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Efficient Market

February 14, 2011

Good morning. We had another quiet but positive week for the broad market last week, with the SPY quietly advancing 2.04 to finish at 133.11 (1.5%). The VIX, mainly due to the very quiet week, was down to 15.68, a drop of another 1.8%, and a level that we reached last April before the market underwent a roughly 15% correction. For whatever reason market advances have been associated with the significant decrease in market fear, so that virtually all market corrections or sell-offs have been associated with low implied volatilities at the start. That really goes back to, in my memory, the almost absurd low implied volatilities present in August 1987, two months before the October Crash. I am surely not predicting anything on that scale, or even a serious correction, but I continue to be amazed at the drop in the price of protection as the value of the asset goes up. As retail traders generally are required to trade from the long premium side (easier to be long premium than short in retail accounts) the potential for profit is much higher when the implied volatility goes down, as spreads can be put on that will benefit from a relatively small market move, and eventually that move will come. The trick is to stay somewhat close to break even, through active management, of the spreads that do not just get up and go our way the minute you put them on.

It is a tough time to trade if you are cautious about either your money or money you have been entrusted to manage for clients. The market continues to creep up, slowly, and seems to be just the tail end of retail mutual fund people switching into (or chasing) equity funds, maybe moving funds from shrinking bond funds. However, that creep can go on for a long time, or could be just a pause before a more vigorous long side breakout if, indeed, everything is now right with the world. There actually have been people on the business channels that have said flat out that there is no risk in the market right now because the Fed essentially has your back, and they (the Fed) stands admittedly ready to pour more money into the system at any hint of a correction. The assumption there obviously is that Uncle Ben Bernanke will essentially give notification of a change in policy in time for anyone smart watching to get out before the next (dumb) guy knows there is a change. I guess it could be that easy, and maybe it is if you are “tuned in” to Fed moves in advance, but it has never been that easy for most of us. The fact is, it is always hard to figure how much of any sort of policy or announcement has already been “anticipated” by the market.

As a Graduate of the University of Chicago School of Business, it was drilled into me the theory of the “Efficient Market” that essentially collectively “knew” all, and this was before Twitter and Facebook, even email and cell phones. If it was hard to keep a secret then imagine now how hard it must be to keep any kind of secret now; it must be almost impossible. Yet the market did not discount for the credit default crisis in a timely manner, in fact it “collectively” seemed oblivious to this entire other world of information contained in this “new” default market and how it would eventually affect the equity market. When the Fed announced this new “QE2” thing it was obvious to me that (by looking at the money supply numbers) they had, in fact, already started the monetary easing a couple of months before and that the market had already started to move up (in effect, had already discounted much of the announcement). Obviously, on the surface, if I were the only person to hear that the Fed had made that policy change, I would have said start buying the market and keep doing it until the first criticisms of the policy start to take root. Being still somewhat of an efficient market person (less now) I never believed that maybe I was the only person to look at the money supply numbers and that the Fed move had not been anticipated at all, but it seems to have been the case, the market started right up and has slowed some, but really has not looked back. The eventual failure of similar policies in 2000 and 2007 seem totally out of the collective memory, does that mean it is different this time or that people have just that, short memories? We will see, but I am not sure at all that we will get the word in a timely manner and all be able to get out when the Fed changes course. After all, to get out don’t we have to sell to somebody, and how do we know he or she will be the willing chump if the tone change is so obvious?

On the Economic number front we again have conflicting numbers (go figure). We have continuing improvement in employment, slower than ideal, but surely heading in the right direction. Or are we? We have seen the numbers turn positive every month, and on balance have seen employment up around a half million and the unemployment rate drop to 9%. Then you have a learned figure like David Stockman (Reagan era Director of OMB) writing and stating that if you counted the half million person adjustment to the Labor numbers last week you have virtually no job creation over the time that the recession has supposedly been over. I think there have surely been private sector gains, but they seem to have been totally offset by public sector layoffs. Then there is the article in Yahoo News by Zachary Roth that points out that according to the Labor Department numbers the total number of people in the labor force has not grown since 2008. Usually when you come out of a recession the labor force grows, as people start looking for work or stop fleeing to school to avoid the bad labor market. This contrasts to an average annual gain in the labor force in the 1990’s of 1.3% per year and 1% per year in the early 2000’s. Nobody new since 2008 seems very strange. I actually think it is easier by far to get a job than it was in late 2008, but maybe the numbers were understated then. In any case it is tough to reconcile. One of the more ominous things said by Mr. Stockman is that the rate of growth, such as it is, is only one third that of the stimulus, which is exactly what I was saying in one of my earlier posts. The size of the stimulus is almost 9% of GDP, growth is 3%, not exactly the relationship you would want.

What about the Middle East? We had a sharp market drop two weeks ago last Friday when the demonstrations in Egypt started, and since then the market (with or without the Fed’s help) has made up and exceeded that loss. Right now we have a military government promising to work towards real elections, with a deadline of this fall. I am sure pulling for them, but books written about militaries forming democracies are pretty scarce. We all should be shocked, shocked, to hear how lucrative it is to be a despot, with Mubarek’s wealth estimated to be anywhere from $4-5B to more that Bill Gates in the $50-60B range. When you have those laws requiring anyone investing in your country to have a 51% partner from inside the country, and you willingly provide sons and those connected as volunteers to be that non-investing but participating 51% things can grow rapidly. Throw in a few average kickbacks for “greasing” virtually every other major construction project and you can get lots of nice houses in nice places. Now, however, what does the world, and Egypt, do about it? Should the Bolshevik strategy, kill every family member you can find, be the answer? Maybe there should be some sort of trial, where the guilty would have to give back the money (risk there is the sleaze balls who gave him the money in the name of “just business” might be named). Or just let him and his scummy family go free with most of the money and say he played ball with the connected and those are the just fruits of a textbook despotism well run. What exactly are the morals for giving kickbacks to those with their greedy palm out? Do we even know? Surely we do not care, it is, after all, just business.

So what about trading? It has been very frustrating in the last two weeks, with some short premium (looking for little or no movement) positions in a few stocks before earnings (MSFT and CSCO for example) looking very advantageous, but were followed by huge collapses on earnings. Corresponding positions in the broad market, again priced very attractively, that looked for movement, have found the market virtually at a standstill except for a slight dribble to the upside. It is somewhat interesting that CSCO fell dramatically after a conference call where the CEO, Mr. John Chambers, cited decreased governmental spending for infrastructure as the reason for slack growth. Does anyone really think this problem will be unique to CSCO going forward? Anyway, I think being long premium at these prices will be the money making position in the next market cycle. The spread we put on last week for those in the SPY PIP needed less that $1.50 in movement in over three days to break even, and the market did not make that move. The odds, in my opinion, were and will continue to be in our favor at those prices. If we can stay anywhere close to break even on the weeks without movement we will be there and ready when the next move happens, and it probably will happen sooner rather than later. If we can get any move out of these bonds over the120 level we will also be looking to go bearish on them. In addition, we will be looking for long premium positions in some of the stocks that have had sustained run ups in the last couple of months, maybe they have come too far, or maybe this is a new and better world and we will be on board if their runs continue.