Are People Voting With Their Feet?
October 3, 2011
Good morning. Quite a week in the market last week, only to have the SPY down less than a point to close at 113.15 (.3%). If you had any positions, it certainly felt a lot different than a flat week, with the range of 112.98 (Mon.) to 119.56 (Tues.), and a huge rally Thursday in the last hour only to be followed by a large sell-off into the close on Friday. The VIX continues to be at very high levels, closing up 1.71 at 42.96 (4.1%). These levels of the VIX, compounded by a fairly pronounced skew going out, surely makes it tempting to try and maintain short premium positions in the weekly SPY options, but those positions (due to amazing intra and inter-day movement) are not for the faint of heart. The market continues to be news driven with very violent moves within, at least so far, the roughly 1105-1215 range in the December S&P Future. Individual stocks are being buffeted by the extreme amount of program trading, rising and falling with the tide of Futures movement as they react to every rumor out of Europe or wherever. Economic numbers, although some are positive, continue in the aggregate to show zero to modest growth in the US, a slight (hopefully) contraction in Europe, and recent fears of a somewhat serious slowdown in growth in China and other developing countries. The Chinese stock market reached a two-year low last Wednesday and has continued to slide. There really does not appear to be a lot of positive surprises capable of driving the market up on the horizon, but the market also continues to be a relatively better buy with every down move, making the initiation of short positions tricky at these levels.
Is the economy continuing to get worse? Why can’t the brightest people seem to get a handle on the problems and get the fixes rolling? Is the scope of the problems beyond the ability of our current political system to deal with? The last question might be the most ominous, and we had quite a debate on that question on today’s Stocks and Jocks radio show. There are plenty of those, in politics and in business commentary for sure, that continue to believe that this ongoing economic malaise is merely a short-term business cycle kind of slowdown that will be temporary in nature. Depending on your political views the fixes (based on that short-term assumption) range from having government do more in the way of stimulus (monetary or fiscal), do less in the way of regulation and enforcement of business practices, but the overriding idea is that somehow two years from now the economy will largely fix itself. I would caution that there are only two ways for the wealth loss and income stagnation to be cured. One is for the “prices” of assets to go back up, somehow for the houses down 30% to go back up on their own. The pre-crash mean of housing prices was roughly $235,000, and there is no way the average family with current mean income of roughly $46,000 qualifies for mortgages at that price. The other is for real income (defined as income above inflation and tax increases) to go up to the point where the average family “makes back” the wealth lost and the debt owed (sort of like people going to work in the factories fueling the WWII war effort). I have a problem seeing either of these things happening anytime soon, surely not a matter of months.
In fact, the hits to individual people just keep on coming. I am sure that most readers of this blog have heard of Meredith Whitney, the economist that loudly predicted the collapse of the Banking system several years ago. She followed up that very accurate and famous prediction with an equally chilling future view of the economic condition of state and municipal governments and their ability to repay the increasing debt on their balance sheets. Obviously, that collapse has (so far) not come to fruition, and people that purchased municipal and state securities after her predictions have done quite well on those investments. In many corners she is being considered a “one correct prediction only” sort of person along the lines of those that predicted the 1987 Crash but said to stay short through the ensuing rally (Elaine Garzarelli for instance). While it must be said that the municipal and state bond market has not collapsed, I find it very politically and socially revealing how (in part) I think Ms. Whitney’s assumptions became flawed. I refer to a Bloomberg story by William Selway that refers to the fact that states and municipalities have actually been able to grow revenue from the level of before the 2008 collapse. That is startling, and clearly nothing that could ever have been predicted at the time of Ms. Whitney’s forward look. What does it say about the political process, and the ability (or inability) of the voting populace to have a say in government as it now exists? State income taxes have actually increased 10% in the last year, as states like Illinois were actually able to force tax rate increases through to an economically wobbling populace. More incredibly, property tax receipts were only down 1.2% in the last year, when the average home value in the last two years is probably down in the 30-35% range. Even though I think the political process is, in general, almost totally unresponsive in most cases to the plight of the average voter, these numbers were a shocker. I think if you would have told Ms. Whitney that somehow states and municipalities would be able to increase revenues in the worst recession than the 30’s she would have asked, “How could that possibly be?” and backed off on her predictions.
How do people (collectively) allow their elected officials to maintain or even increase the returns to some at the expense of others, even in times of hardship? Or maybe people have abandoned the voting process as virtually useless and are voting with their feet? Take Chicago for instance. Last week the Mayor’s merry men (as reported) came up with a multitude of idiotic ideas (making LSD a toll road for one) in an effort to squeeze every nickel they can out of the citizenry so as to maintain “city services,” which really means keeping all absurd contracts, salaries, and perks for those that put these people in office. Remember, however, that Chicago lost 200,000 in population in the last 10 years, or 6.7%. Maybe those people left because they felt the political process in the “City that Works” did not work for them? Now it is necessary, by the numbers just to stay even, to gouge an extra 6.7% of revenue out of the remainder. Again by the math, if another 200,000 leave in the next 10 years, you now need to raise the revenue on those remaining by 7.1%, and so on. At some point, maybe already, the game collapses. Can we say Cleveland anyone? I have never been as convinced of the lack of functionality of the current political process as I am now.
