Trojan Investing Newsletter Volume 2 Issue 3

Trojan Investing Newsletter April 7, 2009 Issue 3 - Volume 2

Welcome Trojan Investors! We would like to thank our contributors and those who have invested their time and effort to make the Trojan Investing Newsletter all that it can be. If you are interested in contributing or editing, please contact us at [email protected]. For those of you who are new to the TIN, read on to find out how you can benefit from joining our readership. Through issues distributed at the beginning of each month, the Trojan Investing Newsletter hopes to bring ideas together that stimulate new ways of thinking to benefit you as an investor. Through critically analyzing economic and sector/industry trends as well as individual securities, we hope to provide you with new insight into how to view the world as a place to invest. We are affiliated with the Trojan Investing Society, the premier finance and investing club at USC. The weekly TIS meetings are a great place to come to express your opinions on the articles written; and where the contributors of those articles will have a chance to answer any questions you have. Being allowed access to a variety of investing ideas through this forum provides our issues depth and breadth that we would otherwise be unable to afford our readership. We sincerely hope that you find our newsletter to be interesting, informative and most of all, enjoyable.

Inside This Issue Trend Analysis

The Hong Kong Housing Market: Opportunity in the Bear Market?..............p.2

Investment Analysis The Gold Mirage..................................... p.4

Learning Center

Stock Twits.............................................. p.6 Covered Calls as a Trading Strategy......... p.7

Market Performance Snapshot 2 - Jan Dow Jones 9034.69 S&P 500 931.80 NASDAQ 1632.21 Russell 2000 499.51 10-Year T-Bill 2.217

6 - Apr 7975.85 835.48 1606.71 447.56 2.93

Return -9.12% -7.5% 1.88% -10.4% -32.16%

“The whole financial structure of Wall Street seems to rise or fall on the mere fact that the Federal Reserve Bank raises Contributors: or lowers the amount of interest. Any business that can’t Joshua Inouye, Richard Graham, Alexander Muhr survive a one percent change must be skating on thin ice. Why even the poor farmer took a raise of another ten per- Co-Editor-In-Chiefs: cent just to get a loan from the bank, and nobody from Richard Graham the government paid any attention. But you let Wall Street have a nightmare and the whole country has to help to get Matthew Riley them back into bed again.” -Will Rogers, 1929 -Trojan Investing Newsletter Staff

Disclaimer: Views expressed in this newsletter are not those of the University of Southern California or any of TIN’s affiliated groups, but the author’s own. Recommendations are made by students, not financial professionals. Readers should not rely on information from the following articles or the recommendations therein for trading or investing. The purpose of this newsletter is to facilitate discussion and broaden students’ awareness of current market issues. This newsletter may contain references or links to websites that are created and maintained by other organizations. TIN does not necessarily endorse the views expressed on these websites, nor does it guarantee the accuracy or completeness of any information presented therein.

The Hong Kong Housing Market: Opportunity in the Bear Market By Richard Graham As a result of the global macroeconomic decline, tight credit markets, and falling real estate prices, the real estate and prop-

erty development industry in Hong Kong and (as a corollary) China is undergoing a period of limited growth and falling profits. While the current environment is certainly hostile to the real estate industry in these areas, low prices and cashstrapped companies provide strong property developers opportunities for long-term growth and profits.

cause buyers become very limited. As a result, prospects for real estate growth are limited until credit markets unfreeze. Opportunities in the Bear Market

