Featured Trades: (VOLATILTIY INDEX), (VIX), (FFIV), (SPX)

2) Buying Straw Hats in the Dead of Winter. I am one of those demented people who buys flood insurance when the sun is shining and sun tan lotion by the gallon from Costco in the dead of winter. I am such an inveterate bargain hunter that I even buy Christmas ornaments during the January sales when retailers are unloading inventories for pennies on the dollar.

It is such instincts that drive me to take a look at the CBOE Volatility Index (VIX), a measure of the implied volatility of the S&P 500 stock index, which has been in a death spiral since it peaked nearly three years ago at the $80 level. You may know of this from the talking heads and beginners who call this the 'Fear Index'.

For those of you who have a PhD in higher mathematics from MIT, the (VIX) is a weighted blend of prices for a range of options on the S&P 500 index. The formula uses a kernel-smoothed estimator that takes as inputs the current market prices for all out-of-the-money calls and puts for the front month and second month expirations. The (VIX) is the square root of the par variance swap rate for a 30 day term initiated today. To get into the pricing of the individual options, please go look up your handy dandy and ever useful Black-Scholes equation.

For the rest of you who do not possess PhD in higher mathematics from MIT, and maybe scored a 450 on your math SAT test, or who don't know what an SAT test is, this is what you need to know. When the market goes up, the (VIX) goes down. When the market goes down, the (VIX) goes up. End of story.

The (VIX) is expressed in terms of the annualized movement in the S&P 500. So today's (VIX) of $17.64 means that the market expects the market to move 5.01%, or 64 S&P 500 points, over the next 30 days (17.62/3.46 = 5.01%). It really doesn't care which way.

It gets better. Futures contracts began trading on the (VIX) in 2004, and options on the futures since 2006. Since then, these instruments have provided a vital means through which hedge funds control risk in their portfolios, thus providing the 'hedge' in hedge fund.

Now, erase the blackboard and start all over. Why should you care? If you buy the (VIX) here at $17.64, you are buying a derivative at a multiyear low at a technically oversold level. Buying (VIX) here is the equivalent of taking out an insurance policy on the long side of your portfolio. If you don't want to sell you stocks in order to avoid capital gains taxes, you can insure yourself against losses through buying the (VIX) to match your portfolio. You can also use options strategies to create a cheap entry point and to limit your risk.

I am not saying you should rush out and buy this thing today. But you might tomorrow. We have gone up virtually in a straight line for five months now, taking the S&P 500 up 28%. A number of technical programs are giving 'SELL' signals. The great New Year's asset allocation, which I managed to grab hold of with both hands, is now done. An awful lot of people have crowded on to the same side of the boat, assuming that Ben Bernanke will keep printing money forever. Remember what happened to the Titanic?

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Does This Come in a 42 Gallon Drum?

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See Any Connection?

Featured Trades: (BIG TECHNOLOGY), (CSCO)

2) Time to Ring the Cash Register on Big Technology. Given the worsening technical picture for the market in general, and technology stocks specifically, I am selling my Cisco Systems (CSCO) March, 2011 $20-$22 call spread at the market. With the stock here at $20.82, I see a middle market for the spread at 98 cents, so I'm using that as my notional exit price. Those 'Macro Millionaires' who came in with me on December 16 when the stock was at a lowly $19.65 are up 66% on the call spread position. Those who shorted the puts with me and covered down 71% three weeks later have made even more money.

Analyze this trade and you'll see what this game is all about. In little more than a month, Cisco Systems stock rose by 5.9%. By risking only 5% of your capital you were able to add 3.31% to the value of your total portfolio.

You found a stock with great fundamentals. You zeroed in on the move with the highest probability of taking place, the next $1 move up, and then leveraged up with a limited risk position that offered much more upside than downside.

This is how you made money on this trade, and will continue to do so on the next one, and the one after that. You could be making your stock picks with a coin toss, and still make money with this strategy. This is how I do it. This is how George Soros and Paul Tudor Jones do it. This is how Morgan Stanley and Goldman Sachs do it. I know because I have been trading with, arguing with, and drinking with these guys for 30 years.

This is not a home run, but is at least a double, and possibly even a triple. Given that in this zero return world, many hedge funds would be happy with an annual 11% return, and would kill for 20%, 3.31% on a single trade is nothing to sneeze at.

I'll probably re enter this trade at a later date with a different set of strikes. On to the next one.

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Featured Trades: (THE MUNI BOND MYTH), (MUB), (JNK), (TBT)

2) The Muni Bond Myth. Have I seen This movie before? Two years ago, analysts were predicting default rates as high as 17% for Junk bonds in the wake of the financial meltdown, taking yields on individual issues up to 25%. Liquidity in the market vaporized, and huge volumes of unsold paper overhung the market. To me, this was an engraved invitation to come in and buy the junk bond ETF (JNK) at $18. Since then, the despised ETF has risen to $40, and with the hefty interest income, the total return has been over 160%. What was the actually realized default rate? It came in at less than 0.50%.

