Sunday, March 1, 2009

Dow and Other Indices Tumble to New Lows

Dow Tumbles to New Lows

The Dow Jones Industrial Average plummeted 938 points in February, falling 11.7% from January’s close. Breaking below the long-term neckline around 7,600 was a wake-up call for myself. I had high hopes that the average would hold this line and had identified dozens of other stocks that appeared to be testing low levels.

As discussed in previous writings, one must stick with the trend as long as Size, my volatility indicator, continues to rise.

Size, or volatility, as a percentage of the current Dow average is nearly 25%. This, by far, is the most volatile time in the stock market at least since 1979, the beginning of my market information database. Even the great crash of 1987 saw volatility increase to 15% and during the 2002 decline, volatility levels reached 11%. For some investors, high levels of volatility is bad. But for others, volatility is good. Higher volatility offers the possibility of higher return for those willing to participate and invest in such a market. A case in point, the 10 month average for the Dow Industrial Average is currently above the 10,000 level. As in most “normal” observations, one can reasonably expect prices to revert to the “mean” or average once some certainty is restored to the market. Such a move now could result in a 40% gain!

One way to exploit high volatility is by selling options. An important component of an option price is volatility. As such, premium payments received for selling options now can be quite high. In our initial portfolio for the year, we bought some stocks but also sold stock options expiring in January 2010 to add some protection against possible downside. Despite huge moves in our stock and option positions, our base $100,000 porfolio stands up about $1,800 on the year or +1.8%.

The model portfolio held up well despite the current market volatility. Most of the individual stock issues were hedged with offsetting long term call options designed to enable us to weather a 30% or more drop in the stock price without us losing in the position. Despite our hedging attempts, the severe drops in BB&T, a Southeastern banking concern and AMR, the American Airline holding company, both dropped significantly. Our breakeven prices for BB&T is 21.46 and AMR is 6.47. The Kroger position is unhedged and is down from the $26 level.

The bright spots in our strategy was selecting the Dow Industrial ProShares Ultra Short instrument which rises 2% in value for each 1% the average declines. Our second best position was a similar position for the bond market.

As the monthly chart above illustrates, bond rates jumped sharply from the panic lows set in December. Bond prices fall when rates rise. Rates may continue to increase a bit more, perhaps reaching the 4% level on the 30 year index. Expect rates then to fall back in March and perhaps April as the market tries to test the rate lows of 2.69%. Successful support here would prompt me to add to my position both using Exchange Traded Funds as well as shorting bond futures and calls on the futures. While I am standing pat in the long term core portfolios and continuing to hold the Ultra Short Bond positions, in our high performance managed accounts, I am shifting our short term bias to be bullish on bonds.

I expect that rates will not go below the previous low of 2.69% but I also did not expect that the Dow Average would break below 7,500. As mentioned before, once momentum begins, there is no telling where it will end. We also face the possibility of government intervention in the bond market. While the Federal Reserve did not actually enter the bond market in December or January, the discussion of this possibility to reduce interest rates and increase the availability of low-cost credit caused the rates to drop precipitously as seen in the chart. Should the markets continue to move lower, as all evidence indicates that they will, expect the Federal Reserve to at least begin discussing their intentions to do everything they can to bring down interest rates in the hopes of stimulating the economy. As one famous investor commented when asked why he is not currently shorting the bond market, “the Fed has more money than me.” Such a move by the government can reduce rates to any level they wish as traders will have no recourse but to step aside. But in my mind, this type of action is one of the key reasons why the markets are falling as they are. They are no longer free markets.


Getting stronger by the day is the US Dollar. I regret that I did not become an Economist as I fail to understand the logic behind the increasing value in the dollar. In my training, I learned that there were principals of supply and demand. The more supply that is available the lower prices should be and demand should not consume the higher supply. This concept does not hold true for the US Dollar nor for US Government debt. The US Treasury continues to auction off more debt but interest rates remain low. The Federal Reserve continues to print trillions more dollars and the value of the dollar goes up. While most of us probably are not going to review the Federal Reserve’s balance sheet to see exactly what kind of assets are backing the integrity of the US Dollar, I can attest that some of the collateral is so-called “Toxic Assets” named Maiden Lane. This is the toxic debt of AIG. The majority of the balance sheet, providing the backing of the dollar is Treasury securities. Imagine the incentive that the Federal Reserve has in keeping the value of Treasury securites high. Falling bond and note prices would undermine the integrity of the dollar! I believe that it is just a matter of time, no matter what the government does, before the US Dollar will collapse.

At some point in time, ESPECIALLY if the economic downturn continues, we are going to see China start selling treasury securities. We will see Saudi Arabia and other countries dollar rich through oil sales needing to raise capital. Will we let them continue to hold their treasury securities and offer them financing? I imagine that the US Government and Federal Reserve will go to great lenths to preserve the value of bonds and the dollar, but it can’t last. When bonds and the dollar collapse, where will one be able to find some investment security?

