Milk The Market Investment Blog

If you thought the fallout over the subprime lending “scare” had already taken place and the market was finding it’s bottom, I think its time to reevaluate that theory. As 3rd quarter results loom over the megacap financial institutions, it’s expected to see $35 billion or more put on the books as bad debt… yes, $35 billion.

According an analyst at JP Morgan, this will effectively wipe all profits off the books. According to Kian Abouhossein, “Banks will have made almost no money over the last quarter. Profits will be close to zero.”

Despite Greenspan’s possible actions that planted the seeds for this mess, he is economically astute beyond most. He recently told us, “The behavior in what we are observing in the last seven weeks is identical in many respects to what we saw in 1998, what we saw in the stock-market crash of 1987, I suspect what we saw in the land-boom collapse of 1837 and certainly the bank panic of 1907″

I’ve had a bearish outlook, but I am now I am considering only taking short position setups in swing trades. Remember, when the market is bullish, bullish setups have better expectancy. When the market is bearish, bearish setups of better expectancy.

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To be honest, right now you need to be very careful as an investor (as opposed to a trader), because of the current market conditions.

However, like Phil says, you can make profits going long in a bear market. The only difference is this is not any old bear, this could be a CAT 5 economic hurricane that puts the S&L scandal to shame.

IMO, we have only seen the tailings, or nose, or how ever you want to put it.

Only time will tell, but it is better to be cautious instead of a consummate optimist. Anyone who confidently believes they’ve seen the worst, and it is all blown out of proportion is a fool and has no concept of economics or the underpinnings of the financial systems. Those people are the ones being fooled by those companies, financial institutions and others with motives to quell the bloodletting. If their opinion is not being based on the words coming out from those places, then they are basing it on nothing but their gut feeling, and we know where that can get you.

When you factor in just the housing, credit, employment, consumer confidence numbers, which are right in front of your nose, it is easy to see something quite troubling. Now factor in insolvency, the dollar, inflation/deflation, bad debt being marked. Look at the bond market… 80% of AAA rated bonds are backed by subprime loans. When people start valuing bonds backed by subprime the same as a US treasury bond (as close to iron clad as you can get), you have a problem.

In a bull market just about any long strategy works well. In a bear market, most fail, so it’s not throwing darts at a dartboard with Rule #1 qualified companies. You will need expand those filters and look for companies that are “relatively” recession proof on top of a great value.

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If you are long term investor, unless you are really really confident fed will cut by 50 bps, be careful in new positions heading into the announcement on Tuesday. The FF (fed futures) is priced in at 50 bps, but there is a reasonable chance that it will only be 25. If it is only 25, disappointment will likely occur to a degree and could send the markets down, as 25 bps is priced in as a certainty in FF. A 25 bps cut is likely being reflected in current prices, though there may be surge or some type of frenzy on Friday due to retail investors who don’t know this buying up everything after the Fed announcement, or just because of general sentiment. In which case, that could lead to a long squeeze of sorts.

But that’s all hypothetical and getting the cart ahead of the horse.

Either way, this could be a tricky week to navigate if you are anything but a day trader. I like to take the side probability and not shear speculation, and right now the upside to 50 bps would probably be quite less than the downside of a 25 bps cut. So I will be waiting until later in the week before I start adding or taking on new positions as an investment.

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I have found that entering long positions has not been as profitable as one would like in this current market. However, doing the reverse, by shorting the worst MOS stocks has.

It seems like we are getting into a period of serious correction at the very least, and perhaps something a bit drastic. Only time will tell, but right now the value of a stock is coming under higher scrutiny because of it. Everyone with their hand in the market is evaluating their holding for dogs and cutting accordingly. A stock that may have had low MOS but kept running would be overlooked in the raging market of yester-months. But now, funds are looking to shift their equities for more efficiency. So what we can do is look for low MOS stocks, research them to see if that MOS has any justification, and short accordingly.

For me, I don’t believe I have to be on the long side to make use of Rule #1 strategies.

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In a previous post I alluded to using this tool to be a mini quant, or hedgie. This strategy is not something covered in Phil’s book, but I myself have found it to be profitable, especially given the instability in the market at the moment. Being market neutral means your portfolio does not care if we are in a bear market or a bull market. Click for details on being market nuetral.

So here is how I do it. I run the screener for the top 20 stocks with the highest MOS. I then run the screener for lowest 20 (worst MOS). I filter out any of these equities based on obvious things that make may make their MOS moderately justified and hence probably not the best choices through individual research. For example, I wouldn’t be going long on financials, even though the prices are dirt cheap, and I wouldn’t be shorting AAPL even though the MOS is quite low.

I then correlate each to their sector, and find pairs (my pairs system is far from as complex a true quant). IE: One very high MOS and one very low MOS that are both part of the Oil Services sector. I buy 500 shares of the high MOS stock and short 500 shares of the low MOS stock.

The theory is that even in a bear market, a high MOS stock will hold its ground or increase in price, while a low MOS stock will surely go down considerably. Any loss from the long position should be outweighed by the short position and vice versa. The reverse would hold true for a bull market.

You can apply this same method to options instead of stocks as well.

Of course, if you know you are in a bear market or a bull market, you can just take a long or short position only. However, the beauty of this strategy is you don’t need to predict what type of market you are in or if it is going to reverse in the near future. The market today is probably a good example of when this strategy is most appealing. Although it looks like we are in for a bear market, you never know what can happen, especially with the Fed ready to intervene at any juncture.

I would try to find about 3 or 4 pairs, let them run for a bit, and cut the 1 or 2 under performing, if any.

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Rule #1 is don’t lose money. If you’re not losing, well, you are not losing. That doesn’t mean you are winning either, but odds are that are winning. Rule #1 Ivesting is also a book by Phil Town on his investing strategy that was taught to him by mover and shaker while he was guiding them on a river rafting adventure. His methodology is practically the same as Warren Buffet and Benjamin Graham. Of all the books I’ve read or skimmed, this may be the only one I would recommend for someone interested in long term stock market investing.

The principles are quite easy. Find a solid company whose stock that is selling very cheap, well below it’s sticker value (true worth) and you can buy it with a high degree of confidence it will go up quite a bit. When the stock is no longer cheap (overvalued) you sell it, take your profit, and if and when it does become cheap again, you buy it back. You do this with as many stocks in as many sectors as possible. The problem is, in this current market, despite the recent downturn, almost everything is overvalued (likely a good part of the reason for the downturn outside the obvious credit, housing and employment issues).

Every time you find a stock to research and spend the 10 or 20 minutes to calculate the formula and back check everything, you find out it falls well outside the realm of a solid Rule #1 stock. What I decided to was not spend months waiting to stumble upon good buys, but to screen every stock on the three majors and get a list of them all. This wasn’t an especially easy task to program, but I did, and it turned out to be quite profitable as one would expect. Truth be told, at this very moment there are no Rule #1 superstars. There are Rule #1 applicable stocks in sticker price and margin of safety (MOS), but they are mostly ADRs. To find superstars right now, you need to bend the rules a little.

I will discuss this more in a future entry.

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