Be all that as it may, did anybody follow my live paper trade today on Twitter? The point was to demonstrate the use of scaling to slowly build a position at a favorable price. It did work to some degree and I think I was able to get the point across, but of course I’d have preferred a nice reversal at the end to end in the black.

Besides that, the put spread hedge that I recommended in early May is now turning out to be helpful after all. I’m also happy that my favoured utilities held up very well today and made it through the selloff almost unchanged.

Other than that, I don’t think anything noteworthy happened today. See ya ladies tomorrow. Let’s see if I can make it through the night here with all these constant storms..

As I was browsing through some elitetrader posts, I noticed how some “traders” keep asking whether scaling in and out of positions is an inferior strategy.

I assume strongly that these people are not consistently profitable in their trading. To become a real trader, one that actually makes money regularly, I believe you have to have had a moment similar to Neo’s awakening at the end of “The Matrix”, the moment when he finally saw the illusion around him for what it was.

To become consistently profitable you have to fully internalize that your trading results are magically linked to your trading personality. The motto clearly is “Know thyself”. Know what position size you are comfortable with. And what time frame you want to trade (intraday, days, weeks, years). And what strategies and products you want to specialize in (stocks, futures, options, etc.)

Learning all of this takes a long time. But if you do not fully understand your own personality, you risk losing everything you ever made once the markets change and turn against you.  And they always, always will.

What does this mean for scaling? It means that you should not bother with trying to figure out what is mathematically or theoretically superior or inferior. It all depends on what works for you. If you feel better taking small profits along the way, then do it. To me it is impossible to answer whether this is mathematically inferior or not. Answering that would require perfect foresight, and if  you had that for even one day alone you could turn yourself into a millionaire overnight.

Just know that as soon as you start getting nervous about a position or your trading style, do something: scale back your size, or hedge it at least partially. The trick is to always stay in the zone.

Know thyself.

Interestingly, the Citi trust preferreds that do not need to be converted, such as the C-PZ, are currently trading lower than the impaired preferreds (such as the C-PP). My trade recommendation is to switch into the trust preferreds for a pickup in yield and to retain the full upside potential in case Citi survives.

Currently some Republican senators such as Richard Shelby are on the tape again, suggesting closing down big, “dead” banks. Reading about these moronic, short sighted statements made me realize something important: there aren’t just Zombie banks in the world, there are also Zombie senators! They just keep aimlessly walking around from, talk show to talk show, but instead of muttering “Brains, Brains”, their mantra is “Nationalization, Nationalization”. They are completely oblivious to simple market relationships and market interdependencies. Why are people like that even in the position to comment on what needs to be done? Shouldn’t that be reserved for financial professionals?

Good thing is, they are largely irrelevant in today’s political world. Unfortuantely, though, they keep on moving and talking. Just like Zombies.

By now you’ve probably read in multiple places that Ultra ETFs are only a trader’s best friend, but shouldn’t be used for actual investing.

Now, it is also no secret that these products aren’t broken. They actually more or less do what they’re designed to. Their goal is to lever your daily, not your long term returns.

Let us look at a small example: An unlevered ETF starts out at 100 and then alternately loses and subsequently gains 5 % day after day. Over time this will result in you losing money in the underlying ETF: after 200 days you’d be left with $ 77.85.

Now let us look at how the two Ultra ETFs would have fared. The Ultra Bear, who is supposed to gain when the underlying ETF loses, would have actually lost way more and would end up at $ 36.60. How sad is that? You had the correct view and yet you lost your shirt. Interestingly, the Ultra Bull would also be around $ 36.60. So you’d have lost money on both funds, even though they did exactly what they were designed for.

So does this really mean that these two funds are only a trader’s best friend? Actually, no, they can still be used as a hedge for a regular long-term portfolio, provided that you do simple dynamic hedging. This means that at the end of the day you would have to take some profits if your Ultra ETF went up or buy additional units if it went down.

The mathematics of how much you’d have to buy or sell depend on your market outlook and your goal for the hedge and this is beyond the scope of this short post. I just wanted to point out something that I haven’t seen come up in any of the countless “Ultra ETFs are poison” posts all over the web.

ETFs should always be the preferred choice for the serene investor when investing in any market, because of their tradeability, transparency, non-leverage, tax efficiency (for the most part) and usually low management fee.

High-yield munis have both lower default rates and lower correlation to equities than junk bonds. Additionally, they’re tax free. And to top it off, currently they’re trading at record spreads. So the question is: is this the beginning of something beautiful? I can’t claim to be an expert in this field, but I find the new offering intriguing.

The expense ratio currently is “only” 0.3 %. Mutual and closed-end funds typically charge well over 1 %. Geographically it seems appropriately diversified, but it does have a relatively high concentration in California and Florida (25 % to both States together).

What also disappoints me is the relatively high concentration in individual bonds. The top five bonds constitute 20 % of the portfolio; I’d have preferred a larger amount of bonds and lower individual weights. Additionally, the fund has a duration of 8, which is relatively long, so there is interest rate risk to take into account. On the positive side, the average yield-to-worst at the moment is 10 %, which is quite attractive, especially for municipal bonds (and keep in mind, this yield is exempt from federal taxes).

Without going too deep into it, I like this new offering a lot and will keep it on my radar. Read the investment brochure here.

Remember Healthshares, the family of ETF’s focusing on 15 more or less narrow medical research areas?

Claymore today introduced a new ETF that just like Healthshares should find no home in any serene investor’s portfolio. FAA, the first index fund for a global index of Airlines, really doesn’t fill any hole that needs to be filled, except for the pie hole of whoever sold this idea to Claymore.

