“We, as well as our SWF and central bank counterparts, are reluctant to make additional commitments.” - A line from Bill Gross in his monthly Pimco Investment Outlook.

A little over a month ago, I questioned …Is Pimco Too Big?   After reading his outlook and watching Gross on television today, the answer appears pretty clear.

He compared Pimco to Sovereign Wealth Funds and Central Banks from around the world.  In a way, it seems like he is even speaking for them.  It’s almost impressive to see Gross talk someone else’s book for once!

Who is in control of our Treasury?

During the campaign and as late as August 1st, Senator Obama (D-IL) proposed to provide $500 per person or $1000 per family to supposedly compensate America for the burden of high gasoline and home heating oil prices for a 4-month period. That will cost about $75 billion. I know how that makes sense to buy votes for an increasingly socialist America. Of course, it does not make sense for capitalism.

For years on this site, I have argued against the concept of a “windfall” or “excessive” profits tax. So I won’t repeat the reasons for my opposition now…just search this blog for “windfall” and read through all my prior articles.

If you are an Obama supporter….do not think this is a political attack on him. It is an attack on the concept regardless of who proposes it. McCain’s summer gas tax holiday proposal was also stupid. Look at the date of the first post on this topic called Taxes As Punishment, it was May 3, 2006 - 9 months before Sen. Obama declared his intention to run for President.

Here is what I said over 2 years ago…

Listening to Sen. Durbin on “Meet the Press” on Sunday and Sen. Dorgan this morning on CNBC was concerning. During his appearance, Senator Durbin said,

“I mean, the bottom line is this: If you do not tax these corporations at this level they will continue to run up the profits to sky heavens.”

And later he said,

“But it also means two other elements we shouldn’t overlook: punishing profiteering. All the market forces not withstanding, if the oil companies still insist on these outrageous profits, the consumers will lose and the American economy will lose.”

In a country that is supposedly based upon capitalism, I find Senator Durbin’s comments to be contrary to that fundamental underpinning of our country, and sadly, I find the masses of Americans who are piling onto this philosophy even more disturbing. Creating “separate and unequal” tax policies for any particular industry (or companies within an industry) just chips away at capitalism and when that happens, inevitably “consumers will lose and the American economy will lose.” The concepts that profits are evil and taxation should be used as a punishment to change an industry’s behavior are scary.

Senator Dorgan echoed the danger of energy company profits this morning on CNBC and he even has a handy calculator of “windfall” profits on his website. For as long as I have heard this term, I have never seen anyone willing to define what an “excess” profit is so I credit Senator Dorgan for being so bold. He suggested that windfall profits are those in excess of $40 per barrel. Do you realistically see $40 per barrel as a baseline for the future?

Specifically, his legislation imposes a 50% excise tax on the “windfall profits” of major integrated U.S. oil companies. I find it interesting that only big oil companies are being singled out. I guess small oil company profits are not “outrageous” even though they may be more profitable on a percentage basis than the integrated oil companies. Which begs the next question - how do you define “big”? But enough of the fine details, the other troubling aspect of this bill is hearing Senator Dorgan explain how his windfall profit tax is different than the last time Congress took this step which actually resulted in lowered production. A provision of this bill would exempt windfall profits from the tax if they were used to increase oil and gas supplies, renewable fuels and domestic refining capacity. This is the part that is supposed to assure you that these taxes will actually force the companies to do what the politicians want them to do. The last part of the bill is about as close to Robin Hood behavior as you can get. The revenues of this bill would be returned in the form of a rebate check sent to each individual American taxpayer over 16 years old. Giving away this money to people whether they actually drive a car or not is “outrageous” to me.

I doubt any windfall profits legislation will be passed by the Congress, much less signed by President Bush. However, the fact that it has gotten so much serious consideration should cause all of us to reflect on what we are willing to sacrifice - an extra dollar per gallon at the pump or capitalism.

For me, this isn’t about the presidential election or politics. It’s about economics……capitalist economics….not political economics.

If you are a regular reader, you’d know that I am not a fan of the Bush administration’s Monetary And Fiscal Failure and the fact that There Are No Cheap Solutions to our mess.

However, Obama’s Windfall Profits Proposal is as dangerous as many of our current administration’s failed policies. Not only does it replace capitalism with socialism, but it will not lower oil or gasoline prices. It is wealth redistribution without any equitable method since not everyone drives the same amount or consumes the same amount of home heating fuel, but everyone gets the same “rebate.” And despite the great intentions, taking profits from “big oil” will not guarantee successful innovation with the cleaner and cheaper alternative energy we so desperately need. Lastly, despite Obama’s promise to pay for his $75 billion “emergency” giveaway with his “excessive” profits tax, I don’t see how that promise will be so easy to keep. Not that politicians keep promises.

