Are the last several days of gains the beginning of a new bull market or is it just a breather in the current bear cycle? In other words, is this a treat or a trick?

The fundamental arguments concerning the extent of the credit crisis (perhaps for another year or more?*) and the strengthening of the greenback point to a protracted bear market. Sure, stocks may not have much farther to fall, but they probably won’t be breaking out of the gate anytime soon, either. Technically, the VIX is still high but if it fails again on Monday, I strongly urge you to either protect or dump your short positions. I don’t mean to frighten you, and although it’s a bit too soon to tell, the market could be staging a temporary comeback.

Even if the market firms up, it’s still not a green light. First, we have to get through a presidential election followed by the meeting of the G20 on November 15th. (FYI, the G20 is an annual meeting of serious financial suits from 20 advanced and emerging market countries. This year Brazil is providing the tea and scones. The major topic will undoubtedly be the global credit crisis and the rising dollar. I’m sure the talks will be accompanied by a lot of finger-pointing directed principally towards the US along with a chorus of me-need-da-money rap tunes.) Many market pundits don’t know what to expect from this summit and I certainly don’t. Since nobody knows anything, adopting a wait-and-see stance couldn’t hurt.

The past few days of positive price movement might have been nothing more than end of the month window dressing and portfolio rebalancing. I can’t tell. Next week, we could be in for another wild ride due to the elections. (Unless the Obama win is already priced into the market.) I apologize that I can’t offer anything more concrete; I don’t think anyone out there can either at this point.

So, protect your short positions and be judicious in taking on any long ones–just don’t be left holding the bag. Unless it’s filled with candy.

Happy Halloween from all of us at the Stock Market Cook Book!

*For an excellent article on the future of this recession, see Jim Jubak’s column today on MSN MoneyCentral: What’s scary about this recession?

Yesterday we looked at the Buy & Hold (B&H) strategy from a historical perspective and saw that portfolio returns are a function of when one decides to enter into positions as well how long one holds onto them. Today, we’ll look at how adopting even a simple market timing strategy can significantly increase your portfolio returns.

A market timing strategy
I came up with a simple market timing strategy and tested it out on the S&P 500 index tracking stock, the SPY, over the past ten years. The results were so far beyond my expectations that I couldn’t wait to share the results with a few friends. Not only were they impressed, but they all said, “Hey D.K., you’re not going to give this one away, are you?”

Yes and no. I’ll show you the results but I’m going to keep my timing scheme proprietary because I do think it’s a marketable commodity. I’m sorry, but I confess to being a capitalist, and although I do love writing my blog, my ultimate goal has always been to turn it into a money-generating enterprise.

The strategy that I devised was very simple. It identified two bull markets and two bear markets (including the one we’re in now) in the past ten years. (My charting and simulation software only has data going back to 1998.) The beauty of this strategy is that it required only four trades in 10 years; on average, that’s one trade every couple of years. Or if you just wanted to play up markets, that would be only two trades in ten years. Making even this minor portfolio adjustment results in a big pay-off as we’ll see in the table below.

B&H versus market timing
I ran four simulations from 2/6/98 – 10/29/08 trading the SPY only. The first simulation was a pure buy and hold strategy; that is, I bought my full SPY position on 2/6/98 and exited it yesterday. In the other three simulations, I used my market timing scheme. The long-only portfolio involved being fully invested during bull markets and going into cash when the market turned down; vice versa for the short-only portfolio. The last simulation was a combination of the previous two—that is, I bought the SPY during bull markets and shorted it during down markets.

Simulation parameters:
$10,000 initial investment
100% margin requirement (essentially no portfolio leverage)
Full cash position used per trade
2% account interest; 3.5% margin interest (default values)
$9.95/trade commissions (no reg. fees included)

[Note: ARR = annual rate of return]
[Click on table to for a larger view.]

