In order to accomplish this, I am going to cite exact passages from the House Bill from last summer (HR3200) and give you page references so you can download a copy of the bill and follow along if you so desire. I am using the older bill because it is much clearer in language than its Senate counterpart, and while not all of the provisions were passed in the exact same form, I believe this is where we’re ultimately going to end up. I am also doing this since many people simply cannot believe that our reps would put such provisions into legislation and will no doubt call me a liar and a shill. Before anyone gets any ideas about turning this into the sadly typical political muckraking that passes for debate these days, I want to refer you back to the articles I wrote in 2008 issuing scathing criticism of the banker bailout, the AIG bailout, Fannie/Freddie, and the housing relief bills, which were pushed by the ‘other’ folks in Congress. I couldn’t give a rip about politics. I am interested in the impact these bills will have on our economy and American families.

Piling on Debt

One of the planks that was used to promote this legislation was the fact that it will be a deficit-reducing measure. Let’s consider a few things here. The IRS will need to hire upwards of 16,000 agents and require an additional $10 Billion over the next decade (reported in the MSM) to ‘police’ the provisions of this new law. So the public sector will get even bigger. The late Milton Friedman did some fascinating research and modeling that pointed to the fact that every public sector job created destroys roughly 2 private sector jobs. That is 32,000 more private sector jobs down the tubes just on the IRS’ account using Friedman’s research, which has proven to be pretty accurate.

The bill itself is advertised to cost $940 Billion. Looking back a few years, we have Medicare Part D, which was advertised to cost around $500 billion. To date Medicare Part D has already added nearly $7 TRILLION in contingent unfunded liabilities to our national balance sheet. While it would be irresponsible to do a naked extrapolation here, the point is simple; this bill will, in all likelihood, end up costing an awful lot more than what has been advertised.

Martin Feldstein who, incidentally, concurs with the above assessment estimates debt service on the debt created by this new law to run around $300 billion over the next decade. In the new financial landscape where we talk in terms of trillions, a mere $300 billion doesn’t seem like a lot. However, when you consider that $300 Billion represents the total of yearly earnings of over 6.5 MILLION average US families, it is obvious we’re not talking about chump change here.

For a nation that already has liabilities that outstrip assets by anywhere between $15 and $20 Trillion dollars, it seems foolish to even consider more debt, but we don’t even blink twice anymore. Our government is probably already aware of the fact that the debt cannot be paid, so why not pile it on as long as others are willing to let the game continue? It’ll be ok until it isn’t, then we’ll have to think of something else. How’s that for an exit strategy?

The Provisions

Page 22 Section 113 – The Health Choices Commissioner along with the Dept. of Health/Human Svcs will conduct an audit of the books of any businesses that self-insure. This constitutes an additional regulatory burden on the small business that chooses the self-insurance route.

Page 50 Section 152 – This will allow illegal aliens to get health insurance; presumably at no cost since nowhere does it mention charging them or making them pay any sort of taxes, fees, or levies. The section reads that health care will be provided ‘without regard to personal characteristics extraneous to the provision of quality health care or related services.’ Although, ironically, Section 246 contains language that purports to exclude ‘undocumented aliens’ from Federal payments towards affordability tax credits. This is something of a joke since these people don’t file returns anyway and would not be able to take advantage of such a credit.

Page 149 Section 313 – Any employer who has a payroll greater than $401,000 and doesn’t offer a ‘public’ option for employees will pay an 8% tax on its payroll – payable to the Health Insurance Exchange Trust Fund.

Page 150 Section 313 – The following schedule applies to smaller employers who don’t offer a ‘public option for employees. The percentage represents the additional ‘tax’ they will need to pay to the Trust Fund:

Does not exceed $250,000 – 0 percent

Exceeds $250,000, but does not exceed $300,000 2 percent

Exceeds $300,000, but does not exceed $350,000 4 percent

Exceeds $350,000, but does not exceed $400,000 6 percent

Also of interest is the fact that Section 313 states that an employer hasn’t satisfied the contribution requirement if they simply cut the employee’s salary by the amount of the contribution. This is best illustrated with an example:

Let’s suppose Employer A has an Employee X who makes $10.00/hour and Employer A doesn’t offer a ‘public option’ for his employees. By law, the employer is now required to pay an 8% tax on payroll (let’s assume Employer A is in the highest bracket). If the Employer simply reduces Employee X’s wage by 8% to $9.20/hour, the Employer is in violation of the statute and is deemed to not have made a contribution. While on the surface this appears good since it forces the employer to effectively increase total employee compensation, this will be a job-killer. Employer A might very easily choose to reduce the workforce by 8% to keep costs the same.

