Revolution in Wisconsin
February 28, 2011
Good morning. Rising tensions in the Middle East caused the market to have its first down week in a while last week, with the SPY closing (despite a strong rally on Friday) at 132.33, down 2.24 (1.7%). The VIX spiked higher to finish at 19.21, up 3.32 (17%) from a very low close before the three-day weekend of 16.43. A lot of this mirrored the trade in oil, which closed the week up (West Texas Intermediate) 8.71 at 98.24, after reaching a high on Thursday of 100.26. Even this high price does not really tell the full tale for the oil market, as the Brent contract (North Sea delivery) is maintaining a roughly $8-10 premium on West Texas, even though it is of a slightly inferior grade. The reason for that is that the U.S. is starting to develop some production in areas like North Dakota, which have transportation issues in accessing the world market easily in the short term. I would suspect that over time that spread will narrow.
The unrest that has been hitting the Middle East, and maybe starting to show some embryonic signs in places like Saudi, China, and maybe even here (say it ain’t so, Joe) has really caught the market off guard. I have been saying for some time (does not make it Gospel) that the market has been having an increasing difficulty in being the all seeing and all knowing barometer that we all (especially old University of Chicago Grads.) like to think that it is. It would seem to go without argument that the market seriously mispriced the crisis affecting Banks, CDO’s, and CDW’s of the recent past, really all the way through, with some stocks trading for real value (like Bear Stearns and Lehman) literally hours before they went under. Now I am not sure the market is right on in its daily handicapping of the social and economic changes happening really worldwide. Could it really be possible that places that have been under despot rule for a long time will be able to throw off the yoke with minimal damage and transform themselves (with no democratic history of orderly transfers of power, loyal opposition, etc) to a more representative system with no corresponding economic collapse? I think everyone is hoping for that, but historic examples are rare. You would like to see the despot out, the money stolen confiscated, the UN send a nation team in (they are actually very good at that), some interim government, and a representative government within a few years. What we might see is a few crushed rebellions, maybe outside intervention, military’s having to take over to “maintain order” and you are right back in the mess. I am hopeful, it is time to throw the bums out, and their families, and the people here who helped them maintain their power through the years. It is time for some good news for these people.
The other issue I am having trouble judging regarding the market is whether the market is accurately valuing the ratio between stimulus and growth. We have mentioned this before, but it is real hard to get a read on whether the 2.8% growth we are seeing (fourth quarter GDP number from last Friday) is good or a total failure given the Federal stimulus of probably 8-10%. In other words, the growth is around one third of the stimulus. Day after day we see earnings come out, and companies with pricing power show earnings increases in double digits, and even substantial revenue increases in some cases, and the market celebrates. As a person always driven by the Math, and admittedly sometimes to a fault, I just get this odd feeling that we are hustling to the cliff. Again, hopefully not, and maybe the economy will begin to sustain itself without the huge stimulus.
If you are like me, you must have found yourself in at least one conversation regarding the situation in Wisconsin, and the full out war being waged there between the new Governor, Scott Walker, and the unions representing public employees. It is getting so that now I ask, when asked about the topic, on what level do you want to have the conversation, since I think there are around four to five real issues buried in the total. On the purely economic level, we have seen the economy (despite clear sailing for some) degrade for really over a decade. When I say that I mean the average person’s income adjusted for even the absurd inflation numbers published has surely not grown, and maybe has gone down. If you add the real outliers of inflation, health care and college tuition, the situation is really somewhat dire. To a large extent those in the private sector have felt that crunch worse than those in the public sector, even though they have not exactly been on the gold highway. Virtually no one in the private sector has a pension plan provided (although there are many companies that contribute) and most have to pay some portion of their health care, and all this with very thin or no raises. The public sector employees have been able to maintain those benefits better, so far, and are now being pointed out as the villain as most states and municipalities are broke. If you just look at the snapshot today, I would say that some adjustment, or giveback, is necessary to get the pain on a more even keel between public and private.
