Gross domestic product, the value of all goods and services produced, rose at an annualized seasonally adjusted rate of 1.6% from April to June, the Commerce Department said Frid

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Yesterday there were more riots in the streets of Athens as labor unions violently opposed a new proposal that would raise the retirement age and cut payments to pension recipients.  It’s understandable that citizens would be discouraged at losing generous benefits that had been promised for years, but one has to stop and think about how realistic these promises have been.

Whether Greece is able to fulfill the labor union’s expectation of generous payday and retirement benefits or not, the international investing community continues to expect high levels of risk.  The risk of a Greece or Spain default is a very serious issue with global repercussions.  Many European banks have significant exposure to Greek and Spanish sovereign debt, and even the expectation of a default can cause illiquidity as banks refuse to lend to each other and capital ratios are unable to be met.

As a trader in primarily US based companies, the European debt situation is still a major concern.  US markets are increasingly keying off of international events including Austerity programs, Chinese economic reports, and trends in emerging markets.  As correlations between geographical regions increase, I am finding few places where long-term investments make sense right now.  There is just too much risk of loss.

So at this point, the best course of action continues to be one of defense.  Consider holding elevated levels of cash in your account.  If you are comfortable shorting stocks and understand the risk, there are plenty of negative fundamental and technical situations that can be capitalized on.  IRA accounts can consider buying puts or inverse ETFs.

There will eventually be opportunities to buy equities with high levels of conviction.  But today’s market allows for very little confidence and requires patience and risk management regardless of your time horizon and risk tolerance.

Reuters blames the weakness on two primary factors.  First, the labor market continues to be soft and consumers are concerned with the employment situation.  Those who have jobs may very well be choosing not to make discretionary purchases and instead build up a savings account in case their employment situation changes.  Obviously those who do not have jobs are even more focused on reining in spending.

The second issue is the European overhang.  While most US consumers don’t actually see significant changes in their lifestyle as a direct result of the European uncertainty, the thought of heavily indebted governments defaulting on sovereign debt is very concerning – especially considering the massive debt the US is currently building.

Additional factors include the real estate market which was artificially propped up by stimulus programs but now appears to be under pressure once again.  If consumers feel that their home value is declining, they are less likely to make large purchases – especially home repairs or remodel projects because there is less justification that these improvements are an “investment.”

Finally, the declining stock market has a very real effect on sentiment.  As consumer see the value of 401(k) holdings, IRA accounts, and traditional investment portfolios decline, it sends a very disturbing negative wealth message.

The end result will likely be contracting multiples on equities and a flight to quality.  Pursuing a conservative investment strategy appears to be the best approach for today and holding significant amounts of cash and potentially inverse ETF positions can help to offset losses in traditional investments.

Enjoy,
ZDS

Lately, almost every financial news network has market analysts talking about the currency markets. At the moment the future of the Euro Dollar is the number one debate. Some say that the European Union needs to exist for efficient trade to take place more freely throughout the E.U. Others have suggested that Greece and the other countries in trouble default on their debt and start anew, without being part of the E.U. If you are a trader looking to play the Euro currency without buying the EUR/USD pair, a good exchange traded fund that will allow you to do this is the Currency Shares Euro Trust, ticker symbol (FXE).

The FXE trades on all the major electronic exchanges. With an average three month volume of over 1.5 million shares traded daily there is more then enough liquidity for traders to trade large orders of this product intraday. The FXE will mimic the price movements of the EUR/USD pair that forex traders would trade, so if as an investor you feel that the Euro will rise buying shares of this ETF will allow you to profit from its appreciation. Likewise if the Euro Falls the ETF will lose value.

At the moment the FXE has been trading between a high of 125.66 and a low of 121.27 over the past week. As you can see by the charts the Euro has been depreciating against the U.S. Dollar since the beginning of the year. In the past month the Greek debt crisis has led to a steeper selloff, bringing more uncertainty into all financial markets.

Traders should be watching the charts in the next few weeks to see if the Euro will regain its footing or fall further. The increased volume that you can see in the histogram on the bottom of the chart indicates that more people have been trading this ETF in the past few weeks. If Greece, Spain and Portugal announce that they are still having debt issues, the Euro and the FXE will fall further.

There is no support below the 121.27 mark that we tested on May 18^th, so a price break below that level on higher volume will indicate another leg down for the price of the Euro. The overall trend has been down since the beginning of the year, making it more probable that we will continue lower. There would need to be a major news story about the Germans backing the future of the European Union and Euro as a currency for it to start to appreciate. The German economy and its strong GDP is the driving force the holds the E.U. together. Germany has the biggest economy in Europe and since they are the most financially stable, they will have to help the other countries with loans to cover their budget shortfalls.

It is never easy for politicians to get their citizens to lend money to other countries that simply do not try and get their budgets under control. Greece is in the process of trying to change their socialistic style of government. As we all can see from the riots on television, this is not going to be an easy transition. If the various governments that comprise the E.U. can get their debt under control before they ask for money to bail them out the Euro has a chance to survive. If we as investors see little progress being made, they Euro will continue to fall. As a trader the best way to profit from the falling price of the Euro is to initiate a short position using the FXE exchange traded fund.

The big decline cast new doubts about the strength of the economic recovery.  Consumer spending accounts for 70 percent of total economic activity.  Economists are concerned that households will start trimming outlays as they continued to be battered by high unemployment and a swoon in stock prices. ~AP

Certain retail stocks have already begun to price in a slowdown in retail sales…  For instance, Abercrombie & Fitch (ANF) has already lost 30% of its market value from its high in April.  Still, other expensive apparel companies such as Lululemon Athletica (LULU) are still trading near their highs and appear to be vulnerable.

The decline in May sales reached 1.2% which was the largest decline since September and the first significant piece of negative news for retailers.  I would be more inclined to sell (or short) any rallies in the retail sector.  Investors will likely place a lower multiple on these stocks given the uncertainty ahead and the significant risk the that US consumer will continue to pinch pennies and reduce spending.

The unemployment rate is still going to be high for a while, and that means that a lot of people are going to be under financial stress

Last week, the employment report was released and was quite a disappointment to most traders.  While government hiring increased as a result of new census workers coming online, the private sector is still struggling to create new jobs.  Since each new government job must be funded by taxpayer revenues or additional borrowing, the number of new census workers isn’t exactly a benefit to the system as a whole.

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Optimists might point to the declining unemployment rate as evidence that the picture is brightening.  But the actual decline in unemployment is more a result of a smaller workforce as the statisticians reduced the denominator of “employable workers.”  This is much more of a statistical magic trick than a true improvement in the employment picture.

Last night, Bernanke also seemed to be hedging his words carefully and possibly hinting at an impending rate increase – which would likely constrain growth:

The Fed chief reiterated yesterday that the central bank’s “extended period” of a record low interbank lending rate is conditioned on high unemployment, low inflation and stable price expectations.

“We have right now a very accommodative, very easy monetary policy,” Bernanke said. “We can’t wait until unemployment is where we’d like it to be” or inflation gets “out of control” to tighten credit, he said.

(Bloomberg)

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So at this point it appears the market fear is pricing in an increasing possibility of a double dip recession – which would be very difficult to endure given the high level of government debt and the relatively high level of unemployment heading into this period.

Investors should continue to be cautious, employ strict risk control measures, and be willing to hold cash positions.  The market continues to be very turbulent and long-only investors are likely to have much better prices for buying a bit farther down the road.

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Unemployment has been an important issue, and one that has been difficult to tackle.  Despite many stimulus projects aimed at improving the unemployment picture, workers are still finding it challenging to find jobs.  This from a Reuters report on the data:

Although the economy has now grown for three straight quarters following the worst downturn since the 1930s and the recovery is broadening, stubbornly high unemployment is eroding President Barack Obama’s popularity…  While other indicators support views the labor market recovery is firming, claims for jobless benefits remain above levels usually associated with sustainable employment growth.

While the jobless report is helpful in determining the state of employment in the US, most eyes will be turned to the more popular Employment Report which will be released tomorrow.  The expectation is for non-farm payrolls to have increased 513,000 in May – much of which is due to the census hiring.

Employment is an important part of any economic recovery because it directly affects the well being and sustainability of the population.  While the US could experience nominal GDP growth as an eventual product of stimulus spending, without a sustained resurgence of private jobs, the recovery will quickly run into substantial challenges.

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Only the first trading day of June 2002 was worse with a decline of 2.48%.  Below we highlight all first days of June that have been down over the last 50 years.  We also provide the index’s performance through the end of the month.  For Junes that have started the month down, the S&P has averaged a rest-of-month decline of 0.53%.

Take a look at the table and you will see the closest two data points led to some very rough returns.

Considering the fact that we just completed the worst May in 50 years, it is clear that the market is vulnerable and investors  (professional and retail alike) are pairing back their risk exposure and looking for safety.

Consumers remain under pressure and if inflation and/or  unemployment statistics begin to tick higher, the pain will be felt not just on Wall Street but more importantly on Main Street.  Investors should be looking for defensive businesses that can survive and even thrive in a weak environment for consumers. Direct payday lenders like First Cash Financial (FCFS) and Cash America (CSH) may be worth watching as they have backed off in recent months but are fundamentally still relatively strong.

At risk are many of the sectors which have seen the most speculative buying since the most recent January swing low.

Markets have continued to motor higher, and recently the crossing of major points of interest (11,000 on the Dow and 1200 on the S&P 500) has had a major psychological effect on short exposure.  For the most part, short-sellers have picked up stakes and gone home – leaving the market more vulnerable to a significant drop.

When there are enough short participants in a market, that can help to add support.  This is because profit taking occurs when markets fall – and shorts covering profitable positions can sometimes be the majority of buying interest in certain stocks or sectors.  With very little short interest, a significant drop in speculative sectors could go un-checked and lead to more volatility.

So due to high levels of speculation and risk – and with the next inclination likely to be a flight to safety, here are the three areas I think traders should be most interested in shorting.

Consumer Discretionary / Retail

The retail industry has logged some impressive gains since the pullback in January / February.  After hitting a low on February 5, the retail HOLDRS (RTH) made a new recovery high in just 20 days, and has continued to march steadily higher.

Individual retailers have been reporting a pickup in sales levels and with inventories largely low and overhead costs also reduced, the profitability increase has been tremendous in some cases.  For the most part, the profitability increases has been boosted by one time issues (it’s unlikely that companies will continue to cut overhead and inventories are already picking up in anticipation of stronger demand).

The same could be said about the consumer demand for goods.  Especially if you buy into the concept of strategic defaults boosting consumer spending.  Since I have written the article on strategic defaults, I have received what I would consider a bi-polar response with many outraged readers suggesting the concept is ludicrous, while the other half actually know at least one (if not more) friends or neighbors engaged in a strategic default situation.

The ability to spend more through living rent-free in one’s house (by simply not paying the mortgage) cannot continue indefinitely and when this practice is stopped, it is likely consumer spending will once again decline – especially since employment numbers have yet to show much in the way of recovery.  When consumer spending is called into question – or simply when managers start applying the “risk off” portfolio management, retail stocks could take the brunt of the selling.

Shorting the RTH vehicle is one broad way of capitalizing on this movement, but it may be more profitable to focus on some individual stocks which have experienced significant gains and could be due for a pullback.  Stocks that quickly come to mind (for more research later) include Abercrombie and Fitch (ANF), Ann Taylor (ANN) and potentially Lululemon Athletica (LULU).

Domestic China Companies

Strong economic growth in China has attracted significant foreign investment and led to strong price appreciation.  While speculative buying has supported strong price multiples, another issue has been reduced supply of available investment vehicles.  Since the Chinese government restricts the amount of financial assets available to foreigners, mutual fund managers and other institutional investors have found it difficult to secure their desired level of exposure to China.  By nature, a low supply of an asset coupled with strong demand will result in higher prices.

With current prices already reflecting strong long-term growth for the Chinese economy, it would only take some small disappointments for this sector to begin to fall.  The strong GDP reports are likely to cause the government to be more aggressive, tightening regulations on the banking sector which would reduce available capital to industry.  As these measures are enforced, the Chinese economy could continue to grow at a slower pace, but the stock prices could decline sharply to reflect the lower growth rate.

