UPDATE: The New, New Deal

December 08, 2008

ACTIONS TO TAKE:

GDX Dec 18-22 (GBJLR/GBJLV) bull-call spread -- Close for $3.30 or better

ADM Jan 20-25 (ADMAD/ADMAE) bull-call spread -- Close for $3.50 or better

 

Dear Fellow Options Trader,

The purpose of our trading landscape letters is to make our best effort to sort out what the key drivers of market movement will be over the near term. With our view of the trading world established, we seek to enter into options trades that make you money.

2008 has been a year of conflict between deteriorating economic conditions and government efforts to arrest the deterioration. Understanding the next possible government action (and its consequences) is a major factor in making money in this market.

Last week, in our Dec. 1 landscape titled "All In," we put forth a model to explain how the government is combating further economic decline with programs that are collectively bigger than The New Deal.

The "New, New Deal" is summarized as follows:

Objective -- To turn on private sector capital flows, thus unfreezing the credit market.

Strategy -- Create a stable financial system (which we'll abbreviate as SFS) by buying below-fair-value financial assets with one hand and using the other hand to provide liquidity to distressed institutions to prevent further "credit events."

Back in September, we reviewed the anatomy of the credit market, using Pilgrim's Pride (PPC) as a case study about how deteriorating home prices could impact the commercial paper market and cause the demise of a company seemingly unrelated to the financial crisis.

Here were our back-of-the-envelope calculations for how the growing fear levels in the credit markets could impact the company:

* No short-term lending = no chicken feed.

* No chicken feed = no chickens.

* No chickens = no chicken jobs and higher prices for remaining chickens at the store.

* No jobs and higher food prices = harder to pay the mortgage on the overpriced house that is underwater.

Since we last examined PPC, sales of fried chicken, chicken nuggets, rotisserie chicken, skinless breast, whole chicken with/without bone, chicken noodle soup, chicken and broccoli, chicken chow mein, etc. have been steady, yet PPC was recently granted bankruptcy protection. PPC is an example of how an otherwise-solid company went under because of a frozen credit market and an inability to obtain critical financing.

Credit events are the triggers for credit-default swap contracts that, if activated, could potentially cause trillions of dollars in obligations to come due and could overwhelm any possibility of unfreezing the credit markets in the foreseeable future (e.g., AIG).

If the government bailout strategy is successful, the theory is that a stabilized private-sector financial system will begin to actively lend, thus bringing life back to our credit-driven economy and infusing value into the assets purchased by taxpayers during the bailout.

The government's strategy is an "all-in" type of approach. Once it starts, it cannot stop until the job is done. An early "fold" before the game is done could cause severe and permanent loss of taxpayer bailout money.

PUTTING THE MODEL TO WORK

Cars & Light Trucks

If a stable financial system is the key to unfreezing the credit markets, the federal government is likely to bail out the auto industry. Certainly a successful rescue would be a positive for keeping people in jobs and maintaining much of our industrial manufacturing capability, but these reasons alone would not justify bailout money.

What is the point of putting good money after bad if our auto companies have bloated cost structures and will eventually fail because on anemic vehicle sales? Why not have them go through a re-organization bankruptcy proceeding, a la Circuit City (CCTYQ) and United Airlines (UAUA)? Bankruptcy laws could facilitate the implementation of competitive cost structures and allow these companies to compete on equal footing in the world market.

The proposed auto bailout request has already veered from $25 billion to $34 billion (in about one week). Some estimates for the final bill are as high as $125 billion. U.S. auto industry vehicle sales dropped 36.7% year-over-year in November to the lowest level in 26 years.

The reason the government must stave off bankruptcy proceedings for our auto manufacturers is because our biggest financial institutions may not be able to withstand the shock of speculative credit-default swap contracts being activated by the failure of our automakers and many of their suppliers. According to "The New, New Deal," what is good for Bank of America (BAC), JPMorgan Chase (JPM) and Citigroup (C) is good for America.

On Thursday, the Dow (INDU) fell 300 points on worries that Congress would not approve a bailout. On Friday afternoon, the Industrials rallied about 300 points partly on renewed hopes the bailout would take place. The biggest drop, and subsequent rally, was in the financial sector.

A stable financial system (SFS) is the strategy. Our guess is that an auto resuscitation plan is on its way in one form or another. All in!

Homes

Buying cheap assets with the one hand and staving off financial collapse with the other is at work in the housing sector, as well.

At the end of September, 1-in-10 U.S. homeowners with a mortgage was either at least one month behind on payments or in foreclosure. We suspect November was not a turnaround month. Foreclosures dramatically accelerate broader home-value depreciation (as banks will sell at almost any price to get the asset off the books).