While the Hong Kong and Chinese real estate market is challenging at the moment, well positioned companies can take advantage of the poor market and position themselves for success in the future. Firms with large amounts of cash on hand and large credit facilities can purchase real estate at fire Housing Woes sale prices from other struggling developers and wait for The world wide macroeconomic decline has resulted in large prices to improve to sell. By buying when the market is low, amounts of layoffs and poor consumer sentiment in Hong firms can position themselves to profit off of the eventual Kong, two factors which hurt prospects for real estate indus- market recovery. try growth. Because of the global economic downturn and worldwide financial crisis, large financial services firms, banks Two firms that are in this advantageous position are Hang like HSBC Holding PLC, retail, and tourism companies are Lung Properties (HK.0101) and Cheung Kong Holdings initiating layoffs. As unemployment increases, individuals will (HK.0001). Both firms have weathered the current downbe unable to afford their current rental and lease payments, town better than their peers. Hang Lung successfully called which threatens revenue for real estate developers. If the the real estate market. They refrained from purchasing land worldwide recession continues to deepen and layoffs contin- during the boom, now sit on a large cash reserve, and have ue, the current market could get much worse. Moreover, low no debt. Cheung Kong diversified their company portfolio real estate consumer sentiment is hurting demand for real during the housing boom, investing in a wide array of real esestate. Worldwide stock market declines have substantially tate and other companies, like biotech. They also sit on large decreased individual wealth, which has decreased the number cash reserves. They also control a large market share in the of buyers in the Hong Kong real estate market and forced Hong Kong market. These firms can aggressively buy in the prices lower. Another indicator of poor consumer sentiment depressed market at below normal prices and build up propis the Hang Seng Property Index, the capitalization weighted erties to be sold when the market recovers. index of all property stocks traded on the Hang Seng Index of the Hong Kong Stock Exchange. Since its high of 33492 Both of these firms will remain competitive in the Hong in May of 2008, the index has fallen 52% to 16046 in mid- Kong housing market in the coming months, even though February, an indicator of poor investor confidence in the real the market will remain depressed. In the short run, these estate industry. As a result of poor consumer sentiment, real firms should exploit their advantageous capital structure as estate prices are predicted to fall an additional 35% in the the market falls and reaches bottom by purchasing land and current year and expected to begin to rebound in the second developing it for low prices. In the long run, prices will rehalf of 2010 . Additionally, as worldwide business begins to cover, and these firms will stand to make substantive profit. slow, demand for commercial real estate will decrease. This This bullish outlook should be treated with skepticism, however, because when the economy will recover remains to be will slow new property development and hinder growth. seen. And until it does, the Hong Kong real estate market will Moreover, tight credit markets are having a negative effect remain depressed. on the Hong Kong real estate industry. Tight credit markets hurt both developers and consumers. Developers are unable to get capital to fund new projects, and consumers are unable to take out loans to buy, lease, and rent property. This effect creates an impasse in the real estate market where buyers and sellers are unable to do business. This forces down prices be

The Gold Mirage By Richard Graham Once again gold is a topic of discussion amongst numerous financial “talking heads” and market participants. In the face of the current economic downturn, the increased demand and increase in gold’s price should be obvious: investors’ appetite for risk has decreased due to large equity and derivative volatility, and investors fear that government spending will erode the value of the US dollar. Investor flight to safety and fear may point to a short-term run-up in the price of gold, though gold will be unable to sustain those gains in the long run.

Gold was worth over $2000 in 1980 if we look at it using 2009 dollars. Because the current recession is on pace to either be as worse or worse than the 1980s’ recession, those extremely bullish on gold (sometimes referred to as gold bugs), are quick to point out that gold has a lot of room to grow (see figure 1). Figure 1

Gold, which has been a precious commodity for thousands of years, is considered an investment to hedge market uncertainty and inflation. It is considered a precious commodity because of its rarity and probably in some part do to its shiny and attractive nature. It is 18x rarer than silver and has significantly fewer industrial uses—meaning only that the supply of gold circulating as bullion, jewelry or stored in giant secure vaults is relatively stable. Output from mining operations remains relatively stable as well. There have been no new major discoveries of gold veins or gold in copper veins and so there is no major output increase in the foreseeable future. Although gold has been traded for centuries, in more recent times it has not really been though of as an investment instrument for the masses. The creation of large gold funds like the SPDR Gold Shares ETF (GLD), makes gold accessible to the broader public and changes gold trading in a significant way.

There are, however, numerous flaws with this outlook for gold. In the long run, the price of gold is highly contingent upon jewelry demand, which has dropped due to the recession. If the recession continues, it will be difficult for investors, who are still a minority conSource: Economist sumer of gold, to fill the large holes the jewelry business leaves (see Figure 2), allowing prices to fall. The Economist forecasts that in 2009, total gold consumption will fall 6.5% even though investment demand is increasing Figure 2 10%. Even though supply will contract, excess supply is projected to increase by 21%. While the 10% increase in investor demand in 2009 seems enticing to potential gold investors, other economic factors clearly need to be considered.

