Macro Tsimmis

intelligently hedged investment

Archive for January, 2009

BUY Dendreon (DNDN) puts and calls—straddle play (again)

Posted by intelledgement on Thu, 29 Jan 09

Yep, we implemented this same trade two years ago prior to the FDA advisory committee meeting that endorsed Provenge, pushing DNDN stock from $4 to $25…a month before it was—shockingly—not approved by the FDA itself, crashing the stock back down to $5—and it was our best speculative play so far, with a 307% ROI in 21 days. The time horizon here is a bit longer, but the principle is the same: there is a binary event approaching on a predictable time frame that is highly likely to materially effect the stock price of Dendreon (DNDN), the biotech developer of Provenge, a vaccine for prostate cancer.

OK, first we suggest you check out this Minionville article which summarizes what is at stake for Dendreon and their prostate cancer product, Provenge and frames the eventualities. Essentially, if the data from the IMPACT Phase III study meet the 22% threshold (with respect to improved survival for the Provenge arm as compared with the placebo arm), then FDA approval is all-but assured and DNDN stock, currently around $3.50, is likely to double or triple at least on the expectation that Dendreon will get revenues starting this year and be profitable by 2011 or even late 2010.

If the data don’t pass muster, the company will probably have to put themselves up for sale, as they lack the funds for another costly Phase III trial—to say nothing of another two-to-three years of paying the electric bill—and are not likely to be able to raise them for what would at that point be a two-time loser vaccine. (They have other candidate drugs in their pipeline, but they are all “active cellular immunotherapies” based on the same process as Provenge, so if Provenge doesn’t work….) Whether any other company would be willing to pay anything for the privilege of sinking more money into funding another study of a two-time loser drug is unknowable, but at that point, DNDN shareholders would be begging, not choosing…and in this event, the stock is likely to plunge 80% or more.

So, we are going with an options straddle play: looking to buy eight Aug $5 calls (UKOHA) for $1.25 or better and six Aug $5 puts (UKOTA) for $3.35 or better. There is healthy open interest for both options. Remember that option prices are quoted in “per share” terms, but each option covers 100 shares; thus one UKOHA August $5 call will give us the right to purchase 100 shares of DNDN for $5/share between whenever we buy it and the day the option expires (21 Aug 09 in this case). Thus the total investment (not counting transaction costs) should be around $1,000 for the eight calls plus $2,010 for the six puts for a total of $3,010.

If the data fail to meet the 22% survivability advantage for Provenge and the stock tanks the expected 80% to 70 cents or so, then the calls will expire worthless but the puts will be worth $430 each for a total of $2,580, or a net loss of (coincidentally) $430. If the stock goes down below ten cents, we will just about break even.

If the data are good and the stock goes up to $14—we don’t think $25 is likely this time until there is actual FDA approval, investors having been burned once—then the puts expire worthless and the calls will be worth $900 each for a total of $7,200, or a net profit of $4,190. If the stock reachs $18, then the calls are worth $1,300 each for a total of $10,400 (net profit of $7,390).

Of course, the risk is that there will be some sort of grey result that only modestly boosts or hurts the stock. For example, there might be a delay in the release of the data, or the results might be fractionally below 22% such that the company elects to apply for approval again anyway based on these results, thus delaying a resolution. Worst case is the stock going up from the current $3.50 to $5, in which case both the puts and calls expire worthless.

Our bet, however, is that even if delayed, the data will be available by mid-August and that any result other than an unequivocal 22% survival edge for the Provenge arm will tank the stock. (And, of course, good results will send it soaring.)

This is a relatively unusual situation where the timing of an event that is likely to have a huge effect on the stock price is known about beforehand: you don’t get better straddle opportunities than this. The way we see it, we are buying a 50%(?) chance to make four-to-seven thousand dollars at a probable risk of $400…pretty attractive odds.

Previous DNDN-related posts:

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BUY ProShares UltraShort 20+ Year Treasury (TBT)

Posted by intelledgement on Wed, 21 Jan 09

Two of the least widely expected symptoms of the financial crash we are living through have been the comeback of the dollar and the increased popularity of U.S. government-issued debt.

We had deflation in the Great Depression, and deflationary pressures in circumstances where spending and employment are steeply declining are not surprising per se. When demand goes down, prices decline; it is a Economics 101. However, in the face of all the liquidity the Fed has injected into the system in an effort to keep credit available, seeing the dollar rally against all major currencies—and, in the midst of a financial crisis, gold decline in value as measured by dollars—is…well…cognitively dissonant.

