A Slacker's Quest For His First Million

Another AIG Scandal?

2009-03-30T00:48:00.002-04:00

Remember how in early March the banks, starting with Citi's (C) purposefully leaked memo, announced that they had operating profits? This was the beginning of a rally of over 20% on the S&P 500, which might now be over.

Zero Hedge reports that these profits everyone thought marked a turn for the economy actually resulted from AIG unwinding its CDS positions. Basically, the government gave money to the banks through AIG, and the banks said these payments were profits.

If that's how the banks booked profits in January and February, it would seem that the current optimism will disappear. The administration, which already has credibility issues, will no doubt face another round of criticism. And maybe this time Geithner will go.

Is what Zero Hedge reports true? I don't know. I'd certainly feel more confident about the reliability of the information if it came from a more established news source. After all, I'm a guy with a blog too. I can post made up stuff and have people link to it. Especially if it sounds true, like another AIG scandal. Nevertheless, we bloggers have reputations to maintain. It wouldn't be in Mr. Durden's interest to publish what he believes to be false (though I'm sure he has that soap company of his to fall back on).

So keep in mind, maybe it's just a rumor. But I think the article is true.

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Sold My Calls This Morning

2009-03-19T12:42:00.003-04:00

Market sentiment changed dramatically since I pondered about the latest rally (the bottom or just another bear market sucker's rally?) just as few days ago. After yesterday's (3/19/09) close, with the S&P 500 up around 18% in a week's worth of trading, the bulls seemed to outnumber the bears and other skeptical investors. The screaming and yelling Fast Money guys seemed particularly bullish last night. More importantly, I feel bullish and think there's no reason for the market to go lower (bearish sign).

Another thing that drove me to sell my calls (for a not so bad profit, but I wish I had bought them later than I did--and they're on the SPY if you've been wondering which calls I keep talking about; and as always, I try to update my trades on the bottom sidebar of this blog) was a video by TheStreet.com's James Altucher. (In the video he's the Sideshow Bob looking guy who is sleeping on the sidewalk and talks like he drinks too much coffee.) He says, "the bull is back." This coming from Altucher, who advises debt free homeowners to take out a mortgage because "cash is king" (genius!) is a bearish signal for me. He's been a frequent guest on Yahoo!'s Tech Ticker, and each time proclaimed that stocks are incredibly cheap or were great over the longer term just as they peaked before a leg down. November 4, 2008, July 10, 2008, December 2007. Maybe it's just poor timing of his appearances, as he'd probably say the same thing on March 9 as he's saying now (and would seem smart today). And I'm sure he's made some good calls in the past (I haven't found any), but I sell when this guy says buy.

I'm not buying puts yet, and maybe I'm a bit early in selling, but I think we're due for at least a small pullback.

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Surprise Surprise

2009-03-19T00:37:00.004-04:00

Everyone seems surprised and upset about the AIG bonuses, but are some government officials of our banana republic just acting?

From CNBC:

In a stunning development, Sen. Christopher Dodd said that Obama administration officials asked him to add language to last month's federal stimulus bill to make sure the controversial AIG bonuses remained in place.

Dodd, chairman of the Senate Banking Committee, told CNN that Obama officials wanted the language added to an amendment limiting bonuses that could be paid by companies receiving federal bailout money. He said they were afraid that without it, the government would face numerous lawsuits from employees who were promised bonuses.

Washington Post:

Senior White House officials said last night that President Obama did not learn that bonuses worth $165 million were to be paid to executives of American International Group until Thursday, one day before they were issued and two days after his Treasury secretary was informed that the payments were going forward.

But how could that be if the administration was asking for language to be added to the "stimulus" bill last month? Besides, CNN reported on the AIG bonuses on January 28th.

Where's the surprise?

And the funniest thing is Geitner's proposal to get the $165 million in bonus money back: reduce AIG's bailout by that amount! Genius! How does that work? You beg me, "please, please, please, lend me some money so I can feed my kids and pay the rent." I give you the money, knowing that I'll probably never see it again, but hey it's for a good cause. Then find out that you subsequently bought everyone drinks at a bar. Geitner's solution is that I take what you've spent on the booze from you, reducing my loan by that amount. Does that change anything? I'm still the one paying for the drinks.

Geitner is either not very smart or is shameless (maybe after he resigns Obama will follow Bush's example and give him a medal). It could be both. That's what it takes to advance in Washington these days.

But we're not so bright ourselves.

They are stealing our money right in front of us. It's not just the bailout of their Wall Street friends. (For instance, most of the AIG bailout is going out the back door to Goldman Sachs et al, for crap that AIG insured. Billions of those dollars will probably be paid out as bonuses at those firms at the end of this year. Paying off Goldman by giving money to AIG is supposed to save our financial system.)

And it's not just the previous bonuses. Are we still angry that around three fourths of Bank of America's most recent bailout was paid out as bonuses? I think we've forgotten. That's billions of dollars, and here we are livid over AIG's $165 million, which is, incidentally, about $5 million cheaper than Obama's inauguration.

Everyone seems so angry about the bonuses, whether main street's real anger or Washington's feigning. I'm not especially.

The real outrage is the nonstop running of the printing presses. The Fed just announced that it will print an additional $1 trillion plus. I've lost count of how much money is floating around out there. This is a far larger theft than the bonuses.

The silver lining, for all you angry people, is that eventually the bonuses you're upset about won't be worth anything anyway.

I say when everything fails (and it will, as our foundation is rotten), we get out the torches and pitch forks, clean up DC and Wall Street, and start over fresh.

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Another Bear Market Rally or Have We Hit Bottom?

2009-03-14T15:03:00.003-04:00

The S&P 500 is up around 10% since its low of 666.79 on Monday. (Investor's sentiment, including my own was so negative, that I decided to sell my puts and buy calls. It turned out to be a week too early, oh well (my calls are now about even).

It's remarkable how when the majority of investors are of a particular view the opposite of that view turns out to be correct. Remember, for example, the notions Nasdaq 6,000, Dow 16,000 (I'm thinking of Morningstar's call a year ago) 36,000, etc, China is safe until the Olympics, we'll have a stock rally until March? These, and many other consensus views have been proven wrong.

In early March, the consensus turned very bearish. The mood was captured in the Motley Fool article "What's Next? Dow 5,000?" and the Wall Street Journal's "Dow 5000? There's a Case for It." The WSJ piece came out on March 9--the day before the current rally started. I hope the WSJ article has the same place in history as Business Week's 1979 "The Death of Equities" cover.

There are still plenty reasons to think the market has far lower to go. We've been hearing the doom and gloom for weeks and know the story: the economy is in shambles, the previous decades' growth was based on spending borrowed money, Eastern Europe is collapsing and might take Western Europe with it, there are looming credit card and commercial loan defaults, hundreds of thousands of people continue to lose their jobs every month, housing prices are still plunging, etc.

But there are also reasons to think that the bottom in stocks was March 8th. Some consumer numbers are improving. The worst banks, if they are to be believed, are making money (but will write downs make them report losses?). The government is, at its customary slow pace, getting ready to reinstate the uptick rule and to modify the mark to market accounting rules. Whether these are good ideas or not, the market may respond positively.

The WSJ piece is another indicator. Further, the sentiment at the moment seems mixed. During all the past rallies many commentators were quick to call the bottom. There are many doing this now too. But what seems different is the growing chorus dismissing this week's market rise as just another bear market rally. The bottom callers and bear market rally callers seem about evenly mixed to me. I'd say this is a substantial improvement from the previous rallies.

Let's hope we did hit bottom. But don't be surprised if we go down another leg. I'll be looking to buy puts if we go up another 10% and I feel euphoric, or it seems to me that most investors are optimistic. An article from a major publication with a headline like "It's Safe to Invest Again" would be most helpful in making bearish bets.

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Risky Leveraged ETF Arbitrage Strategy

2009-03-06T14:33:00.012-05:00

This post is yet another demonstration of why holding leveraged ETFs for a longer period is not worthwhile. It is also a brief examination of how the less risk averse among us might take advantage of this fact.

I wrote a while back about the dangers of holding leveraged ETFs over the longer term. As everyone should know, these instruments are designed to be used for short term trades. You can see this by looking at any of the leveraged bear ETFs' highs and lows. Even while the market is making new 52 week lows, many bear ETFs are off their highs, some by as much as 50% or more. This is because the longer one holds them, the more likely it is that volatility will kill performance. Morningstar recently summed this up in a two part video series.

So if holding the leveraged ETFs for a long time may not be very profitable, what about selling them? Here is a pretty risky arbitrage strategy that should work as long as the market stays volatile. This one is best left for the gamblers among us.

Sell short the leveraged ETFs in pairs. That is, sell short both the bull and bear ETFs for the same underlying index for the same dollar amount. For example, short $10,000 worth of BGZ and short $10,000 worth of BGU. This position is partially hedged. Since the ETFs essentially mirror one another's movements, as long as the market does not take one direction for too long, the position should be relatively stable. For example, suppose BGU goes up 10%. BGZ should fall 10%. You've neither gained nor lost anything. Any underperformance of the ETFs relative to the underlying index is the short seller's profit.

Take a look at the following most liquid 3x ETF pairs, and their performance since November 19, 2008 (the first date on which it was possible to buy/short both simultaneously).

Large cap stocks: BGZ and BGU.

Energy: ERY and ERX.

Small cap stocks: TNA and TZA.

Since November 19, BGZ is up around 10%. Its counterpart BGU is down close to 50%. Shorting both of these in equal dollar amounts would have produced a gain of around 40%. Since November 19, TNA is down around 50%. Its counterpart TZA is also down (although not nearly as much). Although the ETFs trade in opposite directions, one could have made money on both. The same is true for ERX and ERY from November 19 until March 5th. ERY is down around 10%, while ERX is down over 50%.

I've used various different periods, and for the most part, one ETF in each pair is down more than its counterpart is up. Occasionally, over the very short term (i.e., intra day), both ETFs in a pair were up.

If this seems too good to be true, you are right to be skeptical, for there are plenty of risks.

I say above that the strategy of shorting the bull and bear pairs is mostly hedged. It is not completely hedged. For one thing, although the ETFs trade inversely (e.g., if one goes up 1% the other falls 1%), the movements are inexact. It often happens that one ETF rises more than its counterpart falls, and vice versa. A more important reason that the strategy is not completely hedged is that while the ETFs can go up more than 100%, they cannot go lower than 0. In shorting these ETFs, one's potential losses are unlimited. Consider UYG and SKF, where one would have lost money by shorting both:

One way to guard against this would be to purchase out of the money calls (say 100% out of the money) on each position, but the cost of this insurance would likely make the enterprise not worthwhile.

Other risks include liquidity issues as well as difficulty in borrowing the shares. One's broker may also close out a position at the most inconvenient time.

Although the strategy seems to work well over the medium/longer term, it might be safer and wiser to close out the position as soon as it is possible to realize some predetermined gain, say 5% or more. Close out the position then start one anew. One must watch it like a hawk.

I am not going to try this out myself. I am too scared of short selling (perhaps irrationally so) and like to replicate short strategies with puts. Unfortunately, the puts on these ETFs do not go out past October, the strike prices are too low, and the premiums are too high.

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Obama Snubs Geitner?

2009-02-28T12:46:00.003-05:00

Take a look at the last 20 seconds or so of this video. Obama shakes Dodd's hand, Frank's hand, moves past Geitner, and shakes Shelby's hand. It looks as though Geitner reaches out to shake Obama's hand and the President just moves past him.

Probably nothing, but might we have a new Treasury Secretary soon?

(Sorry about the annoying commercial; I don't know how to get rid of it.)

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Professor Obama's Break out Sessions

2009-02-23T13:42:00.003-05:00

In concluding his speech at the start of the Fiscal Responsibility Summit, Obama urged those assembled to separate into groups and have "break out sessions." Then they are to come back later today and report to him what ideas they have discussed.

This may sound oddly familiar to those of us under 30 or so. We've heard this kind of thing ("break out sessions") from moron high school teachers and college professors for years. Remember this nonsense? Separate into groups, talk amongst yourselves, have someone write it down, and then read it in front of the class. The result is always the same: nothing gets done and no one learns anything. OK, we do learn something--how to talk.

And that's the problem. Obama is the end result of "break out session" education, where talking takes the place of thinking; he is the epitome of knowing nothing but sounding like you know something. That's all he knows how to do. All his speeches so far have had no substance, just buzz words. All the plans so far have laid out principals for how responsible hardworking people will bailout the irresponsible. "Transparency," "accountability," "responsibility," and so on. Repeat it enough and people will believe you. Maybe they won't question how you can sign $787 billion in new spending into law and then hold a fiscal responsibility conference with a straight face. Maybe they won't think about how the "stimulus" bill was bullied into passage in the same way the Patriot Act was, and how no one had time to read the damn thing. Very responsible and transparent.

