TrendWatch Weekly

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I’m definitely stepping outside of my comfort zone with this week’s topic, but with the equities markets in retreat right now, it’s time to think about making some money on the downside.

Regular readers know that my policy has been to move into cash as my winning stocks have finally ran out of steam, and I’ve generally stayed in cash until the tide returned to the upside. That served me well during the 2008 meltdown and through much of last summer’s volatile trend (mostly) downward.

But, cash, as you know, earns nothing, unless you play it against other currencies… a topic I’ll leave for another time.

This week I want to walk you through what it takes to live on the edge and try to make money as stock prices decline. I have three tactics in mind, and I’ll describe them below.

But first, let’s have a look at another dismal week in equities…

WEEKLY REVIEW… After a horrible one week performance last week, our chart shows a continuing turn for the worse… with all major indexes falling over the week. This drags the trend values for all of them onto the negative side. In short the odds of picking profitable stocks on the long side are not good. Of course, there will always be exceptions, but you’ll have to decide for yourself whether you want to fight the prevailing trends.

As usual the order of the markets is based on descending order of the (red) trend values, and the US major indexes continue to stay on top. Well, let’s say they performed less worse!

Just 34% of the stocks in the S&P/TSX Composite Index rose last week, reducing the total percentage of companies with positive trend values to 33%. Four of the 10 sector indexes have negative trend values now.

On the US side, the proportion of rising stocks in the S&P 500 Index last week was 35%, and the proportion of stocks with positive trends is now down to 37%. Only two of 10 sector indexes have positive trend values.

One thing I find very puzzling right now is that volatility (as measured by VIX or VIXC) haven’t really risen all that much. I consider 15-20 low on the “fear factor” indexes, as these things are frequently called. Right now the VIX is near 24 and VIXC is 20. Apparently those who buy put-option insurance aren’t too concerned about recent market declines yet.

Looking at the trend rankings of the 10 sectors in both the S&P 500 and the S&P/TSX Composite Index, the “least worse” performers have been pretty consistent for at least a month now… UTILITIES, CONSUMER STAPLES, CONSUMER DISCRETIONARY, and HEALTH CARE.

For more details on sectors and performance of stocks within sectors, visit the DATA & CHARTS workbook.

In our annualized growth rate (AGR) chart below we take the average weekly %-gain/loss in the trend values of all stocks and multiply it by 50 to get a ball-park annualized speed of price movement of the S&P/TSX Composite and S&P 500 stocks. It’s like a speedometer, but instead of miles or kilometres/hour in your car, you will be seeing %-gain (or loss)/year.

Why annualize? Well, it’s not essential, but it provides a fairly meaningful scale and we can use larger round numbers. The differences also stand out more. Your car’s speedometer could read miles (or kilometres) per minute, but the numbers would be pretty small and harder to interpret, like our gains per week numbers. Scaling up the time dimension just acts like a magnifying glass, as it does with your car’s speedometer.

You can see that last week’s performance in equities declined for both the S&P 500 trend benchmark and the S&P/TSX Composite Index trend. S&P 500 stocks are still outperforming the S&P/TSX Composite Index, however… something we’ll be discussing more below.

As you know, the ProfiTrend Portfolio (PTP) is based on my own holdings. It’s a way of sharing with you how well I’m doing relative to the averages, without giving away too many specifics and personal details. You can see from the chart that the AGR for my ProfiTrend Portfolio (PTP) is now at 79%, well up from the previous week, and still well ahead of the benchmarks.

I sold four more positions last week. I’ll be in sell more this coming week… due either to trend shrinkage or sharp declines from my price highs since purchase. These are my two key sell signals.

At the moment, however, the ProfiTrend Portfolio has these characteristics…

• 8 different holdings including an ETF (to short natural gas), a couple mid-cap consumer stocks, and a volatility play using VIX derivatives
• Now 71% in cash with no intentions of going long on anything right now
• Average of current trend values of all holdings, if annualized as in the chart above (i.e. 50 X Trend Value), is 48%
• 75% of the PTP holdings are now in US equities
• Average gain among current holdings: 16% over an average holding time of 10 weeks

I strongly encourage you to track your own portfolio this way. It’s quite easy to do. For each of the stocks you’re holding, simply divide the percent gain to date by the number of weeks you’ve held that stock. Then take an average of those numbers and multiply by 50 (or 52 weeks if you’re a stickler for detail). Track that number weekly as we do in the chart above… comparing it with the benchmark(s) that you think are appropriate.

