Unconventional Way to go long Financials

Once-proud financial-service companies have been humbled, and currently trade at lowly prices usually reserved for unknown, unremarkable companies.

Citi (C) ended at $2.31 at Monday's close. American International Group (AIG) closed below a dollar. Both stocks are up roughly 250% off of all-time lows, but the future of the shares (and companies) are hazy at best. Risk-adverse investors don't necessarily want to gamble on such risky companies, especially while daily price fluctuations are so extreme. At the same time, however, bullish investors may want to be exposed to potential upside in shares of such trampled companies.

Rather than owning the shares of stock, investors could gain exposure to upside movement by selling naked put options.

Selling "naked" puts refers to selling puts without actually being short shares of the stock, which would sometimes create a riskier situation for the seller. However, with C shares so close to $0, even the worst-case scenario is very clear.

When puts are sold, the seller's account gets credited with the amount of the sale and an outstanding obligation shows up. If shares do move lower, the size of that obligation increases as the puts increase in value, and the seller essentially loses money. If shares increase in price, the size of the obligation gets smaller, and the seller enjoys some paper gains.

Below is a table of C January 2010 puts (courtesy of Marketwatch.com)

Though there is little to no volume in the far in-the-money puts, the bid and ask spreads remain reasonable and transaction costs do not inhibit using this strategy. Options close to the current share price retain time value, providing a bonus for the seller.

At the $2.50 level, options traded hands yesterday at roughly $1.25 (we'll take the bid), implying that investors expect C shares to be worth no more than $1.25 in January of 2010. If shares close below that level, the put seller will lose money. If shares became completely worthless ($0) before then, the put seller would essentially owe $250 per contract while he was only credited $125 at the time of sale. However, if shares only appreciate 10% (to over the $2.50 strike price) within the next 10 months, the seller will get to keep the entire credit at the time of sale.

Utilizing this strategy with in-the-money options changes the risk and reward involved. If a seller sold $10 puts for $8.05, he has a possibility of making $800 per contract (if shares close above $10 in Jan '10) while only potentially losing $200 (if shares go to $0).

Selling even farther OTM puts exaggerates the risk/return profile further. Selling $40 puts in the bid/ask spread at $38 seems possible, even though its highly unlikely that C shares will see that share price within the foreseeable future. However, the trade can still be made. Again, downside risk is limited to coughing up $200 if shares hit $0 (which means repaying $4000 compared to an initial credit of $3800), while profit potential remains intact (a $10 share price close would net the seller $800 of profit, essentially). And with C, AIG, BAC, and many other companies trading relatively close to $0, this strategy can be employed for an entire portfolio of companies.

Requirements for selling naked puts differs based on broker, and the strategy isn't for everyone. Like owning shares, downside risk is limited (paying the entire difference between strike price and $0) if the shares become worthless, but gains are capped too (at the initial selling price of the contract). But this strategy may offer an interesting way to expose one's portfolio to the possibility of bullish performance without sacrificing too much capital.



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From Laggards to Leaders

Monday's market action was volatile and interesting, with a couple surprising underlying themes.

The S&P 500 opened higher, peaked midday while up about 2%, and ended up closing marginally lower. Many of the previously worst-performing stocks (financial) had daily charts that resembled the S&P's movement, albeit with supercharged movements.

As AIG made news by listing important counter-parties and declaring that it planned to pay bonuses, the shares exploded higher.

Shares logged a few trades at $1, which was an 100% daily move. Even as trades ticked lower with general market weakness at the end of the day, shares still logged a 66% daily gain. Though the percentage gain is obviously impressive, it pales in comparison to the enormous wealth that was lost as AIG fell from real-company valuation to penny-stock territory. But theoretically, an investor that plowed some money into shares at $.33 recently would have been very pleased with this recent performance.

Some other examples of beaten-up stocks that outperformed today:

E*Trade (ETFC): +9% today (read my recent article about ETFC shares here)
Citi (C): +31% today
Bank of America (BAC): +7%
Freddie Mac (FRE) +21%

Obviously all stocks mentioned are ultra-risky, and some may ultimately be worthless. But such extreme movements are heartening for investors who own shares of said companies, and if any major development in the market or indivual stocks (like ETFC getting TARP money, or the alteration of M2M rules) happens, shares could explode higher. But "investing" in any of the five companies I named (I own shares of ETFC and AIG) is still more like gambling than rational, careful capital allocation.

