“Junk stocks” have dramatically outperformed the broad market since the bottom in March. There’s a reason that junk stocks — stocks in which total debt is three, four, or five times the value of equity — have rallied so sharply.

Written off as imminent bankruptcy risks, the market left these types of stocks for dead, assuming that equity value would be wiped out in any balance sheet restructuring scenario. But the credit markets have thawed enough to allow most of these stocks to hang on a little longer, in exchange for refinancing debt at much higher interest rates.

These temporary reprieves from bankruptcy court merited perhaps 100% or even 200% rallies in these stocks. But in the market’s frenzy to assume risk, it has bid up some junk stocks anywhere from 500% to 2,000% from the March lows!

Car rental stocks are classic junk stocks — especially in protracted periods of depressed consumer and business travel. These companies operate with massive debt loads in a brutally competitive, commodity business. They’ve all been cutting employee head count and car fleets at incredible rates in order to stem losses. Yet even in good times, competition is so fierce that car rental companies tend not to return capital to shareholders via dividends (unless they are debt-funded dividends paid to private equity owners — as in the case of Hertz prior to its IPO). These companies also tend to repurchase stock only at peak prices, which destroys per share value.

It’s All About Fleet Management

Over the past few years, car rental companies have transitioned away from having mostly “program cars” in their fleets. Program cars are a convenient way for the likes of GM and Chrysler to sell heavy car volumes in a pinch, but these carmakers must sign agreements to repurchase the sold cars or guarantee a rate of depreciation during a specified period of time. Due to recent financial turmoil of both parties in this arrangement, this doesn’t make as much sense as it used to.

Now the car rental companies are adding mostly “risk cars” to their fleet.

These cars are bought without the security of repurchase agreements, so they will be sold into an uncertain future used car market. This gives car rental companies more control over the length of time they own the vehicles, but it’s transforming their balance sheets into speculations on the health of the used car market. If used car market values soften, then the car rental companies have to either accelerate their depreciation expenses or risk taking capital losses upon disposal. Used car prices have temporarily spiked since April, as demand exceeded temporarily tight supplies.

There are many reasons for this temporary spike in wholesale prices of used cars, but a big one has to do with the fact that “cash for clunkers” needlessly destroyed an estimated 700,000 vehicles that otherwise would have flowed into the supply of used cars. This spike is likely sowing the seeds for a bigger decline in the future values, because it squeezed dealer profit margins to the point that it’s brought financial stress to a huge swathe of regular buyers: small “mom and pop” used car dealers.

Fleet management has a huge impact on earnings, because most car rental companies turn their entire fleets over every 18 or 24 months. This makes the visibility of free cash flow for these highly levered businesses very uncertain.

Nevertheless, like moths to a flame, value investors fly to these stocks after getting burned over and over. They hope that one day these companies will deliver attractive returns in a utopian scenario in which cash flow doesn’t have to be reinvested into the fleet and customers will not flee to lower-priced competitors.

In the real world, we can see from history, car rental companies must constantly reinvest most of the cash flow into refreshing their fleets, servicing debts, and posting collateral for off-balance sheet fleet financing. Also, we know that the Internet prompts more and more consumers to shop for the best possible deal. The Federal Reserve board may appreciate a “welcome” rise in prices for car rentals, but consumers certainly do not; they’ll shop for alternatives in this commodity business if faced with higher prices.

Lower Volumes, Competition, and Debts Are a Recipe for Disaster

All of the car rental stocks were left for dead in early 2009, because it was doubtful whether they could renew the billions in financing commitments for their gargantuan fleets. The car rental business, in my view, is a dinosaur left over from the era of cheap credit and steadily growing business and leisure travel. In the future, we can expect to see an overlevered, capital-intensive set of competitors battling it out for scarce business. This may be good for consumers, but it’s terrible for owners of car rental stocks.

The biggest driver of car rental stock prices during this rally has not been a revival in sales, but rather the hope that because the industry is shedding capacity at a fast rate, pricing power will return. I have my doubts, because once the most-anticipated “V-shaped” economic recovery in history fails to live up to expectations, many rental companies will resort to price cutting to generate cash for newly tightfisted creditors.

Shareholders of these companies are thus left with the claims of the skimpy, infrequent free cash flow that’s left over after the following senior claimants are satisfied: employees, landlords, suppliers of car parts, advertising, insurance, lenders who finance their fleets, and the tax man.

It’s time to bet against these “junkers” and collect serious gains in the process. I’ve already alerted my Strategic Short Report subscribers to what I think is the best way to play these soon-to-fall rental companies (you can learn more by clicking here), but it’s not too late for you to position yourself too.

With more than a half dozen car rental stocks out there, your options are far from limited.

Regards,
Dan Amoss

November 4, 2009

Make 50% By Selling These Junk Stocks Short was originally featured in the Penny Sleuth.