But if you care about such things… do the math. The plan says that “Barack Obama supports imposing a windfall profits penalty on oil selling at or over $80 per barrel.” Think about that…$80 per barrel at a rate of 20%. Obviously, if oil declines towards $80, almost no windfall profits tax revenues will be obtained. Regardless of the market price of oil, the only way this ridiculous giveaway would ever generate revenues large enough to cover its cost would be to keep changing $80 to whatever Obama feels is a “fair market” price, increase the 20% to a tax rate that Obama feels generates “fair” profit or for consumers to experience significantly higher oil and gasoline prices. All three of these choices suck and all three seem likely to me if this proposal becomes law.

I “overdo” it sometimes with the signals. Sometimes I “underdo” it. One situation causes too much turnover, another causes too little, both usually cause a hit to performance.

Last week, I changed a lot of signals to DOWN while working on Getting Centered and this week, I changed more signals(209) to UP vs. DOWN(152). However, this ratio is misleading.

It is very very rare for me to change the signal on a stock in two consecutive weeks. This week, 45 of the “new” UP signals were “new” DOWN signals last week and 98 of the “new” UP signals were “new” DOWN signals two weeks ago. Of these 143 signals, 71 were losers averaging -5.8% and 72 were winners averaging 4.71%. Without these short term reversals, previous weeks would not have been so negative and this week would be more negative than it looks.

What to make of this? This market is very difficult, almost as tough as it was for me from November until mid-March. Under these circumstances, my normal portfolio management rules against changing signals on the same stock in consecutive weeks has to get thrown out. During these times, I work on my humility and find it much easier to admit when I am wrong and I have no problem “Undoing The Overdone.”

I apologize for anyone following the signals at HEDGEfolios. I hate turnover, especially when it gets excessive. This turnover is “excessive” and abnormal, but I expect it to continue until the sideways movements and volatility subside. I have no idea how long that is going to last. It has been going on for 3 weeks and the last time it persisted for about 4 months.

There is a very big battle going on right now to decide whether the market will retest lows or push higher. As a consequence, we get extreme volatility. I am never “neutral”, and the HEDGEfolios bias tells me to err on the side being Bullish. However, I much prefer to hang around the middle so I can adjust from week to week.

HEDGEfolios year-to-date stock performance for 2008 (through 08/29/08 close) was up 25.84%.

Over the same time period, the S&P 500 index was down -12.61%.

At the end of August, the HEDGEfolios universe consisted of 3,373 stocks.

Commentary: August saw the S&P 500 trade mostly sideways and net a +1.2% gain. HEDGEfolios managed to deliver approximately +4% during the month. Throughout the month, the database averaged approximately 75% UP signals and while I have been trying to get centered, the continued push for a stronger dollar and lower commodities has provided some momentum for the bulls.

Here is the performance chart of HEDGEfolios vs. the S&P 500 for 2008.

Prior Years’ Performance:

• 2007, HEDGEfolios performance was +21.78% vs. + 3.55% for the S&P 500 index
• 2006, HEDGEfolios performance was +25.54% vs. +13.62% for the S&P 500 index
• 2005, HEDGEfolios performance was +19.99% vs. + 3.00% for the S&P 500 index
• 2004, HEDGEfolios performance was +31.19% vs. + 9.00% for the S&P 500 index

Disclaimer: Nothing in my performance quoting is intended as an advertisement or in any other way meant to encourage anyone to subscribe to HEDGEfolios. These performance figures have not been audited or verified by an outside party and are NOT in compliance with the CFA’s AIMR Performance Presentation Standards. They don’t net out any transaction costs such as commissions or management fees and are not a total return calculation as I do not include dividend yields or any compounding factor. These performance figures cover a hypothetical portfolio of the entire HEDGEfolios stock universe with an equal weighting of each security. The calculation is simply the cumulative total of all gains and losses from the signals during the period in question.

The following comes from a July 30, 2008 press release by the Federal Home Loan Bank

Today, the Housing and Economic Recovery Act of 2008 was signed into law by the President.

The FHLBanks are referenced in this legislation, and the most notable changes are as follows:

• The Secretary of the Treasury is authorized to purchase Federal Home Loan Bank obligations in any amount deemed appropriate by the Secretary. This temporary authorization expires December 31, 2009 and supplements the existing limit of $4 billion.

“Any Amount Deemed Appropriate By The Secretary” of the Treasury, Henry Paulson and whoever succeeds him between now and December 31, 2009. Does that make you feel confident or does it scare the hell out of you? Do you feel comfortable placing unlimited power in the hands of one person?

I especially liked the concept that this new power “supplements” the existing limit of $4 billion. To me a supplement is a small addition. To the government, a supplement apparently means “unlimited”.

