The Most Powerful Force in the Universe

E = mc²

E = mc²

Albert Einstein

Mass energy equivalence paved the way for our most powerful weapon and energy source. Nuclear force was not, however, the most powerful force in the universe according to this man. Instead, it was compound interest.

Einstein was a man of relativity, and while it is true that nuclear is the strongest type of force taught in the classroom, in the real world his statement makes a lot of sense. The top 1% of income earners will make much of their income off of investments, and these investments typically yield a certain percent of profit per year which is then applied back upon itself the next year. This is one way in which income inequality grows – because the lower wage earners do not put their money in compounding investments.

It is important for anyone looking to get the highest return on their investment to understand the basics of compound interest.

Rule of 72

For those that don’t want to pull out a calculator to find out how long their investments will double in size there is a helpful and speedy way of figuring out roughly how long it will take to double their money. Divide 72 by the interest rate and that will be the number of years a annually compounding investment will take to double. See examples below:

9% interest – 72/9 = 8 years

5% interest – 72/9 = 14.4 years

3% interest – 72/3 = 24 years

If you use outrageously small or large interest rates the rule of 72 starts to break. Obviously a 100% interest rate will double your money in just 1 year, not eight and a half months!

Compound Interest Formula

The mathematical formula for annually compounded interest is

FV = PV * (1 + i)ᵗ

Where FV is future value, PV is present value, i is the interest rate, and t is the number of years. As most readers know, this is an exponential function of time (See Figure Below).

Solid line is exponential function with lower constant value.

Solid line is exponential function with lower constant value.

As you can see, exponential values can quickly get out of hand. Other real world examples of exponential growth include population growth in developing countries, inflations affect on currency (exponential decrease in value as seen below).

How inflation eats away

How inflation eats away

The phenomenon known as the rising income gap comes largely from these two graphs. The top graph represents invested wealth and the bottom represents buying power of a single unit of a depreciating currency.

What do I do?

If you’ve read to this point then you’ve already taken a good first step – you’re searching for knowledge and exponentially growing your financial acuity rather then let your mind exponentially waste away. I suggest creating a financial plan which takes into account your age (time till retirement), risk tolerance, and net worth and allocate uninvested funds into investment accounts. Investments can range from stocks, bonds, real estate, and even high interest savings accounts. Keep in mind that these days interest rates are amongst the lowest in mankind’s history, in the United States in particular. Most of all, don’t panic!

What Explains the Chinese Stock Market Price Boom?

The Chinese stock market boom has been scrutinized by the US mainstream media for it’s rapid ascendance. You will hear people mentioning that high school dropouts are now investing in large numbers without understanding the basic fundamentals of companies including but not limited to earnings. The Hang Seng (Hong Kong’s Market) has risen 60% this year having been opened up to sell shares to Chinese investors.

In all reality, small scale investors make up a small portion of actual market volume – and while it’s true that a large number of them are trying to get in on the action, the real reason for this steep rise is a law change which hampered real estate investment tactics. This included increasing the minimum down payment on a second property to 20% and increasing the capital gains tax on property sales to 20%. If you’ve lived in Asia you will find out that Chinese investors are big into real estate – and this spreads beyond China and Hong Kong into other ASEAN countries including Australia and New Zealand. Even less educated folks know the value of owning property, and many of them have been fortunate to make a reasonable amount of money in the past few decades as China has progressed to claim the world’s #2 spot economically speaking.

Stack the new property restrictions with two interest rate cuts by the central bank and a specter of a stimulus package down the road and you have the perfect environment for a stock market to flourish. This is similar to how the US stock market has reacted in the past few years to the Federal Reserve stimulus packages and extended periods of historically low interest rates.

Just this week, the Hang Seng market value rose above Japan’s Nikkei – an amazing feat but not unexpected given their market getting opened to Chinese mainland investors. Japan continues to stagnate as its fundamentals and workforce are burdened by a low growth rate and near zero immigration (due to strict immigration laws). The one bright side to the economy these days is higher tourism due to a stronger dollar against the Yen.

