I think few people realize that America/the world is facing the biggest financial storm ever, and how dangerous it is for investing in stocks before a full implosion. The housing-induced credit crisis has gone far beyond anyone can potentially control, probably not even the Fed.

Reading over so many current/future proposals from politicians and bloggers, I have my own thoughts in this. For sure, there simply isn’t a solution without pain. But there can certainly be solutions that are more fair and less pain.

One of the most fair and easiest way to help propping up the housing market is to subsidize all the buying or holding cost for primary residences. Instead of helping on the sell-side directly, the government can help the buy-side. Of course, the subsidy will indirectly go into sellers. But the solution is market-based.

Why is this a fair solution? For sellers, there is simply no direct bailout. For anyone who chooses to buy, the buying decision is done on the open market where everyone else is competing on the same ground with subsidy, and existing real estate investors will also be helped with a more stable housing price. For any renters who choose not to buy and take up the subsidy, their decision is solely of their own based upon their evaluation of the current housing market and personal circumstances.

What kind of subsidy will make sense? The easiest way is certainly done through mortgage interest reduction or tax deduction. The tax deduction cannot be limited by the amount of adjusted gross income, and has to be actually beneficial on top of the existing standard deductions. By reducing the overall housing cost, government will encourage more of it, and prop up the housing market.

Since 65% to 70% of the Americans are home owners, most of this housing aid will effectively become a tax cut for middle class. I suggest that 50% of the total amount of both property tax and mortgage interest from primary residence can be used as a tax credit (rather than tax deduction in the itemized section). Here are some examples of the housing aid scenarios, with loan interest at 6%:

1. $700K home in California with 20% down for someone with tax bracket at 28%:
Because loan amount is $560K, the interest is $42K a year, and the additional tax subsidy amount will be roughly (50% - 28%) * $42K / 12 months = $616 a month. This monthly subsidy will effectively lower the interest rate from 6% ($3357) to 4.25% ($2755). That will be a tremendous stimulus.

2. $500K home with 20% down for someone with tax bracket at 15%:
The additional tax subsidy amount will be roughly (50% - 15%) * $500K * (1-20%) * 6.00% / 12 months = $700 a month. This monthly subsidy will effectively lower the interest rate from 6% ($1852 payment) to 3% ($1686 payment). This is an even better deal for lower income people.

Effectively speaking, this tax cut will target middle-class home owners specifically. Using the assumption of a median home value of $240K, and an average tax bracket of 15%, this tax aid comes to be about $4032 dollar per family household, 110 million US households, with 70% home owners, it will be about $300 billion annually. I’m not going to re-do my numbers here, but probably instead of 50%, one could go for 40% of the interests as tax credit. This will adjust this bill from $300 billion to about $214 billion. I hesitate to go to much lower, simply because in California, where most of the housing problems are, you have to be at 25% to 28% tax bracket to afford the homes. Since one is already getting existing tax benefits at 25% to 28% through itemized deduction, the 40% as tax credit will only give 15% to 12% additional benefit.

Bottomline, this printing of tax money will be truly the best way of distributing the helicopter money, since it goes to the homeowners directly without discrimination, AND it is also tax-progressive. The rich who has a bigger loan do get a lot more, but only because they are paying a lot more for their home. But the middle class will not be left out at all, and will enjoy the biggest piece of the tax reduction. This will effectively encourage home purchase/consumption, and props up housing market. The solution is also market-based without ANY bailouts to those people who abuse the mortgage markets.

In respect to Republican tax position, this is a market-based solution. In respect to Democrat tax position, this is a tax aid for most of their incumbents. In respect to stock markets and US economy from Keynesian economics, this is a huge positive. Tax cuts stimulate economy. On the other hand, money from direct taxpayer bailouts go into the pockets of these fraudulent bankers and homeowners, and continue to encourage moral hazards and speculation.

Frugal at 1stMillionAt33.com

The chance of markets going into freefall mode is increasing as hours go by. Markets are being liquidated. The second strong sector XLE/OIH or the energy companies have fallen right at or below the lower band of Bollinger’s bands. The strongest sector GDX or the precious metals just had a sell signal from MACD signal.

