He says it is essential to guard against today’s downside risks with trailing stops, inverse ETFs, and put options.

And every investor should have a plan to re-engage with the markets when this financial storm passes.

This from Money Morning:

As the worst financial crisis in recorded market history rocks Wall Street, millions of investors on Main Street keep asking a single question.

When will this end?

The market volatility is unprecedented: Where professional traders once ranked a day as “wild” if we witnessed a 300-point swing, in recent months we’ve seen 600- and 700-point swings on a regular basis. On Oct. 9, a Thursday, we rode out a record-setting swing of 1,000 points.

That wild backdrop is bad enough. At the same time, however, the major market indices are heading lower – at times with a speed and ferocity never before seen. But the real killer is that there is seemingly nowhere to hide.

This is what Wall Street’s Armani Army doesn’t tell you about traditional diversification: It doesn’t work when everything goes down at once. (The one exception is the specialized inverse investment vehicles that we’ve repeatedly counseled you to employ precisely to prevent this kind of total freefall. Two examples that we’ve mentioned numerous times were the Rydex Inverse S&P 500 Strategy Fund (MUTF:RYURX) and the ultra-aggressive “2X” ProShares UltraShort Financials (AMEX:SKF) exchange-traded funds).

Most noticeably, of course, was last Friday’s trading, which began after an overnight bloodbath in the markets overseas. A notice from the CME Group Inc. (CME) that stock index futures contracts were “limit down” – meaning they’d achieved their maximum allowable downward move for U.S. stocks even started trading for the day – didn’t help much.

While much of this is commonly explained away as a panic reaction to the news, the reality is that it’s primarily a financial panic that’s driving this market action lately. And, just in case you recall my comments a few weeks ago about not having seen the hair on fire selling I thought lay ahead, this is exactly what I was referring to.

This time around, ironically, it’s not panic from normally flighty retail investors that’s causing the markets to go haywire. Instead, it’s the big boys that are apparently panicking.

My experience suggests that one or more hedge funds have imploded. Whether by margin call or redemption proceedings is a moot point. We won’t know for sure until much later next week when the newspapers finally catch up, but the massive swings we saw in currencies, gold and other commodities are certainly consistent with an unprecedented liquidation – and a forced one at that. Perhaps even more than one.

Long the domain of hedge funds and their uber rich clientele, many hedge funds were over-weighted in these categories in recent months in an attempt to chase performance. Overweighting, in case you’re not familiar with the term, means they’ve made excess investments in those areas. And chasing performance means they’re trying to create higher returns by making disproportionately larger bets than they would otherwise. Part of this could be from simply trying to generate larger performance fees, but it could just as easily be attributed to anxious managers placing ever-larger bets in an attempt to make up losses (most hedge funds are under water this year).

Where this gets fund managers in trouble is when they make these over-weighted bets by using leverage. You’ve probably heard this term a lot lately. In case you don’t understand what it really means, let me digress for a moment to explain it. Leveraging up (or simply “levering” to those in the industry) means using borrowed money to control a huge pile of assets that you wouldn’t otherwise be able to control.

In recent years, for instance, it wasn’t unusual for a hedge fund to lever up 30 to 1, meaning for every $1 dollar they invested they borrowed $29. As a result, a fund with $100 million under management could control $300 million or more of investable assets. I’ve heard of some funds running 50 to 1, while currency traders routinely run 100 to 1.

While using other people’s money dramatically enhances the potential for higher returns, it really enhances the potential for massive losses. Where this gets them into trouble is that a fund running 30 to 1 only has to lose 3% of the $30 worth of equity to get wiped out, as in kaput.

Somewhere along the way, as bad turns to worse and performance deteriorates, a hedge fund’s creditors will place a margin call, meaning they want the hedge fund to pony up more collateral or return the money it was loaned. Or, investors will place redemption requests meaning they want out. Either way, this forces the operator of a hedge fund to raise money any way it can.

If a given hedge fund does not have enough cash to meet the margin calls or redemption requests, they have to raise cash by selling assets. And they typically start with the most liquid stuff like gold, currencies and commodities. At first, the sales progression will be orderly, but as I suspect was the case last Friday (and on many big down days recently where chaos ruled), it will rapidly deteriorate into a fire sale where the hedge funds involved dump everything they can at any price just to get out.

And that’s where their problems affect you and me.

