Investment Capitalist

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Recently, I came across a posting regarding my former employer and old friend, Neal Berger, who now runs a niche ultra high net worth investment advisory service specializing in hedge funds. Neal also runs a niche Fund of Funds that, from what I gather, only invests in “off-the-radar” strategies as he’s a firm believer in finding money in dark crevasses everyone else overlooks; yet he somehow finds with a talent unlike anyone else I’ve seen. I had the privilege and honor of working directly for him while at his previous fund, Apogee, and although my tenure was brief as my “female companion” was not prepared for the culture shock of leaving quaint little Irvine, Ca. for a metropolis like the Big Apple; to avert her experiencing an emotional and mental breakdown, I returned to California and set up shop only to return to New York two years later when I realized it’s best to go as a single, highly eligible bachelor and throw myself into the dating pool without letting it distract me from the intense dedication required to succeed as a hedge fund manager. That last part, not possible by the way.

To my pleasant surprise, and this is a huge endorsement for NY, the women there are over the top gorgeous, from all over the world, intelligent, many in the hedge fund industry but on the other side of the line (sales), and almost all of them treat Hedge Fund Traders under 30 like rock stars! It’s heaven for a single guy. Honestly, it’s the most powerful variable I miss the most about NY and also the reason I’ll be heading back after finishing my PhD at UC San Diego. There’s an abundance of amazingly beautiful, models or model quality girls with very high IQ’s that could easily be supermodels if they wanted but instead chose a more intellectually demanding line of work (as opposed to physically demanding). But I digress. Although my time with Neal was limited , the knowledge I gained was priceless, indescribable, and is one of the main pillars of my present career as a well recognized successful fund manager. To be honest, I actually owe a lot of my success to him because he was the first Hedge Fund to take me in and trust my skill sets without paying credence to where I was schooled; something uselessly abundant in this business and in fact pointless because those Ivy Leaguer’s keep getting us into trouble and costing American taxpayers trillions to clean up their mess while those responsible collect fat bonuses.

I’m starting to think the nations top universities intentionally mislead their students into believing the horse manure called “efficient markets” and other ridiculous concepts supposedly validated through esoteric quantitative studies. I don’t if they still enforce this, although I’ve been told they do, but early in my career, I was offered a job at Merrill Lynch. When I went for my interview, I noticed something bizarre. Not a single screen had a chart of a stock on it. Not one. So I asked one of the traders, and this was a sales trader who’s supposed to work an order to gain the best possible net avg. price for the client, why no one looked at charts, especially sales traders and his response still resonates in my head, “because we’re forbidden from using charts”. Wow. I understand and even believe subjective technical analysis is a piss poor way of trading. Looking for patterns called flags, triangles, double bottoms, wedges, etc.…. The subjectivity in it alone is terrifying and that may be why Merrill banned charts from their trading floor. Or they banned it because Merrill’s a wire house, a wholesaler. They accumulate mountains of stock at market lows and sell it to clients out of inventory during the mark-up stage. So if a broker could see the chart of a stock his manager told him to push that day, he might realize he’s advising his clients to buy into a wall of resistance. Shocking isn’t it? No brokerage would ever push a worthless stock through their army of stockbroker’s trained to sell and close.  Never. Not on Wall Street!  Please.

In the early days of Level 2 trading, where we could see the inside market for the first time, there were such blatantly obvious market manipulations taking place; for example, you’d see an analyst from Smith Barney or Merrill on CNBC ranting and raving about the upside potential in a stock like Intel for example, and then you’d look at the offer and since this was pre ECN days, you’d see MLCO or SMBS on the offer, or whoever it was on CNBC hyping the stock, just sitting their unloading Intel all day long while their analysts keep coming on CNBC or other news outlets over and over ranting about the intrinsic upside value in Intel and listing a litany of fancy sounding data sets to justify their position, while the firms Prime Brokerage or Proprietary Desk was selling as much of the stock out of their inventory as possible. The poor analyst had no clue, 2 years out of college, “instructed by management and told this was a special honor and display of trust by the brass” to go on TV and present a compelling case for INTC; who took it seriously and worked hard building that case for his or her 10 minutes of fame. Oblivious to the fact he or she was a pawn in the firms decision to unload 10,000,000 shares of the stock from one or more of their mutual funds. And with their Prime Brokerage handling the selling on behalf of the Mutual Fund, there was no conflict of interest. This crap still goes on but it’s under the cover of dark pools, anonymous ECN’s and automated execution algorithms, but the only defense against them today are the proprietary black boxes at hedge funds that can sniff out a big seller or buyer even if their firm is on TV pitching the other side of the trade. Just one of the many lessons I learned through Neal when he was my mentor.

Today, it’s a battle of the private black boxes who send thousands of orders per second to the market followed by matching cancel orders to prevent them from getting stuck on the inside all alone. Order discovery involves prices being shown and cancelled up and down the price scale until one ECN is left standing at a particular price, which indicates a natural sitting order, so these boxes find floors and ceilings which they then trade inside of knowing where a natural order sits in case they get stuck with the position as it moves against them. However, none of those individuals are able to trade when the machines go dark and always depend on their own programmers, who then take their algorithms and go start shop somewhere. This is why there’s an arms race for less and less latency, to the point where black boxes are “sharing memory” at the ECN level. Why? Because almost all High Frequency black box trading systems are similar, if not identical except for a few lines of code. So the only edge left is speed, hence the race for ultra low latency execution. Now that’s just unfair. Neal was never gullible enough to allow that to happen. He understood compartmentalization, supporting his traders with whatever it took to make them successful, showing a sense of patience and camaraderie with new hires (like me) that made me feel at home even though I moved 5000 miles just to work for him. After a while, you get a sense of obligation, or a desire to perform at your peak because you didn’t want to let Neal down. That’s what I call a truly inspiring leader. So to see, for the first time, this new fund of his brought back some old school memories that inspired me to write a public “thank you” to him, while also covering areas of the market which have changed since my time at Apogee. He’ll probably never read this but at least there’s a chance he might. I never did get an opportunity to say Thank You for everything he did for me while I was there.

Hearing that his present returns at Eagle’s View are very good, although I can’t verify this for a fact so caveat emptor, makes me extremely happy. I can’t endorse or denounce any hedge fund publicly, but there’s no law that says I can’t mention their name or post a link to their site. However, he is very strict about only taking on ultra high net worth investors, so the qualifications will be far beyond that of an “accredited investor”.

What I found most honorable in Neal, which is truly lacking today on Wall Street, was not only his extensive market knowledge regarding risk and tactical trading strategies; but also his passion for them as well. It’s the latter trait which I related to the most, once telling him “if I had to, I would do what I do for free”, which he thought about for a moment and then said “so would I”. Combined with intense fiduciary concern for all of his investors, he is very honest when it comes time to making the right decision when in Wall Street, making the wrong decision is often so much more profitable and so much easier. That was my “culture shock” when I first moved out to NY. Learning your best friend would kill you in a second if it meant a bigger bonus for him at the end of the year. I had to return to sunny, laid back beachside Orange County, Ca. just to reset before I could return to NY, prepared mentally and physically.

