A Fine Line
March 14, 2011
Good morning. Despite a rally last Friday (after news of the disaster in Japan) the S&P closed down 1.63 (1.2%) to end a fairly volatile week. The VIX was up 5.3% to close at 20.07. Putting the VIX move into real numbers, we had been doing some long premium spreads in the SPY for those in the PIP program when the price of the weekly at the money straddle (SPY@ 132, the combined price of the 132 call and 132 put) was roughly 1.50 with 4-5 trading days to go. Last week, on Thursday night, with only one trading day to go, that same straddle was in the 1.70-1.80 range. Obviously, the judgment of the market in regards to the likelihood of a large daily move has increased dramatically. This had been due (mainly) to the events in the Middle East and the sharp run up in oil prices, threatening to slow the recovery and possibly continue to the stage of oil disruption in that region. The Japanese situation, in addition to the extreme amount of human suffering, is bringing additional questions regarding future growth, ability to maintain U.S. investments, nuclear safety, earthquake preparedness, and general fiscal health of the world’s third largest economy. These are not easy questions to answer in a weekend, hence the increased risk premium in the market.
In regards to political events affecting (prefer not to say driving) the market, where to start? We had been focused on the Middle East and the succession of events that have caused regime changes in Tunisia and Egypt, civil war in Libya, and some unrest in Yemen, Jordan, and even Saudi Arabia. That “unrest” has put the price of crude oil up from around $92 at the end of last year to the high (so far) of $106.95 a couple of weeks ago. Oil from Libya has essentially been cut off (less than 2% of world’s supply), but the big fear is that the regional unrest would spread to Saudi Arabia and disrupt supplies in that country. All of this puts the U.S. into somewhat of a trick bag in designing policy going forward. On the one hand you have the purists, or maybe the average American, that looks at these despot regimes formed at a time of less population as being unable to stand up to the tests of time and growth. All the leaders, from Mubarak to Kadafi to the Saudi Royal Family, have taken a seriously disproportionate share of their respective country’s wealth and have maintained power through some heavy-handed tactics. So, on the one hand you would like them thrown out, or at least see them initiate a series of political and economic reforms. On the other, we want their oil and our big oil companies have been dealing with them for years, as long as gas is cheap do most care if a little went into the despot pocket? It really is a fine line, we are a nation that threw off the colonial yoke and forged ahead with the great democratic experiment, so our heart is always going to be with (unless you are a multi-national that might prefer dealing with one corrupt person) the oppressed when they rise up. Yet the world is made up of many government’s of various degrees of despotism and illegitimacy. Every uprising can’t be guaranteed an aircraft carrier battle group from the U.S.
So how do you get on the right side of history, or morality? When King Saud unified Saudi Arabia, starting in 1902 and culminating in 1932, the population was under two million, mostly wandering tribes. Now it is 27 million, much more educated and aware of the amazing “share” of the country’s wealth the Royal Family feels is “rightfully” theirs by birthright. A lot do not agree with the size of the “share” and are not real happy with the brand of “religion” that seems tailored to keep the Family in power that has been imposed on the population. In my opinion all wars are based in economics (might have a religious overtone), and I do not see the Royal Family lasting in this sort of political power base forever. The economic strains are too great. Would it be nice if they (the Royals) see the future and move towards some sort of constitutional monarchy that is mostly bloodless? It sure would, but time will tell. As for Libya, the questions are easier but the policy is still tough. There is a total despot, and terrorist (Kadafi, or Gaddafi, spelling seems in dispute), in power for 41 years that has been conclusively linked to at least the Lockerbie bombing, probably the violence at the Munich Olympics, and several bombings in Britain. Finally, and with the verbal encouragement of many (including, it can be argued, President Obama who promised to bring him to justice) there is a legitimate uprising against him, yet there has been very little constructive help to those opposing him so far. It has also been reported that, despite being on the terrorist watch group until 2003, he was able to move over $35B into this country without detection.
So what do we do? Do we encourage the rebels and then do nothing? Do we send a battle group and actually help out? Do we send arms? Do we stop Kadafi from obtaining any more weapons from outside (even if it is American weapons finding their way there through a subsidiary type arrangement)? Right now it seems like countries are talking, in an effort to have a unified response, but the risk seems to be that whatever response is decided upon might be way to late. The solution is not obvious, but whatever solution there might be is time sensitive, you can’t help the day after everyone is killed. Sounds like Kadafi and his mercenary pals are much further away from being brought up for crimes than when the President presented it as a concrete goal. You can’t treat an increasingly one-sided uprising, especially one with jets against people on the ground, like a pocket veto. If we are not going to help, Mr. President, let’s say so, maybe some of those fighting can get out and live to fight another day. Why do I have this nasty feeling that some of the tanks and planes that this despot is hurling against the rebels somehow found there way to Libya while there was some sort of embargo in place, and that those “businessmen” or “opportunists” will get away one more time?
Does anyone other than me have a problem with that stolen Kadafi money being here? There is no chance PTI Securities or any firm I know, given the anti-money laundering paranoia at the SEC and FINRA, accepts a check or wire from Libya without checking the legitimacy stringently. Who are these people that just happen to have $35B or more on deposit, and why aren’t they being questioned for at least any part accepted before 2003 (when Libya was taken off the terrorist watch list? I am getting real tired of the growing problem of two sets of rules and two levels of enforcement in this country, the big and connected being above any law.
As if the Middle East problems weren’t enough, the carnage in Japan caused by the earthquake last Friday has everyone horrified by the scene and questioning levels of preparedness virtually everywhere. Of special concern is the state of the nuclear power industry, as the government of Japan struggles to contain problems at three nuclear facilities that represent 25% of the nuclear capacity of the country. Essentially, the earthquake and resulting water knocked out both the main cooling power and the backup power within minutes, and the emergency step of pumping in seawater has been resorted to. That step will probably cause those units affected to be dismantled rather than eventually fixed. Already there are pretty serious reactions around the world regarding nuclear power and its safety, and even the most optimistic probably see the issuing of a permit for a new nuclear plant anytime soon as remote possibility. As of this morning the Bank of Japan has injected over $150B of liquidity into Japanese credit markets, even with that help their stock market was down over 6%. It will be interesting to see how Japan moves, over the next several years, to replace the lost capacity. Who will win out, new nuclear, some type of fossil fuels, something renewable?
So how do we trade this sort of market? Just a few short weeks ago we were doing some long premium trades in the weeklies due to the premium levels being unusually low. We, in the aggregate, ended up positive on those trades, but last week the pricing of those trades changed dramatically and we switched to some calendar spreads to take advantage of the high volatility in the near term. I have rarely seen the nature of the positions with relative “edge” change so rapidly. We have kept the risk on these trades very low, in an effort to pay something nominal but have a potentially violent move deliver a relatively large payday. It does seem that the relatively quiet market advancing almost by the day has changed into something quite a bit more volatile. Also lost in the recent news is the general decline of prices in long-term bonds due to increasing inflation pressures, now overrun in the short-term due to a flight to quality. In the end I believe we will benefit greatly by the opportunity presented by the higher volatility, and right now we have very few positions on, I want to be very focused and ready for whatever opportunities present themselves.