Jan 12, 2008: A floor on US financials? (slightly updated)

  • Market overview
  • Looking forward: a rare opportunity in the making
  • Revisiting our zero-correlated bearish portfolio
  • Market Overview

    So far, our early weak market call, has been right on target. U.S indexes have dropped sharply both in December 2007 and the 1st half of January 2008. Election year or not, it doesn't look like we are going to have a warm and fuzzy January effect this year. We are now at the beginning of the Q4 earnings season, and downgrades and disappointing earnings have been coming fast and furious.

    On the other hand, some silver lining is becoming apparent. On Friday, Bank of America announced it will buy Countrywide Financial for $4.1 billion in stock. The transaction represented a 7.5% discount, indicating how distressed Countrywide was. It was also signalling a possible floor to distressed financial-companies prices. When these are on fire-sale, strong players step in and are willing to scoop-up the bargains. This is a very important development which makes me think financials may be bottoming-out soon.

    While the S&P500 is just about 11% below its October peak, many financials are down significantly in the past 12 months. Some like E*TRADE, and Countrywide are down about 90% from their 52 week highs. Several subprime players have already gone out of business. This is looking more and more like October 1998: shades of LTCM being bailed out and markets rallying strongly.

    Looking forward: a rare opportunity in the making

    Now to the really good news. A friend drew my attention to the fact that the Sovereign Wealth Funds are in control of 2T (Trillion) US dollars and these dollars are burning a hole in their pockets. Parts (not all! I'm referring mostly to certain, no even all, financials) of the US market are now on what appears to be a fire sale, especially when considering how much the USD has weakened against other currencies.

    Indeed, news came out on Friday that Citigroup (NYSE:C) is putting the final touches on a second major capital-raising, seeking up to $14 billion USD from Chinese, Kuwaiti and public market investors. This deal would follow an injection of $7.5 billion into Citigroup by the Abu Dhabi Investment Authority in late November.

    We are starting to see a clear trend of bargain hunting here which leads me to believe that the financials which led this downturn -- well, actually, the home builders did, for those paying attention -- will also be the first to recover. I see no fast recovery for home builders: writing off CDOs off the balance sheets is "easy", clearing real property and home inventories when very few are ready to buy, is much harder.

    When, not if, the financials bottom out, they would represent a truly rare opportunity to scoop-up bargains. I expect this to happen soon, perhaps between now and the Spring.

    And here's what I plan to do. I would buy long term calls (LEAPS options) on selected financials (not all financials!). The idea here is to put a much smaller amount of money up-front (an option costs much less than the underlying stock), but be highly leveraged so that the rebound can result in 10x-50x on whatever you put up up-front, within a year or two.

    The worst case scenario: the U.S. goes the way of Japan in the 90's and nothing in these financials is coming back any time soon. In which case, I lose 10% of my assets at expiration. It is actually a bit better: I can recover about 50% after a year, if I see this adventure leading nowhere, by selling the options. I think this is extremely unlikely. The much more likely scenario: a floor is coming on the financials with a 5x-10x increase in some stock prices. This would mean a much higher appreciation on the long term calls resulting in more than 10x appreciation of 10% of the portfolio. This is equivalent to a portfolio doubling overall, with relatively little risk.

    Disclaimer: Investing with options is not for the faint of heart. You need to understand options and the inherent risk in them, and know what you're doing. Understand the difference between short term calls and LEAPS. I would not touch the short-term calls at all due to the high probability of them expiring worthless before the hoped for scenario unfolds. If you feel confident and comfortable with the general idea of a bottom coming to some US financials, you may buy select US financials ETF rather than options. This article's purpose is to describe my thinking and is not a solicitation to follow my ideas, intentions, and actions blindly. Be aware that I may always be wrong.

