Wednesday, October 30, 2013

Where Does the Fed’s Stimulus Money Go? Part IV

During the past few weeks, we’ve dug into some interesting topics surrounding the Fed’s stimulus. While many questions remain unanswered, one will have the most impact on traders and investors: How will central banks exit the “extraordinary measures” phase and head back toward normalcy? (The other market impact question is “when?” — but the answer to that question is likely to have more short-term effects.)

In May this year, the Geneva Conference on the World Economy focused on the topic of how central banks will unwind. A few presentations from that conference may provide us with some answers about the upcoming process. Once again, we’ll dig into the rich deposits of information that came from IMF consultants Singh and Stella in their white papers that we have referenced before. While the concepts apply broadly to central bank stimulus programs, we’ll simplify the explanation by talking about the exit plan for just the U.S. Federal Reserve.

A legitimate question that one might ask is why would the purchases made through the stimulus program have to be unwound at all? While a comprehensive answer is a little more complicated, the simple way to look at this is as follows: The Fed has lowered interest rates through securities purchases that manipulate the yield curve (and of course by changing interbank borrowing rates). As interest rates approached their lower bound of zero, stimulus efforts took the form of a massive expansion of liquidity. If things were just left “as is” — with the $2.2 TRILLION of added reserves sloshing around on the books, that added liquidity would pose of threat of sending inflation rates to unacceptably high levels, given a period of sustained economic recovery and even a bit prosperity.

To avoid this eventuality (or, in some peoples’ minds, to keep it from happening), the Fed will have to unwind a large portion of this massive liquidity. The Fed will do this by raising interest rates but not by directly reducing its balance sheet and the balance sheets of the commercial banks who have been the willing parties to the multiple QE phases. So then how to unwind trillions of dollars of stimulus? That subject has been debated and now a likely path seems pretty clear.

The Repo Man’s Mirror Image

Peter Stella outlines three ways that the Fed can raise rates: by declaration (or fiat, as he calls it), by raising rates on borrowed bank reserves, or by raising the rates of reverse repurchases.

The first option — raising rates by fiat — has little else going for it beyond simplicity of execution. Divorced from market forces, such changes could lead to significant unintended consequences and may not adequately move longer term rates, which are most important in the real world.

Raising the rates paid on term deposits would have the desired effect of incentivizing banks to reduce their reserve levels, but does little to help banks build back their stocks of tradable securities.

The last option, which most signs point toward as the logical conclusion, is the use of reverse repurchase transactions.

In last week’s article, we talked about the role that repurchase agreements play in providing liquidity to institutions. In essence, as Stella describes it, the Fed would sell Treasury bonds to financial players and agree to buy them back at a set time in the future for a set fee. This fee agreement would allow the Fed to effectively pay interest like it would with term deposits while offering the double benefits of putting more high-quality collateral (namely treasuries) back into play and also being able to include nonbanks in the loop.

Again, Stella emphasizes that the Fed has already spent time and effort to put the infrastructure in place to facilitate these reverse repos including expanding the list of approved (nonbank) counterparties who could buy and then re-sell the reverse repos.

So What?

That’s a fairly quick but head-spinning dive into the minutiae of stimulus unwinding. Still, we can glean a couple of key points from this. First, central banks do have a chance of creating a soft landing coming out of this unprecedentedly massive monetary policy experiment. The mechanisms exist for prudent exit strategies. But — and this is a big but — the global economy is going to have to cooperate. A mild recovery will not produce the financial cover to unwind this gently and any hiccups in the system could lead to 2008-stlyle market plunges.

The size and scope of central bank interventions over the last five years have created a financial compression that may only be relieved by an explosion rather than a process of letting the air out bit-by-bit. And many questions remain unanswered — for example, as interest rates necessarily rise and bond prices drop, who will absorb the losses in those securities as they pass through the repo cycles? More public sector burdens? Will private parties have exposure to some of this risk? We’ll dig into these tough questions next week.

Click Here to Read Parts 1, 2 and 3 of Where Does the Fed’s Stimulus Money Go?

Monday, October 28, 2013

Investing in Insurance

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It has been a pretty great time to be in the property/casualty insurance business. There has been a lack of disasters—so little in terms of payouts—while many items in an insurer’s investment portfolio (like stocks and some bonds) have surged in value.

