In The Dark

September 12, 2011

Good morning. Last week, in a holiday-shortened week, the market experienced heightened volatility on both an inter-day and intra-day basis and closed lower on the week. The SPY was down 1.93 to close at 115.92 (1.6%), and had a low of 114.38 on Tuesday and a high of 120.94 (5.7% spread) on Thursday, before selling off solidly on Friday. The weakness was due to several factors, mainly news from Europe suggesting (due to local election results) that the party of Angela Merkel (strong supporters of European unity and help for struggling countries) was losing support. On top of that the risk of a Greek default, as defined by the price of credit default swaps, continued to increase and was thought by some to be as imminent as this weekend. Finally, the twin speeches last Thursday of Fed Chairman Ben Bernanke and President Obama (coupled with the debate among Republican presidential hopefuls Wednesday night) failed to assure investors that anyone has a plan to stem the economic morass that has enveloped the country (and maybe world).

I heard at a very early age the phrase “It is better to light a candle than to curse the darkness.” There is no doubt that there is wisdom in that old adage, but it pre-supposes that we (meaning everyone) have figured out that it is, in fact, dark. I really wonder if our leadership, and prospective leadership if you count the almost comical group in the Republican Presidential debate last Wednesday night, has any idea what is actually happening. For instance, on June 22 of this year the Federal Reserve officially cut its growth forecast for 2011 from 3.1-3.3% to 2.7-2.9%. In Mr. Bernanke’s speech on Thursday the Chairman mentioned that consumer spending had lagged (surprisingly) in the third quarter but they still thought it would pick up later in the year. However, on Thursday the Organization for Economic Cooperation and Development (OECD) cut their forecast for U.S. growth to 1.1% on the third quarter and .4% in the fourth quarter. Europe the OECD has growing the same 1.1% rate in the third quarter slowing to a minus .4% in the fourth. Ben, you might want to wake up and get out of the limo. This August slowdown is real, and predictably it is worse in the Eastern part of the country, which deals more with the European economy. Does Mr. Bernanke have a solution? It appears just more of what has worked only marginally so far, continue to find ways to expand the money supply at absurd growth rates (20% annual growth rate of M2 over the last two months) and support the “banking system” in case of a problem in Europe. He will continue to ignore whatever collateral damage these policies might do to others in the society.

What do I mean by that? Let me back up a minute and explain in detail why I am convinced that leadership at every level has lost track (maybe due to ignorance but more likely due to a fervent drive to favor those that grease pockets and have leverage) of what is happening to the various segments of our formerly diverse economy. Let’s zero in on just one group (and granted a shrinking group). Remember those memorialized in Tom Brokaw’s book “The Greatest Generation?” It would be those who might be considered our older retirees, men who served in WWII (or maybe Korea) and their spouses and dependants. While each of these people was an individual, as a group they were, and still are, considered to be those who did things properly. They worked hard, they saved, and they put their kids through school, etc. etc. My parents (mom and step-father, now deceased) were part of that group. I am going to guess that they were somewhat typical of the sub-set of that group that did not have a formal employee pension plan (my step-father being a white collar worker for private companies). So their plan was to have the house paid for, work a little longer than 65 (my step-father worked to probably 72 to keep insurance, have something coming in, etc.), and have enough money saved up so that the interest income combined with social security would take care of things. I am going to guess that they had amassed somewhere between $400-500,000 very carefully invested in laddered CD’s, Treasuries, some dividend stocks, and some in that great brokerage firm PTI Securities. Combined I would say they were able to earn somewhere between $20,000- $30,000 depending on the year (4-6% interest) plus social security which I would estimate around $18,000. It was not exactly a fortune, especially when medical issues started to attack the principal, but it was enough to live proudly and independently.

Now what? If they were still here the income would be (maybe) $8,000 per year plus social security, and every manner of tax and fee has gone up. A lot of these people live in areas where property taxes have doubled and tripled, costs for supplemental insurance have skyrocketed, and prescriptions have soared as we furiously defend drug companies right to use U.S. patents to charge sinful prices but hide the income overseas. So Ben, and maybe you also Mr. President, why are you so shocked that this segment of the population is not spending? Are you blind? In Chicago it is real easy to have a non-affluent house wearing a tax tag of $10,000 per year (2% more recently as our new Mayor rewarded the Chicago Public School people that supported him). How much do you think someone has to save to pay a $10,000 tax bill from earned interest at 1.5%? Try almost $667,000, and where is anyone getting 1.5%? I don’t have a pension plan, and know very few private sector people that do. If the Fed continues to have leadership that is purposely breaking the remaining middle class to save the “banking system” how much will I need to save just to be able to live? $10 M at .5% gives me a whole $50,000, and what does anyone think Chicago property taxes, prescription drugs, parking meters, insurance, etc. will be 15 years from now. I am worried, and I will bet anyone that I will at least not be able to live here in Chicago, or maybe anywhere in Illinois if conditions remain like this..

