Buy Sell and Tell Investments

The only investment I have at the moment is a double short of 2 leveraged gold funds T-HGU and T-HGD.  My brilliant brother Howard Joe put me in touch with this interesting trade (and others which I have yet to master).

HGU is levered to replicate twice the movement of gold; if gold goes up $1, the fund goes up $2.  If gold goes down $1, the fund goes down $2.  HGD is the opposite i.e. if gold goes up $1, the fund goes down $2 and if gold goes down $1, the fund goes up $2. These funds are designed to replicate the daily movement in the price of gold.

The basic premise behind the double short is that if the security (i.e. in this case gold) is highly volatile on a daily basis but relatively stable over a longer term, one can make money with a passive buy and hold strategy. If you held a long position in both HGD and HGU, the “up” funds gains/losses would be canceled out by the “down” funds offsetting gains/losses.  Since the funds charge a management fee, over time this long strategy would lose out due to the fees.  Taking a short position in the funds allows you to make money off the management fees as the more fees are taken, the lower the price of the funds.  Being short both positions, you want the fees to be as high as possible.  Also, since both these funds are levered, the fund has to incur additional costs e.g. interest charges to maintain the levered position or option charges if the position is being maintained with calls or puts.  The more charges the fund incurs in maintaining the position, the lower the price of the fund and the better the short position becomes.

There’s additional volatility caused by beta slippage which I’ll address at a later date.

Proof: to back test this trading strategy, graph both HGD and HGU on the same graph and see what the imperfectly offsetting returns look like over 6months…over longer periods the returns are even better.  Note that the more negative the combined returns, the better it is for the short positions.  A 1 year return has HGU returning 20% and HGD at negative 50%.  If you were short both these positions, your combined returned would be positive 30% for the entire position.  Since you have to fund both positions, your return is half of 30% i.e. 15%. A 3 year chart shows both funds returns are negative with the corresponding short HGU having a positive 25% return and the HGD having a 3 year return of close to positive 95%.

I’ve held the above position for about 3 months and prior to the record price of gold this week, my return was 1.6% for the period.  Once gold spiked, my position went briefly negative and is now back to slightly positive. The amount of volatility from the combined position is amazingly low; it’s much lower than the volatility of owning a stock. I’m hoping that gold continues to trade in a volatile fashion on a daily basis, but on a relatively stable basis long term.  More on this in coming blogs.

Arnold Joe

Last week has got to go down as being on of the most manipulated fear driven trading weeks of all time. BUT I’m not going to talk about that right now for it’s provided an opportunity to pick up some ’bargains’. The best purchases would have been made last week but one has to have the fortitude to make those trades and it’s all in the past so where to go from today? My predictions are as follows:

Oil: will gain as much as 6 to 8 dollars over the next week or two because as the storm of last week unfolded the actual supply was squeezed by the BP tragedy. The impacts of this disaster are far from over. Looking forward I would expect the US government to reevaluate their position on opening new offshore drilling permits. If nothing else it will be month before new ones will be considered. I can’t see the green Obama ignoring the environmental threat that these rigs pose…

Gold: will likely remain strong and crawl to the upside as real inflation is still miles higher than the government ‘reported inflation’ numbers.

Banks: especially STD and BBVA will see a large upside as the fears over Spain, in my opinion, are extremely exaggerated (article to follow). Canadian banks are strong and will continue to be. American banks will make fortunes the likes of which few have seen in the past IF congress does not impede the growth through new banking legislation. Assuming the latter BAC, for example, has miles of upside.

Currency: the Euro will stay weak and trade down marginally over the next month. AUS should get weaker in light of uncertainty around this ‘super tax’ on resources putting doubt on foreign investment and it’s resource strong economy. CAD will stay strong and hover around par with the US for the next couple or so. 

As always, good trading!

Stocks to watch:
- Banco Santander, S.A. (ADR) (Public, NYSE:STD)
- Bank of America Corporation (Public, NYSE:BAC)
- Banco Bilbao Vizcaya Argentaria SA (ADR) (Public, NYSE:BBVA)

Wow, it’s been 1.5 years since I updated this blog and the issues that we were facing then are pretty much the same as they are today i.e. I’m still worried about all the money printing that the governments are doing.  Money printing as noted through the various blogs stimulates the economy…unfortunately there is a cost to be paid for this artificial stimulation and that burden falls on the more responsible citizens (yeah, I know you’re probably sick of hearing this, but I hate it when people are treated unfairly). With the economy still showing signs of weakness (e.g. jobs losses), it doesn’t look like the printing presses will be stopping any time soon (other than perhaps in China).

