It is the very nature of the markets to punish the impatient investor and reward patience. If you have your hard earned dollars at risk in the markets it is your responsibility to profit in whatever way you can. You must use every tool, every piece of information and every situation that presents itself to obtain an edge you can use to make a profit.

My regular readers know that I don’t take investing lightly. You’re money is at risk, you better keep your eye on it. Investing is not a hobby. There are far better and more enjoyable ways to lose your money. To play a “hunch” on a stock because of something you might have heard on CNBC is worse than flipping a coin although you might say, it could go up, or it could go down. You can see how it may appear to be a 50/50 call. Insidiously, it is much worse than that.

Consider that fact that once investment information is made public by the mainstream media, all of the information being disclosed is already reflected in the share price as suggested in the “Efficient Market Theory.” This would leave our investor/hobbyist buying in at the very top of an asset’s share price while everyone else (insiders/smart money traders) is selling. With the stock price beaten down to ridiculously low levels, our trader gives up, accepts his loss and sells at the market bottom. Our hobbyist has been slaughtered along with many, many others, an event that repeats itself every day the markets are open. Doesn’t sound like a 50/50 chance to me.

Companies like Goldman Sachs have built a century old empire using crisis investing to their advantage. When there is “blood in the streets” and an asset is despised and shunned by everyone, there lies an opportunity to reap the greatest windfall profits with the least amount of downside risk. The pros know this simple truth and are always alert to “contrarian” investment situations when they present themselves. They built their massive juggernauts on the bones of hated assets that the average retail investors flee from in the face of falling share prices. Therein lies the opportunity for tremendous profit and is the basis for all “Contrarian Investing.” As investing legend Jim Rogers puts it, “you wait until the money’s sitting there on the floor, and then you go over and pick it up.” That’s a true contrarian.

Trading Extremes

In order to be a successful contrarian investor, it is essential that you seek out “extremes.” Whether it is political risk, risk of inflation and it’s effect on dollar traded assets or the price of government bonds, natural disasters (and their effect on industry and insurance companies), acts of terrorism, government intervention (interference) or interest rate fluctuations, these situations create opportunities for profits. If you don’t take advantage of them someone else will.

When faced with an “extreme” trade, it is important to look for “obvious trades” where the information has been widely disseminated and therefore the trade becomes too one-sided. In the case of the U.S. Dollar trade, it has become generally understood that a crisis is in the making. With the Federal Reserve printing massive amounts of dollars, backstopping financial institutions with billions, unfunded social programs and a receding economy it is well understood that the dollar trade has nowhere to go but down. As investors pile into this obvious falling dollar trade (symbol: UUP, U.S. Dollar ETF) and the fact that “short interest” is overwhelmingly one-sided, a small amount of buying could create a sharp rally in the dollar’s value. This would in turn spark a massive “short covering” rally and wipe out the shorts by forcing them to cover their positions. This is another type of “extreme trade” using investors excessive optimism or pessimism as the catalyst for putting the trade on.

Investment Guru’s Rules of Trading

The one thing that all investment gurus have in common is that they all read “The Gartman Letter” written by Dennis Gartman. The following are Gartman’s “Simple Rules of Trading.”

1. Never, ever, under any circumstances add to a losing position… It will lead to ruin.
2. Trade like a mercenary soldier… We must fight on the winning side, not the side we think is economically correct.
3. Mental Capital trumps real capital… holding onto losing positions cost measurable real capital, but it also costs immeasurable mental capital which cannot be replaced.
4. Investing is not a business of buying low and selling high… it is a business of buying high and selling higher. Strength begets strength and weakness begets weakness.
5. In Bull markets, one can only be long or neutral, in Bear markets, one can only be short or neutral.
6. Buy markets that show the greatest strength… Sell markets that show the greatest weakness.
7. Think like a fundamentalist, trade like a simple technician. Be bullish or bearish only when fundamentals and technicals, as you understand them, run in tandem.
8. Trading runs in cycles, some good, most bad… Trade large and aggressively when trading well. Trade significantly smaller when trading poorly. In good times, even errors turn into profits. In bad times, the most well researched trades will go awry. This is the nature of trading. Accept it and move on.
9. Keep your technical systems simple… Complicated systems breed confusion, simplicity breeds elegance. The greatest traders of all time have used the simplest systems.
10. In trading/investing, an understanding of mass psychology is more important that a degree in economics.
11. Bear market corrections are more violent and far swifter than bull market corrections.
12. There is never just one cockroach… the lesson of bad news on most stocks is that more will follow until such time that panic prevails and the weakest hands exit their positions.
13. Be patient with winning trades, be extremely impatient with losing trades.
14. Do more of what is working and do less of what is not… if there is a secret to investing and life, this is it.
15. All rules are meant to be broken, but only very infrequently. True genius is knowing how infrequently it can be done and still prosper. Simple yet profound.