This has kept many bullish on the sector, and especially so when compared to the shaky health insurance space. In fact, the property casualty insurance industry currently has a Rank in the top 5% according to our models, suggesting a pretty widespread bullish case for the segment.

In particular though, one company could be a solid pick in this segment, Cincinnati Financial (CINF). This company just delivered a strong earnings beat, and could be well-positioned to gain further in the months ahead.

CINF in Focus

Cincinnati Financial operates in several segments including commercial, personal, and life insurance giving it a diversified mix. However, CINF is definitely focused on the commercial segment, as this accounts for the bulk of its revenues.

The company has seen strong growth in its earned premiums when compared to 2012, while payouts have stayed pretty stable despite having more policies on the books. This has led to decent sized gains for CINF when compared to the year ago period in terms of earnings, and it has been further compounded by strength in the company’s investment portfolio as well.

Thanks to this strong trend, analysts have started to bump up their expectations for the company’s future earnings. Now, the yearly earnings estimate is up to $2.65/share from $2.22/share 90 days ago, while we have also seen positive moves in other time periods as well.

CINF also has a great track record when it comes to earnings beats, including a solid beat for the most recent quarter of 27%. The company has actually averaged a 64% beat in the past four quarters, and hasn’t missed in more than two years, so clearly it knows how to beat in earnings season.

Due to these factors, Cincinnati Financial has earned itself a Zacks Rank #1 (Strong Buy), suggesting that more outperformance is in the cards for CINF. And with a 6.7% move higher in the past month, this is definitely a solid momentum play as well.

The company is also expected to see 10.4% growth in earnings for the full year, while it is still has a PE below 20, suggesting it is a value pick. Plus, the company pays out a robust 3.3% in yield, so there is definitely income potential in this stock too.

Bottom Line

CINF is in a great industry that has a lot going for it thanks to strong asset performances and a lack of big natural disasters as of late. Due to these factors, analysts and investors have become more bullish on the insurance industry bidding up some names in the space.

Cincinnati Financial could be a great choice to play off this trend as it just beat earnings and it has a top Rank to boot. Add these factors in to a growing portfolio and a solid dividend, and investors may have a winner on their hands with this Ohio-based company.

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Thursday, October 24, 2013

Evaluating the Keltner Bells Forex Trading System

When you're evaluating a new trading system, it is 'mission critical' that you look not just at the wins of the system . . . but at the losses, too.

Anyone can show off a great winning trade. Even truly abysmal trading systems will have a least a couple good trades if only by luck.

What makes Keltner Bells stand out is that our wins are typically MULTIPLES the size of our losing trades. This means that even if you take 10 trades, winning 5 trades and losing 5 trades, you *still* will come out on top.

Take these recent trades, for example. You'll see a win & a loss for each pair.

GBPUSD +81 pips, -13 pips
GBPNZD +135 pips, -60 pips
EURJPY +120 pips, -50 pips
AUDUSD +90 pips, -4 pips
CHFJPY +132 pips, -75 pips
NZDJPY +131 pips, -14 pips
GBPCHF +119 pips, -43 pips
EURAUD +113 pips, -54 pips

No matter how you slice it, the losing trades pale in comparison to the winning trades.

Simply put, when you trade Keltner Bells, you'll always have the odds in your favor on every single trade. When it just comes down to the numbers we have always had more winners than losers in every Forex pair.

More winners in 2011, more winners in 2012, and more winners in 2013. In fact, in any given month in 2013 there was an 85% likelihood any of our currency pairs would be positive. In 2012 the likelihood was 87%! Stability is the key to performance.

Even better, Keltner Bells takes just 10 minutes a day to realize these wins. It is designed for simplicity, showing eye-widening performance across currency pairs with no added time commitment.

Click here to check out this video now. It has a mini walk-through of the Keltner Bells system plus a good cross-section of Forex results you can expect to see actually trading the system.

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Monday, October 21, 2013

Investing in Recreational Vehicles

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What's one of the hottest big ticket items right now? Motorhomes. Winnebago Industries, Inc. (WGO) is cashing in on aging Baby Boomers and the lure of the open road. This Zacks Rank #1 (Strong Buy) can hardly keep up with demand, as its backlog jumped 130% in the fiscal fourth quarter.

Winnebago's brand recognition is so strong that when you think of RVs it's the first name that comes to mind. Founded in 1958 in Iowa, Winnebago manufactures a variety of recreation vehicles ("RVs") including motorhomes, travel trailers and fifth wheel products.

