Political Economics

Good morning. I think the term wild week for last week would be a solid understatement, although in the aggregate the movement on the week was fairly muted considering the intra-weekly swings. Two days of rally mode on Thursday and Friday had the SPY closing down only 1.6% on the week at 118.12, after trading as low as110.27 on Tuesday. For the last two weeks, however, Friday’s close was off a very somber 11+ points, or 14.8%. That is a rough ten trading days by anyone’s measure. The VIX closed at 36.36, up 13.6% on the week and up a very large 44% for the two-week period. Obviously, the week in the market was started by the Friday, August 5 (after the close, though rumored earlier) downgrade of US Government debt by S&P, and the bad news just kept on rolling with one story after another out of Europe regarding whether the ECB (European Central Bank) would step in to buy the bonds of Italy and Spain as they had done with Greece and (to a certain extent) Portugal. The news escalated to whether there was the capability for rescue of Italy should it be needed, since its economy dwarfs Greece and Portugal, to increasing problems in European Banks and more specifically the giant French Bank Societe Generale.

It is really hard to quantify the current economic and political situation and how to survive it, much less profit by the goings on. The branch of Economics that I studied most, in the tradition of former Senator Paul Douglas and Nobel Prize winner George Stigler (both from the University of Chicago) is known as political economics. It essentially says that economics cannot be separated from politics, as the specific economic policies must be part and parcel of the political process. It also means that those who masquerade as part of the solution must have a deep knowledge of the economic problems and possible solutions to have a chance of success (by success I mean solutions to problems, not just getting elected). Do we see any people with that sort of skill set running for anything?  It may be just my opinion, but it sure seems to me that the deeper and more complex the problems become the more likely our electorate appears destined to elect individuals younger, less experienced, more addicted to the one liner, and more liable to oversimplify the situation, not to mention having no idea of the path to recovery. What is the cause of this apparent disfunction, and by that I mean the election of some individuals who, after elected, appear to be less qualified for the rigors of the position than your pet Airedale? Is it the people involved, do they just have immense talent to talk and deceive those that see and hear them? Is it the “system,” that appears to require immense sums of money to be elected, and the only ones giving are those with something specific to gain? Is it the voters, who for some reason have not figured out how the system works and are not willing to “pay up” or even show up to see that they are represented? Is it all of the above?

I wonder how many might have caught Dylan Radigan’s rant the other day on his show on MSNBC. We played it (I believe) Friday on Stocks and Jocks’s show. In it, and I am summarizing, he virtually agrees with a lot of what we have been saying on the show and in this blog for a very long time, but in his own unique way that was very riveting. He basically accuses Congress (leaves the President seemingly out for some reason) of “allowing” a trillion dollar per year looting of America by the people who they are beholden to that sent them the checks for their campaigns. He is looking for a “Teddy Roosevelt” type moment where the President basically calls them on it and says (somewhat like we have been saying) that the issues are not left or right but that Congress is essentially hired by these people and not by the electorate, and that they will be fired by them (through withdrawal of monetary support) if they do not return the favors. Dylan goes on to list the reasons, like a tax code that so benefits the few, regulations that cause an uneven playing field tilted their way, absurd contracts, access to information no one should have and no enforcement of any morality regarding trading on that information, etc. Please listen, it might shake up a few of you who somehow are still locked into the idea that it is Obama’s problem, or a Democratic problem, or a Republican problem.

Why is the electorate blind to this, or do they just not care? It is right there for anyone to see; yet we either are too lazy or dumb to care, or surely to get involved. Are we, really, getting the government we deserve? I will give you a few examples from the great corrupt State of Illinois. We have a new Mayor here in Chicago, a fellow named Rahm Emanuel, who was a former US Representative that later served as Chief of Staff for President Obama (also had a brief stint on Wall Street where he magically made over $16M in less than three years working on connected “deals”). He also made $320,000 per year as a Board Member of Freddie Mac without being assigned to any working committees and meeting six times per year. After his election to the US House he was named to the House Finance Services Committee overseeing Freddie Mac. I could not write fiction like this.