However, it is not that easy. These people had a deal, and other people (politicians, managers, etc.) had the responsibility to make it happen. I am not saying that everything always works out in the investment world, but this is not a six-month phenomenon, but rather a decade plus fiasco. People who manage a pension fund, in this case the state, have a responsibility to actuarially judge the group (life expectancies, etc.), select a number that is the proper estimate of earnings going forward, pick investment vehicles that are cost effective and balanced, and fund it accordingly. I suspect they did none of the above. The number they picked for future earnings was probably laughable, like 8% or something, they probably (in Illinois not probably) had many layers of expenses (politically connected consultants, fund managers) getting top dollar for sub-par management, and probably did not fully fund even to their absurd estimates. Now both the governors of New Jersey and Wisconsin want to hold all of those thieves harmless and flip the blame totally on the employee union. I am having a hard time figuring exactly how the mis-management of the pension fund is the fault of the third grade teacher, but I guess I just have to have a large enough field of vision. Eight or nine years ago the fund managers should have been meeting with the unions with the message that in light of very low interest rates and little market movement we have to drop our estimates, and maybe some adjustments could have been made along the way, don’t fleece and then say it is the fault of the other side. I am shocked that politicians want to hold their brother politicians harmless in regards to fault; maybe we need a little revolution here. These people just do not have a clue. Also, it again points out the economic repercussions of the bank bailouts, the money heaped on them by the government that is causing no interest paid on money balances is affecting every pension fund as well as every PTI client. I love those banks and the politicians they own!
Once in a while I used to frequent a local tap in South Bend, they had good burgers and a pool table with fairly weak players, but I digress. In this bar was a poster that said, in so many words, “Remember, everyone in the world other that you is overpaid and under worked.” I wish I could find that poster. If I see one more high paid loser on TV or in print picking apart the contract of some teacher making $45,000 a year as too much, or they should just be stripped of their pension because they do not believe in pensions for other people, or something similar, I think I might turn into Lloyd Bridges in the movie Airplane, “I sure picked a bad day to quit sniffing glue.” What should they make, in your lofty opinion, $10,000, or $20,000? Maybe they don’t think you should make what you make for your drivel, but you do. The point here is that we are not growing, or the average person is not participating, and collectively we, for the first time (forget 1929) we are going the wrong way. Forty-five thousand for a degreed person with experience does not seem outrageous to me, it is roughly one half what it would take to afford the average home, not the stuff dreams are made of. It seems like the give-backs the union in Wisconsin have agreed to amount to around an 8% pay cut for the teacher making $45,000, seems like a lot but still not the cut someone out of work or someone having to take a much lesser job had to take, without benefits or pensions.
What about the story of the new Governor in Wisconsin, or should we change the title to Supreme Ruler. It is interesting that anyone, Governor Quinn did the same in Illinois, winning a routine election by a few percentage points, would feel that they have this huge mandate to do whatever they wish, but some sure seem to feel that way. I wonder if George Bush, who actually received less votes than Al Gore, felt he had a mandate? I am sure it would make things easier for a brash union buster to not have unions in his way, and strip them of all their rights. What he is really saying is that you cannot count on politicians to have an arms-length negotiating process with public unions, so disband the unions. Does that mean that all politicians cannot be trusted to have arms-length contract negotiations with the other individual contributors and corporations that grease their slimy palms? No mention of that. I know I am old school, but I think people are elected (admittedly with their bias toward their policies) to bring sense to all the groups in an honest manner, to attempt to rid yourself of those you have no use for is an interesting style. I suppose I would like it if I could wish away a lot of people that do not agree with me (but where would be the challenge?), or wish away the other cars in a traffic jam, but it is not practical. I can’t argue with the Governor when he says that having no rights for unions, with virtually dictatorial powers in the hands of municipalities, would make balancing the budget easier. It also would help if they could unilaterally demand new Chevy’s or other products at any price they choose, is that next? Do I detect a little despot in this new Governor? Do you? Are most people ready for their rights ebbing and flowing with every election cycle? I am not.
What about the other side? Let’s not be naïve here. I am not sure about Wisconsin, but the abuse in the pensions here in Illinois on the union side on the part of some has been dramatic. Late career bonuses, stored up sick leave paid in the last year, overtime paid the last year (some of these abuses have been curbed), anything that would inflate the pension above the spirit of the calculation I would stop instantly, if someone challenged it, I would present them a bill for the extra already received. We do not hear anything like this, actually going after abuse, maybe that would be too tough or embarrassing. We just keep going after the regular stiff getting rich on that $45K.
So how do we trade it? We have to be mindful of the interplay between the market levels and the volatility levels. For the past several weeks we have been trying to take advantage of very low implied volatilities in the weekly SPY options. For a few weeks we did not have much movement, but thanks to some good position management we were able to stay slightly below a break-even level. Last week we did get some movement and had a nice week. The implied volatilities have run up so the prices of that sort of spread are not currently where we would like, so we do not anticipate doing a like position this week (unless the prices really change). In fact, right here the opportunity seems to be in buying the slightly further out and selling the near term weekly. We continue to look for opportunities in the resource sector, especially the drillers and in the natural gas space, but so far can’t seem to find any edge in volatility our way. The market sold off near 1335 in the S&P last week, it will be interesting if we can get all the way back there and maybe have the chance to sell it there again, carefully.