Given consolidation in the industry during the Great Recession, Winnebago was able to add to its market share and now has about 20% of the RV market.

Baby Boomers And The Economic Recovery

Motorhome sales peaked in 2004 at 69,000 and plunged during the Great Recession. By 2011, only 25,000 motorhomes were shipped. But that number is expected to slowly rise as the economy improves and the Baby Boomers age.

The key segment of RV buyers is 55 to 64 years of age. The Baby Boomers are just on the cusp of reaching that age range right now with more to come in the next few years. That's a built-in market for RVs.

Additionally, with the stock market at record highs and the housing market recovering in many major metropolitan areas, Baby Boomers finally have the cash to take to the road.

All of this adds up to good things for the RV manufacturers. The RV and manufactured home industry has a top Zacks Industry Rank of 2 out of 265 industries.

Big Beat in the Fiscal Fourth Quarter

On Oct 17, Winnebago reported its fiscal fourth quarter 2013 earnings and blew by the Zacks Consensus Estimate by 35%. Earnings were $0.38 compared to the consensus of $0.28.

Revenue for the quarter soared 31.8% to $214.5 million from $162.5 million. For the full fiscal year, revenue jumped 38.1% to $803.2 million from $581.7 million.

The company has introduced new products, which are proving to be very popular among consumers. Motorhome shipments were up 31% year over year to 2010 units.

Inventory at dealerships also rose 38% as dealers couldn't keep product on the lots. And there was STILL a huge backlog which grew to 3380 units.

Shares at 5-Year Highs

Demand for motorhomes is expected to continue into fiscal 2014. Analysts expect earnings to grow another 10.6%.

Shares have been hot, hitting 5-year highs on the solid Q4 earnings report.

Winnebago is trading at 23x forward estimates but has a price-to-sales ratio of just 1.0. A P/S ratio of 1.0 or less usually indicates a company is undervalued.

For investors looking for a way to play the improving economy, including the housing recovery, Winnebago is one to keep on the short list.

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Friday, October 18, 2013

The 2013 Forex Robot Championships Winner

It`s been 3 months since the Forex Sensation Championship started with the top 29 developers that committed their best Forex robots in a contest whose winning bot is to be crowned "The BEST Forex Robot of All Time" and the winner has just been announced.

The Forex Sensation team pre-screened 784 robot submissions and selected the top 29 contestants based upon several quality criteria, such as


Lack of "filters" such as martingale (<-big plus)

Long-term robustness (no pump and dump robots)

Coding stability

And many more

The top 29 contestants all traded with 10,000 USD real money deposits and the results were far beyond impressive.

The Forex Robot Championship Winner is Oleg Zadorecki's Forex Cash Printer

Thursday, October 17, 2013

Where Does the Fed's Stimulus Money Go? Part 3

Where Does the Fed's Stimulus Money Go? Part III The Repo Man

By Dr. Van Tharp Trading Education Institute

I had a most interesting conversation over lunch yesterday with a modern day “repo man” where he talked about one of the least well-known activities in the financial markets — securities repurchases, known broadly within the industry as a “repo.” I mentioned that folks like him doing repos probably have an identity crisis since the term repo has another connotation in the work-a-day world, and the bond repurchaser sitting across the table readily agreed!

Ask a person on the street what a “repo” is and most will call to mind the off-beat, black Sci-Fi comedy Repo Man starring Emilio Estevez. The movie depicts, in Hollywood fashion, the life of a young punk rocker that has lost his way and finds a career repossessing cars whose owners have fallen behind on their payments. (Another movie of the same name from 2010 starring Jude Law and Forest Whitaker follows a very different premise/plot and has not reached the “cult classic” status of the 1984 film.)

As mentioned above, in the financial world, the term “repo” is shorthand for a repurchase or, more correctly, repurchase agreement. Repos are very common and important activities that allow institutions to generate short-term cash using less liquid securities as collateral.

In essence, a repo functions like a loan backed by collateral with the key distinction that the collateral actually changes hands. In simplified terms, it works like this: the owner of non-liquid securities (e.g. corporate bonds or any security with longer term hold periods) will sell that asset to an ersatz lender in exchange for cash with the agreement to repurchase the asset at a later date.