Contrarian investing offers the opportunity to hit the lottery without incurring the long odds associated with buying a ticket. You may lose on occasion, but the winners and profits will far outpace the losses. Contrarian investing is one of the most effective trading systems available to the individual investor. It’s results are consistent and the selection process is easy to understand. The only requirement is the ability to think for yourself and go against the crowd. If you are able to gauge the emotional responses which traders apply to their investment decisions (see rule #10), then you can profit from contrarian investing. Feel free to review these 15 rules before you place your next trade.

If Fannie ever actually earns a profit, the $6 billion it owes the guv’ment in annual dividends would swallow it whole. Fact is, Fannie Mae and Freddie Mac are completely dependent on the Treasury to support their continued operations.

Their non-performing loans rose to $198 billion in the 3rd Q up from $171 billion on June 30, ‘09 and have doubled from Dec. ‘08.

Last years subprime lender is today’s FHA. Loan defaults, as of Sept. stand at 456,000 and 87% of their entire portfolio has less than 3% equity (a 1% decline in current property values would completely wipe it out) not to mention that the portfolio is growing by 6,000 loans per day (4 x’s the amount in 2006). The sheer number is masking the problem loans as most mortgages don’t get into trouble in the first year. Like a driver going downhill without brakes, FHA is telling Congress everything is just fine. Fortunately for us, FHA loans are bundled as MBS’s (mortgage backed securities) and guaranteed by Ginnie Mae and thus, it is the taxpayer who is responsible for paying Ginnie’s bond holders when FHA backed mortgages default. Same old story.

FDIC bank closures have risen to 124 this year (in 2007 there were 7 and about 10 in 2008). On the brink of insolvency themselves, they decided to charge participating banks 3 years premiums prepaid in advance to fund their continued operations or about $45 billion worth (should last them 6 months at the present pace) and then it’s back to the Treasury for mo’ money (Imagine if your car insurer asked you to pay your car insurance upfront for for the next 3 years). This should do wonders for the bank balance sheets. But that’s what the bailouts are all about anyway, penalize the healthy banks for the ones that that made the riskiest loans and should have been closed down before their assets needed to be seized.

The Commercial Real Estate Crisis should be in full swing by 2010. Current CRE market value is in the order of $3.5 trillion and the loan defaults are expected to come in close to a third of that. Lenders are using loan moratoriums and modifications to postpone the inevitable. They don’t want these frickin’ properties on their books either.

How High Can Gold Go?

People say we’re in a bubble, the price has risen too much, too fast, Gold has no value and pays no interest (otherwise known as a dead money). Let me be clear about this. Gold (and silver) have been used as a store of wealth for thousands of years before the printing press was invented. With the repeal of Betton-Woods in ‘71, Dick Nixon unpegged the dollar to the price of gold (artificially priced at $35.00 at the time) and backed it with the full faith and credit of the government (an IOU), essentially, the US taxpayer’s ability to repay the governments debts. Since that time the dollar has lost 70% of it’s purchasing power.

The latest $12 trillion deficit is nothing more than another nail in the coffin. The world’s central banks have been printing money at a breathtaking pace not to prevent a collapse of society but prevent voters from experiencing the necessary pain and restructuring that recessions bring in an attempt to continue to get re-elected.

Bankruptcy serves a purpose. Failed business models need to go out of business to make room for healthy businesses as surely as dead leaves must fall from the tree in winter making room for a new leaf.

Today, the largest employer in the United States is the government with unfunded liabilities totaling $50 trillion dollars (pensions, social security, medicare, medicaid and a host of entitlement programs).

Government spending is a cost to the economy, not a source of wealth. No amount of deficit spending can produce prosperity.

If the economy recovers, demand for goods will increase and supply will tighten. If the Fed’s “hot money” policies turn into price inflation (highly likely), investors will turn to gold.

If the economy falters, federal stimulus spending will increase and set the stage for greater inflation and further dollar decline, investors will turn to gold to protect themselves. It seems like a one-way bet.

Top Picks

Silver Wheaton (SLW) gold will undoubtedly go higher, silver will out pace gold’s gains.

Eldorado Gold Corp (EGO) gold exploration and development (many will do spectacularly but this one is a great valuation).

Tesco (TESO) designs, sells services “top drive” motors for oil & gas drill rigs (another great valuation play).

Nalco (NLC) patented “enhanced oil recovery (EOR)” system and one of the largest water purification companies in the world.

In the words of Thomas Jefferson, “The government that governs least, governs best.”

Couer D’Alene had an amazing 3Q with an 86% increase in silver production to 5.2 million ounces, 222% increase in gold production to 29K ounces and a 146% increase in revenue to an all time high of $90 million. The stock price is up 150% YTD.

I know several of you own Couer shares outright and I’m probably the only one with the options but it looks like there’s a lot more room to run for the metals and Couer should be a major beneficiary.