Today, I’m going to reveal the biggest secret of them all. And perhaps the one and only reason you should start trading options right now – if you like making a lot of money, fast! It’s a simple strategy that you can use to squeeze penny stock sized gains out of even the biggest blue chips.

It’s why market legend Paul Sarnoff (Steve’s dad) said options are: “The best… Perhaps on the only way to get rich very quickly.”

I’m talking about the secret of “Super-Leverage.”

In a nutshell, “Super-Leverage” allows you to turn a small upfront investment into a potentially life changing payday.

Let me show you how…

When you buy an options contract you are buying the right (not the obligation) to buy 100 underlying shares at a specific price. But, you don’t pay anywhere near what those 100 shares might cost on the open market.

For example:

Steve recommended buying Navistar January $20 calls for $120. At the time, the shares were trading for $16.92.

His charts couldn’t have been more on the money. By the end of that week, the shares were up to $19.59 — a 16% jump.  When it was all over, by the first week of December, the shares topped out at $29.55 a share.  And the options he had recommended were worth $1,150 — an incredible jump of 858%.

You could have bought 10 options for $1,200, and less than two months later, you could have cashed out with $10,300!

That’s the power of “Super-Leverage.”

Can you see why options and “Super-Leverage” can make you rich, quick? Limited risk with unlimited gain is the perfect recipe for explosive profit.

And that’s why, especially now, I urge you to add options to your trading arsenal if you haven’t already. With the market the way it is now, “Super-Leverage” allows you to get in on the action without, gambling your life savings.

Before we wrap up I have one last thing to share. Or rather, options expert Steve Sarnoff does… It’s a FREE ($47 value) report fresh off the press!

It’s called “The Lazy Way To Pick Profitable Options Trades,” and you can download a copy instantly simply by clicking here. (You don’t have to give your e-mail address or anything, just click the link to get the report straight away.)

Cheers,
Jonas Elmerraji

October 16, 2009

Is This the Only Way to “Get Rich Quick”? was originally featured in the Penny Sleuth.

I firmly believe it is my job to be as blunt about that as possible. The potential rewards of options are very tempting, and anyone who forgets about the potential downsides is toast.

Unfortunately, those stark warnings also scare away people who could benefit from options. People who have built solid portfolios… and can easily afford to speculate a bit. They’re the complete opposite of traders who blindly rush in focused on the gains. Instead, they only see the potential losses…

That’s why I offer a simple suggestion — try options trading for yourself. With just a few minutes a day, you can learn how profitable options can be, without risking a single cent.

In the old days — as little as a decade ago — the best way to do this was by paper trading. As the name suggests, it doesn’t involve any real money… or even a broker. Instead, you simply chose an option and kept track of it each day. With a few simple calculations, you could see how you would have done if you actually made the trade.

There are still plenty of good things to say about paper trading. For one thing, it forces you to work — tracking down prices and calculating potential profits. If you’re going to put that much time into an activity, you might be more inspired to do well. It’s a good trait to have if you ever decide to trade for real.

“Virtual Trading” Is the Road to Real Profits

Still, the pen-and-paper method is a little outdated now. Today, lots of websites offer “virtual trading” — free computer programs that let you practice trading without putting any money at stake. Most require you set up an account… not an actual brokerage account, but a membership account — containing basic information like your age and interests.

When you sign up, you’ll get a username and password to get to your account. You’ll also get a small sum of virtual money to start trading with. (Beware of a site that offers to give you more fake money in exchange for real money. The point is to avoid spending ANY out-of-pocket cash.)

I must be honest, I haven’t signed up for many virtual trading accounts — so I can’t honestly compare and contrast them all for you. However, a colleague recently opened up a mock account on the Chicago Board Options Exchange (offered by Options Monster)… so I can tell you all about that.

The CBOE virtual trading site starts you off with virtual money that you can use to simulate trading any of the securities the CBOE tracks — from stocks to options, even some futures.

The Web site does its best to make the trading as realistic as possible. Price quotes are based on the actual prices seen on the exchange. When you wish to buy something for your virtual account, you are given the same kind of choices that you’d face if you were actually buying a real security.

You can dictate limit and stop orders. You can make day orders or standing “good to cancelled” orders. You can even choose to write options or use covered calls.

After you make your virtual order, the software does the rest. If you placed a market order, the security is added to your virtual portfolio. If you used a limit order, the program won’t place your order until the real market hits your limit price.

Everything you need to know is spelled out for you — the program even levies a virtual commission charge on each of your trades.

After that, it’s just a matter of logging in to see how you’re doing. You can also set sell orders, even trailing stops.

Programs like this can be a very useful tool for gauging how well you’d do in the options market — making any lingering fears disappear.

Of course, there are some important differences between real investing and virtual investing that you need to keep in mind.

