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Wednesday, May 25, 2005


I have lost more money to ace-king and blonde hair than anything else in this life.

As soon as the words slipped out of my mouth while indulging in a gin and tonic with a splash of roses discussion of markets and life with a poker playing options guru from the west coast I knew I d uttered a line for the ages, a worthwhile epitaph perhaps for one who has lived the speculative life. Ace-King, the big slick in poker parlance, considered one of the most powerful starting hands. After all, you have a 32% chance of pairing one of the top cards. All the poker books encourage you to bet and bet big when holding big slick…but examine for a minute that there is a 68% chance you wont pair up either card, a 5% chance that someone else at the table has been dealt a pair and has a 10% chance of flopping a third for a set, beating either of your big pairs. Anyone with an over card suited, connected opening hand is in a horse race with you for the pot. If you find yourself heads up against a pair or connectors the pot could be enormous. You have a 29% chance of winning an enormous stack of chips..and a 70%chance of losing one. Know when to hold em, know when to fold em is one of the truest poker maxims ever, and it holds even truer for markets. We have all seen trading systems that have 60,even 70% winners. Excellent odds, and over time should generate enough profits to truly afford all your bad habits and raise your vices to art forms. But bear in mind that the 30% losers can occur in ruinous streaks, that close attention must be made to the $ amount of winners versus losers as a shift here can eliminate your edge and of course the ever changing cycles of the market. Ace-King. A high probability trade in the nazz. Bet it all? What’s the other guy holding? What earnings reports are due from a nazz 100 stocks that can turn your statistical theory into mush?

As for the blonde? Family and friends have told me that from now on I must date, chase and romance only redheads and brunettes for down that path there be monsters. The seductive lure of the long legged girl with flowing golden tresses, the one decision growth stock, the breakout to new highs, the ensuing breathless moments of hope overriding common sense, the wallet emptying crash to earth. We've all been there. To continue to chase momentum or buy 9 dollar cosmos for the Barbie in the bar (you know why the Divorced Barbie is the most expensive of all dolls? She comes with all Kens stuff) is like standing in the alley where you were mugged last night waiting for the guy to show up again. But we’ve all done it. Paid up for stocks that looked to be immortal to watch them do an Icarus. Bought stocks trading at half of book value ignoring the massive leverage on the balance sheet. Shorted bubbles just to watch them reach double-bubble status. Fluttering eyelashes, long blonde hair and moving average breakouts have ruined more poor boys than the house of the rising sun.

So how then to approach these markets so fraught with temptation and frustration? The vast amounts of capital injected in the system have taken the steam out of such sure fire money makers as risk arb,convert arb and distressed trading. I confess to not be smart enough to indulge in global macro against the Willowbridges and Soros’ of the world. Right now I continue to find success with traditional valuation measures and adding some twists. I continue to be enamored of the 3 way approach of valuation, technical (a catch phrase here to include all statistical and math oriented ways of measuring the market) and proper uses of options. Buying or selling of options when the underlying is mispriced at times judged favorable for marker movement in the direction of our trade seems to be the ultimate way to trade these markets of ours. Why doesn’t anyone do it? The only one even close to using this approach right now is Ahmet Okumus of Okumus Capital and he has generated impressive returns over the past 10 years. This remains my favorite area of research and anyone interested in joining the project is more than welcome to the party.

For longer term, less aggressive investors, I think that the time honored corner stones of investing…good returns on equity, price to cash flows and dividend yields along with some good old fashioned dividends to be the best approach Some interesting research from the folks at FirstTrust shows that companies with high dividends compared to the over all market, low price to book value and good returns on assets crushes the market since 1990. My own work looking at low price to book and high return on equity beats by a handy percentage since 1986.Incorporating dividends seems to smooth the overall returns and will perhaps provide a better sleep factor.

So, where are we now? In a nutshell, the Fed is worried about inflation, the bond market is worried about a slowing economy and the options market don’t seem to be worried about anything at all. Volatility has slipped right back down into the low end of the range after giving anther great signal by exceeding two standard deviations (also known as exceeded the top bollinger band) on may 13th. Many of the people I hear discussing volatility keep saying we are right back to the mid 90s levels and all is well. I do not buy it. The world geo political situation is much worse now than then, with more opportunities for the black swan to be born .On going difficulties with nuclear implications in both North Korea and Iran, difficulties with Syria,and other potential worldwide hot spots, combined with valuations on the Dow and sp500 being some 50% higher now than then all seem to give me the impression that there is much greater risk. But I didn’t go to the University of Really Smart math guys so perhaps I’m wrong and the world is a safer, more peaceful place and earnings will grow forever and peace and profits will reign forever and ever amen therefore making the continuing selling of volatility an eternal cash machine. Or just maybe the calculators aren’t adjusting for the fact that the enormous amounts of covered call programs and funds have created a pricing aberration and the risk is much greater than it appears.

As for market levels, the stock market as measured by the sp500 appears to be fairly priced in this general area. As long as economic activity picks up and we hit the earnings estimates AND interest rates do not go higher. But wait..The proverbial fly crash lands in the ointment of valuation. It is rare for economic activity to pick up and interest rates to stay the same or go lower.Lookinmg at my charts and funny little math activity book I see a range here of about 1140 to 1210.At 1190 I think we re close to putting in a short term top than bottom. No, I’m not a perma bear but after calling for a short term rally in April, I ll say now that the likely path of least resistance is down. The combination of bond market rally, decent earnings and falling oil prices failed to push the market past the March highs, generating about a 5% gain since the April lows. Im usually early (when of course I’m not just flat out wrong) but I think we go down from here. Not straight down, but down. I am heartened by the fact that everyone with even the slightest counting knowledge has happily pointed out that when the NASDAQ goes up 8 days in a row it is usually higher. Some 68% of the time a week, one month and 3 months later. Suddenly I’m at a poker table, sitting next to a blonde staring at me from under a veronica lake hairdo urging me "go for it, big boy”. I look in my hand and find…..Ace- King, the big slick of my dreams..or possibly nightmares.

In my personal portfolio, I like sebl, hele, bac, atml, cmos, dtv, tmas on the long side while remaining short erts, fisv, yhoo, hot. Im looking to add shorts on rallies and may even join the Chicago wunderkind and bet against the homebuilders. I mean just who the hell is buying all these houses? As we price the low end, first time buy out of the market, the opportunity for the move-up ponzi scheme we ve been seeing will falter. We saw this exact scenario play out in the 80s. I t takes action on the low end to sustain the rally but the rally itself takes the low end out of the game. Forget people buying rental real estate. It is no longer possible to take in enough rental income to cover even half the mortgage in most urban areas. Again,Im probably early but when it unravels, it will happen quickly.

Random thoughts:

Carl Icahn, who so kindly bbqed so many of us with the bait and switch on KMG has taken a good size position, is sebl. The software company is under priced and may well be takeover bait.

The economy cannot recover without a substantial rally in semiconductors. It’s the only area of the market I consider ultra-cheap. The pricing therein seems to support the argument from the bond traders that the economy is not all its cracked up to be.

.They have to buy the dollar. The Asians need our trade. Without it they collapse. They WILL continue to buy treasuries. This time however they seem to have learned their lesson about buying US assets when the dollar weakens. They learned from Rockefeller center after all.

The damage isn’t over for convert arb. It might make sense to take the opposite side long shares of companies that have converts and high short interest.

The Tiki bar is Open.