, and reading research reports, and blog and message board reviews.  But it’s virtually guaranteed you will stumble into something you don’t like - pending lawsuits, consistent “one time” charges, underfunded pension liabilities, higher input costs, labor disputes and more.

The next question - to hedge or not to hedge? Once you find something you are willing to throw your money at, the next question to ask yourself is whether you want to hedge your bets.  The idea of hedging is that no matter how much research you do, you can still be wrong, and still lose money.  Hedging offers you a way to limit your downside risk in exchange for capping some of your upside risk.  Here are some other articles that discuss hedging, and a book recommendation on PUT Options (one of the most common hedging techniques).

Note:  While it’s great to have the free information in the articles at Geldpress, sometimes it really does help to buy a good book to get the entire picture.

• Trading strategy - hidden jewel in the shorts
• Portfolio protection - hedging todays roller coaster market ride
• Selling puts for income, or as a cheaper investment
• Time for cover - the covered call

Put Options : How to Use This Powerful Financial Tool for Profit & Protection by Jeffrey M. Cohen

Today’s Fast Money show introduced several prevailing themes that Geldpress has been reporting on for some time.  There is no question that the commentators on Fast Money are magnitudes more intelligent then Cramer, but unfortunately, they are not as “fast” as the name of their show implies.

1. The dollar is rising, and there are ways to play it.  See Geldpress article from September 1st entitled:  Preparing for and playing the dollar recovery - bye bye euro
2. Rating agencies are useless and crooked companies.  See Geldpress article from August 8 entitled Why does Warren Buffett like Moody’s?
3. Hedging your investments by being long and short simultaneously.  See Geldpress articles:

• Balanced and hedged portfolio using proshares
• Trading strategy - hidden jewel in the shorts
• Portfolio protection - hedging todays roller coaster market ride

According to the futures report from Bloomberg (as of 10:56pm pst), the market looks like it may continue the rally tomorrow that it built on today. The DJIA and S&P futures are UP 17 and 5 points, respectively.  Good news?  Perhaps.  But just because the futures look good prior to the markets open does not mean the marekts will remain in positive territory through the trading day tomorrow.

One potential red flag for a possible market blood bath tomorrow is the open interest in the October 90, 95 and 100 strikes on the volatility index (VIX).  Since 2000, and prior to 2008, the VIX had only breached the 50 mark twice.  The first time was immediatley following the 911 attacks, and the second time was in the summer of 2002 due to the uncertainty and fear after Enron’s collapse.  WIth the credit crisis of 2008, the VIX has already set several new records, including today when it surpassed 80 for the first time in history.

In general, the VIX increases as the market’s head down and decrease as the market recovers.  But it takes way more than a mild downturn for the VIX to reach beyond the 50 mark.  And each subsequent 10 point increase in the VIX - to 60, 70, 80, etc - requires an even more severe market downturn.   In order for the traders who bought those October 85 and higher strikes in the VIX to make money, it is going to take one hell of a bloodbath in the markets tomorrow.  Do they know something we don’t know?  Sometimes money in the market spells solid rumors in the street.  And if the traders that placed those bets on a high volatility spike for tomorrow are right, then we may definitely see one hell of a blood bath in the markets tomorrow as the VIX reaches for par (100 mark).

Let’s hope they are wrong…

Other volatility articles:

• The volatility clue to the market
• Bring your collar into these volatile markets
• Time for cover - the covered call

It appears that world leaders were scurrying yet again with more rescue packages in time for this week’s opening bell.  Marketwatch reports that world rolling out emergency financial moves.  Among the highlights:

The U.K. government is finalizing plans to invest billions of pounds in four of its largest banks as part of its efforts to stabilize the country’s financial system, a move that could lead to the suspension of London stock trading Monday.

Australian Prime Minister Kevin Rudd said Sunday that his government will guarantee all deposits with institutions for the next three years to bolster confidence in the banking system.

The United Arab Emirates said Sunday it will guarantee all credit risks and deposits at national banks and interbank lending among all banks operating in the UAE.

Germany’s government will set up a fund to provide as much as 100 billion euros ($135 billion) of equity capital to help the nation’s banks through the economic turmoil.