It is pretty easy to see that just these four provisions add some serious burdens on what are considered to be small businesses. These are the business that employ somewhere in the neighborhood of 80% of all workers and create roughly 60% of new jobs. The most logical response of these businesses will be to cut staff or reduce non health-related benefits such as retirement contributions. Still mired in a severe recession, small businesses have not been able to grow top line revenues (nor have large ones to any meaningful extent for that matter) and are therefore going to be focused on controlling costs. This is precisely how the firms that have survived have done so over the past 2 years. This law will put many of them under. I wonder if BLS will take this new reality into account when it pulls CESBD (birth/death model) adjustments out of the black hat each month?

This says nothing of the encroachment on civil liberties such as the IRS having direct access to your bank accounts (Page 59 Section 1173A) and the creation of a National Heath Card ID and giving government instant access to your financial information (Page 58 Section 1173A).

All this and we still haven’t considered the overall impact this will have on the macroeconomy. We know that half a trillion dollars will be transferred from consumers to government vis a vis the ‘Shared Responsibility’ doctrine espoused in the law and it will likely be much more than that. That is an additional half trillion dollars that will not be spent efficiently by consumers, but will be squandered by government. Ok, I’ll admit it – I am deeply skeptical of any government ‘Trust’ Fund. For those who want to bicker on this point, I refer you to the status of the Social Security ‘Trust’ Fund as my basis for skepticism.

We also know that $500 Billion worth of Medicare cuts will be made, which essentially means that another half trillion will disappear from the pockets of households in pursuit of paying higher Medicare premiums. The beauty of the shift is that it is essentially GDP neutral since government spending counts in GDP at the same weight as consumer spending. In this new world of socialized everything we clearly need a new way of measuring economic output or at least differentiating legitimate output from the activities of our borrow and spend politicians.

With all the debt being accumulated, the money being pulled from the real economy in favor of the centrally planned utopia sought by so many on Capitol Hill, and the pressures brought to bear on businesses by this ‘reform’, it is hard to contemplate a set of circumstances under which we avoid another steep contraction in the real economy. It will be interesting to see how long it takes to go from recovery to contraction. My guess is about as long as it takes for a Baskin Robbins double dip to melt.

We have chronicled the damage that Bernanke’s pursuit of QE and near-zero rates have done to savers. Mainly, we’ve focused on short-term implications for those investors who rely on their savings to create income for immediate consumption. But what about the folks who are looking at the pie charts and the promises of over a millions dollars in retirement income? Ah, the powers of compounding. Yes, I have in front of me the literature from 2 national financial service firms that strongly suggest that you too can retire a millionaire for as little as $60/week. Of course there are no guarantees, but the details and assumptions to this rosy scenario on steroids are buried in fine print that you’d need an electron microscope to read.

The obvious conclusion most people draw is that interest rates fluctuate and the phenomenon we’ve witnessed over the past year or so will be transient and eventually higher rates will cycle in and restore the cash flows of fixed income investors. After all, that is what has always happened before, right? Not so fast. There are a couple of reasons to believe this won’t happen anytime soon.

As the graphic below outlines, the Treasury Dept (including debt service) is the third largest line item in the actual FY 2009 budget, at over $700 billion. According to Treasury Direct, the interest paid on the national debt in FY2009 was around $383 Billion. This constitutes an average interest rate of just over 3.1%. Doing a little projecting, if the deficit runs at the estimated $1.5 trillion for FY 2010, the Treasury will need to pay out an additional $431 Billion to service the debt assuming the same 3.1% average interest rate. If early results mean anything though, the amount might be much higher. In the first four months of FY2010, the Treasury has already paid out $164 Billion in debt service, which is setting a pace for nearly $500 Billion. For FY2009, tax revenues were $2.211 Trillion and interest payments on the debt ate up 17% of tax receipts. If the current trend in FY2010 continues, debt service will gobble up around 22% of tax receipts by the time the fiscal year ends next September 30.

While 17% doesn’t sound too bad, think about paying nearly 1/5 of your net income every year to credit card companies. Not a real appetizing thought, but certainly this application of sanity couldn’t apply to the federal government.

