September 9 Post

Hi Again,

First of all, let me say that my 1st edition of the August 2015 newsletter was issued on 8/23/15 so on all the stocks recommended (for nibbling purposes) I am taking the initial price on 8/24/15. I  issued my August newsletter on 8/24/15 after the Dow fell 500+ points on 8/22/15 so you got a good opportunity to ‘nibble’ (buy a little) the stocks I recommended at bargain prices. 

On that day or after the crash, most professionals like Jim Cramer were asking people to stay away from the market but that is why I came up with my ‘nibbling’ strategy as no one can predict a market bottom. I have been asking you to keep at least 50% in cash for the past 3 years. Let us say that your investment budget was $3,500 and you kept 50%in cash and with the other 50% over the past few weeks you gained 16.36% and for the total $3,500, it is a gain of 8.18% (mostly in 13 days)! When Goldman Sachs man in charge of China stated on CNBC (about 3 months ago) that it is not a time to sell Chinese stocks but to buy them I started short selling (via puts on ASHR) and as I have been writing in this newsletter, every time the Chinese market went up, I bought more puts to short sell. 

Now I am doing the same with the US market. Even if the US market goes up, there is more trouble ahead. Even though the market went down 1100 in one day or even though the highest point in the Dow30 to the lowest point in the Dow30 was 2,534 points within the past month, a correction did not place because nothing got corrected. In a real correction, people get a glimpse of fear and stop running to speculative stocks and that did not happen. Even if the market keeps going up we are sure to have a very serious correction in the future. Here are some reasons to expect a rocky September (to say the least; and a bloody October):
•    US Federal Reserve will make a decision on raising rates within the next couple of weeks
•    Big economic data from China during this coming week. What came out last night was not    good. 2014 growth rate was revised down. Per Barron’s, Hong Kong bank earnings could drop 10% to 37%.
•    US stock market analysts are expected to make projections in the next few weeks.
•    US Congress comes back from vacation and the tension with the White House on the budget and other matters could unnerve the market.
•    As with all other years, most market makers were on vacation till Labor Day and real volume and real activity takes place after the Labor Day.
•    Historically September is the worst month for the market and most crashes took place in October. Some see a comparison between 1997 and 2015 but I see a comparison between 1987 and 2015;
    General economy was good in both years
    Rising interest rates
    1987 and 2015 Market reached a top in August which was followed by a volatile August.
•    12 other international stock markets are in bear territory and some countries (i.e. Russia, Canada) are already in a recession.
•    Commodity market bear market is predicting a recessionary environment for most countries-specially.
•    On 8/26/15, respected hedge fund manager Bill Pershing sent a letter stating that ‘there is more pain to come’. 

When analyzing the financial markets, at times, we have no choice but make assumptions. For example, most analysts believe that the Chinese government is selling its US treasuries. They own $1.3 Trillion is US treasuries. Since they do not make announcements regarding such activities, as Bill Gross (one of the best when it comes to bonds) said that “even though it cannot be proved, it seems like the Chinese are selling US Treasuries”. On 8/26/15, Blackrock credit expert was on CNBC and stated that they tried to find out who was selling all these US Treasuries but could not do so; therefore they assume it is the Chinese or other central banks or both. Apart from US Treasuries, foreign central banks own 75% of all gold reserves so that explains why gold has not been going up lately-selling by these banks. What happens if the Chinese sell all their US Treasuries? Our interest rates will go up by 1.5%. Then most institutions will drop stocks and move to risk free US Treasuries. These will be a bonanza for out banks and insurance companies. If I remember correctly, in October 1987, the 30 year Treasury rate went up to 9% for a short period which created chaos in the equity market. I do not know why the Feds have to raise rates as the market is doing their dirty work for them.

