Reflation trade stumbling

Trends reverse asset class by asset class. Here’s where the reflation trade stands about two weeks past its possible peak:

Gold and silver: Nice, clear tops and solid sell-offs. I’m pretty confident about those tops holding, since sentiment readings got so high there. Decent profits are in hand, and I am out of this market as of yesterday, since a corrective rally wouldn’t surprise me here. I am waiting to put on my shorts again.

Treasury bonds: Firm-looking bottom off very negative sentiment and a nice rally so far. There is room to go, though I have sold my calls and now just own TLT. Recent auctions have been very successful, as these nice yields are drawing the highest bid-to-cover ratios since 2007.

The dollar: Back within almost a percent of its recent low, but I’m not worried about a collapse because most people are already positioned for fresh lows. Today’s mini panic looks like a potential set-up for the bulls, and I am very long versus the pound, euro and franc.

Oil: Sentiment here never got extreme, but the chart looks toppy and this trade is not independent from general dollar/reflation fears. I am short futures with a tight stop, since today’s bounce took us right up underneath a clear resistance level. Fundamentally, oil is way overpriced for this environment. I still think $20 awaits at some point in the future.

Copper: Very similar to oil’s situation. No extremes, but toppy. I’m short with a tight stop. I expect $1.00 again at some point once the S&P drops under 600.

Pork: Ok, this has nothing to do with the rest of this market, but pork bellies and hogs have been nice winners for me lately. I believe there is a good chance that they just made a lasting low. The flu panic has never been anything but hot air — just another boogeyman to drive people to love big brother. When the fears fade, demand is going to outstrip supply. China bulls ought to be all over this: the Chinese love pork — they even have a “strategic pork reserve”.

Stocks: The markets were pretty oversold after yesterday, but today we worked off that condition, so anything can happen tomorrow. Everyone is watching the 880 level on the S&P, though it feels like after the 40% rally we could see more nasty 90% down days in the coming days or weeks, which would take us closer to 800 and give the bulls a real gut-check. 880 wouldn’t do that.

If we do get down under 850, things are going to get tricky: we’ll have to look at internals and sentiment to divine whether we’re due for a big recovery and re-test of the highs, or if we’re on the express train to new bear market lows.

It is also possible that we never get a deep sell-off, but just chop around within a 50-100 point range for a few more months while fundamentals deteriorate until Pangloss just can’t justify hitting the offer anymore. Chopping around the 900s without ever breaking clean through 1000 would be nearly as exhaustive for the bulls as this rally has been for the bears. It would draw them all in until none were left and volume dried up. That would be an awesome set-up for bears who aren’t themselves worn out in the chop.

This is why I’m such a fan of long-term puts for playing a bear market: with them you don’t have to worry much about how the market gets to its destination, so long as it arrives and on time. Right now, you can buy 36 months of leeway with December 2011 puts. I bought December 2008 puts in Q2 2006 and 2009s in 2007 — there was drawdown from rallies and time decay, but in the end it didn’t matter.

Stocks are very expensive. Mr. Market is still in denial.

Bottom line: Declines in earnings and mood could result in an 80% drop in stock prices from here.

The S&P 500 is still priced at over 15 times last year’s earnings ($66 as reported*). Since the late ’90s, corporate earnings have been as inflated as the rest of the economy by cheap credit. From 2003, they spiked up even further, way out of line with long-term trends, largely due to inflated financial profits from the real estate scam and consumer-related and other income from society-wide profligacy. Here’s a 20-year chart:

Click image for larger view. Source: Techfarm

Mean reversion

To make matters worse, in the optimism of the bubble environment, investors extrapolated the recent pace of earnings growth out into the distant future, completely forgetting that growth is mean-reverting. This long-term mean in the US has been about 6% (good luck keeping that up under socialism). Earnings growth will always revert to a mean in a market economy simply because excess earnings attract competition. In an economy with government-supported fractional reserve lending, the downside of the credit cycle will also undercut earnings (and generate large losses).