Even stranger is the buying panic that has assaulted debt issues from the U. S. Treasury. The interest rate has declined steadily, actually hitting 0% last month (yep, the U. S. government borrowed $30 billion for 28 days for free!), as institutions looked for a safe haven to park funds. In fact the sale of three-month bonds on 8 December went off at 0.005% interest—the lowest ever—and was oversubscribed. The winners of the auction were able to resell the bonds on the secondary market at negative interest! (Yep, folks were willing to surrender some principal for the chance to have their money “safe” for three months.)

Check out this chart showing the relative performance of 20-year treasuries, the dollar, and gold since last July. (To see the same chart we are looking at, click on the link and then change the “From” date from today’s date to 16 Jul 08 and the “To” date from today to 21 Jan 09…unless of course today is 21 Jan 09, in which case you can ignore that last instruction.) Since last July, treasuries are up 26% (remember when the interest rate goes down, the value of the bond goes up), the dollar is up 17%, and gold is down 10%.

We still think there is more deflation coming, in response to more unemployment and demand destruction, not to mention the continued release of over-pressurized air from the still-deflating housing bubble. However, we are not so sanguine about the prospects for U.S. Treasuries. With the coming stimulus package on top of whatever additional emergencies arise, not to mention the steady drumbeat of debt financing and “normal” deficit government spending—which will be worse than normal with increased unemployment insurance and decrease tax revenues—we expect the supply of treasury debt issues to rise from here. And we expect the supply of willing borrowers to decline, because foreign (especially Chinese) dollar surplus funds are likely to be allocated to (their own) domestic stimulus activities.

We think this demand is likely to be particularly soft for longer-term debt instruments—such as the 20-year bonds—because while deflationary pressures are likely to keep short term bonds safe (in the sense that the dollars you get back in 28 days or three months will still be worth the same or perhaps even a tad more), it is hard to see how five or more years out inflation won’t be a factor. Consequently, we are buying the ProShares UltraShort 20+ Year Treasury ETF (TBT) here. The managers of this ETF seek daily investment results, before fees and expenses and interest income earned on cash and financial instruments, that correspond to twice (200%) the inverse (opposite) of the daily performance of the Barclays Capital 20+ Year U.S. Treasury Index. Thus it is a mirror image of the TLT fund we cited above in the chart, and has declined 42% since last July. (OK, not a mathematically perfect mirror image.)

If we are right, and the market is going to demand increased interest rates for longer-term Treasury issues going forward from here, then the value of outstanding longer-term Treasury bonds will decline, and the value of shares in this fund will appreciate.

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4Q08 Intelledgement Macro Strategy Investment Portfolio Report

Posted by intelledgement on Wed, 14 Jan 09

Summary of Intelledgement’s Model Macro Strategy Investment Portfolio performance as of 31 Dec 2008:

Position   Bought   Shares Paid Cost Now Value   Change       ROI     CAGR
FXI 03-Jan-07 243 37.15 9,035.45 29.09 7,425.21 -14.48% -17.82% -9.38%
GLD 03-Jan-07 142 63.21 8,983.82 86.52 12,285.84 1.70% 36.76% 17.01%
IFN 03-Jan-07 196 45.90 9,004.40 18.30 6,454.28 -19.68% -28.32% -15.38%
SLV 03-Jan-07 700 12.86 9,012.80 11.20 7,840.00 -5.49% -13.01% -6.76%
DBA 13-Mar-08 235 42.50 9,995.50 26.18 6,152.30 -13.34% -38.45% -45.39%
SCC 16-Sep-08 112 86.23 9,665.76 84.78 13,322.87 17.64% 37.84% 202.14%
SZK 16-Sep-08 145 68.25 9,904.25 74.01 13,504.05 29.04% 36.35% 191.03%
SDS 19-Nov-08 88 112.98 9,950.24 70.94 7,253.88 n/a -27.10% -93.60%
cash 24,447.78 31,458.21
Overall 03-Jan-07 100,000.00 105,696.64 -4.81% 5.70% 2.81%
Macro HF 03-Jan-07 100,000.00 107,271.13 -0.91% 7.27% 3.57%
S&P 500 03-Jan-07 1,418.30 903.25 -22.56% -36.31% -20.18%