The Problem

The problem here lies in the fact that the national debt is forecast to increase dramatically in the next 10 years. Estimates range anywhere from $18 to $23 Trillion depending on whose forecast you’d like to use. Let’s use $18 Trillion as our test case. At this level, assuming an average interest rate of 3.1%, debt service by 2019 will cost around $558 Billion per year. If tax revenues don’t change, debt service will eat up 25% of tax receipts. The conclusions that can be drawn from this simple analysis are pretty clear. If the government intends to provide the same levels of service on entitlement programs and maintain other government spending, the deficit will need to increase each year just to accommodate the additional debt service. This is called a spiral. It is akin to the family taking cash advances on a VISA to pay off Mastercard. I am sure there are many who will disagree with this rationale and call me all sorts of vile names for suggesting that we’re spending beyond our means and that somehow this really isn’t a good thing. Unfortunately, in reality, this situation is actually worse than the above paragraph indicates for a second, less publicized reason.

Artificial Interest Rates

Let’s start at the beginning here. Interest rates are payments given to lenders of capital for the privilege of using their money for a period of time. At a very minimum, the interest rate should ensure that the lender’s purchasing power doesn’t diminish due to making the loan. In other words, at the very least, interest rates must equal inflation. Such a situation is generally referred to as ‘free money’ since the lender isn’t actually being compensated for the loan in real terms.

When discussing the federal government and its inclination to spend beyond its means, interest rates are a very important topic at the US Treasury, as they should be. This is one of the reasons why government officials, Fed chairmen, and the absentee press generally try to temper inflationary expectations. If lenders expect inflation, then they’re going to want to see higher interest rates.

I have argued for several years now in this column that inflation in the US is grossly understated, and that it is done for both political expediency and out of absolute necessity, especially in an era of ballooning government debt. John Williams at shadowstats.com estimates (using previous BLS methodologies) that price inflation in the US is currently around 6% per annum. If we had free market interest rates, we would expect the yield curve to start somewhere around 7%, assuming John’s numbers are accurate, and there is no reason to believe that is not the case. It is very easy to see the implications this would have for debt service.

Let’s assume for a moment that under a free market interest rate environment, the US Government could achieve an average borrowing cost of 6.7%, allowing for a similar spread between price inflation and the mean interest rate as what we observe now. Debt service in FY2009 would have been $831 billion and devoured 38% of tax receipts. In 2019, using the same assumptions as previously mentioned, debt service would be $1.2 Trillion and eat up a whopping 55% of tax receipts. I understand there are many assumptions made here, many of which might fluctuate over the period, but the goal of the exercise is to make the simple point that the US cannot afford market interest rates.

It should now be easy to see why inflation is consistently understated, and why the FOMC and its minions are quick to temper inflationary expectations. While that might work to a limited extent when dealing with the general public, does anyone think for a minute that investors around the world don’t know what is going on here? Most of them are doing the exact same thing, albeit to a lesser extent, so you can bet they do.

In Conclusion

Many might look at the above analysis and wonder why it is any big deal. Keep the rates buried at near zero and we can keep getting ‘free money’, right? The problem is that mispriced capital leads to misallocation of the same. The gross misallocation of capital is one of the main ingredients of the ongoing financial crisis. It was willfully done by the Fed previously and it is being done again. These actions will virtually guarantee more misallocation of capital, more bubbles, and more unpleasant results. For savers, the news continues to be bad. We have demonstrated why it is in the government’s interest (a necessity really) to keep rates as low as possible. That means a continuation of the ridiculously low money market, CD and savings account rates. No doubt the pie charts referenced at the top of the essay will need some changing; it seems someone’s taken a few slices away.

This Week in the Markets

US equity markets are getting hammered early this Thursday morning on news that first time jobless claims jumped to 496,000 last week. First time claims have been trending upward over the past few weeks. Yesterday, new home sales put in the worst performance in the history of the data series. This despite the extension of the tax credit program for first-time (and now other) homebuyers. Bad weather was blamed for much of the sour performance. It seems recently the weather is getting blamed for any data point that isn’t in line with the ‘slow but steady recovery’ mantra being put out by the establishment. Oil is back at the $80 mark after being beaten down over the past couple of weeks. On the demand side, petroleum product demand appears to be bottom bouncing; any serious increase in demand will be bad news for consumers at the pump this summer. Forecasts are already in for an average pump price of $3.25-$3.50 this summer.

What does this mean? It means more reliance on foreigners for everything from food to fuel, to consumer trinkets. It means larger trade deficits (since you can’t export government – although it would really be nice to export the whole doggone thing right now!), and further pressure on the US Dollar.

