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Exciting doesn't do it justice

Notice how every time we approach the end of the quarter, all hell breaks loose.

It's the manifestation of hedge funds and their investment behaviors at the end of the quarter:
1. Their profits are determined at quarter end
2. They place their bets before the end of the quarter (within a few weeks of quarter end, a company's business conditions can be relatively well sized up, especially if you spend time collecting insider info)

Another factor is lack of liquidity. Hedge funds thrive on leverage: they borrow form banks and investment banks. Lately, these financial entities are cash strapped, which means that funds are cash strapped.

Lastly, we have a commodity bubble blowing up starting in July. Copper, gold, oil - they went south. Quite a few funds were caught out and have had to sell to raise cash.

In essence, quarter end is setting off alarms and the funds are panicking as they struggle to meet deadlines. As if to prove the point, notice how the Fed's efforts to add liquidity to the market are sparking rallies. It's removing pressure on banks to preserve cash.

As frayed nerves are soothed by the Fed's ready cash, we will see a bounce. But it will be a short lived rally. Quarterly earnings are coming in. The markets will welcome anything short of negative growth, but mediocre growth will be the message.

My prediction:
A rally that will be boosted by options expiration tomorrow.
Then the markets will see-saw back and forth between elation that the government is in control and the reality that the economy is getting worse.
Capitulation by December as layoffs spread and companies can no longer hide the global recession (and seek to take the tax write-offs in 2008).

Meanwhile, it's also clear that the Fed and the Treasury are going to set up a japan-like entity to swallow the bad debt. That means that the time is definitely coming to buy financials.

I would like to add more QID in the rally coming up. Also, if I'm right and we are about to enter another trading channel, it's wise to not hold positions very long. We will probably bounce between 10,600 and 11,100 starting October. Similar to the 11,200~11,600 channel we just left.

Oracle beats - Thanks to the dollar exchange rate

http://biz.yahoo.com/ibd/080918/tech.html?.v=1

* Earnings beat expectations by 7% rising to $0.21 GAAP vs $0.16 last year
* Earnings rose 28% over last year to $1.08 B
* Sales rose 18% to $5.3B

Without a tax gain and the dollar exchange rate, the growth would have been negative.

1. Taxes are 1.2% lower this year versus last year. That generated $15M or $0.03 per share.

2. Exchange rates contributed another $0.05 EPS
- EU sales rose 20% to $1.9B. Of which $190M is from the US dollar being 10% weaker this quarter than last year.
- Asia Sales rose to ~$900M. Of which $90M (10%) is from dollar exchange rates

In fact, remove that dollar exchange rate gain and the Sales growth was a lackluster 11%.

The currency impact is so significant, that Oracle expects it to reduce sales growth by 3% next quarter. Why? Because the dollar is almost flat year over year.

They are forecasting ~10% growth next quarter after the currency issue is taken into account. And that includes the tax gain. So, in fact, Oracle is forecasting almost no growth next quarter.

It's hard to mistake the reality underlying the accounting one-offs. Business is flat at best. Which means it goes negative soon - probably Spring of next year.

More Pain on The Way

A 500 point drop and solidly below the psychologically critical threshold 11,000.

What's next?
The basic trend is down - corporate profits are slowing. The pace of fall will be driven a lot by the dollar & interest rates. The Fed would like to keep the economy ticking away with more interest rate cuts. And easing commodity prices give them much needed latitude to do just that.

A problem is that lower interest rates tend to weaken the dollar. That's a problem only insofar as the Fed needs other countries to buy Treasury notes. It's hard to entice buyers to stock up on even more eroding assets.

In fact, I suspect that Lehman Brothers was allowed to fail because China and others signalled that they wouldn't put up the money.

On the other hand, the volatility and expected market crash is driving a flight to quality - back to Treasuries.

In addition to the dollar question, the major issue now is a scramble for cash. Hedge funds in particular are net sellers of equities. This will push the markets down even further.

We are positioned awkwardly.
The positives - The Ultrashorts, QID and DUG
The mixed: ETFC dropped below $3, but I am not worried. This is a long term play.
The bad: MUR and the calls.

