It’s a tough market out there.? You can’t eat relative performance, and I am off a percent or two year-to-date.? I have made a number of moves in the portfolio recently:

• Rebalancing sale of Jones Apparel
• Rebalancing sale of Shoe Carnival
• Rebalancing sale of Lincoln National
• Rebalancing buy of ConocoPhillips
• Sale of Gehl in entirety

In a bear market, I consider it unusual that I have gotten off so many rebalancing sales, but part of that is being willing to embrace an out-of-favor sector — retail.? That said, my cash position has risen to around 6%.

In this situation, being willing to embrace out-of-favor sectors, but not “doomed” sectors can pay off.? In my opinion, depositary and credit-sensitive financials are a doomed sector until the backlog of questionable names begins to diminish.? Fannie and Freddie are off the table, and didn’t S&P do us a favor by kicking them out of their indexes?? Surely they will add them to the Small Cap 600, right?? Sorry, no.? The cow is out in the pasture; closing the barn door won’t help.

Part of the trouble here is ripple, or, second-order effects.? Ordinarily, second-order effect diminish and get swallowed up by larger factors effecting the economy/markets.? But with financials, because of all of the layers of debt, the failure of a large institution can lead to a cascade of failures.? Much as I don’t like government bailouts, the reason why the Treasury stood behind the senior obligations of Fannie and Freddie was to avoid a cascade of failures, because their senior debt and guaranteed MBS are so widely held by financial institutions.

Until the institutions that can produce ripple effects either fail or conclusively survive, the bear market continues.? Bear markets are most often financing-driven; so long as financial firms are under stress, firms that rely on them for financing will be under stress as well.

Bailout Conditions for Lehman Brothers

On an unrelated note, what should be the terms for bailing out Lehman Brothers?

• The government should only care about systemic risk, not specific risk, so they should only guarantee the derivatives counterparty of Lehman, with significant skin in the game from Lehman.
• The equity, preferred equity, and subordinated debt of Lehman should be wiped out before the Treasury shells out one dollar.
• Senior debtholders should take a haircut — they will get paid in new Lehman stock.

Lehman reports tomorrow, ahead of schedule.? Fears have led to a fall in the stock price.? It is quite possible that Lehman will report a good quarter to dispel doubts; it is also possible that they will announce a government takeover of some sort.? I can’t tell.? I do know that for the market to normalize, the big problem have to be resolved.? Lehman Brothers is one of those problems and it is not resolved yet.

Full disclosure: long LNC SCVL JNY COP