With China exporting deflation, there is no need to worry about inflation and in our economic sectors that rely on China and other affected areas, there would be job cuts so the fact that we are at a technical full employment rate of 5.1% should not be a big concern.  For the past 3 years, people thought I was crazy for predicting a 3,000 to a 5,000 drop in the Dow30. It is already down 2,500 points from the top. Ideally another 5,000 on the downside would be healthy. On 9/2/15, Nobel Laureate Robert Schiller stated that the market should go down to 11,000 (5,000 more to go). A few decades ago, market value of stocks and bonds came to $6 Trillion and now we have $24T in the equity market and $37T in the bond market! Even with this ‘correction’ or ‘bear market’, nothing got corrected; why? Investors and traders do not run after momentum and overvalued stocks days after the market goes down after a correction. This shows that the mental paradigm has not changed. This is what happens when we do not get a 10% correction for 8+ years. In the past few months

I have been saying that it is absurd to go after stocks like Netflix and Amazon at this time. Now the market calls them ‘fang stocks’ (after Dracula). Other ‘fang’ stocks are Facebook, Tesla and Google. Netflix has a PE (Price/Earnings) of 221! It would take them 221 years of this year’s earnings to come to this price. Even if they double their earnings every year and their price doubles every year (less than their previous record), they will never get their PE below 221. The only reason their price fell and PE fell to 221 from 296 last week is that Apple and others are expected to provide a tough competitive environment for Netflix in the future. When a company has to grow rapidly to satisfy investors, they become reckless. Peter Lynch, one of the best mutual fund managers, avoided companies that grew extremely fast. Netflix earnings grew 550% from 2012 to 2013, and then 138% from 2013 to 2014. Compare Netflix’s PE of 221 to Apple’s 12.56 and Google’s 30.87. Carl Icahn held Netflix for years and made billions but he sold his stake a month or two ago. Smart man! The other crazy stock is Amazon which is operating at a loss so there is no PE. However let us assume that they made a profit of 1 cent, then their PE goes to 51,800! For 2014, their operating income was $178MM but their interest expenses came to $210MM! After being in an zero interest environment for 8 years, all expect interest rates to go up for the next decade or so.  

Buying these trendy overvalued stocks are very dangerous. On 12/1/99, Yahoo had a PE of 1,000 and it hit a share price of $100. Then on 8/1/02, the share price dropped to $4.70! Since then the highest it reached was $50 on 11/1/14 and now it is at $32. Yahoo as a company did not cease to exist but if you bought Yahoo in 1999, your loss is severe. Right now Yahoo is not that bad as their assets (i.e. Alibaba share) is worth more than the Yahoo share price so you are getting Yahoo for zero! The biggest downturn we will experience when people will move their 401K funds and other funds from market based mutual funds to cash or bonds. Unlike hedge funds, mutual fund managers cannot hedge and they are mostly fully invested so when redemptions rise, they have to sell what they can.

Compared to the last time we had a major correction or downturn (8+ years ago), this time around we have to face the negative impact of the electronically traded funds (ETFs). Carl Icahn is one of the most vocal opponent of ETFs and the SEC is taking a second look at ETFs. In the past 10 years, more than $1.4 trillion of net new ETF shares have been issued. With the increase in demand, sponsors have offered more ETFs with a greater variety of investment objectives. With nearly $2.0 trillion in assets, the U.S. ETF industry remained the largest in the world at year-end 2014 (2015 Investment Company Fact Book). As I have explained in my previous newsletters, when an ETF for a certain group of companies go down, it brings down all the companies covered by the ETF and it does not discriminate between the ‘good’ and the ‘bad’. Then selling begets selling. Most of these ETF are controlled by ‘robotic computers’. Apart from that as computers do, these robots make errors when the paradigms change. On 8/24/15 when the Chinese market fell by 8.5% and the US market started with an 1,100 drop, the robots did not know how to operate as this was not supposed to happen-especially it could not account for the certain stocks that were temporarily halted as they hit ‘circuit breakers’ set by regulators.  The ETF with the symbol QQQ is expected to reflect the NASDAQ index. When the Dow fell 1100, QQQ fell twice (26%) as much as NASDAQ (13%)! On that day, my QQQ puts to short sell NASDAQ did very well-went up 4 fold!

