With the “not-as-bad-as-expected” news surrounding the economy and the initial government stimulus measures have been priced in to the market, we are moving into a period of profound uncertainty. With the release of Alcoa Inc.’s (NYSE: AA) earnings report, earnings season has officially begun.

In most cases each company’s own “easy” restructurings are also behind us.  They have resorted to massive lay-offs and inventory liquidations to bring costs down to the bare minimum required to run their respective businesses.  Those cuts and gained efficiencies also have been priced in.  Now, it is time for these companies to show what they can do organically.

Energy companies appear to have hit a wall now that China has run out of space to store oil. And other commodities businesses are suffering, too, as the U.S. Federal Reserve seems to have found religion and veered toward a much more prudent monetary policy.

After its last meeting the Federal Open Market Committee (FOMC) signaled the end of quantitative easing, at least for the foreseeable future.  This is of paramount importance, because it seems to be a concession to those who worried that the Fed might debase the U.S. dollar with by over-expanding its balance sheet and fanning inflationary forces down the road.

The Fed has done a tremendous job of first restoring some sense of “normalcy” and confidence in the core markets, like interbank lending and money markets, and then proceeding to work outwards to U.S. Treasuries and mortgage-backed securities.  This later step towards more prudent actions is welcome and you are seeing it in the U.S. dollar and renewed confidence in Treasuries.  The latter have been received extremely well by investors and yields have started to move down, reflecting not only the lack of current inflation, but also the confidence that the Fed will not go bananas with quantitative easing.

So, ahead of a very difficult earnings season, I am not going to try to out-predict the market.  The experts have been going around for a couple of months trying to just that by using expensive consultants that do channel-checking and by contacting the companies themselves to clarify statements made under full disclosure.

But the earnings season has extraordinary challenges to surmount, that are deriving from the uncertainty that is hanging over the markets like the proverbial sword of Damocles.

General Motors Corp. (OTC: GMGMQ) and Chrysler Group LLC are emerging from bankruptcy in record time and their costs, debt and massive corporate restructurings will probably make them internationally competitive once more.  But there are still questions about how these companies will cope with the still dormant auto market.

The outlook for the large financial behemoths that are due report earnings is equally uncertain. We still need to see how these institutions play around with their toxic asset valuations, their loan loss reserves and their predictions for the future, particularly given the potential stumbling blocks on the road to recovery.

The three obstacles that I find especially troubling are:

1. The spike in credit card delinquencies.
2. The outlook for commercial real estate.
3. And the pending second wave of residential foreclosures, now in the prime and option-ARM sectors.

But do not discount the possibility of seeing mark-ups in toxic asset valuations that might favor some financials strongly.

Now, with the Fed seemingly on hold and the U.S. government’s stimuli only 30% deployed and showing little traction, where is the growth going to come from, especially since unemployment blew right through the promised 8% peak to the current level of 9.5%? On top of that, last week’s rise in continuing jobless claims and Friday’s drop in consumer sentiment offered little solace.

The good news in all of this is that savings rates spiked to 7% as consumers used their money to pay down debt.  Even though this improvement in consumers’ balance sheets does not show in immediate sales growth, it bodes very well for the future.  And this savings trend, which translates into reduced demand for imported consumer products, together with rising exports, resulted in the lowest trade deficit in nearly a decade.

We are making the difficult progress that we need to make in order to restore the U.S. economy to financial health, and that, in turn, is helping the dollar and Treasuries in the short term.

So, based on these massive uncertainties, waiting to be played out, the best risk-reward ratio appears to be in bonds.  With a massive U.S. Treasury supply well absorbed, we are going to jump into long term U.S. Treasuries for a conservative upside, while we keep waiting for resolution on the healthcare reform, social security, and corporate earnings.

Recommendation: Buy the iShares Barclays 20+ Year Treasury Bond ETF (NYSE: TLT) (**).

(**) - Special Note of Disclosure: Horacio Marquez holds no interest in the iShares Barclays 20+ Year Treasury Bond ETF.