Well here's a suggestion for your group work assignment, Professor Obama. You can save $787 billion right away. Cancel the "stimulus" bill!

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Where to Buy Gold and Silver

2009-02-22T13:45:00.009-05:00

In general, people buy physical precious metals just in case there is a (currency/financial) collapse, to have a readily available store of their wealth, and because they do not trust paper. If one wants to avoid the risks of owning paper (dollars, stocks, etc), buying more paper (gold certificates, ETFs, futures) doesn't make sense.

Lots of people are currently interested in buying precious metals. When regular Joes and Janes are racing to buy something, this usually indicates the top of that market (stocks, houses, tulips, etc). On the other hand, precious metals prices can continue rising for a long time yet, given the monetary policies of most governments. Whichever way prices go, the buying and selling of physical precious metals is right now a booming business.

As is usually the case with booming markets, there is fraud. Thieves have been known to sell old ladies bricks spray painted a golden color. Companies like Cash4Gold are allegedly buying people's jewelry for as low as 1/3 of the market price. Others are trying to sell various gold coins for much higher than the market price. And so on.

So, if you're interested in buying bullion, you have to be careful. It's easy to find a gold/silver dealer through a search engine, but how do you know what they're selling you is legit and not gold plated lead?

One good place to start is USmint.gov. They have a list of dealers of American Eagle gold and silver coins. These companies are not official dealers of US bullion coins, but their listing on the government website gives them some legitimacy. I would be more comfortable buying from them than from those that are not listed.

After you've narrowed down the list, be sure to check how long the remaining companies have been in business. The longer the better. Next, try to find out how long it takes for them to ship you your order after they receive payment. If the dealer goes out of business before your order is shipped, you may lose your money. Thus, try to make more purchases for lesser amounts, just in case.

Be sure to shop around. There is always a premium over the market price that dealers charge. Some charge more than others. Remember to factor in all transaction costs, including shipping and insurance.

One company that I've been satisfied with is the American Precious Metals Exchange, operating out of Oklahoma. They've always shipped a couple of days after my credit card payment was received. The package is insured and you have to sign for it. Note that they charge cancellation and other fees.

I've never bought from Kitco, so I don't know how good they are, but the website has a wealth of resources.

Northwest Territorial Mint is one to be wary of. Many people say they have great experiences with the company. Others disagree. They complain of long shipping times and unresponsive customer service. The company has recently settled a related lawsuit. The premiums they charge are at times significantly higher than other companies'.

One of the safest (and cheapest in terms of above market premium) ways to get your hands on silver is to buy "junk silver." This includes dimes, quarters, and half dollars minted in 1964 or earlier. They have around 0.715 troy ounces of silver per dollar face value (10 dimes, 4 quarters, or 2 half dollars). (So the next time you want to pay for something with change, check the years of your dimes and quarters. You might get lucky.) Given that coins are hard to duplicate (or maybe no one bothers because the face value is low), when buying junk silver you can easily tell if it's genuine. Many people are even comfortable buying it on Ebay.

If making large purchases, you might consider opening an account with a commodities broker, buying gold or silver contracts, and then requesting delivery.

Some pictures from Zimbabwe. Let's hope that's not what awaits us.

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Some More Doom and Gloom

2009-02-21T16:07:00.002-05:00

I don't know if I'm turning into one of those crazy "the world is ending lets buy physical gold and silver" types, but I found this article interesting and scary. The author provides his interpretation of the Davos Forum. The author comments about Putin's blue print for a post USA world. It seems credible, but it's not mentioned anywhere that Russia is on the verge of bankruptcy. They'll burn through cash very quickly if oil prices don't rise.

I never heard of this guy before, but he seems to be dead on:

Faber says Eastern Europe is collapsing, because they borrowed too much in foreign currencies (this does not bode well for their creditors).

It seems that everywhere I turn there is deep pessimism about the future. As I'm very pessimistic myself (and view myself as a contrary indicator), I've sold my puts and bought calls on Friday. The market can continue falling, of course, but I think we're about due for a rally (probably just shorts covering).

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Jim Rogers Shorting GE, JPM, IBM, Covered Treasuries

2009-02-12T15:28:00.002-05:00

Jim Rogers, the famed investor and writer, is always informative and fun to watch. Below is a recent Bloomberg interview.

Jim Rogers continues to be bearish on US stocks, but has covered his short position in long term Treasuries "because of Mr. Bernanke." Presumably that means Rogers thinks the Fed can keep yields low by buying Treasuries. He also briefly mentions that he's shorting IBM, GE, and JPM.

Rogers says Tim Geitner doesn't know what he's doing, and is responsible for our current situation because of his role as the NY Fed president. That seems correct to me.

Rogers also repeats his solution: let all the insolvent companies fail. Wipe them out and we'll have a fresh start. The economy will start growing again. He didn't mention Korea this time, as an example of a country that let its businesses fail and then had a great growth rate.

I agree, but here's a caveat about growth. Let's say we're at 100 right now and letting everyone fail takes us to 25 (made up numbers, just for the sake of an example). Let's say after that we grow 10% annually (an awesome growth rate). It would take us over 14 years to get back to where we are. This is to say, just because an economy is growing it doesn't mean that it's better off than it was a few years ago. Nevertheless, if we don't let the incompetent fail and keep them around as zombies, we might very well get to 25 anyway, but over a longer period of time. And then we might not grow at all. Look at Japan.

One thing is clear, as Rogers has been saying; you can't solve a problem caused by too much debt and consumption by more debt and more consumption.

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Higher Trading Fees Coming?

2009-02-11T15:29:00.002-05:00

During the testimony of the bank CEOs in front of the House Financial Services Committee today (2/11/09), Congressman Stephen F. Lynch (D-MA) asked what the bankers thought of a "transaction fee" on purchases of stocks and bonds. Lynch's idea is that because a sizable minority of his district does not own stocks, those people who do own stock should pay for the financial bailout. He mentioned a fee of what sounded like "three hundredths of one percent per share." (We'll have to see what the transcript says.) It looks as though the idea I wrote about earlier is gaining ground, unfortunately.

That earlier proposal, by the liberal think tank Center for Economic and Policy Research, called for a fee of 0.25% on every financial transaction. I hope the congressman is thinking of 0.03% (that's what it sounded like he said) rather than 0.3%. We can live with a 0.03% fee, but most day traders will be out of business with a 0.3% fee. That in turn will lead to higher costs for everyone, as well as more job losses for the reasons mentioned here.

Most of the bankers sheepishly answered that "it's a good idea" (e.g. Ken Lewis) or "I don't know" (Vikram Pandit). Only one, John Mack (I think) of Morgan Stanley (MS) said that it would be a good idea if it didn't drive volume away from American markets.

Some sort of fee will ultimately be imposed. I hope it's closer to 0.03% than 0.3%, but with our current congress I wouldn't be much surprised with a fee of 1%.

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Bought TBT, No Plan Geitner, Minneapolis Fed Article

2009-02-10T14:35:00.004-05:00

Oh what luck I just bought TBT for less than I planned (though it may fall more), at $46.34. Reasons for buying are in my last post here. I'll wait for a 10% decline to buy some more. Since leveraged ETFs underperform when there's volatility, a safer play would be to buy very deep in the money puts, say for Jan '11, on TLT. Say a 150 strike or higher. That's almost like shorting TLT, but your downside is limited (and the put will probably still expire in the money even if yields go back down, though anything is possible).

The market is down big today (so far, it can always turn around). Why? Sell the news: Tim Geitner unveiled his plan, which apparently is a set of principles and a new government website. The Senate also voted on and passed its version of the bailout pork spending bill. Now they'll argue with the House over how much they should spend for useless stuff. The market went even lower after Bernanke started talking.

Nothing good will happen until they close down the incompetent banks and give their assets to the competent ones.

Some interesting reading:

Publish at Scribd or explore others:

Disclosure: Long TBT.

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I'm Going Long TBT

2009-02-08T17:18:00.029-05:00

've been watching Treasury yields for a while, looking for a sign that the bubble has burst. It looks to me like it might have. I'm certainly late to the party, as the Ultra Short Lehman 20yr+ ETF (TBT) is up considerably from its lows. However, I think it has far to go up, and the downside risk appears limited. This doesn't mean that it won't reverse course, but I think over the longer term (despite my misgivings about leveraged ETFs), it will do very well.

First some numbers.

The current US public debt outstanding is just over $10.7 trillion.

As of November 2008, major foreign holders of Treasury securities own around $3.0859 trillion in US government debt. The top five are

China $681.9 billion
Japan $577.1 billion
UK $360 billion
Caribean Banking Centers (Bahamas, Bermuda, Cayman Islands, Netherlands Antilles and Panama) $220.8 billion
Oil Exporters (Ecuador, Venezuela, Indonesia, Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, the United Arab Emirates, Algeria, Gabon, Libya, and Nigeria) $198 billion.

The principal reason that these foreign holders have been able to buy so many US bonds was the virtuous circle created by US consumers buying foreign goods and raw materials and shipping US dollars overseas, the proceeds of which were used to buy US bonds (and mortgages, etc). We bought their junk and oil, and they bought our debt. As everyone by now knows, the circle appears to be breaking, perhaps turning into a downward (death) spiral. Despite government calls for people to borrow and spend, consumers are actually starting to save.

The Japanese economy is facing a severe decline. It is expected to contract 2.5% in 2009, according to the IMF. A former Bank of Japan official is more pessimistic, expecting a decline of at least 3.8%. This will be on top of the 10% or more annualized decline in GDP in the final months of 2008 (expected, figures not available yet--the average estimate is for an annualized late 2008 GDP drop of 11.5%). Add to this political turmoil. Japan will probably be a less willing/able bond buyer. It has already reduced its US bond holdings ($582 billion in October 2008).

The United Kingdom's GDP fell 1.5% (a downward revision is expected) in the fourth quarter of 2008. The expectation for this year is a drop of 3%. With the pound falling and some currency experts calling for parity with the dollar, the UK probably won't be able to buy as many US bonds.

China, the world's 3rd largest economy (sorry Germany), is also facing problems. Its GDP is expected to grow at 7% in 2009. This is terrible for a country that requires 15 million new jobs annually just to keep up with population growth. China has already complained about the low bond yields, and has been angered by Geitner's currency manipulation comments. It's now likelier that China will start selling its US bond holdings instead of buying more.

Oil prices have come down a long way, leaving bond buyers like Saudi Arabia with far less cash to spend. Faced with a worldwide economic decline, other major bond buyers will also have less money to invest.

The US bond buying activities of the top foreign bond purchasers, then, should be curbed. With less buying interest from a major portion of the market, it seems that Treasury yields will have to go up. Add to this increasing supply.

According to Bloomberg:

The government will need to auction $493 billion in debt this quarter, 34 percent more than initially projected, the Treasury said on Feb. 2. It will probably borrow as much as $2.5 trillion during the fiscal year ending Sept. 30, compared with $892 billion in notes and bonds it sold the prior 12 months, according to primary dealer Goldman Sachs Group Inc.

Who is going to buy all this debt? As we saw, the major foreign holders may not be as willing or able. Other market participants, will sooner rather than later demand higher yields before they start buying. While yields are up from their troughs, they are still very high historically. Barring another panic like we had in December, rates should not fall very much, if they do at all. (It's certainly possible that 30 year yields can fall to 0% in a super panic, but it is far more likely that they will continue rising. Also, if something like a 0% yield on the 30 year happens, we are royally screwed.)

The buyer of last resort is the Fed (which Marc Faber says follows the "Zimbabwe School" of economic thought). As they print money, they can buy as much debt as they want. If the bond market balks, the Fed will try to pick up the slack. The Central Bank can win a few early battles, but the market will win the war, as it always does. The more the Fed prints, the sooner the dollar's demise. If the Fed has to step in because other buyers are unwilling, those buyers will not be any more willing when the number of dollars increases. Interest rates will have to rise.

If/when interest rates rise, the economy will stagnate further. Consumers will spend less on foreign goods, which will leave less money for foreign bond purchases. Less bond demand (and ever more supply) will make rates go up even higher. We will eventually have inflation, as the Fed prints more money--more upward pressure on interest rates.

We can have inflation even if the economy continues to struggle. The Consumer Price Index was just under an annual rate of 15% in the late 1970s. They called it stagflation. The 30 year Treasury yield, which was around 8% at the end of the 1970s spiked to over 15% in 1981. It's hard to see why something similar will not repeat again.

The 30 year Treasury yield, at the time of writing, is at 3.683%. Let's say it goes back to 4.5% (the 52 week high is 4.813%) in the next few months. That's a loss of around 18.5% for the 30 year Treasury price. As TBT is twice the inverse, we can expect a gain of around 37% or more (as long as there isn't too much volatility). Over the longer term, if the US continues its massive borrowing, which it probably will, the yield can go a lot higher.

