September 13, 2010
Good afternoon. It was a second in a row up week for the market last week, with the SPY advancing .59 to close at 111.48 (.5%). It was significant because the market was able to hold and consolidate the large gains of the week before, leaving the SPY up a strong 4.3% for the two-week period. The VIX was actually up slightly (3%) last week but still showed a large drop of 10% for the two-week period, closing at 21.98. Be careful not to ignore, however, the down move of almost 2% in the long-term bonds over the same two week period, and a move down of 3.6% since the high in the December Futures contract of 135 4/32 on August 31. Why are we talking bonds all of a sudden? In the last few years, as the stock market has treaded water and people have become increasingly concerned about safety of investments, bonds and bond funds have shown huge inflows. Some figures indicate that more retail and pension money is now in bond funds than stock funds. If we now have a day where, say, the market is up 2% (a real solid day) but it is accompanied by a 2% bond sell-off, the net to the average investor could actually be flat to a little negative. Watch those bonds!
Why is the market so aggravating lately? I get that question from everyone, some actually seeming to think that it is aggravating only to everyone except me, and I sure wish that were true. It seems like the market moves just enough almost violently within this range to make short premium positions, like time spreads (which we love), butterflies, and short call and put spreads, a real challenge, but not enough to actually go long premium and have the market break out. It gives you a tease, and then if you do not take your hard earned dime in the short window given, it reverses and tosses you into a loss. Obviously, it is frustrating to not be paid much for money balances, we have clearly promised a lot of retirees that if you save your money it will be worth something in regards to income, not so now. We also are finding it more difficult to roll our call options due to lower premiums, even though we have done a real solid job of gradually “catching” the market rally of last year. My clients even see the difference, and ask (it is a blessing to have bright clients that are aware of what we are trying to accomplish) why it seems like we are not getting as much for the calls options we are selling as in years past, or why the repair strategies we select seem good, but maybe not “as good” as in the past. The answer lies in the interest rate levels, or in the lack thereof.
With all of the things affecting the economy currently (maybe I should have said with all the things wrong with the economy) the one that gets virtually no press (or editorials for that matter) is the effect of virtually zero interest rates on essentially an entire investing population. The standard economic theory says that (and we have mentioned this before) lowering interest rates helps the economy and most people, the idea being that most of the population (at least in their productive years) are net borrowers. As you enter your adult life you buy a home, with a mortgage, buy a car, probably with a loan, etc. This was the theory long before credit cards and six figure tuition loans were even invented. The same mix was thought about business, in a growing business you probably “financed” the firm with maybe 30-50% equity (maybe) and the rest some mix of long term financing (bonds) and shorter term financing (bank credit and commercial paper). So, the theory goes, if the average rate paid on those loans dropped, individuals and businesses would have more money to spend on other things. Anything other than that answer would surely result in a bad grade and maybe summer school for economics 101.
The question is, and is now the great economic experiment being conducted by really two administrations, whether that theory holds in the extreme in a society where investing is almost as important as borrowing for a lot of the population. And let me say this out of the gate, neither Bush nor Obama (in my mind) cares a wit about whether this policy will bury most Americans, it is purely an unintended consequence (to them) of propping up the Banks and the other top 500 people that seemingly run the country. I think there will be many PhD papers in the future regarding what this interest rate policy did to the average citizen, and maybe a Nobel Prize, and I think the answer will be that it harmed the average citizen. I sort of get the feeling that it is akin to responding to someone’s plea for a little warmth on the South Pole by flinging him or her in hell, maybe a little too much heat. Why do I say that? It goes to who gets hurt. I know my clients are being hurt by low interest rates on their money balances held here or anywhere, and the calls we sell are cheaper because of it, but how are they benefiting? If they want a mortgage at 4.6% (a great rate in theory) that is probably 4.1% higher than the rate they are being paid on balances in that bank. I seem to remember the spread in the old S&L days as being more like 3-3.5% (mortgages around 6% and passbook around 3%). A person here in the office applied recently to Citi and the “fees” and points totaled almost 4%. If you do have small business loans that are generally considered hard to get, and what would your rates be, 5.5-7%? That is a lot if your balances are earning almost zero. Credit card rates? Do not get me started. The lack of loan availability and the spreads between paying and getting are nothing more than a serious abuse of monopoly power, in my opinion, and not the help to everyman that is constantly touted.