Source: Buy, Sell or Hold: Buy iShares Barclays 20+ Year Treasury Bond ETF For Solid Profit at a Time of Great Uncertainty ]]> http://www.contrarianprofits.com/articles/buy-sell-or-hold-buy-ishares-barclays-20-year-treasury-bond-etf-for-solid-profit-at-a-time-of-great-uncertainty/19017/feed 0 http://www.contrarianprofits.com/articles/use-fear-to-your-advantage-with-the-sp-500-volatility-index-vix/12687 http://www.contrarianprofits.com/articles/use-fear-to-your-advantage-with-the-sp-500-volatility-index-vix/12687#comments Mon, 02 Feb 2009 17:06:20 +0000 Charles Delvalle http://www.contrarianprofits.com/?p=12687 It’s a widely known that dogs have the capability to sense fear. In that regard, I consider myself a Pit Bull. I can sense fear in the market from thousands of miles away.

Then I “lock my jaws” as I exploit that fear and make lots of money.

No, I didn’t alter my genes to gain an unnaturally strong sense of smell. And no, I can’t really lock my jaws like a Pit Bull. I just look at the S&P 500 Volatility Index (VIX) and everything becomes clear.

What Is the VIX?

The VIX is a basic measure for volatility in the market. Higher levels of volatility in the market coincide with higher levels of fear. Higher levels of fear usually mean investors will pull money out of the markets and you see an overall drop in market value. So when you see the VIX rising, the market usually drops.

How Do You Use the VIX?

The best way to use it is as a tool to supplement your existing technical analysis.

Let’s say the market takes a huge drop one day. How do you know that this is the beginning of a genuine leg down? Sometimes it can be hard to tell. But if you look for a major technical break in the VIX to occur around the same time, the odds of you being right about that drop increase substantially.

A Major Opportunity in the VIX

Take a look at this chart to see the opportunity I’ve been talking about…

This is a three-year chart of the VIX. As you can see, it’s been marked by very clear support and resistance lines – one just under 20 and the other just under 40.

As you can see, the one just under 40 was tested earlier this year. More important, in the past few weeks it tested it again… and managed to close significantly above it.

At the same time, the Slow Stochastic indicator at the bottom of the chart (which is smoothed out over 14 weeks) is showing the VIX as oversold. Nearly every time the Slow Stochastic indicator has become oversold – meaning the red and black lines drop under 20 – the VIX went on to rise for the next ten to twelve weeks.

If the VIX is rising, that means the Dow Jones should be falling, possibly breaking under 8,000 sometime in the next few weeks and head towards 7,000.

The play should be obvious. But I’m going to point it out anyways because I’m feeling saucy.

If the Dow Jones drops under 8,000 as the VIX spikes, buy a put on the Diamonds ETF (NYSE:DIA), which is an ETF that tracks the value of the Dow Jones Industrial Average.

Under normal circumstances, the VIX goes up when the market declines and goes down when the market rises.

Over the past week though, the VIX has been behaving rather oddly. On Friday June 6, the VIX jumped over 26 percent as the market took its nosedive. Then, this past Wednesday when the Dow dropped another 200 points, the VIX was only up four percent.

On Thursday, the Dow was up 57 points and the VIX was down 3.3 percent.

As you can see this is not a perfect inverse relationship between the VIX and the overall market. I know I am comparing it to the Dow rather than the S&P, but the differences in the percentage movements are not that great.

Personally, I think the problem stems from the options on the VIX. A few years ago, the CBOE started offering options on the VIX. To my knowledge, only the hardcore traders are trading the VIX options.

I can say that since the introduction of VIX options, the VIX itself has become a less reliable indicator for me. I always thought of the VIX as a good gauge of overall fear in the market. When puts were being bid up more than the calls, the fear level was increasing and the VIX was rising.

I didn’t always use the VIX the way other traders do or did. My best moves based on the VIX were ones where the VIX jumped sharply or dropped sharply over a ten-day period. Anytime I saw significant, sustained moves in the VIX, almost without exception, a move in the opposite direction was certain.

These days, my old indicator doesn’t seem to work as well, and quite frankly, I don’t watch the VIX as closely as I used to. The reasons behind that could be numerous, but I think it has a lot to do with the options.

First of all, the VIX is a derivative of a derivative. This might seem confusing, but follow along if you would. A derivative is simply anything that derives its value from another underlying instrument. The options on the S&P that are used to calculate the VIX are derivatives. Now the VIX derives its value from those options, making it a derivative of a derivative.

Now you have the options on the VIX, which are derivatives of a derivative of a derivative. Say what?

