As I (and others) predicted yesterday, the market sold off today. The DOW closed at 12,099 on Friday. On a weak open today, it swiftly sold off 460 points to 11,634 and is fighting to hold on to the 12,000 level. There were a huge number of sell orders from around the globe this morning, so the market was bushwhacked.

I remain short-term bullish; short-term only. The market should recover some of the lost ground, but this will only be a bear rally. The medium- and longer-term prognosis is not good. Don’t depend on the election year to save the market. I am not counting on the market to recover today, but it may begin a short-term recovery this week.

Some thoughts for covered call positions:

A lot of covered writers are in impaired positions. However, if you write covered calls on a market rebound, you will be caught in the assignment trap - forced to be called out at a loss or repurchase the short calls as the stock rises. It is usually better in this case to simply let the stock recover. If you are short calls at a strike below your cost basis, consider closing the calls and letting the stocks recover with the market.

When a stock recovers enough, consider taking profits on covered call positions or turning them into SuperPuts by purchasing the long-term puts, where the puts are cheap, with very little time value. It is advantageous to construct the SuperPut at a higher level. By example, if a stock ranges from $100 to $110, it would cost a lot to buy the 110P when the stock is $100 - we would pay $10 in intrinsic value, plus time value. But when the stock rises to 110, this is the time to buy the 110P, which offers far more protection.

Implied volatility being about the same, it will cost about the same to buy the 110P when the stock is $110 as to buy the 100P when the stock is $100. So it makes more sense to add the long put at the higher stock price. This is why I am more inclined to establish the SuperPut at highs, at range tops.

On the other hand, puts get pretty expensive when a stock is falling. We pay too much time value then due to high implied volatility. And when the stock stabilizes, the IV evaporates, diminishing the put’s value. A big key to the SuperPut strategy is not overpaying for puts.

If the puts are expensive (more than 2% monthly), it might be better to find another stock. As the stocks fall again with the market - and they will - the long puts will make it possible to write calls on the stocks (and close and trade the calls to generate additional credits) with impunity, since the long put provides a price guarantee.

I look forward to a brief market recovery and to establishing all SuperPuts at the higher price levels. Don’t be discouraged or freaked out by the market volatility. We are about to be in a terrific position to place SuperPut trades and laugh at further market decline, because the long put will make falling stocks someone else’s problem.

Today (Martin Luther King Day) the US stock markets were closed, but the US futures market was open, as were foreign markets. The picture is fairly grim. Foreign markets are down 4% (Canada) to 7% (Paris). Stocks in Europe are now down more than 20% below 2007 highs, which meets technical definitions of a move into a bear market there. The pan-European Dow Jones Stoxx 600 index slid 5.4% on losses from Societe Generale, Allianz and other banks and insurance funds.

The global sell-off has been blamed on lukewarm reaction to President Bush’s stimulus plan announced last week, but the world’s markets have been cocked and primed for this as the credit crunch worsens and the extent of the subprime problem becomes clearer. Negative comments about subprime from a French banking official sent the Paris market down the most of all. They are now trying to erase his remarks, but the damage was done. This was Europe’s worst sell-off day since 9-11.

US futures were sharply down today, as well. Futures were down on the DJIA (520 points), S&P 500 (60 points) and Nasdaq (76 points). Whenever futures are down before the stock market opens, it usually heralds a down market day. Unless futures spike up tomorrow morning (and perhaps even if they do), there is a real likelihood of a further fall in the stock market.

For those who read the tea leaves, this is not good news. Major publications are using the “R” word pretty freely now, along with terms like “global free fall” and “global train wreck.” I don’t know if it’s as bad as all that, but it ain’t good. Things are going to get worse, much worse.

