A second camp holds that if the first five trading days of a given year are positive, the remainder of that year will be positive as well. For these investors, the entire year is riding on tomorrow. 

                It may seem absurd to base a full year on five days, but of the last 36 times the first five days of the year were positive, full year gains occurred 31 times-an 86% accuracy ratio. As of Wednesday's close, the Dow Jones Industrial Average (Dow) was 7 points lower for the year.  All we need is a positive close Thursday and 2009 could be a good year for investors.

                If Thursday's results indicate that we will finish 2009 profitably, is now the time to buy? Probably not.

Even though countless amounts of time, effort, and money are used to explain daily market movements and what they mean for investors, most price changes offer little predictive value. However, key inflection points occasionally have a profound impact. We are on the cusp of such an event.

                Since bottoming in late November, markets have rebounded sharply. Is this a bear market rally, or the start of a new bull market? Answer this question successfully and great gains will come your way.  Knowing that more money is lost on false bear market rallies than the initial price decline, we must be cautious and resist the temptation to chase each rally. However, if you miss too much of an initial move, your performance will suffer. 

                Looking at the long decline of this market, stock prices have turned lower as they reached a persistent downtrend. The S&P 500 and NASDAQ are now approaching this resistance level. Will the rally stall as it has before, or finally break higher? A close above 965 on the S&P 500 and 1,700 on the NASDAQ would be extremely bullish events that indicate the primary trend is turning bullish. With current prices only 6% from these levels, our answer should be delivered soon.

                The most prudent investment stance is to watch these price points closely before allocating capital. If the market closes above those prices on decisive volume, it would be an indication that the lows are in place and now is the time to buy stocks. Failure to overtake resistance will increase the chance that the lows will be retested. 

                Mostly likely, this rally will fail and new lows await us in the future. Looking at a series of sentiment indicators, the market is overbought. When stocks bottomed in November, my timing model was 100% short-an extreme oversold condition. (My model is neutral when it is between 40 and 60% long. Any reading above 80% in either direction is considered overbought/oversold.) Now it is 70% long. In November, my research universe showed over 60 stocks trading below fair value. Now fewer than 20 stocks are below fair value, and most of them are cheap for a reason. Despite traders openly speaking about the need for prudence, the most speculative stocks have rallied the most in 2009. This trend indicates the desire to take risk. More people are investing out of fear they will miss a market rally, rather than showing concern over protecting their capital. 

             An overbought, speculative market approaching a long-standing downtrend is the perfect recipe for a failed rally. Therefore, it offers aggressive traders an opportunity to get short of this market. By using a 3% move higher as your stop loss, you can reduce the pain of prices moving against you. However, if this rally falters as I expect, great gains will come your way.

Certain investors believe that if you were willing to buy the stock at a higher level, why not buy more now.  Others feel that all investments should be closed after an adverse move and that you should never add to a losing trade.  Where do I fall in this argument?  Somewhere in the middle.

                If you believe in the quality and value of your research, averaging down into a losing trade makes perfect sense.  However, the dangers are obvious.  Some of the legendary investment failures ­-Long Term Capital, Nick Leeson - involved averaging down into losing trades.  Closer to home, anyone who blindly averaged down into Fannie Mae, Lehman Brothers or AIG has seen bad trades turn worse.  With such large risks in averaging down, how do we decide when to cut losses and when to push our luck?

                When a position moves against you, ask yourself three questions to determine your next action:

1. How much faith do I have in the initial analysis?  If you believe the thesis is correct and the market has missed some key factors, stick with the trade.
2. Am I being flexible enough?  Even if you believe you are right, you must process all new data objectively.  If you made a mistake in the initial assessment, it is time to move on.
3. Can I live with a quantified downside? Average down into the trade only if you can survive a worst-case scenario.

               An example of how I have implemented this process in my own investing is my purchase of the Ultrashort Lehman 20+ Treasury Proshares (TBT).  As outlined in my weekly newsletter EPIC Insights, I believe the rush into Treasury bonds has created the next bubble that will burst.  With that thesis in mind, I bought a position in TBT at $43.81.  Two weeks later I had an unrealized loss of 18%, dollar cost averaged into the shares and lowered my cost basis to $40.19.  With the shares trading at $42, I now have a 5% profit as opposed to a slight loss.

              In order to justify the trade, I examined my initial thesis.  I determined that I had honestly processed all relevant information and that may thesis was sound. A Barron's cover story this weekend, "Are Treasury Bonds Safe", echoes my analysis.  When you consider this story occurred nearly a month after I highlighted the trade, subscribers were ahead of the market on this trde.  Most importantly, I was able to quantify a possible 9% downside versus a 50%+ upside potential.  With such an attractive risk/reward scenario, averaging down was prudent.  By staying disciplined and objective, I was able to use a market selloff to turn a losing trade into a winning investment.

Related Stocks:  TBT

     A recent example of the S&P effect is Transocean (RIG).  RIG is the largest offshore driller of oil and natural gas in the world.  With a high level of demand, RIG has excellent earnings visibility and a strong backlog of future business.  Typically, the market would pay a premium for high visibility. Last May, the shares were trading above $161 and the premium was evident.  At the current price level of $52, that premium is gone and the shares are now being offered to opportunistic investors.

     Three main problems have combined to knock the share price lower.  The first two are transient.  With the expectation of higher corporate income-tax rates under the Obama administration, RIG decided to redomesticate to Switzerland.  Doing so made them ineligible to remain in the S&P 500.  Forced selling by index funds caused the shares to drop swiftly.

     The second issue concerns the large decline in oil prices.  Since RIG is hired to extract oil from harsh locations, many felt their profitability and backlog would suffer.  I view this outcome as unlikely.  Most of the projects RIG operates are long term in nature and require substantial capital investment.  I find it improbable that an energy producer would curtail an existing project for which it has already allocated capital.  A sustained period of very low energy prices could hurt the shares.  However, that issue is three to five years down the road and should not drastically affect today's stock price.  After all, with a current P/E of 3 and a market capitalization that is 40% of their current backlog, management could use the earnings and cash flow to finance an LBO.

     The third issue is RIG's high debt level.  Long-term debt represents over 45% of its total capitalization.  In an environment where banks are unwilling to lend, a high debt level can be devastating.  However, 80% of RIG's debt is due in 2010 and beyond, and the company has stated its intention to use free cash flow to reduce its debt levels to a more manageable level.  While acknowledging the risk of buying a company with a potentially troubling financing issue, I believe RIG's current valuation offers a reasonable margin of safety.

     Subscribers to my weekly newsletter EPIC Insights, were alerted to the positive fundamentals of RIG and bought these shares Monday morning at a price of $52.39.  On a day where the Dow Jones Industrial Average dropped .9%, subscribers have an unrealized profit on RIG of ­3.8%.  While the one-day performance is attractive, I maintain a fair value estimate of $75.  With RIG currently 27% below my price target, I like the risk/reward framework and recommend a long position as this week's fundamental trade.

Related Stocks:  RIG

     A gap occurs when a stock price opens at a level that is much different from the prior day's close.  For example, if shares closed the prior day at $15 and opened today at $20, we would view this is a $5 gap higher.  Once a gap occurs, the prior day's close ($15 in this example) becomes a key level of technical support.  When prices gap higher, the gap becomes support; when prices gap lower, the gap becomes resistance.  Until this new support or resistance level is violated, the underlying trend remains intact and allows us to trade accordingly.

     Examining a chart of Dryships, multiple technical patterns emerge.  As the worldwide recession spread and deepened, shipping rates collapsed - DRYS's price quickly followed.  From a high point of $110.74 in mid-May, the stock traded to a low of $3.54 in late November. This stunning 97% drop over six months created a clear downtrend that was rarely tested.  During this long decent, we saw three gaps lower - from $55 to $50 (9%) in mid-September, from $31.50 to $28 (11%) in early October and from $18 to $15 (17%) in late October.  Each time the stock gapped lower, the gap served as resistance to future rallies. 

     Since bottoming on November 21, we have seen three gaps higher-from $9.50 to $11 (16%) on December 10, from $12.50 to $13.50 (8%) on December 18 and from $10.50 to $11.65 (11%) on January 2.  These levels now serve as support that should allow the stock to trade higher.  Importantly, the last gap higher has broken the long standing downtrend and has allowed DRYS to close at its highest level since bottoming in November.  Combining all the technical signals, we see a reversal in the share price that will allow for a sustained move higher.