The results
Wow! You can see that the pure buy and hold strategy is vastly inferior to the market timing strategy. Even if you only played the long side, you’d be in cash during the down cycles where your money would be earning interest (especially if you put it into higher paying vehicles such as short-term CDs). By far the most profitable approach is to play both sides of the market. Here, you have the advantage of compounding your return even further than if you only play one side. Note also that the market timing scenarios resulted in much smaller drawdowns, an obvious observation as larger drawdowns are expected when the market is moving against your position.

Summary
We’ve shown here that even a simple market timing strategy provides superior returns to the traditional buy and hold mantra. There may be other timing schemes that offer better results, but I haven’t been able to come up with one that’s as simple to use nor as effective.

To we continue with Monday’s theme of examining the concept of buy and hold (B & H) from a historical perspective. Before we begin, I want to step on my soapbox for a moment and look at how most of us are duped into thinking that this is the superior stock strategy. I have two words for you: Warren Buffett. Don’t get me wrong, I respect and admire the Oracle of Omaha for how he manages both his personal and professional life. I believe he’s a person of great integrity and of course he possesses an astoundingly astute sense of business. But what I don’t like is how people have taken his business philosophy and applied it to their own situation. “If it works for Buffett, it’s gotta work for me.”

Why B & H works for Buffett
But does it? Is there perhaps a difference between Joe Investor and Warren Buffett? Besides $50 billion or so? Yes, there is—and the difference is a big one. First of all, Buffett has a cadre of lackeys who do nothing but pore over company financials searching for the next big bargain. When they find one, Buffett steps in and wangles a great deal. He’s able to do that because he knows how to do it, he has oodles of dough, and because he is, well, Warren Buffett. Now that he owns the company, he can insert his own management team or he can “guide” current management and let them run the business with them knowing that at any time they could be ousted. You’d better believe that Buffett will try to do everything he can so that his latest acquisition won’t fail, because if it did, he might lose the Oracle title and I’m sure he wouldn’t be happy about that.

Can you see the difference between Buffett’s buy and hold strategy and yours? You buy into a company hoping that what is written on its balance sheet accurately reflects its current condition as well as future sales projections. But unless you’re very wealthy, you won’t have the means to buy enough shares of the company to have a say in how it’s run. For example, you can’t tell the CEO that if his company doesn’t meet expected benchmarks, he won’t get his year-end bonus nor his stock options, can you?

Even John Bogle, the founder of the Vanguard Group (of mutual funds), firmly adheres to the buy and hold forever strategy. (See his “Little Book of Common Sense Investing.”) The key word here is “forever.” Yes, buy and hold works when your time horizon is on the order of 35+ years, but many of us don’t have that luxury. So, how effective is it in the shorter term?

When B & H doesn’t work
Let’s take a look. Here’s a chart of the Dow Industrials from 1905-2005.* You’ll see that there have been three major bull markets in which the vast majority of gains were made interspersed with three bear markets where gains were negligible. Note, too, that the length of bear markets is much longer than bull markets, with the average being 19 years compared with 12.

Let’s look at several examples of what a pure buy and hold strategy might have produced.

Example #1: A 30 year old man starts a retirement account in 1930. If he wants to start drawing from it at age 55, he will have had no gains at all! And if you count in a 3% annual erosion due to inflation, he’ll have considerably less. Twenty-five years is a long time to suffer. (Yes, I know in hindsight this is the worst case scenario, buy hey, stuff happens and there’s no guarantee we’re not looking at a similar situation today.)
Example #2: A 38 year old woman starts her retirement account in 1966. She finds that when she wants to start withdrawing from it 17 years later there’s less there (due to inflation) than when she began.
Example #3: A follow-the-herd investor finally jumps on the tech bandwagon near the end of the bubble when the Nasdaq was trading around 4500. Nine years later, his portfolio is down 63% in asset value alone.

Do not let this happen to you! Sure, asset allocation may help counteract the losses caused by poor market timing but very little in today’s environment (other than holding short positions) will help you. In summary, buying and holding is for investors with extremely long time horizons and even then, I believe that a market timing scheme, even a simple one, is preferable.