It’s a lot easier to trade when you’re not spending real money. But virtual trading is so lifelike, you might actually lose sight of that when you really start trading. This is especially true since actual trading will involve money you can afford to lose. If you’re not careful, it will all seem like a game… and in games, taking unnecessary risks is part of the fun.

The solution is to treat your virtual account as actual money. Don’t make crazy trades just because you can. Instead, only make trades you’d make in real life. It’s not only the best way to get a feel for how you’d actual do with options, but it’s also the easiest way to transition from virtual trading to real trading.

Once you see how much money you’re missing out on by not using real money, it won’t be long before you’ll want to try your hand at actually trading options.

Picking the Right Virtual Trading Platform

Here’s a rundown of several of the free virtual options trading platforms you can sign-up for right now…

paperTRADE
This full-featured trading platform from tradeMONSTER offers newbie options investors the chance to experience options trading on a realistic trading platform.

CBOE Virtual Trade Tool
While not as robust as other trading platforms, this simple options trading tool still gets the job done without the advanced tools that some beginnings may find confusing or unnecessary.

Trade Smarter Options
This innovative binary options platform isn’t as realistic as the other offerings, but this website shines by simplifying the options investing process to limited outcomes. If you’re having trouble grasping options concepts, this site may be a good intermediary step for you.

PaperMoney
thinkorswim’s virtual trading system is simply their award winning real-time trading platform with virtual money. This system offers investors the advanced features you’d expect from a real options broker.

Sincerely,
Steve Sarnoff

October 15, 2009

Perfect Your Options Trades for Free with “Virtual Trading” was originally featured in the Penny Sleuth.

They’re the tools I’ve turned to for decades to maximize my gains as an options investor while keeping my risks tolerable. My Options Hotline readers have used these rules to maximize their options gains over the years too, and now, I’m passing them on to you…

Speculators get a bad rap. The very word conjures up pictures of some carefree playboy throwing money into any crazy investment — not really caring if they win or lose.

It’s not a flattering picture. And that’s why conservative investors shy away from anything “speculative” — lest they be called speculators, too.

Well, I’m here to tell you “speculating” isn’t a dirty word. You can be a conservative investor and still enjoy that chance at phenomenal profits that speculating can bring.

I learned that lesson from my father, Paul Sarnoff. He was one of the first people to offer an options course — introducing novice investors to the concept of Superleverage (more on that on Friday). But he also had a strong conservative streak. In fact, he was an avid fan of precious metals, advocating that they should be at the core of every solid investment portfolio. He even wrote books on gold and silver investing.

My father proved that even cautious investors can benefit from speculating. But as he always stressed — and as I still stress today — the key to being successful was to have a complete plan of action. You never, ever throw your money around casually… even if it is money you can afford to lose. And you must take steps to make sure you never get in over your head.

Of course, that’s easier said than done. That’s why my father developed six simple strategies for keeping a level head when speculating. They may sound common sense, but I’ve spent enough time in the markets to know that common sense isn’t that common when money is involved.

So, if you’re thinking of dipping your toe into the speculative markets, here are a few proven ideas to keep in mind:

1. Create a sound money-management strategy.

This one flies in the face of the conventional image of a speculator. But believe me, all consistently successful speculators start with a plan. It doesn’t have to be anything too involved — just make sure you’re clear on your objectives, and set some guidelines for yourself. Figure out your entry and exit strategy for each play, starting with how much to invest, how many open positions you plan to have, how you will monitor positions, what kind of stop-losses you will use to preserve capital, etc.

A sound money management strategy is the most important factor in successful speculation and it allows you to stay in the game.

2. Know your broker and monitor your investment.

When choosing a broker make sure to ask as many questions as necessary and that you get the appropriate answers before simply giving over your money. If you are a beginner, find out about the broker’s history and references, and speak to them frequently to establish a relationship. Make sure that either you or your broker will be constantly monitoring your investment — today’s markets are very volatile and with options the price can shoot up 30% or more in just a few hours… so it is necessary that your broker is able to see the option is performing and be able to execute an order in a timely manner, to ensure that your capital is protected.

With so many discount Internet brokers out there, it seems like more and more people aren’t doing their homework before opening an account. It’s OK to try and go it alone… unless you don’t know what you’re doing. In that case, it’s well worth the time and money to explore more experienced flesh-and-blood brokers.

And if you want a hand in selecting a broker, make sure you check out the Penny Sleuth’s Discount Broker Guide…

3. Stick with your exit strategy if a trade goes against you.

With a good money-management plan, there should never be any surprises. No matter what price your trade is at, the action you need to take should be clear.

That doesn’t mean you have to be inflexible, however. Just because an option has met your profit target, you don’t have to automatically sell. But there has to be a compelling reason to stick with the trade — something more than a feeling that the trade will continue climbing above your target price. (After all, you selected that target price for a reason.) And always use a stop-loss or a trailing stop order to make sure you’re ready for any reversal that might pop up.

