Prudent Observer Suggested Trade (POST)

It has been a while since our last entry. As part of our comeback, we decided to start a new series called POST (Prudent Observer Suggested Trade). We initially began testing our investment ideas by building a small index back in November of last year. POMP (Prudent Observer Model Portfolio) has returned more than 130% over the past 5 months. The purpose of POST, however, is to test our trade ideas in a more short/mid-term and leveraged setting. Our goal is to manage a small list of trades through a paper trading account, and to update their performance on a regular basis (MWF). More trades will be added to this list.

- Silver/Gold
- Short-Term Silver/Long-Term Silver
- Nikkei/JGB
- GE/GOOG
- Bottom 10% P/E in S&P 500/Top 10% P/E in S&P 500

(Note: the unit size of each trade represents a suggested ratio for each pair of contracts)

1. The Core: Long Silver Futures (+3 ZI APR06), Short Gold Futures (-2 ZG APR06)

Here we want to take advantage of silver's relationship with gold. Historically, the ratio between the spot price of silver and gold has been 1:15. Right now this ratio is at 1:55, so silver has a lot of catching up to do. Moreover, the silver market is about 7 times smaller than the gold market, so any bullish sentiment in precious metals is likely to have a greater impact on silver prices. As for the specifics of the trade (silver bias), we are long 3 silver futures and short 2 gold futures. Although the two metals provide a natural hedge for each other, this is not true all the time. As evident last Friday when gold futures rallied a whopping 1.8% while silver futures gained only 0.5%, a proper stop on both ends of the trade is necessary. For now, we have a stop on long-silver at 10.610, and a stop on short-gold at 562.70. Note: The official launch of the silver ETF will be a crucial point for this trade. According to our view in Quicksilver below, we will temporarily close this trade or even temporarily reverse it once the ETF begins trading.

2. Quicksilver: Long Short-Term Silver Futures (+1 ZI JUL06), Short Long-Term Silver Futures (-1 ZI JUL07)

Now that the Silver ETF is a 90% reality, we expect the silver market to react by moving from a contango market to a backwardation market, where the price of futures contracts is less than the current spot price. The reasoning here is that the silver market has been tightening up due to the expectation of the silver ETF (contango market), and that once the ETF begins trading the silver market will loosen up due to realized expectations (backwardation market). We are assuming that the silver ETF will begin trading before the end of this year. We are not so sure whether a stop is necessary for this particular trade. We will decide on possible stops once we have a chance to monitor this trade.

3. Sushi Roll: Long Nikkei Futures (+1 NIY APR06), Short JGB Futures (-5 SJB JUN06)

Japan has finally been picking up some momentum. Consequently, the BOJ believes that the Japanese economy no longer requires "quantitative easing." We believe that much of this monetary easing in the past two decades has been trapped in the Japanese bond market, where 10-year JGB's have been yielding a mere 1%. We expect the BOJ, however, to raise rates by very predictable baby steps, so we do not necessarily see a downturn in Japanese equities (similar to US equities during recent rate hikes). Instead, we expect a transfer of liquidity from JGB's to Japanese stocks. As for the specifics of the trade, we are long 1 Nikkei 225 futures and short 5 JGB mini futures (Singapore Futures Exchange). This trade is denominated in JPY in order to take advantage of a potentially decpreciating USD against the JPY over the long run.

4. G Money: Long GE (+10), Short Google (-1)

The reason here is simple. In an inflationary market, especially when the Fed is trying to recoil the market for yet another reflation, it is crucial to hold cheap stocks and dump expensive stocks. GE currently has a P/E of 22, while Google has a P/E of 73. GE has strong tangible assets with a patent portfolio life of over 20 years, while Google relies on advertisement revenue based on free products on the Internet that merely improve upon other freely available products (i.e. very weak assets).

5. Lava Lamp: Long Bottom 10% P/E in S&P 500, Short Top 10% P/E in S&P 500

The reasoning behind this trade is simliar to G Money - hold cheap stocks and dump expensive stocks. We are long a basket of 10% of S&P 500 stocks with the lowest P/E, and short a basket of 10% of S&P 500 stocks with the highest P/E. Our view is that over the course of several rate hikes and the subsequest reflation by the Fed, the cheaper stocks will appreciate while the more expensive stocks will depcreciate in value. More details on this trade will be updated once we are able to properly monitor its performance.