With a focus on risk management

Government bailouts trying to re-write the life cycle of failing companies may be the biggest Ponzi scheme ever perpetrated on North American taxpayers. And the auto industry may only be the tip of the iceberg.

Who knows how much intervention and government largesse is going on behind the scenes?
All motivated by a political agenda. That is, to hold things together to ensure a smooth transition of power.

This is not new. The Reagan administration was applying band aids to a festering real estate crisis at the end of their second term. And then, after George Bush senior’s inauguration, the Resolution Trust Organization was created in early 1989.

The Obama transition will be similar, albeit on a much larger scale. We know he intends to initiate the largest infrastructure spending program in history. And we can imagine that the markets will react favorably as the size of the package, and the fine points of the strategy, become known.

But then, as the euphoria subsides, investors will get their first glimpse as to the extent of the carnage. That’s when taxpayers begin to file their returns, and we get some hard numbers on revenue and spending. Which likely will be beyond what anyone was expecting!

About the same time, governments at all levels, along with industries like the automakers, will be presented with demands for payment to make up the deficits in those defined pension plans. That number could be in the trillions! And it will start to surface about the same time the big three automakers make their next trek to Washington, in search of another bucket of band aids. That may well be the true test for the market.

Perhaps a second quarter 2009 re-test of the lows. If the markets hold, then we have a bottom. If they don’t, then we will get a bottom. Albeit at much lower levels… say 5,000 for the Dow, or 6,000 for the TSX composite.

A New Year Strategy

If you think the potential downside is fear mongering, that’s a moot point. The issue is not whether the markets have bottomed. The real issue is that investors need to, now, more than ever, focus on risk management. And for that, options can be a useful tool.

At present, premiums are still high enough to warrant option writing strategies. Mainly because 1) we will not likely see significant short term upside in US or Canadian stocks, and 2) volatility expectations will likely decline as the January 20th inauguration approaches.

If I am right, then we might see the VIX in the 25 to 30 range by the January 20th inauguration. After which, the ensuing Obama euphoria – defined as complacency for option traders – could take the VIX down to the 20 to 25 range for a short period.

It is at that point, you want to go long index puts as a hedge. Think of this as a protective strategy to insure against a breakdown below the aforementioned line of support. If the market has bottomed, then you write off the put as a cost of insurance.