Tomorrow, we’ll look at some market timing schemes that anyone can use and see how they compare with each other. Don’t miss the rest of this valuable series!

[Note: The chart is in pdf format which means you’ll need Adobe Acrobat reader installed on your computer.]

Wah! I decided to catch up on some paperwork this morning instead of my usual routine of chart surfing and consequently missed a great one day play in MANDA, my mergers and acquistions fund. I changed my routine for two good reasons: the credit chill has put the kibosh on M&A activity and I said that I wouldn’t be making any new M&A purchases until the credit market thaws.

However, rules are made to be broken and I missed a golden opportunity this morning when, out of the blue, Apria Healthcare (AHG) announced that its proposed merger with the Blackstone Group (BX) would close later today. The deal was originally announced months ago and since then the stock has steadily fallen from $20 to $14 on fears that the deal might die. In this environment, who wouldn’t be afraid? Anyway, the stock opened up this morning at $20.25, sank to a low of $19.66 two hours later, and has just closed the day as well as its life as an independent company at the buyout price of $21. This was a done deal and would have returned a nifty 3.7% if I had bought on the open; had I been outrageously lucky and bought at the morning low, my return would have been 6.8%–not too shabby for a one day payout! But I missed it, and now I’m crying in my coffee. WAH!

The takeaway lesson here is to expect the unexpected, no matter what the market climate is.

MANDA Updates
Since the last update several weeks ago on October 3rd, Lincoln Bancorp (LNCB) posted a fourteen cent dividend in line with its past four years of quarterly dividends. Rohm & Haas (ROH) announced it will be paying its fourth quarter dividend in line with the previous two quarters. In my last update I said that I would set a stop/loss on Rohm & Haas if it fell below $60. Well, it did and the reason I didn’t pull the trigger was that the move occurred on October 10th, the day the market fell to its lowest intraday level in years. I vowed that if the stock closed the day under $60, I would sell it but a huge end-of-day rally kept it off the chopping block. Whew! Glad I waited on that one!

I wish I could say the same for Bluegreen (BXG). In hindsight I am glad that I finally dumped it when I did as it’s dropped another 30%. However, had I gotten out when I said I would when it closed under its $9 support level on September 15th, the MANDA portfolio would only be down less than 4% instead of nearly 13%. This just shows you how one bad loss can wreak havoc on an otherwise solid portfolio and why setting stop losses is so important. [I hope I’m listening to this.]

Tomorrow I’ll have some results on the buy and hold strategy. So far, the results are quite interesting.

[Click on images to see a larger view.]

That is the question. To paraphrase Hamlet, “Is it nobler to buy stocks now or wait until complete market capitulation when there’s a good chance we could miss out on a major rebound?” Financial pundits have lately been decrying that NOW is the time to get into stocks. They say that many companies have been unfairly beaten down to prices that are well below historical fundamental levels. They’re looking at P/E ratios (price to earnings), price to book (how much a company’s assets are in comparison with market capitalization), price to growth, price to current sales, price to projected sales, etc. And I don’t disagree with them. Many stocks do look enticing, but the real question is:

Can these stocks drop further?
I believe the answer is yes. The major reason the market has dropped so precipitously is because of massive redemptions on the part of hedge funds and mutual funds. They’ve got to get rid of their inventory and they need to do it by yesterday. Jim Cramer pins much of the redemption frenzy blame on hedge fund of fund managers whom he feels are one step below pond scum on the evolutionary scale. These managers buy and sell hedge funds much like an investor buys and sells mutual funds or individual stocks, so when a particular hedge fund is not performing, these fund of fund managers will pull their position forcing the hedge fund to divest itself of its holdings not to mention its business. (Cramer figures that roughly 30% of all hedge funds will not be around a year from now.)

When can we expect a bottom?
To answer the above question, we need to first answer this one: Are the hedge funds done selling? It’s tough to know but one way for the retail investor to tell is to look at volume. The volume on the Dow has been heavy during the past two weeks of selling. Today’s volume is on the light side with the Dow essentially unchanged (as of 3:30pm ET). Every time buyers step in, so do the sellers which means the selling pressure is not over with yet.