Some imagine the Chinese and Hong Kong bull markets will continue for awhile until free cash flow diminishes. Others are more skeptical, including most US pundits – they envision a large correction. I can foresee a huge catastrophe if the tax laws are changed regarding Chinese capital gains tax on stocks, but given the new restrictions on real estate trading this isn’t completely out of the question.

In hindsight, an American investor could have made a fair amount if he/she invested in Matthews China Fund Investor Class (MUTF:MCHFX), which has gone up 20.17% Year To Date. This fund specifically zoned in on Chinese stocks has outperformed one of the best American stocks Apple (Apple has gained 12.96% year to date) and NASDAQ (A piddly 4.57%). Investors can also consider investing in a broad array of Asian dividend stocks using the Matthews Asia Dividend Fund Investor Class (MUTF:MAPIX) which has gone up 12.95% YTD.

It goes without saying that the one who thinks there’s a serious bubble can always short these types of securities, but this is EXTREMELY risky. There is still more free cash flow as a percentage of the stock market capitalization in China than the US, meaning that they can pump a lot more money into the stock market before running short on liquidity. My expectation is that if the Chinese stock market is reaching bubble capacity and collapses, it’s quite likely to impact the US stock market. Even from a psychological perspective, seeing a bubbled stock market pop may cause people to rethink their investments.

How To Capitalize on Low Oil Prices

With crude oil trading the lowest it’s been since 2009 there are a few things you can do today to capitalize:

As Jerry Reed says in his song “Lord, Mr. Ford“:

Well, if you’re one of the millions who own one of them
Gas drinking, piston clinking, air polluting, smoke belching
Four wheeled buggies from Detroit City, then pay attention:

Now is a perfect time to load up the family and take a road trip. A penny saved on gas is worth more than a penny earned (considering taxes).

If the price of oil remains low, many sectors stand to benefit from the cost savings to their business. Obvious candidates include shipping, airlines, and retail. Oil revenue dependent companies should be avoided if low prices persist, such as drilling support and manufacturing companies.

If you think the oil price is bound to jump up sometime in the near future then you can buy oil futures, or if you have a regular stock brokerage account you can trade in exchange traded funds (known as ETFs) which base their performance on the performance of the oil price.

Two of the most popular of such funds are ‘UCO‘ and ‘SCO‘. UCO aims to emulate 2x the positive price change of oil, while SCO aims to emulate 2x the negative price change of oil. Take a look at the performance of these two funds over the past six months.

UCO ultra oil fund performance for past six months

UCO ultra oil fund performance for past six months

SCO ultra oil fund performance for past six months

SCO ultra oil fund performance for past six months

As you can see, UCO has been hammered by the fall in oil price over the past six months while SCO has climbed over 250%. If oil stages a large rally then UCO has a lot of upside potential – while SCO has a lot to lose. Four potential strategies that would benefit from a oil price increase include the following:

  1. Buy call options for UCO
  2. Buy put options for SCO
  3. Buy long UCO
  4. Sell short SCO

Outside of purely playing the oil price movements with these ETFs, you can also consider buying companies that have been hammered by the lower prices. This strategy involves more risk because companies have the possibility of going bankrupt and bringing their share price to zero, while the oil price will never reach zero until a revolutionary technology make it obsolete (and that transition time would be formidable).

Oil behemoths are more likely to survive a sustained weak oil price than smaller more leveraged companies. Some of these giants include:

  • Exxon Mobil Corporation (XOM)
  • Chevron Corporation (CVX)
  • Royal Dutch Shell (RDS.A / RDS.B)
  • BP (BP)

Smaller players that may return a better yield if a oil rally occurs include:

  • ENSCO (ESV)
  • Transocean LTD (RIG)
  • Seadrill Ltd (SDRL)
  • Northern Oil & Gas, Inc (NOG)

 

Whether or not the oil price remains cheap, recovers, or falls even further there are always ways to profit from it if you take a certain degree of risk. Given the deflated state of oil, it’s large but limited supply, and the motives behind the price bullying of American oil operators by OPEC I think oil will stage a moderate comeback in the next few months (make sure to read my disclaimer below).

