Sunday, October 12, 2008

Opportunity.....For A Trade

With the setting of the sun on Sunday evening, a new trading week begins. Governments all over the world have been busy working at nationalizing the world's banking system. This had to happen if there was going to be a banking system come Monday. There are some cheap cheap stocks out there. The problem is they are cheap based off LTM and 2007 numbers. Anybody who tells you they have an idea what earnings for companies are going to be over the next three years are either delusional or making a joke. If you want to participate though, there is plenty out there to trade in.

I think the highest probabilistic outcome is for a multi week, multi month rally of 15% or more. The government seems to be doing what they have to do. Of course the U.S. is still the ones sucking their thumb behind England and the rest of Europe though Paulson is feverishly preparing for equity injections into the banking system (about time).

I don't think this is an absolute bottom and the usual people out there who have gotten slaughtered who have been saying every bottom is the bottom have worked themselves into a fervor preaching bottom. That in itself is discouraging. We need capitulation by most everyone that the market is going to be bad with minimal returns for years to come. You saw it several months ago in housing. Have not seen that in the equity markets.

Wise people know never to predict the end of the world because it only happens once. As a result, you will look like an idiot if you predict the end of the world. I am by no means predicting the end of the world but the unthinkable has a much higher probability than a year ago. If a creature, walks like a duck, looks like a duck, quacks like a duck, it is probably a duck. At this point we have had the worst housing collapse, banking crises, and now stock market crash since the Great Depression. You extrapolate. To be sure there are many things that could happen to catch us and we avoid a depression but how many times out of 10 with these dire of circumstances do we go into a depression? That number is the percentage you would put on a depression. For those of you who say zero then my question would be is what would it look like? What hasn't happened that has to happen to make it at least 1 out of 10?

What I am trying to do is force you to think about something that you have no mental model for. No one alive has a mental model of a depression and so we don't think about, don't talk about, and write it off as wacky and looney. Well we had several in the 1800s. One in 1900s and guess what, if not this time we will have one again at some point in the future. My number is 7 so at this point 70% chance of a depression in my mind. Maybe I am high, I hope I am high, but it is not zero and if you think it is drastically lower, contact me, we maybe be able to work out some kind of bet.

So the next question is what should you do if there is a depression. How does your life look and what can you do to prepare? That answer is personal for everyone. Friday I took several thousand in cash out of the bank. Saturday I started looking for gold (which is actually not a good depression investment) but that is almost impossible to buy now. Nothing overly dramatic but enough for now. A depression won't happen overnight. It will take a year or more to grind into.

So anyway, I don't think this is an absolute bottom but there are trades everywhere. I hate doing trades because I want to own for years not months but at times the probabilities can become high enough that I can play rent a stock to make a bet. Unfortunately, Monday is going to be a sloppy day for trading indicators. Banks are closed on Monday so credit widening and tightening could be misleading. Volume will not be as high as it would be. Indications London may not open on Monday or delay the opening. I wouldn't be shocked to see the U.S. canceling trade tomorrow if London never opens. Morgan Stanley and the rumors of the deal with Mitsubishi UFJ will be at center stage. Then you have options expiration on Friday and massive amounts of economic data coming out. The market promises to be very violent.

I think you have to use options to construct any type of safety. Let's take Wal Mart for example. With the volatility so high there are all kinds of thing you can do depending on what kind of risk you want to to take. Looking at all January options you can sell the 50 puts for $4.45. Use the proceeds to buy the 45 puts for 2.70 and buy the 60 calls for 1.65. Trade doesn't cost you anything (it even covers commissions) and the most you can lose is $5 which is about a 10% loss on the underlying security. Yet you have large upside. With potential for violent moves upwards in stocks that got puked out, this could be very profitable and a low risk trade if the markets decide what the government did does not matter and stocks start plummeting again. I am not pitching Wal Mart. Just randomly picked a name.

I went to bed Friday thinking through the probabilities of a complete collapse of our financial system and trying to figure out what to do. Looking at the government action I don't think that is a concern in the short term (though that could change). What has happened hopefully catches us for a little while though I do not think we are at an absolute bottom. Credit markets will be key.

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