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A Relentless Decay

August 29, 2011


Good morning. It was a nice bounce back rally for the market last week, with the SPY up 5.33 (4.8%) to close at 117.97. Volatility still reigned, however, with the market appearing unstable all week, seemingly always in anticipation of the next piece of news to affect the market. One of the big anticipated news items was the speech on Friday by Federal Reserve Chairman Ben Bernanke from the financial conference at Jackson Hole. It was in that very speech last year that he outlined some of the potential policy initiatives still on the table at that time, and shortly thereafter he announced the so-called Quantitative Easing II (QE II). In fact the market had an over 4% range on Friday (SPY high/low 118.51/113.61) as traders and investors both anticipated and tried to quantify that speech, tried to digest the economic numbers led by second quarter GDP (revised downward from 1.3% growth to 1%), and worried about Hurricane Irene shooting up the East coast. The VIX, despite evidence of continued volatility, was down 17% on the week to close at 35.59 (still a very high number).

Quite obviously, as we have addressed here before, the honored tradition of studying the market from both a technical and fundamental perspective in an effort to invest profitably and wisely appears right now to have become secondary to reacting to the political and macroeconomic news of the day. You may find an undervalued stock through your efforts, either fundamentally, technically, or both, but if you decide to act on that idea through a bullish trade of either the stock or options, right now you really have to hope your bullish trade is not swamped by news of a European Bank going under or some actions by the Treasury or Fed that the market views negatively. Add to that the general dual suspicions that a lot of this very important (to the market) news appears leaked (meaning prices are already moving long before retail or even fringe professional players are made aware) and that somehow the high frequency trading (or something else untoward) is causing these excessive intra day swings. It is hard right now to be a trader, or at least a trader without a plan or knowledge of protection.

The one thing that I would rather not talk about in writing about trading, or certainly in trading itself, is politics. When I was standing in the OEX crowd (for 17 years) it was hard enough to make markets, hedge yourself when needed, keep track of your positions (no computers then), and have something more in your account than when you started the day without having to wonder or prepare for some announcement by someone that moved the whole mess by several percentage points almost instantly. You found out very quickly that sometimes you made out (caught long on an up move) or sometimes you were on the bad side in terms of total position, but usually you were caught wrong on the trade or trades done right before the “announcement.” It is certainly not new that the continually preferenced  “they” always seemed to get information faster than those on the floor, or now upstairs. Let us not forget, as we approach the ten-year anniversary of 9/11, that while many people died and had lives that were tragically altered on that day, there were also those who were eyewitnesses that immediately dived for their phones to sell Futures before they evacuated. Anyway, it has been my experience that sudden occurrences of surprise market-altering news generally hurts the retail trader, either by losing actual cash or in causing him or her to be even less confident about the market in general.

As for the politics itself, it should come as a surprise to most that the general view of Congress right now is negative, with divisiveness, gridlock, and maybe lack of decorum ruling the day. I do wonder why that surprises people, or maybe it is the first time many have looked closely at our Congress in action. Fourth grade Civics should have taught that the House of Representatives was designed by the Constitution to contain those sent to represent the shorter term feelings and “attributes” of the districts they represent. Does anyone think that those sent there (especially the new Congressmen from the last election) were not sent to take an opposite view of a lot of the policies and to be obstructionist (if needed) to be heard? They were sent there to argue, and they argued. It does seem that here is a lack of civility in how some of the debate was carried out, but look around, this lack of civility is everywhere, and even desired by some. All it takes is one nasty exchange caught on camera and posted on the web to “make” someone politically, even if the man or woman has the knowledge and general people skills of a common roach. The question really is whether the legislative process at all levels of government (combined with the executive branch) can identify specific problem areas and potential solutions in a timely enough manner to stop the relentless decay in wealth for huge segments of the population. Jobs are very important, but so are declines in wealth due to home price degradation and negative real interest rates. So far I have my doubts, in fact I wonder if “they” get it at all. Maybe a concerted effort to throw out huge numbers of Congress in the next election is not such a horrible idea.

I have never been part of the “throw everyone out” camp, but now I am starting to consider it. A few governmental decisions, unrelated to each other, have happened in the last couple of weeks that really have me wondering if the whole process and the people involved are beyond repair. Let’s start with Federal Reserve Chairman Ben Bernanke. Through his efforts at QE II he has “allowed” the Treasury to borrow tremendous sums of money without any real market penalty of higher interest rates. That supposedly ended last month (I believe June 30). Even though I have heard nothing on any of the financial news shows or have seen nothing in print (might have been, can’t see everything) I will say to you that QE II has not stopped at all and in fact has been accelerated. Does this supposedly “transparent” new Fed have any concept of what being forthright and truthful really means? According to government statistics the M2 measure of money supply has been on a rocket growth trajectory over the last two months. If you annualize the numbers (seasonally adjusted) for June and July you will find an expansion (on an annual basis) of 19.5% for the two months or 26.6% for the one month. In fact, just the growth of M2 in July (2.2%) is likely to exceed current growth estimates for GDP for the entire year. What are these people doing? Does anyone remotely think that monetary expansion of that magnitude on a moribund economy (or any economy except one that is growing by that amount) is a good idea? Even if we were to concede that some of this growth is probably due to money balances being hastily shifted from some banks in Europe, the numbers are still high enough to where the Fed should have been trying to mitigate the surge. Despite all the recent questions by those in Congress and others regarding how effective the aggressively expansionary Monetary Policy  has performed, and some evidence that some of the effects might be counter-productive, this Fed just presses on seemingly oblivious to the legitimate concerns of others

On the Illinois state level it is probably even worse, and has been for a long time. There is no sense whatsoever of the struggles of businesses and people in the state, it is business as usual for the select few. Last week the Illinois Tollway Authority doubled, yes doubled, the toll rates. The poor visitors that come through (no pass) now have to pay 4X the toll of this week at every booth starting next year.  I am not sure how they figure the people depending on that route have the resources to demand a raise to cover it. The State has also watched many firms flee the State due to increases in income tax and other rates, why would this brilliant idea not cause more of the same? All this Governor (a lifelong political creature) knows is to protect the politicians and keep servicing your supporters with taxpayer money. I say, not good enough!