Not only a lot of people lost money unnecessarily but some other robots that manage money for people sold their entire holdings as the robots were programmed to sell everything when the market went down to a certain level. As you can see from commercials now these robots are taking over managing money for the masses. God bless them all! This means that we will get many unusual opportunities to invest our money. Manna from heaven! This also can create catastrophic down days in the future. I love ETFs. Now there are ETFs for every segment of the market-including the equity market, bond market, foreign exchange market, commodity market, foreign markets and so on. If not for ETFs I would not have been able trade in the commodity, oil. Over the past couple of weeks I have been noticing a resurgence in the commodity markets and related equities; obviously bottom fishing.  In March 2015, when oil(WTI) hit $45 I bought in to the ETF ‘oil’ and sold it in 2 months when WTI hit 60. A few weeks ago, when it hit $45 again I bought more of the ETF ‘oil’; and then when it dropped to $40, I bought more. At this time all the pundits were predicting that oil will not stop till it went down to $25. When it dropped to $37, I was waiting for it to go down to $35 to buy more but in 3 days, it went up from $37 to $48. A technical analyst on the CNBC Jim Cramer show believe that oil has reached a bottom and we could see WTI going over $70.Now most companies that used to hedge have stopped doing it and that is always this way. When they have hedged for a long time and lost their premiums and when analysts predict a never ending decline, people who used to hedge stop doing so and then they get hit by higher prices. People never learn!

On 8/26/15, Jeff Currie of Goldman Sachs was on CNBC saying that the oil demand in China has not gone down; even though they see the demand for other commodities significantly down. As I stated in my last 2 newsletters when all the pundits were saying to avoid commodity related stocks and called Freeport McMoRan (FCX)the worst stock, I suggested that we start nibbling (buying a little) and then Carl Icahn bought 88 million shares while FCX announced a 25% cut in their mining budget. When it comes to ‘activist investors’, Carl Icahn is a demi God! As he did for Apple, he will find a way to raise the value of FCX. Be patient. Carl Icahn buys in to companies using derivatives.  Smart man! He buys calls and sells ‘naked’ puts. Buying stocks through call options is very straightforward. Let me explain how to buy through buying naked put options. Right now Apple (AAPL) is trading at $109.27 and you would like to buy 100 shares of Apple if it goes down to $100. You can sell 1 contract of ‘naked’ puts of Apple that expire 12/18/15 with a strike price of $100 and get a premium of $550 right now. If for some reason, Apple does not fall below $100 by 12/18/15, you will get to keep that $550 and you also do not get to buy Apple for $100 per share. However let us say that by 12/1/15. Apple falls to $95, then the buyer of that put option contract will buy Apple at $95 per share on the open market and sell it to you at $100 per share by exercising the contract. Anyway it was your intention to buy 100 shares of Apple if it goes down to $100 so you get to do that plus you get 2 more benefits: (1) you get the put premium of $550 (2) Apart from paying for the put, you do not have to pay commission again for the purchase of the stock when the buyer of the premium exercises his or her option. If you can do this it is great but make sure that you have enough cash to buy the 100 shares of Apple or you will get a margin call and your broker might liquidate your other assets. Now some Wall Street analysts are talking about a decoupling effect that China might have on the US market but I think that is more or less wishful thinking. 60% of tech revenue comes from overseas and 25% of Apple’s revenue comes from China! Stupid Trump was complaining about the devaluation of the Chinese Yuan but the facts are (1) Chinese Yuan went down by 3.5% while the Russian Ruble is down by 40%, Brazil down by 35% and a host of other countries down in a big way too (2) Chinese devaluation is good for US importers (i.e. Walmart) and bad for exporters (i.e. US Agriculture and companies like Apple, Caterpillar and so on). Since this is good for Walmart, it is also good for their shoppers-average income of $40K per year.

Westerners estimate that the Chinese government put in $200Billion in to their stock market to stop the downfall and they have lost $32B so far! What a waste! As I said months ago, in 1929, old man J P Morgan tried to do the same here but it was like catching a falling knife.According to Jim Cramer they were even buying penny stocks! In June 2015 when Godman Sachs urged people to buy Chinese stocks I did the reverse and short sold through put options (on ASHR and FXI). On the first lot I made a 100% profit within a few weeks and then each time the Chinese market went up I bought more puts (to short sell).  On 7/13/15 I bought some of these puts (ASHR, $25 strike price, Expiring in Jan 2016) for $0.65(each) and sold them on 8/26/15 for $3.71 (each)-371% profit in 44 days! My regret was not buying more on 8/14/15 when the same put fell to $0.35 each due to the artificial raising of prices by the Chinese government. If I bought 10 contracts for $350 on 8/14/15, I could have sold them on 8/26/15 for $3,710-960% profit in TWELVE  DAYS !! Now I am doing the same with the US market. When the market drops I ‘nibble’ at stocks with high dividends and increase my short sales via puts so either way the market moves, I make money. This might surprise you but I started buying a little bit of Chinese index funds (ETF stocks) as a hedge against my short position. Also in the long run the Chinese market might come back. It seems like the Chinese are learning. On 8/31/15, they announced that they will not directly buy stocks to lift the market up. The government also encouraged people to buy their blue chips rather than the technology stocks and other lower end stocks.