When the VIX was initially introduced back in January 1990, the idea was simple…measure volatility. The calculations may not have been all that simple, but the concept was. Now some 18 years later, the value of the VIX is being influenced by the options that are traded on it.

The point is that the VIX has lost of its meaning for me. I still look at it occasionally and it still makes some rounds in the media. But for all intensive purposes, it has lost most of its value.

That being said, the VIX is currently hovering right around its 100-day and 200-day moving averages. The 200-day has acted as support in the past and is now acting as resistance. This could have some merit, more because investors are focused on it.

Now it may seem odd that would base an investment decision on an indicator that I have just been dismissing, but I am looking for a rally in the coming week or so. Part of it is based on the 200-day moving average of the VIX acting as resistance and the index falling. But more importantly, with the big sell-off on the June 6, and the pullback on Wednesday, the S&P has moved into oversold territory on the daily chart.

A little less than 12 months ago, the world’s biggest financial players suddenly found they could not turn some $1.3 trillion of their assets into cash.

These assets — bonds backed by U.S. homebuyers with low (or no) incomes — had become utterly illiquid. No one would buy or lend against them, not at any price. And an asset you can’t sell or borrow against is worth precisely nothing.

The resulting mayhem? It would have sounded frivolous two years ago. But the subprime crisis caused the first run on a British bank run in 130 years, a forced collapse in U.S. interest rates, and the fire sale of Wall Street’s fifth largest investment bank for just 16cents on the dollar.

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“[Now] it seems that the financial system is slowly working its way through this subprime shock,” writes Gillian Tett in the Financial Times. “The largest banks and institutions have written off almost $200 billion and raised more than $100bn-odd of capital to plug this gap.

“Indeed, the write-downs have been so vast that some analysts expect to see some write ups in the next set of results.”

Crisis over? That key marker of investor anxiety, the gold price, fell 15 percent from its top of mid-March to the end of April. The preceding surge had taken gold bullion up from $650 per ounce in August to above $1,030 the day after Bear Stearns was sold to J.P. Morgan.

The proximate cause for gold’s jump — and then setback — was the Federal Reserve’s decision to slash U.S. interest rates. Gold turned sharply higher as the Fed began cutting rates in Aug. ‘07. It only flagged when Fed policy-makers implied a pause in their war against the Dollar (albeit it temporary) seven months later.

That’s why a significant portion of new gold investment since last summer has gone into physical metal — owned outright — rather than simply into paper promises or credit arrangements.

What makes physical bullion stand out for the growing number of private investors choosing outright ownership instead? Gold futures or options would, after all, give them leverage to the gold price, super-charging their gains if they call the short-term direction correctly.

Repeated studies also prove gold’s safe-haven appeal on the basis of its “non-correlation” with securitized assets, such as equities and bonds. Gold prices move independently of the broader financial markets — neither together, nor in opposition. This lack of correlation makes gold a crucial component of any diversified portfolio.

Owning the metal outright — whether as gold coins in your pocket or large bars held securely in market-approved storage — takes you “off risk” with regards to the solvency of banks and brokerages. And it leaves you holding a highly liquid physical asset that’s instantly valued just by checking the gold spot price online.

“While the subprime shock may be ebbing,” continues Gillian Tett in the Financial Times, “the problem is that…as the U.S. economy slows, there is a good chance defaults will soon emanate from the corporate and consumer debt world.

“And the more that banks are forced to tighten credit as a result of the subprime mess or other losses, the greater the risk that this second wave of defaults will emerge — creating the risk of a vicious spiral.”

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The Worst Is Not Over

You may see the markets tick upward as the occasional good news about oil or the dollar gets reported. But according to Fed Chairman Ben Bernanke, the markets are “far from normal.”

In reality, the markets aren’t just abnormal, they’re much worse. If you think the crisis is over, you’d better think again. Click here to see what problems are still out there…

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The current lull in the gold price says fewer investors are worried today. But only this week, Moody’s Investors Service — one of the three credit-ratings agencies now blamed for letting investment banks issue toxic subprime bonds as “triple-A” bonds — warned of a sharp rise in U.S. corporate-bond failures. It sees the default rate on low-rated junk bonds quadrupling to four percent by the end of this year.

Wherever the subprime shock has hit hardest, municipal debt also looks weak. Council members in Vallejo, California voted on Tuesday to file for bankruptcy, thanks in no small part to “house prices in Vallejo and the surrounding area falling some 26 percent on a year ago,” reports The Independent here in London. “The city is expecting $1.6 million less in property sales taxes.”