Because the entity providing the cash actually takes control of the asset (so they can sell them to a third party or at least use them as collateral for other transactions), the transaction costs of the “loan” can be quite small, making this a very efficient transaction. Hence it is a low cost way for companies to generate short term cash or cash from “idle” assets.

In terms that my third grade economics students would understand, repos are a bit like the finance world’s pawn shop — things with value but no liquid market (like the ruby encrusted gold broach you inherited from Aunt Mabel) can be turned into cash. (Thanks to my good friend CRC for this analogy!) In the same way, everything from long maturity treasuries to dusty old corporate bonds sitting in the corner of the vault and just taking up space are turned into short-term cash by using the repo system.

Coming to a Bank Near You: the Reverse Repo

In the first article in this series, we talked about one of the unintended consequences of QE — the reduction in high quality collateral on bank balance sheets. In essence, the Fed has been buying up high quality collateral (treasury securities) and replacing them on bank balance sheets with reserves held at the Fed; reserves that can only be traded among banks and NOT with third parties. This action, along with higher perceived risks, have reduced the repo market considerably since the Great Recession:

This reduction in repo transactions has contributed to the reduction in the velocity of money in the broad economy. The velocity of money is one of ways that we measure the amount of “lubrication” in the market — how easy it is to transact commerce. For that reason, this chart on velocity is well worth repeating:

The collective effects of dwindling amounts of high quality collateral, reduced repo transactions, and contracting velocity of money means that sooner rather than later, the Fed (and other central banks) will have to start unwinding the huge amount of reserves they have created over the last five years.

Next week, we’ll dig into the “reverse repo” transactions that many in-the-know players expect the Fed to use and why it’s important for traders and investors to understand this arcane bit of financial alchemy.

Until then, your thoughts and comments are welcome, click here to send them to us.

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Monday, October 14, 2013

Investing in a Canadian Pharmaceuticals Company

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Looking for a healthcare play with strong consumer products growth and an expanding pharmaceutical pipeline? Then set your sights on Canada's Valeant Pharmaceuticals (VRX), whose recently completed acquisition of Bausch & Lomb makes it the biggest player in ophthalmology and general eyecare products.

Valeant is a specialty pharmaceutical company with many hundreds of products across dermatology, dentistry, neurology, and ophthalmology. Its early and late-stage drug candidates have unique formulations and mechanisms of action including retigabine for the treatment of epilepsy and pain, taribavirin of the treatment of chronic hepatitis C, and several dermatology candidates for the treatment of rosacea, acne, and dermatological fungus.

It's Not Organic, But Investors Still Love the Growth

The company has been primarily built through a series of mergers and acquisitions over the years. It operates in two primary geographical segments, Developed Markets and Emerging Markets. Developed Markets includes U.S. pharma/OTC in dermatology, aesthetics, dentistry, podiatry, ophthalmology, neurology/other, and Canada/Australia/NZ. Emerging Markets includes branded generics/OTC in Central/Eastern Europe, Latin America, SE Asia/Africa.

This growth strategy is producing over 50% sales growth and 40% EPS growth, while trading under 13X next year's $8.66 consensus. And that's why the stock keeps steadily climbing since May. It's that kind of stable, global growth that some investors can't get enough of.

In July, my colleague Nick Kalivas also chose VRX as his Bull of the Day. Here's how he highlighted their acquisition strategy...

Valeant’s aggressive growth strategy and cost savings look attractive. Valeant has produced vibrant revenue growth in recent years helped by an aggressive acquisition strategy. Valeant made 11 acquisitions in 2011 and another 12 in 2012. These actions helped to propel 108% revenue growth in 2011 and another 44% in 2012. In Late May, Valeant announced the purchase of Bausch and Lomb. The deal is expected to generate $800 mln in cost savings, an internal rate of return in excess of 20%, and be accretive to earnings. In a recent company presentation, Valeant highlighted an aging population, increased incidence of diabetes, and rising wealth in emerging nations as factors which will support growth in ophthalmology.

Goldman Sachs Raises the Bar

While many Wall Street firms rate VRX a strong buy, a notable upgrade came recently when GS resumed coverage of Valeant with a $130 price target. offered this quote from the analyst research report on September 17.

"VRX has been a very successful consolidator of assets over the last several years, while focusing on niche specialty areas, looking for opportunities to achieve significant cost and tax synergies, and remaining disciplined on price. We believe investors have not fully recognized the incremental value from its recent strategic acquisitions of Bausch & Lomb (B&L) and Medicis, and our feedback from physicians helps support that. We also believe there is still more runway for VRX to continue to find ways to create value for shareholders with its existing portfolio through additional cost containment and rationalization efforts and new product opportunities, as well as by adding to its portfolio as it continues to be both flexible and aggressive with respect to future M&A."