Two easy vehicles for investors to trade are the iShares MSCI Hong Kong (EWH) and the iShares FTSE/Xinhua China 25 (FXI).  The EWH includes a broader section of the Chinese economy, while the FXI has a larger financial concentration.

For a bit more volatility (and potentially larger gains) traders  could consider short positions in individual China companies:

• E-House China (EJ) – A real estate agency whose profitability is closely tied to property transactions in China’s overheated real estate market.
• Baidu Inc. (BIDU) – The well-known Google competitor running online advertising and internet search capabilities.  The stock has a strong trend but investors are paying 63 times this year’s expected earnings.
• Home Inns & Hotel Management (HMIN) – A Chinese hotel manager with a high multiple and declining revenue growth.  The hotel industry is closely tied to a vibrant economy and any hiccup could send the stock sharply lower.

US Regional Banks

During the last financial crisis, many of the largest banking institutions were deemed “too big to fail” and were subsequently bailed out or backstopped by the US government.  While it is certainly not fair, the majority of US regional banks are decidedly NOT too big to fail and face significant risks in today’s environment.

A rising stock market and improving confidence has led many investors to overlook balance sheets with excessive leverage, and the impending danger of write-downs.  Commercial mortgages still comprise a major risk to regional banks and many of these loan portfolios are still being carried at valuations which imply economic health and little risk of default.

If the Goldman news causes a new “risk off” dynamic with lower amounts of liquidity and a focus on what could go wrong instead of only what could go right, the multiple on many of these smaller and more vulnerable banks could decline sharply.

There are two primary ETFs which were designed to track the regional banks – the iShares DJ US Regional Banks (IAT) is comprised of some of the largest regional banks like US Bancorp (USB) and BB&T Corporation (BBT).  While these banks may be vulnerable, they may also still fit into the “too big to fail” bucket and be propped up by the government in some shape or fashion.

For this reason, I’m more interested in the SPDR KBW Regional Bank (KRE).  The ETF is made up of many smaller banks and even its largest holdings only represent a small portion of the total fund.  Shorting this vehicle will give traders more exposure to the general factors that affect the small traditional US bank, and looking through the top 25 holdings for this ETF (which can be found on Morningstar.com) could yield some individual picks that are even more powerful.

Timing is Everything

Timing will be key when laying out shorts in the post Goldman lawsuit period.  My expectation is for bulls to step in early this week and prop up markets.  After such a stunning run for the last 6 weeks (and for the last 12 months for that matter), it is hard to imagine the market rolling over and heading directly south without at least a week or two of wrestling.

Using reflex rallies to lay out shorts may help to cut risk.  At the same time, small positions could be initiated right away so that if the bearish sentiment takes hold immediately, at least we have some exposure taking advantage of the new trend.

For long positions in these three sectors, I would urge caution.  True investors may want to hold these positions long-term for better tax treatments and for fundamental reasons.  If this is the case, it may make sense to sell calls against individual stocks to create some income and reduce the risk, or potentially buy inverse ETFs which can generate gains while the market falls.  This could help offset traditional exposure and lead to better long-term profitability for your portfolio.

The ZachStocks Newsletter will likely begin adding short positions later this week or early next week.  At this point we are waiting to get a better feel for the market reaction, but should be able to use a reflex rally to step into some profitable shorts at appropriate risk / reward ratios.  The important thing for traders to do at this point is to continue building a watch list of appropriate short candidates so that when the decline begins in earnest, we will have a robust list of short candidates.

FD: Author does not have a position in any stocks mentioned in this article.

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The SEC charge brings up an interesting philosophical debate.  How much liability should Goldman (or for that matter Paulson) have for creating investment products that buyers were clamoring to own – even if it was clear that the end result would be major losses for clients of Goldman.

Keep in mind the years leading up to 2007.  Real estate prices continued to climb and optimism reigned supreme.  Middle class, lower class, and even upper class consumers were all but assured that the way to build permanent, sustainable wealth was to own real estate – a LOT of real estate.  Since land has a fixed supply (how many times did we hear the wisecrack “they’re not making any MORE of it”?) investors expected the price of homes, land, condos and office properties to continue to rise ad-infinitum.

Leverage was strongly encouraged because when prices do nothing but rise, leverage works in the buyers favor.  So Wall Street was all-too-happy to create opportunities for non-creditworthy buyers to get in the home of their dreams.  It all made financial sense because if the buyer eventually defaulted, the value of the property would have risen to more than make up for the loss on the loan.  And typically, owners would simply refinance, borrowing more on the value of the property – and use the money for paying the loan or other discretionary purchases

Owning a home could actually become a self-funding venture.

Caveat Emtor?

So during this manic time period, investor appetite for mortgages naturally increased.  Think about it…  When buying mortgage securities, you were essentially loaning money to purchase properties that continued to appreciate in value.  The collateral was becoming more valuable, meaning that every day your loan became more secure.

In this environment, it’s hard to understand why Goldman wouldn’t offer mortgage products to investors who were begging for more supply.  If you’ve read John Paulson’s book The Greatest Trade Ever (a great read I might add) you would see just how strong the demand was for these securities and how the momentum fed on itself.

I guess my main question is – was Goldman really wrong to sell ill-fated mortgage securities to willing and experienced professionals? I know there is more to the story than this, but the bottom line is that these CDOs weren’t being sold to individual investors who knew nothing about the market.  They were being sold to pension funds, endowments, hedge funds – to institutions managed by professionals who should have researched what they were buying.

Part of the SEC’s accusation centers around the fact that Paulson & Co. helped to pick out the individual mortgages or baskets that went into the CDO securities.  This is certainly something that should have been disclosed to buyers – if the seller has access to non-public information that the buyer cannot uncover, then the playing field is tilted.

But what worries me is the moral hazard that is emerging in the financial markets.  More and more, it seems that we expect gains to be privatized (meaning if companies MAKE money, they get to keep it), but losses are socialized (the government steps in to make losers whole).

What ever happened to a fair market where willing buyers and willing sellers met to exchange goods (be they industrial, agricultural or financial goods)?  If I make a trade and lose money, the responsibility is mine.  My job is to cut my losses, learn a lesson from the mistake, and move on to bigger and better trades.  The same should be true of all market participants, and if you or I buy products that we don’t understand, then we shouldn’t be involved in that market in the first place!

But I digress…

Where To From Here

My suspicion is that the market won’t completely fall apart at this juncture in the game.  The bulls have been entirely too strong and we have been conditioned to “buy the dips” (even though there have been precious few dips to buy recently).  Investors with any capital on the sidelines have largely been kicking themselves for not participating and promising to put their capital to work the next time we get a correction.

So this buying pressure brought on by classical conditioning will likely stabilize the market in the short-term.  So I wouldn’t bet the farm on a major short position Monday morning at the open.

However… I DO think that over the next two months we will have a significant negative move in the market and give up a good portion of recent gains in speculative positions.  Even though a lawsuit against Goldman has very little to do with most industrial, technical, medical or retail stocks, the political risk introduced into the market could have the effect of decreasing the multiple investors are willing to pay on stocks across the board.

Currently, the majority of short positions have been closed as traders have been punished for any bearish bets.  Short sellers usually help to stabilize falling markets because they represent pent up buying pressure as they buy to cover their positions and collect their profits.  With these participants largely out of the market, the decline could turn out to be much more severe.

Prices are currently at levels that imply a full, robust recovery, so any change in this expectation will cause “long and leveraged” managers to re-think their positions.  So after an initial buying period, don’t be surprised to see the market head south in a hurry.

I’ll be using the next week to brush up on my short watch list and look for names that have the most risk, the highest multiples, and investors with the strongest confidence.  While many of these names will be tough to short (due to the strong price momentum), watching the charts carefully for good entry points, and managing risk with stop orders could turn out to be a very profitable endeavor.  I have felt like the first quarter didn’t offer too many opportunities for large profits, but the climate today makes me excited about the new opportunity for traders willing to play both the long and the short side of the market.

FD: Author does not have a position in GS

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This week the ZachStocks Newsletter portfolio was stopped out of a position in Zumiez Inc. (ZUMZ).  Although the position initially showed a profit, a monthly sales report followed by a Wall Street downgrade was enough to send the stock below our stop level…  The small loss is something that we as traders have to get used to in order to stick around long enough to capture the big winners.

The transaction prompted a great comment from reader Alex:

Why is there a stop on this company at $19.80 in your “long position” for your service? Interested in your reasoning why, if this is a long position, you would want to sell when the company becomes cheaper. Wouldn’t a lower stock price without a change in the underlying business be a reason to buy more shares, not sell them?

Thanks for the great question Alex…  It gives me a great opportunity to talk about the difference between tactical trading and true value investing.  True value investors analyze stocks based on what they perceive as a fair price to own the company.  Typically these investors hold positions for an extended time – until the price rises to a point where they believe the market is paying too much for  the investment.

True technical traders, on the other hand, usually pay very little attention to the actual fundamental value for the company in question.  Traders are much more concerned with the direction or trend of the price and often hold positions for much shorter timeframes than investors.  Whether using a “reversion to mean” approach (expecting extended stocks to revert to more “normal” patterns) or a “trend following” approach (holding positions that have strong momentum), successful traders almost always have a very disciplined approach to exiting losing trades.

Disciplined Value Investing

It takes a lot of hard work to be a truly successful value investor.  If you are going to consistently generate profits above the benchmark indices, you have to command both nerves of steel as well as developing some base of information which is better than the general knowledge base on the street.  To quote Gordon Gekko from Wall Street, “The most valuable commodity I know of is information.”

Alex’s rationale is perfectly logical if an investor does his homework, is confident in his findings, and the fundamental metrics of the investment do not change.  If I’m buying a stock at $15 based on the fact that I believe the company should be worth $25, then I should be even MORE excited about buying the same stock at $10.

The problem that most amateur value-based investors eventually face is the fact that it’s nearly impossible to know everything about a company.  And sometimes the minor detail missed can become the most important factor for an investment.  There may be an off-balance-sheet liability which eventually generates a significant loss for the company.  Maybe a particular business line is pressured by unexpected competition.  Or the visionary CEO could have a rare illness kept under wraps to all but a few close friends.

For value investors who miss these subtleties or fail to put all of the pieces together, the oversight can be devastating – and result in material losses.  Usually by the time a serious issue becomes apparent, the stock in question has already lost a significant amount of its market value as “in the know” investors have begun liquidating shares before the public realizes the true long-term ramifications.

So the danger to value investors is doubling down on a position without truly understanding why a stock is trading lower.  The question I usually pose to a value-based investor wanting to buy more at a lower price is – What if you’re wrong? – What will you do to protect your capital against an unexpected change in fundamentals?

The Pure Technical Trader

On the opposite end of the value-based investor is the Pure Technical Trader.  This market participant typically shuns any fundamental information and follows a rules-based technical system.  It may be a trend following system which uses indicators to target particular investments which are exhibiting strong momentum, or a mean reverting system which shorts stocks that have run too high too quickly, and buys significantly depressed stocks.

There are many ways to approach technical trading and it is beyond the scope of this article to dive too deeply into different methodologies.  But when studying successful traders, it has become clear that the ones who are able to stick around for years and years – consistently generating profits – are almost always fanatical about managing risk.

Many of these traders are much like baseball players who almost never have a batting average above 500.  This means that if you look at each position a trader takes over the course of a year or three years or a decade, the number of losing trades is often materially higher than the number of winning trades.

But while this may seem counterintuitive, the reason these traders are able to make huge profits is because they cut their losses quickly.  The great Paul Tudor Jones II is well known for taking hundreds of tiny positions and kicking them out for losses until he finds the perfect investment with the right timing.  At this point he is able to increase his commitment (once the position has proven to be profitable) and eventually generate the majority of his annual profits from just a handful of truly successful positions.

When the market moves against a technical trader, it’s a sign that he is either wrong or that his timing is off.  In this case, the best strategy is usually to exit the position (taking your loss out of discipline) and re-evaluate why the market is moving against you, and whether the original rationale still stands.  There should be no shame in re-entering a position 2,3 or even a large number  of times, provided that the losses are kept small and once the trade becomes successful, the trader sticks with the position long enough to generate a good portion of the possible gains.