Fear Vs. Fundamental Supply and Demand

Source: The Wall Street Journal

Recently, gold prices have increased and have even broken through the long-standing $1000 mar, making the bull case for gold very convincing. The current economic downturn is on pace to rank among those of the 1980s and 1930s. In these uncertain times, gold is an easy investment to turn to. Its value, in contrast to that of equities and corporate debt, is not contingent upon strong company performance, but is rather based off of demand for its safe nature.

Future Inflation? Even in the face of falling demand and excess supply, gold investors argue that gold prices will increase because of gold’s role as a hedge against inflation and currency depreciation (which go hand in hand). While the price of gold has historically dropped when the economy begins to recover, many believe that due to large fiscal stimulus packages, lax monetary policy, and quantitative easing, economic recovery

will be coupled with high inflation rates.

default--all macroeconomic factors that depreciate a currency. These countries have also implemented large stimulus and budget packages on the same level as the United States’. Because currencies are traded in pairs, currency traders are left with a choice: buy dollars, which are historically a safe currency, or invest in any other, unproven foreign currency and their economy. The answer is obvious, buy dollars. In comparison to other economies, the US economy is far more stable and diversified. The economic crisis has revealed major flaws in export driven reserve currency economies like China and Japan. The current appreciation of the dollar proves this claim and it is safe to say that this trend will continue.

People point to US fiscal and monetary policy as the main stimuli for high inflation. On the fiscal side, the US Treasury market is being flooded with trillions of dollars in T-Bills to fund the current deficit. This poses a two-pronged problem (which is a boon for gold investors). First, high deficits and debt erode the value of the US dollar. Second, large T-Bill sales (in addition to the already outstanding national debt) in the current economic climate threaten to literally collapse the market for T-Bills because their security and worth come into question. On the monetary side, they point to Federal Reserve’s policies during this recession. The FED has substantially grown its balance sheet (to record levels) through The kicker argument in this debate involves gold exchange programs like TALF and has recently engaged in quantitative traded funds. Because the average investor is either unable or easing. unwilling to hold actual gold, they invest in exchange traded funds to invest in gold. High demand for exchange-traded Such aggressive monetary policy creates likely prospects for funds means that these ETFs need to purchase gold in orinflation. der to maintain themselves. ETFs like the SPDR Gold Trust, which holds 1,024 tons of gold—this makes them the sixth Inflation, however, may not be as likely. Central banks world- largest holder of gold in the world, holding more gold than wide have slashed interest rates to ultra-low levels. In the China, Japan, and the European Central Bank—are now playevent of inflation, they could easily raise interest rates to ers in the worldwide gold market. The problem, though, lies contract the money supply. Setting an explicit inflation tar- in how these funds operate. When people buy shares, these get is back in vogue, which calms markets, wage growth, and ETFs have to buy gold, when people sell shares, these ETFs consumers alike. Inflation also naturally erodes the value of have to sell gold. If the economy heats up or investors’ appethe money supply, slowing down price growth. Also, most of tite for risk increases, investors will begin to pull their money the FED’s expansive monetary policies have targeted bank out of gold ETFs. The ETFs, as a result, will have to sell their balance sheets. As a result, most of this new money will stay gold, flooding the market. This will collapse the price of gold in the financial system and not even enter the consumer’s by creating a large amount of excess supply. If this scenario pockets. When the economy begins recovering—the time occurs when the economy is heating back up, the ETFs will when inflation prospects are highest—this money will have have to sell their large quantities at fire sale prices, depressing to be paid back to the FED, which will act as a stabilizer and the price of gold more. decreases the money supply. Even if the price of gold increases in the short term, the Additionally, those in the bond markets (for whom it can be upside potential is not worth the downside risk. Gold has argued are able to more accurately predict inflation) indicate consistently been unable to piece the $1000 mark and has a low long-term inflation trend. A quick survey of the index- traded within the $900 range throughout the economic crisis. linked government bond market shows that investors are The downside risk is great. Gold has not fallen like its other not forecasting large amounts of inflation over the next ten commodity counterparts have, and could fall quickly if maryears. ket conditions change. Over the long run, especially as the economy recovers, we can expect to see the price of gold Because gold is traded in dollars and seen as a hedge against decrease as investors move out of gold and into more risky a depreciating dollar, dollar appreciation poses a threat to the investments and as the dollar appreciates. For these reasons price of gold. American national debt may be approaching and others, it is important to stay away from gold, its price is record levels, but the US is still the largest economy in the merely a mirage. world. The US is the only country currently large, stable and diversified enough to support a global currency. Other countries like those in Eastern Europe, Latin America, Europe, Russia, China, and Japan are facing far greater problems, ranging from collapsing tax revenues due to crashing commodity prices to collapsing export markets to bank failure and loan

