Volatility Index

VIX [ http://www.buythebottom.com/vix.html ]
Right now the COT picture for the VIX is not very clear. From the current setup I would not expect to see the VIX breakout above 13, unless net-commercial position first rises above 4,000. And if the VIX – indeed – does not breakout above the 13-level I would not expect the stock-market to see a major decline.

Any market melt-down would most definitely see a spike in the VIX much like we saw in May & June of 2006, when the VIX climaxed in the 23 – 24 range. Regardless of the COT data, if you see the VIX closing above 13, that would be a very big red-flag regarding a potential major leg down in the stock market. Especially when you consider recent commercial selling in the Nasdaq-100 and Dow Jones, this becomes a critical indicator to keep a close eye on.

Broad Markets

Russell 2000 [ http://www.buythebottom.com/rut.html ]
Commercials have been sellers of this market starting around September, but they are far from aggressive, especially over the last two months or so. Strictly from COT data the setup is not at all clear, at least to me, even though a bullish case could be made as the Russell 2000 is testing multi-year highs while commercial selling remains mild…so far.

S&P 500 [ http://www.buythebottom.com/spx.html ]
This index is not as bullish as the Russell 2000 and it is not as bearish as the Dow Jones, I would say it is somewhere in between…leaning probably a little bit more to the bearish side as both large traders and commercials were sellers during the last couple of months leaving small traders as the sole buyers. And the last thing that I would want to do is bet alongside the small-traders.

NASDAQ 100 [ http://www.buythebottom.com/ndx.html ]
Commercials and large traders were both sellers until this week, when net-large-trader position increased while net-commercial position continued to decrease. This confirms that this market remains setup to the downside.

Dow Jones [ http://www.buythebottom.com/indu.html ]
Commercial selling is continuing, with net-commercial position now slightly below -35,000 contracts. This is the lowest reading I see going back at least ten years, probably more, and is a critical development that investors should pay close attention to. As of right now, the setup is clearly bearish pointing to lower prices for this index in the intermediate future.

Commodities

Crude Oil [ http://www.buythebottom.com/wtic.html ]
Oil threw investors a 100 miles per hour curve ball as the first pitch of 2007. From the COT chart it is hard to argue that the market was setup to decline to the extent that it did (thus far in January). USO (oil ETF) never really confirmed the bottom as it failed to make higher highs above resistance in the 55 – 56 dollar range…But then again, this does not necessarily mean that a melt-down was imminent. Let’s come back to the COT chart for a moment: one can argue that commercials were buyers of crude as it drifted down from $80 all the way down to $60 but then turned neutral on this market during the range-bound trading from October through December 2006. But then again, they were neutral on this market and not necessarily all out bearish. Yes they did not buy during this sideways period like they did in May-June of 2006, but on the other hand it is hard to argue that they were aggressive sellers in this market.

The bottom line is that this example demonstrates how critical good money-management really is, and also demonstrates an example of a classical COT setup that did not go according to plan.

Moving on, the current setup does not make life any easier. Two weeks ago net-commercial position increased by 14,861 contracts and the week before that, net-commercial position increased by 13,520; this week however, net-commercial position decreased by 22,316 contracts, all this while oil is sitting a few ticks above 20-month lows. I would pay close attention to COT data for this market in the next little while to see if we get any important clues. Until then we may very well see lower lows, or not, as there is no arguing that this market is very over-sold. I am of the opinion that a bottom is not too far away, as the correction from the July-2006 highs is over-extended and will probably reverse sooner rather than later.

Gold [ http://www.buythebottom.com/gold.html ]
I would look for gold to rally once net-commercial position rises above -80,000 contracts. The last time net-commercial position rose above -80,000 was in mid-2005. And considering that only last week we hit -81,674, this setup may materialize in the very near future. However, before this level is reached, I would look for any premature rally to stall in the 660 to 680 range.