I hate to sell any of my stocks right now, but things just simply do NOT look good. Tuesday opening may be down again it appears for the following reasons:
1. Financial sectors in Europe are crushed on Monday. All global markets have plunged from 4% to 8% on Monday. I have expected emerging markets to fall. But the problem is that they just started falling, with US stocks already breaking supports. Now, I just can’t imagine what would happen when emerging markets are 20%. Will US stocks be 30+% off instead??

2. US dollar index is rising STEEPLY to 76.866 (10:18 on Jan 21). This is ESPECIALLY scary. As I have said many times, for US stock markets to go up, US dollar MUST fall. Here are the currency quotes that I’ve obtained, ALL breaking recent high/low with US dollar gaining strength, except YEN:
EUR vs USD at 1.4485
USD vs JPY at 105.87
GBP vs USD at 1.9458
USD vs AUD at 0.8628
USD vs CAD at 1.0320
This is F***ing scary now, because yen carry trade unwind is in FULL force.

Initially, I expected that precious metal sectors may be spared. My expectation came from the observation of the recent stock market fall as the new year opens. All markets fell, but precious metals went straight up. The currency markets indicated the same phenomenon as of now. However, energy markets later were not spared. Now precious metals stocks have corrected with gold spot almost reaching an all time high and have pulled back to $867. If gold price breaks $850 and then $835, along with Yen strengthening, then I think the black swan dive will be here with us.

Once the market opens on Tuesday, I tentavely think that I probably will purchase puts for February or March expiration (but maybe it’s too late already). The markets show no signs of improving. The last rally on last Wednesday kind of surpised me on the lack of followed-thru, because this sick market canNOT even rally for 1 day. That particular rally was intraday, and was LESS than 1 day. Maybe it is time to face the truth.

I don’t know how ugly this market will get. But the markets are probably more over-sold than the bottom in the last bear market of 2002/2003. Jumping out of the window maybe is the best way to avoid this train wreck now. (Boy, I’m not even panicking at this point. I don’t want to see how low this thing will go when I panic.)

Last night my wireless router is down. I had to connect my laptop directly thru ethernet physically to the wireless router, in order to get onto the internet and blog. Today’s post is therefore late than usual.

I spend some time shopping for wireless routers, and found a really good deal at target.com for the latest and greatest 802.11n router. It’s a D-link 802.11n router, and it’s only $40. If anyone is thinking of getting a new router, this N router is as cheap as other G/A/B router.

For those who are not familiar with 802.11 wireless technologies, 802.11b is the slowest. 802.11g is faster than 802.11b and the most common choice now. 802.11a is the least compatible and rare. And the new 802.11n is about 5X faster than 802.11g, and will be the next generation wireless technology for everyone’s home. Using 802.11n, one can probably transfer big files wirelessly at a very fast speed. More importantly, I believe in the next 2 to 3 years, you can watch HD TV wireless “everywhere” in your home. The speed of 802.11n is sufficiently to support multiple MPEG2 HD quality channels (not to mention that if you use MPEG4, you get more than double of that). There are still difficulties for wireless TV due to potential intermittent transmission quality. However, I think those problems can easily be solved, if you simply buffer a lot of video by combining the storage capacity of the hard disk from your PVR (personal video recording) system with 802.11n.

Anyway. It’s probably too much tech talk for someone simply looking for a cheap router. And in case if you are interested in the main companies who provide these wireless technologies, they are ATHR, BRCM, MRVL, listed in alphabetical order. I don’t advise buying any of those high-tech stocks however. But if you think of buying them, you may choose ATHR which is a very focused and strong player. Their design seems to be some 40% better in terms of cost than the competitors.

By the way, I wouldn’t worry so much about the “draft” N. 802.11n has been around for at least 1.5 years now, that I think any shipping products should be like 98% compatible with the final approved standard, if not 100%.

I saw this article the other day from thestreet.com. It spoke about CGMFX returning 50% in two months. That is simply INCREDIBLE for a mutual fund.

Don’t know if any of you picked up some shares in CGMFX or CGMRX when I first blogged about Ken Heebner and his funds back in April 2007. Heebner moves faster than you can track him. At that time, he was bearish on real estate stocks, bullish on mining and infrastructure stocks, neutral and slighly bullish on brokerage financial stocks. I think I checked his holdings, and he was holding brokerage stocks at one time. But he got out quickly for sure, and both of his CGMFX and CGMRX (supposedly a real estate fund) are showing big holdings in energy/infrastructure names. Yeah, he moves FAST.