Now to the Dollar

For the last 18 months the stock market and the US dollar have moved in an inverse direction. Since the dollar began it’s epic fall the markets have rallied hard. Many believe that the reason for this is that the weak dollar makes exports and multinational companies more profitable and therefore strengthens the economy. Right or wrong, the dollar’s slide helped lift the market averages to remarkable heights. Although, I believe the reasoning is flawed.

There have been several occasions when I have discussed the effects interest rates have on the markets. When rates are low, it makes business more profitable due to low borrowing costs. When rates rise it chokes off investment and growth. With the Fed Funds rate at .25% it has allowed the large banks to borrow from the Fed and use the funds to purchase Treasuries for a 3% return on borrowed money. This is why the almost defunct banks are now sitting on a hoard of cash.

The Fed’s action has created a new “carry trade” similar to what existed in Japan for the last decade. Investors would borrow the Yen at 0% (or short the Yen) and use the proceeds to purchase higher yielding investments. This usually works out fine until interest rates begin to rise or the currency starts to strengthen, or both. It is this excess liquidity that’s sloshing around in the market searching for higher yielding assets that has given rise to the stock market and commodities alike.

At this moment there is the largest short interest in the dollar (97% short dollar) and investor dollar sentiment is at the lowest in 20 years. Everyone believes in the decline of the dollar. The trade is way too one-sided.

If the dollar begins to strengthen even slightly, the short dollar trade will begin to unwind, the “short squeeze” will force them to cover their positions causing the dollar to rise even farther than it would have. The sharp ascent of the dollar will cause a violent decline in the stock market as assets must be liquidated to cover margin requirements.

So, what we have is a beaten-down currency being used to prop up other assets which were inflated enormously since the March lows. Prior to March, the majority of traders were selling assets at bargain prices and looking for safety in the dollar.

Case in point, Fannie Mae is a worthless company and the stock having no equity values at all, but 4 days in August ‘08 FNM rallied more than 140% when short sellers panicked and were forced to sell other assets (stocks/commodities) to cover their shares. They would have been crushed trying to cover their short position as they were buried under a wave of sell orders. That is the risk of unwinding a carry trade.

With the overwhelming dollar short interest, a small strengthening in the dollar could lead to a devastating correction in stocks.

I am waiting for “technical” confirmation in the S&P which seems to be forming. The S&P topped out at 1100 and retraced down to 1050. A move back up to near the 1100 point where it is unable to make a new high combined with a strengthening dollar will signal the beginning of the end for this rally. With a 50% retracement we could easily see a move back down to S&P 850.

I will have a new trade Sunday (Monday the latest).

Even China (the world’s largest holder of U.S. debt) and many other commodity based economies around the globe have sounded a call to replace the dollar as the world’s reserve currency. They know the “Fed” has no intention of repaying the exorbitant deficits they’re incurring. Their only chance of shrinking this mountain of debt is to inflate it away by debasing value the dollar. To be certain, if the dollar lost it’s reserve currency status the Fed would no longer be able to freely print money to fund it’s misguided policies or it would run the risk of creating a hyper-inflationary economy similar to what has happened in Zimbabwe (they are presently printing Billion dollar notes with which to buy a loaf of bread).

With so much of the mainstream media’s focus on the reasons for the dollars decline, and an overwhelming majority of investors convinced that the continued demise of the dollar is imminent, the trade has become extremely one-sided.

From a contrarian view it would seem that the market is setting up to punish the complacent investors who have become lulled into a false sense of security with the “short dollar trade.” If one were to listen to the pundits on CNBC it would seem that the obvious and “comfortable” trade would be the short dollar trade. After all, with the endless stream of negative news surrounding the dollar, only a fool would bet on it’s rising. There is no conceivable reason that it should.

Listen carefully. The world is positioned for a violent and continued decline in the value of the dollar… market participants rarely get what they expect.

The U.S. Dollar has fallen 13% since it’s March high. This is a huge move for a major currency and negative sentiment is at unprecedented levels and the fear trade has been exorcised. You’ve seen what a “short covering” panic has done to shares of government owned entities such as AIG (AIG), Citigroup (C), Fannie Mae (FNM) and Freddie Mac (FRE). Try and imagine then what would happen to the world’s most hated currency if even a small rally is ignited and this massive wall of “shorts” are forced to cover their positions.

Undoubtedly the shares of these stocks, like the US dollar, will eventually be worthless. But not before the market bankrupts as many markets participants who have become overly confident with their “sure thing” trade. In recent weeks the selling surge had lost it’s momentum as traders tried to push the dollar down to new lows but the dollar climbed back to it’s highest point in three weeks.

The world hates the dollar but it’s rising. This is an extremely bullish indicator for a sharp rally when the “shorts” run for the exits. Contrarian plays are difficult calls to make because you are going against the consensus view, standing alone against the crowd and the contrarian is generally thought to be crazy as a loon. My experience with contrarian plays are that they don’t always work out, but when they do it’s like buying a winning lottery ticket. The dollar is set to rise… act accordingly.