I know I’ve mentioned this before but technically I believe the S&P 500 needs to test the 800 level and the Dow has to test the 8000 level. I do believe the VIX will reach 100 before the market finds a bottom. The problem is: I honestly have no idea how low this market can go. Basically, I have no clue as to how much more hedge fund redemption there is left to unwind.

The bottom line
To use CNBC’s Bob Pisani’s catch phrase, the bottom line is that unless you’ve got a very long time horizon, buying now could be detrimental to your portfolio. If you truly believe, however, that a stock you love is a bargain, try averaging into it by buying a quarter position at a time. Sure, we don’t know when the bottom is going to hit and when it does, the market could rebound through the roof. Am I sure of that? I’m not sure of anything, but I do think there’s a good chance it will do just that, but will that be enough for you to make money? Let’s consider an example.

Example of how far the market needs to rebound
Suppose company XYZ’s stock was trading at $100 just before the onset of the credit meltdown. In just the past two months, it’s shed 50% of it’s value and is trading at $50. You think now is the time to step in so you buy your full position. The market keeps tumbling and the stock sheds another 50%, down to $25.

Feeling like a fool, you pray for a market bottom. The Good Witch of the Market hears your prayers and stops the bleeding. A bottom is formed. How much will your stock have to rise for you just to break even? One hundred percent, of course. That’s a lot to ask of a market rebound. But don’t feel too bad—just think how awful you’d feel if you had bought the stock at $100 and are still holding it, like the majority of people with retirement accounts. The stock would now have to rise 300% just for you to break even, and how long to do you think that could take? According to a report I heard on CNBC earlier today, since the depression the average bear market takes three years with the longest bear market lasting eight years. Eight years! Do you want to wait that long for your portfolio to recover?

I think not. So that’s why for the next day or two I’ll be examining the buy and hold philosophy and comparing it with ones based on market timing and various stop/loss criteria. I’ll also examine how shorting in down markets affects portfolio returns. So toss another log on the fire, wrap yourself in your fuzzy throw blanket, brew a cup of cocoa, and settle in for some analysis and discussion of this very important concept that I believe is deluding many people into thinking their retirement accounts are safe. My goal here is not to scare you but to arm you with the appropriate knowledge so that you, too, will be able to avoid “the slings and arrows of outrageous fortune.”

Continuing with my miniseries on capturing high options volatility by selling option premium, today we’ll be looking at covered calls on high dividend stocks. I’m purposely selecting high dividend stocks so that even if the stock drops further, we have the added cushion of a dividend. So far, all of these companies have been faithful in paying their dividends. (If you’re unfamiliar with options, please check out the resource links for educational info. The covered call strategy is discussed in detail in Recipe #7: Covered Call Casserole.)

The set-up
I’m looking for richly priced options on lower priced stocks that pay a decent dividend. I’m also looking for at-the-money or slightly out-of-the-money options. The further in-the-money an option is, the more downside protection you get. Here are my input parameters:

Stock price < $50
Dividend Yield > 3%
Current option volatility > Historic volatility
Open Interest > 50
Downside Protection > 5%

The results
Here’s what my options search software spit out. Although none of these trades are risk-free, the top five are the ones I feel have less risk associated with them compared with the bottom two which are financial stocks. Out of the top five, three are shippers (you’ll note that Diana Shipping was on the naked put list a couple of days ago, too), one jet leasing company (Aircastle), and one utility (Ameren).

All of the companies including investment house Blackstone are still paying their dividends, although Aircastle and Golar cut theirs this year. Diana Shipping actually increased its dividend. Nice! My problem with Blackstone is that its price support level is tenuous. If you still like it, you might want to wait a couple of days to see if its support level holds but note that you’ll be exchanging a reduction in trade risk for a smaller options premium. (The higher the price of the stock, the more expensive the call option and vice versa.)

