Further Reducing Equity Exposure, At Least for the Moment

A new wrinkle in the financial crisis has caused us to purchase some protection against further precipitous market declines.

In a post titled, International Trade Seizing Up Due to Banking Crisis, author Yves Smith cites contacts saying that some banks aren't writing international letters of credit (assurance than an exporter will get paid for the goods he's delivering to the other side of the world). If this kind of news continues, exporters will be less willing to ship goods, we could start seeing some empty shelves, and U.S. exporters will suffer too. There are government agencies that can step in and offer letters of credit, but this may take time.

To purchase protection, we bought the SDS (ProShares UltraShort S&P 500) and RWM (ProShares Short Russell 2000). We purchased these ETFs (exchange traded funds) because they go up when the S&P 500 and Russell 2000 go down. SDS is supposed to go up at 2x the rate that the market goes down, and RWM is supposed to go up at the same rate that the market goes down. We purchased both to compare how they behave in reality. We're a bit nervous that their mechanisms for tracking the indices inversely are loosening amidst the market's turmoil, and we want to further investigate this risk. But "short ETFs" are the quickest way for retail investors to make money if the market declines. We made the purchases in our taxable account because we think we'll have enough tax losses this year to offset gains in these ETFs (which are taxed 60% long-term and 40% short-term).

And to reiterate a comment from our last post, it's important to be ready to reverse such "short" positions quickly, because equity markets have been known to rebound with lightening speed from panic troughs.