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Gang Of Eight Disgorges Draft Immigration Bill

Early Wednesday morning, the so-called "Gang of Eight" -- United States Senators Schumer, Flake, McCain, Menendez, Rubio, Graham, Bennett, and Durbin -- released the text of their 844 page immigration bill. Among other provisions, the bill would give legal status and a pathway to citizenship to the estimated 11 million illegal aliens living in the United States. The Senate Judiciary Committee is scheduled to hold hearings on this bill Friday. If the bill passes the Senate and then the House of Representatives, and is signed into law by President Obama, it may have far-reaching consequences for the US economy. In this post, we'll look at the potential political and economic impact if this bill becomes law, and then we'll look at how it could affect a few specific companies.

Economic Impact

Opinions differ on the economic impact of adding millions of legalized immigrants to the country's population. Proponents of the immigration bill, such as Marshal Fitz of the think tank Center For American Progress, argue that it would expand American gross domestic product. Others, such as Harvard economist George Borjas contend that the bulk of the economic gains would go to the immigrants themselves, in the form of wages, and that the expanded labor pool would lower the wages of current American workers, as the chart below indicates.

Note that employers are expected to gain in this scenario. We will look at a couple of specific examples below.

Political Impact

The political impact if the immigration bill eventually becomes law seems clear: the Democratic Party will be the winner, as will companies in the party's favored industries, such as "green" technology. Granted, that statement raises an obvious question: if the immigration bill will benefit Democrats, why did four Republican Senators join the Gang of Eight to help draft the bill? The non-cynical answer is that the Republicans believe this bill will help them win more Hispanic votes.

That answer strains credulity though, when one considers current poll data and historical electoral results. As Josh Marshall of Talking Points Memo wrote recently, Hispanics tend to vote Democratic because they tend to agree more with the Democratic party on a broad range of issues, not just on immigration. And it's worth remembering that Republicans supported a similar immigration bill which was signed into law by President Reagan in 1986; in the following election, in 1988, Reagan's successor George H.W. Bush won only 30% of the Hispanic vote.

Some Potential Winners And Losers

Before discussing how a few companies may be affected if the current immigration bill becomes law, two notes of caution:

• This is by no means a comprehensive list. If this bill becomes law, numerous companies will be affected, and an examination of all of them is beyond the scope of this article.
• Investment decisions should be based on multiple factors, not just how a company might be affected by the proposed legislation.

Possible Winners

Facebook, Inc. (FB). In a Washington Post op/ed last week, Facebook CEO Mark Zuckerberg offered inspiring reasons why he had joined with other tech executives to lobby for immigration legislation: to help immigrant entrepreneurs achieve the American dream, etc. But the Washington Post later reported that Facebook's lobbyists had managed to insert a provision into the current immigration bill that would lower the company's labor costs:

The payoff on the immigration provision could be substantial, allowing Facebook and other technology companies to avoid a requirement that they make a "good-faith" effort to recruit Americans for jobs before hiring from overseas. Facebook could also sidestep proposed rules that would force it to pay much higher wages to many foreign workers.

Tesla Motors (TSLA). Tesla has benefited from significant federal assistance so far: a $465 million loan arrangement from the Department of Energy, and a $7500 tax credit for buyers of electric vehicles. If the immigration bill passes, and Democrats further solidify their political supremacy, Tesla and other green tech companies could be the beneficiaries of expanded government assistance. As we noted in a recent article though, questions have been raised about Tesla's ability to become a mainstream car maker. Nevertheless, having more friends in D.C. would certainly be a plus for the company.

Tyson Foods, Inc. (TSN). Tyson Foods operates in four segments: Beef, Chicken, Pork, and Prepared Foods. The first three segments of its operation would benefit from an influx of millions of newly legalized manual laborers, many of whom might be willing to work in slaughterhouses for lower wages than current workers.

Possible Losers

Denbury Resources, Inc. (DNR). As Joel Kotkin noted in The Daily Beast last year, Democrats have increasingly turned against the fossil fuel industry. With Democrats winning greater political control, this trend could continue. This could be a headwind particularly for oil and gas companies that such as Denbury Resources that have most or all of their operations in the US.

Bank of America (BAC). Although Bank of America's Consumer Real Estate Services segment might benefit initially from increased demand for mortgages by millions of newly legalized immigrants, to the extent that it keeps those mortgages on its books or is otherwise liable if the borrowers default, BAC may have to deal with a higher rate of foreclosures in the years ahead, if recent trends continue. According to research conducted by UC Berkeley professor Carolina Reid when she worked as a research manager for the Federal Reserve Bank of San Francisco (highlighted by blogger Steve Sailer), Hispanics have been disproportionately represented among foreclosures, as indicated by the chart below from Dr. Reid's paper, "Addressing The Disparate Impact of Foreclosures on Communities of Color".