Stock Twits By Alexander Muhr If you pay any attention to the Internet, as virtually any college student does, then you’ve likely heard of a service called Twitter. Although by Internet standards the company is not that old—it has already been open for more than one year--the media has picked up on the phenomenon as well – as you might have seen on the ubiquitous 24-hour news channel. To be honest, the first time I signed up for twitter I though it was cool, but could not see any benefit: my account was pretty much nonexistent for the past year until I found out about StockTwits. This quirky name might turn some off, but it really does describe the incredible new power and depth that StockTwits gives to the individual investor (and arguably the professional money manager). What is StockTwits? “StockTwits is an open, community-powered investment idea and information service. You can think of it as Bloomberg for the little guy and gal. Eavesdrop on what traders and investors are talking about RIGHT NOW or contribute to the conversation and build your reputation and following as a savvy market wizard.” Most of the information I get is through news websites (WSJ.com, etc.) or my Google Reader (for blogs and company filings I subscribe to), but no service gives me real-time access to the minds of investors. StockTwits does that, taking the Twitter infrastructure and tailoring it to the needs of the trader or investor. Since many news services also have accounts on Twitter, most news is forwarded instantly to your account, so there is no need to keep checking back to a website. Impressively this does not only save time, but also creates instant conversation about news stories or particular trading ideas that crop up from the minds of “the crowd” – except with StockTwits there is a track record. Right now the site has about 30,000 users since it was launched in October of last year, and has a very diverse mix of traders, bloggers, journalists, venture capitalists, hedge fund managers and many more. One particular event that has evolved from the community is the “MacroTwits” hour every Sunday night. This event is lead by GregorMcDonald

who – according to his website – focuses on energy topics. During the hour people field questions about Oil, Natural Gas, etc. and a discussion evolves that sometimes leads to talk ranging from US Treasuries, to the consumer, to much more. This is just a small example of what is talked about on StockTwits. For me, the main benefit is to filter out noise from the news media and be able to “hear” different opinions on various stocks and markets. I accomplish this by filtering my feed to just stocks or markets that I an interested in, even though most users are happy to have conversations about any topic. If you sign up, you’re most likely going to be “talking” to an experienced player that is willing to express their views on the market, which is virtually impossible outside of StockTwits unless you call them up directly. Using StockTwits in essence opens the door to the minds and conversations that market players have every day with themselves or with others. And if you sign up, be sure to follow me – I’d be happy to give some pointers on usage and who else to follow: @ amuhr.

