The recent actions of Paulson, Bernanke, and Cox have made a market crash almost certain. That’s my thesis. Disclaimer: Only a crazy nut job thinks he can predict a market crash. However, the market is going down, and I think it will continue. Now I’ll give the why (intervention backfires), how bad (S&P 1000), when (October), and what to do (cash, covered calls, puts).
Why
Market intervention (aka manipulation) fails. Paulson, Bernanke, and Cox have attempted the mother of all manipulations. First, they banned short selling during the triple witching hour. They bailed out AIG after leaving Lehman to die, and arranged a shotgun marriage of Bank of America and Merrill Lynch. Then they propose the largest bailout package in the history of the world to save the remaining investment banks. Somewhere, Dick Fuld is naked, crying in the fetal position, very confused.
Short Bans Fail
If we want recent examples, we can look at Pakistan, who not only banned short selling, but banned market drops, to see that the first strategy fails. Or Russia. Yes, the US is taking its cue on how to manage markets from Russia and Pakistan, after they demonstrated the ineffectiveness of the techniques. Heck, when the Hang Seng index first started falling, there was a ban on short sales. That market has collapsed. Why? Short sellers buy on the way down to book profits. They amplify small bumps to the upside. In a vacuum, the existence of short sellers cause the market to rise. Without short sellers, there’s nobody to buy in down markets, and downward trends are amplified. This is illustrated with multiple trading idioms:
- The trend is your friend
- Don’t fight the market
- Don’t catch a falling knife
All of these sayings are meant to convey one point: Don’t buy while the market is still falling. Short sellers keep the market honest.
Bailouts Fail
Why will the largest bailout package fail? Again, let’s look at recent history: Bear Stearns was bailed out to prevent the market unwind. Except then Fannie May and Freddie Mac needed bailing out. Then AIG. None of those worked, why should this one? Simply throwing 700 billion dollars at the problem is not going to make it go away. Well, it might, if we had 700 billion dollars. But we don’t, so we are going to try to increase our national debt by almost 10% to support it. Yes, we are going to fight debt with more debt. Unfortunately, Asian investors are tired with their US investments performing poorly. Foreign money is flowing out of American debt investments.
De-Leveraging
De-leveraging will continue. Already, there’s talk of money being pulled out of hedge funds. I won’t be surprised if unemployment causes more money to be pulled out of retirement accounts. This creates a huge downward pressure on the market.
Systemic Problem
The CDS market is $62 Trillion. That’s big. That’s 10,000 bucks for every human on the planet. That’s the net wealth of the United States. That number is hilarious, terrifying, unbelievable, stupefying, and a host of other words with built in superlatives. That market started unwinding with the death of Lehman, one of the top 10 counter-parties (that means they owed big if the market started to unwind). Technically, it started with the Fannie and Freddie bailout, but that was actually a bonus for the counter-parties.
Overtime for Congress? Screw U(S)!
Finally, this is the last act of Congress before they go on vacation. This bailout is being put together with haste and panic. That always works out for the best, doesn’t it?
How Bad
Honestly? I have no idea how far down we are going. Roubini mentioned a 40% fall from peak at one point. That would be S&P at 945. I’ve heard calls for S&P at 800. I’m betting on 1000 myself, but that’s because it’s such a nice, round number. Do I have any technical reasons? No.
The economy is going to have one hell of a hangover, though. Unemployment in California will top 8% this year, subject to the stupidity of over-hiring by retailers. If we don’t break 8% by the end of the year, expect a fast rise in unemployment first quarter as retailers realize their losses.
WaMu’s failure is imminent. Many businesses that have payroll with WaMu will fail immediately. These will be small businesses of about 25 employees that cannot survive with one month of missing payroll, but will exceed the FDIC limit.
Regional banks in California will also start failing. Again, small businesses will go bankrupt when their payroll exceeds the FDIC limits.
By the way, Bank of America is going to need a bailout. The CDS unwind will hit them hard. They are too big to fail. Same goes for Citigroup. Expect something creative when it comes to bailing these guys out.
When
If and when this bailout package is passed, we may get a jump up in the market. I don’t believe this rally will be long-lived. If the bailout package does not pass, the market will tank. I don’t want a September crash. I’m not well positioned, and I told my friend it was going to happen on his birthday. I told him it was a present from me and congress.
September is the end of the quarter for many. October 31 is the fiscal year for many others. That puts a lot of pressure between now and October 31 to book gains and losses. I expect a lot of de-leveraging between now and then, and that could be the precipitating event.
The bond markets are blowing up. Rates just keep rising for corporate debt. Between now and December, there are tens of billions in corporate bonds coming due. The rates are not favorable for new financing. Businesses are going to have to survive off of cash. That’s not going to happen. Businesses, especially newer businesses, do not know how to survive off cash. Instead, they will try to finance, and slowly fail over the next few months.
For these reasons, I put the crash between now and March.
What to do
The rule of the day is: capital preservation. We can do that a couple ways.
Liquidate
Cash is king. Money market accounts are going to be guaranteed by the US government. Liquidating everything before a crash is a good way to preserve capital, provided the account doesn’t disappear when some bank goes kaput.
Hedge
Covered calls provide some downside protection. Of course, if we are expecting a short-lived, but violent rally, you might end up selling the assets you wanted to hedge. This might be a good thing (cash is king), but it might spoil your plans. There’s also the risk that your cushion from the covered call isn’t big enough to absorb the coming loss.
Buying puts on the ETFs that track your portfolio is a good way to hedge. If you believe that March is a make-or-break date, you can buy March puts. Further, you can choose how protected you are. Right now, I’m about perfectly hedged. If there’s a rally, I will buy some more puts to profit if the market moves lower. That’s the position I want to be in. Today, I sold some of my “trading” puts. I booked a profit, but will no longer benefit from market swings. My portfolio will maintain a roughly constant value in the near future, and a slowly sinking or sideways market will cause some of the value to erode as my puts lose their time-value.
Am I Wrong?
If the bailout package fails to pass and markets rally in response, there’s a chance I am wrong. If the bailout package causes a rally of 10% or more, there’s a good chance that the hangover won’t be as deep as I am predicting. But, right now the trend is down, and it will take some convincing and lasting market moves to reverse that trend. If housing markets stabilize for a quarter, I am quite certainly wrong. Unfortunately, I can’t predict what a world like that will look like right now.