Note that if yields fall, the TBT will fall twice as much. Should the fall be significant, the expectation of a 37%+ gain if the 30 year yield is at 4.5% will have to be reduced. Example: the 30 year Treasury yield falls 10%, and then rises 11%. It's back to where it started. In this scenario TBT will fall around 20% and then will rise around 22%. It won't be back where it started. It will be down 2.6%.

I'm going long TBT. If it falls (which it might), I'll buy some more. One major caveat here is that this trade seems like such a no brainer that it's bound to go wrong somehow. Easy money is always the hardest, as they say. If you're following me into TBT (hopefully you're already in it in from the low 40s or mid 30s), don't put everything into it. And please do your own research.

Other ways to play this, as mentioned before at the last market peak, are to short the long 20 yr+ Treasury ETF (TLT), buy puts or sell calls on TLT, or buy calls or sell puts on TBT.

Another way is to sell puts or buy calls on the 30 year Treasury index. These are cash settled. If you are long the option at expiration and it is in the money, you are paid the difference between the yield and the strike price. If you are short an in the money option at expiration you pay the difference between the yield and the strike price. If you are long an out of the money option at expiration, you lose your premium. If you are short an out of the money option at expiration, you get to keep your premium. If the strike prices are puzzling in the Yahoo! link, multiply the yield by 10 (e.g., 3.683% = 36.83).

If you are long Treasury bonds, think about using some of these to hedge yourself.

And of course, if you think Treasury yields are going down, do the opposite--short TBT, go long TLT, etc.

Update 2/10/09:

Links to WSJ charts comparing S&P/DJIA and 30 year yield:

S&P

DJIA

For an opposing view, check out this article at thestreet.com, which says that the bubble is in TBT, not treasuries.

Disclosure: I hold no positions in the above mentioned securities, but am planning to go long TBT.

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Trade Notes March 07 to Feb 09

2009-02-07T14:55:00.002-05:00

My trade notes in the sidebar were getting too long, so I've put them here. As you can see, I was kind of busy in January--which correlates with my less frequent posting. The format for the January trades is different because I just copied and pasted to save time, whereas before I wrote out what the options were. Basically, these are puts and calls on the SPY ETF.

Not listed below, because it's in a different account, but my WFC was called in early February. I had also tried to do a dividend capture with BMY, which succeeded last year.

I'll hopefully have some time to go over the trades below to analyze my successes (luck) and more importantly my failures.

02/10/09 .SWGBL BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SWGBL AT $0.35

02/05/09 .SWGBL SOLD TO OPEN 5 CONTRACTS OF OPTION .SWGBL AT $0.59

02/04/09 .SZCCG BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SZCCG AT $3.40

02/03/09 .SZCCG SOLD TO OPEN 5 CONTRACTS OF OPTION .SZCCG AT $3.60

02/02/09 .SZCPB BOUGHT TO OPEN 6 CONTRACTS OF OPTION .SZCPB AT $5.50

01/30/09 .SZCCI BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SZCCI AT $2.70

01/28/09 .SWGNL SOLD TO CLOSE 6 CONTRACTS OF OPTION .SWGNL AT $4.75

01/28/09 .SWGNL BOUGHT TO OPEN 6 CONTRACTS OF OPTION .SWGNL AT $4.55

01/27/09 .SZCNE SOLD TO CLOSE 5 CONTRACTS OF OPTION .SZCNE AT $2.67

01/27/09 .SZCNE BOUGHT TO OPEN 5 CONTRACTS OF OPTION .SZCNE AT $2.47

01/23/09 .SZCCI SOLD TO OPEN 3 CONTRACTS OF OPTION .SZCCI AT $3.35

01/23/09 .SZCCI SOLD TO OPEN 2 CONTRACTS OF OPTION .SZCCI AT $3.35

01/23/09 .SZCCI BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SZCCI AT $3.10

01/23/09 .SZCCI SOLD TO OPEN 5 CONTRACTS OF OPTION .SZCCI AT $3.30

01/23/09 .SZCCI BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SZCCI AT $3.00

01/22/09 .SZCCI BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SZCCI AT $3.15

01/22/09 .SZCCI SOLD TO OPEN 5 CONTRACTS OF OPTION .SZCCI AT $3.50

01/20/09 .SWGCL BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SWGCL AT $2.73

01/20/09 .SZCCI SOLD TO OPEN 5 CONTRACTS OF OPTION .SZCCI AT $3.30

01/20/09 .SZCNE SOLD TO CLOSE 5 CONTRACTS OF OPTION .SZCNE AT $5.55

01/16/09 .SWGCL SOLD TO OPEN 5 CONTRACTS OF OPTION .SWGCL AT $3.10

01/16/09 .SWGCL BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SWGCL AT $3.25

01/16/09 .SWGCL SOLD TO OPEN 5 CONTRACTS OF OPTION .SWGCL AT $3.45

01/15/09 .SZCNE BOUGHT TO OPEN 5 CONTRACTS OF OPTION .SZCNE AT $5.40

01/15/09 .SZCNE SOLD TO CLOSE 5 CONTRACTS OF OPTION .SZCNE AT $5.50

01/15/09 .SZCNE BOUGHT TO OPEN 5 CONTRACTS OF OPTION .SZCNE AT $5.40

01/15/09 .SZCNE SOLD TO CLOSE 7 CONTRACTS OF OPTION .SZCNE AT $5.10

01/15/09 .SZCNE SOLD TO CLOSE 3 CONTRACTS OF OPTION .SZCNE AT $5.10

01/15/09 .SZCNE BOUGHT TO OPEN 10 CONTRACTS OF OPTION .SZCNE AT $5.00

01/15/09 .SZCCH BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SZCCH AT $4.80

01/14/09 .SZCNE SOLD TO CLOSE 5 CONTRACTS OF OPTION .SZCNE AT $4.20

01/14/09 .SZCBJ BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SZCBJ AT $3.35

01/14/09 .SZCCH SOLD TO OPEN 5 CONTRACTS OF OPTION .SZCCH AT $5.60

01/14/09 .SZCNE BOUGHT TO OPEN 5 CONTRACTS OF OPTION .SZCNE AT $4.05

01/13/09 .SZCBI BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SZCBI AT $4.70

01/13/09 .SZCBI SOLD TO OPEN 5 CONTRACTS OF OPTION .SZCBI AT $4.95

01/13/09 .SZCBI BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SZCBI AT $4.65

01/13/09 .SZCNI SOLD TO CLOSE 5 CONTRACTS OF OPTION .SZCNI AT $4.90

01/13/09 .SZCBJ SOLD TO OPEN 5 CONTRACTS OF OPTION .SZCBJ AT $4.05

01/13/09 .SZCNI SOLD TO CLOSE 5 CONTRACTS OF OPTION .SZCNI AT $4.65

01/13/09 .SZCNI BOUGHT TO OPEN 5 CONTRACTS OF OPTION .SZCNI AT $4.65

01/13/09 .SZCNI BOUGHT TO OPEN 5 CONTRACTS OF OPTION .SZCNI AT $4.70

01/12/09 .SZCMJ SOLD TO CLOSE 10 CONTRACTS OF OPTION .SZCMJ AT $2.00

01/12/09 .SZCMJ BOUGHT TO OPEN 10 CONTRACTS OF OPTION .SZCMJ AT $1.86

01/12/09 .SZCMJ SOLD TO CLOSE 10 CONTRACTS OF OPTION .SZCMJ AT $2.00

01/12/09 .SZCMJ BOUGHT TO OPEN 10 CONTRACTS OF OPTION .SZCMJ AT $1.91

01/12/09 .SZCBI SOLD TO OPEN 5 CONTRACTS OF OPTION .SZCBI AT $5.10

01/12/09 .SWGBL BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SWGBL AT $3.75

01/09/09 .SWGBL SOLD TO OPEN 5 CONTRACTS OF OPTION .SWGBL AT $4.10

01/09/09 .SWGAL BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SWGAL AT $1.59

01/09/09 .SWGAL SOLD TO OPEN 5 CONTRACTS OF OPTION .SWGAL AT $1.81

01/09/09 .SWGAL BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SWGAL AT $1.59

01/09/09 .SWGAL SOLD TO OPEN 5 CONTRACTS OF OPTION .SWGAL AT $1.81

01/09/09 .SWGAL BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SWGAL AT $1.60

01/08/09 .SWGAL BOUGHT TO CLOSE 2 CONTRACTS OF OPTION .SWGAL AT $2.11

01/08/09 .SWGAL BOUGHT TO CLOSE 1 CONTRACTS OF OPTION .SWGAL AT $2.11

01/08/09 .SWGAL SOLD TO OPEN 5 CONTRACTS OF OPTION .SWGAL AT $2.50

01/08/09 .SWGAL BOUGHT TO CLOSE 2 CONTRACTS OF OPTION .SWGAL AT $2.11

01/07/09 .SWGAL SOLD TO OPEN 5 CONTRACTS OF OPTION .SWGAL AT $2.74

01/07/09 .SWGAL BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SWGAL AT $2.56

01/07/09 .SWGAL SOLD TO OPEN 5 CONTRACTS OF OPTION .SWGAL AT $2.80

01/07/09 .SWGAL BOUGHT TO CLOSE 5 CONTRACTS OF OPTION .SWGAL AT $2.69

01/07/09 .SWGAL SOLD TO OPEN 5 CONTRACTS OF OPTION .SWGAL AT $2.83

01/07/09 SPY SOLD 500 SHARES OF SPY AT $91.80

01/07/09 SPY BOUGHT 500 SHARES OF SPY AT $91.59

11/26/08 Sold to close QQQQ Mar '09 34 calls @ $1.11.

11/25/08 Bought SPY Mar '09 put @ $2.45.

11/20/08 Long standing limit order executed this morning. Bought QQQQ Mar '09 34 calls @ $0.89. Jumped in too early? We'll have another rally, but from what trough?

11/19/08 Sold to close QQQQ Mar '09 26 put @ $2.92. Looking to buy March or June calls if market continues going down from here.

11/04/08 Bought WFC @ $34.93. Sold WFC Jan '10 2.5 call @ $32.38.

10/28/08 Sold to close QQQQ Dec '08 34 call @ $1.55. I'll buy a March call on any decent pull back. I don't know if the rally will continue, but I'm pretty happy with the way this trade went. Total for purchase was $3.32. Total for sale was $4.10. Not bad percentage wise, although had I bought that same call yesterday at $0.70 or so, that would've been much better.

As the market went up big today, I bought a QQQQ Mar '09 26 put for $2.25. It was a limit order I set a couple of days ago. Should have put it much lower. There's plenty of time for the market to go down again, though.

10/24/08 Sold to close QQQQ Dec '08 28 put @ $2.55.

10/22/08 Bought ESLR @ $3.05. Sold Mar '09 2.5 call @ $1.22. ESLR cost basis is now $5.18.

10/16/08 Big mistake selling Nov QQQQ 27 put.

Bought QQQQ Dec '08 28 put @ $2.00.

Bought QQQQ Dec '08 34 call @ $1.32. With enough volatility it's possible to make money on both.

10/14/08 Sold to close QQQQ Nov '08 39 calls @ $1.10. Could have sold the 27 put for over $2 on 10/10, but I got greedy. Sold to close Nov '08 27 put @ $0.51.

10/10/08 Sold to close ESLR puts @ $0.15. ESLR cost basis now $5.69.

10/9/08 Shouldn't have sold SPY put.

Going into the weekend, I want to hold puts and calls on an index. Lots of stuff has been happening on weekends recently.

Bought QQQQ Nov '08 27 put @ $1.03. This will make money if things continue down.
Bought QQQQ Nov '08 39 calls @ $0.45. Seven down sessions in a row, there's got to be a rally soon.

10/8/08 Sold SPY Mar '09 72 put @ $2.09.

10/6/08 Sold GE @ $20.11. I plan to buy it back, maybe early next year.

Bought SPY Mar '09 72 put @ $1.35. Will try to buy puts on QQQQ during the next rally.

10/1/08 Sold CPSL Mar '09 5 call @ $0.3.

9/29/08 Bought SOV Oct '08 2.5 puts @ $0.3.

Bought SOV Oct '08 10 calls @ $0.3.

Sold to close SOV Oct '08 2.5 puts @ $0.8 (set limit and left the computer. Should have been watching! I'm an idiot).

Sold to close SOV Oct '08 10 calls @ $0.25.

9/25/08 Bought to close CPSL Oct '08 5 calls @ $.05. Cost basis for CPSL now $3.97.

9/16/08 Bought to close CPSL Sep '08 5 calls @ $.05. Cost basis for CPSL now $4.37.