As for the City of Chicago, we lost 200,000 people in the last ten years, and most would probably see that trend continuing or accelerating.  We also have a new Mayor, Rahm Emanuel, supposedly in touch with the “people” and not happy with “business as usual.”           Yet recently we have welcomed both the G 8 and NATO conferences for next year, complete with the expected 35,000 protestors we have neither the money nor capacity to accommodate. No problem, though, the Hyatt family who supported the new mayor will do just fine, as the Hyatt Hotels will no doubt be ground zero for the events. This last week the new Mayor has hired his election and transition team buddies from Accenture to help audit city contracts and bidding. The catch is that Accenture is going to be rewarded by keeping a percentage of the “savings” they find. Two things about that, one is that you have people on the city payroll right now that no doubt have the job of monitoring city contracts and expenditures. Are we firing them? I think not. Why don’t we go out and hire a few people capable of doing that job, fire the hacks now there, and keep Accenture, and their percentage out of it. By the way, the Accenture contract was never put out to bid, so if your company were willing to do it for a lower percentage “take” you would be “bleep out of luck” The Mayor also announced an additional 2% tax for the Chicago Public School System, the same one churning out high school juniors with an average of 17 on their ACT scores (and an almost legendary source of graft and corruption). I have news for you Mr. Mayor, the problem is not lack of funding, it is lack of teaching and learning, and stealing. Let’s get a few more people moving to the suburbs.

Why does all this political stuff matter, especially the state and local stuff, when all we want to do is trade? It matters, not because we can do anything about it (the revolution appears on hold) but because it affects the wealth of the population and the amount of money people have to invest. It also affects decisions by business as to growth, and where that growth happens. Health of the state and local governments affect the Federal, since it seems that the Federal has a propensity to want to help the states if needed. It also will impede individual growth if that growth is constantly siphoned off by the governmental sector.

To the extent that “outside” events cause more market volatility, how does it affect trading? For stock traders, all it takes is one purchase or sale right before a big move to send someone to the sidelines. If you felt comfortable buying IBM in late July for $185 or so for the long haul, a recent price three weeks later of below $165 might give that long haul idea some second thoughts. That is just a big move for a relatively stable stock in a short period of time. For options traders, retail people usually prefer being long premium (except for covered writers) and the heightened volatility means higher put and call prices, higher break evens, and less chance of profit. One thing retail people can do, and what we emphasize at PTI, is trading more spreads in that type of environment. The logic here is that if you think a certain stock now trading $100 might move to $110, you might want to think about buying the $100-110 call spread instead of the $100 calls individually. Reason? In periods of high volatility the $100 calls are priced higher than normal, so your initial price is higher (meaning risk) and your break even is higher (meaning you have to be more right to just break even). By doing the spread, you are buying a higher than normal priced call, but also selling a higher than normal priced call, so the net price of the spread might be a more normal or “fair” value. Using the spread might bring the break-even prices and potential profit levels back to acceptable levels.

High volatility in the market, and the resulting high levels of option prices, also means that protection of high priced positions, and general risk control, are even more important, but also more expensive. For instance, if you liked the quick run up in gold and wanted to participate to the upside, you had to be aware of the possibility of decisions (political or otherwise) that might change margins or cause banks to make big moves that could affect the price, maybe against you, very rapidly. Therefore, the price of the puts to “protect’ your long position would be higher than normal, but for a reason. To ignore those possibilities and not be protected, given that environment, was too risky for most.

What are we doing? Well, the good news is that a lot of the volatility skew that caused me to have clients in cash has reversed itself. It is now possible to enter the SPY, IWM, XLE, or even XLF with a reasonable risk reward going forward. I still think we might get a better price, meaning the market may have another dip left in it, but getting in here for some of the cash is surely not bad. I continue to marvel, given the money supply numbers I mentioned earlier, and the buoyancy of the fixed income prices. We did have a crack in the longer-term treasuries this past week, and maybe it was the top, but we may get one more rally to sell. Seeing the 30 year at 4-4.5% or the ten at 3% is not much of a stretch, but would be huge percentage move in the underlying, and very profitable if we catch it right.

One thing I think a lot of readers, and listeners, should consider. It is where are you keeping you long-term stock positions. We do a lot of custom management (mostly the same strategy of the Protected Index Program) for those clients with larger individual stock positions. Some people want to have a covered writing strategy, some partial put protection, whatever. The point is that you might want to have your stock in an account at a place where you can talk to someone about what strategies are available on a moments notice. Just because you are “in for the long haul” does not mean that you can’t protect yourself in unusual times, or have someone knowledgeable to at least talk to about what would be available should the need arise.