Position = security the portfolio owns
Bought = date position acquired
Shares = number of shares the portfolio owns
Paid = price per share when purchased
Cost = total paid (price per share multiplied by # shrs plus commission)
Now = price per share as of date of report
Value = what it is worth as of the date of report (price per share multiplied by # shrs plus value of dividends)
Change = Change since last report (blank for positions new since last report)
ROI (Return on Investment) = on a percentage basis, the performance of this security to date
CAGR (Compounded Annual Growth Rate) = annualized ROI for this position (to help compare apples to apples)

Notes: The benchmark for this account is the Greenwich Alternative Investments Global Macro Hedge Fund Index, which historically (1988 to 2007 inclusively) provides a CAGR of around 15.3%. For comparison’s sake, we also show the S&P 500 index, which historically provides a CAGR of around 10.5%. Note that dividends are added back into the value of the pertinent security and not included in the “cash” total (this gives a more complete picture of the ROI for dividend-paying securities). Also, the “Cost” figures include a standard $8 commission and there is a 1% rate of interest on the listed cash balance.

Transactions: Another relatively active quarter with five transactions—three sells and one buy—plus the usual bevy of year-end dividends and capital gain distributions:

  • 7 Oct – IFN dividend of $6.45/shr
  • 11 Nov – Sold 489 PHO for $13.02/shr (ROI of -28.8% and CAGR of -16.7%)
  • 19 Nov – Bought 88 SDS for $112.98/shr
  • 16 Dec – Sold 92 SRS for $61.74/shr (ROI of -35.27% and CAGR of -27.78%)
  • 16 Dec – Sold 97 SKF for $104.70/shr (ROI of 1.5% and CAGR of 4.9%)
  • 22 Dec – FXI dividend of $0. 20802/shr
  • 23 Dec – SCC dividend of $0.008631/shr and capital gains distribution of $33.91358/shr
  • 23 Dec – SZK dividend of $0.006616/shr and capital gains distribution of $18.85726/shr
  • 23 Dec – SDS dividend of $0.028553/shr and capital gains distribution of $11.46188/shr

Performance Review: A mediocre quarter for us, as we beat the market by a country mile, but still both lost to the macro hedgies and lost money overall. For the market, at -22.6% it was not just the worst quarter since the inception of the IMSIP two years ago, but the worst quarter since the fourth quarter of 1987—which included Black Monday—when it finished  -23.3%. The S&P also recorded its worst six month period, -29.4%, since 1974 when it logged -32.4% in the second and third quarters. As for the hedge fund pros, overall 2008 was the first ever negative annual return for the industry since Greenwich Alternative Investments (GAI) began keeping track in 1988. Hedge funds overall clocked in at -15.95% for the year; macro hedge funds, however—our heros!—were the fourth-best performing class out of 18 tracked by GAI at -4.8% for 2008. Not so bad in a year when the market produced a -38.5% ROI.

Tactically, our sale of the water infrastructure ETF PHO in early November was probably a bit premature, as it could run up here on stimulus package-related “obtimism” (that is, Obama administration-related optimism that things will turn around—or, at least, a lot of money will get spent on infrastructure—under new leadership after the inauguration on 20 January). It ended the year at $14.39, so at a minimum, a little patience would have netted us a better sale price. We also should have waited on our SDS purchase in mid-November, for the same reason. Obtimism could drive the price down in the short-to-medium term; certainly the price at the end of the year, $70.94, would have been a much better entry point than the dividend-adjusted $98.10 we paid. Pursuant to our recent analysis of the performance of leveraged short ETFs, we will be looking to replace this fund with the 1x SH fund when the opportunity presents itself.

Obtimism considerations lead us to dump our reverse ETFs for the financial (SKF) and real estate (SRS) sectors in mid-December. So far, so good on this front, as both were lower at the end of the year. Sad to say, we anticipate buying back in post-20 January—once obtimism about how quickly the new administration can effect economic recovery abates—as we still expect things get worse before they get better. (As of now, there are now 1x inverse financial or real estate sector ETFs available.)

Overall for the two years we’ve been tracking the IMSIP, we are now narrowly trailing the GAI Macro Hedge Fund Index, +6% for us to +7% for them. The market overall is a very distant third at -36%.

