Hedging for Disaster - Just in Case!

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 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 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 tax bill, which is being voted on today, 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 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")..