"Gurus" Lose Even More Money

Interesting league table of returns of "gurus" over the last 6 and 12 months. I estimate I'm down 10% over six months and 5% over 12 months. That's similar to Soros and would be one of the best returns in the table. Real numbers coming in a few days.

Worst Since the Great Depression

There is a lot of talk that this is the worst June for the Dow since the Great Depression and the worst month since the 2000-02 bear market. I haven't run the numbers in a while, or posted that much, as they are so bad, but clearly this is my worst month since the 2000-02 bear market. I didn't bet on such a major retracement in the indices - about a 50% retracement of the March-May rally in the NDX, a new bear market low for the Dow, and a pretty much 100% retracement for the SPX. I've been trading on the wrong side of the market for the whole month, somehow, despite this, my trading result should be a little positive unless something real bad happens on Monday but that is offset by horrible investment returns. Friday night in the US my trading positions did go in my direction as the market reversed to the upside in reaction to a collapse in the oil price from a new all time high. The price of oil really drives the US stock market now, second by second. We are going to need to see a substantial fall in the oil price to get any rally going in stocks. I think that's possible. Recent highs in oil seem weaker as they are being made on lower volume etc.

On another positive note, after the close Friday, News Corp announced that it plans to privatise NDS at $60 per share. I currently have 100 shares. My brother is employed by NDS, which is how I heard about it in the first place. It's always been a bit hard to understand why the company was public given the overwhelming majority stake News Corp held. One excuse I heard was that it was to provide incentive options to staff who owned many of the remaining shares. Also, I've not yet seen any explanation as to why News Corp wants to take the company private now.

Three Bad Trades: Two (?) Down, One to Go

Last week I was in three bad trades on each of which I was down significantly. One was long NASDAQ futures, another short QQQQ puts, and the third long SPI (Australian stock futures via CFDs). I managed to close out the long NASDAQ position for a small profit. Tonight, I will close the QQQQ puts position. We will see if for a small profit or a small loss. I could have closed last night for a small profit, but didn't pull the trigger. The long SPI position is still bad, though no worse than it was. I guess I am resigned to waiting for the index to eventually go up, which is a safer bet when you're long than when you are short. I am learning, I hope from the mistakes I made on all of these trades. Otherwise, there are only a few bright spots - Legend International and Southwest Airlines are a couple of them. I took some profits in both of them. Another good recent trade is selling June covered call options on Interactive Brokers. I got $100 for two of the $35 calls just a couple of days ago and the stock promptly sank. I can't see it coming back to $35 tonight.

By the way, I think we may have seen the top in crude oil for a while. Last night's decline in the wake of the Chinese petrol price increases was pretty spectacular and certainly fueled the rally in stocks, which saved my QQQQ trade. If the downtrend continues, it will be the catalyst for the next upwave in stocks. At least in the US. Australia is another question.

On top of struggling with trading this month, yesterday I had a computer mishap when trying to back up my files. I lost a bunch of financial files or now only have the version from September last year. Luckily, none of the most crucial core files was affected. But I did lose my last couple of tax spreadsheets, including the one I have been putting together for 2007-8 Australian taxes. I'll have to reconstruct it from scratch. All the sources are intact at least, just a question of bringing everything together.

Macquarie Capital Alliance Group to be Privatised

Another Macquarie private equity listed fund to be delisted. This bodes well for my various Australian listed funds that are trading at huge discounts to book value: EBI, AEP, IPE, CAM, and PMC. Though CAM and PMC are more traditional share funds. EBI continues to attract new hedge fund investors. The manager of the fund referenced in the EBI announcement, Andrew Weiss, was a professor of economics at my Alma Mater, Boston University. I remember once I went to look for him for some reason, but never did meet him. Some grad student was sitting in his office. EBI are going to introduce a buyback facility that will come into play whenever the fund trades 10% below book value. The problem with AEP is of course that it was an Allco sponsored fund, so no privatization likely there, though I expect another more serious takeover effort if it continues to trade so cheaply.

Another similarity with 1990-91

Record levels of bearishness. As I write, oil just spiked to a new all time high. Seems to me this was a reaction to a bad Empire State Report (NY Fed report on NYS economy) which caused US bonds to rise and therefore the USD to fall. This started a rise in the oil price that then set off a cascade of stop losses at $137, $138, and $139. At least that's what the charts look like... Dow Jones commented on the price spike but didn't report any news except the Saudi decision to raise output which was already known and bearish for the oil price.