The airline sector sucks in every aspect imaginable. With exception of Southwest it seems like pretty much every airline in the U.S. is constantly in and out of bankruptcy protection. The average long-term performance of the sector is abysmal. They are susceptible to any kind of economic bad news, oil price shock, terrorist attack, plan crash, biological scare, you name it. They have huge fixed costs that pretty much put the final nails in their coffins during recessions.

If you want a good laugh, look at the factsheet of this thing:

* Huge historical underperformance? Check (-6 % per year over the last 7 years).

* Twice as much risk as the MSCI World Index? Check (Standard Deviation: 35.28 % for airlines vs. 15.53 % for MSCI)

* Negative correlation to oil? Check. (So if oil goes up, airlines tend to go down. Great hedge for oil price shocks – NOT)

So why in the world would you want to own this thing? Maybe if you love planes. Certainly not if you love money.

Two indicators can derail the positive mood however: the Case-Shiller home price index coming out at 8 ET and the Consumer Confidence / Richmond Fed Manufacturing Index one hour later. Bad numbers are priced in, but if they come in way worse than expected they may derail an advancement for a while.

Interesting will be to see the market’s ability to absorb $ 245 billion of commercial paper that companies sold to the Federal Reserve which needs to be rolled this week.

Anybody interested in buying financials at this level might consider using any of the three preferred stock ETFs instead: PFF, PGF, or PGX. All three have a heavy concentration in financials. PGF is actually a pure play on that sector with 100 % exposure. The other two are slightly more diversified, but really only slightly.

At this point in the game it’s fairly obvious that the government is willing to do anything it can to avoid another bank collapse. This may mean a gradual dilution of common shares for the weakest players. However, after the fiasco of wiping out the preferred stockholders of Fannie and Freddie I’m reasonably certain that the government will try to avoid doing that same mistake again.

If anybody ever wonders why successful investing is hard, then here is his answer. It requires you to look beyond the prevailing current doom & gloom. This means you need to have courage. Courage and faith.

During good times most people will agree with you and say “Amen” when you tell them that to be successful you need to be buy when there is blood on the Street. Alas, when there actually *is* blood on the street the same people will be out of their mind with fear and frantically pull their money out. “Preservation of principal” will be their new mantra. If you then dare to suggest that maybe now was a better time to buy than to sell, they’ll look at you like you’re crazy. Next thing you’ll hear are the most dangerous words in investing: “This time it is different”.

“The age of capitalism is over”, they’ll say.

“The US consumer is completely tapped out”, they’ll say.

And one of my favorites: “The US will be a third world economy soon.”

You know, every now and then, very few and far between though, the world does change and things *are* different indeed. For example, in the 50s, when the average stock dividend yield fell below the yield on bonds, people suggested to pull the money out of stocks, fearing that stocks were overpriced based on a valuation metric that had worked for a certain while. Needless to say, they would have been out of stocks since then and would have missed a very nice return on investment (plus they would have gotten killed in the 70s in bonds).

But can anyone tell me the when the last time was that people were this negative all over the place and there were actually right over the LONG run? Please do not point out the fact that in the Great Depression stocks fell 90 %, and based on that the bottom today may still be nowhere in sight. What these people usually don’t mention is the incredible bull run from the early 20s to 1929, when stocks on average went up 300-400 % in just a few short years. When they started falling they did fall hard, but they bottomed out around a 12 year low.

A 12 year low, huh? What a coincidence. That’s pretty much where we’re at today.

Do you think the world was looking pretty at that low? Do you think people generally agreed that the worst was over and better times would be just around the corner? No way. The night is always darkest just before the dawn and the economic situation always looks worst at the turning point.

Had you bought during the Great Depression after stocks had fallen 50 %, you’d have had to wait around 5-6 years with dividends to recoup your investment, despite stocks having fallen much further right after your initial purchase. Not terribly exciting, but certainly a far cry from the “25 years” that people always talk about when they discuss how long it took to recover your money had you bought at the top of 1929 right before the world went to hell.

What if this time isn’t different? What if things will bottom out this year and get better? How much return do you think you’d have made had you bought anywhere close to the bottom of the Great Depression?

But I can say something in general about stocks that are (or should I say were) spared the worst of a general bear market. There are always stocks that hold up much better than their competitors due to perceived differences in management or product quality or whatnot. In this bear, two in particular had caught my eye: Aflac and Wells Fargo.

Over the past few months I’ve looked at the insurance sector more than once. One company always stood out: Aflac. While all their competition was getting crushed and was generally selling at less than Book Value, Aflac was still trading at 2-4 times of that. Same goes for Wells Fargo in the banking sector. For whatever reason they were still trading at two times Book Value until very recently, even though pretty much every competitor was already well below that, even the better ones such as JP Morgan.

It doesn’t really matter why the market perceived these two companies to be superior. While Aflac may really be better than the everyone else (I just don’t know), it’s completely beyond me why Wells Fargo held up as well as it did, especially after acquiring Wachovia last year.

Usually what happens, especially towards the end of a bear market, is that all the “survivors” will also be beat up. Mostly it’s some analyst who wants to make a name for himself and homes in on whoever is not on the ropes yet. At this point in the business cycle emotions are so fragile that people don’t even care questioning what they read anymore, they just sell. And even more so when it comes to the one or two holdings in their portfolios that have held up well so far. “Of course”, they’ll say, “I should have known. Nobody will be spared. I was foolish for thinking this one was different. Quick, let’s get out”.

Lesson: if you happen to own a company that is valued much higher than their competition, seriously consider about buying protection, such as put options. It doesn’t matter how long they’ve survived without being impaired. Markets are not efficient in the short run, especially not when emotions run wild. It only takes a few days and the company is cut in half or more, and you quickly lose all your outperformance. If you don’t like buying expensive protection, consider swapping out your stock for a sector index ETF.