The Two are Not Mutually Exclusive

As a market participant, you don’t have to choose one or the other.  There are many successful traders who use technical analysis to help fine-tune their timing.  By the same token, quite a few strong traders use fundamental value-based analysis to determine which vehicles or which market direction is likely to produce the strongest opportunities.

The concept has been over-used and trivialized to some extent, but I find it helpful to use fundamental analysis to determine what I want to be long or short, while using technical patterns to develop a sense of when I actually pull the trigger on a trade.  And because I firmly believe that there can always be variables that I was not able to cover in my analysis, I recommend using a stop-loss order to exit a position in the event that it turns against you.

Where to place the stop order is a matter of personal preference and should match each trader’s approach uniquely.  For very active traders, stop loss levels will be very tight, kicking the trader out of many positions with minimal losses and requiring each new position to show profits quickly or else be discarded.  For more fundamental investors, a stop loss may take the form of an alert – “if the market gets to THIS point I will be forced to re-evaluate my position to ensure that my strategy is correct.”

Positioning of stop orders can also depend on the market environment.  In a strongly trending market, traders may choose to keep a wider stop to protect against being taken out of a position pre-maturely.  And during the more choppy times, stops may be tightened and traders may expect to hold positions for much shorter intervals.

The bottom line is that in order to trade successfully for long periods of time, investors and traders alike must understand and manage their risks carefully.  Having a firm grasp on what events would signal that a trade is wrong – and what actions would be taken at that time, should lead to shallow losses and create an environment for much larger gains.  So when managing your investment capital, make sure that you operate with a disciplined plan and always understand what is at risk and how you will manage that risk.

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We’ve faced some very bipolar news on the US consumer over the last two years.  With the unprecedented turmoil in the markets, a real estate market that remains depressed and illiquid, unemployment stubbornly high, and shaky financial ground to begin with – most analysts (myself included) completely discounted the consumer’s ability to spend.

Since consumer spending is known to account for roughly 70% of GDP, this has not been good news.

But with all the headwinds, and with all the negative publicity… the consumer, it appears, is beginning to step up to the plate and once again spend us into recovery.

It should be considered good news, I guess.  After all, numbers don’t lie and the statistics point to a relatively strong consumer with money in his pockets (or maybe plastic) and a list of wants akin to a seven-year-old at Christmas.

The strength is wide across the retail sector.  Apparel stocks like Lululemon Athletica (LULU) and relatively new IPO Rue 21 Inc. (RUE) are only slightly off their all-time highs.  Restaurants like growth stocks Chipotle Mexican Grill Inc. (CMG) and luxury Morton’s Restaurant Group Inc. (MRT) have staged impressive investment gains.  Retailers from budget conscious Family Dollar Stores (FDO) to high-roller Tiffany & Co. (TIF) are all trading as if the consumer is healthy and spending once again.

And despite my reservations on this sector, I imagine that retail same-store-sales which will be reported on Thursday will show at least a stable pickup in consumer spending.

Where is the Money Coming From?

It’s been quite a mystery to me for some time now.  Exactly where is all this pocket change coming from – especially considering the difficulties we are seeing in other areas (savings rates are once again headed lower, consumer credit hasn’t expanded by any material amount, and despite positive payroll headlines, the underlying report is full of  holes).

It wasn’t until this past week when a colleague mentioned the term strategic default did I realize what was likely occurring.  Many consumers are spending their mortgage payments! It’s beginning to make sense in the most disturbing way.  As homeowners face staggering payments on houses that have negative equity, a large number are simply deciding not to pay their mortgage bill, resigned to the fact that eventually they will lose their house.

And what happens with the money that would have been sent to the lenders?  Well, an increasing mentality of “eat drink and be merry – for tomorrow we’re evicted” has set in.

It didn’t used to be this way.  For decades, the US consumer placed priority on home ownership.  We might miss a credit card payment, and we might put off that family vacation, but we were NOT going to default on our mortgage.  After all, home ownership was a privilege, and a serious wealth-building opportunity.  Heck, even today there are plenty of retired Americans who are living solely on the equity they built in their homes over a number of decades.

But a sense of hopelessness has emerged when it comes to residential real estate.  The principal of home ownership as a tool for wealth building is being sharply disputed.  As adjustable mortgages reset to higher rates and payments become more difficult to make, we are likely to see even more homeowners throw up their hands in disgust.  If home prices are likely to be low for years (if not decades) then why sacrifice to pay the mortgage on a home where the mortgage is much higher than the value?

Many consumers are willing to turn in the keys and walk – hoping maybe to get into a better deal once their credit is repaired.

On top of the negative equity issue, restrictions meant to help consumers are actually reinforcing this idea of strategic default.  The past and current administration have both made it a priority to keep homeowners from being foreclosed upon whenever possible.  Lenders are required to go through a series of bureaucratic steps before enforcing a foreclosure and many times this process takes several months to over a year to execute.

The good news is that homeowners who are truly struggling will be allowed to re-negotiate rates, possibly receive a write down on their principal owed, and participate in other federal and state programs aimed at giving them assistance.

But the dark side of this process is that many homeowners are purposefully not paying the mortgage in a strategic decision to allow the foreclosure process to happen and in the meantime to enjoy having the extra spending money.  It is estimated that for every foreclosure on the market right now, there are five or six homes in strategic default.

How Long Can This Last?

The additional measures aimed at keeping homeowners in their houses and encouraging banks to write down loans may very well continue this process for some time.   As with many other “moral hazard” issues, the intentions of regulators may be noble, but allowing a broad portion of the population (whether they be financial institutions or individual consumers) to escape without taking responsibilities for their actions will inevitably cause irresponsible behavior.

It would not surprise me to see several more months (if not a few more quarters) of strong consumer spending in part due to strategic default capital.  Also as the market climbs higher and employment statistics are spun to be perceived as positive, more healthy consumers will likely open their purse strings and begin to increase spending.

The momentum may very well continue and that is why the ZachStocks Newsletter portfolio actually holds a long position in Green Mountain Coffee Roasters (GMCR).  It may surprise readers to see a long position in this name because I have been vocal about my expectation for the stock to decline.  I still believe that at the end of the year GMCR will be significantly lower, but with the current investor capital flowing toward speculative retail issues, we are taking a short-term trade as the stock breaks to new highs.

Unfortunately, while the situation looks sanguine on the surface, the longer we inflate this speculative bubble, the more disturbing it will be when the situation begins to unravel.  I expect regional banks and holders of mortgage debt to be the first firms hurt as strategic defaults cause them to write down the value of loans.

Foreclosing on mortgages and auctioning off these properties is an expensive process and banks are likely to take significant losses at some point this summer or fall.  As strategic defaulters are finally evicted from houses and must pony up rent money, the growth in consumer spending will likely kick in.  At this point many speculative retail stocks will become excellent short opportunities.

The timing is difficult to nail down.  For now, speculation is being rewarded and irresponsible behavior has led to a better lifestyle for many consumers.  Retail traders are likely to be rewarded by either taking a short-term positive positions or sitting on the sidelines.  Once this bubble bursts we will be active on the short side, but until that happens it makes little sense to step in front of the strong positive momentum in speculative retail stocks.

FD: Author has long positions in the ZachStocks Newsletter portfolio

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But the exercise is always helpful in identifying investment themes and then following those expectations throughout the year to determine what adjustments need to be made, and which situations turned out as expected.  As I write a bit before the close on March 31, it appears that all four of my positions are up on the year (thank God for small victories) but at the same time, there are definitely some shifting themes that give me a different perspective on at least one of my recommendations.

So let’s take a look at the status of these four investment opportunities, and then consider following the links at the bottom to see how we stacked up against the competition…

The Blackstone Group LP (BX) – Liquidity has been increasing during the first quarter, simply meaning that investors are willing to make more speculative purchases and banks are slowly increasing the amount of capital they will lend out.  This is an improving environment for BX for two primary reasons.

1. The appetite for new stocks allows private equity firms to issue IPOs to a market that is demanding speculative investment vehicles.  Every time BX turns out stock at a profit, it is able to realize a gain in one of its investment funds – usually initiating an incentive allocation (BX is often eligible to receive part of profits from funds it manages as payment for overseeing the investments)
2. Blackstone is finding it easier to raise new capital (either from investors or debt capital) to pursue investment opportunities.  Rising AUM creates the potential for much higher incentive allocations down the road when those investments increase in value.

Blackstone currently pays a hefty dividend of 30 cents per share each quarter so our return for Q1 should reflect the additional capital investors received.  The dividend yield (roughly 8.5% annualized) is helpful in stabilizing the price of the stock because investors are likely to pick up shares for income – and the increased demand holds the price above a theoretical threshold.

So while the stock is only up about 7% from the 12/31 initial contest price (9.7% if you include the dividend), I expect gains to accumulate throughout the year with a reasonable chance that BX could eclipse $20 before the end of December.

Assured Guaranty (AGO) – As we mentioned on 12/31, this financial insurer is the only major competitor with enough capital to continue to underwrite new business.  Management has proven their ability to navigate turbulent waters by staying away from dangerous mortgage securities that were the downfall of stocks like Ambac Financial Group (ABK) and MBIA Inc. (MBI).

In early March, AGO passed a significant test with the stock holding up well even though a large shareholder dumped several million shares onto the market.  This was not totally unexpected – the shareholder was Dexia which had received a large block of stock as AGO acquired Financial Security Assurance from the firm.  Now that Dexia is out of its stock, I expect AGO to trade sharply higher both due to its strong financial foundation along with the growth from new underwriting.

While it didn’t make sense for the company to participate in the mortgage mania during the boom years of 2007, the purchase of Financial Security Assurance now allows AGO to underwrite mortgage insurance in an environment where premiums are much more reasonable given the amount of risk taken.

Currently our position is only up 2.3% from the 12/31 close, but sometime during Q3 or Q4 I expect to tack on another 18% as traders test the 52 week high posted in November of 2009.  AGO is actually a pending trade in the ZachStocks Newsletter which has been revised to offer timely stock recommendations twice a week for active traders and investors.

IntercontinentalExchange (ICE) – When we looked at ICE at the beginning of the year, it was expected that increased regulation in the financial industry would require futures trading to be “cleared” which means that a third party must manage the risk and guarantee the trade.  ICE and CME Group Inc. (CME) are the two primary exchanges with clearing functions and the capital to manage risk.

During the first quarter, the administrations focus has shifted to health care reform along with other policy issues.  Financial reform is still on the table, but media attention has waned and it is unclear just how much business ICE could gain as a result of the current political environment.

On the other hand, ICE is trading in a very healthy pattern, and on Wednesday it appeared to break out of a “cup and handle” base with the potential to move quickly towards the 2009 highs near $120.  A healthy market appears to be bringing in many participants who are trading ICE’s products although a bit more volatility might actually spur volume increases.

The stock is currently trading at what I would consider a “fair” value.  Without the regulatory reform, there is not too much that gets me excited about ICE for a short-term trade, but as a long-time follower of the company, I believe ICE is an excellent investment with a talented management team.  So to sum it up – I am leaning towards a luke warm opinion of ICE today and if you don’t currently own it, there may not be a strong argument for picking up shares at this juncture.

iShares Silver Trust (SLV) – While I am thankful to be sitting with a small profit on this trade, I am becoming less convinced that silver will be an excellent trade for 2010.

We have experienced a strong market run which indicates investors are willing to take risk and provide liquidity.  The government statistics (flawed as they may be) lead us to believe that an economic rebound is occurring.  And yet with all the government spending, we are not seeing large moves in gold and silver.  Inflation seems to be temporarily at bay.

Now I have to tell you that I don’t totally buy the “no inflation” argument.  There are just too many fundamental factors that should ignite an inflationary environment at some point along the way.  But if we were going to have a hyper-inflationary move, it likely would have occurred during the first quarter – in fact, we didn’t see any alarming statistical or market based evidence of this trend.

To be honest, I’m sitting back and scratching my head at this a little.  It’s not that I don’t understand how the argument against inflation, it’s just that I don’t agree with it!  But until the market actually begins to indicate that inflation is an issue, there will be more productive places for our capital.