I stayed out of the market as I thought there was a good chance that the economy would collapse regardless of the money printing.  Unfortunately this strategy means I missed out on much of the stock market movement in the last 1.5 years. Having missed the boat, I’m probably going to remain on the sidelines for a little while longer hoping that the governments will be forced to withdraw some of the stimulus (either as a result of higher inflation or investor angst over the high supply of newly printed bonds).  The fact that China is taking some initial steps to withdraw stimulus is an encouraging sign.  Since interest rates are already very low throughout most of the world, I don’t think there is much risk of them going any lower.  If I’m right and the stimulus is removed, expect the markets to go through another rough ride.

There’s 2 forces at work in the US. On one hand you’ve got the US government bailing out companies left and right and at the same time the financial institutions aren’t willing to lend money. So which force is going to win?  Will the printing press eventually overwhelm the credit destruction or is credit being destroyed at such a rate that the governments effort to print the money is in vain?

This is an important question because whichever force wins will have huge repurcussion on one’s stock portfolio.  If the printing press wins, you’ll want to be long almost anything other than cash and bonds.  If credit destruction wins, you’ll want to be holding cash as the price of everything else crashes.

I believe that the printing press will eventually win as there doesn’t seem to be any limit to the amount of money the government can print. Banks will eventually resume lending once the taxpayer’s have invested enough money to support them (this is actually forced by government intervention but it doesn’t make any difference between voluntary or not).  With the banks able to borrow at zero interest rates, how hard can it be to make money?  Of course I’m assuming the banks actually do their homework before lending out the money unlike before.

Looks like oil and gas stocks weren’t immune to the stock market crash as I had been hoping. As has been written a number of times on this site, it was expected that markets would crash but it was hoped that oil stocks would outperform as record earnings were expected given that oil prices in the second quarter were the highest ever. As expected, the general market crashed but unfortunately oil stocks joined the crowd and have now corrected 15-20% from their peak.

Oil stocks (e.g. Nexen Inc. T-NXY, N-NXY) were hit with a double whammy of relatively poor earnings and dropping crude oil prices. Oil is now down over $20 a barrel from its peak. The far worse news for Nexen was its pathetic earnings.

Nexen’s second quarter earnings release seemed to be a rather large string of disappointments: oil production volumes were down 6%, the marketing division lost a whack of money and some of the production volume was held in inventory instead of being sold in the quarter. The worse component of the earnings was the huge equity compensation of over $300 million which knocked $0.45 off the earnings per share to a paltry $0.70…this compares to the Q1 results of $1.17. I was forecasting Q2 earnings closer to $1.68 and had bought July call options on both Nexen and Petro-Canada. Obviously after the poor Nexen earnings release, the whole oil sector sold off 10-15% putting my call options out of the money where they expired worthless.

My only saving grace on the loss was the fact that I had earlier sold my stock positions and replaced them with the call options so that when the stocks dumped, I “only” lost the premium. Had I been holding shares instead of call options, my losses would have been much higher. Still, losing $3 to $5 on call options instead of $10 on the stock is small consolation.

I had originally intended to buy more call options on oil stocks if the July strategy didn’t work, but after the poor earnings release and the continuous sell off in oil stocks I didn’t make anymore purchases. The oil market seems to be very bearish right now and until there are signs that the market has bottomed, I won’t be buying anymore stocks or call options.

I’m expecting that as more oil companies report their earnings, their earnings will also be negatively impacted by large executive equity compensation plans i.e. execs are given large equity positions if the share price increases over a certain price.

Lesson Learned:

Expect a stock that has been doing well to report weaker than expected earnings as a result of the executive equity compensation plans. Stocks that end the quarter close to a record high price will have higher compensation expenses than a stock that is far from its high as the company has to mark to market the stock positions that are owed to the executives.