And all this while — 12 months on from the first trouble at UBS and Bear Stearns — the final cost of the subprime shock itself is still pending. Chairman of the Federal Reserve, Ben Bernanke originally put a $100 billion forecast. The International Monetary Fund (IMF) has since set the ceiling at $945bn.

But there are hidden costs too, as Bloomberg reports this week. Now State Street, the world’s biggest institutional fund manager, faces more than $625 million in lawsuit damages, for instance, after being sued by four insurance companies for putting their cash into subprime bonds without their approval.

Let’s imagine all of your wealth is sitting safely outside the next subprime-style blow up. A loss of confidence in one sector can still become a system-wide crisis. And the failure of subprime bonds to pay up should have reminded us all that counterparty risk remains very real, no matter how clever derivatives salesmen become.

This we all know. But what if all goes wrong? What if the people the bank lends to don’t pay them back? What if too many savers want their deposits back? Basically, what if the bank runs out of cash?

Northern Rock posed this question last year. As well as using deposits, the Rock also topped up its lending from the money markets. But then the money markets seized up, and it was game over.

So the question was asked – what should be done now that it’s all gone wrong? It stumped the powers that be. The FSA, the Government, the Bank of England – they all scratched their heads. They scratched and they scratched, for several months, until they’d worn holes in the tops of their heads.

A bank is a private business. A bank that runs out of money, like any business that fails, can expect to go bust.

But, as we all know, that didn’t happen with Northern Rock. Once the head scratching was over, Northern Rock was nationalised. This marked a major deviation from the way private enterprise is supposed to work.

So now, the Treasury is drawing up plans for something called the special resolution regime (SRR). The idea is that in future the SRR would swiftly liquidate a failed bank, strip it of its assets and appoint new executives. Just as would happen with a failed business in any other sector.

But there’s a problem. Who will run the show? The FSA didn’t come out of the Northern Rock crisis very well. But the regulator would no doubt argue that its past performance should not be taken as a reliable indicator of the future.

Bank of England governor Mervyn King has reservations. He suggests there could be reluctance on the part of the FSA to pull the trigger if another bank fails. His reasoning is that this would be an admission of failure on the part of the regulator who allowed said bank to fail in the first place.

But the FSA counters that involving the Bank with a final decision would mean it would also inevitably become involved in monitoring, duplicating the FSA’s role.

Personally, I don’t really care who wins this little turf war. If I had to pick a side I’d go for the Bank. Call me a traditionalist.

A more fundamental question is how on earth have we got into this situation? As noted above, a failing bank should… well, fail. Adam Smith’s Invisible Hand is supposed to allocate the spoils of business to those most deserving. Those who get it wrong get less… if they get it really wrong they get nothing.

But the workings of the market have been gummed up by regulation. That and political fear (runs on banks don’t look good on the telly. Better do something, quick!)

It’s this political fear that creates moral hazard. The banks knew the Government would never risk letting them fail. So they were happy to take big risks.

Now an institution, the SRR, is being created to effectively force punishment upon banks that mess up.

Welcome to the age of the Visible Hand.

Hold your nerve, Merv!

Hurrah! It’s the day before the Bank of England’s Monetary Policy Committee (MPC) meets to decide what to do with interest rates.

Because I’m a sad man, I set up our very own Fleet Street Daily shadow MPC. Better-looking than the official MPC, our committee comprises seven wise men, one wise woman and Glenn, a bloke from Grimsby.

And my, was it close! A five-four split in favour of a quarter-point cut.

Not that this is what we expect the Bank will do. Nor necessarily what it should do.

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“And there’s also talk of US interest rates rising,” adds colleague Frank Hemsley. “That would put sterling in serious trouble! Especially if the Bank of England cuts our rates.”

Indeed. A weak pound would make imports – including food and energy – even more expensive. Meaning more inflation, and pressure to put rates back up if the Bank adopts a US Fed-style aggressive rate cutting policy.

Personally, I’d favour keeping rates on hold. Businesses and consumers are rational. They see the economy is struggling, and they’ve changed their behaviour accordingly. This is why each day we see new ‘bad data’. Cutting the base rate by a quarter-point will do little to change prevailing sentiment.