In reducing interest rates so dramatically, they had essentially fired all of their guns at once and were left with few choices with which to fight off the dreaded deflationary pressures that were already building in the economy. As you may recall, it was deflation that afflicted Japan for the last two decades and crippled their once vibrant economy. Politicians, economists and equity investors have a much greater fear of economic deflation than they do of inflation. In fact, a little bit of inflation helps economies to grow, or at least gives the impression of growth… and in politics, perception is everything.

A small amount of inflation will boost corporate earnings (and stock prices), increase wages, consumption and add to growth in GDP (Gross Domestic Product). It is when inflation begins to spiral upward that the face of the true demon is revealed as it destroys the purchasing power of paper currencies which are basically an IOU backed by nothing more than the promise to repay.

Deflation on the other hand, chokes off growth by devaluing asset prices. No one is willing to borrow money to purchase an asset which is depreciating in value. The effects of deflation are much more difficult to reverse that those of inflation which can be countered by increasing real interest rates.

So What Is Quantitative Easing?

Quantitative easing refers to the quantity of the money supply that is in circulation. By easing or relaxing the restrictions on financial institutions ability to borrow cheaply, the Federal Reserve is increasing the money supply as they attempt to re-inflate the economy and put it back on a path to sustained growth.

The problem lies in the Fed’s ability to turn off this massive flow of dollars and drain the liquidity out of the system. It is Bernanke’s printing presses that have boosted the stock markets by 60% in the last eight months. With the yield on the 10 year note at 3.18%, investors have turned to the equity markets to increase their returns. The huge amount of liquidity sloshing around in the economy has to go somewhere and accounts for this meteoric rise in equity prices.

Needless to say there has been a complete disconnect between the stock market and the economy. When the economy is strong and growing, the fundamentals lead to increased earnings and growth in stock prices. This has not been the case. While the overall economy is still in full freefall investors have bid up equity valuations in the stock market beyond all reality.

The “Price to Earnings” (PE) Ratio of the S&P Index now stands at 18 times next years earnings. Is there a sane person among us who truly believes that earnings and stock prices will rise that much with the domestic unemployment rate approaching 10%?

The ridiculous bank bailouts, TALF, TARP, Cash for Clunkers, the Fed’s purchases of Mortgage Backed Securities (MBA’s) and their purchase of their own treasury agency debt has created a new stock market bubble that is destined to wipe out more wealth than the original problem they were created to fix. It is through the purchase of these mortgage backed securities and treasuries that the Fed has managed to manipulate the mortgage and bond market in an effort to inflate the economy and stimulate growth in the housing market. But, the bond market can not be manipulated.

The Bond Market

It has been said that the Bond market is smarter than the stock market. The sheer size (value) of the U.S. Bond market is 5 times larger than the entire stock market. Bond traders are long term players and therefore tend to take a broader view of the economy than stock traders. One year ago the 10 year bond was priced at 4%, the current yield on the 10 year bond is 3.18%. There is no question that the bond market is pricing in a coming deflationary environment. If the bond market sensed even a minuscule amount of future inflation, it would be demanding much higher rates on the bonds it is pricing today.

The Bush administration had estimated the cost of the Iraq/Afghanistan wars would be $60 Billion dollars (non inflation adjusted). It is now approaching $1 Trillion Dollars. The FHA, as the lender of last resort, has in the past 8 months funded nearly $700 Billion dollars in single family mortgage purchases (at 3% down!!) and has a reserve of less than $4 billion dollars. The Obama Administration is handing out $8,000 tax credits to new home buyers while Bernanke buys up mortgage backed securities in a misguided attempt to force down mortgage rates. Since we have no savings rate, every dollar that is spent must be borrowed and repaid with interest. Someone needs to tell President Obama that you can’t tax and spend your way to prosperity. This is a house of cards and is totally unsustainable.

Supply and demand determine price. The bond market see’s an increasing unemployment rate which eliminates wage inflation and reduces demand for goods and services causing prices to fall further. The American consumer will not buy something when they feel they could get it cheaper tomorrow. This is how a deflationary spiral begins and the bond market has already priced it in. Ignore them at your own peril.

I read that the Treasury is going to be auctioning off more bonds next week, longer term, 20, 30 year. The report stated that foreign interest is diminishing and The Fed is trying to coax institutional investors to have greater participation. One opinion is that this money will come directly out of equities and consequently the S&P could start declining at an accelerated pace by this time next week. My question is: I have long positions all over the place (way too many). Some are your picks (DBA, UNG, CVI, XOM) others are my own (CHK, X, PCX, VALE, PFE, F, DELL, MSFT, APAC, AOI, COMS, EXTR) and a bunch of other smaller positions. When or if, do you think I should start unwinding or even get short? I have some shorts already (FXY, HOT, GS) and I am looking to buy SPG, Oct 75 puts @ 21.20 playing the downside on commercial real estate (another developer with ballooning debt).

Any advice you can offer is greatly appreciated.