     As detailed in my weekly newsletter EPIC Insights, I recommend DRYS as this week's technical trade.  Having experienced a dramatic price decline, DRYS is poised to bounce toward $18 where it will meet its first level of resistance.  I do not expect these shares to ever regain prior all-time highs and many factors make me hesitant to own this position for a long period of time.  However, the technical backdrop and prudent use of stop loss orders make DRYS ideal to rent with the expectation of a quick gain.  Keep your position size modest and use a close below $10.50 as a stop loss.  As we approach resistance at $18, look to harvest gains. 

     I believe quick, opportunistic traders will do well in 2009 and selling into resistance levels is an excellent way to prevent surrendering hard-fought gains.

Related Stocks:  DRYS

                Reviewing my market calls for 2008, I consistently predicted key turning points.  In my weekly market commentary, I started 2008 looking for a 10-15% drop in stock prices.  By mid-February, the Dow Jones Industrial Average (Dow) had dropped 8% and I increased my market exposure from 30% long to 80% long.  By late April, I was warning that the markets were mispricing risk, putting too much faith in the Federal Reserve (Fed) and walking on shaky ground.  However, I also felt markets would move higher in a set trading range.  From my bullish call in early February until mid-May, the Dow rallied over 8%, making my decision to get long very profitable.  On May 20^th, I warned that if the Dow closed below 12,800 it should be seen as a sign to exit the market.  The following day, the Dow closed at 12,601 and would not see 12,800 for the remainder of the year.  During the summer, I warned of the problems with our economy, predicted sub-par growth for years to come and encouraged investors to eliminate index funds.  While correctly calling an oversold rally in July, I also indicated it was a trading event and encouraged everyone to manage risk and be careful.  By mid-October, the Dow was near 8,500.  I indicated that a rally was probable and provided an opportunity to trade long.  Over the next 14 days the Dow rallied 13%.  Since that point, I have continued to emphasize that the stock market will be in a broad trading range for many years and only astute, active traders stand a chance of generating significant returns in the years ahead. 

                For 2009, I plan to follow a similar forecasting pattern.  I will indentify five key trends to watch for and five events that could prove my predictions incorrect.  On a weekly basis, I will share my investment insights and offer timely comments on the markets' direction.  I hope you will find value in the information I share and will use it to produce significant returns.  

                The five key developments for financial markets in 2009 are as follows:

1. Stock markets will plunge to new lows - I develop forecasts to predict fair value of the S&P 500.  The fair value estimate serves as a price point at which I am being fairly compensated for assuming market risk.  I start 2009 with a fair value target on the S&P 500 of 625.  This equates to approximately 6,000 for the Dow and 1,050 for the NASDAQ.
2. Unemployment exceeds 10% - We are living through a powerful transition in our economy as consumers and business deleverage and begin living within their means.  This painful period will result in over 4 million people losing their jobs and unemployment reaching levels last seen in the early 1980s.
3. The mass retail culture dies - Within five miles of my house, I can buy a television at nearly fifteen different stores.  By the end of 2009, I will buy that television at less than five stores.  As unemployment rises, consumer spending will drop and mass retail outlets will diminish.
4. Treasuries are the next bubble to burst - The Fed has indicated they will do whatever is needed to reflate the economy.  Eventually the printing presses will run so hard that investors shun the low yields of Treasuries and inflation returns.
5. Trending markets allow active traders to outperform - As markets skid to new lows, trading opportunities exist.  A second half rebound based on positive growth in 2010 offers potential for gains.  Those who position within these trends will do well.  Those who buy and hold will not.

To summarize, a poor first half driven by a crumbling economy will finally create a permanent bottom that allows for strong gains in the second half of the year.  Opportunistic traders will do well as they position for strong market trends.  While I am confident these predictions will prove accurate, the following events would derail my forecast and point to positive market returns:

1. Biggest January Effect ever - Going into year end, investors have massive amounts of idle cash and no incentive to buy.  Why show your investors that you own stocks that are down 60-80% this year?  Instead wait until January and then buy the stocks you find cheap.  If this were to occur, we will see a massive rally in the first 3 weeks of the year that could easily drive the market 10-20% higher.
2. Obama outperforms - Most Americans have hope that a new administration will cure our economic ills.  Obama will be given leeway to implement his ideas.  If he executes well, the economy will rebound.
3. Fed removes the punchbowl - After successfully reflating the economy and recapitalizing the banks, the Fed efficiently removes excess cash from the financial system.  Doing so allows inflation to remain low, bonds prices to remain stable and equities to outperform.
4. Mean reversion - Historic data shows stocks outperform other asset classes over long periods.  With the S&P 500 trading at 1997 levels, we are looking at 12 years of stock underperformance.  If the historic relationship holds we should see stocks rally over the coming years.
5. World economy heals - If the stars align, policymakers will avert disaster, unclog credit markets and growth resumes.  In this scenario, all asset classes except US Treasuries would perform very well.

Looking at these lists, we have expected actions and events that could disprove my thesis.  Fortunately, many of my positive surprises, if they were to occur, would happen early in the year.  This will allow us to quickly decide if my bearish view shall hold or if 2009 will be a pleasant surprise.  As always, I will be watching the markets and provide weekly updates as facts change.  Happy New Year!

                Inverse ETFs are designed to offer the opposite return on defined index.  If the underlying index declines 1%, the inverse ETF will rise 1%.  In a bear market, these ETFs offer an attractive alternative to shorting stocks.  Further, tax advantages exist for owning an inverse ETF versus being short of a stock.

                Over the months, I have often recommended inverse ETFs in EPIC Insights, my weekly newsletter.  Particularly, I like to use double inverse ETFs (doubles).  These instruments will return twice the return of the underlying index which means a 1% drop in the index offers a 2% positive return.

                The strategy of using inverse funds to express a view seems simple, but there is one key caveat to remember.  The inverse ETFs are designed to return the inverse performance of the underlying index on a daily basis.  At first look, this appears to be insignificant.   After all, any long term period is comprised of a series of shorter periods so why wouldn't the series of daily moves equal the long term movement? 

                To illustrate the danger of relying on a series of daily moves to express a long term view, I ran three scenarios.  All three time series will lose 10% over a 20 day period, but the return patterns differ.  Scenario 1 shows a straight trend where all 20 days are equally negative.  Series 2 shows minimal volatility where every price movement is within a range of -2% to +2%.  Series 3 shows large volatility where all positive moves are greater than 5% and all negative moves are worse than -5%.  The surprising results were as follows:

                Knowing the underlying index has declined 10%, I would expect the double to return nearly 20%.  This occurred in the straight trend and minimal volatility scenarios.   However, large volatility not only failed to deliver the 20% desired return, it resulted in a large loss that exceeds the loss of the underlying index.  How can a double lose more than the index off which it is based?  By delivering daily moves in a highly volatile environment, massive price swings reversed the double's intent and created an unexpected loss.

                Armed with this information, should we dismiss inverse ETFs as another member of the alphabet soup disaster and toss them aside with CDOs and SIVs?  As mentioned earlier, I continue to use doubles and believe they have an important role for individual's portfolios.  However, you cannot predict a market move, buy the doubles and expect gains.  Instead, investors must also consider how volatile price movements will be.  In a scenario where volatility is low, inverse ETFs are powerful tools for long term investors.  When volatility is high, the ETFs should be used as trading vehicles that allow you to express a short term view.  By considering the direction and path of price movements, investors can optimize their performance and prevent the unpleasant surprise that accompanies an investment failing to fulfill your expectations.  Next time you decide to purchase SKF or QID to express views ask yourself if this is a trade or an investment.  The designation may seem subtle, but the difference in return will be immense.

Related Stocks:  QID, SKF

One example featured in EPIC Insights, my weekly investment newsletter, would be the method I use to value energy stocks.  Having seen large increases in the price of oil and gas, integrated oil companies trade at low P/E multiples with high return on equity (ROE) and sizable dividend yields.  If you used a P/E or dividend discount model, the price targets would be so high that an investor would think they should put all of their money into this industry.  The lack of diversification and recent stock performance highlights the negatives of this action.