Mid-Month Update

The numbers in the right column look really awful. The only goal where we're making progress at this point in the month is on realized gains with a net $487 gain so far this month. Investment performance is -7.81% so far against a 4.59% loss for the MSCI and 2.88% loss for the SPX. Numbers were worse before the start of Friday's trading by around $4000 and at the end of Friday were in fact better than this - but there is always a delay in getting the prices for Australian managed funds (mutual funds). The numbers are also better in Australian Dollar terms (-6.34%) as the Australian Dollar is down on the month. I think this is the worst point of the month and hopefully, month ending numbers will be better. The main reason for the poor performance is our much higher level of leverage since April - estimated beta is 1.06 (time series estimate) to 1.34 (naive estimate).

Immigration

Another goal completed, Friday, when we visited the Department of Immigration in Canberra to turn in Snork Maiden's immigration application and pay the $A2,060 fee. When processed they should award her temporary residence status in Australia. As a temporary resident you can work and receive government healthcare (Medicare). You can't receive other government benefits. After two years, our savings in health insurance should pay for the fee. Also after two years, they should grant her permanent residence in Australia and all rights apart from the ability to vote. Another two years on she should be able to obtain Australian citizenship with the obligation to vote and an Australian passport that allows visa free travel to most countries in the world. Still, today we were discussing maybe stopping off in another Asian country on our way back from China later this year. With an Australian work visa, getting a visa for Thailand, Singapore, or Hong Kong should be easy and the embassies are here in Canberra. I've been to both Thailand and Singapore as well as Malaysia. I'd like to visit Hong Kong some time, but no rush. Snork Maiden is most interested in visiting Thailand, I guess because that is the most exotic for someone from China.

The stockmarket finally has turned for the upside on Friday. This week, my trading was not at all good and by Thursday I was running three positions at close to $1,000 losses in each case. It was a rather anxious week. Friday night I got rid of a US futures position at a profit and my Australian futures (via a CFD) and US short options positions significantly improved. I'm not even calculating our current net worth or investment performance at this point in the month as I know they are so bad. I think Wednesday (Thursday in Aus) will be the low point for a while in the market. Wednesday was "Weird Wollie Wed" - the Wednesday of the week before US options expiry week. It seems the market often rises from there into options expiration and my model is now unequivocally pointing up.

Australian Stock Market Update

The chart shows progress so far since all time highs in the Australian stock market at the end of October. A suggested Elliott Wave count consisting of a triple zig-zag W-X-Y-X-Z is shown. In US markets I believe the top was in July. The move out of the August low in Australia has five waves though and plausible counts from the 2003 low place it as the top of the market. Of course, other counts from the high to the March low are possible, but I think this is the most plausible. All E-Wave analysis can tell us, is that the decline, could be complete. The correction might simply be the first wave of a much larger correction if the more bearish scenarios play out. I've also sketched a five wave rise from the March low to the May high. Wave 4, in this sequence doesn't look much like a correction, but this count again is the most plausible. The move down from the May high also looks "impulsive". We've now hit the lower Bollinger Band (34 day moving average minus 2 standard deviations, which is a natural point to attempt a bounce, especially when the moving average is not declining. At the January and March lows the BB didn't arrest the decline immediately, as you can see the moving average and bands were declining steeply. So I expect a bounce of some duration here, and the model is forecasting a rise too in coming days. We are also just above the August low.

This point in the market does seem similar to the January Societé General and March Bear Stearns lows. This is the Lehman low, where Lehman did not blow up but was rescued with a private capital injection. I've also marked a possible inverted head and shoulders bottom. We need to rise above the 6000 level and break through the blue resistance line before this comes into play. If it does, expect a move to the old highs as a minimum target. That's the bullish scenario. Any move down from here would be very bearish. I'm betting on the bullish outcome.

Overnight, the US market seemed to stabilize, Japanese futures are up pre-open as I write. Let's see what happens.

New Investment: Legend International

Legend International is a company run by Joseph Gutnick that is developing a major phosphate mine in northwest Queensland. The stock is an OTC-BB stock in the US, but following a successful private placement the company plans to list on the American stock exchange. The company also plans a secondary listing on the ASX. I bought some shares a few days ago. I compute that based on:

• The company's worst case scenario of a phosphate price less than half current prices
• Assuming that they still need to raise another $700 million to finance the development of the mine by issuing shares at the current share price.
• Applying a P/E of 10. Most fertilizer companies are currently trading at much higher P/Es. BHP has a P/E of 15. Rio Tinto 17. The Australian materials sector has a P/E of 14.

The stock should be worth $5 a share. It's currently trading for about $3.30. The nice thing about this project is that they don't have to find the resources, though proving the size of the reserve is needed. They mainly just need to build a mine, a pipeline to the port at Karumba in parallel with an existing pipeline used by the Century Zinc mine and extra port facilities at the port. They hope to be in production in 2010. I have some confidence in Gutnick, a previously successful miner - I don't think this is a scam - more a Fortescue Metals type story. The Atticus Capital hedge fund is also a major existing shareholder.