Currencies

US Dollar [ http://www.buythebottom.com/usd.html ]
The dollar is now in an ‘early setup’ to the downside. In other words we may see another push up over the next little while (or we may not) before an intermediate top is in place. The big picture with the greenback is far from bullish, strictly from a COT perspective, you can see that on one hand commercials are eager to support it, but at the same time as soon as it rallies they dump it. The trend for the dollar in 2006 has been clearly down, and it looks like it will continue in that direction until we stop making lower lows and start making higher highs…and from COT data thus far, the down-trend looks poised to continue.

Check out

1. Carnival of Investing at The Sun’s Financial Diary. Lots of posts this week for anyone interested in investing & money in general.
2. Carnival of Capitalists at Endless Gibberish PF blog. Lots of posts on money, economy, politics, and even 1031 exchange.

While political pundits were occupying themselves with “to surge or not to surge” and the Dem’s first 100 hrs in congress, the news that China successfully tested an anti-satellite missile by blowing up one of its aging weather satellites almost slipped through the news cycle. This CNN report contains a video link. My impression of the very short clip from the press conference was that Tony Snow was wishing the whole thing would just go away. For some reason, the test was conducted on Jan. 11, and the main stream media did not pick it up until Jan. 19.

Of course, one ought not be surprised, since Russia and China (for that matter the whole international community) has been trying to get US to sign a ban on space-based weapons for some time. It is also common knowledge that US is the undisputed leader in this area even after this latest Chinese advance. Some might characterize this move by China as a ploy to get US back to the negotiation table, but any realist could see that a space arms race, which has long been going on behind the scenes, is inevitable. Space, as they say, is the final frontier.

This is not to assign blame to anyone, for we are squarely in the realm of “real politik”. It’s a classic prisoner’s dilemma situation where nothing good will ensue. A new international agreement, even if signed, will only slow down the arms race in the best case, just as the nuclear test ban treaty simply moved testing to a digital platform. At any rate, we have to realize that satellites directly above someone else’s territory are indefensible. More fundamentally, US’s hegemonic power is predicated upon a monumental overspending which cannot be maintained when the object of subjugation is a rising industrial power with 1 trillion in reserves.

Alright, enough of being fatalistic. I accept the reality of the world we’re living in, and it behooves to position myself the best way I can. So I’ll make the case for investing in the defense industry here. A space arms race, however irrational and unwinnable, is sure to booster the aerospace and defense industry into the “low earth orbit”.

From Jeffery Saut
The basic premise was already strong prior to this latest incident. Following is from a Jeffery Saut missive dated December 26, 2006. It’s no longer available at the Raymond James site but here’s the Google cache page.

This is the interesting bit:

Having lived around “The Beltway,” we have a pretty decent sense for how the political winds blow. Last week’s visit to “The Hill,” however, surprised us. Indeed, we arrived thinking that political gridlock was likely to be the course over the next few years, but that sense changed after a few conversations. Surprisingly, we found many of our Republican and Democratic leaders pretty much in agreement on numerous things. Of particular note was a near unanimous agreement between the Congressional folks from states devastated by companies moving jobs offshore. While said Congressmen can’t force companies to keep jobs in their states, one thing they can do is vote for an increase in the defense budget and mandate that those attendant high-paying jobs be kept in the United States. The last time such a defense build-up occurred was during the Reagan years and it led to a BOOM in economic activity punctuated by near 8% GDP growth. And maybe, just maybe, that is what the stock market is “seeing.” The quid pro quo is that such a boom would obviously be accompanied by more rate ratchets from the Fed . . . aka, “the fooler.”

I think the message was crystal clear. He went on to suggest two ETFs for this sector: iShares Aerospace & Defense Index (ITA) and the PowerShares Aerospace & Defense Portfolio (PPA).