Sold CPSL Oct '08 5 calls @ $0.45.

Bought covered and naked ESLR Oct '08 2.5 puts @ $0.1.

9/15/08 Sold to close LEH Sep '08 2.5 puts @ $2.35.

Bought MER Sep '08 22.5 calls @ $1.24. Sold to close MER Sep '08 22.5 calls @ $1.4.

9/12/08 Bought MER Jan '08 2.5 puts @ $0.3.

9/11/08 Sold ESLR Jan '10 7.5 calls @ $1.6.

Bought LEH Sep '08 2.5 puts @ $0.51.

9/9/08 Bought to close Jan '10 5 ESLR calls for $2.95. ESLR cost basis now 5.89.

8/28/08 Sold Fannie Mae December '08 12 calls for $0.95.

8/22/08 Sold BlackRock Enhanced Equity Yield Fund (EEF) @ $13.70

8/19/08 Bought China Precision Steel (CPSL) @ $4.67. Sold September '08 5 calls for $0.35.

8/18/08 Bought Fannie Mae December '08 12 calls for $0.70.

7/24/08 - 8/5/08

Bought Johnson & Johnson (JNJ) @ average $68.53.

Bought Procter & Gamble (PG) @ average $65.13.

7/30/08 Sold 3 ESLR Jan '10 5 calls @ $6.40.

7/28/08 Bought second and third batch of Evergreen Solar (ESLR) @ $8.77. Average cost basis for ESLR now at $9.34.

7/13/08 WaMu CD matured. Moved to savings, then to buy JNJ and PG.

5/29/08 Bought first batch of Evergreen Solar (ESLR) @ $10.40.

5/21/08 Bought General Electric (GE) @ $31.00. Average cost basis now at $31.31. Dividends are reinvested automatically. Average cost basis will be lower because of fractional shares from future dividends.

5/9/08 Sold Overseas Shipholding Group (OSG) @ $80.20.

5/9/08 Sold Reynolds American (RAI) @ $54.02.

4/21/08 Sold Du Pont (DD) @ $52.00.

4/9/08 Bought Philip Morris International (PM) @ $49.99. Dividends will be reinvested automatically. Cost basis will decrease with future dividend payments.

1/4/08 Bought WaMu CD. 6 months at 5.1% APY

12/17/07 Bought RJA @ $10.90.

12/14/07 Bought Du Pont (DD) @ $44.94.

5/8/07 Bought BlackRock Enhanced Equity Yield Fund (EEF) @ $19.93

4/24/07 Bought General Electric (GE) @ $34.60.

4/23/07 Bought Overseas Shipholding Group (OSG) @ $68.5

3/21/07 Bought Royce Focus Trust (FUND) @ $11.

3/20/07 Bought Reynolds American (RAI) @ $60.02.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.

Stimulus, Day Trading, Municipal Bonds

2009-01-31T14:58:00.024-05:00

Are the House Democrats serious about fixing the economy, or are they just morons? The Wall Street Journal estimates that about 12% of the spending will go to anything that might produce jobs, the rest of it is waste, including $54 billion for Federal programs that can't pass basic financial audits, $600 million for green cars (on top of the $3 billion a year the government already spends on its vehicles), $1 billion for the insolvent Amtrak, $400 million for global warming research, $50 million for arts, $150 million for the Smithsonian, $2.4 billion for carbon capture demonstration projects, and $335 million for sexually transmitted disease education, among other things (most of the money goes to government programs).

I'm a liberal and think some of these things are worthwhile if we have the money for them. If we're spending money we don't have, we must spend it on something that will create jobs. None of the above does.

Whatever they say, I have always thought that Democrats prefer government spending on useless things over tax cuts for the same reason they prefer social security Ponzi scheme over private retirement accounts: it's much easier to steal the money when it's in the government's hands. If you give the people and corporations a massive tax cut, it's hard to divert money to one of your pet projects or your own pockets. (Republicans have their own methods of funneling away funds, but the Democrats are in charge now.)

The bill is supposed to be a jolt for the economy. How can that be when the Congressional Budget Office says that $26 billion will be spent this year, and $110 billion will be spent in 2010. That's only 16% of the bill. What's so bold and swift about it?

But the worst part of the bill is a provision that will prohibit the use of foreign steel and iron for the infrastructure portion of the stimulus. If this or something similar becomes law, other countries will follow suit. Then we'll have war--first with trade, and then with bombs and bullets.

In the meantime, Obama's tax evading Treasury Secretary (and former president of the NY Fed, responsible for implementing the low interest rate policies that got us into this mess) is angering the Chinese, who we desperately need to buy our debt and who are already complaining about low Treasury yields. Why shouldn't they take the money they use to buy US debt and devote it to their own economy, or military spending? It's not smart to anger someone who's got you by the family jewels.

Comrade Obama has also made Biden a "middle class czar." Already party operatives, or should I say apparatchiks?, are making the press rounds bemoaning the low rate of unionization in this country. What great things unions have done for the industries in which they are entrenched! Look how well the automakers have done, for instance.

And coming down the pike there will be a financial transaction tax, perhaps 0.25% or more. Every time you buy or sell a stock, ETF, future, bond, etc, you'll be taxed. Advocates, like Dean Baker of the Center for Economic and Policy Research, argue that such a tax could provide the government with $100 billion or more a year in additional tax revenue while simultaneously discouraging unproductive economic activity like day trading. It is also argued that long term investors will not be significantly affected. What's 0.25%, after all? They might even benefit from a decrease in volatility (assuming that day traders are responsible for market volatility and not the rumor mill).

I beg to differ. Many day traders and hedge funds will be put out of business if a financial transaction tax is established. Say the tax is 0.25% for buying and selling. A typical day trader might buy $100,000 worth of a stock or ETF, say the Nasdaq 100 (QQQQ), at a support level, wait for it to bounce a few cents per share, and sell it. Repeat this process several times a day, and it becomes very profitable. But if the trader has to pay 0.25% of the transaction each way, on the $100,000 that's $500 in taxes (excluding profits and losses) for one round trip. There goes the profit.

Serves him right, one might say. He's not doing anything useful.

But he is. All the discount brokers make their money from day traders, now that interest rates are super low. If the day traders stop trading, some brokers will go out of business (just what we need, more job losses). Others will have to raise their trading fees and layoff employees to compensate for the loss of revenue.

Long term investors will thus have more fees and worse service, and an additional tax, which they'll incur even if they sell at a loss. Bid/ask spreads will widen due to reduced volume, so it will become progressively harder to buy and sell some stocks. If not for day traders, many stocks would be completely dead. Lower volume will also mean lower revenue for the exchanges, which will also lead to job losses.

So let's take that $100 billion target for extra government revenue. The tax revenue currently generated by the exchanges, clearing firms, and brokers, the employees of these institutions, and day traders (including hedge funds) will decrease. So the government will net a lower gain. If most day traders leave the market, guess who will end up paying all of the tax? Why, the long term investors who are not supposed to be much affected by the new tax.

None of the financial media seem to be commenting about this, but there are already whispers about it in the administration. Day trade while you can, because I bet you that as soon as this is brought before Comrade Obama he'll say yes we can.

I've been negative on muni bonds for about a year now, and rightly so. I'm changing my mind. The tax free yields are certainly attractive. Further, now that Obama, the majority of whose investments are in municipal bonds, is in office it seems likely that state and major city governments will not be allowed to fail. The House stimulus bill certainly suggests this. Given that it is better to own debt in a deflationary environment than to sell it, municipal bonds might finally be worth getting into.

It's reasonable to assume a president will implement policies that will help his (or his friends') wallets. For example, oil related stocks like Exxon Mobil (XOM), Chevron (CVX), and Dick Cheney's Haliburton (HAL) all doubled during the Bush Administration's tenure, in addition to paying decent dividends. Obama may very well do for munis what Bush did for oil.

This post is decidedly more political than any of my previous ones. No offense is intended. If we had Republican control of the two (openly) political branches of our government, I'd be complaining about all the stupid things they were doing. And they would be doing stupid things. As soon as one of the parties is filibuster proof, it is inevitable.

Disclosure: At the time of writing I held no positions in any securities mentioned above. XOM and CVX are in my dividend stock portfolio.

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Bait and Switch

2009-01-31T14:41:00.003-05:00

On Tuesday (1/27/09), CNBC's Steve Liesman (terrible last name for a reporter) reports that the Treasury is closer to making a bad bank to buy the crap assets floating around in the financial system. "Liesman suggests the big advances involve how to value the assets and that the government is closing in on a mechanism for doing just that" (CNBC). The market rallies on this rumor, gapping up the following day.

On Friday (1/30/09), CNBC's Charlie Gasparino comes on the air and says the bad bank idea has been put on hold because they don' t know how to value the crap assets--directly contradicting Liesman's earlier report. The market tumbles.

Aside from these two rumor reports, and news reports about them in other media, there has been no information about the bad bank in recent days. So is this market manipulation, or what? Someone is making a lot of money on this.

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Corruption, Lies, and Stupidity All Around

2009-01-20T00:11:00.008-05:00

I've always paid attention to current events and politics, but I don't think I've ever witnessed so much blatant corruption, stupidity, and double talk in such a short period (apart from news out of the various banana republics around the world).

We've got Bernie Madoff (government regulators asleep at the switch), the Governor of Illinois, before that the former New York Governor, New Mexico's Governor, and Tim Geitner's taxes, among many others.

Then we have the wholesale fraud/idiocy on the part of the government and the financial industry that got this crisis started.

The government's supposed to be doing stuff to solve the crisis (more borrowing to solve a problem caused by too much borrowing!), but what's it doing with the bailout funds? It certainly appears that Hank Paulson's actions are influenced by his Wall Street ties, and so on.

Now it appears that Government Regulators Aided IndyMac Cover-Up, Maybe Others. No wonder IndyMac wasn't on the troubled banks list!

Citigroup (C), bailed out by the government, is now splitting itself in two and is selling whatever assets it can, including Smith Barney, which it said it wouldn't sell.

Bank of America (BAC), which said it didn't need money when the government forced it to take billions, was involved in back room talks to get more money.

Wells Fargo (WFC) also complained about not needing bailout funds, then it proceeded to sell shares.

General Electric (GE) said everything was great, then borrowed billions from Warren Buffett at 10% interest and sold billions worth of new shares.

Lehman Brothers, Bear Stearns, and WaMu all said they were fine before they went bust.

Now Barclays (BCS) says it doesn't know any reason for its stock being in free fall (i.e., "everything's fine"). Should we believe them? We'll see.

Amid all this, the worst financial crisis since the Great Depression, when the government is spending money it doesn't have, Barack Obama's inauguration is, by some accounts, the most expensive in history.

There's a lot more, and it keeps piling up each day. And that's just what's happening in America (BCS is a UK bank). The rest of the world isn't much better.

Disclosure: I owned WFC at the time of writing.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.

Dividend Capture Strategies

2009-01-14T17:04:00.039-05:00

A popular strategy among those investors who trade actively is dividend capture. There are several different ways to implement it, and I would like to go through some of them.

The last time to buy a stock and be eligible to receive its dividend is the day before ex-dividend day. That is, if ex-dividend day is December 15, one must buy the stock on December 14 (or the last trading day before December 15) at the latest. If you sell your stock on ex-dividend day, you are eligible for the dividend as long as you bought it, or exercised a call to buy it, the day before.

At the heart of every dividend capture strategy is the fact that on ex-dividend day, all other things being equal, a dividend paying stock opens lower than its previous close by the amount of the dividend. For example, a stock that closed at $50 a share on the day before ex-dividend and which pays a $0.50 dividend, should open, all things being equal, at $49.50 the next day. Given trading and other factors, in reality the stock may open substantially higher or lower than the previous close. The investor who wants to capture the dividend wants to buy the stock for $x and sell it for $x or higher. The dividend and the amount over $x is his profit, less commission costs and taxes.

(1)

The most common dividend capture strategy, and the worst, at least in bear markets, is to buy a stock shortly before ex-dividend day. As the stock trades on and after ex-dividend, its price will of course change. The investor who bought the stock for the dividend in this first way will want to proceed in one of two ways after holding the stock overnight. The investor will either (a) sell the stock immediately after it reaches or exceeds the price at which the investor bought it, or (b) he will wait at least 61 days and then try to sell it for the price he paid or higher. In both cases, the investor uses the sale proceeds to move on to the next dividend paying stock. He will receive the dividend payment on the pay date, which for most stocks is usually a month from ex-dividend day. The person who does (a) potentially has access to his money much faster, thus being able to put it back to work more quickly. In some cases, the dividend paying stock can be sold on ex-dividend day for a profit. However, the dividend this person receives is taxed as ordinary income. The person implementing (b) will optimally sell for a profit right after holding the stock for 61 days. This person can receive up to six dividend payments on the same sum of money per year and be taxed at the qualified dividend rate. If strategy (a) can be implemented successfully on a regular basis, it is likely better than (b) in terms of after tax profits.