For a losing trade, however, you need to be a little more harsh. Options are wasting instruments, and their value dies a little each day. Sometimes it’s better to stick to your strategy and settle for a loss than it is to wait it out and hope for a miracle. That’s money you could be plugging into another play.

4. Always, always, always, ask questions.

The Internet age is creating a generation of independent investors. But some are still too proud to admit that there are things they don’t know. In the speculation game, what you don’t know can hurt you.

If you’ve taken my advice about finding a good broker, you’ve already got a ready source of info to turn to. Dozens of Web sites also offer complete details on options trading. So there’s just no excuse for ignorance any more… and losing money because of ignorance makes even less sense.

5. Learn from your mistakes.

Find out what works for you. There will be losers along the way — but just make sure you know what you did wrong in previous trades (e.g. you set a stop loss of 15% and were stopped out too early and the option rebounded to 56% profits). Take every trade as a lesson and use it to improve as you continue trading.

6. Remember that knowledge is power.

You can never know too much… strive to learn as much as you can about options and their inner workings, strategies, fundamentals, everything… so that you will be better equipped to profit with options trading.

As I’ve said in the past, options trading is more accessible than ever before. And the profit potential hasn’t diminished a single cent. Going out of your way to learn the myriad of ways they can boost your bottom line is the easiest way to discover what works for you.

These are the six strategies that drove my father to success… and they’ve led to fantastic wins for my Options Hotline readers over the years. Now, hopefully they’ll help spur your success, too.

Sincerely,
Steve Sarnoff

October 14, 2009

Maximize Your Options Gains with These Six Trading Secrets was originally featured in the Penny Sleuth.

That kind of talk is just plain dangerous.

Despite my success with options, I would never be vain enough to call my work “investment advice.” When you’re dealing with options, you shouldn’t use the word “investment” at all. It’s speculating. And if you don’t understand the difference, you’re setting yourself up for a massive failure.

You “invest” in things like stocks, bonds, mutual funds, even real estate. You focus on the long-term. Successful investing is like planting acorns and watching them turn into oak trees.

Speculating, on the other hand, is like playing with fireworks on a rainy winter’s evening. You light the fuse, and seconds later, it’s either fizzled out or a huge colorful explosion high up in the sky has illuminated the whole world.

It may sound like gambling. And for people who don’t know what they’re doing, it usually is. But smart traders know how to bend the odds in their favor. Doing that means having a healthy respect for a speculator’s best friend — and worst enemy — leverage.

Leverage is the magic that turns small price movements into large profits…or losses. It is found in many different guises, but the fundamental design is always the same. The leveraged speculator uses OPM (Other People’s Money) in an attempt to make more money than would otherwise be possible with nothing but his own funds. In other words, you augment your position with borrowed money.

It sounds dangerous…and if not managed prudently, it can be bad for your wealth. BUT, if leverage can be applied to situations with strictly limited risk, it takes on a more sensible aspect. It becomes…superleverage.

Superleverage is the art of profiting from changing prices, with limited risk. No margin calls, no demands for additional funds, no forced liquidations.

The instruments of superleverage are exchange-traded stock options.

Options are tradable contracts that give you the right to buy or sell a specific underlying instrument at a specific price within a set time period. Their value closely follows the ups and downs of the stock they cover… yet they usually sell for a fraction of the stock’s price.

That means a small move in the stock’s price can become a huge move in the option’s price.

On the downside, options are wasting assets. They have strict expiration dates. And if the underlying security doesn’t move enough to give you real value, your options will expire worthless. That is your risk.

It was once calculated that 90% of all options expire worthless. That doesn’t mean you have a 90% chance of losing money…a winning options trader will offset one or two spectacular winners against eight or nine losers…and still have money left over. The trick to always coming out ahead is to develop a strategy and stick to it.

My dad, legendary options trader Paul Sarnoff, explained it best: “Every trader with imagination and talent goes into a specific commodity armed with a trading plan.” With his help, I developed a system I call my Complete Game Plan for Trading Success. Followed correctly, it can be a powerful tool to make sure you don’t get in over your head.

It starts with some simple calculations Just ask yourself the following questions before you risk a single cent:

1. How much am I willing to pay for the option? As I said, you can lose 100% of the money you put into an option. So never bet more money than you can afford to lose. Once you’ve set your limit, stick to it. Don’t chase an option that’s more expensive than you want to pay. Either wait for the price to drop, or look for another one to buy.

2. What will I do if I’m right? Have a profit target in mind for each option you buy, and an idea of how long the move will take. Be realistic — what you honestly think will happen, not what you hope will happen. (If you can’t do that, don’t buy the option.) Again, stick to your plan — give the option some time to reach your goal. If you meet your goal, sell right away.

