Laughter, Disbelief, Anger
March 21, 2011
Good morning. Volatile and down week for the market last week, despite a solid bounce off the Wednesday lows. The SPY was down 3.08 on the week to close at 127.76 (2.3%), which was still a solid 2.48 (2%) off the low made on Wednesday afternoon. The news regarding the Japanese earthquake damage and subsequent tsunami, soon overwhelmed by events at the nearby nuclear reactor facility, dominated the trading for the week. A big upward reaction to the market was directly associated with a coordinated G7 (first coordinated intervention in over ten years) move to stop appreciation of the Japanese yen in the aftermath of the disaster. The thought of a strong yen helping to drive Japan into a recession on top of the damage brought by the quake was clearly enough for the G7 nations to act as a group to bring the yen down. So far it seems to be holding, but intervention in the long run if totally conflicting with market forces does tend historically to be a losing game for central banks. They would refer to failed intervention as just that, failed intervention (like it had some noble purpose), we would refer to it as probably just a large losing trade made by the central bank. They have the advantage, however, of losing other people’s money, so the losing trades do not have the same sting.
We continue to have a market dominated by headline news and intervention by various governments and central banks, making things very difficult to trade. In just the last two overnight sessions, last Thursday night and last night, we have had huge moves in the S&P Futures. Last Thursday night we had the intervention of the G7 into the foreign exchange markets to stem the rise in the Japanese yen, causing the Futures to reverse an over eight point sell-off to be solidly positive by the opening. Last night the Futures opened mildly up, but have been driven appreciably higher by the news regarding the AT&T takeover of T-Mobile. In addition, a lot of the breaking news regarding the Japanese nuclear facility and the efforts to save it are happening while our markets are not open and most of us are asleep. It makes for some very interesting trading, and surely puts a strain on the math people that consider option-pricing models (which view news as a continuous stream) to be accurate. In fact, we are seemingly lurching from discrete news event to event, with long hours during the trading day where the market has little, if any, movement. It also appears that the Federal Reserve has every intention of propping up markets to the extent they are able, at this point seemingly without limit. Last week there was talk of the Fed extending their normal hours of market intervention on the day the market was down heavily, should they be needed to “herd” the market back to its (rightful) levels. I would agree that the long term effects of both the situations in Japan and Libya will not be that significant, I am more worried about our own problems internally.
It seems like the final impact of disasters, like most things, is a matter of timing. The recent earthquake, tsunami, and nuclear problems in Japan are not that different from the problems they faced after the Kobe earthquake of 1995. I think this one is worse due to the nuclear issues and in eventual loss of life numbers, but in terms of injuries and long-term care of the injures the Kobe one was probably more costly. Anyway, the one big difference is in the fiscal health of the Japanese government. Now they are considered to be the largest debtor nation on earth, with total debt/GDP approaching 225% vs. around 100% in 1995. The Japanese GDP is also only marginally larger than it was in 1995, $6.1T in 2010 vs. $5.2T in 1995. I would say that their ability to withstand a shock like this is less than it was in 1995, and they are not alone. At some point the continual borrowing cycle needs to end, or at least common sense would seem to say that. Right now the Japanese ratio of debt service to retained tax revenue is getting pretty high (over 50%). Japanese history also calls into question the efficacy of the long-term very low interest rate policy, it does not seem to have had great success there, maybe the only thing it did in the end is penalize savers for a long time. Sound familiar?
I have thought for a while that the (real) correction, or market danger, here will come from problems internal, not external. The catalyst may be external, like a country (maybe Japan) either unwilling or unable to continue to show up at U.S. Treasury auctions, but the real problem will just be the overwhelming amount of the auctions themselves. In the month of February (traditionally a deficit month) the Federal deficit was $222.5B, even higher than the $220B number of last year. Fiscal year to date we (the U.S.) has a deficit of $641.3 ($651.6B last year), which amounts to $5,600 per household in five months. So if the GDP is around $15T and the growth rate is considered 3% we would consider growth in GDP for 5 months to be around $188B. That amounts to less than one third of new borrowing, so our spending is so inefficient that the extra spending does not even amount to dollar for dollar growth. What happened to the multiplier, all you Keynesians? Do you think that a random interview of households in the U.S. that asks the question, “Do you feel like you have received the benefit of the $5,600 the government has spent on your behalf (and you now owe) in the last six months?” I will bet you will be greeted by, in order, laughter, disbelief, and then anger.