As scores of highly leveraged hedge funds dump billions of dollars worth of holdings at once, they effectively “flood” the markets with whatever the asset is that they are trying to sell. In doing so, they push the values down for the rest of us.

For an example, imagine a house in your neighborhood selling for 50% of its appraised value. Upon completion of the sale, all “comparables” in the area, including your own home, will likely take a hit as a result. So it’s in everybody’s interest to keep prices as high as possible.

But nobody can do that when there are more homes than buyers – even in the best neighborhoods.
So when is it going to stop?

We don’t know. No one does. Hedge funds are notoriously secretive in their reporting, so even though there are estimates as to how much they own and (by implication) how much they owe, it’s hard to gain perspective on how much leverage is actually being used. Nor do we really know who holds what asset – especially as it relates to potential liquidations.

Over the weekend, rumors were flying that U.S. Federal Reserve examiners are hounding Citadel Investment Group LLC regarding “counterparty risk” and its exposure to debt. Citadel, naturally, vehemently denies this, but lately where there’s smoke, there’s certainly been the potential for fire.

[...] The bottom line is this: What should we do for now?

That’s actually the easy part even though it may not feel like it.

1. If you’re retired, take a good hard look at how much money you really need for the next five to 10 years. Talk to your financial advisor and, if needed, take some risk off the table. Move what you need into cash, or such safety-first choices like the American Century Capital Preservation Fund (MUTF:CPFXX). Do not own anything you would not want to have in your portfolio if the stock markets were to be shut down for a short time.

2. If you’re not retired – but are close – and have properly diversified your money to something akin to the 50-40-10 structure we advocate (50% base-builders, 40% global growth and income, 10% speculative), hang in there. And remember, this is exactly why we diversified our holdings in the first place – to get through the rough spots. It’s just that this is perhaps the roughest most of us have ever seen.

3. Stick to your plan. Hopefully that includes the disciplined use of trailing stops to capture gains and minimize losses, as well as specialized inverse holdings that profit with each further decline. And don’t forget options to hedge existing risks.

4. Above all else, make sure you have a plan – as we do – for re-engaging the markets when the coast is all clear. It may be awhile before we reach that point, but it’s important to maintain your upside potential in a down market. When the train leaves the station, the one place you don’t want to be is left behind on the platform. Studies like those from Standard & Poor’s show that investors can typically make up 80% or more of bear market losses within the first year of a recovery, once that recovery actually arrives.

Source: Four Ways to Sidestep the Damage Wall Street’s Big Money Movers are Inflicting on Main Street

Rick Pendergraft says no bailout can immediately solve the problems in the housing market. And all indicators suggest these will run well into 2009 at least.

Rick says your portfolio should be all about playing safe for now. He recommends eight inverse ETF plays to hedge against this downside risk.

This from Investor’s Daily Edge:

I can understand the fixation on the bailout, but other economic reports are getting lost as a result.

Last Thursday was a day that the mass distraction was working to its full capabilities. Investors chose to ignore all economic data in order to focus on the progress of Congress.

In case you missed it, durable goods orders for August were down 4.5 percent from July (I guess the stimulus checks ran out), initial jobless claims jumped to 493,000 (the highest figure in seven years), new home sales dropped to a 17-year low and home sale prices dropped 11.8 percent (the largest drop on record).

But the bailout is going to solve all of this and it will do it immediately, right?

I don’t think so. Companies are not going to start borrowing tomorrow and banks are not going to start throwing money at people all of the sudden.

Granted the bailout should help stabilize things and keep us from going into an all out meltdown, but it is not going to fix everything and it isn’t going to do it immediately.

I hate to sound like such a doom and gloomer, but if it’s cloudy outside, I am not going to tell you that it’s sunny and hope that you don’t notice.

Last Wednesday, we had a company wide meeting and we were all asked to state what our goals were for each day. My answer was in two parts: my goal is to make my readers money or educate them. It’s that simple.

Having said this, should a bailout agreement get reached before you receive my article this morning (they are feverishly working on it), expect a rally when an agreement is reached and it is approved in congress. But don’t go buying into the rally.

I think this is going to be another case of buy the rumor and sell the news. Any agreement that is reached will cast a sense of relief for the financial sector, without a doubt. However, it isn’t going to solve the underlying problems with our economy.

We will continue to see job loss in the coming months (the September employment numbers will be released on Friday), consumers will still struggle to keep up with their obligations and the housing market will continue to slip for the foreseeable future.