2006 S&P 500 earnings of $81.51 were an extreme historical anomaly, so applying a 19-handle to them was insanity. If Mr. Market hadn’t been so hopped up on the energy drinks popular at the time, he would have thought long and hard before paying more than $8 for 2006 earnings, especially because stocks were hardly paying any dividends at all.

The first two quarters of 2008 came in with $15.54 and $13.17 in earnings, respectively. If you assume that each of the remaining quarters will be worse than the last by $2 (pretty optimistic if you ask me), you come up with a final 2008 figure of $49.

Mood swings

When thinking about what to pay for those earnings, you want to think about what kind of mood Mr. Market will be in next year. Somehow, I don’t think he’ll be quite as optimistic as of late, since the aftermath of that tuarine/caffeine cocktail can be a downer. After such a frenzy, his mood typically declines for years and doesn’t turn up again until he has put a sub-10 multiple on recession year earnings.

Looking at past episodes, the odds are strong that Mr. Market pays less than $12 for each dollar of 2008 earnings by the end of 2009: an index value of 588 using our ’08 estimate.

But then 2009 earnings aren’t looking so rosy either: even sell-side analysts are predicting that they will be lower than this year’s. Extrapolating a decline of $1 per quarter from our $9.17 estimate for Q4 ’08, you get $27 per the index for 2009. This happens to be about what the 500 earned in the mild recessionary year of 2002. Think next year will be worse? Adjust accordingly.

Whatever your own ’09 estimate, keep in mind that Mr. Market will be downright angry with stocks’ performance and extremely cynical by the time 2010 rolls around. If history is any guide, by the end of 2010 he might not even pay $8 for those earnings. That would be an S&P 500 value just north of 200.

Got LEAPs puts? You can bet on earnings and Mr. Market’s mood out to December 2010 with options on SPY.**

*S&P provides a big Excel spreadsheet of such figures here (download).

**See disclaimer. I own a ton of these.

Careful shorts, don’t press your luck.

This sell-off is nearly overextended. Sure, the odds of a real crash are as high now as they will ever be (markets crash from oversold), but all the same, those are extremely rare events. Bear markets of this magnitude last for years, and there will be lots more rallies to short on the way down. Be prepared for one heck of a dead cat bounce when this panic subsides. The Ministry of Truth is full of fools and knaves bearing advice about averaging down, and there are still lots of buy-and-holders out there whom the market hasn’t sufficiently demoralized.

I started to close out my near-term puts last week, and hope to take care of a bunch more in the coming days. There is nothing wrong with cash. It gives you ammo to do this all over again. And if you don’t want to abandon shorting/hedging altogether, consider switching to long-term puts, like SPY Dec 2010s. They will go down less in a bounce.

That said, I have never seen a more powerful decline than this one, and it could easily take us below 9000 on the Dow by Christmas. It is just that there is no need to swing for the fences when this game lasts your whole life.

Commercial Real Estate Shoe About to Drop

The opportunity to short REITs (or IYR, a REIT-heavy ETF) is fantastic at right this moment. This is about as perfect a short set-up as you could ever wish for: securities of companies in a rapidly deteriorating sector have rebounded to near where they were a year ago when optimism was abundant and the stock market was making new highs. The ETF is actually trading where it was in the first quarter of 2006, the exact peak of real estate prices in the US.

Here is a 5-year look at IYR (I like to take the long view):

Click for sharper view. Source: Yahoo! Finance

There is a heavily traded double-short ETF, SRS, that tracks the opposite of the Dow Jone Real Estate Index with 200% magnitude on a daily basis. My preferred way to short is with LEAP puts, because despite common notions to the contrary, these options are more dummy-proof and safer in some ways than short-etfs, while allowing greater leverage so you can risk less capital on your shorts.

