State of Denial
January 24, 2011
Good morning. It was somewhat of a mixed week for the market last week, with the SPY down .7% to close at 128.37, the Dow Industrials up .7%, and the Russell down a significant 4.3%. It seemed like the news on Apple (Steve Jobs taking the medical leave, stock down 6.2% on the week) weighed more on the small cap stocks than on the more multi-national Dow stocks. Thrown into that mix was the State visit of the Chinese President and the resultant announcements of purchases of planes from Boeing and equipment from GE and others. For those in the SPY PIP Program we did have a ratio back spread in place which was able to take advantage of some of the mid-week down move in the S&P (as implied volatilities remain low in the near term month). We still have the volatility pricing phenomenon of implied volatilities increasing as you go out in time, so the market is still pricing in a larger chance of bigger price moves out a few months, which is still making me curious of what exactly the market collectively “sees” as a problem down the road. It is sort of analogous to your insurance broker telling you he wants five hundred dollars for collision insurance for the next six months, but eight hundred for the subsequent six months. You would wonder if he had prior knowledge of your arm or leg in a cast for that six-month period, or something.
We have talked a lot on the radio show about the Irish Bank bailout situation, and the news this morning is that the shaky government coalition has broken down. Evidently there are still enough votes to pass the so-called austerity budget called upon by the bailout “deal” with the rest of the EU. I find significant parallels to this situation in Ireland and our situation here regarding Bank bailout policy. In a nutshell, the EU (mostly the Germans) essentially have agreed to lend money to the Irish Government to bailout their large Banks (Allied Irish Bank and Bank of Ireland being the biggest), with the proviso that the large owners of bonds, preferred stock, and even common stock not be wiped out. It should be to the shock of no one that a lot of these investors are from Germany, and the deal is to have the loans paid back by the Irish citizenry rather that default on the Banks bondholders. The “oddity” of this arrangement has not been lost on the Irish citizenry, the quite simple “Do well and bondholders and others make money, do poorly and the non-involved plumber bails you out” is not very popular. Yet the Irish government has bought into this. Why?
We have done really the same thing here. With the exception of Fannie and Freddie, and I sure would still like to know the full story someday as to why they were left to founder, the major investors of the largest Banks in the U.S. have been essentially saved by the general population. The only difference here is that the U.S. (yet, anyway) has not elected to drop the bomb on the citizenry that they too will essentially have to “pay up.” In fact, in an amazing show of confidence in the future (or total foolishness) the U.S. has elected to actually lower taxes and just borrow huge into the future to cover the bailouts. It is one thing, socially, for a few people like us to look at the dramatically increasing deficits and see danger down the road; it is quite a different thing when the bills hit the mailbox.
One only has to look at the situation here in Illinois. The State has been in horrible fiscal shape for the better part of a decade, with virtually no significant fanfare. Anyone who cared to look knew there were huge problems, but we actually had politicians so lame and untruthful that they ran on platforms of being able to solve the crisis by just a minor tightening of the proverbial belt. Even the current Governor, campaigning on truth of direction but lying about levels, mentioned a 1% increase during the campaign but immediately changed it to 2.25% after barely weaseling his way into office with his self-described “mandate.” I can only conclude that the State of Denial must be a place of relative comfort, sort of like someone (like the State of Illinois) who switches to a cash accounting method and just does not pay bills on time. The question is, both in Ireland and here, is when the bill does go out will those receiving it have the willingness and ability to pay? Ireland has an unemployment rate of 13.6 (9.4% here), and like here those with wealth are making very little on interest rates or in capital appreciation. In fact, a significant portion of the population that owns a home has just seen a large decrease in net worth. So even if everyone agrees to bend over and cover the foreign “risk” investments in these Banks the question of ability to do so is very relevant. When does anyone here think they can muster up the equivalent of a full years income to pay the Federal government (that is how much you owe), not even counting the state and local fiascos? It sure will be a while for most I know.
Wait a minute! I am forgetting the great Chinese savior. Surely everyone knows that the high growth rates in China (India, Philippines, etc. also count) will bail us all out. We just had the Chinese President here, didn’t we, and he promised to buy something from virtually everyone President Obama invited to the White House to meet with him. Great plane sales by Boeing, buying from GE, the list goes on. However the list does not make it down to anyone that we probably know, much less work for. Plus, doesn’t this fellow represent a totalitarian regime that maybe does not even like us. I understand, since I had occasion to go to the Conrad Hilton in Chicago last Friday (site of the dinner for President Hu Jintao Thursday night) that there were significant protests against his visit that were very “under covered” by the local and national press. So now we are protecting him and his “policies” because we owe him so much and a few of our companies might make out on the deal? Maybe if other totalitarian leaders with questionable human rights histories would just have had the sense to accumulate some of our currency and come over and buy some “stuff” (as President Obama described it) we would have been nice to them and kept alternative press coverage to a minimum. Or maybe censorship would not have been necessary, and this is the real scary part, the press just “knew” that any news coverage negative to just emphasizing the money part would be too unpopular to sell. Yikes! I guess I could reinvent my morals to the point where everything is okay as long as the big firms make money, or import their morals as my own, but I think I will not do that.
I hate to have this long memory, but where in this triumphant visit did we discuss the part about all the pets killed by Chinese dog food having melamine as a main ingredient? What about those poor people down south that have to virtually gut their houses because of the plaster board imported from China that leaks acid? Is that being paid for out of my insurance payments? Is there any sort of level playing field regarding product liability on the “stuff” we import? What about that new Chinese fighter jet that seems to have a lot of the technology of the shot down F-17 in Bosnia? I promised myself I would stay steady regarding my feelings towards this government (not people, government). So I did not entirely succeed with that.
The good news is that despite the amount of negative news overhang business does seem to be getting better. The jury is still out if it is getting better fast enough given the stimulus applied, but it is getting better. Those that have somehow managed to stay afloat in even the automotive supply business have seen business improve to the point of being actually busy. The industries have shrunk to be sure, but the survivors are starting to do well. I might go far as to say the manufacturing area improvement is flirting with becoming self-sustaining. The next big hurdle there might be whether the increased prices for raw materials can be passed along enough to maintain margin. The construction area, and with it the plight of the homeowner, continues to be fairly bleak. Recent increases in existing home sales, without any real increase in prices, is most likely the result of those buying to lock in the current low interest rates. Any further increases in mortgage rates, which will certainly follow if inflation increases, will only delay even more a recovery in the housing area.
So what is the bottom line, with all the indicators all over the place? I have never felt so able to argue both the bull and bear side of things, and never thought that the jury going forward essentially had to debate the future relevance of the good old USA. I know that the current Economic strategy, on the Federal and State level, is flawed. To me we will not have the will to fix those things ourselves, no one will run and be able to get elected on the platforms that will put anyone’s fiscal house in order, “we” like it the way it is, collectively “getting” almost twice as much as “we” are giving (I know the getting is very uneven). Yet I also know that somehow, some way, there will be a shock that causes us to wake up (like Ireland). What could it be, what will it be? Is this concern about the future the reason why volatility is higher the further out in time we go? Maybe. One way we have been trading it is to take advantage of the relatively low volatilities in the short-term options. Last week we made some money in the SPY weekly options, and are looking to do the same this week. Maybe whatever will happen, good or bad, will happen this week, and we will have a spread on that will take advantage of that movement, in either direction. The bad news would be if the market just stopped moving while we had one of these spreads on, but I think being more aggressive here is the better choice. Maybe we should also look at some long premium positions in some of these commodities, we will talk about that next week.