Which Way Wednesday – Hedging for Disaster?

They are messing with the bailout again.

Now the Republicans in Congress are crafting an "alternate" plan that includes a provision to eliminate capital gains for 2 years and provides massive business tax refunds.  Talk about an earmark!  Now I am outraged and demanding my representative vote this down.  Effectively, what this means is that, now that the value of our homes is at a 5-year low and loan virtual portfolios are being written down 50%, the people who come in and buy them at fire-sale prices can do so, double up in 2 years and pay no taxes.  Talk about a land grab for the rich!

At the same time, some House members have signaled they are against allowing changes in mark to market accounting rules that will allow the banks to carry distressed assets long-term, rather than being forced to liquidate them at fire-sale prices.  Does anyone see a pattern here?  No wonder David Fry asks in his S&P chart: "Where are the adults?"

This statement from Congressman David Davis, who co-sponsored the alternate bill, gives you a pretty good idea of how far apart these new provisions are from what was originally proposed.  Davis says of the oirginal bill: "Make no mistake about it, this legislation provides a taxpayer financed bailout of those who have acted irresponsibly. It federalizes and socializes another sector of our economy, fundamentally changing yet again the federal government's role in the private economy. And, most importantly, this bill does nothing to address the problems that led to this financial crisis in the first place."  Interestingly, while he decries bailing out those who act irresponsibly, a cornerstone of his bill is to "Allow companies to carry-back losses arising in tax years ending in 2007, 2008, or 2009 back 5 years, generating a tax refund and immediate capital."  So WALL STREET firms can ask for hundreds of Billions of dollars in taxes back against the write-downs they are taking now in their virtual portfolios!  Madness!!!

The House and Senate also added earmarks for alternative energy credits to the bailout package but there is some logic to that as the impasse of this week has threatened the extension of existing energy credits that are set to expire in three months.  This has been tanking the solar sector and boosting oil in recent trading and is actually an important piece of legislation that the House needed to get done.  "With hundreds of thousands of American jobs and billions of dollars in clean energy investment at risk, we urge congressional leaders not to leave for the election recess" until reaching an agreement, the CEOs of national hydropower, geothermal, solar and wind energy associations said in a statement.

The Senate "rescue plan," which is being voted on tonight, would cost more than $100 billion and extend and expand many individual and business tax breaks, including tax credits for the production and use of renewable energy sources, like solar energy and wind power. The bill would also extend the business tax credit for research and development, expand the child tax credit, protect millions of families from the alternative minimum tax, and provide tax relief to victims of recent floods, tornadoes and severe storms.  Sounds good but who's going to pay for it (more deficit?) and all these major changes make me very nervous that the whole thing may blow up and not get passed.

We know about using the SKFs to cover for a financial meltdown, with that ETF back down at $100, it's a good opportunity to use Jan $100s at $19 for cover as they should retain about 1/2 of their value even if things go great for the financials but, if we drop back to just where we were on Monday, they are 100% in the money and will have very expensive October calls to sell against. 

Another crisis ETF is DXD, an ultra-short on the Dow.  Despite the Dow "only" gaining 485 points yesterday, the DXD plunged back to Monday's open at $61.53, after closing at just under 67 on Monday.  If the economy breaks, Warren Buffett has said we will be looking at the 9,000s on the Dow, close to $80 on the DXD so Apr $55s at $14.20 are not a bad protector, especially as you can already sell Oct $69s for $2.90.  These are, of course, cover plays that you would hope to lose as they are playing for a disaster in the markets but, if you want to take a chance on being uncovered on longs in hopes of a bailout, it does make sense to take out some insurance against a worst-case scenario.  If we rally, the Dow has a declining 50 dma at 11,339 that should offer resistance and that would be a good time to get out (unless we feel the rally is irrational) of the protective plays but that line has held VERY firm since we broke below it in June.

SDS is the ultra-short ETF on the S&P and that one was at $77+ twice this month but retraced to $70.30 at yesterday's close.  The March $77s are back to $9.95 and they were selling for $13 yesterday morning.  Even better, the current $77s can be sold for $4.05 which is a $3 spread against a market melt-down so perhaps a 4:3 spread is a pretty cheap way to add some protection. 

As far as hedging goes, if you are 50% invested and 50% in cash and you are worried about losing 20% on the stock side in a major sell-off, then the logic of these hedges is to take 40% of your cash (20% of your total) and put it on something that may double while the other positions lose.  If things go down, your gains on the hedge offset some of the losses on your longer positions.  If things go up, you can stop out with a 25% loss, which will "only" be a 5% hit on your total virtual portfolio but it means we are breaking through resistance and your upside bets are safe and doing well.  That is not a bad trade-off for insurance in this crazy market.  Also, be aware that these are thinly traded contracts with wide bid/ask spreads and you need to use caution establishing and exiting positions – note the way GOOG was wildly traded into yesterday's close, flushing out stops on both sides of the trade (the Nasdaq canceled many of the trades, calling them "erroneous")..

