Holes in the Apparels:

There is an obvious logic-defying bubble in financial stocks. It is very hard to short these stocks with the Fed (ruled by the banks themselves) doing anything possible at the expense of the taxpayer including borderline illegal operations (reminder: Marc Faber, among others, called Bernanke a “criminal” on Bloomberg TV). Even though these large banks are all insolvent, if you had to go through every item in their books and not just book to model or “comparables” (I have heard instances where CMOs were considered in the same league as treasury bonds or were hedged using treasury bonds), they are being kept alive through liquidity provided by the Fed as well as outright transfer of wealth from taxpayers through funnels such as AIG (read Goldman receiving tens of billions) along with the usual fiat money trick of dollar devaluation and erosion of the purchasing power. It is hard to go against the almighty Fed or the almighty God’s representative on earth Blankfein’s Goldman. So one is left with trying to find some other place where there isn’t as much manipulation/corruption and a place where there is less direct government aid outside of a fiscal stimulus package targeting the consumer directly.

The obvious place is retail and especially apparel stocks, many of which are trading at 52 week, if not close to all time highs. These include names such as J-Crew, Urban Outfitters, Abercrombie and Fitch, and Lululemon as well as department stores such as Macy’s. Despite increasing unemployment, which is already at high levels (and we all know that the real unemployment is a lot higher than the 10.2% government number), decreasing income and wealth, an eroding dollar, and a huge recession that is still going on where home prices are still under huge pressure with more to come as foreclosures and delinquencies are properly handled over time (rather than being swept under the rug as they are now trying to give the impression things are getting better) and the resetting mortgages in 2010 and 2011, these stocks are at incredible levels. It is almost as if nothing happened in the last couple years and the go-go momentum years were continuing. Some of these stocks (there are a few others not mentioned here) have P/E values ranging from low 30s to high 70s. These are obvious shorts. Of course it is hard to go against the go-go nature and the optimism that authorities and bubble-TV tries to present to people (such as when 520k people lose their jobs in a week and bubble-TV spins it as a positive that it was less than the 530k that was expected without talking about revisions to prior weeks that transfer some of the losses to prior weeks). So shorting prematurely could be painful. Besides with retail stocks it seems as if the momentum in a certain name lasts for a while as we have witnessed with Lululemon and Under Armor in the past. Similar trends were visible with Urban Outfitters and J-Crew, too. So one would need know how bad the economy will become before pulling trigger. Or you would have to wait to see (as if it already isn’t for someone with half a brain or for someone who is not a liar) the markets go into a downturn again or the company specific bubble to burst as a result of a bad quarter or bad same store sales number, which we have seen with these names being ignored. Considering all this might take a while one can think of utilizing options to participate without tying up too much capital in a couple of different ways.

One would be to buy some close to the money the put options over a period of 6 months to a year (which hopefully should be enough time for the current bubble to burst, as 2010 will be a horrendous economic year) every month or every two months and making a budget for this period, continuing to spend that amount of money with discipline – we know this is tough. The best way might be buying two front months and continuing to roll as the front month options expire or when there is an opportunity to capture a drop in vol. God knows there have been plenty of chances where the market rallies on bad news.

The second way would be being buying a long-dated out of the money put option. The advantage of the first method is that if you get a signal that the markets are starting to go in the direction they should and the it becomes apparent that crisis is not over, you end up having more leverage and you can add on to your position more aggressively. The reason you would be doing two month rolling options is that if the crisis resurfaces and things start moving too fast, volatility and options prices will increase rapidly – you may not be able to buy at the level you want at the price you want. Besides the intrinsic value of the options could fly very quickly all of which would make the puts very expensive and if the front month is close to expiration you might only participate on part of the drop in prices. Whereas if you have the two front month puts, even after the initial month expires, you continue to participate in the drop in prices which is very likely to happen in rapid fashion.

A third way might be to buy the front month option and sell the second month 1x2 or 1x3 ratios fairly wide if you’re concerned about watching all that premium expire. This will lower the cost (somewhat) and as long as you roll every month before expiration and are wide enough in your spread, you are likely not to get trapped on the naked leg. Moreover, unless you’re really unlucky, the second month vol is not likely to spike as much as the first month providing you with ample opportunity to protect yourself.