Time to Get out of the Pool

I will close ALD and ACI today. There's just too much bad stuff on the horizon.

From the Financial Times comes this story about how a govt bailout of Fannie and Freddie would wipe out $36 billion in regional bank and insurance company holdings of Fannie and Freddie preferred shares. JPM just announced that they've lost 50% or $600 million on these equities. Here's an example in the FT story of how much this could hurt regional banks:

Philadelphia-based Sovereign bank said this week it holds more than $600m in preferred stock issued by Fannie Mae and Freddie Mac, representing 0.78 per cent of its total assets.

Analysts at CreditSights said a full write-off of Sovereign's preferred stock in Fannie and Freddie could represent as much as four quarters of earnings. Sovereign executives warned there was a possibility they could take a significant writedown in the third quarter.

With oil jumping up to $119 on hurricane fears, this will be a golden opportunity to short oil. I'm thinking of shorting DIG instead of buying DUG as the margin for short sales is lower than for owning shares. Also, DIG has been trading above NAV. I will do this trade today if oil hits $120.

Also, we're hearing from the FDIC that they may need a bailout from the Treasury.

(Reuters) - Federal Deposit Insurance Corp (FDIC) might have to borrow money from the Treasury Department to see it through an expected wave of bank failures, the Wall Street Journal reported.

The borrowing could be needed to cover short-term cash-flow pressures caused by reimbursing depositors immediately after the failure of a bank, the paper said.

"Short-term cash flow pressures," you say? Hmmm.... I say, then why has your list of troubled banks risen from 90 to 117?

Keep Scratching

I'm waiting for oil to go back up to about $120, $125. Reuters is reporting that BHP Billiton expects 10% production growth over the next 12 months, even as China slows. This is more news that the commodity bubble has popped. BHP even went so far as to say, "it was in good shape to weather a downturn in the commodities cycle."




Sounds like they're expecting one. Who else is?





Let's look at VLCC tanker rates on Intertanko. They've dropped 95% in the past few weeks. At the same time, US stockpiles of oil were up last week (more than expected). Can anyone put two and two together?

Whooa! Look at that jump! Where did all that oil come from? And why are there so many tankers out there all of a sudden? (Poten and Partners is reporting that tankers available in the next 30 days has gone from 60 to 90 in the past couple of weeks.) I can't figure it out. It's all too complicated. (Smirk).

Very, Very Soon Now!

Over the next six months, the major banks, BAC, JPM, C, etc. have over $200 billion in bonds to refinance. JPM's last long-term bond deal was done at 8.625%.

But there's more. According to the Wall Street Journal, Freddie's Fannie have $225 billion to refinance by the end of September.

Let's see what bonds yields do over the next couple of months....

This will be huge, because it's all happening in such a short timeframe. Also, people are starting to watch this, and the yields investors demand will be front-page news. Time to go bearish on all equities except gold on this one.

I'm really thinking of cutting back on ALD and MCGC while this is out there. I will have to decide whether or not to hold these through, or sell and buy them back after the next market drop.

The VIX hasn't gotten a lot of attention lately, but it's just over 20. If it goes to 25-30 over the next 4-6 weeks, the DOW could drop another 1,000 points.

Or, the VIX could go to 40 and the DOW could drop 3,000 points in a week if Fannie, Freddie, JPM, BAC or someone else real big can't refinance.

Wait and see... and do a portfolio allocation study tomorrow.

What to Do?

Oil keeps sliding (down to $111 today) but DUG's still below where I sold it. Gold is being pummeled, and I'm regretting not dumping it earlier.

I don't like a few of my positions: GG, TBT, ACI, even ALD. We're seeing a real bubble pop here, and my timing is really off here.

So, what do I do about this? Buy bonds? I'm thinking of just switching my bond position here, and leaving the rest for next week. Even though commodities are plunging, I think I'll hold on to GG and ACI for now. The market's at a turning point, and there will be a lot of turbulence.

Looking on the bright side, I really like my financials, homebuilders, and retail shorts.

One part of me wants to dump the things I don't like. If I don't like them, why keep them?
The reason I don't like losing with them is because I don't like them anyway. It doesn't bother me when KBH jumps 8% in a day, because I like my longer-term prospects. However, it bothers me when GG is down 5% because I'm starting to wish I was on the other side of the trade.

On the other hand, I feel like I'm throwing caution, patience, and trading discipline by just dumping things wholesale. Well, I think I'm going to try it and see how it works out.