Fast forward three years to today (has it been that long?). Bank research analyst Meredith Whitney is predicting that the dire straits of state and local finances will trigger a collapse of the municipal bond market that will resemble the Sack of Rome. She believes that total defaults could reach $100 billion. Since September, the main muni bond ETF (MUB) has plunged from $106 to $97.

I don't buy it for a second. States are looking at debt to GDP ratios of 4% compared to nearly 100% for the federal government, which still maintains its triple 'A' rating. They are miles away from the 130% of GDP that triggered defaults and emerging refinancings by Greece, Portugal, and Ireland.

The default risk of muni paper is being vastly exaggerated. I have looked into several California issues and found them at the absolute top of the seniority scale in the state's obligations. Teachers will starve, police and firemen will go on strike, and there will be rioting in the streets before a single interest payment is missed to bond holders.

How many municipal defaults have we actually seen in the last 20 years? There have only been two that I know of. The nearby City of Vallejo, where policemen earn $140,000 a year, is one of the worst run organizations on the planet. And Orange County got its knickers in a twist betting their entire treasury on a complex derivatives strategy that they clearly didn't understand sold by, guess who, Goldman Sachs. To find municipal defaults in any real numbers you have to go back 80 years to the Great Depression.

My guess is that we will see a rise in muni bond defaults. But it will be from two to only 20, not the hundreds that Whitney is forecasting.?? The market is currently pricing in the triple digit number.

Let me preface my call here that I don't know anything about the muni bond market. It has long been a boring, quiet backwater of the debt markets. At Morgan Stanley, this is where you sent the new recruit with the 'C' average from a second tier school who you had to hire because his dad was a major client. I have spent most of my life working with major offshore institutions and foreign governments for whom the tax advantages of owning munis have no value.

However, I do know how to use a calculator. Decent quality muni bonds now carry 8% yields. If you buy bonds from you local issuer, you can duck the city, state, and federal tax due on equivalent grade corporate paper. That gives you a pre tax yield of 16%, almost as high as the peak we saw in the junk market in 2008. While the market has gotten a little thin, prices from here are going to get huge support from these coupons.

Since the tax advantages of these arcane instruments are highly local, sometimes depending on what neighborhood you live in, I suggest talking to a financial adviser to obtain some tailor made recommendations. There is no trade for me here. I just get irritated when conflicted analysts give bad advice to my readers and laugh all the way to the bank. Thought you should know.

There is one additional instructive thing that is going on in the muni market. The mayhem that we are seeing is but a preview to the real violence that we will see when the US Treasury bond market starts to collapse, possible in a few months. That I can trade, through the leverage short ETF (TBT). This is the real lesson of what is going on in muni land.

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This is Not the Muni Bond Market

Featured Trades: (SPX), (BAC), (CSCO),
(DIG), (SSO), (GLD), (TBT), (JJG)

1) Time to Tighten Up Those Stops. Well, the party couldn't go on forever. Yesterday, the S&P 500 took its first 1% hit since November, and the NASDAQ took an even more severe spanking. Like in an Agatha Christie murder mystery, risk has made a sudden reappearance on the scene, after spending much of the show hiding behind the curtains. Since Ben Bernanke launched QE2 and Obama hatched his tax deal with the opposition in mid November, you could count the number of down days in the market on one hand, and the color red had become virtually an extinct species.

What is really interesting about the Wednesday weakness is that it hit virtually every asset class across the board at once. We are not seeing an equity correction, or a commodity correction, but a generalized asset correction of every description. Translate that into a big fat 'RISK OFF' trade. This is why I find hedging across asset classes a useless exercise in a binary world. It just becomes a method for losing money in more interesting and exotic ways.

You could blame Steve Jobs' illness for this state of affairs. In fact, the markets have been over extended for some time. The pros have been expecting this down move with some confidence. This is why I have been steadily scaling back risk in recent days, cutting my (TBT) position in half, bailing on Bank of America (BAC) and grain (JJG) positions, buying back short puts in (BAC) and (CSCO), and cautiously putting out shorts in gold (GLD) and the Euro (FXE).

Given that my 'Macro Millionaire' followers are spectacularly in the money with their seven week portfolios, I am going to exercise some prudence here and tighten up all of my stops considerably on what is left. This is to prevent them from becoming 'Macro Thousandaires'. I am only lowering my stop marginally in the (YCS) to keep someone from stealing my position at the bottom of the market. That way we will still be well ahead of the game if this sell off develops a considerable head of steam. Here are my new stop losses:

(SSO) $48.85
(YCS) $14.85
(CSCO) call spread - $19 in the stock
(TBT) $35
(DIG) $46
(GLD) put spread - $1,450 in gold
(FXE) put spread - $1.40 in the euro

To paraphrase Winston Churchill, this is not the end, nor the beginning of the end. But it is the end of the beginning. If you want to buy dips, you have to sell the rallies.

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Winnie