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Preparing For A Market Collapse, Part III

Summary U.S. equities are down but not cheap. They could fall further. It is time to prepare…. … In fact, it is always a good time to be prepared. This is the third in a series. You can read Part I and Part II for background. Since the series began, the S&P 500 (NYSEARCA: SPY ) is down over 10%; it could have much further to fall. What current shorts have the most asymmetric exposure? How can average investors see the need to short? Here are three specific short ideas followed by three ways for investors, including retail investors, to weigh when to short. China In terms of country exposure, China is among my favorite shorts. Artificial central bank stimulus drove the Chinese equity mania in early 2015. New equity buyers flooded into the market. These new investors purchased stocks using a record amount of margin debt. They had weak hands once the market direction turned around. The supply of new capital was finite. Eager new investors pushed up prices, but quickly pulled out of the market once prices declined. How do you short China? One way is to short Direxion Daily China Bull 3X Shares (NYSEARCA: YINN ). It is down over 70% since I first disclosed this idea, but it could drop much further over time. That being said, not all Chinese equities are expensive. While China is a big short idea overall, there are some small long ideas worth considering, such as Taomee (NYSE: TAOM ). Biotech Turning to sector exposure, biotech is another favorite short opportunity. This has been a hot sector, but one with market prices that are high, unstable, and precarious . It is down over 20% but remains overpriced. In the long term, it will probably decline substantially further. While biotech is a major short opportunity, one can find bargains in the wreckage. Depomed (NASDAQ: DEPO ) is one worth considering. Due to its drug prices, it is far less sensitive to political pressure than Horizon (NASDAQ: HZNP ) or Valeant (NYSE: VRX ). High Yield In the current credit environment, “high yield” is a bit of a misnomer. In fact, it borders on false advertising. This is one of my favorite types of securities to short because high yield is expensive enough that it does not cost too much if it maintains these rarified prices, and investors long this exposure will probably not hang in there if it begins to decline substantially. Retail investors (including not just a few on Seeking Alpha) who seek yield at any price have driven securities with the appearance of stable yield to zany prices. One security to consider is PIMCO High Income Fund (NYSE: PHK ). As of today, it trades at a 13% premium to its NAV. Down over 25%, it is still overpriced. Its price should continue to converge upon its value in the years ahead. If credit spreads widen from here, it could decline substantially. Should you own any broad-based bond exposure? At today’s prices, no. “HPHs [high priced helpers] frequently think of risk as a function of asset class along the lines of “cash is safe, stock is risky, and bonds are in the middle”. In reality, risk is never a function of asset class; it is a function of price. Thinking proxies such as asset class-based risk models are designed only to excuse HPHs from doing any fundamental analysis to determine value. They can’t make you safe because they can’t even define, let alone quantify, risk. If you are a 65-year-old retiree, a smart-sounding HPH might say that you should be 65% in bonds, with others arguing importantly that the right number is 70% or 60%. The right number is 0%. Alternatively, come up with an explanation of how the credit market is currently undervalued. I could, of course, be completely wrong, but the current credit market looks like an epic bubble. It is conventional to own a lot of bonds, but when the bubble bursts, you will conventionally lose a lot of money.” – Where Can I Find Safe Income For Retirement? Shiller P/E When to short? At the level of individual securities, the fundamental analysis and event analysis takes more time than most investors have to short stocks. In terms of shorting country markets, sectors, or parts of the capital structure, there are some readily-available resources that might be helpful in knowing when to short. For a quick heuristic on the market’s price, you might consider the Shiller P/E. This ratio is more indicative of value across business cycles because it is less impacted by fluctuating profit margins. The U.S. equity market’s Shiller P/E is currently over 43% above its historical mean of about 17. Market prices have rarely maintained such high multiples for long. For further reading on topics, including the Shiller P/E, you might like Rock Breaks Scissors: A Practical Guide to Outguessing and Outwitting Almost Everybody . U.S. equities are the fourth most expensive in the world according to this metric, behind only Japan, Ireland, and Denmark. Market Cap/GDP Market capitalization / GDP in the U.S. is another key metric. When it is high, it is a particularly important time to focus on short opportunities. Today, the U.S. market cap is about 112% of the U.S. GDP. Historically, from such lofty levels, subsequent total returns are typically less than 2% per year. The U.S. equity market is pricey on both metrics. Real returns are probably negative or too low to justify the risk. Incidentally, on both metrics, Russia is a bargain. Its Shiller P/E is about 5 and its market cap/GDP is about 18%, close to its historical minimum of 17% over the past 15 years. The inverse, leveraged Russian ETF (NYSEARCA: RUSS ) is down over 25% since our previous article on that opportunity. However, despite the move in price, it remains an attractive short. 