My Response:

I’m glad you liked my little tutorial. As an indicator it makes perfect sense. If you use it to confirm all your long trades you’ll see your percentages go way up. I write these types of articles for my website (options/commercial finance related) and some are especially useful that I like to pass along. If it helps to make money, I’m all for it.

Now down to business. That ROE is one heck of an indicator or even for trade confirmations. Good to know you checked it. CVI is a longer term trade with what I believe to be huge upside. I get the sense you bought the shares outright. You bought in at a great price. It’s a double pronged business model with oil and gas exploration & production using the waste byproduct to make nitrogen fertilizer. The Fertilizer names (Potash, Mozaic etc.) had a huge runup over 60% each, so expect a short term pull back. The direction is up. Energy and fertilizer, great combo. My only thought on the the trade is, as you know I prefer options trades in almost all instances.

In the case of CVI, the Dec 10 calls would only cost $160 each. So instead of tying up $1,600 and get a dollar for dollar return, you leverage up with $320, control the same number of shares good till Dec. If you held the 200 shares until Dec, and it didn’t move, you tied up the use of a good amount of cash that could have been put to work on another trade. Either way, you can’t beat controlling 200 shares, in a great energy/ag stock, with a 32% ROE for $360.

About your other question regarding the Treasury Auctions and the sale of all those bonds, did you receive my emails about shorting the S&P. I know I was a little early on the call, but the move down is inevitable. As I mentioned, I already have a position in Sept SPY puts and the Sept QQQQ puts. I like the SPY better.

From the looks of it, you seem to have a lot of long positions. You didn’t say whether they were option contracts or owned shares. It does matter because some of the stocks you mentioned are good companies and even when the market starts to correct (which I expect will be severe) some of the stronger ones will bounce back first enabling you to add to the better ones.

My biggest concern is the number of total trades. The 20 that you mentioned plus another “bunch” of smaller ones seems to be too many trades. It might just be my personal style, but I prefer to concentrate more on fewer trades (taking multiple contracts, different strikes, different expiration months).

In any event, it would be a meaningful improvement if you were to pair down your portfolio. The trades I recommended are in confirmed uptrends and don’t let market fluctuations shake you out of the hands. I’m hoping you get the updates on the ones I recommend but DBA, UNG, CVI, XOM are excellent positions (DBA’s up 100% already. I recently added the Oct 28 calls).

I would hold HOT because when the market turns down it will kill this one. It may even help you with GS. You and I are in the same spot with FXY. It’s consolidating at around 103. When it breaks out of the consolidation pattern there’s no question the move will be to the downside and it will be big. The question is “will we be in it?” The June expiration doesn’t give us more than 2 weeks but I’m holding it (I also made 240% profit on FXY on the contracts that were closed in March, I rolled some of it over to June). These still have a fifty/fifty shot at turning profitable. A little bad news and who knows?

Take a look at you portfolio.

If you’ve had it for a while and it’s not moving, there’s probably a reason for that.
If you have positions showing a profit, consider taking profits.
If you have stocks that would be vulnerable in a sharp market downturn, consider selling them.
The market will correct and it will be severe, consider buying Sept. SPY puts.
The dollar will continue to fall, hold any Energy, Ag trades.
The dollar will continue to fall, consider buying GDX or SLV with the excess cash you’ve trimmed from your portfolio.

It’s far better to consolidate the holdings and raise as much cash as you can for now. When the market collapses there will be plenty of places to put it to good use.

Little wordy as usual, but they’re not yes or no questions either.

Ray

A little bit of math and a small amount of research and the winning trades would blow your mind. But, therein lies the problem. Tell the average investor that there’s a way to consistently beat the markets and you’ve got their full attention… then you tell them there are some simple mathematical calculations and their vision starts to blur and they can’t hearrrrrr you because of the ringing in their ears.

Some would have you believe that finding any type of indicator that produced a steady stream of winning trades is like finding the holy grail… “it doesn’t exist,” they would say.

Well, I’m here to tell you that it does, and not only does it exist, but I’m going to tell you exactly what it is and how to use it.

Stock market analysts typically tell their clients that picking stocks is too complicated for the average investor and that it’s best left to professionals. After all, they do have to protect their livelihoods. If anyone could do it successfully, why would someone pay them for their mediocre performance. They themselves are sheepish in nature, usually checking with other analysts to see what they’re recommending and comparing strategies. They don’t care if they’re right or wrong or whether you make money or not. The only thing that is important is that our analyst didn’t do worse than the other guy or the benchmark index they compare their performance to. The market could be down 50% but if he/she were only down 40%… they beat the benchmark! They had a great year! I can see them slapping each other on the back congratulating themselves on what a great job they did for their clients… and these guys get paid for this? This simple technique will put them all to shame.

The Inside Track

If you want the inside track on huge momentum plays with explosive gains you need to focus on one of the most useful ratios available to stock pickers.