People courageous (or stupid) enough to invest will continue to see gains or losses that are characatures of the general market.



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Bank of America: Break the Silence

This morning, Friedman, Billings, Ramsey analyst Paul Million said that he believes that Bank of America should walk away from its Countrywide purchase because of deteriorating assets. At the very least, he suggested that BAC should/will renegotiate to a price between "0 and $2" per share (compared to an approximate deal price of $7 based on BAC's closing price on Friday).

Bank of America needs to comment on this suggestion immediately. Countrywide is down over 10% in the pre-market because of this news. In a post-Bear Stearns era, the power of rumors and speculation has been demonstrated. If BAC intends on following through with the deal, they should make it known. If they are indeed thinking about renegotiating or withdrawing, CFC shareholders will take the hit eventually anyway - better now than later.

Rumors such as these can become self-fulfilling prophecies. BAC needs to clarify this issue before more damage is done.

Monday's Biggest Earnings Reports

The deluge of earnings releases will continue this money, as multiple noteworthy companies report earnings.

If Monday's morning reports are good, the market should continue the rally that began last week. Asia is currently up a couple percent overnight, led by exporters like Honda.

The biggest story Monday morning will be Bank of America. According to Yahoo! Finance and EarningsWhispers.com, the average analyst estimate is either $.41 or $.45 per share, though estimates vary wildly from losses to almost $1 of profit.

Based on releases from Citi and other major banks, BAC will probably disappoint, but anything short of absolutely unthinkable will be applauded (ala Citi's earnings on Friday). As many professionals are starting to believe that we are in the bottoming process, they expect bad news, just not new, terrible news.

BAC started last week around $35.5 and ended up 10% at $38.5 - I think it'll trade at $40 after earnings tomorrow. However, if BAC does turn a $.50 profit, maybe the shares will be up 10% at $42.

Netflix is another company reporting today that I'll focus on.

First, according to Yahoo! Finance, insiders sold 700,000 shares, or almost 20% of total holdings, over the past 6 months. It's acceptable to cash out of a successful investment and diversify, but maybe they think the valuation has become too rich.

The average estimate for NFLX's quarter is $.21/share, while EarningsWhisper is calling for $.25. Whether or not they beat the street, I think that the NFLX is already fully valued.

Expecting $1.25 this year makes NFLX's current P/E about 30, while next year's estimated $1.53/share creates a 25 forward P/E. Those valuations aren't insane, but Netflix may not be able to continue growing as quickly as they have in the past.

BlockBuster seems to be getting their act together, as they recently reported a profitable quarter. For some that is interested in mail-in DVDs, BB offers the same mail-in program with the added bonus of in-store exchanges.

However, even the quick 1-2 day turnaround of NFLX may be obsolete in just a few years. Now, movies are available on-demand through digital cable for about $3 a pop - and most cable providers and premium channels include a large library of free movies. Also, companies (including NFLX) are rolling out downloading services, which will become even more accepted as internet connections keep becoming faster.

A 4-month chart of NFLX shows its impressive run-up from about $21 to $40, which occurred even as the wider market was moving sideways (or down). NFLX actually fell about 5% on Friday while the broad market rallied, due to an analyst's comment about valuation.

It looks like this quarter's report will determine the direction of NFLX stock. The long-term uptrend looks like it could be broken as the stock just bounced off an "overbought" RSI level, but there appears to be support at $35, minimizing pain. However, as the valuation is a little rich, I think that a good report may already be priced in. Maybe if NFLX surprises positively, it'll bounce back to $40, which is where it was two sessions ago. There really hasn't been much options volume on NFLX, which can show where investors expect the stock to move to.

NFLX will close near $35 if the earnings don't meet estimates or guidance isn't good, while the stock may pop to $40 if they beat and raise.

In the long term, unless they say they'll make $1.50 this year and $2 next year, I don't see much more upward movement for NFLX over the coming months. As I stated, growth is slowing, competition is increasing, and valuation is already rich (though not ridiculous). 20% is nothing to sneeze at, but I see $45 as the ceiling for NFLX in 2008. If things take a turn for the worse, NFLX has much of a recent 90% price increase to give back.