Since traditional metrics are not useful, how does one trade this sector?  An alternative metric I have used is to examine the reserves each company reports, the current price of energy and then determine a fair value estimate. 

With any alternative method, we must ask if the process intuitively makes sense and why it would be a valid measure.  After all, investors valuing internet companies based on eyeballs during the dot-com bubble soon realized that alternative measures are full of risks.  With energy companies, their business is to drill, refine and sell energy.  Their reserves offer a view of future production and future earnings. 

In addition, a leveraged buyout (LBO) view helps as well.  The futures markets are deep and liquid.  If an energy company is sitting on reserves, their management should be capable of determining when the oil and gas will come out of the ground and be ready to refine.  If you know when the energy can be delivered, you are capable of using the futures market to sell your production at prevailing prices at various dates in the future.  The cash received from the futures market could then be used to take a company private.  After all, if the stock market values your energy reserves at a discount to the future market’s view of energy prices, sell your energy at the higher price, buy back your stock in a leveraged buyout, drill the needed oil to satisfy your delivery obligation and retain the excess profit.

I have been using this metric with conservative assumptions for many years to determine if I thought energy companies where inexpensive or not.  Over the years, this has served me well as I consistently purchased the shares at a 50-70% discount to fair value.  Looking at the market now, something has changed.

Currently, the cost of Conoco Phillips (COP) is equal to my reserve value estimate.  Given that shares purchased in January fetched an 18% discount and shares purchased in 2007 offered a 53% discount, why has the market’s perception changed?  I can think of three reasons.  The first would be the market is bullish on energy prices and COP is priced in anticipation of an increase in oil and gas prices.  For many reasons, I view a sustained rise in energy prices as unlikely and dismiss this explanation.  The second reason is that the market has realized valuing energy companies based on reserve value is proper and the current price is correct.  While possible, markets rarely change so quickly so I find this explanation to be unlikely.  The third, most plausible explanation, is that the stock prices have not reacted to the drop in commodity prices and the stock prices are about to decline.

With the belief that the price of energy stocks will drop, shoring the large oil companies (i.e. – COP, XOM) is an excellent trade.  To hedge the possibility of an increase in oil prices, consider a long position in the US Oil Fund (USO).  By shorting XOM and COP while being long of oil, you profit from a return to the normal relationship between commodity prices and stock prices regardless of the direction of the underlying commodity.

Related Stocks:  COP, USO, XOM

                The above quote is both vague and precise.  We live in a world where information flows in rapid fashion and we are forced to retain important information and filter out the noise.  By focusing on what we know and what we do not know, mountains of information can be consolidated to smaller amounts that allow investors to make informed, intelligent decisions.

                However, Donald Rumsfeld highlighted a key third area that causes enormous problems.  The unknown unknowns - things we don't know we don't know - lead to devastation.  A recent example is the Bernard Madoff scandal.  Madoff was a well respected leader in the financial community who operated a $50 billion scheme to defraud investors.  His scheme lasted for years, was massive in size and has fractured trust in the financial system.  Many of his investors were sophisticated institutions who should have detected the potential fraud.  Instead, they were duped, defrauded and will be reluctant to trust future advisors.

                While the Madoff scandal will have long lasting repercussions in many areas (i.e. - we will most likely see more aggressive regulatory responses) the most damaging legacy will be the shattering of trust.  Looking at our economy, we have evolved into a highly productive service oriented economy.  This has led to increased wealth and improved living standards.  As we have moved in this direction, the economy relies less on tangible goods and more on trust.  Think of the insurance industry.  Insurance companies create many jobs and provide a safety net for consumers.  If your house burns down, the insurance company will rebuild it.  If we die, the insurance company provides life insurance that allows our families to survive.  For this benefit, we pay an annual premium knowing that if catastrophe strikes the insurance company will honor their commit.  We trust that by giving them money now they will help us in the future.

                The same dynamic exists among banks, brokerage companies and retailers.  We trust Fidelity and Citigroup will return our money when we withdraw it.  We trust Best Buy will replace our damaged television.  Without trust, our economy cannot function as we question the intention and existence of every company with which we do business. 

                For now, the markets have processed the Madoff scandal and believe they have discounted the worse.  While I hope this is true, I am less certain.  With so many unknown unknowns, it is never safe to assume the worst is behind us.  The current bear market has led to enormous wealth destruction, but it also has left one key lesson.  In a fast moving digital age, there are many things that continue surprising us.  Within these surprises we see large market movements and violent price swings. 

The Madoff news broke Friday and we are now 3 days into the market's reaction.  Personally, I do not view that as an adequate timeframe to determine the news has been processed and forgotten.  Instead, I fear this is the tip of the iceberg that will cause investors to question the basis of our economy and the blind reliance of acting on trust.  As we work through these issues, the government will increase regulation and productivity will decline.  The end result is subpar performance from markets and declines in our quality of life.  For the next decade I expect opportunistic investors to outperform a buy and hold strategy.  Only the nimble will prosper as our economy tries to discover more of the unknown unknowns.

With the market bouncing off November panic lows, many stocks are showing strong upward moves within an existing downtrend.  As stocks consolidate and move toward the existing trend line, we must consider if a trend is reversing and bullish action will follow.  This leads to my newsletter's (http://www.stocktradingtogo.com/2008/12/14/epic-insights-weekly-issue-7/) technical trade for the week - Amazon.com (AZMZN).

Since August, AMZN has been in a clear, well defined downtrend.  As the price declined, failed rallies in September, October and November created a series of lower highs.  This constitutes purely bearish activity and pointed to lower prices.  As the stock swooned to a bottom in late November, the price was nearly $20 below its trend line. 

Recently the price has reversed, and traded toward the long stand downtrend.  The rally from the November low has created a sharp uptrend punctuated by a series of higher lows.  As lower highs are bearish, higher lows are bullish.  The convergence of the uptrend and downtrend has created a symmetrical triangle.  The beauty of a triangle is that it must provide a conclusive decision.  Once we reach the tip, a break lower means the downtrend will resume while a break higher means the uptrend will continue.  Last week we saw a decisive move higher at the tip of the triangle which indicates the uptrend shall continue.  Even with Monday's price drop, the pattern holds and points to higher prices.

Knowing we are bullish on the stock, we turn to upside price targets.  Typically, a bullish move out of a symmetrical triangle should recover 50% of the prior move.  The downtrend started at $90 and the uptrend began at $35.  50% of the move is $27.50 and results in an upside price target of $62.50.   A rally to this level would run into resistance dating to July and is a reasonable price target for this trade.

Related Stocks:  AMZN

                The Santa Claus Rally is a term often discussed on Wall Street.  It refers to the ability for stocks to rally during December and provide quick gains for the opportunistic trader.  While many different theories abound about why the rally occurs, investors banking on this trend have been satisfied lately.  Looking at the last 10 years, the track record is promising.  December has been positive 7 times for an average gain of 4.3%.  Those prepared for the Holiday Cheer have done very well.  This year I believe the trend continues.

                When investing, we attempt to process mountains of data each day.  Whether it is a general report on the state of the economy or specific information about one company, markets collect data, interpret the value and then adjust stock prices.  In most cases, negative news will take prices lower and positive news will take prices higher.  Over the past 3 months, we have been bombarded with negative information and stock prices have crashed.  However, that trend is now changing.

                The Dow registered a panic low on November 20^th.  From that day, the index has rallied 16%.  While we could dismiss this as an oversold rally, an interesting undercurrent has developed.  Since the low in November, the news on the economy has worsened.  Each day is accompanied by news of bankruptcies, layoffs and policy maker searching for an answer.  Despite this negative backdrop, prices move higher,

                When we see positive reaction to negative news, attention is warranted.  For much of the past 3 months, technical trading patterns have dominated market fundamentals.  Now is no different.  As we rally on each piece of incrementally bad news, a technical rally is forming and gaining strength.  I believe the economic backdrop will worsen over the coming months, but the markets do not care.  For the moment they are determined to press higher,

                Within a strong technical market, we must consider how far prices can move and where this rally will stall.  I see the current rally sustaining and pushing the Dow to 9,600 over the next 6 weeks.  Given an anticipated 8% move, we must remain long and profit from what the market provides.  However, caution is warranted.  More money is lost when people become aggressive during bear market rallies with the hope that the worst has passed and a new bull market is resuming.  As we find ourselves in such a situation, the key strategy is to reduce risk and position for lower prices.  We have witnessed a 25 year bull market and economic expansion that was built off high debt levels and inflated asset prices.  While it would be nice to see the bear market correction finished in a little over 1 year, such hopes are naïve.  For years to come, we will find ourselves in a range bound trading market where those who buy and sell wisely shall prosper.  Take advantage of this rally to realize gains, but prepare for rough sailing in the coming months,

Over the last three months, very little has worked.  Short sellers have clearly profited, but as stock prices have collapsed staying short has become too risky.  Instead investors have searched for safety as fear has overwhelmed greed.  While I understand the need for safety, this trade has become so crowded that we now see parabolic rises that are set to collapse.