If there is a second example of failure of Efficient Market Hypothesis (EMH) besides Warren Buffet, I would say Heebner is high on the list. He has beaten indexes year after year for so many years now. Incredibly record. I have to seriously consider buying his CGMFX really. Maybe EMH is garbage. Or at least it’s a garbage theory definitely to Heebner and the fund holders personally. Some people I guess can really time the market. And timing the market with a big mutual fund portfolio is certainly much harder than a small individual portfolio.

Don’t invest just based on my advice. Caution is always advised. Disclosure: I currently don’t hold CGMFX or CGMRX, but I wish I did 10 years ago.

With the latest Job September report last week, BLS is revealing its biggest lie yet for all to see, or I shall say anyone with eyes. But of course, people on Wallstreet are either blind, or turning a blind eye. Or maybe, this is a collective bluff on the part of government and Wallstreet, to cheat the mass investors into rallying the stock market?

Here is the direct link to the Burea of the Labor Statistics. In the first paragraph:

Employment rose in September, and the unemployment rate was essentially
unchanged at 4.7 percent, the Bureau of Labor Statistics of the U.S. Department
of Labor reported today. Nonfarm payroll employment rose by 110,000 following
increases of 93,000 in July and 89,000 in August (as revised). In September,
health care, food services, and professional and technical services continued
to add jobs, while employment trended down in manufacturing and construction.
Average hourly earnings rose by 7 cents, or 0.4 percent.

Remember that just last month BLS reported that

And that gave away all the excuses for Fed Reserve to cut interest rate. But since $US dollar was free falling. I guess BLS September report becomes the latest booster to $US. The “supposed” error in the August number was close to 100% of the value.

Well, but in the last paragraph of the BLS September Job report, here lies the March revision, downward by 297,000 jobs. It doesn’t take a stupid to figure out that something is quite off. Maybe the birth & death statistics model used by BLS has been skewed heavily towards birth of new jobs, rather than death of old jobs? Here is the last paragraph:

Preliminary Estimates of Benchmark Revisions to the Establishment Survey

In accordance with usual practice, the Bureau of Labor Statistics is announcing its preliminary estimates of the upcoming annual bench-mark revision to the establishment survey employment series. The final benchmark revision will be issued on February 1, 2008, with the publication of the January 2008 Employment Situation news release.|

Each year, the Current Employment Statistics (CES) survey employment estimates are benchmarked to comprehensive counts of employment for the month of March derived from state unemployment insurance tax records that nearly all employers are required to file. For national CES employment series, the annual benchmark revisions over the last 10 years have averaged plus or minus two-tenths of one percent at the total nonfarm level. The preliminary estimate of the benchmark revision for March 2007 is -297,000 (-0.2 percent) for total nonfarm employment.
….

All of the above fishy numbers plus the timing of the reports only tell me that BLS apparently is closely cooperating with other branches of government to financially engineer the markets.

Thinking ahead of the next step in the coming reflation, what would I do to clean up the mess left by Greenspan?

One word, spending (which is the default Keynesian economic solution).

What kind of spending depends on the agenda of voters. However, I think the following industry will probably benefit:

1. Infrastructure: anything that rebuilds the energy, transportation infrastructure, and/or constructions of some sort should benefit. Water and alternative energy are the ones that I can think of, but there can be many other area.
2. Healthcare: with aging boomers, spending in pharmaceutical and healthcare industry probably would increase more than other service industries.
3. Military: with the continuing diversion of strained foreign relationship in Middle East, the military expenses may be ongoing.

By more spending, government could compensate the shortfall of employment in the private industries. Many dollars will go wasted and beefed up unscrupulous government contract bidders/government officials, but they will be just the “necessary evils” that incur as part of the process.