We'll be looking to hold test levels today that were breakout levels yesterday: 10,650 on the Dow, 7,400 on the NYSE and 1,135 on the S&P.  IF we do hang on and head back up, the Russell was a laggard yesterday but still the clear leader in last night's Big Chart review and we need them to retake 700, with 720 being the rally point we need over the 50 dma, which was looking so promising just a week ago.   Coming down from the 750s to 679 (was below 660 on Monday) in just 6 trading sessions makes the Oct %730s, now at $6.20 a pretty nice gamble on the bailout actually doing some good for the markets, as those contracts were trading at $40 on the 19th and over $10 all of last week.

Asian markets were mainly closed for the holidays with China closed through Monday so there is little to be gleaned from thin action over there.  The Nikkei was open and added 108 points but pulled off that trick while trading down all day after getting a big pop at the open, so let's not do a victory dance over that number.  The BOJ's Business Confidence Survey hit a 5-year low, negative for the first time since June, 2003.  Companies grew more pessimistic about nearly all aspects of their business. They are feeling the pinch from soaring prices of energy and raw materials, while being forced to lower the outlook for consumer demand in Japan and abroad.  This survey was completed by many companies BEFORE the US crisis hit the fan and already "Many companies also report funding conditions are severe, in part reflecting credit tightening by banks. The main tankan confidence index for small- and medium-sized companies showed a negative reading of 21, compared with minus 16 in June."

Global funding costs are spiraling out of control and are only held in check at the moment on the promise of the bailout being passed this week.  Although Asian and European governments are flooding the market with liquidity at unprecedented levels, funding costs are continuing to rise as interbank lending rates skyrocket (because banks don't trust each others books enough to hand out loans to each other).  "A lot of companies are saying, 'should I even consider continuing with my current projects?'" said Dr. Subramanian, head of investment banking at Enam Securities in Mumbai. He said power companies in India used to pay 8% for debt that now costs 14% to 15%, while raising money through equity is even more costly.  India's central bank reassured depositors Tuesday about the health of IBN (who we made a well-timed play on Tuesday morning) following rumors of some financial distress and reports of cash withdrawals.

Europe is mixed an hour ahead of the US open, with the FTSE up 1.5%, the CAC flat and the Dax down 0.7% as overnight LIBOR rates shot up to 6.88% (they were in "crisis" on Monday when they touched 4%) and now the 3-month dollar LIBOR has hit 4.05%.  The dollar continued to climb against the Euro, keeping a lid on gold and oil despite upward inflation pressure on a global scale as Central Banks literally flood their countries with currency.  In France, President Nicolas Sarkozy met Tuesday with heads of the country's financial institutions to assess their ability to borrow money, and promised measures by the end of the week to ensure they can carry out what the president's office called their "primary task of financing the economy."

We talked about Ireland's extreme measures in yesterday's morning post and the ECB dropped another $50Bn into overnight funds and received bids for $70Bn right away so another case of possibly too little, too late.  The BOE filled all $13.4Bn worth of overnight bids for $30Bn worth of capital set to mature on October 7th.  The Swiss National bank said it also maintained its overnight offering of dollars "in a generous and flexible manner," without providing further details.  "Central banks can address the problem of liquidity, but they cannot address the problem of solvency and trust among banks," said UBS economist Stephane Deo.

One or more financial institutions parked a staggering €102.81 billion ($144.72 billion) overnight in the ECB's deposit facility, which pays a low rate of 3.25%, data from the central bank showed Wednesday. The significance is that European banks would rather park funds at the central bank at a lower rate than lend to other banks at a higher rate.

Credit is so tight in the US that LVS CEO, Shelly Adelson, had to lend $475M to his own company in order for LVS to avoid breaking the terms of a $5Bn credit facility.  Investors and analysts had speculated for weeks over how the gambling company — best known for the Venice-themed Venetian resort in Las Vegas — would navigate a cash-flow shortage that would have put it out of compliance with its loan terms, and in the difficult position of renegotiating with lenders as Wall Street continues to be consumed by turmoil.  Meanwhile, GGP (another company big on property development) is down 73% on concerns that that company may not be able to service their $27Bn in debt.

These are the consequences being faced after just 2 days' "delay" of signing the bailout package.  Congress  many think Paulson and Bernanke and Warren Buffett are kidding when they say we are about to go over an economic cliff but I think there is certainly enough evidence to merit serious concern.  In part, we have a crisis of confidence and – even if it were true that we could "muddle through" without a bailout, if just 1/3 of the investors believe that we can't and pull out of the markets, what good will it do the remaining optimists?

Needless to say, be very careful out there!