The futures market is already responding ahead of the opening bells this week, and the current expectation is for a green day tomorrow on all the U.S. major indexes.  But just as with other weekend stimulus pumping sessions, there is no guarantee that the positive reactions will sustain themselves.  I can see the future, and the future looks green, but I’m not ready to jump back into these wavy market waters with my money.

Note:  Static image below!  Trade at your own risk!

The Associated Press reported this morning on rumors of the Italian government shutting down their markets:

Italian Premier Silvio Berlusconi said Friday that world leaders might consider suspending stock markets in response to the financial meltdown.

Berlusconi told a press conference in Naples that EU leaders may hold a summit on the crisis Sunday in Paris. He also said leaders from the Group of Eight also were considering a summit in the coming days.

The solutions to the crisis will have to be “global and innovative,” Berlusconi said. “There is talk of suspending the markets” while international financial rules are “rewritten.”

Rumors like these, especially when substantiated by a direct quote from one of the G-7 officials, is just adding more fuel to the drastic sell off.  In this environment, it has been proven that what starts as a rumor often ends in fact.  As of noon eastern time, all three major indexes in the United States are off 4-5% or more.  The 2008 financial crisis is a very serious matter caused by reckless credit markets of the last decade.  World financial leaders need to understand that continually changing rules - prohibiting short selling and shutting down markets - only serve to incite additional panic and more selling.  If the G-7 leaders want to work together to solve this crisis, they should start by working together to keep their mouths shut until they have something of value to say, and preferably something final.

Marketwatch also reported on the market closing rumors:

The White House denied Friday that it had any intention of closing financial markets. “There are absolutely no plans or discussions to interfere with the functioning of markets in the United States,” White House spokesman Tony Fratto said in an email message.

Hmmm…Didn’t the U.S. government also deny that it would rescue failed inurance giant AIG, just days before it swooped in with an $85 billion rescue package?

Thoughts?

Jim Cramer expressed his outrage at the Fed today on his Mad Money show.  He was outraged because the coordinated rate cut was not enough, and called for “many more larger rate cuts”.

Cramer said the Fed needed to be much more aggressive. And why not? Former Fed Chairman Alan Greenspan brought rates down to 1% in 2003 when the economy and markets were in much better shape. Bernanke, despite all the hardship we’ve seen, is still holding rates at 1.5%.

As of today, the Federal funds rate stands at 1.5%, after a .5% reduction this morning.  Let’s assume for a moment that a 1% reduction would be good enough for Cramer as a single rate cut.  But Cramer also stated explicitly today that not only was the rate cut not large enough, but that we needed “many more” rate cuts to get this economy going.  If we assume that “many more” implies only 3 additional rate cuts, that would put Jim Cramer’s requested fed funds rate at a NEGATIVE 1.5%.  That’s right, Jim Cramer wants the federal government to pay us to borrow money.

Rather than pay citizens to borrow money, here is another idea.  Let’s banish Jim Cramer so we can get on with handling the financial crisis in a more responsible manner, freeing the mostly ill informed populous from his idiotic rants.

Thanks to a loyal Geldpress reader for forwarding this link showing the many sad faces of traders around the world, with very entertaining and humorous captions included.

Sad guys on trading floors

For those looking to better understand the credit default swap market and all the intertwined counterparty risk, seekingalpha has a great summary here.  I had intended to write a similar description, but no sense in re-inventing the wheel.

With a CDS, you could go out and find someone who will insure against the default risk. For a given premium, the seller of the CDS will pay off on the GM bond if GM goes belly up. Now, if it was from a real insurance company, the insurance company would be regulated and would have to hold enough money in reserve to pay you off in case GM actually did go belly up…However, since this is an unregulated market, someone can sell you a CDS and blow the money in Las Vegas…the CDS market has seen more growth than practically any market in the history of mankind. It is currently at over $62 TRILLION, up from under $1 Trillion a decade ago. It would not take a very big percentage of that market to fail to leave a very big mark on the world financial system.

For a more detailed view of credit swaps, counterparties, interest rate swaps and options, currency options, risk management with options, and more, then the following is a must read:

Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options (The Wiley Finance Series) by Andrew M. Chisholm

The SEC’s ban on short selling the 799 listed financial firms has not been as affective as they intended it to be.  It may be illegal to sell short those firms, but it is certainly not illegal to sell them outright.  And that is exactly what the institutions holding those shares did since the ban went into place.  Marketwatch reported that since the ban took place, those 799 listed stocks were down an average of 5.5%.  Much bigger losses were seen from Wachovia, down 87% and Washington Mutual, essentially insolvent and dead.