Low Dollar Stocks Not Necessarily Cheap

The statement “cheap does not mean cheap” has never been more meaningful. The first “cheap” means price relative to fixed amount say $100, and the second cheap means how much the stock costs relative to the value of the underlying company. A $1 stock might seem cheap to the inexperienced investor but a $100 stock might have a lot more value and be cheaper in relation to how much of a return you will be getting based on a company’s earnings.

Case in point – Advantage Oil & Gas Ltd is trading at just $4.59 , but it’s last reported earnings per share was just three cents! For those who know what P/E ratio is that would be a whopping 134.72. On the other hand, you might have a company like Chevron with a price of $108.21 but earning $10.86 per share while paying dividends of over a dollar per quarter! I would much rather choose Chevron over Advantage simply because the first is more of a gamble!

I think the biggest problem people have is that they think that a single or a few shares of an “expensive” stock is more risky, when in fact the opposite is true! See how investors in China are piling money into penny stocks, which might sustain itself if enough people keep joining in but most likely will result in a huge bust.

I’m not saying that high or no P/E ratio stocks should be ignored completely, however these types of securities are more risky than others. If you think there’s an upper bound on a share price you are wrong, as the $224,000 price for Berkshire Hathaway proves.

Using a stock filter, I have randomly chosen a few stocks that are ‘cheap’ under the layperson definition and ‘cheap’ under the investor definition. I will post their five and ten year performance below.

Cheap (dollar wise)

Of course, one of the reasons you might stumble across a cheap stock is because it's price has already stumbled so much!

Of course, one of the reasons you might stumble across a cheap stock is because it’s price has already stumbled so much!

Helios and Matheson Analytics Inc – Perhaps the only good random pick, pays a 5% dividend but the price change has been disappointing in the past 5 years considering the rest of the market

Vaporin Inc – looks like this stock got vaporized

 

Cheap (P/E ratio)

ACE Limited - Looks like a steady price increase, yielding almost 140% in the past 5 years on top of regular dividend payments.

ACE Limited – Looks like a steady price increase, yielding almost 140% in the past 5 years on top of regular dividend payments.

Allstate Corp - 125% return on past 5 years along with regular dividends. Another winner in my book.

Allstate Corp – 125% return on past 5 years along with regular dividends. Another winner in my book.

Andersons Inc - 186% return in past 5 years with a small dividend. Not too shabby.

Andersons Inc – 186% return in past 5 years with a small dividend. Not too shabby.

While there are thousands of more examples to go through, just a random selection of a few showed that the first version of cheap should have just been thrown in the trash and the second, intelligent, version is what you should be looking out for.

Good hunting!

Is The Bear Here?

Is the bear here? Have six years of solid yields in the stock market going to be wiped away by a massive correction? Should you be worried?

I have no idea, but I’m prepared to a certain extent whether or not a bear yields its ugly face. You can do the same, as long as you are approved for options trading.

 

Strategy #1: Make sure you have put options covering or exceeding the amount of shares you have in companies – for example if you are holding 100 shares of Apple which is worth around $106.25 after falling almost 7% in the past five days, you should hold at least one put option of Apple. The strike price for the put option is where a lot of the magic comes into play, as if you buy a put option with a strike price above Apple’s current market value you are making a very conservative play that will be handsomely rewarded if Apple stock price falls but costs a moderate amount more than an option with a strike price around $100 for example.

In my real-price example I will use the March 20th, 2015 expiration date. The Put option with strike price of $110 (above the market price of AAPL which is $106.25) costs $850. The put option for $100 costs $370. The difference is $480, which is less than the difference in share price for a given options “basket” which is $625. That means that It makes more sense to buy the more expensive put option if the stock falls, because even if it falls past the lower strike price you will be making more money.

Let’s say Apple falls to $90 per share by March 20th – with the more expensive put option you make $20 per share in your basket minus the commission which comes out to a profit of $1150. If you had purchased the cheaper lower strike price option you would make $630. Of course you stand to lose more if Apple goes up by March with the first option, which is why options being supported by a long ownership of Apple makes sense.