As I like to emphasize, if you’re not outperforming the average(s) all of the time, that could mean that you’ve gotten a bit lazy about dumping your losers and/or replacing them with equities that have more attractive trend and consistency values. Dropping losers before too much damage has been done is like dropping ballast from a hot air balloon. Without the extra weight, your portfolio will soar higher, as you can see from the PTP results above.

PLAYING THE SHORT SIDE… With all major North American indexes now trending lower, and all 37 of the country ETFs that we track trending lower too (see DATA & CHARTS workbook), it’s time to consider profiting from further declines. This is a brief primer on that topic.

Over the years, we’ve generally been conservative enough to take a “move into cash and stay there” approach in situations like this. That’s what I’ve been gradually doing with my own portfolio over the past month or so. You’ve been able to follow that in the previous section of our TrendWatch Weekly updates.

Now it’s time to consider shorting the markets for a while, so I’m going to run through three different alternatives. Those of you who routinely use short-selling as required won’t learn anything new here. This is mainly for those who are for the most part unfamiliar with the fact that you can make money with consistent downward trends too. But, proceed with caution. The risk is higher, since over the very long term stocks always move higher. Hence, there’s a bias that we’re fighting with any shorter-term strategy in the opposite direction.

Selling stocks and ETFs short. When you sell stocks or ETFs short, you’re essentially borrowing someone else’s shares and selling them immediately. It’s totally transparent to you (and the person whose shares have been sold), since your broker has many accounts under management and can freely “borrow” anyone’s portfolio holdings and move them around as they see fit. You granted permission for them to do that with your own portfolio in the fine print that you signed when you opened your account. If the person whose shares were borrowed decides to sell, your broker’s task is to quickly replace them (probably with yet another person’s stock) so the sale can go through. It’s all one big shell game.

That part shouldn’t concern you. You’ve sold someone else’s shares and expect to buy them back when the price drops (hopefully a lot). When you’ve closed your position, the shares go back into the “borrowing pool” or eventually to the original owner, by the time he or she wants to sell. And since you sold high and bought-back low, you pocket the difference.

Because you’re selling something that doesn’t belong to you, however, you have to have sufficient collateral in your account to cover your losses if the stock price goes up instead of down.

The worst case scenario is when there are a lot of short-sellers of a particular stock, and suddenly the price starts climbing significantly. In principle at least, there may not be sufficient shares out there to buy-back; and by the time there is, the price will be even higher… exaggerating your losses. I don’t have any hard data on how often this happens given today’s super-efficient computer systems, but you still read or hear about these “short squeezes” every now and then.

On the other hand, the ideal short sale is when the stock that you’ve borrowed and sold keeps falling to virtually nothing. Usually even before the shares hit zero, the company in question has declared bankruptcy and all shares are declared worthless. Hence, a nice fat profit and no concern about buying back shares to cover your short position.

In between these two extremes there are lots of opportunities to play the short-seller’s game. It’s typically best to short larger, more liquid companies’ shares to ensure that the buy-back will happen without a huge bid-ask spread. The same goes for ETFs.

Inverse ETFs. Since the popularity of ETFs is largely due to their simplicity (while offering diversity), it shouldn’t be surprising that you can now buy inverse ETFs that move up in value as the underlying index that the ETF tracks declines. Someone not willing to hand-pick individual stocks that are declining the fastest and most consistently, might just buy an inverse ETF on a major stock index instead.

Alternatively, if you want a bit more risk, and potentially more reward, find a more focussed inverse ETF that tracks an index that is falling faster than the general market indexes. Better yet, try to find one with leverage, so you’ll get a multiple of the price change as the index declines. Think about these alternatives in terms of risk/reward…

• The (large-cap) S&P/TSX 60 Index is now declining at -0.8%/wk with 58% consistency. You could short an ETF based on that index (e.g. SXO) and expect as much gain as you see in the decline in the index until you buy-back. OR…
• You could buy an HBP S&P/TSX 60 Bear Plus ETF (HXD) with 2X leverage. The HXD trend is +1.5%/wk with 54% consistency. It’s no surprise that +1.5% is almost exactly twice the inverse of -0.8% for the underlying index. OR…
• Throw caution to the wind. We already know that the current decline in equities is global, so why not buy a Direxion Russian Bear 3X ETF (RUSS) that is currently returning 5.7%/wk with 68% consistency, or an Ultrashort MSCI Brazil Proshares ETF that is rising +3.7%/wk with 76% consistency, as the Brazilian equity index it’s based on declines.