    Revisiting our bearish zero-correlation model portfolio

    The 8-ETF bearish model portfolio suggested in the November column has been doing better than I could possibly imagine. Since it was published, it is up 8.22% while SPY is down 5.72%. What's more remarkable is that its volatility has been 18% lower than the index. The result is an almost unheard of Sharpe ratio of 4.76 (calculated on a monthly basis) and an annualized return of 103%.

    Since it is obvious that a 103% annual return is totally unrealistic, and the markets are now severely oversold. I think it is time to cover the shorts, and wait for the inevitable rebound in the markets. Upcoming events that will probably lift the markets at the tail of this earnings season:

    So now is the time to take the short money (TWM, SDS, SRS) off the table and perhaps reenter after a 5%-10% rebound in the SPY. Note that even as some financials may be testing a floor, other financials (credit-card companies for example), are not there yet. Plus, the broader indexes may still lag for another quarter or two, due to the sharp slow down in the economy and the bad earnings. In any case, a short term broad index rebound looks like the most likely scenario to me, right now.

    Here's how our bearish model portfolio has performed since it was published.

    Portfolio[8 components]:   SDS TWM SRS DBA IHF IXC JXI KXI
    %Change[28 trading days]:
    	0.70 1.36 -1.14 -1.05 0.03 -0.69 1.72 1.27 -0.61 0.85
    	0.61 -0.58 -0.19 -0.32 -0.51 -0.97 0.36 0.91 0.69 -0.08
    	0.45 1.90 1.83 0.40 1.94 -0.56 -0.93 0.64
    Correlation matrix [2007-12-01..0w/1d]:
           SDS  TWM  SRS  DBA  IHF  IXC  JXI  KXI
    SDS      -  .95  .84 -.03 -.78 -.77 -.63 -.51
    TWM    .95    -  .85  .05 -.79 -.74 -.59 -.48
    SRS    .84  .85    -  .02 -.66 -.55 -.45 -.34
    DBA   -.03  .05  .02    - -.12 -.01 -.21 -.02
    IHF   -.78 -.79 -.66 -.12    -  .60  .68  .42
    IXC   -.77 -.74 -.55 -.01  .60    -  .67  .59
    JXI   -.63 -.59 -.45 -.21  .68  .67    -  .77
    KXI   -.51 -.48 -.34 -.02  .42  .59  .77    -
                                            Mean correlation: -0.044727
    [2007-12-01-0w/1d 8]    Portfolio        SPY    Portfolio-vs-SPY (better: > 1.0)
    --------------------    ---------       ------  ----------------
    %Total_Return:               8.22        -5.72              +INF
    %Annualized:               103.62       -41.17              +INF
    %Return_Mean:                0.28        -0.21              +INF
    %Return_StdDev:              0.94         1.11              1.18
    %Volatility:                14.94        17.56              1.18
    %Max_DrawDown:              -1.14        -2.74              2.40
    Omicron:                   2.0305       0.6190              3.28
    Omega:                     1.4291       0.2385              5.99
    Omega/Omicron:             0.7038       0.3853              1.83
    %Alpha(annual):             47.02         0.00                 -
    Beta:                       -0.66         1.00              1.53
    Alpha/Beta:                 71.72         0.00                 -
    R(correlation):             -0.76         1.00              1.31
    %R2:                        58.29       100.00              1.72
    Sharpe_ratio:              4.7656      -3.0175              +INF
    Sortino_ratio:             4.4572      -3.3109              +INF
    DBA     PowerShares DB Agriculture
    IHF     iShares Dow Jones US Healthcare Provider
    SDS     ProShares UltraShort S&P 500
    TWM     ProShares UltraShort Russell 2000
    SRS     ProShares UltraShort Real Estate
    JXI     iShares S&P Global Utilities
    IXC     iShares S&P Global Energy Sector
    KXI     iShares S&P Global Consumer Staples

    As always, every investor should make up their own decisions. The above is an approximate description of what I'm doing in my own portfolio, and is not a solicitation to buy or sell anything. Any feedback, question, request, criticism etc. is very welcome.

    -- ariel