Please read this wonderful commentary by Lee Hamilton, former Congressman in which he states:

The framers of the Constitution, mindful of “taxation without representation” suffered by colonists under the British crown, took care to specify in the Constitution that the ultimate power to tax and spend resides in the hands of the legislative branch - which is closer to the people - not the executive branch.

The power of the purse is the most important power of Congress. James Madison in the Federalist papers called it “the most complete and effectual weapon with which any constitution can arm the immediate representatives of the people”. It checks the power of the President and gives Congress vast influence over American society, because federal spending reaches into the life of every citizen……

Congress used to have the “Power of the Purse”. It does not anymore. They gave it away. In my opinion, The Housing and Economic Recovery Act of 2008 approved by Congress and signed into law by the President a few weeks ago, is not only scary, it has ruined the Constitution and the importance of the Founding Fathers’ system of checks and balances. How this is not Unconstitutional is beyond me.

In the past few days, there has been much talk about the strength of Fannie and Freddie and how they were able to raise debt and how they don’t need to be nationalized. Do you really believe that? Do you think that would have been possible without the unlimited powers of the Treasury? The whole thing looks like a sham to me.

Consider that the Treasury Secretary can lend to Fannie and Freddie and almost any bank that wants to use its FHLB branch as a conduit in Any Amount Deemed Appropriate By The Secretary. This opens up the opportunity for a giant abuse of power whenever it is required to make everyone feel comfortable about the mortgage and debt markets. For as long as this power exists, I do not understand how any American can look at the balance sheet of any bank, any FHLB, any GSE or more importantly, the balance sheet of The United States of America and have any confidence.

Please click here and watch this video of Rep. Ron Paul (R-TX) about the “Mother of All Bailouts”. Warning….you will might should be troubled by the open ended nature of the Housing and Economic Recovery Act of 2008 and that little bit about raising the national debt by $800 billion and that little bit about big brother tracking every one of your credit card transactions via the IRS.

After the SEC ban against naked shorting of Fannie and Freddie and 17 other companies was allowed to expire on August 12th at midnight, FNM opened at $8.00/share the next day. From that Wednesday to Friday August 15th, FNM traded in a range of $7.55 to $8.62 and closed the week at $7.91. If you believe in the short ban, you might have thought that the shorting would have immediately crushed FNM, but it did not. Of course, the loudest supporters of the SEC’s attempts to limit shorting were mostly silent. That’s what happens when the facts get in the way of the bullish hype agenda. The way the anti-short crowd promoted things, you would assume that the SEC’s ban would be largely responsible for “stabilizing” Fannie and Freddie from July 21 to August 12 while the ban was in place. That’s interesting given that FNM opened at $15.25 on July 21 and closed at $8.02 on August 12. I wouldn’t call that stabilizing.

But when FNM started plummeting again during the week that began August 18th and hit its low of $3.53 on August 21, suddenly the removal of the naked shorting ban was used to explain why the stocks might be declining(in addition to the missing Uptick Rule). Of course, this is stupid. There happened to be a few other things going on than just the initiation, implementation and then removal of the SEC’s ban. It’s just really convenient for people pushing an agenda to ignore facts in opposition to their argument and then apply coincidences that support their claim. Never mind that FNM has advanced 80% since the August 21 low at a time when the short ban was not in place.

The naked short ban had some effect on the stocks because all market rules impact trading in some way. However, it is tough to identify what effects it really had and to what degree. We do know that it did not provide stability and it did not prevent selling of the stock and it did not guarantee that buyers would show up. During the naked short ban, the protected stocks went up and down. Without the naked short ban, the protected stocks went up and down.

Maybe it is unfair to place the success or failure of the naked short ban by just analyzing Fannie’s stock movements. Okay. Pull up the charts of the following 17 companies that were on the SEC’s list of 19 companies protected(I am excluding BNP Paribas and Daiwa since they do not trade on the NYSE)….AZ, BAC, BCS, C, CS, DB, FNM, FRE, GS, HBC, JPM, LEH, MER, MFG, MS, RBS, UBS). Do a price study of these stocks on the following dates…. July 15th close, July 21 open, August 12 close, and today’s close.

You’ll find the following performance:

• From July 15 close to July 21 open - all 17 stocks appreciated with an average gain of +35.7%
• From July 21 open to August 12 close - 11 of 17 stocks declined with an average loss of -17.5% and an average gain of +6.3%
• From August 12 close to August 27 close - 15 of 17 stocks declined with an average loss of -7.9% and an average gain of +2.5%

Here’s my take…The announcement of the ban on naked short selling caused a short squeeze and speculative momentum play from the announcement date (midday on July 15) until the ban actually took effect starting with the open on July 21st. Regulators like the Fed and the SEC love to put temporary floors in markets and create bullish spikes by squeezing shorts and encouraging bullish speculative trading on the momentum that follows. Bernanke did that on several occasions since August 17, 2007 so I guess it is only fair that Cox had his day. I find it interesting that Cox tried to prevent manipulation by short sellers by manipulating short sellers. Good one! Is this the kind of thing that gives investors confidence in markets and regulators?

