Paybacks Are Hell, But Volatility Creates Opportunity

|
 |  Includes: SDS, SH, TVIX, TZA, UVXY, VXX, VXZ
by: Seth Walters

Much has been made of the so-called "Fiscal Cliff" recently. I have to say that I find all the hand-wringing and agonizing over it incredibly amusing - if you think about what it really means. We are running an annual deficit of over $1 trillion in this country. This money, for the most part, isn't being used to invest in infrastructure or anything else that will give great returns in the future - it's being used to keep the economy on life support. It's being used to enable consumption. Most of the so-called entitlement spending and tax cuts that are being discussed represent a massive governmental wealth transfer to consumers who will spend a good amount of each marginal dollar of that wealth. Easy credit is like cheap vodka, and America is like an alcoholic. The government is afraid that if the booze is taken away too quickly, the country might suffer pretty bad withdrawal.

But, like drinking to excess every day, there are a number of severe downsides to continual consumption of easy credit in lieu of actual earnings.

1) It fuels malinvestment on a large scale. Does anyone think that Amazon (NASDAQ:AMZN) would be trading at a P/E ratio of 3,442 and salesforce.com (NYSE:CRM) would be trading without a P/E ratio at all at a combined market cap of almost $150 billion in an environment where the US was living within its means? People like to talk about how "stocks are cheap" because of P/E ratios, but in truth our current P/E ratios (of the stocks that even have them now) are built on unsustainable earnings margins that rob the American worker (consumer) of any real chance at deleveraging or consuming a healthy amount of goods and services (within his means, not on the back of some contrived bubble). The better a company can make its earnings and growth look, the higher its stock price will go and the more the stockholders will profit; but the massaging and manipulation of earnings have market distorting effects. There is a danger that easy credit and massive, market-distorting pumping of the financial system will not allow the country to recover, but will build a foundation of sand that will make managing a stable recovery even harder and make future growth even more uncertain.

2) Every penny that we as a nation spend on this malinvestment has to be paid back, with interest. The higher we run up the tab the more of a drag this is going to be on real economic growth in the future.

3) Our political standing in the world is being affected. The US dollar's status as a reserve currency is less and less attractive with each malinvested borrowed dollar that pumps our distorted markets higher and higher. A world in which the US dollar loses reserve currency status, or a world in which the US defaults on its debts, for whatever reason, is a darker and dangerous world. Every credit rating downgrade will make us lose a little bit more respect, and the loss of respect for America will have real consequences for the world. For all the negative things that small-minded foreigners have had to say about the US and our foreign policy, the Pax Americana of the last 50 years has brought an unprecedented era of global trade, prosperity, advances in science and technology, and social freedom. We keep the peace through strength, and through respect, and through tradition. A world with a fallen or withdrawn America is a world where human beings worldwide can be more easily killed and repressed by petty tyrants and dictators. Famines, disease, poverty, war, and abject human misery will all become more commonplace. It is a world in which advances and progress will move forward slowly, if at all. It represents a failure on a colossal scale both to those who are here now and to those who have yet to be born.

Moving back to this "Fiscal Cliff," it doesn't even make our massive debt start going down or keep it from going up; it just slows the rate of the increase a little. Of this, everyone is terrified. And with good reason. There isn't so much of a real economy going when you take away a big chunk of a Trillion bucks of extra spending. It's been said that going over the Fiscal Cliff would put the US into recession for at least 3 quarters. The Fiscal Cliff by itself isn't a solution to our problems, but it does at least slow down the creation of more problems - malinvestment, debt, and loss of standing. It would be better if we had a really functional government who passed better bills, but what we have is mostly just the ineluctable nature of politics to breed horrendous inefficiency and stupidity. This isn't because our elected representatives are idiots, but because the game of politics that they are playing forces them to act like idiots. I've seen it time and time again, and it is quite frankly disgusting that this is the best system for governance the human race has figured out.