It’s called, “Return On Equity” (ROE). Return on equity gives you the most complete snapshot of a company’s profitability. It shows exactly how much profit a company generates from the cash money it’s shareholders have invested. I will now show you how you can determine what this number is and how profitable it can be. Incidentally, return on equity has been the leading indicator used by Warren Buffet for the past fifty years to determine a business’s profitability before he invested in them (and we know that worked out for him).

You calculate ROE by dividing “net income” by “shareholder’s equity.” The higher the number, the more effective a company is at using it’s assets and employees to generate cash for it’s investors. That’s why people invest to begin with, to earn a return on invested dollars in the form of growth in equity.

Here’s an example. From 1999 to 2003, Dell Computer’s enormously efficient business model and high profit-margins paid off in the form of earnings growth and a double-digit ROE of 46%. During that same period Dell’s shares rose 96% cascading money down on it’s shareholders.

The ROE Formula

Net Income / Shareholder Equity = ROE

Taking the net operating income and dividing it by shareholder’s equity (number of shares outstanding) gives you the return on equity as a percentage.

The only way this ratio stays elevated is by reducing the number of outstanding shares (shareholder equity) or to increase the company’s net income. If management attempts to dilute the earnings by issuing more shares (a common practice is for management to issue stock options as a way of sucking out excess liquidity or issuing more shares through a seasoned equity offering), you will be alerted by the drop in the ratio. Investors who only focus on net income will not be aware of this situation because the net income will stay the same. ROE is the strongest and most reliable indicator of effective management and out-performing growth.

ROE is easy to track from a number of free financial websites like Google Finance and Yahoo! Finance.

Using the “get quote” search box to look up a particular selection. Select “key statistics.” On the same page in “management effectiveness” section you will see the value for “Return on Equity (ttm).” This will be expressed in a percentage of profits being generated for shareholders.

A higher ROE number shows how effective it’s management is in it’s growth strategy, a company’s profitability and if the stock in undervalued. Watch this number closely and you’ll notice how ROE changes (hopefully increasing).

You are looking for double-digit percentages for ROE. Double-Digit ROE is one of the most reliable, fundamental indicators you can use for picking consistent winners.

Ray

My response:

You need to keep those beers a little closer (that one must have been a “40″). I agree, it does suck getting old.

If you bought UNG using my recommendation it would have been a 15 strike price and it looks like it broke above 15 today. Hitting the strike price is definitely not the gist of this trade. As you know, I look for positions that will return 100-300% or better. In the case of UNG and DBA it will be much better. The UNG pullback was needed to confirm the trade when it retraced close to the 52 week low of 12.69. It never hit it and it never will.

Fundamentally I suspect that the new cap & trade emissions regulations will force more utilities to switch from coal generation to using nat gas. Couple this with any drawdown in inventory and/or supply disruption and you’ll see a raging bull market off the lowest gas prices in 7 years. It’s tough calling market tops & bottoms but that’s exactly what we’ve been doing. I’m glad to hear you’ve been adding to your Nat Gas position. You will be richly rewarded.

So much for my fundamental analysis. The pricing structure for both UNG & DBA plays has lined up perfectly and those are the only places I put my money to work. The patterns that I trade rarely vary much and though they are by no means infallible they work out in a big way much more often than not.

Did you happen to see the YTD results? It’s not often you see a string of 100%+ winners like that on the same page and it’s only since Jan.

Let the trade play out. Rarely does any traded security go straight up with no pullbacks or consolidation. If it did the trade would burn itself out. When they start talking about Nat Gas being the next big thing for what ever reason or the new Nat Gas bull market, it will be time to sell.

Acting in a contrarian manner takes balls. You need to put your money to work (and at risk) when everything you see, hear and read tells you the trade is dead money. If there is intrinsic value and either buyers or sellers become exhausted, the chart patterns clearly show this… and this is where the big money is made.

I also have the July 24 contracts on DBA and recently bought the Oct. 28 contracts (on the other days interday pullback… it didn’t last an hour). The price pattern and the fundamentals are in perfect alignment.

You would have to go back to the ’70s to find today’s low level of grain inventory. There’s a lot more affluent mouths to feed today than there was then. China’s grain production is a full 1/3 less than it was this time last year. As the summer droughts start to appear you begin to see price spikes. The AG’s are in a long term, multi-year bull market trend. As with all big trends, they tend to retrace so as to shake out the “weak hands,” steal their money and move on with the biggest moves.

FXY did the same thing. Everyone knows that Japan is in a swandive and they are gradually debasing their currency. We may not be in it to see the biggest moves down but our job is to take profits. It had two sustained rallies up to 105 and was not able to move above it. If you look at the 1 year or 6 month chart you’ll see it stopped out right at that spot both times. The move from here is down (I think it’s down $2 today). Talk about shaking out the “weak hands.” Hang in with it and I’m certain it will work for you.

Where was I? Ok. I can say with virtual certainty that the Sept. FXY puts will give you an exceptional payoff. The Yen pays nothing and is backed by huge debts that can never be repaid. It’s an export economy with a GDP that is underwater, aging population and a shrinking tax base. The only way for Japan’s Gov. to increase exports and revenues is to devalue the currency. I still firmly believe this is a solid trade. The trade was down 1.80 Thurs. and up 1.50 today. Those are huge swings for any currency. I feel it’s starting to play out now.