Ameliorating The Risk Of Owning These Stocks

At this point, the immigration bill represents increased uncertainty for all of the companies mentioned above -- the ones likely to benefit if it becomes law, and be adversely affected if it doesn't, and those in the reverse situation. For investors in these companies who are wary of the risks, but would rather not sell their shares at this point, we'll look at a couple of different ways they can hedge against significant declines over the next several months. To illustrate, we'll use one of these companies, Facebook, as an example. Then we'll show the costs of hedging the other stocks we've discussed here in the same manner.

Two Ways Of Hedging Facebook

Below are two ways for a Facebook shareholder to hedge 1000 shares against a greater-than-20% drop between now and late September.

1) The first way uses optimal puts*; this way allows uncapped upside, but is more expensive. These were the optimal puts, as of Wednesday's close, for an investor looking to hedge 1000 shares of FB against a greater-than-20% drop between now and September 20th:

As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 4.09%.

2) An FB investor interested in hedging against the same, greater-than-20% decline between now and late September, but also willing to cap his potential upside at 20% over that time frame, could have used the optimal collar** below to hedge instead.

As you can see at the bottom of the screen capture above, the net cost of this collar, as a percentage of position value, was 0.04%.

Note that, to be conservative, the cost of both hedges was calculated using the ask price for the optimal puts and the put leg of the optimal collar, and the bid price of the call leg of the optimal collar; in practice, an investor can often buy puts for some price less than the ask price (i.e., some price between the bid and ask) and sell calls for some price higher than the bid price (i.e., some price between the bid and the ask).

Hedging Costs For All Of The Names Mentioned Above

The table below shows the costs, as of Wednesday's close, of hedging all of the stocks mentioned above in a similar manner as FB above: first, with optimal puts against a >20% drop over the next several months; then, with optimal collars against the same percentage drop over the same time frame, while capping the potential upside at 20%. The SPDR S&P 500 ETF (SPY) was added to the table for comparison purposes. There was no optimal collar available for Tyson Foods given these parameters as of Wednesday's close.

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The screen captures of optimal hedges above come from the Portfolio Armor iOS app.

Additional disclosure: I recently purchased optimal puts on SPY, as a hedge against a possible market correction.

Gold gets hammered

Gold futures for June delivery had dropped nearly 8 percent, trading at $1380.20 on the New York Comex intraday Monday. The gold-tracking ETFs SPDR Gold Shares (GLD) and iShares Gold Trust (IAU) were down 7.4% and 7.5%, respectively, on the day. Monday's bloodletting followed another awful day for gold investors on Friday; from Thursday's close, GLD and IAU investors were down about 11.5% as of intraday Monday.

Gold is malleable -- are gold investors?

One of the physical properties of gold is that it is highly malleable, so gold can get hammered (into gold leaf, for example, which is pictured nearby) without breaking.

Whether gold investors will be as resilient if this steep correction continues remains to be seen, but the speed of this collapse is bound to be disconcerting for gold longs, considering that it has outpaced some of the more prominent, recent bearish outlooks on gold.

For example, in a report released on April 2nd ("The End Of The Gold Era?"), analysts at Societe Generale (SCGLY.PK) predicted gold could trade at $1375 per ounce by year end, with an average price of $1500 for 2013. More recently, on April 11th, analysts at Goldman Sachs (GS) issued 6 month and 12 month target gold prices of $1490 and $1390, respectively. Gold has dived faster in the last two trading days than even these bearish institutional analysts anticipated.

Downside Protection And Malleability

As we noted in a post as gold was heading toward its peak in 2011 ("Gold Goes Parabolic, Hedging Costs Rise"), one of the advantages of being hedged is that it obviates the need to panic or run for the exits:

If you're hedged when the next correction in gold hits, you'll have the breathing room to consider whether that correction is analogous to 1980's crash from gold's generational peak or to 2008's sharp, though temporary, correction.

Remember that in 2008 gold fell to a low of $712.50 per ounce, after having peaked at over $1,011 per ounce earlier in the year. A gold investor who had been hedged could have, if he were still bullish on gold at that point, sold his hedges and used the proceeds to increase his position in gold.

Malleability works as a metaphor here, since a hedged gold investor's portfolio could potentially handle getting hammered by a gold correction, more so than an unhedged portfolio. Consider, for example the hypothetical gold investor we mentioned in a post earlier this year ("Two Inexpensive Ways To Hedge GLD").

Hedging a gold position on January 25th

In the article mentioned above, we gave examples of how a hypothetical investor with a 1000 shares of GLD could have used optimal puts* or an optimal collar** to hedge against a greater-than-10% drop between then and late June. This was the optimal put hedge:

As you can see at the bottom of the screen capture above, the cost of this put protection, as a percentage of position value, was quite inexpensive: only 0.77%. Note that, to be conservative, the cost here was calculated using the ask price of the optimal puts. In practice, an investor can often buy puts for a lower price, i.e., some price between the bid and ask.