The city was very surprised at the announcement late last year that long time Mayor Daley would not run for re-election, and a virtual army of pols threw their hats and bonnets in the ring. Not one was really “outside” the system, just various people from different parts of the government trough group. There was no “outsider” that could claim he was successful in a succession of things like running a business, writing something worth reading, some accomplishment in academia, or the military, or anything really. The electorate in the aggregate, despite what some individuals may say, basically waited to see which candidate was able to attract the “money,” meaning which of them could garner the support of those “in the system” and once that was known it became obvious that you could not support someone else for fear of retribution. Throw in a few clandestine meetings with some of the other candidates where “in one persons opinion” some part of the City booty was compromised and “presto” you have a new Mayor. I have no problem with the man, and actually hope he can rise above this garbage and elevate the place above the corrupt mess that it is, and maybe we will not lose another 200,000 people in the next decade. But I have my doubts, right now I do not equate Rahm Emanuel with Bobby Kennedy (not yet anyway), and I know those people gave that money for a reason, and they always get what they pay for. Why didn’t the electorate see who the “in” guys were greasing and vote for someone else if they are tired of it? That is the mystery. It is the same mystery why the most powerful people in Illinois, like State Speaker Michael Madigan, virtually runs unopposed, and gets to put his daughter in the Illinois Attorney General position (she did have to win an election, but you better have supported her if you want something out of the State). It could not happen if we did not let it happen, and is almost beyond imagination that it does happen. Maybe people care enough only to have something to complain about. If you really care or see the handwriting on the wall the only answer for you or me might be to leave the city or state. Anyone who thinks reform is possible through the political process in Illinois really has the wrong color glasses on.

Fast forward to the Federal situation, and let’s stick to those things affecting trading. In the last three years we have had serious issues with things on Banks books that no one could value, but somehow were profitable (on paper anyway) to the Banks and their management, called Credit Default Swaps. These are essentially insurance policies written by financial institutions on other companies or countries, or states, as to whether they will pay on their bonds. Well, we found out in 2008 that these CDO’S were seriously mis-priced in many instances, and the government (despite serious reluctance to help any individual American) gladly paid off these bets for some (like AIG) to the likes of GS and others. Of course this brought about a huge hue and cry in Washington about increased regulation, how did this happen, and it can’t be allowed to happen again. They even pushed through some huge and overbearing (to anyone innocent) bill (Dodd Frank) to make sure it never happened again. Yet here it is, two years later and CDO’s are surfacing as an issue again with these European countries and banks (with undetermined US exposure). The roundly vilified CDO’s have not been forced onto an Exchange, where they can be viewed and priced, they are not banned, and they are not even (to my knowledge) available to be seen on the Banks balance sheet for review by investors. The government has not even come out and said, “If a Bank were to fail, we will back the deposits as we have stated, but we will not pay off one dime of a Credit Default Swap with taxpayer money. You better know your counter-party, do not think it is the US Government.” None of those things has happened, the relentless work by the Bank Lobby has continued to minimize and delay any meaningful reform in this area. It just goes to show how hard it is to proceed with common sense when those in power are bought and paid for.

There is a second issue, and one front and center. Did anyone notice the volatility in the market seemed a little extreme last week? Remember the so-called “flash crash” of last year? Remember all the accusations regarding high frequency trading, black pools, front running orders, etc, and the “groups” of learned men and women that were to “study” the issues. For God’s sake there had to be several mini flashes, up and down, in just the past week. Why? Well, the current group at the SEC, and Congress, seems so “in” with the designers of this “new” market that they can’t study them at all. It is hard to study when your nose is in the feedbag provided by those you are studying. Does anyone think that at any time, let alone times of high market stress, that the market is made less volatile by having certain groups able to “view” the order flow, then rush to get ahead of it before the original trade actually takes place. Does anyone think the real estate market would be better served if you told your realtor that you wanted to pay $180,000 for a certain house, then he or she was able to race in front and buy it for $175,000, then try to either sell it to you for the $180,000, or more, without telling you? I think that is fraud, or at least breech of agency responsibility, but in the stock and option market it is “providing liquidity.”

So, having said all that, how do we trade it? Can we, quite bluntly, make some of this chaos and suffering of others just long the market work for us? To a large extent those in the PIP program are virtually untouched. People having positions from long ago had in the money calls that gave them dollar for dollar protection on the way down, and are probably up slightly on those positions. Those with more recent positions, especially in the XLE, were protected by puts and had out of the money calls so were down a fraction of the market’s severe drop in that area. We were able to adjust the positions much more easily than in March 2008 so right now are in position to benefit more aggressively by a rebound then at that time. Most all puts have been rolled down and we have a blend of no covered calls, some repair strategies, or higher strike calls than before. We would love a little stabilization here and a few months of high volatility call writing. It is also a good time to increase exposure in the PIP program, we have been waiting for a better time, so now is the time for a little investment if you have been heavy in cash (protected of course).

I also have to comment a little on the bonds, and therefore interest rates. It is stunning, no other word for it, that the US Treasury Securities have continued to advance (meaning lower yields) in the face of continued flooding of the country in money. I have even heard on several occasions’ commentators (criticizing S&P for the downgrade) say that there is no problem with the US paying bills, we will just push out enough cash so everyone is paid back with money worth half as much. It is an interesting idea, but not exactly a revolutionary thought in economic history. The question is, and I think the answer is no, will the market allow them to deflate the currency dramatically with no increase in interest rates designed to make up for the currency downgrade. I think we need to look for spots to short these bonds, maybe the bad auction of the 30 year on Thursday will be seen as the turn (or maybe not).