However the Chinese government encouraged their pension funds to get more involved in the stock market. Now they are trying to destroy the pensions of hard working people who were not foolish enough  to get caught in the crash. US markets loved it when the Chinese lowered their interest rates and lowered their bank reserve requirements. This is the 3rd time they lowered the interest rates and it seems to have no effect. Some say that they have run out of ammo. Lowering the bank reserve requirement is for a different purpose. Over the past few decades when trillions flowed in to China they had to keep increasing the reserve requirements to keep lending getting out of hand and now that there is massive outflow of capital, they have to increase the reserve requirement.  On 9/7/15, after another 2.5% decline in the stock market, the Chinese central bank announced that the correction is almost over. Can they get anyone to believe them? Still they have not lifted the holds on most of the stocks traded over the exchanges. Well respected in the international economic scene, current governor of the Reserve Bank of India, Rajan (who once gave a tongue lashing to Bernanke when he stopped QE2) recently told BBC that for the past few decades, central bankers have been keeping the world economy intact but they are finding it difficult to do it anymore.

Alberto Gallo, head of macro credit research at the Royal Bank of Scotland put it best as “More and more central bankers are showing that the emperor has no clothes”.  Right now all eyes are on the US Federal Reserve and if the world loses faith in them, expect the price of gold to skyrocket. There are signs that Europe and Japan are recovering as you can see by their currencies gaining ground against the US Dollar. Hopefully the US, Europe and Japan will drag the rest of the world in to economic prosperity. Remember that during the next few weeks, we could have volatility that might take the market much lower and thereby create good opportunities to do more ‘nibbling’ (buying a few shares) as the market goes down. When the market goes down in a big way, most stocks go down so we can focus on the good ones. For the past 100 years, there has been a saying on Wall Street, “ When the vice squad raids a bordello, at times, even the piano player gets arrested”.

If I feel that there is a need, I will write more during September 2015. I will be extremely surprised if we do not see volatility and more down days during the next 2 months. We must all be aware that there is always a possibility that the market might not come back for decades-as it happened in 1929 and as it happened in Japan in 1990. If this volatility and down turn lasts for a few more weeks, people will have more redemptions from mutual funds and that will force the mutual funds to sell stocks indiscriminately. Let us say that you worked for 30 years and had $1MM in a growth fund on 8/1/15; and as most stocks are down about 20%, now you could have only about $800K. Most prudent people might move those funds in to cash and others might stay in so as not to miss out on maximizing their gains. For the past 8 years (almost a decade without even a 10% correction) the market moved only in one direction (up) so what I am saying is that we are in ‘untested waters’.

As Carl Icahn predicted months ago, the international currency crisis is happening right now and he also said that the currency crisis will turn in to a debt crisis and then that would bring down the equity market as well as the property market. Since we had zero interest rates for 8 years, most emerging countries and companies borrowed in US dollars for the past 8 years. If you run a Russian company that gets revenue in rubles and you borrowed $100MM in USD in 2013, now with the currency falling 40%, you owe 40% more due to currency depreciation. Also people and companies in those countries are trying to get their money out in so that they would not lose more due to currency devaluation. On Friday, 9/4/15 it was in the news that the owners of Alibaba were borrowing $2Billion against their company stock. On a rebound, if the investors stop running to ‘fang stocks’ (Netflix, Amazon and Tesla, mainly), you will know that investors and traders are using common sense again. The following is a scorecard that I created according to the stocks I recommended in my monthly newsletter. If you want a free copy of the newsletter (for now), send me an email to

Until we meet again, I wish you all the best!


From "L S Fernando Monthly Stock Newsletter"