A Hedge

Typically my views on the overall market is never overly optimistic or pessimistic. I tend to look at valuation and that what guides my investment decisions. I tend to dismiss most writings that discuss an overly bullish or bearish case on stock market direction, as no one really knows the direction of market prices. Moreover, I do not understand people's obsession of calling bottoms or tops, for me it is always a valuation issue. There are two cases to be made for the current US market: a bullish case and a bearish case. I will review reasons for each case.

10 reasons to buy US equity, courtesy of BlackRock CEO:

Investor and consumer sentiment measures are very pessimistic, which often marks the bottom of equity market falls.

Monetary policy in the United States is being eased earlier and more rapidly than is usual.

U.S. households are about to get fiscal stimulus checks from the government.

The current earnings recession of negative year-over-year comparisons will last four quarters. Q2 2008 will be the fourth.

The cheap U.S. dollar means boom conditions for U.S. exports, a significant offset to the residential real estate recession.

The health of the non-financial corporate sector remains strong, with healthy cash flows.

Credit-related downturns often include the failure of an important financial organization, followed by double-digit growth in the S&P 500 .SPX. The failure of Bear Stearns on March 17 has passed.

Credit markets have improved noticeably since Bear Stearns' failure.

Technical factors have also improved since March 17, including the fact that up-day volume has been heavier than down-day volume.

The earnings yields of equities compared with 10-year Treasuries are at their best level in 30 years.

So why not to be too bullish, my views:

1. Inflation growth will eat away at corporate earnings and consumer ability to spend.
   
2. Credit crises will dampen earnings growth. The ability to borrow by businesses is critical for economic expansion and without it many growth plans are halted and so is earnings growth. As long as we are in a credit tightening cycle I do not see how a sustained growth in earnings going to be achieved in the following year or two.
   
3. US economic weakness will eventually make its way to the global economy and will reduce US international earnings. Global economy demand is lagging the US economy and will soon feel the affects of the slowing demand of the US. The US is still a large chunk of the global economy and it sluggishness will have an impact.
   
4. Residential real estate is still far from stabilization and recovery.
5. Rich valuation for the entire market. I wrote about the US market valuation here.
6. Global banks are in trouble and yet to find stability in their capital needs:
1. Bank Stock Valuations Are Still Excessive:
• Current stock valuations of the Top 50 banks relative to historical valuations, remain expensive -- even with the recent poor performance.
• The Top 50 banks' forward 12-month P/E ratio stands at 13.2x, which is roughly one standard deviation above the mean (25-year avg of 10.9x).
• During the trough of the last two bank stock bear markets, 1990-91 and 2000-01, P/E ratios for the top 50 banks declined to 5.7x and 10.1x, respectively.
2. Recessionary Forces Will Lead To Bigger Credit Quality Problems:
• In prior recessionary periods, credit problems typically followed as a result of the weakening economy.
  
3. Loan Loss Reserves Are Too Low:
• Bank management teams will often claim loan loss reserve adequacy only to boost reserves in subsequent quarters. BofA has boosted its reserves substantially in its latest quarters other banks have not takes such conservative steps and may have to report lower earnings in the future.
  
4. More Credit Problems may be in store for Banks :
• If the economy deteriorates significantly then commercial real estate, construction and leveraged loan portfolios have significant room to weaken in 2008 and cause write-offs.

So where does this leave me? I still look for undervalued companies as I thinks some companies have declined by more than they should given the US slow down. However given my estimate the the US market overall is still overvalued given the backdrop of economic events, I have taken a short position on the S&P 500 by buying puts.

I have bought December 2008 SPY 120 puts at $3.6 per contract. The puts will act as a hedge for my stock positions. The case for the position is as follows:

Scenario	Return	Pay off $	Probability	Prob. Weighted
Decline	(10%)	+2.8	55%	+1.54
Trading range	0%	-3.00	30%	-.9
Increase	+5%	-3.6	15%	-.54
				+.10

The option has a delta of $.2, so for each point decline in the SPY I earn $.20. I expect a 10%, or 14 points decline, so that translate to $2.8 expected pay off. Theprobabilities outlined in the table works to give me an expected payoff of 3%. I am fine with such a low payoff as I continue to allocated more funds to equities in the meantime, so if the market recover, the returns on those equities willoutweigh my loss.