Issue #289 19 December 2008

This newsletter is written on a weekly basis to help investors understand and learn the principles of market analysis for themselves. We don’t provide investment advice, but we do aim to provide a straight talking review of the market action over the previous days with a focus on how real life analysis techniques could be applied.

Editorial: Fee Fi Fo Fum! I smell the blood of the Fed Reserve man!

Tom Scollon Chief Editor

Governments panic. Well Governments might say the Feds are independent and it is the Feds who are panicking. Maybe in normal times Governments and Feds don’t talk a lot but these are far from normal times. And in any case I am not convinced they don’t talk, period. And I also smell the governments slick salesman. I am getting sold. And I am really suspicious about all these handouts and the printing of all this spondulicks. And I know I definitely don’t want my tax money spent on all manner of bailouts. The smart money, represented by unprecedented quantum’s of global cash, sits on the sidelines. We smell blood. We smell panic. We know this continuing panic is going to rock markets further and send them lower. As investors we are holding out on our governments knowing that governments will just panic more. Scratch their head and panic more. Give us more lollies until one day we know there are not many lollies left in the cupboard. Of course we know the cupboard is getting bare, but not yet. But some investors are saying the end is already here. The cupboard is bare. Take the lollies now. Take the cheap stocks now. I would be very careful about doing that. It appears there could be the potential for a rally but it will be limited. And it is possible it will be just the calm before the next storm. These are not normal times. The usual formulae don’t work. Overnight OPEC cuts back oil production for the third time in a matter of weeks to shore up prices and oil falls 8%. OPEC clearly didn’t read TTN a few weeks ago. It is a very different world OPEC. A new paradigm. So as the ‘annus horribilis’ draws to an end I also scratch my head and ask where is the bottom of this almighty pit. I still don’t know yet and will try to tell you when it is roughly here. But for the moment I reckon it is prudent to stand aside. I always ask the question: ‘what if I am wrong?’ I have been wrong before. But in this case I don’t think we have to second guess the markets or panicking governments or confused Feds. There will be plenty of time to get on board this next rally. But in the meantime don’t turn your back on the market. And if you are looking for real movement, uncertainty and volatility and money to be made, take a look at currencies – but only if you are qualified! Yes another year has flown and memorable by the destructive path it has left behind. I genuinely hope that for you it is a healthy and more prosperous 2009 and that you have a wonderful Christmas and break. Enjoy the ride Tom Scollon Chief Analyst

Fundamental Analysis: The best and worst of 2008

Andrew Page

There’s no doubt that 2008 will go down in history as one of the worst years on financial markets. In Australia the bourse has dropped by around 45%, making this the worst calendar year in more than 50 years. But that doesn’t mean that all stocks have done poorly; in fact there have been a number of great success stories over the past 12 months. Indeed there have been over 70 companies on the ASX that have gained ground since the start of the year, the best being Altera Resources which has climbed over 1800% higher! But even if we look only at stocks with a market capitalization of more than $500m, there have still been some great performers. Company % Gain Linc Energy Ltd 143% Sunshine Gas Limited 107% Origin Energy 87% Queensland Gas 86% Aneka Tambang 67% New Hope Corporation 38% Midwest Corporation 34% AGL Energy Limited 14% Iluka Resources 12% Navitas Limited 11% Coal & Allied 8% Ansell Limited 7% Santos Ltd 6% Felix Resources Ltd. 4% Of course, hindsight is a wonderful thing, and even though most of us would have missed out on many of these wins, there are nonetheless some valuable lessons we can draw from these examples. One thing that stands out is that most of these companies belong to the energy sector – even though oil has tumbled from almost US$150 / barrel to less than US$40 / barrel in the past 5 months. A big part of the explanation is the revaluation of coal seam gas assets, and the slide of the Aussie dollar, but in this regard both of these factors would have been difficult to forecast. However the other thing that most of these companies have in common is conservative gearing levels and quality assets. Factors that were largely ignored by investors prior to the credit crunch, but are now being closely watched. There’s no coincidence that companies that have minimal debt refinancing obligations and solid balance sheets have been the ones to do well in the current environment. Indeed, those at the other end of the spectrum, have been those with very high levels of debt, and assets that have plummeted in value. Consider the worst performing stocks with a market capitalization of more than $10m. Company % Loss Babcock & Brown Ltd -99% City Pacific Limited -98% Becton Property Grp. -98% Babcock & Brown Pwr -98% Admiralty Resources. -98% Albidon Limited -97% Allco Finance Group -97% Bluefreeway Limited -97% Valad Property Group -97% Everest Babcock & B -96% Living & Leisure Grp -96% ING Re Com Group -96% So the moral of the story? If a company is sitting on poor assets, and has borrowed to excess – ignore it at all costs! Many traders argue that fundamental considerations such as these are unnecessary, but as you can see, they can help you avoid some very costly mistakes. Make the markets work for you Andrew Page

