1. Since the recent market bottom in the middle of July, the divergence in action between a handful of sectors says there’s optimism from equity traders. Optimism, we’ve learned, is dangerous.

The Homebuilders ETF (XHB) is up 35%, the Financial ETF (XLF) is up 25%, and the Retail ETF (RTH) is up 15%. But as Bespoke shows, the only things really pushing close to new highs are the countercyclicals – healthcare and staples. Utilities, oddly enough, aren’t included in that mix – perhaps high commodity prices have them down? Anyways, the few indicators of momentum I do watch have begun to roll over, suggesting that further buying is going to meet much more selling pressure in the coming weeks. What really bothers me is how low the indicators were when they started turning; the last time I looked at these I suggested the prudent thing to do was to be quick to lighten up long trading positions, and I’m worried now how far the next down wave could go. Can anyone say S&P 500 at or below 1150?

I don’t really like exercises like market forecasting, but from a conceptual standpoint I find it useful to ask what theme(s) will dominate the market over the next few quarters, and the impact those will have. Right now, I think there’s too much hopefulness on the equity side coupled with more forecasts that need to be cut to end the year materially higher from this point. Just a guess, though, because it all depends on just how sweeping the GSE rescue plan is.

2. If it’s structured correctly, a Fannie/Freddie bear hug by the government could do enough good in the near-term to offset the price (real and indirect) that citizens will be forced to pay.

Making the government take control of the GSEs is monumental – this is truly an extraordinary time to be following the markets. Lots of people will raise noise about moral hazard, the effect on the dollar of billions more in government liabilities, and similar, but the bottom line (this coming from someone whose generation will pay for the current recklessness and clean up, you’re welcome) is that if this sends a signal to financial players that mortgage paper backing is good, liquidity is present, and Fannie/Freddie spreads come down to the point where the companies have earnings potential, it will be worth it. Whatever the plan is, hopefully it will involve a complete wipe out of the common equity; the market is already pricing it as crap (Caa3 for Fannie, Ca for Freddie) according to Moody’s market implied ratings. Holding common now is pure speculation that shouldn’t be rewarded.

Hopefully the next President will stand behind whatever solution the Bush Administration comes up with, because all hell will break loose if political rhetoric adds to the uncertainty. While it would be preferable if liquidity/capital was provided on an as-needed basis until after the elections to allow for a coherent plan put in place by the people who will actually be carrying it out, preserving the ability for potential homeowners to get a classic conforming loan is crucial given how bad the housing and lending environments are. Just get it done, and please get it done right, so try to get ahead of the next crisis-in-the-making.

3. It is one thing for the government to backstop the mortgage market, but making $50 billion in loans to automakers would be an extreme example of overstepping.

Mortgages are important, they let people buy homes. And whether right or wrong, much of our financial system is structured around and levered to home price appreciation. Most markets are efficient most of the time and government intervention generally does not help, but when crucial markets cannot function, government needs to step in. I wouldn’t blink at $50 billion for Fannie/Freddie, but $50 billion for Ford (F), General Motors (GM), and Chrysler? You’ve got to be kidding me. This is almost like a temporary, backdoor bailout of the Pension Benefit Guaranty Corp., because – at least in the case of Ford and General Motors – those companies are owned not by the common stockholders, but by the pension recipients.

How about this for an alternative while we’re bailout happy? The government takes over three companies, assumes all the existing pension liabilities, and terminates all the remaining promises to the UAW about future benefits. The common of each gets zero – where it’s probably going anyways – with the government retaining all the equity, and then the companies are merged and consolidated down to the point where there is sanity in domestic auto supply.

The existing route I see is basically the American automakers saying they can’t compete for yet another reason – financing costs – that are really just a symptom of their underlying malaise. Nobody wants to finance these companies because they don’t believe they’ll get their money back.

4. The most overlooked part of growing as an investor is understanding risk management.

I’ve been reading Seth Klarman’s Margin of Safety lately, and one of his main points is that investors too often speculate in situations where safety of principle is far from assured. By placing the desire for capital gains ahead of capital preservation, investors take on far too much risk without adequate compensation.

When I think about this in the context of my own learning, I know that when I first started looking at the markets, I saw “opportunity” – the quotation marks are intentional – far more clearly than I understood risk. I think this is only natural in the sense of wanting to establish oneself through outsized returns, but it really is dangerous – especially for beginners who happen to have their first pick or two work out and develop a false sense of confidence.

It might seem odd or otherwise contradictory for me to talk about this when I’m solely invested in one company, but that position was not one taken on with the idea of showing large returns quickly. I simply liked the easy-to-model exposures, and (in a probabilistic sense, at least) the large odds in my favor. This was clash between the axioms of “diversify to stay in the game” and “play for large stakes against disadvantaged opponents,” and the latter won out. I still don’t know how the Primus common (PRS) or debt (PRD) will ultimately turn out, but if I get black-swanned out of that, hopefully this is the start of some small good that will emerge as a consequence.

One of my hopes is that, as I progress in my learning, readers come to see better discussions of risk management at this site, as well as other investing blogs. For those of you who don’t have a copy of Margin of Safety ($1,000 and up on Amazon), I suggest reading David Merkel. More than any other professional out there, his goal is to help investors grow their skill set through the lens of risk management.

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