Wednesday, November 26, 2008


I did read the transcript of the Strategic Hotel's earnings call and I did notice that management affirmed its intent to pay the preferred dividend after eliminating the common stock dividend.  This intent is subject to change  Seeking Alpha (see page 7) I actually do read these transcripts even if my only involvement is owning a preferred stock or a bond.  I am always interested in a companies ability to pay the preferred dividend or the interest on the bond.  The only way to make that judgment is to review the balance sheet, the relevant financial ratios and debt maturities, types of debt, its operations and earnings.  I am not concerned with BEE's earnings growth or even when it will be able to reinstate its common dividend.  I am only concerned with one thing, its ability to pay me my preferred dividend and it is skating on thin ice now as I already knew.

Every day this week, when the market has rallied, the CBOE volatility index for the S & P 500 has declined.  We are still in an unstable range at the current 57.30 and this is still within bear market territory.  I would not declare an end of this bear market until the VIX fell under 20 and stayed below 20 for at least 3 months. We are experiencing a better bear market rally than the previous one day wonders which means to me that more people are starting to believe a bottom was put in last week.  I will find it a bit encouraging if the S & P 500 can close the month at the current level of 864.  

For those who know me, this will not come as a surprise.  I said in a post last night that I was going to buy a preferred stock of Lexington Realty when it fell to 6 or below. Lexington Realty Preferred: LXPPRD  What I am about to say has happened to me earlier last month. I forgot that I had a limit order to buy 50 in place at 6.60 which was filled yesterday when the motivated seller drove the price down from about 7 to 6 late in the day.  I had forgotten about it until I looked at my account this morning.  But I look on the bright side and I am surprised that I remember as much as I do given my advanced age.

To get a quote on the VIX, you can enter ^VIX and yahoo finance or VIX at marketwatch. VIX Stock Quote - Cboe Volatility Index Stock Quote - VIX Quote - VIX Stock Price  The brokers have different ways to obtain quotes.  Fidelity for example requires you to enter .VIX.  I monitor the volatility indexes all day and can tell you have each major average is doing based on my reading of these indexes. 

I have said that a durable volatility reading for VIX at below 20 is a necessary condition for a bull market.  There were some gyrations in the VIX between 1997 to 2000 that indicate to me that we were in the death phase of a major bull market that took an unusually long time to die, probably due to the enthusiasm generated by technology in the later part of the last decade and the involvement of individuals pushing prices to levels that made no sense.  The VIX jumped out of a stable bull pattern in 1997, hitting 35 in October 1997 during a financial crisis. This would signal to me now a forced reduction in my allocation to stocks which would have appeared to me premature judging from events over the next two years.  In retrospect, it would have been the right decision.

For me, when I receive this first warning signal in what is still an ongoing bull market, I will reduce my stock allocation by 10% when the VIX falls back to the 16 to 20 range, as the bulls and bears engage a fierce tug of war.  This happened in February 1998 with the S & P 500 at 1050, well above where it is now. It was at 914 in October 1997. So, while the future may not give you this kind of opportunity to pare at higher levels, it has in the past.  The VIX returned to over 40 by August 1998, which would be the second trigger for a forced reduction in stocks, which for me would be another 10% when the VIX returned to below 20 (when a younger man, I would try to wait for below 18). This did not occur until August 2000 when the VIX  hit 16.84 and the S & P 500 was at 1518.

Why so long between the trigger and the forced reduction?  I postulate that it was due to people becoming crazy in 1999.  The VIX was in the mid 20s during 1999, when the Nasdaq was going parabolic, which says to me that the move was not being confirmed by the VIX and was phony.  Now, I have a confirmation of a bear market coming, at least two whipsaw patterns moving from below 20 to over 30 or 35, or even 50 and back down to below 20. Any period below 20 is of short duration which makes it totally distinct from a stable bull market pattern.

Now, I look for just one thing to re-commit the cash raised. A return to below 20 in the VIX for at least 3 months.  This happened in January 2004.  You would miss a few months of rally. Phase two of the bull move began in March 2005 with the VIX falling to a stable range of 10 to 15. The first forced reduction would be triggered by the move in the VIX to 30 on August 2007 which for me triggers a forced reduction, no matter what I think about it, in stocks when the VIX returned to 16 to 20.  This would be in October 2007 when the Dow was over 14,000.   The second and final trigger happened in just a few days, unlike the 1997 to 2000 period where insanity started to rule the roost,   when the VIX spiked from below 20 back to over 30 by November 12, 2007. The fall to below 20 was soon thereafter, around 12/21/2007 and was brief.

As I have become older, I may shift my allocations quicker and by larger amounts.  So I might bail now by 20% on the first move out of the stable bull range to close to 30, rather than over 30, and do another 10 to 20% reduction on the second trigger.  My asset allocation model tied to the reading of all the volatility indicators would have also worked in the early 1990s.  The first readings from the CBOE VIX, which starts in 1990, show an ongoing unstable VIX whipsaw pattern, suggesting an ongoing bear market which is resolved in favor of a bull market when the VIX stays below 20 for 3 months in August 1991 when the S & P 500 index was at 395.  So I am back in at that point.  The model has me in until 2/98 when I am required to do a reduction when the S & P is at 1050.  I would also be buying now SSO when we enter a stable bull phase 2 pattern which happened in May 1994 and the S & P 500 index was at 456.

A venturesome investor might put that on when the VIX falls into a stable pattern initially,  and this can be adjusted for risk tolerance.  Being somewhat conservative, I would wait for phase two and sell it on the first significant spike over 20 without a moments thought. This would have happened during the summer of 1997 when the VIX started to warn of a potential problem by moving out of the stable bull pattern and starting to trade in the mid 20s.  A more venturesome and fearless investor would put SSO on earlier than me and take it off later.  But I would suggest the wild and crazy ones need to sell it after the first trigger point is reached with a spike of the VIX above 30 and a return to below 20, waiting for the VIX to fall before selling. The fall in the VIX to below 20 would happen under my theory only if the market had gone back up after being jolted down by some major event. The rise in the VIX is associated with major events which talking heads may dismiss but the VIX does not so lightly. Then, the swing trade could start for the fearless as I discussed earlier, the swing trade for the unstable bear market VIX pattern.

For the most recent bear market, spikes in the VIX coincided with the bad news on mortgages. The first spike was timed by the first major news stories coming out in February 2007.  On 2/23/2007, the VIX was around 10.   On 2/27/07, it shot out of the stable  bull market 2 pattern with gusto and rose to over 18. The news was starting to pour out in 2/2007 about the subprime fiasco which market participants tried to put aside for several months as "containable" but it just kept coming back showing just how serious it was going to be, with the bad news accelerating in August 2007. The VIX warning in August was unmistakable. The VIX model is based on a theory and the theory does not permit any thought in this situation except on the degree of forced reductions and what to sell. No matter what anyone was saying, no matter what the political and business leaders were claiming, the model said sell in October 2007.

As with any model based on theory, it will have to be changed as circumstances change. And it always has to be tailored for the individual's willingness to accept risk and their particular financial position.   Someone who is  already very nervous about stocks to begin with could go 100% into cash at the first sign of trouble, and that would have been great in October 2007 to say the least, whereas someone else would modify the forced reductions in other ways, by increasing the reductions in higher or lower amounts according to the individual's preference. I did 10% and 10% and I will change that for the next one since it was not enough for this bear to say the least at my current age. As I grow older, I am naturally increasing my exposure to bonds. 

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