About That “Flash Crash”…
May 24, 2010
Good morning. Wild and down market last week, despite the late day rally on Friday. For the week the SPY was down 4.78 (or 4.2%) to close at 109.11.The low on Friday of 105.36 was only slightly above the so-called flash crash low of 105, not a pretty site if you were in the camp that the “flash crash” was just an anomaly. Depending on whom you listen to or what you read the problems are either emanating from Europe, have to do with a slow down in China and Japan, maybe are being caused by budget and other issues here, or some combination of all of the above. For sure the situation in Europe, maybe unique to them temporarily because of their inability to have a central budget process, is a case of not being able to continuously afford government stimulus programs until their economies revive. The stock market here, through some combination of actual stimulus money going into the market and belief that the unprecedented fiscal stimulus would actually work, had run way ahead of the economy as a whole, and seems to be rethinking that somewhat.
The risks in the economy in the U.S., and the government’s response to the problems here, have been obvious to many for a while, and I have talked about them before. The whole idea that the issues were somehow caused by the “wrong” people buying houses while lying about their income to a bunch of unscrupulous mortgage brokers certainly would lead to a set of policies and attitudes. I actually talked to a fellow this weekend that was of this (somewhat misinformed) opinion, complete with the democrats (Bill Clinton, Charlie Wrangle, etc.) pandering to “these people” and getting them in houses they did not deserve, etc. From there, the greedy banks took over and over-leveraged to the point where the rest of the “real people” had to bail them out for more money than any regular person can even imagine. You don’t want to even think about the incredible losses that “real” people have had as they bought their dream home at the then market prices with real down payments and real jobs that are now priced way less with jobs either wobbly or gone. The point here is not that some people were wrong in assessing the problem, it is that the response, massive bolstering of the banks and a slew of short term programs (money for buying houses, buying cars, keeping teachers and others employed at the state and local level) was designed to fix a short term blip in the economy.
The housing issue was never the problem; it was the catalyst that brought the problems out in the open. The problems have to do with actual employment in many states down on the decade, despite populations up. It has to do with a median income of somewhere near (for an individual) $35,000, when it probably takes an income of close to $90,000 to afford the average house (higher before housing prices collapsed). It has to do with governmental units continuing (stupidly on a dollars and cents basis) to give raises in the public sector over really two decades far in excess of the increases in the private sector over the same period. The housing bubble (and the rise in the stock market for a while), in my opinion, did nothing but mask the real problem of lack of income growth, it did not matter to some if you received a raise or not if your house went up in value and you could borrow against it, or your mutual fund went up. Homeowners and “investors” took center stage, and the degradation of income for the mass of those employed was virtually ignored.
Okay, why talk about this again? We know politicians (other than the peculiar skills needed to get elected) might not be the brightest bulbs in the box regarding business and economic issues. We need to talk about it because if you misdiagnose to problem you will surely mess up the cure, and if you add the usual political impetus to do something, anything (especially to reward the thieves and hacks who put you in office) in time for the next election you will surely fail. My uncle told me once the off color story of the old bull and the young bull, standing on a hill overlooking a group of cows. The young bull says, “Let’s run down there and (take care) of one of those cows.” The old bull says “No, let’s walk down and (take care) of them all.” If you could go back and listen to some of the strident speeches from members of Congress and our still new President from early last year all you would hear would be he need for something to be done without delay, with the phrases “immediate help,” “without delay,” “get stimulus in the hands of consumers,” banging on your ears on a daily basis.
So we did, we had a program to write a check to “some” people who bought cars. Does anyone actually think that the increase in cars purchased over that period plus the year after actually went up, or did the rest of us just write a check with borrowed funds to those positioned to need/buy a car at that particular instant? I have the same opinion regarding the payment to people for buying houses. Those people would have bought houses anyway, probably at a price exactly one half less of the check written to the buyer (there was a time I could have gone through the math and the graphs to reach that conclusion, but trust me). Was it a horrible idea, like the car payoff? No, if we were indeed involved in some short-term economic blip, like what was caused (for instance) by the Russian currency crisis years ago, it might be good policy. The problem is, you idiots, we are not in a short-term blip. This is a crisis decades in the making. The manufacturing, especially autos, is not going back to places like Janesville, Wisconsin, or maybe Rockford, Illinois. The future will probably mean those people will have to commute farther to find the new jobs that will, hopefully, become available. I would much rather spend, seeing the problem as I see it, the money we tossed away (but still have to find someday to pay) on some of these short-term fixes, for an extension and improvement of commuter rail so people in those two cities could commute to Chicago or the O’Hare corridor. Akron, Ohio, lost the rubber companies, but it is still close enough to other industries in Cleveland to be served by an efficient rail service that would preserve Akron as a good place to live. Find long-term solutions to the long-term problems, not the short-term giveaways with money that does not exist.
I think we have a real chance of a double dip recession, and will be more than happy to buy drinks around some night for my readers and listeners if I am wrong. The Leading Economic Indicators for April showed a decline of .1%, down from a strong positive 1.4% for March, not the reading sustained expansions are built on. Now, however, we have the added pressure of being seriously broke while possibly entering a recession. The UK, one of the countries in Europe that can’t manage their budget and are messing us up, reported a record budget deficit in April of $14.4 B, or roughly $720 per household. Clearly they are idiots and are endangering the world, not just their people, by their profligate ways. The US, on the other hand, confident to the max in our policy and direction, had a combined Feb/Mar budget deficit of $286 B, or roughly $2,800 per household. I will tell you what, we better hope the pie in the sky people are right, and are seeing something I am not. I really hope they are, and not just smoking a banned substance, because this money hole is getting awfully deep.
So how do we invest? Market looks terrible, flash crash has everyone thinking the game is rigged, no money for money balances (talked to a guy that said USA Bank offered him .25% for a 1 year CD). Those of us in the PIP are not affected, as we had some in the money calls and some long puts. In fact, most should be up a little (depending on which underlying you have) since he steep sell-off started. I still have a tremendous amount of cash to commit when the time seems right. The VIX is real high, so the cost of protection in making a further market commitment with a protected position is surely higher than we would like. The solution is to wait until the underlying reaches a price where we are comfortable that buying some protection might be enough. For example, if we want to buy the XLE (oil ETF) at $80, we really have to be concerned about the price paid for the $80 puts. The XLE has a long way to potentially fall form $80. If we can buy it at $50, and the VIX is real high, maybe we can actually get some reasonably premium for, say, the $20 puts. In that instance we can buy the $50-20 put spread, protecting (minus the cost of the spread) down to $20. What we lose in paying a high price, in terms of implied volatility, for the $50 put we negate a little by selling at a high price the $20 put. Is it as good, in terms of protection, as just being long the $50 puts? No for sure, but most might agree that it would be a real bad scenario (a not impossible, but unlikely event) for the XLE to trade much below $20. These are the types of positions that we are looking at if the sell-off were to continue a little and appear to be bottoming out. For a pre-holiday week, this week should be interesting.