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The financial markets are in turmoil.  Nobody disputes that.  The mystery is how we are going to get out of the mess, and how we will prevent a similar mess in the future.  But in an election year, both presidential candidates are scrambling to present their solutions to the mess.  The most interesting solution comes from John Mccain.  McCain has always stated openly and honestly that he knows nothing about economics or finance.  It’s no surprise then, that his solution is to authorize a high level commission to study the turmoil and find out what went wrong.  Such a high level commission would surely cost American taxpayers millions of dollars.  What McCain does not realize is that the exact cause of this crisis has already been conclusively determined. (Hint:  Housing Bubble)  The cause is clear, the damage has been done, and the American public is simply looking for a path out of the mess.  And they are looking for a path that does not put the taxpayers on the hook for bailing out incompetent banking and brokerage CEO’s.  If McCain is serious about leading the country out of the mess, he should stop reading Age of Turbulence, and instead concentrate on the following books that explain the mess:

Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve by William Fleckenstein

Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments by John Waggoner

Bear-Trap: The Fall of Bear Stearns and the Panic of 2008 by Bill Bamber

As expected, the market sell off today was brutal and far reaching. The Dow Jones and the S&P were off 4.4% and 4.7% respectively, and according to the futures, the sell off will continue in tomorrow’s session as well. Some say “the trend is your friend”, and would advise you to just short the collapsing markets. But the turn around could be painful when the institutions pile on to pump up the shares and crush the shorts. And just when they see everyone covering, they are sure to pounce on the shares again and resume the painful sell off.

As the markets continue the downward trend, more and more people are piling into safer but lower return instruments such as bank CD’s and treasuries. For those who insist on staying in the game (Wall Street is the biggest and best poker game on earth), there is a simple strategy that all the best traders employ. It’s called “balanced trades” by most people. I call it the “hidden jewel in the shorts”.  As an aside, hidden Jewel is also a rock climbing term that signifies that secret and tiny finger pocket at a critical juncture of an otherwise blank and featureless wall.

The art of balanced trading refers to maintaining a healthy balance of both long and short positions.  My hidden jewel in the shorts implementation refers to shorting an index, while simultaneously going long a small portion of that index that is the best of the crop – the hidden jewel.

Consider the basic materials sector, which is under significant downward pressure of late.  Proshares offers an ultra short basic materials ETF (SMN), which attempts to produce a performance of twice the inverse performance of the basic materials sector.  The top five components of the sector are Monsanto, Freeport McMoRan copper and gold, Du Pont, Dow Chemical, and Praxair.  The ultra short fund acts as the short side, and the trick is to find the hidden jewel in that pack of shorts that will hold up better then the shorts, and balance out the combination trade.  It’s a completely subjective exercise, but assume for the moment that your hidden jewel is Dow Chemical (DOW).

At the beginning of the quarter on July 1st, SMN closed at 29.52 and DOW closed at 35.17.  Purchasing 100 shares of each would set you back a total of $6,467.  SMN acts as your downside protection (the “Shorts”) while DOW acts as the “Hidden Jewel”.  Taken together, the pair trade acts to maintain a little more stability in your account and reduce the overall volatility and price swings.  As of today, SMN closed at 44.93 and DOW closed at 35.14.  The combined position – “Hidden Jewel in the shorts strategy” – rose in value from $6,467 to $8,007, for a return of nearly 24% since July 1st.

Keep in mind that this is just one example of the strategy, and not a recommendation going forward.  But if you do insist on staying in the markets, and you are tired of the wild fluctuations or huge declines in your account, you may want to search out and find your own hidden jewel in the shorts.

If you thought shares of financial firms were collapsing  last week, just wait until U.S. markets open tomorrow morning.  Lehman, which was on the verge of collapse last week, was not able to secure a weekend deal to save itself.  Weekend long jam negotiation sessions with Barclays and Banc of America failed to bring a buyer for the 158 year old firm.  And federal officials are reluctant to rescue any more incompetent financial firms with taxpayer money, due to the public opinion revolt that resulted from previous bailouts of equally incompetent firms Bear Sterns, Fannie Mae, and Freddie Mac.