So everything can be made whole? How can any free money/job be created without any consequences? Well, the answer would be that US dollar will continue its descent, and dilute any US dollar holders. I expect that Federal Reserve will continue to support profligate spending in Washington by monetization. By buying up long term treasury bonds, and keeping long term interest rate low, Federal Reserve can keep a higher P/E ratio for stock market, and laying support for crumbling housing market. The only thing that will get destroyed in this gradual process is the value of US dollar. Let’s say the supply of US dollar doubles overnight. Congress can use the new additional trillions of US dollars to boost up the economy, at the expense of diluting the US dollar value by 50%. The obvious losers will be the US dollar and bond holders (China & Japan of course). The lost wealth will then be transferred via government spending to various beneficiaries. The tiny nest egg built by middle class people will be made smaller due to inflation, while the rich and the powerful simply gets even richer in the wealth redistribution process.

Since US government will not dilute US dollar by 50% overnight, it is up to you and me to guard our precious capital against inflation (and tax if possible) before the process is complete.

I don’t know whether it’s alarming to you, but US debt ceiling is going to increase from 8.965 trillion to 9.815 trillion. As far as I can recall, since 2000, such increase in the debt ceiling has become more frequent, and the amount of increase is getting bigger too. Trillion of US dollars goes by really fast in the USA. For any financing shortfall that foreigners and foreign central banks don’t take up, they will end up as pure monetization in the US financial system, and manifest itself as direct inflation. And inflation is the “best policy” for government, since you get to steal another 30% to 50% back via “capital gain”, plus that you can cover yourself up by fudging statistics and the best liar teams at Federal Reserve and BLS, and cut the unofficial inflation rate in half easily. Great, huh? The only thing that US needs to make sure is that it can prolong the confidence game (in US dollar) for as long as possible so that the dilution can last without running into the end-game of hyper-inflation.

Incidentally Mark Hulbert is posting another bullish post “Ahead of the (yield) curve - Commentary: Post-Fed curve much steeper, a good sign for the economy”. I must say that everything of what he said about a smaller chance of recession based on the steepening of yield curve is correct on paper. However, I cannot agree that one can simply use only the yield curve to determine the odds of recession.

For one thing, because the long term bond markets are not collapsing or dropping dramatically after Fed raising interest rate, while the short term interest rates are falling, it appears to be a good sign that Fed still having everything under control for now, except on US dollar index cutting through multi-years support at 80. But based on Bob Hoye’s historical analysis (pg.2 at this link), such post-bubble yield curve steepening is more ominous rather than a bullish sign. Bob’s recent forecast has been quite accurate, and I would trust his words as a market historian rather than Mark Hulbert’s who has been putting out 8 to 9 bullish articles out of 10 this year. Such yield curve steepning according to Bob Hoye is simply part of the post-bubble credit contraction process. Certainly, if long term bond yields start to go up much more, they will simply deepen the housing recession. Now, I don’t care about how accurate the predicative power of yield curve. It is simply a black-and-white matter that housing markets will get worse if the bond yields go up. With the housing bubble unfolding, my only attention would be the absolute level of the long term bond yields, rather than whether the curve is inverted or not.

By the way, if I didn’t make it clear in my yesterday’s post on “is it 1998 or 1970?”, I will now. I believe that more of the emerging markets will be in the 1998-style progression, while more of the senior markets will be in the 1970-style. I think US stock market will be going thru an extended period of sideway with possibly a bullish slant, with $US falling gradually. The best thing for US dollar holders should be trading in this sideway market to make up the $US fall in purchasing power. But you do need to wait for a round of cleansing before jumping into it.

Best luck, and have patience.

I watched quite a bit of CNBC last week. Among other things, I caught the interview with Countrywide’s Angelo Mozilo who called for a recession in no uncertain terms. This of course, is the man who had steadfastly defended CFC’s business while cashing out some $250 million of options in the past year. Nonetheless, the CNBC anchors all went ga ga over this comment and actually put up several economists/strategists of the more pessimistic bend. Long time readers know that I have long held the same view; however, the very fact that the “R” word is mentioned on CNBC about once every 10 minutes may well mean that a short term bottom is in. Sure enough, Friday saw some nice upside action following a strong durable goods report.

While I remain suspicious American consumer’s continuing willingness/ability to pile on debt, I give more credence to the other leg the bulls stand on: strong global growth. Nowhere is this more evident than in China. The Shanghai stock market made consecutive new highs last week to end at 5108. Again recall that not too long ago the ubiquitous worry was for an implosion in the China to bring down global markets. The fact is, since the July 19th peak in US and the rest of world markets, SSEC has gained over 25%. On Friday, FXI, the FTSE/Xinhua 25 ETF, also made a new high, finally confirming the move in Shanghai.