By the way, yesterday, I sold ITB short at $15.

The dollar has really rallied a lot: the Euro's down to $1.46 and the Pound to $1.86.

So, here are today's trades:

Sold TBT @ $66.75

Bought $17,000 of US 30-yr Treasuries at ytm of 4.49%.

My computer is not cooperating, so as I'm not using any margin for the larger bond position, I'll sell GG and ACI later.

Looking Ahead

I can see pretty clearly what's happening right now. The long financial/short crack-up-boom trade is reversing (Oil +$4, etc.). I bought a half position in SKF to jump on the bandwagon. I'm tempted to pile on more, but I'm already positioned almost perfectly for more crack-up-boom commodity bubble activity as the shorts take profits and go back to shorting the bounce in financials.

I was looking at shorting FNM again today as yields on FNM bonds rose to 6.08%. The 30-yr mortgage rate is at 6.45%. This will probably rise much higher over the rest of the year, maybe to 7%. This will further depress the housing market. I like my 23% short position in housing, but TOL is too strong. I'm thinking of covering TOL for a short FNM position. However, this might be kind of risky, due to the fact that FNM has fallen back to $7.80 from its short-covering high of $18.85. However, real value is negative. I might do this for a quick trade as the tide turns.

I'm still not sure what to do with my Treasury short. I'm just going to keep it until I make up my mind. One other thing I'm thinking of shorting is WB. They have $200 billion in commercial business loans, half of which they made in the last 5 years. These are souring very quickly: the delinquency rate has jumped from 0.07% a year ago to 0.88% last quarter. That's $1.58 billion over the last year, with huge exponential acceleration. We could easily see this quadruple to 3% and over $5 billion in losses over the next year. This would crush the stock.

My exposure in financials is now - 39%. Long exposure in the form of MCGC and ALD is + 13%.

I'm leveraged pretty much right now, but I see pretty clearly now. Commodities will have one more good bounce which should last a month or two, but it won't reach previous highs (barring some kind of geopolitical shock for oil). Then it will be down, down, down. When commodities resume free-fall, I don't think financials will get much of a bounce.

Trade

I couldn't resist taking 8% on my FXA short. An 8% swing in Forex in 6 weeks is just too much to pass up.

The short commodities/long financials trade reversed today. We'll see how long that lasts. One thing I do know is that this cannot be longer than a short-term trading phenomenon. Everywhere there is greater and greater evidence that the global economy is plunging deeper into recession.

I am thinking more and more that I am on the wrong side of the bond trade. The strongest bearish argument is that a commodity/China/emerging market collapse will remove a large part of dollar recycling demand for Treasuries. At the same time, the government will be borrowing more than ever to get out of the hole it's dug for itself.

To play devil's advocate, I'd say two things. First, a commodity collapse will strengthen the dollar, which could outway the loss of demand from dollar recycling. Also, Treasuries have been sharing the dollar recycling market with agencies. The short Treasury/long agency trade that I had anticipated has not materialized. Dollar recycling won't go away, and the shift from agencies to Treasuries might keep demand for Treasuries pretty much the same.

Another way to look at this is that demand for credit is very weak. Few want to borrow. Those who do are encountering the greatest tightening of bank credit since the Great Depression. Even prime mortgages are being tightened. It is highly unlikely that Treasury yields will rise in this environment. As for the dollar recyclers, it is the outflow of dollars from the US that pushes yields up. The buying of bonds is on the back end, not the front. There will be no need for dollar recyclers to push down Treasury yields when the dollars don't leave to begin with.

I'll wait for one good down day to buy my bonds. I will take a half or a full position, but I haven't decided yet.

Assessment

Here are some key pieces of information that I have uncovered today, as part of my research.

1. China's imports of oil for July were down 7%. Their stock market is now down 60%.

2. The recent plunge in the Euro vs. the dollar was precipitated by the ECB buying 10 billion US dollars (and selling $10 billion worth of Euros), as well as weakness in commodities. The real reason is that the dollar has been undervalued relative to the Euro, the Pound, and commodity currencies such as the Aussie and the Loonie.

So, the question I must answer is, "What direction do I want to be headed in?"

The dollar will continue to come back.

The commodity bubble has popped. Speculators dont's run into headwinds (such as China's plunging demand for oil) for very long.