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Our Next President...

After seeing the brilliant orator Barack Obama speak in front of 20,000 of my fellow intelligent, rational students, I can proudly say I will vote for him in November.

His hour-long speech touched criticized the current government for 20 minutes, talked about raising my taxes for 5, and then spent 15 minutes defining hope, 10 minutes asking the crowd to believe in it, and finished up discussing change.

April Fools (yes, the above joke was terrible). But for a couple good April Fools pranks, go to gmail's homepage today (gmail.com) or read an article about Sun Microsystem's past pranks (published recently in a business publication, or just google it).

I am still in the thick of exams, but some brief thoughts:

• BWLD is rallying 10% today along with the broad market on no news. Now way off of its 52-week low of $18, the stock appears to have some strength. Trading at 16x next year's earnings with a .8 estimated 5-year PEG ratio, it's still a value-growth play at these levels. I have been recommending it forever, and I'm finally just about back to break-even.
  
• I think (and hope) that this market will run for a while, so I'm not trying to short CMG... but hopefully once things settle down, there will be shares available to short.
• For the fiftieth time, the CFC/BAC arbitrage is still available for any takers. Intra-day prices value CFC shares at $7.32, still about a 20% premium over their intra-day price of $6 (after a $.50 gain today).

And a broader, less specific thought...

The market is now up 5% since March 10th, when I speculated that we had reached a bottom. If this stock market uptrend continues, bolstered by a better economic environment and less fear (the VIX is now down to 23 after topping 35 two weeks ago), expect a sell-off in commodities. As I've written about before, the broad-based commodities rally extended beyond the domains of gold bugs and Texas oilmen; wheat, corn, soybeans, and pretty much every other tradable commodity reached an all-time or recent high. As the hot money raced into the DBA (ag ETF) and other vehicles to trade that boom, it may be withdrawn just as quickly. The speculation and retail-investor interest that propped up those commodities may indeed be their undoing, too. If you've got faith in the dollar, buy UUP - a strong-dollar ETF weighted against a basket of multiple currencies.

As both the stimulus package and rate cuts effectively hit the economy starting this summer, there's a possibility for a quick and strong (albeit, articulated and arguably-artificial) recovery. I'm not trying to hype-monger, but the policies that have been enacted over the past six months will come to fruition soon, and if they work as intended, then Goldilocks will be back.


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Two Public Figures, Lots of Homework, a Little Stock Talk

I apologize for the absence of new posts this week; I've had two exams (well, Macro Econ is tomorrow morning at 10:10) and lots of other work.

Plus, on Wednesday, Jim Cramer came to do his show here. Tonight (Thursday), Bill Clinton came to speak on behalf of his wife.

I semi-reluctantly went to see Cramer put on his show, and I'm glad that I did. I hate the caricature-Cramer of the show, with yelling, screaming, hyperbole, and sound effects - but in real life, I was able to see a different side of him.

And, interestingly, his on-show appearance is turned on and off like a light switch. As the cameras rolled, he was in his TV persona, but as soon as they cut to commercial (when filming here, the "commercial" breaks were about ten minutes long), he began to speak candidly. He fielded long questions and lightning-round quickpicks from investment club and secular audience members; instead of screaming about them, he responded logically and thoroughly. He talked a little about himself and his life, in a very personal and honest way.

So I definitely have a new respect for Jim Cramer. I'm still not a fan of the show, but I like the real Cramer (or at least as much of the real Cramer as I got to know in that hour). He seems like a great guy to have dinner, a beer (if you're of age), or a round of golf with him. One last, possibly jaded comment; if he doesn't like his TV semi-insane alter ego, I feel bad that he has to turn it on for hours every day. However, if it's fun for him... then good for him. He's making money doing it.


Concerning Mr. President William Clinton's appearance tonight...

It was worthwhile to see him, but instead of talking about himself (which I would have cared more about), it was all about his wife and her policies.