Let me clarify my view on the Chinese market. Many have compared it to the Nasdaq bubble based on price trajectory alone. I will not debate that point. I will even grant that the Chinese market is in a bubble. But in my opinion, that misses the point entirely. Bubbles are grand money making opportunities, during both the expansion and implosion phases if you know which side of the market you’re on! So let’s put emotions aside and look at some relevant recent developments.

First of all, let’s look at some negative factors.

• Chinese exporters enjoy a rebate of value added tax. On June 20, China announced that it will reduce tax rebates on exports of high energy-consuming, resource-intensive and environmentally-harmful products. The measure will take effect around September/October. Given that Chinese exports amounts to 30-40% of its GDP, lowering the rebate is a far more effective way to slow down its red-hot economy than raising interest rates.
• Of course, they can do both at the same time! Chinese CPI was a blistering 5.6% for the month of July. The index was paced by food, especially pork , prices. In response, the PBoC (People’s Bank of China) raised deposit rates by 0.27% to 3.6%, and lending rates by 0.18% to 7.02%. It was the fourth raise this year.
• I’ve always held the non-convertibility of the Yuan as a positive since the individual investor has few choices besides the domestic stocks. For example, some key state owned enterprises have listing in both Hong Kong (H shares, aka red chips) and Shanghai (A shares). But the A shares are far more expensive than H shares because there is too much money chasing the same shares. Two weeks ago I would have said that the day that the Yuan becomes fully convertible would be the top in the Chinese stock market as individual investors diversify out of the country en masse. In a surprise move last week, China declared it would allow individual investors investing abroad, starting with Hong Kong. The news sent the Hong Kong’s Hang Seng index up 10% last week with broader Asian markets following suite. Of course, some capital will be diverted away from the A shares market; on the other hand, this is gradual approach eliminates future shocks. It cools down the domestic market and relieves some exchange rate pressure at the same time – a stroke of genius really.
• The Bank of China (BOC, not to be confused with PBoC, the central bank) and its Hong Kong arm disclosed that they hold $11.25 bn of CDO’s based on US subprime mortgages. The Industrial and Commercial Bank is on the hook for $1.23 bn.
• Recalls of Chinese products, from tooth paste to sea food to toys with lead paints, are grabbing headlines everywhere.

The intriguing thing is that all these happened prior to last week where the Shanghai market had five consecutive up days. You can chalk it up to irrationality but the price action is to be respected nonetheless. In a way, it shows the power of liquidity since Chinese citizens are still pouring money stocks. Let’s now look a few positive factors.

• One of the signs of excess that bears love to point to was the number of new stock trading accounts opened daily. It was somewhere around 100k before the last correction in May. Well, with the market at new highs, that number has increased to 150k or so – TDAmeritrade/eTrade, take that! Anyway, I never understood that logic behind that particular argument in the first place. Common sense says that the flow of money should peak well after the peak of number of accounts open. Besides, while 100k or 150k per day is a huge number, the number of potential investors in China is, well, huger!
• If you’re wondering where all the juice in the Chinese market is from, just look at how fast Chinese wages are growing:
  

  Combined annual wages reached 2.34 trillion yuan ($308 billion) at the end of last year, up from 1.32 trillion ($173 billion) in 2002, representing an average annual rate of increase of 13.5% after inflation, according to a report from state-owned Chinanews.com.cn on official figures released at a meeting put on recently by the China Association for Labor Studies.

  Note this double digit increase is after inflation has been taken factored in. In coastal cities, annual wage increase in the high teens for the college-educated, 25-35 crowd is common. This increased wealth fuels the equity market both by fattening companies’ bottom line from increased consumption, and by channeling disposable income into the stock market.

• Finally, while the health of the export sector may give investors doubts, recent advances in SSEC have been lead by RE developers/construction companies.

Despite new highs in SSEC as well as a clear non-correlation between Shanghai and the rest of global markets investor continue to shun Chinese stocks as indicated by the growing discount in the MS A shares closed-end fund (CAF) that now stands at 20%. For whatever it’s worth, my own view is that aside from the threat of a weak Christmas shopping season in the US, the prospects remain rosy until the Olympics next August.

Disclosure: I own FXI and CAF.

