January 3, 2011
Good morning, and Happy 2011 to all. Last week the market basically flat lined, with the SPY up .15 on the week, call it even. The VIX was actually up 7.8% on the week to close at 17.75, reflecting the idea that the post holiday weeks will probably be somewhat more volatile than the very slow markets we have seen in the last week. For the year the SPY was up 12.8%, 10.2% of which occurred in the last quarter. The relatively rapid market rise corresponds almost exactly with the Federal Reserves actions to increase the money supply growth beginning last August. It has also been accompanied by rapid rises in virtually all commodity prices, somehow failing to affect the “official” price level. Long term interest rates have shown significant recent increases, but still remain down some on the year (30-year started at 4.64, traded 3.46 on 8/25, then finished at 4.42- ten year started at 3.83, traded 2.33 on 10/8, then finished at 3.39). So the Fed attempts to keep interest rates low, or actually lower them, seems to have run into the problem of increased inflationary expectations, which have actually caused rates to go up at a time of fairly expansive easing. Shades of the late 1970’s.
On the political front we have a new Congress being sworn in today, and a lot are waiting anxiously for all the promised “changes” soon to be brought about by the new and more aggressive members. In the meantime, however, the Federal government has racked up another $290 B in deficits in just October and November, a scant $6 B improvement over last years’ first two months. So whatever it is that the new group plans on fixing, they have a lot more of it to fix just in the time since the election was held. The good news is that the economy itself, by most measures, is actually on the mend. Although slow, there is improvement across the board in hiring, hours worked, personal income (very slight), retail sales, car buying, etc. If the Federal government, both the Fed and Congress, were even in a moderately expansive mode I would be saying that we are on the way to a nice recovery in most sectors. They are not, however, but rather in almost a panic mode to use up virtually every economic bullet at their disposal. The question still is, then, what should the economic numbers look like, given the governmental stimulus of unprecedented size and duration? I would say the growth in GDP should be way over 5%, maybe even approaching 8-9%. Remember, we are talking about governmental largess just on a fiscal level to the tune of over $1,000 per month per household. Add to that the money the Fed is manufacturing and pouring in and we should be in hog heaven growth wise.
Why aren’t we, or at least aren’t yet? That is what has everyone so nervous. It has to be some combination of a lot of things. I think a lot of the money being manufactured by the Fed is leaving the country for projects elsewhere. There have been many huge foreign firms raising capital here for expansion projects in their own countries, are we becoming the new Japan where people borrow money here cheaply and export it? Have we lost so much ability to manufacture that no amount of stimulus will cause someone to start something up here from scratch? Has the Federal stimulus money, incenting people to build and hire, been negated by cities and states raising fees and taxes on anything that grows or shows life? Have some of the new rules and regulations caused such a cost that firms can’t deal with the overhead? The show of people racing out at Christmas to spend more than their increases in income on goods manufactured somewhere else sure seems sobering to me, yet they seem to be enjoying themselves. The big question still remains, what if the government runs out of stimulus, or is forced to cut back by borrowing or rate restrictions, before the self-sustaining recovery takes hold? I am not sure we want to witness that scenario.
As for the states and municipalities, could there be any more of a mess? For now, however, the market has chosen to ignore those problems, and maybe we have to as well, until something happens to make people focus. Tricky, to negotiate the hill at night knowing a cliff might be nearby, but something we may have to do if the market continues to advance through the ice flows. I do not believe, however, those that absurdly say that the market has priced in a slew of muni bankruptcies and state insolvency issues. I really believe that cliff is out there, but we need to participate until the fall occurs, then be hedged.
The positive news for investors is that a lot of companies seem to have made it to sufficient size and multi-national footing where they might to be able to go on without the U.S. General Motors (for example), now free from debts they incurred (stiffing creditors), relatively free from pension liabilities (unions received stock in new company), and with a lower base labor rate for most employees, is free to make money by selling cars in China and elsewhere. It does not feel right, they having just stiffed stockholders as well, to invest in the “new” GM, but it might be the right play. Maybe those of us that remember the Federal Reserve induced market bubbles of 2000 and 2007 should just forget that history and get on board, because IBM, INTC, CAT, AAPL and MSFT aren’t as beholding to the USA near as much this time around. All they will do is borrow money here at low rates and build elsewhere, and we will respond by lowering their tax rates even more. As an investor, however, you might want to own them. Watching them (multinationals) increase revenue and even profits, growing massive war chests of cash, during a fairly nasty recession is something certainly worth noticing and maybe acting on. Or will governments look to those war chests of cash for some much needed tax money? Right now it sure seems like the biggest firms are bigger than the governments of the world, and are acting as such. One problem is that some seem too big to care about their shareholders as well.
What about the market, and the PIP Program? The option market continues to be priced with near term volatilities relatively cheap, and then volatilities increasing as you go out in time. For instance, AAPL (stock 328.56) has implied volatilities of 22.6, 29.8, 31.1, and 33.1 in the 330 calls for this week, February expiration, July expiration, and next Jan. expiration. That means, assuming we would want to commit more funds to the PIP Program, that we would have to spend way more (in terms of implied volatility) to purchase our protected puts than we would receive on our covered calls. This phenomenon is accentuated by the fact that lower interest rates lower the prices of the call options relatively (the options we sell) and raised the value of the puts (the ones we buy). That has caused us to stay a little more in cash that we normally would, and that caution has been rewarded with a seemingly relentless rally that we have not participated in to my satisfaction. When someone has been a successful floor trader you pick up a set of skills that few have, an ability to protect positions, an ability to assess risk and apply it to real individuals and their goals, and sometime the ability to identify real investment opportunities. One skill that is somewhat elusive for a skilled hedger is the ability (once you identified a good buy at, say, $5) to look the other way as the purchase goes to $50. The instinct, at $7 or $8, is to say “Enough is enough” and to either sell or lock in the nice profit, not to say “We are just warming up, this thing has $100 written all over it.” Once in a while in the market stuff just gets on a roll, for whatever the reason (even totally artificial, like the government) and those that do not look to lock in gains do better than those that do. Once in a while a stock does just go seemingly non-stop from $5 to $100, and it would be nice to do nothing but watch, I guess. Most of the time, however, it does not hurt to lock in the gains at a few points along the way. Last quarter, in retrospect, it would have been the time just to watch. This year I think it will be our turn.
I do think that we need to get in the habit, when our calls are lagging some and the volatility is this low, of having something above the market just in case of a breakout. We certainly appear to be in a time where the government wants a new stock bubble. We surely will work on that for the New Year. We are also going to take advantage of some of this low volatility on the weekly options. It is time to make some money, wherever the market goes.
I invite you to register for our (always complimentary and always no-pressure) Protected Index Program® In-Office Seminar to be held at PTI’s Downtown Chicago Offices on Saturday, January 15th, 2011 from 9:00am – 12:00pm. My brother Dan and I will be talking about how the PIP strategy works and fielding questions. Seating is limited but you must register to attend here. I look forward to seeing you there!