I have not been following PCX although the coal trade has some more good upside. Arch Coal July 15 calls are trading close to 18 today and I expect to hit 20 (the top of the trading range). Coal is moving up with the energy complex but it has a separate set of issues of which we’ve talked about. Keep a close watch on your coal trade and don’t hesitate to take profits (I suspect you’re in the money on Patriot also).

I don’t follow GS and have never traded it so I can’t really offer anything constructive, but I am totally convinced the market is setting up for a substantial correction (at least 100 pt S&P and very possibly much more). If that happens in your time frame it could easily drag GS down with it.

Whenever I find an attractive short position it usually starts with a specific segment or industry (on a macro level). Then I try to isolate the biggest dogs in that field. There are a number of “at risk,” biggest dogs and zombie banks that qualify as short plays. I’m not sure that I would place GS in that category.

The Regional Banks (I believe it’s KBW and the individuals within the basket) are the walking dead. Their exposure to commercial real estate could well be the nail in their coffin.

Even JPM (Morgan Chase) has an giant exposure to the defaulting credit card market which would put them at risk but GS is really more of a trading desk, M&A and arbitrage. Again, I don’t really follow GS.

The inflation trade is already beginning with the move up in commodities. This is the surest place to profit as the money printing and monetizing the bond market starts to take hold. The real impact will probably be in the early part of 2010 (and beyond). Once they let the inflation demons out of the bottle, it’s very hard to put it back in, meaning that once the trend begins to manifest itself it will be in place for quite some time. The Fed’s not in any position to start raising interest rates in such a weak economic environment to fight inflationary fear that they perceive as non-existent or even healthy. They will not be able to pull the massive liquidity out of the market and risk causing a double dip recession.

Inflation in many respects is already upon us. The giant ocean liner that is the U.S. economy is too big to turn on a dime. They’re usually long, slow, wide turns and they are telegraphed well in a advance.

I am a gold, commodity, interest rate and inflation watcher kind of guy so I’ll keep you posted when I see something changing. This market is going to start getting serious very soon.

Ray

The market indexes are weakening and looks to be rolling over on it’s side. The dollar is starting the long and irreversible slide I’ve talked about for months. The bond market (those guys are the smartest money on wall street) have already begun to notice problems with the dollar as the reckless bailouts have moved the nation toward hyperinflation. We’re also seeing the rates on Treasuries increasing daily. There is not a single event that will stop a stock market advance in it’s tracks like a spike in interest rates.

“Money goes where it’s treated the best”

As the rates on Treasuries move higher it forces all other rates to increase along with them. They’re all competing for the same pool of capital and the Fed has already placed a floor under them by reducing the Fed Funds Rate to .25% (why not just make it 0%).

China has stated clearly it has no interest in supporting our deficit spending by buying into the long end of the Treasury Auction. This week being a huge offering makes this perfectly clear. The short end, 1 year, 2 year and tomorrow’s 5 year (and possibly the 10 year) have been well received, but that’s not where the problem lies. When the Treasury starts auctioning the longer dated bonds (20’s/30’s/40’s) they will have few buyers. The Fed will step in, print more dollars to buy them (in a misguided attempt to artificially keep mortgage rates at the 4.5-5% range).

The chain reaction will be a sharp spike in interest rates (crushing the price of the long bond), the falling dollar will add to inflationary pressures and the market rally will be history. I’m initially looking for a 125 point drop in the S&P from the 913 level. There is resistance at 875 but once it’s through that I expect to see 788. This does not even take into account the serious issues taking place in commercial mortgage defaults ($3.5 trillion market cap), the Alt-A mortgage resets (expected to be 2x’s the size of sub-prime), credit card defaults, 9% unemployment and a new wave of foreclosures from prime borrowers who lost their jobs. Not a pretty site.

In keeping with our theme, “money goes where it’s treated best,” a major shift is taking place from equity markets to commodities and natural resources. The falling dollar will support commodity prices as hard assets are always the absolute best place to be in inflationary times. All the BS about deflation is just that.

Please notice that just the other day Moody’s downgraded the UK’s sovereign credit rating and the pound has risen against the dollar every day since then. The exodus from the dollar will be swift and painful. My UUP puts are up 40% and this is the 2nd rollover.

DBA is in full swing even showing amazing price strength on selloff days. Don’t take the short money on this one. This is a long term uptrend. I increased my own position going out to October on the last pullback.

UNG is giving you a 2nd chance and it’s setting up to be a huge move. After the 1st recommendation we got a nice 20% bounce and watched as it retraced, close to it’s 52 week low of 12.69 (it closed today at 13.72). May sound strange but the pullback was great news having set up the pattern I was looking for to confirm the trade. The breakout point for UNG will be @17.50 (the point at which it reversed).

