Transaction Canceled

Agreement in principle was announced by lawmakers on the $700 billion financial bailout plan -- proposed option transactions have been canceled.

http://news.yahoo.com/s/ap/20080925/ap_on_bi_ge/financial_meltdown

Market Manipulators

If you look at the last two posts you may be confused. A week ago I argued things aren't as bad as the press is making them out to be -- earlier today I posted a proposed transaction designed to capture extreme market movements (up and down). What, you may ask yourself, has happened in the meantime?

The government got involved.

I don't mean namby-pamby involvement like taking over Fannie Mae & Freddie Mac and bailing out AIG. We're talking some serious money here -- $700 billion -- and an even more serious dismantling of capitalism.

Everyone's a libertarian until their neighbor puts something ugly in the front yard or until they start losing money. The current 'capitalists' in the government have proven to be no exception. In a startling move, Treasury Secretary Paulson announced a $700 billion bailout plan and beseeched Congress to pass it within a week. The plan: "Let me (Paulson) buy whatever I want to keep the markets going."

A little perspective here: $700 billion is bigger than the estimated cost of the Iraq War to date. The annual estimated cost to provide health care for the uninsured is $100 billion.

It gets better.

In the original plan, there was no oversight and no review -- the Secretary could buy whatever he wanted -- bonds, mortgage-backed assets, equity stakes in failing banks, equity stakes in failing car companies -- you get the picture. There has been agreement on oversight now with Congress, but this is still a HUGE grab of private enterprise by the government. Imagine what will happen when the administration and the Congress are run by the same party.

And if this wasn't bad enough, money being spent is like blood in the water for congressional sharks. The inevitable bills are being added on the bail out mortgage holders. One can only imagine what the final cost will be.

That cost, of course, will be raised though borrowing, driving down the value of the dollar and, eventually, driving up inflation and/or taxes. The long-term ramifications for our economy and our governance are staggering.

But I suspect that, if passed in a form reasonably close to what was proposed, we will see a substantial rebound in the market in the short-term.

And what if Congress doesn't play along? Will we see blood in the streets? It's debatable if, before Bernanke and Paulson made this argument, markets would have plunged and credit dried up, but now it's on the verge of being a self-fulfilling prophecy. I would not be surprised at a panicked reaction.

So I'm planning to hedge -- a reasonably straightforward procedure until lately. In addition to options, instruments many investors are not comfortable with or authorized to trade in their brokerage accounts as they stand, short ETFs have cropped up in recent years. These are designed to move in the opposite direction of the market or a sub-sector of the market. But in another manipulative move to prop up the market, short sales have been banned, effectively ruining these instruments as a hedge. Let's hope options are still allowed to pay off in October if they expire in the money.

So I would expect extreme movement in the market in the short term -- which way I don't know. It'll depend less on economics and more on politics but given our propensity to delay pain, I expect some form of bail-out to occur. Based on that, I would not exit the market, but if you have the ability to hedge the downside risk, I would seriously consider it.

Proposed Transaction

I will take a long option strangle position on S&P Depository Receipts (SPY) for October '08 expiration after 2:30 pm Central September 25, 2008 contingent on the following:

1) No announcement of congressional agreement or rejection of the proposed $700 billion Treasury-led bail-out of the financial markets

2) Total option cost (excluding commission & fees) < 1.5% of SPY market price at time of order

Strike prices will be at least 10% less (put) and 10% higher than the SPY market price at time of order.

The Day The World Didn't End

Meltdown. Crash. Plunge. Skid.

Traffic is snarled and anarchy reigns. Ruined investors are plunging from skyscrapers. Wild animals have taken over the suburbs. (OK - that one is true).

If you look at the headlines, the world came to an end this week. The failure of Lehman Brothers, the purchase of Merrill Lynch, the yet-to-be-resolved bailout of AIG all signal the death throes of Wall Street and America itself if CNN & Yahoo! Finance are to be believed.

Don't believe it for a second.