So if you’re reading this today and you have a large position in SLV as a result of my recommendation, you should certainly do your own homework, but my recommendation is to close the position until we once again see signs that the market is focused on the demise of currency and the importance of hard assets.

That just about does it for this quarter.  Be sure to check back and view the other participants links.  We will review the picks again at the end of Q2.

• My Traders Journal
• The Wild Investor
• Where Does All My Money Go
• Intelligent Speculator
• Four Pillars
• The Financial Blogger
• Dividend Growth Investor
• Million Dollar Journey

FD: Author has long positions in stocks mentioned in Sound Counsel Investment Advisers portfolios

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As the market trends higher and investors gain more confidence, business owners and private equity firms are increasingly tapping into the available market liquidity.  The opportunity at this point is for businesses to raise capital through an IPO transaction, selling shares of the company to the general public.  Private equity firms which own and manage individual companies are also cashing in.  A market of willing buyers allows the private equity managers to sell portions of these companies (or the entire company) and often realize healthy profits on their initial investment.

But how exactly does this process work?  As a fund manager who focuses on new issues, I have seen hundreds and participated in dozens of these transactions.  While there are often many moving parts and more than a little “slight of hand,” the IPO transaction is a fairly simple concept to grasp.  And whether you are a business owner or an investor, you should be aware of and understand the basic building blocks of this type of transaction.

The Cast of Participants

In order for a company to start trading on the public exchanges, there are basically three parties who are instrumental in the process.  The seller is the party distributing the shares and receiving the capital.  The underwriter facilitates the transaction much like a broker would facilitate a real estate transaction.  Finally, the buyers actually pay for the newly issued shares for the company.

So let’s look at each of these parties a bit more carefully.

Sellers Seeking to Raise Capital

When I look at an IPO transaction from an investor perspective, one of the most important questions I ask is who is selling the shares?

Usually, I am most excited about participating in the IPO when the shares are primary or being sold by the company.  This means that the capital that I pay for the stock goes largely back into the company which allows for growth.  The capital can be used to expand the sales force and pay their salaries, it can be used to expand a plant or facility that allows for better production, or it can be to pay down debt to make the financial foundation more stable.

The more specific a company can be about what they are doing with the capital, the more confident I can be that the money raised will be put to good work.  Too many times a selling firm will announce that the capital will be used “for general corporate purposes.”  That simply means the management team is asking for a blank check to spend however they see fit.  Not exactly a great way to instill confidence.

Other sellers can include the company’s founders, a private equity firm, or a wealthy individual or trust who has previously owned all or a large portion of the business.  While I understand that these parties need to sell at some point to monetize their investment, I’m instinctively uncomfortable with a current investor selling shares to the public.  Since in this case the seller knows more about the inner-workings of the company than I could hope to learn in a few weeks time, I’m curious whether he or she sees a problem and that is motivating them to liquidate.

Whether a private equity firm or an individual investor is selling shares in the transaction, there are a couple of things that can be done to make the deal a little more appealing.  If the seller retains a large portion of their investment, then I can feel confident that they still believe in the future of the business – but they just want to begin collecting capital from their success in building the company.  I understand this need and if they still stand to benefit or lose from the ongoing success or failure of the company, then I am a more willing buyer.

A second way for sellers to make the deal more appealing would be to issue a mix of primary and secondary shares.  This way the company is still receiving part of the money from the transaction and the sellers are liquidating a portion of their holdings as well.  This way there is still a reason to expect the company to benefit from my investment and the selling parties receive an opportunity to monetize their investment as well.

Underwriters Introduce Buyers and Sellers to Each Other

Underwriting firms are usually well known brokerages such as Goldman Sachs, Merrill Lynch (now a division of Bank of America), Morgan Stanley and similar firms.  In recent years, the number of top tiered underwriting firms have decreased as a result of the financial crisis.  But there are still plenty of niche boutiques which also have the ability to act as underwriters for IPO transactions.

The underwriter is responsible for putting together the prospectus which is an offering document with all of the pertinent information that investors need to make an educated decision as to whether to invest or not.  Typically, underwriters are part of a brokerage firm which will service a number of institutional and retail investment accounts – thus bringing the buyers into the picture.

After performing due diligence on the company, the underwriter will determine a “fair market” price range for the IPO.  This is based on their assessment of the profitability of the business, its risks and growth expectations, and the price at which similar investments are trading for in the open market.

Once an acceptable price range has been established, the underwriters will then turn to the buyers to place the stock with willing investors.

Usually there is more than one underwriter working on a deal.  The LEAD underwriter is usually the firm responsible for performing the due diligence and determining the acceptable price range.  Secondary underwriters are simply brought in to help place the deal.  Since it is important to have a broad number of investors in the stock, underwriters usually work in teams to distribute the stock to a wide assortment of investors.

The underwriting firms are typically paid very well for their assistance in getting the stock distributed to investors.  Typically the underwriting fees are between 6% and 10% of the stock price, so if a company is selling 30 million shares at $14.00 per share, the underwriters could split between $25 million and $38 million.  Underwriting fees can often make up a large portion of revenue for a company like Morgan Stanley.

Buyers Invest In an Unproven Vehicle

You’ve probably heard that the average investment return is highly correlated with the risk taken.  While I don’t think that’s an absolute truth, there is a certain amount of return an IPO investors should expect due to the risk he is taking.  After all, there has never been a market for this stock before and the buyer is being asked to trust the underwriter’s “fair market” valuation of the company.

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Since as a buyer, I am putting my investors capital at risk on an unproven stock, I expect the deal to be profitable immediately.  Underwriters understand this dynamic and so they are constantly trying to please both their buyers and sellers.  After all, they need both parties in order to generate their fees.

So IPO transactions are usually priced with the expectation of being a bit below the expected market price.  That way buyers are pleased with their transaction and are willing to come back the next time the underwriter has a new IPO to pitch.  But if the IPO pricing was TOO low and the stock jumps 50% or 100% from the pricing immediately, the sellers could become angry because they could have received a better price for their stock.  So there is a fine line, but the pricing of the transaction usually favors the buyer.

Buyers of IPOs are typically institutional investors, although it’s not impossible for retail accounts to participate in many of these transactions.  Underwriters typically approach the buyers with information about the stock, the expected price range, and maybe some color as to how much demand there is for the stock.  Buyers will then offer an IOI or Indication of Interest, stating how much stock they would like to buy when the transaction is completed.

When indicating for a particular stock, I am always interested to know how much stock the underwriter believes he can get for me.  There is a bit of reverse psychology at play here because if the underwriter says “this is a great stock and the best news is that I can get you all the shares you want!” then I quickly become nervous that the demand is very low.  However, if the story is “We don’t have much of this one available,” then I am much more interested because it is likely that demand will drive the price higher once the stock begins trading.

After the Process Is Complete

You might think that once the sellers have received their capital, the underwriters have collected their fees, and the buyers begin trading the stock, that the process is over.  However, just like a baby, the newly issued stock still needs some care to survive to maturity.

Underwriters have a definite incentive to make sure IPO transactions work and the stock remains a viable investment vehicle.  After all, they want to make sure that sellers look them up when they have a company to sell to the market, and the only way buyers will stay interested is if the IPO continues to trade in a positive manner.

So it’s a loosely guarded secret that many underwriting firms “support” the stock in the first few months of trading.  That simply means that when and if the stock trades back towards the offering price, the underwriter very well may place large buy orders in the market to keep the stock from falling below the IPO price.  If you look through the charts of a dozen recent IPOs, you will probably see 6 or 8 of these stocks which trade right down to the IPO price and then mysteriously find support.

Another issue is the research process.  Since many investors are hesitant to invest in a stock without receiving a few second opinions from analysts, it is important for these stocks to catch the eye of research departments in various investment firms.  Ironically, the underwriters usually know the most about these companies because of their due diligence process, and yet the underwriters are restricted from offering analysis for a period of time after the offering.

But once that “quiet period” is over, you will often see several underwriting firms issue reports on the newly issued stock.  More often than not, the analysts will have a “buy” rating on the stock which helps to attract more buying interest and once again beef up the stock.

A word of caution here:  If an IPO breaks below the offering price, the risk immediately becomes exponentially higher.  At this point every investor in the IPO transaction is now under water.  There are exceptions, but usually a break below the IPO price leads to massive distribution which can take days, weeks, or even months to run its course.  This is where the risk comes in and while it may be frustrating to sell an IPO at a loss within the first few days, there is a very real risk that the loss will get much worse.

Opportunities and Risk

So IPO transactions offer exceptional opportunities along with material risks.  As a primary buyer, it is important to have a strong relationship with an underwriting firm (or several underwriters if your account size is large enough).

There is opportunity to participate in many of the gains just by investing in IPOs after they have begun trading.  These stocks are usually very dynamic with wide swings and attractive trading opportunities.  But remember to keep your trades sized smaller than a typical established stock because of the large swings associated with unstable supply and demand dynamics.

IPO transactions can be an excellent way for traders to generate returns provided appropriate risk controls are in place.

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Yesterday, the market dealt a disturbing blow to frustrated bulls who were riding the recent rebound in equities.  Before the market opened, futures were a bit weak after a report showed German business sentiment was not as strong as expected.  (Remember, Germany is one of the primary countries which is expected to be responsible for bailing out Greece).  But while the pre-market futures were relatively tame, the market quickly turned lower after the US consumer confidence numbers were released at 10:00 AM EST.

Economists were surprised to see the confidence index drop to 46 which is the lowest reading since 2009.  At issue was the continued absence of employment recovery and a frustratingly lower reading in the “future expectations” category.  It seems that while the market has been pricing in a robust recovery, the average American is not quite assured.  Since consumer spending is a major part of our economy, weakness in consumer confidence is particularly troubling.

Fed laid groundwork for tightening last week

Weak confidence calls into question the stealth rate increase which the Fed undertook late last week.  The Fed is walking a delicate tightrope between loose policy which could quickly lead to excessive inflation, and tight policy which could cut off growth in our fragile economy.  Raising the discount rate last week signaled that the Fed was ready to begin tightening, which could have widespread implications on the economy.  One of the more disturbing results could be an increase in mortgage rates charged by refinance companies which would increase the difficulty of home refinancing for many borrowers.

As adjustable rate mortgages reset (at potentially much higher levels) this could not only reduce the amount of discretionary spending available to many consumers, but it could also cause another wave of losses for banks and mortgage lenders.  Such a crisis could have ripple effects including continued restraint in lending to small businesses which in turn could be unable (or unwilling) to increase hiring in the face of uncertainty.  Not to sound like a broken record, but it appears the dominoes are stacked and the consumer confidence report may have been one of the first to fall – setting off a chain reaction and leading to lower market prices.

Lower prices and a difficult economy does not mean that we as investors need to be resigned to suffer losses.  There are plenty of opportunities to use this scenario to our advantage including purchases of companies that will thrive in this environment as well as owning ETFs that trade inversely to market trends.  One example of an industry that should do well in a poor consumer environment is the payday loan / pawn shop industry.  ZachStocks has discussed a potential investment in First Cash Financial which should see its business pick up as consumers look for non-traditional financing options.

Inverse ETFs are also a helpful tool to offset losses in more traditional growth investments.  New products are quickly being rolled out that allow investors to bet against individual sectors, commodities, or geographic regions.  If you have significant exposure to energy companies, you might consider taking a position in the ProShares Ultrashort Oil and Gas (DUG) which will increase as this sector declines.  The beauty of these instruments is that they can usually be traded in an IRA (which typically would not be able to short securities) and offer an excellent hedging opportunity.

Before investing in any vehicle, make sure you understand the risks and potential rewards.  This is true for both traditional growth stock positions as well as less traditional positions that allow you to hedge your exposure.  If you are worried about potential losses associated with declining consumer confidence and the potential for more economic and market volatility, then please visit Sound Counsel Investment Advisers and allow us to help you navigate the turbulence.  Potential for market losses are significant, but sound investors should be able to use discipline and many available tools to keep their capital intact and even benefit from what may very well be a sustained downtrend.

FD: Author does not have a position in any stocks mentioned in this article.

