The Negative Wealth Effect…

There is a term economist use for when individuals feel good about the direction of the economy and the relative value of assets such as housing and 401Ks are generally in an uptrend. That term is the “wealth effect”. The wealth effect is most always based on unrealized gains such as in the case of many homeowners who benefitted from the skyrocketing value of real property between 2002 and 2006 or the inflated value of 401K’s during the internet bubble days of the late 90’s. The problem with this” wealth effect” is really at the core of the problems we face today in our economy. As americans felt the “wealth effect” of inflated investment/retirement accounts and housing values, spending on credit skyrocketed (equity line anyone?)  That, compounded with the easy money policy of banks fueled an unprecedented spurt in consumer debt.

At the present moment, the very opposite is the case. Americans are feeling the effects of  the “negative wealth effect”. Even though most Americans remain employed and have no reason to either access cash from their retirement accounts or access the equity in their homes, most feel “less wealthy” today than say 12 months ago. The dangerous aspect of this is obvious. If you feel insecure in your personal finances, you will spend less and invest less. If you are a company, you may not hire as many employees or expand your business. Not a very good omen heading into holiday season…The bright side of this is that for those fortunate enough to have means, this has created unbelievable opportunities. Warren Buffet, for example, will make billions of dollars from this downturn due to his timely investments in various companies including Goldman Sacks. For the rest of us mere mortals, by the time the economy turns around, the market opportunities will be long gone…

Housing Markets Continue To Show Weakness

The housing markets continue to slide according to  the S&P/Case-Shiller Home Price Index, which measures home prices in 20 U.S. cities. The data for August shows a decline in prices of an additional 16.6% following a 16.3% decline in July. This is the 19th consecutive month of declines in home prices and while some cities registered a moderate uptick such as Boston and Cleveland, cities such as Las Vegas and Phoenix showed drops of 30% and 31% respectively. Although the data is troublesome it was within the expectations of most wall street analysts.

The good news here is that there continues to be a drop in new home inventories which should continue to  offset some of the increasing number of foreclosures. Bottom line here is that the economy needs to improve for main street before this trend is reversed. Unfortunately, I believe Wall Street will see improvements before main street does and that means at least another 9 to 12 months before we see stabilization in the housing markets.

Is The Bottom In?

Most analyst and pundits out there are always afraid to call a market bottom or top for that matter. No one wants to go on the record and say that ” a bottom is in” and then have egg all over their face when the market plummets. In this age of lawsuits and more lawsuits I can’t really blame them. Well, I am going out on a limb here and say that I believe the lows set in the Dow and S&P 500 are going to hold and that we have set an intermediate term bottom. What does it mean? Well it means that for the next several months, the markets should test but not penetrate the lows set in October which for the Dow Jones Industrials is roughly 7800 and for the S&P 500 around 840. The reasons for my assertions are the following:

1 The market seems to be making higher highs and higher lows from the bottom set October 10th. Usually a sign of strong support.

2 Although we are headed for recession, (if not in one already) the market as a discounting mechanism has already seemed to price in a moderate recession.

3 The government’s massive bailout plan has effectively placed a safety net on the banking system and fear regarding the failure of global banks is subsiding. As the (TED) spread tightens, lending should resume, albeit slowly, and that has already begun to show up in the credit markets.

Now I am not sounding the all clear, but simply stating that we may hold ground at the above mentioned levels in the intermediate term. Longer term it will depend on the depth of the global recession and policy from the new administration.

I see the markets range bound between 7800 and 9500 in the Dow Jones Industrials and between 840 and 1050 or so on the S&P 500 well into 2009 as the affects of the global recession are reflected in market prices.

How Low Can It Go?

Well if you listen to the credit markets, we can extrapolate a level of about 7500 on the Dow Jones industrials…Whatever happened to fundamentals? Whatever happened to Apple and Google and the fertilizer companies such as the formerly high flying Potash? How could all the analysts have been so completely wrong? Well in many cases they really weren’t. This weeks drop is completely absent of fundamentals. If it were due to fundamentals, you would not see the Dow Jones industrials drop 20% in one week.  The market isn’t trading on technicals either as support levels have gotten taken out as fast as a cold glass of water in the hot desert…

I was at the post office early this morning and the fellow working the counter, someone who has been an employee of the U.S. postal service for 30 years, was visibly upset and red eyed. I asked if he was OK and he looked at me and muttered that his life savings had been decimated by the recent turmoil in the markets. He said that not only was he losing his house to foreclosure but the money socked away in his retirement account was down to 25% of its value one year ago.

The time to place the blame for this crisis will come in the future. Right now we need to look at  the situation at hand and make tough decisions. Why is the market falling so dramatically fast? Well one of the main reasons are margin calls- Institutions, pension funds, hedge funds and retail investors are selling because they have to and not necessarily because they want to. Another reason is panic selling which is forcing funds to liquidate in order to raise cash for client redemptions. As a result, traders are not willing to take long positions in equities not only in our markets but worldwide. What is going to get us out of this funk? Well the market needs to see some bargain hunting at the institutional level. Large institutions, governments- somebody is going to have to step up and buy this market.  Being that this is a crisis of confidence, when the market reveals that the big players are moving in to take advantage of these depressed values the markets should react in a positive knee jerk fashion. A 1000 point short term rally in the Dow Jones is not out of the question in the next few trading sessions. 

Longer term it is a much more complex situation. It remains to be seen what will be the true outcome of the massive rescue package passed by congress. It remains to be seen what new regulations are implemented in global markets so that this situation does not happen again. It remains to be seen if the above mentioned gentleman, the post office clerk,  and many individuals just like him, all over the world, ever have the courage to invest their hard earned money in the stock market. That may ultimately be the most important issue to resolve and may mean a very slow long term recovery for the markets….

