How to protect yourself in this market

ASSESSMENT
This is a follow-on post to the previous “Or Not …” which deals with the possibility of a run on the financial system itself, which in turn follows on “Big Rally Ahead”, with reasons why we might see a short-covering rally.

The last post was written the day before the Fed dropped their discount rate by 50 basis points (.5%).  On Friday August 17 the market rallied instantly on the news. 

I figured the Fed would have to do something this dramatic before the weekend.  Had they not, you most certainly would have seen another nasty day on Friday, and, with the whole weekend to stew on that, tomorrow would have been like 19 October 1987.  I still remember that day in technicolour.

I wasn’t kidding about a run.  Country-Wide Financial (NYSE: CFC), in the midst of the whole sub-prime mortgage mess as the largest holder of mortgages in the U.S., also has a banking arm.  The Wall Street Journal reported last Thursday that there was actually a line-up of people outside the Calabasas, CA headquarters there to get their money out.  That is a run.

The market keys like a hawk on any interest rate move by the Fed, and by default will rally sharply on a cut, and did so Friday.  However, notably, it pulled back and never penetrated the euphoric high of the first few minutes of trading, even though there must have been a tremendous amount of short covering (people buying back in a panic shares they previously sold short).  It was almost like, OK, that got our attention for 5 minutes – now what?

A lot of the upside on Thursday’s end-of-day rally and Friday’s jump may have already discounted the Fed’s move.  A rate cut was widely expected (though it wasn’t the Fed funds rate, which is the big one everyone watches - pretty slippery, Mr. B), because a chimpanzee could figure out that things were about to get butt-ugly. 

Two major credit markets had just literally seized up – high-yield junk bonds (which now included sub-prime mortgage backed securities) and leveraged buy-out debt, with a third – commercial paper  - suddenly having its eyes rolling into the back of its head.  Now that should get your attention.  Every retail investor at one time or another has parked money in a “safe” money-market fund.  Well guess what the money market invests in?  If you wanted to find the perfect way to scare the crap out of everybody all at once, having their money market accounts start to go negative would probably be it.

By the way, the discount “window” is a credit facility that generally hasn’t been used of late.  Access to it is limited to deposit-taking institutions.  The Fed Funds rate is the one everyone watches every month.  It is the rate at which the Fed and financial institutions lend to each other overnight, and is accessible to more than just deposit-taking institutions.  (Judging by Friday’s reaction, I don’t think 3/4 of investors noticed the difference – or cared.)

For a sustained advanced, what the “market” will want to see is some kind of plan for dealing with the massive amount of always bad but newly junked (downgraded) debt out there and avoiding a tidal-wave of home foreclosures.  It will also need to see some evidence that such plan is actually working.  This won’t happen overnight, so the uncertainty and volatility will continue to plague the markets – grinding down investors’ resolve and most probably leading to new lows.

OTHER SHOES THAT COULD DROP
The above assumes we are talking about just what is known to this point.  What are some other nasties that could come out of the woodwork?

The commodity markets, for one.  It doesn’t take rocket science to figure out that there’s a pretty good chance the U.S. is sliding into recession.  If that’s the case, consumers and companies will re-trench, and commodities will suffer first.  Sure, China has been buying resources like crazy, but their stock market is a de-facto casino at this point.  As soon as it takes a one or two-day shellacking, everyone will be tripping overthemselves to dump the metals and energies.  We saw a bit of that kind of liquidation last Thursday.

A rout in the commodity markets would immediately spill into the stock market, because a big component of weighted indices are the basic materials and energy stocks, and the futures speculators with margin calls will selling stocks and bonds to raise the money.   

Because of the various inter-relationships between markets, just simple rotations out of sectors thought to be at extra risk could catch many investors off-guard and prompt them to bail on other things as well.

And there could be any number of high-profile financial institutions suddenly announcing insolvency.  What about the ones that aren’t in transparent jurisdictions?  The emerging market funds could suddenly take a bath at any time. 

According to an article in Barron’s this weekend “On Borrowed Time”, it also seems that Europeans and Asians were sold a bill of goods with these sub-prime bonds.  Apparently foreign reserves (the other side of the U.S. trade deficit and national debt) and petro-dollars (oil money wtih which OPEC countries are awash) had standing orders to buy any AAA rated debt coming available in the US.  So what does Wall Street come up with?  “Hey,  how much do we pay that nerdy guy in the back again?  Let’s see if we can get him to figure out how to make this BBB- ass-wipe look AAA!”  The rest is history – yet to be written.  Use your words, Deutsche Industriebank – use your words!

And finally, what better time (from a jihadist’s point of view) for another major terror attack like 9/11? 

I think that getting out of the current credit/liquidity crisis without further damage is still far from a done deal, and believe there is even the risk of a financial collapse worse than what we’ve seen before in the post-WWII era.