We'll see how this works out.

Asynchronous Diagonal Put Spread Trading

I'm now at the second stage in my new U.S. based options trading strategy. I'm trading QQQQ options at the moment. I'm short 4 June $48 puts and long 4 September $49 puts. This is a "diagonal put spread". A horizontal spread is the same strike in different months and a vertical spread different strikes for the same month. The asynchronous bit means that I didn't trade the two options at the same time, but allowed the market to move in between the two trades.

We know that ">put selling is extremely profitable. We also know that it can be extremely dangerous. For example, Victor Niederhoffer sold a large amount of out of the money S&P 500 puts in 1997. When the market fell the value of these puts rose partly due to the fall in the market and also due to the accompanying rise in implied volatility and his fund got a margin call that blew it up. This is despite the puts still being out of the money at that point. So I was interested in selling puts, but wary of the danger, and that led to the development of this strategy which I am beginning to implement. Another reason that I am interested in trading options, is that gaining from the time erosion of sold options means that I have to be less accurate in my trading in order to make money than is the case with futures. This is useful as I can't watch the US market all the time.

This is the strategy:

1. When my trading model gives a buy signal I short just out of the money puts for the current month. These puts have the largest time value of the current contract and the current month has the fastest time decay of all months. It makes no sense that I can see to ever sell anything but the current month (especially when spreads and commissions are low). I only sell a small number of puts - only as many as I am willing and able to buy stock in the event of being exercised at expiry. This is the first safety provision.

2a. Hopefully the market rises and the value of my puts falls rapidly. When my trading model generates a sell signal I buy a put. This put is for at least 3 months out - which has half the theta - sensitivity to time erosion. 6 months out has a third of the sensitivity but the bid-ask spread can be sufficient to negate the advantage. This means that the spread gains value over time ceteris paribus. The later option also has a greater vega - is more sensitive to volatility - which tends to increase when the market declines. Ideally, I buy this option a little in the money, but even if it is out of the money the delta (sensitivity to market movement) of this option is greater than that of the sold option. These differences in delta and volatility mean that if the market declines the spread increases in value. By not buying back the sold option I continue to gain from its time erosion and to save on commissions and spread - if the market is trending upwards it will likely expire worthless. It also partly hedges my bought put if I'm wrong about the market going down.

2b. If the market goes sideways, I just wait for the sold option to expire worthless.

2c. If the market goes against me - the model is wrong and I buy a later option to create a calendar spread to protect me against a crash and potentially benefit from rising volatility. When I think the market has bottomed, I'd probably just sell the bought option and redeem the sold option closer to expiry unless it was now very much in the money and had little chance of expiring worthless.

3. If 2a happens and we now have a diagonal spread, I wait for the model to generate its next buy signal. I then sell the bought put and hold the sold one and either it expires worthless or I buy it back closer to expiry. If the market has risen considerably since I first wrote the put, I will consider buying it back and writing a new one at a higher strike. And if the market has declined considerably, buying it back and writing a new one at a lower strike.

We are now just past 2a with the value of the spread increasing as the market declines.

I think this strategy cleverly exploits the advantages of put selling while mitigating some of the risk, exploits my model, and takes into account my location far from the U.S. time zone. I still need to be available either at the beginning or end of a US market session to make trades when neccessary.

Trading options in Australia has several disadvantages:

a. Very big contract sizes for the SPI futures options. I could write options more out of the money to reduce the risk, but that has Black Swan (i.e. tail event) risk.

b. The SPI futures options only exist for each quarter - my strategy is far more effective with monthly options.

c. There are also "XJO options" traded on the ASX 200 Index on the ASX. These are for 40% of the size of the SPI contract. Still big for me at the moment, but more manageable and these are monthlys. Problems with these are the very wide bid-ask spreads - SPI futures options have a tight spread (though you can't see bid ask quotes on IB's TWS...). If can get Interactive Brokers to approve me to trade them,* I can get low commissions - compared to CommSec's very high commissions. It's likely I will try trading these at some point.

Another possibility is futures options on the Nikkei traded on the Osaka futures exchange. These are also a big contract size but they are monthlies. The spread is 10 points, but so is the spread of the underlying contract. Commissions with IB are low and I already have the trading permission.

* I signed up for my account in the US and US residents are banned from trading options on foreign exchanges by the SEC. Futures options are OK because they are regulated by the CFTC. I've told IB I now live in Australia but regular Australian options are still blocked.