Let’s look at some charts:

The DOW closed at 12,099 on Friday, which is almost 15% below its 2007 high of 14,198 and well below August’s correction low of 12,517. We have a long way to go to reach the 20% mark off the 2007 high (11,358), which would be a technical signal we are in a bear market. The bear is, I have noted on prior occasions, snuffling his way our way. It’s only a matter of time. Is the time now? Maybe, but my money is on a snapback in the market and continuing the rolling pattern it has been in - if we don’t break sharply lower. In the chart below, note how the DOW has broken below its recent trading range, with two closes below the bottom trendline:

The sell off in recent weeks has occurred on increasing volume. The DOW is now testing the low of the Feb-March correction from 2007. Just doodling on the chart, below, I am wondering if we have not possibly seen a head-and-shoulders top to the market?

It looks kind of like a H&S, and the neckline falls rather classically, does it not? If the top was a head-and-shoulders formation, then the market has broken decisively below the neckline. Needless to say, a break (several closes) below the Feb-March correction low will be trouble. I think the old bull still has some legs left. At some point, traders and investors will decide that the market has sold off enough (for now) and buying will come roaring back in. The problem is, the big institutional players actually read and digest the financial news and its economic implications and are bearish. But the problem with going to cash is that so many places we would put our cash also are beset with subprime and similar problems in their asset mix. Hmmm, want to put your money in a bank? Better pick the right one…

What to do?

First, be watching the futures before the stock market open tomorrow, which MarketWatch.com usually covers. Although I rarely trade in the first 30 minutes of the day, be thinking about buying puts to cover long stock. I would consider buying ATM or near-the-money FEB puts on unprotected positions. If the market does not sell off or the sell-off is short lived, close the puts. A short-term bullish sign would be for the DOW to break higher back into (close in) the range it has been making. Even at 9-11, the market didn’t keep plunging, and it won’t this time, either. I will only buy puts tomorrow for the opportunity to profit on them if the market seems to be selling off again, because I expect the market to snap back.

Second, your future covered call writes should be SuperPut-protected. Those who wrote at higher price levels using the SuperPut strategy are not concerned with the market sell-off. Bluntly, it ain’t their problem. This is the way you should be trading. Limit your losses to a few percent of the trade debit, and soon make the trade completely riskless. This is the way to write covered calls, and you can do it all through the worst bear market. In fact, the dropping stock becomes your friend.

I’ll be giving out more information soon about my SuperPut strategy and our new SuperPut lists, so keep watching. A bear market is to be feared only by those who aren’t protecting their stocks properly.

The question on everyone’s mind: whither the market? Let’s see, the dollar’s tanking, the subprime mortage mess hasn’t even warmed up, the housing market is in trouble and it’s getting worse, the economy is cooling (that’s why the Fed cut the rate), etc., etc. None of these things fuel a bull market. I have been saying for some time, as have many others, that this bull market (now nearly 5 years old) will end when corporate earnings deteriorate, since earnings - driven by a good economy - is what starts a bull market to begin with. After all, why would anyone pay market-top prices arrived at during a strong economy once the economy cools and earnings ain’t what they used to be? Exactly! Actually, the market will tank ahead of the real earnings slide as the economy begins to cool in earnest.

But we don’t really want bull markets to end, thus they are tenacious. Does the chart tell us anything? Following is a daily chart of the DJIA. Note that in July the market went from an uptrend into a range as it corrected, the range being marked by horizontal lines - the range is actually kind of classic. But a range is often a congestion pattern, which could indicate an uptrend ahead. Have a look:

TREND
The red trend line could well indicate that the medium-term trend is continuing. Notice how it was thoroughly tested, twice in August, once in September, making higher lows. In this analysis, the market has pulled back again to test the trend line in late September and last week, the low of last week’s test being a tad higher than October’s test low - important because successive tests of an uptrend line should be higher. The Dow pulled back to the 200-MA in August, but except for that, the 200-MA has been out of the action, so it is not very reactive with the Dow.

TRIANGLE?
Note also how the trend line and the top range line indicate that an ascending triangle could be forming, which is generally a bullish sign. The Dow peeking above the range line does not necessarily invalidate the triangle, though it certainly is not a “perfect” ascending triangle. But, the Dow has made consistently higher lows, a hallmark of the AT. Note also how volume fell off as the high was reached in October, also a good sign for the AT.