There are moments in life when you know you’ve crossed paths with someone who made a lasting impression on your life, changed your personality and the way you think, or humbled you in a way you’ll never forget. Neal is one of those guys; and I’ve never again been fortunate enough to work for a Hedge Fund owner even in the same league as him. Although it was 8 years ago, he’s still affecting my decisions to this day. Whenever faced with a choice, I take the high road because it’s honest and most of all, it’s safe in a business entirely fraught with danger. I can truly say I was lucky to have crossed paths with him at such an early stage in my career when I was most impressionable. The hedge fund industry is overflowing with narcissists, mega-maniacal lunatics, over the top ego’s and guys spewing with overconfidence because they threw a dart and it landed on the right stock, so they tell their clients and colleagues how much of a genius they are until they begin to believe it themselves, and that’s when truly talented traders rip them of any gains and then some. At the core, they’re just your typical, hot-key obsessed, trading arcade idiots who generate 3 times as much in commissions as they do in trading income for a firm who doesn’t even have the decency to recognize them employees just to skim a few more points off the top by avoiding payroll taxes.

So the guy with a $5mm trading line and an 80% payout is actually getting a fraction of that because of a couple factors: excessive churning and trading commissions, and an employer who is most likely running a black box while calling it a “risk management system”. This box is designed for two things under the cover of risk management: first it takes the other side of all new traders because they’re playing the odds, then when a trader establishes a consistent pattern of profitability, the black box is programmed to coattail that trader by jumping ahead of his order a split second before it’s filled then flipping to the other side and filling the same trader when he takes the order to market in frustration and fear of missing the trade. It blows me away how little most traders at prop firms know about the business they’re engaged in. When I found out, I sued my firm. Neal had this extremely competitive streak which rubbed off on me, and when I traded for one of the largest proprietary firms in New York, that competiveness not only kept me grounded, but also prevented the firm from taking advantage of me through an unreasonable “employee contract” while still having the audacity to blatantly lie and misclassify employees as “Independent Contractors”.

Any non-compete, exclusivity clause immediately invalidates the idea of an Independent Contractor. Also, anytime you work for the same employer, show up at a the same hour and leave at roughly the same hour because they’ve told you if you don’t, you’ll lose your trading privileges for the day, utilize the firm’s equipment, are mandated to attend meetings or employee training, and are not permitted to work for another firm during or after your termination for any reason and for any length of time, YOU ARE AN EMPLOYEE. Therefore, you’re owed a lot of money depending on how long you’ve worked there regardless of what the minimum wage is. Even if it’s low, don’t fret. At least in NY, there’s a punitive clause that automatically rewards double the amount owed in wages. Now that you know this, what are you going to do? If you don’t know, drop me a line and I’ll introduce you to the attorney that handled this for me and my colleagues in NY. He’s a stand up guy, which is rare, to say the least. Who said Wall Street wasn’t corrupt? And if you’re a hopeful discretionary trader picking your trades in the morning, no pre-defined “macro theme”, clueless as to using your platform’s advanced execution functions, especially if they can be customized, then your time is very limited in this business. Quit now before you quit because your nerves are shot. Otherwise, go learn the basic language, which is Ruby on Rails, and use a platform like www.Marketcetera.com which is open source (i.e. free) to design your own automated strategies. If you have a strategy that can be repeated, then it can be automated. If you want longevity of career, you need to learn how to automate all the models in your head and know when and how to tweak them, when to shelve them, when to take them off the shelve, what stocks to feed into them, etc.… 

If you aren’t even making an effort, you’re a dinosaur going extinct, even if you’re 21 years old. Don’t blow it. Go back to graduate school, specialize then come back to trading. The market’s not going anywhere.  In Neal’s case, like most brilliant managers, he not only educated me about the inner workings of the market, today referred to as the “market’s micro-structure”, a term you’ve seen me use hundreds of times, but he also invests his own capital in his fund. Neal always insisted on finding a quantifiable edge that can be repeated. His dogma was and I bet still is, “without a quantifiable edge that can be defined and repeated, you’re trading from the hip,” and at his firm, there was only one trader allowed to shoot from the hip: Neal.

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Who said the founder’s of Democracy were civilized?

Greece balked at pension cuts w/ elections 2 months away, but agreed to deep cuts over next 2 yrs. Markets should’ve tumbled on last min. surprise, especially the risk carry. Bids remain strong regardless of Greece. Cuts in defense likely to replace pension cuts. Future cuts not an issue as elections will have passed. Prognosis: Debt deal imminent w/ Greek delegation intentionally creating a market pullback for a privileged few to capitalize on. So very Greek of them.

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Dear Investment Capitalis followers, please forgive the “forced” history lesson regarding recent headline grabbing events transpiring with Netflix (NFLX) as well as the broadr markets in general, and I hope you don’t construe this as an indication I’m downplaying your intelligence. Hopefully, you’ll see the data on this article before it become stale, but there are powers that think you, the reader, require additional hand holding than I would have thought. So as a bow of respect to them, I give you a more instructional analysis of said events. In January, Investment Capitalist covered Netflix in depth when the stock was in the low $70′s, calling it a risky but high probability/high reward buy recommendation. The culprit was short term market inneficincies combined with possible corporate downtalking of the stock price to allow the company treasury to purchase stock recently exercised by employees, thereby preventing a dillution to earnings. We took the events which led to Netflix being mispriced in our opinion as buy opportunities because of an intimate familiarity with their business model, their deeply entrenched market position, recent corporate decision from the CEO that alhtough made many customer angry, were obvously designed to better position Netflix for a future where streaming content would be the norm and the DVD would go the way of the cassette tape. We cautiously advised getting long at an almost 60% discount to recent prices at the time, into a company whose has an outnding business model and an almost prescient view of the long-term. A company with the courage to ignore the short-term quarterly hit they knew they would take in order to position themselves for a much different long-term business landscpape where broadband video streaming would make DVD rentals in the mail go the way of the cassette tape. Because as you know, they raised prices on their DVD membership plans but left their streaming content membership prices unchanged.

As a Global Macro Trader, the rear view mirror always provides insight into the future because as it does everywhere else, history tends to repeat itself because human nature repeats itself. That repitition may manifest with a modern twist, but the single overwhelming fact is empirical evidence regarding election years. If you combine this empirical data with the March 2009 “super-bottom” in stocks, you’ll realize the path of least resistance for stocks are up. If you recall, the massive one-day reversal of 2009, which covered 1,700 Dow points in a single trading session may no longer be relavent from a traders perspective, but combine it with Federal Reserve behavior during an election year, you’ll reliaze the winds are blowing towards higher stock prices and more lax fiscal and monetary policy, at least until post elections. This gives Trader’s the knowledge they won’t be fighting the Fed during 2012 if they remain on the long side of stocks. The only major concern I hope everyone understands is that liquidty has yet to return to the levels they once were before the 2008-2009 meltdown. However, with the right tools at your disposal, you can overcome these minor challenges if you trade heavy size, and if you don’t, well you needn’t worry about this issue as it doesn’t concern you.