3. When will I get out if I’m wrong? This one’s tough. No one wants to admit they’re wrong. And everyone hopes they’ll eventually be proven right. But that’s where another benefit of options trading comes in — with options, you have always known and strictly limited risk. Or, said a different way, you never stand to lose more than you put up. If you invest in stocks, you may have to worry about where to set stop losses so that you don’t lose your fortune. But with options, your stop loss is already built in. They’re the only sensible way to speculate.

You should always speculate based on what you can lose, not what you can gain. Be prepared to handle trading losses. Never add to a losing position. That is how many players get knocked out of the game. You want to be in there when the market goes your way. You, or your broker, must monitor your positions closely. They don’t ring a bell when it’s time to get out, so make sure you have an exit strategy in place for each trade.

It may sound like a lot of work — but believe me, it’s worth it. I’ve seen options skyrocket 210% in three weeks…472% in less than a month…even 260% in eight days…

Of course, I’ve also seen a good number of trades go nowhere. But following the Complete Game Plan for Trading Success, the odds are good you’ll still come out ahead.

Just never make the mistake of thinking that you’re “investing.”

Sincerely,
Steve Sarnoff

October 13, 2009

The Three Questions You MUST Ask Before Trading Options was originally featured in the Penny Sleuth.

Every day, scores of novice options investors get burned. It’s not because they’re bad investors, it’s simply because they’re not following the rules. There’s no question that options are tricky – it can take years to learn precisely how options work – but that doesn’t mean that understanding the options game is out of reach, or that it’s relegated to the big guys on Wall Street.

Despite their complexity, there’s plenty of reason to pay attention to options. Options provide incredible amounts of leverage with relatively limited downside. That leverage means that a relatively small increase in a stock’s share price can turn into a potentially huge gain in an option for that same stock. Just look at shares of the ProShares Ultra S&P 500 ETF (NYSE: SSO), a 5.3% climb in that stock over the course of just two days in July turned into a 28% profit for investors who bought one strike of that fund’s September call options.

Put these three must-know rules into play, and your chances of booking profitable options plays increase exponentially…

1. Think About Value, Not Just Price

Most people think that options prices (also known as premiums) are tied to the prices of their underlying stocks, but that’s not entirely true. Like stocks, options trade on the open market, which means that technically, options investors themselves set the prices of options through their bid and ask prices.

That doesn’t mean that you’ll see an option trading way out of line with its underlying, but it’s certainly not uncommon to see examples of options prices that don’t mesh with what their values should be.

That’s because unlike a mutual fund or ETF, which is priced based on the value of its assets right now, options take extrinsic variables, like the time value of money into account. There are a number of ways to value an option, including the Black-Scholes model and the Monte Carlo method, but if you want to avoid the mathematical formulations, most financial websites and trading platforms can come up with an option value almost instantly. Use that price as a starting point when you decide if an option is worth your time.

2. Don’t Get Greedy, Use Goals

“Hogs get slaughtered.” No, that’s not some sort of farmyard to-do list, it’s a phrase Wall Streeters use to remind each other – and themselves – that greed is the fast track to serious losses. It’s all too common for investors to hang onto a winning position too long, hoping for a few extra points, only to see those gains reverse themselves. That’s especially true of options, where a position can swing from a double-digit gain to a serious loss overnight.

Now, that doesn’t mean that you should sell your positions off as soon as you’re up more than 5% — goals are the secret to beating this pitfall. Get a grip on greed by setting your target gains before you enter a position, and stick with them unless something fundamentally changes in the underlying stock.

3. Take One Play a Week

The only way to make money on options is to play them – and to keep making options plays, even if you’ve just picked a loser. After your first bad trade, it’s incredibly easy to give up and just stick to stocks. But that’s a huge mistake. The only way to learn how to use options profitably is to use them often, so always try to make a new trade every week.

If money’s the issue, it shouldn’t be. There are scores of “paper trading” platforms out there – many of them free to use – that let you make hypothetical trades without risking your real-life capital. Trading paper for a while can help build your options investing skills until you’re ready to put your cash back on the line.

When deciding on which paper trading platform to use, it’s best to go with a broker. Many brokerage firms (including Thinkorswim, Scottrade, and optionsXpress) will let you test-drive their actual trading platforms with a practice trading account. Using the real platform means that the gains you get in the virtual world will mirror the gains you can expect when you switch to real money – and it also means that you’ll get used to your broker’s software and tools.

You Have Options

There’s no question that investing in options comes with a steep learning curve. That said, profitable options plays don’t have to be a faraway goal. Invest in options using these three rules and you’ll be well on your way to seeing profits from your calls and puts.

Cheers,
Jonas Elmerraji

September 17, 2009

Three Must-Know Rules to Profit from Options was originally featured in the Penny Sleuth.

In the last year, my Resource Trader Alert readers have already had the chance to book 143%, 148%, even 200% gains thanks to the commodities market. And in the current economic climate, as commodity prices start to heat up once again, the profit potential is amazing.