Thus far, I have had success with our prime hedges in the core portfolio: the short dollar and short bond positions. Also, I have been accumulating positions in OIL, an exchange traded security that moves similarly the the oil futures market. While I have made two OIL purchases thus far in the core portfolio, in other accounts, I have purchased shares incrementally down to the $14 range. I will continue to add as prices warrant. I have also established positions in a Gold exchange traded fund, ticker symbol GLD. Hard assets such as oil and gold should rise when the dollar declines.

In addition to gold and oil, other defensive exchange-traded vehicles to consider are the PowerShares US Dollar Bearish fund (UDN) and the PowerShares Agricultural Fund (DBA). As I discussed, I believe that the underlying assets supporting the dollar will eventually decline perhaps resulting in a mass exodus in the Dollar. Investing in hard assets that have some tangible value will prosper. While I have not gotten technical buy signals on UDN or DBA yet, I have begun to establish pilot positions in certain managed accounts and recommend that pilot positions be established in most portfolios.

The theme here is to be defensive in your positions. A big reason why so many lost so much money could have been because although portfolios might have been diversified, the assets were too correlated, meaning that they all moved up or down together. It’s important to have a good variety of uncorrelated assets even including put options against an existing stock or portfolio, short calls, exchange traded short position funds and other instruments that will move up when the stock market moves down.

When selecting your money manager, make sure that he or she is competent in all available instruments to help you design a portfolio providing the return that you require at the least amount of risk.


Surpringly, a number of retail stocks appear to be in a good position for accumulation. Consider adding Kohls to your portfolio but as with all other stock purchases at this point in time, I also recommend that you sell a January 2010 call option to protect yourself in the event of further decline. Currently Kohls sells at $35.40. The January 2010 $35 call is currently fetching $7.20. Buying the stock and selling the call would result in a cash price of $2,820 per 100 shares with the potential maximum gain of $3,500 or more than 20%. If you are even more risk averse, consider selling the $30 call against the position. With the call fetching $9.80, your cost would be $2,560 with a potential payout of $3,000, still a strong return given our current market – while receiving 30% downside protection.

While the buy list this month is limited as most stocks made new lows along with the indices, there appear to be some opportunities not only in retail but technology as well. We will be adding the Kohls buy/write position to the core portfolio at the market open on Monday morning.

So many people are confused now. What do I do? Whom do I trust? The problem is though, most people don’t know what their financial position is now nor what they need to do to achieve their goals. I always strongly recommend that you engage in a comprehensive financial plan to first, establish what your goals are and to see what condition you are in today. You need to visit not only your investment holdings, but also your cash reserves, your tax situation, your insurance and other important areas of your financial life. Only then can you even begin to understand what you need to achieve financial success.

Too many people are only interested in making as much money as they can. We have been told over and over again that we need to be patient and diversified but our current situation shows that perhaps the conventional wisdom just doesn’t hold true anymore. While the classic Brinson & Associates study showed that 91% of wealth was gained through asset allocation, ask anyone who invested in the last 10 years and they will tell you that this ain’t necessarily so! So what is the solution? What do we do? How should we invest?

Being diversified in line with modern portfolio theory appears to work in some years but not others. I remember, years ago, as a mutual fund salesman, I was impressed with a certain fund that returned 10% every year. When compared, over time, with the high tech funds that returned 80% in some years but down 40% in others, the slow and steady 10% outperformed the rockin high tech fnd! How hard is it to earn 8% to 10% annually with a low amount of risk and a high level of probability??? Not as hard as you might imagine. Just look at our example with Kohls Department Store. We can develop risk management strategies using options sold against our stock position to reduce our risk and define our return. A well rounded investment professional with experience in stocks, bonds, derivatives and other investment tools can design a portfolio providing you with a high probability of receiving the return you require with a reduced level of risk. If you knew that you could achieve your goals by being conservative, why would you not do it? Achieiving financial security in your lifetime should be your key financial goal.

Who would go to the doctor and learn that they had a serious ailment and ask the doctor for a more risky remedy than they needed? It could be suicide! Why risk financial suicide? You need to understand what your required rate of return is and achieve this goal with the least amount of risk possible. If you have additional funds outside of your goal setting savings, only then should you consider riskier investments.


Many in Mexico have been reluctant to invest now in the US as the US Dollar is too expensive. But despite Mexico’s very strong balance sheet. the value of the peso has continued to plummet against the US Dollar. As the next chart shows, the momentum continues to be strong (in favor of the US Dollar). At the end of January, one dollar bought 14.34 pesos, up sharply from the steady state between 10 and 11, that the peso enjoyed for so long. At the close on Friday, the dollar bought 15.25 pesos, an increase of 6.3% in February. While the Mexican government has tried intervening to defend the peso, at some point in time, they will have to abandon their defensive posture. Until the US economy shows signs of improvement and oil prices begin rising, the outlook for the peso is not good.

Owners of Mexican Pesos would do well to hold at least a portion of their cash holdings in US Dollars or even better – gold or silver coins. Another important reason to hold some investments in the US is the availability of products that you can use to truly diversify your portfolio.
Trendsetter is produced by Gary Lewis, CFP®, ChFC, MBA 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 almost 20 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 including a pdf containing illustrations, contact Gary at
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