I will focus upon two distinct instruments to highlight the safety trade - US Treasury bonds (UST) and the CBOE volatility index (VIX).  USTs are the safest of all investments.  Investors believe the US government will never default and rush toward their bonds as fear increases.  Lately, the rush has become a stampeded.  As investors focus on return of principle over return on principle, prices have skyrocketed with UST yields at historic lows. 

Volatility is the lifeblood of the option market.  All else being equal, high volatility leads to increases in option prices and low volatility leads to declining option prices.  VIX measures option volatility.  Since options are often used as a way of insuring a portfolio against loss, VIX has become known as the fear index.  When VIX is high, options are expensive and the cost of insurance increases as people are fearful that stock prices will collapse.  With collapsing prices all around us, it is not surprising that VIX pushed to record highs.

Understanding why the fear trade has worked, what could cause a reversal?  There are two distinct factors - one technical and one fundamental.  For the fundamental reason, turn to the UST market.  To combat the threat of deflation, the Federal Reserve (Fed) has flooded the banking system with unprecedented amounts of dollars.  As the printing press operates at full speed, the Fed has offered nearly $8 trillion of loan guarantees through various lending programs.  As markets deleverage, the Fed has acted to prevent widespread deflation from crippling the economy.  This deleveraging has slowed the velocity of money and prevented inflation from taking hold.  However, the Fed will eventually succeed in halting deflation and be left with a massive amount of excess dollars in the banking system.  The end result will be swift inflation.

As for the VIX, we now see clear technical patterns that point to a collapse in volatility.  Since bottoming at 16.3 on May 15^th, VIX has spiked as high as 80.9 and currently trades at 58.5.  Over the past two months, VIX has carved out a head and shoulders top and is in process of violating a key uptrend.  When this violation occurs, I expect VIX to collapse toward 30 over the coming 6 weeks.

So how do we synthesize all this information into a trade?  Falling VIX will be bullish for stocks, but why bother with second derivative ideas?  Currently, individual investors have a way of profiting from both falling bond prices and falling VIX.  As highlighted in my weekly newsletter (http://www.stocktradingtogo.com/2008/12/07/epic-insights-weekly-issue-6-2/), inverse ETFs offer a way to profit from falling bond prices and VIX options allow you to profit from falling VIX.  As the fear trade unwinds, consider Proshares Ultrashort Treasury ETF (TBT) and out of the money VIX puts.  TBT offers a leveraged short of the UST market as TBT increases in value at twice the rate the long bond falls.  The January 55 VIX put (VIX+MJ) offers tremendous optionality.  If VIX falls toward 30 by mid-January, these options offer a 7 to 1 payoff.

For the past three months, the fear trade has offered great protection for investors.  However, all trades run too far in one direction and eventually collapse.  VIX and UST have gone too far and opportunistic traders using ETFs and options can profit from the eventual unwinding.

Related Stocks:  TBT

                Last week indicated that the oversold bounce was occurring.  After hitting an intraday panic low and reversing, the Dow moved nearly 19% in five days.  To start this week - a 7.7% drop.  As the market has attempted to respond to this drop, we must still ask the question - will a rally ever occur?

                It will and it has.  One of the more important aspects of a market to track is how stocks respond to news.  As we all know, the economic environment is poor and deteriorating.  As I outlined in my weekly newsletter, http://www.stocktradingtogo.com/2008/11/30/epic-insights-weekly-issue-5/, the employment picture is set to worsen over the coming months.  With that, we should see a drop in consumer spending, asset values and more business closures.  When negative news enters the market, the natural path is for stock prices to fall.  When markets cease falling on bad news, a temporary bottom has been established.

                Today's performance of Research in Motion (RIMM) has me believing the next major move is higher.  Tuesday after the market closed, RIMM preannounced earnings and revenues that missed analyst forecasts.  The miss was quickly followed by analyst downgrades as concerns mount over RIMM's ability to sell their product in the current economic environment.  When I turned on my trading system this morning, I saw the shares trading near $32 and expected the worse.  However, the shares opened at $35.40, strengthened during the day and closed near $39 - a gain of $1.64 on the day and nearly $7 (22%) above the premarket level.  When a company with poor earnings and negative analyst comments stages such a move I pay attention.  A market that rallies on bad news is destined to move higher.  After all, if bad news resulted in such a move, how high would the price go if we received positive information?

                Over the next 6 weeks, I expect an uneven march higher.  Given the large decline in the Dow, we could easily move toward 9,600 and remain in a well-defined bear market.  Such a move would offer nearly an 11% upside from today's close and would represent a 27% move from the panic lows that occurred on November 21^st.

                While this move is expected and welcome, I caution investors to not become complacent or greedy.  I firmly believe we will experience difficult economic conditions for the next 9-12 months that will dwarf what most people have experienced in their lifetime.  Personally, I see unemployment reaching 10% as nearly 4 million Americans lose their jobs.  Our economy and banking system is not built for this level of unemployment and the downstream effects will be painful and difficult.  For this reason, I urge investors to use any coming rally to realize gains, rebalance their risk profile and prepare for the road ahead.  Eventually the market will hit bottom and have only one direction to travel - up.  However, that point remains in the future and rallies are to be sold in order to prepare for lower prices that lie ahead.

Related Stocks:  RIMM

At times, the market does allow us to behave like a hedgehog.  When these opportunities arrive, we must take advantage.  After all, I would rather trade a stock with which I am comfortable and knowledgeable than spend hours searching for the next big idea.

We now have such a trade.  For the past three weeks I have discussed MasterCard (MA) in my weekly newsletter (http://www.stocktradingtogo.com/2008/11/30/epic-insights-weekly-issue-5/).  The fundamentals of MA are well known and deteriorating.  MA is a former market darling that has crashed to earth.  When most felt the credit crisis was contained, MA was seen as a place to hide.  By acting as a transaction processor, MA assumes virtually no credit risk and earns a fee each time their card is used.  If consumer spending held, their business would continue to grow.  However as the credit crisis has expanded beyond the banks and now threatens a deep, consumer led recession, MA's core franchise is under attack.  With predictions circulating of banks cutting credit lines, MA's growth will be curtailed and their earnings power will suffer.

The drop in price has resulted in a clearly defined channel that has held for over 4 months.    As the market rallied last week, MA has bounced off the lower end of the trading range, retested the top of the range and then pulled back.  The result is a stock at the higher end of its trading range, that has set another lower high (its 4^th lower high since September) and enjoyed a 26% one week move on declining volume.  Knowing that volume should follow the trend, a stock that rises on declining volume should not be trusted.

Deteriorating fundamentals, a clear technical pattern and unsustainable moves on declining volume combine to offer an excellent short sale candidate.  MA remains a unique stock in a challenging market.  Over the past three weeks, I have shorted the shares above $142, covered at $126 and now gone short above $139.  With a clear technical pattern, all signs point to a drop in MA shares that should violate the recent intraday low of $115.

Related Stocks:  MA

http://www.stocktradingtogo.com/2008/11/30/epic-insights-weekly-issue-5/

Related Stocks:  AAPL, MA, NLS

http://www.stocktradingtogo.com/2008/11/23/epic-insights-weekly-4th-edition/

This lack of clarity would lead many investors to remain on the edges and refrain from assuming risk.  However, there is great opportunity cost with such a stance.  Instead, I prefer to find stocks with a downward bias that allow me to hedge my current portfolio yet offer the comfort of a clear technical pattern.  This search brings me to MasterCard (MA).

