The Global Debt Bomb

Plus: ANF Reports

PLAY: Sell your ANF March 33 Calls (O:ANF 10C33.00) at market, good for the day. Hold your ANF March 32 Puts (O:ANF 10O32.00).

Dear Bottarelli Research Member,

Good morning. I spent some time over the long weekend to get caught up on all of the overseas debt problems that have been spooking the global financial system. In particular, it was Greece’s budget crisis that exposed the euro zone’s fundamental weakness. Here is a quick summary of what’s happening…

When the nations of Europe formed their monetary alliance in 1999, they opted to share a single currency. But at the same time, they also allowed each member state near-total political and budgetary autonomy. That’s how Greece (and other nations) have been able to run up crippling debt without any political accountability. But now, that might all come crashing down.

According to Forbes, “the world has issued so much debt in the past two years fighting the Great Recession, that paying it all back is going to be hell – for Americans, along with everybody else. Taxes will have to rise around the globe.”

As it stands, national governments will issue an estimated $4.5 trillion in debt this year, which is almost triple the average for mature economies over the preceding five years. The U.S, for example, has allowed the total federal debt (including debt held by government agencies like the Social Security fund) to balloon by 50% since 2006 to $12.3 trillion. But for us, the pain of repayment is not yet being felt, because interest rates are close to 0% on short-term Treasury bills. These rates cannot remain this low forever. When they eventually rise, taxpayers like you and me will feel it like a swift punch in the stomach.

In fact, when I look at this situation, it looks like we’re getting ready for a new wave of sovereign defaults, which occurs when a country stops paying its bills. Historically, these sovereign defaults come in waves (and are often followed by financial crises). In 1998, for example, Russia and the Ukraine defaulted. In 2000, it was Ecuador. In 2001, Argentina. And in 2004, North Korea. I fear that we’re setting up for another rash of defaults. In other words, when I review everything happening right now, it’s pretty clear that the devil is coming to breakfast soon, and it won’t be a pretty sight. Therefore, we’ll continue to proceed with extreme caution.

In the meantime, we have our earnings plays starting to report. Abercrombie and Fitch (ANF – NYSE), for example, reported earnings of $0.91 per share, which beat the estimates by $0.04. But at the same time, their revenues fell 4.6% year over year to $936 million, which came in below the consensus of $953.7 million. In fiscal 2010, ANF has plans to open flagship stores in Copenhagen, Denmark and Fukuoka, Japan. They also plan to open a Hollister Epic store on Fifth Avenue in New York, which could offer investors some optimism going forward.

As you know, we entered the ANF March 33 Calls (O:ANF 10C33.00) and ANF March 32 Puts (O:ANF 10O32.00) for a total of $3.20. As I write, the calls have ticked up to $2.60 and the puts are trading at $0.70, good for a total price of $3.30. So even after the earnings release, we’re still sitting at break even on the play. With ANF shares only moving $1.00 on their mixed report, this muted reaction has (thus far) stymied our profit potential. Based on this situation, let’s sell our calls and hold our puts. If ANF shares drift lower, which might happen, we’ll be in good shape.

PLAY: Sell your ANF March 33 Calls (O:ANF 10C33.00) at market, good for the day. Hold your ANF March 32 Puts (O:ANF 10O32.00).

As always, I’ll follow up with more updates as the trading session progresses. Until then…

Lock and load!

Sincerely,