Here are the resource plays that I see rocketing right now…

Gold and Silver are leading the markets higher with the decline in the U.S. Dollar.  The greenback is at its lowest levels in since September 2008.  Gold is solidly above $1000 an ounce and looks positioned to easily make new all time highs on a course to $1200, from my projections.

Silver has made an impressive rally as well – one that I see continuing into the upper teens.

Recently I’ve been concerned about the lack of recent strength in Crude compared to new highs in stocks and metals.  Last week, that disconnect was repaired with a 5% move in prices putting oil solidly above $70 a barrel again. And it looks like oil hasn’t stopped its ascent either…

More Fuel for Higher Market Prices

The Organization of the Petroleum Exporting Countries (OPEC) did a good job of pushing oil prices up this summer. While OPEC managed to boost oil prices in the last six months, at current levels black gold is still a far cry from where it was a year ago – and where it could be again soon. This from Bloomberg:

“OPEC’s success in more than doubling oil prices since a five-year low in December will probably persuade ministers to maintain production quotas after this week’s meeting.

“Reducing shipments beyond record cutbacks last year would endanger the global economic recovery, the Organization of Petroleum Exporting Countries’ president said last week. Oil rose to $75 a barrel on Aug. 25, the price Saudi Arabian King Abdullah says is fair for consumers and producers.”

A major flaw in the governments’ unfair obsession with speculators is the failure to acknowledge the role of OPEC in energy prices.  They are a cartel!  Traders can buy and sell but only OPEC colludes to determine price levels.  Until hybrid cars, solar and geothermal technology, and algae fuel replace black gold we can fight the battle for financial gains.

We’ll continue to do just that.

It ALL comes back to commodities,
Alan Knuckman

September 14, 2009

What You Need to Know About the Future of Silver, Gold and Oil was originally featured in the Penny Sleuth.

And that financial malady is now traveling to Main Street as banks – including the latest FDIC rescue operation here in Baltimore on Friday – crumble all around us. Here’s what you need to know to profit from this mess…

The market’s mood can swing between mania and depression over short periods of time, but over longer stretches, stock prices eventually reflect the real value of underlying businesses and whether that value is growing or contracting.

Many stocks will not revisit their lows forged during last fall’s panic, but many others will break to new lows. Right now, the market is positively giddy about the future earnings streams of banks and thrifts and has bid the stocks up in anticipation of a miraculous economic recovery…a recovery that will be weak and limited to few sectors – certainly not including consumer finance, retail, and real estate.

The next move in the financial stocks will be down and regional banks and thrifts will lead this move. As Chris Whalen, a leading authority on the health of the banking sector, notes in the lead quote above: “In bad periods, banks typically set aside twice as much as they charge off, but now a lot of them are at one-to-one.” Most banks are reluctant to book the provision expenses necessary to maintain loss reserves, because this cuts into net income. But delaying recognition doesn’t mean they’ll go away; delay just means that losses in the future could be bigger and exacerbate the trend toward tighter credit. The market for bank stocks is not discounting this development right now, but it will over time. None of these smaller institutions are “too big to fail,” so many will be resolved by the FDIC, and acquired or liquidated.

This month, we’re shooting for 150% gains in put options on a thrift that strayed from its humble roots and is now dangerously undercapitalized.

What we usually do in Strategic Short Report is a form of “time arbitrage.” We recognize that euphoria can push the stocks of capital-destroying companies far above what they’re worth and we take opportunities that the market offers to sell short over a time frame when we expect common sense to prevail and prices to fall. Sentiment toward the financial sector is positively giddy right now, and stock prices have rallied to levels that discount a swift return to happy days and tiny credit losses. But the recession is over, right? No way, if you’re measuring it honestly. And for the banking sector, it’s definitely not over.

Bank Profits Cannot Grow When Balance Sheets Shrink

Now that we’re in a new ice age for the financial sector, many banks will be shrinking their balance sheets. This shrinkage occurs as healthy borrowers pay down debts and are not interested in taking on more debt. With so much excess capacity in so many industries, why should entrepreneurs with good credit look to expand? Especially with the guarantee that if they grow, these entrepreneurs would be, in the eyes of a cash-strapped government, an even juicier source of tax revenue?

This is bad news for banks, because growing private sector demand for credit is the key for banks looking to “earn their way out” of their festering losses.

Such is the paradox of runaway government spending, which is so massive that it’s temporarily boosting GDP figures. But this spending is ultimately self-defeating: The more the government spends, the more the private sector will tap on the brakes. In my view, this is the weak link in Keynesian policies, which Washington, D.C., policymakers keep pursuing aggressively. The federal government is the only notable borrower with growing demand for credit, so lots of banks will wind up buying the bonds of a spendthrift government – hardly the kind of lending that infuses cash into productive private investments and private sector jobs.