As initially featured in my weekly newsletter (http://www.stocktradingtogo.com/2008/11/16/epic-insights-weekly-3rd-edition/), MA is a former market darling that has crashed to earth.  When most felt the credit crisis was contained, MA was seen as a place to hide.  By acting as a transaction processor, MA assumes virtually no credit risk and earns a fee each time their card is used.  If consumer spending held, their business would continue to grow.  This thought process led many momentum investors to pile into the stock and drove the price to an all-time high of $320 on June 2^nd.  Since that point, a weak market and overvaluation have combined to drop the stock to the current price of $141.40.

The drop in price has resulted in a clearly defined channel that has held for over 4 months.  Currently, the channel shows MA trading between $130-150 over the coming weeks with a downward bias that should result in a new low.  At current levels, MA is approaching the top of the channel and offers an excellent time to initiate a short position with a clear technical pattern.

While I do not like jumping on trades that have moved this far in a short period of time, MA is unique.  The fact that the channel has persisted during multiple market rallies provides comfort.  Further, a well received earnings report two weeks ago pushed the price over $170 before resuming the downtrend.  Also, this latest failed rally was the third lower high since late September (9/19 - $225, 10/14 - $174, 11/4 - $170.  Lower highs are characteristic of falling markets and lead me to think MA may retest the October 27^th low of $126.35.

Combining these observations, MA offers unique attributes in today's market.  It faces economic headwinds that will restrain business growth, trades in a clearly defined downward channel and has been showing technical weakness with a series of lower highs.  Therefore, I view it as an ideal short sale candidate.  If the general market continues lower, we profit.  If the technical pattern holds, we profit.  Given the uncertainty in this market, I welcome the opportunity to trade with clear patterns and defined fundamentals.

Related Stocks:  MA

http://www.stocktradingtogo.com/2008/11/16/epic-insights-weekly-3rd-edition/

                While bottom fishing, we must also remember that markets can stay irrational longer than we can remain solvent.  Therefore, look to hedge your positions in the most advantageous manner you can find.  Traditionally, investors buying stocks could pay a small premium for a put option to insure against large losses.  With VIX trading above 60, option hedges have become uneconomical.  Knowing this, I look toward pair trades as a means of hedging my risk.

                The purest pair trade is one where you are long and short of two stocks in the same industry.  Doing so allows you to eliminate factors that would affect the industry and trade the relative valuation of each competitor.  I often look to be long of the stock that is either more reasonably valued or is the better operating company.  Conversely, I will short the company that is overvalued or has an inferior operating business.  Within this framework you can often find trades where one of the two criteria is met.  On rare occasions you are presented an opportunity to own the stronger company at a low valuation and be short the weaker company at a high valuation.  Today we are presented that opportunity.

                I find the trade in the airline industry.  While I acknowledge that the airline industry has large structural problems and little earnings visibility in the current economic environment, I do not want to make a statement on absolute valuation.  Instead I will focus on relative valuation and the opportunities presented.

                For the long side, I recommend buying Continental (CAL).  CAL is among the strongest of the airlines and has tended to trade at a premium valuation to its competitors.  On a trailing 4 quarter basis, CAL has lost $.3 million on sales of $15.1 billion.  Looking at their balance sheet, debt is high with total debt nearing 76 times total capital.  While the inability to earn a profit on $15 billion of sales and a large debt level would scare most away, looking at certain competitors justifies the pair trade.

                On the short side, UAL (UAUA) - more commonly known as United Airline - has lost nearly $4 billion on sales of $20.5 billion over the past four quarters.  Looking at the balance sheet, UAUA's debt is approaching 119 times total capital.  If we thought CAL's results and balance sheet were poor, UAUA's are frightening.

                Given the profitability and leverage of each airline, I could recommend shorting UAUA and buying CAL.  However, investors are offered one additional benefit.  For the past 6 months, CAL has traded at an average premium to UAUA of 158% with a median premium of 155%.  Currently the premium is 108%.  The last two times the relative valuation was this low, CAL's average premium was restored in 13 and 18 trading days, respectively.  This quick mean reversion translated into 30% gain in a few weeks time.

                This market has been unforgiving over the last two months as indiscriminate selling has altered how investors behave.  Within this chaos, opportunity exists.  Being long CAL and short UAUA allows an investor to reduce risk to the overall economic environment while being long a superior company at low relative valuations and short a weak competitor at high relative valuations.  Whether it is the economic backdrop or company specific news, I expect CAL's traditional premium to UAUA to resume and deliver quick, meaningful profits to opportunistic investors.

Related Stocks:  CAL, UAUA

Personally, I have watched this market with the belief that we have overshot to the downside and normal technical factors would work prices higher.  For a few days that theory worked.  The Dow Jones Industrial Average (Dow) hit a closing low of 8,175 on October 27^th.  From there the markets worked higher with the Dow closing at 9,625 on November 4^th (18% in 6 days).  Since that day, we have spiraled lower with the Dow threatening to retest the October low.

Such violent action makes predicting the next move difficult.  A violation of the October low would have severe repercussions as support levels are violated and the market spirals to unknown levels.  However a resumption of the uptrend that pushed toward Dow 10,000 would incite bullish actions and could result in a surprisingly strong market rally.  While some investors will sit on the sidelines and wait to see which price point falls first, doing so has enormous opportunity cost.  Properly trading the rally or decline can make a large difference in your portfolio performance.  Therefore, I prefer to analyze the internal market actions and best assess where the next move will take us.

Looking at the Dow, I will focus upon price change, daily volatility and volume.  Further, I have broken the market actions into three main time periods.  These periods are September 2^nd - 30^th (when a down year turned ugly), October 1^st - 27^th (when the bear market spiraled lower in relentless fashion) and October 28^th - November 10^th (the period when the Dow has moved toward a retest of the prior lows).

Entering September, the Dow was down 13% for the year.  Most investors were displeased with the market's performance, but had not turned despondent.  During September we saw the failure of LEH, various financial rescue plans and a bad market turn worse.  By the end of the month, the Dow was 18% lower for the year and had officially entered bear market territory.  During the month, the Dow finished lower 11 trading days and higher 11 trading days.  However, down days saw declines of -2.62% on average volume of 6.1 billion shares and up days saw average gains of 1.9% on volume of 7 billion shares.  Although the market had dropped 6% on the month and daily volatility (measured as the difference between the high and low price on a given day) averaged 4.2%, there was reason for optimism.  During the month, large declines were followed by sharp rallies and the internals of the market showed volume higher on up days than down days.  Unprecedented fiscal and monetary stimulus had been applied and the belief was policymakers would do all in their power to keep the economy from traveling into the abyss.  Those thoughts were premature.

During the 19 trading days between October 1^st-27^th the bottom fell out.  Over those 19 days, the Dow finished lower 15 times with the average drop being 3.25% on volume of 7.2 billion.  While the 4 positive days staged rallies of 5.6% on volume of 6.9 billion shares, the overwhelming negativity damaged investors' portfolios and psyches.  Daily volatility skyrocketed with the VIX reaching all time highs and the daily price swing in the Dow averaging 7.9%.  On 5 days, the average price swing exceeded 10%.  We have all heard how long term stock returns average near 10%.  A lucky trader who was short at the high of the day and closed his position at the low had 5 chances to make one year's gain within a few hours.

The internals of these 19 trading day show a market being crushed by the bears.  With relentless drops in the Dow, volume was higher on down days and volatility spiked.  While the Dow staged an occasional rally, the gains were infrequent and could not stop the downtrend.  During this period my timing model was 100% (an unheard of oversold signal) and required a 55% rally in the average stock for the model to reach a more neutral reading.  Looking at these statistics, one could expect the capitulation phase was reached and that markets had bottomed.

Calling a bottom and trading long since October 27^th looked brilliant for a week, but now raises questions.  Was the 18% rally a bear trap or is the current retest what is needed to reaffirm that we have hit bottom?  Turning to the internals, I am hopeful that the current move is a retest of the lows that will set the stage for a sustained move higher.  Over the past 10 trading days we see the market finishing higher 5 times and lower 5 times.  On the up days, the market has moved 4.2% higher on average volume of 6 billion shares.  For down days, the market has fallen 2.3% per day on volume of 5.5 billion shares.  During this period, daily price swings have dropped to 5%.  The ability to move higher on rising volume, go lower on shrinking volume and see volatility decrease are all bullish events.  Therefore, I see the current sell-off as a retest of the prior lows.  If those lows hold, we should begin moving higher in a fashion that sets the stage for a powerful market rally.