I actually registered as a democrat (though I consider myself to be more republican) so I could have a meaningful vote this April in the Pennsylvania primary. Though I'm not a fan of Barack's 20-30% capital gains tax (and main campaign platform of "hope"), I think I'll probably vote for him over Hillary next month. I firmly disagree with many of her policies (as outlined by Bill), except for one - she supports a troop withdrawal, beginning within 60 days of taking office. Iraq is a waste of time, lives, and most importantly, money - money that is spent now, will continue to cost more money later (as veterans require medical care, future aid because of mental illness, etc), and money in the future (in the form of repayment of national debt). It really doesn't matter to me if we're "winning" or if the surge is "working" - great! our generals learned how to fight this war. Just because we're doing better doesn't mean that we should continue to be there. I have friends from high school that went to the Naval Academy, and I hope they'll be deployed in a time of peace.


A couple quick stock thoughts:

I put in a super-lowball bid on a lottery-ticket option for Penn National Gaming (PENN). They are (supposed to be) bought by Fortress (FIG) by the summer, at $67/share. I put in a low bid and got April $55 contracts for $.15 - I'll actually probably sell now that it's a quick double in value. However, if the deal somehow closed between now and then, it would be jackpot for me.

I also tried to short my long-loathed CMG over the past few days, as it's bounced up about $20 for no reason at all... but Ameritrade doesn't have any share available for me to short. Options aren't worth it (premiums are too high), but I'm staying on the lookout for an opportunity to get short.

Financials are coming back down, which I dislike (because I own CFC and ETFC) but also like (because I'd like to buy some LEAP calls of other ones). I think FIG and BX are good buys at these levels; both are about as low as they have ever been, and I think they're likely to snatch up a few good bargains as things have cheapened, which they'll be able to sell for much more when conditions improve. If they fall a little farther, I'm still not against buying FRE or FNM, because I think the quasi-government connection provides safety. Brokers are still dangerous, I think - I'd rather go with a BAC or C, but in a few months after they write down some more of their balance sheet.


Lastly... I'm still in TMA. They'll probably be stagnated between $1-$2 for a while, but it seems like the danger of bankruptcy has passed. If one can endure the 10% daily moves, I think there's an outside chance that its a $5-10 stock in a few years.



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Was that the bottom?

I wrote on March 11th that I had thought we had hit bottom. On March 10th, the S&P established a double-bottom, and the market rallied off of that bottom on the 11th.

One week ago, the market did break through that bottom, as news of Bear Stearn's fire-sale bailout rocked the markets. However, markets recovered from that shock, and actually ended last week positively.

Today, the major indexes are up multiple percent on news of the higher-priced BSC buyout, CIT financing, better-than-expected home sales, and just good feelings. One can almost feel the fear slowly trickling out of the market - and if they don't want to go by feelings, the VIX, often called the "fear indicator" (but actually a measure of options volitility) has fallen from an intra-day high of 35 last Monday to 25 today.

Thankfully, the pathetic-performing financial in my portfolio have begun to pick up some lost ground - Countrywide has moved from $4/share last Monday to over $6 today. (As I love pointing out, Countrywide is in the process of being purchased by Bank of America - at this time, that deal would close at $7.80 based on BAC's share price). I added 30% more CFC at $4.44, and I sold off that block at $6.20 today. I'm holding the rest until the merger close or, at least, the arbitrage gap starts to narrow.

I also bought CIT at $9.90 in the pre-market today as I thought they'd announce good news about financial backing; they didn't even have to announce anything to be up about $3 today. I have an itch to sell now and take my nice daily gain, but I think I'll use my seemingly well-timed entry as a basis for a long-term investment. After all, CIT has fallen from about $60/share, and until recently, its business was not tainted by the subprime fiasco.

I missed out on Freddie and Fannie - I thought were good vehicles to play a housing/economic recovery because of slightly less danger due to their quasi-government status. Both were trading near (or below) $20 last Monday; both are above $30 today.

One of the most interesting aspects about this rally is the depth of companies participating in it. It may be short covering (which I never regard as a bad thing), but many general market laggards are performing, or even outperforming, the overall indexes as they rally. For example, Buffalo Wild Wings, a company that I regard as undervalued, continued to slide and suffer as the markets fell in January, February, and March. However, starting last Tuesday, BWLD reversed the trend, and share price has increased from $20 to $26 in the past four sessions. (Note: The increase is partly due to an analyst upgrade). Crocs and eBay, two more laggards, are both up 15% percent in the last week.


I'm not 100% certain that the market won't face pressure in the coming days, weeks, or months, but the combination of technicals (double bottom, higher lows), data (housing numbers, Fed opening discount window, BSC bailout) and mentality may just mean that the bottom is in.