[In the following table, D/P= Downside Protection; % Un = % Unassigned; % Assn’d = % Assigned. Click on table for larger view.]

Other strategies
Writing calls that are deep ITM (in-the-money) is one way to decrease your downside risk. However in this scenario, if your stock doesn’t fall below the strike price of the written call, you risk losing it, especially near the expiration date.

That’s it for now.

I’m in the midst of putting together today’s blog and watching the VIX (volatility index) climb into new, uncharted territory. It just topped 78–an all-time high in this current incarnation, and the way its daily chart is looking, I don’t think that 100 is out of the question. In fact, a check of the movement in the other major indices appears that another significant downturn is in the cards unless they can hold current levels which I think unlikely. Support for the Dow is 8000; for the S&P it’s 800, and the Dow Transports–a leading indicator of market direction–is sitting right on support at 340. If you think things are grim now, wait until next week. It could be scarier than a haunted mansion full of trick or treaters; think Nightmare on Wall Street.

HOWEVER! This is pure extrapolation from what the charts are telling me, and I hope this time I’m not right. Even though I do feel the other shoe in the unwinding of the credit crisis hasn’t dropped yet, I do think it prudent to start protecting your short positions, especially if you’re holding ultrashort ETFs. BUY SOME PUTS OR COVERED CALLS ON THEM NOW! We’ve seen how quickly they can turn against you. Don’t be left holding the bag again.

Protect your positions. DO IT NOW!!!

–A public service announcement from Dr. Kris

Oil continues its decline falling by over $5 today. I mentioned pure oil plays in last Thursday’s blog (“Texas Tea Proxy Plays”) and want to mention that going long the airline stocks is another ancillary way to profit from the drop in oil.

Most of the major US air carriers have staged significant comebacks on the order of 200-300% in just the past week! Many are on the verge of breaking out of their bases, most notably Airtran (AAI), United (UAUA), Northwest (NWA), Delta (DAL), Alaska (ALK), and American (AMR). Most of the stocks hit the ground running this morning and I thought that many of them would break out, but the airline rally starting losing steam by midmorning and has taken a nose dive in just the last half hour (3pm ET). Northwest (NWA), for example, was down $1.65–20% off its intraday high just a couple of minutes ago but is now charging back and is up almost a point since I began this paragraph. Talk about intraday volatility–wow! [Chartwise, I saw this turnaround coming as it put in three long bottoming tails on the 5 minute chart just before exploding to the upside.]

I’m not here to relate intraday movements but I couldn’t resist as today has been an exceptionally wild ride for the group. My purpose here is to give you some airline plays that are viable for the next couple of weeks, or until oil finds a bottom and begins to turnaround.

My airline picks
The above mentioned stocks sport the best charts with Air Tran (AAI) looking to be the best of the bunch. It’s also the cheapest one of the group currently trading at $3.36. The November options field isn’t very robust but if you’d like to own the stock at $2.50, you could sell a cash-secured Nov 2.5 put (open interest = 10). The current price is $0.15 x $0.25 and you might be able to pick it up for $0.20 which amounts to an 8% naked yield. Plus, the option is trading at a premium which we love when selling options. (See Recipe #6 for strategy details.)

As part of my mini-series on taking advantage of high options volatility, today we’re looking at selling cash-secured puts to not only generate income but as a tool to buy high dividend stocks that you’d like to own. Note that this option strategy IS allowed in retirement accounts (check with your broker). If you’re unfamiliar with this strategy, please review Recipe #6: Put Pot Pie located under Recipes and Cooking Tools, and if you don’t know anything about options, DO NOT ATTEMPT THIS NOR ANY OTHER OPTIONS STRATEGY! At least until you paper trade it for a while. (Sorry for yelling but I can’t emphasize this enough–options are not as simple as most people will have you believe. They’re like anything else–you need to get some experience before you can start making consistent money with them.)