NOW WHAT?
If the AT is valid, the market needs to break through the upper range line to new highs and hold them, which might not happen until 2008. Will the market continue to fight the increasing weight of negative expectations?

A breakdown below the trend line would invalidate both the trend and ascending triangle analyses. A breakdown would be a series of closes below the trend line indicating that the major uptrend is over and the market is moving into a range; or worse. If this breakdown happens, the market needs to find support at either the 200-MA or the range bottom at 13,000. Not holding the 200-MA would be bad, and a breakdown below the range bottom would be very bad news. One trip down to 12,500 was a correction; another one would be, well, disaster.

So we wait and see. The real question is whether there is enough residual bullishness to move the market higher, especially since the falling dollar isn’t exactly drawing foreign players like bees to honey.

Tomorrow afternoon, Wed. October 31, the Fed’s Open Market Committee will meet and decide whether to again trim the FedFunds rate, which it cut 0.50% at the last meeting to 4.75%. The market is expecting a cut of 25 to 50 basis points, and if there is no cut, I expect a bit of volatility tomorrow afternoon. The market thinks the possibility of a recession is real, despite half-hearted assurances from on high, and a rate cut is needed to convince the market that the Fed is taking things seriously.

But I think the market will not be mollified by patter about inflation or anything else; it wants a cut. An article in the WSJ noted that the FOMC will either take no action or cut another 25 points. I expect a 25-point cut, because they can always cut again, but cannot keep changing it up and down, like Mexico. I don’t think the FOMC will ignore market concerns, but also does not want to signal undue concern about the economy, which a 50-point cut might do.

Be advised that the market could sell off if no cut is announced, and might sell off on anything less than 50 basis points. Some think the market sold off today (Dow down 77 points to 13,792) on anticipation of no cut or a small cut tomorrow, and if this is true, a 25-point cut may not provoke a sell-off.

Implications for covered call writers:

Anyone putting on a covered call position tomorrow should be prepared for more volatility and possibly another sell-off. If the market sells off tomorrow afternoon, consider buying a NOV or DEC put on long stock positions in order to take an extra profit from market volatility, closing the put on the pullback. Be watching the market tomorrow afternoon if you do this, since it sometimes gives head-fakes of a sell-off and then recovers. You can always sell the put.

The market is selling off today, the DOW down 328 points and change as I write this, with the Nasdaq Composite and the S&P 500 down an equivalent amount. It’s the 20-year anniversary of Black Friday, which means nothing except in the human psyche. As I wrote days ago, there still is a lot of volatility in this market. I doubt if the bear market is here, but if the market keeps tanking, I may have to adjust my thinking.

Someone once asked legendary economist John Maynard Keynes whether a position he espoused wasn’t contrary to an opinion expressed at an earlier time. Keynes responded, “When the facts change, sir, I change my opinion. What do you do?” Since I don’t see any reason for glumness, I doubt that a bear market has begun, though when earnings are clearly deteriorating across the board, I may change my mind.

Those who were alert this morning to weakness in the market bought huge amounts of index puts and have been well rewarded for their perspicacity. But how now for covered call writers?

CLOSE THE SHORT CALLS
First of all, you should be closing any short calls if the stock is down with the market pull back, which most are today. Remember that you rack up a nice little credit when buying back the short calls for a price lower than you received upon writing them.

MORE PRICE SLIDE
If you are concerned about a continuing market slide, you could roll the calls down to a lower strike, and then close those also if the stock continues to fall. Be careful about this, however, since if the market and the stock rebounds, you can be trapped in the new, lower-strike calls and be put in the position of having to either close them as the stock advances again (paying more for them than you received) or be called out at a loss. Writing calls at a lower strike when the stock has temporarily taken a dip is a good way to put yourself in the assignment trap.