7-Year Real Return Forecast GMO publishes a monthly chart comparing the estimated prospective annual real return over the subsequent seven years of various asset classes from current market prices. The comparison between the 6.5% long-term historical U.S. equity return and the returns from today’s levels is not favorable for today’s equity investors. Average returns will probably be around zero, with somewhat negative returns overall and only marginally positive returns for equities that GMO considers to be high quality. At least we have plenty of timber in Maine, so we have that one covered. Conclusion Part I covered the virtues of maintaining both sizing discipline and a cash balance. “Ordinary opportunity sets should lead to only ordinary position sizing, leaving extraordinarily large positions for only the rarest of opportunities. At a one percent position, one could conceivably find subsequent risk:reward opportunities to double down three times and still have a statistically diversified portfolio. Hyper-diversification accomplishes very little, but having a dozen truly uncorrelated positions accomplishes much of what correlation can offer. However, if one starts with a 5% position and doubles it three times on apparently better subsequent entry points, one is left with an over-concentrated or overleveraged portfolio.” “When everything is going horribly wrong, the comparative advantage of being more liquid than your marginal counterparty becomes extreme. So, while I do not know what the right amount of cash is, I am certain that it is better to have more. You should have more than whomever you are trading against when nothing is working in the markets. How much is that? I currently have 25% of my assets in easily accessible cash and am glad that I do. My percentage might be too low but I am virtually certain that it is not too high. Whatever opportunity cost that I pay in terms of diminished return can be quickly recouped during the next market collapse.” Part II covered some of my favorite company-specific short ideas. The ten disclosed short ideas declined from 2 to 35% since publication; none have yet to fully converge upon their intrinsic values. The average decline of 16% is over three times the S&P 500 ( SPY ) decline over the same period. The larger point is that a flexible mandate that allows one to go long or short creates an optimal environment for analytical rigor. “When someone is able to buy or short investment opportunities, he can first be analytical – gathering relevant facts, measuring value, and examining events that are likely to unlock or reveal that value. One need not be a fan, only an analyst. Regardless of whether or not you like what you are looking at, there is something to do either way. One can buy, one can short, one can ignore. One does not need to prejudge before reaching a conclusion informed by the relevant premises.” You can protect your capital by shorting expensive (and therefore risky) securities with exposures to China, biotech, and high yield credit as described above in Part III. Additionally, you can monitor the Shiller P/E ratio, the market cap/GDP, and the 7-year return forecast for a quick look at the market’s price. These tools are valuable additions to the toolkit of the prepared investor. Regardless of the specifics on how you choose to prepare for the possibility of a market crash, it is unlikely that the next half-century will look anything like the past. It is (barely) conceivable that it continues at the current pace and the S&P 500 races through 48,000. But even if it is possible, it is not a safe bet. When it comes to investing, I do not hope for or expect any single outcome. I do not hope or expect that my home will burn down either, but I still have fire extinguishers and plenty of insurance. None of this is a call to panic; it is a modest call to prepare. I would be perfectly happy to be wrong in my view that such preparation is both wise and timely. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

IShares MSCI Poland Capped ETF: Playing The European Growth Story Without The Commodity Risk

Polish equities seem highly attractive given their exposure to the European growth story and the oil price decline with little risk from China and the commodity slowdown. Poland’s fundamentals look relatively strong with few overbearing structural issues. Trade prospects and strong competitiveness coupled with attractive long term valuations should drive stock price appreciation. Political uncertainty and economic risks have been overstated given rising lending and the ability to ease policy further. International markets, especially emerging markets, have sold off violently in recent months with the MSCI EM Index down almost 20% YTD. The selloff has been widespread, leaving investors the question of where it is most appropriate to find value and what stock markets have been unjustly discounted while also limiting exposure to the uncertain environment in China and commodities. Polish equities seem highly attractive in this context given their exposure to the European growth story and the oil price decline which are still not fully priced in. US investors seeking to invest in Poland can find exposure through the iShares MSCI Poland Capped ETF (NYSEARCA: EPOL ). Unlike a large portion of the emerging markets space, Poland’s fundamentals look relatively strong with few overbearing structural issues. Poland’s growth