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UPDATE: Debt v. Prosperity (2008) -- Waiting for a Verdict

November 25, 2008

Dear Fellow Options Traders,

Since the day we started ChangeWave Options Trader our goal has been to help you make profitable option trades following the "smart money" on Wall Street.

In the last four years, little as changed when it comes to finding good option trades. The "smart money" always sniffs out the first news on earnings, mergers/acquisitions or upgrades. We continue to look for and find some of the best trades by riding the coattails of big institutional investors and traders.

But, things have continued to change for me. I've found another way to help investors and traders. This month marks the launch of a new trading brokerage dedicated to providing excellent trading and investing services for the individual investor, and you can find it at www.trademonster.com.

Unfortunately, this new brokerage relationship means I have to step aside from Options Trader and recommending trades directly to you in this service, so as not to present a conflict of interest. But don't worry, you're in good hands with Nick Atkeson and Andrew Houghton.

Starting this week, Nick and Andrew will be taking over Options Trader full time based on the same approach I use to find great options trades by following the "smart money."

Nick and Andrew are two professional traders running a ton of hedge fund money, and they can give you the sort of on-the-ground market intelligence that separates the pros from the pigeons.

You see, their days are filled with computer screens and phone calls from big-money clients. They're seeing, talking and trading around the smart money all day long.

They've already been providing you with their weekly "trading landscape" to give you the outlook for making trades on the "smart money." And, more importantly, you will be getting their option trades based on following the "smart money." And let me tell you, the guys have been hot -- even in the middle of this financial crisis.

Since June, they have closed out 37 trade recommendations with 28 winners and 9 money-doublers.

I have always geared this service toward regular investors -- those with a little experience and risk capital -- who want to add the wealth-building power of options trading to their overall investing arsenal.

Nick and Andrew have that same goal of providing you with 1-2 winning trades each week based on what the "smart money" is doing. You don't have to do anything but continue to look for these great trades in your inbox each week.

Enjoy this week's Trading Landscape and get ready for the next trade. And, remember, friends -- pigs get fat, but hogs get slaughtered!


Jon "Doctor J" Najarian

Your Weekly Trading Landscape

DEBT V. PROSPERITY (2008) -- WAITING ON A VERDICT

In the case Debt v. Prosperity, bulls and bears have presented powerful evidence and now await the judge, Mr. Market, to make the verdict.

Bulls, representing the side of prosperity, argue that the S&P 500, which is down 45% year-to-date and has had its worst year since 1931, has priced-in the consequences of de-leveraging and the effects of that on consumption and the economy. With the exception of the 1929-1932 market, no downturn in the 20th century exceeded 50% in the S&P 500. On Thursday, we achieved this mark and were looking at the worst year in the market since 1872.

Essentially, the bulls' case boils down to valuation and a recognition that at market extremes, investors tend push a theme too far. In this case, all of the hand-wringing by the bears about excessive debt and its likely further negative impact on equity prices has gone too far. If Mr. Market decides in favor of the bull case, it is likely we could see at least a 50% retracement back toward the highs in a period of months.

Bears argue that the negative feedback loop involving tightening credit, falling asset values (home prices), lower consumption, declining GDP, fewer jobs, debt defaults and further tightening of credit ... will play on. More importantly, they argue that the off-balance sheet derivates debt is so irresponsibly large, it is beyond the capacity of our largest financial institutions and government to handle.

Bear evidence already on record includes Bear Stearns, Fannie Mae, Freddie Mac, Washington Mutual, Lehman Brothers, AIG, junk bond spreads above 20% and credit default swap premiums on Treasuries escalating. Further evidence presented during the past week includes:

1. Citigroup's (C) 60% equity drop for the week because of its exposure to billions of dollars worth of potentially non-performing collateralized debt obligations (CDOs) tied to residential mortgages.

2. Berkshire Hathaway having sold at-the-money puts on the equity indexes from 2005 to 2007 which, if marked to market, would cost the company about $1.7 billion. Thankfully, expiration is not until 2019 and later.

3. A letter, sent Friday from the state of California, talking about the state's liquidity problems associated with interest-rate swaps and variable-rate-demand-obligations (VRDOs). To simplify, VRDO bonds issued by states can be put back to banks if the bond collateral is determined to be deficient. This represents another hidden liability for banks and greatly increases state's borrowing costs.