One more thing that makes this such a great short is that, in contrast to financials, there has not been much of a panic sell-off yet. XLF (a popular financial ETF), made a waterfall plunge from June to mid-July, which, while certainly not the final bottom, served to blow off some steam for the short-term.

I haven’t said anything about fundamentals here, but it should be obvious to anyone that commercial real estate, like residential, was heavily overbuilt because of cheap credit readily extended to Joe Blow Developers, Inc. We now have way more shopping malls, office parks and trendy urban condo complexes than we could possibly use at prices high enough allow Joe to cover his debt payments.

As the consumer gets frugal, the corporate sector contracts, and inner cities get scary again, vacancies in the respective developments will soar and rents will drop. And because this game, like housing, is played with leverage, holders of CRE are in big trouble (as are the banks that hold these loans on their books – they will soon be the not-so-proud owners of shiny new rental properties).

It should also be noted that as Treasury rates have fallen (a big red flag for the economy), there has been a little fad to buy CRE or REITS for the slightly better yield, as though they can be compared to Treasuries! Gimmie a break! Holders of this junk are in for a world of hurt, sooner rather than later.

Inverse ETFs vs. LEAPS puts

Inverse ETFs are best used for trading, rather than to buy and hold for the duration of a bear market. Non-traders looking to hedge their longs or profit from the bear market should consider long-term put options instead. Contrary to popular belief, options can require less expertise and offer a lower overall risk to a portfolio than short ETFs.

Brutal math

The main problem with short ETFs is that as the underlying indexes get lower, small dollar moves become large percentages, especially in 2X funds. This math works against you as the market exhibits volatility on its way down. A dollar of loss in an index wins you a smaller gain in your short fund than a dollar of gain in the index from that lower level gives you a loss in your fund.  Here’s an illustration:

Imagine if XLF (a financial index ETF) goes from 20 to 19 one day, and SKF (SKF’s 2X inverse) goes from 100 to 110.

$1 out of $20 is 5%, so SKF goes up 10%

$1 down = $10 up

The next day XLF goes from 19 to 20, so SKF goes to $98.42 . $1 out of $19 is 5.26%, so SKF goes down $11.58.

XLF is back where it started, but SKF is down 1.42%.

As many have learned in the bounce from the July 15 lows, this math can be brutal with larger percentage swings, and these moves will only get wilder as the market goes lower.

LEAPS are lower risk than short ETFs (in smaller quantities)

If you are very confident about financials or REITs or the broad market going lower and are not a proven trader, use LEAPS (Long Term Equity Anticipation Securities), long-dated options. The whole idea behind the existence of an options market is to decrease risk. Make the concept work for you.

You can buy January 2010 puts on XLF, IYR, SPY, IWM, QQQQ, whatever you want, and just sit tight. 2011 LEAPs are being rolled out, and December 2010s are available on SPY. Don’t trade in and out if you aren’t a pro. Those blistering rallies on the way down won’t change the fantastic percentage gains that await if you have the longer trend right.

So many people risk big chunks of money in double short ETFs, and then screw it all up through bad trading, when they could just put a fraction of the money into LEAPS puts and get out of their own way, with the ultimate dollar gains being the same in the end. The balance saved can be kept safe in treasury bills, and those could be a lifesaver if things get really hairy and the markets are compromised. This strategy offers lower risk than inverse ETFs without sacrificing potential gains.

LEAPS may also offer reduced counterparty risk due to the rules of the options market, as opposed to whatever wizardry the investment banks use to make those funds do what they do.

FAQ: How high can inverse ETFs go?

For the record, the theoretical gains in any short ETF are unlimited. You can always go down another 1% or 10% or 50%, no matter how low an index goes, so a short ETF can keep going up by the same (or double) percentages forever. The catch is that volatility and the math explained above will keep things down to earth.

Don’t dismiss cash. It’s in a bull market.

I am not recommending shorting to anyone. Only you can decide what may be appropriate, and the key to getting through the next few years will just be to come out with your capital intact. That will be heoric enough.