I know that is only one group, but maybe next week I will talk about the plight of the average male worker, who has seen (ages 30-50) median wages decrease on an inflation adjusted rate by 27% since 1969. It is not my intention to put anyone in a depressed state, but I firmly believe that to solve any real problem you have to have a clue what the problem is and what is causing it. We do not need some supposedly brilliant Fed Chairman economist being surprised people have not stepped up spending, he should know many are draining assets by the month and have very little to spend. Of course, money is probably flying across the bars on K Street and I am sure his limo is stocked with the good stuff.

We have to discuss Europe just a little bit. Why does so much seem to matter what happens to a relatively small country like Greece? Remember those Credit Default Swaps that caused a lot of the problems two years ago, the ones that we were supposed to get all over and stop from ever causing problems again (Dodd-Frank?). Well, they are alive and well in Europe, and it seems a lot of European Banks are big investors in the so-called “sovereign debt” of these fiscally challenged countries. In short, no one really cares about bailing out Greece; it is the German of French banks (we might find a U.S. Bank in there when the smoke clears) that do not have enough capital if they have to write down their Greek debt. Plus, we have the tremendous amount of Credit Default Swaps that “someone or some ones” have sold to people to protect their exposure to Greek default. Are we going to find another U.S. institution in that mix? On the surface, the solution would seem to be that you would just let the Greeks default, return 70 cents (or whatever) on the dollar, and start over. Argentina did it, Iceland did something like that, and they survived. Then, however, instead of sending money to Greece as a conduit back to banks in Germany, France, and wherever, they (the politicians) would have to say boldface “Such and such Bank screwed up, again, and we (the political leaders) are going to take funds out of the hide of the rest of the population (again) to maintain their exalted status as wealthy but foolish people, but they have put us in office and we owe them. By the way, we would like to let them just go down, but they are too big to fail.” It is awful to say, but very true. Add to that the inevitable stack of Credit Default Swaps that no doubt are piled onto the actual Greek default number and there is probably the makings of a serious crisis, not just a small country with issues.

Enough, it is tedious to even think about it. Why does it not change? Are we, meaning the huge amount of readers of this blog and listeners to Stocks and Jocks and others that act right and care, just a bunch of lemmings? Why do we just let it happen again and again, banks being bailed, the guilty being exalted instead of convicted, people who obviously have bought their way in (since we now know who sends the checks to these political hacks) getting solid returns on their “investments” right before our eyes. Are the good people totally impotent? Maybe we are, maybe the best we can do is just argue about it over drinks or once in a while write an article about it (like this). What will it take to actually change something for the better? Will it be a third party, a huge organization to combat the current lobbying domination, violence someday, or do we just continue to acquiesce? I will tell you what, they say if you are not the lead dog the view never changes, and to this dog the view of the same people getting all the political benefits is looking pretty familiar. How about you?

Now that we have determined that we will probably need an awful lot of money to retire, how do we accomplish that? Right now the market is volatile and tricky, probably as difficult to trade as I have ever seen. Investors have to be mindful of the potential problems, one thing that can’t be allowed to happen is a big loss, and so protection or another form of risk control (like trading small and using spreads) is very important. The PIP Program, while not returning as much as an up market with normal priced calls would deliver (low interest rates negatively affects call option prices) has proven to be a solid source of protection and in some cases has provided some trading opportunities as put protection has been “rolled” up and down with the movement in the market. Recently, we have begun a program (for those for whom it would be appropriate) of creating a basket of higher dividend paying stocks (average dividend over 5%) and hedging it with SPY puts. This position does contain basis risk in that the SPY in certainly not a perfect hedge for those stocks, but for those that think that the market is becoming more correlated due to the macro moves coming from news events it might provide enough of a hedge. Obviously, we will be monitoring the correlation and adjusting on an ongoing basis. My instinct says this strategy will probably work well in the long term and boost returns as desired, but will take some serious monitoring and quick moves on at least a couple of occasions. Again, be very wary of an unhedged long position in either gold or Treasuries, especially Treasuries, even though the Fed is pouring money into the system. Those trades are getting real crowded, and it would seem that a ten year Treasury rate of 1.9% with inflation actually trending higher than that might be a risky thing, even though it has continued to move against conventional wisdom so far. Do not be an unprotected part of any of these inevitable mini-bubbles as people desperately chase returns.