May 2008 Report

A good month, though returns were not as spectacular as in April. Mid month, investment returns were more than double what they were by the end of the month following a pullback in the markets. In the chart, month's above the red line have risk adjusted excess returns, while those above the blue line have above average risk adjusted returns:



The gap between the blue and red lines is alpha. May had returns that are typical of good months.

But we are on track to meeting all our annual goals, which are assessed in the first part of this report. Other statistics appear towards the end of the report. All amounts are in U.S. Dollars unless otherwise stated.

1. Net Worth Goal: Reaching $500k We made progress on this goal as net worth rose by $17.7k to $482.3k and in Australian Dollars rose $A11.7k to $A505k. USD results were again boosted by the continued rise in the Australian Dollar.

2. Alpha Goal: Alpha of 8.5% The point of this goal is to earn at least an average wage from risk-adjusted excess returns. Using my preferred time-series method our returns had a beta of 0.85 and an alpha of 10.0% with respect to the MSCI World index, which meets our annual goal. The risk adjusted excess return for May based on this analysis was 1.71%. Multiplying this by net worth gives an income of $8,090. For the year so far the risk-adjusted excess return in dollar terms has been $26,222. Using the estimate of alpha the smoothed annual income is $47,303. In Australian Dollars terms returns are somewhat lower, while they are higher using the S&P 500 as a benchmark.

3. Increasing Non-Retirement Net Worth by More than the MSCI Index The point of this goal is to make sure that we only spend out of non-investment income and excess returns and don't use the normal market return on investments to fund spending. In other words, this makes sure we have positive saving. Non-retirement accounts rose by 5.02%, while the MSCI index rose by 1.68%. So far this year these accounts have grown by 6.51% in excess of the MSCI return.

4. Achieving Break-Even on U.S. Taxable Accounts This goal was achieved. At the end of the month we were $751 above the breakeven point with a gain of $1,311 for the month. The rate of return on these accounts was 1.87%.

5. Make at Least $15,000 from Trading Realised gains this month were $1,586 and so far this year $3,584. I've now had four positive months in a row, which is a record. Earlier today I raised the annual trading goal to $15,000.

Background Statistics

Income and Expenditure



Expenditure was $3,472 in line with recent numbers. Spending included $76 of implicit car expenses - interest only as the car didn't depreciate this month according to RedBook. In addition to her ordinary pay Snork Maiden received her IRS tax refund and stimulus check and Moom was paid a small consulting fee, which raised non-investment income to $6,225.

Non-retirement accounts gained $9,091 with the rise in the Australian Dollar contributing $1,969. Retirement accounts gained $5,613 but would have gained only $3,319 without the change in exchange rates.

Investment Performance

Investment return in US Dollars was 7.75% vs. a 5.65% gain in the MSCI (Gross) All Country World Index, which I use as my overall benchmark and a 4.87% in the S&P 500 total return index. Returns in Australian Dollars and currency neutral terms were 4.47% and 5.21% respectively. So far this year we have gained 2.58%, while the MSCI and S&P 500 have lost 4.04% and 5.03%, respectively.

The contributions of the different investments and trades are as follows:



The returns on all the individual investments are net of foreign exchange movements. Again the biggest gain was in the CFS Geared Share Fund which is our biggest investment. Australian listed fund of hedge funds Everest Brown and Babcock continued to recover from a steep discount to book value but my other "deep value" Australian investments showed little movement or like Challenger Infrastructure and Clime Capital, declined.

Asset Allocation

Allocation was 41% in "passive alpha", 71% in "beta", 3% allocated to trading, 6% to industrial stocks, 3% to liquidity, 3% to other assets and we were borrowing 27%. Our currency exposures were roughly 56% Australian Dollar, 21% US Dollar, and 23% Other and Global. In terms of asset classes, the distribution was:



Due to the use of leveraged funds, our actual exposure to stocks was 118% of net worth. I slightly trimmed exposure to stocks as the market rose while increasing exposures to bonds and alternative assets by a little more, resulting in an increase in borrowing. Cash also increased, mainly due to setting up a new trading account with City Index.

New Trading Goal for 2008

I'm upping my trading goal for 2008 from $9,500 to $15,000. This means making about $2000 per month for the rest of the year except in the month when we visit China. I've had realised short-term gains in shares and mutual funds (selling the fund, not getting a distribution) of more than $2,000 for the last three months. My futures results in the last two months has dragged performance down. I'm figuring that the new options trading strategy I'm implementing in the US (more on this some time soon) can make about $500 per month currently and CFD trading in Australia so far seems to be able to generate a similar amount perhaps. Then I only need $1,000 in stocks etc. to round the number out. $15,000 also represents a similar percentage improvement over 2007's result ($9,224) as 2007's represents relative to 2006 ($5,368).