March 22, 2010
Good morning. Last week the market was up fractionally, with the SPY up .51 to close at 115.97. That is still a spectacular move up from the gloomy days of last March, when on last March 19 the SPY closed at 78.94 (47% increase). It also is an interesting contrast to the VIX, which was down on the week to close at a low number of 16.96. That is down dramatically from the number last March 19 of 43.68 (61% drop). One of the strangest things about the market is when the value goes up, and logic tells you that there is more value to insure in the case of a catastrophe, people feel way more comfortable staying unprotected, even though the cost of the protection may be cheaper. Last March, when the SPY was near it lows of 67.06, the December 70 puts of 2011 were in the $19-20 range. Now, the $115 puts with the same expiration (with 21 months to go vs. 33) are trading around $13. So, in rough numbers, people were paying (and sellers were demanding) 25% of the underlying to protect a $70 asset with 33 months to go last March. Now the price is only 11% of the underlying, with admittedly less time. Still, the idea of the protection to be way less expensive as the value of the asset has increased is somewhat counter-intuitive.
In addition to the price of protection being less for the LEAP puts as prices have increased, we have the added phenomenon that the implied volatilities have a pronounced upward skew going forward. The implied volatility of the March month end 115 puts is roughly 15, the April’s 16, the May’s almost 18, on out to the December’s at 21.5. So for some reason, or combination of reasons, the market is “telling” us to expect a quiet market near-term with increasing volatility as we move towards the end of the year. As to why this is happening is anyone’s guess, the standard reasons probably are the November elections and nervousness about the stimulus programs generally winding down. But, in truth, no one really knows the “reasons”. Personally, I am very nervous about the market, as it has continued to slowly grind up seemingly in the face of what is happening (or not happening) in the rest of the economy. There is no question that we are a year past the financial Armageddon that almost took the economy down, but really at the cost of simply moving the problem assets from the books of the banks and others to the government. A financial system that caused problems partially due to over concentration is now, by anyone’s count, even more concentrated and able to exercise pricing power, as evidenced by the amazing rapidity that the more public of the government’s largess was repaid. Anyone watching can see any attempt to put controls on the remaining powerful players to be little more than a sham, despite Fed Chairman Bernanke’s vows to have some meaningful regulation.
On a social level we are clearly divided and pointing fingers in every direction. Clearly Middle America (to the extent they count with anyone) has gotten a bad deal. Even though the incredible amount of $1,000 per household has been shoved (stimulated) into the economy on a monthly basis for the last 15-20 months, most people have not been beneficiaries of anything other than the eventual bill. True, some are benefiting by increased unemployment benefits in their time of need, and help with COBRA, and a few other programs, but it sure does not feel like $100 B per month is doing as much as you might expect. That is really the crux of the debate about where we are, and where the market is. We seem to have hit some sort of bottom in jobs being lost, and maybe have a little up tick in GDP, but given the stimulus packages and mortgaging of the future that is going on shouldn’t it be better? How can anyone think right now that if we were to take away the $8,500 pay-off for people to buy a home, stop buying the worthless mortgages from the slimy banks to make sure they are healthy and able to fleece even more, and cut back half of the stimulus (to a still incredible $50B per month) that we would not go straight down again. I will buy drinks around if I am wrong, but it seems like we will be forced to cut back on the stimulus due to the massive debt burden long before the recovery becomes self-sustaining. Throw into the mix a health care bill tearing at the social fabric (for really a multitude of reasons), and a pending trade war with a large trading partner and holder of huge amounts of our debt, and it is easy to be nervous. God help you if you look at details regarding quality of old jobs vs. new, the fact that states and municipalities have cushioned the employment problem the last decade by hiring 2 M people and are now laying off, and the fact that it would take a person in the top 15-20% of wage-earners (with a down payment) to afford the average house (even at the lowered average price). It is very hard to ignore all this and just bank on the fact that some companies have become so powerful that none of this will ever affect them, and that their stock price will continue to appreciate.
This weekend we had a seminar at PTI, and I was able to attend a St. Patrick’s Day party in Ogden Dunes on Saturday night. In both cases I was able to get some feedback from thoughtful people regarding what is happening in the economy, and the growing disconnect between government officials and the general populace. To me it is not about having a Health Care System better than the one we currently have, everyone sees the current system at some degree of malfunction. It is all about the total lack of trust of government’s ability to help. The White House has admitted to over $90B of fraud in the current version of the Medicare and Medicaid systems, yet feels comfortable in increasing their involvement by a factor of two or three without addressing that issue. Also, even a low level economist would say that a lot of the issues in today’s health care system are a failure of any anti-trust enforcement in the industry. The Los Angeles Times reports that there have been over 400 combinations in the health care insurance business in the last ten years, clearly leading to the concentrations that cause higher prices and less coverage. Yet this issue is not addressed (to my knowledge). In fact, we may be making sure that we never get competition back. No one feels that the Homeland Security Bill or Iraqi aid packages (Pres. Bush), or the various stimulus packages (Pres. Obama) have been anything other than fraud pits, and why should this be different? Try to find anyone who believes the total governmental cost estimates are on the same planet with what will actually be the bill for this legislation. Don’t the people in Washington of either party understand the size of their credibility problem? Put another way, a tremendous amount of the American people view you (politicians) as under qualified, pompous, self-serving, pocket lining, and totally incapable of the truth. Is the word statesman still in the dictionary?
Anyway, how to invest? I think we still keep protected and maybe have some cash reserves, as painful as that is with virtually no returns to money balances. Last week the return on near term US debt actually nudged higher than the return on the debt of a few large companies, either an unusual phenomenon or a sign the AAA rating of the USA is being questioned. We might want to keep an eye on the natural gas prices, as they continue to make new lows. There are surely enough reasons for natural gas prices to be low, high inventories, lower than expected usage, active drilling, etc. but still we might want to set up a long term bullish position if the price declines become even more excessive. You might also want to watch gasoline, if the pickup in gasoline demand this summer is weaker than expected some of the refiners might be a little vulnerable. If we get another chance on the XLE in the 54-55 range, and can get some puts at a reasonable price, we will probably look to put some more cash to work in there. It is clearly a time to look hard at your portfolio in light of the strong market move and the continued move down in price on some of the potential protective puts. As usual, we at PTI are there to help.
If you missed the Protected Index Program from this past weekend, be sure to sign up for this Wednesday’s (March 24th) PIP Teleconference. All you need to attend is a phone and PC — from your home or office — and there is no charge to you. It will be from 6:00pm – 7:30pm CST and my brother Dan Haugh will be presenting and answering your questions. I highly encourage you to attend! REGISTER HERE by 3:00pm on Wednesday at the very latest to attend. Enjoy!