It’s All Greece to Me
February 13, 2012
Good morning. Last week the market was essentially flat, with the SPY down .21 to close at 134.36. That still leaves the SPY up 7% on the New Year in six weeks. The VIX, mostly due to Friday’s recently rare down day, was up 22% on the week to close at 20.79. At this point in 2012 the market has been eerily similar to the start in 2011, which had the SPY starting the year at 125.75 (.25 over this years starting number) and reaching a peak on February 18 of 134.53, pretty close to where we are now. Obviously in 2011 the market gave back all those initial gains and was down heavily at one point (SPY traded 107.43 on October 4) before rallying into year-end. I would say that the general opinion right now is that the economy is in better shape than at this time last year and there is a greater chance of the economy (and the market) gaining some self-sustaining traction than last year at this time. Like most opinions, however, they are just that, opinions.
I, for one, have never found it easier to argue both the bull and bear sides of the market’s future. If you want to just block off any sense of general economic health as defined as rising income, rising property value, stable inflation (lower than rising income), and returns on savings so you can focus solely on returns to Corporations it is easy to argue the bullish case. Corporations have done and are doing very well (especially multi-national corporations) through pricing power, some serious cost cutting, and increasing demand both in the U.S. and worldwide. Even though the growth levels of less than 3% do not seem to be enough to get the general population on the mend (especially if the person has housing issues) it seems to be enough to provide large corporations with all the growth they need. Any metric of earnings per share of the S&P 500, growth in earnings, even dividend growth, would indicate that the general market levels here are not too high, and may in fact be cheap. There are a lot of solid companies trading at very low multiples, in the 8-14 range, and paying dividends very high when compared to the risk-free rate (which is essentially nothing). I surely can understand how those (including many notable talking heads on financial news channels) who focus, maybe somewhat narrowly, on the fundamental company numbers are very bullish and think the rally (unlike last year) is very sustainable and maybe just getting started.
However, if you look outward some from the Company numbers the picture certainly gets a little cloudier. Even with the fourth quarter growth in GDP of 2.8% the whole year averaged around 1.6%, really sub-par. The important thing is that the growth number is growing, and the 2.8% number is way better than contracting or the numbers below 2% that we have become used to seeing. It is not happening in a vacuum, however, as the Federal Government is pouring $100 B per month into the economy (roughly 8% of the total spending). We know (or surely should know as a country) that the $100 B per month excess spending is not sustainable over the long term, so the question then becomes how can (or can we) gradually lower the excess spending without disturbing the slow growth that seems to be starting. I am not sure it is possible, and even Fed Chairman Ben Bernanke, at testimony before Congress last week, warned that reigning in the deficit spending too quickly would cause a shock to the economy sufficient to threaten the current growth. Even the most Keynesian among us, those that say it is never an issue whether a government can pay back its debt, only a problem if the rate of growth of the debt is greater than the rate of growth of the economy, must have a problem with the U.S current situation. In 2011 the rate of growth of the economy was 1.6%, the rate of growth of the debt was roughly 8%, high for even Keynesians on steroids. So something has to give, and soon.
One thing is for sure; we will soon get to see an experiment on what happens if fiscal stimulus is withdrawn quickly by watching the developments inGreece.Greecehas a sovereign debt issue, in gross numbers not that far from theU.S.numbers. Since they no longer have their own Greek currency, using the Euro currently, they do not have the ability to print currency. This means that a governmental budget deficit will lead to a default much more rapidly than if they could just print more money and use that to service the debt (at least for a while). So, lacking that ability, the Greek leaders are being forced to essentially balance their historically deficit budget very rapidly and risk exactly what Ben Bernanke warned against. They are talking, in round numbers, of cuts in Federal pension checks in the 35% range, cuts in minimum wages of 30-40%, mass layoffs of Federal employees, etc. The experiment, right in the middle of the debate here between Democrats and Republicans, should be interesting to watch (painful to the Greeks). Will the dramatic and rapid cuts undercut the Greek economy to a degree such that the Greeks collectively end up in an economically worse place than they started? Will cutting, say, pension checks from roughly $750 per month to $550 cause a recession so deep that tax receipts will slow so much that the Greek government ends up with the same deficit they have now, or worse. Or will the rioting in the streets torpedo the cuts before they really get started? As they used to say, stay tuned.