I have expressed in IDE many times that I don’t think the economy turns around until the housing market turns around. Based on the housing reports last week and the inventory of homes on the market, housing isn’t going to rebound in 2008. My guess is that it will be at least the second quarter of 2009 before we see housing start to stabilize, and then the second half of the year may produce an actual upswing in housing.

Until the economy starts showing some improving vital signs, your best bet with your portfolio is to play it safe. Keep part of your portfolio in cash and use part of it to play the downside.

A few weeks ago I mentioned inverse ETFs as a way to play the downside. I received an email from Joan K. asking for a list of inverse ETFs, so for Joan and all of your benefit here is a short list.

ProShares Ultrashort QQQQ-QID
ProShares Ultrashort Dow 30- DXD
ProShares Ultrashort S&P 500- SDS
ProShares Ultrashort Russell 2000- TWM
ProShares Ultrashort Semiconductors- SSG
ProShares Ultrashort Financials- SKF
ProShares Ultrashort Basic Materials- SMN
ProShares Ultrashort Technology- REW

If you want to hedge your portfolio appropriately, you can buy the inverse ETF that most accurately depicts the rest of your portfolio. For instance, if you own numerous technology stocks, to hedge your portfolio you can buy the QID or the REW. The REW is the leveraged inverse technology fund, but the QID should also gain if technology stocks continue to drop.

Source: Once Again, Wall Street Gets Distracted

As my colleague Glenn (himself a former council worker) points out: “The lowest-paid member of staff tends to be the guy who locks and unlocks the office. So if he strikes, you’ve kind of got no choice!”

I’ve been predicting industrial unrest for months now. As I see it, a union’s natural inclination is to demand higher pay if its members are feeling poorer. Right now, the official inflation rate is 3.8%. But if you look at the retail price index (RPI) — the measure commonly used in pay negotiations — it’s 4.6%.

So, people feel poorer, and Unison, the public sector union, has called a two-day strike.

Brendan Barber, secretary general of the TUC, supports the action.

“All they want,” he says, “is a decent living wage. “Claims that decent wages will lead to spiraling inflation are wrong.”

But the sad fact is that these claims are not wrong — and I’ll explain why.

One of the reasons inflation rates — including the higher RPI measure — appear suspiciously low is because they track a whole range of products that we buy.

Crucially, those purchases that are rising most quickly are the very ones we can’t do without — food and fuel. No wonder Unison members are feeling the pinch.

But here we come to the sad truth of the matter. Food and oil prices are set on the global market. Britain is, to use the economic term, a price taker. We can’t influence what we pay for these essentials. That we’re having to pay more for them is a symptom of the fact that we, as a nation are getting poorer.

We managed to mask this fact for a while by resorting to credit. But now the credit’s run out.

To put it in crude terms, we can no longer have as much ‘stuff’ as we used to have. Other people — Chinese, Russians, Indians — want it. And many of them have more money than we do.

Pushing up nominal wages here won’t make the country wealthier. It’ll just mean prices will have to adjust more — upwards — to reflect our straitened circumstances. Wage rises will cause a wage-price spiral.

Either that, or the recession will kick in hard, throw more people out of work, and dampen aggregate spending power that way. This is the sad truth — we’re poorer as a nation, and we have to accept it. What was once a ‘decent wage’ is now an unfordable luxury.

So you can understand why Alistair Darling has reiterated his call for wage restraint. But it’ll fall on deaf ears. Pay in the private sector isn’t the government’s business — and private sector employers will do what’s best for themselves.

Of course, public sector pay is the government’s business. Or so you’d think. But here’s an odd thing. While the chancellor is urging restraint, a spokesman for Gordon Brown says that local authority pay — the subject of the current strike — is not set by the government.

That may be so. But it’s a curious point to make right now; effectively, the government has washed its hands of a problem it expects every other employer to tackle head on.

We’ve not heard the last of all this. There’ll be other strikes — and other attempts by politicians to look tough while being anything but.

Indeed, the thing that will save us is the recession. It’s sad but true that those fearful for their jobs are less likely to strike.

It may be cold comfort, but when the downturn bites hard, at least your bin will be collected.

Name the successful investment

The markets took yet another smashing yesterday. Very depressing stuff.

So, to lighten the mood, here’s an interesting poser I was sent by my colleague Frank Hemsley.