As an increasing number of homeowners are finding themselves "underwater," an increasing number of homeowners are not willing to pay their mortgages. If they're not going to pay the mortgage, then they are unlikely to pay their property tax, which could be a surprise to many state and local government budgets in 2009.

Add to this a rising unemployment rate (533,000 jobs lost in November -- the most in 30 years) and the home-value declines become tangled in a negative feedback loop.

A negative home value feedback loop is not part of the plan. Preventing the collapse of homeowners and subsequently their lenders is.

The government has been active in the area of loan modification. The Treasury and the Fed have proposed to buy back $600 billion in Fannie Mae (FNM) and Freddie Mac (FRE) debt in an all-out attempt to drive mortgage rates down by lowering the cost of capital for FNM and FRE.

The Treasury Department has proposed that banks offer 4.5% mortgages to new, conforming homebuyers as a way to stimulate increased demand to help rectify the lopsided supply/demand balance. In turn, the S&P Homebuilders SPDR ETF (XHB) has experienced a 46% up move off of its low reached about two weeks ago.

High Market Volatility

This bear market has distinguished itself above and beyond the typical bear with its high volatility. The S&P 500 (SPX) has moved up or down by more than 4% intraday almost 50% of the trading days during the past three months. Comparatively, from 1950 until mid-2008, intraday moves of this size occurred on about 0.2% of the trading days.

The persistently high volatility is best explained by the timing differences between government announcements and natural economic forces.

Government rescue plans are huge and are coming at a weekly pace, and they only take minutes to announce or speculate about. Debt reduction, asset deflation and employment declines can take years to reach an inflection point with trendlines that are linear.

Voila, we have created a recipe for a dramatically down market that reflects the constant pressures of a worldwide, across-the-board recession marked by sharp rallies as investors gamble that the latest federal rescue announcement was the straw that broke the bear's back.

Add extremely high levels of confusion about the effectiveness and eventual consequences of $8.5 trillion of government bailout money to the timing differences between sudden government bailout announcements and steady economic deterioration, and we have a formula for sustained high volatility.

We suspect that this current market pattern is likely to persist well into 2009, as the fundamental economic backdrop continues to sour and the government continues to play "all in" with The New, New Deal.

All else being equal, high volatility is generally a negative for the market. Volatility represents high uncertainty and investors do not like uncertainty. Persistently high uncertainty in the equity market can cause investors to look for more stable places to invest their money.

The CBOE Volatility Index (VIX) is currently about 60. The VIX has been higher than what used to be considered an extreme high of about 40 for well over two months.

What to Watch for This Week

The important market drivers this week will be developments in the "save the auto industry and homeowner" themes.

So far, the pattern has been a market run-up on anticipation of the news, only to sell off on the announcement (e.g., TARP enactment, FNM/FRE takeover). As the bailout discussions progress, the implication for this week is that we could see an extension of the rally that began last Tuesday.

The credit markets remain frozen and the ice is getting thicker. Credit-default swap spreads on U.S. government securities maintain a steady rise (higher insurance premium translates into increased concern of possible U.S. government default).

Despite rising default expectations, investors who believe there is nowhere else to turn are driving Treasury yields to the lowest levels since the government started issuing them. Given the leading role that credit is playing in this crisis, credit indicators have proven to be our most accurate intermediate-term indicators this year.

One of the difficulties the credit market is facing as the crisis continues is the deteriorating credit-worthiness of the borrowing population. This is somewhat ironic, as comfort was high when loan-to-value ratios were considered safe on inflated asset prices. Yet with asset prices substantially reduced, banks now are less sure of loan-to-value ratios going forward.

Our leading option indicators continue to oscillate week to week and are struggling to capture a meaningful intermediate market move. This is true primarily because, over the past 60 trading days, there hasn't been a steady market trend other than down, with the occasional burst up.

As we enter the final weeks of the year, be aware that large institutions make adjustments to portfolios that can cause seemingly inexplicable, awkward market movements in a thinly traded market. The final two weeks can be especially unpredictable because of these end-of-year activities, and we should proceed with caution.

REVIEW OF RECENT ACTIONS

We closed one trade this week.

Dow Chemical (DOW) -- On Monday, Nov. 24, we recommend selling the DOW Dec 17.50 Puts (DOWXW) for $1.10 or better.

As expected, time decay helped reduce the price of these options to 55 cents by Thursday and 50 cents by Friday close. We recommended closing this trade for 55 cents or better on Dec. 3 for a 50% return.

REVIEW OF OPEN POSITIONS

Tekelec (TKLC) -- On Tuesday, Nov. 25, we recommend buying the TKLC Jan 10 Calls (KQAB) for $1.85 or better. These options immediately jumped up and our entry price was $1.90. They closed on Friday at $1.95.