The calls could breakeven if one or two rally. BIG, for example.
But the Puts are the big problem. With 4 months until expiration, I am more than a little concerned. I am counting on this quarter to put some fear into retail stocks.
The puts aren't performing at all. I am amazed that HOG won't crash despite the obvious

Writing ETFC Covered calls

Writing the ETFC $4 Oct calls
10 contracts $0.15 per share

Here's the math:
Sold Oct $3 $0.50
Bought back Oct $3 $0.35
Selling Oct $4 for $0.15
----------------------------
$300 cash for the calls
Moved strike price from $3 to $4

Buying back ETFC Oct $3 calls

10 contracts
$0.35 each

Week Preview: Big Moves Up

The markets will love the FRE/FNM takeover. This will be taken a s a sign of the bottom, and in a way it is for the investment banks. I expect ETFC to move up sharply. The systemic financial market risk has been removed.

As a Citigroup analyst put it:
"This stops well short of the 'nightmare scenario' where foreign investors start to sell the stock of their U.S. holdings, triggering a U.S. dollar collapse, but represents another factor arguing against more dollar-favorable capital flows."

In other words, a short term panic is averted. But the bad news has not been addressed. I expect the positive momentum to carry forward as banks report earnings. Then I expect retail to bring the markets back down. To reality.

Which means bad news for the puts and ultrashorts and possibly good news for the calls. After all, the real reason for the rapid run-down in commodities is hedge fund panic. Also, Hurricane Ike is sweeping up the Gulf and this time it might be a serious impact on Gulf oil and gas production.

US owns Fannie Mae and Freddie Mac: Inflationary or not?

The government unveiled their plan to takeover FNM/FRE.

A quick re-cap of why this matters.
The mortgage industry today is structured very differently today. Mortgages are bought and sold to government entities, pension funds and other investment groups that want a steady cash flow. The banks processing the individual loans rely on a clearinghouse to aggregate the loans and sell them on. This role has been played by Fannie Mae.

Fannie Mae's role is more than just an expediter. It provides a certain amount of liquidity and risk management, both of which keep mortgage prices low. Without a Fannie Mae, mortgage rates would soar. FNM's business model is simple - they make money on the difference between the rates on the money they borrow and the rates on the loans they buy. That might only be 1/4%, but it's across trillions of dollars.

Lately FNM/FRE have faced a serious problem. Entities don't want to buy their debt because they rightly doubt the companies' longterm viability. Inability to borrow cash is a double hit: FNM/FRE can't buy mortgage loans and FNM/FRE capitalization (aka solvency) is a problem.

To calm the markets, some tricks have been rolled out. last month they sold $2B in new debt. http://news.moneycentral.msn.com/ticker/article.aspx?Feed=OBR&Date=20080825&ID=9058077&Symbol=FNM
In reality, they just rolled over new debt for old debt. Buyers of new debt were guaranteed that FNM/FRE would use the cash to buy back the same amount of old debt. In other words, buyers did not want to increase exposure to FNM/FRE but they were willing to go along with the game to bolster FNM/FRE shows of strength. Not only that, but FNM/FRE capitalization didn't change. Why the charade? To prevent a massive dumping of FNM/FRE debt. That would make their capitalization that much worse and make the value much less for the bond holders.

China had $340B in FNM/FRE debt, and they are selling it and not buying any more.
http://www.nytimes.com/2008/09/05/business/worldbusiness/05yuan.html?bl&ex=1220760000&en=911c9604f792c501&ei=5087%0A

The implications of a FNM/FRE failure go beyond the US housing market and hit directly at the entire US economic model. We depend on low-cost debt. The term "too big to fail" is bandied around a lot, but the reality is, if we don't keep FNM/FRE in business, then global investors will lose faith in our system. If we had to compete for money in the global marketplace, we would have to raise interest rates a lot higher.

Even saving FNM/FRE opens the door to inflation. A lot of money has to get printed to cover the debt. The US Government just added $5T in debt.

Now, not all of that debt is bad. But would you, as an investor, feel comfortable trusting anyone to tell you which is which? Especially given the current climate of accelerating foreclosures and falling prices.

In fact, price stability is critical. Can it be delivered? It will be very hard in a recessionary climate with unemployment rising. Incredibly, making housing out of reach for the majority of Americans is th eonly way to keep the US economy afloat.

It's hard to know how the markets will react. They will favor the 'business as usual' approach that will maintain the current system of writing mortgages and selling them on.
ETFC and other investment companies should look good because they can now unload their FNM/FRE debt onto taxpayers.

The dollar could even rise as US economic stability is delivered, regardless of the cost. After all, wth global recession on the way and inflation largely tamed, other countries have scope to drop interest rates. By default, that makes the dollar stronger. That would mean a further drop in commodity prices. Oil at $80???