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On a personal level, the last few weeks have also been challenging as I was admitted to the hospital with an infection in mid January and ended up spending 17 days recovering before I was released to go home.  Unfortunately, it will likely still be another 6 to 8 weeks until I am fully recovered, but I am thankful to be out of the hospital and slowly getting back to work.  Thanks to many of you who have checked in on me and I look forward to being back to a normal work schedule in the weeks to come.

From an investment standpoint, caution continues to be a theme as the recent declines in the market are more likely to be the beginning of a new trend than an isolated event.  Investors who are positioned conservatively risk missing some opportunities to capture profits, but should find their account to be more stable than more speculative investors.  At this point I would rather miss an opportunity or two, than allow my clients to shoulder too much risk and potentially sustain major losses. There are three issues which are particularly concerning to me and seem to encapsulate the risk investors are dealing with today:

1. China Hits the Brakes While China continues to be one of the fastest growing economies, many (including the Chinese government itself) are concerned that a speculative bubble could potentially be on the rise.  In a proactive move, the Chinese regulatory officials have raised the reserve requirements for bank lending, effectively reducing the amount of capital available to lend to businesses and individuals.  While this move is likely a wise decision to curtail speculative lending and borrowing practices, it could begin to weigh down Chinese growth which would in turn become constricting for many other nations as well.  If China is not able to carry the growth torch, there are very few countries which have the resources to step in and take their place.
2. European Debt Concerns Greece has become a ticking time bomb as the country struggles to meet heavy debt obligations.  Unlike the US, Greece cannot simply print its way out of a debt crisis as the country does not have the authority to manufacture Euros.  The global recession has sent tax revenues lower, and a weak financial position means that borrowing costs are prohibitively high (or simply not available).  While many economists say that Greece isn’t large enough to cause a major problem, investors fear contagion where problems spread to other vulnerable countries such as Portugal, Ireland and Spain.  A major disruption in Europe could be a very disturbing catalyst for global markets.
   
3. US Economy Continues to Struggle Despite the fact that headline unemployment dropped during January, the employment picture is actually quite bleak.  Many workers have been unemployed for so long that they have given up looking for work (and consequently dropped off the unemployment tally).  There are a rising number of workers who have exhausted their unemployment benefits, and plenty of part-time workers who are “under-employed” and simply doing their best to make ends meet.  Some estimate that 20% of the US workforce is either unemployed or significantly under-employed and this dislocation is causing economic growth to stall.  Statistics are easily manipulated to look good, but in reality our economic expansion is quite weak and vulnerable to a double dip recession.

So with these concerns on the horizon (or directly overhead) it makes sense for investors to employ risk management techniques to guard against investment losses.  These techniques could include raising cash by selling portions of existing positions, adding short exposure through purchasing inverse ETF positions or shorting individual stocks, or possibly using option strategies to lower account volatility.  If you would like more information about how to implement a defensive investment strategy please fill out an information form for Sound Counsel Investment Advisers and I will personally get in touch with you to discuss how we can protect your account. As always, stay nimble and make sure you have an appropriate plan in place for the current market environment.

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A leveraged ETF is designed to trade at twice (or three times) the velocity of an underlying index.  So if the Russell 2,000 were to trade 3% higher today, the Daily Small Cap Bull 3x Shares (TNA) should rally by a full 9%.  In contrast, the leveraged 3x short vehicle (TZA) should trade down by 9%.  The inverse funds can be very helpful in helping long-only managers to offset their daily risk as a small position in the 3x bear funds can capture significant gains on a negative day which will offset that managers portfolio losses.

But leveraged vehicles have gotten a lot of bad press lately because of a mathematical property I call volatility decay.  Now to be clear, this is not an error in the design of the funds, it is simply a mathematical property that many do not take into account when using these tools.  The tools work exactly the way they were designed to – it’s the investors who need to understand how to use the tools.

Let’s take a volatile week and see how a triple index fund would perform:

• Monday: Down 5%
• Tuesday: Up 3%
• Wednesday: Down 4%
• Thursday: Up 6%
• Friday: Down 2%

Using the returns for the index, you would end up with a 2.42% loss.  So if you were using a triple leveraged inverse fund, you might expect your gains to be 7.26%.  However, the math doesn’t quite work that way.  Here is how a $10,000 position would likely trade if the fund perfectly tracked the market:

• Monday: Up 15% – now holding $11,500
• Tuesday: Down 9% – now holding $10,465
• Wednesday: Up 12% – now holding $11,721
• Thursday: Down 18% – now holding $9,611
• Friday: Up 6% – now holding $10,188

So you see, in a volatile period, the investment would only have returned 1.88% despite the fact that the market was down 2.42% and your investment was supposed to return three times the opposite of the index.  That’s because each day the funds reset to offer 3x exposure the next day.  This daily reset works to our favor in a steadily trending environment (assuming the trader picks the right direction), but works against us in a highly volatile market.

But don’t give up on the idea of using a leveraged investment to help protect your capital (or supercharge your returns).  Direxion Funds has developed a series of mutual funds which are designed to help avoid the volatility decay associated with the daily volatility.  These mutual funds are instead geared to return double the monthly performance of the index they track. So with these funds, if you buy on December 31, you can expect that on January 31, you will receive 200% of the price movement of the underlying index.  The funds do not reset daily and so you don’t have the negative (or positive) compounding effect on a daily basis.  There is still a volatility decay property to the funds, but it occurs on a monthly basis rather than a daily basis.  This is much easier to manage and makes the mutual funds a bit more relevant to long-term investors.

One thing to consider is that if you buy a fund in the middle of the month, you may be getting higher or lower exposure to the market through the end of the month.  This is because the funds do not reset mid-month to account for the price movement that the market has already undertaken.  But Direxion has a good solution for this potential problem.  If you click on this link you can see the “estimated current exposure level” which can serve as a guide for how much of a particular fund you should buy to meet your hedging or speculation target. Mutual funds offer the benefit of more accurately offsetting your losses over a longer period, or making a directional call on the market for a wider time frame.  However, the drawback is that the funds are traded on a daily basis, so you can’t liquidate your position at any point throughout the day.  But don’t worry, there are plenty of leveraged ETFs to help offset your mutual fund exposure throughout the day!

FD: Author does not have a position in any stocks mentioned in this article.

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To paraphrase a hedge fund manager that I follow closely, “Nothing has happened this year the way I expected it to.”  While this statement does little to instill confidence in this money manager, William posted returns north of 20% for the year in his long-short fund which remains fairly neutral as far as market exposure is concerned.  The point is that although 2009 was a year of major shifts in market direction, policy decisions, and investment risk; it was still possible to adjust trading style along the way to account for the changes and book significant profits.

My four picks for 2009 did not turn out to be very profitable despite a significant market rally from March through December.  Thankfully, portfolios managed for Sound Counsel Investment Advisers were able to trade actively throughout the year and performed much better than the 2009 recommendations.  As I choose growth opportunities for the portfolios I manage, I am careful to use stop points in order to exit losing trades, while letting winners continue to compound gains.  Often we use covered calls to manage some of the risk, and the advent of inverse ETFs has also been helpful in managing downside risks for entire markets as well as individual sectors.

So without further adieu, here is some commentary on the four picks for 2009.  Stay tuned for the 2010 picks which will be posted January 1.

1. JA Solar Holdings (JASO)
   While Alternative certainly received its fair share of headlines this year, the solar industry was plagued with rising inventory levels and falling prices for solar products.  On top of the supply dynamics, many countries which had implemented strong solar energy tax incentives had to pull back on the stimulus measures due to financial strain.  As a result, many solar companies experienced a difficult period and those with excessive leverage were especially hard hit.  At the time of writing, it looks like JASO will finish the year with a gain of 30.5% which is certainly healthy, but the majority of the gains came in the last few weeks of the year.  JASO could continue to post additional gains in the coming year, but there are still significant uncertainties surrounding the alternative energy market.
2. AECOM Technology Corp (ACM)
   AECOM is an international construction management company which is expected to benefit from global stimulus projects aimed at improving infrastructure projects such as bridges, roads, power plants and other developments.  Since AECOM has a well diversified client base, it was expected that the company would grow earnings (which occurred quite nicely) and see its stock price rise as a result (which unfortunately did not occur).  Much of the stimulus spending took longer than expected to reach the market, and investors have placed a lower multiple (paying a smaller price for every dollar that the company earns).  The lower multiple is likely due to a perception that the company will not continue to grow quickly after the stimulus projects are completed.  At this point AECOM still looks like a great investment with little debt and a low earnings multiple, but it has taken longer than expected for the stock to bounce.  Currently it looks like ACM will finish 2009 with a loss of 1.2% – not a very healthy showing considering the strength of the market.
3. TBS International (TBSI)
   At the end of 2008, it looked like shipping companies were primed for a significant rebound.  The financial crisis had sent many of the more leveraged players into the abyss, but companies with longer-term charters and reasonable debt levels were showing signs of improvement.  The wildcard in this industry was whether the day rates for dry bulk shipping would improve over the coming year.  Unfortunately, shipping has continued to be a challenging area for the economy, and since TBSI does not pay a dividend, it has been especially unattractive to investors.  The stock is down 27.2% for the year which is extremely disappointing.  Looking into the coming year, there is little evidence that this company will offer investors much hope of improving profits so I would not recommend an investment in this stock and have kept clients out of this name for some time.
4. China Medical Technologies (CMED)
   China Medical is another disappointing story as the stock is now down 30.2% for the year.  Midway through 2009, CMED had traded higher as the company’s rapid growth caught investor’s attention and the diagnostic company was expanding its base of customers.  However, a management change along with significant debt has caused investors to lose confidence.  At the current price, CMED is looking like a very solid value, but I am not invested right now because I want to know for sure that the business metrics are solid.  If management were to issue healthy guidance for the coming year (ending March 2011), I would consider working back into the stock, but for now it appears to hold excessive risk.

We have many risks and many opportunities in front of us as we enter this new decade.  Flexibility and damage control will be important skills to employ as the markets face the risk of inflation, mounting sovereign debt, and significant fluctuations in currency rates.  I would welcome the chance to help you develop a comprehensive plan for your investments in the coming year.  Please email me if you would like more information on Sound Counsel’s investment strategies.

Wishing you a happy New Year!

Other Bloggers 2009 Results

Intelligent Speculator

The Financial Blogger

My Trader’s Journal

The Wild Investor

Four Pillars

Where Does All My Money Go

Million Dollar Journey

This week, Barack Obama delivered a very pointed address to US banks, declaring that he didn’t run for office to help a bunch of “fat cats” get rich.  With many high profile banks repaying TARP liabilities and removing themselves from the compensation restrictions imposed by the government, Obama is sending the message loud and clear that banks are still required to be good stewards of their capital.  This implies that the president believes that US banks should significantly increase lending in order to supply liquidity to businesses and consumers in need of financing.

Currently, banks are enjoying one of the best rate environments possible due to the low short-term borrowing costs these institutions can take advantage of.  With the Fed Funds target rate at zero to 0.25%, banks can borrow for quite literally no interest expense (or marginal expense at worst) and invest that capital in nearly anything paying a nominal yield.  Of course Bernanke would like to see this capital lent to businesses and individuals for higher rates of return but also to prime the pump for additional economic growth.  But most recently, banks have been taking the capital they can borrow at low rates and investing in treasuries which carry a smaller profit but much more stability.

The process of borrowing cheap and investing “just a bit less cheap” does very little to stimulate our economy.  In fact, the only good it really does is to help the bank report stable profits and show a balance sheet with an improving risk picture.  (Now I’m well aware that most major banks have plenty of legacy risk associated with assets already on their books – but new lending is following the path of zero risk tolerance).  If banks continue on this path, they will likely face even more harsh criticism from an administration who believes that the financial institutions owe it to the taxpayers to be offering more liquidity.

As it turns out, the choices for banks are not pretty regardless of which angle you take.  If banks are more free with their lending, the amount of risk taken could turn out to be devastating.  This is actually a major part of the problem that got us into our difficult position in the first place.  Credit flowing freely to consumers and businesses who are not good credit risks is certainly not a good idea for the banks, or for the taxpayers.  Imagine the public backlash if these new loans turned to losses and the government had to bail out the banks again! You can bet the heads would start to roll.