From an investment perspective, how should one use this information?  Carefully.  I am currently long of the market and expect to maintain my positions.  I will be using the volatility to indentify trading targets, but am shying away from committing large amounts of capital.  As the Dow falls toward the October lows, short weak stocks and buy those that are strong.  Doing so will allow you to balance risk while realizing gains.  If we test the lows and move higher, skew the portfolio long for a quick rally.  Given the speed with which this market moves, it is important to be nimble, effectively manage risk and always look for the next trading target.

http://www.stocktradingtogo.com/wp-content/uploads/2008/11/epic-insights-2nd-edition.pdf

1. The Week Ahead - Identify key economic reports, earning's releases, and other events that could lead to swings in stock prices.
2. Technical Trades - Trade ideas via technical analysis.
3. Fundamental Trades - Trade ideas via fundamental analysis.
4. Option Trades - Trade ideas through options.
5. General Comments - Sean and his team share their general market thoughts.
6. Current Recommendations - Track Sean's recommendations to see how they would perform each week in a live portfolio.

I designed the newsletter to be beneficial for any investors regardless of experience. It will prepare you for the week ahead and provide actionable trade ideas that all traders can use to improve their portfolio's return.  It is a fantastic read and should become a Sunday night routine for any investor wanting to stay on top of the market.

To read the letter and subscribe to the email distribution, use the following link:

http://www.stocktradingtogo.com/2008/11/06/read-sean-hannons-new-financial-newsletter/

                JPM possesses advantages other firms lack.  They have among the best management teams in the banking industry, one of the stronger balance sheets and ability to manage risk that few others have mastered.  These attributes have allowed JPM to play a key role during the crisis and absorb both Washington Mutual (Wamu) and Bear Stearns in government assisted mergers.  By helping increase the deposit base and adding complementary lines of business, JPM is now a key competitor in every area in which they operate.

                When acquiring Bear Stearns, JPM's risk profile was clear.  With Wamu, the downside was unknown.  Wamu possessed one of the worst balance sheets I have ever seen.  Littered with Option ARMs in inflated housing markets, JPM faced a tough decision.  If they allowed these loans to continue to negatively amortize (negam), JPM would be making a huge bet on the housing market.  However, if they stopped the negam and modified these loans to current market rates, borrowers would be unable to afford the higher monthly payments and would be forced into foreclosure.  Knowing that banks are in business to collect money, not own homes, neither option was appealing.  Last week JPM unveiled the first step in a process that both limits negam and prevents further foreclosures.

                Last Friday, JPM announced the intent to modifying $150 billion of mortgage loans.  While details were limited, we can expect some combination of lower interest rates and reduced principal balances to help homeowners obtain a monthly payment they can afford.  The greater affordability will allow people to remain in their homes, will stem the tide of foreclosures and should eventually provide support to the housing market. 

                Personally, I do not like the path that massive loan modifications represent.  By reducing loan balances and interest rates, bankers are penalizing prudence and rewarding speculation.  While I could write pages on how this will only cause future problems that is a pointless exercise.  As investors, our job is to predict actions, determine their effect and decide how to profit.

                Looking back to the mortgage bubble, three main lenders were seen making questionable loans in mass size.  These lenders were Countrywide, Golden West and Wamu.  Today, Countrywide is part of Bank America (BofA), Wamu part of JPM and Golden West part of Wells Fargo (Wells) via the Wachovia merger.  With JPM's modification intentions, we can expect that BofA and Wells must follow suit.  Maintaining high mortgage payments when your competitors are reducing them is politically unpalatable.

                Knowing other banks will follow suit, JPM has taken a proactive lead to weaken their competitors.  BofA and Wells have weaker balance sheets and more pressing needs.  Both these companies are undertaking transformative mergers outside of their areas of expertise.  Combine the management uncertainty with the capital needs, a large scale loan modification is an event they would rather not face.  However, JPM has pushed these banks in that direction.  By dictating the pace of the conversation and having the capital needed to take action, JPM will emerge as the strongest bank.  The end result will be increased market share and higher future profitability.

                Based on long term earnings power, JPM could trade toward $55 in the coming months.  With the shares trading near 1.6x tangible book value, we see a stock with strong upside potential, a nice level of current income (3.7% dividend yield) and a reasonable valuation that provides a margin of safety.  All in, this is a stock to own for the future.

                Buying JPM is a clear choice, but risk management remains a concern.  A prudent investor will hedge their risk while attempting to profit from a move higher in JPM's stock price.  Since option strategies are uneconomical, I recommend a short position in Wells.  While JPM trades at a reasonable 1.6x tangible book value, Wells trades at 3.1x tangible book value.  Further, I believe there are risks in Wells' home equity portfolio that the market has not fully digested.  This provides a rare opportunity where a pair trade can offer appreciation on the long side and profit from a short sale as well.  Over time, the valuation of Wells and JPM should converge.  By shorting what is dear and buying what is cheap, an investor can manage their risk profile while skewing the portfolio for future gains.

Related Stocks:  JPM, WFC

                While these drops have been devastating, the internals of the stock market are enough to shake the core of most investors.  During October, the Dow has closed higher on 4 trading days.  On those positive days, the average gain has been 5.2%.  On down days, the markets has fallen an average of 3.4%.  The average spread between the high point and low point in a given days has been 722 points. 

                I have often said that confusion presents opportunity.  At current price levels, all major indices are now trading well below my fair value targets.  Value Line reports the average Price/Earnings ratio (PE) of 12.1.  The prior bear market low was 14.1.  Many leading companies are selling at prices that are 60-80% below where the traded a year ago.  From a technical perspective, stocks are as oversold as they have ever been.  My timing model needs an average rebound of 55% in order to revert to a more balanced position.  With markets wound this tight in one direction and values appearing across the board, the likelihood of a sharp rally increases.  However, we must remember a few key lessons.  When living through paradigm shifts, cheap stocks can become cheaper and oversold markets can remain oversold.  Expecting the selling to cease does not translate into markets immediately moving higher.

                For this reason, the next two months will be among the most important periods in stock market history.  In one week, the Presidential election will end.  This will remove a layer of uncertainty.  Further, Treasury will be implementing additional pieces of the TARP plan and Congress has indicated they may pass an additional stimulus bill.  By late November, massive amounts of liquidity will be in the system, some pieces of uncertainty will be resolved and consumers will begin focusing on the holiday season.  Within this environment, stocks should behave well, unwind the oversold nature and recoup losses.  To me, a rally into Dow 10,000 seems plausible and achievable.  After that, bigger questions remain.

                Having suffered through such a harrowing drop, investors are frightened and angry.  The Dow trades near the same level as August 1997.  Twice in a 10 year span investors have seen stocks rally sharply to crater just as quickly.  With a 42% drop from the October 2007 peak of 14,164, many investors have seen a lifetime's savings cut in half.  Those who used modest leverage have seen their wealth drop greater percentages.  As the Dow has made no money in a decade, people begin questioning the wisdom of a long term allocation to equities.  Add in the extreme volatility and investors quickly decide that fleeing the market is a wise choice.

                I easily understand the motivation and actions of investors who are scared of what lies ahead.  People approaching retirement now face a situation where they must either continue working or alter their lifestyle.  Investors will begin reevaluating their willingness to accept equity risk and money that is needed for expenses in short time periods will be shifted to safer havens.  Combined with the deleveraging of banks and hedge funds, fewer buyers exist for the stocks traded in the market.  The clear result is prices must drop to lower levels to reflect this new supply/demand balance.

                The clear implication of this trend is that all rallies will stall, stocks should no longer be held as long term investment and the only people to prosper for years will be nimble traders who quickly realize gains, avoid missteps and do not allow losses to grow.  This trend is logical, yet may be oversimplifying the situation.  A small subset of people who can survive with low single digit returns will look toward alternative investments and bonds.  However, most people need return in order to achieve their long term goals.  For years, people have been assuming high rates of return in their savings calculations.  Most private companies have applied returns of 8-10% in their pension calculations.  In order to meet these goals, people will continue to seek higher return alternatives.  While this bear market has devastated investors and shaken their confidence, a sustained move high will serve as the remedy to all their ills.