SO WHAT TO DO?
What I’ve done is move about 90% into cash.  I’ve sold virtually all my long positions, and placed tight stop-losses under the remaining 10%.  I’ve also sold my short ETFs, because I could just as well get burned to the upside as down in this environment, and more importantly, Proshares, the company that issues these derivative securities may itself be subject to counter-party risk;  that is to say, being hit with liquidity issues in the credit or derivatives markets they use to structure the products.  (A shiver went down my spine on Friday when my quotation list showed no price or volume on the short ETFs for better than half the day.  It turned out to be the AMEX quote feed, but they sure had me going.  Great quote-guy prank.)

You definitely need to rid yourself of margin debt, and strongly think about getting a significant portion of your portfolio/savings back under your mattress – or something to that effect.  Now, cash, not Elvis, is king.

WHAT IS CASH?
Cash is:

• physical currency,
• a cash balance in a segregated brokerage cash account
• your margin balance (cash or T-Bills) in a futures account (believe it or not)
• segregated mutual funds (invested in T-bills)
• a cash balance in a segregated registered account like a 401K, RRSP, or RESP,
• federal government (any major government) treasury bills of 90-days or less duration.

It is very important that your account be segregated, meaning, that by law the assets are in your name and not part of the capital of the financial institution.

Note that in the futures context “margin” means a good-will deposit you put up to back your positions, as opposed to “margin” in a brokerage context which means a loan from your broker against the securities in the account.

WHAT ISN’T CASH
Cash is not

• a balance in a chequing or savings account (you are lending to the bank/financial institution)
• a balance in a margin, short, or options account (your assets are commingled with the firm’s – your balance is again effectively a loan)
• a money market account (these are invested in commercial paper – see above about that market) or money market fund
• certificates of deposit – these are just longer-term loans to your financial institution
• any securities in which you are invested other than government treasury bills, including mutual funds, stocks, options, and futures
• your hedge funds

If your financial institution is going to blow up, your money should be OK if parked in the first list.   You are at risk of losing all or part of it if you are in the second.  There is federal deposit insurance for bank accounts, and some reserve funds in the brokerage and insurance industries to bail out maybe a handful of institutions at a time.  But if a whole whack of institutions fail together, these facilities are not deeply enough funded to protect you.  At the very least, getting any money back will be a long and messy process.

I have all my assets in segregated registered accounts, at one of the big five Canadian banks. As long as the Canadian dollar doesn’t go worthless (damn – didn’t think of that), that’s not too bad a vantage point from which to troll for some small trades. 

WHY AM I TELLING YOU ALL THIS?
Just so you are aware of where the risks lie if things get beyond nasty.  You should assess the financial exposure and strength of the financial institution(s) you are dealing with, especially if your money is in non-segregated accounts.  For example, if I had a margin account with a smaller discount broker, I would want to clear any debt balance and transfer it to a cash account, or out of the institution altogether.

GOING FORWARD
In a stable environment, I would remain fully invested, but right now things look less-than-stable, with the potential to imminently swing into uncharted territory.  So it’s mostly cash for now.  However, since the coming volatility should create some opportunities (and I am down about 10% since we’ve shared this space together), I might trade a little here and there until I’m satisfied we have the ”all-clear” on the financial melt-down front.

WHAT TO TRADE?
Stocks that have shown high relative strength on the worst days, defensive stocks that people would tend to gravitate to in times of uncertainty, and possibly good-quality companies that get hammered down to throw-away prices just for the hell of it.  I’ll give you names as they come to me.

HOW TO TRADE
The only trading system that really works is to take a small initial position, and then average up only after you have a profit.  Place a tight stop-loss on the first entry; a bit wider if it moves in the right direction.  This is effectively momentum trading, but it has the benefit of keeping your initial risk low, and then a margin of safety once the position is in the money.  A good ratio is to start with 40% of your intended “line” with a 10% stop-loss, then 30% more 10-15% higher, then the final 30% tranche 10%-15% above the last trade.  As the security rises, raise your stop-loss price (on the full position).  This is the way Jesse Livermore did it and explained in his classic (superb) book “Reminiscences of a Stock Operator”.  Never average down when you’re trading, and always use stops.

I’d keep the trade sizes relatively small at this time because even a sneeze could pile-drive a stock through its stop-loss price.

CURRENT POSITIONS
The only positions left in the portfolio which didn’t get stopped out and are by default my new trading positions are:

• Credo Petroleum (NASDAQ: CRED)
• Cryptologic (NASDAQ: CRYP)
• Western Digital, (NYSE: WDC) and
• Precision Drilling Income Trust (NYSE: PDS)

 I could be dead-wrong in all of this like I was early (a euphemism for dead-wrong) on the China meltdown in Feb/March, but at least I can’t go dead-broke.  (Can I?)

Paranoid and proud,
Allocator

WHAT DO YOU THINK?
So I don’t have to change my name from Allocator to Pontificator, I would certainly love to hear your thoughts and comments – especially experiences.  The comment block is your canvas.  Feel free to leave links that you might think useful and topical.