Geldpress

It’s pretty clear now that the entire housing market run up over the last 10 years was fake, and mostly based on wide spread fraud.  Anyone still in denial needs to read the latest businessweek article entitled Sex, Lies, and Subprime Mortages.

The women allegedly offering sexual favors were bank employees. Evan Stone, president of Walnut Creek (Calif.) mortgage brokerage Pacific Union Financial, says “minimally trained and minimally dressed” wholesalers often wooed brokers. He says he regularly got visits in his suburban office from representatives wearing unusually short skirts to entice him and his team of brokers to party at the local Ruth’s Chris Steak House. Stone says one New Century wholesaler offered to fly him to Chicago to “have a good time.” He says he declined all offers of sexual favors. “There were some indecent proposals made,” he says. “That was part of building the relationship.”

Check out the New York Times article, entitled “Investors buy U.S. debt at Zero Yield“. The rampant fear in the market and flight to safety is pushing demand for U.S. treasuries so high, that yields have approached zero.  And for brief moments the yields even dipped into the negative territory!  At negative yields, you are essentially paying the government to “preserve” your cash.  And at negative yields, now may finally be the time to stuff some of your cash under the mattress, where you will at least preserve your capital.

In the market equivalent of shoveling cash under the mattress, hordes of buyers were so eager on Tuesday to park money in the world’s safest investment, United States government debt, that they agreed to accept a zero percent rate of return…Demand was so great even for no return that the government could have sold four times as much…In addition, for a brief moment, investors were willing to take a small loss for holding another ultra-safe security, the already-issued three-month Treasury bill.

The bright side of this news, of course, is that incoming president Obama will likely no longer be dependent on the Chineese for funding new and rolling over our existing government debt obligations.  There are enough suckers right here at home to obviate the need for Chineese debt investors.

Warren Bufett’s derivative positions in his Berkshire Hathaway fund are being discussed more frequently lately.  In 2003, billionaire Warren Buffett called financial derivatives “the ultimate financial weapon of mass destruction“.  That claim has become all to clear in the midst of the 2008 financial crisis, claiming such formerly perceived indestructibles such as Bear Sterns, Lehman Brothers, Countrywide, Washington Mutual and others.

Financial derivatives are essentially side bets on the market and come in many forms.  That can be as innocent as an option covered call contract sold against a position you already own.  But they can also approach destructive levels, as in the case of AIG’s selling hundreds of billions of dollars in credit default swaps that it had no capacity to honor.  AIG is now the recipient of a massive taxpayer subsidized bailout package.

Berkshire Hathaway does currently hold several billion dollars in derivative contracts.  Here are a few excerpts from the latest Berkshire Hathaway annual report.

Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories.

First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013.  At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses;  and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Our yearend liability for this exposure was recorded at $1.8 billion and is included in “Derivative Contract Liabilities” on our balance sheet.  The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.

Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.

Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.

Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.

The 2008 annual report is not expected out for several more months, but Buffett is certain to announce even larger derivative bets when it does.  He has reportedly sold larger chunks of naked puts in the major indexes over the last few months to take advantage of market lows and high volatility.   According to this Bloomberg article, Berkshire currently has about $35.5 billion in naked put options with expirations starting in 2019.  But unlike AIG, and as highlighted in the annual report above, Berkshire does have the cash to cover all derivative bets.

Active Value Investing, by Vitaliy Katsenelson, is another one of those “must own” investment books to buy and keep.  Read it and tab out the important pages that you may want to refer back to, and keep it on your bookshelf forever.  Similar to John Mauldin’s Bull’s Eye Investing, Katsenselson also talks about collapsing p/e ratios during secular bear markets, a simple concept that far to many people neglect and get burned on.  But Katsenelson goes a step further to break down more precisely the mechanics for determining fair value.  Forget about those lunatics on television telling you XYZ stock is cheap because of it’s low p/e ratio compared to peers.  Instead, use the absolute p/e model discussed in detail in the book and determine what the fair p/e ratio is based on the expected EPS growth rate.  The base and fair p/e ratio for any stock growing earnings at 5% per year is only 11.25, according to Katsenelson.  From that number you add in expected dividend payments and subtract out the risk factors (business, financial, and visibility) to determine the absolute p/e ratio in the current environment.

You really need to buy this book!

Active Value Investing: Making Money in Range-Bound Markets (Wiley Finance) by Vitaliy N. Katsenelson

Have you seen the “Channeling Stocks” television commercials where the 20 something geek says good-bye to his co-workers on his retirement day?  “How did you do it?”, they ask.  The geek then respond, “I simply buy and sell the same stock, over and over again.”.