The deficit for the first 10 months of fiscal year 2009, which began October 1, reached 1.3 trillion dollars, close to 880 billion dollars greater than the deficit recorded through July 2008, said the US Congressional Budget Office (CBO).

Outlays rose by almost 530 billion dollars, or 21 percent, and revenues fell by more than 350 billion dollars, or 17 percent, compared with the amounts recorded during the same period last year, the non-partisan CBO said.

Read Full Article Here

Kotlikoff Discussion

To hear our other ‘Spin Cycle’ Episodes including recent visits from Michael Panzner, Zapata George Blake, and John Williams, please visit www.contraryinvestorscafe.com and find the ‘Spin Cycle’ pane in the middle of the main page.

It is therefore worth chronicling his recent reversal on the prognosis for the US economy. Long known as a ‘bear’ and as recently as June 15th skeptical of Helicopter Ben’s ‘Green Shoots’, Roubini now sees ‘light at the end of the tunnel and for once, it is not a train’.

It is hard to understand how any economist who looked at our broken system in a proper enough fashion to predict what has happened over the past 18 months could suddenly come to a different conclusion given that virtually nothing has changed – unless you want to count the exacerbation of many of the problems which got us into this mess to begin with.

How could persistent multi-trillion dollar deficits, more intrusive government policies, the apparent guarantee of additional tax burdens, debt monetization, and higher than expected unemployment numbers (even the watered down BLS numbers are above administration and Fed estimates) cause someone of Roubini’s intellect to suddenly change his mind and see green shoots instead of yellow weeds?

Whatever the reasons were, the markets loved it. The DOW continued its winning streak, dragging the NASDAQ and S&P500 with it. Interestingly enough, the Wilshire 5000 did not exactly follow suit, actually losing ground at the end of the day while the benchmark indexes gained.

This is just another bit of anecdotal evidence that the rally from March 6th has nothing to do with green shoots for the broader markets and the economy, but rather resembles Jack’s beanstalk. And we all know what happens when you play with magic beans.

Added from Roubini’s Blog on 7/16:
“It has been widely reported today that I have stated that the recession will be over ‘this year’ and that I have ‘improved’ my economic outlook. Despite those reports – however – my views expressed today are no different than the views I have expressed previously. If anything my views were taken out of context.”

Much of the scuttlebutt at the time centered around the ratings which were assigned to these mortgage bonds and people started asking questions about how all of these Triple-A rated bonds could suddenly be worthless and why bonds with this high of a rating were paying historic spreads above and beyond US government debt of the same maturities (which are also rated Triple-A).

An Example of the spread between Triple-A rated securities

Of course the foundations for this comparison in the first place are the quality and status of US government debt, which, until recently, was sacrosanct in borrowing circles. In the past week there have been headlines galore (again) that the US is in jeopardy of losing its Triple-A credit rating. Given what we already know about the government’s finances, how can a pristine credit rating and Uncle Sam be mentioned in the same sentence? And perhaps more importantly, can ratings issued by the major agencies be worth more than a defaulted mortgage tranche after the ratings fiasco of the past few years? Consider the following:

“According to the Financial Times report, “Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch Triple-A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower.” Yet the ratings were maintained at Triple-A.”

So why the big todo about the US Government and its Triple-A rating? The point is it shouldn’t have one to begin with. While I am sure this statement doesn’t constitute a revelation to anyone, it is a point that most in the main stream media are once again missing. Some big names have lost Triple-A credit ratings over the past few months. General Electric and the venerable Berkshire Hathaway are two notable examples. AIG lost its Triple-A rating in 2005, and bond insurer Ambac lost its Triple-A rating in 2008.

In the case of normal businesses, the credit rating is a reflection of the firm’s financial position and the market forces that are likely to impact the firm over various periods of time. The firm’s balance sheet is examined. Its revenues and obligations are dissected. The credit rating is then assigned based on the preponderance of these factors and indicates to investors the likelihood of default on the firm’s debt. Investors are then able to make informed decisions. At least this is how it is supposed to work.

Moody’s / S&P Default Probability Models

However, there is one major difference between a normal business and the US Government. Unlike a normal business enterprise, the US Government has a bank on retainer that can create money from nothing and is willing to lend at ridiculously low rates. It can accomplish this task in many ways, but the most direct is called monetization, which consists of the Fed buying bond issues directly from the government. Ostensibly, this is done to prevent the government from having to fund its massive appetite for funds externally. As if there is something honorable about owing your future to a private bank as opposed to another sovereign nation. Further evidence of the Fed’s willingness to monetize additional debt emerged this week:

“Some members noted that a further increase in the total amount of purchases might well be warranted at some point to spur a more rapid pace of recovery.”