This leaves the banking system in a situation in which most borrowers seeking new loans or refinancing are not good credit risks and the borrowers who are good credit risks are not interested in more credit. And let’s not forget the elephant in the room: residential mortgages. This is a problem that cannot be resolved by just refinancing at low rates, or extending terms, because most homeowners with mortgages do not have enough equity to refinance.

The biggest mistake the banking system made was believing that the average value of U.S. houses could never go down. This mistake would have been avoidable with a bit more free market discipline in the banking system, which would have slowed credit flows into mortgage lending once prices had detached from median incomes. It also would have helped if mortgage originators were required to retain a portion of the credit risk involved with each new loan.

Bankers aren’t the only ones to blame. Policymakers made a grave mistake by pursuing the goal of homeownership for everyone. They did not distinguish between homeownership and a “call option on homeownership,” which is a more accurate definition for a low- or no-money down purchase. With the benefit of hindsight, we know that not only did these call options on homeownership expire worthless, but with the smidge of equity gone, the incentive for many homeowners to keep making mortgage payments is also gone.

There are a few more assumptions that fans of bank stocks are ignoring at their own risk. These fans are looking at the experience of the sector during the early 1990s to draw conclusions about the likely trajectory of credit losses, recoveries, and spreads on future lending. They foresee a period of consolidation, followed by a return to the pleasant lending environment.

These bulls are misdiagnosing the situation, and here’s the main reason: The banking system has no experience managing through the current “negative home equity” environment. This is an environment in which mortgage rates are already about as low as they can get and consumer balance sheets are as stressed as ever. Due to the nonrecourse nature of mortgages, most borrowers have no financial incentive to keep paying. Many are choosing to mail the keys back to the lender.

This problem will cap the upside of bank stocks for years to come, and this sector will offer lots of short selling opportunities.

Regards,
Dan Amoss

August 31, 2009

The Ugly Truth About Bank Stocks was originally featured in the Penny Sleuth.

No one thinks they’re doomed.

I’m talking about the Canadians, of course.

See, lately, I’ve read a lot about the superiority of the Canadian banking system. And naturally, my contrarian instincts prompted a search for a way for you to make money as the Canadian banks go down.

As you may know, an easy way to play the downside of stocks is through put options. Here’s a quick primer on how they work…

Put options are a limited risk, leveraged way for you to make money when stocks drop.

For example — when a stock falls 5% in a day, put options may go up 50%. When big drops happen, puts can go up hundreds of percent in hours.

And since they’re limited risk, if you’re wrong, you’ll never lose more than you put up.

My point is — there’s no easier, safer, and faster way to grab huge gains from downward stocks than through put options.

Having said that, let’s take a look in on how you can use them to make money on the Canadian banks. First, the “macro view…”

The Canadian banking system has won accolades for avoiding direct exposure to the most tempting forbidden fruit: products like subprime mortgages, credit cards, leveraged buyout loans, and loans to finance insane commercial real estate purchases.

The financial press loves Canadian banks. On May 19, The Wall Street Journal ran a piece suggesting that these banks are a model of sustainability, and now have the opportunity to acquire U.S. banks on the cheap:

“Not long ago, Canadian banks were considered slow footed, provincial, and too conservative to flourish in the global boom for financial institutions. Now that banks in the U.S. and Europe are reeling from loan losses and face growing government scrutiny and ownership, Canada’s six major banks are seen as a potential model for battered financial institutions. TD Bank, Royal Bank of Canada, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce, and National Bank of Canada posted more than C$3 billion (US$2.5 billion) in combined profit in the latest quarter.” [Ed. note: quarter ending April 30, 2009.]

Canada’s biggest six banks account for more than 85% of the assets in the country’s banking system. By and large, these banks made a smart decision to avoid securitization. Securitization refers to loans that banks originate, bundle together, and sell off to pension funds, money market funds, insurance companies, and other institutions.

But this doesn’t mean that Canadian banks have no credit risk. On the contrary, they have plenty. Mark to market accounting has not yet cut down Canadian bank earnings, because the Canadians have not yet accounted for the impending wave of mortgage, consumer loan, and corporate loan losses.

They will by the end of 2009. It’s impossible to avoid. And just to give a perspective on how quickly lending grew at the Canadian banks, the chart below shows that assets at the top six Canadian banks grew from C$1.3 trillion in October 1999 to C$2.7 trillion in October 2008. Equity at these top six banks grew in line with assets; all six kept their ratios of assets to common equity fairly constant since 1999.

Growth in assets, even if accompanied by growth in equity, is always a risky proposition for banks. At the time the loans are made, everything seems fine. Then, when a serious recession arrives, and a dramatic credit loss cycle begins, the market value of loan portfolios can rapidly decline by 5% or 10%, pushing the banking system to the edge of insolvency. Insolvency is when the value of assets is less than the value of liabilities. Bank regulators don’t like this scenario and pressure weaker banks to raise very expensive, dilutive equity capital in order to protect more senior lenders, including depositors, from suffering losses.

