Weekly Update Ending December 5, 2008

Resilient Despite Economic Woes!

The market lost 2.3% on the S&P and 1.7% on the NASDAQ last week but that performance was much more interesting when viewed in context of what transpired. We expected a pullback following the extreme performance from the prior week and the market responded by dropping 8.9% on Monday to start the week. But then, the market showed its resilience by increasing 7.3% over the next four days despite an avalanche of bad economic data. The strength shown by the market was very encouraging in light of an economy that continues to worsen. No doubt the economic woes will continue well into 2009. However, the market appears to be showing more resistance at current levels probably due more to the fact the market had been way oversold even after consideration of the ongoing and deep recession.

Economic Conditions Worsen!

We finally got the official word on what we all already knew, we are in a recession! In fact, the experts now say we have been in recession for one year, since December 2007. That is no surprise to us as that has been our prediction all along. But last week brought stark data on just how bad the economy really is. The ISM manufacturing index came in at 36.2, the lowest reading since 1982 and far below the level considered contraction. The ISM Services index also hit record lows. November same-store sales reported declines and continuing claims for jobless benefits reached a 26-year high. Some reports have the percentage of home loans at risk of default (foreclosed loans and those with late payments) at record levels. Of course, the biggest news was that payrolls declined 533,000 in November, the largest decline in 34 years! Obviously the unemployment rate continues to rise as companies across many industries rush to announce more job cuts. The automakers testified on Capitol Hill to receive bailout funds, but no agreements were reached. The prospects for the auto industry are indeed very dim, as GM reported a decline in November sales of 41%. On a positive note, the government is looking at initiatives to help drive mortgage rates down and interestingly, mortgage applications showed an increase over the prior week. Also, gas prices continue to fall after hitting a 4 year low, and lower prices will help improve cash flows and confidence. But the real story is housing and employment, both of which have to improve before the economy can make headway and start growing again.

Market Beating Foresight

Despite the overwhelming bad news, the market only lost 2.3% and in fact, gained significant ground over the last four trading sessions. What could account for this resiliency? We think the stock market has reached oversold levels given a 53% decline since October 2007 highs. That and the fact that the market has largely already accounted for much of the bad news just released. There is little doubt in our minds that the economy is bad and that only time and perhaps government intervention can turn the tide. Next week will bring additional reports on unemployment and retail sales. In addition, there is speculation that a bailout plan for automakers may finally be settled. Given the weight of bad economic conditions, the government will likely implement other initiatives to help provide support for the economy. Obama will likely push additional measures when he takes office in the new-year. These efforts will help the economy over time, but it is still likely to be well into 2009 if not year-end, before we start to see an economic revival. Short term these government measures will help, but we are also concerned that inflation over the long term may again rear up as we struggle with growing budget deficits as a result of government interventions. The market has risen in eight of the past ten trading sessions, a remarkable feat considering the plethora of bad economic news. We view this as a positive sign for the market, a sign that lends support to the argument the market may have established a trading range bottom. We think the worst may be over for the stock market, despite the poor economy. However, that does not mean the market will not drop further, in fact the market trend will likely remain very bumpy or even rocky over the next three to six months.

Market Beating Options

The Market Beating Options Portfolio ended the week up strong and now sports an exceptional 263% return since January 2007. Year-to-date, this portfolio continues to beat the market return by a large margin, with an excess premium of almost 30%! We mentioned in prior discussions how to make money writing options as the risk premiums remain quite high given recent market turbulence and the extreme volatility. The spread position we entered against the market index remains in positive territory, but is now teetering with an index trading at levels near the exercise price. We still may get a market pullback this week, which may put this position back in the red. However, the spread options expire in two weeks, and we still think the market will close above 875 (our exercise price) as the general market selling pressure subsides. In the prior week we also sold to open a put option (VIXXN) on the CBOE Volatility Index with an exercise index of 60. Option premiums are still high given the extreme volatility we have seen over the past two months and we thought we would take advantage of that. The volatility index remains above 60, but is trading at levels near the exercise price. We made huge gains last week on this position with the option increasing in value 48% just last week alone. The option expires in less than two weeks and we still expect to make money. However, volatility may start to trend down which is a good thing for the overall market, but not for this position which would put us at risk for losing some of our gains. However, for us this was a very short term trade that is also a hedge against the overall market. For example, if the market does well this position may lose money, but this position will do well if the market convulses. In other words, if we lose on this position because the market does well, that would not be bad since our long position gains will more than make up for the loss. Our other position, a long term call option on the market index, was down slightly in line with the overall market decline, but we think this option will do very well over the next year as the market recovers.

We still think there are option plays that can be very profitable given the volatility and price swings that are occurring regularly in this market. We expect the market to swing wildly up and down within a trading range of 825 and 900 over the next month or so. With that in mind, we are looking to trade both a call and a put on the market index with the same expiration date. We are looking to buy an 850 Jan 09 call and an 875 Jan 09 put if we can get in at good prices. If we can get in at good prices, we will sell each position after the market swings in the right direction after target gains of 20-30%. We will also look for additional spread positions for writing options, but will only consider those with exercise prices that are more than 10% from current market prices and with very short durations. With daily market swings of more than 5% occurring frequently, writing options is risky and investors need to manage risk by limiting their risk of loss. We are still not ready to begin buying straight call options on individual stocks as the short term direction of the stock market is still volatile and difficult to predict, with the 3-6 month outlook very uncertain.

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