The Lehman news had a strong affect in Asian markets, with shares in Australia, Taiwan, and Singapore all down sharply.  Markets in Japan, China, Hong Kong and South Korea were closed for public holidays.  The futures reading on the Dow is predicting more then a 300 point drop when markets open.  But despite the governments advertised statement of not commiting additional tax dollars for rescue attempts, the bailouts are expected to continue in a more stealth fashion.   The federal reserve is expected to expand its lending facilities to incompetent financial firms, expanding the list of worthless securities it would accept as collateral for new government loans.

T Boone Pickens likes to portray himself as an environmentalist, but deep down inside, he is just a capitalist, wanting to get richer from your hard earned tax dollars.  The Pickens Plan is flooding all areas of the news lately.  At the surface, it seems logical – reduce dependence on foreign oil, and aggressively pursue environmentally friendly energy sources.  But in reality, T Boone Pickens is just begging congress for handouts to support the growth of his wind energy companies.  And those T. Boone handouts are making progress, with congress introducing measures recently (Max Baucus and Chuck Grassley) to give Boone the money he is asking for.

But wind is not the only catalyst for T Boone Pickens to steal your tax dollars.  He has also bought significant water rights throughout Texas, and also bribed lobbied government officials to create a town out of the land he bought above the Ogallala fresh water aquifer, the largest in the United States.  The plan is that this new town can sell water directly to municipalities, including Dallas, netting T Boone Pickens potentially hundreds of millions per year.  And the United States government is willingly picking up the tab for the dual purpose wind and water land under the false presumption of “reducing dependence on foreign oil”.

If you are trying to steer clear of mortgage backed securities and all those clever tranches of Moody’s “AAA” rated debt, then you may want to steer clear of Fidelity “Government Bond” funds.  Take a look at the current holdings of the Fidelity Government Income Fund (FGOVX).  Notice the circled “MBS Passthrough”, which according to the Fidelity representative I just talked to, refers specifically to those clever mortgage pools that were supposed to be as safe as government bonds.

If you are looking for a real government bond fund, safe from all the MBS garbage, then you may want to consider the iShares “Lehman short term treasury bond fund” (symbol SHV).  According to the iShares website, it has a low operating expense of only .15%.  It trades as an ETF, and it is nearly 100% invested in short term United States treasuries.  The listed 5 year annualized return on the shares is only 3.26%, so you probably won’t get rich buying it.  But then again, you probably won’t encur massive losses from all the other supposedly “AAA” rated “Government Bonds”.

Do you remember DIG DUG, the famous arcade game released in 1982 by Namco?  The object of the game is to eliminate underground-dwelling monsters, either by inflating them until they pop, or by digging up and dropping rocks on them.  Perhaps the managers of proshares were fans of the game, or perhaps they just ran out of interesting letter combinations, because DIG and DUG are more then just the components of the 1982 game.

In the land of proshares, leveraged ETF’s, DIG is the ETF to  attempts to match twice the performance of the Oil and Gas sector.   And DUG is the opposite, attempting to match twice the INVERSE performance of the Oil and Gas sector.  Both have been around for quite some time, but with the recent volatility in the energy sector, they are both seeing increasing trading interest.  And the good news for options traders is that both of these ETF’s are optionable.  They usually have high implied volatilities which are great for selling calls against.

Similar to the proshares DIG and DUG, Rydex Funds also offers double exposure ETF’s.  Their energy ETF’s are REA, which is exposed to twice the upside performance of the S&P Select Energy sector, and REC, which is exposed to twice the inverse performance of the S&P Select Energy sector.