For the former group, it starts by taking full inventory of the technology at your disposal, designed to either give you an edge or prevent you the firepower to access liqudity on a level playing field with larger, more sophisticated firms employing sophisicated algorithmic strategies and even more sophisticated execution algorithms. And no they are not one and the same. One advantage discretionary traders using customized execution algorithms have over those shooting from the hip using “hot keys” to gain a feeling of technological superiority over whatever they think is competing against them is the dominant but rarely used ability to quickly step in and provide liquidity at a time when liquidity is scarce. Scarcity produces an opportunity for risk and the analogy is simple. The major wirehouses will accumlate vast inventories of stock during major market panics, as we witnessed during the one-day 1700 point swing in March of 2009. After plunging 1000 points, a 700 point recovery into the closee put “sealed” on the idea of one-day reversal. The inventory of stock to sell was exhausted, and sensing this, the short positions began to cover to book their profits and the bulls jumped in to make doing so quite difficult, while also trying to catch the revesal, as we did. Large, institutional traders will execute when they can, not when they want. Remember that and you’ll save yourself some stress. It took a great deal of patience, perseverence and courage to wait for as long as it took to get the green light without permitting your instincts from taking over and trading for the sake of trading. An unfortunate reality for almost every “day trader” I know. They live and die by their “daily performance” whereas Global Macro practitioners only care for their quarterly and annual performance. Although we’re masters of our trading platform and use it better than any daytrader when the time calls for rapid fire market making and execution in mutliple stocks, we are not inclined to trade just because we’re sitting infront of our array of monitors with buying power at our disposal. We know that a 3-5 day move, if caught correctly without the stress of having to crawl out of a deficit, will product monumental gains with the potential of making one’s year. Why suffer the stress and the defeatist mentality that comes with it by trading during the market’s “back and fill” environments, or whipsaw action caused by a lack of market participants for whatever reason?

Here’s a quick lesson for you newbies, who need this more than veterans, on how 21st century Market Makers and Specialists operate powerful arrays of automated algorithms in their market making activities. Automation enables a single trader to make markets in an obscene number of stocks never before possible by high touch trading. During a major volatility spike in all sectors, correlations that cause all asset classes to trade almost in total synch, or as the industry jargon likes to say “correlations spike to one”, trigger risk alarms that force the automated algorithms to go “dark”. Automated market making has a built-in safety net to generally shut down when Sigma (volatility) breaks 5, correlations spike to 1, or when a trader hits a market maker hard and fast to get them lopsided. Those chaotic moments are trading nirvana for experienced traders who know their execution platforms like extensions of their body, much like master musicians. I’m not referring to simple “hot keys” which went out of style in the late 90′s and are often defaulted to settings which cost the trader a lot of money in execution fees to the benefit of their firm. This is why I think Proprietary Trading firms are recinarnated bucket shops. On the other hand, it may have been your first experience or for whatever reason you were caught on the wrong side of a violent 1700 point single day range. If you blew up, consider it a blessing (as hard as that sounds). The best traders have had their share of blow up’s and have felt the pain deep in their gut.

Back to the point I’m trying to make if readers are given an opportunity to understand, because I firmly believe the Seeking Alpha reader is a sophisticated reader and doesn’t need things put in “layman” terms and unfortunately, some non-trader types think that’s the only way an article should be written. Regardless of the fact that a 12 year hedge fund veteran is the one
sharing his insights. Whether you’re at a major fund or a reputable proprietary trading shop, both offer powerful technology which enables the trader to launch dozens of baskets to simultaneously neutralize a heavy beairsh bias under such extreme conditions while also acquiring long positions at the same time. Most manual traders will do each half individuall. By that I mean they will cover their short positions first, perhaps even using a large long position in the Spyder’s (SPY) as a partial hedge while they do so, then they’ll switch over to accumulating long positions in stocks they havne’t been monitoring but buying as symbols pop in their head because they know this is a rising tide that will lift the marke. Not an ideal way to trade if you’re a professional. There are multiple strategies, involving derivatives overpriced due to spiking volatilility and an aversion to risk (e.g. selling naked puts rather than buying long). Using these baskets, which are fed through customized execution algorithms creates an environment best described by using a shot-gun to hit all market centers showing liquidity in a way without causing markets to run away from you because with correlations at 1, you need to concentrate on fewer stocks and larger sizes, or a huge list of stocks with smaller sizes. It’s the dollar amount you’re exposing, not what you’re buying. Because under these circumstances, the market’s in all stocks will move in tandem.

But to reverse a huge trading book from short to long within minutes without allowing annoying and opportunistic predatory algorithms running prices away from you is what traders live for. An entire year of doing nothing is worth a week where you produce a 6, 7 8 or figure profit on paper. This is what the disciplined trader waits for, this is Trading Nirvana. The unskilled, undisciplined trader who just happened to be in the right place at the right time will generally give back on average 50% to 80% of their profits, while some give back all of their gains and then some because they trade from a position of anger, a feeling of fighting to regain what was theirs to begin with, and an overall irrational mindset. Regardless of how much you made, if you fall into this trap, the best service you can do for yourself is walk away, and although it’s easy to write, I know from experience it’s almost impossible to do. Long-term success rides on your ability to bank windfall gains without any temptation to keep going at full throttle when the action rapidly diminishes. Most traders become careless following very quick and very large gains. They tend to fly off the cliff going full throttle in fifth gear. What you need to remember, the rule I live and die by is when you’re waiting for and prepared to act the moment such an event occurs (because the blood and fear or more quantitative data sets have given you indications) and generate significant gains due to your readiness,you’ve just crossed the finish line. The amateur thinks the race just began at that point and trips over themselves giving their gains back as fast as they made them during the ensuing back and fill action that causes major damage to day trader’s books. Trying to navigate in choppy waters is just money for your broker and the automated market makers back online to drive short-term, fast money traders insane with “liquidity seeking” behavior. Only traders will understand this, not editors, not teachers, not subscription newsletter writers who need to produce trades to keep their subscription base. Imagine a subscription service saying “no trades for the next few weeks because the market is too choppy and we just booked monster gains”. It’s unlikely the latter statement is true about the gains being booked, but the former statement will result in a rapid drop off in memberships. Are you on one of those members? If you are, tread very very carefully.

Why do experienced traders walk away following huge profits due to a sudden volatility/correlation spike? We all know such events are followed by equally rapid regressions in volatility and liquidity as stocks search for price equilibrium.

