October 31, 2011
Good morning. It was a huge week for the market last week, with the SPY up 4.63 (3.7%) to close at 128.60. That strong up move was accompanied, as it often is, but an even larger downturn in the option premium levels as defined by the VIX. Those levels, the so-called fear index, were down a whopping 22% on the week to close at 24.53, the lowest close since August 4 of this year. Quite obviously the combination of headline news items associated with the sharp rally were the announced framework of a resolution to the Greek debt issue and some slight increase in the tone of domestic economic reports. The Greek resolution involves almost exactly what had been leaked for days, namely a haircut on Greek debt of around 50%, a substantial sum of money (1.3T) pledged by Euro-governments to shore up Banks and others with exposure to the now decreased value bonds, and some work-out agreements with lead Banks to reformulate their capital structure to achieve 9% capital ratios by mid-2012. The good news domestically was the first estimate of third quarter GDP, coming in at a positive 2.5% compared to first and second quarter readings of .4% and 1.3%. Although still weak and very tainted by the shear levels of stimulus being applied both fiscally and monetarily, the 2.5% does show steady progress over the last two quarters.
I remember, and it was not too long ago, when it was much more difficult to get information, especially financial information. Most of it came by daily papers like the Wall Street Journal, which someone like Matt Weber would have to hustle to find early enough to read before our 5:30 AM radio show, or you would get the whole week in review in something like Barrons. The one positive thing, however, was that the actual raw numbers were on pages of the paper off by themselves, you could actually page back to the real numbers without having to stomp through someone’s opinion or listen to the “spin” to see them. I suppose if you really wanted to you could do the same thing on the internet, in fact I have been fairly successful at finding some of those pages, although some of the best sources of pure numbers from the government seem to “evolve” some over time. Anyway, what I am getting at is that if you allow yourself to be “pointed” to certain information and “spun” by the talking heads you sometimes can miss the real picture, or can actually form a strong opinion which the “real” numbers might not support. How many, for instance, have heard that the Federal Reserve policy of monetary expansion (the so-called QEII) ended on June 30 and that the latest policy initiative (Operation Twist) was merely an adjustment on the yield curve to the Fed holdings involving little or no net gain or loss to the Fed’s balance sheet. In fact, the only announced real “expansion” is the continual reinvestment of interest and principal payments on paper owned by the Fed. In addition, how many have heard the (I will say absurd) debate on whether there should be a QEIII or III ½ or something to further stimulate the economy, as for now the Fed appears to be doing nothing of substance? I think everyone who listens to a station that is not all cartoons has heard something to that effect.
What if I were to point out that in the last three months of the so-called QEII, months March to June, adjusted M2 (M1 plus retail MMF’s, savings, and small time deposits) grew at an annual rate of 7.7%. I suspect you would, if you were any sort of a student of Monetary History, say that a rate of advance of that magnitude (especially given the very meager 1.3% growth in the second quarter) was expansionary to the point of recklessness, and that the risks to inflation were very high. But, you might also say it was an aggressive attempt by an activist Fed to make sure that “general” deflation did not happen, and it was part of a (very misguided in my opinion) plan to re-inflate the stock market and housing market (even though any economist on the Fed level should know that trying to “point” where you would like to inflate has probably never worked). Either way, it was over on June 30 and people are back to their senses with an outside few lobbying to do it again. Right? You could not be more wrong! In the three months since QEII has supposedly stopped M2 has increased at the stunning annual rate of 21.2%, over three times faster than during the supposed expansion. To be fair, some of this might be some deposits entering the US from Europe, but still the Fed should be fighting to drain dollars from the system to account for that. With this monetary backdrop how enthusiastic can anyone really be with the “substantial” 2.5% growth in the economy in the same quarter. I intend to do a little research before next week to see if we have ever, in this country, have had money supply growth of these levels. Even in March 1980, when the inflation rate was over 14 % the growth in M2 was only running in the 7.1% annual range.