All you need to do is keep in mind that our DATA & CHARTS workbooks have most of the info you need to get started in profiting from declining equities, as this global trend continues. And, if you don’t find enough data there, consider subscribing to one or more of our Premium Service databases. Every week, you’ll find a far bigger pond to fish in, when looking for downside profits. We have close to 250 Canadian ETFs and about 1200 US ETFs in our ETF Premium Service database. We send out the latest data out to subscribers weekly. Not surprisingly, all of the biggest winners at the top of the ranked performance list have “short” or “bear” in their title, along with “2X” or “3X”.

Put Options. I’m a big fan of equity, index, and ETF-based options too; but I like to keep my coverage to a minimum here. You really need to bring your investment skills up another big notch to fully understand what’s involved. You need to know a lot about probability theory, volatility, and time decay functions to really become a successful options trader. That’s certainly not for everyone; and leveraged ETFs can be a successful and (believe it or not) more conservative alternative than taking a course in options trading and practicing what you’ve learned.

But to be complete in playing the short-side, this choice can’t be ignored. When you buy an options contract, you’re paying for the right to buy (or sell) a certain number of shares in an underlying company (or index or ETF) over a certain period of time for a certain preset price. That’s the easy part.

Here’s an example. RIMM is trading at about US$12 right now. You can buy a RIMM Dec 12 Call option for $2.12 or a RIMM Dec 12 Put option for $2.28 today. You’d buy a call expecting the price to go up and a put if you expect the price to go down… so let’s concentrate on the second one.

Since 100 shares of stock are involved, you’re paying $228 for the right (but not the obligation) to sell 100 shares of RIMM for $12. A simple short-seller would just sell 100 shares of RIMM today at $12, but there would have to be enough collateral in his account to cover the borrowed shares.

The put option holder would be crazy to exercise his right to sell at $12 today, because he’d lose that $228 he paid for the contract. Besides, he doesn’t have the 100 shares of RIMM… unless he went out and bought them. RIMM would have to fall below $10 before he would break even (and then only if he had the shares to sell). But what if RIMM dropped 50% to $6. The short seller would likely buy back the shares sold short and claim a $600 profit (less commissions). Since $1200 collateral was required to do the deal, that’s a 50% profit.

The put option guy, without even buy shares of RIMM, would see the value of his contract grow from $228 to an absolute minimum of $600 (($12 sell price - $6 current price) X 100). If the stock reached $6 well before December expiry, the contract would actually be much more valuable. A large part of the price paid for an option contract is in its time value. So, at the worst case, the put-holder, if he simply sold his contract, would receive a 63% profit from putting up just $228. More likely, he might have bought 10 contracts originally for $2280, and collected a minimum of $6000 when selling the contract, for a profit of at least $3720.

So that’s how options speculators make money during a downturn. The combination of picking the strike price and the time duration for the put option can lead to an almost infinite variety of leverage possibilities. Don’t go there unless you really know what you’re doing.

I’ve used a stock example (RIMM), since you might use our trend and consistency data to help choose your option candidate, but you can do the same thing with major stock indexes. In fact some investors prefer not to sell off all or most of their stocks during a decline like we’re seeing right now. Instead, they’ll buy put options on a large market index like the S&P 500 or the S&P/TSX Composite Index in sufficient quantities and with enough leverage to offset the losses in their holdings. Because of the high leverage potential, it is just like insurance. They put up a relatively small amount of money to protect themselves from a catastrophic loss like a market crash. Of course, if the catastrophe doesn’t happen, they tend to lose the premiums they’ve paid.

So, there you have the major choices available to you, if you want to keep your money working for you during a downturn. A final alternative, I suppose, would be to find another investment class that rises as stocks fall. Right now, I would welcome any suggestions along those lines, but I don’t see any… unless it’s something exotic like fine art collecting, or selling endangered species on the black market.