Analysis: Too bad we don’t recommend individual stocks for most clients because if we did, a neck brace manufacturer would look good just about now. While 4Q08 at -22.6%s was not the worst ever for the S&P 500, it may well have been the most volatile quarter ever. Normally, the daily ebb and flow of prices amounts to less than ±1% for the S&P 500 index. If you round off the nearest whole number, the average daily change in the S&P 500 in all of 2006 was 0%…in 2007 it was 1%…and last year it was 2%. Here is a comparison of the fourth quarter for all three years:

Year 0% Days 1% Days 2% Days 3% Days 4% Days 5% Days 6% Days 7-9% Days 10%+ Days
4Q06 48 15 0 0 0 0 0 0 0
4Q07 23 27 8 6 0 0 0 0 0
4Q08 6 16 6 9 9 5 6 4 2

Six days in 4Q08—10% of the trading sessions—on which the market was up or down between 7% and 12%! About six year’s worth of value change in six days! Folks, this is a cry for help. The market is telling us that no one knows from day-to-day what the right value for stocks is. And the reason this uncertainty exists, in our opinion, is that almost all the “rescue” plans promulgated so far by the Paulson administration (W having apparently taken early retirement here) seem to be aimed at papering over our problems, rather than dealing with them forthrightly and genuinely moving forward.

As we have said before, we got into this mess by overspending, borrowing beyond our means, and speculating on bubble-valued assets. Any “solution” that involves lowering interest rates, increasing our debt levels, and easing credit/issuing more money is, essentially, attempting to put out a fire by dousing it with gasoline. The government does not have the resources to “rescue” all the zombie banks whose obligations exceed their assets, not to mention all the homeowners whose mortgage obligations now exceed the value of their properties, not to mention all the industrial companies whose profligate and short-sighted management have left them vulnerable to the economic tsunami we are experiencing…etcetera, etcetera. Aside from laudibly refusing to rescind the mark-to-market rule, the only honest move the administration made in this sorry mess was allowing Lehman Brothers to go bankrupt…and typically, that is now seen as a misstep.

The one facet of our desultory march into hades has surprised us is the strength of the dollar. We expected that the gobs of money the Fed has injected into the system in an effort to stimulate lending would be immediately inflationary; we failed to adequately reckon with two contrary effects. The first of these is the deflationary effects of demand destruction. When everyone has degraded retirement savings, a home that is worth 30% less, and—if still employed—job security issues, no one is out there buying new cars or even new clothes…or, at least, not with the same old reckless abandon. When demand fades, supply waxes…and prices fall. The second effect that surprised us was the flight-to-safety effect that—ironically—has money piling into treasuries. So desperately were money managers seeking a safe haven for funds that last month we had the spectacle of the USA borrowing money at 0% interest! Folks, when the safest place on the planet to put money is in bonds issued by a virtually insolvent government, we are in deep doo-doo.

Of course, Paulson is history and Obama is imminent. No matter what, 20 January will be a day of optimism and celebration for the USA. Perhaps the new man’s vaunted pragmatism will light the way towards smarter and less short-range responses. We hope so with our hearts, but our heads are saying, “don’t invest on it.”

Conclusion: Let’s hope for the best. The incumbant crew was most definitely leading us deeper into the morass; the new crew recognizes we are in a big hole…perhaps they will be smart and brave enough to stop digging. We subscribe to the injunction to make love, not war, but we still believe in being prepared for both. Accordingly, we retain three inverse ETFs in the portfolio…covering the consumer goods (SZK) and services (SCC) sectors as well as the S&P 500 overall (SDS). We still expect the cumulative effect of the liquidity injections and increased need for borrowing by the USA to eventually degrade the dollar’s value, and consequently remain long our commodity plays (GLD, SLV, and DBA). And finally as a hedge against a quicker-than-anticipated recovery, we still retain our China and India emerging market funds (FXI and IFN)—as we expect those economies to lead the recovery.

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Dec 08 Intelledgement Speculative Opportunity Portfolio Report

