“The Santa Monica Technique”

By Travis Johnson, Stock Gumshoe, January 1, 2008

Let’s start out the new year with a look at another new investment teaser that gives a mysterious name to a commonplace investment — and thereby makes the strategy seem much more complex, exciting, and secret … perhaps leading to an impulsive newsletter subscription purchase.

This is for a newsletter called the Strategic Short Report from Agora, edited by Dan Amoss, which they’re launching soon at a price likely to be above $1,000 a year. It mentions his past successes in shorting mortgage insurers and Hansen with pretty good profits.

But the teaser part of this email, which is all about a trading technique, not a particular stock, is wrapped in mystery …

“New options research service uses the covert Santa Monica Technique that made what the Financial Times calls “the most profitable single trade of all time”

And what was the “most profitable single trade?”

Another quote to tantalize you:

“A tiny, little-known fund in sunny Santa Monica has just cranked out a 1,000% return. Here’s how the hidden fund did it. It used a secret technique — what I call the ‘Santa Monica Technique’ — to bet against crummy mortgage loans.”

And if you want to hear a little more to get your juices flowing, here’s the full quote from the Financial Times that the Agora folks share with us in the teaser:

“The decision to use [the ‘Santa Monica Technique’] to short, or bet against, low-quality U.S. home loans taken by a select group of hedge funds last year appears to have become the most profitable single trade of all time, making well over $20 billion in total so far this year.”

OK, so … I don’t have a company to share with you this time around, but the Gumshoe can certainly tell you that this “Santa Monica Technique” is a wholly invented term for …

Derivatives.

OK, they’re being a bit more specific than that — They’re mostly talking about trading options, probably mostly buying puts, since they’re talking about making bets on the downside.

But I read that Financial Times article, and the word they’ve obscured is simply “derivatives.”

For anyone who doesn’t know, derivatives are just financial instruments whose value is based on some other instrument. Options, for example, are derivatives, because their value is based on the price of the underlying stock. Futures contracts are more complex derivatives.

The hedge fund that got the 1,000% return from betting against subprime mortgages was Andrew Lahde’s Lahde Capital, which is indeed based in Santa Monica, and did indeed have that spectacular return for 2007 as of about a month ago. There are several other hedge funds that are reporting returns of more than 500% from very similar strategies.

There are also, of course, many more hedge funds that were holding huge piles of subprime mortgages and went under, lost lots of money, or had to be bailed out by investment banking partners or parents (as with the Bear Stearns hedge funds several months ago). The point being, even with those 1,000% or similarly outsize returns from a select few hedge funds, I wouldn’t be surprised if the overall performance of hedge funds — and most hedge funds use derivatives or short stocks — was negative for the year (though I don’t really know).

For most individual investors, derivatives are a loooong way out of their wheelhouse, and simply a way to lose more money, more quickly. That’s why trading services that use them are so popular and so expensive — the mysterious nature of derivatives for most people, and the promise of truly outsize returns, are enough to get divers to jump in the water even when they can see the sharks circling.

This new Strategic Short Report seems to be well-timed, launching just now as investors are incredibly skittish about the stock market and worried about how they can make a profit when pundits are almost all predicting a slow start to 2008 (and those are the optimistic ones).

I have never heard of our new adviser, Dan Amoss, though apparently he did make several good short recommendations and if you’re in to this kind of thing, it’s certainly possible that he’s as accomplished as any other bearish newsletter advisers or options or shorting service gurus.

But just to give you a couple things to think about, when you’re tempted to use options trading, other derivatives, or short selling to profit from a falling market (for those of you who are already experts in all this stuff, please forgive the Gumshoe for starting the year on his soapbox):

1) The current, though uneven, is against you. A regular “long” investment in a common stock or in the overall market has good odds of benefiting over time from the fact that the tendency of the market is to go up over time — there are certainly bad years, but the average return is a positive 8-10% annually, so that means you’re fighting the overall market in the long run. Given an average day, week or month in the market, you’ll be b