Do you know anything that can quadruple in about 2 years, and wouldn’t take a substantial fall? The rise of Shanghai stock market has every look of a bubble. I think that there is a possibility that international stock markets will fall together with the bursting of Chinese stock market.

Here is a chart of the 2000 high-tech bubble:

The important thing to note here is that it took about 1.5 year for the Shanghai index to double from 1000 to 2000. But it is only taking 0.5 year for it to almost double again from 2000 to 3841. If it’s 0.75 year (or in less than 3 months from now), this index would be on a super-exponential curve: the time for each doubling shrinks by half. In fact, the curve is closing to 4000 level faster than 3 months away. A super-exponential curve is destined to crash if you are familiar with my “Why stock markets crash” article.

Once again, stock markets are probably due a bigger fall in my opinion. Watch out below.

I have been contemplating how I can hedge my portfolio with less risk. I decided to take a look at how Hussman mutual fund managers do it. Using from their semi-annual report, I found out that they had the following outstanding option positions:
Effectivley Long: Call on 10000 S&P 500 index option, expiring 2/17/07 at $1420 strike price.

Effectively Short:
1. Put on 8000 Russell 2000 index option, expiring 03/17/07 at $780.
2. Put on 10000 S&P 500 index option, expiring 03/17/07 at $1330.
3. Put on 6000 S&P 500 index option, expiring 03/17/07 at $1400.
4. Sold Call on 8000 Russel 2000 index option, expiring 03/17/07 at $700.
5. Sold Call on 6000 S&P 500 index option, expiring 03/17/07 at $1250.
6. Sold Call on 10000 S&P 500 index option, expiring 03/17/07 at $1330.

Whether Hussman had gains or losses from these trades, it really depends on how well he timed the market. First, I’m just going to study the hedging strategy these options provide to his portfolio.

His long position basically cancel out short position #2, without regard to the difference in the calendar dates. The rest of positions, only Put can provide full downside protection. Selling calls only allow your downside protection to the strike price. The thing to note here is that at the time when this report is out (12/31/06 I supposed), the price for S&P 500 was at 1418.30, and Russell 2000 was at 787.66. If you take a look at the calls that were sold, all of them were deep in the money. When deep-in-the-money calls are sold, it basically amounts to short-selling with less time premium (but more downside protection to the strike price). The puts that were purchased were mostly at-the-money. With this combination of calls & puts, Hussman is able to provide a downside protection from both of his calls & puts, assuming that S&P 500 stays above 1250/1330, and Russell 2000 stays above 700. The total hedging power assuming that S&P 500 stays above 1330 would be roughly (6000 + 6000 + 10000) * $100 per contract * S&P 500 value + (8000 + 8000) * $100 per contract * Russell 2000 value = 4.38 billion. (S&P 500 and Russell 2000 values are from 12/31/06). Or 2.96 billion if S&P 500 falls below 1330, but stays above 1250. Since the total NAV is 2.84 billion, and total common stock value is $2.89 billion, Hussman had his portfolio fully hedged.

Now if I look at the actual gain/loss from his positions, his effectively long position lost about $5.8 million, and his puts lost about $5.1 million, while his sold calls lost about $8.8 million. If he has not closed out his hedging positions since 12/31/06, his hedging positions would be losing more money by now since overall the market has moved higher. Obviously, his long stock positions are moving higher too to counter the losses from the hedges. But with a total loss of about $19.7 million, he is able to pretty much fully hedge a portfolio value of $2843 million or 2.843 billion. That’s a loss of about 0.7% (on 12/31/06).

Such hedging strategies definitely provide a very good protection when the market falls. However, because of the hedging, Hussman strategic growth fund has been underperforming the general market in the last 2 to 3 years. Such is the cost of being a market timer when the market does not cooperate with your actions.

In the next post “The price of a free(?) hedge”, I will look at my own hedging strategies using stock options of calls & puts in a similar fashion that Hussman has done. It’s certainly much easier to study what others do than putting everything in action. One can be so grandiose about the term hedging, but after all, what it really means is selling out in a certain way. Whether this “certain way” is smart or not, the performance will speak for itself.

P.S. By the way, the pricing/cost between options on futures market and options on stock market is similar (or else someone can arbitrate between the two). The only difference in cost may be simply the brokerage commissions.