Is an entity that requires this type of arrangement for its financial survival deserving of the highest credit rating? How about an entity that is going to have to borrow 46 cents for every dollar it spends during FY 2009? How about an entity that is institutionalizing trillion dollar deficits for the next decade? How about an entity that has a bare minimum of $53 Trillion in contingent unfunded liabilities (nearly four times GDP)?

After this most recent bevy of news headlines regarding the rating situation, Treasury Secy. Tim Geithner promptly got on TV to talk about cutting the budget deficits.

“It’s very important that this Congress and this president put in place policies that will bring those deficits down to a sustainable level over the medium term,” He added that the target is reducing the gap to about 3 percent of gross domestic product, from a projected 12.9 percent this year.

Putting this in the context of our current situation, this would require the deficit to be cut from a projected $1.8 Trillion to just $418 Billion – which is where it was before the current blowout. This is an important distinction as promises by government officials to actually balance the budget are fading quickly into the ether. Now we’re only worried about carrying ‘sustainable’ debt. The problem is that none of these debts are ever paid back and as such, they accumulate all the while piling on interest.

In order to pay off our debt, not only would we have to stop running deficits, we’d actually have to run surpluses. If we ran could manage a surplus that was 3% of GDP each year, it would take us over 30 years to pay off what we already owe on the national debt. That is three decades of smaller government, bare essential expenditures, and the complete dissolution of the ‘cradle to grave’ mentality our government has espoused for the last half century.

Geithner, 47, also said that the rise in yields on Treasury securities this year “is a sign that things are improving” and that “there is a little less acute concern about the depth of the recession.”

This is nothing more than just economic pumping. What the rise in yields is really saying is that when the Fed doesn’t step in and buy US Government bonds that nobody else wants them either. Why would any sane individual lend to somebody that is up to their eyeballs in debt and isn’t even the least bit interested in changing their behavior? To make matters worse, why would any sane individual lend to an entity that proposes to repay the loan in currency that is losing its value?

30-Year Bond Yields

In the above chart, we can see the yield for the 30-year bond. The Fed began indirectly monetizing in the fall of 2008 as the proceeds of TAF, TSLF, etc. went directly to the Treasury window driving yields to nothing. Another spurt of direct Fed monetization in March led to a quick drop in yields, but since then they have been moving relentlessly higher. Foreigners have not stopped buying US Treasuries by any means, but they have certainly slowed their purchases. This leaves the Fed as the buyer of last resort. Certainly Secy. Geithner understands all this, especially considering he used to be the President of the NY Federal Reserve Bank.

Does any of the above sound financially virtuous and deserving of a pristine credit rating? In the end it matters not what Moody’s or S&P have to say about the creditworthiness of the US Government. Our creditors are already speaking. And they aren’t singing our praises.

In our ‘Spin Cycle’ podcast, we are currently doing a 7-part series in which we depict the factors affecting the US economy as sides of a Rubik’s Cube – independent, yet interrelated. On June 3rd, we welcome Professor Laurence Kotlikoff to discuss generational accounting and our mounting debt. To listen, visit www.my2centsonline.com/radioshow.php

]]> http://www.sutton-associates.net/blog/2009/05/22/triple-a-or-bust/feed/ 7 http://www.sutton-associates.net/blog/2009/05/15/hedging-your-bets/ http://www.sutton-associates.net/blog/2009/05/15/hedging-your-bets/#comments Fri, 15 May 2009 19:44:52 +0000 TwoCentsEditor http://www.my2centsonline.com/blog/?p=221 05/15/2009

While it may seem rather inappropriate to talk about hedging strategies while the markets are retracing at least a portion of 2008’s devastating plunge, common sense continues to support the position that the worst is yet to come. Granted, focus has shifted to ‘less bad’ economic data and the anointing of government spending as the elixir that will return the American economy to prosperity. Yes, that whole “We’re going to spend our way to prosperity” mantra is once again in play. Make no mistake about it; what we are witnessing right now will be viewed years from now as the biggest suckers rally in history – so far.

That said, now is the time to start talking about protecting portfolios from the next move down. The techniques below were used either singly or in tandem to drastically limit losses in our client portfolios during the 2008 liquidation. Some of these strategies have been sold to the investing public as ten feet tall and bulletproof, but don’t work out too well unless the intricacies are understood. And still others are exceedingly complicated to execute and rely on a preponderance of difficult predictive successes to be beneficial.