Critics of strategy (1) often say the dividend capture is a myth. I am inclined to agree, especially with regard to (a). What the investor is really doing is trying to get a capital gain. It is the stock's move up after ex-dividend that results in the profit. This is the same as buying any stock, not necessarily dividend paying, at any time and waiting for it to go up some specified amount before selling it. Strategy (b) has more right to be called a dividend capture strategy, but it too relies on capital gains in order to be successful.

With both strategies there is no guaranty whether the stock will go back up to the price the investor paid for it. There is also no guaranty over how long it will take for the stock to go back up. Sometimes it never does.

(2)

Another dividend capture strategy is one that I have implemented with some success. It involves buying a stock before ex-dividend day while simultaneously selling a deep in the money call. The trick is to find a call whose delta is as close to 1 as possible and whose premium at least compensates you for all your transaction costs should the stock be called before ex-dividend day (exercise notices are accepted until 4:30 P.M. Central Time). Just like the first strategy, this second strategy has two types. The investor sells the stock and buys back the call either (a) on or immediately after ex-dividend day, or (b) after 61 days. The other possibility is (c), the investor does nothing until the stock is called away. This can mean that he collects more than one dividend payment on the stock, depending on the call's expiration date. For purposes of this post, (b) and (c) will be treated as equivalent.

Update: 1/19/09 from IRS

Holding period reduced where risk of loss is diminished. When determining whether you met the minimum holding period discussed earlier, you cannot count any day during which you meet any of the following conditions.

1.

You had an option to sell, were under a contractual obligation to sell, or had made (and not closed) a short sale of substantially identical stock or securities.
2.

You were grantor (writer) of an option to buy substantially identical stock or securities.
3.

Your risk of loss is diminished by holding one or more other positions in substantially similar or related property.

A big thanks to Nick for catching this error.

Why the highest delta? The higher the call's delta, the more likely it will move along with the stock. For example, if the stock goes up by $2 per share, the call whose delta is close to 1 should also go up by $2. If the stock falls by $2, the call should fall by $2. The higher the delta on the call, the more likely it is that one can exit the position for the same price that one entered into it, regardless of the stock's price movement (provided it doesn't fall too sharply, in which case the call might be more expensive compared to the stock's price if it becomes in or out of the money).

Here's an example. Stock XYZ trades at $30 a share on the day before ex-dividend day. It is supposed to pay a $0.40 a share dividend, and the pay date is a month from now. At the same time, a 5 strike call is trading for $25.20. (This is rare, but it does happen). The investor proceeds to enter a multi-leg order, usually called a "buy write" on the order screen of his brokerage account (strategy (2) is not worth doing without a muli-leg order; that is, if you have to make two separate transactions, you might lose money if the prices change too quickly). This order has two legs, one to buy the stock and one to sell the call. In leg one, the investor enters buy 100 shares of XYZ. In leg two he enters sell to open 1 XYZ 5 strike call. Where he specifies the price, the investor enters a net debit of 4.8. If the order is filled, the investor will receive 100 shares of XYZ into his account and he will be short 1 call, while $480 (plus commissions) leaves his account.

The next day, ex-dividend day, if the investor's shares haven't been called, he will enter into another transaction. He will proceed to the same screen on his brokerage account, except now he will sell 100 shares of XYZ in leg one and buy to close 1 call in leg two. Where he specifies the price, he will enter a net credit of at least 4.8. If his order is filled at 4.8, he will receive $480 in his account (less commissions), he will no longer have the XYZ shares, and he won't be short the XYZ call. A month later, he will receive XYZ's dividend of $40. This, minus commissions and taxes, is his profit from the entire enterprise. If he is able to reverse his position for a higher net credit than his debit, this will add to his profit.

Note that the stock's price action does not matter unless it goes down substantially. If XYZ went up by $5 a share to $35 during the two days, the call would also go up by $5 to at least $30. If the stock went down by $6 to $24 a share, as another example, the call would go down by $6 to around $19.

Why the deepest call possible? Two reasons. First, the deeper in the money the call is, the more protection the investor has against an adverse stock movement (in this case down). The investor does not lose money unless the stock goes below his net debit. In the example above this would be XYZ going below $4.80 per share. Second, since only the net debit leaves the investor's account, the dividend can be greatly leveraged. Notice that in the example above it cost the investor $480 to receive a $40 dividend, less commissions. An investor using strategy (1) above would have to put $3,000 at risk (if XYZ is trading at $30 per share) to get the $40 dividend. The investor in strategy (2) can buy 600 shares for less than $3,000, and the dividend he would receive would be $240, less commissions. Now that's leverage, and very low downside risk.

It is important to note that calls are most likely to be exercised early the day before ex-dividend day. This is why it is necessary to find a call that offers a premium, so that if the shares are assigned early the premium compensates the investor for his transaction costs and may even leave some profit. To be worthwhile, the net debit of the transaction must be below the call's strike by at least the amount of all the broker fees the investor will incur.

I believe (2) can more appropriately be called dividend capture than strategy (1), as the strategy seeks to minimize all potential capital gains and losses. The main source of profit is the dividend payment.

(3)

Along the same lines as strategy (2), but with no leverage at all and with the expenditure of more money but almost no risk, the investor buys the dividend paying stock the day before ex-dividend day while at the same time buying an in the money put. The deeper in the money the put is, the more likely the investor will receive an advantageous price for it. Just as in (2), the investor's aim is to enter and exit the transaction for the same price. That is, the net debit for entering the transaction should equal the net credit for exiting it. The dividend received, minus transaction costs and taxes, is the profit.

Here's an example. Stock XYZ trades at $30 a share. The 50 strike put trades at $20. Before ex-dividend day, the investor enters a multi-leg transaction on his brokerage screen, typically called a "protective put." In leg one he enters buy 100 shares of XYZ. In leg two he enters buy 1 XYZ 50 strike put. Where he specifies the price, he enters 50. If his order is filled, $5,000 will leave his account (plus commissions) and he will receive 100 shares of XYZ and 1 XYZ 50 strike put. On ex-dividend day or after, the investor will either attempt to close out his position by doing the same multi-leg order in reverse--sell 100 shares and sell 1 put--for a net credit of 50 or more, or he will exercise the put, whichever is cheaper in terms of commissions, unless the net credit is sufficiently over his original debit to give a profit, in which case he will do the multi-leg order.

For example, if the investor can sell the shares and put for a credit of 51, he will earn an extra $1 per share of profit (less commissions). In the worst case, the investor will exercise his put. That is, in the worst case, the investor will receive the $5,000 back into his account, no matter what the stock does. On the pay date, he will receive the dividend, which will be his profit, less commissions and taxes.

Note that here there are no adverse stock moves. Suppose XYZ goes to $0. The investor can exercise his put and get his $5,000 back. Or suppose the stock goes above $50 a share. The investor can still get his $5,000 back, but if the stock rises enough, he can get more. For example, suppose XYZ goes to $50 per share. The investor will now be making $20 per share on the stock. If the put is worth more than $0, which it should be since it's at the money, the investor will receive more than $5,000 in closing out his position by selling the stock and put. As another example, suppose XYZ goes up to $100 per share. The investor will make $70 per share on the stock, but the put will probably be worthless. Still, he'll make $5,000 by selling the stock. That is, he'll receive $10,000 for selling XYZ, resulting in a $5,000 profit.

As this dividend capture strategy is a no lose situation (except if the stock doesn't pay the dividend, in which case the most one can lose is commission costs), in the money put sellers have long factored in the dividend. It is rare when one can find a stock trading at $30 with a 50 strike put trading at 20. This happens occassionally, but more likely than not the put will be more expensive.

Thus, strategy (3) is only worthwhile if the dividend payment will cover all commission costs and taxes and the difference between the strike minus the stock price and what the put is trading for. That is, suppose XYZ pays a $0.40 dividend and is trading at $30 on the day before ex-dividend day while the 50 strike put is trading at $20.10. The transaction will cost the investor $50.10 per share plus commissions. Let's say all commissions, for entering and exiting the position, equal $0.10 per share. That means that the entire transaction will cost the investor $50.20 per share, or, if this is for 100 shares, $5,020. Implementing strategy (3) in this case would still be worthwhile, because the dividend is $0.40 per share. Here, the investor's profit would be $0.20 per share, or $20. This does not factor in taxes, which would be based on the entire $0.40 dividend and which would be charged at the ordinary income rate ~~if the investor exits the position within 61 days of entering into it.~~ Update: Charged as ordinary income regardless of when position is exited.

Here is a real life example. Eli Lilly (LLY) is going ex-dividend on February 11. It will pay $0.49 a share on March 10. It closed today at $37.47 per share. The 55 strike April put has a bid of 17.80 and an ask of 18.10.

Suppose that the put can be bought for 17.95 and the stock can be bought for $37.47. Buying 100 shares for $37.47 and the put for $17.95, gives the investor a net debit of 55.42. If he enters into this transaction today, the worst that can happen is he'll get a credit of $55 per share when he exercises the put on or after February 11. This gives him an up front loss of $0.42 a share. The dividend, however, is $0.49 per share. Excluding commissions and taxes, the transaction would give a profit of $0.07 per share. If commissions and taxes are less than $0.07 per share, the transaction will be profitable. The risk would be $0.42 per share plus commissions if Eli Lilly does not pay the dividend.

If he has a lot of money to work with and his commission and tax costs are low (say this is an IRA account with cheap commissions, and/or the broker is offering free trades as a promotion), the transaction may be worth doing for the investor.

The above assumes that the position is closed by exercising the put. It is possible that the difference between the stock price plus the put price and the strike price (in our LLY example $0.42) will stay the same or change in the investor's favor. If this is true, the investor's profit can potentially be $0.49 or even greater. That is, the $0.07 above, minus commissions and taxes, is the minimum profit the investor will receive as long as LLY pays the dividend.

Note that it might be better to start early. When I looked at this same transaction two weeks ago, the minimum profit was $0.17, based on the put's ask price. The ex-dividend date's approach (along with more market volatility) has made puts more expensive, it seems.

If there is still a profit after taxes and commissions, and the investor has a lot of money to work with, he can potentially make a consistent and practically risk free return on the same sum of money every day. That is, the transaction is entered into on Monday before XYZ goes ex-dividend on Tuesday. The position is closed on Tuesday, and the proceeds are immediately invested into ABC, which is going ex-div on Wednesday. The ABC position is closed on Wednesday and the investor immediately invests the proceeds into ZYX, which goes ex-dividend on Thursday. And so on. It is hard work, but it may be very worthwhile, for there is practically no risk.

Note that in strategy (3), it is OK if the net debit exceeds the strike price, as long as the dividend more than covers the difference and all the costs. Unlike in strategy (2), there is no risk for the investor of losing his shares. This is because as the option holder he controls whether and when the option is exercised, so long as the option's expiration date is after ex-dividend day.

Just like strategy (2), the profit for strategy (3) comes from the dividend minus transaction costs. It is therefore more appropriately called a dividend capture strategy than (1). For tax reasons, strategies (2) and (3) are best implemented in a tax sheltered account. Most broker IRA accounts allow covered calls. Protective puts should also be allowed, but each broker has its own policies.

Variations on the Above Three Strategies

(4)

One variation on strategy (1) is take advantage of the difference between a deep in the money call's price plus the strike and the price at which the stock is trading. Typically, assuming there are no commission expenses, it is cheaper to buy a deep in the money call and exercise it than it is to buy the stock. For example, Verizon (VZ) is trading at $30.62 as I'm writing, while the January 2010 5 strike call has a bid of 25.45 and an ask of 26. If I can buy the call for under 25.62, it is more worthwhile for me to do so and immediately exercise the call than it would be to buy the stock, if we assume there are no commissions. Suppose I am able to buy the call for 25.50. When I exercise it, an additional $5 per share exits my account, and I end up buying the stock for $30.50 per share, $0.12 lower. Doing this before ex-dividend day offers a little protection over strategy (1). The investor, just as in (1), hopes the stock will go up by at least the amount of the dividend on or soon after ex-dividend day. The profit will be the few cents earned on the call along with the dividend payment to be received, minus transaction costs and taxes.

Generally, retail investors' commission costs prohibit this strategy. Institutional investors, or those with little or no commission costs engage in this activity all the time. I have a feeling (but no proof) that retail brokers fleece some of their customers in this way. For example, say someone implements strategy (2). If on ex-dividend day the stock is up in pre-market, the broker takes away the customer's shares and sells them on the open market, pocketing the dividend and the commissions, and telling the customer that his shares were called away the day before. It is as if the broker implemented strategy (4). If the stock is down in pre-market, the broker lets the customer keep the shares. There are complications, but this font running scheme seems pretty feasible and I wouldn't be surprised if it is conducted. But like I said, I have no proof. If I ran a crooked Wall Street outfit (is that redundant?), I might do something like this to make a few extra bucks.

