Enjoy the Calm Before the Storm

by Michael Shulman | September 1, 2011 10:59 am

Enjoy the Calm Before the Storm

The last week of August is typically quiet, enlivened this year by fears — or hope — of a repeat of the turmoil we saw in the first weeks of the month.

That turmoil has abated and everyone is asking the same questions: What happens with higher volumes after Labor Day? What will the Fed discuss and decide in mid-September? What will Obama say or not say in his Labor Day speech? What will the German Parliament do when it reconvenes in mid-September. Each question reflects on aspect of uncertainty in the market today – and all are tradable.

The Market: The volatility we saw in August should consistently repeat itself in the next few weeks, but the CBOE Market Volatility Index (VIX) going above 40 and staying there is not something I think will happen. A great many positions were unwound in August and new ones are being built at a measured pace. The trade here? Consider buying puts on the iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX[1]), the ETF for the VIX.

The Fed: There is not much more the Fed can do in the real world, but traders are relying on every word that even hints of the potential to change policies with minimal impact on the economy. Many analysts reading out-of-date textbooks — most were physics majors anyway, they know nothing of economics except what they hear from their equally ill-educated peers on CNBC — believe Fed policies will cause inflation. Given that home prices are down 33% and China has more than enough unused capacity to manufacture everything, including new economic textbooks so desperately needed, I find these fears laughable.

That being said, these people trade fear and they do that with gold – buying it that is. The trade here are calls on the SPDR Gold Shares (NYSE:GLD[2]) exchange-traded fund – which, for a moment a week or two ago, was the most traded ETF in the world.

Obama: He is in a jam created by a) a willfully incompetent administration, in a fiscal sense, preceding him and b) misunderstanding or ignoring the depth of the nation’s economic ills and having body language and words that is less than warm toward the business community. Not to mention most people making a quarter of a million a year feel anything but rich – they are not to be pitied, but their fear of tax hikes is hurtful to the economy. He may offer big words on Monday but he will get nothing past the House of Representatives that is aggressive or creative enough to make a dent in the coming recession.

The trade here? Short the banks. They are flailing in the real world and falling in the stock market, and they have no power to grow earnings. In addition, as the economy slips their balance sheets will take more hits. And remember those toxic assets? They have not exactly moved to Oz – plenty of writedowns to come from old assets that are bad, not to mention the newer ones that will turn bad. You can buy puts on the Financial Select Sector SPDR (NYSE:XLF[3]) exchange-traded fund or Citigroup (NYSE:C[4]), a real mess of a company. Look at nothing past earnings announcements in October.

Europe: We are in great shape compared to Europe – we can always pay our bills by printing money, and they will have to do the same. That means Germany either a) ignores its own voters misplaced fears of inflation or b) modifies or breaks up the eurozone. Do I exaggerate? The problem is not that Greek one-year bonds yield near 60% (I did not add a zero by accident), the problem (and the French head of the IMF agrees with me), is that European banks are woefully undercapitalized, leveraged 40- or 50-to-1 in some cases, and they hold lots of lousy sovereign as well as private debt.

They need to be recapitalized, and this can only happen with taxpayer money that is collected through taxes — or by printing money, something the European Central Bank can’t do right now. Given that headlines move things one way or another very quickly, look at longer term puts on the big banking names – Deutsche Bank (NYSE:DB[5]) and Banco Santander (NYSE:STD[6]), the biggest bank in Spain, which are staring at a real storm headed their way.

 

 

 

Endnotes:
  1. VXX: http://studio-5.financialcontent.com/investplace/quote?Symbol=VXX
  2. GLD: http://studio-5.financialcontent.com/investplace/quote?Symbol=GLD
  3. XLF: http://studio-5.financialcontent.com/investplace/quote?Symbol=XLF
  4. C: http://studio-5.financialcontent.com/investplace/quote?Symbol=C
  5. DB: http://studio-5.financialcontent.com/investplace/quote?Symbol=DB
  6. STD: http://studio-5.financialcontent.com/investplace/quote?Symbol=STD

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