As the broader US indexes slip into bear market territory and the Canadian market (S&P/TSX 60) slips into correction mode, there are exceptions. Exceptions that explain the value of sector rotation. Most notable in this case, the materials sector, which is enjoying something of a rally amidst the carnage.

Basically, gold mining companies are enjoying a revival owing to the resurgence of gold as the ultimate store of value in troubled times. Which by any definition is exactly what we are experiencing.

Turmoil in the credit markets continue to lay waste to large swaths of the financial sector. Fannie Mae (NYSE: FMN, US$10) and Freddie Mac (NYSE: FRE, US$7.50) being the latest potential casualties.

One way to play this, of course is to bet on further trouble in US financials and attempt outright short positions on Financial index ETFs or attempt to go short through put option strategies. Although, as you might expect, that’s a pricy proposition. Some might argue… too pricy!

The July options on Fannie Mae and Freddie Mac are trading with implied volatilities of 400% or more. The August at-the-money options were implying 275% volatility. Levels that, on a mathematical basis, are too high to justify buying puts outright. Yet, as we learned from our trade on Lehman Brothers (posted on June 7, 2008), in cases like this, the options market is often right.

A couple of points to consider. The options market is pricing a bankruptcy scenario. Which by the way, is exactly what the financial markets are doing. Consider that the current market cap on Fannie Mae is about one third of its reported first-quarter capital cushion of US$42.7 billion, according to an editorial in The Wall Street Journal. Freddie Mac fared even worse, with market cap falling to US$6.8 billion, compared with first-quarter reported capital of US$38.3 billion.

Clearly, investors are heading for the exits concerned that existing capital won’t be enough to keep the companies solvent in the face of relentless pressure from the imploding housing / mortgage market. If you buy the bankruptcy scenario, then no price for the options is too high.
Which is to say, buy FMN or FRE at-the-money July or August puts.

The other view says that these companies are too large to fail. And the arguments supporting that view are quite strong, given that these two companies back US$500 trillion in US mortgages. But even buying into this scenario, nothing is left for the equity stakeholders, and we will likely see more downside before the Fed pulls the companies back from the brink. A July bear call spread is one way to play this out. With the bear call spread, you mitigate the high cost of the options and hedge the upside if the Fed life line is extended before the options expire.

Certainly, either of these scenarios will not play out in a vacuum. Until we get a definitive position on the status of any bail out, the broader markets (Dow Industrials, S&P 500 composite and Nasdaq) will continue to feel the pressure. Possibly ending with a sharp capitulation before the bail out takes place.

What is interesting, is that options on the indexes have yet to reflect the real concern in the marketplace. The DIA and SPY options are trading at 27.5% implieds. Which means that buying puts on the Dow, S&P or Nasdaq may be the best trade of all.

The final strategy brings us full circle and back to the concept of sector rotation. That is rotating into the materials sector as a way to play a catastrophe from a bullish perspective. For example, buying calls on gold ETFs like iShares CDN Gold Sector Index Fund (TSX: XGD), or fundamentally sound miners like Goldcorp Inc. (TSX: G), or even buying calls on the Materials sector using an optionable ETF like the iShares CDN Materials Sector Index Fund (TSX: XMA).