In regards to call and put pricing, interest rates have a very large effect. In the SPY (stock trading at 111.50, the theoretical value of the March 2011 (not that far away) 112 calls and 111 puts are 6.98 and 6.55 respectively, virtually even. If you raise the interest rates to 5%, a historically fairly low number for broker call over the last 15 years, the respective theoretical prices of the 112 calls goes to 8.48 and the 111 puts decreases to 5.62. Clearly the covered writer and the protective put buyer are being harmed, as the implied interest benefit buried in the fully paid for stock is virtually nonexistent. In other words, there is a “benefit” usually in owning something free and clear when everyone else would have to pay interest to get to the same right of ownership, and that “benefit” decreases with dropping rates. It should be noted that if the interest rates were to go to zero, like in pricing a futures contract, the calls and puts become virtual mirror images of each other, meaning at 120, say, the 120 calls and puts would be virtually equal in value and both have a 50 delta.
The question remains, should we get on board the current market rally taking place in a way less than perfect economic environment? Whenever the market recently makes it back to the upper end of the range it has been in, roughly 1115-1125 in the S&P, the market looks like it is gaining momentum and it feels like a buy, only to fall back. What about this time? It does feel to me that a breakout to the upside is more likely this time, even with the huge overhang of bad economic news. This morning we had good news results for manufacturing in China and the absurd news that European Central Bankers will give Banks up to 8 years to become compliant to new rules. What a joke! However, it does seem like the Banks have been propped up enough to where we will not have problems from them in the near future, and so far it seems like the rest of the population has accepted the bill (or can’t comprehend the size of the bill). If necessary, we will hold our nose and buy a few of these monopolistic companies that have seemed to become immune from normal competition and rules. The money made with your nose held still spends. There also is the political issue of mid-term elections, and both sides appear ready to take credit for any rally that takes place between now and November. I happen to think that from the Economic policy side of things neither side has any recognition, at least publicly, of the depth of the economic problems or backbone for any meaningful reform. That does not mean that the market can’t rally, at least in the short term.
In regards to countries in Europe having financing problems, that story has cooled recently in the press as well. It is surely interesting to note how “we” have all become intoxicated by the new mantra that if someone, from somewhere, shows up to lend money to a country (or state, or city) despite their obvious fiscal problems, that the problems really can’t be as severe as anyone previously thought. Last week, all fears of the Greek fiscal problems seemingly went away because Norway showed up with cash, the idea being that if the problems in Greece were really bad the all–knowing Norwegians would not have shown up. All I can say about that logic, given the previously supposed bright professional people buying mortgage backed paper, Bank stocks, FRE and FNM stocks, and now state and local paper and U.S. Treasuries, is YIKES! As long as someone bought it, it must be OK. You would think we would have learned.
Politics? As low as I think it can go, it seems to go lower. As bad as the economy has impacted a lot of the citizenry in the last several years, nothing, to me, has happened to change any of the stripes on the creatures we continue to elect. We continue to argue amongst ourselves and elect people who are incompetent and dishonest. Nothing stops the run on the federal, state, or local bank by those who can. We continually cut services to the many and raise fees to maintain the exorbitant dole for those with their nose in the trough. The only thing I can say is that things must be still good enough for the rest of us (collectively) to care more about the Bears game than the future of the country. Maybe we have lost the backbone to do something about it, it really is a lot more comfortable with a beer on the sofa watching the Bears that wearing one of those ill-fitting sandwich signs on the demonstration line. Or maybe we try to go below rock bottom and run with a Sarah Palin/Glenn Beck ticket. How far can I get with my truck on a raft with a makeshift sail?
So how do we trade this conflicting mess? We have had a tough time with the weeklies, after a hot start, the last few weeks. It seems there has been a big move day every week, taking us out of the range we would prefer. It is especially troubling when the spreads were skewed to the upside, meaning we were bullish, but that the move up was so fast that we were not winners. I still feel that the 6-8 point volatility advantage we have been getting when we initiate these positions will make us solid winners in the long run. We initiated some new positions in the XLF under $14, and those have worked out, and I continue to feel like the Banks are a place where we want to stay long. We are sort of in the position, for our most aggressive traders, of long oil, long banks, short treasuries, and a little long in the PIP. I like those positions in general, but will look to roll up the PIP calls and puts at a our earliest opportunity to do so, locking in some of this late rally and giving more chance of upside appreciation.
If you are interested in learning more about the Protected Index Program (PIP), PTI Securities & Futures is hosting a complimentary In-Office Seminar on Saturday, October 2nd, 2010 at PTI’s Chicago Loop Office from 9:00am to noon. Topics covered in these education sessions include: review of option basics, investment program objectives, diversification solutions, SPY basics, index portfolio examples, option time decay and Protected Index Program portfolio example, strategy expectations and objectives and longer-term fixed income products. A continental breakfast and classroom materials will be provided to all registered attendees – but you must register at www.PTISecurities.com/Education.htm – I hope to see you there!