remains around a 3-handle, largely driven by domestic demand which also provided support during the global financial crisis. Resilient domestic demand helps shelter Poland from external shocks. Growth will likely benefit indirectly from European QE, and with the benchmark rate at 1.5%, the Polish central bank still has some ammunition to ease policy. Poland’s trade situation is likely to improve going forward given strong forward-looking fundamental in Europe and the recent slide of oil prices. According to MIT’s Observatory of Economic Complexity, Poland’s largest export destinations remain Germany, France, and the UK. German domestic demand and consumption are experiencing a cyclical upswing given a tightening labor market, QE (until September 2016), and a rise in European bank lending. In addition, an uptick in spending in the US should increase German production and incomes which could easily transfer to Poland through exports. France also benefits from some of the same cyclical forces as Germany, while the UK continues to be one of the strongest domestic demand stories in all of Europe, with potential rate hikes coming in 2016 given strong GDP growth and increasing wage inflation. Given that Poland’s primary import is crude oil which has gone through a large correction, its trade balance should continue to improve as more income stays in the pockets of exporting businesses and domestic consumers. Lower oil prices not only help bolster production in Poland but are beneficial to the Euro Area as a whole, providing more wealth by which to buy Poland’s exports. In contrast to a number of emerging markets, especially in Eastern Europe, Poland is in a strong position to take advantage of positive trade developments. According to the OECD, Poland’s real effective exchange rate adjusted for unit labor costs has declined significantly over the last few years. Price competitiveness gains are not possible for the European periphery (a strong competitor of exports to Germany) due to being part of a single currency union. Likewise, the rest of Eastern Europe and much of the emerging markets space is just now devaluing to adjust for weaker global demand. Poland’s lack of exposure to the slowdown in China and general commodity prices should also help differentiate the region from other vulnerable emerging markets. (click to enlarge) Source: Bluenomics https://www.bluenomics.com/ Paired with the strong trade prospects for Poland are attractive valuations that could play out over the short and medium term. The Shiller CAPE (valuation metric that has a strong correlation with 5-year and 10-year equity returns) for Polish equities is estimated to be around 10, setting up an attractive entry point for potential investors. This also resides in the context of low interest rates, low inflation, and growing bank lending. EPOL maintains a large exposure to financials whose equity prices directly benefit from increased lending while capital ratios remain high in Poland. EPOL provides an attractive dividend yield of 3.64% and is down 15% YTD. Risks to the outlook for Polish equities include political uncertainty, direct exposure to Russia, and a large external debt stock. Given where valuations are currently and the future trade prospects of Poland, these risks should not derail a strong recovery in Polish equities. Poland’s presidential elections earlier this year saw PiS candidate Andrzej Duda win the general election, representing a change to a more populist mindset by the Polish public. This could have important implications on upcoming parliamentary elections which are significantly more relevant for policy and the economic outlook in Poland. PiS currently leads parliamentary polls by a significant margin, suggesting a change in government and potential leftist policy shifts. According to Reuters, the composition of the Polish central bank could also change as a PiS parliamentary majority appoints less hawkish members. Despite the danger of a more populist government, PiS rhetoric has softened in recent months as the party attempts to appeal to more centrist voters. According to Bloomberg and other news outlets, PiS will likely continue to abide by the European Union’s deficit requirements of 3%. In addition, taxes on banks could be less onerous than originally thought. Given strong adequacy ratios and profitability, lending should not be affected materially especially with European QE in full swing. According to Poland’s central bank, the total capital ratio of banks in Poland is at 14.9% as of the first quarter of this year, having increased by over 6% over the previous year. This is in the context of decreasing impaired loans and stable domestic growth. Lending is also tracking GDP growth at around 3%, which suggests sufficient credit conditions for a stable economy. Some relief for domestic consumers, especially those still servicing Swiss mortgage debt, could also be in store from increased corporate taxes. Less hawkish central bank members potentially appointed by the PiS could also provide for easier monetary policy in the near-term, containing any negative lending developments. Events near the Russia-Ukraine border as well as sanctions against Russia are a continuing negative for Poland, but do not seem to be playing much of a role in depressing equity prices. Poland’s export exposure to Russia seems to be already priced in and, despite being a relatively large exposure, could be offset by positive developments with its other European trading partners. According to the Financial Times , farmers in Poland who can no longer