If you don’t own UNG… Buy It!
If you already own it… HOLD It!
If you want to add to your position… buy the farther out contracts.

The new Cap & Trade legislation and emissions standards will cost the coal companies billions. The only viable alternative to using coal (I still think ACI has more room to run) is natural gas (it’s fairly clean, it’s cost effective and it’s plentiful). The only downside is the huge inventory of nat gas and the pipelines that are in place that keep pumping it out whether we use it or not. More than half the nat gas producers have gone offline and will take months to resume production. When the “forward looking mechanism” (stock market) realizes the increased demand from the lowest cost producers I believe we (and UNG) will be off to the races.

I believe UNG & DBA will be the best trades of 2009.

New Recommendation

In spite of the fact that I am confidant the market will tank soon, I would like to make one “long call.”

Lorillard, Inc. (NYSE: LO) The 3rd largest cigarette manufacturer in the US. Now wait a minute. I can hear you and I have not lost my freakin’ mind! Hear me out.

LO is a solid takeover target which could mean a possible 500% or better gain depending on the takeout price. Here’s why I like it:

1) It’s Newport brand owns the menthol category with 35% of the market.

2) Gross margins are 45%, the highest in the domestic tobacco market. Lorillard banked 76 cents per pack last year compared to roughly 50 cents for Altria & Reynolds.

3) Newport brand posted a 3% increase in volume sales while the industry contracted 3% on average.

4) Stock trades at 11.5 forward earnings (bargain pricing). Lorillard has $1.5 billion in cash/no debt and just authorized a $250 million buyback. Management knows it’s a bargain price.

5) The tobacco industry is consolidating. LO’s one product focus (Newport brand in 94% of LO’s revenue), clean balance sheet and strong revenue growth pins a target on it’s back.

6) Potential buyers include Phillip Morris (MO), Imperial Tobacco and Japan Tobacco with Reynolds topping the list. Could wind up with a bidding war (wouldn’t that be a shame).

Further government restrictions would seem unlikely since it makes vast amounts of revenue from “butt taxes” to consider it with a fragile economy and litigation is priced in.

It’s cheap, cash-rich, debt-free and steady growth. Just a note, with a 5.4% dividend if you buy the shares outright you will receive the next dividend payment of $.92 per share on June 12 (you can sell it the next day). If you buy a 100 share lot you can collect the dividend, sell a covered call for a few dollars higher and pick up some premium while your waiting.

If the market collapses (as I expect) this conservative dividend payor should still perform well in a flight to safety. If it gets a takeover bid the options will knock it out of the park.

Heads you win, tails you win.

Ray

UUP (U.S. Dollar Index) March 26 puts closed 1/8/09 …… +38%

QQQQ (Nasdaq 100) Jan 30 puts closed 1/12/09 …… +62%

XLF (Pro Shares Financial ETF) Jan 13 puts closed 1/12/09 …… +140%

SA (Seabridge Gold) May 15 calls bought 11/26/08, closed 3/10/09 …… +124%

BBY (Best Buy) March 25 puts, bought 12/23/08, closed 3/6/09 …… -45%

FXY (Japanese Yen) March 14 puts, bought 12/18/08, closed 3/17/09 …… +287%

VE (Veolia Environment) July 25 calls, bought 2/8/09, closed 5/11/09 …… +62%

QQQQ (Nasdaq 100) May 29 calls, bought 3/12/09, closed 5/7/09 …… +293%

MRO (Marathon Oil) July 30 calls, bought 3/13/09, closed 5/12/09 …… +172%

K (Kellog Co.) April 40 calls, bought 3/23/09, closed 4/15/09 …… -25%

Aray (Accuray) May 5 calls, bought 4/16/09, closed 5/11/09 …… -22%

Since January ‘09 our total of all closed positions showed a staggering cumulative gain of +1086%.

Out of 11 executed trades (no one can accuse us of over trading) we had 8 winning trades and 3 losers with the average percentage gain on winning trades +147% and the average losing trades -30%.

Considering after a +35% bounce in all the major indexes they’re about flat for the year, I have to say the results have exceeded even my own expectations. There are some major league trends developing and it looks like it’s going to be a great time to be an options trader. Let’s bank some cash.

Current Portfolio 5/26/09

DBA (ag commodity index) July 24 calls (+94%)

FXY (Yen) June 10 puts – stopped at resistance of 105

SPY (S&P index) Sept. 85 puts

QQQQ (Nasdaq 100) July 33 puts

UUP (U.S. Dollar index) June 26 puts

UNG (Natural Gas index) July 15 calls – look for a huge surge in June.

ACI (Arch Coal) May 15 calls – tough restrictions on “cap & trade” emissions. Should hit 20 with really strong headwinds.

XOM (ExxonMobile) July 75 calls – looks to be setting up for a great trade.

CDE (Couer D’Lene Mines) Jan. 2010, 2.50 calls – It’s still a hold. Very high expectations.

Ray