As for the price action during the naked shorting ban, it did not suggest that the ban had an identifiable effect. Just consider how many of the covered stocks declined during the ban period of July 21 to August 12.

Since the ban ended, most of the protected stocks have declined. If you have read this whole post and still believe that the removal of the ban and manipulative short selling was the primary reason for the declines, please don’t waste your time reading my crap. It will not help you.

Naked short selling has been, is, and should be illegal regardless of whether the regulators choose to enforce existing rules for all or some of the stocks.

When Cox announces his next attempt to limit the effects of shorting, either naked or otherwise, please realize that the implementation of these rules does not materially affect prices. However (and this is the important part), the announcement of rules provides the majority of the gains and those gains are very short lived.

If you are running forward, the best posture is a forward lean. I’ve been leaning heavily in the bullish direction since mid-July and that has worked out quite well. However, if you expect to change direction in the near future or if you just fear that you are being too aggressive and might fall over on your face, it helps to do two things. The first is to slow down and the second is to get centered.

For the last 3 weeks, I have been working on those two strategies as I have gone from 80% UP signals to 63% (now). This week was more aggressive than last and I gave 429 new DOWNs vs. only 27 new UPs in the stocks I cover and 112 new DOWNs vs. only 1 (USO) in the ETFs. That may not sound like I am going slowly, but just consider this….I evaluated over 900 candidates for new DOWN signals this week and decided to avoid such an extreme move and did less than half that amount. To me, that is slowing things down. As for “getting centered”…. I am not quite at the 50/50 level and I may not get there exactly, but I am much more comfortable at 63% than I would be at 80%. Note that 80% felt like the right “lean” a few weeks ago. But that was when I was confident in the direction and pushing to optimize the ground I could cover.

Am I expecting a bearish reversal in the market? Yes.

I am just not convinced that the reversal is exactly right now. I am willing to forgo some bullish profits as I neutralize the portfolio a bit during this period. My analytical work on direction relies heavily on the ability to be as balanced as I can at the moments that are pivot points. So as I start to feel the shift, even if I am not convinced a change is imminent, I work really hard to find what I call the “portfolio center of gravity.” If you are a runner, sprinter or athlete of any type, you’ll know what I mean. If you are a physics geek, you’ll know what I mean.

Evaluate your portfolio. How far are you leaning in either direction? How fast are you moving? If you are uncomfortable with either or both of those factors, consider going slower and getting yourself centered. If the market reaccelerates in the bullish direction, you will be sufficiently balanced to rapidly position your portfolio to profit. If, on the other hand, the market heads lower, you will have a better chance to avoid losing your balance, and losing your gains.

I call FNM and FRE “toy stocks”.

Countrywide (CFC) became a toy stock before it disappeared. Bear Stearns (BSC) became a toy stock before it disappeared. Subprime lenders like Novastar and New Century became toy stocks before they got delisted.

When a stock no longer trades based upon fundamentals and gets in the hands of speculators that love to treat it like a plaything, it’s a “toy stock.”

On a day like today, with FNM and FRE up over 30% from their open to their intraday high based upon Freddie Mac being able to borrow more money, these toys made some people happy. Just don’t confuse an investment with a toy.

During one of my research efforts in support of a different post, I came across this JP Morgan position piece (circa 2004) attempting to convince participants in trade transactions how useful CDS contracts might be.  Please click here and read it.

This nonsense is just one example of how far the industry is willing to go to promote “financial innovation”.   The CDS market is unregulated and apparently unlimited in its suggested applications.  It’s out of control and we are all at its mercy.

Last week, I implored bullish investors to Pay Attention to some early signs of weakening that I saw during my assessment of the market.  Now that another week has gone by, I am suggesting that you should Pay Closer Attention.  In general, many previously strong stocks are slowing and some are weakening.  Although this isn’t usually enough to encouraging me to change an UP signal to DOWN, it does change my behavior. When this happens, I pay closer attention and tend to be more cautious about putting on new longs and more aggressive about exiting.   The light volume that typically occurs in the three weeks preceding Labor Day makes market assessment very difficult.  Some commentators tell you to downplay or almost ignore what happens during this period and wait until the big players get back from vacation.  To me, that’s crappy advice and instead, I just ask you to pay closer attention.