Description of the Day

I took extraordinary action in my fund today. I never thought I would ever do what I did. My usual problem is inaction, not action. I honestly feel very at peace with the decision and think it was the right one regardless of what happens. We will most likely see a massive rally followed by a crash. How massive a rally depends on how much smart money sells into it. Maybe I am wrong. I honestly hope I am. Below describes my thoughts on the day with a slightly altered investment letter I sent out to Partners.

Dear Partners,

I can't believe I am sending out another mass email but things have changed dramatically since yesterday with issues that you should be made aware of.

Because of government action today in London that I believe will likely be replicated in the U.S. and maybe even expanded, I have decided on a mass liquidation of the funds portfolio. This decision was not made lightly. I discussed this decision with one of the partnerships larger investors, another fund manager, and a couple of friends in the financial world. There is a massive information gap that creates extreme bifurcated outcomes. Instead of being able to invest, it becomes gambling. I can't play if I don't know the rules of the game or if those rules are constantly changed. I don't gamble unless I have an extreme advantage. There were three government actions in the last twenty four hours that forced me to fold and wait for another hand.

1) Yesterday morning SEC Chairmen Christopher Cox announced sweeping rules on naked short selling (I won't go into the technicalities of what this means). First of all, I am not aware of anyone who participates in naked short selling besides market makers who have been exempted of this rule (they aren't any longer). There has been investigation after investigation looking for naked short selling and nothing has been turned up. Second of all, I am completely in favor of these rules. Naked short selling has been banned for over 70 year, I don't think it is happening, if it is, end it. However, last night Chairmen Cox came out with proposition for additional rules that will cause hedge funds over a 100 million in assets to report short positions on a weekly basis. This effectively kills or greatly curtails short selling for large funds for multiple reasons. It also greatly hurts mutual funds who also now short.

2) The much bigger issue and what ultimately triggered my decision was that during the middle of the day, London announced they were banning all new short selling on all financials until mid January. I never thought I would have seen this in a free market economy. This causes massive problems!!! If your a market maker and sell a naked put to an investor buying protection for a stock that he is long, you can no longer short the stock to protect yourself. As a result, insurance from a long perspective becomes much higher if it exists at all. If your a fund looking to hedge your book you cannot short another bank.

3) Paulson came out with an RTC proposal today throwing back to the S&L loan crises. I thought this was coming but thought it would be over the weekend. I applaud this action though I don't think it will work. The RTC in the 80s never bought assets. They took them over from failed S&L institutions and then slowly sold them over a period of 5 years. What is being proposed is that this entity will buy junk assets from the banks. Sounds good in theory but my guess is that no one is going to be willing to sell them. Because of accounting games, Bridgewater has estimated that there is over 500 billion in markdowns the U.S. banking system has not taken being hidden on their balance sheet. Banks are not going to want to sell these assets because then they would have to take losses not disclosed. I hope this works but my guess is it won't. Even Bill Seidman, who ran the RTC back in the 80s, doubts that this will work. I remain a skeptic but a supporter because we need something.

Reasons for Liquidation

I believed we have passed the point of no return. I believe we are heading into a recession not seen since the 1970s and quite possibly a depression. The government can scream about short sellers and the SEC can practice market manipulation the day before options expiration but it doesn't change the fundamental problems. In fact it displays they are still clueless from recognizing the actual problems and I think verifies my thesis that we are no where near a market bottom. As a result, there is very little if anything I want to be long without a short book. The problem is, the battle against the shorts is making it almost impossible to short. What started today could be a massive unwind of huge short exposure in the market. I am talking massive. 20 to 30% in a couple of weeks or months on the entire market. I was short a bank today that I believe should be much lower no matter what the government does. The stock went from $33 a share to over $47 on the London shorting news in less than two hours. That is over a 43% move on a stock that is actually near a three month high going into today. It was not a stock being driven down by evil shorts. I was short a stock that in August alone on a short squeeze went up 173%. These are the type of moves you are looking at if we see a gigantic short squeeze like you have never seen before. I am willing to live with this (I have been short 4 different stocks this year that at some point while I was short went up 70% or more while I was short, I was right and made money on all 4) but not if I don't know what the rules are, where I can hedge or add to my short position, or if I will be forced out completely by the government.