Also don’t get greedy by doubling up on cheap option positions when the stock trades down especially when the general market is already in a recession.

My investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security.

There have been a lot of things happening in the markets recently but it all goes to support the stagflation is here argument. It seems every inflation indicator shows that inflation is getting worse (i.e. higher) regardless of which country is reporting. At the same time, most countries are also reporting weak growth. Today was no different as GM slashes more jobs and eliminates its dividend, Fannie Mae and Freddie Mac are being pummeled as equity investors fear the US government will have to bail out the mortgage insurers and the Producer Price Index in the states grew at a 9.1% clip year over year, the fastest rate in 27 years.

With both the Canadian and US governments more concerned about the recession than inflation; the central banks have let interest rates remain stimulative. It’s been mentioned numerous times in my previous blogs that the governments would take no action to fight inflation other than talk tough. As a result of the stimulative monetary policy, inflation continues to get worse. In such an environment I felt a defensive portfolio was best and my portfolio became weighted mostly to cash, defensive stocks and call options on oil stocks. As the recession continues to get worse, I am having second thoughts on defensive stocks as it appears more and more likely that the recession will bring down all stocks.

Obviously my call options on oil stocks aren’t doing well as oil stocks have been getting hammered along with the general stock market even though the price of oil is only $6 off its peak of $145. I’m still a believer in oil stocks but fear that even with excellent earnings, the stocks may not respond. I’m predicting that Nexen Inc (T-NXY, N-NXY; oil and gas producer) will show a 50% increase in earnings in the second quarter over the first quarter; this compares to most analyst expectations of only a 25% increase in Earnings Per Share. We should know very soon who is correct as Nexen releases its earnings on July 17. Call options are a defensive way to get exposure to the equity market with only having to risk a fraction of the share price of the stock. Of course my plan would have worked quite well if I hadn’t doubled up on my call positions by buying more when the stock initially sold off.

Investor Implications:

If your portfolio isn’t already defensive, it’s probably a good idea to cut your losses and increase the cash weighting in the portfolio as the stock markets in general will get a lot worse before they get better. Even if your portfolio is already defensive, a portfolio close to 100% cash would be ideal if the markets unfold as badly as I anticipate.

My investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security.

Economics:

Stock markets in North America have been taking a beating recently especially the oil and gas sector. Oil has dropped about $10 in 2 days and oil stocks have sold off to much lower levels than when oil was last back at this level. It’s not just oil and gas stocks that are selling off as most commodity based stocks seem to be in a free fall and the Dow Jones has hit a technical recession i.e. some arbitrarily defined 20% drop from its high. Of course the big question is what’s an investor to do?

In a previous blog on July 1 (Time to get defensive, sell stocks buy calls), I mentioned that it was time to get defensive as I felt the economy would become even more recessionary and that stocks in general would perform poorly. It seems that I was correct on this point. I also thought that oil stocks were probably going to be one of the few sectors that would do well in the recession, on this point, it seems I’m wrong as no sector seems to be performing well. However, I imagine that when the oil company earnings are released, they will confirm my opinion about their excellent earnings.

Money Supply Growth:

Looking at the money supply numbers out of the US and Canada helps shed some light on what is happening with the stock markets and the currencies. In the US, the growth in money supply has been much lower and was even negative at the M1 level. If the money supply is growing very slowly, this should have very little if no inflationary impact; as a result the prices of everything will remain stagnant including the stock market. When inflation is high the price of everything rises. Since the US economy is fundamentally weak in so many different ways (i.e. budget deficit, trace deficits, housing crisis, credit crisis, job losses etc), it’s not at all surprising that without the support of money supply growth, the stock market is declining.

Canada’s situation is a little different as its money supply growth is much faster than the US, as a result this has been more supportive to its stock market but less supportive to the currency.

Investor Implications:

It’s probably best to maintain a defensive position as the recession in the US is only going to get worse and spread. For those wanting to maintain some exposure to the stock market, the best strategy is probably to sell the stock and replace the position with call options. As mentioned a number of times in previous blogs, when markets are this volatile and options are cheap, it’s better to hold calls rather than stocks. With call options, your risk is lower as the price of the option is only a fraction of the stock price.

My investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security.