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Skewed Volatility

October 11, 2010


Good morning. The Federal Reserve gave us another strong market last week, with the SPY up 1.93 (1.7%) to close at 116.54. That is the highest close in the SPY since last May 12. The VIX was down sharply on the week, closing at 20.7 (down 8%), which is the lowest closing since May 3 of this year. Again the investing public appears comfortable with the price of insurance on the market decreasing as the market advances, something that, to me, has always seemed counter-intuitive. For instance, with the SPY at 116.54, the December 120 2012 puts are roughly the same price as the 70 puts were at the height of the panic in 2009. Most would think that as the price of the protected asset goes up, be it house, car, boat, or stocks, the cost of protection would go up, but not so normally with the market. When the market is going up and people are comfortable buying (and listening to those who downplay the risks involved) they feel less and less the need for protection. Always, and still, seems strange to me.

What we are seeing now, however, are other signs of concern. The first, and something that makes it difficult to do the spreads we like to do (including the PIP) is the skewing of implied volatility to the upside as time goes out. For whatever reason or combination of reasons the market (people) feel that the risks get greater the further out in time you look (this same phenomenon showed up as in late 2009). For example, the implied volatility in the SPY 117 calls expands as follows, Nov 2010 18.8, Dec 2010 20, March 2011 22, and Dec 2011 23. The December 2012 puts, the ones we would look to buy in the Protected Index Program, are trading at roughly a 25 implied volatility. That represents a premium of almost $5 over where they would be if priced at a 20 volatility similar to the closer in calls. For that reason I have not been quick to invest everyone’s last nickel in the market, I do not like putting clients money (or mine) to work with what I call “negative” volatility edge. The position could still work out and be profitable, the market could advance, near term volatility in the calls we will sell along the way could go up during the two plus years, it all could work out. I just do not like it, a sports analogy might be in thinking the Irish might win, but having to give six points. The second concern is that a lot of the discretionary spreads we like to do involve buying further out options and selling closer in. Now the prices are forcing us to be very selective in doing those sorts of spreads.

Up until now, however, the pressure has not been on to put money in the market despite theoretical “edge” problems and general misgivings about the markets strength. The Federal Reserve is threatening (and really already acting) to force everyone out of cash. In keeping with the wordage from the last Fed meeting, and something we noted in this blog a couple of weeks ago, the Fed is now embarking on a “yes to inflation” policy. What that means is that they (the Fed) is going to increase the amount of reserves in the system through something called Quantitative Easing (the so-called QE II, not to be confused with the ocean liner of the same name). What that simply means is that the Fed is going to create more money in circulation through their normal open market operations. The mechanism is that they enter the market, normally on Monday, and buy U.S Treasury Securities in the open market. Suppose they buy $100,000 worth of Bonds from Joe, Joe now puts that $100,000 in cash into his bank. The Fed has essentially “created” $100,000 by “buying” back that Bond from Joe. Now Joe’s bank is free to lend most of that money to someone else, then that person deposits what they borrowed, then that bank can lend most, and on and on. So it is not only the original $100,000, it is the “multiplier” effect of the $100,000 as it works its way through the system. The problem now is that the banks, either due their own policies or from a lack of demand for loans, are not lending very much (at least domestically), causing this assumed multiplier to be severely impaired and the Fed having to do more buying for the same effect.

The risk you (the Fed) runs when embarking on this policy is that the money does not cause more productive loans and real growth, it merely creates a flood of money causing goods to be re-priced upward as too much money just chases too few goods (inflation). In fact, people on TV have been alleging that the Fed actually is worried enough about deflation to actively work towards a “safe” inflation number of around 3%. All I can say is that they must be out of their minds, where do we get these people at the top of the leader board? The average American has seen his housing value plummet, he has seen virtually no raises for several years (maybe a cut), has had his benefits slashed, his real taxes (maybe disguised as fees) soar, has earned virtually no money on savings except that invested in overpriced bonds, and has seen the value of his cash holdings drop on world terms, now you are going to drop the inflation anvil on his back? Where do we get these idiots, or is it a plot to take any hint of wealth or power from the average person.