Canada has just entered what will ultimately be an enormous credit loss cycle, and by the time it’s over, the Canadian banks could easily lose their pristine reputations. Until the middle of 2008, Canada’s economy was booming. Its mining, energy, and manufacturing sectors are world-class, and every other sector was pulled along for the ride.

But the wheels fell off last fall. According to Statistics Canada, the unemployment rate rose to 8.4% in May — the highest in 11 years. Ontario, with its heavy manufacturing base and ties to the “Detroit Three” auto companies, is especially hard hit; Ontario lost 234,000 jobs, or 14% of its entire manufacturing work force, since last October. Ontario will lose even more jobs this summer as GM and Chrysler dramatically cut auto production. Alberta has slowed dramatically too. Just a year ago in Alberta, every skilled construction worker was working overtime on oil sands projects. Now many projects are postponed and workers are getting laid off. The unemployment rate in Alberta nearly doubled from May 2008 to May 2009, to 6.6%, and is heading higher.

For Canada, this credit cycle will probably be worse than the one in the late 1980s. According to RBC Capital Markets, annualized loan loss provisions for the entire Canadian banking system peaked at 2.88% of all loans in 1988. As of April 2009, this figure was just 0.77%. Over the next year or two, loan loss provisions should easily triple or quadruple, which would cut deeply into profits and capital… sending the worst of the Canadian bank stocks down.

So how do you play it?

First, I recommend you dig in to the major banks to figure out the one with the most exposure to unemployment rates. Then, simply visit Yahoo! Finance, enter in their symbol and click on “options” on the top left hand side underneath “Quotes.”

You’ll see all of the put options available on that stock. Pick a good one and you’ll be able to double your money as these stocks go down.

Regards,
Dan Amoss

August 12, 2009

How to Play the Canadian Banking Crisis for a Quick Double was originally featured in the Penny Sleuth.

And I’m going to give you a chance to join them.

If you think Canada escaped the downward trend in U.S. banking, think again. While the country may not have plunged headfirst into subprime mortgages, it did dip heavily into risky derivatives. The leverage it took on generated impressive returns on equity in good times, but that same leverage is set to wipe out equity today.

Shareholders in one “safe” Canadian bank will have to rethink their loyalty. Its looming solvency crisis practically guarantees a dividend cut. And that’s our catalyst for this month’s short play action – offering us a chance for 200% profit potential.

Accounting secrets have not yet obliterated Canadian bank earnings – like those of U.S. banks – because the Canadians have not yet accounted for the coming tsunami of mortgage, consumer loan, and corporate loan losses.

Here’s how they loaded those loan books with hidden risk.

The Basics of Bank Accounting

Bank shareholders leverage their capital by borrowing short-term money, primarily from depositors. Your bank account is an asset for you, but it’s a liability for your bank. For every dollar of capital, bank shareholders borrow 15, 20, or even 30 dollars from senior creditors – otherwise, they could not afford to own their huge portfolios of loans and securities. Here’s the core problem: Bank shareholders and their agents (bank executives) are lending other people’s money. So bankers are looser with lending than if they were lending their own savings.

The accounting process to determine commercial bank profits is inherently speculative, as well. Banks book an upfront profit on every new loan they make, minus a small “provision” for loan losses – just in case some loans wind up going bad. These upfront profits have the habit of disappearing when loans “season,” and banks discover how many deadbeats owe them money. In case you’ve been wondering what has wiped out the majority of the S&P 500’s trailing earnings, here’s your answer: Banks and brokerages reversing most of the profits they booked on loans made and securities bought at the peak of the bubble.

Banks claimed to make good money loans to every borrower. But somebody sure was lying, since they’re taking charges against these older vintage loans and securities left and right. And the industrywide provision for loan losses, which is the single most important – and unpredictable – cost in a bank’s income statement, has been soaring. Once these provision expenses soared on the backs of delinquent loans, the banking sector’s earnings plunged deep into negative territory.

Throw in a few more explosive ingredients like deposit insurance, central bank lending facilities, loan syndication, and securitization and we’re left with a system for which sales volume – not risk management – is priority No. 1.

Those who claim the banking system is well capitalized – including those who designed the unstressful “stress test” – hold rosy assumptions about how many loans will go bad and how much banks will earn from existing loans to have a shot at outrunning their credit losses.

Lots of bank stocks remain in a fragile state. This month, we’re going to buy puts on the Canadian bank most ready to fall. And now’s your chance to join us. If you want the name of my latest play, just click here to learn more about Strategic Short Report.

Regards,
Dan Amoss

August 10, 2009

Don’t Bet on Canada’s Banks was originally featured in the Penny Sleuth.