ITA vs. PPA
ITA tracks the Dow Jones aerospace and defense index (components) whereas PPA tracks PowerShares’ proprietary SPADE™ defense index. The main difference seems to be that PPA contains some consumer discretionary names like DirectTV and EchoStar, as well as some IT names related to biometrics and homeland security. ITA was just introduced last May. Over its short life, PPA has outperformed slightly. ITA has an expense ratio of 0.48% vs. 0.60% for PPA. I personally gravitated towards the former but both capture the desired exposure well. Daily dollar volume is equally low at $1.5-2 million. ITA trades only about 30k shares; however, I have noticed persistent 30 lot orders with a bid/ask spread of 4 cents. I’m not sure if there is a market maker providing liquidity. Perhaps a more knowledgeable reader can shed some light here.

Technical Picture
On the daily chart ITA just completed a breakout and a retest of the $54 level. One may ask whether this is a late stage breakout, but the benefit of the doubt resides with the trend until proven otherwise. As long as it stays above $53, I’m not going to fret much.

The long term DJUSAE vs. S&P chart makes a very convincing case for this sector. In fact, it can be argued that we’re at the brink of a new leg up and this latest incident could very well be the catalyst.

Disclosure: I’m long ITA and all the usual disclaimers apply.

A while ago, I wrote about 529 plans and new tax deductions in some states. Just to recap the basics about 529 plans:

• Contributions are not deductible on federal returns; however, many states provide a deduction for contribution to in-state plans. Certain states even have deductions for contribution to out-of-state plans.
• Although the state income tax deduction has an upper limit (e.g., for contributions up to $12,000), there is no overall contribution limit that I’m aware of. [You should consult a tax advisor here. This IRS publication states that the amount of contribution cannot be more than the qualified education expenses of the beneficiary, but I’m not sure how it is enforced. Most plans have an account limit of $2-300,000 per beneficiary.]
• Inside the plan, money grows tax free. Qualified withdrawals for education purposes are not taxed.
• Nonqualified withdrawals, however, have the earnings taxed as ordinary income with a 10% penalty levied.

This last point is what I want to address today. Two blog entries at MyPocketChange and RetireEarly started exploring this question:

Since the money inside a 529 plan grows tax-free, is there a break-even point, beyond which it’s more advantageous to invest in a 529 plan than in a regular taxable account even after paying the penalty?

Essentially, the interlocutor is asking whether the 529 plan can function as a stand alone retirement savings plan without contribution limits. This can be calculated quite easily if we make certain assumptions about the rate of return, current and future tax bracket, etc. But to gain a better understanding, let me rephrase the requirement into two separate conditions.

A. In each given year, the advantage of tax-free compounding must out-weigh the extra expenses for the 529 plan, viz.

R₅₂₉ – ER₅₂₉ > R_taxable – ER_taxable – TR_taxable

Where R is the return; ER is the expense ratio; and TR is the tax expense for the taxable account. If this condition fails to hold, then compounding will only make things worse.

The current tax expense, TR_taxable, is given by,

TR = D * STportion * STrate + D * LTportion * LTrate

Where D is the distribution rate; STportion and LTportion are the fraction of D that are short term gains or long term gains and dividends; STrate and LTrate are the current applicable short and long term marginal tax rates. D also includes any gains realized for rebalancing.

Assuming the 529 plan has a wide enough choice such that R₅₂₉ and R_taxable are equal, you can tilt things in 529 plan’s favor by choosing a plan with low fees, choosing investments with high distribution rates and be in a high current income bracket.

B. The second condition is that you have to wait long enough for the money in the 529 plans to grow enough to offset the tax penalty.

P₅₂₉ (1 – MR₅₂₉) > P_taxable (1 – MR_taxable)

Where P is the portfolio value; MR₅₂₉ is 10% + future bracket; MR_taxable is the future long term cap gain rate. Again for things to be in 529 plan’s favor, you have to wait long enough and withdraw the money when your future tax bracket is as low as possible; or to be more exact, when the differential between MR₅₂₉ and MR_taxable is as small as possible.