Normally borrowing on this magnitude would be limited by the Federal Treasuries’ ability to borrow, meaning that the interest rates should go up as the Treasury continually increases the amount of the borrowing. The market should provide the discipline, and the higher rates paid would eventually eclipse the amounts garnered by the auctions, that would be the theory if the Treasury (which technically cannot create money on its own) was forced to actually borrow. In this case, however, the Federal Reserve (which can create money) is embarking on its so-called QEII, which essentially is pumping $650B of new money into the economy. Let’s see, $641.6B of supposed borrowing by the Treasury and $650B of pumping by the Fed, maybe we should just fire all these guys and just let the Treasury just write the check with nothing behind it to create money. Now we have, in brief:
1) Go out to auction, have primary dealers get their cut, possibly trade ahead of the information.
2) Have primary dealers charge their customers, usually mark-up, not commission, but enough to make a fortune for virtually no risk
1) Use a broker to enter the market and buy, usually Treasury Securities but lately anything, including mortgage dreck, at probably way more than the stuff is actually worth.
2) Somehow try and manage the inventory, which may include thousands of mortgages, by having non-competitive bid contracts given to preferred “servicers”.
3) At some point try and sell this stuff at now market price, or less, to the “right” people.
4) Pretend there were no losses on the transactions
What a disaster! Yet there is the mindset that the U.S. economy is (and until now has been) resilient enough to somehow grow its way out of this huge debt and any amount of ancillary stealing that may be taking place. I hope so, but the numbers seem a little too big for me. Does anyone think that the average household is in imminent danger of having such a surge in fortune that he will gladly accept the $5,600 burden the Fed has given him in just the last five months? I think not. In fact, he is probably headed the other way. He is being bombarded with price increases, scarce increases in income, and has to listen to his paid employees, the Federal Reserve, tell him that inflation is really not a factor and he is very close to being better off. Like I said, the problems we have to worry about are not in Libya or Spain, they are right here. We have had a fairly dramatic political change, in terms of change that can be brought about by elections, and in my mind nothing has changed. Collectively the politicians are still out of touch; the staff is making huge monetary decisions with little or no oversight, and the same people are benefiting that always have. Change, where?
Where is the successful trading strategy? It has to always be in a low risk position; you can’t run the risk of being unbalanced. What I mean by unbalanced is in having one or two losing trades overwhelm five or six winners. Normally I would say to stay in lower risk spread type positions, and keep trying to hit the single, but with the gyrations we are seeing in the market the execution of spreads have become somewhat tricky. Sometimes you find that some of the relative “safety” of having a very focused and risk minimizing spread position is given up by the frustration of not knowing when the execution will take place. If a singular option (say a call option) is quoted 5-5.20 and 40 are offered at 5.20 you can virtually always buy the 40, but with a spread you run the risk of only getting filled when the stock value (the underlying security) shows some weakness. The more short term the trading becomes the more that problem happens, if it is a simple bull spread out nine months you probably do not care if you are only filled during a momentary weakness in the stock, you think it will be up just fine nine months from now.
The other phenomenon we are seeing is that a lot of the “action” is in products that are in the Futures arena, such as corn, beans, wheat, etc. Trading of these products directly (although some ETF’s exist) require a Futures account, and that means a totally different set of trading systems and rules. It is not a big inconvenience to maintain such an account, we will only fund it from your Mesirow account if used, and it is something some may want to think about. For the PIP participants, we are starting to put a little money to work in the XLE (oil), XLB (materials), and XLF (financials) sectors. One of the issues we are dealing with is that the market has reached some levels that I am not quite as comfortable protecting with put spreads rather than just the put itself. When the SPY was 90, I was comfortable protecting the position with the 90-50 put spread (seeing 50 as a very remote possibility) but I do not view the 129-90 put spread the same way. We were just under 70 within in the last few years, 90 does not seem anywhere near as remote a possibility as 50. We continue to try and trade a little more short term for people in the program, but do not want to risk very much in that effort. There have been some opportunities and some winners, but a streak of winners is elusive so far in this market, maybe this rally overnight will drop the volatility enough to find some positions with some theoretical edge.