But on the other hand, if the lending institutions decide not to extend credit to businesses and instead use the low borrowing rates to fortify their balance sheets, they will likely face the ire of an administration desperate to manufacture economic growth.  As it stands now, rates for borrowers are extremely low – definitely an attractive point for businesses.  But the credit standards required are extremely high.  Even showing a rock solid balance sheet, business plan, and collateral does not ensure that a business will be able to raise capital.

My personal fear is that banks are buttressing their capital base because of the off-balance sheet exposure that many still have to weak assets and structured products.  As these products are moved back on the balance sheet due to regulations imposed next year, the capital picture could turn much uglier.  With this in mind, I would recommend steering clear of major banks as an investment in the first half of 2010 while regulation continues to unfold and the picture becomes clearer.

As for the banking industry, the government should certainly continue to monitor the risk associated with these institutions, but should refrain from pushing these companies toward making loans.  Once the risk picture is cleaned up and transparency returns, competition will cause the banks to naturally lend at fair market rates.  But forcing these institutions to lend regardless of credit quality will ultimately lead to higher risk and systemic failure.

FD: Author does not have a position in stocks mentioned in this article.

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This year we may face fewer shoppers than we have traditionally seen, due to lingering unemployment, an economy likely to still be in recession (or only recently beginning to show signs of recovery) and a level of wealth that is diminished from last year.  However, we may still end up with a significantly “black” Friday as far as the markets are concerned.

Most US investors were unaware of the carnage that was sweeping world markets yesterday as we all binged on turkey and remembered to be thankful.  However, the European markets along with many other international markets were down more than 2% as Dubai rocked the international sense of economic improvement.  Dubai World is a sovereign wealth fund which has huge liabilities related to its leveraged investment.  On Thursday, the country announced that it would seek arrangements to delay the repayment of a good portion of its debt.  This has caused quite a stir in the international community and brings liquidity questions into play.

As I write, the US pre-market futures are pointing to a negative open of about 3%.   While a drop of that magnitude is not extremely concerning, it should be noted that markets are likely very susceptible to a sustained decline, due to rich valuations in equities, and generally bullish pricing trends on securities across many asset classes.  Sometimes it only takes a small catalyst to shift sentiment enough to completely reverse the trend.  In today’s markets, there is enough dry powder which could lead to a morally bruising market decline, and Dubai’s news could be just the spark to set off the explosion.

US markets will only be open a half day today with the majority of the country still in celebration (or shopping) mode.  That leaves trading desks largely full of rookies whose trading decisions are fairly unpredictable.  If these managers begin to panic with losses mounting, selling could begin in earnest shortly after the 9:30 open.  If this happens, there will be very little liquidity in the market to support prices and the declines could quickly accelerate.  I’m not predicting this to be the most likely outcome, but investors should at least understand that this is a possibility.

With equities largely pricing in a full fledged economic recovery, stocks holding multiples that imply significant growth, and short-term treasuries at levels that are simply unsustainable, there are few safe places to hide.  We have been recommending purchases of precious metals for quite some time, but it now looks like gold may e a bit extended on a short-term basis, and while silver may have a long way to run, it will likely experience a temporary pullback if the markets decline.

So please keep your capital safe and wait patiently for buying opportunities.  I wouldn’t plow any capital into growth positions today or next week, even if the prices drop significantly.  The market will need to take some time to adjust to the declines and buying opportunities should only be pursued after careful thought and deliberation.  So keep the defense on the field and watch out for the dreaded “Black Friday” Enjoy this article? Sign up for the ZachStocks Newsletter, Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies

What if I walked up to you this afternoon and asked you personally for a loan?  I know, we probably haven’t met and already you are uncomfortable with my overt start to our conversation.  But let’s run with this for a few minutes…  Assuming you had the money to lend, and I appeared to be a legitimate borrower with every intention to repay my personal loans, you might actually consider the transaction.  After all, loaning someone money can be a benefit to both the borrower and the lender – I would have the capital needed for whatever project I was undertaking, and you would negotiate a reasonable return for the capital you trust me with.

Treasury securities are not all that different.  In fact, a good friend and colleague of mine likens treasury liabilities to Loans to Congress. Essentially, buyers of these securities are allowing the US government to borrow capital, and Congress is the body primarily responsible for spending that money.  So let me pose my original question to you from a different standpoint.  If your congressman walked up to you this afternoon and asked you personally for a loan – would you consider lending him money?  Would your answer change if he offered the full faith and credit of the United States as a guarantee on your principal?  Well, many investors today are saying “yes” to this request – possibly without fully understanding the risks involved.

Three Considerations for Lending Money

When loaning money to an individual – or for that matter when loaning capital to a corporation – there are three primary categories that must be analyzed in order to make a rational decision.  Banks perform this type of analysis all the time as part of their underwriting process.  In order to distribute capital, lenders should look at the borrower’s position on these three factors.

1. Revenue or Income – What type of cash inflow is expected to be used in order to repay the loan?
2. Fiscal Strength – What shape is the borrower in financially – what assets and liabilities should be considered?
3. Ongoing Expenses – What level of operating expenses or household spending is in place and how will that affect repayment?

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As far as revenue or income is concerned, I would likely be a decent credit risk.  I receive a monthly check from a publishing company which has employed my services to write a series of financial newsletters.  I own an investment advisory which yields and increasing amount of revenue, while also performing some consulting work on the side.  It makes for a busy life, but a lender would see a diverse and stable source of revenue which would certainly be attractive.

Looking at Uncle Sam, the revenue base is more complicated.  Currently, the Internal Revenue Service (IRS) is dealing with low receipts as the economic recession has caused both businesses and individuals to earn less and therefore pay lower taxes.  Now Congress can easily pass laws requiring higher tax rates (and I believe we will see this as a trend over the next several years), but that strategy can be self-defeating.  Not only could citizens and businesses move offshore to countries with better tax rates, but heavy taxation can also lead to frustration where employees and employers alike simply do less business because there is less incentive to succeed.

The Issue With Printing

Now when we talk about our Loans to Congress (Treasury Securities) most people feel relatively safe because the notes are backed by the full faith and credit of the United States of America.  Even if the economy tumbled to the point where revenues were cut in half – or by 80%, the US could still print the money necessary to pay for the treasury liabilities.  So we are secure knowing that even with a worst-case scenario, the income stream can come from the printing press.

OK, let’s assume I made the same argument to a banker when I was applying for a loan.  ”Sir, I have an off-set printer in my basement that can turn out genuine $100 bills and while I don’t intend to make use of this, you should know that if my revenue decreases I will resort to printing these bills and you will still get paid.”  Of course this is highly illegal (and for those spoofs out there reading, I actually do not have an off-set printer in my basement.  But even stepping away from the legality of the situation, why would that be such a bad idea?  Why is printing money illegal in the first place?

The act of illegally printing money can have a devastating effect on the local or even national economy.  As cash floods the system, the laws of supply and demand come into play.  More cash chasing fewer goods leads directly to inflation.  It’s not a theory, it’s a fact!  As this money circulates, the value of each dollar will decline.  The US government places a high priority on guarding against counterfeit money as a means of protecting the integrity of our currency.

But in our Loans to Congress example, the government is essentially making the other side of the counterfeit argument.  ”If we get into trouble, you can rest assured that we will simply print more cash in order to make sure that you get paid.”  Why is that not comforting?

Fiscal Strength

Moving on to our second metric worth considering before making a Loan to Congress, we want to look at the fiscal strength or balance sheet for anyone we lend money to…  If you were looking at my personal finances, you may have been comfortable with the income side of my equation, but the balance sheet may paint a different story.  As a dad with six kids and some medical issues in the family, we have accumulated a bit of debt from hospital admissions, surgical procedures, and medical specialist consultations.  On top of that, we have the mortgage on the house, and a mortgage on a rental property.

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While the family is making progress working down these balances, the numbers would be enough to cause a banker to raise his eyebrows and consider charging a higher interest rate.  After all, the more debt that is on our balance sheet, the more risk the bank is taking.  The only saving grace for our family would be the progress we have made over the past few years in decreasing those liabilities.

As we look at the balance sheet for Uncle Sam, the picture is much different.  Not only do we see an eye-popping number eclipsing $10 trillion dollars, the level of indebtedness continues to rise at an alarming rate!  This week the Treasury Department is scheduled to sell more than $80 billion in notes and bonds to the general public as part of its ongoing funding process.

In addition to the explicit debt in the form of outstanding treasury securities, the US government has made enormous agreements to backstop financial and industrial institutions which still have a very real risk of failing.  The FDIC has a $500 billion dollar credit line which it can borrow from the Treasury should it need additional capital and many of the stimulus and rescue programs of the past year have included Treasury guarantees on loans and asset values.

The fiscal strength of the US government is not in a state that should make lenders feel comfortable.   Ironically, we are currently operating in an environment where yields on treasuries are some of the lowest in history.  Investors are flocking to the “relative safety” of treasuries because the risk in other asset classes is high.  Unfortunately, the risks in Treasuries are masked, but still significant.

Ongoing Expenses

The final issue that a lender should consider before making a Loan to Congress, or a loan to any other applicant, is the level of ongoing expenses which must be paid.  After all, as your borrower is paying his expenses, there needs to be enough cash left over to eventually pay off the loan.

On a personal level, my household would likely have a difficult time meeting standards in this regard.  With my oldest turning 10 last month, there is less than a decade until the college expenses start to hit.  And with my youngest two just turning a year old (twins), it is likely that quite a few dollars will go to the hallowed halls of many of this nation’s higher education institutions.  Top it off with five weddings to pay for (yes, David has five little sisters), I am basically out of luck when it comes to long-term expenses.

Turning to Congress, the picture doesn’t get much brighter.  We are in the middle of a raging debate over health care and how much responsibility should be taken on by the government.  Health care costs have been rising sharply over the last several years (rightfully so considering the advances in medicine and what we receive for these costs).  At the same time, the current population is entering a demographic phase where there will be significantly higher need for long-term medical care.

At a time when we can ill afford to debate this issue, it appears that the US government will begin spending billions (if not trillions) to ensure health care is provided to every citizen.  Now don’t get me wrong, I’m a compassionate guy and want the best for each of our countrymen…  But from a financial perspective, we are running into some pretty serious challenges.

Add to that, the cost of social security which is the biggest (legal) Ponzi scheme in history, and you have a recipe for disaster.  The young and emerging workforce paying into the system will not be able to keep up with the withdrawals from retirees and within the next few years, this source of government funding will quickly become a net exporter of money.  So the long-term prospects for government expenses makes for a dismal picture and it is difficult to rationalize lending money to this type of institution.

Alternative Capital Allocation

So what is the solution?  What should investors who need stability and income do?  Well, unfortunately, there are precious few “good” solutions right now when you consider the risk and potential return for investment capital.  But I do think that long-term treasury securities are some of the most dangerous vehicles to own for the reasons mentioned above.  Eventually when rates are ratcheted higher and lenders require a higher return for the risk of 30 year treasuries, the face value on these Loans to Congress will drop significantly and cause huge losses for many who believed they were in “safe investments”

Instead, I would consider very short-term treasury securities and bank deposit products (FDIC insured of course) for capital that you simply must have protected.  Over time, it makes sense to diversify into resource rich investments including precious metals, commodities, and foreign currencies with higher yields.  While these asset classes may sound more risky, the benefit of diversification, coupled with a conservative approach can actually add stabilization to your true purchasing power or real net worth.

Gold and silver have had a sharp run in recent weeks and while I like them as investments for a long-term approach, there may be some weakness in the coming few weeks as investors take profits.  Using pullbacks to slowly add exposure can be a conservative way to approach these trending markets.

Similarly, commodities have volatility, but can offer stability.  Aside from hiring a commodities broker, you can also look at individual equities which have exposure to the agriculture, energy, or metal prices.  Many of these investments can be in blue chip names that actually pay healthy dividends and yield capital appreciation.  This can be significantly better than the tiny yields currently paid on treasury securities.