Because we are always at our most vulnerable following a period of tremendous profitability.

Professional traders must have the tools, confidence and mental discipline to stay calm and properly navigate a multi-sigma event of unprecedented proportions; profit as effectively and efficiently as possible from the event, then go “flat” as we say on the floor within minutes, knowing it’s time to play defense mainly against one’s own weaknesses. Adrenaline charged traders caught in a daze of euphoria caused by windfall gains will lose focus and hand back those gains due to a lack of patience and discipline to exploit high probability opportunities. Only veteran traders will understand this, non traders judging the editorial value of this material will not get what I’m saying in the slightest bit. Much like my Graduate School Economics Professors never understood and always asked me to intervene during sections covering market inefficiencies and how to exploit them, as well as to refute the formerly widely held belief out of the University of Chicago that market’s are rational. The latter is quite easy to refute.

Gains, no matter how large and how quickly accumulated, will vanish in seconds when a skull crushing reversal kicks in to retrace 70% of the cascade sell-off. Those heavily short into the cascade use the opportunity to close out and possibly reverse their direction extremely fast during a momentary sea of liquidity. Significant bottoms experience tremendous volume spikes but a large chunk of that volume is comprised of major institutional buying. The ensuing few days exhibit a rapid withdrawal of liquidity. When I was younger, we were trained to hit and hide. Stay in the tree’s until you have near certainty then jump in aggressively and jump back out to bank your profits.. With proper execution, preparation and an almost instinctive understanding of the technology at your disposal, giving it all back should never be a problem.

I used to have a mentor who was the greatest stock-picker I had ever worked with, but as I ultimately surpassed my mentor, as is the goal for all students of a great trader, I realized he was the sloppiest trader I had ever seen. With only a 7 figure line, the footprints he left when he executed a trade were the size of an elephant, as if Fidelity was in there buying millions of shares! The idea of “information leakage” never kicked in with him, so his executions resembled a buyer at the NYSE using a bullhorn to announce they were executing a large buy order and getting scalped by all the floor brokers. I was on the same platform as he was. He had access to the same tools as I did. But he didn’t use them. It was always a hot key to buy and a hot key to sell, both at market, both with a single click and very little brains. Instead, by using dozens of baskets, each containing 10-12 stocks in conjunction with strategic execution tactics, the trader can reverse, load up, get flat or neutralize market beta (i.e. directional exposure) within minutes. When short a large book because the market’s in a cascade sell-off, and then fear a bone crushing reversal is developing, the most obvious action is not the correct action. If you try to cover your shorts with no concurrent long orders in other stocks, you feed the squeeze that’s about to pop your head off. Instead, you simultaneously work to get long and cover your shorts by maximizing the platform’s capabilities.

Remember, when correlations are at 1, you don’t need to expose yourself with dozens of positions. You can buy a few generals that have enough liquidity to let you take blocks without moving the stock and gain enough exposure in a few names vs buying dozens of names. Simple enough right? You wouldn’t believe how many so-called traders have no conception of correlation, sigma or neutralizing one’s beta. Most don’t have to care because they’re running small amounts of money, but there are those running enough money where this matters!

Using your tools, skills and training to systematically and tactically cover your short positions and increase your long positions on pullbacks until your exposure is pointed in the right direction is critical. Smart, capable traders write naked puts on stocks that display signs of severe exhaustion to capture the inflated volatility in premiums in addition to getting long the stock with leverage at a time when leverage should be aggressively deployed. There’s a time for all the leverage you can get, and there’s a time when you’re not even 30% deployed, instead sitting on cash. Even if it seems like an eternity, it actually happens within minutes before the market realizes supply is exhausted, with nothing left to sell or borrow. Those few seconds, or minutes are your edge: when liquidity is greatest in the market just before vanishing, as reflected in those skyscraper volume bars during 15 minute reversals (or pick your fast time frame).

The rest of your success as a trader is whether or not you understand the market’s micro-structure and stay on top of fluid, constantly changing rules. Always be aware of charges and rebates from ECN’s for adding or taking liquidity and when major market crosses take place in the dark pools. Some ECN’s are natural dark pools like the Nasdaq itself, and a plethora of other constantly evolving elements that comprise the market’s “micro-structure”. Knowing how to pick stocks and how to customize your execution algorithms to suit your trading style are only half the battle. The rest requires a “better than average” understanding of the global macro picture along with an almost intuitive familiarity with the market’s micro-structure. If you don’t know what “market micro-structure” is, have never heard of it, or have heard of it but haven’t the foggiest clue about where to keep close tabs on it, you have only until your next losing day to start learning.

Part II will focus on a top-down analysis from a global macro perspective with an election year thrown in. The empirical evidence pertaining to Presidential election years is considerable and easy to find. I’ll also do a follow up to the long recommendation on Netflix which was covered extensively at Investment Capitalist in late December/early January. The trade was screaming out at you if you understood a couple key items: How corporate treasuries conduct stock buybacks to offset massive employee stock options that vest and are simultaneously exercised; and of course, how the micro-structure of the market behaves in such cases. Tuesday, January 26th and the Wed. January 27th both proved to be extremely profitable days for holders of Netflix stock from the low $70′s, and also an opportunity to bank gains from 50% to 80% in a few weeks. Of course I’m still holding a fairly large net long position but I’ll be trading around it at all times and have an early target of $150. That’s a natural ceiling and a good area for the stock to rest, back and fill tight stops or shake out weak hands, and build a good base to potentially use for the next leg up. I am a long-term bull on this stock and buying my entire line in the low $70′s while banking gains and rebuying those shares at even slightly lower prices gives me a cost basis way below $70, thus allowing me the benefits of patience and tactical maneuvering in the market. I also see the stock conducting a split this year if it approaches $200 again, or even breaks it. Based on recent action, the stock shows it can jump over $25 to $55 in a very short period of time. As another internet high-flyer, the risks are there but so are the rewards. Beyond what’s printed in this article, their’s not much hand holding I can do, nor the patience to be told by individuals with no trading experience what trader’s need to hear. I’ve put in too much time and gained too much respect to have to. But if you wish to access advanced market analysis, you are invited to sign up for Investment Capitalist, which is a free, highly actionable, and infrequently posted market research blog.

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We’ve been bombarded with emails asking for a follow-up post on Netflix (NFLX) since recomminding a long position in late December and early January when the stock was in the low $70′s. As is typical, many of you are seeing the stock in the $125 range and wondering if now is the time to buy the stock. If you didn’t think it was a buy at $70, why do you want to chase it at $125? However, for those of you that put the trade on, we’re not yet considering letting go of a single share of our core position other than to increase it by trading around major moves like last weeks sudden $10 decline after a straight line run to $125 from $70. This offered both a profit taking opportunity as well as an opportunity to leg into additional shares. I reitirate the first major target remains $150 for no reason except the fact that $150 is a round number. However, in the next 5 years, ask yourself where you think NFLX is going to be trading, without taking into account the potential for splits. We’ve asked ourselves that and even fed the numbers into our models every which way you can possibly imagine. The range of price potential remains between $350 and $425. That’s only a 5 to 6 bagger when I prefer 10 baggers. However, I do expect the stock to split, or perhaps even spin off one of its business lines to be called “Quickster”. This will create tremendous value for long-term shareholders and that value will make up the difference. Ultimately, this long position is destined to be a 10 bagger.