                With the emotional tug between reducing risk and seeking return, we must watch the market's action over the coming weeks.  To work off an oversold nature, markets will either stabilize or rally.  Assuming a rally, we need to see how far the market can travel.  Most expect any rally to be met with selling as investors move to a lower risk profile.  If this occurs, the fears over future stock market returns will be justified.  However, markets rarely behave in set, preconceived manners.  A sustained rally that pushes us over Dow 10,000 could make people forget the recent past and embrace the long term potential.  While the paths the markets will take are unclear, one thing is certain.  Over the next two months we should begin to see a trend develop that will persist for years into the future.  Successful investors need to watch this underlying trend, position accordingly and look for opportunities as they develop.

                These losses are staggering.  However, more disappointing is that market seems unable to rally, even for a day, from extremely oversold conditions.  For perspective, consider the 1987 stock market crash.  Through September 30, 1987 the Dow was higher for the year by 37%.  The Dow continued higher for the first week of October, began to head lower and crashed 22.6% on October 19, 1987.  After the crash, the Dow was down 33% for the month of October, but proceeded to rally 14.6% over the next nine trading days with positive closes on 6 of those 9 days. 

Comparing to the current environment, we have experienced similar losses, but they have occurred in an unrelenting fashion.  As the market heads lower each day, investor enthusiasm is sapped as we question why an oversold market cannot rally and wonder when the end of the decline will occur.  The inability to rally for even one day leaves investors fearful that markets may never return to normal.

I often write about the need to examine investor sentiment, position against the crowd and reap profits when markets stabilize.  Looking at four different measures, I see unprecedented levels of fear.  Using my timing model, only one stock is rated a buy resulting in 99% of stocks being rated sell.  This is unlike any reading I have ever witnessed and speaks to the extreme oversold nature of this market.  VIX currently trades near 70 and is 60% higher than the prior peak during the Long Term Capital meltdown.  The NYSE bullish percentage stands at 2.7%.  This compares with nearly 25% during the dot-com bear market and 8% following the 1987 crash.  Similarly, the percent of stocks trading above their 50 day moving average has dropped to 1.3% - well below the levels seen at prior market bottoms.  Consolidating these data points, the clear view is that we are experiencing a fear driven crash that has created the most oversold market of the past 25 years. 

The key to successful investing is looking at probabilities, making your best judgment and employing capital when the likelihood favors success.  Applying probabilities to this market, it is likely that we are approaching a large, positive rally.  As always, the question remains, when?  Many investors believe oversold markets need to immediately reverse conditions.  However, oversold markets can remain oversold.  I bought stocks Tuesday and Wednesday and have nothing to show but losses.  While the CNBC crowd finds a need to call a bottom, I will resist.  There is no clear answer to when this market decline will end, what the next price move will be or which stock sectors will outperform others.  Instead, focus upon the market participants, broad market technicals and individual stock fundamentals.

Assessing these three areas, the only people who have prospered over the past few weeks have been the bears.  At this point, with large gains, logic would dictate they reduce position sizes to avoid giving back hard fought profits.  This will create a mild amount of buying interest while also reducing selling pressure.  I have covered the technicals above.  The logical outcome would be for the market to either stabilize or reverse the oversold condition and head higher.  Finally, from a fundamental viewpoint stocks are trading at levels we have not seen in years.  As examples, Chubb trades at a 6 P/E and 3.30% dividend yield.  Pfizer has an 11 P/E and 8.5% dividend yield.  These are levels not seen in years and offer excellent value for a patient, long term investor.

Adding the factors together, we see solid value, an oversold market and eventual end to selling pressure.  This increases the probability that the next move will be higher.  Implementing this view is more difficult.  We must remember that this decline will eventually run its course and markets will improve.  To those unwilling to deploy capital, I understand.  For those thinking of selling now or going short to try to capture more downside, be cautious.  Markets have a way of reversing once too many people have crowded into the same trade.  Continuing to sell is crowding into a trade that will eventually reverse course and yield large losses.

     Our current crisis is much different.  As the credit bubble expanded earlier this decade, household debt grew from 60% of GDP to 97% of GDP.  Similarly, household debt as a percentage of disposable income (measured as income after taxes) grew from 89% to 127%.  Normally high debt levels would force prudent lending standards as the risk of loss is elevated.  Instead, the credit bubble was inflated as investor demand for extra yield and the belief that asset prices only increase caused many lenders to loosen underwriting standard and create subpar loans. 

     As many homeowners find themselves with negative equity, the rationale for owning a home shifts and their choice is to walk away. Normally, we see economic stress cause people to lose a home they would rather keep.  Currently, we have seen people willing walk away from homes prior to a true downturn in the economy.  This has caught many lenders off guard and has led to tightening of credit to nearly all clients.  Thus today's borrowers suffer for yesterday's mistakes.

     With the access to credit eliminated and debt levels high, individuals find few options to expand consumption.  If consumer spending drops, economic growth also drops.  So what are the alternatives?   Since the economy is dependent upon borrowed money to grow, we must rely on the one entity with the ability to borrow and spend - the federal government.

     While I rarely advocate increasing deficits, the current economic picture requires extreme measures.  With individuals and companies locked out of the credit markets, the risks are massive.  As we have seen in the last 6 weeks, financial markets are awakening to these risks and the results have been brutal.  With the focus on the Treasury's most recent band aid, the Dow Jones Industrial Average (Dow) has dropped below 10,000 while volatility continues to soar.  Buying bad assets may help eliminate uncertainty, but it does not guarantee that credit markets unclog and lending continues.  Instead, we need more drastic actions to stem asset deflation. 

     Looking at our country, our needs are numerous.  Our infrastructure has fallen into disrepair and needs updating.  An expansion of both education and healthcare services would be easily justified to the American people.  Tax incentives for research and development would increase employment and innovation.  Combined, the federal government would be using its borrowing capacity as a way to reinflate the economy, raise asset prices and increase our standard of living. 

     Normally, I would never advocate inflation to cure our economic ills.  These are not ordinary times.  Given the size of the problems and the effect it is having, failing to take an inflationary path will lead to, at best, a deep recession and increase the possibility of a severe depression that will affect the entire country and thus, the world. 

     If I am correct about the need and intent of the government to inflate the economy, the investment implications are many.  In an inflationary environment, Treasury bonds will suffer.  Currently, the 2 year Treasury pays 1.45% and the 10 year Treasury pays 3.49%.  The initial steps of an orchestrated increase in inflation will be led by a Federal Reserve (Fed) interest rate reduction.  When it occurs, you should expect Treasury yields to decline further.  At that moment, I would exit these positions as increasing inflation will erode the value of the bonds.

     The largest beneficiary of increased inflation will be hard assets and related companies.  Gold offers the purest exposure, but all commodities should do well.  Equities that either supply commodity producers (i.e. -fertilizer companies such as POT) or currently possess abundant commodity reserves (i.e. - oil companies such as XTO) should see their shares perform well.  Real estate should begin to bottom and then eventually outperform. 

     As the Presidential election is near, keep a close look at the economic plans presented by the candidates.  It is my belief that in order to prevent another Great Depression, greater and more painful than the one in our past because so much more wealth is at stake and the population of our country has increased, our government must spend on infrastructure, healthcare and education.   Constructing a portfolio focused on these areas should yield excellent results.

                To gain perspective, during September we have seen key linchpins of the housing market placed into conservatorship (Fannie Mae and Freddie Mac), the failure of two large banks (Washington Mutual and Wachovia), the nationalization of the largest insurance company (American International Group), the elimination of the stand alone investment bank (Lehman's bankruptcy and Morgan Stanley and Goldman Sachs becoming commercial banks) and the disappearance of the largest brokerage firm (Merrill Lynch merging with Bank America).  With the government failing to approve a rescue bill, we have entered a period of heightened uncertainty, lower tolerance for risk, lower levels of financial leverage and lower innovation.

