“When the Bubble Bursts” Part Two

By Travis Johnson, Stock Gumshoe, August 10, 2011

Yesterday I started looking into some Mark Skousen-teased ideas for ways to profit when the Chinese bubble bursts — today, as promised, we’ll steer the Thinkolator further along this same path and see if we can identify the other ideas he pitched. If you missed part one of our journey, you can see it here.

Right to it, then! Hints, please:

“‘Bubble-Proof’ Profit Opportunity #3: Shorting the Chinese Stock Market

“One of the best things about ETFs and the other new investment vehicles is that they make it possible for anyone to make the kind of ‘sophisticated’ trades that only professionals used to make.

“Example: ‘Shorting’ — a way to profit from something that goes down. As when hedge-fund honcho John Paulson famously bet in 2007-8 that the housing and subprime-mortgage bubbles would burst — and walked away with a cool $20 billion (give or take).

“So, how can you make a bet like Paulson’s that allows you to profit from the bursting of the China Bubble?

“Answer: through an easy-to-buy ETF that allows you to short 25 of the largest and most liquid Chinese stocks listed on the Hong Kong Stock Exchange (HKEX). When these stocks go down — as most of them surely will when bubble bursts — this leveraged fund allows you to earn double in profit the amount of their losses. If the market goes down 10%, this ETF will be up 20%.”

So who is it? This one, my Gumshoe friends, is the ProShares UltraShort FTSE China 25 ETF (FXP).

If you’re not familiar with the “short” and “ultrashort” ETFs, they essentially aim to do just what Skousen says — they use derivatives and swaps to mirror the performance of a particular index, you can find short ETFs for most major asset classes now and they are expected (on a daily basis, not long term) to do the opposite of the index. “ultra” short ETFs are those that also leverage the return, so in this case the ETF is expected to move twice as far as the FTSE China 25 Index, and in the opposite direction.

It’s working today — the FTSE 25 ETF (FXI) is down about 4.75%, and the UltraShort ETF (FXP) is up about 9.5%. They don’t always work as cleanly as that, and investors often find that holding these kinds of leveraged short ETFs over a longer period means the overall performance lags the expectation in part because of tracking error and in part due to the greater impact of compounding on leveraged funds, but for short periods they usually work pretty well — these are designed for traders, not for investors. There was a good article in Barron’s a couple years ago that explained some of the problems with leveraged ETFs, you can see that here (and that was a time of China turmoil as well, so they actually used this example of the FXI and FXP).

But yes, on days when the Chinese “red chips” are down, this ETF should do very well. The FTSE China 25 that you’re betting against is an extremely financials-heavy index, by the way, it is made up of most of the huge Chinese banks as well as the well-known premier large cap Chinese companies like China Mobile, CNOOC, Sinopec, and Ping An Insurance. Very few of these companies are trading at expensive valuations or subject to the same kind of fear as the sneakier little Chinese reverse merger stocks, and most of these companies are state-controlled (to differing degrees) — this is more like the Dow Jones index of China large caps, so it’s a reasonably clean bet against the broad Chinese economy but will especially move based on the performance of the big Chinese banks.

And if you’ve other stuff you want to bet against there’s a pretty decent list of the short, ultrashort and ultra-ultrashort (3X leverage) ETFs here that looks pretty complete, though new ones seem to come out nearly every day. Be careful with these, but they can be a fun way to make small bets or hedging trades — and some of them even have options trading available, so you can imagine how wild the options move on a thrice-levered ETF during chaotic market moves. Take your Dramamine and enjoy!

Moving on!

“‘Bubble-Proof’ Profit Opportunity #4: The Ultimate Hedge Against Financial Crisis

“Gold traditionally is a good investment during a crisis. No wonder it’s no longer just “gold bugs” who are putting their money into gold — it’s master investors like George Soros and John Paulson.

“Durable and highly liquid, the economic forces that determine the price of gold are different from the economic forces that determine the price of many other asset classes such as equities, bonds or real estate. A potential safe haven from the uncertainty of economic events, political unrest and high inflation, gold offers investors an attractive opportunity to diversify their portfolios — potentially reducing overall portfolio risk and ultimately preserving portfolio wealth…

“In short, every investor should maintain a position in gold — and so should you. The question, of course, is how?

“The unique gold fund I’m recommending allows you to participate in the gold bullion market without the necessity of taking physical delivery of gold. By eliminating the complicated logistics that go into buying, storing and insuring gold, this fund makes it easy and inexpensive for you to use gold as an asset allocation and trading tool.

“… I’ll tell you all about this fund — and why it’s by far the most cost-efficient and safest way to invest in gold.”

Well, duh. If even Jim Cramer is touting gold every morning on CNBC, and big hedgies have been accumulating the shiny stuff for years, and it has gone up dramatically during the last week of market wackiness, I think we can all agree that investors are looking at gold as one of the few “safe haven” places to stash their cash right now. I personally think of gold as a way to diversify my savings, not as an investment, but that doesn’t mean there isn’t a lot of speculation in the stuff — and ETFs are one of the best ways to speculate.

Skousen could be teasing any of the physical gold ETFs, but I think it’s extremely likely that he’s pitching good old GLD — the SPDR Gold Trust ETF. This is the original gold ETF, and it is by leaps and bounds the largest and most liquid — the trust basically just manages a gold hoard, buying and selling it as necessary when new shares are created or existing shares are redeemed by institutional holders, the gold is held in HSBC’s London vaults and the net asset value of the gold is published on their website (spdrgoldshares.com), the goal is for the price of the ETF to track the price of gold on the spot market minus the expenses of the trust, which are well below 1%, so each ETF share is roughly equivalent to a tenth of an ounce of gold, minus expenses. Some other reasonably large physical gold ETFs (as opposed to leveraged ETFs or gold miner ETFs) that track the gold price without usually straying very far off track are the iShares gold trust (IAU) and the ETFS Gold Trust (SGOL). There’s also the Sprott Physical Gold Trust (PHYS in NY, PHY in Toronto), but that one tends to trade at what I think are unacceptable premiums to the net asset value.

There are some arguments against investing in gold through ETFs, and they mostly fall into the “fear of government” camp — investors who believe that the gold will be confiscated in some way or otherwise don’t trust that it’s really there, or who simply believe that it’s safer to hold the gold yourself in physical form or in “real” allocated storage (ie, buying personal ownership of gold held in a custodial vault somewhere that you can go pick up when you want to, which is a bit more direct than an ETF holding). Unfortunately, most of these ways to own gold are far more expensive — coins and bars trade at pretty big premium prices even if you have a reputable dealer, particularly when gold prices are skyrocketing, and you have to pay for storage or insurance yourself. So I’m pretty sure Skousen is suggesting GLD as the cheap and easy way to get pretty pure gold exposure in your brokerage account, and he’s got a point — if you just want exposure to gold’s moving price, this is an easy way to go, oftentimes gold discussions get so bogged down in minutiae and paranoia that we forget that sometimes the simple and relatively cheap way is just fine.

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