The guts of the problem, from the bears' perspective, is after exponentially pilling on off-balance sheet derivatives obligations for the past decade, we have created a liability with magnitude and impact that is only beginning to emerge. Banks are not lending today because they are unable to measure with confidence the value of their assets or the extent of their liabilities mostly associated with credit default swaps. Banks now hold $592 billion in reserve balances, up from $15 billion prior to September.

This frozen lending state persists even in the wake of the Fed pumping about $2.2 trillion into the financial system over the past 11 months and lifting its own leverage to about 53-times its capital base. Based on capital ratios, if the Fed were a private bank, it would be a candidate for receivership.

Guilty Until Proven Innocent

When the market is uncertain, it generally loses value. Mr. Market, is truly confused as the CBOE Volatility Index (VIX) persistently remains between 60 and 70. With the VIX going to historic levels since mid-September, we have now scrubbed off about a decade's worth of value accumulation in equities.

More important than uncertainty in the equity market is continued uncertainty in the debt markets.

Think of junk yields as your debt market VIX. They are currently spiked above 20%. With lenders not lending, fundamentally sound companies are becoming cash starved. Even when loans are made, borrowing costs are so high they materially erode future profit potential.

The bulls, during this time of uncertainty, will continue to highlight history and valuation. Additionally, they can now point to Timothy Geithner, currently president of the Federal Reserve Bank of New York and soon to be the new Secretary of the Treasury, as a leader who understands the off-balance sheet derivatives world and will be effective at finding a way to manage these liabilities.

As we pointed out last week, regulators are going full bore to lasso the credit default swap market and place it inside a coral of transparency and limits by year end.

Possibly most critical for the bull case is that the bear case has been fully laid out. What was unknown is becoming fully known. If this is true, the VIX and junk debt yields should begin to pull back.

What to Watch for This Week

Our broader market option indicators are continuing to give us bear signals. But, as we have previously highlighted, with the VIX at elavated levels, these option indicators have become less stable and reliable indicators of intermediate market trends.

Yesterday, the government devised a rescue plan to save Citigroup (C) involving a $20-billion capital injection and a $300-billion loan guarantee. While this action helped lift the indices, we will have to wait and see if the rescue has a lasting positive impact on the market.

Today, the S&P/Case Shiller home-price index for September is expected to show an accelerating rate of decline.

On Wednesday, we will see a slew of economic announcements: initial jobless claims for the week, personal spending, personal income, new-home sales, durable goods and the November Chicago Purchasing Managers' Index (PMI). We expect that these data will do little to settle the mind of Mr. Market either in favor of the bulls or bears.

REVIEW OF OPEN POSITIONS

This past week, we allowed our IPI Nov 20 Puts (IPIWU) and SPN Nov 17.50 Puts (SPNWW) short positions to expire and take ownership of the stocks at $18.50 and $16.30 respectively (strike price less premium collected plus commissions). IPI opened today at $18.24 and SPN opened at $15.20. These are extremely depressed valuations and we expect to be able to profit from these stocks as the market recovers.

Pitney Bowes Inc. (PBI) -- On Nov. 12, we recommend buying the PBI Dec 22.50 Puts (PBIXX) up to $1.45. These options opened today at 95 cents.

Vasco Data Security International (VDSI) -- On Nov. 4, we recommended buying the VDSI March 15 Calls (QFNCC) for 95 cents or better. These options opened today at 75 cents.

Hain Celestial Group (HAIN) -- On Oct. 21, we recommended you buy HAIN Feb 25 Calls (QQHBE) and simultaneously sell an equal number of the Feb 35 Calls (QQHBG) against them for a net debit of $3.05 or less. By simultaneously buying and selling volatility, we are canceling out some of the cost of the long position.

Hain is a fundamentally strong company. However, it does have some long-term debt. The stock is going down on fears that the company may struggle to refinance this debt when it comes due. Until the credit market loosens up, the stock is likely to be under pressure. But, when the credit market does begin to flow, this stock should go much higher.

PARTING SHOT

Incredibly enough, November has proven to be more difficult than October. Last week was especially difficult. There were few powerful option indicators, as the credit market became even more frozen and the equities market broke to new lows.

We made no new recommendations last week. This is unusual. Our commitment to you is to stay true to our discipline of following smart money in the options market to bring to you winning trades. This week has gotten off to a great start, though, with our newest trade in Dow Chemical already up 22%. We'll continue to send e-mail alerts as more opportunities present themselves.
Have a great week trading and Happy Thanksgiving.



Nick Atkeson and Andrew Houghton