The question here is, what about us? We have this debate between Democrats and Republicans over Federal spending, with both sides giving the same tired-ass old arguments that they have done for years. How basic is it? The Dems want to spend huge on various programs even though many of the programs have, over time, proven to be ineffective and wracked with fraud, while the Repubs still are firm believers in some iteration of the Trickle Down Theory with their supporters being recipients of the first check. The real question is, and I have seen no one on either side with either the vision to see the problem clearly or the talent to solve it, is whether it is even possible to drain (over a relatively short period of time) fiscal stimulus (ignore the complementary monetary stimulus) of the magnitude of 5-6% of GDP out of the economy without disturbing a pathetic growth rate of even 2.8%. There are a couple of bright spots. One is that we are concluding two wars, and the absurd way the wars were fiscally handled (in the sense that huge amounts of money were paid to foreign contractors) should mean that those monies saved should not affect domestic demand. I think the excess money politically connected Joe was paid in his foreign Corp. for meals inIraq(and Joe probably never brought the cash back here to spend) was probably the example of perfect fiscal waste, so stopping it should not affect domestic demand. That is the good news.
The bad news, and it goes hand in glove with some of the other topics we have discussed recently, is that a lot of the Federal dollars (not unlike Greece) go to regular people. All Social Security checks, pension checks for former Federal workers, disability checks to wounded Vets, you name it, most go to those who have planned their lives around the dependability and amount of that check. We all can recite stories of the Army Captain that retires at 42 with full pension and has another job the next day (sometimes doing his old job as a consultant), and in those situations (if we could identify them) we certainly could adjust with some sort of a give back if there is another job. I think, however, that most cases are not like that, most are actually retired or disabled, or both. The numbers I see would call for an immediate reduction in those checks not unlikeGreece, roughly 35-40% to make things square. What would that do to our economy? Could the Republicans actually do such a thing for real, or would they do something useless like saying we will cut the growth of spending so by the year 2525 we will be OK? If you did cut to that extent, where would it get you? I would guess we would be in an immediate recession in terms of growth, and so many people would have to leave their homes that thousands of municipalities would be bankrupt within two years as the remaining homeowners could not make up the slack (even though they somehow have so far). Would the deficit even fall? Or would the drop in tax receipts put us right back in the situation we were in?
This is an immense problem, both theoretical and practical, and I think more than enough to challenge even the brightest people unencumbered by special interests to solve, and where are we going to find people like that? There was a situation (economically at least) similar right after WWII. At the conclusion of the War the role of the Federal government in the economy was sharply curtailed fairly rapidly, and an awful lot of people (former soldiers, defense contract workers, even logistics type personnel) were suddenly on the unemployed side of the balance sheet. However, the unemployed were relatively young, relatively highly skilled, and very motivated to start families and new businesses (or go to school on government programs). It did not take very long for the economy to “replace” the Federal jobs with other jobs. Even though the era might have been similar economically those times may have had some advantages socially and demographically. Right now I really do not think that we can go with another several years of Trillion plus deficits and somehow come out of it, the solution better be somewhat imminent. So I guess your feelings on the market basically come down to how long or how successfully you think the “market” or the large firms most people associate with the market can act independently of the storm clouds swirling, and maybe the answer is a long time, maybe not.
So how do we trade this sort of thing? Well, for the first time in a while the short-term volatility has dropped to a level where it may be more advisable to be long volatility than short. The longer-tern volatility has not come down nearly as much, so caution needs to be shown there. For example, I have the weekly implied volatility in the SPY for the at the money call and put about 15, 17 for the July, 20 for the year end Decembers, and 22 for the January of 2014. That kind of a calendar skew makes it tough to initiate new PIP positions but certainly would favor using options in any short-term trading strategies that look for stock movement. It also would make it relatively easy to protect (on a short-term basis) profits that may have been made on the recent market advances. We have had a nice run doing some short-term spreads in the weeklies of stocks coming out with earnings, but the almost brutal sell-off in volatility in the remaining long option positions post earnings has made us a little more careful. The money to be made here is in being patient and then putting on a long premium position when the time is right. I do not think we are there exactly yet, but maybe are not too far off.
Next column I will write on why it may be that the economy can’t right itself in a vacuum of both political leadership and maybe moral issues. Can the current mantra of many “if you are not cheating, then you are not trying hard enough” actually be hurting economic growth? Has the current political and Regulatory climate of “the bigger you are the more you can cheat” acted to stifle the entrepreneurial spirit? We will discuss.