Let’s talk about inflation first. We have (collectively) let these people (our governmental employees) give us numbers that we believe for a long time. Does anyone actually think there is no inflation? The actual reported number of the CPI has been up .3% for the last two months, for starters that is surely not nothing. We continue to weight the housing issue as a huge positive (for purposes of calculation of inflation), as the “price” of shelter has come down, but it has taken peoples buying power down with it. I also have not seen the actual cost of rents declining that rapidly, as people thrown out of their houses now must rent, but I will go along with the idea that they may have come down some. We continue to be told that the price of food is stable, but is it? I heard one fellow talk this week that the government (our employees) have been totally fooled by the decreasing sizes of packages in the food store, maybe he is right. Surely the absurdity surrounding health care does not make it fully in the numbers, if you correctly account for just that piece of a families budget (including the amount the employer no longer pays) how could you not come up with some seriously positive inflation number in that area. Look at airfares (and yes, you morons, you have to add all the added fees on luggage, etc into the number of 5 years ago to compare) and what would the inflation numbers show there? Or any kind of education, let’s not even go there? So where is the deflation, except in the pricing power of those businesses that either do not have some anti-competitive pricing power or do not have their nose in the government trough?

As an investor (including most 401k participants) the shining light of the last few years have been bonds and bond funds. Decreasing interest rates have caused the value of bonds and bond funds to appreciate. Most people, however, are not inclined to sell, as it could have been their only winner. Is our Fed going to warn these bondholders what their new “inflation is good” policy might do to those values? Right now the 30-year bond has a market rate of 3.75%. If you look at the CPI for the last two months you could make the argument that we could be in the 2-3% inflation range already, and now the Fed is trying to re-inflate. Suppose they succeed, and it drives even their “funky” rate to 3.5-4.5%. Even if you add a historically low 1% real rate (more like 2-3% throughout history) we are now talking 5% nominal rate or greater, meaning an initial drop of 15-20% in the price of all longer term bonds and bond funds. Not a good situation. So why does the Fed want to do this? Simple, they want to pay people back in the future for their irresponsible borrowing with money that is worth less. They also want to deflate the dollar to make exporting companies, in the short run, sell more overseas. Of course, that only works until the other country does the same thing, and we are seeing this devalue fight playing out already among countries.

But what about you? You have retired with money you thought was enough, but have been disappointed in the returns vs. those promised and those historically achieved. Those in the PIP have done better over the eleven year period than just about anyone else, but still less than we would have thought starting in 1998. Now your government is embarking on a policy designed to make your nest egg worth way less in real terms. Would we even treat our enemies like this? Of course if you were in the position to know the Fed actions before hand you could move your money to Europe overnight, bring it back the next day, and now be up not only on absolute terms, but really up on relative terms. Everyone else has lost 1% of value with the 1% drop in the dollars value, but you participated in the 1% run up elsewhere, so are now 2% richer than your neighbor overnight. How do you think the wealthiest people in Mexico became that way? Not by having their wealth in the lowly peso on those days when it was devalued and the rest of their “countrymen” were being fleeced.

So how do we trade? Clearly, when the dollar is being devalued and inflation is being officially “sought” having your wealth tied up in cash can be a problem. On the other hand, when inflation was 15% bonds were trading at less than half where they are now and the Dow was somewhere south of 800. We could go for hard assets, and maybe we will go that way. We will certainly look at doing some protected type of strategy in ETF’s that represent precious metals or agriculture commodities, and it probably makes sense to increase our holdings (carefully) in the market. After all, the Fed is trying to inflate things, even the market, and it looks like a lot of the new created funds are heading there. I would say we will look more at ETF’s in the market that have some natural resource base behind it, possibly heavier in the XLE. The good news is that the puts have come down some, so it helps lower our protection costs should the market turn down.

As for me, I am thoroughly disappointed by the response of our elected officials to this ongoing crisis, and feel that this new inflation strategy is just another in a long list of short-term misguided fixes to a long-term problem. I see no possible outcome in this upcoming election that is likely to bring any adult thought to the table, just more fighting among the new breed of carpetbaggers on each side of the aisle. Let’s see, if we elect which one of the eminently experienced, qualified, and determined statesmen from Illinois, Gianullious or Kirk, will we really change things for the better? It is really hard for me to commit funds in the short term when I think the end result is a bust. I know that you need to chase hard assets in times of inflation, yet buying gold at a record high would not be my first choice for anyone’s hard earned money. I have every intention, since these are the cards we are being dealt, of lowering our collective cash positions in the must careful way I know to participate in this Fed inspired run, but I do not have to feel good about it. I also have every intention of profiting, when it happens, by this impending bond implosion.