                These expected changes have a dramatic implication over how we will invest.  To consider the effects, I have developed the "Five Lessons of the Crisis".  They are as follows:

1. Solvency, not liquidity, is king.  After the collapse of Bear Stearns in March, many investors believed that a lack of liquidity had lead to Bear's demise.  Following this script, the Fed began allowing broker-dealers to access the Fed window and broadened their list of acceptable collateral with the intent of allowing firms to conquer short term funding issues.  As we learned from Lehman, Wamu and others, this is not the case.  Bad loans and poor trades eroded the capital base and left these companies insolvent.  Rather than allow an insolvent company to grow out of its problems, we have seen bankruptcy, nationalization and asset seizures.
2. Valuation is in the eye of the beholder.  As a value investor, I have watched stock prices drop to levels I never thought possible as companies I thought would never be attractively priced are now outright cheap.  However, these same stocks have become even cheaper.  At a certain point we will look back at this period and discuss how shrewd investors snapped up shares at bargain prices.  For now, those same investors are experiencing escalating losses.
3. Public policy cannot cure private market woes.  As of now, every piece of government policy has failed.  With each proposed measure, markets have rallied.  Inevitably the measure fails and markets swoon.  Only through time and pain will excesses in the private markets be purged, bottom and lead to rebound. 
4. Deleveraging markets kill innovation.  What started as a credit crisis has morphed into a Main Street crisis.  The major negative to deleveraging is that new loans are not being made.  Without new loans, companies do not expand, employment does not grow, the incentive to create and market new products declines and economic growth declines.  Together, we have a weaker economy and a lower standard of living.
5. No company is too big to fail.  For years, the presence of the Greenspan Put and Helicopter Ben has led many to believe that certain companies are too big to fail.  This thought no longer holds.   Going forward we should expect investors' required return hurdle to increase as old rules no longer apply.  The result will be lower future gains as the days of P/E multiple expansion are now past.

Knowing the rules of the market have changed, we need to decide how to progress.  The answer is cautiously.  Right now, buying stocks remains far from anyone's mind.  However, within fear opportunities exist.  Capitulation is needed for a market bottom and that has finally arrived.   An investor looking for an excellent business at a cheap price should look toward XTO Energy.  XTO possesses oil and gas reserves in geopolitically safe areas.   Market value of their natural reserves exceeds $60 per share and a high amount of 2009 production has been hedged at energy prices that are higher than prevails today.  Therefore, XTO offers excellent value with limited exposure to volatile commodity prices.

Related Stocks:  XTO

                Extreme volatility offers ample opportunity for both profit and loss.  With markets swinging wildly one must be patient and disciplined.  Look to book profits quickly and reenter trades when the risk/return tradeoff is favorable.  What may look like a foolish trade today is likely to look brilliant tomorrow.

                A more important lesson we can draw from this period is to reexamine why we make certain investment choices.  The basic investment choices can be broadly dissected into four major categories - cash, bonds, commodities and equities. 

                Across these asset classes, cash offers the lowest returns and equities the highest.  As one would expect, cash offers the lowest risk while equities the highest risk.  When deciding where to invest your money, there are many different factors people will consider. While we can run scenarios and attempt to define people’s risk tolerance, it is often difficult to determine a concrete answer.  Most investors know that stocks offer higher returns than other assets and convince themselves that volatility can be tolerated as we search for higher gains.  However during chaotic markets, investors often panic, change their minds and make decisions at the worst possible time. 

For this reason, I believe the most important factor that should be considered is the investor’s time horizon.  Funds that are needed in less than one year should stick with low risk cash and fixed income alternatives while money that is not needed in the immediate future should be in an equity portfolio that employs strategies with which you are comfortable.

                This distinction of time is one of the key traps for most investors.  During the height of the dot-com stock market bubble, I knew a very successful day trader.  After a tremendous 1999, the trader had accumulated large gains and an equally large tax bill.  Knowing he would eventually need to pay the IRS, the trader had a certain amount of his portfolio designated for future taxes.  As the internet market was hot during the 1st quarter of 2000, this trader could not bear reducing his equity position to pay taxes.  Instead, he decided to employ his capital and seek more gains. Initially this plan worked.  However, by mid-March he had suffered losses he was unprepared to realize.  By May, he had missed filing his taxes, seen his positions decimated by margin calls and was left with an outstanding tax bill he would never be able to pay.  Knowing the government is not the most forgiving of creditors, this person has spent nearly a decade trying to recover from past mistakes.

                How did a smart person with great experience make such a mistake?  Faith was put in the flawed assumption that since equity markets offered higher rates of return, excess cash should always find its way into the stock market.  As the past few weeks have taught us, markets can act irrationally, oscillate wildly and cause frustration.  People who have a need of capital over short time periods would be better suited to reduce risk and seek safety.  Those with time on their side should develop a strategy, execute it in the markets and allow the strategy to deliver gains.  Constantly reworking your risk tolerance, time horizon and investment goals will often cause you to make poor decision at inopportune times.  For this reason I recommend investors with a lengthy time horizon create a portfolio that balances risks across investment choices while still offering upside investment return.  At the moment, construct a portfolio with 10% commodity weighting via the Powershares DB Commodity Index (DBC), a group of well priced value stocks with attractive dividends (BAC, GE, XTO) and a small portion of your assets dedicated to long-term growth companies (AAPL, RIMM).  Such a diverse asset mix should provide current income, offer diversification and lean toward growth when the market begins recovering.

                This week there is no need to develop a clever analogy.  Simply, this market is brutal and I fear that more pain lies ahead.  On September 2^nd, the Dow Jones Industrial Average (DJIA) closed at 11,516.  The markets had been rallying from their July 15^th low and many commentators were debating whether the bottom had occurred and we were ready to resume a move higher.  At that time, I expressed my view that more pain should be expected and a cataclysmic event would occur to push prices to new lows (http://www.epicadvisorsllc.com/images/Weekly_2008-09-02.pdf).  In the two weeks since writing this, we have seen the Dow and S&P 500 close at new yearly lows with the NASDAQ just 10 points away from its annual low.

                The events that took us to this level are well advertised.  What started with the nationalization of Fannie Mae and Freddie Mac has led to the bankruptcy of Lehman Brothers, forced merger of Merrill Lynch and serious liquidity problems at both AIG and Washington Mutual.  Yesterday, the Dow  dropped an incredible 504 points (4.4%) as equity markets had their worst day since after the 9/11 terrorist attacks.  During the carnage I commented to a client that in a 6 month span we are going to witness the disappearance of the largest mortgage company (Countrywide), the largest brokerage firm (Merrill Lynch), two of the four major independent investment banks (Bear Sterns and Lehman Brothers), the nationalization of the housing industry (Fannie Mae and Freddie MAC) and most likely the demise of the largest insurance company (AIG) and the largest savings and loan association (Washington Mutual).  Surely these events must be considered cataclysmic.  Is it reasonable to assume that the bottom is in and now is the time to buy stocks at bargain prices?

                While I think we are now closer to a bottom than 2 weeks ago, we are not there yet.  Too many people are spending time calling a bottom than fleeing from the markets.  Until we see widespread pessimism with everyone running for the exit, a bottom will not occur. 

                With all the chaos in the market, how do I decide that pessimism and fear has not reached extreme levels?  To do so I use many different models to measure investment sentiment.  As with most things in this market, arguments can be made in favor of either a bearish or bullish viewpoint.  I will look at a few factors that support each perspective with hopes of developing a definitive answer.

First we will examine the bullish factors.  The VIX (a measure of fear based on option prices) spiked 6 points higher yesterday and now trades above 31.  Importantly, the current reading is seven points above the 10 day moving average.  This type of spread between the current price and moving average often represents extreme investor fear and an approaching bottom.  The NYSE New Highs-New Lows reached -611 yesterday.  This means that new lows on the New York Stock Exchange (NYSE) outnumbered new highs by 611.  This reading is similar to what was seen when the market reached temporary bottoms in March, but well below what was seen in July.  I would call this slightly bullish.  The final bullish factor is that many companies are now very cheap from a pure valuation perspective.  However, as we have seen cheap stocks disappear (i.e. - Fannie, Freddie, Lehman, AIG, etc.) one is wise to question these value metrics during such turbulent times.

The bearish viewpoints are more numerous yet share key factors.  There are many different ways to examine how most stocks are behaving,  A few I use are the NYSE bullish percentage, percentage of NYSE stocks above the 50 day moving average, percentage of NYSE stocks above their 200 day moving average and most importantly my timing model.  Looking at these metrics we see the same results.  While stocks are weak and pointing lower, we are nowhere near the extreme readings that are needed for a true market bottom.  For example, my timing model is 31% long.  While leaning bearish, I do not consider it oversold