I believe that we are going to go over this Fiscal Cliff. John Boehner did not recite the Serenity Prayer as a show of piety, but as a heartfelt expression of helplessness over the state of American politics and the lack of an implementable solution to our financial problems.

I don't believe that there is a bull case for our markets from these levels. People like to talk about the recovery in housing and autos and the economic data improving, but the truth is that all of that data is built on the massive deficit spending we've been doing over the last 4 years. Borrowed money. And you have to realize that some of that housing data may actually be an ancillary effect from the cheap and easy credit we've had. Just as equities have been pushed up, so have other assets, including gold. It would be unsurprising to me to find that real estate speculators are actually responsible for a lot of the housing data, fueled indirectly by all that money we've been printing.

Well, markets have been going up for about 4 years now. If this isn't a bull market, what is it? Some people might call this a bear market rally, but considering what it is built on, I think that calling it a pig market is more apt. There is an old saying, that in the stock market, bulls can make money, and bears can make money, but pigs get slaughtered. I believe that the slaughter of this pig market is about to begin. It can't be rescued forever, and it going down should not be a cause for undue alarm. All the market going down will be is some of the lipstick being wiped off the pig. Remember, the Fiscal Cliff doesn't remove all the deficit spending or actively pay down the debt, it just slows it down some.

What should you do to protect your money here, or try to profit from a market adjustment? There are a lot of options available, from selling call options or buying put options on US equities, to selling long equity holdings, to initiating short positions in equities, or even buying positions based on the VIX. Depending on how aggressively you engage in this, you can position yourself to profit from a possible market crash, or you can simply hedge your long positions. There are a large number of ETF and ETN hedges available, of which I have made a small table below:

Click to enlarge

(NYSEARCA:UVXY) (NASDAQ:TVIX) (NYSEARCA:VXX) (NYSEARCA:VXZ) (NYSEARCA:TZA) (NYSEARCA:SH) (NYSEARCA:SDS)

This should provide a sense of how risky each is compared to the reward/hedging protection offered during a severe market correction. All of these hedges will decay in value under normal market conditions, so buy with this in mind and be ready to accept significant losses as well as potentially reap even more significant gains depending on how market events play out.

I wrote an article a couple months ago that noted the existence of a large rising wedge pattern in the US stock market indexes, and charted that pattern in the Dow. I will also update that today with a bit of commentary. Rising wedges are generally considered a bearish pattern and are thought to break to the downside about 70% of the time. Since I wrote my article, the Dow reached the bottom of the rising wedge lower channel I identified and rebounded strongly. In the past few days, it has been falling a bit. If it falls significantly below the lower trendline, then I would say this portends a large move downwards and constitutes a completed pattern. Right now, a move to the November lows would accomplish this. The updated chart is presented below, the first is in the linked article above.

Click to enlarge

This is not the end of the world. It is not the end of the US's position in the world economy. It is a crisis. There is danger in crisis, but there is also opportunity. Furthermore, some have criticized this crisis as being created by Washington. That may be true, but it was done years ago. We've been living off the fat of borrowed credit. A little credit is great. A little alcohol is great. But too much of either can cause hangovers, addiction, and eventually... death. John Boehner and the Republican party have made a stand to at least start to slow down the credit flow. To stop the spending. To begin payback. They are wiping the lipstick off the pig. I believe that this pig will be slaughtered, and I believe that the American people are great enough to finally turn away from bubbles and other financial band-aids and start to fix the real issues that are causing this crisis, some of which I have written about previously. It starts with writing your representative and advocating your ideas, or running for office. Someday, this will work. Our system helped us build the greatest country on earth, so it can't be all bad.

So you, the investor, the trader, the speculator - you now have a choice to make. Do you stay away from the dinner table, do you eat pork chops, or do you become the pork chops? Because I believe that John Boehner has decided to kill the pig. And I believe that those who feast on it well will be best suited to participate in the great bull market that will come when we fix the real problems in this country, not with credit, but with policies that stimulate hard work, a fair deal for everyone, and real growth.

Disclosure: I am long UVXY, TZA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.