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Fed or Foe?

Tomorrow, the Federal Reserve Open Market Committee (the FOMC, or simply, the Fed) will emerge from deliberation and direct monetary policy in this country.

Futures have priced in a 50 basis point (.50%) cut.

Therefore, the Fed will cut at least 50 basis points. Many market analysts have pointed out that the tail (Futures markets) may be wagging the dog (the Fed), which is probably partially true. However, at this point, both fiscal policy (taxes, etc. - determined by Congress) and monetary policy (interest rates, etc. - determined by the Fed) seem aimed to prevent recession (or a slowdown) at all costs.

Fiscal "hawks" had been concerned about inflation in the past, but it now seems that cuts in favor of economic stimulation have taken priority. Little resistance has been seen when the Fed has cut in the past; as more write-downs and bad news continue to trickle out, I don't know why opposition would materialize now.

So 50 basis points is a virtual guarantee for tomorrow's announcement, while 75 is a realistic possibility. Here's how I see the market reacting:

• A cut of 50 basis points will be immediately disliked. Financial stocks and homebuilders may sell off. (This will be bad for me, since I currently hold Countrywide shares and Hovnanian LEAP calls.) However, I think the market will eventually right its overreaction (whether it be by the end of the day, week, or in a few weeks).
• A cut of 75 points will please the cheerleader analysts. The market will probably finish up a few percent. The downside? Much of the gains due to the announcement of interest rate cuts may be superficial and short-lived, considering monetary policy doesn't even affect the economy for six months.
• A cut of 25 points will be disastrous for the markets tomorrow. Even if the Fed rationalizes it with improving economic data, the same cheerleaders will boo the decision as irresponsible and unreasonable.
  

Since I have already mentioned them, I'll reiterate an investment idea I've made before:

Buy Countrywide (CFC).

Countrywide is set to be bought by Bank of America sometime this year. When the deal closes, investors holding CFC shares will get .1822 BAC shares for each one of CFC. As of the market close today, a share of Countrywide costs $6.31 and BAC sells for $41.94.

If the deal closed tomorrow, Countrywide would essentially be bought for $7.64 per share. Or, to look at it another way, you can buy a Bank of America share for $34.63 by buying the corresponding amount of CFC.

Of course, there is some possibility the deal won't close. However, BAC's deal terms cited only unknown, unexpected, and misleading information as a reason for breaking the deal. Countrywide reported earnings today, losing a ton of money, but nothing was surprising or misleading, and BAC said nothing about any problem going forward from this point.

Yes, there is inherent risk of owning a financial stock right now. But the arbitrage spread is still over 20%, so there's lots of money to be made in a very questionable market. If you're looking to own Bank of America over the next 5, 10, or 20 years, this may be your best opportunity.

If the Fed doesn't please tomorrow, both BAC and CFC may get hammered. It's certainly going to be a volatile few months for financials, but the reward may be worth the risk.

For my sake, and for the portfolios of millions of investors like me, I hope that the tail keeps wagging the dog tomorrow.



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Terrible Tuesday

After US Index Futures trading on global markets had priced in a 5% plunge when the markets open today, the Fed decided to try to salvage the situation by cutting rates by 75 basis points.


Immediately, futures gained lots of lost ground, as Nasdaq 100 ETF is only pricing in a mere 2% decline. (QQQQ quote taken 8:30 AM).

But was this the right thing to do?

I'm not so sure.

First, let me establish that I don't want stocks to fall. I own an Ultrashort Oil & Gas Fund (DIG), which can be seen as a hedge against oil (and the entire economy), but I am very, very long, which is clearly not the place to be right now. I'd like nothing better than to see the market go up 20% tomorrow, but for logical, meaningful, substantial reasons.

The Fed's early cut is purely symbolic, not something that will actually have an effect on the financial situation in America. Since the policy (rate cuts) take many months for their effects to be felt in the economy, realistically, waiting until the meeting to cut 75 points would have provided the same stimulus in the second half of this year. If anything, I think it may have been better to cut then - if things got even worse, then they could cut a full point without making it seem like the sky is falling.

