January 31, 2011
Good morning. A significant sell-off last Friday left the SPY down slightly on what had been a positive week, with the SPY closing down .65 for the week at 127.72 (.5%). The VIX closed up 8.7% but still was not that elevated at 20.07. Most of the Friday sell-off was attributed to the spreading political issues in the Middle East (as well as F, AMZN, and MSFT earnings), as uncertainties surrounding the future of Egypt and the Suez Canal took center stage. As of now, to the extent that anyone can predict the outcome of unrest due to 30 odd years of heavy-handed rule, the situation does not look dire or likely to spread rapidly or violently to the surrounding countries. Obviously, all of that is subject to change, and rapid change. It also is interesting that one of the catalysts of the unrest is the recent spike in food prices, something that could clearly be one of the consequences (intended or otherwise) of the recent Federal Reserve effort to create inflation (create inflation and then deny the existence of inflation). I think we all know that the seeds of discontent in countries like Tunisia and Egypt go much further than commodity prices, but there needs to be a spark to get the fire going. History surely has an example, where the seeds of conflict before WWI were sowed long before Archduke Ferdinand was shot; yet it provided the unlikely spark (did anyone even like the fellow?).
Why does it matter here, or will it matter for more than a day in the market? Normally, or should I say most of the time during my lifetime, I would say no. It looks to me like the Egyptian President will abdicate, with a large part of his stolen booty, to some high end retreat with a few hundred of his kindred family and other partners in corruption. Hopefully there will be someone who can gain power temporarily as the UN helps with the electoral and nation building process, and a few years down the road the whole experience will be viewed as a net positive for rights, markets, democracy, etc. Can a lot of things go wrong along that path; from religious fanatics becoming a factor to so much unrest the Army must (in their mind) initiate marshal law, or even an outside country becoming involved? Anything is possible in a crisis. Will someone, as Shakespeare once said, “Cry havoc, and let slip the dogs of war” or will some of the rioters turn into looters and pillagers to the extent that armed intervention is called for? If four or five countries are out of control can anyone trust the remaining to not use the situation to take advantage in the name of “order?” Let’s hope no to all of the above.
The nervous part, at least the way I see it, is the timing. It goes without saying that the U.S. is still a military superpower, and if the situation in the Middle East would call for an aircraft carrier or two, or a temporary peacekeeping force, the U.S. surely has the capability. In terms of economic condition, however, the U.S. is far from healthy. We are deeply in debt and the policy going forward (I know, some groups say they want to do real fixes) is some combination of ignore the problem, kick the problem down the road, make it worse in the hopes that overspending will help the situation, or blame it on the opposition party. The issue with that is that a lot of the influence a country projects is economic strength, not armed strength. The Berlin airlift was possible because we had the will and money to pay for countless supply flights; Russia went down due to their economic system losing to ours with the resultant inability to fund their superpower status. This would be a real awful time for the U.S. to have to expend any real resources in keeping the Middle East from blowing up. We have put ourselves on the edge, and for some of the same reasons of corruption as the current administration about to be tossed in Egypt. Egypt has a huge disparity in income, rampant stealing on the governmental level, rising food prices, increasing unemployment and underemployment, etc. and a government that is unresponsive and repressive. Obviously, there are some differences here, for the present we still have elected governments and it is still possible (but increasingly unlikely) for someone relatively independent to become a serious elected official. Still, when Mr. Mubarak and his group depart there will be this feeling of “Where did the money go?” as people will no doubt be stunned by the huge wealth void caused by thirty years of corrupt rule. How is that much different than people here asking someday “How exactly did you spend those kinds of fees on pension fund management that did nothing but lose money?” or “You spent how much on Homeland Security yet we still can’t evacuate a city of 100 in a timely or orderly fashion and have a staging area for them to go?” or “Who were all these private contractors in Iraq and what exactly did they do for all these billions?”
The point is that we, meaning the collective we, somehow feel like we have all the time in the world to right our economic ship, that no outside catalyst will wreck our timing. I thought, and still think, that this Middle East situation could be the beginning of timing going awry, or at least a wake up call. As a trader I could tell numerous stories of people having exposed risk, feeling that they had all the time they needed to address the risk, and then getting buried by an untimely takeover or other outside event. Do people really think that the world will give us until 2025, or 2035, or whenever we feel we will have addressed our “issues” without a bump? Do we really think that the U.S. economy can handle lengthy oil disruption and $150 oil? Are these the same people that cheer every earnings announcement with the statement that Company XYZ “Has maintained their pricing power by being able to increase prices more than the increased costs of raw materials” yet in the next minute declare that “There is no indication of inflation.” Can we really have both?
Why do I continue to be so guarded in my opinion of the market? Everyone in the world appears to be bullish, some to the extreme. All the economic reports seem mildly positive, and fourth quarter GDP came in at a positive 3.2%. This morning both the Chicago PMI and Personal Income (except wages and salaries) were fairly positive. Why don’t I just say, “This is it!” and “Buy, buy!” My hesitancy still has to do with the governmental piece of the pie. The U.S. GDP is a little over $14T. Right now the Federal government (not to be confused with the Federal Reserve) is adding roughly $120B per month on average, roughly half of which they are borrowing from people outside the U.S. (if all the borrowing was being done internally the analysis would be different). That means that over 10% of the purchasing each month, let’s say 5% and count the external borrowing only, is being done at the Federal level with borrowed funds. Does that mean that the real growth number from the rest of us, since the total growth is 3.2%, is a negative 1.8%? Shouldn’t the total growth in the GDP be greater than the amount the Government is putting in if growth were in fact “catching fire” and “becoming self-sustaining?” That is assuming no growth whatever from the domestic borrowing piece, and classic Keynesian Theory says there should be some there as well, if it were truly working. It also totally ignores the incremental growth that the Federal Reserve is pushing. I just do not think it is enough, at this level of stimulus we should be having growth at 6-7%, but given the total loss of dozens of industries here the capacity for real short-term growth just seems to be not there. If not real growth, then just inflation?
What have the issues in Egypt and elsewhere done to the trading? The increase in the VIX last week dramatically lowered the skew going out we have been seeing. Last week the volatilities in the SPY ranged from as low as 14-15 in the near term weekly to over 20 in the LEAPS. Today the near term is a solid 17. If that evens out a little more we will be committing some cash to the market in the traditional PIP Program, although we will be keeping our protective puts very tight. The last couple of weeks have seen those in the SPY PIP Program profit by a couple of expiration type back spreads that took advantage of the relatively low implied volatility in the weekly options. The position two weeks ago worked in a fairly straightforward manner, but last week it took some timely active management to produces a winner. The object here is to generate some income using the undervalued (or so we think) weeklies, then to use that income to bring our short calls closer to at-the-money. It has worked for two weeks, but so far this week the prices so far seem a little too high to initiate a position. I also am a little reluctant to call for an all clear on these Middle East issues, and say it is okay to get back in the investment pool. Anything over a normal bounce today might want to be looked at as an opportunity to lighten up on the market.