Posted by intelledgement on Tue, 13 Jan 09

Position Purchased Shares Paid Cost Now Value Change YTD ROI CAGR
VRTX 18-Apr-07 57 31.65 1,812.05 30.38 1,731.66 23.55% 30.78% -4.44% -2.63%
NBIX 22-May-07 158 11.33 1,798.14 3.20 505.60 2.89% -29.52% -71.88% -54.47%
GSS 19-Jul-07 451 4.19 1,897.69 1.00 329.23 36.99% -68.35% -76.23% -62.78%
GSS 24-Aug-07 613 3.08 1,896.04 1.00 447.49 36.99% -68.35% -67.67% -56.53%
BBY 19-Sep-08 -58 41.49 -2,398.42 28.11 -1,638.50 35.73% -46.61% 31.68% 165.39%
MA 19-Sep-08 -11 225.18 -2,468.98 142.93 -1,573.88 -1.70% -33.58% 36.25% 199.51%
WMT 19-Sep-08 -40 59.70 -2,380.00 54.77 -2,200.32 -1.99% 15.23% 7.55% 29.45%
CAB 19-Sep-08 170 14.08 2,401.60 5.83 991.10 -6.72% -61.31% -58.73% -95.67%
APWR 18-Dec-08 422 6.14 2,599.08 4.30 1,814.60 n/a -67.79% -30.18% 100.00%
SOHU 18-Dec-08 58 45.13 2,625.54 47.34 2,745.72 n/a -13.17% 4.58% 251.66%
cash -189.22 19,669.50
ISOP 03-Jan-07 10,000.00 24,923.44 -2.21% 14.09% 149.23% 58.12%
Global HF 03-Jan-07 10,000.00 9,340.35 0.74% -15.95% -6.60% -3.37%
NASDAQ 03-Jan-07 2,415.29 1,577.03 2.70% -40.54 -34.71% -19.25%

Position = symbol of the security for each position
Purchased = date position acquired (for long positions) or sold (for short positions)
Shares = number of shares long or short in the portfolio
Paid = price per share
Cost = what portfolio paid (including commission); note for short sales, the portfolio gains cash
Now = price per share as of the date of the report
Value = what it is worth as of the date of the report (# shrs multiplied by price per share plus—or minus for short positions—the value of dividends)
Change = Change since last report (not applicable for positions new since last report)
Year-to-Date = Change since 31 Dec 07
Return on Investment = on a percentage basis, the performance of this security since purchase
Compounded Annual Growth Rate = annualized ROI for this position since purchase (to help compare apples to apples)

Notes: The benchmark for the ISOP is the Greenwich Alternative Investments Global Hedge Fund Index, which historically (1988 to 2008 inclusively) provides a CAGR of around 13.4%. For comparison’s sake, we also show the NASDAQ index, which over the same time frame has yielded a CAGR of around 9.6%. Note that for the portfolio, dividends are added back into the value of the pertinent security—or subtracted from the value of short positions—and not included in the “cash” total (this gives a more complete picture of the ROI for dividend-paying securities). Also, the “Cost” figures include a standard $8 commission and there is a 1% rate of interest on the listed cash balance.

Transactions: The market calmed down considerably in December, and—following three consecutive months of unmitigated disaster—closed up. With the immediate risk of a financial meltdown reduced and the probability of a post-election “Obtimism” rally increasing, we liquidated our four financials sector shorts as well as our real estate short.

News:

Comments: To quote our IMSIP 4Q08 report, “Let’s hope for the best. The incumbent crew was most definitely leading us deeper into the morass; the new crew recognizes we are in a big hole…perhaps they will be smart and brave enough to stop digging. We subscribe to the injunction to make love, not war, but we still believe in being prepared for both.” Accordingly, while we do not believe it is likely we can avoid a crash, it does appear likely that the herculean efforts of the powers-that-be to paper over the cracks in the system are taking hold (for now) and that, combined with optimism that the new regime might work miracles is likely to buoy markets in the short-to-medium term. This we are still short retailers—because we don’t believe the American consumer has any spare cash or credit to spend—but have covered our financial sector and real estate sector shorts for now. Plus in congruence with our long-term belief in the prospects of China, we have filled a gap in the port with two Chinese-market acquisitions.

At the end of the month, we were -2%, the hedgies were +1%, and the NASDAQ was +3%. For 2008 overall, we were +14% while the hedgies lost 16% but still handily beat the NASDAQ, which was -41% (worst year ever!). Overall after two years since inception, the ISOP is now +149% compared with -7% for the hedgies and -35% for the NASDAQ. Please note we generally consider the purchase of individual stock equities to be speculation, rather than investment, because of the high risk associated with owning a particular stock…and we recommend that the ratio of funds under management be about 10:1 in favor of investment over speculation—which is why this speculative portfolio started with $10,000 while our Intelledgement Macro Strategy Investment Portfolio started with $100,000 back at the beginning of 2007. (Of course, speculative risk can be mitigated by owning large numbers of stocks; this is why we recommend investing in exchange-traded funds, which typically do just that.) While this order of volatility is not unusual for speculative positions, the ROI we have attained here is unrealistically high. Over 40% of our net profits after two years still derive from trading one stock and associated options—DNDN—in the first few months of 2007. So, we’ve been lucky and good so far…but it could just as easily go the other way in 2009-10.