Keeping it real…

In today’s market , its important we keep things in proper perspective. As an options trader who operates an options trading newsletter, I like to put forth the following example to illustrate the folly of what your financial adviser may be trying to sell you. As we stand right now, the S&P 500 has returned a big zero for the past 10 years. Zippo, nada…except alot of headaches, stomach aches and general anxiety. The mainstream financial community has always told us that if we are patient, investing in equities for the long haul will provide us with better returns than if we keep our savings in CDs or U.S. Treasuries. Well here is the truth.

Let’s say you were fortunate enough to have $100,000 to invest in October of 1998. Following your broker’s advice, more than likely you were sold a bunch of mutual funds investing in equities and if you were lucky, diversified across many market caps and industries. Lets say, for the sake of this example, you were again fortunate and your fund  grew in value and returned you a whopping 30% over the 10 year period ( Again, that is 30% more than if you had invested in the S&P 500) Your $100,000 investment is now valued at $130,000 (minus any management/sales fees which on average probably cost you between 1.5 and 2% a year…and maybe much more). Keep in mind that the markets have been extremely volatile over the last 10 years and if you have had any experience with financial markets lately, you now that it has been feast or famine… The period of 1998 to 2008 encompasses the internet bubble crash of 2000, 9/11, the Iraq war, and lately the housing/credit crisis. Obviously if 100% of your investment account was allocated to equities or equity funds, your full account was at risk. There are no guarantees in the equity markets as we are all painfully aware. Your account value could have, at any point, been much higher or much lower than your original $100,000 investment. Now unless you have a stomach made of steel, you probably sold some, if not all, of your positiosn at some point at a loss or bought into the market at its highs and are deeply under water today. If that is your case (and it probably is) don’t feel so bad because most of us are in the same boat today.

Now, lets say that if you took the same $100,000 and invested $90,000 of it in bank FDIC insured CDs or U.S. Treasuries at an average of 5% per year return and you took the remaining $10,000 and traded an income options strategy such as the Iron Condor ( yes I laughed as well when I first heard the name of this strategy) that yielded 5% per month (yes 5% per month…on average most competent traders of these strategies make between 5% and 15% per month on their risk capital), after the same ten year period your initial $100,000 would be worth $252,615.14 or a cumulative return of 152.5%!. This calculation takes into consideration that you reinvested the monthly income from the options strategies and the interest payment from the CDs or Treasury at the same 5% yearly return compounded semi-annualy. Obviously the return itself is much superior than the 30% on the funds but the real kicker is that if you followed the options strategy, at no point did you have more than 10% of your capital at risk!. That is huge folks…Remember, managing risk is what smart investing is all about. Its not how much you make today but how little you loose tomorrow

Again for the sake of this example, lets say that during the 10 year period, once during each major crisis, you lost 100% of your initial options account value. That’s right, a $10,000 loss at the internet crash of 2000, $10,000 during 911 and $10,000 now during the housing/credit crisis. At each event, you recapitilized  your options trading account by withdrawing $10,000  from your treasury bill or CD. Even with those severe losses, the value of your $100,000 investment after 10 years would be $202,776.24 a cumulative return of 102.7%. I did not take taxation into consideration in the above example and it is important to note that it is possible to trade these strategies in a tax deferred IRA account. Smart options trading is not only proper for many investors, but it is the intelligent way to invest.

 If that made sense to you, take a look at our home page http://www.TradingOptionsForIncome.com. We are a newsletter trading service that will help you trade these strategies successfully! Also, we offer lots of information on how these conservative trading strategies work as well as links to great sites that will help educate you in options trading.

Here Comes The Thaw…..

Now that the Congress of the United States has done its job, the Treasury and the Federal Reserve face the most difficult aspect of this bailout. How to value these illiquid assets that no one wants and how quickly can an effective plan be established. Most experts seem to suggest that it will be at least 6 weeks until the Treasury can purchase its first distressed asset and more than likely not before the elections. How will the credit markets fare until then? probably not very well as banks have adopted a wait and see attitude and will probably continue to restrict credit to all but the most creditworthy institutions and individuals. But the good news is…The thaw is coming.

As distressed assets come off the books of these institutions, the markets should have a better idea of the true value of the remaining assets and therefore, a better grasp on the market value of the financials, the major holders of this toxic debt. The current state of uncertainty should subside. Since this has been primarily a crisis of confidence, this action should ensure that banks begin to regain confidence in one another and real lending to individuals and institutions should slowly resume.  Also, as the  financial landscape is transformed, the traditional banking model of taking in deposits and lending them to creditworthy businesses and individuals will rule the day. How do traditional banks make money? By making smart loans. Just take a look at institutions such as Hudson City Bank. Smart underwriting of their loan portfolio and the discipline to stay away from these toxic instruments have made them, as well as several others, the true winners of this crisis.

The real issue behind this mess is the fact that these securities are illiquid and current mark to market accounting rules require that they be marked based on today’s market values. Not necessarily a bad thing if banks had shown restraint and limited their exposure to these assets, but as we all know, that was not the case.  It is not clear to most, but the overwhelming majority of these assets are notin default. Even though many cities across the U.S. are suffering deeply from this housing crisis, the vast majority of sub-prime mortgages in the U.S. are not in default. Although I am generally opposed to these huge bailouts as a matter of principle, I believe this will actually go down as one of the best investments in U.S. history. Not only will we (the taxpayer) make money on this investment  ( based on current interest payments and eventual maturity of these assets) but also on the overall positive impact that this action will have on the general global economy. Again, as is most often the case with government, it remains to be seen how effectively this plan can be managed and how well costs are contained. Hopefully, history will mark this bailout as a good example of American leadership in times of crisis and not another step towards our demise.