Are we flat out being lied to, are we being “spun” to look only at the slightly increasing GDP growth numbers? Why doesn’t any single one (that I have heard anyway) of the talking heads, when questioning the need for a QEIII, just come out and say “Well, if you look at the M2 number it looks like QEII never ended.” So far, the Fed has had the steadily growing money supply drive the real rate of interest decidedly negative (nominal rate of interest in the 0-1% range with CPI roughly 3.8%) but there sure seems to be pockets of steadily increasing inflation starting to appear. The point is why do people in our government feel they can be so reckless, and I would surely characterize 20+% growth in M2 as reckless, and then basically deny the policy? Clearly the Fed is in the midst of some tremendous secret policy initiative, and interviews of even the dissenters on the Fed do not address this issue at all, much less the risks involved. If I am missing something, for instance if it were true that multi-billions came flying over to our banks from Europe in some sort of short-term move that is already being reversed, why isn’t that being explained, or at least asked of the seemingly always talking new “transparent” Fed? Or do people value their spot in the big press conferences so much that they will not risk the tough question? I honestly do not know, but am very worried.
How exactly am I going to maintain (or exceed) the buying power of my clients’ money with an inflation rate of 6-9% with interest rates of 2-4% and possibly a moribund market? Somewhere, buried in this “strategy” must be the belief that this “targeted” inflation will drive the market to new heights. Maybe so, so far the pricing power seems to be concentrated in the hands of the largest multi-nationals, natural resource, and health care areas, and I guess the plan is for “people” to make up for their being fleeced by the few with the ability to raise prices the most by owning stocks in those companies. All I can say to that strategy for the population in general (although we may profit by recognizing it) is WOW! Talk about how class warfare gets started. Plus I have this nagging memory that the last time this strategy was essentially “tried,” meaning the tossing of excess money at a stagnant economy (late 70’s-early 80’s) the market was anything but a hedge, the Dow was around 800. I also know that some people did way better with inflation than others in those days.
Tell me if this is how this scenario might actually play out for someone we know. You have a person, say 34 years old. He or she went to college, maybe grad school, and graduates with a substantial student loan. He or she gets married, and buys a house several years ago, for $275,000 (down payment of $50,000 from savings and parents) and has a 6.25% mortgage. The house is now worth $175,000, and he is unable to refinance for the now market 4.25% because the place will not come close to appraising, even though he is current on payments. If there is any sort of a blip, either he and/or the wife either lose their job or even get transferred to a job in another location (or have any sort of medical issue or unplanned expense) and the house needs to be sold it enters this limbo land of short sales. Someone new now gets to buy this house at a financing deal way better than that available to the current owner, so he becomes a renter with no chance of a rebound in prices saving him. Enter the Fed. They now want to, without any regard for this fellow, now re-inflate the market so now five years from now this house is “inflated back” to $350,000. This fellow, since the savings and potential from the parents is gone in the first down payment, now has to pay some seriously inflated rent to someone maybe “benefiting” from either just good timing or some secret program aimed to the few. Maybe he can rent his old house back for some multiple for what he would have had to pay with an adjusted mortgage, courtesy in part to a dysfunctional Fed. What a great age to be an American! Now how exactly does this fellow fight this sort of policy stupidity, write a letter to his Representative, make sure to vote, carry a sign, get a FOID card? Pretty sad commentary on the American dream, where exactly does the wealth creation start for this fellow (after this mess) so he can send his kids to college and retire?
So how do we trade it? We have to stay protected and hit some singles. Obviously it would have been a nice week to just own some stray calls last week, as an almost 4% move in a week is pretty powerful. It does give some pause, however, to see that magnitude of a move (even to the upside) on information that was not really all that original or detailed. The natural thing would be to wonder how much we could move down on a similar break the other way in this seemingly headline driven market. However, for the moment we will applaud the rally and be happy we did get long a few beaten up stocks a few weeks ago. So far, those investing in our new hedged (will not say Protected like the Protected Index Program (PIP) due to some basis risk) dividend program have been very pleased with the results, but it will take several cycles of different sorts of market moves to really get a feel for how it compares to the basic PIP. I think it is possible here, and we have had some success, to take advantage of these back and forth swings. In other words, waiting for a run up or sell off to look a little extreme and taking a very, repeat very, small and limited risk position that would benefit from a market swing the other way. For instance, a small put spread after a large up day, maybe a small call spread after a large down day.
I am actually very pleased how the PIP has held up to this market volatility, and those PTI clients who have large positions in individual stocks where we manage the risk have found even greater benefits in most cases of being protected. Risk control is very important here, we want to not only survive these times, but also win in the long run. Please email me or call me at 800.821.4968 if you have any questions about the PIP.