(5)

Another variation on strategy (1) is to combine (4) with (2). That is, it involves buying deep in the money calls and exercising them at the same time as selling other or same strike in the money calls and hoping these are not exercised. While the optimal time to exercise a call option early is the day before ex-dividend day, some number of calls are not exercised. This may be because the call holder forgets, doesn't have enough money to do so, or doesn't think it's worthwhile.

Just as in (4), institutional investors frequently engage in this activity. Commissions usually make this strategy cost prohibitive for individual investors.

(6) and (7)

Do the same thing as strategies (2) and (3), but use margin to get more shares than you could otherwise afford by using cash only. Profit is increased by the extra dividends received, minus the margin borrowing rate and the extra commissions for selling or buying more option contracts.

This is for educational and entertainment purposes only. Some of the risks may not have been mentioned or accurately described. Use these strategies at your own peril.

Disclosure: At the time of writing, I did not own any securities mentioned above. VZ is in my buy and hold forever dividend stock portfolio.

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Technical Analysis Continued

2009-01-11T01:06:00.005-05:00

A month ago (December 10, 2008), I started an informal technical analysis experiment:

Certain chart and volume patterns are supposed to foretell a stock's (commodity's, ETF's, etc) future price movement. Occasionally, if I come across such chart patterns I'll post about them. Then, I'll check back after a while to see how the predictions turn out.

Two stocks were selected. American Capital Agency (AGNC) exhibited a double top chart pattern, which is supposed to be a a bearish signal. It closed at $19.13 per share that day. Drugstore.com (DSCM) closed at $1.19 per share, and had a double bottom chart, which is supposed to be a bullish indicator.

AGNC's last close was $20.83, and it closed as high as $21.95 per share between the day it was selected and the time of writing (January 11, 2009). Shorting it until now would have been a losing trade. Nevertheless, on December 11, 2008, the stock closed at $17.93 a share (I doubt it was the result of my post, but anything is possible). It went up on December 12, and back down to $17.93 on December 15, so short sellers had some time to cover and make a profit. In this case it was 6.27% over the course of one or three trading days. It looks like, then, that the bearish signal was correct. That is, one could have made money shorting the stock on December 10.

Drugstore.com (DSCM) was supposed to go up, but from December 10 to December 15 it fell around 20% to $0.93 per share. Then it went up to $1.39 a share on December 17, for a 16.8% gain from its December 10 price. It traded down to a loss of over 10% by December 30, only to bounce up to $1.40 a share on January 5. So, one could have made money buying DSCM on December 10, although a much better entry was on the 17th.

It appears then, that both technical indicators were correct. But one can also say they were wrong. In the case of AGNC, one had to exit the trade early to make money. The pattern was a week long, but it was most profitable to exit after one or three days. In the case of DSCM, one had to hold on and suffer a significant paper loss, but the pattern was a longer one. Should this then be deemed inconclusive?

Success or failure is harder to determine than I expected. So here's a rule that I think is sensible. For future trials, the trade in question has to produce at least a 10% gain over a period of time not longer than the chart pattern took to develop. On these criteria, DSCM would be a successful trade while AGNC would not be.

So let's try it again, with the same chart formations. Liberty Media (LMDIA), which closed at $18.14 on 1/9/09 is displaying a double top on its chart. The pattern takes shape over about a week. We're looking for the stock to fall, as a double top is a bearish signal.

OceanFreight (OCNF), which closed at $5.23 on 1/9/09 just completed a double bottom formation. The pattern's duration is 39 days. We'll be looking for OCNF to go up, as a double bottom is a bullish signal.

Let's see what happens with these stocks.

Technical analysis is a lot of things to a lot of people, so despite what I wrote to the contrary last time, it cannot be disproved. That is, it can always be claimed that I'm not doing it right, even with archetypal chart patterns. In general it is hard to disprove many things (ask Richard Dawkins). For example, you can't disprove that there is an invisible, intangible, weightless monster sitting on your monitor. But things can be proven (to a greater degree than they can be disproved, anyway), and I'm hoping the experiment will do that.

Disclosure: At the time of writing I did not own any securities mentioned above.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.

Proceed with Caution

2009-01-06T23:51:00.009-05:00

This is one of those "the market will either go up, down, or sideways" posts. Read no further if that infuriates you.

The number of stock market bears seems to get smaller every day. It seems as though every new survey of market strategists and fund managers by publications like Barron's and USA Today says that now is the time to buy stocks, at least until March. We hit bottom in November, and now we're going to get a good bounce. Anchors on CNBC are reporting the folklore that an up January means an up year. Others are saying an up close on the first trading day of the year means an up year.

"All the bad news is priced in," "there are trillions of dollars on the sidelines, just waiting to get in," they've said everyday on the financial channels for the past two years. It is bound to be right eventually. Are they right this time? Who knows.

But even I feel more optimistic (which I view as a bearish signal). Despite almost daily bad news, the market is, as of writing, up near 20% since the November low, and many stocks still look tempting. Blue chips are sporting dividend yields not seen in a long time. The last two years' star stocks are trading substantially below their highs. How can investors not rush in?

Everyone seems to agree on two things: stocks should rally and there's a bubble in Treasuries.

When it comes to the markets (stocks, economy, etc), when everyone agrees on something, it usually turns out to be wrong. The greater the optimism, the greater the fall. The internet bubble, the housing and credit bubble, and the notion that investing in China was safe until the Olympics are examples.

There's plenty of scary stuff on the horizon. Noted economists like Paul Krugman say we'll probably have another depression. Others remind us that we're maybe about a third of the way through the credit bubble. Around a trillion dollars worth of subprime mortgages has led us to where we are now. In the coming months and years, around $1.5 trillion in adjustable rate and similar mortgages are going to reset. Credit card defaults are mounting. Commercial mortgage defaults are still coming. Many troubled borrowers who have renegotiated their mortgages are defaulting again. Unemployment seems to be rising, while consumer spending is shrinking. Banks are not lending and are cutting existing lines of credit. Housing price declines are accelerating. State unemployment insurance funds are insolvent, and they are receiving so many new claims that their websites are crashing. The Federal government is borrowing heavily while the buyers of its bonds, mostly foreign investors, are starting to complain about the low yields.

Will stocks continue to rise if the S&P 500 and DJIA have negative earnings? It's certainly possible, since stocks rise and fall with expectations. During the Great Depression, the DJIA quadrupled from July 1932 to January 1937.

Times can be terrible, but stocks can still go up. That's what the bulls are telling us now.

But consider the other side. From October 1929 to July 1932, the market lost around 88%. During the two and a half year period, there were a series of significant rallies. From January 1930 to April 1930, for example, the market went up 20%. It did this a number of times. There were at least six significant rallies that lasted weeks or months, all while the longer term trend was down. It was a step ladder down that gave opportunities to make up losses, but also drew in more buyers that ended up losing money.

The same sort of thing happened with the Nasdaq from March 2000 to October 2002. The index fell around 77% during the period, but had rallies that lasted weeks and months, some of which produced gains over 30%.

This just shows that there are periods of optimism during the longer term where the trend is significantly downward. Many of those who jumped into the market during the rallies, thinking that it hit bottom, were wrong. Was November 2008 the bottom, or just another step down? Who knows.

If you're one of those thinking that the market will head higher until March (and there are quite a few investors with this thought--I even heard it on the subway!), beware. Chinese stocks fell long before the Olympics started. Everyone thought, "it's safe until the Olympics, so I'll just sell early." Some arbitrary date before the Olympics, when the number of sellers was highest, turned out to be the peak. So if the market is supposed to be safe until March 2009, it's probably going to peak before then.

Buying blue chips now to lock in their high dividend yields is not a bad idea, especially if you plan to hold them forever. But remember, the market is more optimistic at the moment than it was a month and a half ago, and so can head lower. Don't spend all your money in one place, and have a plan. If you're holding stocks that you have paper losses on and you don't want to sell, you might consider taking advantage of rallies by buying puts on your positions during them. Now might be a great time to buy puts on stocks you already own.

As for the Treasury bubble that everyone is in agreement on (I've been eying puts on the iShares Long Term Treasuries ETF TLT for months), we can have low interest rates for a very long time. While it seems to make no sense to buy and hold a 30 year bond paying a dismal 3% while the government announces more borrowing and more spending, it might turn out to be a good investment. Look at Japan's years of low interest rates. (There are differences between the USA now and Japan during the last two decades, such as USA's terrible fiscal policy and the propensity of consumers not to save anything over the last few years. However, there are sufficient similarities to warrant the comparison.)

Even if bubbles aren't hard to see, it can be difficult to profit off of them. For example, the housing and stock market bubbles were readily apparent in 2005 and 2006. Your best clue was that everyone had two SUVs, a leased BMW, and a couple of houses while living from paycheck to paycheck. Shorting financials at that time would have made sense, but would only have brought you losses.

If you think the Treasury bubble will burst soon, there are a number of plays including: shorting TLT, buying puts on TLT, going long TBT (twice the daily inverse of the Lehman 20+ year index), or buying calls on TBT.

All these involve risks. In short selling, your losses are theoretically unlimited. TLT shouldn't go too much higher, but everything is possible. Also note that short sellers have to pay the dividend on whatever they're shorting, and TLT pays monthly. Using puts instead limits your losses to whatever you buy the puts for, but if you don't time it right you can lose the entire position. Same thing with calls on TBT. And as for the ultrashort ETF, remember it's for a trade and not for the long term, particularly because it resets everyday (for example, the long index can go down over the course of a couple of months, but given enough volatility, the ultra short ETF can also end up down over the same period).

Disclosure: At time of writing, I was long SPY, long SPY March puts, and short SPY January calls.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.

Limit Your Costs and Risks, Some New Year's Resolutions

2008-12-28T12:07:00.028-05:00

As investors we cannot generally control the prices of the assets we invest in. We can control only two things: our risk exposure and the costs we incur. All else being equal, minimizing these ensures better returns. With this in mind, below is a list, New Year's resolutions as it were, of things we can all do to limit our costs and our risks. The list is compiled from my own mistakes and those I've observed others making. I've mentioned some of these before in previous posts. They may seem obvious, but time and again we see smart people make silly mistakes.

Costs

1. Are you overpaying for a service? If you can do the same thing at an equally reputable broker for less than at your current broker, why wouldn't you?

2. Limit the commissions you pay as a percentage of your investment to as little as possible. If you pay $10 in commissions to buy $250 worth of stock, for example, your stock has to go up 8% for you to break even. In other words, you pay $10 to buy and $10 to sell. Your position has to appreciate $20 in value for you not to lose any money when you sell.

3. Are you paying an account maintenance fee? Why? There are plenty of equivalent institutions that don't charge fees. If your IRA has a fee, switch to one that doesn't. If your bank account charges you fees, get a new bank account that offers the same features and is free.

4. If you invest in an index mutual fund or ETF, is there another index fund that is basically the same but charges less fees? In most cases there is. Most Vanguard products, for instance, charge less fees than competitors. So if you're using a competitor's products, you might be overpaying. For example, why pay 0.2% in fees with the iShares Total Market ETF (IYY) when you can pay 0.07% for a similar fund with Vanguard (VTI)? Granted that in real terms the difference is negligible and for small amounts probably unnoticeable, but the iShares ETF is almost three times as expensive for pretty much the same thing. With other funds, such as bond funds, where yields are important, the fund fee can take a big chunk out of your returns.

For mutual funds, avoid funds that charge you fees for buying and selling. There are plenty of mutual funds out there with similar strategies that don't charge any transaction fees. For example, why go with a growth stock mutual fund that charges a 3.5% load when you buy when you can get a growth stock mutual fund that doesn't charge you anything to buy it? With that second mutual fund you are 3.5% ahead of the first one right away.

5. Do you subscribe to publications that you can read for free on the internet, or that you may already be paying for? Is the cost of the physical product worth it?

Risk

1. Never invest in something (stock, house, bond, art, etc) just because someone else says it's a good idea. It doesn't matter if it's a newsletter, a guru, someone on TV, a family member, etc. The person's track record doesn't matter either. You must do your own homework. This homework does not involve reading or inquiring about others' opinions on the investment, although these are good for confirmation and to get ideas. It involves, rather, forming your own opinion based on facts. For example, if an analyst says XYZ will earn $4 per share next quarter, take that as an opinion. If XYZ announces that it was awarded a new contract valued at $x, take that as a fact.