Flight to Cash and Equivalents

This move is an obvious one and constitutes either a partial or total exit from the market in question and the capitalization of whatever gains/losses existed to that point. Depending on the type of account you’re dealing with you will have a taxable event. Under many circumstances, it may be detrimental to sell out of the market. This can especially be the case if you are one of those folks who have invested in a dividend-producing portfolio and need the income from those investments for living expenses. Obviously, people in this position don’t want to see their portfolio go down in value, but can’t necessarily afford to sell those assets either.

In terms of the average investor, this is undoubtedly the easiest hedge to execute with the opportunity costs being commissions, possible tax consequences, and the forfeited gains if you’re wrong.

Going Short the Market

Shorting shares and/or indexes is one way investors will choose to hedge portfolios during times when they believe markets will head lower. Let’s use the DJIA as an example.
Let’s say that an extremely prescient (and lucky) trader identified the last major top in the Dow Jones on 5/19/2008 at 13,028.16. That day he shorted 100 shares of DIA at a price of $130.23 for a total of $13,023 with a $10 commission. So our trader has $13,013 in his pocket, knowing he’ll have to cover those shares at some point. Let’s assume once again that our trader gets lucky and picks the precise bottom on 3/6/2009 with the DIA at $66.23 and decides to cover. He buys 100 shares for $6,633 ($10 commission) and has $6,380 as his gain.

Obviously, this is a best-case scenario, and ironically enough, this is often how many investment ‘get-rich-quick’ schemes are presented.

The following is the flip side of shorting the market.

In this scenario, our trader, having seen his brokerage account drop by 25% since the beginning of 2008 decides to short DIA on 10/22/08. He is scared to death of a further decline. He shorts 100 shares at a price of $84.59 on the DIA, pays the same $10 commission and has $8,449.00 in his pocket. Unfortunately, he has picked a short-term bottom and the market rallies substantially immediately after he takes his position and our trader is scared into covering on 11/4/08 at $95.19. Including commissions, his short position just cost him a quick $1,080 – in just 9 trading days.

With the benefit of 20/20 hindsight we can easily point out that our trader would have been much better off waiting a few more weeks to cover. He would not have lost anything, and in fact would have helped his portfolio.

The take-home point here is that shorting is not for the faint of heart. You’d best have a solid understanding of market behavior and fundamentals before even considering short-selling shares. As we learned above, the risk to the trader is unlimited. Lets say the DJIA would have gone all the way back up to its 2007 high after our trader shorted on 10/22/2008. He’d have been out over $5,700. In shorting, the rewards are finite (a stock can only go so close to zero) whereas the risks are theoretically infinite.

For the average investor, shorting shares is difficult in that you must pledge the balance of your account as collateral in case your bet goes bad. This nullifies the ‘qualified’ status of IRAs therefore IRA custodians will not extend margin privileges to IRA accounts. Standard brokerage accounts may be used to short stocks and such an account could be used to hedge other investments. While this strategy may bear occasional fruit, it is not for everyone, particularly those with short time horizons or a low appetite for risk.

Inverse Funds – Not what they’re cracked up to be?

Before beginning this segment, a few things must be said. For those who read this column regularly, you know that I rarely use specific companies or funds in these discussions, and tend to stick to sectors, fundamentals, and macroeconomic conditions. However, in this article, specific examples are going to be used to illustrate the points made and to show investors how these funds don’t always perform the way they’d expect. This is not to imply that there is an attempt to deceive on the part of the fund sponsors, but rather a misunderstanding by the investing public of the stated objectives of these funds.

Dow Jones UltraShort Profund (DXD) – The stated objective of this fund is as follows:

The Fund seeks daily investment results, before fees and expenses that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones Industrial Average.

Let’s use a couple of hypothetical examples to illustrate how a leveraged inverse fund works. We enter our position when the DOW is at 10,000 and the price of DXD is $100/share. For the purposes of the example, we’re going to forget about the expense ratio. While the expenses must be considered, they are not necessary to make our point.

So over the course of our hypothetical 10-day trading period, the DJIA lost 8.28%. Conventional wisdom would have expected DXD to come in at a 16.57% gain. However, it only returned 14.44% (before expenses). Granted, this is not a big difference, but when you start putting it in the context of a million dollar investment you’re talking about some serious money.

Now, for the sake of argument, let’s use DOG, which is the non-leveraged inverse ETF for the Dow Jones Industrial Average, and see what happens.

