Hedging for Disaster

... I think it’s time to revisit the concept of hedging for disaster, something I advocated during another "recovery," in October of last year, where we made our cover plays to carry us through a worrisome holiday season and into Q1 earnings - "just in case." The idea is of disaster hedges high return ETFs that will give you 3-5x returns in a major downturn. That way, 10% allocated of your portfolio to protection can turn into 30-50% on a dip, giving you some much-needed cash right when there is a buying opportunity.
... As far as hedging goes, if you are 50% invested and 50% in cash and you are worried about losing 20% on the stock side in a major sell-off, then the logic of these hedges is to take 40% of your cash (20% of your total) and put it on something that may double while the other positions lose. If things go down, your gains on the hedge offset some of the losses on your longer positions. If things go up, you can stop out with a 25% loss, which will "only" be a 5% hit on your total portfolio but it means we are breaking through resistance and your upside bets are safe and doing well. That is not a bad trade-off for insurance in this crazy market. Also, be aware that these are thinly traded contracts with wide bid/ask spreads and you need to use caution establishing and exiting positions.

... “Investor sentiment is worsening because of the reignited uncertainty about credit,” said Naoteru Teraoka, who helps oversee $16 billion in Tokyo at Chuo Mitsui Asset Management Co. “There’s uncertainty about the future and companies are cautious.” The Nikkei pulled back another 135 points (1.34%) and finished right at the 10,000 line while the Hang Seng dropped 318 points (1.44%), after failing to hold the critical 22,000 mark, and wound up at 21,741 and the Shanghai Composite also dropped 1.4%, failing to hold support at 390 and looking more like a double top here than an index that’s consolidating below 400.

Europe is holding on to small gains ahead of our open (8:30) as German Exports continue to do well and the UK declares they will keep their stimulus plans (and presumably, easy money policies) in place through 2010. No news coming out of Europe is going to impress us at the moment as the FTSE failed our 5,250 watch line and the DAX failed at 5,750 as well, so those are bearish signals for the global economy. Certainly this is a reflection of default concerns from both Greece and Dubai, who have both had their ratings cut to near junk status this week. Russia’s finance minister added to the chorus of concerns Tuesday. He said Russia is "still a weak link" in the global economy and would be vulnerable in case of a reversal of the tide of money now flowing in, partly because of higher oil prices.

Greece’s case could present the European Central Bank and the European Union with a dilemma: whether to bail out the country or possibly see a euro-zone member face a debt crisis. The first course could reduce the pressure for fiscal discipline, while the second could damage the credibility of Europe’s great single-currency experiment. The real danger here is triggering a rapid rise in interest rates before international banks have a chance to stabilize their balance sheets.

Mario Draghi, the governor of the Bank of Italy, highlighted the danger posed by a "huge wall" of corporate and public debt. He cited estimates of around $4 trillion in non investment-grade and commercial-real-estate-based debt coming due over the next five years, "trillions" of dollars of bank debt and public debt on top of all that. "We are actually seeing sovereign risks that materialize," Mr. Draghi noted, referring to Fitch’s downgrade of Greece’s sovereign debt Tuesday. "All of this will certainly increase the risk premium in an otherwise safe asset, and may bring in sometime higher interest rates," he added.

We’re already well short on Commercial Real Estate but that sector never ceases to amaze us by staying up despite all news to the contrary. At the moment, we are resigned to being patient until Jan earnings announcements give us a better look under the hood of these players and, until then - we have our disaster protection - just in case things go south faster than we thought they would.

Keep in mind that this morning we are playing for our bounces but by no means bullish overall. Goldman’s market goose of the day is to announce that there will be no Fed hike until 2012 so all aboard the free money express. Of course, someone should tell GS that the money train left the station a long time ago and, unless the Fed is going to start paying us to borrow money, rates aren’t going any lower. Today is not a big data day, with Wholesale Inventories at 10 and Oil Inventories at 10:30, where we may finally get a draw after 2 weeks of builds. Since a 2Mb build is being forecast by crooks in the pockets of Big Oil analysts, it will be very easy to beat and move oil higher.

High oil was a big factor in killing consumer confidence in last night’s poll, with half of those polled saying they feel LESS financially secure than they did last year and just 1 in 3 people saying they think the economy will improve in the next 6 months. Mortgage Applications came in mixed but the numbers can easily be spun positively and that’s all that will count this morning on that report.

We’ll try to be agnostic and watch our levels, but let’s all be careful out there, I’ll feel much better with a little more disaster protection despite the fact that we are mostly cash and bearish since taking it off at the top over the past couple of weeks. As I said above, we were so bearish we had to sell DIA puts to lock in gains, but we’ll be happy to buy them back if our lower levels start failing and we’re on the way to that 1.25% sell-off for the day.

(by Philip R. Davis at SeekingAlpha, December 9, 2009)