Finally, foreign currencies can offer diversification and better returns.  Consider the Australian dollar.  The country recently increased its equivalent of the Fed Funds rate, and Australia is rich in natural resources.  This bodes well for its currency which is holding up strongly against other currencies despite our turbulent markets.

The bottom line is that when you make an investment (whether in treasuries, metals, commodities, equities – or loaning capital to an individual or business) you need to understand the risks and potential rewards.  Loans to Congress have underlying risk that may not currently be priced by the market.  Having a defensive approach to your investments may include a more diversified approach – after all, you are the one who has to live with the risk and return for your own investments.

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Essentially, it looks like the committee is trying to have its cake and eat it too.  The official posture is that the economy is improving and capital markets are once again functioning.  To back up this assumption, the Fed points to improving consumer spending, and home buying activity.  Now those two areas have been artificially propped up by two major government programs…  The “cash for clunkers” measure, along with the first time homebuyers tax credit.

While these programs have been terribly inefficient and mismanaged, they did in fact push consumer spending into a positive trend.  The government has taken capital from current and future taxpayers, allocated it to encourage two specific types of transactions, and then used these transactions as “proof” that the economy is recovering.  Meanwhile, unemployment continues to increase, and an asset bubble has begun to inflate around risk related assets.

The Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability. ~FOMC Press Release

At the same time the Fed is stating verbally that the economic picture is improving, the posturing states that they are scared to death of the underlying economic situation.  Keep in mind that a zero to 0.25% interest rate is basically unprecedented in modern economic history.  The decision to cut rates to zero was born in the days of full-fledged panic when it looked as if our entire global financial system would fall apart.  Even a 1.5% or 2% fed-funds interest rate is considered “accommodative.”  But our rate structure implies that we are still at DEFCON 1.

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The difficult pill to swallow in this situation is that fiscally conservative individuals are being unfairly treated in an attempt to create more risk taking.  Interest rates on deposit accounts are at all time lows.  Retirees with more than a million in net worth cannot possibly live on the interest they receive on their capital.  Not unless they put that capital at risk in a shaky economic environment where they could easily lose a substantial portion of their nest egg.  It seems the government is content to offer incentives to encourage the very same risky behavior that got us into this mess in the first place.

A prominent money manager has been quoted (and this is admittedly a poor paraphrase) as saying that the tragedy of this recession is that we will emerge having learned absolutely nothing.  I fear that this may be true for our society in general, but does not have to be true for us individually as investors.  Some of the takeaways I have gleaned from the last 24 months include:

• Risk control is always paramount in any investment strategy
• Markets can be carried to unexpected extremes (both higher and lower)
• Lost opportunity is easier made up than lost capital
• Always understand the other side of the trade

We’ve got a ways to go before the economy and our markets are out of the woods.  If you have participated in the run up since March, count your blessings but make sure you have an exit strategy in place.  The markets gave up nearly all gains in the wake of the “positive” FOMC announcement which may be indicative of a sharply lower move in the next few weeks.

So keep your defense on the field and consider raising cash or initiating short positions.  There’s no reason to lose all of the gains from the last eight months.

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The health of the most recent deals will have a major affect on both the pricing and frequency of upcoming deals.  If investors are willing to take on risk and the market has a speculative tone, then underwriters will likely have little trouble in pricing deals and getting top dollar for the selling shareholders.  But as we start to see a shift to more caution on the street, underwriters will have to adjust terms in order to get shares sold.  This doesn’t necessarily mean the rate of deals will decline, but it may mean that sellers will have to settle for lower prices and for selling smaller allocations in order to match market demand.

Dole Food Company Inc. (DOLE) was able to raise $419 million in its most recent transaction, netting the underwriters more than $26 million in fees.  The stock met selling its first day of trading with the IPO price of $12.50 quickly shunned by investors.  The majority of the capital is expected to be used to pay down the company’s debt which is likely to be a wise move given the uncertainty surrounding capital markets and the company’s interest expense.  However, investors appear to be worried that a faltering economy could still pressure shares and without earnings growth, the debt repayment will do little to add to shareholder value.

On a more positive note, Verisk Analytics Inc. (VRSK) was offered to the public at $22.00 and has quickly traded higher offering the IPO investors a handsome profit.  The risk management and analytics company is broadening its customer base to extend beyond its roots with insurance companies.  Essentially, the company will be able to offer internal credit reports for customers in many industries and should be able to grow revenue and earnings steadily in future quarters.  While the stock has pulled back a bit in the last week of trading, it is still 24% above the IPO price which is encouraging for the IPO market.

The most anticipated upcoming IPO is undoubtedly Hyatt Hotels.  Barron’s had a scorching article on the company this week including information surrounding the family squabbles which have plagued this closely held company for years.  The company is expected to offer 38 million shares to the public between $23 and $26 per share, valuing the entire firm near $4.1 billion.

Investors could justified in concern over the Pritzkers dysfunctional management of the company, especially considering that the family will retain voting control over the company through the use of two classes of shares representing ownership of the company.  The public will be issued class A shares, while the family will retain class B shares for their continued ownership.  The class B shares have 10 votes for every vote class A shares have which means that for the foreseeable future, the family will retain control over Hyatt.  Institutional investors will likely bulk at such a stipulation, which will likely lead to a lower share price than would be reasonable if the company were controlled equally by investors.

Although there are negative issues surrounding the deal, Hyatt has a strong brand, a full portfolio of attractive properties, and a top tier underwriting firm.  Goldman Sachs (GS) will likely pull out all the stops in order to get this deal priced and trading attractively.  I would not be surprised to see the company buying shares heavily after the deal to prop up the price and maintain that the deal was positive.  This would give the Pritzker family more confidence in the investment bank so that when it is time for round two of selling (a secondary offering) Goldman will get the deal and collect the fees.

I would keep indications low if you intend to participate in the IPO.  While profits could be substantial if Goldman does a good job, the risk in this offering is higher than normal.  I would prefer to allow the stock to start trading and establishing a pattern before committing capital.

FD: Author does not have a position in any stocks mentioned.

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Welcome to the October 23, 2009 Edition #112 of the Carnival of Financial Planning.

The Carnival of Financial Planning takes a long-term view of personal financial planning for individuals and families. We focus on efficient and sustainable personal financial planning practices that can lead to lifetime financial security.

This edition is arranged by subject heading, so that you can browse efficiently.

Enjoy!

The Skilled Investor, Editor

Budgeting

Wise_Bread presents 3 Steps to Organize and Track Your Finances Without the Hassle posted at Wisebread.

GLBL presents Money Savings Tips for a Wedding posted at Gather Little By Little, saying, “I will share all the money savings tips related to weddings that I used for my own wedding: – Talk to people – Go back to school – The DIY method – Try combinations – Prioritize”

Susan Savering presents Personal Budgets posted at Family Financial Planners, saying, “When you don’t understand how much you spend and how much you save and invest, you do not have a financial plan. This dramatically increases your family’s long-term financial risk.”

Economics

Darwin presents Could the US Dollar be Replaced as the World’s Reserve Currency? What it Would Mean posted at Darwin’s Finance, saying, “Could the US Dollar be Replaced as the World’s Reserve Currency? Based on alleged secret meetings between Central Bankers of foreign countries that fund our debt, the US Dollar may have seen its best days. What it Would Mean?”

Roshawn Watson presents The Rich Get Poorer posted at Watson Inc, saying, “The implications of this recent recession have been far-reaching enough to put a big dent in American and world wealth. Both the magnitude of wealth and the number of millionaires decreased profoundly in 2008.”

Tyler Tervooren presents I Am Responsible for the Corporate World’s Waste, or A Lesson in Micro Economics posted at Frugally Green, saying, “When a fellow blogger questioned why we focus our environmental efforts at the individual level when large businesses waste so much more than each of us without prejudice, this is the response I wrote. The answer, interestingly enough, is all about money. You may not have much, and I may not have much, but together, we have more than we could ever imagine. Money talks, and when we use it to tell the business world what we really value, they listen and provide.”

Zach Scheidt presents Mortgage Crisis, Part Deux posted at ZachStocks, saying, “Commercial Mortgages continue to clog bank balance sheets and losses do not appear to have been recognized. Watch for weakness in regional banks with heavy exposure to commercial real estate loans.”

Estate Planning

The Financial Blogger presents Estate Planning: 5 Reasons Why You Should Have A Professional Among Your Liquidators posted at The Financial Blogger, saying, “managing an estate is more complicated than simply writing a few checks! Fortunately, for those who can afford it, you can name a professional among your liquidators.”

Financial Planning

Patrick @ Military Money presents How Much Life Insurance Do Military Members Need? posted at Military Finance Network, saying, “Military members may have different life insurance needs than civilians. Here is information regarding how much life insurance military members should buy, and some resources for finding the best life insurance deals.”

Big Larry presents Fantastic Free Resources for Your Annual Credit Check-Up posted at Out of Debt Christian, saying, “Just like your annual physical, it’s vital that you perform a credit check-up each year. We’ve uncovered some great and truly free resources to help you make sure your credit reports are accurate and your scores are as high as they can be.”

jim presents Beware Bank-paid Complimentary AD&D Insurance posted at Blueprint for Financial Prosperity, saying, “If your bank offers you “free” AD&D insurance, take a closer look because you might be signing up for more than you bargained for.”

Susan Saverton presents Financial Advisor Pasadena California posted at Pasadena Financial Planner, saying, “Appropriately setting your personal asset allocation in line with your personal risk tolerance is a critical decision for every investor. The percentages that are allocated to various asset classes tend to change slowly over time, so it is important to get it right at the outset.”

Dividend Tree presents Building Core Competency for Long Term Survival posted at Dividend Tree, saying, “whether it is running a business or individuals’ investment portfolio, it is important to build a core competency for long term sustainability. In my case, I focus on good quality companies that consistently pay or have potential to pay growing dividends over time.”

Financing a Home

Alex Fotopoulos presents When to Refinance a Mortgage? posted at My Trader’s Journal, saying, “Some key points to consider when refinancing your home.”

Financing Education

Praveen presents Will Education Follow the Housing Bust? posted at My Simple Trading System, saying, “Tips for students to avoid excessive loans and debt”

Health Care

KCLau presents Withdraw EPF Fund to Pay Insurance Premium? posted at KCLau’s Money Tips, saying, “Vincent Lee from Penang generously shares an idea to use your EPF”

Income

FMF presents The Top Ten Turnoffs About Networking posted at Free Money Finance, saying, “Networking is a key part of making the most from your career. This piece lists some of the circumstances that keep people from reaching out to others.”

April presents Five Steps to Six Figures in Seven Years posted at Get Rich Slowly, saying, “FMF from Free Money Finances offers up a guest post in which he recounts, step-by-step, how he was able to generate a 6-figure income in just 7 years.”

Dividend Tree presents Three Companies with Sustainable Dividends posted at Dividend Tree, saying, “Even in soft economic environment, there are companies out there that are continuing to increase dividends for their shareholders. While dividend increase is good, it is more critical to make sure we understand that companies can sustain their dividends.”

Investing

The Investor presents Think you’ve spread your risk? Think again posted at Monevator.com, saying, “Research shows different asset classes are more closely correlated than ever before. Is it still possible to create a less risky portfolio?”

Super Saver presents Why Stocks Still Make Sense to Me posted at My Wealth Builder, saying, “I still believe stocks are a great investment.”

Manshu presents Brazil ETF List posted at OneMint, saying, “A list of ETFs that give you exposure to Brazil”

ABC presents Stock Purchase – Bid/Ask Prices posted at ABCs of Investing, saying, “Bid and Ask prices – Information if you are buying or selling a stock.”

Praveen presents India Fund (IFN) Trade Example posted at My Simple Trading System, saying, “An example of how having a trading system gives you an edge, and let’s you take advantage of market moves outside of your control.”

Jules Wells presents Best Investment Strategy posted at Financial Planning Software, saying, “Personal investing seems incredibly complex, but the best investment strategy also tends to be a more simple investment strategy.”

Leslie Brown presents The Ten Best ETFs You’ve Never Heard Of posted at ETFdb.

Zach Scheidt presents Strategic Acquisition Boosts EBIX posted at ZachStocks, saying, “Ebix Inc. (EBIX) made a strategic acquisition this month which should increase earnings and give the company an inroad to serving a new sector of clients. Shares could increase 50% in the next few quarters.”