Or will the markets realize that this can not be funded without printing more dollars, undermining its value? It's a fight between reality (the dollar is more worthless) and systemic collusion (governments fighting to keep the dollar strong)

Q2 GDP: Domestic recession and Export Strength

I look at unemployment data for two very important reasons. First, because it gives a general sense of where the economy is heading. Unemployment is both a lagging indicator (business is good/bad and so they are hiring/firing) and it’s a leading indicator (the US economy is driven by consumer spending, which in turn is driven by income). Unemployment at 6.1% is at recessionary levels.

But a far more specific reason to watch unemployment is that it can reveal which sectors are doing well. If boom times mean heavy hiring, then heavy hiring confirms boom times.

http://www.bls.gov/news.release/empsit.t14.htm
From March to July, preliminary figures say that payroll has dropped 215K jobs (seasonally adjusted), and at a constant rate of ~50K jobs per month. Because the actual numbers are massaged and rarely believable, I will concentrate on the trends.

Most of the drop is from construction and manufacturing, just as most of the rise is in extracting and shipping coal, gas, oil and other mined products.

Over 50% of all sectors are firing people. Ignore Healthcare and the government, and there is almost no hiring. But the strongest growth in employment in relative terms is oil & mining. Nearly 5% growth in payrolls in just 5 months. Business must be good for those sectors.

For the rest of the economy, however, things are clearly trending down. Compared to the last recession, unemployment rates are almost as high. Also interesting is how similar the unemployment picture looks compared with the 2001/2002 recession
Sharp spikes in unemployment on a month-to-month basis
All monthly changes are increases in unemployment

The GDP numbers are also revealing. The first challenge is that the reported figures are based on seasonally adjusted and inflation adjusted figures. The problem is that this methodology says that spending on electricity and gas has been flat for 5 months.
Instead, lets use the raw data – not adjusted for inflation or seasonality.

The 2008 Q2 GDP was $1.43T, a $600B increase over 2007 Q2 GDP of $1.38T.
* Personal Consumption $500B: $100B more for food (7% annual increase) & $120B for gas/electricity (23% increase). Also $100B for medical care.
* Private Investment -$150B: Continued commercial construction grew $75B but was more than offset by a $150B drop in home buying and a $75B drop in business inventories.
* Exports/Imports: Exports rose $300B and imports surged $313B.
* Government spent an extra $200B.

Think about this for a moment. GDP spending increased because people had to pay more for food, gas and healthcare. They stopped buying homes and businesses stopped adding inventory. The only big spending entity was the government. That is not productive growth and it is not a good picture of the future economy.

If anything, this is proof that we are in a major domestic recession and only exporters are doing well:
- Companies are hurting
- Corporate Profits are down 7% since last year
- Investment is down (15% of GDP) and businesses are unloading goods and not restocking
- Consumer spending (71% of GDP) is going to essentials (food, gas, medical) and squeezing out everything else
- Durable goods (7% of total GDP) is down 2%
- Non-durable spending is up (22% of total GDP) but that’s mainly on food & gas
- Service spending (42% of GDP) is up and that’s medical care
- Exports rose – but that’s mostly commodities, which is not broad based
- Imports also rose, but that does not reflect a strong consumer appetite but the higher prices paid for gas. Peel out the gas component, and spending on non-oil related products is sharply down.

Business is belt tightening in response to lower consumer spending – administrative and support staff are being laid off, inventory is being dumped and not replenished, what’s next?

Reviewing the situation

It's been 2 months since I posted the portfolio (sorry) so I'll do that this weekend. It does not look good but I am actually feeling very positive.

Bearish positions are improving:
* Ultrashorts are rebounding. This is 25% of the portfolio, so continued weakness in the markets will move these up nicely
* Puts are rebounding a bit. This is now ~20% of the portfolio but has more potential impact given the leverage. I think AN, HOG, & NKE may pull through for us. ZLC and VMC are showing just too much resistance.
* DUG is up big. I wrote covered calls at $40 (instead of selling at $39.50). This may get exercised.

ETFC excepted, long positions are close to worthless. The calls alone created a massive $12K+ loss.

My mistakes the last 2 months are strategic and tactical.
Strategic: getting into commodities. I interpreted the July drop as a pullback when it was the start of the crash. My analysis of the fundamentals is correct (these companies are incredibly profitable and will remain so). But the point is that the market does not think so.

Tactical: Removing my STOP loss. It is there for a reason and I have not applied it twice: once to ensure the Puts yielded maximum return in July and again when the calls started to drop. STOPs are there for me to lock in gains and limit the downside, and by temporarily abandoning this critical tool, I am facing a loss this year. I can only hope tha tthe Puts yield some golden fruit. Next month is critical.