The performance of the non-leveraged inverse ETF wasn’t quite as bad as it netted 7.64% (before expenses) when compared to an 8.28% loss in the Dow Jones Industrials Average.

Now let’s apply a real-world example from earlier this year and watch what develops:

On February 9th, 2009, the Dow Jones Industrial Average closed at 8270.87. The Ultrashort DOW ETF (DXD) closed at $58.07 that same day. Now, shortly before close on 5/13/2009, the Dow Jones Industrials Average is at 8274.05, while DXD is at $51.33 – a difference of $6.74 from the 2/9/09 price. Conventional logic would have surmised the DXD prices would be within a few cents given the trivial difference in DOW levels. For comparison, the non-leveraged ETF (DOG) closed at $71.82 on 2/9/2009 and sits at $68.60 shortly before the close on 5/13/2009 – a difference of $3.22. Conventional logic would have also expected the price of DOG to be very similar. What is going on here?

Here’s what. It is all in the objective of the fund. Remember how it mentioned the daily performance? These funds track the index on a day-by-day basis, but as time goes on, the tracking becomes more and more sloppy. Volatility enhances this condition as was evidenced in our 10-day hypothetical study from above.

It is due to the fickle nature of mathematics that a 10% drop followed by a 10% gain doesn’t put you back where you started. This is where the inverse funds fail to protect portfolios in the longer-term. Now, if prices always moved in straight lines, the inverse funds would do fine. Obviously prices don’t behave that way. The above analysis should not be construed as an indictment of the DOG and DXD inverse funds, but rather suggests they only be used with a clear understanding of their objectives. Furthermore it must be realized that you might not get quite the level of protection you anticipated even if you’re right and the market goes down but takes a lazy path to get there.

For the average investor, inverse funds are an easy way to ‘short’ the market without actually taking the full risk of shorting. Think of it this way: if you invest in an inverse fund and the fund goes to zero, you’ve lost only your initial investment. Your actual risk is known going in. A second plus is that inverse funds may be bought in non-marginable accounts like IRAs. The major drawback, outlined above, is that you may not get the performance you expected for your buck – particularly over extended periods of time.

Using Options to Hedge Portfolios

Another potential strategy for hedging portfolios is through the use of options. We have previously discussed covered call writing for the purposes of generating income, but this week’s topic varies considerably and requires looking at things from a totally different perspective. This discussion focuses on using options for protection ONLY – not for day trading or other speculative activities.

While this is not intended to be a primer on options trading and involves prerequisite knowledge, there are some important concepts that must be highlighted when using options for hedging purposes. For most average investors, hedging with options involves the purchase of put options, which can be done from many types of accounts. However, individual brokers have their own restrictions on what can and cannot be done in particular types of accounts.

Time – Options are good for a specified period of time and after such time has passed expire worthless. Even in the month (or sometimes more) before their witching (expiration), options begin to degrade in value and investors find that they’re not doing their job in terms of protecting the portfolio. Options have ‘sweet spots’ and if you’re going to use them to protect a portfolio you’d better be able to align the option’s sweet spot with the period when the market’s decline will be most dramatic. Otherwise you’re not getting the full benefit of the option and your portfolio isn’t being protected. This is no easy task by any stretch of the imagination.

Strike Price – In the case of the Dow Jones Industrials Average, put options could be purchased on DIA. If you feel the decline will last 6 months and start today, you’d look at options that expire 11/2009 or beyond. In the case of DIA, 12/2009 put options are available. Now you must decide how far you think the market will fall. Buying an option with a strike price that is too low may result in it staying out of the money in which case you might not get the full performance; especially if the decline is not as steep as you anticipated. Buy an option at a strike price that is too close to the current price of DIA and you’re going to pay a hefty premium for the option. If your prediction ends up being right that won’t be an issue, but if you are wrong, you just wasted a lot of your money.

Know Your Portfolio - A common mistake of investors who use options for hedging is that they buy the wrong option. It is imperative to understand the components of the portfolio that you’re trying to protect. For example, hedging a portfolio of junior gold mining stocks with Dow Jones Industrials Average puts is probably not a great idea. While the junior gold stocks may trace the DJIA to a certain extent there are plenty of times when such is not the case. Using a simple statistical correlation study between your portfolio’s value and the value of different market indexes can help you identify which markets your portfolio tends to track and you can then hedge more effectively.