Strategy #2: Short the stock market. Sell  shares of a company you don’t own with the intent of buying them back later at a lower price. This is a highly risky strategy as shorting a stock makes you liable to pay any dividends they issue from your account and without a call option to secure the short position the loss potential is astronomical. One company that is heavily shorted is Herbalife Ltd., which some hedge fund managers consider to be a pyramid scheme soon to be busted by the government. If you short the stock market you will make money in a bear market.

Strategy #3: Sell all of your stocks and invest in corporate bonds or bank CDs. This is sort of like giving up on high yield investing, find a bond that suits your risk level or go with a municipal bond that may offer tax savings at the state level. Even more risk averse you can put money into T-Bills, which is what countries like China have done to protect the value of their huge cash surplus.

What’s a Bull Spread?

A bull spread is a type of call option that aims to profit off of a underlying security that has a specified percent increase. Most of the time investors aim for moderate or low price increase.

An example of a bull spread is to buy a call option for Apple for a expiring three months from now for a strike price of $130 per share. Apple trades at $113.99 as of right now (premarket 12/29/2014). The call option costs $1.37 market price, so for a single option you will be paying $137 (options come in stacks of 100). If you wanted to lower that cost all you’d have to do is sell another call option for Apple for say $140. You’ll get 50 cents for this, so you’ll lower your total cost for this “play” to 87 cents. So pay $87 rather than $137 to make at MOST $10 per share, or $1,000.

I personally am not a fan of the bull spread because of the fact that you’re limiting your winnings, it’s like buying insurance on your winnings. I must prefer having unlimited UPSIDE potential with a put option in place as INSURANCE. Even so, when you’re hedging your investments you are limiting your profit potential.

You can also do what I call a “bear spread” by buying a put option and then selling a put option for a even lower strike price. This would be in anticipation for a moderate downfall in the price of an underlying security. I would personally never do this, it would almost take a wizard or oracle to predict such a price fall to such a degree. You’re better off shorting a stock then paying such hefty premiums for these options.

If you’re interested in seeing what a bull spread looks like on a profit-loss graph here it is below:

Call option March 20 leg 1 buy $130, leg 2 sell $140

Call option March 20 leg 1 buy $130, leg 2 sell $140

When Politics Influences the Stock Market

Politics ALWAYS influence the stock market. Higher taxes usually means lower returns for companies and a falling stock market. Low interest rates means cheaper capital for companies as well as lower return alternatives for investors which drives stocks up. Why put money in a 0.1% interest account when you can be investing in a stock that pays 3% in dividends every quarter? Below is an example if you’re doubtful:

3% Dividends four times a year

3% Dividends four times a year

Higher regulations on the coal industry during the Obama administration have virtually killed coal stocks such as ABX which fell from over $73 in 2008 to its current price of $1.93. I’m not here to state a value judgement, but a pure stock price judgement – so make sure you pay close attention to campaign promises of politicians. Here’s a video of Obama basically promising to bankrupt coal companies. Whether you like it or not, industries change and the President or other politicians can help spur this change.

From $73 to $1.93 in the past six years

From $73 to $1.93 in the past six years

Keep a close eye on what the media and politicians say about regulation on the soft drink or tobacco industry, as well as the budget set aside for defense and even our space agency NASA. Oil prices are largely affected by conflicts in the Middle East, and trade protectionism also is something to watch out for.

Is DCA Right For You?

Dollar cost averaging is sometimes boasted as the best way to invest your money – over time in order to avoid investing a lump sum at a time of over-inflated prices. If you contribute to a 401k plan every pay check you are involved in this investment strategy, however the benefits of such a strategy are largely focused on investor’s emotions rather than being the statistically right choice.

If you want to eliminate the seasonal trends of the stock market, then a DCA over a period of one year might be right for you – for example investing $100,000 into the stock market by adding $8,333.33 to your portfolio each month. Some folks take a different stance and invest around November and sell their investments in April – based on a historical trend of stocks rising in these months more than the others. This is called the “Best 6 Months” strategy.

However, the best 6 months strategy when applied to taxable investments will always result in short term capital gains which are taxed more heavily than long term capital gains (See Stocks for more information). Also keep in mind that you are losing out on dividends when you don’t hold shares. If you are planning a six month strategy I suggest doing so in a tax-free account such as a Roth IRA using a mutual fund to capture a large portion of the market.