In the near term, a great deal of market chatter and color regarding Netflix has hit the wires recently. The Deal, Businessweek and The Wall Street Journal all the way down to the blogosphere are making noise. An executive decision by Reed Hastings, Founder and CEO, announcing a whopping 60% price hike while simultaneously announcing his intention to spin off the DVD rental division has taken a heavy toll on the stock. Not to mention an unknown inquiry by the SEC. After choosing to name the spin-off “Qwikster”, the company has justifiably endured the wrath of online ridicule and become the butt of sarcastic financial reporting. A plethora of synonyms for Qwikster, the most popular being a quick, painless death of the company’s main cash cow: its mail order DVD business. This business runs on auto-pilot requiring very little human intervention and has historically been a cash cow for the company. NFLX realized early on that less human intervention equates to higher productivity. Here was Reed Hastings announcing to the world he was separating the golden goose from the main company and renaming it, and not only that, for the main company under the moniker of “Netflix”, he was instigating a price hike of 60%. Two shocking blows to send investors fleeing, the trend and momentum traders to hit the bid, and the bears to start coming in. We’ll get to the reason in a second.

First, the recording industry taught us that although they knew their model’s broken, they entrenched their positions in order to maintain the status quo for as long as possible instead of embracing rapid change, as is the dogma of high tech companies. Until this decade though, music was not considered a “high tech” business. In fact, it was quite the opposite. The delivery device was always the technology, the music the product being delivered. Today, the delivery mechanism is ubiquitous: The Internet. So music is now multimedia and often “enhanced” by software. They realized in 2004 during the Atlanta CIAA wireless conference their model was based on fooling their customers and in the 21st century, this model wouldn’t fly with informed consumers. The idea of taking a CD with 2-3 good songs, and stacking it with another 10-12 songs to sell the final product for $15+tax was no longer acceptable to the almighty consumer. Change or get downloaded for free until your industry is forced to change. That’s what happened in music. Reed Hastings, NFLX, and a few other Hollywood connected companies decided to get ahead of the problem before it became one.

Paying for packaging, distribution, the retailer’s cut, and the artist’s royalty; the last item being the most important, while getting the smallest percentage of the pie was a broken model for an interconnected world. This was a no brainer to me! Artists deserved at least 75% of the revenues in a digital world where distribution needn’t go through the old channels but instead should get to the customer digitally, the way iTunes was invented, and at a price point where the consumer didn’t think twice about downloading their favorite single without paying for unnecessary overhead. Although the illegal downloads would continue even with iTunes and the demise of Napster, in Atlanta I had an epiphany which I shared with my partner who was an attorney that represented big name artists. I told him the industry was shifting to the single (remember, this is 2004 and the RIAA was still suing teenagers publicly to set an example while Metallica was the spokesperson of the evil corporate machine, making things much `worse). My advice to my colleague, from a global macro long-term perspective, was that the single and all the pirated downloads were going to become de facto marketing for the artists to go on tour, which is where they would make their money. This to me was a no brainer but to my colleague was a total game changer and almost gave him a heart attack. The manager made 10% of tour revenues while the attorney made 10% of album sales and sponsorships. Therefore, it was time for him to change his entire business model and to do it right away before the managers, which tended to be drugged out “enablers” of the artists, figured out the new game in town.

I explained singles and online music sharing was in fact the panacea of marketing a band’s tour. Release the singles in low quality all over the P2P networks or give them away as free downloads by putting those little cards in every Starbucks within the marketing zone of the band’s next concert. I’m glad to say my colleague took my advice and is now showered with praise for figuring out the new model years before anyone else did. No worries, I don’t need the credit. I went there for him. However, the RIAA fought this for so long instead of creating a new model they lost over $100 billion in gross revenue for the same people they were supposed to be lobbying for. Rage Against the Machine, Chili Peppers and many new bands have caught on and are actually releasing their new work free on their own websites, or selling the singles without iTunes as the middleman for a price less than iTunes can handle. Moreover, they maintain all rights and trademarks, all masters, and have the flexibility to offer significant incentives for fans to buy merchandise. Those that have tapped into the social networking world, and I don’t mean a Musical MySpace account, are able to reach out to fans in specific cities and offer them concert tickets as a package deal with merchandise, music and anything else. Using Google print and radio ads, along with social networks like Facebook, bands can localize their advertising and marketing rather than rely on corporate carpet bombing, group marketing, random interviews, fliers, posters, commercials and hope the music catches (the best example is Tom Cruise’s role in “Tropic Thunder”).

The answer lies in what Joseph Schumpeter referred to as Creative Destruction, originally written about by Karl Marx in the Communist Manifesto. This brings us back to Netflix and why Reed Hastings is going crazy in the eyes of the blind. First, let’s put to rest one fact, which is that Netflix is an extremely “intelligent” company with Intellectual Property that borders on artificial intelligence at the speed of light. The algorithms that run Netflix’s suggestion tool based on perceptions of what you like according to what you’ve watched, how you’ve organized your cue, how you’ve altered that cue, how quickly you return your movies, how you prioritize your cue, etc… you get the picture. Netflix offered a $1mm prize to the first team that improves this algorithm by a very modest percentage. After several rounds, many teams realized they didn’t have the manpower or the combined skill sets to improve what Netflix had created, so the most unexpected occurred: the top teams began to partner up and the longer the race continued, the larger the clusters became, with members all over the world from hackers to top scientists at IBM to Astro-Physicists at CERN joining forces in a show of human determination rather than human greed. Programmers who had never met became overnight best friends in a coordinated attack on the problem from multiple angles, communicating only over the web, the winning team members had never even met until the day of the award. The true winner was Netflix as it harnessed the programming world’s best of breed to do all the heavy lifting for an advanced behavioral analysis and recommendation engine, all for a measly $1 million dollars. Seriously, if you paid salaries to just the winners, you would far exceed labor costs of $1mm. That’s literally a song for a company whose stock was trading at almost $310 before Reed Hastings came out and “stumbled” or “tripped” or “blew a gasket”, depending on who you watch and listen to. The programmers weren’t doing it for the money but as engineers do, they did it for the challenge and recommendation. That’s why CEO’s are rarely engineers and it’s a rare engineer who runs a company.

