Wednesday, January 7, 2009

Prepare for January Test of the Lows

7 January 2009

The trading year 2008 has finally come to an end and the new year has started off well for stocks. But what can we expect going forward and what are the best ways to make money?

The chart above is a long-term, monthly chart of the Dow Jones Industrial Average. We can clearly see that there should be strong support at the solid horizontal line just below the 8,000 level. Stock market technicians may quickly recognize this level as the “neckline” of a head and shoulders top formation. With the Dow average trading at 8,800 this morning, I suspect that despite a strong start to the market this year, it will eventually turn negative and seek this level below 8,000.


One of the key indicators in my work is the volatility levels of the price action. The following chart indicates that monthly volatility for the Dow Jones Average has been rising sharply each month and, in fact, is at the highest level seen in over 20 years. When this indicator is rising, it is wise to stick with the trend. Only when this indicator reverses and starts falling can one have some reasonable assurance that the current trend may be coming to an end.


Molson Coors (TAP). The chart above is reflective of a large number of stocks that I follow. Stocks have risen for the past two months, many touching a resistance level in the form of a moving average. While most are only touching the 4 month moving average, Molson Coors has surpassed the four month average to touch the 10 month average.

When stocks rise, as they have over the past two months, they inevitably will pull back trying to find support. Usually, support happens over three periods. Thus, I am always looking for a three period test of the low. In the case of Molson Coors. The monthly low price occurred in October at 37.36. It rose in November and reached its peak in December at 49.89. Expect this stock to fall back. I would begin taking a position at 43 but if the market is very weak, expect a test of the 37 level.

I expect a number of other stocks to make the 3-month test of the low price in January. As a result of this overview, I expect stock prices to be weak this month.

Still, there are many opportunities in the market where you can make money regardless of the market move.


Ultra Short Dow (DXD). We purchased shares of DXD in our 2009 portfolio at the close on 12/31. Many investors lost heavily in 2008 not because of a lack of diversification in their portfolios, they lost because everything they owned went down. True diversification consists of assets that are not positively correlated. Had you been correctly diversified, your investment manager would have made sure that some of your positions were going up while others were going down providing you with a moderate return.

As both stocks and bonds rose and then fell together, many portfolios suffered heavy losses across the board. One way to manage a portfolio is to include shares of ProShares short or ultra short products. Reviewing both the S&P 500 and Dow Jones Industrial averages, at the end of the year, I felt that the S&P could fall around 6% while the Dow could fall 11%, reaching perhaps the 7,500 level. Thus I chose to include DXD in my portfolio. When it appears that the market has bottomed and found support, this position will be reduced or totally removed but for now, it stays as there are still heavy downside market pressures that will come to light soon.


Proshares Ultra Short 20 Year Treasury (TBT). The US Federal Reserve has been pushing interest rates down as a way to enhance liquidity in the financial system. US Congress and the Executive Branch have been spending furiously trying to preserve the banking system and most recently, the auto industry. Trillions of US dollars have already been spent and the new president has indicated that Trillion Dollar Deficits are likely to be seen for years to come. Despite the level of debt currently taken on by the US and the more debt that is likely to come, it’s beyond belief that investors could be happy buying US debt that pays virtually no interest! While the US will do everything it can to preserve the dollar and maintain steady interest rates, at some point, foreign governments who are currently buying billions of US debt are going to start thinking twice. In my world, when I incur more debt, my interest rates go up. At some point, investors are going to realize that they need to get returns for their investments. Rates will rise, bonds will fall and the dollar will most likely be under pressure. I recommend steady buying of TBT at these current low rates. This should be a core holding in your portfolio.


Crude Oil Total Return (OIL). An easy way to play oil. Who hasn’t heard that the price of crude oil has fallen from $147 a barrel to under $40. While the price of this exchange traded instrument isn’t the same price as a barrel of oil, it does track the price quite well and enables investors an easy way to participate in the oil market. After a nice rally, oil appears to be dropping but don’t wait for lower prices to appear. While demand is still weak, start building a position and buy more should prices fall. This also should be a core holding as a weak dollar will affect the price. Eventually, an improved economy will stimulate prices and OPEC’s constant manipulation with prices will also result in eventual higher prices.


Another good way to protect yourself from the effects of the falling dollar is to own GOLD. While gold and silver coins have been hard to come by lately because of hoarding, there are other options that investors can utilize to maintain a position.