Proshares and Rydex are ETF providers that offer Inverse or double inverse funds.  The short ETF’s offer a convenient way for investors to short the market, or individual sectors of the market.  And both of them have double inverse financial ETF’s that have serious implications due to the SEC ban on short selling financials.  Proshares release a short statement on their website this morning related to the uncertainty:

Due to the emergency action announced by the Securities and Exchange Commission on September 18, 2008, temporarily prohibiting short sales of shares of certain financial companies, Short Financials ProShares (SEF) and UltraShort Financials ProShares (SKF) are not expected to accept orders from Authorized Participants to create shares until further notice.  Unless notified otherwise, shares will be available for redemption by Authorized Participants as normal. The shares of these ProShares are expected to trade in the financial markets. As disclosed in the prospectus, ProShares may at times trade at prices that are not in line with their intraday indicative values.

The SKF got absolutely hammered last Thursday in anticipation (SEC LEAK ANYONE??) of the short sale ban, and again on Friday when the ban was officially announced.

So what does all this mean for SKF and other ultra short investors?

The proshares prospectus clearly outlines their method of obtaining double exposure to the inverses.  They do not actually short the market.  Instead, they use multiple financial instruments, in an attempt to mimic the inverse performance of the underlying.  Per the prospectus, those instruments are:

• Futures contracts and options on futures contracts
• Swap agreements -  In a standard “swap” transaction, two parties agree to exchange the returns (or differentials in rates of return) earned or realized on particular predetermined investments or instruments.  The Funds are subject to credit or counterparty risk on the amount each Fund expects to receive from swap agreement counterparties. A swap counterparty default on its payment obligation to a Fund may cause the value of the Fund to decrease.
• Forward contracts - two-party contracts entered into with dealers or financial institutions where a purchase or sale of a specific quantity of a commodity, security, foreign currency or other financial instrument is agreed upon at a set price, with delivery and settlement at a specified future date.”
• Options on securities and Stock indexes and investments covering such positions

Proshares does not disclose the specifics of which of the above instruments they utilize at any given time to seek their double inverse returns.  My personal hunch tells me that most or all of the double inverse returns were coming directly from the two party counterparty swaps - at least until the SEC short sale ban last Thursday anyway.  The scenario is usually pretty simple.  Proshares would agree to pay a fixed amount of interest in exchange for a counterparty paying the return on an inverse index.  It is the counterparties, and not proshares, that actually does the shorting of the market or index.  And the counterparty risk associated with proshares ETF’s is the risk that these counterparties will become insolvent and not be able to pay the agreed upon inverse returns.

After the collapse of Bear Sterns, there was significant speculation around proshares, and whether they had any exposure to Bear Sterns as a counterparty.  Proshares in that case did come forth with additional details on their counterparties.  They still would not state clearly who their swap counterparties were, but they at least admitted that Bear Sterns was NOT one of them.

With the ban on short selling, the landscape and risk exposure of proshares inverse ETF’s changes completely.  Counterparty risk is still a concern on existing swap contracts, but by far the biggest counterparty risk is the US Government, and their under analyzed short sale ban. In the new environment, it does not really matter who the proshares swap counterparties are.  If those counterparties are unable to short the market, they have two choices, and neither of them are good for proshares:

• Discontinue counterparty swap agreements with proshares
• Assume near infinite, and unhedged risk (agree to pay inverse returns, but don’t short the market to hedge those risks)

In all liklihood, the proshares inverse funds will continue to exist in the short term, but the mechanisms they use to achieve their results will significantly change, and the risks to shareholders will go up as well.  Don’t expect full disclosure on what changes proshares implements, but it will likely be to utilize more options and futures and a lot less third party swap arrangements.  But with the spreads on options and futures increasing significantly over the last few days, it will be increasingly more difficult for proshares to come close to the desired performance.  The proshares prospectus explicityly lists correlation risk, but in the new landscape, that correlation risk could become much more significant.