So why don't I go long if I think this short rally is coming? Because I am not a speculator and not a gambler. I think the market is massively overvalued on a fundamental basis. Once the ask quits being hit by the short coverers, I think it is possible you will see a massive crash. There will be no more buyers because fundamentally you are buying a train wreck. Maybe we crash tomorrow as investors realize the fraud that is taking place, maybe it is in a month, or maybe three months. I don't know but I am not going to speculate long playing a bounce that is government manipulated.

Outcome

So today I covered every short I had except one. A small retailer that even in good times I think files chp 11 in the next twelve months. I liquidated several long positions. Half of my remaining long book will probably be taken tomorrow by calls I previously sold. The majority of the other half I will trickle out of over the next couple of days. I also kept my remaining Russell 2000 puts. The bounce was so violent with the entire Russell 2000 index ending up close to 6% that I couldn't get out of them at a price that I thought was acceptable. These puts make up about 2% of the portfolio. If they expire worthless it will costs us 2% but they don't expire until January and by then they have a decent chance of being worth a fair amount.

Conclusion

The battle against the short sellers is misguided and one based out of complete ignorance or denial of truth. The short sellers have been the ones telling you this was coming for years. People should not be able to stand in a crowded theater and yell fire. However, people should be able to stand across the street pointing to an old theater telling everyone around that the building is a fire hazard. David Einhorn did this with Lehman, Bill Ackmen did this with MBIA, etc. etc. and instead of people listening to the whistleblowers, they ridiculed them, they defamed them, they subpoenaed them and people marched right on into the theater anyway. When the theater did catch on fire and there were casualties, those who survived tried to kill those who warned them in the first place. China has had these types of shorting rules in place for years, the stock market is still down over 60% this year. This stuff doesn't change anything but it has the potential to ruin those who are right. I honestly believe this has the potential to exacerbate a potential crash. Depending how misguided the government gets, this may ruin my profession as a hedge fund manager. It also could move stocks on a valuation basis permanently lower as a greater risk premium will be demanded if you are unable to short and buy protection.

I do not know how long I will be out of the market. It may be days or longer than a month. I have to know the rules to play the game. I would love to say we are near a bottom and this is a buying opportunity of a lifetime but I don't think it is. Assuming we are in normal times consider these numbers that an investor friend emailed me yesterday. The S&P 2007 sales were 1025. If you take normalized operating margins going back the 1940s of 8%, subtract out taxes at a rate of 30%, put a 15.6 multiple on it which is the long term average multiple going back to the 1940s you have a fair value of the S&P 500 of 855. Assume a 5% increase in sales for 2008 and the number becomes 904. Grant it those assumptions adjust slightly and you get much different value but there is no margin of safety with an S&P above 1200 especially considering the fact that we are not in normal times.

I am an avid Texas Hold Em player and the best hands I have ever played were hands where I had a large amount of money in the pot and was able to fold my hands to play another hand.

I leave it with this. I heard a trader say today that everything that has happened today is long for a trade but bad for the future of America, my future, and my children's future. I agree. The only way this works out is if we do get a 30% rally and banks use that window of opportunity to recapitalize their balance sheets selling massive amounts of stock. They won't because there is nothing wrong with them, it is all the fault of the short sellers. We may be down 20% in the next two days and I would have benefited greatly by staying in my positions. Who knows. I do know I will get two more cards next hand to play with again. As Kenny Rogers sings "know when to hold them, know when to fold them." With the government changing the rules in mid day and manipulating the market a day before options expiration day, it is time to fold them.