I can't say that a decline of "only" 5% isn't bad (especially since some stocks I own, like Countrywide (an arbitrage, at this point)) were set to open down 10% or more. But global markets have faired even worse over the past two days - Indian and Chinese markets are down 10-20% since last week.

It's hard and unreasonable to tell people to do this, but if people could just act rationally, and avoid clicking "close" next to all of their positions, we'd be a lot better off. For example, I follow Activision (ATVI) and Electronic Arts (ERTS), two stocks who should have shot up after news of an absolute blowout of video game sales numbers during the holiday season. However, both were flat (or down) last week after the announcement was made, and both were/are pricing in a 5% dip today. Clearly, if we're in a recession, people are still buying Guitar Hero and Call of Duty; if anything, investors should be buying up shares of a seemingly-stable niche.

Now that the day's news (BAC's awful earnings and the Fed cut) are on the table, it looks like markets will open down about 3%. What they do during the day is anyone's guess - We could finish positive, or we could lose 10%. According to WSJ articles over the weekend, markets have priced in 80% of the impact of a recession - this potential decline today should increase that figure further. I truly believe that a recession is fully priced in; there's clearly some stocks that are still overvalued (I think that tech like Apple, RIM and Amazon are still grossly overvalued), financials seem to be fully discounted.

Barrons wrote an article about the bond issuer MBIA this weekend; they stated that the company's liquidation value is at least $30, while the stock currently trades around 8. Countrywide is being merged into BAC; the terms of the deal, which can be broken but are generally unconditional, priced CFC around $7; now, when CFC converts into BAC at .1822 shares, you're essentially buying BAC stock for $25 (instead of the market's $33) if you buy Countrywide today.


If you can stomach a short term loss, in five years, they should identify early 2008 as the best buying opportunity in years. Yes, the economy may not be great. Yes, the subprime problems are not over yet. But companies (and the entire market) are heavily, irrationally discounted, and an investor with a strong stomach will thank his nerves a year or two from now.



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My Economic Stimulus Plan

Later today, President Bush is supposed to discuss his plan to stimulate our "weakening economy."

His plan is likely to give money back to individual taxpayers and ease business liabilities, stimulating both consumers and industry. Bush proposed rebates of up to $800 for individuals or $1600 for families, while lawmakers wanted to lessen that amount and limit who receives it (Yahoo! Finance article).

I think that this plan is stupid.

Maybe it will help the economy a little bit if each family of four goes out and purchases four new iPhones. However, I think that a simple injection of money into the economy through intending to increase consumer spending is short-sided and futile.

Instead, I believe that the government, if they are going to aid anyone, should look at the corporations.

Over the past days, weeks, and months, foreign sovereign funds have injected billions of dollar into US corporations. Most of the major financial companies have received large investments from outside sources. Japan's major investment banks are reportedly pooling billions of dollars for investment in a struggling Wall Street counterpart.

I'm not an isolationist, but why let wealth leave our country when we could easily keep it here?

Instead of dishing out money for people to buy new purses, the government should focus on preserving stock market capital, and thus, the value of millions of individual Americans' investments.

If the government doesn't want to directly purchase equity or bonds like foreign investors have been doing, there are much easier solutions; provide long-term, low-interest loans or simply open the discount window, repercussion-free, at a rock bottom interest rate (say, 2%). However, as long as qualified financial analysts looked it over beforehand, putting $20 billion of Social Security money into Wall Street could end up being an excellent long-term investment.

If the government is still interested in helping individuals, they should help financially-responsible people who were romanced into adjustable-rate mortgages. I'm sorry, if you bought a $500,000 house on $30,000 of annual income, I don't think that you deserve to keep it. However, for someone with a steady job who just can't make the adjusted-up payments, the government could step in to help those individuals.

First, the government could work through the mortgage broker to negotiate a new rate that the borrower can pay and will still provide profit for the lender. That way, everyone wins; shareholders of the big banks (BAC, who will soon own Countrywide, etc) won't unjustly miss out on profit that was already accounted for, while individuals will face a more reasonable repayment rate.

My last article discussed how the US economy is already contracting; if it's not, it's certainly slowing down. Discussing ways to improve economic conditions is the right thing to do, but simply handing consumers a check isn't.

Help out the people that truly need help - from Joe Dirt's adjustable mortgage to Merrill's write downs, there's better ways to fix the economy than to hand me $800.




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