My Little Canadian "JNJ"

I have owned VRX since July for my Follow The Money (FTM) portfolio, where we track institutional buying in stocks with a strong Zacks Rank. I actually traded this name a few times in 2012 between $45 and $55, but when the stock popped from $75 to $95 on the B&L buyout in May, I took quick notice of how institutions really wanted to own VRX and how analysts were ramping up earnings estimates. Neither of those trends has changed.

As I learned more about the Valeant's aggressive growth strategy, I began calling it my "little JNJ" as it seemed to have that giant pharma/consumer products feel to it. I looked for a good entry and I'm glad I pulled the trigger at $90.

Even though a $35 billion market cap is not generally where I like to put money for FTM, I can't argue with the growth strategy and the institutional "whales" who want to own it. Here's what one of my favorite big shareholders, Wally Weitz, had to say in his Q2 letter to shareholders...

"What follows is a quick spin through the ten largest holdings among our family of funds. All of these companies will be familiar to long-time shareholders. I will not belabor the case for each, but the point is that we think that each will earn good returns for us from today’s prices and we would be very happy to buy more of each if their prices decline."

First on Wally's list was VRX...

"Valeant Pharmaceuticals continues to make acquisitions (most recently agreeing to purchase Bausch and Lomb), wring cost savings from the combined operations, and grow earnings per share. The outlook for Valeant’s well-diversified portfolio of 1,100 products is relatively predictable. The company has a robust pipeline of acquisition candidates and we expect Valeant to build on its dermatology and eye care franchises over the next few years."

Now that Goldman is on board, and the earnings momentum is still strong, my bet is that we will see VRX above $120 by the first quarter of 2014.

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Friday, October 11, 2013

The New US $100 Bills: Tuck Away All the Benjamins That You Can

You might do a double take the next time you get hold of a $100 bill.

The new Benjamins debut on October 8 with striking features that are designed to thwart counterfeiters, including the Liberty Bell in an ink well and a blue 3-D security ribbon. Larry Felix, the director of the Bureau of Engraving and Printing says that this $100 bill is the most complex note the United States has ever produced. "The 3-D security ribbon is magic. It is made up of hundreds of thousands of micro-lenses in each note," he says. (AP, October 7)

Tuck away all the new $100 bills or U.S. currency in any denomination that you can rightfully get your hands on. Elliott Wave International believes cash will soon be king.

Cash is the only asset that assuredly rises in value during deflation. One safe “parking place” for capital during a deflationary crash is cash notes — for example, $100 bills, £50 notes or the equivalent in your home currency — in a safe depository that you can always access. That way, you will have money if the bank fails, you will have money if credit collapses, and you will have money if the government defaults on its debt. I suggest that you have at least some currency on hand if you expect a deflationary crash. -- Conquer the Crash, second edition, p. 164

The prices of most assets decline during deflation, so cash will buy more. Cash will be in demand; credit will be shunned. Indeed, U.S. consumers have already cut back on purchases with plastic.

Americans’ credit-card debt declined in July, a sign that cautious consumers might give the economy a smaller lift in coming months. Consumers’ revolving credit, which primarily reflects money owed on credit cards, fell by $1.84 billion, or at a 2.6% annual rate, in July from a month earlier. That came after a 5.2% drop in revolving credit in June. -- The Wall Street Journal, September 9

Expect the trend toward credit contraction to intensify. Make sure you have plenty of cash on hand before deflation becomes obvious.

The question naturally arises: Where can I safely store cash so I can scoop up once-in-a-lifetime bargains at the bottom of a deflationary crash?

Answer: The SafeWealth Group of Elliott Wave International tells you how you can access some of the world's safest storage facilities in their manual, Wealth Preservation in Very High-Risk Financial Times.

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Wednesday, October 09, 2013

Where Does the Fed’s Stimulus Money Go?