Putting the numbers together
Since no one can predict future tax law changes, an exact analysis is not possible. For example, it’s highly debatable whether the current low capital gains and dividend tax rates will be extended after they sun-set in 2010. The best we can do is to take the current tax rates and make reasonable projections into the future. My assumptions are as follows:

Portfolio annual return: 10% (As you’ll see later, I suggest investing with the most aggressive option. At any rate, it matters little when the returns of the 529 plan and the taxable plan are equal.)
Taxable plan fee: 0% (No extra fee besides the intrinsic mutual fund expenses.)
529 plan fee: 0.60% (e.g. the Nebraska program)
Current marginal tax rate: 31% (federal + state)
Current long term capital gains rate: 15% (ignoring any state tax liability here)
Early withdrawal penalty: 10%

Distributions and gains realized for rebalancing as a percent of the portfolio: 6%
- Of which are long term capital gains or dividends: 75%
- Of which are short term capital gains: 25%
TR_taxable: 1.14% (This is the amount of annual taxes to be paid from the taxable account. Since this is greater than the 0.6% expense rate of the 529 plan, condition A is satisfied. Given time the 529 plan will overcome the extra tax burden at liquidation.)

The output is in the table below. For each dollar invested in year 0, I computed the after tax (and penalty) liquidation value of the accounts as a function of the respective future tax rates and number of years invested. Some rows were hidden to make the table smaller.

It can be seen that a LT cap gain of 5% is pretty tough to beat. Even at a low marginal rate of 10% (+10% penalty), it takes 33 years for the 529 plan to catch up ($15.712 vs. $15.695). However, if the future LT cap gain rate goes back to 10%, the break-even occurs after year 20. Still a very long time but doable. The difficulty of the task grows if your future brackets are higher. It will take 36 years for the 15% future income bracket to break-even with a 10% LT cap gain. And if you are fortunate enough to be in the 25% income bracket in retirement, it will take a long, long time (54 years to be exact), to exceed the corresponding 15% LT cap gain.

At this point, you’re probably thinking, “Why bother!” Indeed, 401(k), Roth IRA or the traditional IRA, even the non-deductible kind are much better ways to save for retirement. It is only after those have been maxed out, does the 529 plan emerge as a potential alternative. As described so far, it’s applicable to only a very small segment of the population with high disposable income or a lump sum to invest early on.

If the story ends here, this would not have been a useful exercise. Fortunately, there is much more, both in terms of the 529 vs. taxable plan comparisons and ways of utilizing the 529 for qualified educational expenses thus avoiding the 10% penalty. Please stay tuned for Part 2!

At the end of every year, I briefly review how I am doing with respect to stock commissions that I’m paying. Just simply making sure that I’m not being stupid, paying thousands of dollars to the online brokerage companies while burning a big hole in my pocket without getting returns on my stocks.

For the year 2006, my total commissions paid to brokerage house is 0.1% of the stock asset value on 12/31/06. I think it’s quite good, considering that almost 23% of that were due to buying Canadian stocks at Scottrade (cost $20 extra, besides the regular $7) and a couple of selling covered calls that I did. By the way, on the covered call that I did, it was in the money call so my stocks got called away. But boy, it got called away in 3 different pieces, resulting extra charges than I was expecting.

Obviously, 0.1% is still some amount of money. I could have bought several low-end digital cameras. My own target is NOT to exceed 0.5%, so in fact, I’m doing quite well in respect to my target.

So how much did you spend trading? Don’t burn a hole in your own pocket by over-trading. But don’t hinder your trading by the trading costs either.

In fact, I’m looking forward to some even lower cost trading platforms. When the trading is close to free, there is a distinct advantage that you can free yourself on limiting the number of transactions that you want to do, and therefore improve your trading somewhat (or so I believe). This is especially helpful when you want to phase into the market gradually, and/or trying to catch the top/bottom of the markets.

There are quite a few instances where I only have a limited amount of capital allocated for a certain stock/sector, and I would like to split my transactions into 2 or even 3 separate transactions because I was not so sure about the timing. However, because of the amount of capital that I’ve allocated, it wouldn’t make much sense to split the entire transaction into pieces.

Maybe I will try Zecco like ML at some point too. In fact, I’m waiting for Bank of America to offer their free online trading service in California in the spring of 2007.