Apple held it’s Let’s Rock event today to unveil its new iPod line and iTunes offerings.  The iPod nano offers a taller and more colorful look.   It is the thinnest iPod to date, includes a few enhancements (accelerometer, shake to shuffle), better battery life, and a lower price.  The 8GB version now goes for $149, and a new 16GB model sells for $199.  The iPod classic also gets a minor upgrade, with the 120GB version selling for the old 80GB price of $249.  The iPod shuffle got a few new colors, but no improvement in pricing.

The long awaited iPod touch disappointed the crowds.  Apple missed its opportunity to challenge Garmin in the GPS navigation wars and released the new touch with minimal changes, and without GPS.   The new touch, however, does include new 2.1 firmware, support for Nike+iPod, built in speakers, and a new genius playlist feature.

Itunes 8.0 was also announced at the event.  Apples’s description of “Genius”:

Play a song, click the Genius button, and iTunes creates a playlist of other songs from your library that go great together. Genius playlists help you discover songs in your library you never knew you had — and rediscover forgotten favorites.

With itunes 8.0 also comes the availability of HD television shows, and a few other fluff changes, such as Grid View (shows your library using cover art), and a Visualizer app that lights up your desktop to the beat of the music you are playing.

The United States press is not the only place we are seeing calls for a dollar rally.  The United Kingdom Times Online has a story very well worth reading, Profit from a plunging pound.

They are predicting continued weakness in the pound, and advising British citizens to “Invest in America”.

The pound has fallen 16% against the euro over the past year and hit an all-time low of €1.23 last week — compared with €1.47 this time last year. It also hit a two-and-a-half-year low against the dollar, falling to $1.77 — down 12.4% on the year and 16% from its peak of $2.11 in November.

Related Reading on dollar rally call:

• Preparing for and playing the dollar recovery – bye bye euro
• United States ranks 51 in Nationmaster debt to GDP

This country may participate in capitalism on the way up, but the rules have changed on the way down. Socialism, in the form of massive government bailouts of private enterprises, is the prevailing theme of the day. The Freddie Mac (Fraudy) and Fannie Mae (Phony) bailout news story is everywhere, so I won’t add my own summary here. But I will provide links to some noteworthy worthwhile reading:

• Statement by Secretary Henry M. Paulson, Jr. on Treasury and Federal Housing Finance Agency Action to Protect Financial Markets and Taxpayers – Take note of paragraph 11 quote from Paulson,  “I have long said that the housing correction poses the biggest risk to our economy. It is a drag on our economic growth, and at the heart of the turmoil and stress for our financial markets and financial institutions. Our economy and our markets will not recover until the bulk of this housing correction is behind us.”  My question to Paulson is simply where was he during the huge and unstable run-up in housing prices that caused all the mess we are now seeing, and are likely to see for a long time to come?!?!?!
• New York Times summary of takeover
• Bloomberg interview with Poole, estimating $300 billion loss to Government and taxpayers
• Big Picture summary of 10 key points of bailout
• First look inside Fannie / Freddie bailout plan

Also check out these books:

Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments by John Waggoner

Bear-Trap: The Fall of Bear Stearns and the Panic of 2008 by Anonymous

Too Big to Fail: The Hazards of Bank Bailouts by Gary H. Stern

From Buildings and Loans to Bail-Outs: A History of the American Savings and Loan Industry, 1831-1995 by David L. Mason

Fannie Mae And Freddie MAC: Scandal in U.S. Housing by

This weekend the government has taken control over Fannie Mae (“Phoney”) and Freddie Mac (“Fraudy”), with your tax dollars.  The markets are behaving as if all the financial turmoil and the mortgage meltdown has ended abruptly.  Both major averages are up significantly – the Dow Jones up over 2% and the S&P 500 up ove 1.5%.  But according to the volatility index (^VIX), which is also going up along with the market (NOT NORMAL), it may be wise to remain cautious, or hedge your positions accordingly.

Related Reading:

• The volatility clue to the market