If concerned about a further slide, consider instead buying a protective put that is two or three months out. It will gain value impressively as the market falls, if it falls. Yet if the market appears to be bouncing back next week, you can close the puts with only a small debit. They put you in the driver’s seat. TIP: After the open next Monday, give the market a half-hour before doing anything; get a feel for direction. if futures are sharply down Monday before the open, get ready for another sell-off day. If futures are up, it could augur a recovery day.

WRITING NEW CALLS AS STOCK RECOVERS
As the market and your stock snap back from this sell-off, don’t write any calls with a strike below your cost basis. Let the stock regain some value, since you don’t want to write calls that you will be forced to buy back.

An alternative technique that can work well when the stock is snapping back from a sell-off is to buy calls ATM or slightly OTM and write higher-strike calls against them. This creates a bull call spread, in which the potential profit is the total spread less the cost of putting the spread on. Or if quite bullish, simply buy some calls. This is a much better technique than writing calls when the stock is down, in expectation of the snap-back.

It is not a cause of major concern when the stock is down with a market pullback. The real concern is when the stock is down on its own. When the market pulls back like this, look for ways to profit from it: “How do I make a buck off this?” is the question to ask.

The falling dollar has, justifiably, gotten a lot of press lately. It should get more. America spends like a drunken sailor on shore leave, far more than we take in. Thus we borrow almost unimaginable amounts of money from foreign governments to finance our spending spree. Recent articles by Ed Ponsi on the weak dollar have been enjoyable for their cogency, if depressing.

But it isn’t Ed who is depressing me; it’s the dollar. As he noted, the greenback has hit a new 15-year low. The Canadian dollar is at a three-decade high against the dollar. The Euro is close to a multi-year high. The big brokerages are calling for further Asian currency strength against the dollar.

Ed’s email today noted that Williiam Poole, president of the St. Louis Federal Reserve branch, had recently described the dollar’s fall as “inexplicable.” Ponsi then noted that 1) we are borrowing about $3 billion a DAY, and 2) Mr. Poole’s Fed keeps pumping more currency into our financial bloodstream, which also devalues it. Of course, a devaluing currency makes borrowing harder and drives up the interest we pay to big lenders, because lenders are being repaid in dollars with increasingly less value.

As Ed noted, the Fed refuses to tell us how much money it is printing because - get this - it is too expensive to compile the data. [The Fed has ignored Ed’s sage advice to simply print a few more dollars to pay the compilation costs.] The administration simply doesn’t want us to know the numbers. The administration pays lip service to wanting a strong dollar, but prefers to let market forces establish the dollar’s value - which the market is doing. Both George W. Bush and Hank Paulson have said so, recently. In other words, Mssrs. Bush and Paulson prefer to let the dollar float on down, because that is what market forces and doing and the only possible result to administration inaction.

The ONLY good thing about the falling dollar is that it makes our products and services more affordable. But since we are not primarily a manufacturing nation anymore, that increasingly is less of an “advantage.” On the other hand, if you order from abroad or travel abroad (which we are doing in fewer numbers) and spend, it simply costs more all the time.

Of course, the poor and elderly on fixed incomes are hurt the worst, because their fixed dollars buy less all the time. I’m seeing Canadians and other investors increasingly loathe to buy and write covered calls on US stocks for fears that the falling dollar will erode any gains made in the account - a reasonable fear. In fact, your bank account, your securities account, your house and every investment you own is becoming worth less by the week. How does that feel?

One not-so-bright spot: the combination of falling dollar and falling housing prices make our real estate pretty darned attractive to foreign buyers. With markets like Orlando taking it up the tailpipe, foreigners can get a vacation place close to Mickey Mouse at reasonable prices - getting more reasonable by the day.

Every time another media dust-up arises about abortion, gay marriage and similar hot-button topics, I want to scream: What about the dollar!?!?!

Well, Washington is not listening to pundits. But it would listen to all of us, woudn’t it? Consider writing or emailing your Senator and Congressman that you want something done about the weakening dollar, and you want it now. If you don’t believe that such actions could make a difference, look what our combined inaction is accomplishing.

