Monday, February 20, 2006
These days, millions of people around the world have pretty much the same problem. They see America borrowing like crazy and making a mess of one foreign adventure after another, and they suspect that U.S. markets, as a result, are headed for disaster. But they don’t know what to do about it. Five decades of growth and prosperity have trained them to look at only the long side of the market. The short side—that is, betting on things going down—is foreign territory.
So this column will be the first in a series on how to make money when the Dow and the dollar both head south. The plan is come back every few months to see how we’re doing. My guess is that we’ll be doing great.
Let’s begin with options, which are contracts to buy or sell 100 shares of stock for a given period of time at a given strike price. A call option gives its holder the right to buy (or call away) 100 shares, while a put confers the right to sell (or put the shares into someone else’s account). Said another way, calls become more valuable when the underlying stock goes up, and puts become more valuable when it goes down. If not exercised by their expiration date, options cease to exist, costing the owner their entire investment. This short lifespan was a drawback of old-style options, which ran for only nine months. But that problem was solved by the creation of Long-Term Equity Anticipation Securities, or LEAPS, which last up to two-and-a-half years.
LEAPS let you place multi-year bets for relatively little money. But they’re tricky. They come in a wide variety of expiration dates, strike prices, and underlying securities, which makes it possible to construct strategies both brilliant and incredibly stupid. Doing LEAPS right requires expert help.
So I stopped by the office of Bill Lambert, a Moscow, Idaho money manager and options guru who spends his days constructing arcane strategies with amusing names, most of which make his clients a lot of money (call him at 866-525-9194 for a free consultation). We spent an hour in front of Bill’s four 19 inch screens, him pulling up charts, running simulations and rattling off figures for volatility and delta and gamma (“the Greeks,” he calls them), and me scribbling furiously and asking the occasional really dumb question. The result: four slick ways to turn bad times into major windfalls.
Gold Price Suppression Short Squeeze Spread
In sound-money circles, it’s accepted as fact that the world’s central banks have been colluding with a handful of commercial banks (known as bullion banks) to depress the price of gold. For the full story, see Sprott Asset Management’s “Not Free, Not Fair,” at http://www.sprott.com/resources/reports.php. But for now, suffice it to say that the central banks secretly lend their gold to bullion banks, which sell it on the open market (thus depressing gold's price) and invest the proceeds. The bullion banks are obligated to return the gold to the central banks someday, which means they're short gold and stand to make a lot of money if gold goes down. But of course it hasn’t gone down. It's up big, which means:
1) The bullion banks have tens of billions of dollars of unrealized losses on their gold shorts which, when reported, will crush their stock prices.
2) At some point the bullion banks will have to buy all this gold back, which will send its price through the roof. A classic short squeeze!
So let’s buy LEAPS calls for GoldCorp, a high quality, low risk gold mining company, and LEAPS puts for Goldman Sachs, reputed to be one of the leading bullion banks. We’ll buy round lots of ten contracts (giving us exposure to 1,000 shares of stock) at their closing prices on Friday, February 17. Total cost: $13,900.
Bill’s take: “Goldman can peel off $50 easy. If it does, this put will go up 600%-700%.”
|Buy GoldCorp $30 Jan 08 call|
|Buy Goldman $130 Jan 08 put|
|Total Cost|| || |
Gold Price Suppression Short Squeeze Calendar Spread
For a less costly variation on the above spread, let’s also sell a shorter-dated Goldman Sachs put, and use the proceeds to defray the cost of the longer-dated put. Ten of the Jan 07 130s bring in $4,800, lowering the up-front cost of the strategy to $9,100. This is what’s known as a calendar spread. With it, you don’t make as much if Goldman tanks in 2006. But 2007 is when everything is due to fall apart anyway. And in the meantime, you still win big if GoldCorp goes up.
|Buy GoldCorp $30 Jan 08 call|
|Buy Goldman $130 Jan 08 put|
|Sell Goldman $130 Jan 07 put|
|Total Cost|| || |
Oil Kills Retail Spread
Now let’s say you expect oil to soar in the next couple of years. $4 gas might finally convince American consumers to stop their obsessive shopping, which in turn would cause upscale retailers like Abercrombie & Fitch to implode. So we’ll go long Exxon $65 calls of 08, and short Abercrombie & Fitch via its Jan 08 $70 puts.
Bill’s take: “Exxon is a right near its ‘05 high. It’s been going sideways for a year, building a base. It’s a slam dunk to go higher. Abercrombie & Fitch was $15 in ‘02, and now it’s $65. It’s put in a beautiful double top, and could fall to $30 easy.”
|Buy Exxon Mobil $65 Jan 08 call|
|Buy Aber. & Fitch $70 Jan 08 put|
The NASDAQ Tanks in 07 Calendar Spread
One of the risks of using options on individual stocks is that any given company can do things —good and bad—that have nothing to do with the market. GoldCorp could a have mine accident or Exxon another Valdez. Or Goldman Sachs could merge with CitiGroup or some other monstrous entity, making its puts worthless.
