Bottom of the Economic Tub
December 7, 2009
Good morning. It was a strong week for the market last week after that sneaky sell-off the day after Thanksgiving due to the impending default of Dubai World. Dubai World, $60 B, Dubai stock market down 6% this morning, chump change, who cares? In terms of actual money on a world scale I would certainly have to agree, but as a wake-up call to possibly problems in other developing market debt it has to be observed carefully, as the world economic recovery remains fragile. It is interesting to hear the same pundits talk about how increasingly unimportant the U.S. business is to some industries, such as architectural firms and construction crane firms due to the inordinate amount of building in a place like Dubai, only to have virtually the same pundits (maybe I just have trouble telling the talking heads apart) say it really is not important if the place goes under. It would seem you couldn’t have it both ways. Again, I do not put Dubai’s issues on the front burner of a worldwide crash, but it surely would seem to not be a part of the so-called recovery for quite a while.
The market averages have continued to advance, albeit at a much slower rate. The VIX is continuing to drop, and last week closed at 21.25, down 3.48 (or 14%) on the week. People are getting increasingly comfortable selling risk premium, especially in the shorter-term. For instance, I have the implied volatility in the SPY Dec 111 calls this morning trading at under 18 while the March 111’s are closer to 22. If you go out to December of 2011 the volatility in the 110 puts is approaching 26. It is exactly like the market is telling you that the next couple of months will be quiet, but people are less likely to take that view going out. What does that mean for us? As retail investors one of our most powerful tools is to be able to buy further out options and have them “cover” the nearer-term options we sell against them. In that way we have some time decay coming our way on most of our spreads, and even if we may be wrong on the predicted direction of the stock or index there is a good chance we can “save” the position. That is increasingly hard to do when you start with negative volatility edge, we do not normally want to buy a 26 volatility and sell a 17 against it as a hedge. For that reason a lot of you have seen less activity in your accounts, but if it continues to skew in this direction we may have some long premium positions ready to take advantage.
Another issue with the current market is the relative narrowness of the advance. It seems like the S&P Futures are being traded as a commodity in part of the sell dollar, buy gold and oil, and buy S&P Futures. It is causing the same stocks to advance, and even more strongly the more multi-national exposure the company might have. Yet the obvious plays, given the size and direction of the government stimulus package, have not performed well at all. The large banks, amazingly fat and happy due to governmental largess and usurious practices towards customers, have gone virtually nowhere in the last few months. The XLF (financial sector of the S&P), trading 14.55 this morning, was virtually the same level early last August. Two serious infrastructure plays, FWLT and FLR, are either slightly up (FWLT) or sharply down (FLR) in the last five months. The XLB (materials section of SPY), containing such stocks as DuPont, Celanese and Weyerhaeuser is up, but not on a par with the major averages. It has been very easy to be long a portfolio of stocks that have not participated in the “official” rally, even though it would seem like they should have if the economy was really getting stronger. You especially wanted to avoid natural gas stocks or oil exploration stocks, in anticipation of some change (or creation of) some sort of a national energy policy. Again, very counter-intuitive.
So where are we heading? I hope everyone, even though it was during the day, was able to hear a little of the testimony in the Senate regarding the re-confirmation of Ben Bernanke as Fed Chairman. The questions were remarkably bare knuckle for national TV, giving a revealing look at the budget going forward concerning entitlements as percentage of the budget, and some frank discussion about the current recovery from the eyes of constituents of some of the Senators. It is especially interesting to hear the disconnect between Bernanke (or Geithner) regarding how the banks are going to pay the government back (therefore making them heroes) and the questions from people like Sen. Shumer asking where was (or is) the regulation that would curb the amazing bank practices allowing them to pay things back so quick, or how the “trickle down” is not trickling so well. I surely think the Sen. Bunning grilling (at the risk of being called a Republican again) should be required reading. He basically lambasted the Fed, both Greenspan and Bernanke, for their performance over more than the last decade, and it is really hard to disagree with any of it. The check written to AIG to pay back Goldman, Merrill, and others for 100% on the dollar is an amazing thing in light of what has happened to the rest of the economy, and really calls into question how anyone (even an independent Fed) can write a check for upwards of $105 B without some sort of oversight.
I get this feeling we are sort of standing in the bottom of an economic tub. We have had a severe contraction, followed by governmental stimulus at an unprecedented level, and now are seeing some signs that the contraction is easing and maybe has begun to flatten out. The problem is that the severity of the contraction has left literally millions of people affected, by both loss of income due to job loss and severe wealth contraction in both stock and real estate values. If you add to that the implied cost of the stimulus going forward the numbers are really hard to even imagine. Everyone knows, and I mean everyone, that any hope of a recovery will be immediately swallowed up by increased taxes, fees, whatever, that is already taking place at the state and local level. We are taxed to the point of impeding any sort of recovery, yet in terms of what government is spending we are incredibly under taxed as a society, and no one want to hear that. The neo-cons want to continue to fight 2 wars, but not pay for them, large corporations want every advantage known to man, but view taxes as “non-competitive” in the “global” picture, and liberals want every social program to continue regardless of effectiveness or “other” peoples ability to pay for them. All this is happening with a background of massive fraud on virtually all governmental levels, and as a country we are now almost totally unable to deal with that fraud. If the Supreme Court this week throws out the law regarding theft of services (an unclear and poorly written law, but virtually the only law used to fight corruption in government or corporations) we will be left with almost no legal weapons, amazing considering we have had people passing laws for over 200 years. We might even have to let Blago go free in Illinois, yuck!
As far as investing, I continue to think we are in the right place. We need to have some cash available, so if some opportunity in the market or fixed income comes available we can be ready. I also am hesitant, without some real conviction that the market will rally strongly from here, to pile everything into the Protected Index Program given the disparity in volatilities. If we want to stay a little long, probably the right position, I prefer to do it through smaller spreads instead of committing all our spare cash. Sometimes doing less is the way to go, and it seems like it might be one of those times. We will get our chance, and if the volatility wants to continue to drop we will get our chance on the long side of that volatility. That is OK; money made long volatility spends just as well.
P.S. PTI Securities & Futures will be hosting an In-Office Protected Index Program Seminar on Saturday, January 9th from 9:00am – 12:00pm. My brother Dan and I will be discussing how the PIP works for clients within their individual risk parameters. For details and to register, visit www.PTISecurities.com/Education.htm.