The market swooned today and then came roaring back, though it did not erase the entire pullback. Opening at 14,092, the market bottomed today at 13,904 but came back in afternoon trading to close at 13,984.80, making up close to half the drop from Friday’s close. So we finished the day down 109 points and change, which is only a drop of 0.73%. But like a football game that ends as one team is driving to the goal, had the market close been slightly later, the market would have recovered much more of the lost ground, maybe even have gotten flat. Clearly, Mr. Volatility has come to live at our house.

The ostensible reasons for the drop were 1) Citigroup’s earnings report, and 2) $86 oil. Amazing. The market was perhaps expecting glowing news from Citigroup, the largest bank in the country? And did higher oil catch everyone by surprise? Oil companies like Exxon (XOM) and Tesoro Petroleum (TSO) were up today, not surprisingly. And even Citigroup only sold off 1.7% by day’s end.

The correction is I think officially over. But market volatility is not. Everyone is gun-shy, which is why these volatility days occur. Traders rush for the exits to beat bad news sell-offs, which exacerbates the sell-offs. But the market came roaring back, because it’s still a bull market. So the only people hurt are those who panic and sell when the market experiences a volatility down day. These are delightful days for traders buying calls and puts on the market.

Black Gold, Texas Tea
Get ready for $100 oil. Not tomorrow or next week, in all likelihood. But articles have begun appearing in the WSJ and other respected sources, ruminating about how we will handle $100 oil. They have all concluded that we will muddle through. And they’re right; the republic won’t fall. SUV sales have remained strong despite rising oil prices and growing environmental concerns. But that is not my point.

The point is that the powers that be are starting the process of preparing us for $100 oil. Not that I didn’t expect it. Every force we can think of is pushing oil higher - lower Arab production, sharply rising 3rd world consumption; you name it. Russia turns out to have vast reserves, but don’t expect them to flood the world with cheap oil. Like I said, get ready, because it’s coming.

Stock and Covered Call Positions

It is important that stock investors and covered call writers not get panicked by these volatility days. Selling positions at a loss on a simply down day like today hands investors a completely needless loss. In fact, down days like these are perfect for establishing covered call positions: down stock + down market day. When the market snaps back, it gives a nice profit. In fact, this is a perfect time to write out-of-the-money calls.

Covered call writers who want to add some zest to a position would buy the stock on a day when both stock and market are down but only write the call when the market (and the stock) snaps back. This gives a jet boost to the position.

Don’t view market volatility down days like this as irksome problems; see them for what they are: opportunities. But even if that seems too rich for your blood, don’t let Wall Street pick your pocket by taking a loss on these down days.

It almost gets old talking about it - almost. The week before the July 19th beginning of the market correction, I stated in this blog that it was about time for a major correction and that in fact a correction would be desirable and healthy. So when the sell-off began, I was not concerned. That’s what markets DO. When a market, or stock for that matter, goes too far up without a correction, I get very antsy. I want to see the steam blown off. And sooner or later, it always happens. Through August and September, I waded through dozens of articles in magazines and online speculating about whether the bull market was over and a new secular bear market had begun.

The Dow crossed the 14,100 mark yesterday to new highs and settled to close to 14,087. Can everyone breathe a sigh of relief now? Gosh, just a few short weeks ago the Dow was at 12,500. It’s easy to crow when you’ve read the market right, but it also illustrates the adage (spelled out best of all by Larry McMillan) that in order to profit, we have to predict something. We all of necessity form an outlook about the market and specific stocks. We are only human and that is all we can do, but traders and investors must do it in order to function. And when we form an outlook we should stick to it, unless the facts informing our views change.

Where the market will be tomorrow, I don’t know. Or next week. But larger movements in markets are usually predictable to a degree, barring the inexplicable event like 9-11. There are no guarantees, of course, and it is just possible that a new bear market had crept up on us. But while that was possible, I stuck by my guns, not out of stubborness (death to investors and traders) but simply because the facts underlying my market assessment had not changed. Every one of my blog articles stated unequivocally that 1) the market was only correcting, but that the correction would be a big one, because a huge asset/credit bubble is ending, 2) the market would rebound to new highs [done], and 3) that the bull market would have legs for a while longer. I still stick by those sentiments.