Fred Elkins presents Bond Fund Primer: Part Two – Look Before You Leap posted at Finance Banter, saying, “Part two of our bond fund investing series”

Tomas Escent presents Professional Investment Management posted at Nerds on Wall Street, saying, “Think of this book as sort of a Hitchhiker’s Guide to Wired Markets. There are no robots parking cars for six million years, but there are robots trading millions of shares in six milliseconds, so maybe that’s close enough.”

The Skilled Investor presents Investing Strategy posted at Personal Investment Manager, saying, “Investors more easily understand investment costs that are directly measurable, such as fees deducted on investment statements. However, many investors ignore or are unaware of the opportunity costs of their sub-optimal investment behaviors. Opportunity costs are usually much more difficult to measure directly, but these investment costs can be even higher than more visible investment fees.”

The Financial Blogger presents ETFs VS Index Mutual Funds: The Ultimate Battle! posted at The Financial Blogger, saying, “Let’s look at why you probably think ETFs are the best investment in the world: The very first argument is the one that doesn’t lie: yield graph over the past 5 years comparing the TSX 60, the XIU (TSX 60 ETF) and the Altamira Canadian Index Fund (NBC814)”

The Smarter Wallet presents Lending Club Review: Lending Money For Profit posted at The Smarter Wallet, saying, “Alternative investing using a lending platform.”

Tushar Mathur presents Can’t Control the Markets? Try controlling the Costs posted at Everything Finance, saying, “As 2008 proved, the financial markets are prone to unpredictable periods of turbulence. That can make investing feel a bit like a roller-coaster ride. The disappointing results that many mutual funds posted in 2008 and at the outset of 2009 may have left you feeling concerned over your financial future. You’re not alone.”

Frank Vertin presents Low Cost Index Fund posted at Best Index Fund, saying, “Buying an S&P 500 index fund through an investment counselor can substantially increase your initial purchasing costs and and drive up your annual management expense fees. Unfortunately, the vast majority of individual investors buy mutual funds and ETFs through brokers and investment advisers. Rarely do financial advisors recommend that you buy index funds with low fees. This is because low cost, no load mutual funds do not pay them as well as loaded, high fee mutual funds.”

Dividends4Life presents 3 Dividend Stocks Rewarding Their Shareholders posted at Dividends Value, saying, “Investing in dividend stocks provides the investor with continuous feedback. As time passes, dividend investors see their income steadily grow. You do not have to wait five to ten years to determine if the strategy is working.”

FMF presents Bond Primer: Yield vs. Total Return posted at Free Money Finance, saying, “The basics of investing in bonds.”

Larry Russell presents NoLoad Mutual Funds posted at Best No Load Mutual Funds, saying, “Taken as a whole, the vast body of investment research studies show that there really are better approaches to buying and owning mutual funds and ETFs. You do not need to frantically chase fund performance. Performance chasing simply does not work.”

ABC presents More Exciting Facts About Stock Indexes posted at ABCs of Investing, saying, “Some interesting facts about stock indexes.”

Mike Piper presents The Best (Lowest-Cost) ETFs to Buy & Hold posted at The Oblivious Investor, saying, “A collection of the lowest-cost ETFs in each asset class–ideal for constructing a buy & hold portfolio.”

Managing Debt

Adam Williams presents Dave Ramsey said to sell my stuff and payoff debt posted at RabbitFunds.com, saying, “A post in the form of a letter to Dave Ramsey about my experiences in selling my stuff to pay down debt as Dave suggests in his Financial Peace University course.”

Peak Personal Finance presents Teach Your Child About Responsible Credit Use posted at Peak Personal Finance, saying, “Help your children understand proper use of credit.”

Patrick @ Cash Money Life presents What to do About Increased Credit Card Interest Rates posted at Cash Money Life, saying, “Tips on your options if your credit card company raises your interest rates or changes the terms of your credit card agreement. Options include closing the card, transferring the balance to another credit card, or accepting the terms.”

Tom Drake presents When To Consider Filing For Bankruptcy posted at The Canadian Finance Blog, saying, “There are many people who are feeling overwhelmed by the burden of their high credit load. If you are feeling like you’ll never be able to pay off the debt you’ve accumulated, you might be wondering if you should file for bankruptcy.”

The Smarter Wallet presents How To Get A Credit Card That’s Right For You posted at The Smarter Wallet, saying, “How to shop for the right credit card.”

MoneyNing presents Credit vs Debit Transactions with Your ATM Card posted at Money Ning, saying, “Are there any difference with saying credit or debit when you hand over an ATM card?”

FMF presents Make Sure Your Credit Card Has Smart Features posted at Free Money Finance, saying, “Use the right credit card and make it work FOR you — not against you.”

Peak Personal Finance presents How to Compare Secured Loans posted at Peak Personal Finance, saying, “Selecting the right secured loan can save you a heap of money over the life of the loan. This article helps you avoid common pitfalls to identify the best loan for you.”

Miscellaneous

FMF presents The Basics Will Make You Rich posted at Free Money Finance, saying, “If you follow a few, simple steps, you will become wealthy.”

No Load Bond Funds presents Low Cost Bond Funds posted at Bond Index Fund, saying, “Simply put, if you pay higher bond mutual fund fees, then these bond management expenses tend just to be a deadweight loss to you. The best bond fund buying strategy is to pick only very low-cost no load bond funds.”

nissim ziv presents Career Statement: Examples of Career Statement posted at Job Interview Guide, saying, “The purpose of writing a career statement is to give the professional a clear direction for the future. A career statement is a creation of your career vision for inspiring and motivating youself.”

Roshawn Watson presents Should You Buy A House Outright? posted at Watson Inc, saying, “Suppose you find yourself in the somewhat unique predicament of having the resources to purchase your house outright without a mortgage. Is it then financially-wise to make the purchase?”

Susan Savering presents Personal Financial Strategy posted at Family Financial Planner, saying, “When pursuing optimal financial planning and investing strategies and controlling your costs and capital gains taxes, you also need to establish a time-efficient system to monitor, adjust, and adhere to your financial plan.”

Retirement Planning

Jeff Rose presents Why You Should Keep Contributing to Your 401k posted at Jeff Rose.

Madison presents 2010 Roth 401k and Roth IRA Limits posted at My Dollar Plan, saying, “Time to plan for 2010. Here are the 2010 401k and IRA limits.”

Patrick @ Cash Money Life presents Should You Rollover a 401k into an IRA? posted at Cash Money Life, saying, “When you leave your company you have to decide what to do with your 401k. One option is to roll it over into an IRA.”

Paul Kamp presents Bad Attitude, Las Vegas, Retirement, Caution, Risk, American International Group, Gambling Bias, Rationality posted at Don’t Quit Your Day Job – Personal Finance, Economics and Investing, saying, “Vegas is not a good place to learn about retirement planning. It is a good place, however, to learn what not to do.”

Top Stock Index Mutual Funds presents Stock Index Funds posted at Top 10 Index Fund, saying, “To build your retirement portfolio, buy some of these top 10 very low cost no load S&P 500 index mutual funds directly. You do not have to pay the heavy added expenses of buying through a stock broker, financial adviser, investment adviser, or investment counselor.”

Risk Management and Insurance

Jeff Rose presents Term Life Insurance Vs. Cash Value Life Insurance: What Is the Difference? posted at Jeff Rose, saying, “Depending on what your needs are will decide if term life insurance vs. cash value is better in your situation.”

Evolution Of Wealth presents Social Psychological Change posted at Evolution of Wealth, saying, “Have you ever heard of cognitive dissonance? Chances are it is intertwined with your life. It is probably causing some undue stress. If you don’t know you have a problem or want to pretend you don’t then it becomes extremely difficult to fix it. It might just be time to make a change in your financial world.”

Patrick @ Military Money presents COBRA Benefits 2009 Economic Stimulus Recovery Act posted at Military Finance Network, saying, “The 2009 Economic Stimulus Plan includes additional COBRA and unemployment benefits.”

Savings

Silicon Valley Blogger presents Ally Bank (GMAC Bank) Review posted at The Digerati Life, saying, “A review of a popular savings bank.”

Jody T Fransch presents The Law of Saving | jody fransch posted at jody fransch.

MoneyNing presents Why Do High Yield Savings Account Rates Change posted at Money Ning, saying, “Here’s a way to figure out which online bank is best for your money going forward.

KCLau presents How much money you spend in a lifetime? posted at KCLau’s Money Tips, saying, “How much do u spend in a lifetime”

Four Pillars presents $8,000 Credit For First-Time Homebuyers Extended 6 Months – Not Increased To $15k posted at Quest For Four Pillars, saying, “Home buyers credit extended 6 months.”

Four Pillars presents Back To School Cell Phone Deals posted at Quest For Four Pillars, saying, “Comparison of the best cell phone deals for students heading back to school.”

Taxes

Mike Piper presents 72(t) Distribution Rules posted at The Oblivious Investor, saying, “An explanation of the 72(t) rule, which can be used to withdraw money from an IRA prior to age 59 1/2 without having to pay the 10% penalty.”

Jeff Rose presents 2010 Traditional IRA to Roth IRA Conversion Tax Rules posted at Jeff Rose, saying, “Tax implications of converting from a Traditional IRA to a Roth IRA. Don’t forget the after-tax contributions.”

Super Saver presents End of Year Tax Planning – Deductions posted at My Wealth Builder, saying, “For me, October is a good time to review my 2009 financial status for tax return filing purposes. It gives me a few months to make any changes that can lower my taxes.”

That concludes this edition. Submit your blog article to the next edition of Carnival of Financial Planning using our carnival submission form. Past posts and future hosts can be found on our blog carnival index page.

Technorati tags: carnival of financial planning, blog carnival.

On Saturday, the China regulatory body, the General Administration of Press and Publication issued an announcement which bans foreign investors from participating in profits from the country’s online gaming business.  These investors are not allowed to participate in wholly owned investments, joint ventures, or any other manner in which they could profit from the thriving business.

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While the issue at stake appears to be protectionism (an individual country protecting industry within its borders by shutting out foreign competition), the method used to enforce this issue appears to be censorship.  The new restrictions would require approval for all new games launched within China.  This adds another layer of risk to businesses who produce these games as companies could spend millions of dollars to develop games only to be turned down by regulators after the games had been produced.

New games are not the only targets as any upgrades to existing programs will also have to be approved.  Nearly every game that has been successful for a long period of time, has performed well because of continual upgrades to the platform.  Gamers continue to play and generate revenue because the game continues to evolve and capture their imagination.  If this process is thwarted it will likely allow smaller gaming companies to compete, but it could also be very detrimental to to the industry as a whole.

One of the companies which could be most affected by the regulations is Netease.com (NTES) which recently bought the license to distribute Wold of Warcraft in China.  Despite the fact that this license was formerly held by The9 Ltd. (NCTY), China has delayed approval of the game now that NTES is has the license.  If games that are currently licensed in China face scrutiny once they are transferred to another parent company, it could be a significant burden on commerce.

Other companies that may be effected include Shanda Interactive (SNDA) and their recently issued spin off Shanda Games (GAME).  The uncertainty in the market surrounding these regulations has caused the stocks to trade off even given the positive fundamentals.  It does little good to own a company with strong earnings and a healthy cash position if the Chinese government is going to cap growth or potentially nationalize the industry.

While the news is certainly negative for the industry, there are many regulatory bodies in China – not all of which appear to be against foreign investment.  The GAPP has significant influence, but China is also cognizant of the benefit of foreign investment to drive industry growth and technology advancement.  One player in the sector that appears to be holding up well is Perfect World (PWRD).  The stock has pulled back to it’s 50 day average, but technically still looks very sound.  The company is expected to earn $3.43 per share in 2010 which represents a 21% growth rate over 2009.  The stock is just above $40 which is a reasonable multiple given the growth.

Investors should probably wait for a bit more clarity from regulators before committing significant capital, but PWRD may merit further investigation.  A good strategy may be to initiate a small or partial position at the current price and then begin to build that position as the situation improves.

FD: Author has a long position in SNDA and NTES in the ZachStocks Growth Model

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