My quest for more dividend paying stocks led me to another category that my partner Frugal wrote about a while ago: oil tanker shipping companies. The short list he gave was: Nordic American (NAT), Frontline (FRO), General Maritime (GMR), and Knightsbridge (VLCCF).

Of the group, I like the current chart of NAT (yielding 15.9%) the most: It bounced off its 200 dma recently within the confines of a well formed triangle.

Cramer vs. the futures market
On the other hand, Jim Cramer has this to say about Frontline and the rest of the tanker companies (subscription required for the whole article)

Frontline and the rest of the big tanker stocks have yields that are can’t miss, right? I don’t think so. Bloomberg has a great story this morning about how the excessive building in tankers could lead to repossession of the giant ships when the new fleets, the biggest additions in 50 years, hit the market. Big yields are always seductive. I got caught up in one two years ago, Fording Coal, 12%; can’t miss. But there’s always a price to be paid for these things, and an outsized yield is often more of a red flag than a opportunity. I can’t tell you how many times people asked me about these stocks on “Mad Money” when oil was going up. They figured rates had to go up. But these tanker stocks are levered to tanker building’s supply and demand, not oil prices. Now oil prices are plunging and tanker rates are…

Depending on your opinion of Cramer, this could be construed as a positive for this sector I couldn’t find the Bloomberg article he was referring to; however, my cursory glance at the Imarex tanker futures which go out to calendar year 09 did not reveal anything alarming. So I’ll leave you to decide who to believe.

According to its latest letter to shareholders, NAT currently operates 12 double-hull, suezmax tankers with a low break-even of $9,500 per ship per day. The single-hull tankers are facing mandatory phasing out by 2010 (remember Exxon Valdez?). Perhaps the “excessive building in tankers” is related? Anyhow, the chart by itself was convincing enough for me. Crucially, with a clearly defined trend line, it’s easy to figure out where my stop loss should be.

As always, please do your own research before making any financial decisions.

To the regular readers of 1stM@33,

I have recently added the Digg buttons on some of the articles, like the one in the beginning of this article “Digg this? Thanks” or showing some number of diggs. It’s my hope of driving more traffics to the site via digg.com which is a social bookmarking site. If you feel that you have a bit of spare time, and would like to help out promoting 1stM@33, you can register at digg.com, and click on those buttons to digg a few articles. When you digg, you can choose Business/Finance category for most articles on this site.

Your help is greatly appreciated. Higher traffics is certainly correlated to higher enthusiasm on my & ML’s part, which in turn will improve this site in both short and long term. But of course, only do so when you think the article is worth sharing with others.

Thanks in advance.

Frugal

I guess by now everyone has seen the iPhone from Apple. Steve Job has done it again with his visionary leadership. Apple has been a terrific innovator. In fact, the opposite is probably more true, the competitors are too timid and stupid not to come up with more innovation.

So what did you see in iPhone besides the cool user interfaces and features? Do you see what Steve Job is seeing? In fact, Apple has leveraged its success in iPod in a tremendous way, changing the music distribution industry in a big way. iTune has been a great way for Apple to leverage its music platform. Music distribution companies like Sony have the inferior end of negotiation when it comes to iTune. What may be coming for iPhone will be bigger than iPod.

What I see in iPhone is PORTAL. Let me define what I mean by portal. Portal is essentially a gateway through which traffics need to go through. The people who recognize the concept of Portal in internet has made it big: Yahoo, and the search engines. Google certainly has proved that you don’t need to be the first in market, but the best will do. Internet traffics go through internet portals, such as search engines. The person who controls the gateway controls EVERYTHING.