While there was lots of macro news—mostly desperate (and ill-considered) attempts by the government to fend off immediate collapse, it was a quiet month for our stocks. Our gold miner Golden Star (GSS) was up big (+37%) mostly on a rebound in the price of gold and possibly also on an unusual lack of bad company-specific news. Vertex (VRTX) recovered nicely (+24%) from last month’s overblown concerns that the new Obama administration would be anti-biotech. Neurocrine Biosciences (NBIX), our other biotech stock, was up 3%. Of our four retailers, two were flat (Mastercard/MA and Walmart/WMT) while Cabelas (CAB) which we are long was down 7% and Best Buy (BBY) which we are short was up 36%. And despite the fact that the price of oil declined in December by 18%, our double inverse oil ETF (DUG)—instead of being up 36% as we might have expected—was down another 20%. Clearly something is wrong there. Finally, our Chinese newcomers were a mixed bag: Sohu.com (SOHU) was up 5%, but A-Power (APWR) was blown down 30% on revised guidance.

The risk of a serious downturn remains but appears to be less immediate, and consequently we reduced our short positions. Unfortunately, it still appears that the new administration is angling to establish continuity with the old one with respect to the policy of material intervention in the market to prop up insolvent “too-big-to-fail” enterprises. While we feel these policies are long-term disastrous, there is some “upside risk” should the collective wisdom of the market come to think otherwise. Generally, new political leaders get some benefit of the doubt. So we will be prepared for a “melt-up” as well. With systemic risk on the loose, the variation in plausible valuations for almost anything is very wide and consequently the risk of volatility—which reached record levels in 2008—remains high.

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Ultra inverse ETFs fall short of expectations

Posted by intelledgement on Mon, 05 Jan 09

Aide: We’ve analyzed their attack, Sir, and there is a danger. Should I have your ship standing by?
Grand Moff Tarkin: Evacuate? In our moment of triumph? I think you overestimate their chances.

Intelledgement’s strategy is macro-based, which means we analyze broad trends and make investments designed to align with them. Thus if we expect energy and China and Brazil to do better than average in the long run, we will seek to go long (buy) securities that are likely to reflect those successes. Conversely, if expect an economic reversal that will hurt real estate values and depress consumption, we will seek to go short (sell) securities that are likely to decline in price.

Generally, we do not recommend owning (or shorting) individual stocks for most of our clients, because it is easier to be right with a more broadly targeted mutual fund or exchange-traded fund (ETF)—which invest in numerous stocks—than trying to divine the fate of a single company (which could run into accounting problems and tank even if the industry they are in does well overall, for example). And very few of our clients are comfortable with margin accounts and short selling, which is inherently more risky than buying stock (as we have explained elsewhere). Therefore, the tactic we employ to invest money on the short side when the macros so dictate is buying so-called “inverse” ETFs, such as our current position in the the ProShares UItraShort S&P 500 ETF, which is designed to “correspond to twice (200%) the inverse (opposite) of the daily performance of the S&P500® Index,” using short sales, options, derivatives, and other relatively arcane maneuvers. This enables us to take a virtual short position without employing margin or undertaking the theoretically unlimited risk associated with an actual short position.

Now, while ETFs have been around for 20 years, it wasn’t until 1998 when State Street introduced “Sector SPDRs” that it became possible to employ a robust macro strategy using exchange-traded funds. And even then, it was not possible to bet against sectors or national indexes or commodities other than by selling the requisite ETF short. Until 2006, that is, when Proshares introduced their line of inverse ETFs, that go up when the targeted index goes down, and vice versa. So inverse ETFs, including “ultra” inverse funds—which aspire to double (or triple) inverse performance—don’t have a long performance track record.

Ultrashort ETFs—along with their ultralong cousins—have commonly been regarded as the Deathstars of exchange-traded fund investing. Afterall, it stands to reason, if you are absolutely convinced that the price of oil is going down, why be content with an mere inverse fund oil fund when you can buy an ultrashort fund that tracks 2x the inverse of any change in the price of oil?

One concern that commentators have pointed out is that the design of the funds—to reflect the inverse of fund performance on a daily basis—gives them an inherently bearish bias in a volatile environment, because mathematically, an x% move down always trumps an x% move up. That is, if you start at 100 and have a 10% up day followed by a 10% down day, you end up at 99; and by the same token if again starting at 100 you have a 10% down day followed by a 10% up day, again you end up at 99. A slow and steady move in either direction minimizes this effect, but it is likely to be augmented when volatility is high, as demonstrated by Eric Oberg in his thestreet.com article last month.