GLD is a Gold Trust that tracks the price of gold without the inconvenience of actually owning to precious metal. I recommend taking positions in this entity but at lower prices. As the chart below indicates, GLD experienced a topping formation over the past two weeks and began falling. We will be adding positions of GLD as well as Barrick Gold (ABX) to managed portfolios at lower prices. You should also maintain a precious metal position in your portfolio. A lower priced stock that has been moving well with precious metals prices is Silver Wheaton Corporation (SLW).


While these positions should help you to build a healthy portfolio that will stand up to the worst news the economy can bring, there are other tactics that I am employing now to provide solid returns while having reduced risks.

As seen earlier in the newsletter, VOLATILITY LEVELS are at all-time highs. Those who follow the stock market closely are familiar with the VIX, a volatility index for options on the S&P 500 index.

The above chart shows the VIX index on a daily basis over the past year. Notice how dramatically higher this index rose when the stock market was falling. This index denotes fear and it indicates the premium that investors are willing to pay for portfolio insurance. And while the index has fallen substantially from its highs, high levels of volatility remain in today’s market.

While most investors wish to avoid volatility, in today’s market, this is virtually impossible. Here is a way that you can use volatility to help you generate a good return from your investments while managing your risk.


This strategy involves buying a stock and also selling an option related to this stock. What is a stock option? It is the right (but not the obligation) to buy or sell a stock sometime in the future at a specific price. Call options give the buyer the right to purchase a stock at a given price by a certain time in the future. A Put option gives the purchaser the right to sell a stock at a given price at some time in the future. For this right, the purchaser pays the selling a premium. Since premium levels are very high now, you can receive this premium amount to help define your risk and return in an investment strategy. I recommend that 40% of your portfolio at this time consist of this type of strategy.

For our 2009 portfolio, we established buy/write positions in AMR, BB&T, JB Hunt, Potash, Teva and Occidental Petroleum. I will illustrate the workings of the AMR strategy to show the benefits that such a strategy can bring.

On December 31, we purchased shares of AMR at 10.30 and sold a January 2010 10 call at 4.20.

The long term monthly chart of AMR shows that the stock dropped to $5 a share but appears to be making a base. Just buying the stock at $10 seems to be a good long term opportunity considering that the stock has been up to the $40 level twice in the past ten years. But for the moment, and with your money, I prefer to be a little more conservative. In this case, I bought the stock for $10.30 but also sold someone the right to buy the stock from me at $10. I will lose $0.30! But, for that right, the speculator paid me $4.20.

As the table above illustrates, we paid out $10.30 for the stock and received $4.20 for the option. Our net cash outflow is $6.10 or $6,100 for 1,000 shares. In January of 2010, should the stock be at or above $10 per share (it currently looks like an easy bet), the speculator who paid us $4.30 for the right will take the stock from us at $10 a share. Not including commissions, our gain per share is $3.90. As our cost per share was only $6.10, our percentage gain is nearly 64%. Since this transaction occurred at the end of December, 13 months remained so our annualized rate of return comes to 59%!

Sure, the stock could be at 20 or 30 next year should the markets turn around. If that is the case, then this strategy would appear to be foolish. But the strategy not only provides a substantial return for the next year, it also provides us with considerable downside protection should the market decline. AMR could fall to 6.10 before we would have a paper loss on our investment. But what is the worst outcome? We would now own AMR at 6.10 a share and would be free to again sell option premium for the next year out if we choose.

The stocks that I chose for our initial 2009 positions all provided at least a 20% potential gain with downside protection of at least 33%. If the overall market (and our stocks) dropped 33% next year, we would be at break-even (while your friends are suffering through the second heavy year of losses in a row).

Trendsetter is produced by Gary Lewis, CFP® and is intended to be of an informational nature only. Recommendations mentioned in this writing should be implemented only after reviewing your specific situation with your investment adviser or financial planner. Also, prices used in this publication change and could be very different than reflected here. Gary Lewis and his clients may own investments mentioned in this newsletter.

Gary Lewis’ portfolios take advantage of his more than eight years experience working as a specialist in the deriviatives industry and over 30 years working with investments. He specializes in designing portfolios that meet the client’s required rate of return with a minimum of volatility. Using a comprehensive financial plan as a starting point, Gary helps you to determine your action plan. If you wish, Gary can help you implement the plan so that you can achieve your future financial goals.

In addition to holding the Certified Financial Planner (CFP®) certification, he also holds the Chartered Financial Consultant certification (ChFC) and has earned an MBA in Finance from Northwestern University. Gary currently resides in Mexico City.

For more information, contact him at

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