October 6, 2008 Comments

Bailout Passes – Stock Markets Down

On Friday, Congress passed the Emergency Economic Stabilization Act of 2008. Since its peak on Friday, the Dow has gone down as far as almost 1000 points, or nearly 10%. Asian and European markets tanked on opening Monday and the U.S. markets have followed suit. If you’re confused as to why the markets have not rallied in response to the bailout, it is because the bailout has nothing to do with the stock market. If you read my post on the initial defeat of the bailout, then you’ll see that the stock market and credit markets are completely separate markets.

So why are the stock markets down in response to the passing of the bill? Although the bill has passed, the fact remains that credit markets are still failing and it is still difficult to borrow money. The credit markets really act as a fuel for the economy, as they make capital readily available that otherwise wouldn’t be. Capital allows companies to make capital investments (purchase of plant & equipment, i.e. long-term assets) for corporate growth which results in economic growth as well. Consumer credit also allows consumers to make purchases they may not otherwise be able to make if they could not repay them over time. This also helps to stimulate the economy. Without credit the economy suffers. The market value of stocks is fundamentally based on future cash flows (how much money companies are expected to make and grow), so when the economic outlook is poor stock prices will suffer.

It will take time before the situation in the credit markets improve and ultimately the stock markets improve as well. So what can you do to protect yourself? That of course depends on your overall situation and your tolerance for risk. If you are in it for the long haul and you have long positions on some stocks or exchange traded funds that you do not intend to sell, you might want to consider selling covered calls. The VIX (CBOE Volatility Index) is currently over 50, which means that huge premiums are being paid for options. This is premium you could pocket by selling covered calls.

However, one problem with this strategy is that if you are below your cost basis (very likely), you would be locking in losses by selling calls at strikes below your cost basis, if a miraculous recovery takes place before the expiration of the option you sell. If it takes a long time for the stock markets to recover (which I believe it will), you can sell slightly out-of-the money covered calls month after month and help to some of your losses and use your positions to generate income. Another problem with the strategy is that if the stock markets continue to fall rapidly, you’d just be better off liquidating your positions rather than trying to use covered calls for income. The income from the covered calls may not be sufficient to recover continuing losses.

If selling covered calls doesn’t sound like your cup of tea, but you are still in it for the long haul then you probably should simply do nothing. If you can’t stand watching your portfolio continue to fall, you may want to consider selling off and holding on to your cash in an FDIC insured account. If retirement is a long way off, you should continue to contribute to your 401k and IRAs. If you can afford it, you might even want to try increasing your contributions a bit. If you are approaching retirement, hopefully you’ve adjusted your asset allocation accordingly and your portfolio is not heavily weighted in equities. There is one thing I’m certain about and it’s that the stock market will eventually recover. Even in the worst of times, they always do. I take solace in that and you should too.