Where Does the Fed’s Stimulus Money Go? The Obscure, Convoluted and Scary Story

By Dr. Van Tharp Trading Education Institute

Click the Images for a Larger View

The single worst cholera outbreak in England’s history happened in 1854 in the Soho district of London. It left hundreds dead, although the broader cholera epidemic around London claimed tens of thousands of lives. At the time, the world did not know that microorganisms caused many diseases (Louise Pasteur would not discover what has become known as “germ theory” until several years later). In fact, the prevalent common knowledge was that diseases like cholera where caused by “bad air.”

So when physician John Snow eventually traced the outbreak to a single public water pump (the infamous Broad Street pump), he had to make an overwhelming data argument to convince public officials to shut down the water source by removing the pump’s handle. The thoroughness of his study and his hypothesis that people could get sick from drinking contaminated water made Snow a seminal figure in the fields of public health and epidemiology. He’s also a hero figure in entry level texts about water treatment.

The parallels to today’s seemingly infinite “pump priming” by the Fed (and other central banks) are ironic, to say the least. Snow didn’t understand what was going on in the water to make people sick — he just knew he had to get people to stop drinking it. In the same way, most investors and traders don’t really understand the inner workings of money creation in today’s world, but they can sense that our central bank’s “money pump” could lead to an economic epidemic. In a real last turn of irony — after the cholera epidemic of 1864 had waned, government officials put the handle back on the Broad Street pump, allowing the flow of dangerous water to continue… Does that ring a bell to anyone who listened in last week to the Fed’s “keep the spigot flowing” decision? Let’s dig in to see what the addition of $2.2 trillion dollars has bought us in terms of liquidity and economic growth so far.

The Obscure Part: Has All the Stimulus Been Helping?

Lots of stimulus has been tossed into the system. In fact, let's take a quick look at the M1 chart, one many of you will be familiar with —

But has any of this trickled down to Main Street? Spoiler alert — the velocity of money (the financial lubricant that our credit-driven system so badly needs to thrive) has actually dropped and the bulk of the stimulus money has found its way into risk assets like the stock market, not into growth areas of business and real estate loans. Alas, Main Street is left holding the bag — taxes and deflated dollars are paying for the largess that allows large institutions to play with the Fed’s exponentially expanding balance sheet as if it were Monopoly Game money.

Let’s look at perhaps the most disturbing picture first. Trillions of dollars of stimulus is put into the system while household incomes are actually dropping - by a lot. Below is a graph of the Census Bureau’s latest data.

Since 2007 (not the highest point on the chart, mind you), Real Median Household Income has dropped more than 8 percent. Not exactly a victory for Joe or Jane Sixpack, but at least all this stimulus has helped out the employment picture, right? The Fed’s infamous dual mandate includes fighting inflation and maximizing employment. So what kind of jobs growth does TRILLIONS of new dollars buy you? Let’s head back to the Fed’s own database:

Ouch — this one is still startling. Despite all the bluster from Washington, the U.S. employment picture is pretty darn flat (and at an unacceptably low level) since late 2009. It’s also one of the reasons cited last Wednesday by the Fed for keeping the handle on the stimulus pump.

But at least some things have been getting better — namely risk assets:

Who knew that the Fed kept stock price charts on their site? Here you have one of the main locations where all the Fed stimulus has landed. How it got there takes a bit of explaining.

The Convoluted Part: How Fed Stimulus Gets Into the Markets

Here's a very insightful chart that I couldn’t get from the St. Louis Fed site. It looks at that big rise in stock market cap divided by the Fed’s burgeoning balance sheet (source: Haver Research and Gluskin Sheff):

As you can see, since the beginning of the stimulus, the market’s capitalization has essentially kept pace with the Fed’s money pump. This gives us some hints about stimulus money and the market but we are missing an important piece of the path. Let’s dig deeper.

In a very illuminating Working Paper entitled Collateral and Monetary Policy, Manmohan Singh of the International Monetary Fund gives a mind-numbing look into the new money creation paradigm that the Fed has created (more details on that will have to wait for a later article). For our purposes today, let’s cut straight to how QE money from the Fed winds up in the stock market instead of going out as new business or real estate loans. Let’s start with an astonishing chart from the folks at Zero Hedge. They have taken data straight out the Fed’s H-8 report and made some simple bar graphs showing U.S. bank balance sheets before the stimulus hit the fan up to now:

Here you can see that the banks’ balance sheets have grown by $2.2 trillion as the Fed buys Treasuries or Mortgaged Backed Securities from them. As Singh describes in great detail — the immediate effect is to increase bank deposits (as shown above). It’s up to the bank to decide how to handle these new deposits; it can loan them out or use the “deposit to loan gap” for other purposes.