Until consumer spending - a huge component of the US economy and thus corporate earnings - falls enough to start degrading earnings, the market should prosper. But the housing and other woes will start to tell on the economy, so sometime next year, perhaps in the spring or summer, I expect this bull to fall from exhaustion.

My point isn’t that I was right, though. It is that I formed an outlook and acted upon it. Had the facts changed, I would have changed my opinion. The wrong thing, though, would’ve been to panic from reading the many articles stating that a bear market had begun and to get out of equities.

But enough beating of my masculine chest… what now?

COVERED CALLS:
As I have also stated many times, now is the time for covered call writers to focus on the large-cap stocks. The internationals are best, since their global cash flow tends to even out local quirks. I am not alone in this. John Mauldin and many others hold the same opinion. As a bull market gets long in the tooth, there is a flight to quality (large-caps) that causes the blue chips to outperform the overall market. The smaller and mid-size stocks will not - as an asset class - perform as well as, much less outperform, the large caps from here on out. Market managers increasingly are rotating out of mid-caps into large-caps.

This is where covered call writers should be. For CallWriter members, look first to our S&P 100, Nasdaq 100 (the large-cap technology sector is doing quite well), and S&P 500 lists. If you are not a CallWriter member (huh?!), then stick to those indicies, however you find trades.

Let’s make some money!

I predicted this market correction a week or so before it happened in July, which subsumes the fact that I consider it a correction - meaning that the market will find the July highs again and go on to higher ground. I’m not always right, so it feels good. 336 points on the DOW today; biggest one-day gain in five years or so.

To recap, I’ve been saying for a while that we’re in the waning stage of a bull market, that a correction was due, that the summer sell-off was a correction only, and that the market will recover to the July level and new highs. Sometimes we really have no clue what comes next, but - love me or hate me - I was rock-solid on this call.

So we recover; but then what?

The bull doesn’t have a whole lot farther to run, that’s what. I’m guessing the stumble will come by next summer, if not sooner. Like a doctor examining a terminal patient, I cannot say the date, but like the doctor, I have no doubts, either. With nearly five years under its belt, how much longer can the bull run, with a global credit crisis occurring and housing dragging our economy down further by the day? I’ve written about this extensively, so I won’t regurgitate it here.

I get emailed newsletters DAILY urging me not to panic, not to lose faith in the market, that the powers-that-be have the potential economic crises well in hand, and that the market will go on to incredible new highs. We’ll see some new highs, yes (barring the other economic shoe dropping too soon), but the market’s end is in sight; get serious. I’m not selling this blog or any newsletter, nor do I market hot stock picks, so these are my actual, unexpurgated thoughts. It’s not about faith or reading the tea leaves, it’s about applying common sense to the data.

When corporate profits start to falter, the market will go bearish for real. Actually, the market will turn south before the cascade of bad earnings, because certain forces always are, shall we say, ahead of the economic curve. But even these “forces” don’t know the “date.”

If you were on the fence whether we’re just having a correction or the bear market had begun, does the resurgence of the brokers like Lehman (LEH) in the last few days provide any reassurance? They have some of the largest credit-crunch and mortgage-meltdown exposure of any, other than mortgage and directly housing-related companies. Yet the brokers are soaring. This would not be happening if the bull were not getting back on its legs. Even Lowes (LOW) and Home Depot (HD) have been showing strength lately, not exactly a bearish sign for the near term.

I know, sigh, we had an artificial boost today from the FOMC, and the Fed can’t cut rates every day. But the market wants to go back up, and this provided a terrific morale boost. The bets placed on a rate cut are winning big.

We’ll probably have a hiccup or two on the way back to the market top, but I am bullish now for the medium term. The market may pull back again one or more times on the way back uptown, and I won’t panic if it does. The market usually surges in November (Halloween Effect), and may well surge earlier this year. Even at new highs, expect a lot of volatility - think of it as lots of chances to trade the calls!

