Macro Tsimmis

intelligently hedged investment

BUY ProShares Short Financials ETF (SEF)

Posted by intelledgement on Mon, 25 Jan 10

For a year now, we have been complaining that the Obama administration has totally failed to deliver “change we can believe in” with respect to the most important issue affecting the USA—managing the economy.

The G. W. Bush administration presided over the terminal phase of a real estate bubble that was exacerbated by lax and irresponsible regulation (to be fair, the real estate bubble was stoked by the Clinton administration and easy money policies go back further than that). When it finally blew up in our faces in 2008, instead of working to fix the problems—letting the overextended companies go bankrupt, working to reduce deficit spending and strengthening the dollar, and putting in place regulatory reform to address dark markets, overleveraging, and naked short selling—we instead attempted to paper over the problems: prop up all the troubled companies with toxic assets, extend artificially low easy credit, inject massive amounts of liquidity thus further weakening the dollar.

Enter the Obama administration, whose leader had decried the policies of his successor. But ironically—and to our dismay—when it came to managing the economy, it’s been hard to tell that there’s been an election and change in control of the government. Here it is a year later, and we are still propping up the companies that had failed and should have gone bankrupt (AIG, Fannie and Freddie, Citibank, GM et al), still maintaining 0% interest rates, our debt levels are up since January 2009, the dollar is down 9% year-over-year, and we still await meaningful regulatory reform. Only the names have been changed to protect the…oh, wait…nevermind…Obama even has the same folks in charge of the economy that G. W. Bush did.

Until—perhaps—last week.

Last Thursday, Obama announced proposals to restrict banks with Federally-insured deposits from conducting proprietary trading and from owning or investing in private equity funds or hedge funds. While the details remain to be spelled out, it appears that this is an attempt to transform savings bank/mortgage writing activities into a utility-style of business—heavily regulated, with limited profitability and insulated from more aggressive financial activities. Given that we have consistently criticised Obama (and previous presidents) for essentially taking their cues from the same guys that got us into this mess, it is bracing to finally see a policy proposal from him that did not have a stamp of approval from Goldman Sachs sputniks Larry Summers and Timothy Geithner.

Now, we don’t actually think much of these particular proposals. Had they been in effect in 2008, they would have applied to Citibank and JP Morgan Chase, but not to Bear Stearns or Lehman Brothers or AIG or Fannie or Freddie. And of course they would have done nothing to address the policies of easy money and easy credit that stoked the real estate bubble. And nothing to regulate the dark markets through which these bad loans were securitized and distributed. On the margins, it’s not a bad idea to insulate savings banks from what amounts to financial chicanery, but if on the other hand the government is still encouraging such chicanery…well, we can’t seriously expect to get healthier with this course of treatment; about the best we can hope for is to get sicker more slowly.

But when the car is going the wrong direction and you change drivers but keep going in the wrong direction, finally changing the navigator is a good sign.

So if this is (potentially) good news, why are we shorting the financials here?

Well, as much as we enjoyed watching Geithner squirm as he pretended to agree with these proposals, in the final analysis, we do not expect the Obama administration to substantively reverse course here. To truly put things right—reduce deficit spending, support the dollar, cease propping up zombie banks, enforce already-existing regulations limiting leverage, naked short selling, and other financial shenanigans which have largely been winked at for decades—would be painful. Painful in the short term for everyone, and in the longer term, for a lot of powerful folks from New York to Washington to London to Beijing. If Obama were of a mind to tackle that Sisyphean task, he should have started a year ago, when he could clearly have blamed everything on G.W. Bush and might have had a chance to make enough progress by 2012 to be re-elected. Now he has followed the same path as G.W. Bush for a year and we are a year further down the wrong road—whose fault is that? Even if he wants to reverse course, he lacks the moral authority and time to succeed.

So what is driving this conniption? We think it’s the loss of the Senate seat held by Ted Kennedy to the long-shot Republican challenger Scott Brown last week that has clearly energized the Obama administration to position themselves as less friendly to “Wall Street.” And folks, this is not positive energy we’re talking about here. The reality is that we have a capitalist system that is debilitated and the spectacle of the government vilifying the banks for no end other than political expediency is most definitely not a step towards healing. Politicians fighting for their (political) lives are not likely to make statesmanlike decisions and exhibit restraint; things are apt to get ugly. That is to say, more ugly.

And if we have misjudged Obama, and he truly does make an attempt to change direction here, then we will really see some economic and political turbulence.

Actually we think Bush-Obama troops have done a decent job, considering the size of the problems we have, sweeping them under the rug once again. Thus we could well get a continued overall market rally so long as job losses continue to slow and consumer spending does not decline further. But we don’t believe the financial sector is likely to lead such a rally. Thus it is a logical choice to short here, as insurance against a downturn sooner than we expect.

Thus we are buying the ProShares Short Financials ETF (SEF) here. This ETF is managed with the intent of obtaining a return of -100% of the Dow Jones U. S. Financials Index each single day. Thus the value of each share of the ETF should go up when the index declines, and vice versa. We have shorted the financials twice previously, both times utilizing the Proshares Ultrashort Financials ETF (SKF; this fund seeks a return of -200% of the Dow Jones U. S. Financials Index each day)—we made compounded annual growth rate profits of 45% and 5% respectively on those trades, but in light of our analysis that leveraged ETFs don’t perform well over time, we are going with the SEF this time around.

Previous SEF-related posts:

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