Of course, we don’t have a lot of performance data to analyze—as the inverse ETFs are so new—but let’s take a gander at the data we do have:

Security Symbol Inception Cost Value ROI Index Index ROI Rating
Cons Svs Ultrashort SCC 02-Feb-07 46.47 84.78 82% DJUSCY -39% +3
S&P500 Short SH 21-Jun-06 55.81 72.02 29% GSPC -28% +1
DOW30 Short DOG 21-Jun-06 57.69 68.55 19% DJI -21% -2
QQQ Short PSQ 21-Jun-06 60.43 73.03 21% IXIC -26% -5
Cons Goods Ultrashort SZK 02-Feb-07 52.92 74.01 40% DJUSNC -24% -8
Oil & Gas Short DDG 22-Jul-08 57.72 68.16 18% DJUSEN -35% -17
S&P500 Ultrashort SDS 13-Jul-06 57.28 70.94 24% GSPC -27% -31
DOW30 Ultrashort DXD 13-Jul-06 51.33 53.56 4% DJI -19% -34
QQQ Ultrashort QID 13-Jul-06 60.79 57.35 -6% IXIC -23% -52
Financials Short SEF 22-Jul-08 68.32 76.03 11% DJUSFN -66% -54
Financials Ultrashort SKF 01-Feb-07 66.74 103.01 54% DJUSFN -55% -57
Oil & Gas Ultrashort DUG 22-Jul-08 26.45 25.04 -5% DJUSEN -35% -75
R/E Ultrashort SRS 01-Feb-07 62.07 50.71 -18% DWRSF -60% -138

Security = the name of the exchange-traded fund (ETF)
Symbol = the symbol of the ETF
Inception = date the ETF started trading
Cost = closing price of the ETF on the first day it traded
Value = closing price of the ETF on 31 December 2008
ROI (Return on Investment) = on a percentage basis, the performance of this ETF from inception to 31 Dec 08
Index = the market index the ETF is tracking (inversely)
Index ROI = on a percentage basis, the performance of this index from inception of the associated ETF to 31 Dec 08
Rating = how well the ETF has performed relative to expectations (see notes below)

Notes: our rating is derived by comparing the ROI of the inverse ETF with the ROI of the index it is tracking and calculating how the ETF has performed relative to expectations. For example, if the underlying index declined 10% since the inception of the fund, we would expect an inverse fund to be +10%, and an ultra inverse fund—which, you will recall, strives to log 2x or 3x the inverse performance of the underlying index—to be either +20% or +30%. So, if the index has declined by 10% and an inverse ETF is up 10%, that yields a rating of 0 (zero), as it matches our expectations. For example, as of 31 December 2008, the Proshares S&P 500 Short fund (SH) was up 29% since inception while the S&P 500 index itself (GSPC) was down 28%…so that ETF has a rating of +1. In contrast, Proshares Real Estate Ultrashort fund (SRS) is down 18% since inception while the index it tracks is down 60%…we would expect SRS to be +120% and thus it has a rating of -138.

In general, the news is bad for the “ultrashort” 2x funds. Every single one of the eight ultrashort funds we analyzed are tracking an index that was down through 31 Dec 08…and therefore we would expect them all to be up twice as much as their respective index was down. This was true of only one: the Consumer Services Ultrashort ETF (SCC), which was up 82% while the Dow Jones US Consumer Services Index (DJUSCY) was down 39%. Four of the remaining seven ETFs were up, but only one of them was close to expectations: the Consumer Goods Ultrashort ETF (SZK), was up 40% while the underlying index was down 24%. The Financials Ultrashort ETF (SKF) was up 54%, but that was less than half what it should have done relative to its index, which was down 55%. And the S&P 500 Ultrashort ETF (SDS) was up 24%, less than half what it should have done relative to the GSPC, down 27%. The DOW 30 Ultrashort was up 4%…way lower than it should have been with the DJI down 19%.

From there, it gets really bad. The other three ultrashort funds were all down, even though with their respective index down, they should have been up sharply. We would have expected the QQQQ Ultrashort ETF (QID) to be up 46%…but it was down 6%. We would have expected the Oil & Gas Ultrashort ETF (DUG) to be up 70%…but it was down 5%. And the SRS was discussed above (should have been +120%, was -18%).