NOTE: The following sections often remain unchanged for several weeks. We’re now using a symbol to alert you of updates when they occur, or when new sections are added. That might help you skip over sections that you’ve read before. The flag will be removed two weeks after the new material has been added.

STATE STREET INVESTOR CONFIDENCE INDEX (APRIL 2012)… The global SSICI dropped 3.9 points in April after rising 5 points in March.

We like the SSICI since it’s not just based on a snapshot of opinion. State Street tracks actual money flows among institutional investors from low risk assets (bonds) to high risk assets (stocks) and vice versa. More equities = more confidence.

The more interesting results are almost always in the regional differences. The Europe index held steady from March and is clearly favoured from a risk perspective over the other regions. I wonder why we don’t hear about that on BNN or other media that follow global equity markets. The 7.5 point decline in the Asia index over the past month is largely responsible for the global index decline.

The next SSICI monthly update will be released on May 29.

PREMIUM SERVICES… Join the ranks of our power traders by subscribing to one or more of our Premium Services.

Our premium subscription services provide investors with much larger databases of stocks than you’ll find at our web site; and the weekly updates are delivered conveniently via email attachments. Trend and consistency values for all stocks and ETFs are provided for three time frames… 10-weeks, 20-weeks and 40 weeks using our relative trend analysis™ (RTA) approach. Check our Premium Services page for more details on the data fields included in each database.

A US Equities Database is now publicly available with nearly 5000 stocks, complete with trend and consistency data. We also have a new “.UN” database of Canadian income trusts, REITs and Master Limited Partnerships (MLPs). Aside from the usual trend and consistency data for 10, 20 and 40 week timeframes, we’ve included annualized yield information, since these vehicles are currently delivering 8% per year on average on top of any capital gains that you’ll enjoy by picking those with consistent positive trend values. In addition there is a field for general type (REIT, MLP, other) and a more specific label for the nature of the business (financial services, real estate, industrial products, consumer goods, etc). We’re offering a one-year subscription of weekly updates for just $49.95. (Sorry, no pay-as-you go monthly option on this one, since the price is already so low.)

BOOK STORE… Investors might appreciate our recommended book section which takes the form of an Amazon mini-book store.  Buy for a fellow investor or treat yourself to some excellent educational reading.

MICRO-BLOG(S)… Follow us on Twitter if you’re so-inclined. A typical “tweet” will draw attention to an interesting perspective on the markets, and include a link to the source. A brief opinion might also be included.

Since we’ve now consolidated our three web sites into one, we’re simplifying our Twitter presence as well. Previously, tweets on the Canadian markets were obtained via @TSXtrendwatch. For US equities it was @USequitytrends, and for ETFs @ETFtrendtracker. We also had a Twitter feed for income trusts… @IncTrustTrader.

Those will all continue for a few more weeks, but if you follow @ProfiTrend, you’ll receive tweets on all of these topics, plus some more generic investing posts… all in one place.

If Twitter isn’t your thing, the same regular intra-week updates are routed onto a “badge” at the ProfiTrend Advantage web site.  (Badges are info boxes with the most recent tweets.)

On average, there are typically 3-5 of these postings weekly. Because many are quite timely in nature, you won’t see them revisited in our weekly update. For that reason alone, we recommend that you follow us on Twitter or visit http://PTA.ProfiTrend.com frequently, if you prefer that approach.

COMING SOON… Here are a few topics I intend to cover in 2012 (but feel free to offer other suggestions)…

• More chart chat… they’re eye-catching and look scientific, but often they’re a wolf in sheep’s clothing
• What’s “normal”?… is a -4% decline in a single week a lot? is an annual 10% gain in your portfolio good, bad or just average? It’s good to have some benchmarks
• Back-testing… you’re wasting your time!

VIDEOS… Whenever we find videos on various investment topics that may be of interest here, we add them to our video jukebox.  Be sure to check that page now and then to take in an interview or commentary from some knowledgeable analysts.

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CONTACT… Contacting us is as simple as sending an email to info@ProfiTrend.com. Put as much info in your message subject field as possible, before elaborating on the problem. Overly simple subject titles like “Problem Report” may not get noticed. Something like “Sector chart is missing in the US Equities Data&Charts page” will stand out.