The set-up
I’m looking for rich options on lower priced stocks that pay a good dividend. Here are the parameters I input into my options strategy software:

Stock Price < $50
Dividend Yield > 3%
Black-Scholes ratio (historic) > 1 (looking for overpriced options)
Black-Scholes ratio (SIV) > 1 (looking for overpriced options)
Open Interest > 100 (to provide liquidity)

The results
Here’s the chart of my four picks: (Click on chart for larger view.)

It’s no surprise that it’s comprised of two real-estate investment trusts (REITs) and shippers. This list is meant to be a springboard for your own research. If you like any of these, wait until the stock trades at a relative low and put in a limit order (usually between the bid and the ask). Remember to make sure that you have enough cash in your account to cover the cost of the stock should you be forced to buy it and check with your broker concerning margin requirements. (If you have the cash free and clear it shouldn’t be a problem.)

All of these stocks have been badly beaten down, but that doesn’t mean they can’t drop further. I just think that even if you did apply this strategy and got the stock put to you, at least you’ll have a juicy dividend to assuage your grief, not to mention the extra downside protection afforded by the sale of the put.

In the next couple of days, I’ll be looking at other high-dividend stock plays as well as premium-rich covered calls.

Excelon makes a stock swap bid for NRG
Two major deals were announced today. The first was Excelon (symbol: EXC), the largest nuclear power operator in the U.S., announcing a take-over bid for NRG Energy Inc. (symbol: NRG). If the merger goes through, the combined company would be the largest energy provider in the country.

The proposed deal is a $6.2 billion stock swap: 0.485 shares of Excelon for one share of NRG. Based on Friday’s closing price, that translates in $26.43 for one share of NRG–a 37% premium over Friday’s closing price of $19.33. I’m not buying NRG for the MANDA Fund right now for several reasons.

Fundamentally, NRG is groaning under $8.1 billion in long-term debt which could lower Excelon’s credit rating. The deal is subject to regulatory approval which Excelon believes can be achieved by “modest divestitures of some assets.” The unsolicited offer is currently being reviewed by the NRG suits. If it they reject the offer, a hostile takeover is likely; if they accept it, the deal will then require approval of both companies’ shareholders, and most importantly, will be subject to due diligence. [Aside: It was this due diligence process that effectively tanked the BXG takeover recently forcing me to sell it in MANDA, although the deal is not completely dead.] If the energy and utility sectors keep dropping, Excelon can use the due diligence excuse as a way to worm out of the deal.

Technically, I’m not a fan of stock swap deals, especially in a declining market. Even if the deal is approved by both companies, it probably won’t close until at least the first quarter of 2009 and who knows what will be the price of the market and Excelon stock? Adding to that, our new commander-in-chief may have his own ideas on energy policy and corporate taxation, as if we need to throw another factor into this already loaded equation. So, no thank you for now. But I’m keeping this one on my radar screen.

CEO of Landry’s Restaurants seeks to buy outstanding shares
The CEO of Landry’s Restaurants (symbol: LNY) lowered his bid to purchase the outstanding shares of his company for yet a third time this year. The first time was in January when he offered $23.50 a share. The second time was April when the price was lowered to $21 a share. Today, the offer was lowered to $13.50 a share. Sound like a bad deal? Not when you consider that $13.50 is a 49% premium over Friday’s closing price. Will the deal go through this time? I don’t know, but people are staying away from restaurants in droves, and if this situation continues, the prospects for financing grow dim. The deal is expected to close before February 15, 2009 which is the expiration date of the lenders’ financing commitment.

At least this is a relatively “clean” deal, that is, no regulatory issues need to be addressed, there’s no due diligence, and there’s no stock swap—just clean, cold cash per share. I like all of that. But I’m not in this one, either. Before I make another MANDA purchase I’ll need to see the credit market stabilize first…and that could take a while.

Upcoming blogs
I know I keep promising high dividend plays and hopefully tomorrow I’ll be able to provide you with some good candidates for your income portfolio and/or retirement accounts. The VIX is coming down and I do also want to give you some solid covered call candidates so that you can profit from inflated options premiums. Maybe I’ll tackle that one first…