If you want to move on to a bigger example, I also discussed on the Show this morning a report by David Crane regarding the pay and benefit expansion in the Sate of California. I actually thought that if anyone could fight the battle out there it would have been Gov. Terminator, but it appears that the level of state pensions as a percentage of the state budget doubled under his watch. Direct spending on employee pay and benefits were up 65% in the last 10 years, compared with higher education down 5%, health and human services up 5%, and parks and recreation even. Where exactly does the average voter get to vote on this? Where in Illinois does someone get to vote on whether your tax bill on your home begins to challenge your mortgage as a monthly expense? Lack of a responsive political system can be very synonymous with tyranny in the result, with no clear-cut alternative. Choosing between two candidates both bought and paid for by those getting the wealth is hardly a choice.
Let’s try to focus, for a little while, on why there seems to be a lack of the “normal” growth of new businesses and innovation that usually accompanies bad economic times. No one can seem to figure out why the explosive growth that normally is associated with a business cycle type recession ending is not happening. Where are all the people who, when laid off, traditionally react by starting something new and now become part of the new economic base? I think a combination of factors is a work: the degradation of wealth needed for even the most basic research, the difficulty in getting financing for the next level, and some major structural issues in the form of barriers put up by the competition with governmental help. Focus in on what it takes to go from idea to successful product. You first identify a need, and then conceive of a product or service that is designed to meet that need. In this country it is a good idea (if the product is innovative) to register that product as your own, meaning get a patent. Suppose you do just that, and you begin to produce and test that product. Well, the good news is that you supposedly have the right to this product or process for 17 years, the bad news is that there are probably many patents just sitting there that people have never used that may be close enough to cause you legal issues. The CEO of Google was interviewed last week regarding Googles’s purchase of Motorola Mobility, and he discussed quite candidly the reasons for purchasing vast amounts of patents and how difficult it would be (with a lot of non-used patents sitting there with broad definitions) for someone small to not be challenged and held up by litigation from someone trying to keep you from market with maybe a competing idea. Is anyone even talking about how 17 years is way too long in this day and age for a patent to exist, or whether a “not used” patent should be used as a barrier to someone else who wants to move forward?
I think it is fair to say that some have been able to “invade” government and government policymaking to the point where they have been able to restrict innovation. Patents are clearly one way to thwart competition; another is the high cost of “approval” in areas like the FDA. If a group of researchers discover a new drug and want to bring it to market, that process is cumbersome and very expensive, way beyond the budget of virtually any start-up company. The biggest barrier to revising that process, making it smoother and cheaper, is surely the bigger drug companies. They want the process slow and expensive so only they have the money and expertise to navigate the bureaucratic morasst. That way smaller firms are forced to either sell out or partner up with a bigger firm just to deal with government. So how exactly do I find a way to vote for more common sense in the patent or drug approval process, or find a candidate that cares about anything like these issues described here? Well, these issues, and many more in my opinion, have combined over a long period of time to take the drive out of what are naturally a very innovative and hard working people, us. PTI Securities has been around long enough and has enough expertise to (not without cost) deal with the regulation that is really designed to put smaller securities firms out of business, but I cannot imagine someone today starting a less than ten person securities firm. I know that somewhere in Washington some lobbyist sleazebag paid for by a large firm is sitting with some Congressional aide trying his best to write a regulation designed to put firms like PTI out of business, but I can only hope we can continue to adapt and stay ahead. A relative few have “captured” a lot of government and have made it very difficult for others to even start, much less catch up. Where exactly do I vote against that, and why do the politicians look so surprised at what is happening, or not happening? Are we all going to be either voting with our feet or taking to the streets? I hope not, those sandwich signs do not look comfortable, but the political system is not working, or working fast enough.
So how to trade, making money certainly helps! If we make a real lot maybe we can buy our own politicians. We should have an advantage at PTI; all those experiences in the wild markets of 1987, 1989, 2001, and 2008 should point out what to look for. Clearly, the plan is to stay long or neutral premium levels on the way up, so when it tops out we can find a way to sell it in a relatively risk effective manner. This sell-off seems different than those of the past, however, maybe most closely resembling 2001, in that the “solution” that would normally be accompanied by the bottom and resulting rally seems elusive. We do not really have a “problem” like an event (United stock crash in 1989) but more of an economic malaise with many things having to come together for the solution. The VIX is surely high enough for our instincts to say find a way to short it, but it is also obvious that it is high for a reason; the market is very unstable. In other words, it could go higher. In that case you want strategies that are “short premium” but have defined risk. We have considered some extended butterflies (going long a monthly call or put and using weeklies to complete the spread) or time spreads, or plain butterflies, or iron butterflies, and had some success. Quite obviously, if the strike you select is close to the right one these spreads can be very profitable with limited (not zero at all) risk. They also have to be done at a size small enough to allow you to stay with the position through the inevitable moves happening by the hour.
Any big positions, especially concentrated positions, need to be protected. Everyone needs to put a test on his or her portfolio of an additional market move down of 20-30% and see how that would impact their wealth going forward. We need to think protection, but also think that if there is more to go to the downside we want to be able to be a buyer if real bargains develop. We can’t be broke and be a buyer. Stocks might even get low enough, with this high volatility, to where some smaller covered straddle writes might be in order. We have done a few of these very small in some lower priced stocks, like AKS and MTW, and have had to roll the puts down even further. I believe that prices will probably go a little lower, but having some percentage in a protected program is a good idea, and we might not be that far away from a bottom. I have never seen anything quite like this in the economy or the market, and it seems like the normal things we do, the normal investments, the normal adjustments, and the taking advantage of volatility skews in a limited risk manner is clearly the way to go. We will have the ability to take advantage of even lower prices should they happen.