Again, Zero Hedge (with an assist from JP Morgan) gives us some insight into what one commercial bank did with its newly acquired deposits last year:

The red lined blue box in the center column above represents JP Morgan's $423 billion deposit to loan gap. On the left, the yellow portion of the red lined box is $323 billion labeled as “CIO AFS securities” (Chief Investment Office Available for Sale securities). What happened next is well known to anyone following the financial news; the so-called London Whale in JP Morgan’s CIO group (with full knowledge of the company executives) took on huge positions that cost the company billions of dollars in losses in a truly excruciating proprietary (prop) trade gone bad. The whale story may be intriguing but its details hide a significant point highlighted by the chart above. Most importantly, it lets’ us see the inner workings of how stimulus money goes from the Fed to the securities market without ever leaving the bank’s balance sheet (it is marked as a liability — essentially lent to itself). The underlying deposits can then be leveraged and used by prop trading desks to return outsized gains (in theory and usually in practice, though not in the case of the London Whale) versus what could have been made through loans to real estate investors, businesses, and consumers.

What's scary is that this is not even the scary part.

The Scary Part?

I'll leave you with these departing thoughts and one more chart: the current usage of all of this extra money has DECREASED the velocity of money, the speed of its movement through the economy while it has INCREASED the systemic risk.

First for monetary velocity: more money is doing less (being loaned out, etc.) since the stimulus has started. Singh estimates that collateral turnover has dropped from 3x in 2007 to 2.2x in 2012. And the Fed’s own measure of velocity shows a clear drop:

The importance of the velocity of money can be found in the definition from the FRED site, “The velocity of money is the frequency at which one unit of currency is used to purchase domestically-produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.”

Velocity of money tells us how much money in circulation is being used as a lubricant — reducing the friction for economic transactions. As we can see above, we are well past the point of diminishing returns.

Now about that systemic risk — banks’ balance sheets have swelled thanks to the Fed’s ever-present purchases. These additional reserves would seem to provide added safety for banks until you look at their nature. In a vast over-simplification, the Fed has been buying the banks’ highly liquid AA+ rated securities (e.g. Treasuries, etc. — which are very easily traded on the open market) and has been replacing them with bank reserve deposits at the Fed - which are only available for interbank trade.

Peter Stella of Stellar Consulting LLC wrote a detailed and illuminating piece on the implications of the current bank reserve situation just last Friday. Stella points out that the massive shift in bank holdings from liquid US Treasury securities to Fed bank reserve deposits does not pose a credit risk issue; Fed reserves and treasuries are equally safe. Fed reserve deposits, however, are marketable only to a very select audience, namely US banks. The shift in trillions of dollars of bank holdings out of very liquid securities to much less liquid Fed reserve deposits has injected a new systemic risk into the economy. This money supply / bank reserve relationship will be the subject of our next article.

If you’ve found this article useful or thought provoking (or both), contact us at Dr. Van Tharp Trading Education Institute.

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Monday, October 07, 2013

Investing in Warren Buffett and Berkshire Hathaway

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While some might not be familiar with the name of ‘Berkshire Hathaway (BRK.B)’ every investor has undoubtedly heard of the man at the helm of this company, Warren Buffett. The current CEO and Chairman, Buffett has guided Berkshire from a small textile company into the massive conglomerate it is today reports Zacks Investment Research.

Berkshire in Focus

Today, Berkshire Hathaway engages in a number of businesses, but has a focus on property and casualty insurance. The company uses the premiums from this business, before claims are paid out (called the ‘float’), to buy up investments in other industries.

While the firm does have a number of wholly-owned companies—including railroads, newspapers, and clothing companies just to name a few—it also has big holdings in several of the most easily recognizable American brands too. These include firms like American Express (AXP), the Coca-Cola Company (KO), and International Business Machines (IBM), although the list stretches far beyond this trio.

Either way, as primarily an insurance business that has had great success in its investment portfolio, the company is also benefiting from recent trends in the space. A wider spread between long and short term rates has certainly helped the company, while a booming stock market has also increased Berkshire’s value.

Earnings in Focus

Thanks to this trend, BRK.B is looking pretty good from an earnings estimate revisions picture. Analysts have recently bumped up their expectations for the company, including one increase in just the past seven days.