And it gets still worse! In every case where there are both an inverse ETF (targeting mirror image performance of the underlying index) and an ultra inverse ETF (targeting 2x inverse performance), the performance of the inverse ETF is relatively better than that of the ultra inverse ETF:

Index Short Fund Ultrashort Fund
S&P 500 +1 -31
DOW 30 -2 -19
QQQQ -5 -52
Oil & Gas -17 -75
Financials -54 -57

In absolute terms, the SKF ultrashort financials ETF still outperformed SEF, the inverse ETF (as you would expect when they both underperformed their expectations by about the same degree). But in the other four instances, the four inverse funds not only did relatively better, but beat their ultrashort cousins in absolute ROI. The DUG and QID ultrashort ETFs actually lost money, even though their respective indices each was in the red.

While this does not prove Oberg is correct in his analysis that volatility is doing in the ultrashort ETFs, it does constitute prima-facie evidence that his conclusion—the ultrashort ETFs are underperforming—is on target.

And accordingly, it is time to consider evacuating the Deathstar.

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BUY Activision Blizzard (ATVI)—games people play

Posted by intelledgement on Fri, 02 Jan 09

The merger of Activision and Vivendi (former corporate home of Blizzard and Sierra) last July has created a game publisher powerhouse. Between them, the Activision Blizzard (ATVI) combine have leading franchise-level products in the online, computer, and console markets including first-person shooter, sports action, role-playing, and strategy games. Among their leading products are Cabela’s line of hunting games (yes, they are allied with CAB, another ISOP pick), Call of Duty (first-person shooter), Guitar Hero (music role-playing), Spiderman, Starcraft (strategy), Tony Hawk (sports action), Transformers, X-Men Origins, and World of Warcraft (fantasy role-playing).

Revenues and operating profits and net profits had all been growing strongly leading into the merger. While growing, net profits were only around 10% of revenues due to significant R&D investments. (As with movies, game publishing requires significant up front development and marketing investments.) Of course, the merger means that it will be hard to derive much utility from quarter-over-quarter comparables for the next year or so. But a spate of significant releases in 2009—including significant additions to the Call of Duty and Guitar Hero franchises, the years-in-the-making Starcraft II release, and licensed product games Ice Age and Madagascar—should not only boost revenues but improve the ratio of net profits to revenues.

In their most recently reported quarter (3Q08), the company had revenues of $711 million, up on a y-o-y basis for the 19th consecutive quarter. They recorded a net loss of $108 million—breaking a string of profitable quarters—which loss was mostly attributable to one-time merger costs, which turned what would otherwise have been a seven cents/share profit into an eight cents/share loss. Their debt is negligible and they have $2.4 billion of cash on hand. And some of that cash is being used for an ongoing $1B share buyback program.

The $711 million of 3Q08 revenues was mostly from massively multiplayer online role-playing game (MMORPG) subscriptions (38%; most of this is World of Warcraft) and console game sales (38%; Guitar Hero and Call of Duty are the two leaders here). Handhelds game sales account for 11% of sales, and PC game sales—the only segment that is declining in absolute dollars year-over-year—account for 4%. Distribution of third-party interactive entertainment hardware and software products—mostly in Europe—accounts for 8% of revenues. Regionally, revenues were: Americas 41%, Europe 41%, Asia 9%, and distribution (which for some reason is not broken down regionally) 8%. $6 million of revenues generated from discontinued Blizzard operations accounts for the last 1% in both the regional and product breakdowns.

While we anticipate tough times ahead for the economy, traditionally the entertainment sector has done well under those conditions. Movies famously were very profitable during the Depression. And purely from a consumer value perspective, computer games are a superior entertainment value. An $8 ticket to a first-run movie buys you two hours of entertainment; $60 for Diablo gets you at least 30 hours—if all you do is play through the AI vs. player set scenarios that come with the game—but more likely hundreds of hours if you play other players over the web on Activision Blizzard’s free-to-Diablo-owners Battle.net servers. A W0W subscription is $15/month (less if you pay upfront for multiple months) and on average, players are online for about 22 hours a week, so that is a similar entertainment bargain. (And with the WoW subscriber base now in excess of 11.5 million, that’s a nice revenue stream for the company.)

Be that as it may, the market’s overall view of ATVI is not very rosy just now. During 2008, it fell from a split adjusted $14.85 to $8.64,  a decline of 42%. The NASDAQ was down 41% in that same timeframe, but we believe that ATVI should be significantly outperforming the market, and is relatively undervalued here.

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