The logic seems so simple, but does it work?  When looking at historical price tables, the answer is definitely yes.   Looking back at history, it’s easy to see how you could have made money by buying at the low end of the channel and selling at the high end of the channel.  But looking forward is an entirely different story, especially knowing that those magical price channels can and do change! Look at the sample McDonalds chart below for evidence of changing price channels.

Can price channels help me make money in the future? - The first point to realize is that while price channels can help you, they are only a tool, and there are no guarantees.  But the second point is that YES, price channels are the easiest, and probably most widely used and most successful tool in technical analysis.

How to use price channels to buy low and sell high

• Step 1 - Always look at stock charts in BAR or CANDLE mode, as shown in the Yahoo Finance chart above.  This will show you not only the closing point of the day, but the range of prices throughout each day.
• Step 2 - Determine the channels.  In the chart above, there are at least two distinct price channels, and a shady (and scary!) area in the middle for the junction between the two channels.
• Step 3 - Draw lines around the channels using the low and the high points from within the channels.  But recognize that this is not an exact science, but only a rough guide for what the future may hold.
• Step 4 - Determine what type of channel you have.  If the lines are not parallel, then skip this stock and move on to another, unless you also know something about ascending and descending triangles and other chart patterns.  For trading channels, parallel lines work best.  But note that you will never see perfectly parallel lines for indefinite periods of time.  It is a subjective call at best.
• Step 5 - Determine where the stock lies in the last channel (channel on the right).  If it is in the upper half or quarter of the channel, then the bias is for the stock to head back down.  Note, “bias” does NOT mean guarantee!  If it is in the lower half or quarter of the channel, then the bias is for the stock to head back up.
• Step 6 - Buy when the bias is up, and sell when the bias is down.

Variations of buy low and sell high

• Buy the stock at the low end of the channel, and sell a covered call at the high end of the channel.
• Buy at the money call options at the low end of the channel, and exchange those call options for put options at the top end of the channel.  VERY RISKY!
• Use leveraged Bull Index ETF’s at the low end of the channel and leveraged BEAR Index ETF’s at the high end of the channel.

Other helpful guidelines

• Know your own risk tolerance level before placing any trade!
• Use stop losses as needed to protect yourself from drastic channel changes!
• Accept full and complete responsibility for your own trades.  There will be no bailouts for your losses!

The Ashes Ashes blog just wrote an excellent piece on The Global Poker Tour, and its striking similarities to the widespread bailouts going on.  It’s definitely worth reading for a good laugh, or perhaps a cry!

The Masters decided that they would create two new parts of the GPT: one would be a method by which spectators could wager with each other on who each thought would win the tournament, who would survive longer in the tournament, who would win a given hand, even who would finish their free cup of coffee first!…The second part would be a program by which players AND side-betting spectators could purchase insurance against their bets AND debts, just in case some member of the GPT or some member of the spectator group had unexpected bills to pay…

And for the true poker fans, also check out another great Geldpress poker article:

• Poker - If The Cards Don’t Get You, The IRS Will!

Redmond Townhomes are on sale, but according to the marketing e-mail, you better act quick because the sale will end in 72 hours.  Incidentally, this limited timeframe sale has come through my e-mail several times over the last few months.

Here is a Remax link of one of the townhomes with a list price of $359,900.  When I first looked at this property earlier this year, the townhomes were starting from the mid $400k range.  They assured me the prices would go up and that I needed to Act Quickly!.  Well, several months have passed and the prices are going nowhere but down.  And as for the 72 hour limited sale, I’m sure there will be another one next weekend, and the next, and the next, and the next…

The Geldpress team is going away for the Thanksgiving holiday.  We will return in early December for more insightful market commentary, and financial insights.  In the meantime, have a wonderful holiday shopping experience!  The economy needs you.

