Era of the Hypocrite

Good morning. It was a strong first week for the market in 2010, with the SPY closing up 3.13 on the week to 114.57 (2.8%). More importantly (maybe) is the amazing drop in the VIX, from 21.68 to 19.12, an astounding 16%. Could an expiration back spread be in our future? I am surely tempted, and may jump on one as soon as today. The SPY 114-108 sure looks tempting. For those who do not remember the price action in early 2009, the SPY started the year with an initial run-up of around 3%, only to end the month of January down 8%. I am not predicting that here, but the rally is getting a little long in the tooth in some sectors, and I will predict that it needs to broaden out some to continue. I think that even if the rally continues it may not work to stay long the same fifty to seventy-five stocks that formed the bulk of the run-up in the last few months.

It would be very difficult to read or listen to virtually any financial or political broadcast or publication without hearing the word reform. We need financial reform, regulatory reform, political reform, throw the bums out, regulate them more, regulate them better, etc. I will predict this; we may refer to this age in the future (sort of like the steroid era in baseball) as the “era of the hypocrite”. Is it a sign of something that the more we talk about reform the worse things seem to be? I see no reform of any kind; I see groups of people talking reform with no idea of what they are doing and no ability to either see the fraud around them or have the courage to call out those lining their pockets at others expense. For an example I will refer to the State of Illinois, and their antics of the last week. Remember that this is the State (arguably the most crooked in the country) that has sent the current “reform” group to Washington to straighten things out. Even though I voted for the current President I will surely state that I am aware of no instance in his career in Illinois that any level of corruption offended him enough to say or do something about it.

Anyway, last week the State of Illinois went out to borrow roughly $3.8 B dollars, for the purpose of funding the absurdly under-funded state pension funds. We could talk for a long while as to whether this is a good idea, the courageous thing might be to lower pension expectations since even this infusion does not get the funds remotely close to fully funded. Or we could talk about the financial wisdom of paying an average of 4% for money to put in a fund that I seriously doubt has come close to that return in years. This is the same fund that legit firms like PTI would love to help manage for way less fees than they are currently paying, but the cost of entry (allegedly $250,000 to some future penitentiary inhabitant for the ability to make a presentation) seemed to high and too dishonest for some of us, but I digress.

The State of Illinois, due to a budget shortfall (despite a Constitution requiring a balanced budget) somewhere between $5-15 B, has managed to acquire the second lowest rating at Fitch for a state at A (California is lower at Baa1). Largely due to this bad rating, the sale of the $3.8 B last week nets a price on the debt in the neighborhood of 175-182 basis points over the Federal Government. That is awful high, even keeping in mind that debt for this purpose does not carry the normal state tax exemption. As published in a Bloomberg article by Mike McDonald and Mike Quint, that number represents a full 120 basis points over the debt of Dr. Pepper Snapple Group, rated one notch above junk. So despite the high price Illinois had to pay due to a bad rating, they managed due to incompetence (or worse) to pay way more that. One hundred and twenty basis points on $3.8 B represents approximately $45 M per year, made worse if the pension fund is unable (most likely) to match that figure (maybe the pension fund should buy the bonds).

Where is the outrage? I watched the gaggle of would-be future Governors and Senators at various debates and forums this weekend, and no one referred to anything like this as something they would stop. John Sinsheimer, State Director of Capital Markets, is “Very pleased” with the results. The consulting firm on the deal, Peralta Garcia Solutions, is a minority/female firm with experience at holding big jobs at the politically connected and astutely well run (that is a joke) Metropolitan Pier and Exposition Authority. I doubt if they received this contract by either talent or low price. Maybe we should have a contest over which would-be or actual politician can use the word reform the most while actually pushing corruption. Are we incapable of seeing the difference between electing some hack to a low level job because he or she might get Uncle Charlie a job in good times, and the current situation where we are heading towards bankruptcy, lay-offs, reneging on pensions, etc? Are we so used to and blinded by morality as defined by corporations and politicians that we don’t even know (collectively) what fiduciary responsibility and real morality is? I am really beginning to wonder.

What sent me off on this subject? Partially it was the concern voiced by the terrific group we had at last Saturday’s PIP seminar. To a person they were concerned about their financial future, and seriously were aware that people’s financial future, employment future, tax future, etc. are somehow all intertwined with politics to a degree they have never seen. Almost every question had to do with finance/public policy. Questions like “How come interest rates paid are so low when interest rates to borrowers are still relatively high?” and “How will someone’s idea of a transaction tax affect trading?” and “How exactly are all the people out of work going to find a job paying enough to help pay for all the debt the various governments are amassing?” I did not have the answers, does anyone? I do know that before you can fix all the problems state-wide, you need to know what the individual problems and individual acts of larceny are, and stop them (like the one described above). Talking over the problems with general platitudes (Mr. President) does not get the job done.

How do we trade it? If the VIX keeps dropping we will aggressively trade it from the long side, and whether the government solves things and causes a rally, or messes things up even more and causes a sell-off we will benefit. The seeming incongruity between concerns about deficits, possible state bankruptcies, new laws affecting business, and the steady decline in the VIX, should mean that we can participate in big moves and protect our investments better and cheaper going forward. Right now the cost of insuring an SPY position is roughly 30% cheaper than in March, with the SPY roughly 50% higher. It is still not at a historically low level, but is clearly reaching a level where we can enter the market and buy protection at a much more reasonable price. It has been difficult for me to have such high cash balances, since they are returning such a small amount, and if the VIX continues to drop we will put some money to work going forward. I would prefer to get a lower price for the market in addition to the lower VIX, but if the VIX were to get low enough I would get in at this level and maybe buy some extra puts as a hedge against a double dip marker drop. We will see, I think it is about to get interesting.

We have scheduled a Protected Index Program® Teleconference for Wednesday, February 3rd from 6:00pm – 7:30pm CST. All you need to attend is a phone and a PC. My brother Dan will be outlining the specifics of our managed money program, which focuses on portfolio diversification and protection. He will be answering all your questions live and this session is 100% free to you. You must register to attend in order to receive participant instructions via e-mail. Get details and register here!