Now, look at iPhone. If it is as successful as iPod, as a platform for communication and multimedia, it will control things like a portal. Who gets the cell phone business? Cingular for now. Who gets to be the internet search engines? Yahoo & Google for now. If the number of units of iPhone reaches a certain threshold, the power of Apple will be tremendous. Let’s say one day Apple wants to drop Google and use AOL search exclusively, it will definitely bring BIG impacts. In fact, iPhone controls the front door to the search engine portal. Whoever has the exclusive keys to the front door has more power. And the same goes for music/video downloads via cell phones. Or geographic maps for that matter. Distribution of map with vital information such as restaurant locations, etc. is another gateway of information. It’s like a yellow page with map, AND controlled by whoever built your phone.

Note that another keyword here is exclusivity. Many things on iPhone have been protected by 200+ patents. I assume that competitors won’t be able to make another phone that is anywhere close to Apple’s, unless they innovate beyond Apple. The exclusivity is always a problem in every competitive landscape. If you look at what has transpired in Apple’s computers, the key to Apple’s failure (in my opinion) was that a computer has too many components and technologies to be handled by a single computer in a cost effective way. Various public standards have helped bringing more competitors for different PC components to bring better and faster technologies to the end-users. A monopolistic market without serious competitions almost always fail. CPUs in Apple computers simply cannot catch up with vehement competition in PC. Same for every other components. The speed of commoditization and innovation of PC components is incredible, and overcomes a few leading advantages that Apple would have.

If we compare the phone and PC market, phone will be always simpler than PC (since it is smaller than PC). There can only be so many IC chips in a phone that will fit. Furthermore, most of the difficult challenges have been solved by the IC design companies. Once you put together all the needed functions, it’s up to the phone maker in how to present the entire phone experience to the users. Therefore, Apple is relieved from having developed all if not most of the ICs, while it is left with the task that Apple does best: user interface.

I believe that Apple will succeed and maintain its competitive edges for quite some time. By lowering the price in the future for further market adoption/penetration, Apple can further leverage its platform as the central MOBILE gateway to many many things. If Apple plays its business cards right, it can emerge as the important player on many negotiation tables.

No doubt that there will be a big fight for the cellphone market, but it’s the votes from the end users that count. Whoever pleases the users with their simplicity, beauty, and wallet, will win this game. If Apple can manage its price curve to keep ahead in market share, competitors will be forced to form wide alliances across different domain to have any chance of breaking Apple’s stronghold.

Repeat after me, PORTAL!

P.S. A monopoly is never good for consumers. Monopoly is always pricey, if not lack in features (or full of bugs like MS). And I guess a more likely scenario for Apple is that their arrogance (& unwillingness to lower price) prevents them from becoming a widely adopted platform, and they will again remain as a niche player like in Apple’s computers. After all, a cell phone is not like a iPod music player. Cell phone needs to be cheap, while iPod can remain expensive.

I decided to put this post on Monday instead of Wednesday, so that my fellow bloggers can get more exposure. But it also means that the notice will be late by a week.

Here are all the great money/finance carnivals featuring 1stM@33 submissions. Please visit them for more good readings.

1. Carnival of Investing at BinaryDollar
2. Festival of Stocks #18 at StockReply

Look at the following charts from stockcharts.com:

The first chart is the CRB, which was a more pronounced bull market in the USA. The bottom chart with $CRB divided by $USD (US dollar index) shows that commodity markets were ranged bound in the last two years priced in US dollar index (or a bucket of international currencies), and seem to have a bottom at about 3.30 for the last two years. Both charts have fallen under 200 days MA however. I believe determining whether the international commodity market has broken down is very important. If the commodity market priced internationally is not broken down, then it should be positive for BOTH stock and commodity markets towards 2009.

Obviously, using $USD index is still somewhat faulty since it doesn’t take the currency values of the major commodity consumers into account. The best chart would be constructed from all currencies, weighted by the amount of commodities that each country consumes. But this is the best that I can chart. You will need to combine both $CRB and $CRB:$USD in a weighted fashion to account for US contribution. Of course, China/India are still missing in the combined pictures. Here is the contribution for each currency in USD index.

The bull market in the past has been more pronounced priced in $US. But nevertheless, it has been a bull market in all currencies until the recent “breakdown”. Let’s see if $CRB:$USD will turn up in the next couple of months.