Now the stock is hovering at $70 after reaching $300 in mid-2011 and the chart looks exactly like the dot com bubble of 2000. This is another indication of overwhelming manipulation followed by a bear raid, both sides of which the public paid a heavy toll. As this is being written, the stock closed up over $4 (6.33%) on unimportant news regarding BBC content being made available in the UK and Ireland. The announcement triggered a short squeeze more than anything, and I would use this as an opportunity to hit bids on the stock to build a short line until at least the gap is closed near $67, although this isn’t the intended point of this editorial. The downtrend hasn’t even begun the early phases of a base, let alone indications of a bottom, so the trend remains down and the stock should continue to be sold on spikes like the one that occurred on Tuesday. Although the stock is 1/4th it’s recent high, until . Netflix was a high flyer net stock favored by the fast money monkeys who are generally referred to as “day traders”, with their keyboard hotkeys and arcade like set ups, trading discretionary strategies at a time when discretionary is the equivalent of tape players as opposed to iPod’s. Nonetheless, the stock was flying, but that’s the rub. Netflix is notorious for paying employees with stock options, and the 1999-2003 vintages were so far under water the company repriced them to hold onto their most prized employees, their brain power. The only thing that keeps Netflix worth what it is. Aside from the fact that Netflix is working fast to transition to a world without DVD’s, where Blu Ray and Hi-Def 3D can be delivered over the net, or over PS3 or the Xbox. Ultimately, the writing’s on the wall and Netflix will adapt as nimble Silicon Valley companies do or they end up in the vast cemetery of has been’s like Excite, The Globe, World Com and hundreds of other companies. But not Netflix. They are too smart and Reed Hastings is too shrewd to let that happen to his company. By splitting the company in two, he is detaching the future from the past. Qwikster is probably a rub on how quickly the company will disappear, following the footsteps of Blockbuster. When Netflix acquired Starz and other media content holders, they were preparing for this day. The day when all things are delivered over the web.

Where this leads us to is interesting from both a trader’s perspective as well as long-term investors. First, Netflix is a screaming buy at these prices but I wouldn’t load the boat or back up the truck. Slow and stead accumulation is the way to go about this play. There is nothing to light a fire under this market until February of next year, when the election year goes full throttle. Let’s return to why Reed Hastings announced a massive 60% price hike AND a division of the company all at the same time when he could have not only spread the announcements out, but could have raised the prices gradually, or using different type plans, like the phone companies. But this is not the point of this article. The point is that there was a strategic incentive for the stock price of the company to come down in the near term. No company with long-term ambitions likes to see their stock go parabolic like NFLX did. It creates a bubble and we all know bubbles burst. But once the fast money monkeys had this stock in their sights, the fight was lost. The company couldn’t issue new stock, if they split it would make matters worse by allowing smaller investors to join in the party, so what do they do? They take a page out of Microsoft’s playbook, which many companies have done so because of the advice of Wilson Sonsini, the heavy weight lawyers to a large majority of major tech companies.

Microsoft in the early days of its rise to the top of the world and masters of the universe, quickly learned that one doesn’t just get out in front of the analysts and say whatever is on their mind, like the CEO of Overstock.com, who was branded “crazy” and “delusional” for ranting about the conspiracy to short his company into a death spiral, although it eventually went in the opposite direction and followed the lead of Priceline.com, hitting triple digits and not looking back. What Bill Gates and Steve Balmer figured out was that the script has to be designed to in a special sequence. Not withhold information or provide false or misleading data, as that would violate too many securities laws. The idea was to move sections of the presentation around in order to have the effect most desired. Good news, when there was any, was at the top of the list and bad news, as always, went to the bottom of the script. Why? Because more analysts are tuned in at the beginning of the call than at the end. But when there’s bad news, even one analyst is enough to damage the stock considerably. Most tech companies eventually realized that the weapon of choice, stock options, which got them to where they were by lowering their cost of labor, and tax footprint, was just a way of putting off the inevitable. Because it created the classic “Innovator’s Dilemma”. Their use of such tools helped propel the stock to new heights, however, eventually employee’s would eventually vest and exercise their stock options, which meant flooding the market with new shares. New shares equals a lower EPS as the new stock dilutes earnings without lowering it. So the magic potion was to “sterilize” this new stock by having the corporate treasury buy it back in open market activities without tipping its hand to the market. The whole point of issuing options was to save money, but being forced to buy that stock back at or near its highs was a nightmare for many companies. But the choices were few and far between. Either you buy the stock back and reduce your cash on hand, or you face a declining EPS which “green”, fresh out of college analysts would construe as declining revenue. Although it was true that shareholder equity was being diluted, the value of the company was not. If you’re a company in the privileged position of Microsoft, who kicks off approximately $137,000,000 PER DAY in free cash flow, then you do what’s called sterilization which means removing that excess stock from the market, which ended up there due to employees exercising their options. The tax savings, the savings in cost of labor, the deferred compensation, all came around at once to hit the company like a freight train. Which is really all an ESOP (Employee Stock Option Program) is. A way to push forward the inevitable. However, Microsoft, being the pioneers and brains behind the explosion in technology in the 1980′s and ultimately the mid 1990′s, figured a way to beat this fiasco. When it was time for the Treasury to kick into gear and buy the excess stock off the market, Bill and Steve would have an analyst meeting and near the end, they would vaguely say something about uncertainty in the future. In those days, cellular phones were the size of lamps so not many analysts carried them. Instead, the would rush out the door before Bill even finished his sentence, so that they could contact their companies, whether an Investment Bank, a Brokerage, or the Wall Street Journal, to proclaim that the invincible “Softie” was talking about uncertainty. Now, what exactly does uncertainty mean? It means an unknown which could go in either direction, or be nothing at all. However, it achieved the goal of Bill and Steve, to where they were quoted in a book as saying “this is too easy”. In no way am I implying they were intentionally manipulating the stock, but they had figured out that the human factor, the behavioral mechanism which resulted in a Nobel Prize in Economics in 2006 for research on Behavioral Economics and Finance, was always inclined to brace for the worst. It appears we, as human beings, are pessimists when it comes to our money. One word and we jump. Or, looking at it another way, one word and the Bears raid. Thus allowing the company treasury to purchase the stock back at a discount to where it had been trading the weeks prior. Just a 5% decline saves the company hundreds of millions in capital, so a 15% decline hits the billion dollar mark for a company the size of Microsoft. The final act in this game is to have the treasury retire the newly acquired stock in order to reduce the number of shares and thus increase EPS or keep it going in the trajectory they wanted. This was not illegal. This was not against any moral or ethical guideline. This was a smart company having figured out how to use the emotions of uninformed analysts who slept through most of the meeting, and only caught the last few paragraphs which were negative, to their advantage. The only company that does this but does NOT retire their stock is Exxon/Mobile. The reason they do this is because they trade their own stock. When the stock is high, the treasury issues new shares and keeps feeding the market for as long as it will take it. Thus raising capital and using their high-valued paper to acquire assets. On the other hand, when their stock is down significantly, the treasury authorizes a multi-billion dollar buyback program but doesn’t retire their acquired stock, instead, they park it, as if they invested in their own company, so that when the stock inevitably rises again (the energy complex is cyclical of course), they use that stock to either raise massive amounts of cash or as I said, they use the stock for highly advantageous acquisitions that saves the company billions in taxes.