Most folks engage in DCA through regular 401k contributions, many companies match a portion of this contribution. It would be foolish to not contribute up to the employer match.

How to Weather the Storm

Are you fearful of a market crash? Do you want to prevent what happened to your portfolio in 2008 and 2002? The simplest and fastest way to protect yourself from a market crash is to sell all of your stocks and wait – the only problem with this is that you are not making any returns on your cash, another more sophisticated way of buying “insurance” is to buy call options for negative ETFs or buying put options for stocks you own.

The first example could mean buying call options for such ETFs as “DOG”, “SH”, etc. (You can look these up later)

Buying put options will yield you much greater returns as these would take the maintenance cost of inverse ETF’s out of the equation. In fact, buying put options for positive ETF’s is probably an even better strategy since that would be putting the downward pressure from fund maintenance in your favor.

For example, if you owned 100 shares of Apple (Ticker AAPL), you could write a single put option for AAPL that expires next year with a strike price of $90 per share. That means if you’re holding Apple stock and it drops below $90 per share you won’t have to sell your stock but instead you would be gaining for every cent below $90 may fall by the time your option expires. That means you can also hold your shares without worrying until next year about how Apple stock price performs if you are in it for the long haul.

The only disadvantage to using options is that they expire, so the worst timing would be if they expire right before a huge market crash. To avoid this you can continue to buy put options as long as you hold shares – you need to pay for these options but doing so will insure you from the possibility of a even larger loss.

If you do the math many times this strategy will still yield more returns than holding cash but will offer a sort of insurance. The actual price today for a put option that expires in January for AAPL is $160. If Apple falls to $80 per share by that time, you will have made ($10 * 100 shares) – $160 investment, or $840 dollars. As you can see, you may also use this strategy to aggressively bet against the stock – something I do not subscribe to but something that would have paid off considerably in previous stock market pullbacks.

Below is a profit/loss chart for a $90 put option of Apple, as of September 27th. If we see a bear market or if Apple stock in particular falls, you will see the price for the option increase over time and you have the ability to sell your option up until it expires.

profit loss chart

 

Keep in mind that historically the stock market will continue to rise, but given it’s 2013 leap and uncertainty about the world economy and prime interest rates it doesn’t hurt to keep your bases covered.

How To Avoid Pump and Dump Schemes

On September 11, 2014, 8 traders were indicted on duping almost $300 million out of mom and pop investors [1]. How do you avoid this trickery and avoid buying stocks for companies that are “shells”?

The answer is simple- look at the company’s market capitalisation. These fraudster’s companies usually have a very small amount of market capitalization if any reported and shown, such as less than two million dollars. Any major fraud involving the stock price of a multi billion dollar company is rare and will get news coverage equivalent to what Enron or MCI Worldcom received in the 90’s and early 2000’s. My rule of thumb is to never invest in companies with less than 300 million in market capitalisation. Looking at the integrity of the company’s website is not a sure way of knowing if you are dealing with a legitimate company. After market capitalisation, you should avoid buying shares ‘Over The Market’ – instead stick with companies listed on the Dow Jones or Nasdaq.

One of the websites they channelled their spam through was called ‘pennypic.com’, and of course now the website is offline. In order to research what type of stocks these fraudsters had I used the WayBackMachine on web.archive.org.

Take a look at XUII, it was the symbol blaring on their unbecoming website as their “Monster Pick”, it now trades at $0.0003 per share on the over the counter market (a.k.a. bankrupt) – take a look at it’s price history starting on June 13th when they were advertised.

Scammers inflate the price to draw more people in along with sending spam, then they dump the stock.

Scammers inflate the price to draw more people in along with sending spam, then they dump the stock.

As you can see the price was 23 cents on June 13th, and inflated to almost 68 cents when the scammers started selling – pushing the stock down to 6 cents in just two months.

 

[1] Rosenburg, Rebecca. “8 Traders Indicted in $300M Pump and Dump.” New York Post. New York Post, 11 Sept. 2014. Web. 11 Sept. 2014.