Covered Calls as a Trading Strategy By Joshua Inouye strike price of 84, which corresponds to the location of the Covered calls are often mentioned on the news or when kink, and the price at the time of this writing was 4.70. Due discussing options strategies, simply because they are the to this price, the maximum profit that can be realized from most commonly used strategy, especially by retail investors, this strategy is 4.70 (per share, which is a gain of 5.6%--a due to their simplicity. A covered call refers to a call option very nice gain if the stock was at 84 or above at expiration, that is sold, but covered by the ownership of the underlyespecially because this is over a period of 2 weeks). A key ing security. Ordinarily, a call option that is sold naked (not point is that if SPY advances very far, the outright ownercovered) will be subject to the possibility of unlimited loss, similar to shorting a security. However, owning the underly- ship of the stock will outperform the covered call strategy. ing security in an appropriate ratio hedges against unlimited The point at which this occurs is where the 2 lines intersect, which is at 88.96. Therefore, the conclusion is as follows: loss, and drastically changes the profit/loss characteristics if SPY is above 88.96 at expiration, of selling calls. This is also known Figure 1 outright ownership will outperas a buy-write strategy (i.e., you form the covered call strategy, buy the underlying security and and if it is anywhere below 88.96 write—or sell—calls on it). at expiration, the covered call strategy will outperform the SPY outright ownership. Additionally, the covered call strategy will still Figure 1 shows the profit/loss turn a profit if the SPY drops graph of a covered call on SPY, slightly (provided it does not using recent (early April) prices drop below 79.56—see graph). of the call and SPY itself. There are several aspects of this graph It is also an important point that to take note of. The outright if the market moves sideways ownership (dotted line) shows and SPY is very near 84 at expiyour profit/loss if you simply ration, the outright ownership own SPY. The price of SPY strategy will not gain anything was 84.26 at the time of this but the covered call strategy will writing. The graph should make still make about 5%. As an aside, intuitive sense. If SPY is exactly if you could employ this strategy the same way continuously 84.26, then the profit/loss will be 0. If SPY is at 95, then throughout the year and if the market moved sideways, you the profit would be 10.74 (since you could sell it at that would have a 355% gain after compounding. You would price for a profit of 10.74). Conversely, if it dropped to 75, have made nothing if you were simply long the stock and it you would have a loss of 9.26, as can be seen in the graph. moved sideways for a year. However, these opportunities do Ultimately, for SPY ownership, you make 1 dollar for every not always present themselves due to the price and volatility dollar the SPY moves up and vice-versa. The profit/loss fluctuations of SPY and its options. but The central theme line is linear. of this strategy still remains true: you can make money if the stock do not move or even if it drops a certain amount. However, if you write a call (or calls, depending on the Unfortunately, you never get something for nothing in the number of shares you own—you would write one call for every 100 shares of SPY that you own to obtain the profit/ financial markets, and to obtain this benefit you must give loss graph shown above), your profit/loss at option expira- up some upside potential. The nature of this strategy is intrinsically less volatile, although the long-term performance tion would be that indicated by the kinked solid line. Note of this strategy vs. outright ownership depends on the time that option in this chart is an at-the-money option that frame chosen. In general, it will outperform the underlying expires in April (2 weeks from the time of this writing), security if the security falls in price, stays the same, or even which implies that it has the greatest time-value premium rises a little bit. But, it will generally underperform in a ragof options with the same expiration. This option has a

ing bull market since upside potential is given up.

The ^GSPC (red or top line) gained about 25% from March 9-April 3, 2009. This demonstrates the upside potential that is given up with the covered call writing strategy.

Let us look at a few situations by examining the performance of ^BXM, which is the Chicago Board Options Exchange benchmark for covered call writing strategies on the market as a whole vs. the performance of the S&P 500 (^GSPC). These charts were taken from finance.yahoo.com.

Fouth Case: Longer Term Performance Over The Past Several Years

First Case: Falling Market

! The ^BXM (blue or top line) lost only about 9% since 2005, while the ^GSPC has lost about 30% to date. Again, note ! that the divergence mainly comes from the sharp drops or pops in the ^GSPC; also there is slightly less volatility in the The covered call index (blue or top line) fell only 20% be^BXM. The amount of relative divergence on specific martween September 19, 2008, and November 17, 2008, while ket moves is based on the option implied volatility. the S&P 500 fell about 28%. Note also that while the two are fairly well correlated, the ^BXM has slightly less volatilYou can employ this strategy by writing calls on stock you ity. already own, or you can actually buy an ETF that employs this strategy for you (e.g, BEP, BEO, MCN, etc.). These Second Case: Sideways Market ETFs employ the strategy on the whole market, but you can utilize this strategy on any stock or ETF that has listed options. In conclusion, the strategy of writing covered calls, while less risky than naked calls or outright ownership, will produces returns greater than the market in times of sideways and downward market movement. However, due to this low ! risk, when the market substantially gains, the strategy will produce less than the market return. The covered call index (blue or top line) gained about 3.5%, while the market was generally sideways overall in this time period of July 11-October 3, 2005 and only gained 0.5%. It can be noted that most of the relative gains of ^BXM over ^GSPC were when the ^GSPC fell relatively sharply. Third Case: Sharply Rising Market

!

This strategy could be applicable to today’s market. While the market has rallied substantially in the past few weeks, many market observers expect the market to fall or move sideways during the upcoming earnings season. This strategy could be used to provide extra returns if these observers are correct. However, regardless of what direction the market moves in the coming months, one thing is certain: the covered calls strategy is an effective low risk options strategy that should be a part of any portfolio.