The nationalization of Fannie Mae and Freddie Mac, the collapse of Lehman, the acquisition of Merrill Lynch and the bailout of AIG have all created significant uncertainty in the financial market. There are continued talks of failures, shakeups and bailouts; in fact, deals between a number of financial institutions are being discussed as we speak. Volatility is at the highest in months as a result of heavy speculation on two differing sides, the longs and the (naked) shorts.
The longs are betting on a recovery of the financial system, typically 3-5 years out. Some of them believe the worst is behind us, and the recent deals and bailouts are signs that the market is bottoming. The only way to stop the deleveraging of financial institutions is to A. Pay off the debt they have accumulated over the years. B. Rebuild their capital base. And C. Write-down the value of distressed assets on their books. Many long investors believe this is taking place or has already taken place.
The shorts on the other hand are not betting on a recovery in the near future. Many short sellers believe the worst is yet to come, and that there will be continued shakeups in the financial system. With an estimated total mortgage write-down of over $1.3 trillion, we have only hit the half trillion mark. In addition, other banking divisions not exposed to the mortgage crisis are also feeling the pain, as investors are pulling money out of the banks, and M&A and IPO activities are dwindling. In other words, there is a long way to go.
If you are a retail investor, you have four choices amid the crisis:
1. Long/Short Financials
2. Long/Short Other Sectors/Markets
3. Stay With Cash
4. Combination Of The Above
Unless you’re playing for the 3-5 year route in financials, I would opt for a combination of options two and three. Smart money started by shorting financials many months ago and have long exited the scene. Everyone else is now fighting for the breadcrumbs left on the plate. There are currently no clear signals to distinguish good from the bad, creating an extremely risky environment. Trying to time the market is a fool’s errand. Why rest your portfolio in the hands of Mr. Paulson and Dr. Bernanke, who are essentially in control of determining who and when bailouts occur? Even if you were playing the 3-5 year game, why would you want to get yourself into this mess now? Why not wait for a more convincing signal and enter there? Besides, there are better investments out there.
First, cash is never a bad investment in this environment. Of course, all of us want our portfolios to grow, not to stay at even, particularly when the Fed has the presses working at 100% utilization. Yet, there is no reason why you should not allocate say 50% of your portfolio to cash and wait for the crisis to unwind.
The other 50% could be used to trade other markets, including non-financial industries, currencies, commodities or ETFs. There are plenty of opportunities in these markets where you can still conduct sound fundamental and/or technical analysis and not be overshadowed by all the speculation. Yes, it may take “longer” to generate returns, but I would rather generate returns than take the risk of losing everything.
Disclosure – Author is long healthcare, commodities, infrastructure and short automotive, internet, airlines and transport.