However, I need a decent bounce in commodities before I pick out some shorts. In the meantime, I will hold TSO. I am holding PWE as natural gas still is undervalued relative to oil. However, North American production is up about 8% this year, so I may sell if PWE goes back over $30.

Deflation won't help the banks, as collateral for their rotten loans will continue to be devalued. When consumers see falling prices, they will be more inclined to save. I will stick with my bank, homebuilder, and retail shorts.

I will stick with my international shorts on BCS and the Shanghai market.

I will hold onto my ALD and MCGC positions, but I will be more cautious about investing in income plays after taking a 40% hit on MCGC. For example, I will hold off on my idea to buy XGM or HGM.

That leaves me with two positions that I am conflicted about: gold stocks, and Treasury shorts. Will gold fall with oil? I need to think about this one more. My first reaction is to say, "Yes," because the commodity bubble has been a multi-year phenomenon, and gold has risen along with it. I will think about paring back my exposure to gold.

As far as Treasuries goes, I can't make up my mind. So, let's make a bullish list and a bearish list and see which one, if any, is convincing.

Bullish for Treasuries:

deflation
falling commodities
weak stock market
bank failures
dollar strength against other currencies
Fed rate going lower, not higher
higher unemployment

Bearish for Treasuries:

huge amounts of borrowing from government
big spenders running for President

Well, not much of a contest any more. Time to look for an opportunity to sell off TBT and buy some 30-yr. Treasuries. Plus, by being on the long end, I'll pick up 4.6% in interest.

Currency

The Dollar is king once again. The Euro dropped over 2%, the Pound over 1%, Canadian Dollar plunged 3.9% this week, and the Australian dollar has fallen for the ninth straight day.

The Crack-Up-Boom (CUB) is over.

I was thinking about covering my FXA short with a 7% profit, as it dropped 2% today. Not bad for a currency holding opened July 1st. However, I need to delever a little. I also don't want to get caught out, not being able to short FXA as I tried and wasn't able to short FXE (Euro) or FXB (Pound). I also see this as a cheaper long term loan. Let me explain what I mean. If I want to leverage my portfolio, I need to borrow something. Instead of borrowing money, which I have to pay for, I can borrow FXA and then sell it for money, which I can use as collateral for another position. I pay a 5.36% dividend to borrow FXA, while I'd be paying 8.5% to borrow on margin. In addition, the rate on the Australian dollar will be coming down, which will cause further falls in their currency. However, speculating in currencies requires one to dance, and if I did not fear no being able to short FXA again in the future, I'd have closed it today.

The Crack-Up-Boom is over. Now what?

1. Look for a short covering opportunity to sell ACI. The smart money's been in this trade for at least a month. (Most likely, they are breaking even because they were too early.) Now that the drop in oil and the rise in CUB currencies is over, the dumb money is piling in. Remember, markets first overreact, and then underreact. This is my #1 rule of trading, which I got from Satyajit Das.

2. Wait for a bounce in commodities which I can short into. The bounce should be at least halfway between this year's high/low.

3. With the CUB commodity bubble now popped, I need to keep thinking about how a deflationary environment will affect financial markets.

As an important development that cannot be ignored, Fannie Mae announced a huge $2.3 billion loss for Q2'08. They also announced that their Alt-A mortgage portfolio has jumped from 1.8% 90-days delinquent on 12/31/2007 to 3.7% by the end of June. Fannie owns or guarantees payments on $190 billion in Alt-A's. That's $7 billion in losses in just on quarter if this was marked to market. Alt-A's are only 60% of their losses. I continue to be very bearish over the next year and a half on housing.

Reversing Course!

For the past month, my focus has been on a coming deflationary wave hitting crack-up-boom stocks. Just last week, I shorted DUG the Ultrashort Oil ETF. Well, I closed that one today for a 14% gain. I also bought a position in ACI (Arch Coal). Barron's is a good barometer of the smart money. Well, when they have an article about how the long-short mutual funds are shorting ACI, POT, and BTU, you know that any deflation in the next six months is priced in. On top of that, there were several more articles and research reports that mentioned "deflaion" and "slowdown" over and over again. So, I closed the short oil position, and I opened ACI. It's down 40% since the end of June. 40%! Year-over-year earnings growth is up over 200%. With a 7% short ratio (these are always a month behind, so probably it's really double that) any good news will send the stock up big time. Oooooh, the Fed's propping up the dollar. We'll see about that when the next big bank goes ker-plunk.