Now, the consensus full year earnings estimate for Berkshire is at $5.79/share, a modest increase from the $5.66 that was seen two months ago. Meanwhile, year-over-year growth looks to be just under 14% for the full year, a pretty solid figure for a company with a $280 billion market cap.

BRK.B also has a great track record when it comes to earnings dates too. The company has beaten in each of the last four quarters, including three double digit surprises in the last four releases, so increased expectations should be no problem for this company.

And if that wasn’t enough, investors should note that the Zacks Industry Rank for the Insurance Property & Casualty space is quite favorable. The current rank for this segment is 36 out of 260, suggesting that there are few sectors that are better positioned than insurance at this time.

Due to these factors, Berkshire Hathaway has earned itself a Zacks Rank #1 (Strong Buy). This means that we are looking for the stock to outperform its peers, and continue to post solid gains in the weeks ahead.

Bottom Line

Insurance is a great business to be in right now as there are several positive trends in this space. Not only is a bigger spread helping this segment, but a solid stock market is also assisting the sector as well.

This makes an investment in a top Ranked insurance company a very intriguing idea, especially if these current trends continue. And considering that Berkshire is world-class and is seeing solid earnings estimate revisions, this company could definitely be the way to play the trend in the near-term.

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Friday, October 04, 2013

Using Options to Profit from Earnings Season

Getting Ready for Earnings Season with Options by Zacks Investment Research

With earnings season set to officially begin next week, here's an options strategy that's perfect for a company about to report.

A straddle involves buying both a call and a put at the same strike price (at-the-money) at the same time.

With options, you buy a call if you expect the market to go up. And you buy a put if you expect the market to go down.

A straddle, however, is a strategy to use when you're not sure which way the market will go, but you believe something big will happen in either direction.

And earnings season is a great time to do this because very few things can send a stock soaring or plummeting like an EPS surprise.

For example: let's say a stock was trading at $100 a few days before their earnings announcement. So you decide to put on a straddle by buying:

the $100 strike call

and the $100 strike put

Because you only plan on being in the trade for a few days (to maybe a few weeks), you decide to get into the soon-to-expire options.

Note: usually, I'll advocate buying more time and getting in-the-money options. And I still do -- when playing one side of the market.

But when playing both sides of the market simultaneously for an event you expect to take place in the near immediacy, the opposite is best. Why? Because at expiration, your profit is the difference between how much your options are in-the-money minus what you paid for them. So if you don't need a lot of time, this keeps the cost down and your profit potential up.

If you paid $150 for an at-the-money call option that will expire shortly and another $150 for an at-the-money put option that will expire shortly, your cost to put on the trade was $300 (not including transaction costs).

If that stock shot up $10 as a result of a positive earnings surprise, that call option that you paid $150 for would now be worth $1,000. And that put option would be worth zero ($0).

So let's do the math: if the call, which is now $10 in-the-money, is worth $1,000; then subtract the $150 you paid, and that gives you an $850 profit on the call.

The put, on the other hand, is out-of-the-money, and is worth nothing, which means you lost $150 on the put.

Add it all together, and on a $300 investment, you just made a profit of $700. Pretty good - especially for not even knowing which way the stock would go.

However, if you paid more for each side of the trade, those would be extra costs to overcome.

But by keeping each side's cost as small as reasonably possible, that leaves more profit potential on the winning side and a smaller loss on the losing side.

Moreover, if the stock stays flat (in other words, the big move you expect to see doesn't materialize, thus resulting in both sides of the trade expiring worthless), your cost of the trade was kept to a minimum.

So buying a straddle by its very nature should be looked at as a short-term trade. If the outcome of the event that prompted you to get into the straddle in the first place now has you strongly believing that a continuation of the upmove or downmove is in order, you could then exit the straddle and move into the one-sided call or put and apply the in-the-money and more-time rules for those.

Here are 5 optionable stocks due to report earnings over the following two weeks (10/8 thru 10/18) that could see some volatile price action one way or the other:

(EBAY) Ebay (reports on 10/16)

(FDO) Family Dollar Stores (reports on 10/9)

(RPM) RPM International (reports on 10/9)

(UNH) UnitedHealth Group (reports on 10/17)

(YUM) Yum! Brands (reports on 10/8)

Whether they report a positive or negative surprise, a big move could be seen in either direction. And the cost of these straddles are very reasonable.

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Wednesday, October 02, 2013

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