You can eliminate this risk with options on broad indexes like the S&P 500 or the NASDAQ. Because the NASDAQ is heavy on tech and light on energy and mining companies, its options, known as QQQQs, are especially juicy shorts. The QQQQ is currently $41, so let’s buy the Jan 08 $40 puts and sell the Jan 07 $40 puts, for a net cost of only $1,075 on ten contracts.
Bill “I’m looking for the Qs to be down in the 20s…hell, you’ll be $15 in the money if the market tanks in 07.”
|Buy QQQQ $40 Jan 08 put|
|Sell QQQQ $40 Jan 07 put|
By John Robino of DollarCollapse.com
Every great turning point has its Irving Fisher. He was the Yale economist who in October of 1929 proclaimed that stocks were at a “permanently high plateau.” Later that same month, the market crashed, the Depression started, and Fisher became an object lesson in the dangers of public prediction. Less perfectly timed but still pretty memorable was Business Week’s 1979 “Death of Equities” cover story, which declared stocks passé as an investment vehicle--just before the start of the greatest bull market in history.
Now Business Week is back for another bit of dubious immortality, with a February 13 cover story titled “Unmasking the Economy: Why it’s so much stronger than you think”:
"But what if we told you that the doomsayers, while not definitively wrong, aren't seeing the whole picture? What if we told you that businesses are investing about $1 trillion a year more than the official numbers show? Or that the savings rate, far from being negative, is actually positive? Or, for that matter, that our deficit with the rest of the world is much smaller than advertised, and that gross domestic product may be growing faster than the latest gloomy numbers show? You'd be pretty surprised, wouldn't you? Well, don't be. Because the economy you thought you knew -- the one all those government statistics purport to measure and make rational and understandable -- actually may be on a stronger footing than you think."
The article goes on to explain that government statisticians are stuck in the days of railroads and factories, when physical structures mattered. But today the real action is in R&D and brand building and intellectual property, things that GDP numbers largely miss. Add them back, and deficits shrink while growth soars. Far from being a decadent late-stage empire, the U.S. is actually a vigorous young nation with a bright future. Heck, we're the creators of the iPod, Starbucks and exchange-traded funds. We rock!
Now, some of the above is undeniably true: R&D could be better represented in GDP calculations, and American corporations are efficient in ways that are hard to quantify. And we do invent a lot of cool stuff. But the conclusion--that the U.S. is actually a healthy system--is wrong in a way that illustrates how our perspective changes at the end of every long cycle. When time-tested measures like book value or debt/equity or P/E begin to conflict with the impulse to extrapolate the recent past into the indefinite future, people start looking for reasons to ignore the old metrics. And they eventually come up with new ones that fit their worldview.
Back in the late 90s, for instance, tech stock investors dismissed concerns about NASDAQ companies' lack of earnings as dinosaur thinking. For New Economy companies, earnings were "optional" (I swear three different people told me exactly that in 1999). Eyeballs and mindshare were what mattered. As TheStreet.com's Jim Cramer put it at a 2000 tech stock conference, "Most of these companies don't have earnings per share, so we won't have to be constrained by that methodology for quarters to come."
But old-fashioned things like earnings and debt service ratios do matter in the end. So how do we separate reality from New Era hype this time around? One way is to look at the effects of all this "dark matter" R&D and brand building. If it's real and producing wealth, then the rest of us should be reaping some benefits. Our incomes should be rising and/or our balance sheets should be strengthening. But as you can see below, this isn't the case. U.S. disposable income is crawling upward at about the rate of population growth plus inflation, while debt is soaring. A decade ago, Americans' disposable income exceeded household debt by about half a trillion dollars. Now debt exceeds income by $2 trillion.
What's really happening? The same thing that happens in every credit-driven boom: Easy money allows companies and individuals to do things that make it look like a new era has dawned. In the 1920s it was Ford and RCA changing the world with auto assembly lines and radio networks, financed by sales to investors with growing stock portfolios. In the 90s it was Amazon and Inktomi shifting the whole economy into cyberspace, funded by a soaring NASDAQ. Today it's Intel and Wal-Mart building super-fast chips and futuristic supply chains, fueled by families borrowing against their homes. The good things are undeniably good; computers keep getting faster and supply chains more efficient. They just aren't enough to offset all the new borrowing.
So the end will come as it always does. When the credit spigot is turned off--as it will be soon--consumers will stop spending, businesses will find that their R&D isn't yielding the expected return, and the economy will head south. Sorry Business Week, but under the surface, things are actually much worse than they seem.