Don't get me wrong, it's been bad. A lot of people worked all last year, saved, invested, only to find they're worse off than they were a year ago. That hurts. But disaster? Not even close. Ask the folks who went through Hurricanes Katrina & Ike what disaster is. Even if the markets were to drop another 20% there's no excuse to confuse discomfort with disaster. Let's have a look at what's really happened.

REAL ESTATE

Foreclosures are up but, according to numbers from RealtyTrac® far under 1%. Though there are the usual numbers of houses lost due to illness or job loss, a significant amount of the growth in foreclosures came from Adjustable Rate Mortgages (ARMs) and Interest Only (IO) Mortgages, mortgages that were designed specifically to entice buyers into homes they could not otherwise afford. Interestingly, short duration mortgages with balloon payments were the norm during the last great wave of foreclosures, The Great Depression. It was expected that homeowners and farmers in particular would get another loan to payoff the balloon -- but when credit and income dried up . . .

And what of home values?

Let's look at the S&P/Case-Shiller Composite Home Price Index for twenty cities. January 2000 is set at 100. By November 2005, the index had more than doubled -- an annual growth rate of 12.7%, sustained for nearly five years, at a time when inflation was below 3%.

Where is it now? (now meaning the latest month available, June 2008)

The index is at 167.69, down significantly from the highs and even year-over-year, but still showing a 6.3% annual growth since the turn of the century. What's been lost in home values was the bubble. The outsized returns were never real. They were driven by demand generated by the mortgage practices noted above. If you owned your home in 2000 and still own it (and were prudent enough not to borrow against the inflated value) you should be pleased with your return over the last eight-plus years. If you are buying your first home right now, you should be elated prices have fallen. Only if you are being forced to refinance or sell are you hurt.

STOCKS

The S&P 500 is down a little over 25% off its all-time highs as I write. If you believe the market's long-term average of 11% will continue (I don't), you've lost a little over three years of investment returns (the year it took to fall and the two it will take to recover). At a more realistic rate of around 6%, we're looking at about 5-1/2 years lost. Annoying, but not an unrecoverable disaster.

What if you're closer to retirement and 5-1/2 years is a big deal? Hopefully, you're not 100% in stocks. A balanced fund like the Vanguard® LifeStrategy Income Fund (VASIX) is down only 3.64% YTD. Again, not pleasant but no reason to panic.

LESSONS TO REMEMBER

Cash is King. AIG is running out of cash. Freddie Mac & Fannie Mae needed cash to refinance. Forget the balance sheet, you're done when you can't pay someone what you owe them. Upside down mortgages are not the problem (unless you have to sell) -- not being able to make the monthly payment is the problem. Six months expenses and twelve months rent/mortgage on hand make for much more restful nights.

Time, Time, Time, is on Your Side (Yes It Is). With all apologies to Mick & the Boys, the long-term engine of economic growth pushes real value up. Three to six years of returns have been lost, but what's that in a lifetime of investing?

Diversification Works. Losses have been everywhere it seems, but not to the same extent. Stable assets, though they have lost real value, have not been battered like equities.

This Too Shall Pass. In the short term, the good usually gets better and the bad gets worse. There is a herd mentality in markets that is part psychological and part real (defaults at Fannie Mae have triggered write-downs at other banks).

Once an overreaction corrects however, there is a rebound in the other direction -- bubbles burst in overbought markets, bargains can be found in oversold markets.

In the long-term though, real (after-inflation) returns tend to follow increases in earnings and growth in earnings for the market as a whole is tied to increases in productivity. As long as the events unfolding do not permanently impair the world's ability to increase productivity, we will be fine. But Keynes left us with an appropriate warning on this point, forgotten by the over-leveraged failures that ignored the "Cash is King" dictum, "The markets can remain irrational longer than you can remain solvent."

As I get ready to post this, the Dow is looking at another loss today -- down between 200 & 300 points. I realize taking a position like this in writing may make me look like Irving Fisher in the future (though not as famous), but I'm expecting the world to go on for a little while yet.

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