export apples to Russia (one of Poland’s largest agricultural exports) have looked to other markets including the Middle East, Hong Kong, and India. It is difficult to see a near-term resolution to the crisis but there could be relief of sanctions on Russia with an escalation of the Syrian refugee problem. Europe may have to rely on Russian leverage in the region given that Syrian rebels have made little headway in Syria. A resolution to the crisis may involve keeping Bashar al-Assad in power and striking some kind of agreement. A removal of sanctions could lead to a removal of a Russian ban on Polish exports, further improving the trade balance. Perhaps the most serious risk to Polish equities is the large stock of external debt the country must service and the effects of Fed tightening on the ability of Polish households and companies to service that debt. Though Fed tightening may lead to an emerging market liquidity squeeze (anticipation of rate hikes has already created an environment of large capital outflows), Poland seems to be less exposed than other markets. Poland lacks many of the structural issues present in a number of emerging market economies. Domestic growth remains strong and the current account balance is only slightly negative. This is in contrast to a number of Latin American economies that are directly exposed to commodity prices and China. In addition, lending and capital adequacy ratios remain strong, lessening the effects of a liquidity shock. The central bank of Poland has stated that Swiss mortgages should only have a moderate effect on economic activity going forward if the Zloty were to depreciate (January 2015 saw the Swiss Franc appreciate 15-20% but with few negative consequences for Polish households). Meanwhile, central bank data suggests general foreign currency loans have stabilized and continue to fall year over year. Competitiveness is higher than in countries like Turkey, Russia, and Brazil where significant devaluations in exchange rates must take place. Poland is also experiencing no inflation, providing plenty of room to ease policy if downside pressures were to materialize. Not all emerging markets are created equal and Poland certainly stands out as a potential outperformer. Political and economic risks have been overemphasized as serviceability of debt and growth remain healthy. Poland is a unique way to play the European recovery and the oil price decline with attractive growth prospects at discounted valuations.

ETFs Driving Big Gains For Oil Shorts

Summary Money moving in and out of long and short oil ETFs, as low oil price visibility creates more uncertainty. Retail investors should focus on only holding for a very limited time period if they go short. There is nothing to suggest oil prices can rise to sustainable levels in the near future. Traders with a high tolerance for leveraged risk have been making a killing by shorting oil in 2015, led by a number of ETFs that have been, in some cases, up well over 200 percent on the year. There has been a lot more volatility than usual in these types of instruments, as headlines contradicting one another on the movement of the price of oil have money moving in an out of ETFs catering to short and long outlooks for oil. Some large players have been short oil all year, but for the retail investor, it would be wise to take a position in these ETFs for a very short period of time. Some ETFs even suggest and encourage that to their investors, saying in many cases they’re built to hold a position for only one day. All the volatility and inflows and outflows reinforce the fact no one really knows where the price of oil will go, with some like Goldman Sachs saying it could plunge to as low as $20 per barrel, and OPEC recently saying it’s looking at it rebounding to $80 per barrel. In the case of OPEC, that’s primarily because it believes a decrease in American production will begin to offset excess inventory, and start to drive up prices. That is based upon its assessment it has beaten down a lot of the tight or shale oil drillers, which it believes will be a sustainable event. I disagree with that because of the plethora of drilled but uncompleted (DUC) wells, which can quickly and inexpensively be brought online in response to an increase in the price of oil. The truth is, as the market is showing, it could go either way. ETF oil shorting products Before getting into a couple of products and some interesting facts about their performance and why money has been changing hands, it’s worth looking at a couple of elements related to these types of ETFs. As already mentioned, most if not all retail investors should be thinking very limited holding periods for ETFs that short oil. They are extremely volatile, and can move up or down very quickly. If using leverage to make the trade, when including daily rebalancing, the short term movement can be very different than what is expected of the long-term performance data of the ETF or ETN. At this time risk/reward is worth the plunge for those that have some spare capital and a high tolerance for risk. There has to be the belief the price of oil will continue to go down to enter this play. I’m not in this particular play at this time, but I’ve done it with other commodities, and there is a lot of money to be made if you’re right in your assessment of the market. That said, leverage is becoming more of a risk as things get murkier, as conflicting outlooks suggest the underlying catalysts for either direction are no longer as sure – at least in the mind of traders – as they were earlier in the