2. If you give your money to someone else to invest for you (mutual fund, portfolio manager, hedge fund, etc), make sure you understand their strategy. If necessary, have someone explain it to you. Never give your money to someone else because you don't understand or their strategy is too complex for you. If you can't understand the strategy, on what basis do you think investing with that particular manager is a good idea? While track records are good indicators, past performance does not equal future success, and past performance can be fabricated. You should only entrust your money to others when you understand the strategy and having someone else implement it for you is cheaper/less time consuming than doing it yourself.

3. Never keep your assets in one place.

This includes a single money manager, a single institution, and a single asset class. That is, don't keep all your investments in one fund; don't keep all your cash at one bank (or in one place, like in your house); don't own only stocks (or bonds, or commodities, etc), and among each asset class don't only own one (real property is probably the only acceptable exception).

If you invest in your employer (e.g., you can buy stock at a discount or are given shares as compensation), do so as little as possible. If your employer prospers, it's true that you won't participate in the appreciation of its stock price, but you'll be more likely to keep your job and maybe get a raise or bonus (the company is doing well, right?) If your employer experiences problems, you face a greater chance of losing your job and your investment will suffer. If your employer goes out of business, not only will you lose your job, you'll also lose your investment. Think of Bear Stearns and Lehman Brothers. Don't invest where you work, unless it's your own business. If it's your own business, make sure to invest in other places just in case something goes wrong.

4. Don't keep more in any account than you are insured against. For example, don't keep more than the FDIC limit at your bank. Don't keep more at your broker than insurance protects.

5. Limit your losses. After a certain point, it can take a very long time to recoup losses. For example, suppose you own stock XYZ, which has lost 30% in value since you bought it. For you to break even, XYZ has to go up 42.85%. If you've lost 50%, as another example, you have to gain 100% to get back to even.

Take one of my mistakes. I've been bullish on General Electric (GE) for some time, despite all the warning signs. I bought the stock for an average cost basis of $31.31 per share. In October, when the stock was at $20.11, I finally came to my senses and sold. That's a 35.77% loss (slightly less because of the dividends I received). Had I kept the stock, it would have to go up 55.69% for me to break even from that point. I'm glad I didn't keep it, for its last close was $15.97. If I still owned GE, I'd be down 48.99%. The stock would now have to go up 96% for me to break even.*

There are different reasons for selling a stock. Chief among them is whether you think the money will earn a better return elsewhere. If you have a losing stock but think that it has the best chance, among all other options, of growing your money, by all means don't sell. Put differently, if you'd buy the losing stock today (for valid reasons--not a pure gamble), there's no reason to sell.

6. When you decide to invest in something, say a stock, have a plan and a reason for buying. Why are you buying the stock? Why now? When will you sell?

It's an interesting psychological phenomenon, as soon as we find a stock we think is a good investment most of us want to buy it right away. Never rush to buy anything. If it's a good deal today, it probably will be tomorrow. If you find a stock you like, don't chase it. Let it come to you for the price you want to pay. Remember, if it gets away, you don't lose any money, and every day offers new opportunities.

One thing to consider here is writing (selling) cash secured puts. A put is a contract that gives the buyer of the contract the right to sell the writer of the contract an asset for a certain price within a certain time. Puts generally go up in value when their underlying asset falls in value (one can use puts instead of shorting stocks).

Let's use Boeing (BA) as an example. Say you want to buy 100 shares of BA stock, which is currently trading around $40.53 a share (last close). And let's say you want to buy it now. Unless you have some sort of timing system that tells you when to buy your stocks, there's no reason to act immediately. But let's say you feel you must.Your total cost, if you buy the stock now will be $4053 plus whatever you pay your broker.

One way to minimize your downside risk is to sell 1 put on the stock, say a month or two out, at the strike price you want to buy the stock, in this case $40. Selling the February 2009 put at the 40 strike will place around $320 into your account, minus broker commissions.

If BA trades under $40 a share between now and when the put expires on February 20, 2009, your put will be exercised and you'll get 100 BA shares for $4,000. Since you were paid $320 for the put, your total cost for the 100 shares is $3680, plus broker fees. It's as if you paid $36.80 per share (will be slightly more because of broker fees).

Had you bought BA in the regular way, for $40.53 a share, and the stock went down, you'd be losing money. Using the put to buy the shares, on the other hand, unless BA goes under $36.80, you don't lose any money.

Now, let's say you were correct that BA would go up. The stock has to go up over $43.73 between the time you would have bought and when the put expires for buying the stock outright to be better than using the put strategy.

In short, if you want to buy a stock right away, for no reason other than you just discovered the stock, sell a put for each 100 shares you want to buy at the strike price at which you'd buy the stock anyway. You either get the stock for the price you wanted plus a cash bonus, or you are compensated for the lost opportunity if the stock gets away. In this case, you make almost 8% if BA gets away from you.

Note that BA is just an example. Although it's in my dividend stock portfolio, I don't know one way or another if it's a good stock to buy right now. (It just raised its dividend, but there are concerns that because of order cancellations and production delays the current dividend rate is unsustainable.)

7. Just as you shouldn't chase a stock on the way up, don't chase it on the way down. The only way one can buy a stock at the bottom is through luck. While selling puts is one way to avoid risk, doing so in a bear market comes with its own risks. That is, stocks can fall much farther and faster than you anticipate. While selling puts can offset your losses, it may be harder to get out of your positions and may lead you to incur more losses than if you simply bought the stock in the regular way and sold it.

*Some may find a contradiction between what I say here and what I've written in the past (here, here, here and here) on owning dividend paying stocks forever. I don't believe there is one, but as this post is already too long (I didn't have time to write a shorter one), I'll leave that for another day.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.

Luck, Some More Thoughts on Dividend Paying Stocks

2008-12-19T18:03:00.026-05:00

My previous ruminations on dividend paying companies can be found here, here and here.

What do you think of the following "investing" strategy?

Put money (not needed for the next five to ten years) away to invest as you would normally. Place it in the highest yielding, safest asset (e.g., a money market account, high yield savings account, a short term CD). Figure out how much of the original amount (leave any interest you earn alone) you're willing to lose per year for the chance to gain that amount, e.g., 5%, 10%, 15%, 20%.

Once each year, take that portion out of your safe account, and go to a casino. Find a roulette table and bet the entire amount on black or red. You have a 47.37% chance of winning, and a 52.63% chance of losing. Say you take 10% of your investing money. If you win, you'll have a 10% gain for the year (not counting taxes), plus whatever you earned in interest as well as savings on broker costs you would have paid trading stocks, and minus the cost of going to the casino. If you lose, you'll have a 10% loss, minus whatever you earned in interest and would have paid in broker commissions plus the cost of going to the casino.

The lucky practitioner of the above strategy will handily beat the market. Since the odds favor the house, however, the average person will lose money at the casino. Whether principal will be lost will depend on how much interest gains offset "investing" losses and expenses. For example, if your safe account earns 5% interest for the year (after taxes), and your gambling losses and expenses amount to 2%, you'll be up 3% for the year. If you earn 5% in interest, but your losses and expenses amount to 12%, as another example, you'll lose 7% for the year. You don't lose principal when your losses and expenses are lower than what you've gained in interest after taxes.

As far as strategies go, I don't think the above is any worse, or much different from investing in individual non-dividend paying stocks. It might even be better, as far as your odds go.

Picking a long term winning stock is in all cases a matter of luck, unless you can see the future. No one knows what will happen in five years, or ten, twenty, etc. A company that looks great today may not be around in ten years. A company that looks great today and still does so ten years from now may have a lower stock price then than it does today, even if its earnings grow.

Examples are easy enough to find. As I mentioned in a comment here, take a look at Google (GOOG) and Apple (AAPL). Google traded over $300 a share when its earnings were around $5 a share; it traded over $400 a share when its earnings were around $9 a share; and it traded over $700 when earnings were $13 a share. Now that its earnings are around $15 a share, Google is trading around $310.17 (last close), at the same level as when earnings were three times lower. Apple was around $150 when earnings were $3.90. Now, when earnings are $5.36, the stock is at $90.

Or take a look at Cisco Systems (CSCO). Below are charts of its earnings per share and price per share for the last ten years. The two bear little relationship.

Buying Cisco in 1999 and holding it until today would result in a loss of around half your principal, while the company quadrupled its earnings per share. (Note that holding it longer, say since the early 1990s, would have resulted in an awesome gain.)

There are many other, similar examples. You have to know when to buy and when to sell. Research can certainly help. Perhaps you would have avoided Cisco in 1999 because its P/E was around 100, but you would have missed the big gains to come, as the stock tripled in price from January 1999 to March 2000.

The point here is that how well you do in long (or short) term investing is a matter of luck. This is true of all stocks (and other asset classes). With dividend paying stocks, however, there is one big difference. You don't have to trade. While knowing when to buy is important (to lock in your yield), you don't have to sell to realize all your gains. Non-dividend paying stocks are useless unless you sell them (that's what infuriates me about share buybacks),* so you have to be lucky twice--when you buy and when you sell. Stock prices have little to do with earnings. They have all to do with expectations and optimism/pessimism. People usually buy when they're optimistic about a stock, and sell when they're pessimistic, which seems like a recipe for buying high and selling low.

Many will say, OK, that's probably true, but you can get way bigger gains with non-dividend payers because they grow much faster. I agree 100%, but would still rather own a dividend payer, because with a non-dividend payer you have to know when to sell.

Consider Cisco again. It grew its earnings 4.22 times from 1999 through 2008. Procter & Gamble, as a comparison, grew its earnings 2.8 times over the same period. Cisco's stock lost almost 50% during the ten years, while Procter & Gamble gained almost 50%. Procter, which traded around $45 a share (split adjusted) at the beginning of 1999 also paid $10.1925 per share in dividends during the period, that's a 22.65% gain without having to sell your stock (not very much, but you'd get nothing while holding a non-dividend payer). Stock price appreciation, along with dividends received amount to a 70% gain for Procter over the ten years, beating Cisco by around 120%, even though Cisco grew earnings faster. The time to sell Cisco was in 2000. Few people figured that out before they lost money on the stock.

Note that Cisco kills Procter & Gamble over the longer term in share price performance. Buying the stock in 1990 and keeping it until now would have increased your investment around 200 times. Selling it in 2000 would have increased your investment 800 times. And that's the thing--when do you sell, and when do you buy? Earnings have continued to increase over the last ten years, but the share price plunged. Do you sell now or keep holding it? You get nothing as you wait, and what if the stock continues going lower?

With a dividend payer you don't have to worry about that. As long as the company remains strong, either having stable or increasing earnings, you get paid to hold its stock. Procter & Gamble's 22.65% dividend return over the last ten years is on the lower end of those dividend paying stocks that have done well. Frontline (FRO), another stock in my dividend portfolio, for example, has returned over 600% in dividends over the same period (a little shorter, actually).

Getting back to the above casino "investing" strategy, one complaint against it could be that it's not investing. As I noted previously, though, unless you buy stock directly from a company you're not really investing either--you're just buying a piece of paper from some other person; the company benefits indirectly, if at all. With a non-dividend payer, you're hoping the Ponzi scheme we call the stock market survives at least until you decide to sell your stock, and that people are willing to bid the stock's price up while you're holding it. On the other hand, the dividend payer gives you cash for owning it, no matter what is happening to its share price. With the best dividend payers, you never have to sell.

Since you have to trade non-dividend payers to make money, and no one knows where a stock's price is going next, you're gambling. And what do you do with that money once you sell? If you invest it in another stock, you're gambling some more.

As long as you're gambling, the casino strategy is not much different. One thing in its favor is that you can calculate its expectable outcome before proceeding, since all the probabilities are known. You also don't have to worry about doing research or watching the daily ticker.

As the odds of losing are greater than those of winning in the casino strategy, it is a losing strategy over the long run. Nevertheless, as most investors, including professionals, tend to lose money on individual stocks or at least underperform the market, there's a good chance that the casino strategy may outperform most retail investors' portfolios composed of individual non-dividend paying stocks. If a losing strategy outperforms, maybe it's best to avoid picking individual non-dividend paying stocks.

That's why I favor index investing over individual stocks, and dividend payers over non-dividend payers.

* Some of Cisco's earnings per share growth has come from share buybacks. (Less shares = higher earnings per share even if actual earnings stay the same). Had the company used those billions of dollars to pay dividends instead of buying back shares, it would have been a better stock to own over the last ten years.

Disclosure: At the time of writing, I owned PG and had an open order on FRO.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.

Index Linked CDs, Are They Worth It?

2008-12-16T18:07:00.010-05:00

In this new era of extremely low interest rates, is it possible to get a decent return without taking on too much risk?

