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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The consumer is dead…  Long live the consumer!

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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At the beginning of the year I entered “round two” of a friendly stock competition with a few other financial websites.  The rules were simple:  Pick four stocks or ETFs which should do well in 2010.  Of course it’s difficult to buy anything December 31 and hold through the full year – especially in such a dynamic period with regulatory changes, shifting economic trends, and global imbalances.

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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The last few weeks have been challenging for the markets as trend lines are being broken, and many speculative issues are reversing to give up recent gains.  After falling 3.7% in January, the S&P 500 has begun February with plenty of volatility and is currently showing losses for a second straight month.  Both domestic and international forces are combining to leave investors unsettled, and it is unlikely there will be any quick solutions to the issues the market is beginning to discount.

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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In today’s uncertain market, investors are looking for a wider variety of tools to help them capture returns and protect their investment capital.  One of the most powerful (and sometimes dangerous) tools is the leveraged ETF.  These investment vehicles have been trading for a few years and have become very popular both with daytraders and investment managers looking for ways to hedge their exposure.

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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Note: This is a recap of performance for the stocks picked at the beginning of 2009.  Picks for 2010 will be posted January first.

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

It’s not easy being a bank these days.  Oh sure, it’s nice to still be alive.  After all, last year at this time it was uncertain exactly how many financial institutions were actually going to stay in business.  But after begging for taxpayer money to keep them alive and kicking, banks are now finding that the strings attached are more like giant anchor chains and regardless of whether an individual firm has paid back the funds or not (and really it doesn’t matter whether the institution received any funds or not), banks are now being held to a standard that requires them to focus on the public good more than the pursuit of profits.

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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Today is traditionally known as “Black Friday” in the retail industry for a number of reasons.  Traditionally, it was the day after Thanksgiving when many retailers actually crossed into the black, meaning they became profitable for the year.  More commonly, retailers and shoppers  refer to the day after Thanksgiving as “Black Friday” because of the madness at store locations where door busters, huge crowds, and short tempers make for a chaotic shopping experience.

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