This brings us back to Netflix and the recent, out of character and abrupt announcements from the CEO indicating the company was taking two extraordinary measures which they knew would hammer the stock down. If I was Reed Hastings and playing the long game, I wouldn’t want my stock in a parabolic frenzied rally that eventually becomes a short squeeze as bears get in and get squeezed out by the momentum daytrading monkeys that are nothing but fast money. Google stays at lofty levels for the same reason Berkshire Hathaway does, in order to keep the fast money out. But Netflix hit some serious lows after the crash and became a heavily diluted stock. So when the trend was established, every trend following money manager with a momentum derived system had the stock on their radar and buying on classic 3 step declines. In the case of NFLX, after their stock took a beating like all net stocks did, they adjusted the strike prices of their employee stock options to bring them in line with what other tech companies were doing in order to hold onto their best and brightest. But unlike the others, NFLX saw its stock soar to new, unexpected heights. Does anyone really think the company is worth $ The last thing a corporate treasurer wants to do is “top tick” or even pay dearly for this forced stock sterilization. So they would talk down the price of the stock and the company would commence massive stock buybacks without having to pay way over the top for the stock.

Is this what Netflix just pulled off.

Taking a page out of Bill and Steve’s playbook, in the early days of the company’s history, as was written extensively about in several books and magazines, the two were notorious for providing a room full of analysts with accurate information pertaining to the company, including negative news. The trick was, they would save the bad news for the very end so that the analysts had a chance to rush out of the room and make the phone calls they needed to make, to clients, to Head Analysts, to Sector Analysts, to Clients even, that the two highest ranking officers of Microsoft just made some comments that may be construed as negative by the press or by some lone nut job that decided to hammer the company for. Hedge funds, as we all know, are notorious for building large short positions in a company, then releasing multiple press releases to get the story out and the analysts, as well as other hedge funds to listen. Obviously hoping to attract aggressive sellers to help push the stock down. Little did they know they were playing right into the hands of Bill and Steve, because by pushing the stock down, it permitted the company treasury to buy back or sterilize the excessive stock floating around because of the millions of shares in exercised options. Rather than pay dear, the treasury could buy lower, preserving the tax advantages that accompany a typical tech company ESOP and saving the company hundreds of millions of dollars, each and every time. It always focused on top line revenue growth being “foggy” as was once said by John Chambers, the CEO of Cisco, another heavy issuer of stock options.

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In late December, early January, there was widespread talk about the potential earnings hit Netflix (NFLX) was destined to take as they prepared to enrage their customers by implementing two huge changes. The first was an across the board membership price increase, which didn’t include streaming-only memberships, and the second had to do with the breaking off of negotiations with Starz, which wanted an almost 10-fold increase in royalties in order to allow Netflix to continue streaming media from Starz. What many analysts said would be a major faux pas, we strongly disagreed then and still do. Netflix is not tied to Starz media the way the talking heads made it sound. In fact, our research as well as data from Netflix shows only eight percent of the streaming content is generated from Starz media. Although that’s 8% of high quality content, it’s certainly not the end of the world for a company that generates tremendous free cash flow. Moreover, Netflix made the right decision to walk away because it saved them from eating into their growing hoard of cash, which they can use to acquire other content from various sources. More importantly, with SOPA almost close to becoming law, and the recent shutdown of Megaupload has pushed a lot of web media viewers towards legitimate sources of content which they don’t have to pay for each time they watch something. In other words, rather than the “iTunes” model, where you buy the music and can only play it on your iPod, Netflix’s subscription model for streaming media allows members to view whatever is available whenever they want and however many times they want. This keeps their pricing model simple, members know exactly how much they’re going to pay each month and it becomes a “sunk cost” to the consumer. In other words, since they know they’re paying for the subscription, they’ll make sure they watch enough content to “feel” happy and satisfied for the price they’re paying. Moreover, what’s $7.99 when it gives you access to an enormous pool of streaming content which continues to grow by the day? The move to raise prices for subscriptions involving DVD rentals, the idea is to ultimately push everyone into a streaming only subscription over the next few years as Netflix moves all of their media content online as they work hard towards negotiating with all the major movie distribution companies. Perhaps in five years, we’ll see tiered pricing like today’s cable television, which charges more for premium channels. The point is that Netflix is ideally positioned to benefit from the Tsunami effect after Congress implements some version of anti-piracy laws being discussed on Capital Hill. We saw the first signs of this when Megaupload was shut down and although new sites came into play and tried to fill the massive, gaping hole left by Megaupload’s demise, other large file sharing services immediately took down copyrighted media and entered into negotiations with copyright holders to come up with some sort of royalty structure. What the movie industry needs is similar to what the music industry has with the RIAA, a central depository for royalty payments that distributors can work with and streamline payments to a single source. Hollywood is working towards this model and it will only benefit Netflix. They have the mass, the eyeballs, and the deeply entrenched customer base that will allow the company to quickly move towards a more copyright friendly world. The most important fact is that Netflix comes standard on most internet enabled Blu Ray players as well as HD and 3D television sets with built in internet functionality, whether wireless or wired. And with the move towards streaming content from your mobile device wirelessly on your television, the general masses are becoming comfortable with streaming media on their T.V.’s and as much as the bears hate what we’ve been saying, Netflix is rapidly becoming ubiquitous in almost every home with internet enabled, HD/3D T.V.s. Furthermore, as Apple is showing, their new Apple TV is taking off as well as the new Google TV. Both are merely app’s designed to push revenue towards these two giants, but at the end of the day, Netflix was the first and prime mover and therefore holds an enormous lead against its competitors. The company’s subscription based business model and fixed cost structure creates huge profit margins as the company grows. Netflix to this day has not had a larger drop-off of customers than new sign-ups in a quarter. That’s an amazing accomplishment and also why the stock exploded from the low $70′s to the $120 level in only 3 weeks. It’s also the reason why we were screaming that Netflix was an attractive buy in the low $70′s as loud as we could for anyone to hear.

The Netflix long recommendation made in early January on  Seeking Alpha and covered in extensive detail as well on Investment Capitalist has produced a windfall gain in less than a month, jumping from the low $70′s where it was first recommended to almost $124 on Friday’s close, with $17 of that coming in the prior 2 trading days. As previously instructed, when a windfall gain manifests itself in a short period, most tend to believe they’ve just began a marathon whereas if you’re an intermediate term trader, the explosive move is what we’ve been waiting for. The first major target is $150, but as I’ve always stressed, it is crucial to trade around your core position. There’s a reason the stock closed just below $125. That’s a natural area of resistance so I expect some backing and filling over the next few sessions while the stock gathers the strength to punch through $125. It’s likely the stock will find a trading band (i.e. range) where it will oscillate for a few days at least while it finds support and resistance bands, during which time the consolidation for another push will gather steam as weak stock is moved from fast money traders to smart money with longer time periods. I will be trading the stock at resistance and supporting it near a support zone which I believe will be near $120. So buying at $120 and selling at $125 until the stock clears $125 decisively. If it was only that easy. I can’t predict the bands, but I do suggest you look for them to evolve over the short term.