How GLD Has Performed Since We Posted That Hedge

Not well. GLD has declined about 17% since, as of intra-day Monday.

How Those Optimal Puts Reacted To GLD's Drop

The screen capture below shows how those optimal puts we showed back in January reacted to GLD's drop as of intra-day Monday.

As you can see in the screen capture above, those puts jumped more than 166% intra-day Monday when had GLD dropped 7.6% by the same time. This is an example of the nonlinearity of options, which enables a small dollar amount of options to protect a much larger position in an underlying security, such as GLD.

How That Hedge Cushioned GLD's Drop

GLD closed at $160.65 on January 25th. An investor who owned 1000 shares and bought the optimal puts to hedge it against a >10% drop that day had $160,650 in GLD and an outlay of $1,230 on the puts (again, assuming, conservatively, that he bought the puts at the ask). $160,650 + $1,230 = $161,880.

As of intra-day Monday, GLD traded at $133.15, and those puts traded at $15.20. As of intra-day Monday, our investor's GLD shares were worth $133,150 and his put options were worth $15,200: $133,150 + $15,200 = $148,350.

So, although GLD dropped about 17% from January 25th's close to intra-day Monday, April 15th, an investor who bought those puts on January 25th was only down about 8.4% on his combined hedge + underlying stock position over the same time frame.

More Protection Than Promised

Recall that the optimal put hedge was designed to protect against a greater-than-10% decline. Because these had time value in addition to intrinsic value as of April 12th's close, they offered more protection than that.

Inexpensive To Hedge For Most Of This Year

As I noted on the Index Investing Show two weeks ago (starting at about 25:28 of the recording at the link), despite its poor performance from the beginning of the year until then, it was actually less expensive to hedge GLD than it was to hedge SPY.

Hedging GLD Now

It's still possible to hedge GLD, but it's not as cheap to do so. The screen capture below shows the optimal puts, as of intraday Monday, to hedge 1000 shares of GLD against another, greater-than-10% drop by September 20th.

As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 3.79% - nearly 5x as expensive as it was to hedge against the same percentage drop back in January.

A Less Expensive Way Of Hedging GLD Now

An investor looking to limit his downside in GLD to 10% over the next several months, but also willing to cap his potential upside by 10% over the same time frame, could have used the optimal collar** below to hedge intraday Monday.

As you can see at the bottom of the screen capture above, the net cost of this collar was 0.68% of position value.

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The screen captures of optimal hedges above come from the Portfolio Armor iOS app.

(Updated as of intra-day Monday)

How You Could Have Hedged Your GLD Shares

In late January, we posted two inexpensive ways to hedge 1000 shares of the SPDR Gold Trust ETF (GLD) against a greater-than-10% drop over the next several months. This was one of them:

As you can see at the bottom of the screen capture above, the cost of this put protection, as a percentage of position value, was quite inexpensive: only 0.77%. Note that, to be conservative, the cost here was calculated using the ask price of the optimal puts. In practice, an investor can often buy puts for a lower price, i.e., some price between the bid and ask.

GLD has declined about 17% since January 25th's close, as of intra-day Monday.

How Those Optimal Puts Reacted To GLD's Drop

The screen capture below shows how those optimal puts we showed back in January reacted to GLD's drop as of intra-day Monday.

As you can see in the screen capture above, those puts jumped more than 166% intra-day Monday when had GLD dropped 7.6% by the same time. This is an example of the nonlinearity of options, which enables a small dollar amount of put options can protect a much larger position in an underlying security, such as GLD.

How That Hedge Cushioned GLD's Drop

GLD closed at $160.65 on January 25th. An investor who owned 1000 shares and bought the optimal puts to hedge it against a >10% drop that day had $160,650 in GLD and an outlay of $1,230 on the puts (again, assuming, conservatively, that he bought the puts at the ask). $160,650 + $1,230 = $161,880.

As of intra-day Monday, GLD traded at $133.15, and those puts traded at $15.20. As of intra-day Monday, our investor's GLD shares were worth $133,150 and his put options were worth $15,200: $133,150 + $15,200 = $148,350.

So, although GLD dropped about 17% from January 25th's close to intra-day Monday, April 15th, an investor who bought those puts on January 25th was only down about 8.4% on his combined hedge + underlying stock position over the same time frame.

More Protection Than Promised

Recall that the optimal put hedge was designed to protect against a greater-than-10% decline. Because these had plenty of time value in addition to intrinsic value as of April 12th's close, they offered more protection than that.

Hedging GLD Now

The screen capture below shows the optimal puts, as of intraday Monday, to hedge 1000 shares of GLD against another, greater-than-10% drop by September 20th.

As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 3.79% - nearly 5x as expensive as it was to hedge against the same percentage drop back in January. It's still relatively cheap to hedge against a larger drop, though.

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a postdoctoral fellow at Princeton University's financial engineering department to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.