year. That’s one of the major reasons, even as oil has remained under pressure, a lot of money has been taken off the table. VelocityShares 3x Inverse Crude Oil ETN (NYSEARCA: DWTI ) Since DWTI has been one of the top performers in the sector in 2015, we’ll take a look at it first. DWTI offers 3x or 300% exposure to how the S&P GSCI Crude Oil Index ER performs on a daily basis. It does have a fairly high annual fee of 1.35 percent. Since this and others are so volatile, I’m not going to even attempt to look at how much it’s up for the year. It changes significantly in a very short period of time, as you can see in the chart below. Its prospectus states it’s “suitable” to be held by most investors for one day. This is a short-term play where it simply doesn’t matter. Again, larger investors can hold longer if they believe the trend will remain down, but now that the price of oil has fallen so much over the last year, leveraged players are under increasing risk if things surprisingly and abruptly turn around. Daily average volume is a solid 1.8 million shares, but as with its share price, its asset base can be very volatile. (click to enlarge) source: YahooFinance PowerShares DB Crude Oil Short ETN (NYSEARCA: SZO ) Since SZO doesn’t use leverage, it is probably one of the safer instruments in this space, if the term ‘safe’ can be applied. It offers inverse exposure to WTI crude, tracking the Deutsche Bank Liquid Commodity Index, which covers how well a group of oil futures contracts are performing. Over the last three months it is up about 30 percent, and has an expense ratio of 0.75 percent. It trades far less than DWTI, with a 3-month daily average of approximately 35,000 shares. Not nearly as popular as DWTI, it only has net assets of about $28.59 million. (click to enlarge) source: YahooFinance ProShares UltraShort Bloomberg Crude Oil ETF (NYSEARCA: SCO ) My final short to look at is SCO; its goal is to attempt to provide double the daily inverse return of the performance of the Bloomberg WTI Crude Oil Subindex. Over the last three months it has generated a return of about 56 percent. Total expenses amount to 95 basis points. I wanted to highlight SCO because it has been one of the top performing ETFs this year, and yet over $175 million has been removed from assets, according to Bloomberg. That points to growing skittishness over the uncertainty the price of oil is going to go. (click to enlarge) source: YahooFinance The United States Oil ETF (NYSEARCA: USO ) Since USO is a long play on oil it is included to confirm there is a lot of money moving in and out of the long and short ETFs, and not all of it is intuitive. With USO, it has enjoyed near $2.75 billion in new cash investment, even though it has lost over 50 percent of its value so far in the last twelve months. There is no doubt this represents investors believing there is going to be a rebound in oil prices; at least in the short term. This, combined with the outflows from SZO, reiterate concerns over the risk associated with using leverage to short oil, and having no visibility on where the price of oil is going. (click to enlarge) source: YahooFinance Conclusion Shorting oil using ETFs has been very lucrative this year, and my thought is there is a more room to make money for those shorting oil within a limited time frame. For myself, I wouldn’t use leverage any longer because of the low visibility factor concerning oil prices, and I wouldn’t stay in longer than a day. I’m primarily speaking to retail investors here, although until there is more clarity in the short term, larger investors will likely play by similar rules, if they continue to use a shorting strategy in oil at all. My final thought concerning oil is a lot of the headlines are misleading because of the fact OPEC know larger shale producers can put production on hold if the price of oil continues to fall, and if it rebounds, can quickly respond within less than a month with its DUC wells. So the idea it can shut down a competitor like it has in the past, in my opinion, is a misguided one. Shale oil isn’t Russian oil or other types of oil that may take a lot of time to get back into production once it has been shut down. Companies with shale exposure can simply bide their time and wait until the price of oil moves up, and they can almost immediately start production. OPEC can do nothing to stop the larger shale companies. And even if the smaller capitalized companies go out of business, it doesn’t take away the fact the oil is still there. Larger companies will acquire the assets. OPEC has signaled it will continue to produce oil in order to maintain market share. While that has resulted in U.S. companies cutting back on production, there is so much supply out there, it will take a lot more to provide support for oil prices. There is a message being sent, but OPEC doesn’t have the teeth it had before shale, and going forward it has to deal with the fact that once production is lowered and prices start going up, shale companies will simply ramp up production and the cycle will continue. That means eventually OPEC will have to lower production if oil price are to increase at sustainable levels. With Russia so dependent on its oil for revenue, it’s not going to do so, which means this is a long-term trend that at this time, doesn’t have an answer outside of OPEC losing market share. For that reason these ETFs built to take advantage of low oil prices, will make money for those willing to take the risk and holding for very short periods of time. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.