The Rules Of The Game Have Changed

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September 21, 2008 | Stocks | | Author Asif

In an unprecedented move, the current administration unveiled a simple three page plan on Saturday that will provide the treasury with $700 billion to buy toxic assets off the balance sheets of financial institutions. Combining this bailout plan with the $85 billion loan to AIG and the $200 billion to rescue Fannie and Freddie, we the taxpayers are eventually likely to incur a bill of $1,000,000,000,000. In case you did not have the time to count all those zeros and calculate what you might be liable for, that is $1 trillion and works out to a little over $3,250 for every man, woman and child living in the United States.

We have come a long way in this crisis that has devoured most of the independent mortgage lenders and left just 3 out of the 6 investment banks that started this year. Almost every weekend there is news of yet another small bank going under and real estate shows no signs of turning around. Nearly 47% of all homes sold in the state  of California last month were foreclosures and the median home price in the San Francisco bay area fell from $655,000 in August 2007 to $447,000 last month.

Following in the footsteps of our neighbors across the pond, the SEC temporarily banned short selling in the stocks of 799 financial institutions in an orchestrated effort to shore up markets. While I felt that the SEC’s move to ban naked short selling was a good move, I think a ban on short selling of any kind makes no sense. Essentially we can only buy stocks to go long or sell our existing positions but cannot hedge our portfolios by selling stocks that may be overvalued?

Short selling is an activity that even noted British economist John Maynard Keynes indulged in as far back as 1919 and is not the evil activity it is being painted out to be in the media. Try telling fund managed Ken Heebner who graced the cover of Fortune magazine just a few months ago that he has to change the structure of his 130/30 fund (130% of assets are invested in long positions and 30% are invested in short positions) because he can no longer sell short even if he identifies overvalued or mismanaged companies in the financial sector.

In its press release regarding the short selling ban the SEC admits, “Under normal market conditions, short selling contributes to price efficiency and adds liquidity to the markets.”. Clearly this action is targeted towards institutions that were aggressively short selling financial stocks and unless extended, it should end on Oct 2, 2008. Thankfully naked put options and the ultrashort ETFs, our instruments of choice to hedge the SINLetter model portfolio, were not included in the ban.

So how are investors going to be affected by these events? We are going to see increased volatility in the market, especially in the financial sector, which has been handed a Christmas gift a few months in advance. As mentioned in my previous blog post, we added to our position in Barclay’s (BCS) on Wednesday evening and the stock appreciated almost 44% in the following two trading sessions. There is a good chance we might see financials continue to rise over the next few weeks until the next earnings season comes along.

Since this was clearly a bailout of Wall Street and not Main Street (some democrats are calling for an additional stimulus package for taxpayers as part of this plan), the economy is likely to continue sputtering along or even worsen in coming months. Retail and especially luxury goods are likely to continue weakening. I still remember hearing arguments last year that this cycle will not affect the upper echelons of society and hence luxury goods will not be affected as much as the regular retail sector. Looking at the one year graph of the SPDR S&P Retail ETF (XRT) and the Claymore/Robb Report Global Luxury ETF, which ironically (or cleverly) trades under the symbol ROB, it is clear that luxury has performed worse than the rest of the retail sector and I believe this trend is likely to continue.

It may not be too late to short either one of these ETFs or start a position in the Proshares Ultrashort Consumer Services ETF (SCC). SCC is based on the Dow Jones U.S Consumer Services Index, which in addition to retailers also includes hotel, car rental, airline and cruise line companies. You can find its entire list of holdings here (excel file).

We are already beginning to see the dollar weaken against other currencies and the best way to play this (besides shorting the dollar) could be to take long positions in other currencies through ETFs like Currency Shares Australian Dollar Trust  (FXA), Currency Shares British Pound Sterling Trust  (FXB), Currency Shares Canadian Dollar Trust  (FXC) or Currency Shares Swiss Franc Trust (FXF). If picking a specific currency is too daunting a task (it is for me), then the “carry trade” ETF PowerShares DB G10 Currency Harvest Fund (DBV) could provide a useful alternative. The simple premise of this ETF is that higher yielding currencies tend to outperform lower yielding ones and hence this ETF goes long the highest yielding currencies while simultaneously shorting the lowest yielding currencies. You can learn more about the carry trade and DBV from this BusinessWeek article titled Trade Currencies Like A Hedge Fund.

Bond prices have also dropped in anticipation of the U.S government issuing more debt to finance this bailout. Most homeowners tend to either move or refinance their homes within a 10 year period. Hence 30 year mortgages are closely correlated to the 10 year Treasury note and have already jumped last week in response to this bailout plan. Not only are financial institutions being given a “get out of jail free” card but responsible first time home buyers who waited out the real estate bubble are going to pay the price immediately through increased financing costs.

I may act upon some of these strategies (short retail, currency carry trade, etc.) in the near future based on market developments and if I do, I will post it on the blog or in the next investment newsletter that is due out on October 1st.

Voluntary Disclosure: I hold a long position in Barclays (BCS).




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Comments

  1. deepak
    September 21st, 2008

    Do you think that commodities might make a comeback due to expected weakness in Dolllar?

  2. Asif
    September 21st, 2008

    Deepak, the obvious conclusion would be that a fall in the dollar could reignite a bull market in commodities but with global growth slowing down, the conditions for a commodity bull are not ideal. I was bullish on Gold early last week and mentioned Newmont Mining and Barrick Gold as potential investments last Tuesday before the big run-up.

    I am also looking into timber but have not completed my research yet. I am a little wary of steel and would like to see some price stability before I invest in Schnitzer Steel (SCHN).

  3. tskreddy
    November 18th, 2008

    Asif,

    I just noticed that the model portfolio reflects the last trade price as the current value of a stock / option.

    I think the ask price would be a more accurate picture….specially for options

  4. Asif
    November 18th, 2008

    Tskreddy, you make a good point about using the ask price especially in relation to options that are not very liquid. We will keep that in mind when we make changes to the portfolio to incorporate other subscriber feedback such as incorporating a daily change column and including charts.

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