One way to limit your losses and stay in the stock market to participate in any upward gains is to take a loss upfront by buying puts on your stock positions. But how would you like to participate in the stock market's returns with no risk to your principal? Index linked certificates of deposit, or ICDs, promise to let you do just that, and are starting to be recommended by some financial advisors. Although they have been around for years, ICDs are relatively obscure and not widely available.

ICDs are similar to regular CDs, in that they are FDIC insured and sold by banks. As long as you stay within FDIC limits, you cannot lose your principal (unless the FDIC goes bust).

ICDs differ from regular CDs in how your returns are determined. These certificates of deposit are linked to stock market indexes, most commonly the S&P 500 or the DJIA but also the Nasdaq and even currency and commodity indexes, and their rates depend on how the index does. ICD maturities usually range from one to five years, and any interest due is usually determined at maturity.

ICDs differ from bank to bank. Some typical offerings provide from 85% to 100% participation in the index's gains. So, if the market goes up 10% from when you buy the ICD to when it matures, you could potentially get from an 8.5% to a 10% return. If the market goes down between the time you buy the ICD and when it matures, you get your principal back. Some banks have in the past offered a minimum return no matter what the market does. In such a case, you would get a gain even if the market goes down.

The only risks appear to be losing to inflation and giving up sure gains in equally safe investments like regular CDs or Treasuries. But there are a few things to note.

One thing to look out for is how the bank measures an index's return. Say the S&P 500 is at 1,000 when you buy your ICD and is at 1,200 when the ICD matures. Had you bought the individual stocks or the ETF (SPY), you would have a 20% gain plus dividends (which should be around 2 to 3% per year). Would you receive a 20% return on the ICD? Probably not.

For example, the bank may measure the index's return by averaging the index's closing prices for a certain period (maybe every trading day, or a set of specific "pricing" days, etc). Using the above example, the S&P 500 may be all over the place between the 1,000 when you buy the ICD and the 1,200 when the ICD matures. It may be around 800 for a while, who knows. It can turn out that the average closing price during your holding period is well below 1,200. Let's say it's 1090. Your return on the ICD would thus be 9%, even though it's "100% linked" to the S&P 500.

There are other considerations. For example, holding SPY for over a year and selling it for a 20% gain should give you a smaller tax bill (capital gain) than a 20% gain on an ICD (ordinary income). With the ICD you also miss out on the dividends you would have received if you owned the stock index. If the market is higher when the ICD matures than it was when you bought the ICD, the ICD will most likely underperform. If the market stays flat, you will probably get little to no return with the ICD, which may be smaller than the dividends you would have received with the stock index. That's better than losing money in stocks, but a regular CD might outperform an ICD in every case.

The fine print may have other qualifications. For example, there may be a cap on gains or the bank may be able to call the ICD when a certain event occurs. The market can go up 100%, but if the cap is at 11%, that's the most you can make.

Liquidity is something else to think about. If you own the ETF and suddenly need the money, you can sell it as soon as the market opens or in extra hours trading. Whether you lose any money on the sale depends on the ETF's market price. With the ETF, you have the option of selling a portion of your stake. If you own the ICD and need the money, you are likely to incur a withdrawal penalty and possibly face a delay before you get your money back. If you would like to redeem a portion of your ICD rather than the entire investment, that may be difficult or impossible. If the bank goes out of business, it may also take a while to get your money.

Related to liquidity, since the interest you earn with most ICDs is paid at maturity, you will not get current income from most ICDs.

The question then arises, given all these uncertainties (except for the fact that you won't lose your principal), why would anyone want to buy these products? The only answer I can think of is to try to beat inflation. Pinning returns to stocks while giving up some of the upside potential in exchange for no downside risk (in terms of principal, not purchasing power) can be a way to do that. I Savings Bonds ($5,000 a year limit) and inflation protected bonds seem a better way to go, however.

Unless you find an ICD with a guaranteed minimum return you'd be happy with, it's probably not worth the trouble.

If you are interested, below are a few banks that offer ICDs. These are not recommendations. They are posted for your convenience. Please read the fine print carefully, do your own research, and consult your financial or tax advisor to see if it is the right thing for you.

Everbank

Harris Bank

Stanford International Bank (Not clear if FDIC insured)

Washington Mutual (Chase)

Wells Fargo

Weymouth Bank

This is obviously not a complete list. Small local banks are probably the largest sellers of ICDs, so if you are interested, see the banks in your community.

Disclosure: At the time of writing, I own puts on SPY. I also own Wells Fargo stock, on which I wrote calls.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.

Dividend Portfolio Update

2008-12-13T16:09:00.002-05:00

Here is this month's update of the Buy and Hold Forever Dividend Portfolio. This and all future updates will be posted here. The spreadsheet tracking the portfolio is available on the original post and here.

In accordance with the results of a poll, where I asked whether Coors (TAP) should replace BUD in the portfolio, TAP has been added at Friday 12/12/08's closing price. The $350 that was originally used to buy BUD was used to buy TAP. The rest of the BUD sale proceeds ($41.47) will count as a dividend.

Here are the other dividends received since the last update:

BNI 10-Dec-08 $ 0.40 Dividend * 3.93 = 1.572

FRO 5-Dec-08 $ 0.50 Dividend * 11.006 = 5.503

JNJ 21-Nov-08 $ 0.46 Dividend * 5.706 = 2.62

KO 26-Nov-08 $ 0.38 Dividend * 7.944 = 3.0187

MCD 26-Nov-08 $ 0.50 Dividend * 6.042 = 3.021

PEP 3-Dec-08 $ 0.425 Dividend * 6.139 = 2.609

UNP 26-Nov-08 $ 0.27 Dividend * 5.242 = 1.415

WMT 11-Dec-08 $ 0.238 Dividend * 6.271 = 1.49

Update 1/6/09:

CPB 18-Dec-08 $ 0.25 Dividend * 9.223 = 2.30575 -1.194

DOW 29-Dec-08 $ 0.42 Dividend * 13.118 5.50956 2.0956

GE 24-Dec-08 $ 0.31 Dividend * 17.94 5.56 2.0614

KFT 23-Dec-08 $ 0.29 Dividend * 11.995 3.47855 -0.021

MO 22-Dec-08 $ 0.32 Dividend * 18.239 5.836 2.336

PM 23-Dec-08 $ 0.54 Dividend * 8.052 = 4.348 0.848

USB 29-Dec-08 $ 0.425 Dividend * 11.741 = 4.9899 1.4899

VNQ 24-Dec-08 $ 0.935 Dividend * 8.432 = 7.88 4.38

Update 2/9/09:

AXP 7-Jan-09 $ 0.18 Dividend * 12.727 = 2.29086 - 1.20914

BA 4-Feb-09 $ 0.42 Dividend * 6.677 = 2.80434 1.97434

CHD 5-Feb-09 $ 0.09 Dividend * 5.923 = 0.53307 -2.43693

INTC 4-Feb-09 $ 0.14 Dividend * 21.834 = 3.05676 2.61676

PFE 4-Feb-09 $ 0.32 Dividend * 19.763 = 6.32416

OKS 28-Jan-09 $ 1.08 Dividend * 6.356 = 6.86448 3.36448

PG 21-Jan-09 $ 0.40 Dividend * 5.423 = 2.1692 -1.3308

SI 23-Jan-09 $ 2.023 Dividend * 5.819 = 11.771837 8.271837

T 7-Jan-09 $ 0.41 Dividend * 13.074 = 5.36034 1.86034

VZ 7-Jan-09 $ 0.46 Dividend * 11.796 = 5.42616 1.92616

WFC 4-Feb-09 $ 0.34 Dividend * 10.279 = 3.49486 3.48486

XOM 6-Feb-09 $ 0.40 Dividend * 4.722 = 1.8888 0.2788

YUM 14-Jan-09 $ 0.19 Dividend * 12.065 = 2.29235 -1.20765

Disclosure: At the time of writing, I owned JNJ and have a limit order for FRO.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.

The Amusing Madoff Scandal and Other Ponzi Schemes

2008-12-13T16:08:00.013-05:00

Bernard Madoff, former chairman of the Nasdaq, has apparently been running a Ponzi scheme. According to some, he stole $50 billion--$1 billion for each of his 50 respected years on Wall Street.

The news coverage of this latest Wall Street scandal amuses me. It's shocking, commentators say, that something like this could have happened. The only shocking thing is that more individuals and firms on Wall Street haven't been accused of/caught running Ponzi schemes. After all, what types of individuals work in the financial sphere? Isn't greed one of the primary qualifications? Finding a fraudulent investment business on Wall Street is about as surprising as finding a liquor cabinet empty after entrusting it to an alcoholic.

Another amusing aspect of the Madoff scandal is who the victims are. Henry Blodget, the ever entertaining host of Yahoo! Finance's Tech Ticker (not a stranger to scandal himself), reported that some of Madoff's investors knew something fishy was going on. That's why they invested. No one could produce such high, steady returns year after year with such a safe investing strategy. While they were being cheated, they thought Madoff was cheating others through insider trading. Serves them right. It won't be at all surprising if all these thieves in their own right get compensated for their losses by their government friends. (It would be nice if innocent victims were compensated, though.)

A Ponzi scheme is a simple thing. The thief sets up a fake investment enterprise, and persuades his friends, coworkers, etc, to invest in it. He then sends them statements or even cash dividends, showing that the investment is going well. This attracts more money from the original investors and new ones. Should any investors wish to withdraw their money (in normal circumstances most won't, because their statements show that their investment is doing well), the money from newer investors is used to pay them. Early investors who decide to withdraw their money are paid by the funds new investors deposit. On it goes, until the thief's greed is satisfied and he makes off with the money or there aren't enough new investors to fund the redemptions of earlier investors.

The latter is what happened to Madoff. Losing money everywhere else, too large a number of his investors were forced to redeem their deposits. If the markets hadn't crashed, it's quite possible Madoff's scheme would go on much longer, and some of his investors could have made money (if their orderly withdrawals coincided with equal or larger new deposits).

This brings me to some of the Ponzi-like schemes almost all of us participate in.

Stocks: We buy paper with the hope that some sucker in the future will buy that paper from us for more than we paid. (Perhaps not quite as true with dividend paying stocks.)

Social Security: The money deducted from our paychecks isn't put away for our future use. Rather, it is used to fund currently retired workers. When we retire, those who work then will fund our SS payments. If this isn't a Ponzi scheme, I don't know what is: early investors are paid by the contributions of new investors. The entire thing is based on the premise that there will be more and more workers in the future. It's far from certain that this premise is true.

Our Economy Before the Credit Crisis: People took out loans on their houses and bought junk. When their houses rose in value, they took out larger loans, repaid the old loans (early investors paid off with the deposits of later investors), and bought more junk. Repeat this a few times. Then some of the loans reset at higher interest rates and couldn't be paid back (more redemptions than can be funded by new investors). This triggered more loan defaults, and the buying of less junk, which resulted in more defaults.

Government (and Corporate) Bonds: You buy a government bond. The interest the government pays you comes from the money it borrows from others, that is, other bond buyers (and to a lesser and lesser extent tax revenues). When your bond matures, the government pays you with more borrowed money (and to a lesser and lesser extent from tax revenues).

Insurance (car, medical, loan default, unemployment, stock broker, etc): This is just like Social Security. We pay a premium to the insurer in exchange for compensation when an event insured against occurs. When the event insured against happens (doctor's visit, stolen or damaged property, etc), the insurer funds our compensation from others' premiums. That is, it's like having new investors pay for the redemptions of earlier investors. If the insurer has too many claims, it won't be able to pay all its clients. Some state unemployment funds are facing this problem. As unemployment rises, they have to pay out more benefits while the premiums they collect get smaller. The last workers, while paying everyone's benefits, will get nothing when they lose their jobs.

Bank Deposits: Not quite a Ponzi scheme, but close. We put our money in the bank, and the bank is supposed to invest it. Put another way, the bank borrows money from us and lends it to others. At some banks we get interest for our trouble. Withdrawls are funded mostly by new depositors, or with other borrowed money. Should a large enough percentage of depositors want their money back at once, the bank will fail. Assuming there's no insurance, not all the money will be returned, as some of the bank's investments will not be good ones.

There are many more Ponzi schemes, I'm sure.

As long as there is confidence, a Ponzi scheme can work for a long period of time. Nevertheless, its design is such that it cannot work indefinitely. Either confidence is lost or it grows too big to be sustainable, and the whole thing collapses. Ponzi scheme collapse isn't just possible. It's inevitable.

So what do we do? Press our policy makers for reforms. Build systems that aren't pyramid schemes. And if you're forced (or choose) to participate in Ponzi schemes, try to get paid in cash or real assets that you can use even if no one wants to buy them from you. For example, if investing in stocks, prefer dividends. Convert some of that cash into stuff you can use just in case cash becomes worthless, etc.

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