Foreign Exchange: A Captain’s Knock

Mathew Barnes

Trading is a business, but to me, it is also a game. There are winners, there are losers, and there are spectators. Last Saturday I was asked to help out a friend’s cricket team which didn’t have enough players for a match. I love cricket, but I hadn’t played in five years, so you might say I was unfit and a little bit “out of touch.” I showed up to the ground feeling more than a few nerves. After all, opening the batting can be tough and even a little dangerous at the best of times, let alone when you haven’t picked up a cricket bat for five years! Our team dismissed the opposition for a relatively small total, so at least when I went out to bat, we weren’t chasing a lot of runs. The strong wind was causing the ball to swing wildly, so batting wasn’t easy, but I figured I would hang around in a support role and let the other batsmen score the runs. I was sure I would have enough trouble just staying at the crease. I decided to approach my innings just like I approach my trading – with a plan! I knew that as a batsman my three best shots were drives, leg glances, and blocks. These are low risk shots, not going to score runs quickly, but not likely to get you out either. There are other, more glamorous shots, like hook shots and pull shots, but these were higher risk, so I decided not to use them in this innings. This is just like trading. Sure, picking an exact top or bottom can make you look like a hero, but it has also caused some people to “fall in love with their forecasts” and end up wiping out their trading accounts. In cricket, the history books might show a batsman scored 100 runs, but nobody asks if the batsman played stylish cricket or clever cricket or boring cricket. The results simply show 100 runs. If you make a million dollars from trading, do you care whether you made it by calling exact tops and bottoms, or by trading the swing charts? In the game, my plan was to accumulate runs and slowly work my way into some kind of rhythm, while assisting the other batsmen. Our team’s top three batsmen fell with our score only on six runs and all of a sudden what initially looked like a small total to chase was now looking a lot more difficult. I stuck to my plan, but at the same time, I realized that I could no longer depend on others to score the runs for the team. Even though I was out of form, I realized I needed to step up and take control of the situation. I changed my mindset from being a “supporting batsman” to being a “responsible batsman.” I wasn’t the captain of the team. I wasn’t even a senior player. But in my mind, all that was required for the team to win was for me to perform. I knew that if I kept my head and weathered the storm, my team would win. Ball by ball, I patiently stuck to my plan. I let the good balls go, and placed the bad balls into the gaps. You could say I was playing with a high probability, low risk, low reward “trading plan.” Occasionally, I “timed” my shots well and they went for four runs. They were the same shots that would previously score me only one run, but sometimes luck just seemed to send the ball through the gaps and out to the boundary. That’s just like trading. The same setup might work six times out of ten for you, scoring a small win. Twice it might get you a breakeven, and once a loss. The tenth time, it might make you a huge win. I ended up batting for the whole innings, until we scored the winning runs with six wickets down. Physically, I was exhausted and could hardly walk, but mentally I was pleased with myself, because I had overcome a challenge. I had played a “Captain’s Knock,” even though I wasn’t the captain. When you are trading, there are no team mates out there to help you. Sure, you can contact a Trading Tutor, but ultimately your success or failure rests with you. Don’t see it as something intimidating – see it as a challenge to bring out the best in you. Whether you are batting or trading, set yourself a mental challenge of performing to the best of your ability. As David Bowden says, “make each trade your personal best.” Work out the trades that are likely to return profits to you, and not likely to “get you out”. In cricket, the saying goes that if you stay at the crease long enough, the runs will come. The same goes in trading. If you protect your capital and stay in the game long enough, your profits will come. Be Prepared! Mathew Barnes

Options Corner: Getting into the Christmas Spirit

Ken Paddison

Could there be a Christmas rally this year after all? Will everyone spend Kevin’s bonus on presents to stimulate the economy now that interest rates and the price of fuel are still dropping? If so, where better to take advantage of it then with one of the big retailers. Well, there’s no guarantee that a rally will happen, but I’m going to jump on the band wagon with a low risk, bullish options trade on Woolworths (WOW). This company has held up well during the market turmoil and is currently trading in an Elliott Wave sideways pattern after coming off its recent lows. See Chart 1: click to enlarge I have chosen to trade WOW with an Out of the Money Calendar spread using Call options. I am buying the March 09, $28 contract because I believe that WOW has the potential to trade back up to this price over the next 2 months and I want to use longer dated options to give myself time to be right. The problem is that options are still expensive due to the current implied volatility levels. So, to offset a lot of the cost of this trade I’m going to sell the February 09, $28 Call contract and create a Calendar spread. The actual order that I give to the broker will be this. Buy to open 1 March 09, $28 Call contract and at the same time sell to open 1 February, $28 Call contract for a debit of 35 cents. This means that I’m not concerned with what price the individual contracts are, as long as I only pay 35 cents for the spread. The trade will actually cost me $350, as one contract contains 1000 shares. Now, how do I work out easily what the profit is likely to be if I’m right and WOW is trading around the $28 level when my short February options expire? The process is fairly simple, at that time; my long options will still have 30 days to expiration and are basically at the money. To get a reasonable idea of my profit then, I just need to look at what the current January 09 $25.50 options are worth now, to see what 30 day, at the money options are worth. In this case that’s about $1.25. This means that I can expect to make around 90 cents ($1.25 minus the 35 cents I paid originally) or $900 per contract profit. This is supported by the risk graph in Chart 2: click to enlarge The initial trade plan is simple. The best outcome would be to have the February contract expire worthless and then sell the March contract for a profit. However, should WOW rise above the $28 level, I would have to make a different adjustment. This would probably involve buying back my short position and then deciding whether or not I would sell my long position at that time. How I decided to adjust the trade would be determined by my analysis of where I thought WOW was likely to go next. That’s the beauty of options trading, the risk is normally low and there is more than one type of adjustment that can be made. I will explore some of these alternatives in a future article should WOW rise above $28. Remember, you always have options, Ken Paddison