The major benefit of buying options is that you’re taking a known level of risk. Your outlay for the option and related commissions is the extent of your risk. If you are wrong and the market moves up your option will expire worthless and you lose your initial investment only. It must be noted that this defined risk does not apply when one is writing uncovered (naked) options. These types of activities are extraordinarily risky and are highly inadvisable merely for hedging purposes.

In conclusion, there are many other factors that play into hedging and would require a dissertation to elucidate all of them to proper justice. Each investor must consider their own objectives and risk tolerance and should also consult a qualified advisor before implementing any investment strategy.

The important thing to take away from this discussion is that if done properly, hedging can provide relative comfort during periods of market mayhem such as we just witnessed last year. However, if undertaken without a solid understanding of both the benefits and detriments of the hedging methodology you choose to employ, not only will you not enjoy comfort, you’re quite likely to be a regular in the antacid aisle at your local pharmacy as well.

Improper hedging techniques and use of hedging vehicles are some common mistakes investors make. Consider taking a look at our free report about 7 additional mistakes investors make – and how to avoid them. To get your copy click the following link: www.sutton-associates.net/7mistakes_report.php

Back in 2006, Marketwatch Columnist Mark Hulbert made the comment that those who had invested at the 2000 market top had finally gotten their money back.A long six years to get back nominal dollars that had decayed significantly by the time they were ‘gotten back’.

We wrote the pilot issue of the Centsible Investor in early November 2007; right after the market peak. Was this an accident? Hardly. Our keynote article in that issue dealt with our purchasing power coming under attack and we vowed to put together a portfolio model that would fight inflation by providing a high rate of current income with a secondary goal of capital preservation.

Today, I am proud to announce that while the Dow, NASDAQ and S&P are all down (38%, 39%, and 40% respectively), that the total return on our Portfolio Model is now positive at .51% as of close of business 5/8/09. Where traditional investors had to wait several years from the bottom to get their dollars back, our Portfolio Model has accomplished the same feat in just over 2 months – and has paid great dividends while we waited!

For those who have been subscribers over this 18 month roller coaster called the markets, I am hopeful that our publication has demonstrated its worth and you will consider renewing. For those who have not subscribed to this point, I am hopeful you will consider doing so. The attack on our purchasing power is only beginning and will feed on the inflation created to support unsustainable government spending and the various bailouts. Vigilence is required now – more than ever.

As an added incentive, we are currently offering $30 off our one year subscription. Get 12 issues plus interim updates for just $99. This special will last through Memorial Day.

The Centsible Investor’s Subscription Page may be found below. If you have any questions or need assistance, please reply to this email.

http://www.sutton-associates.net/newsletter.php

Best Regards,
Sutton & Associates, LLC

DISCLAIMER: The statements made in this communication are for informational and educational purposes only and do not constitute an offer to either buy or sell any security, nor should any statements herein be construed as investment advice. Neither Sutton & Associates, LLC nor any contributor to the materials contained in the above-referenced report shall be liable for any losses as a result of these or any other investments.

Recently, there has been more than idle talk about converting most of these loans to equity stakes, which do NOT need to be paid back. Furthermore, future disbursements would like be made by buying equity stakes in the firms rather than making loans. Sound the same? Not quite. Here are some reasons why:

1) In the event of bankruptcy, creditors are paid off before shareholders from any proceeds of liquidation. Given the vaporization of BSC and LEH, this is definitely worth mentioning. Historically, shareholders are left holding the bag in a true bankruptcy and subsequent liquidation.

2) Even if the firms remain solvent, there is significantly more risk in holding equity than debt. The taxpayer’s investment would be subject to all the risks generally associated with holding stocks. Taking a look at the performance of banking stocks during 2008 gives a pretty good idea of what I am talking about here.

3) Current shareholders are negatively impacted by dilution if more shares are created out of thin air for the government to purchase. And even if the shares are bought in the open market, the mere size of the stake could have a rather deleterious affect on existing shareholders should that stake need to be sold en masse.

4) By taking an equity interest, the government is consummating an incestuous relationship with the banking industry. Nationalization is the term typical used in this type of situation, but the term has become taboo in the mainstream media in recent weeks.

5) Also, bear in mind that the banks don’t really need this money at all. They have been printing their own currency for years now via unregulated, non-transparent OTC derivatives. Now that some of their bets have gone bad, the taxpayers have been forced to ‘legitimize’ this activity by the infusion of trillions of less-funny-money (dollars).

Sea changes can be either dramatic or subtle. The recent direction in terms of supporting the financial system sounds subtle enough, but with dramatic results.