The black Friday holiday shopping starts this Friday, and you can expect some amazing deals, especially on electronics products.  But before you go spending your hard earned money on a new digital camera this holiday season, please consider the cost saving benefits of buying a high end used, or refurbished camera from Amazon.  Celebrate the recession by saving money on high end, but out of date electronics.  Here are two recommendations in two different price points:

Canon Powershot prosumer line - This is the line that Canon refers to as the “prosumer” category.  The first in the series was the Canon Powershot G1.  It came out around 2000, and retailed for $999.  But it was and still is an amazing camera, with a 3.2 megapixel sensor and automatic, and full manual controls.   The latest in the series is the Powershot G10, which retails for $435 on Amazon.  My personal favorite, and best bang for the buck is the Powershot G5.  It came out in 2003, and is a 5 megapixel full manual prosumer digital, with a remarkable f2.0-3.0 4x optical zoom lens.  Manual shutter speeds can be controlled from 1/2000 to 15 seconds.  There are also fully automatic or manual adjustments for white balance, ISO, metering, flash and continuous shooting.  And it can shoot close to 2 framers per second in continuous mode.  This is an out of date camera, but it’s easily worth the $150-$175 average used selling price on Amazon.

Canon Digital Rebel - The Rebel SLR was one of Canon’s best selling SLR cameras, and it was no surprise that the first digital version of the Rebel, the EOS 300D, was an instant success.  It came out in 2003 and originally sold for $899.  The latest in the Rebel line is the EOS Rebel XS, and it currently sells for $473 on Amazon.  But the original Rebel EOS 300D is still an amazing camera if you can find it at a decent price ($250-$275 is a great deal) from a used seller on Amazon.  It has a 6.3 megapixel sensor, has full automatic and full manual shooting modes, and can shoot an amazing 2.5 frames per second.

These home auctions are very common all across Las Vegas, California, Florida and Phoenix.  But the last real estate holdout market of Seattle has not seen these panic auction sales - until now that is.  There is wide scale evidence that the Seattle market is tapering off - increasing inventory, lower sales numbers, and falling prices.  But interestingly enough, most Seattle homeowners are still in denial about the risks of vanishing equity.  Until recently, those 50% off auction sales were limited to those other bubble areas, and surely, Seattle would not take part in the madness.   Well Seattle, the game is over.  Say good-bye to your equity.  The auctions have landed.

Here’s a helpful tip for those wanting to learn and utilize stock options in today’s market - sell options when volatility is high and buy options when volatility is low.  If you are still uncertain as to whether 2008 is a high or low volatility market, then you probably need to just stay out of the market.

For those that recognize the answer that 2008 is a high volatility market and want to SELL OPTIONS, then covered calls are one of the best ways to do so.  Once you pick a stock to utilize a covered call on, you then need to pick an expiration month and strike price to sell for your cover.  Below is the December option chain for McDonalds from Yahoo Finance, as of the close of day November 13th.  McDonalds closed today’s trading session at $52.91.

If you are going to do a covered call on McDonalds, here are the steps:

Step 1 -  Buy and read the following book from Amazon.  It’s just to dangerous to think you can trade options after reading this short post.  Just click on the book cover below to purchase.

Covered Calls and LEAPS–A Wealth Option + DVD: A Guide for Generating Extraordinary Monthly Income (Wiley Trading) by Joseph R. Hooper

Step 2 - Pick an expiration month.  November expiration has only 1 trading day left so that is out of the question.  December expiration is on December 19th, which gives plenty of time to collect some good premium, especially in this high volatility market.  January expiration is also an option.  Going beyond January is also possible, but not very appealing to me personally because it ties up the position for to long without much benefit of additional premium.

Step 3 - Analyze the potential return for getting called out of the position based on each strike you are considering.  The most popular strikes are going to be at the money, or a few strikes in or out of the money.  The separation of “IN” and “OUT” of the money is shown above by the change from yellow to white shading.

Example:  Analyze the potential called out return of purchasing 100 shares of McDonalds and selling a December 50 strike.  Assume today’s closing price and option chain are still available.

- Buy 100 shares for $5,291 and SELL TO OPEN (1) contract of the December 50 for $520.

- Net outlay and net risk is $5,291 - $520 = $4,771

- Assume McDonalds follow through with the promised dividend payment of $50 prior to expiration

- If McDonalds ontinues to trade above $50 on December 19th, then you will be forced to sell your 100 shares for $50 each, or $5,000

- Total collected from being called out is $5,000 + $50 (dividend) = $5,050

- Profit from trade = $5,050 - $4,771 = $279

- Net return if called out = $279 / $4,771 = 5.8%

- Downside protection breakeven point = $4,771 - $50 (dividend) = $4,721

Can you live with this scenario?  If so, then it is a good candidate.  If not, then perform the same analysis for other strike prices, and possibly other expiration months.

Step 4 - Decide on the combination of strike price and expiration month that is the most appealing to you personally.  It is a personal and subjective decision that takes your personal risk tolerance into play.  Nobody can tell you the correct answer except for you.

Good Luck, and as always, trade at your own risk!