What it will do, though, is further undermine the Bank’s reputation as an independent inflation fighter. So I’m hoping the Bank stands firm and leaves rates where they are. It won’t be popular, but being popular is not the Bank’s job.

Pretty much everyone, from homeowners to the Confederation of British Industry (CBI) wants rates to come down… the market has priced in a quarter-point cut… and what’s this? Gordon Brown — the same Gordon Brown who, as chancellor, granted the Bank operational independence in 1997 — is also sticking his beak in.

“If you look at this situation, because we’ve got low inflation we can cut interest rates,” the prime minister said.

Hang on, Gordon. Isn’t the MPC supposed to set rates independent of political considerations? Naughty, naughty Mr Brown…

In fact, there’s some speculation that Brown’s comments may have angered the MPC hawks, who’ll now argue more fervently to keep rates on hold. I’ve said before I’ve got this hunch the MPC might take the chance to wrong foot the market and boost its credibility. Now that Brown’s lumbered into the debate, might that now prove too tempting a proposition?

I’m at odds with my colleagues on this one. They, along with most people, expect the base rate to come down to 5% tomorrow. After all, there’s plenty of gloomy news about to prompt a loosening of monetary policy. Halifax has revealed that house prices fell 2.5% in March — the biggest (seasonally adjusted) monthly fall since September 1992, when they fell 3%.

Meanwhile private banks remain reluctant to lend. But there are signs that the market could be starting to find a solution. HSBC, which doesn’t rely on the money markets to make loans, is offering to match homeowners’ existing fixed-rate deals. Some of these mortgages rates are as low as 4.54%.

HSBC will do well out of this, mopping up a lot of new business. It’s benefiting from its strong position, brought about by a solid business model. It’s profiting from its competitors’ weaknesses.

That’s how capitalism works.

US Federal Reserve makes earth-shattering prediction

I’m going to be upfront with you. The headline above is sarcastic. It refers to the minutes of the Fed’s meeting of March 18, which were published yesterday.

The minutes contain such statements as “prolonged economic downturn could not be ruled out” and “many participants thought some contraction in economic activity in the first half of 2008 now appeared likely”.

Also making big waves is the International Monetary Fund (IMF). Today it made front page news (in Metro anyway) by putting a figure on how much the credit crisis will cost.

The figure, printed by the Times in a scary red typeface, is $945,000,000,000 — almost $1 trillion.

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Indeed, the IMF’s Global Financial Stability report, in which the estimate was published, contains the following line:

“The critical challenge now facing policymakers is to take immediate steps to mitigate the risks of an even more wrenching adjustment.”

The air rings with clamours for leaders to “Do something”. It’s what that something is that worries us…

Gold analysts… oil analysts… they’re all wrong!

Gold fell through $909 yesterday, and still looks to be falling. It’s making a few investors nervous about the yellow metal…

“Ignore them!” is the shout from our commodities desk — where Garry White (who’s already done nicely out of gold, thank you) reckons conditions are ripe to send the price much, much higher.

Oil, meanwhile, is around $108 a barrel. Garry doesn’t see that falling much either. Even oil analysts are starting to catch up with him. The Energy Information Administration, and arm of the US Department of Energy, last night upgraded its oil price forecast by a massive amount.

As well as gold, Garry’s got great exposure to oil, too. And he’s got a clever little move that could prove highly profitable — if you get in before 29 April that is…

Where the money is, that is where we shall go…

“This proves what I’ve been saying all along,” said an excited Manraaj Singh this morning, with that trademark gleam in his eye.

Manraaj, our emerging markets hot shot, was telling me about an auction that took place at Christie’s yesterday. Buyers paid huge sums for such artefacts as single leaf from an ancient Koran manuscript. The bids received shattered what Christie’s expected to get.

So why is Manraaj so excited? Because of who the buyers are, that’s why! There’s a huge amount of money out there in the developing world, and conspicuous consumption such as that seen yesterday proves it.

But this money isn’t just being spent at auctions. It’s being invested — and Manraaj is keeping a close eye on where it’s going.

“We’re talking trillions and trillions here,” he says. “If we make the right calls now, we’ll clean up!”

And that’s exactly what Manraaj plans to do! Find out how, with one specific investment, you could clean up as trillions of dollars of Gulf oil money is invested worldwide…

Until tomorrow.

Ben Traynor

Editor

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