Shaw Group (SGR) -- On Wednesday, Nov. 26 we recommend buying the SGR April 15-25 (SGRDC/SGRDE) bull-call spread for a net debit of $3.60 or less. We also recommended selling the April 12.50 Puts (SGRPV) for $2 or more. The total net debt of all three transactions was $1.60 or less.

This was a trade with many parts, all of which we like. By selling two options and buying one, we greatly reduced the cost of having upside exposure to SGR. Additionally, we believe if the stock were to go below $12.50 and it is put to us, it is an attractive stock holding. On Friday, the bull-call spread closed at $3 and the short SGR April 12.50 Puts closed at $2.25.

Pitney Bowes (PBI) -- On Nov. 12, we recommend buying the PBI Dec 22.50 Puts (PBIXX) up to $1.45. PBI rallied strongly in the last hours of trading on Friday. As expiration is in two weeks, we will be looking to find a profitable exit point in the near term.

Vasco Data Security International (VDSI) -- On

Nov. 4, we recommended buying the VDSI March 15 Calls (QFNCC) for 95 cents or better. This position closed the week at 50 cents. Although the stock has pulled back, the original signal is still valid and we are staying with the trade.

Hain Celestial Group (HAIN) -- On Oct. 21, we recommended you buy HAIN Feb 25 Calls (QQHBE) and simultaneously sell an equal number of the Feb 35 Calls (QQHBG) against them for a net debit of $3.05 or less. By simultaneously buying and selling volatility, we are canceling out some of the cost of the long position. This position is clearly struggling and we don't recommend adding new money here.

REVIEW OF OTHER OPEN TRADES

There are six other trades on the board. With some nice profits to protect with some of these position, and with December expiration fast approaching for some others, we recommend taking action on two of these positions and letting the rest ride for the time being.

Single-Option Trade

Jabil (JBL) -- The long JBL Dec 12.50 Calls (JBLLV), recommended on Sept. 30, are trading for a nickel. There is no action necessary at this time but we'll look to take advantage of any upward move before expiration on Dec. 19.

Bull-Call Spreads

Market Vectors Gold Miners ETF (GDX) -- The GDX Dec 18-22 (GBJLR/GBJLV) bull-call spread, recommended Oct. 24, is behaving nicely and showing a profit of more than 150%. We recommend closing the spread for $3.30 or better to take the profit. With the stock above the $22 strike, the majority of the potential gain has been earned.

Archer Daniels Midland (ADM) -- The ADM Jan 20-25 (ADMAD/ADMAE) bull-call spread, recommended Oct. 20, is also in-the-money and prime for profit-taking. With 100% returns on the table, we recommend closing the spread for $3.50 or better. With the stock trading above the $25 strike, the majority of the potential gain has been earned.

BP Plc. (BP) -- On Oct. 13, you were given a choice of two bull-call spreads in which to play potential upside in BP, whether via the BP Jan 45-50 (BPAI/BPAJ) bull-call spread or the BP Jan 50-55 (BPAJ/BPAK) spread. Both are currently trading at about breakeven. With a potential further end-of-year bounce, let's let this one ride. BP is trading at $45 and looks like it could be forming a bullish technical pattern.

Jabil (JBL) -- The Sept. 30 recommendation in Jabil gave you a choice between playing a single option (as described above) or buying the JBL Dec 10-12.50 (JBLLB/JBLLV) bull-call spread. There is no bid for JBL at this time, so let this one ride till expiration.

CIT Group (CIT) -- This has been on the board since Aug. 15, long before the market began its downward slide in earnest. The CIT Jan 10-12.50 (CITAB/CITAV) bull-call spread is in the same boat as Jabil but with an extra month to go. Let it ride and we'll get out on any strength.

PARTING SHOT

Earlier, we abbreviated stable financial system as SFS. Incidentally, SFS is also the abbreviation for the Sidwell Friends School in Washington, D.C., where President-elect Barack Obama's two daughters will be going.

It's a very good private school but, while the financial crisis will eventually pass and the markets will someday trend higher, if Obama really wants to make a lasting difference in this world, he should remember he is Commander-in-Chief of our public schools.

Rather than doing what every American president in modern history has done before him (except for Jimmy Carter), he should send his children to public schools and make the issue of improving our schools less academic and more personal.

The timing is ideal because the D.C. public school system is in the midst of a major reform effort that could have a profound, positive impact on the public school systems across America if it works.

Obama campaigned on the promise of change. It would be refreshing if change is what happens in both substance and appearance. Restoring the nation's public school system to a world-class level will have much deeper and longer-lasting effects than creating a new way for the government to blow a few trillion dollars on highly speculative assets created by the runaway greed of market participants who might have made better decisions if they had been better-educated.

As we gyrate into the end of this year, there is no reason to try to be a hero. Clear option signals will emerge, and we will raise full sail when they do.

Have a great week trading.

Nick Atkeson and Andrew Houghton