In a classic George Soros moment, the legendary investor snapped his whip loud and hard against those running his massive hedge fund. Although this has been a common theme since the moment George Soros withdrew from day to day management, it’s my first time seeing him do it in a public forum, as guest of a YouTube financial show, “Freeland File”. Asked about his recent $2 billion purchase of Italian 10 Year Bonds from MF Global, he stated in no uncertain terms that if he were managing the portfolio, he would have a “much larger position in Italian Bonds”. Ouch. He may as well have gone on CNN and said “I don’t think my head manager understands risk”. He was actually asked if his managers first consulted with him prior to putting the position on. His response was classic Soros; “I haven’t been involved in managing the fund for a very long time now but if I was, I would have a much larger position in Italian bonds”. Further explaining that around 6% to 8% the bonds are offering a fantastic speculative return, but around 3% to 4%, the funds are too risky. Now if you’ve never read Alchemy of Finance, you wouldn’t catch the point. He’s explaining how irrational markets behave as indicated by the fact that Italian bond markets are “broken”. He also hedged himself by saying “it’s also a very dangerous trade”. Ok, so it’s both “fantastic and very dangerous”. Now that’s a paradox, which is precisely how Soros describes financial markets in the book.

The risk is rates blow out to 10% or something, causing a substantial loss on the position (obviously he’s using leverage). The only way that would happen however, is if Italy was allowed to default on its sovereign debt; something Soros said would “destroy Europe”. Moreover, it’s a risk-less trade for Italian Banks because they’re directly correlated with the fate of Italy, as Soros pointed out in order to show the existence of a large natural bid in the market. In other words, “if Italy was allowed to go broke, the banks would also be broke”. They would never allow Italy to default, as indicated by Europe’s push to stop any financial crisis in Greece. By saving Greece, it’s logical to assume Italy would also be protected. But that begs the question: What if the ECB decided to let Greece default thereby triggering defaults in other poorly managed countries attached to the Euro? In such a case, the Euro would shrink to a handful of countries with strong, fundamentally sound economies, while the rest returned to their former state currency. Some might say this would be advantageous for the remaining Euro members as their countries would experience a flash export of inflation and the correlated surge in imports from the non-Euro countries. In other words, supply side economics is once again working to fix the problem in weaker nations. Tourism would be hit pretty hard, and German exports would also take a beating because of a stronger Euro. In the case of the latter, Germany is one of the world’s largest exporters. This is why Angela Merkel is keeping a poker face in the fight to stave off a Greek default. By leaning on the potential positives of letting Greece fail and insisting the market would function properly and keep the Euro from rising too much, she is reducing her country’s potential exposure.

ECB rates are at historical lows, so there’s a tremendous amount of room for rate hikes. Furthermore, if the ECB is considering inflationary risks and a pre-emptive hike in rates sometime this year, those countries whose economies are already in bad shape would simply suffocate. This is why England dropped out of the EMU (predecessor to the Euro). According to Keynesian economics, governments must be disciplined enough to swing into temporary deficits when their economy slows. To do so, they must reduce rates to an appropriate level. But if you’re tied to a basket of economies whose mandate it is to enforce a “band” which rates must stay within, and rates in your country are already at the lower range of the band, even trading below it on the institutional market, the only possible option is to drop out of the monetary union to prevent a run on the currency.

This was precisely the scenario when Soros made a billion dollars overnight betting against the Pound because he knew England had no choice but to withdraw from the EMU. And he knew this because he had already tested his theory on Italy prior to England’s withdrawal. Italy also withdrew from the EMU at the time in order to deflate the lira. Never one to manage debts properly, Italy is on a collision course with the ECB again. Could Italy be thinking they want the same flexibility as the Bank of England? Or is the thought completely preposterous as George Soros is suggesting? If I had to speculate, I’d bet on Soros. We’re dollar denominated anyway and it’s a good trade since I don’t see the US Dollar rallying significantly this year.

The Federal Reserve never raises rates during an election year. In fact, the Fed tries to stay dormant until after the elections, but still has quantitative easing if needed by buying government debt. This is why I feel the US Dollar isn’t going anywhere this year so Soros’ bet on Italian 10 year bonds seems like a high probability trade with the potential for massive gains because of the leverage involved. First, the 6% yield provides for a cushion in case the Euro fell and rates headed higher. If rates head lower to be more in-line with their theoretical value, or as Soros put it, “the market fixes itself”, the trade would return around $500 million on a $2 billion bet; which probably has a notional value of around $18 to $22 billion depending on the leverage ratio. We’ll pay attention to this trade throughout the year. Since we can’t trade it, we’ll at least live vicariously through Soros.

The following letter is a contributing factor behind NFLX’s 75% decline from recent highs that touched $300; although simultaneous announcements of spinning off the DVD division into a stand alone company called “Quikster” and the company’s decision to raise prices by 60% (although they back tracked from this) have created uncertainty in a stock that used to be a golden goose, throwing off cash at unprecedented rates. A company running on auto-pilot, wheel’s greased and every cog and widget spinning at the ideal frequency to not only kick off maximum amounts of cash, but to also raise the barrier to entry for would be competitors. With a good look at the future of broadband television and Netflix’s installation in almost every new LED/LCD or Plasma TV, Xbox, soon to be PS3 and already streaming over the web, I have no doubt Netflix will maintain a leadership position in determining the delivery of broadband entertainment for generations to come. More importantly, Netflix has now become ubiquitous in millions of living rooms and because of the structure of the internet, and the ownership of content, a “BIDU v. GOOG” type rivalry is unlikely to ever develop, or “Ali Baba v. Ebay”.  The studios have seen the writing on the wall and are beginning to release new movies in theaters in conjunction with either the content packed Blu-Ray DVD or via On-Demand. Netflix can only benefit from this monumental shift in Hollywood, and will also be pivotal in the front lines of defending against piracy. I have little doubt NFLX will recover from the current slump in the stock. Stay tuned…, there’s a trade here coming up shortly. But it’s premature to think buy right now. On the contrary, I’d be a seller on major pushes to the upside that last for a few days, which are probably short-squeezes against hot money (e.g. weak hands aka. ‘daytraders’). Eventually, I think NFLX is a stock to own in the long run. For trading purposes, trade the trend and trend is still down, although the slope is not as steep.

NFLX SEC Letter Under the Freedom of Information Act