TRADING:
Covered calls have been tough in the last two months for straight writers, though not bad for those adept at trading calls. But better times are a’coming. I think it’s about time to get long, actually. Buying calls or writing covered calls will work for a while yet, as will naked puts. In fact, OTM covered calls should be very productive in coming months as the market gathers its last strength. However, the real gainers, the safer stocks, are the large caps.

If you are not a well-practiced covered call writer, stick with the S&P 100 and Nasdaq 100; or at least the top half of the S&P 500. Quality, quality, quality.

Covered writers and naked put writers should in my opinion avoid small caps and all but the strongest mid-caps with the least exposure to housing woes, because if they fall it could be hard and fast. The market is cutting these stocks VERY little slack any more. A few will be great, yes, but you’d better be able to pick them. You will have a greater comfort level with covered calls on these if buying a cheap, long-term protective put.

The big brokers Morgan Stanley (MS), Lehman Brothers (LEH), Bear Stearns (BSC) and Goldman Sachs (GS) all report earnings next week for the quarter. Merrill Lynch (MER) reports in October. These are all important players on the world financial stage. Their financial results will be a good barometer of how bad the credit crunch in past months actually has been. Bear and Lehman have the most exposure to the credit crunch, since they rely more on fixed income sales, which means they heavily sold collateralized mortgage products, but all of them have substantial fixed income sales. The merger and buyout deals generate gigantic fees for these chaps, and the deals have slowed to a crawl as a result of the meltdown. Here’s where the brokers stood as of 9/7/07:

MS - 62.50, down from 90.00 (-30.5%)
MER - 73.20, down from 95.00 (-22.9%)
GS - 179.00, down from 233.00 (-23.1%)
BSC - 105.00, down from 172.00 (-39%)
LEH - 53.00, down from 86.00 (-38.3%)

Several hedge funds have collapsed, notably two run by Bear Stearns. Even Goldman had to pump $2 billion of its own money into one of its big hedge funds after losses in August. Brad Hintz of Bernstein Research (and former Lehman CFO) notes that the big brokers have substantial exposure to subprime because they securitize mortgage loans by cutting them up into tranches and selling the tranches. But the brokers wind up having to take the riskiest tranches that are exposed to the first losses (growing, and they will become gargantuan in 2008), known as residuals. BSC, LEH, GS, MS and MER have as much as $11 billion of these “residuals” on their balance sheets. They also get stuck with leveraged notes and other assets that no one wants now, because one of the ways they get underwriting deals is to take the paper and gamble on being able to resell it.

The market is waiting to see how much effect the crunch will have, how much their asset holdings (which are marked to market) will be devalued, how recent volatility has affected trading profits (they should be up) and how much the slowdown in M&A activity has hurt profits.

Many financial pundits are starting to say that the big brokers are so devalued that they are bargains. Maybe so, but they may be more of a bargain after next week… unless you think they have not been affected by the sheer immensity of the summer’s crunch and the fact that some of their most profitable activities have been virtually stopped dead in their tracks.

Trading and Call Writing
There will be lots of people shorting these stocks (many already have), though it may not be easy. When short interest gets large enough, where will you find stock to borrow? But even your Aunt Mabel can buy puts or place a bear put spread.

Anyone with a covered call on these stocks and who has not purchased a multi-month put to protect the position might consider doing so. Putting a covered call on these stocks requires such a put at this point. If the stock pulls back and catches support convincingly, the put (which will have increased in value with the stock’s drop) can be sold at a profit. Or the put can be exercised if necessary. Unprotected covered calls simply will have to ride it out, although the calls can be traded with the stock’s movement to produce trading profits.

These brokers are some of the most important financial companies in the world, so they are unlikely to vaporize. Bear Stearns is the greater risk and has been scaring people, Lehman is the next most likely to take a large hit. But the problems affecting the brokers are not resolved and not at a crescendo yet, either.